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Principles of Economics
Lecture 1
Introduction to Economics
Marginal
Benefits
Marginal
Costs
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
You clip
You take a taxi
grocery
on the way to
coupons but
work but not on
your friend
the way to
Naruto does
school
not
At the stadium,
you pay extra
You skip your
to buy a soft
regular dental
drink from the
check-up
hawkers in the
stands
Economic Surplus
The economic surplus of an action is equal
to its benefit minus its costs
Total Total
Benefits Costs
Economic
Surplus
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
Benefits Costs
Actions are more likely Actions are less likely
to be taken if their to be taken if their
benefits rise costs rise
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?
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:
$4 Given price, how much
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
D
change P or Q
12 Q
Buyers are on their (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
$3 Equilibrium
the quantity offered for sale
decreases along the supply D
curve
8 12 16 Q
the quantity demanded (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 Q
1 2 3
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 $2
quantity demanded $1 D
A change in quantity 8 10 Q
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
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 $60
D
P
S
P'
P
D'
D
Q Q' Q
Supply and Demand Shifts:
Four Rules
An decrease in demand will lead to a decrease
in both equilibrium price and quantity
P
S
P
P'
D
D'
Q
Q' Q
Supply and Demand Shifts:
Four Rules
An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
P S
S'
P
P'
Q Q' Q
Supply and Demand Shifts:
Four Rules
An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity.
P S'
S
P'
P
D
Q' Q Q
Supply and Demand Both
Change: Tortilla Chips
Oils used for frying are harmful AND the price of
harvesting equipment decreases
S
S'
Price ($/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