Lecture 1

Five Core Principles

1) Scarcity implies trade off: We have unlimited wants and limited resources. Hence having more
of one good thing usually means having less of another.
2) Bargaining Strength Comes Through Scarcity
3) An action should be taken if, and only if, the benefit is at least as great as the cost
4) The likelihood of taking an action rises as the benefit rises and falls as the cost rises.
5) Focus on Your Comparative Advantage: Everyone gains when each individual (or each
country) concentrates on the activities in which her opportunity cost is lowest.

Concept of Scarcity
Limited resources (quantity) cannot satisfy unlimited wants (Demand)
Individuals face a scarcity of resources, e.g., money, time.
Society faces a scarcity of resources:
1. Labor: Number of workers
2. Capital: Physical capital (tangible like factories and machines and tools), human capital
(workers’ knowledge skills and experience)
3. Land and natural resources: Fossil fuels and mineral ores
4. Entrepreneurship: Refers to someone/firm that is responsible for decision making that
combines labor, capital, land and resources to provide a goods/services. In return,
entrepreneurs receive profits for their entrepreneurial abilities.

Concept of Opportunity Cost

Making decisions requires comparing the costs and benefits of alternative choices.
The opportunity cost of any choice is whatever must be given up when we make that choice.
Opportunity Cost is the next best alternative forgone after making a choice
1. Explicit cost: monetary sacrifice.
2. Implicit cost: non-monetary sacrifice, e.g., time.
Opportunity Cost = Explicit cost + Implicit cost
When the alternatives to a choice are mutually exclusive (meaning 2 or more events cannot
happen at the same time, you can either have this or that) , the implicit cost of the choice is the
value of the next best alternative.
When the alternatives to a choice are not mutually exclusive (meaning 2 more of events can
happen at the same time, both this or that can happen), should select all choices available
Three exceptions that there will be no opportunity cost:
1) Free goods: Goods produced by nature and in abundance such that no opportunity cost is
involved in their use.

 Abundance  More than enough to go around to those that wants it

 Produced by nature  no sacrifices in resources for other production
 Example: Sand from Sahra Desert, sea water, air
2) Idle factors or production: Unemployed/ Idle factors of production such as unemployed
workers, unutilized cranes. Then is possible to not forgo anything and the opportunity cost of
using these idle factors of production is zero.
3) Single-use factors of production: When factors of production can only be used to produce a
particular type of good and nothing else. Opportunity cost of using the factor of production = 0
as no other alternatives given up. An example would be hydroelectric plants (capital) built to
produce electricity. Once the plant is constructed, there is no other use apart from producing
electricity. HOWEVER, the construction of the hydroelectric plant is not 0 opportunity cost.

Concept of Positive Economics vs Normative Economics

Positive Economics:

 Can be answered with the tools of economics (theories and facts), without interjecting
any value judgment as to whether the particular outcome is desirable or harmful.
 Either true or false
 The statement can be tested or verified
Normative Economics:

 Answers to normative questions require value judgements.

 Statement cannot be tested or verified
 It is the values/feelings of people
Concept of Production Possibilities Frontier (PPF)
A graph that shows all combinations of two goods that can be produced given the available
resources and technology.

Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to
the production of the other good.

 To get one more unit of good X how many units of good Y should I give up?
 The slope of the PPF indicates the opportunity cost of good x in terms of good y.
When looking for the opportunity cost of something (X). X should be in the DENOMINATOR
and in 1 unit

PPF curve shift outwards  Economic growth (additional resources such as labor or land or an
improvement in technology) Pivotal shift at one point also means economic growth but only in
1 industry only
PPF curve shifts inwards  the economy is shrinking due to a failure to allocate resources and
optimal production capability. A shrinking economy could result from a decrease in supplies or a
deficiency in technology.
Comparative Advantage vs Absolute Advantage
Two countries can gain from trade when each specializes in the good it produces at lowest
cost.
Gains from trade arise from comparative advantage (differences in opportunity costs). When
each country specializes in the good in which it has a comparative advantage, total production
in all countries is higher, the world’s economic pie is bigger, and all countries can gain from
trade.
If each country has an absolute advantage in one good and specializes in that good, then both
countries can gain from trade.
Absolute advantage: the ability to produce a good using fewer inputs (such as labour hours)
than another producer.
Comparative advantage: the ability to produce a good at a lower opportunity cost than
another producer. (Give up less unit of goods)

 In the case of 2 goods, having a comparative advantage in 1 good means not having a
comparative advantage in another.
Having a comparative advantage does not equate to absolute advantage.
 Lecture 2
Market economy allocates resources through the decentralized decisions of households and
firms as they interact in markets for goods and services.
In perfectly competitive markets:

 Goods and services are practically identical.

 Buyers and sellers are so numerous that no one can affect the market price.
 Everyone is a price taker.

Demand Supply
The quantity demanded of any good is the Quantity supplied of any good is the amount
amount of the goods that buyers are willing of the good that sellers are willing and able to
and able to purchase.  A specific number sell  A specific number
(10 pints of ice cream, 20 units of XX)
Law of supply: As the price of a good
Law of demand: As the price of a good increase, the quantity supplied increase,
increase, the quantity demanded decrease, ceteris paribus.
ceteris paribus.
Price affects quantity supplied  It is a
Price affects quantity demanded  It is a movement along the curve (No left/right
movement along the curve (No left/right shifting of curve)
shifting of curve)
Non price factors affect supply  It is a shift
Non price factors affect demand  It is a in the curve (A left/right shift)
shift in the curve (A left/right shift)
Non price factors include:
Non price factors include: Number of sellers (More sellers  increase
Number of buyers (More buyers  increase quantity supplied at each price  shifts S
quantity demanded at each price  shifts D curve to the right)
curve to the right)
Input prices – Cost of producing the good
Income (More income  increase quantity Examples of input prices: prices of raw
demanded at each price  shifts D curve to material, wages, prices of machinery,
the right for NORMAL good) rental prices of retail space.
A fall in input prices makes production more
Income (More income  decrease quantity profitable at each output price  firms
demanded at each price  shifts D curve to supply a larger quantity at each price  S
the left for INFERIOR good) curve shifts to the right.

Taste and Prefernce (Anything that causes a Technology (A cost-saving technological

shift in tastes toward a good will increase improvement or more efficient technology
demand for that good and shift its D curve to has the same effect as a fall in input prices,
the right.) and shifts the S curve to the right.)
 Expectations affect consumers’ buying Weather for agricultural commodities
decisions, e.g., If people expect their incomes Ideal weather conditions bring a bumper
to rise, their demand for meals at expensive harvest of sweet and rosy apples; the S curve
restaurants may increase now shifts right.
Freezing temperatures in California damage
Two goods are substitutes if an increase in the state’s citrus crops; the S curve shifts left.
the price of one good causes a(n) increase in
the demand for the other good. Expectations affect producers’ supply
decisions.
Two goods are complements if an increase in Events in the Middle East lead to
the price of one good causes a(n) decrease expectations of higher oil prices. In response,
in the demand for the other good. oil fields in Brunei reduce supply now, saving
some inventory to sell later when prices are
higher. The S curve shifts left.

Concept of Surplus and Shortages

Concept of Shift in Supply and Demand

Both curve shift right  Q will definitely increase but effect on price ambiguous depending on
which curve shift more

 If Demand increase more than supply  Price increase

 If supply increases more than demand  Price decrease
 Lecture 3
Elasticity is a measure of the responsiveness of QD or QS to one of its determinants (price, price
of a related good, income)
Concept of Price Elasticity of Demand

Price elasticity of demand measures how much Q D responds to a change in P

 Price is the factor that change  Quantity will respond to the price change
 PED measures Qd (movement along the Dd curve)
 Loosely speaking, it measures the price-sensitivity of buyers’ demand.
 Value PED is not equal to the slope of the curve
The price elasticity of demand is closely related to the slope of the demand curve.
Rule of thumb

 The flatter the curve, the greater the elasticity.  more elastic
 The steeper the curve, the smaller the elasticity  more inelatic
 Perfectly inelastic demand Inelastic Demand Elastic Demand Perfectly elastic Unit Elastic Demand
demand
Verbal Consumer does not No matter how Consumer Consumer Price change is
explanation respond to price much price change responsive to very proportionate/equal
changes at all  No still have to buy  price changes responsive to to the change in Q
change in Q no matter Consumer not (price price changes
how the P change responsive to price sensitive) 
changes change in price When P
will lead to a change a little
Reduction in price more than  QD shifts
does not increase proportionate by a lot
demand much, and change in QD
an increase in price
does not hurt Price fall < rise
demand in QD
Q has a bigger
Price fall > rise in QD effect

Examples Water, Salt Necessity like rice, Luxury items Very high end
water like cars products
Graph Vertical demand curve Steep curve Flat curve Horizontal Intermediate slope
curve

Numerical PED = 0 PED < 1 PED >1 PED =1

value
The price elasticity of demand depends on:

 how broadly or narrowly the good is defined (The price elasticity of demand is greater
for narrowly defined goods than for broadly defined ones.  Consumer more
responsive in narrowly defined goods as there are more substitute available)
 whether the good is a necessity or a luxury ( PED more elastic for luxuries products vs
necessity)
 the extent to which close substitutes are available (The more substitutes available for
products will make the demand more elastic)
 how expensive the good is (The price elasticity of demand is greater for expensive goods
 than for cheap ones.)
 the time horizon — elasticity is higher in the long run than in the short run (In the long
run, there will be more options for you to respond, more responsive = more elastic)

Concept of Cross-price Elasticity of Demand

 Positive (>0) or Negative (<0)?

 For substitutes, cross-price elasticity > 0 Positive (Increase P of one good  Increase
demand for qty of substitute good)
 For complements, cross-price elasticity < 0 Negative (Increase P of one good  Decrease
demand for the quantity of complements)
Cross-price elasticity of demand measures how much QD responds to a change in the price of
another good.

Concept of Income Elasticity of Demand

Income elasticity of demand measures how much QD responds to a change in income
For normal goods, income elasticity > 0 (Positive) Income go up by X%  Consume more normal
goods.
For inferior goods, income elasticity < 0 (Negative) Income go up by X%  Consume less
inferior goods

Concept of PES (Price Elasticity of Supply)

Price elasticity of supply measures how much Q S responds to a change in P
Use the midpoint method
Price elasticity of demand measures how much QS responds to a change in P

 Price is the factor that change  Quantity Supplied will respond to the price change
 PES measures Qs (movement along the SS curve)
 Loosely speaking, it measures the price-sensitivity of Seller Supply.
 Value PES is not equal to the slope of the curve
The price elasticity of supply is closely related to the slope of the supply curve.
Rule of thumb

 The flatter the curve, the greater the elasticity.  more elastic (Seller more
responsive)
 The steeper the curve, the smaller the elasticity  more inelastic (seller less
responsive)
PES is determined by:

 The more easily sellers can change the quantity they produce, the greater the price
elasticity of supply, e.g., The supply of submarines is harder to vary and thus less elastic
than the supply of sampan.
 For many goods, the price elasticity of supply is greater in the long run than in the short
run because in the long run firms can build new factories, or new firms may be able to
enter the market.
Concept of WTP and Efficiency of market
Willingness to Pay (WTP)  A buyer’s willingness to pay for a good is the maximum amount
the buyer will pay for that good.
WTP measures how much the buyer values the good. A buyer will buy a good only if his
willingness to pay (WTP) is at least as high as the price.
Consumer surplus (CS) is the amount a buyer is willing to pay minus the amount he actually
pays.
CS = WTP – P. A higher price reduce CS (Fall in CS due to remaining buyers paying higher P and
Fall in CS due to buyers leaving market)
Concept of Concept and Producer Surplus
Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost)
including the cost of inputs and the value of the seller’s time.
A seller will produce and sell a good only if the price is at least as high as his cost of producing.
Hence cost is a measure of willingness to sell.
Producer surplus (PS) is the amount a seller is paid for a good minus his cost.
PS = P – Cost
A welfare loss in the market is the dollar value of potential benefits not achieved due to
inefficiency in that market.
First Fundamental Theorem of Welfare Economics
Assume that:

 There are markets and market prices for all goods.

 All buyers and sellers are competitive price-takers. (meaning no externality)
 Each person’s utility depends only on his own consumption. (meaning no externality)
Then any market equilibrium is efficient. If assumption do not hold then the market is not
efficient
If any of the assumptions do not hold, e.g., if markets are not perfectly competitive, then
resources may not be allocated efficiently.
Examples of market failures:

 Markets are not perfectly competitive, i.e., a buyer or seller has market power — the
ability to affect the market price.
 Transactions have externalities (side effects that affect bystanders, e.g., pollution)
 Lecture 4

 Price ceiling: A legal maximum on the price of a good or service, e.g., rent control.
 Price floor: A legal minimum on the price of a good or service, e.g., minimum wage.
 Tax: Payment by buyers/sellers to the government on each unit bought or sold.
 Subsidy: Payment by the government to buyers/sellers on each unit bought or sold.

A price ceiling may result in a black market, where goods are sold illegally at prices above the
legal ceiling, and typically above the original equilibrium price.
Concept of Tax

 Tax on buyers shifts the D curve down by the amount of the tax  Wedge in tax from
left
 Tax on sellers shifts the S curve up by the amount of the tax.
The consequence of imposing a tax on a good that has no negative externalities
will lead to losses in surplus for buyers and for sellers (meaning DWL) that,
taken together, exceed the tax revenue collected by the government = DWL
always larger than TR assuming elasticity is not 0
A tax distorts the incentives of both buyers and sellers. And it prevents some buyers
and some sellers from realizing gains from trade.

The effects on P and Q and the tax incidence are the same whether the tax is imposed on
buyers or sellers.
Whoever is more inelastic (PED or PES) gets the most/worse out of the subsidy or tax.
Tax reduced the equilibrium qty from Qe to Qt
Because of the tax, the units between QT and QE are not sold. The value of these units to
buyers (Pb) is greater than the cost of producing (Ps) them. The tax prevents some
mutuallybeneficial trades (either the buyer or seller or both will benefit from the trade)
What determines the size of the DWL? The price elasticities of supply and demand.

More inelastic  harder to leave the market  Tax only reduce Qty by a little so DWL is small
More elastic the demand  Easier it is for buyers to leave the market  Q will experience a
great fall  Greater DWL

Concept of subsidies
A subsidy to buyers shifts the D curve up by the amount of the subsidy.
A subsidy to sellers shifts the S curve down by the amount of the subsidy.