Business Economics

Session 1
Professor David Shepherd

Economics: Concepts and Methods

Reading:
Pindyck and Rubenfeld, Chapters 1 & 2
Sexton, Chapters 1, 2 & 3

What is Economics?

Economics is the study of the system that operates to allocate scarce

resources between competing ends

Key considerations

o Productive resources are scarce

o Material needs and desires are effectively unlimited
o People have diverse objectives (or preferences)
o Choices and decisions have to be made

The Production Process

Production is limited because resources are limited

Productive resources
o Labour (L)
o Capital (K)
o Technology (A)
o Land (fixed in the background, including natural resources)

The Production function

Inputs

Productive capacity is set by the availability of L,K and A

Yt= f (Lt ,Kt) At

Outputs

Production Possibility Frontier

1.

Output is constrained because

productive resources are
scarce

2.

Trade-offs are always present

3.

From A to B, what is the cost of

obtaining the extra five units
of food? Opportunity Cost

4.

What happens to opportunity

cost as food production rises

Food

25

F
20

40

50

Machinery

The Economic Questions

1.

What determines the

allocation of existing
resources? A, B or C

2.

What causes productive

capacity to expand? A , B or C
to say D

3.

What causes under-utilization

of resources? Such as E

D
C
A
E
B

M
6

Specialisation and Trade

A modern economy has a high degree of specialisation in employment and

production

Specialisation is the basis of our prosperity, it allows the introduction of

more efficient systems of production, with machinery and automation, and
encourages technological development.

Specialisation means that we have to trade with each other. The baker
supplies bread for money and then buys things that others have produced.

In the absence of trade we would have to be self-sufficient, like Robinson

Crusoe, and we would be poorer in material terms

Individuals specialise and nations specialise

Absolute Advantage

Adam Smith (An Inquiry into the Nature and Causes of the Wealth of
Nations, 1776) suggested that individuals (and nations) should specialise in
the areas of activity in which they have an absolute advantage over others

The UK could grow bananas, but it is more efficient to buy them from
countries in Central America, which have an absolute advantage in
production. In exchange the UK sells goods for which it has an absolute
advantage in production

Trade implies a more efficient use of the worlds resources

Similar reasoning holds for trade within the economy

Individuals should specialise in areas of activity in which they have an

absolute advantage over others

Comparative Advantage

Absolute advantage is an important basis for specialisation but what if an

individual (or a nation) has no absolute advantage in area of production

Does it mean that the individual cant find a suitable job and must live on
benefits?

Does it mean that the nation must protect its markets from more efficient
foreign producers?

Answers..no.andno

David Ricardo (The Principles of Political Economy and Taxation, 1817)

argued that everyone can gain from specialisation and trade because it
depends on COMPARATIVE rather than absolute advantage

Comparative Advantage and Opportunity Cost

Consider 2 people. Person 1 is a brilliant surgeon and a very good gardener.

Person 2 would be a terrible surgeon and a reasonable gardener

Person 1 has an absolute advantage in both areas of activity. Should he or

she do both?

NO Person 1 can earn a lot of money as a brain surgeon and the

opportunity cost of devoting time to gardening is therefore high

Is more efficient for person 1 to specialise in brain surgery and employ

person 2 to do the garden. Person 1 has a comparative advantage in brain
surgery, but person 2 is the low cost producer of gardening services and has
a comparative advantage in that area of activity

Similar reasoning applies in the case of international trade.countries

should specialise according to comparative advantage
10

A Numerical Example

Labour Needed to Produce 1 F

US: 2 hours UK 18 hours

Labour needed to Produce 1 M

US 4 hours UK 6 hours

UK: 1F costs 3M
1M costs 1/3 F

The US has an absolute advantage

in both F and M production

But what about opportunity cost?

US: 1F costs M
1M costs 2F

The US produces food at a lower

cost than the UK, but the UK
produces machinery more
cheaply than the US. The UK thus
has a comparative advantage in
machinery production
11

Comparative Advantage and Trade

Suppose for numerical simplicity that the US and UK agree to trade food and
machinery at the rate of 1F for 1 M

The US saves 1 F by getting a machine from the UK rather than producing

the machine itself (it costs the equivalent of 2F to produce 1M in the US)

The UK saves 2M by getting a unit of food from the US (it costs the
equivalent of 3M to produce 1F in the UK)

The US and the UK both gain from trade, even though the US has an
absolute advantage in both areas of production

Trade depends on comparative advantage, reflected in opportunity cost

differences
12

The Terms of Trade

Trade at 1F: 1M is assumed purely

for convenience

Can we identify the boundaries

within which the terms of trade
must lie?

What is the maximum amount of

food the US will offer for 1M ?
Answerit will not offer more than
2F, because it can produce
machinery at this cost itself

What is the minimum amount of

food the UK will accept for 1M ?
Answerit will want at least 1/3 F
because this is the UK domestic
cost of producing 1M

The terms of trade will thus lie

between 1F: 2M and 1F: 1/3M

Within these boundaries the actual

terms of trade depend in part on
the relative strength of demand for
the products in the two countries
13

Trade and Money Prices

In the real world goods are bought and sold with money and trade will take
place only if money prices reflect opportunity costs. Consider the following
example:
Labour Input
United States
1F
1M
1hour
2 hours
United Kingdom
1F
1M
18 hours 6 hours

Wage Rate

$20

Exchange Rate

Money Prices

1 = $2

1F
$20 (10)

1M
$40 (20)

1 = $2

1F
90 ($180)

1M
30 ($60)

In this case, it looks as though trade will not take place because British
machinery is more expensive than US machinery
How can we resolve this situationare there any adjustment
mechanisms to ensure that trade will take place?
14

The Economic System

Specialisation and trade is efficient, but economic activities have somehow

to be organised. Decisions have to be made about what gets produced and
who works in which area.

The economy is the system that operates to organise economic activities

The system is effectively a set of institutions, rules, laws, customs,

agreements, etc

Economic Systems:
o Planned Economy
o Market Economy
o Mixed Economy
15

The Nature of Markets

A market is an arrangement through which buyers and sellers are brought

together and transactions are made

There are many different types of marketsproduct markets, labour

markets, financial markets, and so on

There are two sides to a market

o Demandarising from those who want to buy the product or service
o Supplyarising from those who want to sell the product or service

16

Market Dimensions
Location - the market may or may not have a specific geographical
location
Pricethe unit price at which the product is bought and sold
Quantitythe amount of the product which is bought and sold
Timethe period of time over which the market transactions are
made

17

Market Demand

In a product market, demand is the amount that consumers (households)

want to buy over a given period of time. This depends on several factors:
o
o
o
o

The products own price

The price of alternative substitute products
Household incomes
Consumer preferences

DX=f (PX , PN, I, Preferences)

Changes in any of these factors cause demand to change

18

Analysing the Factors Influencing Demand

The ceteris paribus assumption. We examine changes in each factor,

assuming other factors do not change

Suppose there is a fall in the prices of apples. Demand goes up, but
why?........Substitution effect and income effect

Suppose household incomes rise. How does this affect the demand for
apples? .Income effect

Suppose the price of pears goes up. How does this affect the demand for
apples?.......Substitution effect

Suppose we discover that apples are bad for our health. How does this
affect the demand for apples? Consumer preferences
19

The Market Demand Curve

1. If P falls from P1 to P2, demand rises
from Q1 to Q2.a movement from A
to B along the demand curve Dx1

Price

P1

2. If household incomes rise, the

demand curve shifts to the right to
Dx2 and at price P1 demand rises to
Q3a move from A to C

P2

3. If the price of a substitute product

falls, the demand curve shifts to the
left to Dx3 and demand falls from Q1
to Q4.a move from A to D

Dx1

Dx3
Q4

Q1

Q2

Q3

Dx2

4. What about a shift in preferences

away from this product?

Quantity (per month)

20

Market Supply

In a product market, supply is the amount that sellers (firms) want to

supply over a given period of time

Market supply is the total amount supplied by all firms operating in the
market. This depends on several factors:
o The price at which the product is sold
o Production costs and technology
o The number of firms operating in the market

SX = f (PX , Input Costs, Technology, Number of Firms)

Changes in any of these factors cause supply to change

21

Analysing the Factors Influencing Supply

The ceteris paribus assumption. Again we examine changes in each factor,

assuming other factors do not change.

Suppose there is an increase in the price of wheat. Supply goes up because

wheat production is more profitable

Suppose that wage costs or energy costs fall. Supply goes up because
wheat production is again more profitable

Suppose technological progress causes an increase in crop yields. Supply

goes up because farmers can produce more with existing fields

Suppose other farmers move into wheat production. Supply goes up

because there are more producers
22

The Market Supply Curve

Price

1. If P rises from P1 to P2, supply

rises from Q1 to Q2. a move
from A to B along the supply
curve Sx1

Sx3
Sx1
Sx2

P2
P1

B
D

A
C

Q4

Q1

Q2

Q3

2. If new firms enter the market,

the supply curve shifts to the
right to Sx2 and at price P1 supply
rises to Q3..a move from A to C
3. If input costs rise, the supply
curve shifts to the left to Sx3 and
at price P1 quantity supplied falls
from Q1 to Q4a move from A to
D

Quantity (per month)

23

The Market Equilibrium

.

1. The demand curve shows only

the quantities that consumers plan
to buy at different prices

Price

2. The supply curve shows only the

quantities that firms plan to sell at
different prices

Sx1

P1

3. The market equilibrium is

determined at P1, at the point
where demand and supply are in
balance, at Q1..In equilibrium, the
plans of consumers and producers
are in balance.

Equilibrium at D=S

Dx1
Quantity (per month)
Q1
24

Disequilibrium and Price Adjustment

At P1 the market is in
equilibrium with D = S at Q1
and there is no tendency for
price to change

Price
Sx1
P2

At P2 the market is in a position

of excess supply (D < S) and the
market price falls towards P1.

D<S

P1
P3

At P3 the market is in a position

of excess demand (D > S) and
price rises towards P1

D>S
Dx1
Q1

Quantity (per month)

25

Adjusting to a Change in Demand

An Increase in Demand

1. Initial equilibrium at P1/Q1

2. D shifts from D1 to D2 and
excess demand prevails at P1
with demand at Q3 and supply
at Q1

Price

3. Price begins to rise,

stimulating supply and causing
demand to contract

P2
P1
D2

4. Equilibrium is re-established
when price rises to P2 and
demand and supply are again
in balance at Q2

D1
Q1

Q2

Q3

Quantity(per month)
26

Adjusting to a Change in Supply

An Increase in Supply

1. Initial equilibrium at P1/Q1

Price

S1
S2
P1
P2

Q1

Q3

Q2

2. S shifts from S1 to S2 and

excess supply prevails at
P1 with demand at Q1 and
supply at Q2
3. Price begins to fall,
reducing supply and
stimulating demand
4. Equilibrium is reestablished when price
falls to P2 and demand and
supply are again in
balance at Q2
Quantity (per period)
27

END OF SESSION 1

28

Business Economics
Session 2
Professor David Shepherd

29

Understanding Markets

Reading:
Pindyck and Rubenfeld, Chapter 2
Sexton, Chapters 5, 6 & 7

Imperial College Business School

30

The Demand and Supply Model

The demand and supply model explains how price and output are
determined and how they adjust demand or supply conditions change

For example, if demand contracts, the demand curve shifts to the left and,
other things equal, we expect price and output to fall

Or if supply expands, the supply curve shifts to the right and, other things
equal, we expect price to fall and output to rise

But usually we want to be more precise (or more detailed) and answer
questions about the quantitative magnitudes of the changes in P and Q
rather than just the qualitative directions of change

31

Demand and Supply Responses: Elasticity

To get a proper understanding of market behaviour, we need to know by

how much demand and supply change when there are changes in market
conditions

We can think of these changes (or responses) in terms of demand elasticity

and supply elasticity

In particular:
o Price elasticity of demand
o Income elasticity of demand
o Cross-price elasticity of demand
o Price elasticity of supply

32

Price Elasticity of Demand

For any product, price elasticity of demand is a quantitative measure of the

change in demand that occurs when there is a change in the products own
price
Price elasticity (p) is measured as the percentage change in quantity
demanded divided by the percentage change in price
o p = Q/Q P/P
o suppose p falls from 10 to 8 and q rises from 100 to 140

o P/P = 2/10 = 0.20 = 20% and Q/Q = +40/100 = 0.4 = + 40%

o p = 40% 20% = 2.0, indicating that the percentage increase in
Q is twice the percentage reduction in Q

33

Price Elasticity Ranges

Suppose that consumers buy 100 units of x a week at a price of 2 per unit
and price rises by 10% to 2.20. How do consumers respond ?

Suppose demand falls by 20% from 100 to 80. Price elasticity is then
calculated as 20%/10%= 2. The percentage change in quantity is
greater than the percentage change in price and demand is classified as
elastic

Now suppose that demand falls by only 5%, from 100 to 95. Price elasticity
is calculated as 5%/10% = 0.5. The percentage change in quantity is
smaller than the percentage change in price and demand is classified as
inelastic

Note, if demand falls from by 10%, from 100 to 90, elasticity is 10%/10%
= 1. In this case, the percentage change in demand is the same as the
percentage change in price and demand is said to be unit elastic, meaning
that it is neither elastic nor inelastic.
34

Elastic and Inelastic Demand

Price Elastic

Price Inelastic

40% / -20% = 2

10%/ -20% = 0.5

-20%

10

10

100

140
+40%

100

110

+10%
35

Comments on Price Elasticity

Price elasticity is a negative number, because a change in price leads to a

change in demand in the opposite direction

In practice the negative sign is often omitted, because it is assumed that

everyone knows that a fall in price causes demand to rise

In mathematical terminology, for small changes, price elasticity is

p = (dQ/Q) / (dP/P)

This can alternatively be written as

p = (dQ/dP) (P/Q)

36

Price Elasticity and the Linear Demand Curve

Elasticity is not the same as slope of the demand curve. Slope is constant along a
straight line demand curve, but elasticity varies along the curve.
Consider the curve P= a bQ. The slope is dP/dQ = b and its inverse is dQ/dP = 1/b.
The slope and inverse are constant if the curve is a straight line, but P/Q varies along
the curve, so elasticity (dQ/dP)(P/Q) must change along the curve.

Q 0 so p

a
elastic region

p = -1
a/2
Inelastic region

P 0 so p 0
0
a/2b

a/b

Q
37

Elasticity at the mid-point

Elasticity is equal to unity ( 1) at the mid-point on a linear demand curve

Proof:
For the curve P= a bQ, at the mid-point P is a/2 and Q is a/2b

dQ / Q
dQ
P

dP / P
dP
Q

1
a/2

b
a / 2b

1
b 1
b

38

Straight Line Demand Curves

It is convenient to draw demand curves as straight lines

Even if demand is actually non-linear, these straight line curves can be
thought of as approximations of demand over a given price range

Q
39

Price Elasticity and Slope Again

Although price elasticity and slope are not the same thing, over a given price
range, the more shallowly sloped D1 is more elastic than D2.
p = dQ/dP P/Q

As the slope increases b is

higher and 1/b is smaller. For
given P/Q, p falls as 1/b
becomes smaller. The
implication is that demand is
more price inelastic for a
steeper curve over a given P/Q
range.

More inelastic

D2

D1

40

Perfectly Inelastic and Perfectly Elastic

Demand
Perfectly Inelastic. A rise or fall
in price has no impact on
demand and price elasticity is
zero
P

Perfectly elastic. At 10 consumers

will buy any quantity. A rise in price
causes demand to fall to zero and
price elasticity is infinite
P

12
10
10

100

q
41

Tracing the Impact of an Increase in Supply

1. Initial market equilibrium at
p1/q1
2. supply rises from s1 to s2
3. With demand shown by d1,
a new equilibrium is
established at p2/q2

p
s1
s2

p1

4. With demand more elastic

at d2, a new equilibrium is
established at p3/q3

p3
p2

d1
q1

q2

q3

d2
Q (per period)
42

Determinants of Price Elasticity

Availability of substitute goodsdemand is more likely to be elastic

when there are lots of close substitutes available

Luxuries and necessities.demand for necessities is likely to be price

inelastic than the demand for luxury goods

Market definition..the more widely narrowly we define a market, the

greater the price elasticity is likely to be. For example, the demand for food
is more inelastic than the demand for a particular type of food

Timedemand is likely to be more elastic in the long run than the short
run, because buyers have more time to find substitutes and alter behaviour

43

Price Elasticity and Business Revenues

Price Elastic: if price falls (from 10 to 8) buyers spend more and the total
revenue earned from the sale of the product rises from 1000 to 1120
(from 10 100 to 8 140). Demand is responsive to the price change
and the revenue lost by selling units more cheaply is more than offset by
the revenue gained from selling more units. The reverse is true for a price
rise..total business revenue falls

Price Inelastic: if price falls, total revenue falls from 1000 to 880.
Because demand is not responsive to price, the revenue gained from the
sale of extra units does not offset the revenue lost by selling units more
cheaply. The reverse is true for a rise in price..total business revenue
rises.

44

Demand and Business Revenues

Inelastic Demand

Elastic Demand

10
8

10

Revenue
lost

Revenue
lost

Revenue
gained

Revenue
gained

100

Imperial College Business School

140

100

110

45

Income Elasticity of Demand

Changes in income lead to changes in demand

Income elasticity measures the responsiveness of demand to income

changes, measured as the percentage change in quantity demanded
divided by the percentage change in income

i = Q/Q I/I

If incomes rise by say 5% and the demand for product x rises by 10%,
income elasticity is 5%/10% = 2

46

Normal Goods and Inferior Goods

Normal Goods..the usual case, in which an increase in household incomes

generates an increase in demand.income elasticity is positive

Inferior Goodscases in which demand falls when incomes rise.and

income elasticity is negativeexamples?

Luxuries and necessitiesas incomes rise and increasing proportion of the

increase tends to be devoted to luxuries rather than necessities..luxury
goods tend to have a higher income elasticity than necessities

Necessitiesfood, clothing, heating .and?

Luxuries.jewellery, designer clothesand?

47

Cross-Price Elasticity

The impact on demand arising from changes in the prices of other goods
can also be expressed in elasticity terms

For 2 goods, x and y, the cross-price elasticity of demand for X is measured

as the percentage change in the quantity of X demanded divided by the
percentage change in the price of Y

cp= Q x / Q x P y /P y

For substitute goods, cross-price elasticity is positive because a rise in the

price of Y leads consumers to switch to X

For complementary goods, such as tea and sugar, cross-price elasticity is

negative, because a rise in the price of Y leads to a fall in the demand for Y
and hence also a fall in the demand for the complementary good X

48

Preference Elasticity ?

We have discussed the impact of changes in the products own price,

changes in incomes, and changes in the prices of other goods

The impacts can all be measured in terms of elasticity

The remaining factor affecting demand is consumer preferences

Can we calculate a preference elasticity of demand?

PREF= Q / Q PREF /PREF

If not, why not?

49

Price Elasticity of Supply

Market supply is the total quantity supplied by all of the firms operating in
the market

It is usual to suppose that an increase in price leads to an increase in

quantity supplied

Price elasticity of supply is a measure of the responsive of supply to

changes in price

It is measured as the percentage increase in quantity supplied divided by

the percentage increase in price

We can think of supply as being elastic or inelastic, according to whether

quantity supplied changes by a larger or smaller percentage than price

50

Elastic and Inelastic Supply

Inelastic Supply. Elasticity is less
than 1 and any given percentage
change in price rise leads to a
smaller percentage change in
quantity supplied
p

Elastic Supply. Elasticity is greater

than 1 and any given percentage
change in price leads to a larger
percentage change in quantity
supplied
p

s
12

+20%

12

+20%

10

10

100

110

+10%

100

140

+40%
51

Perfectly Elastic and Perfectly Inelastic Supply

Perfectly Inelastic Supply.
Elasticity is zero and any given
percentage change in price leaves
the quantity supplied unchanged
p

Perfectly Elastic Supply. Elasticity is

infinite and firms will supply as much
as people want to buy at the given
price. At a lower price nothing is
supplied.
p

12
+20%

10

10

100

40

100

+ 0%
52

Tracing the Impact of an Increase in

Demand
1. Initial market
equilibrium at p1/q1
p

2. demand rises from d1 to

d2

s1

p2

3. With supply shown by

s1, a new equilibrium is
established at p2/q2

s2

p3

4. With supply at s2, a new

equilibrium is
established at p3/q3

p1

d1
q1 q2

q3

d2

Q (per period)
53

Market Adjustments and Time

Market adjustments take place over time and the longer the period of time
considered, the greater the potential responsiveness of demand and supply

The longer the period of time under consideration, the more elastic
demand is likely to be, because consumers can adjust their behaviour and
switch to alternative products

The longer the period of time under consideration, the more elastic supply
is likely to be, because new firms can enter the market and existing firms
can adjust their capacity, or leave the market

This implies that price and output adjustment may change over time, as
demand and supply responses change

54

The Short Run and Long Run

The short run is a period during which the number of firms operating in the
market is fixed and each firm operates with fixed capital capacity and a
given technology

In the short run, firms can alter production by employing more or fewer
people. Supply can therefore change, but only within the constraints of
existing capacity and technology

The long run is a period during which existing firms can alter capacity,
technology may change and new firms can enter the industry

In the long run, larger adjustments in production can occur and supply is
more elastic than in the short run

55

A Technological Innovation in Farming

1. Initial equilibrium at p1/q1

2. A technological innovation in
farming increases supply. How are
farm incomes affected?

S1

3. With demand at d1, a new

equilibrium is established at p2/q2
and farm revenues fall from (p1
q1) to (p3q3)

S2
p1
p2
p3

d1
q1 q3 q2

d2

4. With demand more elastic at d2, a

new equilibrium is established at
p3/q3 and farm revenues rise from
(p1q1) to (p2q2)

5. How would farm incomes be

affected by adverse weather
conditions that caused a reduction
Q (per period) in supply?

56

The Impact of a Tax on Cigarettes

Inelastic Demand

Elastic Demand

Price rises substantially but demand

falls by a much smaller percentage

Price rise is limited, and demand falls by

a much larger percentage

Smokers spend more of their income

on cigarettes (p2q2) > (p1q1)
S + tax
p

Smokers spend less of their income on

cigarettes (p3q3) < (p1q1)
p
S + tax

Tax
Tax

S
S
P2
P3
P1

P1

D
q2 q1

q3

q1

q
57

END OF SESSION 2

58