Chapter 1 Notes

Because you can never satisfy all of your wants, making the most out of your life requires
smart choices about what to go after, and what to give up.
● The problem of scarcity arises because of limited money, time, and energy.
● Economics is how individuals, businesses, and governments make the best possible choices
to get what they want, and how those choices interact in markets.

Opportunity cost is the single most important concept both in economics and for making
smart choices in life.
● Because of scarcity, every choice involves a trade-off — you have to give up something to get
something else.
● The true cost of any choice is the opportunity cost — the cost of the best alternative given up.
● For a smart choice, the value of what you get must be greater than value of what you give up.
● Incentives — rewards and penalties for choices.
● You are more likely to choose actions with rewards (positive incentives), and avoid actions
with penalties (negative incentives).

Opportunity cost and comparative advantage are key to understanding why specializing and
trading make us all better off.
● With voluntary trade, each person feels that what they get is of greater value than what they
give up.
● Production possibilities frontier (PPF) — graph showing the maximum combinations of
products or services that can be produced with existing inputs.
● Absolute advantage — the ability to produce a product or service at a lower absolute cost
than another producer.
● Comparative advantage — the ability to produce a product or service at a lower opportunity
cost than another producer.
● Trade makes individuals better off when each specializes in the product or service where they
have a comparative advantage (lower opportunity cost) and then trades for the other product
or service.
● Specialization according to comparative advantage and trade allows each trader to consume
outside her PPF, a combination that was impossible without trade. All arguments you will ever
hear for freer trade are based on comparative advantage.
● Even if one individual has an absolute advantage in producing everything at lower cost, as
long as there are differences in comparative advantage, there are mutually beneficial gains
from specializing and trading.

The circular-flow model, like all economic models, focuses attention on what’s important for
understanding and shows how smart choices by households, businesses, and governments
interact in markets.
● An economic model is a simplified representation of the real world, focusing attention on
what’s important for understanding.
● The circular flow model of economic life reduces the complexity of the Canadian economy to
three sets of players who interact in markets — households, businesses, and governments.
– In input markets, households are sellers and businesses are buyers.
– In output markets, households are buyers and businesses are sellers.
 – Governments set rules of the game and can choose to interact in any aspect of the
economy.
– Inputs are the productive resources — labour, natural resources, capital equipment,
and entrepreneurial ability — used to produce products and services.
● Economic models, which assume all other things not in the model are unchanged, are the
mental equivalent of controlled experiments in a laboratory.
● Positive statements — about what is; can be evaluated as true or false by checking the facts.
● Normative statements — about what you believe should be; involve value judgments.
– Cannot be factually checked.

The Three Keys model summarizes the core of microeconomics, providing the basis for smart
choices in all areas of your life.
● Microeconomics analyzes choices that individuals in households, individual businesses, and
governments make, and how those choices interact in markets.
● Macroeconomics analyzes performance of the whole Canadian economy and global
economy, the combined outcomes of all individual microeconomic choices.
● The Three Keys Model to Smart Choices:
Choose only when additional benefits are greater than additional opportunity costs.
Count only additional benefits and additional opportunity costs.
Be sure to count all additional benefits and costs, including implicit costs and
externalities.
● Important concepts in the Three Keys model:
– Marginal = “additional”
– Marginal benefits — additional benefits from the next choice.
– Marginal opportunity costs — additional opportunity costs from the next choice.
– Implicit costs — opportunity costs of investing your own money or time.
– Negative (or positive) externalities — costs (or benefits) that affect others external
to a choice or a trade.

Chapter 2 Notes
Your willingness to buy a product or service depends on your ability to pay, comparative
benefits and costs, and the availability of substitutes.
● Preferences — your wants and their intensities.
● Demand — consumers’ willingness and ability to pay for a particular product or service.
● For any choice, what you are willing to pay or give up depends on the cost and availability of
substitutes.

Key 2 states, “Count only additional benefits and additional costs.” Additional benefits mean
marginal benefits — not total benefits — and marginal benefits change with circumstances.
● Marginal benefit — the additional benefit from a choice, changing with circumstances.
● Marginal benefit explains the diamond/water paradox. Why do diamonds cost more than
water, when water is more valuable for survival? Willingness to pay depends on marginal
benefit, not total benefit. Because water is abundant, marginal benefit is low. Because
diamonds are scarce, marginal benefit is high.

The demand curve combines two forces — switch to substitutes; willingness and ability to pay
— determining quantity demanded, and can be read as a demand curve and as a marginal
benefit curve.
● Quantity demanded — the amount you actually plan to buy at a given price.
● Market demand — the sum of demands of all individuals willing and able to buy a particular
product or service.
● Law of demand — if the price of a product or service rises, quantity demanded decreases,
other things remaining the same.
● Demand curve — shows the relationship between price and quantity demanded, other things
remaining the same.

Quantity demanded changes only with a change in price. All other influences on consumer
choice change demand.
● Demand is a catch-all term summarizing all possible influences on consumers’ willingness
and ability to pay for a particular product or service.
– Increase in demand — increase in consumers’ willingness and ability to pay.
Rightward shift of demand curve.
– Decrease in demand — decrease in consumers’ willingness and ability to pay.
Leftward shift of demand curve.
● Demand changes with changes in preferences, prices of related goods, income, expected
future price, and number of consumers. For example, demand increases with:
– increase in preferences.
– rise in price of a substitute — products or services used in place of each other to
satisfy the same want.
– fall in price of a complement — products or services used together to satisfy the
same want.
– increase in income for normal goods — products or services you buy more of when
your income increases. (Normal goods are goods that have an increase in demand
when income goes up. Inferior goods are goods that have a decrease in demand
when income goes up eg. public transit)
– decrease in income for inferior goods — products or services you buy less of when
your income increases.
– rise in expected future prices.
– increase in number of consumers.
Chapter 3 Notes

Businesses must pay higher prices to obtain more of an input because opportunity costs
change with circumstances. The marginal costs of additional inputs (like labour) are ultimately
opportunity costs — the best alternative use of the input.
 ● Marginal cost — additional opportunity cost of increasing quantity supplied, changing with
circumstances.
– For the working example, you are supplying time, and the marginal cost of your
time increases as you increase the quantity of hours supplied.
● Differences between smart supply choices and smart demand choices:
– For supply, marginal cost increases as you supply more.
– For demand, marginal benefit decreases as you buy more.
– For supply, marginal benefit is measured in $ (wages you earn); marginal cost is
the opportunity cost of time.
– For demand, marginal benefit is the satisfaction you get; marginal cost is measured
in $ (the price you pay).

Sunk costs that cannot be reversed are not part of opportunity costs. Sunk costs do not
influence smart, forward-looking decisions.
● Sunk costs — past expenses that cannot be recovered.
● Sunk costs are the same no matter which fork in the road you take, so they have no influence
on smart choices.

If the price of a product or service rises, quantity supplied increases. Businesses increase
production when higher prices either create higher profits or cover higher marginal
opportunity costs of production.
● Supply — businesses’ willingness to produce a particular product or service because price
covers all opportunity costs.
● Quantity supplied — quantity you actually plan to supply at a given price.
● Marginal opportunity cost — complete term for any cost relevant to a smart decision.
– All opportunity costs are marginal costs; all marginal costs are opportunity costs.
● Increasing marginal opportunity costs arise because inputs are not equally productive in all
activities.
– Where inputs are equally productive in all activities, marginal opportunity costs are
constant.
● Market supply — sum of supplies of all businesses willing to produce a particular product or
service.
● Law of supply — if the price of a product or service rises, quantity supplied increases.
● Supply curve — shows the relationship between price and quantity supplied, other things
remaining the same.
– There are two ways to read a supply curve.
– As a supply curve, read over and down from price to quantity supplied.
– As a marginal cost curve, read up and over from quantity supplied to price. A
marginal cost curve shows the minimum price businesses will accept that covers all
marginal opportunity costs of production.

Quantity supplied is changed only by a change in price. Supply is changed by all other
influences on business decisions.
● Supply is a catch-all term summarizing all possible influences on businesses’ willingness to
produce a particular product or service.
● Supply changes with changes in technology, environment, prices of inputs, prices of related
products or services produced, expected future prices, and number of businesses. For
example, supply increases with:
 – improvement in technology
– environmental change helping production
– fall in price of an input
– fall in price of a related product or service
– fall in expected future price
– increase in number of businesses
● Increase in supply — increase in businesses’ willingness to supply. Can be described in two
ways:
– At any unchanged price, businesses are now willing to supply a greater quantity.
– For producing any unchanged quantity, businesses are now willing to accept a
lower price.
● Decrease in supply — decrease in business’s willingness to supply.

Chapter 4 Notes

Markets connect competition between buyers, competition between sellers, and cooperation between
buyers and sellers. Government guarantees of property rights allow markets to function.
● Market — the interactions between buyers and sellers.
● Because any purchase or sale is voluntary, an exchange between a buyer and seller happens
only when both sides end up better off.
– Buyers are better off when businesses supply products or services that provide
satisfaction (marginal benefit) that is at least as great as the price paid.
 – Sellers are better off when the price received is at least as great as marginal
opportunity costs.
● Property rights — legally enforceable guarantees of ownership of physical, financial, and
intellectual property.

When there are shortages, competition between buyers drives prices up. When there are surpluses,
competition between sellers drives prices down.
● Prices are the outcome of a market process of competing bids (from buyers) and offers (from
sellers).
● When the market price turns out to be too low:
– shortage, or excess demand — quantity demanded exceeds quantity supplied and
frustrated buyers
– shortages create pressure for prices to rise.
– rising prices provide signals and incentives for businesses to increase quantity
supplied and for consumers to decrease quantity demanded, eliminating the
shortage.
● When the market price turns out to be too high:
– surplus, or excess supply — quantity supplied exceeds quantity demanded.
– surpluses create pressure for prices to fall.
– falling prices provide signals and incentives for businesses to decrease quantity
supplied and for consumers to increase quantity demanded, eliminating the surplus.
● Even when prices don’t change, shortages and surpluses also create incentives for frequent
quantity adjustments to better coordinate smart choices of businesses and consumers.

Market-clearing or equilibrium prices balance quantity demanded and quantity supplied, coordinating
the smart choices of consumers and businesses.
● The price that coordinates the smart choices of consumers and businesses has two names:
– market-clearing price — the price that equalizes quantity demanded and quantity
supplied.
– equilibrium price — the price that balances forces of competition and cooperation,
so that there is no tendency for change.
● Price signals in markets create incentives, so that while each person acts only in her own self-
interest, the result (coordinated through Adam Smith’s invisible hand of competition) is the
miracle of continuous, ever-changing production of the products and services we want.
Invisible hand refers to the force that causes the market to move towards equilibrium which
works better for everyone.

When demand or supply change, equilibrium prices and quantities change. The price changes cause
businesses and consumers to adjust their smart choices. Well-functioning markets supply the
changed products and services demanded.
● For a change in demand (changes in preferences, prices of related products, income,
expected future prices, number of consumers)
– an increase in demand (rightward shift of demand curve) causes a rise in the
equilibrium price, and an increase in quantity supplied.
– a decrease in demand (leftward shift of demand curve) causes a fall in the
equilibrium price, and a decrease in quantity supplied.
● For a change in supply (changes in technology, environment, prices of inputs, prices of
related products produced, expected future prices, number of businesses)
 – an increase in supply (rightward shift of supply curve) causes a fall in the
equilibrium price and an increase in quantity demanded.
– a decrease in supply (leftward shift of supply curve) causes a rise in the equilibrium
price and a decrease in quantity demanded.
● When both demand and supply change at the same time, we can predict the change in either
the equilibrium price or in the equilibrium quantity. But without information about the relative
size of the shifts of the demand and supply curves, we cannot predict what will happen to the
other equilibrium outcome.
– when both demand and supply increase, the equilibrium price may rise/fall/remain
constant, and the equilibrium quantity increases.
– when both demand and supply decrease, the equilibrium price may rise/fall/remain
constant, and the equilibrium quantity decreases.
– when demand increases and supply decreases, the equilibrium price rises and the
equilibrium quantity may rise/fall/remain constant.
– when demand decreases and supply increases, the equilibrium price falls, and the
equilibrium quantity may rise/fall/remain constant.
● Price and quantity changes are the result, not the cause, of economic events.
● Comparative statics — comparing two equilibrium outcomes to isolate the effect of changing
one factor at a time.
● Increase in both demand and supply causes ambiguous change in price (increase in quantity)
An efficient market outcome has the largest total surplus, prices just cover all opportunity costs of
production and consumers’ marginal benefit equals businesses’ marginal cost.
● Reading demand and supply curves as marginal benefit and marginal cost curves reveals the
concepts of:
– consumer surplus — the difference between the amount a consumer is willing and
able to pay, and the price actually paid. The area under the marginal benefit curve but
above the market price.
– producer surplus — the difference between the amount a producer is willing to
accept, and the price actually received. The area below the market price but above
the marginal cost curve.
– total surplus — consumer surplus plus producer surplus.
– deadweight loss — decrease in total surplus compared to an economically efficient
outcome.
● Efficient market outcome — coordinates smart choices of businesses and consumers so
– consumers buy only products and services where marginal benefit is greater than
price.
– product and services are produced at lowest cost, with prices just covering all
opportunity costs of production.
– at the quantity of an efficient market outcome, marginal benefit equals marginal cost
(MB = MC).
Chapter 5
Elasticity measures how responsive quantity demanded is to a change in price.
● The tool that businesses use to measure consumer responsiveness when making pricing
decisions is elasticity (or price elasticity of demand), which measures by how much quantity
demanded responds to a change in price.
● The simple formula is:

The midpoint formula between any two points on a demand curve like (Q0, P0) and (Q1, P1) is:

● Inelastic demand — small response in quantity demanded when

– Example: Demand for insulin by a diabetic.
– Value for formula is less than one.
– Low willingness to shop elsewhere.
– Perfectly inelastic demand — price elasticity of demand equals zero; quantity
demanded does not respond to a change in price.
● Elastic demand — large response in quantity demanded when price rises.
– Example: Demand for blue earbuds.
– Value for formula is greater than one.
– High willingness to shop elsewhere.
– Perfectly elastic demand — price elasticity of demand equals infinity; quantity
demanded has an infinite response to a change in price.
● The price elasticity of demand of a product or service is influenced by:
– available substitutes — more substitutes mean more elastic demand.
– time to adjust — longer time to adjust means more elastic demand.
– proportion of income spent — greater proportion of income spent on a product or
service means more elastic demand.

Elasticity determines business pricing strategies to earn maximum total revenue — cut prices
when demand is elastic and raise prices when demand is inelastic.
● Total revenue — all money a business receives from sales = price per unit (P) multiplied by
quantity sold (Q).
 – For businesses facing elastic demand, price cuts are the smart choice and increase
total revenue.
– For businesses facing inelastic demand, price rises are the smart choice and
increase total revenue.
● As you move down a straight line demand curve, elasticity changes and is not the same as
slope.
– Elasticity goes from elastic, to unit elastic, to inelastic.
– Total revenue increases, reaches a maximum when elasticity equals 1, and then
decreases.

Elasticity of supply measures the responsiveness of quantity supplied to a change in price,

and depends on the difficulty, expense, and time involved in increasing production.
● Elasticity of supply measures by how much quantity supplied responds to a change in price.
● The formula is:
● Elasticity of supply = 
● Percentage change in
● quantity supplied
● Percentage change in price

– The midpoint formula between any two points on a supply curve like (Q0, P0) and (Q1, P1) is similar
to the formula for price elasticity of demand.

● Inelastic — For inelastic supply, small response in quantity supplied when price rises. Difficult
and expensive to increase production.
– Example: supply of mined gold.
– Value for formula is less than 1.
– Perfectly inelastic supply — price elasticity of supply equals zero; quantity supplied
does not respond to a change in price.
● Elastic — For elastic supply, large response in quantity supplied when price rises. Easy and
inexpensive to increase production.
– Example: snow-shovelling services.
– Value for formula is greater than 1.
– Perfectly elastic supply — price elasticity of supply equals infinity; quantity supplied
has infinite response to a change in price.
● Elasticity of supply of a product or service is influenced by:
– availability of additional inputs — more available inputs means more elastic supply.
– time production takes — less time means more elastic supply.
 ● Elasticity of supply allows more accurate predictions of future outputs and prices, helping
businesses avoid disappointing customers.

Elasticity measures explain the responsiveness of quantity demanded to changes in prices of

related products and income, and the division of a tax between buyers and sellers.
● Cross elasticity of demand — measures the responsiveness of the demand for a product or
service to a change in the price of a substitute or complement.
– The simple formula is:

● Cross elasticity of demand is a positive number for substitutes. The larger the number:
– the larger the change in demand.
– the larger the shift of the demand curve.
– the closer the products or services are to being perfect substitutes.
● Cross elasticity of demand is a negative number for complements. The larger the number:
– the larger the change in demand.
– the larger the shift of the demand curve.
– the closer the products or services are to being perfect complements.
● Income elasticity of demand — measures the responsiveness of the demand for a product or
service to a change in income.
– The simple formula is:

– Positive for normal goods;

increase in income increases demand for normal goods.
– Negative for inferior goods;
increase in income decreases demand for inferior goods.
● Income inelastic demand —
– income elasticity greater than 0 but less than 1
– percentage change in quantity is less than the percentage change in price
– normal goods that are necessities
● Income elastic demand —
– income elasticity greater than 1
– percentage change in quantity is greater than the percentage change in price
– normal goods that are luxuries
● Tax incidence — the division of a tax between buyers and sellers; depends on
elasticities of demand and supply
● Elasticity of demand and tax incidence:
– perfectly inelastic demand — buyers pay all
– more inelastic demand — buyers pay more
– more elastic demand — sellers pay more
– perfectly elastic demand — sellers pay all
 ● Elasticity of supply and tax incidence:
– perfectly inelastic supply — sellers pay all
– more inelastic supply — sellers pay more
– more elastic supply — buyers pay more
– perfectly elastic supply — buyers pay all
● The more inelastic demand and supply are, the greater the tax revenue for government. For
maximum revenue, governments try to tax products and services with inelastic demands and
supplies.

Chapter 6

When the government fixes prices, the smart choices of consumers and businesses are not
coordinated. Quantities adjust to whichever is less — quantity supplied or quantity demanded.
● When price is fixed below market-clearing:
– shortages develop (quantity demanded greater than quantity supplied) and
consumers are frustrated.
– quantity sold = quantity supplied only.
● When price is fixed above market-clearing:
– surpluses develop (quantity supplied greater than quantity demanded) and
businesses are frustrated.
– quantity sold = quantity demanded only.
● When prices are fixed, quantities adjust to whichever is less — quantity supplied or quantity
demanded.
● Governments can fix prices, but can’t force businesses (or consumers) to produce (or buy) at
the fixed price.
– Businesses can reduce output or move resources elsewhere.
– Consumers can reduce purchases or buy something else (there are always
substitutes).

Rent controls fix rents below market-clearing levels, and quantity adjustment takes the
unintended form of apartment shortages.
● Rent controls: example of price ceiling — maximum price set by government, making it illegal
to charge higher price.
● Rent controls sometimes justified by Robin Hood principle — take from the rich (landlords)
and give to the poor (tenants).
● Rent controls have unintended and undesirable consequences:
– create housing shortages, giving landlords the upper hand over tenants.
– subsidize well-off tenants willing and able to pay market-clearing rents.
– inefficiency, reducing total surplus below market-clearing amounts.
● Alternative policies to help the homeless that do not sacrifice market flexibility are
– government subsidies to help those who are poor pay rent.
– government-supplied housing.
● All policies have opportunity costs.

Minimum wage laws fix wages above market-clearing levels, and quantity adjustment takes the
unintended form of unemployment.
● Minimum wage laws: example of price floor — minimum price set by government, making it
illegal to pay a lower price.
 – Living wage — estimated at $20 per hour, enough to allow an individual in a
Canadian city to live above the poverty line.
● Minimum wage laws create unintended consequences.
– When governments set minimum wages above the market-clearing wage, the
quantity of labour supplied by households will be greater than the quantity of labour
demanded by businesses, creating unemployment.
– Inefficiency, reducing total surplus.
● Quantity of unemployment created by raising minimum wage depends on elasticity of
business demand for unskilled labour.
– When demand for unskilled labour is inelastic and businesses have few substitutes,
rise in minimum wage produces small response in decreased quantity demanded.
– When demand for unskilled labour is elastic and businesses can easily substitute
machines for people, rise in minimum wage produces large response in decreased
quantity demanded.
– Minimum wages help the working poor if gains from workers who remain employed
and whose incomes go up are greater than losses of incomes of workers who lose
their jobs.
● Alternative policies to help the working poor that do not sacrifice market flexibility are:
– training programs to help unskilled workers get higher-paying jobs.
– wage supplements.
● All policies have opportunity costs.

Well-functioning markets are efficient, but not always equitable. Government may smartly
choose policies that create more equitable outcomes, even though the trade-off is less
efficiency.
● To say that well-functioning markets produce the products and services we value most means
outputs go to those most willing and able to pay.
– Efficient market outcomes may not be fair or equitable.
– Efficient market outcome — coordinates smart choices of businesses and
consumers so outputs are produced at lowest cost (prices just cover all opportunity
costs of production), and consumers buy products and services providing the most
bang per buck (marginal benefit greater than price).
● Consumers who do not buy at equilibrium, market-clearing prices are:
– unwilling because marginal benefit is less than price (even though could afford to
buy), and/or
– unable to afford to buy, even though they are willing (marginal benefit is greater
than price).
● Allowing markets to operate without government interaction is a choice with an opportunity
cost — unfairness or inequality. There is a trade-off between efficiency and equity. In
comparing U.S. market-driven health care with Canadian universal, government-run health
care:
– Canadian-style government outcome is more equitable, but at the cost of being less
efficient.
– U.S.-style private market outcome may be efficient, but at the cost of being less
equitable.
– Health-care waiting lists are a quantity adjustment when prices . . . are fixed too
low.

Once you choose to support a political position or social goal based on your values, positive
economic thinking helps identify the smartest choices to efficiently achieve that goal.
 ● Positive (or empirical) statements — about what is.
– Can be evaluated as true or false by checking the facts.
● Normative statements — about what you believe should be; involve value judgments.
– Cannot be evaluated as true or false by checking the facts.
● Two definitions of equity:
– Equal outcomes — at the end, everyone gets the same amount.
– Equal opportunities — at the start, everyone has the same opportunities, but the
outcomes can be different.
● For any policy choice, always weigh benefits against opportunity costs.

Chapter 7

Accounting profits equal revenues minus all obvious costs, including depreciation. But
accounting profits miss the hidden, implicit opportunity costs of a business owner’s time and
money.
● Obvious costs (explicit costs) — costs a business pays directly. Accountants count all obvious
business costs and include depreciation:
 – decrease in the value of equipment over time because of wear and tear and
because it becomes obsolete.
– allowable yearly depreciation cost is the price of equipment divided by number of
years it lasts.
● Accounting profits — Revenues – Obvious Costs (including depreciation).
● Implicit costs — hidden opportunity costs of what business owner could earn elsewhere with
time and money invested.
– Opportunity cost of time — best alternative use of business owner’s time.
– Opportunity cost of money — best alternative use of business owner’s money
invested in the business; must include compensation for risk.
● Risk compensation depends on attitudes toward risk.
– A risk-loving investor does not require much compensation for taking risks.
– A risk-averse (risk-avoiding) investor requires a high compensation for taking risks.

Smart business decisions return at least normal profits — what a business owner could earn
from the best alternative uses of her time and money. There are economic profits over and
above normal profits when revenues are greater than all opportunity costs of production,
including hidden opportunity costs.
● Normal profits:
– compensation for business owner’s time and money
– sum of hidden opportunity costs (implicit costs)
– what business owner must earn to do as well as best alternative use of time and
money
– average profits in other industries
● Economic profits equal
– Revenues minus all Opportunity Costs
– Revenues − (Obvious Costs + Hidden Opportunity Costs)
– Revenues − (Obvious Costs + Implicit Costs)
– Revenues − (Obvious Costs + Normal Profits)
● Key difference between economists and accountants is that economists subtract hidden
opportunity costs when calculating profits.
– Economic profits are less than accounting profits.
● Economic losses — negative economic profits.
– If revenues are less than all opportunity costs, business owner has not made a
smart decision and would be better off in alternative uses of time and money.
– With economic losses, business owner is earning less than normal profits, less than
average profits in other industries.

The simplest rule for smart business decisions is “Choose only when economic profits are
positive.” When businesses pursue economic profits, markets produce the products and
services consumers want.
● Economic profits (and losses) serve as signal for smart business decisions.
– With economic losses (red light): businesses leave industry, supply decreases,
pushing prices up, until prices just cover all opportunity costs of production and
economic profits are zero.
– With breakeven point (yellow light): businesses just earning normal profits. Market
equilibrium with zero economic profits or losses. No tendency for change.
– With economic profits (green light): businesses expand and enter industry, supply
increases, pushing prices down, until prices just cover all opportunity costs of
production and economic profits are zero.
 ● Short-run market equilibrium — quantity demanded equals quantity supplied, but economic
losses or profits lead to changes in supply.
● Long-run market equilibrium — quantity demanded equals quantity supplied, economic profits
are zero, no tendency for change.
– The price consumers are willing and able to pay just covers businesses’ opportunity
costs of production, including normal profits.
– The difference between short-run and long-run market equilibrium is the additional
time it takes for supply changes to adjust economic profits to zero.
● On the supply side of markets, economic profits are the key signal directing businesses to
produce the products and services that consumers want. Changes in economic profits trigger
changes in supply, which changes prices, moving an industry from a short-run market
equilibrium to a long-run market equilibrium.

Chapter 9 Notes

Marginal revenue equals price for price takers and is less than price for price makers. Smart
businesses choose actions when marginal revenue is greater than marginal cost.

Marginal revenue — additional revenue from more sales or from selling one more unit. Marginal
revenue depends on market structure (how competitive an industry is) and whether a business is a
price taker or a price maker.

– Marginal revenue equals price for price-taking businesses in perfect competition.

– Marginal revenue less than price for price-making businesses in all other market structures.

One-price rule — products easily resold tend to have a single price in the market.
– When a price-making business lowers price, it must lower price on all units sold, not just new sales.
– The one-price rule is why marginal revenue is less than price for price makers.

As output increases, marginal cost increases for businesses operating near capacity or when
businesses’ additional inputs cost more. Marginal cost is usually constant for businesses not
near capacity.

- Diminishing returns — as output increases, decreasing productivity increases marginal costs.

- Businesses operating near capacity, or shifting to more expensive inputs, have increasing
marginal costs to increase output.
- Businesses not operating near capacity have constant marginal costs to increase output.

A smart business decision for maximum economic profits involves both quantity and price
decisions. The quantity decision is: Produce all quantities for which marginal revenue is
greater than marginal cost. The price decision is: Set the highest possible price that allows
you to sell that quantity. Key to maximum profits is to focus on marginal revenues and
marginal costs, not on total revenues and total costs.

- Recipe for maximum profits is easiest to follow by first looking at the quantity decision, then
the price decision.
 - – Increase in quantity yields increase in profits if marginal revenue is greater than marginal
cost.
- – Stop increasing quantity when marginal revenue is less than marginal cost.

- Once you choose the quantity with maximum economic profits (target quantity), the price part
of the recipe is to set the highest possible price that allows you to sell the target quantity.
- Intersection of the MR curve and MC curve is the key to the recipe for maximum profits.
- Fixed costs — do not change with the quantity of output produced. – rent and insurance are
examples of fixed costs.
- Economic profits = revenues – (obvious costs + normal profits)

Price discrimination is a business strategy that divides customers into groups. Businesses
increase profits by lowering the price to attract additional price-sensitive customers (elastic
demanders), without lowering the price to others (inelastic demanders).

- Price discrimination — charging different customers different prices for the same product or
service.
- Price discrimination breaks the one-price rule. Possible only when business can:
- – prevent low-price buyers from reselling to high-price buyers
- – control resentment among high-price buyers

- Most examples of price discrimination involve services, which cannot easily be resold.
- Price discrimination increases profits by:
- – charging lower price to elastic demand group (lower willingness to pay)
- – charging higher price to inelastic demand group (higher willingness to pay)

- Price-discriminating business estimates marginal revenues and marginal costs for each
separate group, then sets prices allowing the sale of all quantities for which marginal revenue
is greater than marginal cost.

Maximum profits bring efficiency for perfect competition, but inefficiency for market structures
with price-making power.

- Perfect competition, with price-taking businesses, is an efficient market structure.

- – Businesses just earn normal profits — economic profits are zero.
- – Maximum total surplus (consumer surplus plus producer surplus).

- All other market structures, with price-making businesses, are inefficient.

- – With the same inputs, businesses reduce output and raise prices.
- – Businesses earn economic profits.
- – Total surplus is less than perfect competition because of deadweight loss from reduced
output.
- There are benefits to market structures with price-making power and economic profits.
- – Product variety.
- – Economic profits finance innovations and creative destruction, improving living standards for
all.

Chapter 10 Notes
Natural monopolies are a market-failure challenge for policymakers — gain the low-cost
efficiencies of economies of scale, but avoid the inefficiencies of monopoly’s restricted output
and higher price.
● Market failure — when markets produce outcomes that are inefficient or inequitable.
● Economies of scale — average total costs decrease as quantity of output increases.
● Natural monopoly — economies of scale allows only a single seller to achieve lowest average
total cost.
– Natural monopolies are an example of market failure.
– Natural monopolies are based on current technology. When technology changes,
natural monopoly may change to more competitive market structures.
● The two major policies governments use to deal with challenge of natural monopoly are public
ownership and regulation.
– Crown corporations — publicly owned businesses in Canada. – Achieve economies
of scale, but lack of competition weakens incentives to reduce costs or innovate.
– Rate of return regulation — set price allowing regulated monopoly to just cover
average total costs and normal profits.

Strategic interaction among competitors complicates business decisions, creating two smart
choices — one based on trust and the other based on lack of trust.
● Game theory — a mathematical tool for understanding how players make decisions, taking
into account what they expect rivals to do.
– Gasoline pricing is a strategic decision that can be understood using game theory.
● Prisoners’ dilemma — a game with two players who must each make a strategic choice,
where results depend on the other player’s choice.
● Nash equilibrium — outcome of a game in which each player makes her own best choice
given the choice of the other.
● Two smart choices exist in a prisoners’ dilemma game: one based on lack of trust and one
based on trust.
– If the other player cannot be trusted, the smart choice is to cheat/confess; all
players are driven to the Nash equilibrium outcome where everyone
cheats/confesses.
– If the other player can be trusted, the smart choice is to cooperate/deny; all players
are driven to the equilibrium outcome where everyone cooperates/denies.
– The prisoners’ “dilemma” is that each player (prisoner) is motivated to cheat
(confess), yet both would be better off if they could trust each other to cooperate
(deny).

Governments use laws and regulations to try to promote competition, discourage cartels, and
protect the public from dangerous business practices.
● Collusion — conspiracy to cheat or deceive others.
● Cartel — association of suppliers formed to maintain high prices and restrict competition.
– OPEC (Organization of Petroleum Exporting Countries) is an international cartel
that acts like a monopoly.
● – Desirable competitive behaviour — always an active attempt to increase profits and gain the
market power of monopoly — is hard to distinguish from undesirable collusive behaviour.
● The Competition Act attempts to prevent anti-competitive business behaviour and raises the
expected costs to business of price fixing (through prison time, fines, legal prohibition) relative
to the expected benefits (profits).
 – Criminal offences (punished by prison time, fines): price fixing, bid rigging,
false/misleading advertising.
– Civil offences (punished by fines, legal prohibitions): mergers, abusing dominant
market position, lessening competition.
– The Competition Tribunal weighs the costs of lessening competition against the
benefits of any increased efficiencies.
● Caveat emptor (“let the buyer beware”) — the buyer alone is responsible for checking the
quality of products before buying.
● Certain products — nuclear power, medicines, poisonous insecticides — are regulated by
government because the average consumer cannot know the product’s quality.
● Major forms of government regulation in Canada: government departments, agencies and
boards, professional associations.

The public-interest view of government regulation suggests government actions improve

market-failure outcomes, while the capture view suggests government actions produce
government failure.
● Public-interest view — government regulation eliminates waste, achieves efficiency, and
promotes the public interest.
● Capture view — government regulation benefits the regulated businesses, not the public
interest.
● Evidence is mixed on government regulation — some supports the public-interest view, some
supports the capture view.
– Most economists agree that the Competition Act serves the public interest well.
● Government failure — when regulations fail to serve public interest.
– Sometimes the market outcome, even with monopoly power, is better than the
government regulation outcome if there is significant government failure.
– Sometimes the government outcome, especially with public interest regulations, is
better than the market outcome if there is significant market failure.
● Economic thinking cannot make normative policy choices for you, but can help answer the
positive question, “Will government action improve market failure outcomes, or will
government action fail and produce a worse outcome than market failure?”

Chapter 11 Notes

When externalities exist, prices don’t reflect all social costs and benefits; markets fail to
coordinate private smart choices with social smart choices.
● Negative externalities (external costs) — costs to society from your private choice that affect
others, but that you do not pay.
● Positive externalities (external benefits) — benefits to society from your private choice that
affect others, but that others do not pay you for.
● Externalities occur when clear property rights are missing.
– Tragedy of the commons — the overuse and depletion of a resource that no one
can be excluded from because of missing property rights.
– Free riders — those who consume products or services without paying.
 ● When externalities exist, prices don’t reflect all social costs and benefits, and markets fail to
produce efficient outcomes. Instead markets produce:
– too many products and services with negative externalities (second-hand smoke,
pollution, traffic jams).
– too few products and services with positive externalities (vaccinations, education).

For an efficient market outcome when there are negative externalities, choose the quantity of
output where marginal social cost equals marginal social benefit.
● “Efficient pollution” balances the additional environmental benefits of lower pollution with the
additional opportunity costs of reduced living standards.
– The socially desirable amount of pollution is not zero; at some point the additional
opportunity costs of reducing pollution are greater than the additional benefits of
lower pollution.
● The market quantity and price are determined at the intersection of the marginal private
benefit and marginal private cost curves.
● For any product or service that generates an externality, the rule for a smart choice is:
Choose the quantity of output where marginal social cost equals marginal social benefit.
– Marginal social cost (MSC) = marginal private cost (MC) plus marginal external cost
– Marginal external cost = price of preventing or cleaning up damage to others
external to the original activity
– Marginal social benefit (MSB) = marginal private benefit (MB) plus marginal external
benefit
– Marginal external benefit = price of the value or savings to others external to the
original activity
● Markets overproduce products and services with negative externalities; the price is too low
because it does not incorporate external costs.

For an efficient market outcome when there are negative externalities, choose the quantity of
output where marginal social cost equals marginal social benefit.
● “Efficient pollution” balances the additional environmental benefits of lower pollution with the
additional opportunity costs of reduced living standards.
– The socially desirable amount of pollution is not zero; at some point the additional
opportunity costs of reducing pollution are greater than the additional benefits of
lower pollution.
● The market quantity and price are determined at the intersection of the marginal private
benefit and marginal private cost curves.
● For any product or service that generates an externality, the rule for a smart choice is:
Choose the quantity of output where marginal social cost equals marginal social benefit.
– Marginal social cost (MSC) = marginal private cost (MC) plus marginal external cost
– Marginal external cost = price of preventing or cleaning up damage to others
external to the original activity
– Marginal social benefit (MSB) = marginal private benefit (MB) plus marginal external
benefit
– Marginal external benefit = price of the value or savings to others external to the
original activity
● Markets overproduce products and services with negative externalities; the price is too low
because it does not incorporate external costs.
With positive externalities, buyers and sellers are not paid for the external benefits their
exchange creates. The market-clearing price is too high for buyers to be willing to buy the
socially best quantity of output, and too low for sellers to be willing to supply.
● Public goods — provide external benefits consumed simultaneously by everyone; no one can
be excluded.
– Public goods like lighthouses and national defence are extreme examples of
positive externalities.
● Free-rider problem — markets underproduce products and services with positive externalities.
– Price charged to buyers is too high.
– Price received by sellers is too low.
● The smart social quantity of output with positive externalities is at the intersection of the
marginal social benefit and marginal social cost curves.
– With positive externalities, no single price can coordinate smart individual choices
and smart social choices.
– The market-clearing price is too high for buyers to be willing to buy and too low for
sellers to be willing to supply.

When there are positive externalities, government subsidies can get everyone to voluntarily
choose the socially best quantity of output where marginal social benefit equals marginal
social cost.
● Subsidy — payment to those who create positive externalities.
– Smart subsidy = marginal external benefit of savings to others associated with an
activity.
– Subsidies remove the disconnect between prices for buyers and sellers caused by
positive externalities, leading individuals and businesses to voluntarily choose the
quantity of output best for society.
– Subsidies to either suppliers or demanders can achieve an efficient social outcome.
● Public provision — government provision of products or services with positive externalities,
financed by tax revenue.

Chapter 12 Notes

Incomes are determined by prices and quantities in input markets, where households supply
to businesses labour, capital, land, and entrepreneurship in exchange for wages, interest, rent,
and profits.
● In input markets, households are sellers and businesses are buyers.
● Income — what you earn — is a flow.
— Flow — amount per unit of time.
— Income for labour, capital, and land = price of input × quantity of input
● Wealth — total value of assets you own — is a stock.
— Stock — fixed amount at a moment in time.
 ● Key concepts for explaining input incomes are
— marginal revenue product for labour
— present value for capital
— economic rent for land
● Entrepreneurs earn profits. Economic profits are a residual — what is left over from revenues
after all opportunity costs of production (including normal profits) have been paid.

For maximum profits, businesses should hire additional labour when marginal revenue
product is greater than marginal cost.
● To hire labour, business must pay the market wage reflecting the best opportunity cost of the
input owner.
● Business demand for labour is a derived demand — demand for output and profits
businesses can derive from hiring labour.
● Marginal product — additional output from hiring one more unit of labour.
— When businesses hire additional labourers there is diminishing marginal
productivity — as you add more of a variable input to fixed inputs, the marginal
product of the variable input eventually diminishes.
● Marginal revenue product — additional revenue from selling output produced by an additional
labourer.
— marginal revenue product = marginal product × price of output.
— Marginal revenue product diminishes for additional labourers.
● Recipe for maximum profits for business — hire additional inputs when marginal revenue
product is greater than marginal cost.

Present value tells you what money earned in the future is worth today. Present value
compares the price you pay for today’s investment against the investment’s future earnings.
For a smart choice, the present value of the investment’s future earnings is greater than the
investment’s price today.
● The present value of a future amount of money is the amount that, if invested today, will grow
as large as the future amount, taking account of earned interest.
● Present Value = Amount of Money Available in n Years(1+ Interest Rate)n
● Revenues available in the future are not worth as much as revenues today because today’s
revenues earn interest.

— Discount — reduction of future revenues for forgone interest.

● Present value simplifies the future stream of revenues from an investment to a single number
today. It converts the flow of future revenues into stock concept, a value today that you
compare with cost today to make a smart choice.
● Recipe for a smart investment choice — invest when the present value of the stream of future
earnings is greater than the price of the investment.

Income for any input in inelastic supply, for example land or superstar talent, is economic rent,
which is determined by demand alone.
● Economic rent — income paid to any input in relatively inelastic supply.
— Land is a classic example of an input in inelastic supply.
● For inputs like land in inelastic supply, prices are effectively determined by demand alone.
 ● For most products and services, high input prices cause high output prices.
● For inputs in inelastic supply, high output prices cause high input prices — high economic
rents.
●
Government policies to address the market’s unequal distributions of income and wealth
involve trade-offs between efficiency and equality.
● “What are you worth?” is a positive question; depends on quantities of inputs you own and
prices markets place on those inputs.
● “What should you, or any person, be worth?” is a normative question you must answer as a
citizen.
● Poverty results from not owning labour skills or assets that the market values, or from not
getting a high enough price for what you do own.
● Policy options to reduce inequality and poverty: education, training, progressive tax and
transfer system.
● Improving human capital through education and training addresses underlying cause of
poverty: lack of inputs the market values.
— Human capital — increased earning potential from work experience, on-the-job
training, education.
● Federal and provincial tax systems use progressive taxes — tax rate increases as income
increases.
— Regressive taxes — tax rate decreases as income increases.
— Proportional (flat-rate) taxes — tax rate the same regardless of income.
— Marginal tax rate — rate on additional dollar of income.
— Transfer payments — payments by government to households.
● Due to incentive effects, “A more equally shared pie may be a smaller pie.”
● An efficient market outcome is not necessarily fair or equitable. May include poor people
unable to pay for basic necessities like shelter, food, medical care.
● Governments can reduce poverty and inequality using tax–and-transfer systems to take from
rich and give to poor (like Robin Hood).
— Costs and benefits of policies to help the poor apply to different people. How you
feel about Robin Hood’s motto depends on whether you are being taken from or
given to.