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1: Ten Principles of Economics

Economy: Greek word for one who manages a household.

Households and economies both face many decisions
Who will work?
What goods and how many of them should be produced?
What resources should be used in production?
At what price should the goods be sold?
Scarcity: Society has limited resources - cannot produce all the goods and services
people wish to have.
Although there are lots of resources, but relative to the needs of society, it is limited
Wants and desires are unlimited


Study of how society manages its scarce resources.

Study of decision making
Behaviour of the economy reflects the behaviour of the population.

10 Principles

People face tradeoffs. - You win some, you lose some

The cost of something is what you give up to get it. In accounting, cost is explicit
(money transfer), but in economics, cost is implicit: ie. Opportunity costwhat you have
to give up to get something else.
Rational people think at the margin. Make small changes.
People respond to incentives. (in this case, price)
Trade can make everyone better off. (if voluntary)
Markets are usually a good way to organize economic activity. (Markets are
efficient, but they dont eliminate scarcity or poverty.)
Governments can sometimes improve economic outcomes. (Macroeconomics)
The standard of living depends on a countrys production. (ie. GDP/capita)
Prices rise when the government prints too much money.
Society faces a short-run tradeoff between inflation and unemployment. (As
inflation increases, unemployment rate decreases because losing ur job is far more of a
crisis than increased prices.)

Principle #1: People Face Tradeoffs

To get something, we usually have to give up something else.

Leisure time v. work
Efficiency v. equality
For an economy to be efficient, it must use the resources it has, to satisfy all the
wants and needs of society: *PPF
Efficiency: Society getting the most that it can from its scarce resources. Greatest bang
for my buck
Equity: The benefits of those resources (economic prosperity) are distributed uniformly
among the members of society.

Principle #2: The Cost of Something Is What You Give Up to Get It.

Decisions require comparing costs and benefits of alternatives.

College or work? Study or movie?
Opportunity cost of an item: what you give up to obtain that item.
The value of the next best choice

Principle #3: Rational People Think at the Margin

Rational people carefully do the best they can to achieve their objectives,
given the available opportunities.
Marginal change: small, incremental adjustment to an existing plan of action.
People make decisions by comparing costs and benefits at the margin

Principle #4: People Respond to Incentives.

Incentive: Something that induces a person to act

Could be positive (reward) or negative (punishment)
Cost is a huge incentive even marginal changes
When alternatives benefits > costs = decision!
Many policies change the costs or benefits that people face change in behaviour
E.g. tax on gasoline: encourages people to drive smaller, fuel-efficient cars (Europe has
high gas taxes vs. US where low gas taxes and huge cars)

Principle #5: Trade Can Make Everyone Better Off.

Competition allows for people to gain from their ability to trade with one another.
Trade allows you to specialize in what you do best.
Trade: Think of the cost of producing it here, vs producing it somewhere else.
By trading with others, people can buy a greater variety of goods and services at a
lower cost.

Principle #6: Markets Are Usually a Good Way to Organize Economic


Market economy: An economy that allocates resources through the

decentralized decisions of many firms and households
Economic activity is driven by
self-interest of individuals in
Households decide what to buy and who to work for.
the market
Firms decide who to hire and what to produce.
Adam Smith: Households and firms act by an invisible hand.
Because households and firms look at prices when deciding what to buy and sell, they
unknowingly take into account the social costs of their actions.
As a result, prices guide decision makers to reach outcomes that tend to maximize
the welfare of society as a whole.

Principle #7: Governments Can Sometimes Improve Market Outcomes.

Gov. must maintain institutions and enforce rules to enable Invisible hand
Property rights: The ability of an ind. to own and exercise control over
scarce resources.
2 reasons why the gov. would intervene in the economy

Promote efficiency
Promote equity
Market failure: A situation where the market on its own fails to produce an
efficient allocation of resources.
May be caused by an externality - impact of one person or firms
actions on the well-being of a bystander.
Market power - ability of a single person or firm to influence market
When the market fails (breaks down) government can intervene to promote
efficiency and equity.
You usually have 2 parties in a market transaction buyer and seller. But you also
have stakeholders or bystandersa third party that gets affected negatively or
E.g. Pollution is an example of an externalityinnocent bystanders are affected

Another possible cause: market power:

the ability of a single person/group to have a substantial influence on market prices.

Principle #8: The Standard of Living Depends on a Countrys Production.

The total market value of a nations production

Living standards usually vary by countries productivities.
Productivity the amount of goods and services produced from each unit of
labour input.

Principle #9: Prices Rise When the Government Prints Too Much Money.

Inflation - increase in the overall level of prices in the economy.

Cause: the growth in the quantity of money.
When the government creates large quantities of money, the value of the money


Principle #10: Society Faces a Short-run Tradeoff Between Inflation and


Increasing the amount of money in the economy stimulates the overall level
of spending and thus the demand for goods and services.
Higher demand over time may cause firms to raise their prices, but in the
meantime, it also encourages them to hire more workers and produce a
larger quantity of goods and services.

More hiring means lower unemployment.

The Phillips Curve: Greater the Inflation, lower the Unemployment


When individuals make decisions, they face tradeoffs among alternative goals.
The cost of any action is measured in terms of foregone opportunities.
Rational people make decisions by comparing marginal costs and marginal benefits.
People change their behavior in response to the incentives they face.
Trade can be mutually beneficial.
Markets are usually a good way of coordinating trade among people.
Government can potentially improve market outcomes if there is some market
failure or if the market outcome is inequitable.
Productivity is the ultimate source of living standards.
Money growth is the ultimate source of inflation.
Society faces a short-run tradeoff between inflation and unemployment.

Ch. 2 Thinking like an Economist

Economists as Scientists

Make positive statements - claims that describe the world as it is can be

confirmed by evidence

describe the world as it is

these statements can be confirmed or refuted.

Employ the scientific method to develop and test of theories about how the world

The Economist as Policy Advisor

Make normative statements - claims that attempt to prescribe how the world
should be cannot be proved
Governments employ many economists for policy advice, to improve
economic output

Finance Canada to help design tax policy

HRDC to help formulate labour-market policies

Environment Canada to help design environmental regulations.

Why Economists Disagree

Economists may disagree about the validity of alternative positive theories

about how the world works.
have different values different normative views about what policy should
try to accomplish
Income distribution, minimum wages, income tax rates
Yet, there are many propositions about which most economists agree. but politics
stand in the way ie. tariffs

Assumptions and Models

Assumptions simplify the complex world to make it easier to understand.

Allows us to focus our thinking on the essence of the problem.

Example: when studying international trade, we might assume the
world consists of two countries and two goods.
A model is a simplified representation of a more complicated reality. Economists use
models to study economic issues.

First Model: The Circular-Flow


A visual model of how the economy

is organized and how participants in the
economy interact with one another.
Shows the economic
transactions that occur in markets
between households and firms.
Simplified to show 2 types of
Households: Own the factors of
production (rent to firms) and consume
the goods & services produced.
Firms: Produce goods & services by
hiring and using factors of production
Includes two markets:
Market for goods and services (firms sell to households)
factors of production: Inputs like labour, land and capital (Household sell to firms
they provide the inputs that firms will use to produce.)

Second Model: The Production Possibilities Frontier (PPF)

Shows the combinations of two goods the economy can possibly produce given the
available factors of production and the available
production technology.

Economy can produce any combo that is on

or inside the PPF line...points outside the frontier
are not feasible given the resources.

Example: The economy can use all of

its resources and produce 1000 cars and 0
computers, or 3000 computers and 0 cars
Realistically, they will find a good balance.

Efficient outcome: if the economy is getting all it

can from the available scarce resources. (point on PPF)
Inefficient outcome: Economy is producing less than it could from the resources it has
(caused by unemployment, underutilized workers) under PPF
Trade-of: Once we reach one of the efficient points, the only way of producing more of
one good is to produce less of the other.
Negative slope: since the resources are fixed, producing more of one good will result in a
cut-back of the other.
OC: At A, the OC of 100 cars is 200 comps

*The OC = slope of PPF Steeper the slope, greater the OC

The OC is not constant in this casekeeps decreasing (thus a negative curve)
Moving along a PPF involves shifting resources (ie. labour) form one to the other
Shape of PPF: Straight or curved depends on the OC as the economy shifts resources
from one industry to the other.
When the OC is constant, the PPF is linear
IF the OC of a good rises as you produce more of it, then the PPF is curved/bow-shaped
PPF is curved when workers have different skills (ie. beer brewers vs. bike-makers)
* Economic growth occurs when the PPF moves horizontally (phase shift to the right)

Ch. 3 Interdependence and the Gains

from Trade

Trade allows each player to specialize in what

they do best mutual benefits
Two countries can gain from trade when each
specializes in the good it produces at lowest cost.

Specialization & Trade


Scarce production resources are allocated to the most efficient producers
Export products for which production is efficient and import products for which production
is inefficient
Economies of scale:
Decreasing average production costs
Improved production techniques
Better management, inventory control
Division of labour; better financial terms
Shortcomings of Specialization:
Can create a dependency for developing countries
Markets dont always distribute the gains equally
Absolute Advantage:

The ability to produce a good at a lower cost in terms of the inputs/resources reqd
to produce it
The ability to produce a good using fewer inputs than another producer; more
goods with the same # of inputs
Used when comparing the productivity of one player to that of another
o Ex: If time as the only input, then compare the time taken to produce a unit
of either good.
If each of the 2 countries has an absolute adv. in one good, and specializes in that
good, then both countries can gain from trade
Opportunity Cost & Comparative Advantage:
OC of an item is what we must give up to obtain that item Measures the trade-off
btwn the 2 goods
o Time spent producing potatoes takes away time that could have been used
to produce meat
Comparative adv: Ability to produce a good at a lower OC than another producer
o Whoever has to give up less of other goods to produce Good X has a smaller
OC has comparative adv
Possible for one player to have an absolute adv in both goods
Impossible for one player to have a comparative adv in both goods (OC of one good is the
inverse of the OC of the other if you have a low OC for one good, then it will be high for
the other)

Comparative Advantage & Trade

Gains from trade are based on comparative adv.
When each player specializes based on their CAs respectively, total production in
the economy rises.
Since players usually have diff OCs, they can both benefit:
o Each gets the good for a lower price than their OC of that good
Price of the Trade
What determines the price of the trade?
How are the gains of trade shared btwn partners?
o For both parties to gain from trade, the price at which they trade must lie
btwn the 2 OCs

Applications of Comparative Advantage

Explains interdependence and gains from trade

Ex: Should Beyonce mow her lawn?
o Suppose Bey can mow her lawn faster than anyone else, but in the same 2 hrs, she
could film a tv commercial for $20,000
o Meanwhile, Beibs can mow Beys lawn in 4 hrs, but in those 4 hrs, Biebs could work at
McDs for $40
o Absolute adv. in mowing goes to Bey (she can accomplish the work in lower input of
o Comparative adv. goes to Biebs, b/c his OC is only $40 compared to Beys $20,000

Exports, Imports, Net Exports

Imports: Goods produced abroad and sold domestically

Exports: Goods produced domestically and sold abroad
Net Exports (NX) = (value of a nations exports) (value of nations imports)
o Also called Trade Balance
Trade Deficit: Net exports are negative
o Imports > exports
Trade Surplus: Net exports are positive
o Exports > Imports
Balanced Trade: Net exports =0
o Exports = imports
Factors that Afect NX
1. The tastes of consumers for domestic and foreign goods.
2. The prices of goods at home and abroad.
3. The exchange rates at which people can use domestic currency to buy foreign
4. The incomes of consumers at home and abroad.
5. The costs of transporting goods from country to country.
6. The policies of the government toward international trade.
Terms of Trade
Explains interdependence and gains
ie. 1B < 1w < 4B
o Since trade transactions do not simply occur btwn 2 people in the real world, but btwn
billions of people, free societies must allocate resources through the market forces of
supply and demand.

We consume goods and services produced both domestically and globally. Interdependence and
trade are desirable b/c they allow everyone to enjoy a greater quantity and variety of stuff.
2 ways to compare the ability of 2 producers for a good: The person who can produce the good with
the smaller quantity of inputs has an absolute advantage in producing the good. The person who
has the
smaller opportunity cost of producing the good has a comparative advantage. The gains from trade
are based on comparative advantage, not absolute advantage.

Ch. 4 Market Forces of Supply & Demand

S & D determine the quantity of each good produced and the price at which is it


Two countries can gain from trade when each specializes in the good it produces at
lowest cost.

Markets & Competition


A group of buyers and sellers of a particular good or service.

The buyers collectively decide on the demand, and the sellers decide the supply


Competitive Market: A market where there are so many

buyers & sellers that each has a negligible (insignificant)
impact on the market price
o Ex. ice cream market A seller has little reason to charge
more or less than the going price, because buyers can
easily buy elsewhere
The buyers collectively decide on the demand, and the sellers
decide the supply
For a market to be perfectly competitive...
1. The goods for sale are exactly all the same
2. The buyers and sellers are so plentiful that no single B or
S has an influence over the market price.
Monopoly: If a market only has 1 seller, then the seller sets the price (local cable provider may
have a monopoly over the community)

Demand Curve (Price vs. Quantity Demanded):

Quantity Demanded (QD): The amount of a good that buyers are willing and able to purchase.
Law of Demand: In an equal environment, as the price of a good increases, the Q D decreases
Demand Schedule: A table showing the QD of a good, at each price.
Demand Curve: Graphs the relationship above. (Price on y-axis and QD on x-axis)
o Usually, negative slope, because as P, QD

Price of Cone ($)

of Cones

Market Demand vs. Individual Demand

Market demand is the sum of all individual

demands for a particular good (at each price)
Price ($) P1 QD P2 QD Market QD

Shifts in the Demand Curve:



Many things can change the QD at any given price, thus shifting the curve.
o Ex. If the Canadian Medical Ass. announced that ice cream helps you live longer, then there
would be a greater demand for ice cream, at any given price.
o Any change that QD will cause a shift to the right
o Any change that QD will cause a shift to the left
Income: Lost job/lower job lower demand for icecream
Normal good: income = QD
Inferior good: income = QD (ex. the bus if you have enough money to afford a car, then your
demand for the bus will )

Prices of Related Goods:

Substitutes: an in price of A = in demand for B
(an in price of A = in demand for B)

If the price of frozen yogurt fell, then you will likely buy less icecream and
more frozen yog. (b/c they fulfill the same desires)

Goods that are often used in

place of each other movie tickets and
DVD rentals
Complements: an in price of A = in demand for
B (an in price of A = in demand for B)

If the price of golfclubs, then

the demand for golf balls would likely (b/c
if no one can afford to buy a club, then why
would they need balls?)

Goods that are often used

together - peanut butter & jelly
Personal Tastes: If you love ice cream, then you
may buy more of it, regardless of the price.
Expectations: Your expectations of the future might affect your demand for a good today.
If you expect something to come on sale next week, then you wont want to buy it at todays price
If you expect to get a higher pay next week, then you might start splurging now.
Number of Buyers: Obviously, the more buyers you have, the greater the market demand.
Consumers will buy more of a good when...
Its price is lower
When their incomes are higher
When the prices of substitutes for the good are
When the prices of complements of the good

Supply Curve (Price vs. Quantity Demanded):

Quantity Supplied (QS): The amount of a good

that sellers are willing and able to sell.
Law of Supply: In an equal environment, as the
price of a good increases, so too does the QS
Supply Schedule: A table showing the QS of a
good, at each price.

Supply Curve: Graphs the relationship above.

(Price on y-axis and QS on x-axis)
o Usually, positive slope, because as

Price of Cone of

Market Supply vs. Individual Supply

Market supply is the sum of all supplies of all sellers (at each
Price ($) DQ QS McD QS Market QS

Shifts in the Supply Curve:

Market supply is the sum of all supplies of all sellers (at each
o Any change that QS at every price will cause a shift to
the right (increase in supply)
o Any change that QS at every price will cause a shift to
the left (decrease in supply)
Input Prices: When the price of input(s) , the good is less
profitable and firms supply less.
For icecream: cream, sugar, machines, sauces, price of
milk, cooks
o If these inputs become more expensive, then DQ
cannot afford to produce that much icecream
Technology: Technology often saves sellers money, thus
their QS
Mechanized ice cream machines save time, work and
money, allowing DQ to supply more ice cream
Expectations: The amount of a good a firm supplies may
depend on its expectations of the future.
o If DQ expects the price of icecream to rise in the future, it might put some of its current
production into storage, and supply less to the market today.
Number of Sellers: Obviously, the more sellers you have, the greater the market supply.

Supply & Demand Together


When the market price has reached a level at which QS =


Price at this intersection is the equilibrium price (aka market-clearing price) and quantity is
equilibrium quantity (# of demands and supplied)
At the eq. price, the # of goods that buyers want to buy = # of goods sellers can sell.
a) Surplus(excess supply): QS > QD
o Market price is above eq. price, so sellers cannot get rid of surplus they must
lower prices
o Cutting the price means more demand, but less supply
o Moving along the curves: price continues to fall until market reaches equilibrium.
b) Shortage(excess demand): QD > QS
o Market price is below eq. price, too many buyers are chasing too few goods sellers
can higher prices
o Raising the price means less demand, and more supply
o Moving along the curves: prices continues to rise until market reaches equilibrium

Law of Supply & Demand: The price of any good adjusts itself to bring the QS and the QD into

3 Steps to Analyze Changes in Equilibrium:

When a factor shifts one or both the curves, the equilibrium in the market changes, resulting in a
new price and new quantity exchanged btwn buyer and seller.
1. Decide whether the event shift the supply curve, the demand curve, or both.
2. Decide if the curve(s) shift to the right or left.
3. Use graph to compare original and new equilibrium, and how the shift affected the eq. price &
Shifting vs. Moving along Curves:
o A shift in the supply curve is called a change in supply
o A shift in the demand curve is called a change in demand
o A movement along the supply curve is called a change in the quantity supplied
o A movement along the demand curve is called a change in the quantity demanded

Ch. 5 Elasticity & Its Applications

Elasticity: A measure of how buyers and sellers respond to changes in market conditions.

A measure of the responsiveness of quantity demanded or quantity supplied to a

change in one of its determinants.

Quantity Demanded

Elasticity of Demand
Price Elasticity of Demand

The law of demand states that a fall in price results in an increase of demand.
PEoD: Measures how much the QD responds to a change in price.
Demand for a good is elastic if the QD responds greatly to changes in price
Demand is inelastic if QD only responds slightly to changes in price.

Factors that influence price elasticity of demand:

Availability of Close Substitutes

o Goods with close subs have more elastic demand, b/c its easier for
consumers to switch btwn goods.
o Ex. Butter is elastic (easily switch to margarine), but eggs are less elastic (b/c
they are unique)
Necessities vs. Luxuries
o Price elasticity is greater for luxuries than for necessities.
o Ex. No matter what the price of medicine, the demand wont decrease,
however if the price of luxury watches suddenly increase, then the quantity
demanded will fall significantly.
Definition of the Market:
o Narrowly defined markets have more elastic demand than broadly defined
markets, b/c it is easier to find subs for narrowly defined goods
o Ex. Food is a very broad category so it has inelastic demand. Ice cream is
narrower, and has more elastic demand b/c you can find other dessert subs.
Vanilla Ice cream is even narrower, and is very elastic b/c there are so
many other flavours.
Time Period:
o Goods have more elastic demand over a long time period.
o Ex. When gas prices rise, the demand will stay relatively same initially, but
then over time, people will buy more fuel-efficient cars, make lifestyle
changes, etc. Demand will fall more substantially.

Calculating the Price Elasticity of Demand

Since QD is negatively related to its price, the % change in quantity will always
Quantity Demanded
have the opposite sign as the % change in pricewhich would make E (-)
Ex. Suppose a 10% rise in the price of candy caused the demand to
fall by 20%,
then E = -20% / 10% = -2
o Means that the change in the QD is proportionally twice as large as the
change in price.
o Note: in this course, we will drop the negative sign, and use absolute
o So, a larger price elasticity means a greater responsiveness of quantity
demanded to changes in price.

Calculating % Change:

Standard way:


Price = (250-200)/200 = 25%

Quantity = (8-12)/12 = -33%





e a







The problem with using this method is that the

elasticity form AB will not be equal to from BA

Midpoint Method:

The midpoint is the number halfway between the

start & end values.
Doesnt matter whether we go from AB or
BAwe will get the same answer!



Economists classify
to their elasticity.
The price elasticity of
to the slope of the
o The flatter the
o The steeper the
Perfectly Inelastic Demand: E = 0
o Extreme
o D-curve is vertical
o QD stays the same regardless of price
Inelastic Demand: 0 < E < 1
o D-curve is relatively steep
o QD doesnt change much.
o Low consumer price sensitivity
Unit Elastic Demand: E = 1
o D-curve is intermediate
o QD changes in equal
price change.
o % change in price = %
Elastic Demand: E > 1
o D-curve is relatively flat
o QD changes a lot
o High consumer price sensitivity

5. Perfectly Elastic Demand: E =



Price = = 22.2%


E = 22.2
Quantity = = 40%

Variety of Demand
demand curves according
demand is closely related
demand curve.
curve, the greater the
curve, the smaller the

proportion to
change in demand.

D-curve is horizontal
Very small changes in price can lead to huge changes in Q D

Elasticity of a Linear Demand Curves

The slope of a linear demand curve is constant, but its
elasticity is not.
When E>1, demand is elastic
When 0<E<1, demand is inelastic
When E=1, demand has unti elasticity

Total Revenue and Price Elasticity

TR: The total amount paid by buyers and received

by the sellers of a good
o TR = P x Q
o TR is represented by the area under the
A price increase has 2 effects on TR:
o Higher P means more revenue on each unit
o But Law of Demand states that you will sell fewer units.
So, the impact of a price increased on TR depends on the elasticity of demand.
o When demand is inelastic, TR b/c the extra rev. from selling at a higher
price overpowers the losses from selling fewer units. Also means that no
matter what the price, the quantity wont change.
o When demand is elastic, TR b/c the drastic fall in QD overpowers the rev.
form increasing the price. Also means that since demand is sensitive, a
price rise will drop sales, so lower revenue.
Unit Elastic
P & TR move in same
P & TR move in opposite
TR remains constant as price

Other Demand Elasticities

Quantity Demanded
Income EoD: Measures how the QD changes as consumer incomeschange.
o In calcs, price should remain constant!!
o Normal goods: Higher income raises QD Since QD and income move in
the same direction, normal goods have E > 0.
Necessities have smaller income elasticities (both rich and poor need
milk, eggs)
Luxuries have larger income elasticities (poor people dont buy caviar)
o Inferior goods: Higher income lowers QD Since QD and income move in
opposite directions, inferior goods have E < 0

Cross-Price Elasticity: Measures how the QD of one good responds to a change

in price of another good. (think substitutes and complements)
Quantity Demanded of Good A
o *** Remember to keep negative signs in calcs!
Price of Good B
o Substitutes: Cross-price elasticity > 0
If the price of butter , then the QD of margarine will

Complements: Cross-price elasticity < 0

If the price of golfballs , then the QD of golfclubs will

Elasticity of Supply
Price Elasticity of Supply

Measures how much the Quantity Supplied of a good responds to a change in price
of that good.
Supply for a good is elastic if the QS responds greatly to changes in price (E>1)
Supply is inelastic if QS only responds slightly to changes in price. (E<1)

Factors that influence price elasticity of supply:

Flexibility of Seller
o PEoS depends on if the seller can change the amount of good they produce.
o Ex. Beachfront property has an inelastic supply, b/c they cant produce more
of it.
o Manufacturable goods such as books, TVs have elastic supplies.
Time Period:
o Supply is usually more elastic in the long-run than in the short-run.
o In the short-term, firms cant make immediate changes in the size or # of
their factories, so supply is not very responsive to price in the short-run.

Calculating the Price Elasticity of Supply

Refer to Midpoint method.

Quantity Supplied

Variety of Supply Curves


Economists classify supply curves according to their elasticity.

The flatter the curve, the greater the elasticity.
The steeper the curve, the smaller the elasticity.
Perfectly Inelastic Supply: E = 0
o Extreme case
o S-curve is vertical
o QS does not change regardless to price.
o 0 seller price sensitivity
2. Inelastic Supply: 0 < E < 1
o S-curve is relatively steep
o QS doesnt change much compared to price.
o Low seller price sensitivity
3. Unit Elastic Supply: E = 1
o S-curve is intermediate
o QS changes in equal proportion to price change.
o % change in price = % change in demand.
4. Elastic Supply: E > 1
o S-curve is relatively flat
o QS changes a lot compared to price
o High seller price sensitivity
5. Perfectly Elastic Supply: E =

Extreme case
S-curve is horizontal

Price does not change, but QS changes by any %

Elasticity and Changes in Equilibrium

Ex. Suppose demand for both beach-front properties and new
cars doubled

When supply is inelastic, demand has a greater impact

on price.
When supply is elastic, demand has a greater impact
on quantity.
Thus, the beachfront property will shoot up in price, while
the # of cars supplied will increase.

Varying Elasticity

Supply often becomes less elastic as quantity rises, due to

limited capacity.
At lower prices, quantity supplied is also low, but a small
increase in price will yield a large increase in Q. (therefore,
At higher prices, quantity supplied is also high, so increasing the price even more
will not increase the Q by much (because of limited capacity), therefore, inelastic.

Ch. 6 Supply, Demand and Government Policies

Controls on Price



Buyers of any good always want a lower price, while sellers want a higher price.
A legal maximum possible price a good can be sold at.
Not binding: Eq. price is below ceiling price, so no effect
Binding constraint: Eq. price is above price ceiling (so market price become
ceiling price)
o Result: When the gov. imposes a binding price ceiling on a competitive
market, a shortage of the good results, and sellers must ration off the scarce
goods among the large number of buyers.
Ex. Rent control max. price that landlords can charge making housing more
affordable for the poor
o But short-run supply and demand for housing is relatively inelastic, so only
small shortage
o Long-run is elastic, so larger shortage.
o Downfall: Lowering rent control means that even rent will be low, it also
discourages landlords from maintaining their buildings and makes housing
hard to find.

A legal minimum price, under which a good cannot be sold.
Not binding: When eq. price is above floor price, no effect.
Binding constraint: When eq. price is under floor price, then market price increases
to floor price = surplus
Ex. Minimum wage: Lowest price for labour/hr. that any employer must pay.
o When there is a binding minimum wage, the surplus results in unemployment
o Min. wage is most binding for teenagers than any other members of the
o Increasing minimum wage increases unemployment as well.


Governments use taxes to raise revenues for public projects (ie. infrastructure,
schools, nat. defense)
When taxes are increased, who pays? buyers or sellers, or how should it be
Tax incidence: How the burden of a tax is distributed among the various people
who make up the economy.
Taxes on Sellers
1. Does it affect supply or demand?
o Supply
2. Which way does the curve shift?
o Tax on sellers raises the cost of supplying ice cream, so curve shifts to the
left (upwards)
3. How does the shift affect the equilibrium price and quantity.
o Buyers buy less and sellers sell less, so the tax reduces the size of the ice
cream market.
Tax incidence: Although sellers send the entire tax to the gov., buyers and sellers
share the burden
Without tax, buyers pay $3, sellers get $3. With tax, buyers pay $3.30 and sellers
get to keep $2.80
o So both parties lose out.
Therefore, taxes discourage market activity. When a good is taxed, the less goods
are sold at the new eq
Taxes on Buyers
1. Does it affect supply or demand?
o Demand
2. Which way does the curve shift?

o Tax on buyers raises the price of good, so curve shifts to the left (downwards)
3. How does the shift affect the equilibrium price and quantity.
o Buyers buy less and sellers sell less, so the tax reduces the size of the ice
cream market.
Tax incidence: Although sellers send the entire tax to the gov., buyers and sellers
share the burden

Ch.7 Consumers, Producers and

Market Efficiency

Welfare economics: Study of how the

allocation of resources affects economic wellbeing
Allocation of resources: How much of each good
is produced, which producers produce it, which
consumers consume it.

Consumer Surplus
Willingness to Pay: The maximum amount that a buyer is willing to pay for a good.
WTP measures how much a buyer values the good.
If the price is less than your WTP, then youre eager to buy, but will refuse if it is
Ex. If your WTP is $100, but you end up paying only $80, then your consumer
surplus is $20
Consumer surplus: The amount a buyer is willing to pay for a good minus the
actual price you got it for.
Demand Curve
Relationship btwn height and the buyers WTP:
o At any quantity, the price (height of d-curve) shows the WTP by the marginal
buyer: the buyer who would leave first if the price was any higher.
Staircase shape: One buyer per step
Consumer surplus is the area under the demand curve and above the
horizontal price line.

In a market with many buyers, the steps would be so tiny, that it would just look like
a smooth curve.
A lower price = increased consumer surplus:
o Either existing customers paying an even lower price.
o New customers joining market.

What does CS measure?

CS measures the benefit that buyers receive from a good as the buyers themselves
perceive it.
o Good measure of economic well-being if policymakers want to respect the
buyers choices.
o Assuming that buyers are rational when making decisions

Producer Surplus
The value of everything a seller must give up to
produce a good. (opportunity cost)
Includes cost of all inputs (ie. resources, money,
A seller will only produce and sell the good if the
price exceeds their cost (profitable)
Cost is a measure of Willingness to Sell
Often, the job goes to the seller who can do the
work for the lowest cost.

Producer surplus is the amount a seller is paid minus the cost of production (ie.
their profit)
o PS measures the benefit sellers receive from participating in a market.

Supply Curve
At any quantity, the price shows the cost of the marginal seller (who would leave
first if the price were any lower)
Producer surplus is the area below the horizontal price line and above the
supply curve. (the total are is the sum of all individual sellers surpluses)
Lots of sellers = smooth curve
An increase in price = more producer surplus
o Existing producers get to sell at a higher price (more
o New sellers enter market at a higher price.

Market Efficiency

CS and PS are what economists use to study the welfare of buyers and sellers in a

Measuring Societys Well being

CS = Value to buyers amount paid (Measures benefit buyers receive from

participating in the market)
PS = Price sold for sellers cost (Measures the benefit sellers receive from
participating in the market)
Total (social) surplus = CS + PS (Measures total gains from trade in a market)
o TS = (Value to buyers) (Cost to
Efficiency: Allocation of resources that
maximizes total surplus
o The goods are being produced by
the sellers with lowest cost
o The goods are being consumed by
the buyers who value them most
highly (Highest WTP)
Equality: Distributing economic wellbeing fairly among members of society.

Evaluating Market Equilibrium

AE: Buyers who value the good more
than price buy the good.
CE: Sellers whose costs are lower than
the eq. price will choose to produce and sell the good.
3 Insights about free market outcomes:
Free markets allocate the supply of goods to buyers who value them highest (WTP)
Free markets allocate the demand for goods to sellers who can produce them at the
lowest cost.
Free markets produce the quantity of goods that maximizes the sum of consumer
and producer surplus.
The market equilibrium is efficient b/c the value to buyers exceeds the cost to
Economic well-being cannot be increased by changing the allocation of
consumption among buyers or the allocation of
production among sellers
The government cannot improve on the market
outcome. Laissez faire: The government should
not interfere with the market
Market failures:
When unregulated markets fail to allocate resources
o Market power: A single buyer or seller can
influence the market prices (ie. monopoly)
o Externalities: Side effects of transactions (ie.
o When markets fail, public policy may remedy
the problem and increase efficiency
o Invisible hand remains very important