Basic Concepts of Economics

All economic questions and problems arise because human

wants exceed the resources available to satisfy them.
Scarcity
Scarcity is the condition that arises because wants exceeds
the ability of resources to satisfy them.
Faced with scarcity, we must make choiceswe must choose
among the available alternatives.
The choices we make depend on the incentives we face.

Definitions and Questions

Economics is the social science that studies the choices that
individuals, businesses, governments, and entire societies
make as they cope with scarcity, the incentives that influence
those choices, and the arrangements that coordinate them.
Economics divides into two parts:
Microeconomics: The study of the choices that individuals
and businesses make and the way these choices interact and
are influenced by governments.
Macroeconomics: The study of the aggregate (or total)
effects on the national economy and the global economy of
the choices that individuals, businesses, and governments
make.
5

Definitions and Questions

Faced with scarcity, we must make choiceswe must choose

among the available alternatives.
How do choices determine what, how, and for whom goods
and services get produced?
What, How, and For Whom?
Goods and services are the objects (goods) and actions
(services) that people value and produce to satisfy human
wants.
What goods and services get produced and in what
quantities?
How are goods and services produced?
For Whom are the various goods and services produced?

The Opportunity Cost

The Opportunity Cost of a Cell Phone
The opportunity cost of a cell phone is the decrease in the
quantity of DVDs divided by the increase in the number of
cell phones as we move along the PPF.

The Opportunity Cost

IncreasingOpportunity Cost
The opportunity cost of a cell phone increases as more cell
phones are produced.

COMPETITIVE MARKETS
A market is any arrangement that brings buyers and sellers
together.
A market might be a physical place or a group of buyers and
sellers spread around the world who never meet.

DEMAND

Quantity demandedis the amount of a good, service, or

resource that people are willing and able to buy during a
specified period at a specified price.
The quantity demanded is an amount per unit of time. For
example, the amount per day or per month.

DEMAND
The Law of Demand
Other things remaining the same,
If the price of the good rises, the quantity demanded of that
good decreases.
If the price of the good falls, the quantity demanded of that
good increases.

DEMAND
Demand Schedule and Demand Curve
Demand is the relationship between the quantity demanded
and the price of a good when all other influences on buying
plans remain the same.
Demand is illustrated by a demand schedule and a demand
curve.

DEMAND

Demand schedule is a list of the quantities demanded at each

different price when all the other influences on buying plans
remain the same.
Demand curve is a graph of the relationship between the
quantity demanded of a good and its price when all other
influences on buying plans remain the same.

DEMAND
Individual Demand and Market Demand
Market demandis the sum of the demands of all the buyers in
a market.

The market demand curve is the horizontal sum of the

demand curves of all buyers in the market.

DEMAND
Changes in Demand
Change in demand is a change in the quantity that people
plan to buy when any influence other than the price of the
good changes.
A change in demand means that there is a new demand
schedule and a new demand curve.

Figure 4.3 shows

changes in demand.

1.When demand decreases, the demand curve shifts leftward

from D0to D1.
2.When demand increases, the demand curve shifts rightward
from D0to D2.

DEMAND
The main influences on buying plans that change demand are
Prices of related goods

Expected future prices

Income
Expected future income and credit
Number of buyers
Preferences

DEMAND
Prices of Related Goods
Asubstitute is a good that can be consumed in place of another
good.
For example, apples and oranges are substitutes.
The demand for a good increasesif the price of one of its
substitutes rises.
The demand for a good decreasesif the price of one of its
substitutes falls.

DEMAND
Acomplement is a good that is consumed with another good.
For example, ice cream and fudge sauce are complements.
The demand for a good increasesif the price of
one of its complements falls.

The demand for a good decreasesif the price of

one of its complements rises.

DEMAND
Expected Future Prices
A rise in the expected future price of a good increases the
current demand for that good.
A fall in the expected future price of a good decreases current
demand for that good.
For example, if the price of a computer is expected to fall
next month, the demand for computers today decreases.

DEMAND
Income
A normal goodis a good for which the demand increasesif
income increases and demand decreases if income decreases.
An inferior goodis a good for which the demand decreasesif
income increases and demand increases if income decreases.

DEMAND
Expected Future Income and Credit

When income is expected to increase in the future, or when

credit is easy to get and the cost of borrowing is low, the
demand for some goods increases.
When income is expected to decrease in the future, or when
credit is hard to get and the cost of borrowing is high, the
demand for some goods decreases.
Changes in expected future income and the availability and
cost of credit has the greatest effect on the demand for big
ticket items such as homes and cars.
DEMAND
Number of Buyers
The greater the number of buyers in a market, the larger is
the demand for any good.
Preferences
When preferenceschange, the demand for one item increases
and the demand for another item (or items) decreases.
Preferences change when:
People become better informed.
New goods become available.

DEMAND
Change in Quantity Demanded Versus Change in Demand

A change in the quantity demanded is a change in the

quantity of a good that people plan to buy that results from a
change in the price of the good.
A change in demand is a change in the quantity that people
plan to buy when any influence other than the price of the
good changes

Chapter 2:Basic Concepts of Supply and Market Equilibrium

SUPPLY
Quantity supplied is the amount of a good, service, or
resource that people are willing and able to sell during a
specified period at a specified price.

The Law of Supply

Other things remaining the same,
If the price of a good rises, the quantity supplied of that good
increases.
If the price of a good falls, the quantity supplied of that good
decreases\

SUPPLY
Supply Schedule and Supply Curve
Supply is the relationship between the quantity supplied of a
good and the price of the good when all other influences on
selling plans remain the same.
Supply is illustrated by a supply schedule and a supply curve.

SUPPLY
A supply schedule is a list of the quantities supplied at each
different price when all other influences on selling plans
remain the same.
A supply curveis a graph of the relationship between the
quantity supplied and the price of the good when all other
influences on selling plans remain the same.

SUPPLY
Individual Supply and Market Supply
Market supply is the sum of the supplies of all sellers in a
market.
The market supply curve is the horizontal sum of the supply
curves of all the sellers in the market.
SUPPLY
Changes in Supply
A change in supplyis a change in the quantity that suppliers
plan to sell when any influence on selling plans other than the
price of the good changes.

A change in supply means that there is a new supply schedule

and a new supply curve.
2015 Pearson
4.2 SUPPLY
2.When supply increases, the supply curve shifts rightward
from S0to S2.
1.When supply decreases, the supply curve shifts leftward
from S0to S1.
Figure shows changes in supply.
SUPPLY

SUPPLY
The main influences on selling plans that change supply are
Prices of related goods
Prices of resources and other inputs
Expected future prices
Number of sellers

Productivity
SUPPLY
Prices of Related Goods
A change in the price of one good can bring a change in the
supply of another good.
A substitute in production is a good that can be produced in
place of another good.
For example, a truck and an SUV are substitutes in
production in an auto factory.
The supply of a good increasesif the price of one of its
substitutes in production falls.
The supply a good decreasesif the price of one of its
substitutes in production rises.

SUPPLY
A complement in productionis a good that is produced along
with another good.
For example, cream is a complement in production of skim
milk in a dairy.
The supply of a good increasesif the price of one of its
complements in production rises.
The supply a good decreasesif the price of one of its
complements in production falls.

SUPPLY
Prices of Resources and Other Inputs
Resource and input prices influence the cost of production.
And the more it costs to produce a good, the smaller is the
quantity supplied of that good.
Expected Future Prices
Expectations about future prices influence supply.
Expectations of future prices of resources also influence
supply.

SUPPLY
Number of Sellers
The greater the number of sellers in a market, the larger is
supply.
Productivity
Productivityis output per unit of input.
An increase in productivity lowers costs and increases
supply. For example, an advance in technology increases
supply.
A decrease in productivity raises costs and decreases supply.
For example, a severe hurricane decreases supply.

SUPPLY
Change in Quantity Supplied Versus Change in Supply
A change in quantity supplied is a change in the quantity of a
good that suppliers plan to sell that results from a change in
the price of the good.
A change in supplyis a change in the quantity that suppliers
plan to sell when any influence on selling plans other than the
price of the good changes.

MARKET EQUILIBRIUM
Market equilibriumoccurs when the quantity demanded equals
the quantity supplied.
At market equilibrium, buyers and sellers plans are
consistent.

Equilibrium priceis the price at which the quantity demanded

equals the quantity supplied.
Equilibrium quantityis the quantity bought and sold at the
equilibrium price.
Figure shows the
equilibrium price and
equilibrium quantity.
1.Market equilibrium at theintersection of the demand curve
and the supply curve.
2.The equilibrium price is $1 a bottle.
3.The equilibrium quantity is 10 million bottles a day.

MARKET EQUILIBRIUM
Price: A Markets Automatic Regulator
Law of market forces
When there is a shortage, the price rises.
When there is a surplus, the price falls.

Shortageoccurs when the quantity demanded exceeds the

quantity supplied.
Surplusoccurs when the quantity supplied exceeds the
quantity demanded.
MARKET EQUILIBRIUM
Figure achieves market equilibrium.
At $1.50 a bottle:
1.Quantity supplied is 11 million bottles.
3.There is a surplus of 2 million bottles.
4.Price falls until the surplus is eliminated and the market is in
equilibrium.

Figure achieves market equilibrium.

At 75 cents a bottle:
1.Quantity demanded is 11 million bottles.
3.There is a shortage of 2 million bottles.
4.Price rises until the shortage is eliminated and the market is
in equilibrium.

2.Quantity supplied is 9 million bottles.

MARKET EQUILIBRIUM
Event: A new zero-calorie sports drink is invented.
In the market for bottled water:

1.The new drink is a substitute for bottled water, so the

demand for bottled water changes
2.The demand for bottled water decreases and the demand
curve shifts leftward.
3.What are the new equilibriumprice and equilibrium quantity
and how have they changed?

Figure shows the

outcome.
1.A decrease in demand shifts the demand curve leftward.
2.At $1.00 a bottle, there is a surplus, so the price falls.
3.Quantity supplied decreases along the supply curve.
4.Equilibrium quantity decreases.

MARKET EQUILIBRIUM
When demand changes:
The supply curve does not shift.
But there is a change in the quantity supplied.

Equilibrium price and equilibrium quantity change in the

samedirection as the change in demand.

MARKET EQUILIBRIUM
Effects of Changes in Supply
Event: European water bottlers buy springs and open plants
in the United States.
In the market for bottled water:
1.With more suppliers of bottled water, supply changes.
2.The supply of bottled water increases and the supply curve
shifts rightward.
3.What are the new equilibriumprice and equilibrium quantity
and how have they changed?

Figure shows the

outcome.
1.An increase in supply shifts the supply curve rightward.
2.At $1 a bottle, there is a surplus, so the price falls.
3.Quantity demanded increases along the demand curve.
4.Equilibrium quantity increases.

MARKET EQUILIBRIUM
When supply changes:
The demand curve does not shift.
But there is a change in the quantity demanded.
Equilibrium price changes in the oppositedirection to the
change in supply.

Equilibrium quantity changes in the same direction as the

change in supply.

MARKET EQUILIBRIUM
Effects of Changes in Both Demand and Supply
When two events occur at the same time, work out how
each event influences the market:
1.Does each event change demand or supply?
2.Does either event increase or decrease demand or increase
or decrease supply?
3.What are the new equilibriumprice and equilibrium quantity
and how have they changed?

MARKET EQUILIBRIUM
Increase in Both Demand and Supply
Increases the equilibrium quantity.
The change in the equilibrium price is ambiguous because
the:
Increase in demand raisesthe price.
Increase in supply lowersthe price.
Figure shows the
effects of a decrease in

both demand and supply.

1.A decrease in demand shifts the demand curve leftward.
A decrease in supply shifts the supply curve leftward.
2.Equilibrium price might rise, fall or not change.
3.Equilibrium quantity decreases

MARKET EQUILIBRIUM
Decrease in Both Demand and Supply
Decreases the equilibrium quantity.
The change in the equilibrium price is ambiguous because
the:
Decrease in demand lowersthe price
Decrease in supply raisesthe price.

MARKET EQUILIBRIUM
Decrease in Demand and Increase in Supply
Lowers the equilibrium price.
The change in the equilibrium quantity is ambiguous because
the:
Decrease in demand decreasesthe quantity.
Increase in supply increases the quantity.

MARKET EQUILIBRIUM
Increase in Demand and Decrease in Supply
Raises the equilibrium price.

The change in the equilibrium quantity is ambiguous because

the:
Increase in demand increasesthe quantity.
Decrease in supply decreasesthe quantity.

Factors of Production
WHAT, HOW, AND FOR WHOM?
What Do We Produce?
We divide the vast array of goods and services produced into:
Consumption goods and services
Capital goods

What do we produce?
Consumption goods and services are goods and servicesthat
are bought by individuals and used to provide personal
enjoyment and contribute to a persons standard of living.
Examplesare movies and laundromat services.
Capital goods are goods that are bought by businesses to
increase their productive resources.
Examplesare cranes and trucks.

How do we produce?

How Do We Produce?
Factors of productionare the productive resources used to
produce goods and services.
Factors of production are grouped into four categories:
Land
Labor
Capital
Entrepreneurship

LAND WHAT, HOW, AND FOR WHOM?

Land
Landincludes all the gifts of nature that we use to produce
goods and services.
Land includes all the things we call natural resources.
Land includes minerals, water, air, wild plants, animals,
birds, and fish as well as farmland and forests.

LABOR WHAT, HOW, AND FOR WHOM?

Labor
Laboris the work time and work effort that people devote to
producing goods and services.

The quality of labor depends on how skilled people are

what economists call human capital.
Human capitalis the knowledge and skill that people obtain
from education, on-the-job training, and work experience.

CAPITAL WHAT, HOW, AND FOR WHOM?

Capital
Capitalconsists of tools, instruments, machines, buildings,
and other items that have been produced in the past and that
businesses now use to produce goods and services.
Capital includes semifinished goods, office buildings, and
computers.
Capital does not include money, stocks, and bonds. They are
financial resources.

ENTREPRENEURSHIP WHAT, HOW, AND FOR WHOM?

Entrepreneurship
Entrepreneurship is the human resource that organizes labor,
land, and capital.
Entrepreneurscome up with new ideas about what and how to
produce, make business decisions, and bear the risks that arise
from these decisions.
For Whom Do We Produce?

Factors of production are paid incomes:

RentIncome paid for the use of land.
WagesIncome paid for the services of labor.
InterestIncome paid for the use of capital.
Profit (or loss) Income earned by an entrepreneur for running
a business.
ECONOMIC COST AND PROFIT
The Firms Goal
To maximize profit
AccountingCostandProfit
An accountant measures cost and profit to ensure that the
firm pays the correct amount of income tax and to show the
bank how the firm has used its bank loan.
Economists predict the decisions that a firm makes to
maximize its profit. These decisions respond to opportunity
costand economic profit.
ECONOMIC COST AND PROFIT
Opportunity Cost
The highest-valued alternative forgone is the opportunity cost
of a firms production.
This opportunity cost is the amount that the firm must pay
the owners of the factors of production it employs to attract
them from their best alternative use.

So a firms opportunity cost of production is the cost of the

factors of production it employs.

ECONOMIC COST AND PROFIT

Explicit Costs and Implicit Costs
Anexplicit costis a cost paid in money.
Animplicitcostisanopportunitycostincurredbyafirmwhenituse
safactorofproductionforwhichitdoesnotmakeadirectmoneypay
ment.
The two main implicit costs are economic depreciation and
the cost of using the firm owners resources.
Economic depreciationis an opportunity cost of a firm using
capital that it ownsmeasured as the change in the
marketvalue of capital over a given period.
Normal profitis the return to entrepreneurship.
Normal profit is part of a firms opportunity cost because it is
the cost of the entrepreneur not running another firm.
Economic Profit
A firms economic profitequals total revenue minus total
cost.
Total cost is the sum of the explicit costs and implicit costs
and is the opportunity cost of production.

Because the firms implicit costs include normal profit, the

return to the entrepreneur equals normal profit plus economic
profit.
If a firm incurs an economic loss, the entrepreneur receives
less than normal profit.

Opportunity cost is the sum of

Explicit costs and
Implicit cost (including normal profit).
The Short Run: Fixed Plant
The short runis a time frame in which the quantities of some
resources are fixed.
In the short run, a firm can usually change the quantity of
labor it uses but not the quantity of capital.
The Long Run: Variable Plant
The long runis a time frame in which the quantities of all
resources can be changed.
A sunk cost is irrelevant to the firms decisions.
To increase output with a fixed plant, a firm must increase the
quantity of labor it uses.
We describe the relationship between output and the quantity
of labor by using three related concepts:

Total product
Marginal product
Average product

Total Product
Total product(TP) is the total quantity of a good produced in
a given period.
Total product is an output ratethe number of units
produced per unit of time.
Total product increases as the quantity of labor employed
increases.

Figure shows the total product and the total product curve.
Points Athrough Hon the curve correspond
to the columns of the table.
The TPcurve is like the PPF: It separates attainable points and
unattainable points.

SHORT-RUN PRODUCTION
MarginalProduct
Marginalproductisthechangeintotalproductthatresultsfromaon
e-unitincreaseinthequantityoflaboremployed.
Marginalproducttellsusthecontributiontototalproductofadding
onemoreworker.
Whenthequantityoflaborincreasesbymore(orless)thanonework
er,calculatemarginalproductas:
Marginal product

Change in total product

Change in quantity of labor

Figure shows total product and marginal product.

We can illustrate marginal product as the orange bars that
form steps along the total product curve.
SHORT-RUN PRODUCTION
The height of each step represents marginal product.
SHORT-RUN PRODUCTION
IncreasingMarginalReturns
Increasing marginal returnsoccur when the marginal product
of an additional worker exceeds the marginal product of the
previous worker.
Increasing marginal returns occur when a small number of
workers are employed and arise from increased specialization
and division of labor in the production process.
Decreasing Marginal Returns
Decreasing marginal returnsoccur when the marginal product
of an additional worker is less than the marginal product of
the previous worker.
Decreasing marginal returns arise from the fact that more and
more workers use the same equipment and work space.

As more workers are employed, there is less and less that is

productive for the additional worker to do.
Decreasing marginal returns are so pervasive that they qualify
for the status of a law:
Thelaw of decreasing returnsstates that:
As a firm uses more of a variable input, with a given quantity
of fixed inputs, the marginal product of the variable input
eventually decreases.

Average Product
Average productis the total product per worker employed.
It is calculated as:
Average product = Total product Quantity of labor
Another name for average product is productivity

Market Structures
The four market types are
Perfect competition
Monopoly
Monopolistic competition
Oligopoly

Perfect Competition
Perfect competitionexists when
Many firms sell an identical product to many buyers.
There are no restrictions on entry into (or exit from) the
market.
Established firms have no advantage over new firms.
Sellers and buyers are well informed about prices.
MARKET TYPES

Other Market Types

Monopolyis a market for a good or service that has no close
substitutes and in which there is one supplier that is protected
from competition by a barrier preventing the entry of new
firms.
Monopolistic competitionis a market in which a large number
of firms compete by making similar but slightly different
products.
Oligopolyis a market in which a small number of firms
compete

A FIRMS PROFIT-MAXIMIZING CHOICES

Price Taker

A price takeris a firm that cannot influence the price of the

good or service that it produces.
The firm in perfect competition is a price taker.
In perfect competition, market demand and market supply
determine price.
Monopolyis a market for a good or service that has no close
substitutes and in which there is one supplier that is protected
from competition by a barrier preventing the entry of new
firms.

How Monopoly Arises

Monopoly arises when there are
No close substitutes
Barriers to entry
No Close Substitutes
If a good has a close substitute, even though only one firm
produces it, that firm effectively faces competition from the
producers of substitutes.
A Barrier to Entry
Any constraint that protects a firm from competitors is a
barrier to entry.
There are three types of barrier to entry:
Natural

Ownership
Legal

Ownership Barrier to Entry

A monopoly can arise in a market in which competition and
entry are restricted by the concentration of ownership of a
natural resource.
In the last century, DeBeers created its own barrier to entry
by buying control over most of the worlds diamonds, which
prevents entry and competition.

Legal Barrier to Entry

A legal barrier to entry creates legal monopoly.
A legal monopolyis a market in which competition and entry
are restricted by granting of a public franchise, government
license, patent, or copyright.

Monopoly Price-Setting Strategies

A monopoly faces a tradeoff between price and the quantity
sold.
To sell a larger quantity, the monopolist must set a lower
price.

There are two price-setting possibilities that create different

tradeoffs:
Single price
Price discrimination

Single Price
A single-price monopolyis a firm that must sell each unit of
its output for the same price to all its customers.
DeBeers sell diamonds (quality given) at a single price.
Price Discrimination
A price-discriminating monopolyis a firm that is able to sell
different units of a good or service for different prices.
Airlines offer different prices for the same trip.

Monopolistic competition is a market structure in which

A large number of firms compete.
Each firm produces a differentiated product.
Firms compete on price, product quality, and marketing.
Firms are free to enter andexit.

Large Number of Firms

Like perfect competition, the market has a large number of

firms. Three implications are
Small market share
No market dominance
Collusion impossible
Product Differentation
Product differentiation is making a product that is slightly
different from the products of competing firms.
A differentiated product has close substitutes but it does not
have perfect substitutes.
When the price of one firms product rises, the quantity
demanded of that firms product decreases.
Competing on Quality, Price, and Marketing
Quality
Design, reliability, after-sales service, and buyers ease of
access to the product.
Price
Because of product differentiation (some people will pay
more for one variety of a product) so the demand curve for the
firms product is downward sloping.
Marketing
Marketing has two main forms: Advertising and packaging

Entry and Exit

No barriers to entry.
So the firm cannot make economic profit in the long run.
Unlike a monopoly, firms in monopolistic competition cannot
make an economic profit in the long run. If the firms are
making an economic profit, other firms enter the market.
Entry continues as long as firms in the industry make an
economic profit. As firms enter, each existing firm loses some
of its market share. The demand for each firms product
decreases and the firms demand curve shifts leftward.
Eventually the demand decreases enough so that the firms
make zero economic profit and entry then stops.
Identifying Monopolistic Competition
Two indexes:
The four-firm concentration ratio
The Herfindahl-Hirschman Index
MONOPOLISTIC COMPETITION
The Four-Firm Concentration Ratio
Thefour-firm concentration ratio is the percentage of the
value of sales accounted for by the four largest firms in the
industry.
The range of concentration ratio is from almost zero for
perfect competition to 100 percent for monopoly.

A ratio that exceeds 60 percent is an indication of oligopoly.

A ratio of less than 40 percent is an indication of a
competitive marketmonopolistic competition.