10 PRINCIPLES OF ECONOMICS

10 principles of Economics are:

1. People Face Tradeoffs

o To get one thing, we usually have to give up something else
 Ex. Leisure time vs. work
2. The Cost of Something is What You Give Up to Get It
o Opportunity cost is the second best alternative foregone.
 Ex. The opportunity cost of going to college is the money
you could have earned if you used that time to work.
3. Rational People Think at the Margin
o Marginal changes are small, incremental changes to an existing plan
of action
 Ex. Deciding to produce one more pencil or not
o People will only take action of the marginal benefit exceed the
marginal cost
4. People Respond to Incentives
o Incentive is something that causes a person to act. Because people
use cost and benefit analysis, they also respond to incentives
 Ex. Higher taxes on cigarettes to prevent smoking
5. Trade Can Make Everyone Better Off
o Trade allows countries to specialize according to their comparative
advantages and to enjoy a greater variety of goods and services
6. Markets Are Usually a Good Way to Organize Economic Activity
o Adam Smith made the observation that when households and firms
interact in markets guided by the invisible hand, they will produce the
most surpluses for the economy
7. Governments Can Sometimes Improve Economic Outcomes
o Market failures occur when the market fails to allocate resources
efficiently. Governments can step in and intervene in order to
promote efficiency and equity.
8. The Standard of Living Depends on a Country's Production
o The more goods and services produced in a country, the higher the
standard of living. As people consume a larger quantity of goods and
services, their standard of living will increase
9. Prices Rise When the Government Prints Too Much Money
o When too much money is floating in the economy, there will be
higher demand for goods and services. This will cause firms to
increase their price in the long run causing inflation.
10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment
o In the short run, when prices increase, suppliers will want to increase
their production of goods and services. In order to achieve this, they
need to hire more workers to produce those goods and services.
More hiring means lower unemployment while there is still inflation.
However, this is not the case in the long-run.
DIFFERENCE BETWEEN MICRO ECONOMICS AND MACRO ECONOMICS
 Microeconomics Macroeconomics

                                                                             Meaning

Macroeconomics is the branch of

Microeconomics is the branch of
Economics that deals with the study
Economics that is related to the
of the behaviour and performance of
study of individual, household and
the economy in total. The most
firm’s behaviour in decision making
important factors studied in
and allocation of the resources. It
macroeconomics involve gross
comprises markets of goods and
domestic product (GDP),
services and deals with economic
unemployment, inflation and growth
issues.
rate etc.

Significance
  Area of study
It is useful in regulating the prices of a product It perpetuates firmness in the broad price level,
alongside the prices of factors of production and solves the major issues of the economy like
Microeconomics studies the Macroeconomics studies the whole
(labour, land, entrepreneur, capital, and more) deflation, inflation, rising prices (reflation),
within the economy. particular market segment of the
unemployment, economy, thatascovers
and poverty several market
a whole.
economy segments

                                                                             Limitations
                                                                             Deals with

It has been scrutinised that the misconception of

It is based on impractical presuppositions, i.e.,
composition’ incorporates, which sometimes fails
Microeconomics
in microeconomics, it is presumed that there isdeals with Macroeconomics
to prove accurate deals that
because it is feasible withwhat is
full employment in the community, which is
various issues like demand, supply, various issues like national
true for aggregate (comprehensive) may not be
not at all feasible. factor pricing, product pricing, income, distribution,
true for individuals as well.
economic welfare, production, employment, general price
consumption, and more. level, money, and more.

                                                          Business Application

It is applied to environmental and
It is applied to internal issues.
external issues.
 
 

                                                                                 Scope

It covers several issues like

It covers several issues like
demand, supply, factor pricing,
distribution, national income,
product pricing, economic welfare,
employment, money, general price
production, consumption, and
level, and more.
more.
what a competitive market is

A competitive market is one in which a large number of producers compete with each other to satisfy
the wants and needs of a large number of consumers. In a competitive market no single producer, or
group of producers, and no single consumer, or group of consumers, can dictate how the market
operates.
EXAMPLE: The market for wheat is often taken as an example of a competitive market, because
there are many producers, and no individual producer can affect the market price by increasing or
decreasing his output. ... Finally the buyers can costlessly observe prices and can buy at the lowest
price.

what determines the demand for a good in a competitive market.

In a competitive market, there are many buyers and sellers, each of whom has little or no influence on
the market price. The demand curve shows how the quantity of a good demanded depends on the
price. According to the law of demand, as the price of a good falls, the quantity demanded rises.

what determines the supply of a good in a competitive market

For every good in the economy, the price ensures that supply and demand are in balance. The
equilibrium price then determines how much of the good buyers choose to consume and how much
sellers choose to produce.

how supply and demand together set the price of a good and the quantity sold.

Supply and demand is an economic model of price determination in a market. It concludes that in a
competitive market, the unit price for a particular good will vary until it settles at a point where the
quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at
current price), resulting in an economic equilibrium of price and quantity.

The four basic laws of supply and demand are:

1. If demand increases and supply remains unchanged, then it leads to higher equilibrium
price and higher quantity.
2. If demand decreases and supply remains unchanged, then it leads to lower equilibrium
price and lower quantity.
3. If supply increases and demand remains unchanged, then it leads to lower equilibrium
price and higher quantity.
4. If supply decreases and demand remains unchanged, then it leads to higher equilibrium
price and lower quantity.

the key role of prices in allocating scarce resources in market economies.

As resources are scarce relative to the insatiable demands of human wants, economies are concerned
with basic questions of allocation. The free market price mechanism answers the questions of- 

What and how much to produce? 

For whom to produce? 

How to produce?

In a market, resources are allocated based on the demand/supply in which prices plays an signalling
function as it allocates resources to the production of different types of goods. It also acts as signalling
mechanism between buyers and sellers; telling them how much and what to produce.

What and how much to produce?

Resources are limited and cannot produce enough goods and services to satisfy human wants which
are unlimited.
The economy must make a choice on the types of goods and services that it wants to make available
to the country. For example, an economy has to decide on the different types of goods to produce,
determined jointly by producers and consumers through the signalling role of prices and their self-
interest. Price shows how much consumers are willing and able to pay, signalled by
the demand curve. How much producers are willing and able to produce, is shown by supply curve
In this way, the price acts as a signal telling the producers what to produce and how much of the good
to produce.
For whom to produce?

Price mechanism also shows who to produce these resources for. This is shown by the demand curve
which signifies consumers’ willingness and ability to pay. In a way it represents their economic dollar
votes and shows that producers should produce for these consumers.
Resources are scarce, no society can satisfy all the wants of its people.
How the limited supply of final goods/services produced is allocated among people?
Price acts as a mechanism in a market economy and distributes the output only to people who are able
and willing to pay for the good.
This in turn depends on the purchasing power and the value that people place on the good. Consumers
pay and consume goods to maximise consumer welfare while producer try to maximise profits. 
How to produce?

Prices of resources and factors of production also address the question of how to produce various goods and
services. An economy can choose to produce using use various factors of production like labour (human) or
capital (machines). Price of resources should guide firms’ production methods and firms choose resources that
are cheapest and incur the lowest opportunity cost.
In the factor market the producers demand for resources and the consumers are factor owners that supply the
resources.  The allocation of resources among the competing uses is based on the prices of the resources.
For example, a manufactured good can either be produced by capital intensive methods (where there is little use
of labour and greater use of machines) which are more efficiency or labour intensive methods (where greater use
is made of labour).
A firm’s main aim is to reduce the cost of production as guided by relative prices of factors of production.

the meaning of the elasticity of demand.

Elasticity of demand is an important variation on the concept of demand. Demand can be classified as
elastic, inelastic or unitary.
An elastic demand is one in which the change in quantity demanded due to a change in price is large.
An inelastic demand is one in which the change in quantity demanded due to a change in price
is small.
The formula for computing elasticity of demand is:
(Q1 – Q2) / (Q1 + Q2)     
(P1 – P2) / (P1 + P2)
If the formula creates an absolute value greater than 1, the demand is elastic. In other words, quantity
changes faster than price. If the value is less than 1, demand is inelastic. In other words, quantity
changes slower than price. If the number is equal to 1, elasticity of demand is unitary. In other words,
quantity changes at the same rate as price.
An example of products with an elastic demand is consumer durables. These are items that are
purchased infrequently, like a washing machine or an automobile, and can be postponed if price rises.
For example, automobile rebates have been very successful in increasing automobile sales by
reducing price.

Other Demand Elasticities

1. Cross-Price Elasticity of Demand

The cross-price elasticity of demand measures how the demand for one good is impacted by a change
in the price of another good. It is calculated as the percentage change of Quantity A divided by the
percentage change in the price of the other.

If the cross-price elasticity of demand between two goods is positive, it implies that the two goods are
substitutes. Consider the following substitute goods – good A and good B. If the price of good B rises,
the demand for good A rises.

On the contrary, if the aforementioned goods were complements, when the price of good B increases,
the demand for good A should decrease. It is what is implied through the cross-price elasticity of
demand formula. It is important to note that the cross-price elasticity of demand is a unitless measure.

2. Income Elasticity of Demand

The income elasticity of demand is defined as the measure of the percentage change of the quantity
demanded of a good in reference to changes in the consumer’s income. Calculating the income
elasticity of demand allows economists to identify normal and inferior goods, as well as how
responsive quantity demanded is to changes in income.

 If the income elasticity of demand is positive, the good is considered to be a normal good –
implying that when income increases, the quantity demanded at any given price increases.
 If the income elasticity of demand is negative, the good is considered to be an inferior good –
implying that when income increases, the quantity demanded at any given price decreases.
 If the income elasticity of demand is higher than 1, then the good is considered to be income
elastic – implying that demand rises faster than income. Luxury goods include international
vacations or second homes.
  If the income elasticity of demand is higher than 0 but less than 1, then the good is income
inelastic – implying that demand for income-inelastic goods rises but at a slower rate than
income.

What determines the elasticity of demand?

 Many factors determine the demand elasticity for a product, including price levels, the type of
product or service, income levels, and the availability of any potential substitutes.
 High-priced products often are highly elastic because, if prices fall, consumers are likely to
buy at a lower price.
 Compared to essential goods, luxury items are highly elastic.
 Goods with many alternatives or competitors are elastic because, as the price of the good
rises, consumers shift purchases to substitute items.
 Incomes and elasticity are related—as consumer incomes increase, demand for products
increases as well.
Price Levels
The price level of an item affects the demand for a good or service, and the price elasticity of demand
can be used to measure the sensitivity of a change in the quantity demanded of a good or service
relative to a change in price.

For example, luxury goods have a high price elasticity of demand because they are sensitive to price
changes. Suppose the prices of LED televisions decrease in price by 50%. The demand increases
because they are more affordable to those who were unable to purchase them before.

The type of good or service affects the elasticity of demand as well. A good or service may be a
luxury item, a necessity, or a comfort to a consumer. When a good or service is a luxury or a comfort
good, the demand is highly price-elastic when compared to a necessary good.

Incomes and Alternatives

The availability of alternatives or substitute goods can affect demand elasticity. Hence, the demand
for goods or services with many substitutes is highly price elastic; a small increase in the price levels
of goods causes consumers to buy its substitutes. For example, the demand for soda is highly price-
elastic because of a large number of substitutes. If the price of one soda rises, consumers can opt to
buy the cheaper substitute.

Lastly, the level of consumer income plays a role in the demand elasticity of goods and services.
The income elasticity of demand is used to measure the sensitivity of a change in the quantity
demanded relative to a change in consumers' incomes. Different types of goods are affected by
income levels. For example, inferior goods, such as generic products, have a negative income
elasticity of demand because the quantity demanded for generic products tends to fall as consumers'
incomes increase.

The meaning of the elasticity of supply.

The price elasticity of supply is a measure of the degree of responsiveness of the quantity supplied to
the change in the price of a given commodity. It is an important parameter in determining how the
supply of a particular product is affected by fluctuations in its market price. It also gives an idea about
the profit that could be made by selling that product at its price difference.

5 Types of Elasticity of Supply

1. Perfectly Elastic Supply: A commodity becomes perfectly elastic when its elasticity of
supply is infinite. This means that even for a slight increase in price, the supply becomes
infinite. For a perfectly elastic supply, the percentage change in the price is zero for any
change in the quantity supplied.
2. More than Unit Elastic Supply: When the percentage change in the supply is greater than
the percentage change in price, then the commodity has the price elasticity of supply greater
than 1.
3. Unit Elastic Supply: A product is said to have a unit elastic supply when the change in its
quantity supplied is proportionate or equal to the change in its price. The elasticity of supply,
in this case, is equal to 1.
4. Less than Unit Elastic Supply: When the change in the supply of a commodity is lesser as
compared to the change in its price, we can say that it has a relatively less elastic supply. In
such a case, the price elasticity of supply is less than 1.
5. Perfectly Inelastic Supply: Product supply is said to be perfectly inelastic when the
percentage change in the quantity supplied is zero irrespective of the change in its price. This
type of price elasticity of supply applies to exclusive items. For example, a designer gown
styled by a famous personality.

What determines the elasticity of supply?

The price elasticity of supply is determined by:
 Number of producers: ease of entry into the market.
 Spare capacity: it is easy to increase production if there is a shift in demand.
 Ease of switching: if production of goods can be varied, supply is more elastic.
 Ease of storage: when goods can be stored easily, the elastic response increases
demand.
 Length of production period: quick production responds to a price increase easier.
 Time period of training: when a firm invests in capital the supply is more elastic in its
response to price increases.
 Factor mobility: when moving resources into the industry is easier, the supply curve in
more elastic.
 Reaction of costs: if costs rise slowly it will stimulate an increase in quantity supplied.
If cost rise rapidly the stimulus to production will be choked off quickly.

Examples of different types of good

 Luxury good – Superfast broadband, organic luxury coffee, Netflix tv, Porsche, a
foreign holiday to Bali
 Normal good – ordinary broadband, ordinary tv license, Ford Focus car, holiday to
somewhere close to where you live
 Inferior good – Supermarket own brand coffee, bus travel, a day out at theme park.
 

Other types of goods

  Necessity good – something needed for basic human existence, e.g. food, water,
housing, electricity. Though this becomes a subjective term, is electricity a necessity?
Is broadband internet a necessity?
 Comfort good – a good which isn’t a necessity, but gives enjoyment/utility, e.g.
subscription to netflix or take-away food. A comfort good may become a luxury.
 Complementary Goods. Goods which are used together, e.g. TV and DVD player.
see: Complementary goods
 Substitute goods. Goods which are alternatives, e.g. Pepsi and Coca-cola.
See Substitute goods.
 Giffen good. A rare type of good, where an increase in price causes an increase in
demand. The reason is that the income effect of a rise in the price causes you to buy
more of this cheap good because you can’t afford more expensive goods. For
example, if the price of wheat rises, a poor peasant may not be able to afford meat
anymore, so has to buy more wheat. See: Giffen goods
 Possible examples of Giffen good – rice, potatoes, bread.
 Veblen / Snob good. A good where an increase in price encourages people to buy
more of it. This is because they think more expensive goods are better. See: Veblen
good
 Example of Veblen / Snob good – some forms of art, designer clothes.
Market Failure

 Public goods – goods with characteristics of non-rivalry and non-excludability, e.g.

national defence. See: Public Goods
 Quasi-public good – goods which have some of the characteristics of non-rivalry and
non-excludability, but not 100%. For example, interest is mostly very cheap to
access. Once provided, you can access most website – though some websites may
charge to view (e.g. newspapers).
 Merit goods. Goods which people may underestimate benefits of. Also often has
positive externalities, e.g. education. See: Merit goods
 Demerit goods. Goods where people may underestimate the costs of consuming it.
Often has negative externalities, e.g. smoking, drugs. See: Demerit goods
 Private goods – goods which do have rivalry and excludability. The opposite of a
public good See: private goods
 Free goods – A good with no opportunity cost, e.g. breathing air. 

Inferior good
An inferior good means an increase in income causes a fall in demand. It is a good with a negative
income elasticity of demand (YED). An example of an inferior good is Tesco value bread. When your
income rises you buy less Tesco value bread and more high quality, organic bread.
Luxury good
A luxury good means an increase in income causes a bigger percentage increase in demand. It means
that the income elasticity of demand is greater than one. For example, HD TV’s would be a luxury
good. When income rises, people spend a higher percentage of their income on the luxury good.

Normal good

A normal good means an increase in income causes an increase in demand. It has a positive income
elasticity of demand YED. Note a normal good can be income elastic or income inelastic.