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Principles of Economics
Lecture 1
Introduction to Economics
2 $7 $3.5 $4
3 $12 $4 $5
4 $20 $5 $8
5 $32 $6.4 $12
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?
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
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
$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)
Supply of Supply of
P Donuts S P Tuna
S' S*
S
$2
$2
8 9 Q 8 9 Q
(000s of pieces/day) (000s of cans/day)
Causes of Shifts in Supply
A change in the price of an input
Steel for bicycles, skill workers wages
A change in technology
Desktop publishing and term papers
Internet distribution of products (e-commerce)
Weather (agricultural commodities and outdoor
entertainment)
Number of sellers in the market
Expectation of future price changes
P
S
P'
P
D'
D
Q Q' Q
Supply and Demand Shifts:
Four Rules
An decrease in demand will lead to a decrease
in both equilibrium price and quantity
P
S
P
P'
D
D'
Q
Q' Q
Supply and Demand Shifts:
Four Rules
An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
P S
S'
P
P'
Q Q' Q
Supply and Demand Shifts:
Four Rules
An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity.
P S'
S
P'
P
D
Q' Q Q
Supply and Demand Both
Change: Tortilla Chips
Oils used for frying are harmful AND the price of
harvesting equipment decreases
S
S'
Price ($/bag)
P'
D
D'
Q' Q
Millions of bags per month
Changes in Supply and Demand
Supply
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