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Overview: Introduction to
term economics covers such a broad range of meaning that any brief definition
is likely to leave out some important aspect of the subject. It is a social science
concerned with the study of economies and the relationships between them. Economics
is the study of how people and societies choose to employ scarce productive resources
(which could have alternative uses), produce various commodities and distribute
them for consumption. Economics generally studies problems from society's point
of view rather than from the individual's. Finally, economics studies the allocation
of scarceresources among competingunlimitedwants.
Below, I have given you a general overview of the field
of economics. As you work through the units of your course, you will see each of
these things again in more detail. Students are often intimidated by economics …
You shouldn’t be! Let me offer one word of caution, however. Economic concepts build
on each other and you must be careful that you understand basic concepts in order
to understand advanced concepts.
If you skip a concept in Unit Two, for example, you
may well have trouble understanding the concepts in Unit Six. If you have trouble
understanding a concept, slow down and go back over the material as many times as
necessary. Take advantage of all of the resources I’ve provided. If you stick with
earlier concepts until you understand them, you’ll have little trouble with later
I. The Goals
As a science, economics must first develop an understanding
of the processes by which human desires are fulfilled. Second, economics must show
how factors that affect production and consumption lead to various results. Furthermore,
it must draw conclusions that will serve to guide those who conduct and, in part,
control economic activity.
II. Micro and
Macro Views of the Economy
While there are numerous specialties within the academic
field, at its most basic level economics is commonly divided into two broad areas
of focus: microeconomics and macroeconomics. Microeconomics is the study of smaller
levels of the economy, such as how an individual firm or a small group of firms
operate. Macroeconomics is the study of whole economies or large sectors of economies.
Microeconomics is the social science dealing in
the satisfaction of human wants using limited resources. It focuses on individualunits that make up the
whole of the economy. It examines how households
and businesses behave as individual units, not as parts of a larger whole. For
instance, microeconomics studies how a household spends its money. It also studies
the way in which a business determines how much of a product to produce, how
to make the best use of production factors and what pricing strategy to use.
Microeconomics also studies how individual markets and industries are organized,
what patterns of competition they follow and how these patterns affect economic
efficiency and welfare.
Macroeconomics studies an economy at the aggregatelevel. It is concerned with the workings of the whole economy or large
sectors of it. These sectors include government, business and households. Macroeconomics
deals with such issues as national economic output and growth, unemployment,
recession, inflation, foreign trade, monetary policy and fiscal policy.
Basic economic principles include the law of demand,
demand determinants, the law of supply, supply determinants, market equilibrium,
factors of production, the firm, gross product, as well as inflation and unemployment.
A. The Law of Demand
When an individual want is expressed as
an intention to buy, it becomes a demand. The law of demand is a theory about
the relationship between the amount of a good that a buyer both desires and
is able to purchase per unit of time, and the price charged for it. The
ability to pay is as important as the desire for the good, because economics
is interested in explaining and predicting actual behavior in the marketplace,
not just intentions. At a given price for a good, economics is interested in
the buyer's demand that can effectively be backed by a purchase. Thus, it is
implied with demand that a consumer not only has the desire and need for a product,
but also has the money to purchase it. The law of demand states that the
lower the price charged for a product, resource or service, the larger will
be the quantity demanded per unit of time. Conversely, the higher the price
charged, the smaller will be the quantity demanded per unit of time — all other
things being constant. For example, the lower the purchase price for a six-pack
of Coca-Cola, the more a consumer will demand (up to some saturation point,
B. Demand Determinants
Movement along the demand curve — referred to as
a change in quantity demanded — means that only the price of the good
and the quantity demanded change. All other things are assumed to be constant
or unchanged. These things include the prices of all other goods, the individual's
income, the individual's expectations about the future and the individual's
tastes. A change in one or more of these things is called a change in demand.
The entire demand curve will move as a result of a change in demand.
movement along the demand curve = change
only in price or quantity demanded
movement of entire demand curve = change in one or
more demand determinants (not price or quantity)
Law of Supply
The law of supply is a statement about the relationship
between the amount of a good that a supplier is willing and able to supply and
offer for sale, per unit of time, and each of the different possible prices
at which that good might be sold. This law further states that suppliers
will supply larger quantities of a good at higher prices than at lower prices.
In other words, supply generally is governed by profit-maximizing behaviors.
The supply curve indicates what prices are necessary in order to give a supplier
the incentive to provide various quantities of a good per unit of time. Just
as with the demand curve, movement along the supply curve always assumes that
all other things are constant.
D. Supply Determinants
At the opportunity for sale at a certain price,
a part of total supply becomes realized market supply. Economics emphasizes
movement along the supply curve in which the price of the good determines the
quantity supplied. As with the demand curve, the price of the good is singled
out as the determining factor with all other things being constant. On the supply
side, these things are the prices of resources and other production factors
(including labor costs), technology, the prices of other goods, the number of
suppliers and the suppliers' expectations.
movement along the supply curve = change
only in price or quantity demanded
movement of entire supply curve = change in one or
more supply determinants (not price or quantity)
E. Market Equilibrium
Supply and demand interact to determine the terms
of trade between buyers and sellers. In theory, supply and demand mutually
determine the price at which sellers are willing to supply just the amount of
a good that buyers want to buy. The market for every good has a demand curve
and a supply curve that determine this price and quantity. When this price and
quantity are established, the market is said to be in equilibrium. The price
and quantity at which this occurs are called the equilibrium price and equilibrium
quantity. In equilibrium, price and quantity have the tendency to remain unchanged.
equilibrium: price and quantity demanded = price and
F. Factors of Production
Factors of production are economic resourcesused in the production of goods, including natural, man-made and human
resources. They may be broken down into two broad categories: (1) property resources,
specifically capital and land; (2) human resources, specifically labor and entrepreneurial
Managers often speak of
capital when referring to money, especially when they are talking
about the purchase of equipment, machinery and other productive facilities.
Financial capital is the more accurate term for the money used to make such
purchases. An economist would refer to these purchases as investments. The economist
uses the term capital to mean all the man-made aids used in
production. Sometimes referred to as investment goods, capital consists of machinery,
tools, buildings, transportation and distribution facilities, and inventories
of unfinished goods. A basic characteristic of capital goods is that they are
used to produce other goods. Capital goods satisfy wants indirectly by
facilitating the production of consumable goods, while consumer goods satisfy
To an economist, land
is the fundamental natural resource that is used in production. This resource
includes water, forests, oil, gas and mineral deposits. These resources are
rapidly becoming scarce. Land resources, which include the natural resources
above, on and below the soil, are distinguished by the fact that man cannot
Labor is a
broad term that covers all the different capabilities and skills possessed by
human beings. While this often means direct production labor, it includes management
labor as well. The term manager embraces a host of skills related to
the planning, administration and coordination of the production process.
Entrepreneurialability also is known as enterprise. Entrepreneurs
have four basic functions. First, they take initiative in using the resources
of land, capital and labor to produce goods and services. Second, entrepreneurs
make basic business policy decisions. Third, they develop innovative new products,
productive techniques and forms of business organization. Finally, entrepreneurs
bear the risk. In addition to time, effort and business reputation, they risk
their own personal funds, as well as those of associates and stockholders.
G. The Firm
Production (land, capital and labor) are brought together in a production
unit referred to as a business or firm. The firm uses these resources to
produce goods that are then sold. The money obtained from the sale of
these goods is used to pay for the economic resources. Payments to those
providing labor services are called wages. Payments to those
providing buildings, land and equipment leased to the firm are called
rent. Payments to those providing financial capital, such as loans,
stocks and bonds, are called dividends and interest. In other
words, since capital goods are man-made and reproducible, they tend to
increase the productivity of labor.
H. Gross Production
The total dollar value of all the final goods
produced by all the firms in an economy is called the gross product. This
commonly is measured by one or both of the following:
Gross national product (GNP)
includes the value of all goods and services produced by firms originating
in a single nation. This means that foreign direct investment (FDI) — such
as a Japanese auto plant in the US — is not included in GNP, even though
the plant might employ US workers and sell its output exclusively to US
consumers. Conversely, the value of production by US-based firms abroad
would be considered part of the US GNP.
Gross domestic product (GDP)
includes the value of all goods and services produced within a nation, regardless
of where the owners of production are based. In this case, FDI into the
US would contribute to US GDP, while US investment in other countries would
contribute to those countries' GDP, not that of the US.
GNP = value of all goods and services produce by all
US firms no matter where located
GDP = value of all goods and services produced by all
firms located in the US
GDP is the preferred measure of gross product for
many kinds of economic analyses. This is because foreign investment has grown
rapidly around the world, and because foreign-owned assets, such as a manufacturing
facility, tend to have a greater net influence on the domestic economy in which
they are situated. Both measures of gross product calculate the value of products
and services on a value-added basis so that output is not double-counted, such
as when products are resold through different phases of the supply and distribution
In order to make comparisons, economists often
use real GNP or GDP, which means the figure has been adjusted to hide
the effects of inflation, or the general rise of prices relative to the quantity
or quality of goods produced. Therefore, real gross product is commonly taken
as an indicator of overall economic health. A rise at a moderate, sustainable
pace is considered healthiest. However, if gross product is declining or rising
at an unsustainably fast pace, it usually is interpreted as a negative signal.
I. Inflation and Unemployment
The economic health of a nation, of which gross
product is one measure, is directly affected by two other important factors
– inflation and unemployment.
is an ongoing general rise in prices without a corresponding rise in
the quantity or quality of the underlying merchandise or services (i.e.,
getting "less for more"). Inflation represents an economic imbalance and
diminishes a currency's real and nominal purchasing power. The steeper the
rise, the faster the decline of the currency's purchasing power. Rapid economic
expansion is one factor that can lead to price inflation, as can lax or
inconsistent control of the money supply (such as through a central bank’s
monetary policy). Leading measures of inflation in the US are the Consumer
Price Index (CPI) and the Producer Price Index (PPI). When
inflation data are used to adjust the estimate of GDP, it is known as the
2. The unemployment
rate measures the percentage of the total number of workers in the labor
force who are actively seeking employment but are unable to find jobs.
While this seems straightforward, there are some measurement issues to consider,
such as what constitutes looking for a job, how part-time labor is interpreted
(i.e., being underemployed rather than unemployed), and what happens when
an individual is technically employable but not actively seeking employment
for whatever reason.
In general the higher the unemployment rate, the
more the economy is wasting labor resources by allowing people to sit
idle. Still, when unemployment rates are low there is a tendency toward wageinflation because new employees are harder to find and workers often
require additional incentives in order to take or keep a job. Because having
a moderate pool of unemployed workers serves as a buffer to rising labor costs,
most economists view full employment (zero or negligible unemployment) as impractical
and even undesirable. Structuralunemployment seemingly allows
human capital to flow more freely (and cheaply) when there are changes in demand
for labor in various parts of the economy. Of course, this does not mean that
high unemployment is viewed as positive.
of Economic Thought
While many basic economic principles and ideas are
widely accepted by economists, there have been and continue to be differing theories
about some areas of economic behavior. The following is a brief overview of the
three most influential theoretical perspectives.
A. Classical Economics
Dating back to 18th-century Europe,
classical economics posited the market system would ensure full employment
of the economy's resources. Classical economists acknowledged that abnormal
circumstances such as wars, political upheavals, droughts, speculative crises
and gold rushes would occasionally deflect the economy from the path of full
employment. However, when these deviations occurred, automatic adjustments in
prices, wages and interest rates within the market would soon restore the economy
to the full-employment level. A decrease in employment would reduce prices,
wages and interest rates. Lower prices would increase consumer spending, lower
wages would increase employment and lower interest rates would boost investment
spending. Classical economists believed in Say's Law, which states that supply
creates its own demand. Although more recent economic philosophies differ
in some of the specifics, particularly on the roles of government, the central
bank and international trade, many tenets of classical economics are still accepted
B. Keynesian Economics
As a consequence of the 1936 publication of British
economist John Maynard Keynes's General Theory of Employment, Interest and
Money, mainstream economists came to give less importance to the role of
money in the economy than had classical economists. Keynes sought to explain
why there was cyclical employment in capitalistic economies. Keynes's analysis
of how total demand determines total income, output and employment, and
the potentially key role for fiscal (government) policy in the process,
captured the attention of most economists.
Moreover, the General Theory seemed to make compelling
arguments for the use of government fiscal policy to avoid such problems and
to smooth out economic instability. Keynesian followers believe that savings
must be offset by investment. They termed propensity to consume as a
person's decision on how much of total income will be allocated to savings and
how much will be spent. The Keynesian view sees the causes of unemployment and
inflation as the failure of certain fundamental economic decisions, particularly
saving and investment decisions. In short, the Keynesian view is one of a demand-based
More recently, the monetarists, led by Nobel laureate
economist Milton Friedman, argued that money plays a much more important role
in determining the level of economic activity than is granted to it by the Keynesians.
Monetarism holds that markets are highly competitive and that a competitive
market system gives the economy a high degree of macroeconomic stability.
Monetarists argue that the price and wage flexibility provided by competitive
markets causes fluctuations in total demand rather than output and employment.
Monetarism is concerned with controlling the money supply and not with
injecting excess liquidity into markets. This view is somewhat compatible with,
but not identical to, the supply-side school of economics.
the Economy Films: Chapter 1: What is the economy?
How did the economy get started? Meet Ugg, Glugg and Tugg, three enterprising
cave men who accidentally invented trade, marketing and the base elements of
the modern market economy.
Why is the law of supply and demand so powerful? A whimsical tale of
love, dance and the economic concept of supply and demand. Bored in class, Jonathan
and Kristin are woken up by our friendly narrator who helps guide them on an
adventure in economics and... um... dance.
How do we measure the economy? Two economists settle their differences
- in the professional wrestling ring. Watch and cheer as John Maynard Keynes
and Friedrich Hayek square off in a testosterone-fueled battle over how to measure
How does government regulate the economy? In an idyllic suburban neighborhood,
Jerry runs his big business lemonade stand and has the market cornered -- until
ten-year-old Addie opens her own stand across the street. Competition equals
war, and both sides use -- and abuse -- a government regulator to try and win.
In the end, one special customer will decide their fate.
Are natural resources vital to the economy? Why should nature be taken
into account when looking at the economy as a whole? "A Bee's Invoice" uncovers
and incorporates the hidden value of natural capital in the measurement of our
years ago, The Times Magazine published an essay by the
economist Milton Friedman that became highly influential. It had a
plain-spoken headline - “The
Social Responsibility of Business Is to Increase Its Profits” -
and argued that corporate executives should stop worrying about
paying high wages, protecting the environment and other do-gooderism.
They could best help society, Friedman argued, by maximizing the
value of their companies.
The essay helped lay the groundwork for a laissez-faire
revolution, in the US and elsewhere. In the years since, many
American companies have prospered, with soaring profits and stock
prices - but there have also been big downsides. The incomes and
wealth of most American workers have grown slowly. Some other
measures of well-being, like life expectancy, have also stagnated.
The planet is facing the destructive crisis of global warming.
It's extremely important that you learn and understand each of these terms.
That will be easier as you start to use them. As you progress through the rest
of the units, make certain you come back to this list as needed and refresh your
memory. If you do that, you'll soon begin to genuinely know and understand the
The study of how people allocate their limited resources
to satisfy their unlimited wants ... ultimate purpose of economics is to understand
the part of economic analysis that studies individual decision making undertaken
by individuals (or households) and by firms.
Macroeconomics: the part of economic analysis that studies the behavior of the economy
as a whole. It deals with economy-wide phenomena such as changes in unemployment,
the general price level, and national income.
Rational Self-Interest: economic assumption that individuals act as if they are motivated by self-interest
and respond predictably to opportunities for gain
The Rationality Assumption: the assumption that individuals will not intentionally make decisions that would
leave them worse off
Responding to Incentives: the reward for engaging in a given activity … people react to an incentive by
making a rough comparison of costs and benefits
Defining Self-Interest: the pursuit of goals that make the individual feel better off … in economic analysis
goals are often measured in monetary terms although the pursuit of other goals (prestige,
love, power, etc) can be analyzed using this concept
Models and Realism: economic models or theories, which are simplified representations of the real
world, are developed and used as aids in understanding, explaining, and predicting
economic phenomena in the real world. A model should capture the essential relationships
that are sufficient to analyze the specific problem or answer the specific question
being asked. No economic model is complete in the sense of capturing every detail
and relationship that exists in the real world. A model is by definition an abstraction
from reality. This does not mean that models are deficient simply because they are
unrealistic and use simplified assumptions. Every model in every science requires
simplification compared to the real world.
define the set of circumstances in which a model is most likely to be applicable.
Every model, therefore, must be based on a set of assumptions.
The Ceteris Paribus
Assumption (All Other Things Being Equal): assumption that nothing changes
except the factors being studied … used to isolate the effect of a change in one
variable on another one by assuming that all other variables do not change.
Deciding on the Usefulness
of a Model: a model is useful if it yields usable predictions and implications
for the real world … if a model makes a prediction and factual evidence supports
the prediction, the model is useful.
of Behavior, Not Thought Processes: models relate to the way people
act in using limited resources and not to the way they think … normally
generalize people’s behavior
The Two Common Pitfalls in Understanding How the Economy
Works: (1) failing to understand
the ceteris paribus assumption and (2) confusing association
Association and Causation:
We cannot always assume that when one event follows another, the first caused
the second. Just because two things are associated – by timing or anything else
– does not mean there is a causal relationship.
Direct/Positive Relationship: A direct or positive relationship between
price and quantity supplied means that if one goes up the other goes up and if one
goes down the other goes down. Supply curves have a positive slope because only
at a higher price will it be profitable for sellers to incur the higher opportunity
cost associated with supplying a larger quantity.
Inverse/Negative Relationship: An inverse or negative relationship between
price and quantity means that if one goes up the other goes down and if one goes
down the other goes up. Demand curves have a negative slope because only at a lower
price will consumers be willing to demand a higher quantity.
Positive versus Normative Economics
deals with whatis. Positive economic statements are “if-then”
statements. Since positive economics predicts consequences of actions, it can be
used to predict the effects of various policies to see if the policies aid in achieving
desired goals. Positive economics cannot provide criteria for choosing which outcomes
or goals are best.
deals with what some individual thinks ought to be.
Normative economic statements involve value judgments and normally have the words
“ought” or “should” in them.
Warning: It is easy to define positive economics.
It is often difficult to identify unlabeled normative statements.
Factors of production / inputs used in the production
of things that people want
any activity that makes the things that exist and that we use more valuable to us
Labor: all productive
contributions made by individuals who work
Physical capital or capital
good: all manufactured resources used for production
Investment is the accumulation of capital – such as factories, machines and
inventories – that is used to produce goods and services. When an economy does not
invest in new technology, everything else being equal, the economy will not grow.
The opportunity cost of investment is the consumer goods that could have been purchased
now but weren’t because the money was spent for plants and other capital. But an
increase in investments makes it possible to have economic growth and more goods
and services in the future. The normal rate of return
is the amount that must be paid to an investor to induce investment in business.
The normal rate of return is also the opportunity cost of capital.
training and education workers receive that increases their productivity
Entrepreneurship: a type of labor that organizes, manages and assembles other factors of production
to make business ventures … takes risks associated with introducing new methods
and other types of new thinking that could lead to more income
Goods and Services
from which individuals derive satisfaction or happiness
good for which the quantity demanded exceeds the quantity supplied at a zero price
or used by consumers with no physical characteristics
Wants are unlimited
Not objectively definable in economics - some individuals
might view shelter as a need, others might not
Those things that are absolute necessity to stay
alive - food, water, etc - are obviously needs but perhaps not the only
Wants are unlimited but, by definition, the supply
of economic goods is limited.
The things consumers want and need are scarce.
Scarcity requires that individuals and societies make
The dilemma created by unlimited wants and scarce goods
is the central concept in economics.
The central problem of economics is providing for people’s wants and needs in
a world of scarcity.
The three fundamental economic questions: (1) What to produce? (2)
How to produce? (3) For whom to produce?
When one choice is made, another is always given
Opportunity Cost: the alternative given up when a choice is made
Your textbook had a dollar cost of $50 plus
an opportunity cost of what you would have bought with that $50 had you not
bought your text.
In economics, we always view cost as a
foregone opportunity, an opportunity given up in favor
of something else.
Marginal analysis is an examination of the effects of an addition to or subtraction
from a current situation ... analyzing the margin. Marginal changes are small, incremental
adjustments to an existing plan of action. Marginal thinking requires decision-makers
to evaluate whether the benefit of one more unit of something is greater than
In the situation below, thinking about the benefit and cost of whether to add each
additional hour is marginal analysis.
Production Possibilities Curve (PPC)
Sometimes called a production possibilities frontier.
The PPC shows...
"all possible combinations of output that can be
produced from a fixed amount of resources of a given quality and the efficient
use of those resources over a specified period of time."
Movement from one point to another on the PPC shows
that some of one good must be given up to have more of another.
The assumptions on which the PPC
is based are:
Resources are fully employed.
There is a specified time period, for example,
Resources are fixed in both quantity and quality.
Technology does not change.
"Off the PPC"
Any point outside the PPC cannot be reached
for a specified time period.
Any point inside the PPC is attainable but
represents an inefficient use of resources.
Producing the maximum output with available technology
and resources OR a given output is produced
at a minimum cost
An economy is efficient when it is on its PPC.
Increasing relative cost
As society takes
more and more resources and applies them to the production of any one item,
the opportunity cost increases for each additional unit produced.
Illustrated by an outward shift of
the production possibilities curve.
Working at a relatively well-defined, limited activity
leads to an increase in productivity.
Absolute advantage: ability to produce more units of a good or service using a given quantity
of labor or resource inputs … the ability to produce the same quantity of a good
or service using fewer units of labor or resource inputs
Comparative advantage: ability to produce a good or service at a lower opportunity cost compared to other
producers … the basis for specialization
Division of labor: a term first used in Adam Smith’s The Wealth of Nations to describe
the narrow specialization of tasks within a production process so that each worker
can become a specialist in doing one thing, for example on an assembly line. Using
his famous example of pins, Smith asserted that ten workers could produce 48,000
pins per day if each of eighteen specialized tasks was assigned to particular workers.
Average productivity: 4,800 pins per worker per day. But absent the division of
labor, a worker would be lucky to produce even one pin per day if he had to do everything
from start to finish.
The advantages of division of labor:
increases productivity (and so increases wealth)
eliminates the long training period required
to train craftsmen
uses lesser paid but more productive unskilled
higher average standard of living
the growth of total trade
the rise of capitalism
the increased complexity of industrialized
processes (and so more sophisticated output)
workers need less training to master a small number of tasks
faster to use one particular tool and do one job over and over
workers can concentrate on those jobs which best suit their skills
The Law of Demand:
the quantities of a good or service that people will purchase at any price during
a specified time period, other things being equal. The law of demand states that
there is an inverse relationship between relative price and quantity demanded, i.e.
when the relative price of a good goes up, people buy less of it and when the relative
price of a good goes down, people buy more of it, other things being equal.
The Demand Schedule:
The demand schedule is a numerical representation of the inverse relationship between
specific prices and quantities demanded of a good measured in terms of constant
quality units in a given time period.
Price per Constant-Quality Rewritable
Constant-Quality Rewritable CDs
The Individual Demand Curve:
The demand curve is a graphic representation of the demand schedule. It is a negatively
sloped line showing the inverse or negative relationship between the price and the
quantity demanded, meaning that if one goes up the other goes down and vice
market is any arrangement in which buyers and
sellers interact to determine the price and quantity of goods and services exchanged.
is the summation of the individual demand schedules in a market.
price changes, there is a change in thequantity
demanded and so movement along the curve.
something other than price changes, the whole curve shifts ... there is a
change in demand. Changes in non-price determinants
of demand can produce a shift in the demand curve, but not movement along
the demand curve.
Shifts in Demand:
A movement of the entire demand curve so that at each price the quantity demanded
changes. A leftward shift of the demand curve means the quantity demanded at each
price decreases and is called a decrease in demand, while a rightward shift of the
demand curve means the quantity demanded at each price increases and is called an
increase in demand.
The Other Determinants of
Demand: These are non-price factors which determine how much will be
bought, other things held constant. A change in any one of these factors will cause
a change in demand.
Income: For a normal
good, an increase in income leads to an increase in demand, while a decrease in
income leads to a decrease in demand. For an inferior good, an increase in income
leads to a decrease in demand, while a decrease in income leads to an increase in
normal good is any good for which there is a
direct relationship between changes in income and its demand curve. If income increases,
demand for normal goods increases.
inferior good is any good for which there is an inverse relationship
between changes in income and its demand curve. As buyers’ incomes increase, demand
for inferior goods decreases.
Tastes and Preferences:
If consumer tastes change in favor of a good, then there is an increase in demand
for it. If consumer tastes move against the good, then there is a decrease in demand
Prices of Related Goods (Substitutes
and Complements): When two goods are related a change in the price of
one of them changes the demand for the other. Substitutes are goods that can be
used to satisfy a similar want. If the price of one changes, demand for the other
changes in the same direction. Complements are goods that are consumed together.
If the price of one changes, the demand for the other changes in the opposite direction.
Substitute goods are goods that compete with
one another for consumer purchases. If a product’s price begins to increase, the
demand for similar but less expensive products (substitutes) will increase.
Complementary goods are goods that are jointly
consumed with another good – coffee and cream, peanut butter and jelly, printer
ink and paper. As a product’s price increases, the demand for that product and for
its compliments decrease.
of future increases in the price of a good, increases in income, and reduced availability
lead to an increase in demand now. Expectations of future decreases in the price
of a good, decreases in income, and increased availability lead to a decrease in
Market Size (Number of Buyers):
An increase in the number of buyers in the market causes an increase in demand.
A decrease in the number of buyers causes a decrease in demand.
Changes in Demand vs Changes
in Quantity Demanded: A change in demand refers to a shift of the entire
demand curve to the right or left if there is a change in a determinant of demand
other than price. A change in quantity demanded refers to a movement along a given
demand curve caused by a change in price.
The Law of Supply:
the relationship between price and quantity supplied at different prices in a specified
time period, other things being equal. The law of supply states that the higher
the price of a good, the larger the quantity sellers will make available over a
specified time, other things being constant.
The Supply Schedule:
The supply schedule is a table that shows a direct relationship between price and
quantity supplied at each price in a given time period.
Price per Constant-Quality Rewritable
Quantity of Rewritable CDs Supplied
(1,000 of constant-quality units
per year supplied)
The Individual Supply Curve:
This is a graphic representation of the supply schedule that is an upward sloping
line showing a direct or positive relationship between price and quantity supplied,
meaning that if one goes up the other goes up and vice versa. Supply curves have
a positive slope because only at a higher price will it be profitable for sellers
to incur the higher opportunity cost associated with supplying a larger quantity.
Market supply is the summation of all the
quantities supplied at various prices that might prevail in the market.
price changes there is a change in the quantity supplied
and so movement along the supply curve.
something other than price changes, the whole curve shifts. There is a
change in supply. Changes in non-price determinants
of demand can produce only a shift of the entire supply curve, not a movement
along the supply curve.
Shifts in Supply:
A change in supply is a shift of the entire supply curve so that at each price the
quantity supplied changes. A leftward shift of the supply curve means that the quantity
supplied at each price decreases and is called a decrease in supply, while a rightward
shift of the supply curve means that quantity supplied at each price increases and
is called an increase in supply.
Other Determinants of Supply: These are factors other
than price which determine how much will be produced and are held constant when
identifying supply. A change in one of these factors will cause the supply curve
Cost of Inputs Used to
Produce the Product: An increase (decrease) in the price of one or
more inputs will cause a decrease (increase) in supply.
Technology and Productivity:
An improvement in technology will cause an increase in supply.
Taxes and Subsidies:
Increases (decreases) in indirect taxes have the same effect as raising
(lowering) costs and, thus, decreases (increases) supply. A subsidy is a negative
An expected increase (decrease) in the relative price of a good can lead
to a decrease (increase) in supply.
Number of Firms in the
Industry: If the number of firms increases (decreases), supply will
Changes in Supply vs
Changes in Quantity Supplied: A change in quantity
supplied refers to a movement along a given supply curve caused by a change in price.
A change in supply refers to a shift of the entire supply curve to the right or
left caused by a change in a non-price determinant of supply.
Putting Demand and Supply
Together: Understanding how demand and supply interact is essential to
understanding how prices are determined in our economy and other economies.
Demand and Supply Schedules
Combined: When the supply and demand schedules are combined, an equilibrium
or market-clearing price is determined. This is a price at which quantity demanded
equals quantity supplied. There is neither an excess quantity supplied (surplus)
nor an excess quantity demanded (shortage).
is a stable point. When equilibrium is reached, there is no tendency for change
unless supply and/or demand change. Equilibrium is a situation where quantity supplied
equals quantity demanded at a particular price. Equilibrium occurs where the supply
and demand curves intersect.
A change in demand or a change in supply will cause a change in market equilibrium.
Shortages: A shortage
is a situation in which quantity demanded is greater than quantity supplied. At
a price below the equilibrium price there is a shortage which is corrected when
price increases. Quantity demanded will fall and quantity supplied will increase
until equilibrium is reached.
Surpluses: A surplus
is a situation in which quantity demanded is less than quantity supplied. At a price
above the equilibrium price there is a surplus that is corrected when price decreases.
Quantity demanded will rise and quantity supplied will fall until equilibrium is
So how do we answer the three
fundamental economic questions?
(1) What to produce? (2) How to produce? (3) For whom to produce?
WHAT we produce is determined by the equilibrium of the markets.
HOW we produce is determined by profit- seeking behavior and efficient resource
FOR WHOM we produce is determined by those willing and able to pay the equilibrium
and quantity are determined by the intersection of supply and demand.
A change in supply,
or demand, or both, will necessarily change the equilibrium price, quantity
It is highly unlikely
that the change in supply and demand perfectly offset one another so that
equilibrium remains the same.
Supply is constant, demand increases.
The new demand curve (DEMAND 2) is located on the right hand side of
the original demand curve.
The new curve intersects the original
supply curve at a new point. At this point, the equilibrium price (market
price) and equilibrium quantity are higher.
Demand is constant, and supply
increases. The new supply curve (SUPPLY 2) is located on the right side
of the original supply curve.
The new curve intersects the original
demand curve at a new point. At this point, the equilibrium price (market
price) is lower, and the equilibrium quantity is higher.
The increased demand curve and
increased supply are drawn together. The new intersection point is located
on the right hand side of the original intersection point.
The new equilibrium point indicates
an equilibrium quantity higher than the original equilibrium quantity.
The equilibrium price is also higher. In this case, it's because demand
has increased relatively more than supply.
An economic system in which relative prices constantly
change to reflect changes in demand and supply. Prices act as signals of relative
scarcity to everyone in the system.
Rationing Function of Prices
Prices are indicators of relative scarcity and ration
goods to those who are willing to pay the most. Because of scarcity, it is not possible
for everyone to have everything they want. There must be some method of rationing.
Rationing by a freely functioning price system is the
most efficient because all gains from mutually beneficial trade will be exhausted.
Goods can also be rationed on a “first-come, first-served”
basis, by the use of political power, by physical force, by lotteries, by coupons,
and by cultural, physical, and religious differences.
Government-Imposed Price Controls
The rationing function of prices is often not allowed
to operate when government sets price controls called price floors (minimum
legal prices) and price ceilings (maximum legal prices).
If the market equilibrium cost is perceived as
unfair or unjust the government can intervene in the market in a number of ways
... including banning the production and consumption of certain goods and services
entirely. Government can also regulate industries such as banking that it deems
too sensitive to be left alone.
price ceiling is a legal maximum that can be
charged for a good. The ceiling is shown by a horizontal line at the ceiling
price, which is set below the equilibrium price. The chart shows a price
ceiling of $2, at which the quantity demanded is 40 units and the quantity supplied
is 20 units. The result is a shortage because the quantity demanded exceeds
the quantity supplied. Rent controls are good examples of real-life price ceilings.
A city might impose a ceiling of $1,000 per month on two-bedroom apartments.
Price ceilings help some groups and hurt others.
For example, caps on apartment rents help tenants who pay below-market rents
but hurt landlords and other prospective tenants who are shut out of the market
due to the shortage. Rent-control cities are usually full of buildings that
landlords abandoned because the buildings became unprofitable to operate. Because
of that, the total supply of apartments is lower than it otherwise would be.
Intervention in markets should not be taken lightly
because often serious by-products emerge. With apartment price ceilings,
underground markets often appear in which landlords and tenants agree to the
"official" contract rate but tenants agree to make additional side payments.
In addition, if landlords can't set prices, they begin to adjust the quality
of their apartments, letting them fall into disrepair. Some tenants end up living
in unkempt conditions and are afraid to report the landlord because they may
find themselves homeless if the landlord quits renting the apartment.
A price floor
is a legal minimum that can be charged for a good. The floor, as shown in
the chart, is represented by a horizontal line. To be effective, the floor must
be set above the equilibrium price. In the chart, the floor is set at
$4. Quantity demanded is 20 units and quantity supplied is 40 units. The result
of the floor is a surplus of 20 units. Common examples of price floors are found
in agricultural markets such as sugar, wheat and milk. The minimum wage is also
a price floor because it sets a minimum dollar amount that employers can pay
employees. Therefore, there is always a "surplus" of minimum-wage workers. If
employers were allowed to pay salaries at the equilibrium point, all of those
surplus workers would be employed ... although all of the previous minimum-wage
workers would make less.
As with price ceilings, the same tradeoff occurs
between equity and efficiency with price floors. Some groups benefit while others
lose. In the case of the minimum wage, those who are able to find the higher
paying jobs benefit. Employers who must pay higher wages lose along with those
in the labor force who cannot find jobs because wages are too high. Agricultural
price floors benefit farmers at the expense of consumers. Nevertheless, society
has thus far deemed the benefits received from the price floors to be worth
Governments can impose quantity restrictions on a market, such as a ban on ownership
or trading of goods (human organs and certain psychoactive drugs). The most
common quantity restrictions in international trade are import quotas. A quota
is a quantity restriction that prohibits the importation of more than a specified
quantity of a particular good in a one-year period. The United States has had
import quotas on tobacco, sugar, and immigrant labor. The beneficiaries of quotas
are importers who get the quota rights and the domestic producers of the restricted
We have price ceilings and price floors because of failures in the free market.
A market failure is a situation in which the
price system creates a problem for society or fails to achieve society’s goals.
Market failure happens when competition is lacking. Two examples of market failure
are incomeinequality and externalities.
The benefits of a price system
are high levels of economic efficiency, the existence of consumer sovereignty, promotion
of personal freedom, and prevention of coercion of buyers and sellers by the existence
of competition. A price system can also produce market failures for which government
interventions may be wanted.
How the Price Mechanism Helps Us Make Decisions
from Economics Mafia (5:35)
The Price Mechanism in Action
Geoff Riley (22:40)
Correcting for Externalities:
An externality is a situation in which a benefit or a cost associated with an economic
activity spills over to third parties, i.e., parties who are not direct participants
in the market transaction. A cost is imposed on or a benefit is given to people
other than the consumers and producers of a good or service (third parties).
A negative externality is one that is detrimental
to third parties, such as pollution.
A positive externality is one that is beneficial
to third parties, such as vaccinations or public goods.
When the supply curve fails to include negative external costs, the equilibrium
price is artificially low and the equilibrium quantity is artificially high.
External costs cause the market to over allocate resources, and external benefits
cause the market to under allocate resources.
When externalities are present,
market failure gives incorrect price and quantity signals, and resources are
How Government Corrects Negative
Special Taxes: Taxes on output would reduce output,
but would not provide an incentive to reduce pollution per unit of output. Taxes
on the amount of pollutants emitted would provide an incentive to reduce pollution
per unit of output.
Regulation: The government could specify a maximum
allowable rate of pollution.
How Government Corrects Positive
Government Financing and Production: When positive
externalities are large (e.g. public goods), government may finance and produce
the good or service.
Subsidies: A subsidy is a negative tax: a payment
to the consumer or producer of a good or service for consuming or producing
that good or service
Regulation: Government can require that certain
actions be undertaken, e.g. inoculations of school children.
Providing a Legal System:
All relationships among consumers and businesses are governed by legal rules.
Much of the legal system is involved with defining and protecting property rights.
Promoting competition is a way of increasing the efficiency of the economy. Antitrust
legislation is used to reduce the power of monopolies and to discourage certain
activities that restrain trade.
Providing Public Goods:
Public goods are goods to which the principle of rival consumption does not apply
(rival vs non-rival) and are jointly consumed by many individuals simultaneously
(excludable vs non-excludable). This is in contrast to private goods that can be
consumed by only one person at a time.
A public good is a good that, once produced, has two properties: (1) users collectively
consume benefits and (2) no one can be excluded. National defense, public education
and roads are examples of public goods.
If public goods are available only in the marketplace, people wait for someone else
to pay. The result is an underproduction or zero production of public goods.
of Public Goods
Public goods can be used by more and more people
at no additional cost and without depriving others of any services of the goods.
It is difficult to design a collection system for
a public good on the basis of how much individuals use it.
The free rider problem is a situation associated
with public goods when individuals presume others will pay for public goods,
so they can escape paying for their portion without causing a reduction in production.
Merit and Demerit Goods:
The government defines certain goods and services as desirable or undesirable. A
merit good is a good that has been deemed socially desirable by the political process,
and will be provided by government or subsidized. A demerit good is a good that
has been deemed socially undesirable by the political process. It will be prohibited,
taxed, or regulated to reduce consumption.
Government explicitly redistributes income by progressive taxation and by transfer
payments and transfers in kind. Transfer payments are money payments made to individuals
for which no services or goods are concurrently rendered. Transfers in kind are
payments in the form of goods and services for which no goods or services are concurrently
Ensuring Economy-wide Stability:
The federal government is charged under the Employment Act of 1946 with stabilizing
the economy at high levels of employment.
Fiscal policy is a broad term used to refer to the tax and spending policies
of the federal government. For example, when demand is low in the economy, the
government can step in and increase its spending to stimulate demand. Or it
can lower taxes to increase disposable income for people as well as corporations.
Fiscal policy decisions are determined by Congress and the Executive branch.
Monetary policy is a term used to refer to the actions of central banks to achieve
macroeconomic policy objectives such as price stability, full employment and
stable economic growth. In the US, Congress established maximum employment and
price stability as the macroeconomic objectives for the Federal Reserve. They
are sometimes referred to as the Federal Reserve's dual mandate. Apart from
these overarching objectives, Congress determined that operational conduct of
monetary policy should be free from political influence. As a result, the Federal
Reserve is an independent agency of the federal government.
The Business Cycle
The business cycle is comprised of four phases of economic growth and decline.
It's sometimes called the boom and bust cycle. The goal of economic policy is
to keep the economy growing at a healthy rate -- fast enough to create jobs
for everyone who wants one, but slow enough to avoid inflation. The business
cycle is caused by the forces of supply and demand, the availability of capital
and expectations about the future.
There are four phases that describe the business cycle. At any point in time
the economy is in one of these stages:
Contraction: The economy starts slowing
down. It's usually accompanied by a bear market. GDP growth rates usually
slow to the 1%-2% level before actually turning negative. A contraction
is usually triggered by an event, such as a rapid increase in interest rates,
a financial crisis or runaway inflation. Fear and panic replace confidence.
Investors sell stocks, and buy bonds, gold and the US dollar. Consumers
lose their jobs, sell their homes and stop buying anything but necessities.
Businesses lay off workers and hoard cash. At this point, a stock market
correction may indicate that assets are overvalued. The Fed can switch to
expansionary monetary policy if economic growth slows or even turns negative.
That means it will lower interest rates and buy Treasuries in open market
operations. This is when expansionary fiscal policy is desperately needed.
That means cutting taxes and increasing spending to create jobs, demand
Trough: The economy hits bottom, usually
in a recession. GDP growth may still be negative, but it's not as bad. It's
clear that the economy has turned a corner. Confidence must be restored
before the economy can enter a new expansion phase. That often requires
intervention with monetary or fiscal policy. Central banks pull out all
the tools to jump start the economy out of a trough.
Expansion: The economy starts growing
again. It's usually signaled by a bull market. GDP growth turns positive
again, and should be in the healthy 2%-3% range. If the economy is managed
well, it can stay in the expansion phase for years. When consumers are confident,
they buy because they know there will be future income from better jobs,
higher home values and increasing stock prices. As demand increases,
businesses hire new workers, which increases income, further stimulating
more demand. Too much capital will turn a healthy expansion into a peak.
That's because there's too much money chasing too few goods. This causes
inflation. Central banks try to keep the core inflation rate at around 2%
to create a healthy expectation of inflation. In the United States, that
means the Federal Reserve will keep the Fed funds rate right around 2%.
If economic growth remains at the healthy 2-3% growth rate, the Fed won't
make any changes.
Peak: The economy is overheated, and
is in a state of "irrational exuberance." This is when inflation may hit.
The economy's expansion slows. It's usually the last healthy growth quarter
before contraction starts. You usually don't know you are in a peak until
it is too late. However, if the GDP growth rate is 4% or higher for two
or more quarters in a row, the peak is not far off. If demand outstrips
supply, then the economy can overheat. In addition, investors and businesses
compete to outperform the market, taking on more risk to gain some extra
return. You can usually recognize a peak by two things: First, the media
says that the expansion will never end. Second, it seems everyone and his
brother is making tons of money from whatever the asset bubble is. Central
banks use contractionary monetary policy during an expansion to avoid the
irrational exuberance of a peak. That means they raise interest rates. If
needed, they will sell Treasuries and other assets during open market operations.
The National Bureau of Economic Research
(NBER) analyzes economic indicators to determine the phases of the
business cycle. The Business Cycle Dating Committee uses quarterly GDP growth
rates as the primary indicator of economic activity. The Bureau also uses monthly
figures, such as employment, real personal income, industrial production and
retail sales. For this reason, the NBER has the final say on economic expansions
and contractions, or business cycles.
One of the main basic economic models is the circular-flow model, which describes
the flow of money and products throughout the economy in a very simplified way.
The model represents all of the actors in an economy as either households or firms
(companies), and it divides markets into two categories:
omarkets for goods and services (product markets)
omarkets for factors of production (factor markets)
(Remember, a market is just a place where buyers and sellers come together to generate
The concept of a circular flow of income involves two
principles; (1) in every economic exchange, the seller receives exactly the same
amount that the buyer spends and (2) goods and services flow in one direction
and money payments flow in the other. (Note that money, by definition,
flows from buyer to seller in all markets.)
Profits are a part of
costs because entrepreneurs must be rewarded for providing their
services, or they will not provide them.
is the total of all individuals’ income and is also defined as the annual cost
of producing the entire output of final goods and services.
Total output is the value of all of the
final goods and services produced in the economy during the year.
Households are the buyers and businesses are the sellers of consumer goods.
Households buy finished products from firms that are looking to sell
what they make. In this transaction, money flows from households to firms.
Finished products flow from firms to households in product markets.
Households are the sellers; they sell resources such as labor, land, capital
and entrepreneurial ability. If markets for goods and services were
the only markets available, firms would eventually have all of the money
in an economy, households would have all of the finished products, and economic
activity would stop. Luckily, product markets don’t tell the whole story,
and factor markets serve to complete the circular flow of money and resources.
The term factors of production refers to anything that is used by
a firm in order to make a final product.
Some examples of factors of production are labor (the work done by people),
capital (the machines used to makes products), land and so on. Labor markets
are the most commonly discussed form of a factor market, but it’s important
to remember that factors of production can take many forms.
In factor markets, households and firms play different roles than they do
in product markets. When households provide labor to firms, they can be
thought of as the sellers of their time or work product. (Technically, employees
can more accurately be thought of as being rented rather than being sold,
but this is usually an unnecessary distinction.) Firms provide money to
households as compensation for the use of factors of production. Therefore,
the functions of households and firms are reversed in factor markets as
compared to in product markets.
is income earned by households in payment for the production of these goods
and services. The value of total output is identical to total income, since
spending by one group is income to another.
When factor markets are put together with product markets, a closed loop for
the flow of money is formed. As a result, continued economic activity is sustainable
in the long run, since neither firms nor households are going to end up with
all of the money. (It’s also worth noting that firms are owned by people, and
people are parts of households, so the two entities are not quite as distinct
as the model implies.) Firms use factors of production to create finished products
and households consume finished products in order to maintain their ability
to provide factors of production.
The basic circular flow of income, or two-sector circular
flow of income model, consists of six assumptions:
The economy consists of two sectors: households and firms.
Households spend all of their income (Y) on goods and services or consumption
(C). There is no saving (S).
All output (O) produced by firms is purchased by households through their
There is no financial sector.
There is no government sector.
There is no foreign sector
This model is simplified in a number of ways, most notably in that it represents
a pure capitalistic economy with no role for government. One could, however,
extend this model to incorporate government intervention by inserting government
between the households, firms, and markets. (See model below.)
It’s interesting to note that there are four places where government could be
inserted into the model, and each point of intervention is realistic for some
markets and not for others. (For example, an income tax could be represented
by a government entity being inserted between households and factor markets,
and a tax on a producer could be represented by inserting government between
firms and goods and services markets.)
In the five-sector model the economy is
divided into five sectors:
Firms or Producing sector
Financial sector : banks and non-bank intermediaries who engage in the borrowing
(savings from households) and lending of money
Government sector : consists of the economic activities of local, state
and federal governments.
International sector: transforms the model from a closed economy to an open
The five sector model of the circular flow of income is a more realistic representation
of the economy. Unlike the two sector model where there are six assumptions
the five sector circular flow relaxes all six assumptions. Since the first assumption
is relaxed there are three more sectors introduced.
In general, the circular-flow model is useful because it informs the creation
of the supply and demand model. When discussing the supply and demand for a
good or service, it is appropriate for households to be on the demand side and
firms to be on the supply side, but the opposite is true when modeling the supply
and demand for labor or another factor of production.
One common question regarding this model is what it means for households to
provide capital and other non-labor factors of production
to firms. In this case, it’s important to remember that capital refers
not only to physical machinery but also to the funds (sometimes called financial
capital) that are used to buy the machinery used in production. These funds
flow from households to firms every time people invest in companies via stocks,
bonds or other forms of investment.
Households then get a return on their financial capital in the form of stock
dividends, bond payments and the like, just as households get a return on their
labor in the form of wages.
Leakages and injections
In the five sector model there are leakages and injections.
oLeakage means withdrawal from the flow. When households and firms
save part of their incomes it constitutes leakage. Leakages may be in form
of savings, tax payments or imports. Leakages reduce the flow of income.
oInjection means introduction of income into the flow. When households
and firms borrow savings, that constitutes injections. Injections increase
the flow of income. Injections can take the forms of (a) investment, (b)
government spending or (c) exports. So long as leakages are equal to injections
the circular flow continues indefinitely. Financial institutions or the
capital market play the role of intermediaries.
Leakages and injections can occur in the financial sector, government sector
and international sector:
1. In the financial sector
In terms of leakages in the circular flow, financial institutions provide
the option for households to save their money. This is a leakage because
the saved money cannot be spent in the economy and thus is an idle asset
so that not all output will be purchased. In terms of injections, the financial
sector provides investment (I) in the business/firms sector.
2. In the government sector
The leakages in the government sector occur with the collection of revenue
through Taxes (T) provided by households and firms to the government. Taxes
are a leakage because it reduces current income thus reducing expenditures
on current goods and services. Injection provided by the government sector
occur via government spending (G) that provides collective services and
welfare payments to the community.
3. In the international sector
The main leakage from the international sector occurs because of imports
(M), which represent spending outside the country by residents. The main
injection provided by this sector is the exports of goods and services.
Those exports generate income coming into the country for domestic exporters
from overseas buyers.