Definition of EconomicsAll economic questions arise because we want more than we can get.Our inability to satisfy all our wants is called scarcity.Because we face scarcity, we must make choices.The choices we make depend on the incentives we face.An incentive is a reward that encourages an action or a penalty that discourages an action.

Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices.Economics divides in to main parts:

Microeconomics Macroeconomics

We need to distinguish between them.

Microeconomics is the study of choices that individuals and businesses make, the way those choices interact in markets, and the influence of governments.

Macroeconomics is the study of the performance of the national and global economies.

Two Big Economic QuestionsTwo big questions summarize the scope of economics:

How do choices end up determining what, how, and for whom goods and services get produced?

When do choices made in the pursuit of self-interest also promote the social interest?

What, How, and For Whom?Goods and services are the objects that people value and produce to satisfy human wants.

How?Goods and services are produced by using productive resources that economists call factors of production.Factors of production are grouped into four categories:

Land Labor Capital Entrepreneurship

- The “gifts of nature” that we use to produce goods and services are land.- The work time and work effort that people devote to producing goods and services is labor.

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- The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, on-the-job training, and work experience.- The tools, instruments, machines, buildings, and other constructions that businesses use to produce goods and services are capital.- The human resource that organizes land, labor, and capital is entrepreneurship

For Whom?Who gets the goods and services depends on the incomes that people earn.

Land earns rent. Labor earns wages. Capital earns interest. Entrepreneurship earns profit.

You make choices that are in your self-interest—choices that you think are best for you.Choices that are best for society as a whole are said to be in the social interest.An outcome is in the social interest if it uses resources efficiently and distributes goods and services fairly.The Big QuestionIs it possible that when each one of us makes choices that are in our self-interest, it also turns out that these choices are also in the social interest?

Self-Interest in the Social Interest Five topics that generate discussion and that illustrate tension between self-interest and social interest are

Globalization The information-age economy Global warming Natural resource depletion Economic instability

Opportunity CostThinking about a choice as a tradeoff emphasizes cost as an opportunity forgone.The highest-valued alternative that we give up to get something is the opportunity cost of the activity chosen.

The Economic Way of ThinkingChoosing at the MarginPeople make choices at the margin, which means that they evaluate the consequences of making incremental changes in the use of their resources.The benefit from pursuing an incremental increase in an activity is its marginal benefit.The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.

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CHAPTER-2THE ECONOMIC PROBLEM

Why does food cost much more today than it did a few years ago? We use an economic model—the production possibilities frontier—to explain the economic problem. (Scarcity-problem)We also use this model to study how we can expand our production possibilities; how we gain by trading with others; and why the social institutions have evolved.

Production Possibilities and Opportunity CostThe production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant.That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods we’re considering.

Production Possibilities and Opportunity CostProduction Possibilities Frontier

Figure 2.1 shows the PPF for two goods: cola and pizza. Any point on the frontier such as E and any point inside the PPF such as Z are attainable.Points outside the PPF are unattainable.

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Production EfficiencyWe achieve production efficiency if we cannot produce more of one good without producing less of some other good.Points on the frontier are efficient.

Any point inside the frontier, such as Z, is inefficient.At such a point, it is possible to produce more of one good without producing less of the other good.At Z, resources are either unemployed or misallocated.

Tradeoff Along the PPFEvery choice along the PPF involves a tradeoff.On this PPF, we must give up some cola to get more pizzas or give up some pizzas to get more cola.

Opportunity CostAs we move down along the PPF, we produce more pizzas, but the quantity of cola we can produce decreases.The opportunity cost of a pizza is the cola decline.

In moving from E to F, the quantity of pizzas increases by 1 million.The quantity of cola decreases by 5 million cans.The opportunity cost of the pizzas is 5 million cans of cola.

In moving from F to E, the quantity of cola produced increases by 5 million.The quantity of pizzas decreases by 1 million.

Because resources are not equally productive in all activities, the PPF bows outward—is concave.The outward bow of the PPF means that as the quantity produced of each good increases, so does its opportunity cost.

Using Resources EfficientlyAll the points along the PPF are efficient.To determine which of the alternative efficient quantities to produce, we compare costs and benefits.

The PPF and Marginal CostThe PPF determines opportunity cost.

The marginal cost of a good or service is the opportunity cost of producing one more unit of it.

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Figure 2.2 illustrates the marginal cost of pizza.As we move along the PPF in part (a), the opportunity cost of a pizza increases.The opportunity cost of producing one more pizza is the marginal cost of a pizza.

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Preferences and Marginal BenefitPreferences are a description of a person’s likes and dislikes.To describe preferences, economists use the concepts of marginal benefit and the marginal benefit curve.The marginal benefit of a good or service is the benefit received from consuming one more unit of it.

In part (b) of Fig. 2.2, the bars illustrate the increasing opportunity cost of pizza.The black dots and the line MC show the marginal cost of pizza.The MC curve passes through the center of each bar.

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We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or service.

- It is a general principle that the more we have of any good, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it.- We call this general principle the principle of decreasing marginal benefit. - The marginal benefit curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.

The curve slopes downward to reflect the principle of decreasing marginal benefit.- At point A, with pizza production at 0.5 million, people are willing to pay 5 cans of cola for a pizza.- At point B, with pizza production at 1.5 million, people are willing to pay 4 cans of cola for a pizza.- At point E, with pizza production at 4.5 million, people are willing to pay 1 can of cola for a pizza.

Figure 2.3 shows a marginal benefit curve.

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Allocative Efficiency

When we cannot produce more of any one good without giving up some other good, we have achieved production efficiency. We are producing at a point on the PPF.When we cannot produce more of any one good without giving up some other good that we value more highly, we have achieved allocative efficiency, We are producing at the point on the PPF that we prefer above all other points.

Figure 2.4 illustrates allocative efficiency.The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost.If we produce exactly 2.5 million pizzas, i.e. at the equilibrium, the marginal cost equals marginal benefit.

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If we produce less than 2.5 million pizzas, i.e. an equilibrium, the marginal benefit exceeds the marginal cost.

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Economic GrowthThe expansion of production possibilities—and increase in the standard of living—is called economic growth.Two key factors influence economic growth:

Technological change Capital accumulation

Technological change is the development of new goods and of better ways of producing goods and services.Capital accumulation is the growth of capital resources, which includes human capital.

The Cost of Economic GrowthTo use resources in research and development and to produce new capital, we must decrease our production of consumption goods and services.So economic growth is not free.The opportunity cost of economic growth is less current consumption.

If we produce more than 2.5 million pizzas, i.e. the equilibrium, the marginal cost exceeds marginal benefit.

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chapter 3 : How Markets WorkDemand

Introduction• Economics is about choices that people make to face scarcity and how

those choices are affected by incentives.• Prices act as incentives.• The demand & supply model is the main tool of Economics . It tells us

how people respond to prices and how prices are determined by demand & supply.

• This model helps us to answer the economic questions : What How , and for whom are goods and services are produced?

Prices And Markets• Prices of goods and services are determined by demand and supply of

these goods and services in the markets.• A market has two sides : buyers & sellers.• Examples of goods and services:• Some markets are physical places where buyers & sellers meet.• Some markets are groups of people around the world who never meet ,

but connected through Internet. Examples: E-commerce markets and currency markets.

Money Prices & Relative Prices• A Money Price of a good is the amount of money must be paid in exchange

of it.• A Relative Price is the ratio of the price of one good to another and it is

an opportunity cost.• Example : If the money price of coffee is 1 SR and the money price of

gum is 0.5 SR , then the relative price of coffee to gum= 1 /0.5 = 2 : 1 and

Figure 2.5 illustrates the tradeoff we face.We can produce pizzas or pizza ovens along PPF0.By using some resources to produce pizza ovens today, the PPF shifts outward in the future.

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it is the opportunity cost of a cup of coffee : To get one cup of coffee ,you must give up two packs of gum.

Demand• If you demand something that means:• You want it. • You can afford it ,and• Plan to buy it.• Demand reflect a choice : What wants to be satisfied and by what goods

and services.

The Quantity Demanded• The quantity demanded of goods & services is the amount that consumer

plan to buy during a period of time at a particular price.• Many factors influence buying plans and price is one of them.

The Law of Demand• Other things remain the same , the higher the price of a good , the smaller

the quantity demanded and the lower the price of a good , the greater the quantity demanded.

Substitution Effect and Income Effect• To explain why a higher price reduce the quantity demanded ?• For two reasons:

1. Substitution Effect: When the price of a good rises . Other things remaining the same, its relative price ( the opportunity cost) rises. As the opportunity cost of a good rises , the incentive to reduce its use and switch to a substitute becomes stronger.

2. Income EffectWhen the price of a good rises , Other things remaining the same , people face a higher price and an unchanged income. They cannot pay for all goods and services that they used to buy. So when the price of a good rises , Other things remaining the same , they must decrease the quantities of some goods and services specially the good whose price has increased.

The Demand Curve• shows the inverse relationship between the quantity demanded of a good

and its price , other things that affect demand being the same.

A Demand Schedule

Quantity demanded

Price Point

22 0.5 A15 1 B10 1.5 C

It lists the quantity demanded at each price other things that influence demand being the same. Example:

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7 2 D5 2.5 E

The Demand CurveDraw it

A change in the quantity demanded• A change in the quantity demanded = movement along the demand

curve • If the price of the good changes, but no other influence on buying plans

changes, that means we have movement along the demand curve ; there is a change in the quantity demanded as price changes.

• The change in the quantity demanded due to the changes in the price of the good.

A Change in Demand

• When a factor that affects the buying plan other than the price of the good changes , there is a change in demand.

• Increase in demand means movement of the demand curve to the right and quantity demanded increases at each price. (draw it)

• Decrease in demand means movement of the demand curve to the left and quantity demanded decreases at each price. (draw it)

Factors bring Changes in Demand1. The Prices of Related Goods:

The related goods are: Substitutes &Complement. A substitute is a good that can be used in place of another one. There is positive relationship between the price of a substitute and the demand for the good. If the price of tea rises the demand for coffee increases and vise versa. A complement is a good is used with another one to satisfy the same needs. There is negative relationship between the price of a complement and the demand for the good. If the price of sugar rises the demand for tea decreases and vise versa.

2. Expected Future Prices: If the price of a good is expected to rise in the future , and if the good can be stored , the demand for the good increases today and vise versa. Examples.

3. Income: Consumers’ income influences demand.• When income increases , consumers buy more of most goods and when

income decreases , consumers buy less of most goods.• The positive relationship between income and demand for the good is

true for most goods, they are the normal goods. But the relationship

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between income and demand for the good is negative for few goods; the inferior goods.

• Example: air travel and long – distance bus trips.

4. Expected Future Income & Credit: When income is expected to increase in the future . Or when credit is easy to obtain , the demand might increase now. Example.

5. Population : Demand depends on the size and the age structure of the population . The larger the population ,the greater the demand for all goods and services and vise versa.

• Also ,the larger the proportion of the population in a given age group , the greater is the demand for the goods and services used by that group. Example.

6. Preferences: Demand depends on preferences . Preferences determine the value that people place on each good and service. Preferences are affected by things such as weather , information and fashion.

The demand for the good Decreases if :

1. The price of a substitute falls.2. The price of a complement rises.3. The price of the good is expected to fall.4. Income falls.5. Expected Income falls or credit becomes harder to get.6. The population decreases.

Increases if : …….

Supply

If firm supplies a good or a service , the firm:Has the resources and technology to produce it , Can make profit from producing it , and Plan to produce & sell it.

The Quantity SuppliedThe quantity supplied of a good or a service is the amount that producers plan to sell during a given time period at a particular price.

The law of supply states: Other things remaining the same, the higher the price , the greater is the quantity supplied; and the lower the price , the smaller is the quantity supplied.The reason for the positive relationship: When price rises , other things remaining the same , producers can bear higher costs by increasing the quantity supplied.

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Remember : Opportunity cost ( the cost of the last unit produced of the good measured by the decrease in the quantity of the other good ) increases as the production of the good increases.

Supply Schedule

The Supply Schedule of Energy BarPrice The

Quantity Supplied

A 0.5 0B 1 6C 1.5 10D 2 13E 2.5 15

The Supply Curve of Energy Bar: The supply curve shows the relationship between the quantity supplied of a good and its price when all other things that affect producers’ planned sales remain the same. (Draw it)

A Change in Supply

• When any other factor affecting supply of a good other than its price changes , there is a change in supply curve it would shift to the right or to the left. ( draw it )

We are going to study these factors and their effects on the supply curve

1. The Prices of Factors of Production ( - ) : The prices of factors of production are costs of production , if they increase this means higher costs and lower profits so producers decrease production at each price and supply curve shifts to the left.

2.Prices of Related Goods Produced :• If price of a substitute ( - ) rises , firms switch production from the good

to the substitute and supply decreases ,and vice versa. ( example ).• If a price of a complement ( + ) rises , the supply of the good increases

and vice versa.Example : chicken and eggs are complements in production ; they must be produced together.

3.Expected Future Price ( -) :

The supply schedule lists the quantity supplied at each price when all other things that affect producers’ planned sales remain the same.

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If the price of the good is expected to rise , supply decreases today and increases in the future.

4.The Number of Suppliers ( + ) :The larger the number of suppliers , the greater is the supply of the good. As firms enter an industry , the supply increases.

5.Technology ( + ) : It means the way that factors of production are used to produce a good.If technology improves and we use new method that lowers costs of production , production of the good increases and supply shifts to the right.

6.The State of Nature :This includes all natural forces that influence production.

• Good weather can increase the supply of agricultural goods and vice versa.

• Extreme natural event such as earthquakes , tornados, and hurricanes can influence supply.

A Change in Quantity Supplied VS. a Change in Supply• A change in quantity supplied means movement along the curve and it

happens when the price of the good changes.• a change in supply means that the entire supply curve shifts, it happens

when any of the other factors that influence supply other than the price of the good changes ( draw it )

Changes in SupplyDecreases if :

1. The price o a factor of production used to produce it rises. 2. The price of a substitute in production rises.

The price of a complement in production falls.3. The price of the good is expected to rise.4. The number of suppliers decreases.5. A technology change decreases production of the good.6. A natural event decreases production of the good .

Increases if : ……..

Market Equilibrium• Equilibrium in a market occurs when the price balances the plans of

buyers and plans of sellers.• The equilibrium price is the price at which the quantity demanded equals

the quantity supplied.• The equilibrium quantity is the quantity bought & sold at the equilibrium

price .

Price as a Regulator• The price of a good regulates the quantity demands and supplied.

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• If price is too low , the quantity demanded > the quantity supplied , and we have a shortage . The shortage bids up price till we reach equilibrium.

• If price is too high , the quantity supplied > the quantity demanded , and we have a surplus . The surplus e bids down the price till we reach equilibrium. ( draw it )

Price per unit

Qd Qs Shortage (−)Or

Surplus (+)

0.5 22 0 -221 15 6 -9

1.5 10 10 02 7 13 6

2.5 5 15 10

Price Adjustment

A shortage forces the price up:

• When there is a shortage ,producers raise the price. When price rises Qd decreases and Qs increases until we reach equilibrium.

A surplus forces the price down: • When there is a surplus ,producers cut the price. When price falls Qs

decreases and Qd increases until we reach equilibrium. ( draw it )

The Effects of changes in Demand and Supply on Market EquilibriumPP. 70-71

An Increase in Demand• When number of consumers or income of consumers increases ,or other

things that cause demand increases , the demand curve shifts to the right . . Both the equilibrium price and quantity increase. ( draw it )

A Decrease in Demand• When number of consumers or income of consumers decreases ,or other

things that cause demand decreases , the demand curve shifts to the left . Both the equilibrium price and quantity decrease. (draw it )

An Increase in Supply• If costs of production fall or producers use a new technology that cause

increase in supply , or other things happen that increase supply , supply curve shifts to the right.

Table p. 68 shows :-The equilibrium price at which Qd = QsAbove the equilibrium price : Qs > Qd A surplus

-Below the equilibrium price :Qd > Qs A shortage

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The equilibrium price decreases and the equilibrium quantity increases. (draw it)

A Decrease in Supply• If costs of production rise or producers switch to a substitute, or other

things happen that decrease supply , supply curve shifts to the left.The equilibrium price rises and the equilibrium quantity decreases. (draw it)

Chapter 4 ElasticityPrice Elasticity of Demand

In Figure 4.1(a inelastic demand), an increase in supply brings -A large fall in price

- A large fall in price

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The contrast between the two outcomes in Figure 4.1 depend on The price elasticity of demand which means the measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.

Calculating Elasticity

Price Elasticity of Demand = % age change in Quantity Demanded % age change in Price

= = DQ/Qave /DP/Pave

To calculate the price elasticity of demand:We express the change in price as a percentage of the average price—the average of the initial and new price,

In Figure 4.1(b elastic demand), an increase in supply brings- A small fall in price

- A large increase in the quantity demanded

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and we express the change in the quantity demanded as a percentage of the average quantity demanded—the average of the initial and new quantity.

calculates the price elasticity of demand for pizza from the following table :

The Original

Point

The New Point

The Average

P1

= 20.5 P2

= 19.5 P aver

= 20

Q1

= 9 Q 2

= 11 Q aver

= 10

The price falls to $19.50 and the quantity demanded increases to 11 pizzas an hour.The price falls by $1 and the quantity demanded increases by 2 pizzas an hour.The average price is $20 and the average quantity demanded is 10 pizzas an hour.

The price initially is $20.50 and the quantity demanded is 9 pizzas an hour.

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The formula yields a negative value, because price and quantity move in opposite directions. But it is the magnitude , or absolute value, of the measure that reveals how responsive the quantity change has been to a price change.

The ratio of two proportionate changes is the same as the ratio of two percentage changes.The measure is units free because it is a ratio of two percentage changes and the percentages cancel out.Changing the units of measurement of price or quantity leave the elasticity value the same.

Inelastic and Elastic DemandDemand can be inelastic, unit elastic, or elastic, and can range from zero to infinity.

The percentage change in quantity demanded, %DQ, is calculated as DQ/Qave, which is 2/10 = 1/5.The percentage change in price, %DP, is calculated as DP/Pave, which is $1/$20 = 1/20.

The price elasticity of demand is %DQ/ %DP = (1/5)/(1/20)

= 20/5 = 4

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- If the percentage change in the quantity demanded is smaller than the percentage change in price, the price elasticity of demand is less than 1 and the good has inelastic demand.For example Insulin; patients that require insulin will continue to pay almost any price for it.

- If the percentage change in the quantity demanded is greater than the percentage change in price, the price elasticity of demand is greater than 1 and the good has elastic demand.For example: The airline industry is very elastic because all airlines offer a very similar service.

- If the quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero and the good as a perfectly inelastic demand and the demand curve is vertical.

- If the percentage change in the quantity demanded equals the percentage change in price, the price elasticity of demand equals 1 and the good has unit elastic demand and the demand curve with ever declining slope.

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Factors Affecting Elasticity :

The elasticity of demand for a good depends on:

1. Substitutes: When there are more substitutes for a good, elasticity is higher, as consumers can easily switch to other goods in response to price changes.

2. Proportion of Income Spent on the Good : The greater the proportion of income consumers spent on a good, the larger is its elasticity of demand.

3. Time Elapsed Since Price Changes : In the short run, demand for goods tends to be inelastic. But In the long run, demand for goods tends to be elastic, as consumers have the opportunity to change their spending habits.

4. Necessity and luxury: Necessities, such as food or housing, generally have inelastic demand.Luxuries, such as exotic vacations, generally have elastic demand.

- If the percentage change in the quantity demanded is infinitely large when the price barely changes, the price elasticity of demand is infinite and the good has a perfectly elastic demand, and the demand curve is horizontal .

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Elasticity Along a straight- Line Demand Curve

Note: we use average price & average quantity in each case to calculate elasticity.Elasticity decreases as the price falls and quantity demanded increases.

Total Revenue and ElasticityThe total revenue from the sale of good or service equals the price of the good multiplied by the quantity sold. TR = P x QdWhen the price changes, total revenue also changes. But a rise in price doesn’t always increase total revenue.

The change in total revenue due to a change in price depends on the elasticity of demand:

If demand is elastic, a 1 percent price cut

Elasticity decreases as the price falls and quantity demanded increases.At midpoint of a demand curve , the demand is unit elastic.At prices above the midpoint of a demand curve , the demand is elastic.At prices below the midpoint of a demand curve , the demand is inelastic.

-For example, if the price falls from $25 to $15, the quantity demanded increases from 0 to 20 pizzas an hour.The average price is $20 and the average quantity is 10 pizzas.The price elasticity of demand is (20/10)/(10/20), which equals 4.-If the price falls from $10 to $0, the quantity demanded increases from 30 to 50 pizzas an hour.The average price is $5 and the average quantity is 40 pizzas.The price elasticity is (20/40)/(10/5), which equals 1/4.-If the price falls from $15 to $10, the quantity demanded increases from 20 to 30 pizzas an hour. The average price is $12.50 and the average quantity is 25 pizzas. The price elasticity is (10/25)/(5/12.5), which equals 1.

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increases the quantity sold by more than 1 percent, and total revenue increases.

-at the same time your expenditure ( as a consumer ) on the item increases .

If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent, and total revenues decreases.

-at the same time your expenditure ( as a consumer ) on the item decreases .

If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue remains unchanged.

- at the same time your expenditure ( as a consumer ) on the item does not change.

The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (when all other influences on the quantity sold remain the same).

For example if the price falls from $25 to $12.50, the quantity demanded increases from 0 to 25 pizzas, the demand will be elastic, and total revenue increases.

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More Elasticities of Demand

Cross Elasticity of Demand

The cross elasticity of demand measures how the quantity demanded of a good responds to a change in the price of a substitute or a complement, other things remaining the same.

-At $12.50, demand is unit elastic and total revenue stops increasing. ( At 25, demand is unit elastic, and total revenue is at its maximum ) .

-As the price falls from $12.50 to zero, the quantity demanded increases from 25 to 50 pizzas. Demand is inelastic, and total revenue decreases.

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Cross Elasticity = % age change in Quantity Demanded % age change in Price of substitute or complement

The cross elasticity of demand is :

Positive for substitute goods : the increase in the quantity of pizza demanded when the price of burger (a substitute for pizza) rises.

Negative for complement goods : the decrease in the quantity of pizza demanded when the price of a soft drink (a complement of pizza) rises.

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Income Elasticity of Demand

The income elasticity of demand measures how the quantity demanded of a good responds to a change in income, other things remaining the same.

Income Elasticity = % age change in Quantity Demanded % age change in Income

If there is an increase in the price of pizza (a substitute of burger), people will switch to burger, therefore the cross elasticity of this substitute good moves right-side (positive).

If there is an increase in the price of Pepsi (a compliment with pizza), then people will reduce their demand for pizza and Pepsi, both, therefore the cross elasticity of this compliment goods moves left-side (negative).

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- If the income elasticity of demand is greater than zero, the good is a normal good.

- If the income elasticity of demand is less than zero (negative) the good is an inferior good.

- If the income elasticity of demand is greater than 1, demand is elastic and the good is luxury goods.

- If the income elasticity of demand is less than 1, demand is inelastic and the good is essential goods.

In Figure 4.7(a), an increase in demand while the supply is inelastic, bringsA large rise in priceAnd A small increase in the quantity supplied

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Chapter 8 : utility of demand

PreferencesA household’s preferences determine the benefits or satisfaction a person receives consuming a good or service.

In Figure 4.7(b), an increase in demand while the supply is elastic, bringsA small rise in price and A large increase in the quantity supplied

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The benefit or satisfaction from consuming a good or service is called utility.

Total utility (TU) is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility.

Total utility from a good increases as the quantity of the good increases. For example, as the number of movies seen in a month increases, total utility from movies increases.

Marginal utility (MU) is the change in total utility that results from a one-unit increase in the quantity of a good consumed.

As the quantity consumed of a good increases, the marginal utility from consuming it decreases. We call this the principle of diminishing marginal utility.

Table 8.1 provides an example of total and marginal utility schedule.

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Figure 8.1(a) shows a total utility curve for soda.Total utility increases with the consumption of a soda increases.

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The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility.

The Utility-Maximizing Choice

Figure 8.1(b) illustrates diminishing marginal utility.As the quantity of soda increases, the marginal utility from soda diminishes.

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We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination.The utility-maximizing combination is called a consumer equilibrium.

Table 8.2 shows Lisa’s utility-maximizing choice.

-Lisa has $40 a month to spend on movies and soda.The price of a movie (PM) is $8 and the price of soda (PS) is $4 a case.Each row of the table shows a combination of movies and soda that exhausts Lisa’s $40.

-Lisa chooses the combination that gives her the highest total utility.Lisa maximizes her total utility when she sees two movies and drinks 6 cases of soda a month.

-Lisa gets 90 units of utility from the 2 movies and 225 units of utility from the 6 cases of soda.

Choosing at the Margin

A consumer’s total utility is maximized by following these rules:Spend all available income.Equalize the marginal utility per dollar for all goods (the marginal utility from a good divided by its price ).

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Total utility is maximized when:MUM/PM = MUS/PS = 5

Table 8.3 shows why the utility-maximizing rule works.The combination is each row is affordable (costs $40).In row C

If MUM/PM > MUS/PS, ( in point B ), then spend less on soda and more on movies.MUM decreases and MUS increases.

If MUS/PS > MUM/PM, ( in point D ), then spend more on soda and less on movies.MUS decreases and MUM increases.So Only when MUM/PM = MUS/PS, is it not possible to reallocate the budget and increase total utility.

Predictions of Marginal Utility Theory

A Fall in the Price of a Movie

When the price of a good falls the quantity demanded of that good increases—the demand curve slopes downward.

For example, if the price of a movie falls, we know that MUM/PM rises, so before the consumer changes the quantities bought, MUM/PM > MUS/PS. To restore consumer equilibrium (maximum total utility) the consumer increases the movies seen to drive down the MUM and restore MUM/PM = MUS/PS.

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A change in the price of one good changes the demand for another good.

You’ve seen that if the price of a movie falls, MUM/PM rises, so before the consumer changes the quantities consumed, MUM/PM > MUS/PS.

To restore consumer equilibrium (maximum total utility) the consumer decreases the quantity of soda consumed to drive up the MUS and restore MUM/PM = MUS/PS.

Table 8.4 shows Lisa’s affordable combinations when the price of a movie is $4.Before Lisa changes what she buys MUM/PM > MUS/PS To maximize her total utility, Lisa sees more movies and drinks less soda.

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Table 8.5 shows Lisa’s affordable combinations when the price of soda is $8 a case and a movie is is $4.

Before Lisa changes what she buys MUs/Ps < MUm/Pm , To maximize her total utility, Lisa drinks less soda.

Figure 8.3 illustrates these predictions.A rise in the price of soda decreases the quantity of soda demanded—a movement along the demand curve for soda.

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Chapter 11 : output and costs :

Decision Time FramesThe firm makes many decisions to achieve its main objective: profit maximization.

Some decisions are critical to the survival of the firm, Some decisions are irreversible (or very costly to reverse), and Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit.

All decisions can be placed in two time frames: The short run and The long run.

The short run is a time frame in which the quantity of one or more resources used in production is fixed.

For most firms, the capital, called the firm’s plant, is fixed in the short run. Other resources used by the firm (such as labor, raw materials, and energy) can be changed in the short run.

Short-run decisions are easily reversed.

The long run is a time frame in which the quantities of all resources—including the plant size—can be varied.Long-run decisions are not easily reversed.

Short-Run Technology ConstraintIn the Short Run We assume that:

1. Labor units are homogenous.2. Capital & Technology are fixed.3. We can increase or decrease production by increasing or

decreasing the variable resources such as labor.

Three concepts describe the relationship between output and the quantity of labor employed: Total product, Marginal product, and Average product.

-Total product is the total output produced in a given period.

-The marginal product of labor is the change in total product that results from a one-unit increase in the quantity of labor employed, with all other inputs remaining the same.

- The average product of labor is equal to total product divided by the quantity of labor employed.

Table 11.1 shows a firm’s product schedules. As the quantity of labor employed increases:

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Total product increases. Marginal product increases initially but eventually decreases. Average product increases initially but eventually decreases.

Product Curves

Product curves are graphs of the three product concepts that show how total product, marginal product, and average product change as the quantity of labor employed changes.

Figure 11.1 shows a total product curve :The total product curve shows how total product changes with the quantity of labor employed.

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The height of each bar measures the marginal product of labor. For example, when labor increases from 2 to 3, total product increases from 10 to 13, so the marginal product of the third worker is 3 units of output.

The total product curve is similar to the PPF.It separates attainable output levels from unattainable output levels in the short run.

The figure shows the marginal product of labor curve and how the marginal product curve relates to the total product curve.If the first worker hired produces 4 units of output.And the second worker hired produces 6 units of output and total product becomes 10 units. The third worker hired produces 3 units of output and total product becomes 13 units. And so on.

To make a graph of the marginal product of labor, we can stack the bars in the previous graph side by side.The marginal product of labor curve passes through the mid-points of these bars.

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Almost all production processes are like the one shown here and have:

Increasing marginal returns initially Diminishing marginal returns eventually

Increasing marginal returns arise from increased specialization and division of labor.

Diminishing marginal returns arises from the fact that employing additional units of labor means each worker has less access to capital and less space in which to work.

Diminishing marginal returns are so pervasive ( general ) that they are elevated to the status of a “law.

The law of diminishing returns states 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 diminishes.

- When the marginal product of a worker exceeds the marginal product of the previous worker, the marginal product of labor increases and the firm experiences increasing marginal returns.- When the marginal product of a worker is less than the marginal product of the previous worker, the marginal product of labor decreases and the firm experiences diminishing marginal returns.

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Short-Run Cost

To produce more output in the short run, the firm must employ more labor, which means that it must increase its costs. We describe the way a firm’s costs change as total product changes by using three cost concepts and three types of cost curve:

Total cost Marginal cost Average cost

Total Cost

A firm’s total cost (TC) is the cost of all resources used.

Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.

Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output.

Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC

Average Product Curve: Figure 11.3 shows the average product curve and its relationship with the marginal product curve.-When marginal product exceeds average product, average product increases.-When marginal product is below average product, average product decreases.-When marginal product equals average product, average product is at its maximum.

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Notice that the TP curve becomes steeper at low output levels and then less steep at high output levels.In contrast, the TVC curve becomes less steep at low output levels and steeper at high output levels.

Figure 11.4 shows a firm’s total cost curves.

Total fixed cost is the same at each output level.

Total variable cost increases as output increases.

Total cost, which is the sum of TFC and TVC also increases as output increases.

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To see the relationship between the TVC curve and the TP curve, lets look again at the TP curve.

But let us add a second x-axis to measure total variable cost.

If wage rate is $25 per worker, then:1 worker costs $25; 2 workers cost $50: and so on, so the two x-axes line up.

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We can replace the quantity of labor on thex-axis with total variable cost.

When we do that, we must change the name of the curve. It is now the TVC curve.

But it is graphed with cost on the x-axis and output on the y-axis.

Redraw the graph with cost on the y-axis and output on the x-axis, and you’ve got the TVC curve drawn the usual way.

Put the TFC curve back in the figure, and add TFC to TVC, and you’ve got the TC curve.

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Marginal Cost

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product.

-Over the output range with increasing marginal returns, marginal cost falls as output increases.

-Over the output range with diminishing marginal returns, marginal cost rises as output increases.

-When marginal output at its maximum point, marginal cost at its minimum point.

Average Cost

Average cost measures can be derived from each of the total cost measures:

Average fixed cost (AFC) is total fixed cost per unit of output.

Average variable cost (AVC) is total variable cost per unit of output.

Average total cost (ATC) is total cost per unit of output : ATC = AFC + AVC

M C

Output

Min. point

M P

Labor

Max. point

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-The figure shows the MC, AFC, AVC, and ATC curves.The AFC curve shows that average fixed cost falls as output increases.-The AVC curve is U-shaped. As output increases, average variable cost falls to a minimum and then increases. -The ATC curve is also U-shaped. -The MC curve is very special.-The outputs over which AVC is falling, MC is below AVC.-The outputs over which AVC is rising, MC is above AVC.The output at which AVC is at the minimum, MC equals AVC.

-Similarly, the outputs over which ATC is falling, MC is below ATC.

-The outputs over which ATC is rising, MC is above ATC.

-At the minimum ATC, MC equals ATC.

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Why the Average Total Cost Curve Is U-Shaped?

-The AVC curve is U-shaped because:-Initially, marginal product exceeds average product, which brings rising average product and falling AVC.-Eventually, marginal product falls below average product, which brings falling average product and rising AVC.- The ATC curve is U-shaped for the same reasons. In addition, ATC falls at low output levels because AFC is falling steeply.

Cost Curves and Product Curves

The shapes of a firm’s cost curves are determined by the technology it uses:-MC is at its minimum at the same output level at which marginal product is at its maximum.-When marginal product is rising, marginal cost is falling.-AVC is at its minimum at the same output level at which average product is at its maximum.When average product is rising, average variable cost is falling.

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Shifts in Cost Curves

The position of a firm’s cost curves depend on two factors: Technology Prices of factors of production

TechnologyTechnological change influences both the productivity curves and the cost curves.An increase in productivity shifts the average and marginal product curves upward and the average and marginal cost curves downward. If a technological advance brings more capital and less labor into use, fixed costs increase and variable costs decrease.In this case, average total cost increases at low output levels and decreases at high output levels.

Prices of Factors of ProductionAn increase in the price of a factor of production increases costs and shifts the cost curves.An increase in a fixed cost shifts the total cost (TC ) and average total cost (ATC ) curves upward but does not shift the marginal cost (MC ) curve.An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ), and marginal cost (MC ) curves upward.

Long-Run CostIn the long run, all inputs are variable and all costs are variable. The Production FunctionThe behavior of long-run cost depends upon the firm’s production function.The firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labor.

Chapter 13 : Commodities markets

Economists identify four market types: Perfect competition, Monopoly, Monopolistic competition, and Oligopoly.

1.Perfect competition is a market structure with Many firms sell identical products to many buyers. No restrictions on entry of new firms to the industry Both firms and buyers are all well informed about the prices and products of

all firms in the industry. Established firms have no advantages over new ones.

2.Monopoly is a market structure in which

. One firm produces the entire output of the industry.

. There are no close substitutes for the product.

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.There are barriers to entry that protect the firm from competition by entering firms.

How Monopoly Arises A monopoly has two key features: No close substitutes, and Barriers to entry.

-No Close Substitute: If a good has a close substitute, even if it is produced by only one firm,

that firm effectively faces competition from the producers of the substitute.

A monopoly sells a good that has no close substitutes.

-Barriers to Entry:A constraint that protects a firm from potential competitors are called barriers to entry. Three types of barriers to entry are:

a.Natural Barriers to Entry: A natural monopoly is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost.

b.Ownership Barriers to Entry: An ownership barrier to entry occurs if one firm owns a significant portion of a key resource.

c.Legal Barriers to Entry: A legal monopoly is a market in which competition and entry are restricted by the granting of a Public franchise, Government license, and Patent or copyright.

A monopoly is a price setter, not a price taker like a firm in perfect competition. To sell a larger output, a monopoly must set a lower price.

Monopoly Price-Setting Strategies A single-price monopoly Price discrimination. Many firms price discriminate, but not all of them

are monopoly firms.

3.Monopolistic competition is a market structure with A large number of firms compete: which implies:

-Each firm has limited market power to influence the price of its product -no one firm’s actions directly affect the actions of others.

Each firm produces a differentiated product. Firms compete on product quality, price, and marketing. Firms are free to enter and exit the industry.

4.Oligopoly is a market structure in which A small number of firms compete. The firms might produce almost identical products or differentiated

products.

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Barriers to entry limit entry into the market.

*Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions.

*A Cartel: is an illegal group of firms acting together to limit output, raise price, and increase profit.

Chapter 12: perfect competition

How Perfect Competition Arises

When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry.

And when each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from.

Price Takers

In perfect competition, each firm is a price taker.

No single firm can influence the price, it must “take” the equilibrium market price.

Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

Economic Profit and Revenue

The goal of each firm is to maximize economic profit, which equals total revenue minus total cost.

-Total cost is the opportunity cost of production, which includes normal profit.

-A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P × Q.

-A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

Calculation of Total Revenue & Marginal Revenue

Quantity Sold Price Total Revenue Marginal

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Q P TR= P×Q Revenue=ΔTR / ΔQ

8 25 200

9 25 225 225 – 200 / 9– 8 = 25

10 25 250 250 – 225 / 10 -9 = 25

Figure 12.1 illustrates a firm’s revenue concepts.Part (a) shows that market demand and market supply determine the market price that the firm must take.

Figure 12.1(b) shows the firm’s total revenue curve (TR)—the relationship between total revenue and quantity sold.

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*The demand for a firm’s product is perfectly elastic because one firm’s sweater is a perfect substitute for the sweater of another firm. But the market demand is not perfectly elastic because a sweater is a substitute for some other good.

*A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces.So the firm must decide:1. How to produce at minimum cost2. What quantity to produce3. Whether to enter or exit a marketWe start by looking at the firm’s output decision.

The Firm’s Output Decision “Profit-Maximizing Output”

A perfectly competitive firm chooses the output that maximizes its economic profit, by looking at the total revenue and the total cost curves (Economic Profit = TR – TC ).

Figure 12.1(c) shows the marginal revenue curve (MR).The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.

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Marginal Analysis and Supply Decision

-Part (a) In Figure 12.2 shows the total revenue, TR, curve.-Part (a) also shows the total cost curve, TC, which is like the one in Chapter 11.-Total revenue minus total cost is economic profit (or loss), shown by the curve EP in part (b).

-At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.

-At intermediate output levels, the firm makes an economic profit.

-At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns.

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The firm can use marginal analysis to determine the profit-maximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC.Table 12-3 shows how we can use marginal analysis to determine the profit-maximizing output.

QuantityQ

Total Revenue

TR

Marginal Revenue

MR

Total CostTC

Marginal CostMC

Economic Profit

( TR – TC)6 150 25 126 12 247 175 25 141 15 348 200 25 160 19 409 225 25 185 25 4010 250 25 212 26 3811 275 25 245 33 30

The firm maximizes its economic profit when it produces 9 sweaters a day.

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Profits and Losses in the Short RunMaximum profit is not always a positive economic profit.To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost at the profit-maximizing output with the market price.

Output, Price, and Profit in the Short RunThe next figures show the three possible profit outcomes.

-Figure 12.3 shows the marginal analysis that determines the profit-maximizing output.-If MR > MC, economic profit increases if output increases.-If MR < MC, economic profit decreases if output increases.-If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

In part (a) price equals average total cost and the firm makes zero economic profit (breaks even).

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In part (b), price exceeds average total cost and the firm makes a positive economic profit.

In part ( c ), price is less than the average total cost and the firm incurs an economic loss – economic profit is negative.

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The Firm’s Output DecisionTemporary Shutdown DecisionIf the firm makes an economic loss it must decide to exit the market or to stay in the market.If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily. The decision will be the one that minimizes the firm’s loss.

Loss ComparisonThe firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR).Economic loss = TFC + TVC - TR

= TFC + (AVC - P) × QIf the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm incurs an economic loss equal to TFC. This economic loss is the largest that the firm must bear.

-A firm’s shutdown point is the price and quantity at which it is indifferent between producing and shutting down.-This point is where AVC is at its minimum (where MC crosses the AVC).-The firm incurs a loss equal to TFC from either action.-Minimum AVC is $17 a sweater.-If the price is $17, the profit-maximizing output is 7 sweaters a day.-The firm incurs a loss equal to the red rectangle.-If the price of a sweater is between $17 and $20.14, the firm produces the quantity at which marginal cost equals price. The firm covers all its variable cost and at least part of its fixed cost.It incurs a loss that is less than TFC.

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The Firm’s Supply Curve

A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same.Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve.But at a price below the shutdown point, the firm produces nothing.

-Figure 12.5 shows how the firm’s supply curve is constructed.

-If price equals minimum AVC, $17 in this example, the firm is uninterested between producing nothing and producing at the shutdown point, T.

-If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC.

-If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC.

-The blue curve in part (b) traces the firm’s short-run supply curve.

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Market Supply in the Short RunThe short-run market supply curve shows the quantity supplied by all firms in the market at each price when each firm’s plant and the number of firms remain the same.

-The figure shows the supply curve for a market that has 1,000 firms like Campus Sweaters.-The quantity supplied by the market at any given price is the sum of the quantities supplied by all the firms in the market at that price.-At a price equal to minimum AVC, the shutdown price, some firms will produce the shutdown quantity and others will produces zero.-The market supply curve is perfectly elastic.

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Short-Run EquilibriumShort-run market supply and market demand determine the market price and output.

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A Change in Demand

-An increase in demand bring a rightward shift of the market demand curve: The price rises and the quantity increases.

-A decrease in demand bring a leftward shift of the market demand curve: The price falls and the quantity decreases.

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