01

KEY CONCEPTS: WELCOME TO THE PRINCIPLES OF ECONOMICS

Microeconomics examines the behavior and decisions of individual firms and households and
the way they interact in specific industries and markets. We would use microeconomics to
analyze decisions made by individual firms, or to look at how certain factors can affect the
market for a specific good.

Macroeconomics focuses on the whole national economy or even the whole world economy.
Macroeconomics examines the workings and problems of the whole economy, looking at
features such as GDP growth and unemployment. We would use macroeconomics to examine
the factors that contribute to a country or region's overall economic growth, or to determine
the cause of economic fluctuations (e.g. recessions).

02
KEY CONCEPTS: THE CENTRAL IDEA

Economics mantra: people make choices with scarce resources, and they interact with others
when they make these choices.

Opportunity cost is the value of the next-best forgone alternative to making a choice.
Economists consider this the real cost of a decision; for example, if a baseball player decides to
attend college on a scholarship instead of entering the MLB draft, then even if he is going to
school for free, the opportunity cost of that decision is the salary he could be making as a
professional.

Gains from trade are improvements in income, production, or satisfaction owing to the
exchange of goods or services.

This economic interaction can lead to the following:

Specialization: a concentration of production effort on a single specific task.

Division of labor: the division of production into various parts in which different groups of
workers specialize.

Comparative advantage: a situation in which a person or group can produce one good at a lower
opportunity cost than another person or group.

These can lead to greater production due to greater efficiency which can make all actors better
off.
Trade can make two individuals or firms better off than if the trade did not happen. Because
of this, in this framework, an important role of government is to ensure that trade can happen.
There are five main components to this:

Predictable policy framework: the government needs to be predictable in its decision-making

process.

Rule of law (e.g. property rights): property rights need to be clearly defined and enforced.

Reliance on market economy: the government needs to allow the market to determine prices
and quantities produced.

Good incentives: the government needs to provide good incentives for economic activity, such
as patents to encourage innovation.

Specific role of government: the government needs to be able to intervene in the case of market
failure, when the market would fail to reach the efficient outcome.

03
PRODUCTION POSSIBILITIES AND ECONOMIC GROWTH

The production possibilities curve (or production possibilities frontier) is a graph which
illustrates the tradeoffs that an economy faces when deciding what to produce. It has a bowed-
out shape, implying that opportunity costs increase as production increases. The curve below
illustrates a hypothetical tradeoff between computers (on the y-axis) and movies (on the x-
axis).
Points on the curve are considered to be efficient levels of production. Points below the curve
are inefficient, because the economy could produce more of one good without sacrificing
production of the other. Points outside the curve are impossible; given its current capabilities,
the economy cannot reach those levels of production. Note that the production possibilities
curve does not indicate which good we prefer, or the optimal point on the curve; it merely
indicates what amounts of production it is possible to achieve.

Over time, the production possibilities curve shifts out. The magnitude of this shift depends
on investment in the economy; more investment will eventually lead to greater growth, and
less investment will lead to slower growth.

Conclusion

In this unit we looked at the foundational ideas of economics and some of the questions that
we can use them to answer. We introduced the mantra of economics: people make choices
with scarce resources, and they interact with others when they make these choices. We
applied this idea in particular to the production possibilities curve, which illustrates how
countries face tradeoffs between producing different types of goods. Many of these ideas will
be fundamental throughout this course. For example, whenever we discuss the costs of a
choice, we will take that that to mean the opportunity cost of that choice.

KEY TERMS: GETTING STARTED

Microeconomics: the study of individual firms and households in specific industries and
markets

Macroeconomics: the study of the entire economy of a region, a country, or the entire world

Opportunity Cost: is the value of the next-best forgone alternative to making a choice

Gains from Trade: improvements in income, production, or satisfaction owing to the exchange
of goods or services

Specialization: a concentration of production effort on a single specific task

Division of Labor: the division of production into various parts in which different groups of
workers specialize

Comparative Advantage: a situation in which a person or group can produce one good at a
lower opportunity cost than another person or group

Production Possibilities Curve: a graph illustrating the tradeoffs an economy faces when
producing two different goods
Increasing Opportunity Costs: the idea that as production of a good increases, the opportunity
cost of producing that good becomes higher

04
OBSERVING AND EXPLAINING THE ECONOMY

The work of an economist includes observation (describing economic events), explanation

(identifying potential causes of the events) and policy recommendations (courses of action for
government or business to follow).

Analyzing economic data and finding trends is a challenge. Data often come in widely
different magnitudes and units. They can be uninformative or misleading if they are not
appropriately transformed, say by considering percentages.

Finding an economic explanation for an economic event is also challenging. Often there are
several explanations which must be tested against each other. Even if you can find variables
that are correlated with the events in question, correlation does not imply causation.

Research on the causes of economic events often has policy implications. Making
recommendations is called normative economics, in contrast with the economic analysis of the
event, which is called positive economics.

Economists often disagree, and it is important to understand why. Disagreement is often

greater in macroeconomics than in microeconomics. The inability to run controlled
experiments makes it difficult for economists to establish definitively a cause for an economic
event. Sometimes partisanship or personal beliefs may also affect their conclusions.

Conclusion:

Causation: the concept that one event brings about another event.

Correlation: the concept that one event is usually observed to occur along with another event;
note that correlation does not imply causation

Normative Economics: economic analysis that makes recommendations about economic policy

Positive Economics: economic analysis that explains what happens in the economy and why,
without making recommendations about economic policy.
 05
SUPPLY AND DEMAND

Demand is a negative relationship between the price of a good and the quantity demanded by
consumers. It can be shown graphically by a downward-sloping demand curve.

It is very important to note what results in a movement along the demand curve and what
results in a shift of the demand curve.

A movement along the demand curve occurs when a higher price reduces the quantity
demanded or a lower price increases the quantity demanded. This is illustrated in the figure
below as a movement from point A to point B or C.

A shift of the demand curve occurs when something besides a change in price changes the
quantity of a good that people are willing to buy. An increase in demand is a shift to the right
of the demand curve. A decrease in demand is a shift to the left of the demand curve.
Shifts of and Movements Along a Demand Curve:
Supply is a positive relationship between the price of a good and the quantity supplied by firms.
It can be shown graphically by an upward-sloping supply curve.

Like demand we can differentiate between movements along and shifts of the supply curve.

A movement along the supply curve occurs when a higher price increases the quantity supplied
or a lower price decreases the quantity supplied. This is shown in the figure below as a
movement from point D to point E or F.

A shift of the supply curve occurs when something besides a change in price changes the
quantity of a good that firms are willing to sell. An increase in supply is a shift to the right of
the supply curve. A decrease in supply is a shift to the left of the supply curve.

Shifts of versus Movements Along the Supply Curve

 06
MARKET EQUILIBRIUM

The equilibrium price and equilibrium quantity are determined by the intersection of the
supply curve and the demand curve. At this intersection point, the quantity supplied equals
the quantity demanded there are no shortages or surpluses.

The adjustment of prices moves the market into equilibrium. In situations where there is a
shortage or an excess demand for goods, price will rise, increasing the quantity supplied and
reducing the quantity demanded. In situations where there is a surplus or an excess supply of
goods, price will fall, decreasing the quantity supplied and increasing the quantity demanded.

We can use the supply and demand model to analyze the impact of changes in factors that
move the supply curve or the demand curve or both. By shifting either the supply curve or the
demand curve, observations of prices can be explained and predictions about prices can be
made.

When the demand curve shifts to the right (left), both equilibrium price and equilibrium
quantity will increase (decrease). When the supply curve shifts to the right (left), the
equilibrium price will fall (rise), and the equilibrium quantity will rise (fall).
 CONCLUSION: THE SUPPLY AND DEMAND MODEL

In this lesson you have learned the basic definitions of supply and demand. You have also
learned to analyze the concepts of supply and demand graphically. Demand is a relationship
between two economic variables: (1) the price of a particular good and (2) the quantity of that
good that consumers are willing to buy at that price during a specific time period, all other
things being equal. For short, we call the first variable the price and the second variable the
quantity demanded. The relationship between price and quantity demanded is called a demand
schedule. The relationship shows price and quantity demanded moving in opposite directions.
Supply is a relationship between two variables: (1) the price of a particular good and (2) the
quantity of the good that firms are willing to sell at that price, all other things being the same.
For short, we call the first variable the price and the second variable the quantity supplied.

Economists sometimes refer to demand and supply as the law of demand and the law of supply.
The law of demand says that the higher the price, the lower the quantity demanded in the
market; and the lower the price, the higher the quantity demanded in the market. In other
words, the law of demand says that the price and the quantity demanded are negatively related,
all other things being equal. The law of supply says that the higher the price, the higher the
quantity supplied; and the lower the price, the lower the quantity supplied. In other words,
the law of supply says that the price and the quantity supplied are positively related, all other
things being equal.

This lesson has also shown how to use the supply and demand model to find out how
equilibrium price and quantity are determined in markets where buyers and sellers interact
freely. The supply and demand model is probably the most frequently used model in
economics, and it has been in existence for over a hundred years in pretty much the same form
as economists use it now. You will come to appreciate it more and more as you study
economics. A key feature of the model is that the equilibrium price and quantity are found at
the intersection of the supply and demand curves. We can use the model to analyze how a
change in factors that shift either the supply curve or the demand curve (or both) will affect
equilibrium price and quantity in the market.

KEY TERMS: THE SUPPLY AND DEMAND MODEL

Demand: A relationship between price and quantity demanded.

Price: The amount of money or other goods that one must pay to obtain a particular good.
Quantity Demanded: The quantity of a good that people want to buy at a given price during a
specific time period.

Demand Schedule: A tabular presentation of demand showing the price and quantity
demanded for a particular good, all else being equal. Below is an example of a demand schedule
for bicycles.

Law of Demand: The tendency for the quantity demanded of a good in a market to decline as
its price rises.

Demand Curve: A graph of demand showing the down-ward sloping relationship between
price and quantity demanded. Below is an example of a demand curve for bicycles, showing
shifts of the demand curve versus movements along the demand curve.

Supply: A relationship between price and quantity supplied.

Quantity Supplied: The quantity of a good that firms are willing to sell at a given price.

Supply Schedule: A tabular presentation of supply showing the price and quantity supplied of
a particular good, all else being equal. Below is an example of a supply schedule for bicycles.
Law of Supply: The tendence for the quantity supplied of a good in a market to increase a its
price rises.

Supply Curve: A graph of supply showing the upward-sloping relationship between price and
quantity supplied. Below is an example of a supply curve for bicycles, showing shifts of versus
movements along the supply curve.

Shortage (excess demand): A situation in which quantity demanded is greater than quantity
supplied.

Surplus (excess supply): A situation in which quantity supplied is greater than quantity
demanded.

Equilibrium Price: The price at which quantity supplied equals quantity demanded.

Equilibrium Quantity: The quantity traded at the equilibrium price.

Market Equilibrium: The situation in which the price is equal to the equilibrium price and the
quantity traded equals the equilibrium quantity. The figure below shows a market equilibrium.

07
INTRODUCTION: USING THE SUPPLY AND DEMAND MODEL

This lesson builds upon what we have seen thus far in our analysis of the supply and demand
model.

First we discuss a key point in economics: elasticity.

The concept of elasticity helps us understand how much the equilibrium price and quantity
change in response to changes in supply or demand. This has very important implications for
policymaking. In addition, this concept will help solidify your understanding of the important
role played by prices in the allocation of resources.

Second we turn to government interventions in the market, specifically price ceilings and price
floors.

We consider two ways in which government interventions can affect market prices. When
the government perceives that an equilibrium price is "too high," it might intervene and
impose a price ceiling. Or the government might intervene and impose a price floor when a
price is perceived to be "too low." We use the supply and demand model to analyze the impact
of these interventions.
 KEY CONCEPTS: PRICE AND ELASTICITY

Understanding the roles of prices in a market economy is extremely important.

Prices have three major roles:

Prices are signals

Prices provide incentives
Prices affect income distribution

Elasticity is a measure of the sensitivity of one economic variable to another.

Price Elasticity of Demand is the percentage change in the quantity demanded of a good
divided by the percentage change in the price of that good.

Elasticity is important because it is a way in which economists quantify how responsive

economic actors are to price signals. If a consumer changes how much of a good they purchase
by a large amount when price changes by a certain amount then their demand is thought to
be relatively elastic. If consumers change how much of a good they purchase very little when
price changes, then their demand is thought to be relatively inelastic.

So that we can compare elasticities across different goods elasticity is always measured in
percentage terms. Elasticity is a unit-free measure.

Demand is said to be elastic if the price elasticity of demand is greater than 1 and inelastic if
the price elasticity of demand is less than 1. The elasticity of demand for a good depends on
whether the good has close substitutes, whether its value is a large or a small fraction of total
income, and the time period of the change.

Examples of goods that generally have low price elasticity of demand include cigarettes and
gasoline. Consumers change their purchasing behavior relatively little with changes in price.
Examples of goods with higher price elasticity of demand include luxury goods such as jewelry.

The graphs below illustrate the concept of price elasticity of demand by using an example of
the market for crude oil.

In this figure we can see that with a relatively high price elasticity of demand consumers
change how much they consume very much in response to a price change.
However, in the next figure we can see an example of relatively low price elasticity of demand
where consumers change their quantity purchased much less in response to a change in price.

Similar to price elasticity of demand we can measure a supplier's willingness to supply more
or less of a good in response to price changes as price elasticity of supply.

This is the percentage change in quantity supplied divided by the percentage change in price.

If a good has a high price elasticity of supply, then a change in price will cause a big change in
the quantity supplied. Conversely, if a good has a low price elasticity of supply, then a change
in price will have only a small impact on the quantity supplied.
 KEY CONCEPTS: APPLYING THE SUPPLY AND DEMAND MODEL

One of the most import applications of the supply and demand model is to the analysis of
government interventions in markets. The case of price ceilings and price floors is an important
example. Such interventions occur when people in government, or those that influence people
in government, perceive the market equilibrium price to be too high or too low.

A price ceiling is a government price control that sets the maximum allowable price for a good
or a service. For a price ceiling to have any effect at all in a market it must be below the market
equilibrium price. A price ceiling may be put into place because policymakers believe the price
of a good is too high and thus not afforable for certain citizens (i.e. rent control). However, the
low price will lead firms to reduce the quantity they will supply and result in a shortage.

Example:

Rent control: a government price control that sets a maximum allowable rent to a house or an
apartment.

A price floor is a government price control that sets the minimum allowable price for a good
or a service. For a price floor to have any effect at all it must be above the market equilibrium
price. A price floor might be put into place to try to help suppliers of a good because
policymakers believe the price being received by suppliers is too low (i.e. a higher minimum
wage is intended to help workers--the suppliers of labor). However, this reduces the quantity
demanded and results in a surplus. In the case of a labor market this surplus is known as
unemployment. In the market for a good, the government often must purchase the suplus of
goods to support this price at a great cost to government.
Example:

Minimum wage: a wage per hour below which it is illegal to pay workers.

CONCLUSION: USING THE SUPPLY AND DEMAND MODEL

In this lesson we covered some key economic concepts that help us understand the interaction
of firms, consumers and workers in a market. We discussed the roles of prices, elasticity, and
price controls. Price elasticity of demand helps us understand how consumers respond to price,
while price elasticity of supply helps us understand how suppliers respond to price. We also
examined how the supply and demand model can be used to analyze the impact of real world
events such as a reduction in the demand for oil in the United States.

Price controls include price ceilings that might be imposed when government believes that a
price is too high and price floors that might be imposed when government believes a price is
too low. The supply and demand model helps us understand some basic issues related to
minimum wage or rent control policies, which frequently appear in the news today.

KEY TERMS: USING THE SUPPLY AND DEMAND MODEL

Elastic Demand: demand for which the price elasticity is greater than 1.

Inelastic Demand: demand for which the price elasticity is less than 1.
Minimum Wage: a wage per hour below which it is illegal to pay workers.

Perfectly Elastic Demand: demand for which the price elasticity is infinite, indicating an
infinite response to a change in price and therefore a horizontal demand curve.

Perfectly Elastic Supply: supply for which the price elasticity is infinite, indicating an infinite
response of quantity supplied to a change in price and therefore a horizontal supply curve.

Perfectly Inelastic Demand: demand for which the price elasticity is zero, indicating no
response to a change in price and therefore a vertical demand curve.

Perfectly Inelastic Supply: supply for which the price elasticity is zero, indicating no response
of quantity supplied to a change in price and therefore a vertical supply curve.

Price Ceiling: a government price control that sets the maximum allowable price for a good.

Price Control: a government law or regulation that sets or limits the price to be charged for a
particular good.

Price Elasticity of Demand: the percentage change in the quantity demanded of a good divided
by the percentage change in the price of that good.

Price Elasticity of Supply: the percentage change in quantity supplied divided by the
percentage change in price.

Price Floor: a government price control that sets the minimum allowable price for a good.

Rent Control: a government price control that sets the maximum allowable rent on a house or
apartment.

Unit-Free Measure: a measure that does not depend on a unit of measurement.