Summary

Principles of Economics

N. Gregory Mankiw
6th Revised Edition
Contents
1. Ten principles of Economics ................................................................................................................ 6
1.1. How people make decisions ......................................................................................................... 6
1.2. How people interact ..................................................................................................................... 7
1.3. How the Economy as a whole works ............................................................................................ 8
2. Thinking like an Economist ................................................................................................................ 10
2.1. The economist as a Scientist ...................................................................................................... 10
2.2. The economist as a policy advisor .............................................................................................. 13
3. Interdependence and the gains from Trade ..................................................................................... 14
3.1. A parable for the modern Economy ........................................................................................... 14
3.2. Comparative advantage: The driving force of Specialization ..................................................... 15
4. The market forces of supply and demand......................................................................................... 18
4.1. Markets and competition ........................................................................................................... 19
4.2. Demand ...................................................................................................................................... 20
4.3. Supply ......................................................................................................................................... 23
4.4. Supply and demand together ..................................................................................................... 25
5. Elasticity and its Applications ............................................................................................................ 28
5.1. The Elasticity of Demand ............................................................................................................ 29
5.2. The Elasticity of Supply............................................................................................................... 32
6. Supply, Demand and government policies........................................................................................ 34
6.1. Control on prices ........................................................................................................................ 35
6.2. Taxes ........................................................................................................................................... 38
7. Consumers, Producers, and the Efficiency of Markets ..................................................................... 41
7.1. Consumer surplus....................................................................................................................... 42
7.2. Producer surplus ........................................................................................................................ 44
7.3. Market efficiency........................................................................................................................ 45
8. Application: The costs of taxation ..................................................................................................... 47
8.1. The Deadweight loss of Taxation ............................................................................................... 47
8.2. The determinants of the deadweight loss ................................................................................. 49
8.3. Deadweight loss and tax revenue as taxes vary ......................................................................... 50
9. Application: International trade ........................................................................................................ 52
9.1. The determinants of trade ......................................................................................................... 52
9.2. The winners and losers from trade ............................................................................................ 53
9.3. The arguments for restricting trade ........................................................................................... 56
10. Externalities ..................................................................................................................................... 58
10.1. Externalities and market inefficiency ....................................................................................... 58

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 10.2. Public policies towards externalities ........................................................................................ 60
10.3. Private solutions to externalities.............................................................................................. 61
11. Public goods and common resources.............................................................................................. 62
11.1. The different kinds of goods .................................................................................................... 62
11.2. Public goods ............................................................................................................................. 64
11.3. Common resources .................................................................................................................. 65
12. The design of the tax system ........................................................................................................... 67
12.1. A financial overview of the US government............................................................................. 68
12.2. Taxes and efficieny ................................................................................................................... 68
12.3. Taxes and equity....................................................................................................................... 69
13. The costs of production ................................................................................................................... 72
13.1. What are costs? ........................................................................................................................ 73
13.2. Production and costs ................................................................................................................ 74
13.3. The various measures of costs ................................................................................................. 75
13.4. Costs in the short run and in the long run ............................................................................... 77
14. Firms in competitive markets .......................................................................................................... 78
14.1. What is a competitive market? ................................................................................................ 79
14.2. Profit maximization and the competitive firm's supply ........................................................... 80
14.3. The supply curve in a competitive market ............................................................................... 82
15. Monopoly ........................................................................................................................................ 84
15.1. Why monopolies arise .............................................................................................................. 85
15.2. How monopolies make production and pricing ....................................................................... 86
15.3. The welfare cost of monopolies ............................................................................................... 87
15.4. Price discrimination .................................................................................................................. 88
15.5. Public policy toward monopolies ............................................................................................. 90
16. Monopolistic competition ............................................................................................................... 92
16.1. Between monopoly and perfect competition .......................................................................... 92
16.2. Competition with differentiated products ............................................................................... 93
16.3. Advertising................................................................................................................................ 96
17. Oligopoly.......................................................................................................................................... 97
17.1. Markets with only a few sellers................................................................................................ 97
17.2. The economics of cooperation ............................................................................................... 100
17.3. Public policy toward oligopolies............................................................................................. 102
18. The markets for the factors of production .................................................................................... 104
18.1. The demand for labor............................................................................................................. 104
18.2. The supply of labor ................................................................................................................. 106

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 18.3. Equilibrium in the labor market ............................................................................................. 107
18.4. The other factors of production: Land and capital ................................................................ 108
19. Earnings and discrimination .......................................................................................................... 110
19.1. Some determinants of equilibrium wages ............................................................................. 111
19.2. The economics of discrimination ........................................................................................... 112
20. Income inequality and poverty ..................................................................................................... 114
20.1. The measurement of inequality ............................................................................................. 114
20.2. The political philosophy of redistributing income.................................................................. 116
20.3. Policies to reduce poverty ...................................................................................................... 117
21. The theory of consumer choice ..................................................................................................... 120
21.1. The budget constraint: What the consumer can afford......................................................... 121
21.2. Preferences: What the consumer wants ................................................................................ 122
21.3. Optimization: What the consumer chooses........................................................................... 125
21.4. Three applications .................................................................................................................. 128
22. Frontiers of microeconomics......................................................................................................... 130
22.1. Asymmetric information ........................................................................................................ 130
22.2. Political economy ................................................................................................................... 133
22.3. Behavioral economics ............................................................................................................ 135
23. Measuring a nation's income ........................................................................................................ 138
23.1. The economy's income and expenditure ............................................................................... 139
23.2. The measurement of gross domestic product ....................................................................... 139
1. The components of GDP.............................................................................................................. 141
23.4. Real versus nominal GDP........................................................................................................ 142
23.5. Is GDP a good measure of economic well-being? .................................................................. 144
24. Measuring the cost of living .......................................................................................................... 146
24.1. The Consumer price index ...................................................................................................... 147
24.2. Correcting economic variables for the effects of inflation..................................................... 150
25. Production and growth ................................................................................................................. 151
25.1. Economic growth around the world ...................................................................................... 152
25.2. Productivity: Its role and determinants ................................................................................. 152
25.3. Economic growth and public policy ....................................................................................... 154
26. Saving, investment and the financial system ................................................................................ 158
26.1. Financial institutions in the US economy ............................................................................... 159
26.2. Saving and Investment in the national income accounts....................................................... 161
26.3. The market for loanable funds ............................................................................................... 162
27. The basic tools of finance .............................................................................................................. 166

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 27.1. Present value: measuring the time value of money .............................................................. 166
27.2. Managing risk ......................................................................................................................... 167
27.3. Asset valuation ....................................................................................................................... 169
28. Unemployment.............................................................................................................................. 172
28.1. Identifying unemployment ..................................................................................................... 173
28.2. Job Search............................................................................................................................... 175
28.3. Minimum-wage laws .............................................................................................................. 177
28.4. Unions and collective bargaining ........................................................................................... 177
28.5. The theory of efficiency wages............................................................................................... 178
29. The monetary system .................................................................................................................... 181
29.1. The meaning of money........................................................................................................... 182
29.2. The Federal Reserve System .................................................................................................. 184
29.3. Banks and the money supply ................................................................................................. 185
29.4. The Fed's tools of monetary control ...................................................................................... 186
30. Money Growth and Inflation ......................................................................................................... 189
30.1. The classical theory of inflation.............................................................................................. 190
30.2. The costs of inflation .............................................................................................................. 193
31. Open-economy macroeconomics: Basic concepts ........................................................................ 195
31.1. The international flows of goods and capital ......................................................................... 196
31.2. The prices for international transactions: Real and nominal ................................................. 198
31.3. A first theory of exchange rate determination ...................................................................... 200
32. A macroeconomic theory of the open economy .......................................................................... 202
1. Supply and demand for loanable funds and for foreign-currency .............................................. 203
32.2. Equilibrium in the open economy .......................................................................................... 205
32.3. How policies and events affect an open economy................................................................. 206
33. Aggregate demand and aggregate supply..................................................................................... 209
33.1. Three key facts about economic fluctuations ........................................................................ 211
33.2. Explaining short-run economic fluctuations .......................................................................... 212
33.3. The aggregate demand curve................................................................................................. 213
33.4. The aggregate supply curve ................................................................................................... 216
33.5. Two causes of economic fluctuations .................................................................................... 219
34. The influence of monetary and fiscal policy on aggregate demand ............................................. 221
1. How monetary policy influences aggregate demand.................................................................. 222
34.2. How fiscal policy influences aggregate demand .................................................................... 225
34.3. Using policy to stabilize the economy .................................................................................... 226
35. The short-run trade-off between inflation and unemployment ................................................... 228

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 35.1. The Phillips curve.................................................................................................................... 228
35.2. Shifts in the Phillips curve: The role of expectations ............................................................. 230
35.3. Shifts in the Phillips curve: The role of supply shocks ............................................................ 232
35.4. The cost of reducing inflation................................................................................................. 232
36. Six debates over macroeconomic policy ....................................................................................... 235
1. Should monetary and fiscal policymakers try to stabilize the economy ..................................... 236
1. Should the government fight recessions with spending hikes rather than tax cuts ................... 237
1. Should monetary policy be made by rule rather than by discretion .......................................... 238
36.4. Should the central bank aim for zero inflation....................................................................... 239
36.5. Should the government balance its budget ........................................................................... 240
36.6. Should the tax laws be reformed to encourage saving .......................................................... 241

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1. Ten principles of Economics
A society faces many decisions in real life. Like a household, a society as a whole
must decide how to allocate its resources. Because there is only a limited amount of
resources, we say that resources are scarce. Economics is the study of how society
manages its scarce resources. In this chapter we will study how people make
decisions and why.

The fundamental lessons about individual decision making are that people face trade-
offs among alternative goals, that the cost of any action is measured in terms of
forgone opportunities, that rational people make decisions by comparing marginal
costs and marginal benefits, and that people change their behaviour in
response to the incentives they face.
• The fundamental lessons about interactions among people are that trade and
interdependence can be mutually beneficial, that markets are usually a good way of
coordinating economic activity among people, and that the government can
potentially improve market outcomes by remedying a market failure or by promoting
greater economic equality.
• The fundamental lessons about the economy as a whole are that productivity is the
ultimate source of living standards, that growth in the quantity of money is the
ultimate source of inflation, and that society faces a short-run trade-off between
inflation and unemployment.

1.1. How people make decisions

The four principles of individual decision making are:

(1) People face trade-offs
(2) The cost of something is what you give up to get it
(3) Rational people think at the margin
(4) People respond to incentives

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 1. People face trade-offs: To get one thing we like, we usually have to give up
another thing that we like. For example you have to choose between going to
the cinema with a friend or work in a supermarket for money.
2. The cost of something is what you give up to get it: Suppose you’re going to
college and you want to calculate your costs. It is tempting to only include
tuition, books, room and board. This is a bit misleading, because even if you
weren’t going to school you had to pay for food and housing. Second, this
calculation ignores the largest cost of going to college; your time! During the
time you were studying, making homework or attend classes you could have
earned money with a job. These costs are called opportunity costs. The
opportunity cost of an item is what you give up to get that item.
3. Rational people think at the margin: first of all we have to define what rational
people are. People are considered rational if they consistently do their best
they can to achieve their objectives. Second, we will always assume that
people or firms think at the margin. The marginal change is an incremental
adjustment to a plan of action. If a firm decides whether to produce an extra
unit of some good, it will always look at the cost of producing 1 extra unit
versus the benefit of producing 1 extra unit. If the benefit/revenue is higher
than the cost, it will decide to produce an extra unit.
4. People respond to incentives: An incentive is something that induces a person
to act. Consider, for example a government which imposes a higher tax on
cigarettes. This causes people to stop smoking.

1.2. How people interact

As we go about our lives, many of our decisions affect not only ourselves but other
people as well. The next three principles concern how people interact with one
another:
(5) trade can make everyone better off
(6) Markets are usually a good way to organize economic activity
(7) Governments can sometimes improve market outcomes

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 5. Trade can make everyone better off: Countries as well as families benefit from
trade by specializing in the things they are good at. This results in lower prices for
goods and a more efficient production process.

6. Markets are usually a good way to organize economic activity: In a market

economy decisions are made by millions of firms and household. A firm decides how
many workers to hire and household decide what to buy for their income.

7. Governments Can Sometimes Improve Market Outcomes: The government can

impose important laws to stimulate economic activity. One way to establish this goal
is by means of property rights. Property rights are defined as: the ability of an
individual to own and exercise control over scarce resources. A singer wouldn’t
produce any music if he knew everybody could get an illegal copy of his music.
Another reason why government can be important is in the case of a market
failure. This occurs when a market fails to allocate recourses efficiently. Consider the
case when you are the only one who is able to produce and sell eggs in a town. You
can basically ask any price for your eggs, since you have a lot of market power. In this
case a government can choose to intervene and to set a maximum price for your eggs.
Another possible cause of market failure is an externality, which is the impact of one
person’s actions on the well-being of a bystander. Suppose your firm is producing a
lot of pollution, which has a negative effect on the region, the government can choose
to set rules for the maximum amount of pollution.

1.3. How the Economy as a whole works

The last three principles concern the workings of the economy as a whole:
(8) A country's standard of living depends on its ability to produce goods and services
(9) Prices rise when the government prints too much money
(10) A Country’s Standard of Living Depends on Its Ability to Produce Goods and
Services: Society Faces a Short-Run Trade-off between Inflation and Unemployment.

8. A Country’s Standard of Living Depends on Its Ability to Produce Goods and

Services: There is a big difference between annual incomes for countries around
world. Why is there such a big difference? The answer is that some countries can

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produce much more with 1 unit of labour input than other countries. We call this a
difference in productivity, which is the quantity of goods and services produced from
each unit of labour input. In western-Europe we can make a lot more with 1 unit of
labour compared to Nigeria.

9. Prices rise when the government prints too much money: Almost every year we
see that prices rise, but in some countries much faster than in other countries. The
general term to indicate an increase in the overall price level is inflation. What causes
inflation? In almost all cases of large or persistent inflation, the culprit is growth in the
quantity of money. When a government creates large quantities of the nation’s
money, the value of the money falls.

10. A Country’s Standard of Living Depends on Its Ability to Produce Goods and
Services: Society Faces a Short-Run Trade-off between Inflation and
Unemployment. Most economists describe the short-run effects of monetary
injections as follows:

• Increasing the amount of money in the economy stimulates the overall level
of spending and thus the demand for goods and services.

• Higher demand may over time cause firms to raise their prices, but in the
meantime, it also encourages them to hire more workers and produce a larger
quantity of goods and services.

• More hiring means lower unemployment

Hence, for society there is a decision to make: Choosing for lower unemployment and
higher inflation or vice versa.

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2. Thinking like an Economist
Economics is divided into 2 subfields: macro and microeconomics. Economists try to
analyse macro and microeconomics by making appropriate assumptions. Since
various economists have different (political) views, this may lead to conflicting
conclusions. Sometimes economists are united in their advice, but policymakers may
still choose to ignore this.

Economists try to address their subject with a scientist’s objectivity. Like all scientists,
they make appropriate assumptions and build simplified models to understand the
world around them. Two simple economic models are the circular-flow diagram and
the production possibilities frontier.
• The field of economics is divided into two subfields: microeconomics and
macroeconomics. Micro economists study decision making by households and firms
and the interaction among households and firms in the
marketplace. Macroeconomists study the forces and trends that affect the economy
as a whole.
• A positive statement is an assertion about how the world is. A normative
statement is an assertion about how the world ought to be. When economists make
normative statements, they are acting more as policy advisers than scientists.
• Economists who advise policymakers offer conflicting advice either because of
differences in scientific judgments or because of differences in values. At other times,
economists are united in the advice they offer, but policymakers may choose to
ignore it.

2.1. The economist as a Scientist

Economists try to address their subject with a scientist’s objectivity. They approach
the study of the economy in much the same way a physicist
approaches the study of matter and a biologist approaches the study of life: They
devise theories, collect data, and then analyse these data in an attempt to
verify or refute their theories. Let’s discuss some of the ways in which economists
apply the logic of science to examine how an economy works.

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The first model we will explore is the circular-flow diagram, used to represent an
economy that shows how dollars flow through markets among households and
firms. The inner loop represents the flows of inputs and outputs, whereas the outer
loop represents the corresponding flow of dollars. Note that in this model we did not
include the government and international trade. This model is used to give you a basic
understanding of how an economy works; later on we will include import, export and
government spending.

Our second model concerns the production possibilities frontier. This is a curve that
shows the combinations of output that the economy can possibly produce given the
available factors of production and the available production technology. Let’s assume
an economy is only producing 2 goods; refrigerators and cars (a bit unrealistic but just
to keep things simple). Below you see the points A, B and C on the curve which
represents the amount of refrigerators and cars produced in the economy. Note that

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the curve is downward sloping, so that if we decide to produce more cars we can
produce fewer refrigerators. All points which lie on the curve (A, B and C) are
considered efficient since if we want to produce more cars we can produce fewer
refrigerators. Point X is considered inefficient since we can decide to produce more
cars without producing fewer refrigerators. This is perhaps due to widespread
unemployment. Point Y is considered unattainable since we cannot reach this point
given our available resources.

Although point Y is unattainable now, it does not mean that we can never reach that
point. An increase in technological progress might shift the ppf curve upwards, so that
we are able to produce according to point Y.

Although economics can be studied on various different levels, we usually subdivide it

into 2 broad subfields; Macroeconomics and Microeconomics. Macroeconomics is the
study of economy wide phenomena, including inflation, unemployment, and economic
growth. Whereas Microeconomics is the study of how households and firms make
decisions and how they interact in markets. Despite the inherent link between
microeconomics and macroeconomics, the two fields are distinct. Because they
address different questions, each field has its own set of models, which are often
taught in separate courses.

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2.2. The economist as a policy advisor

In economics there are thousands of different theories and opinions. When

economists are asked to explain causes of economic events, they usually give
different answers depending on their background. For example, we distinguish
between the role of an economist as policy advisor and an economist as scientist.
This, in turn, leads us to the definition of normative and positive statements.

When economists discuss various topics we have to make a distinction

between normative and positive statements. Normative statements are claims that
attempt to describe how the world should be. For example if you say: “Government
should raise the minimum wage.” This is different from a statement like: “Minimum-
wage laws cause unemployment.” This is an example of a positive statement. A key
difference between positive and normative statements is how we judge their validity.
We can, in principle, confirm or refute positive statements by examining evidence,
whereas normative statements often involve our view on ethics, religion or political
philosophy.

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3. Interdependence and the gains from
Trade
People face trade-offs between certain goods because their budget is limited. That's
why it's better that people specialize in the things they are good at so that they can
trade with each other. The decisive determinant which decides who specializes in
which product is the comparative advantage. When you have the comparative
advantage you are able to produce more goods with fewer inputs than another.

 Each person consumes goods and services produced by many other people
both in the United States and around the world. Interdependence and trade are
desirable because they allow everyone to enjoy a greater quantity and variety
of goods and services.
 There are two ways to compare the ability of two people in producing a good.
The person who can produce the good with the smaller quantity of inputs is
said to have an absolute advantage in producing the good. The person who has
the smaller opportunity cost of producing the good is said to have a
comparative advantage. The gains from trade are based on comparative
advantage, not absolute advantage.
 Trade makes everyone better off because it allows people to specialize in
those activities in which they have a comparative advantage.
 The principle of comparative advantage applies to countries as well as to
people. Economists use the principle of comparative advantage to advocate
free trade among countries

3.1. A parable for the modern Economy

People face trade-offs in daily life, because their budget is limited. Only the points
inside and on the production possibility frontier are attainable for a person. But
when trade is allowed, people will specialize and they are able to obtain points
outside the possibility frontier.

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Consider the following situation: We have a farmer and a rancher both producing
potatoes and meat. The farmer can produce 1 ounce of meat per hour or 4 ounce of
potatoes per hour. The rancher can produce 3 ounce of meat per hour or 6 ounce of
potatoes per hour. We see that the Rencher has an absolute advantage in producing
both goods. He can produce more meat and more potatoes in one hour. Initially the
farmer is producing 16 ounce of potatoes and 4 ounce of meat for himself, whereas
the rancher is producing 24 ounce of potatoes and 12 ounce of meat. At first glance it
may seem that the Rancher cannot benefit from trade, because he is more productive
in both goods.

But the rancher has thought deep about the situation and offers a deal to the farmer:
"Suppose you devote all your time to produce potatoes, then you can produce 32
ounce. If you give 15 ounce to me and I'll give you 5 ounce of meet, then you can
consume 17 ounce of potatoes and 5 ounce of meet, which is more than you would
have if you worked for yourself!”

The farmer is doubtful and asks: "This sounds great, but what are your benefits then?”

Rancher: "If I devote 6 hours of my time to produce meat and 2 hours to produce
potatoes, then I have 18 ounce of meat and 12 ounce of pot. I'll give you 5 ounce of
meat and you give me 15 ounce of potatoes, so after trade I can consume 13 ounce of
meat and 27 ounce of potatoes, more than I would have without trade!

This example is used to illustrate that both people can gain from trade even if
someone is more productive in both goods. Recall that their initial consumption is a
point on the production possibilities frontier. After trade both the Rancher and the
Farmer are able to obtain a point above the ppf curve, which was unattainable
without trade. The term indicating that the farmer devotes all his time producing
potatoes is known as specialization.

3.2. Comparative advantage: The driving force of Specialization

The one who has the comparative advantage determines who specializes in what
product. This is because the one who has the comparative advantage can produce

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something at lower opportunity cost. If people allow mutual trade, they are able to
consume both more. This is because they are able to reach points outside the
production possibilities frontier.

Recall that absolute advantage was defined as: the ability to produce a good using
fewer inputs than another producer. In the example of the previous paragraph we
noted that the Rancher had an absolute advantage over both goods. In that example
the only input is time, which is then the only cost.

In chapter 1 we defined another type of costs, namely opportunity costs. These costs
play a crucial role in the understanding of trade. If the farmer decides to devote 1
hour extra of his time to produce potatoes, he is giving up 1 ounce of meet. Put
differently, if the farmer produces 1 ounce of potatoes extra, he is giving up 1/4
ounce of meat. So his opportunity cost of potatoes is 1/4 ounce of meat. Similarly his
opportunity cost of meat is 4 ounce of potatoes.

Now let's look at the rancher, if he is producing 1 extra ounce of potatoes he is giving
up 1/2 ounce of meat. So his opportunity cost of potatoes is 1/2 ounce of meat and
the opportunity cost of meat is 2 ounce of potatoes.

If we compare the rancher and the farmer we note that the farmer's opportunity
cost of potatoes are lower, namely 1/4 ounce of meat vs. 1/2 ounce of meat. In this
case we say that the farmer has a comparative advantage over
potatoes. Comparative advantage is the ability to produce a good at a lower
opportunity cost than another producer. Again we note that the rancher has the
comparative advantage over meat since his opportunity cost is only 2 potatoes vs. 4
potatoes for the farmer. Although it is possible for one person to have an absolute
advantage in both goods (as the rancher does in our example), it is impossible for one
person to have a comparative advantage in both goods. Because the opportunity cost
of one good is the inverse of the opportunity cost of the other, if a person’s
opportunity cost of one good is relatively high, the opportunity cost of the other good
must be relatively low. Comparative advantage reflects the relative opportunity
cost. Unless two people have exactly the same opportunity cost, one person will have

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a comparative advantage in one good, and the other person will have a
comparative advantage in the other good.

The gains from specialization and trade are based not on absolute advantage but on
comparative advantage. When each person specializes in producing the good for
which he or she has a comparative advantage, total production in the economy
rises. This increase in the size of the economic pie can be used to make everyone
better off. We can also look at the gains from trade in terms of the price that each
party pays the other. Consider the proposed deal from the viewpoint of the farmer.
The farmer gets 5 ounces of meat in exchange for 15 ounces of potatoes. In other
words, the farmer buys each ounce of meat for a price of 3 ounces of potatoes. This
price of meat is lower than his opportunity cost for an ounce of meat, which is 4
ounces of potatoes. Thus, the farmer benefits from the deal because he gets to buy
meat at a good price.

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4. The market forces of supply and
demand
Supply and demand are the two words economists use most often—and for
good reason. Supply and demand are the forces that make market economies work.
They determine the quantity of each good produced and the price at which it is sold.
If you want to know how any event or policy will affect the economy, you
must think first about how it will affect supply and demand. The demand curve is
downward sloping and the supply curve is upward sloping. In a free market without
government intervention, resources are allocated efficiently, meaning that there is
no mutual desire to change the market outcome.

Economists use the model of supply and demand to analyse competitive markets. 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. Therefore, the demand curve slopes downward.

In addition to price, other determinants of how much consumers want to buy include
income, the prices of substitutes and complements, tastes, expectations, and the
number of buyers. If one of these factors changes, the demand curve shifts.

The supply curve shows how the quantity of a good supplied depends on the price.
According to the law of supply, as the price of a good rises, the quantity supplied
rises. Therefore, the supply curve slopes upward.

In addition to price, other determinants of how much producers want to sell include
input prices, technology, expectations, and the number of sellers. If one of these

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factors changes, the supply curve shifts.
The intersection of the supply and demand curves determines the market equilibrium.
At the equilibrium price, the quantity demanded equals the quantity supplied.

The behaviour of buyers and sellers naturally drives markets toward their equilibrium.
When the market price is above the equilibrium price, there is a surplus of the good,
which causes the market price to fall. When the market price is below the equilibrium
price, there is a shortage, which causes the market price to rise.

To analyse how any event influences a market, we use the supply-and-demand

diagram to examine how the event affects the equilibrium price and quantity. To do
this, we follow three steps. First, we decide whether the event shifts the supply curve
or the demand curve (or both). Second, we decide in which direction the curve shifts.
Third, we compare the new equilibrium with the initial equilibrium.

In market economies, prices are the signals that guide economic decisions and
thereby allocate scarce resources. 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.

4.1. Markets and competition

The terms supply and demand refer to the behaviour of people as they interact
with one another in competitive markets. A competitive market is one with many
sellers and many buyers. There are other types of markets which we will examine in
later chapters.

A market is a group of buyers and sellers of a particular good or service. The buyers as
a group determine the demand for the product, and the sellers as a group
determine the supply of the product. Needless to say, there are many different forms
of markets and the structure of a market depends on the good or service. There are
markets which are highly organized (agricultural commodities), but usually markets are
less organized, for example the ice-cream market.

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