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HE9091

Principles of Economics
Lecture 1
Introduction to Economics

Tan Khay Boon


Email: khayboon@ntu.edu.sg
Topics
Scarcity and Cost-Benefit Principles
Opportunity Cost and Incentive Principle
Demand and Supply
Market Equilibrium and Price Control
Shifts in Demand and Supply
Efficiency and Equilibrium Principles
Reference: FBLC, chapters 1, 3 & 6
The Scarcity Principle
The Cost-Benefit Principle
Take an action if and only if the extra benefits
are at least as great as the extra costs
Costs and benefits are not just money
Applying the Cost Benefit
Principle
Assume people are rational
A rational person has well defined goals and tries to
fulfill those goals as best they can
Would you walk to town to save $10 on an
item?
Benefits are clear
Costs are harder to define
Hypothetical auction
Would you walk to town if someone paid you $9?
If you would walk to town for less than $10, you gain
from buying the item in town
Cost Benefit Principle
Examples
Economic Surplus
The economic surplus of an action is equal
to its benefit minus its costs
Opportunity Cost
Opportunity cost is the value of what must
be foregone in order to undertake an activity
Consider explicit and implicit costs
Examples:
Give up an hour of babysitting to go to the
movies
Give up watching TV to walk to town
Caution: NOT the combined value of all
possible activities
Opportunity cost considers only your best
alternative
Sunk Cost
Sunk Costs are costs that are beyond
recovery when a decision is made
Irrelevant to future decision making
Only costs that influence a decision are
those that can be avoided by not taking
the decision
Only benefits that influence a decision are
those that would not occur unless the
action were taken.
Buyers and Sellers
Cost-Benefit Principle is behind decision making
Buyers: buy one more unit?
Only if marginal benefit is at least as great as
marginal cost
Sellers: sell one more unit?
Only if marginal benefit (marginal revenue) is at
least as great as marginal cost
Opportunity Cost also matters
Buyers: hamburger or pizza?
Sellers: recycle aluminum or wash dishes?
The Importance of Opportunity
Cost
Harry can divide his time between two
activities:
Wash dishes for $6 per hour
Recycle aluminum cans and earn 2 per can
Harry only cares about the income
How much labor should Harry supply to each
activity?
Harry should devote an additional hour to
recycling as long as he is earning at least $6 per
hour
Economic Models
Simplifying assumptions
Which aspects of the decision are absolutely
essential?
Which aspects are irrelevant?
Abstract representation of key relationships
The Cost-Benefit Principle is a model
If costs of an action increase, the action is less
likely
If benefits of an action increase, the action is
more likely
Marginal Analysis Ideas
Marginal cost is the increase in total cost
from one additional unit of an activity
Average cost is total cost divided by the number
of units
Marginal benefit is the increase in total
benefit from one additional unit of an activity
Average benefit is total benefit divided by the
number of units
Marginal Analysis: NASA
Space Shuttle
Total Cost Average Cost Marginal Cost
# of Launches
($B) ($B/launch) ($B)
0 $0 $0
1 $3 $3 $3

2 $7 $3.5 $4

3 $12 $4 $5
4 $20 $5 $8
5 $32 $6.4 $12

If the marginal benefit is $6 billion per launch, how many launches


should NASA make?
Normative and Positive
Economics
Normative economic Positive economic
principle says how principle predicts how
people should behave people will behave
Gas prices are too The average price of
high gasoline in May 2010
Building a space base was higher than in
on the moon will cost May 2009
too much Building a space base
on the moon will cost
more than the shuttle
program
Incentive Principle
Microeconomics and
Macroeconomics
Microeconomics studies Macroeconomics studies
choice and its implications the performance of national
for price and quantity in economies and the policies
individual markets that governments use to try
Sugar to improve that performance
Carpets Inflation
House cleaning services Unemployment
Microeconomics considers Growth
topics such as Macroeconomics considers
Costs of production Monetary policy
Demand for a product Deficits
Exchange rates Tax policy
Simultaneous Equations
Two equations, two unknowns
Solving the equations gives the values of the
variables where the two equations intersect
Value of the independent and dependent variables
are the same in each equation
Example
Two billing plans for phone service
How many Mbytes make the two plans cost the
same?
Simultaneous Equations
Plan 1 B = 10 + 0.04 D
Plan 2 B = 20 + 0.02 D
Plan 1 has higher per minute price while Plan 2 has
a higher monthly
fee
Find B and D
for point A
Simultaneous Equations
Plan 1 B = 10 + 0.04 D Find B when D = 500
Plan 2 B = 20 + 0.02 D B = 10 + 0.04 D
Subtract Plan 2 equation from B = 10 + 0.04 (500)
Plan 1 and solve for D B = $30

B = 10 + 0.04 D OR
B = 20 0.02 D
0 = 10 + 0.02 D B = 20 + 0.02 D
B = 20 + 0.02 (500)
D = 500 B = $30
What, How, and For Whom?
Every society answers three basic questions
WHAT Which goods will be produced?
How much of each?

HOW Which technology?


Which resources are used?

FOR How are outputs distributed?


WHOM Need?
Income?
Central Planning versus the
Market
Central Planning The Market
Decisions by Buyers and sellers
individuals or small signal wants and costs
groups Resources and goods are
Agrarian societies allocated accordingly
Government programs Interaction of supply and
Sets prices and goals for the demand answer the three
group basic questions
Individual influence is
limited

Mixed economies use both the market and central planning


Buyers and Sellers in the
Market
The market for any good consists of all the
buyers and sellers of the good
Buyers and sellers have different motivations
Buyers want to benefit from the good
Sellers want to make a profit
Market price balances two forces
Value buyers derive from the good
Cost to produce one more unit of the good
Demand
A demand curve
illustrates the quantity Demand for Donuts
buyers would purchase P
at each possible price
Demand curves have a $4
negative slope
Consumers buy less at $2 D
higher prices
8 16 Q
Consumers buy more
(000s of pieces/day)
at lower prices
Law of Demand

Law of Demand
Consumers buy less of a product
as the price of the product rises
Price and quantity demanded are inversely related
Law of Demand
Cost-Benefit Principle at work
Do something if the marginal benefits are at least
as great as the marginal costs
An increase in the market price approaches our
reservation price
If market price (cost) exceeds the reservation price
(benefit), buy no more
Demand Slopes Downward
Buyers value goods differently
The buyers reservation price is the highest price
an individual is willing to pay for a good
Demand reflects the entire market, not one
consumer
Lower prices bring more buyers into the market
Lower prices cause existing buyers to buy more
Income and Substitution Effects
Buyers buy more at lower prices and buy less at
higher prices
What happens when price goes up?
The substitution effect: Buyers switch to
substitutes when price goes up
The income effect: Buyers' overall purchasing
power goes down
Interpreting the Demand Curve
Horizontal
Demand for Donuts
interpretation of
P
demand:
Given price, how much
$4 will buyers buy?
At a price of $4, the
$2 D quantity demanded is
Q 8,000 slices/day.
8 16
(000s of pieces/day)
Interpreting the Demand Curve

Demand for Donuts Vertical interpretation of


demand:
P
Given the quantity to
be sold, what price is
$4 the marginal consumer
willing to pay?
$2 D If 8,000 slices are sold
Q the marginal consumer
8 16 is willing to pay $4 per
(000s of pieces/day)
slice.
The Supply Curve
The supply curve illustrates the quantity of a
good that sellers are willing to offer at each price
Producers incur costs in order to obtain resources
to produce output and sell to consumers at the
market price to maximize profits
The Low-Hanging Fruit Principle explains the
upward sloping supply curve
The sellers reservation price is the lowest price
the seller would be willing to sell for
Equal to marginal cost of production
Law of Supply

Law of Supply
Producers supply more of a product
as the price of the product rises
Price and quantity supplied are positively related
Interpreting the Supply Curve
Horizontal
Supply of Donuts
P interpretation of
S supply:
Given price, how much
$4
will suppliers offer?
$2 At a price of $2,
suppliers are willing to
8 16 Q sell 8,000 pieces/day.
(000s of pieces/day)
Interpreting the Supply Curve
Vertical interpretation of
Supply of Donuts supply:
P
S Given the quantity to
be sold, what is the
$4 opportunity cost of the
marginal seller?
$2 If 8,000 pieces are
Q sold, the marginal cost
8 16 of producing the
(000s of pieces/day)
8,000th piece is $2.
Market Equilibrium
A system is in equilibrium when there is no
tendency for it to change
The equilibrium price is the price at which the
supply and demand curves intersect
The equilibrium quantity is the quantity at
which the supply and demand curves intersect
The market equilibrium occurs when all buyers
and sellers are satisfied with their respective
quantities at the market price
At the equilibrium price, quantity supplied equals
quantity demanded
Market Equilibrium
Quantity supplied
equals quantity Market for Donuts
demanded AND P
S
Price is on supply
and demand curves $3
No tendency to
change P or Q D
Buyers are on their 12 Q
(000s of pieces/day)
demand curve
Sellers are on their
supply curve
Excess Supply and Excess
Demand
Excess Supply Excess Demand
At $4, 16,000 pieces supplied At $2, 8,000 pieces supplied
and 8,000 slices demanded 16,000 slices demanded

Market for Donuts Market for Donuts


P P
Surplus S S

$4
Shortage
$2
D D
Q 8 16 Q
8 16
(000s of pieces/day) (000s of pieces/day)
Incentive Principle: Excess
Supply at $4
Each supplier has an
incentive to decrease the Market for Donuts
price in order to sell more P
Lower prices decrease the S
surplus $4
As price decreases: $3.50
the quantity offered for sale $3 Equilibrium
decreases along the supply D
curve
the quantity demanded 8 12 16 Q
(000s of pieces/day)
increases along the
demand curve
Incentive Principle: Excess
Demand at $2
Each supplier has an
Market for Donuts incentive to increase the
price in order to sell more
P Higher prices decrease the
S
shortage
As price increases
$3
Equilibrium the quantity offered for
$2.50
$2 sale increases along the
D supply curve
8 12 16 Q As price increases, the
(000s of pieces/day) quantity demanded
decreases along the
demand curve.
Rent Controls Are Price Ceilings
A price ceiling is a
maximum allowable price, Market for New York City Apartments
set by law
Rent controls set a maximum P
price that can be charged for S
a given apartment
If the controlled price is $1,600
below equilibrium, then:
$800
Quantity demanded D
increases
1 2 3 Q
Quantity supplied
(millions of apartments/day)
decreases
A shortage results
Movement along the Demand
Curve
When price goes up,
quantity demanded Demand for Canned Tuna

goes down P
When price goes
down, buyers move to
a new, higher quantity $2
demanded $1 D
A change in quantity Q
8 10
demanded results (000s of cans/day)

from a change in the


price of a good.
Shift in Demand
If buyers are willing to
buy more at each price, Demand for Canned Tuna

then demand has P


increased
Move the entire demand
curve to the right $2
Change in demand D'
D
If buyers are willing to
8 10 Q
buy less at each price, (000s of cans/day)
then demand has
decreased
Causes of Shifts in Demand
Price of complementary goods
Tennis courts and tennis balls
Price of substitute goods
Internet and overnight delivery are substitutes
Income: normal or inferior goods?
Preferences
Dinosaur toys after Jurassic Park movie
Number of buyers in the market
Expectations about the future

Price changes never cause a shift in demand


Tennis Market
If rent for tennis court decreases, demand for tennis
balls increases
Tennis courts and tennis balls are complements

Tennis Court Rentals Tennis Ball Sales


P P
$10 S
$1.40
$7 $1.00
D D'
D
4 11 Q 40 58 Q
(00s rentals/day) (millions of balls/day)
Demand for Apartments
If income rise, demand for
apartments increases
Apartments Demand increases
P D D' S Price increases
Quantity increases
Demand for a normal
P' good increases when
income increases
P Demand for an inferior good
increases when income
decreases
Q
Q Q'
(units/month)
Movement Along the Supply
Curve
When price goes up,
quantity supplied Supply
P of Donuts
goes up S
When price goes up,
$4
sellers move to a
new, higher quantity
supplied $2
A change in quantity Q
8 16
supplied results from (000s of pieces/day)
a change in the price
of a good.
Shift in Supply
Supply increases when Supply decreases when
sellers are willing to offer sellers are willing to offer
more for sale at each less for sale at each
possible price possible price
Moves the entire supply Moves the entire supply
curve to the right curve to the left

Supply of Supply of
P Donuts S P Tuna
S' S*
S
$2
$2
8 9 Q 8 9 Q
(000s of pieces/day) (000s of cans/day)
Causes of Shifts in Supply
A change in the price of an input
Steel for bicycles, skill workers wages
A change in technology
Desktop publishing and term papers
Internet distribution of products (e-commerce)
Weather (agricultural commodities and outdoor
entertainment)
Number of sellers in the market
Expectation of future price changes

Price changes never cause a shift in supply


Shifts in Supply: Bicycles
Costs of production affect the supply of a
product
Cost of steel for bicycles increases
Supply decreases
Supply of Bicycles
With no change in demand,
the price of bicycles P S'
S
increases to $80 and quantity $80
decreases to 800 $60
D

600 800 1,000


Q
(bicycles/month)
Shift in Supply: Handmade
Carpets
Cost of labor used to produce handmade
carpets decreases
The Market for Handmade Carpets
Supply increases
Demand is constant P S
The price of handmade $120 S'
$90
carpets decreases to
D
$90,000 per carpet
Quantity increases to 50 40 50 Q
(carpets/
month)
Supply and Demand Shifts:
Four Rules
An increase in demand will lead to an increase in
both equilibrium price and quantity

P
S
P'
P
D'
D
Q Q' Q
Supply and Demand Shifts:
Four Rules
An decrease in demand will lead to a decrease
in both equilibrium price and quantity

P
S

P
P'
D
D'
Q
Q' Q
Supply and Demand Shifts:
Four Rules
An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
P S
S'
P
P'

Q Q' Q
Supply and Demand Shifts:
Four Rules
An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity.

P S'
S
P'
P
D

Q' Q Q
Supply and Demand Both
Change: Tortilla Chips
Oils used for frying are harmful AND the price of
harvesting equipment decreases

S
S'
Price ($/bag)

P'
D
D'

Q' Q
Millions of bags per month
Changes in Supply and Demand

Supply

Demand Increases Decreases

P Depends P Increases
Increases
Q Increases Q Depends

P Decreases P Depends
Decreases
Q Depends Q Decreases
Efficiency and Equilibrium
Markets communicate information effectively
Value buyers place on the product
Opportunity cost of producing the product
Markets maximize the difference between
benefits and costs
Market outcomes are the best provided that
The market is in equilibrium AND
No costs or benefits are shared with the public
Cash on the Table
Buyer's surplus: buyer's reservation price
minus the market price
Seller's surplus: market price minus the seller's
reservation price
Total surplus = buyer's surplus + seller's
surplus
Total surplus is buyer's reservation price seller's
reservation price
No cash on the table when surplus is
maximized
No opportunity to gain from additional sales or
purchases
Efficiency Principle
The socially optimal quantity maximizes total
surplus for the economy from producing and
selling a good
Economic efficiency -- all goods are produced at
their socially optimal level
Efficiency Principle: equilibrium price and
quantity are efficient if:
Sellers pay all the costs of production
Buyers receive all the benefits of their purchase
Efficiency: marginal cost equals marginal
benefit
Production is efficient if total surplus is maximized
Equilibrium Principle
Equilibrium Principle: a market in equilibrium
leaves no unexploited opportunities for
individuals
Only when the seller pays the full cost of
production and the buyer captures the full
benefit of the good is the market outcome
socially optimal
From Graphs to Equations
Sample equations

P = 16 2 Qd
is a straight-line demand curve with intercept 16
on the vertical (P) axis and a slope of 2

P = 4 + 4 Qs
is a straight-line supply curve with intercept 4
and a slope of 4
To Equilibrium P and Q
Equilibrium is where P and Q are the same for
demand and supply
Set the two equations equal to each other (P = P)
and solve for Q (Qs = Qd = Q*)
16 2 Q* = 4 + 4 Q*
6 Q* = 12
Q* = 2
Use either the supply or demand curve and Q * =
2 to find price
P = 16 2 Q* P = 4 + 4 Q*
P = $12 P = $12

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