Unit 1: Introduction to Economics

1. The foundations of economics

The Social Nature of Economics

● Economics is a social science
○ Social sciences study societies and the human interactions within those societies
○ Human interactions are complex and are influenced by many variables
○ Social sciences also include subjects such as Psychology, Politics, Geography and Business
Studies

● Due to the complexities within societies, economists build models so as to better understand certain
interactions
○ A model is a simplified version of reality
○ Some models are more complex than others. Examples of models include, the circular flow of
income, production possibility curves, demand and supply
○ All models make a range of assumptions. These are often generalizations about behaviour,
choices and likely outcomes
○ These assumptions are necessary so as to account for complex human behaviour and
constantly changing variables
○ When evaluating different models, the underlying assumptions should always be considered

● To think like an economist involves identifying which variables will be studied and which ones will be
excluded
○ This way of thinking considers the type of relationship between variables (causal or correlation).
E.g. Data shows that when ice cream sales increase, so do car thefts. Correlation, yes.
Causation, no
○ Some economists will build an argument to include certain variables in a study and others will
argue to exclude them. They will each provide a justification for their decision
○ Two economists analyzing the same data may end up with vastly different interpretations. This
is often due to the different variables that each economist chooses to focus on
○ This is the complexity found within social sciences

Microeconomics & Macroeconomics

● Microeconomics is the study of individual markets and sections of the economy, rather than the
economy as a whole. Microeconomics examines:
○ The different choices individuals, households and firms make
○ What factors influence their choices
○ How their decisions affect the price, demand and supply of goods/services in a market
○ How Governments influence consumption and production

● Macroeconomics is the study of economic behavior and decision making in the entire economy, rather
than just an individual market. Macroeconomics examines:
○ The role of the government in achieving economic growth and human development through the
implementation of specific government policies (fiscal, monetary and supply-side)
○ The role of the government in achieving price stability, low unemployment and a stable Current
Account balance on the Balance of Payments account
○ The interaction of the economy with the rest of the world through international trade
Some of the Differences Between Micro and Macroeconomics
Microeconomics Macroeconomics

Single market e.g milk Entire economy e.g Singapore

Price of a good/service Average price levels in an economy

(inflation/deflation)

Individual/market demand Total demand in an economy

Individual firm/market supply Total supply in an economy

Government intervention in a market e.g cigarettes Government intervention in the economy e.g income
tax

Reasons for differences in workers wages Unemployment and minimum wages

The Nine Central Concepts

● Most student learning focuses on topics and within each topic is the acquisition of facts
● Each topic is better understood within broader concepts
○ E.g. globalization as a topic is interesting, but it makes much more sense when studied within
the concept of interdependence that exist between nations

Understanding the concepts and using them helps to deepen your critical thinking skills
E.g. Thinking about how a particular tax policy relates to the concepts of equity, efficiency or
government intervention requires critical thinking

Scarcity: since resources are scarce, economics is a study of choices. It is clear that not all needs and wants
can be satisfied; this necessitates choice and gives rise to the idea of opportunity cost. Economic
decision-makers continually make choices between competing alternatives, and economics studies the
consequences of these choices, both present and future

Efficiency: is a quantifiable concept, determined by the ratio of useful output to total input. Allocative efficiency
refers to making the best possible use of scarce resources to produce the combinations of goods and services
that are optimum for society, thus minimizing resource waste
Intervention: intervention in economics usually refers to government involvement in the workings of markets.
There is often disagreement among economists and policymakers on the need for, and extent of, government
intervention. There is a considerable debate about the merits of intervention versus the free market

Change: the economic world is continuously changing and economists must adapt their thinking accordingly.
Economics focuses not on the level of the variables it investigates, but on their change from one situation to
another. There is continuous and profound change at institutional, structural, technological, economic and
social levels

Choice: since resources are scarce, economics is a study of choices. It is clear that not all needs and wants
can be satisfied; this necessitates choice and gives rise to the idea of opportunity cost. Economic
decision-makers continually make choices between competing alternatives, and economics studies the
consequences of these choices, both present and future

Sustainability: is the ability of the present generation to meet its needs without compromising the ability of
future generations to meet their own needs. It refers to limiting the degree to which the current generation’s
economic activities create harmful environmental outcomes involving resource depletion that will negatively
affect future generations

Equity: in contrast to equality, which describes situations where economic outcomes are similar for different
people or different social groups, equity refers to the idea of fairness. Fairness is a normative concept, as it
means different things to different people. The degree to which markets versus governments should, or are
able to, create greater equity or equality in an economy is an area of much debate

Interdependence: individuals, communities and nations are not self sufficient. Consumers, companies,
households, workers, and governments, all economic actors, interact with each other within and, increasingly,
across nations in order to achieve economic goals. The greater the level of interaction, the greater will be the
degree of interdependence

Economic well-being: is a multidimensional concept relating to the level of prosperity and quality of living
standards enjoyed by members of an economy.
It includes
● present and future financial security
● the ability to meet basic needs
● the ability to make economic choices permitting achievement of personal satisfaction
● the ability to maintain adequate income levels over the long term

NOTE
The definitions for these 9 concepts have been supplied by the International Baccalaureate (IBO). These
concepts are widely defined and open to interpretation, hence it is important to use these concepts exactly as
the IBO has defined them

The Factors of Production

● Factors of production are the resources used to produce goods and services
○ Land, labor, capital and enterprise

● The production of any good/service requires the use of a combination of all four factors of production
○ Goods are physical objects that can be touched (tangible) e.g. mobile phone
○ Services are actions or activities that one person performs for another (intangible) e.g manicure,
car wash

The Four Factors of Production

1. Land
Non man-made natural resources available for production. Some countries have a vast amount of a particular
natural resource and so are able to specialize in its production e.g. oil

2. Labour
The human input into the production process. Labour involves mental or physical effort. Not all labor is of the
same quality. It can be skilled or unskilled

3. Capital
Capital is any man-made resource that is used to produce goods/services e.g. tools, buildings, machines and
computers

4. Enterprise
Enterprise involves taking risks in setting up or running a firm. An entrepreneur decides on the combination of
the factors of production necessary to produce goods/services with the aim of generating profit

● In a free market economic system, the factors of production are privately owned by households or firms
○ Households make these resources available to firms who use them to produce goods/services
○ Firms purchase land, labour, and capital from households in factor markets

● Households receive the following financial rewards for selling their factors of production. This reward is
called factor income
○ The factor income for land → rent
○ The factor income for labour → wages
○ The factor income for capital → interest
○ The factor income for entrepreneurship → profit

The Basic Economic Problem: Scarcity

● The basic economic problem is that resources are scarce
○ In economics, these resources are called the factors of production

● There are finite resources available in relation to the infinite wants and needs that humans have
○ Needs are essential to human life e.g. shelter, food, clothing
○ Wants are non-essential desires e.g. better housing, a yacht etc.

● Due to the problem of scarcity, choices have to be made by producers, consumers, workers and
governments about the best (most efficient) use of these resources
● Economics is the study of scarcity and its implications for resource allocation in society

All Stakeholders in an Economy face the Basic Economic Problem

Consumers Producers Workers Government

In a free market, scarcity Producers selling Workers may want a Governments have to
has a direct influence on products made from more comfortable and decide if they will provide
prices scarce resources will find safer working certain goods/services or
their costs of production environment but their if they will allow private
The scarcer a resource are higher than if they employers may not have firms to provide them
or product, the higher the were selling products the resources to create it instead
price consumers will pay made from more
abundant resources Their decision influences
the allocation of
resources in society
Opportunity Cost Defined
● Opportunity cost is the loss of the next best alternative when making a decision
● Due to the problem of scarcity, choices have to be made about how to best allocate limited resources
amongst competing wants and needs
● There is an opportunity cost in the allocation of resources
○ E.g. When a consumer chooses to purchase a new phone, they may be unable to purchase
new jeans. The jeans represent the loss of the next best alternative (the opportunity cost)

Opportunity Cost in Decision Making

● An understanding of opportunity cost may change many decisions made by consumers, workers, firms
and governments
● Factoring the opportunity cost into a decision often results in different outcomes and so a different
allocation of resources

Examples of how the Consideration of Opportunity Costs can Change Decisions

Stakeholder Example

Consumer ● Ashika is wanting to visit her best friend in

Iceland
● She looks at flight prices from London to
Reykjavík
● On Friday night it costs £120 whereas
Thursday night is only £50
● She is about to book the Thursday flight but
then realises that the opportunity cost of
saving £60 on a flight is the inability to work
on Friday (loss of £130 income)
● Ashika books the more expensive flight. If
she had booked the cheaper flight, it would
have cost her the income from the missed
day of work (£130) + £50 for the ticket

Worker ● Ric has been offered two jobs and is deciding

which one to accept
● Job A offers £400 a month more in salary
than Job B, but Job B offers the flexibility of
working from home
● Most people would only consider the actual
cost of commuting before they make a
decision, which in Ric's case is £40 a week or
£160 a month
● Ric values his free time and decides that
each hour he can save in commuting is worth
£20 to him (£180 a week), he is considering
the opportunity cost of commuting
● Ric decides to take Job B as the cost of
monthly travel (4 x £40) and value of the lost
hours spent commuting (4 x £180) adds up to
£880 a month
Economic Goods & Free Goods
● Economic goods are scarce in relation to the demand for them
○ This makes them valuable
○ Due to their value, producers will attempt to supply them in order to make a profit
○ Anything that has a price tag on it is an economic good e.g. oil, corn, gold, trainers, watches
and bicycles

● Free goods are abundant in supply

○ Due to this abundance, it is not possible to make a profit from supplying free goods
○ Drinking water has been a free good for thousands of years, but as the population increases
and water sources become more polluted, it has become an economic good
○ E.g. sunlight, the air we breathe, sea water

Economic Systems
● In order to solve the basic economic problem of scarcity, economic systems emerge or are created by
different economic agents within the economy
○ These agents include consumers, producers, the government, and special interest groups (e.g.
environmental pressure groups or trade unions)
○ Any economic system aims to allocate the scarce factors of production

● The three main economic systems are a free market system, mixed economy, and planned economy

What determines the economic system of a country?

How the three questions are answered determines the economic system of a country
● Each economy has to answer three important economic questions

1. What to produce? As resources are limited in supply, decisions carry an opportunity cost. Which
goods/services should be produced e.g. better rail services or more public hospitals?

2. How to produce it? Would it be better for the economy to have labour-intensive production so that more
people are employed, or should goods/services be produced using machinery?

3. Who to produce it for? Should goods/services only be made available to those who can afford them, or
should they be freely available to all?
How These Questions are Answered Determines the Economic System
Types of system What to produce? How to produce? For whom to produce?

Market system Demand and supply (the Most efficient, profitable Those who can afford it
price mechanism) way possible.

Mixed system Demand, supply and the Some efficiency but also Those who can afford it,
Government a focus on plus some provision to
welfare/well-being those who cannot afford
it

Planned System The Government Ensure everyone has a Everyone

job

The Production Possibilities Curve Model (PPC)

An Introduction to the PPC
● The Production Possibility Curve (PPC) is an economic model that considers the maximum possible
production (output) that a country can generate if it uses all of its factors of production to produce only
two goods/services
● Any two goods/services can be used to demonstrate this model
● Many PPC diagrams show capital goods and consumer goods on the axes
○ Capital goods are assets that help a firm or nation to produce output (manufacturing). For
example, a robotic arm in a car manufacturing company is a capital good
○ Consumer goods are end products and have no future productive use. For example, a watch
Diagram Explanation
● The use of PPC to depict the maximum productive potential of an economy
○ The curve demonstrates the possible combinations of the maximum output this economy can
produce using all of its resources (factors of production)
○ At A, its resources are used to produce only consumer goods (300)
○ At B, its resources are used to produce only capital goods (200)
○ Points C and D both represent full (efficient) use of an economy's resources as these points fall
on the curve. At C, 150 capital goods and 120 consumer goods are produced

● The use of PPC to depict opportunity cost

○ To produce one more unit of capital goods, this economy must give up production of some units
of consumer goods (limited resources)
○ If this economy moves from point C (120, 150) to D (225, 100), the opportunity cost of
producing an additional 105 units of consumer goods is 50 capital goods
○ A movement in the PPC occurs when there is any change in the allocation of existing resources
within an economy such as the movement from point C to D

● The use of PPC to depict efficiency, inefficiency, attainable and unattainable production
○ Producing at any point on the curve represents productive efficiency
○ Any point inside the curve represents inefficiency (point E)
○ Using the current level of resources available, attainable production is any point on or inside the
curve and any point outside the curve is unattainable (point F)

Assumptions of the Model

● The PPC Model is a simplified version of reality and so makes the following assumptions about the
state of resources in an economy at a particular moment in time

1. Only two goods are produced: any two goods can be used to illustrate the underlying principle. In
reality, an economy produces many goods/services but focussing on two makes the analysis possible
2. Scarcity of resources exists: the factors of production are limited so choices have to be made about
how they are used
3. Production is efficient: it is assumed that there is no wastage and that all resources are used in such a
way that the maximum output is attained from the inputs used. In reality, this is often not the case
4. The state of technology is fixed: as the model represents a particular moment in time, it is assumed that
the technology is not changing. In reality, improvements in technology are continuously occurring and
they create the potential to increase the output using the scarce resources
Increasing Versus Constant Opportunity Cost
● Two different types of opportunity cost can be illustrated using PPC curves
● Constant opportunity cost occurs when all of the factors of production used to produce one good can
be switched to producing the other good without any loss/wastage of resources
○ One unit given up one of good results in one unit gained of the other
● Increasing opportunity cost occurs when the factors of production cannot be perfectly switched
between the two products
○ One unit given up of one good results in less than one unit gained of the other

Constant opportunity cost occurs when switching production from T-shirts to hoodies while there is increasing
opportunity cost when switching production from consumer goods to capital goods

Diagram Analysis
● For a country producing only T-shirts and hoodies, the factors of production can easily be switched
between the two products e.g. the same labour and land (cotton) can be used to make both products
○ Changing production from point F to G decreases the production of T-shirts from 4 to 3 and
increases the production of hoodies from 3 to 4
○ There is constant opportunity cost when production is switched
● For a country producing consumer goods and capital goods, the factors of production cannot easily be
switched between the two products e.g. the labour required to make a washing machine may not have
the skill to produce a robotic arm used in car manufacturing
○ Changing production from point A to point C results in a decrease of 130 consumer goods but
yields an increase of 180 capital goods
○ Changing production from point C to point B results in a decrease of 120 consumer goods but
only yields an increase of 20 capital goods
○ There is an increasing opportunity cost as production moves closer and closer to any particular
axis
Changes in Production Possibilities
As opposed to a movement along the PPC described above, the entire PPC of an economy can shift inwards
or outwards thereby changing its production possibilities

Outward shifts of a PPC show potential economic growth and inward shifts show economic decline

Diagram Explanation
● Economic growth occurs when there is an increase in the productive potential of an economy
○ This is demonstrated by an outward shift of the entire curve. More consumer goods and more
capital goods can now be produced using all of the available resources
● This shift is caused by an increase in the quality or quantity of the available factors of production
○ One example of how the quality of a factor of production can be improved is through the impact
of training and education on labour. An educated workforce is a more productive workforce and
the production possibilities increase
○ One example of how the quantity of a factor of production can be increased is through a change
in migration policies. If an economy allows more foreign workers to work productively in the
economy, then the production possibilities increase
● Economic decline occurs when there is any impact on an economy that reduces the quantity or quality
of the available factors of production
○ One example of how this may happen is to consider how the Japanese tsunami of 2011
devastated the production possibilities of Japan for many years. It shifted their PPC inwards
resulting in economic decline

The Circular Flow of Income

● The circular flow of income is an economic model that illustrates the money flows in an economy
○ There is a simple model which shows the money flows between households and firms
○ There is a more complex model which adds in other economic agents including the government,
financial sector and foreign trade (net exports)
 A diagram showing the simplified Circular Flow of Income between households and firms

Diagram Analysis
● Households own the wealth in the economy
○ These are the factors of production
● Households supply their factors of production to firms and receive income as a reward
○ They receive rent for land, wages for labour, interest for capital, and profit for enterprise
○ With this income, they purchase goods/services from firms
● Firms purchase factors of production from households
○ They use these resources to produce goods/services
○ They sell the goods/services to households and receive sales revenue

Leakages & Injections

● Money can enter or leave the circular flow of income in an economy
● Injections add money into the circular flow of income and increase its size
○ Increased government spending (G)
○ Increased investment (I)
○ Increased exports (X)
● Leakages (withdrawals) remove money from the circular flow of income and reduce its size
○ Increased savings by households (S)
○ Increased taxation by the government (T)
○ Increased import purchases (M)
● There are high levels of interdependence between households, firms, the government, the financial
sector, and the foreign sector (foreign firms and households)
A diagram that shows the injections and leakages that influence the relative size of the circular flow of income

Diagram Analysis
● Government: Government spending (G) is an injection and taxation (T) is a leakage
● Financial sector: Investment (I) is an injection and savings (S) is a leakage
● Foreign sector: Exports (X) is an injection and imports (M) is a leakage

● The relative size of the injections and withdrawals impacts the size of the economy:
○ Injections > withdrawals = economic growth
○ Withdrawals > injections = fall in real GDP

● Injections represent new income in the economy

● Changes to any of the factors that influence government spending, investment, consumption and net
exports will increase/decrease the relative size of the circular flow of income
○ E.g. An increase in interest rates will increase savings (withdrawal), and reduce consumption
and investment

Positive & Normative Economics

What is positive economics?
● Positive economics is concerned with objective statements of how a market or an economy works
● These positive economic statements are based on empirical evidence and tend to be statements of fact
● They can be proven to be true or false
● Examples of positive economic statements include
○ The unemployment rate in India has fallen from 8% to 7.3% in the past twelve months
○ Increasing the minimum wage last year in the UK resulted in improvements to wage inequality
○ Prices in the EU have risen dramatically, partly due to the 20% increase in the price of oil

What is normative economics?

● Normative economics focuses on value judgements
● These judgements are built around opinions and beliefs as to what the best economic policies or
solutions may be
● These judgements are called normative economic statements
● Normative economic statements are often the basis for the manifestos of political parties and the
different economic agendas they put forward
● Examples of normative economic statements include
○ Every economy should aim to provide free healthcare for its citizens
○ Corporation taxes in an economy should be higher than personal income taxes
 ○ The best way to deal with a rise in crime is to employ more police

The Role of Positive Economics

● As a social science, Economics deals with complex and continuously changing human interactions
● For this reason it is harder to examine a relationship between two variables and always conclude it is
exactly the same (as can be done in Science or Maths)
● There are a number of tools which are utilised in economic analysis to help ensure that positive
(factual) statements can be made with a higher degree of reliability

1. The use of logic

● When analysing markets, a range of assumptions are made about the rationality of economic agents
involved in the transactions
● In classical economic theory, the word 'rational' means that economic agents are able to consider the
outcome of their choices and recognise the net benefits of each one
● Rational agents will select the choice which presents the highest benefits
○ Consumers are assumed to act rationally. They do this by maximising their utility
○ Producers are assumed to act rationally. They do this by selling goods/services in a way that
maximises their profits
○ Workers are assumed to act rationally. They do this by balancing welfare at work with
consideration of both pay and benefits
○ Governments are assumed to act rationally. They do this by placing the interests of the people
they serve first in order to maximise their welfare

2. The use of hypotheses, models and theories

● The social sciences use a variation of the scientific method of research which is called the social
scientific method
● There is an inability to make scientific experiments the results of which can be proven time and time
again
○ This is due to the complexity of human nature and the significant number of social interactions
that are taking place in any economy at any given point in time
● The steps in the social scientific method are similar to the scientific method but there is a key difference

The social scientific method uses empirical research to gather data

● Empirical research is collected through observations, surveys, opinion polls etc.

 ○ The results of the same hypothesis can vary significantly when conducted by different
researchers at different time periods and between different places and cultures

● Refutation is the act of a statement or theory being proved to be wrong by the empirical evidence
○ Refutation helps to determine if an economic statement is positive

● Economic models are developed by economists once a hypothesis has been repeatedly proven or
rejected in different circumstances
○ A model is a simplified version of reality
○ All models make a range of assumptions. These are often generalisations about behaviour,
choices and likely outcomes
○ These assumptions are necessary so as to account for complex human behaviour and
constantly changing variables
○ When evaluating different models, the underlying assumptions should always be considered

3. The ceteris paribus assumption

● Due to the large number of variables that can influence any particular economic interaction in society,
economists create models using the principle of ceteris paribus
○ Translated from Latin, ceteris paribus means 'all other variables remain constant'
○ It allows economists to simplify and explain causes and effects, even if the explanation is
somewhat limited by the assumptions
○ E.g. There are many factors that affect the level of unemployment in an economy (interest rates,
consumer confidence, firms' investment, government policies etc.). Using ceteris paribus,
economists can simplify the economic model to analyse just two variables (e.g. unemployment
and interest rates)

Rational Decision Making

● When analysing markets, a range of assumptions are made about the rationality of economic agents
involved in the transactions
● In classical economic theory, the word 'rational' means that economic agents are able to consider the
outcome of their choices and recognise the net benefits of each one. Rational agents will select the
choice which presents the highest benefits
○ Consumers are assumed to act rationally. They do this by maximising their utility
○ Producers are assumed to act rationally. They do this by selling goods/services in a way that
maximises their profits
○ Workers are assumed to act rationally. They do this by balancing welfare at work with
consideration of both pay and benefits
○ Governments are assumed to act rationally. They do this by placing the interests of the people
they serve first in order to maximise their welfare
● In many ways, the assumption of rational decision making is flawed. For example, consumers are often
more influenced by emotional purchasing decisions than a rational computation of net benefits
The Role of Normative Economics
● Value judgements influence governments' choices with regards to the economic policies they choose to
adopt and spend money on
○ The USA spends more money on imprisoning drug users than rehabilitating them
○ In the UK, the Government has recently increased its spending on rehabilitation
○ To say the UK approach is better would be a normative statement
○ To say that the UK government spends more per head on rehabilitation would be a positive
statement

● Equity is concerned with economic fairness in the distribution of resources

○ Individuals and societies have different views on what is fair and this influences government
policy
■ E.g. Some countries believe it is fair for all of their citizens to be able to access
healthcare, irrespective of their ability to pay, whereas other countries believe that 'no
pay, no access' is fair

● Equality is concerned with everyone being equal and having equal recognition
○ Equality is often a normative concept. When are all people equal? When do people all have
equal opportunities?
○ Statistics on inequality would be considered to be positive economic statements
■ E.g. In 2018, women in the USA were paid 12% less than men in comparable jobs

Unit 2: Microeconomics
Demand and Supply

Terminologies and Definitions

1. Demand: the ability and willingness of an individual to buy a product at a certain price in a specific time
period.
Demand is the amount of a good/service that a consumer is willing and able to purchase at a
given price in a given time period
If a consumer is willing to purchase a good, but cannot afford to, it is not effective demand
2. Supply: the ability and willingness of a firm to provide/sell a product at a certain price during a specific
time period.
3. Law of demand:
a. There is a negative causal relationship between demand and price.
b. When the price of a product increases, quantity demanded decreases.
c. when the price of a product decreases, the quantity demanded increases.
d. ceteris paribus; all other things being equal." In economics, it acts as a shorthand indication of
the effect one economic variable has on another, provided all other variables remain the same.
4. Law of supply:
a. there is a positive causal relationship between supply and price.
b. When the price of a product increases, the quantity supplied increases.
c. when the price of a product decreases, the quantity supplied decreases.
d. ceteris paribus.
5. Market demand:
a. sum of all individual demands in the market.
6. Market supply:
a. sum of all individual supplies in the market.

Demand
Why the demand curve is downward sloping
● Law of decreasing marginal utility:
 ○ As you consume more of a product, the added benefit or satisfaction you get from each
additional unit decreases.
○ Therefore, for each additional unit demanded, the consumer will only be willing to buy it at a
lower price.
● Income effect and substitution effect:
○ There is a negative effect between price and quantity demanded due to income and substitution
effects, which explain the law of demand.
○ Income effect:
■ As price falls, the quantity of a good that can be bought with the same income increases.
So, quantity demanded increases.
■ As price increases, the quantity of goods that can be bought with the same income
decreases. So, quantity demanded decreases.
○ Substitution effect:
■ As price falls, the product becomes relatively cheaper than its substitutes, so some
consumers buy it in place of the substitutes.
■ As price increases, the good becomes relatively more expensive than its substitutes,
causing some consumers to buy the substitute instead.

● A demand curve is a graphical representation of the price and quantity demanded (QD) by consumers
○ If data were plotted, it would be an actual curve. Economists, however, use straight lines so as
to make analysis easier
● The law of demand states that there is an inverse relationship between price and quantity demanded
(QD), ceteris paribus
○ When the price rises the QD falls
○ When the price falls the QD rises

Individual and Market Demand

● Market demand is the combination of all the individual demand for a good/service
○ It is calculated by adding up the individual demand at each price level

The Monthly Market Demand for Newspapers in a small village

Customer 1 Customer 2 Customer 3 Customer 4 Market Demand

30 15 4 4 53

● Individual and market demand can also be represented graphically

Market demand for children's swimwear in July is the combination of boys and girls demand

Diagram Analysis
● A shop sells both boys and girls swimwear
● In July, at a price of $10, the demand for boys swimwear is 500 units and girls is 400 units
● At a price of $10, the shops market demand during July is 900 units
Factors affecting demand
1. Price
2. Advertising
3. Price of complements
4. Price of substitutes
5. Interest rates
6. Taxes[Direct]

Assumptions Underlying the Law of Demand

● The law of demand is based on three key assumptions:
○ The income effect
○ The substitution effect
○ The law of diminishing marginal utility
● These three assumptions collectively contribute to the understanding of the law of demand and how
consumers' behavior is influenced by changes in price
○ The income effect and substitution effect highlight how changes in price affect consumers'
purchasing power and their choices among different goods
○ The law of diminishing marginal utility explains why consumers are less willing to pay higher
prices for additional units of a good

An Explanation of the Three Assumptions

The Assumption Explanation

The Income Effect ● The income effect refers to the change in a

consumer's purchasing power resulting from
a change in the price of a good/service
○ When the price of a good decreases,
consumers' purchasing power
increases as with the same income
they can buy more of the good
○ When the price of a good increases,
consumers' purchasing power
decreases as with the same income
they can afford to purchase less of the
good
● The income effect assumes that consumers
will adjust their consumption patterns based
on changes in their purchasing power caused
by price fluctuations

The Substitution Effect ● The substitution effect suggests that

consumers will substitute goods/services that
have become relatively more expensive with
those that have become relatively less
expensive
○ When the price of a particular good
rises, consumers may seek
alternatives that provide similar utility
or satisfaction at a lower cost
○ E.g. if the price of brand A coffee
increases, consumers may switch to
brand B coffee, assuming it provides
a similar level of satisfaction but at a
lower price
● The substitution effect assumes that
 consumers are rational decision-makers who
have perfect information and respond to
changes in relative prices by adjusting their
consumption

The Law of Diminishing Marginal Utility ● The Law of Diminishing Marginal Utility states
that as additional products are consumed, the
utility gained from the next unit is lower than
the utility gained from the previous unit
● Marginal utility is the additional utility
(satisfaction) gained from the consumption of
an additional product
● The utility gained from consuming the first
unit is usually higher than the utility gained
from consuming the next unit
○ For example, a hungry consumer
gains high utility from eating their first
hamburger. They are still hungry and
purchase a second hamburger but
gain less satisfaction from eating it
than they did from the first hamburger
● Lowering the price makes it a more attractive
proposition for the consumer to keep
consuming additional units - and there is a
movement down the demand curve

Movements Along a Demand Curve

● If price is the only factor that changes (ceteris paribus), there will be a change in the quantity
demanded (QD)
○ This change is shown by a movement along the demand curve

A demand curve showing a contraction in quantity demanded (QD) as prices increase and an extension in
quantity demanded (QD) as prices decrease

Diagram Analysis
● An increase in price from £10 to £15 leads to a movement up the demand curve from point A to B
○ Due to the increase in price, the QD has fallen from 10 to 7 units
○ This movement is called a contraction in QD
● A decrease in price from £10 to £5 leads to a movement down the demand curve from point A to point
C
○ Due to the decrease in price, the QD has increased from 10 to 15 units
 ○ This movement is called an extension in QD

Non-Price Determinants of Demand

Shifts of the Demand Curve
● There are numerous factors that will change the demand for a good/service, irrespective of the price
level. Collectively these factors are called the non-price determinants of demand and include
○ Changes in real income
○ Changes in tastes/preferences
○ Changes in the price of related goods (substitutes and complements)
○ Changes in the number of consumers
○ Future price expectations
● Changes to each of the non-price determinants, shifts the entire demand curve(as opposed to a
movement along the demand curve)

A graph that shows how changes to any of the non-price determinants shifts the entire demand curve
left or right, irrespective of the price level
● For example, if a firm increases their Instagram advertising, there will be an increase in demand as
more consumers become aware of the product
○ This is a shift in demand from D to D1. The price remains unchanged at £7 but the demand has
increased from 15 to 25 units

An Explanation of how each of the Non-Price Determinants of Demand Shifts the Entire Demand Curve at
Every Price Level
Non-Price Explanation Condition Shift Condition Shift
Determinant

Changes in ● Real Income determines Income D Increases Income D

real income how many Increases Shifts Right Decreases Decreases
goods/services can be Shifts Left
enjoyed by consumers
● There is a direct
relationship between
income and demand for
goods/services

Changes in ● If goods/services Good D Increases Good becomes D

taste/prefere become more preferable becomes Shifts Right less preferable Decreases
nces then demand for them more Shifts Left
increases preferable
● There is a direct
relationship between
changes in
taste/preferences and
demand
● Advertising or branding
 can change
tastes/preferences

Changes in ● Changes in the price of Price of Good D for Price of Good A D for
the prices of substitute goods will A Increases Good B Decreases Good B
substitute influence the demand for Increases Decreases
goods a product/service Shifts Right Shifts Left
● There is a direct
(Related relationship between the
goods) price of good A and
demand for good B
● E.g. The price of a Sony
60" TV (good A)
increases so the demand
for LG 60" TV (good B)
increases

Changes in ● Changes in the price of Price of Good D for Price of Good A D for
the prices of complementary goods A Increases Good B Decreases Good B
complement will influence the demand Decreases Increases
ary goods for a product/service Shifts Left Shifts Right
● There is an inverse
(Related relationship between the
goods) price of good A and
demand for good B
● For example, the price of
printer ink (good A)
increases so the demand
for ink printers (good B)
decreases

Changes in ● If the population size of a Population D Increases Population D

the number country changes over Increases Shifts Right Decreases Decreases
of time, then the demand Shifts Left
consumers for goods/services will
also change
● There is a direct
relationship between the
changes in population
size and demand
● Demand will also change
if there is a change to the
age distribution in a
country as different ages
demand different
goods/services e.g an
aging population will buy
more hearing aids

Future price ● If consumers expects the Expectations D Increases Expectations D

expectations price of a good/service to price will rise Shifts Right price will fall Decreases
increase in the future, Shifts Left
they will purchase it now
and demand will
increase
● If consumers expects the
price of a good/service to
decrease in the future,
they will wait to purchase
it later and demand will
decrease
Supply
Introduction to Supply
● Supply is the amount of a good/service that a producer is willing and able to supply at a given price in a
given time period
● A supply curve is a graphical representation of the price and quantity supplied by producers
○ If data were plotted, it would be an actual curve. Economists, however, use straight lines so as
to make analysis easier

● The supply curve is sloping upward as there is a positive relationship between the price and quantity
supplied (QS)
○ Rational profit maximizing producers would want to supply more as prices increase in order to
maximize their profits
○ When anything except the price changes (Non-price determinants) the curve itself shifts which
is known as curve shift.

● The law of supply states that there is a positive (direct) relationship between quantity supplied and
price, because the profitability increases; ceteris paribus
○ When the price rises the QS rises
○ When the price falls the QS falls

Factors affecting supply

● Price
● Price of related products:
○ Competitive supply: occurs if two goods compete for the same resources or factors of
production. This means that the firm cannot increase supply of one without reducing supply of
the other.
○ Joint supply: occurs if two goods are derived from the same product. In this case, it is
impossible to produce more of one good without producing more of the other
● Price of other products
● Costs of production
● Subsidy
● Tax
● Supply shocks

Individual and Market Supply

● Market supply is the combination of all the individual supply for a good/service
○ It is calculated by adding up the individual supply at each price level

The Monthly Market Supply of Bread from 4 Bakeries in a Small town

Bakery 1 Bakery 2 Bakery 3 Bakery 4 Market Supply

300 600 180 320 1400 loaves

● Individual and market supply can also be represented graphically

Market supply for smartphones in December is predominantly the combination of iPhone and Samsung supply

Diagram Analysis
● In New York City, the market supply for smartphones in December is predominantly the combination of
iPhone and Samsung supply
● At a price of $1000, the supply of iPhones is 300 units and the supply of Samsung phones is 320 units
● At a price of $1,000, the market supply of smartphones in New York City during December is 620 units

Assumptions Underlying the Law of Supply

● The law of supply is based on two key assumptions
○ The law of diminishing marginal returns
○ Increasing marginal costs

● Both of these assumptions focus on the cost-related factors that influence the supply decisions of
producers
○ These assumptions explain why the supply curve slopes upward

Using Examples to Explain the Assumptions Underlying the Law of Supply

Assumption Explanation Example

The Law of Diminishing Marginal ● As more of a variable ● E.g. consider a farmer who
Returns factor of production (e.g. has a fixed amount of land
labor) is added to fixed and hires additional
factors (e.g. capital), there workers to cultivate the
will initially be an increase crops
in productivity ○ Initially, each
● However, a point will be additional worker
reached where adding contributes to a
additional units of the significant increase
factor (e.g. hiring an extra in crop output
worker) begins to decrease ○ However, as more
productivity due to the workers are hired,
relationship between labor the additional
and capital output generated
by each new
worker starts to
decline
○ This is because the
fixed amount of
land and other
 resources become
increasingly
crowded relative to
the growing labor
force, leading to
diminishing returns
from each
additional worker

Increasing Marginal Costs ● The concept that as a ● A bicycle manufacturer

producer increases the may have spare production
quantity of a good/service capacity and can increase
supplied, the additional output by simply utilizing
cost of producing each existing resources more
additional unit also efficiently
increases ○ As production
● This relationship is increases, the firm
reflected in the may need to invest
upward-sloping supply in additional
curve, indicating that equipment, hire
producers are willing to more workers, or
supply a greater quantity at incur other costs to
higher prices to justify the maintain the same
higher costs of production rate of expansion
○ These additional
costs contribute to
increasing marginal
costs

Movements Along a Supply Curve

● If price is the only factor that changes (ceteris paribus), there will be a change in the quantity supplied
(QS)
○ This change is shown by a movement along the supply curve

A supply curve showing an extension in quantity supplied (QS) as prices increase and a contraction in quantity
supplied (QS) as prices decrease

Diagram Analysis
● An increase in price from £7 to £9 leads to a movement up the supply curve from point A to B
○ Due to the increase in price, the quantity supplied has increased from 10 to 14 units
This movement is called an extension in QS
 ● A decrease in price from £7 to £4 leads to a movement down the supply curve from point A to C
○ Due to the decrease in price, the quantity supplied has decreased from 10 to 7 units
○ This movement is called a contraction in QS

Market Equilibrium
Equilibrium price: the price at which quantity demanded is equal to quantity supplied.

Price mechanism
● Interaction of buyers and sellers in free markets enable goods, services, and resources to be allocated
prices.
● Relative prices and changes in prices reflect the forces of demand and supply.

Rationing function of the price mechanism

● Whenever resources are scarce, demand exceeds supply and prices are driven up.
● The effect of such a price rise is to discourage demand and conserve resources.
● The greater the scarcity, the higher the price rise and more resources are rationed, as a result.
● This can be seen in the market for oil. As oil slowly runs out, its price increases and demand is
discouraged, leading to more oil conservation.
● The rationing function of a price rise is associated with a contraction along the demand curve.

Incentive function of the price mechanism

● An incentive is something that motivates a producer or consumer to follow a course of action or to
change behavior.
● Higher prices provide the producer with an incentive to supply more due to the possibility of higher
revenue and greater profits.
● The incentive function of a price rise is associated with an extension along the supply curve.

Signaling function of the price mechanism

● Price changes send contrasting messages to consumers and producers about whether to enter or
leave a market.
● Rising prices give a signal to consumers to reduce demand or withdraw from the market completely.
They give a signal to producers that a shortage exists and tell potential producers to enter the market
and existing producers to increase supply.
● Conversely, falling prices give a positive message to consumers to enter the market and increase
demand. Meanwhile, they tell producers that a surplus has been created and tell them to reduce supply
or to leave the market completely.

When there is market equilibrium there is no surplus or shortage of products.