Ilovepdf Merged

•PMME
The Role and

Method
of Economics
©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or
part.
1.1 Economics: A Brief Introduction
• Economics is the study of the allocation of our limited
resources to satisfy our unlimited wants.
• Resources are inputs that are used to produce goods and
services.
• Scarcity forces us to make choices on how
to best use our limited resources.
• The economic problem: Scarcity forces us to choose, and
choices are costly because we must give up other
opportunities that we value.
©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Scarcity
• Economics is primarily concerned with scarcity–

how well we satisfy our unlimited wants in a world
of limited resources.
• As long as human wants exceed available
resources, scarcity will exist.
part.
The scarce resources that are used in the production
of goods and services can be grouped into four
categories:
• labor
• land
• capital
• entrepreneurship
part.
• Labor is the total of both physical and mental
effort expended by people in the production of
goods and services.
• Land is the natural resources used in the
production of goods and services.
part.
• Capital is the equipment and structures used to
produce goods and services. Office buildings,
tools, machines and factories are all considered
capital goods.
• Capital also includes human capital, the
productive knowledge and skill people receive
from education and on-the-job training.
part.
• Entrepreneurship is the process of combining
the labor, land and capital together to produce
goods and services.
• The entrepreneur is the one who makes the
tough and risky decisions about what to produce
and how to produce.
part.
• Entrepreneurs are always looking for new ways
to improve production techniques or to create
new products. They are driven by the lure of
positive incentives—profits.
• We are all entrepreneurs when we try new
products or when we find better ways to manage
our households or our study time.
part.
• Goods are those items that we value or desire.
• They can be tangible goods that can be held,
heard, tasted or smelled or intangible goods
such as fairness for all, friendship, knowledge,
security, and health.
• Services are the intangible acts for which people
are willing to pay such as legal or medical
services.
part.
• The scarce goods that are created from scarce
resources are called economic goods.
• If there are not enough economic goods for all
of us, we will have to compete for those scarce
goods.
part.
1.2 Economic Behavior
• Economists assume that individuals act as if
they are motivated by self-interest and
respond in predictable ways to changing
circumstances.
• To a worker, self-interest means pursuing a
higher paying job and/or better working
conditions.
• To a consumer, self-interest means gaining a
greater level of satisfaction from their limited
income and time.
• Most economists believe that it is rational for
people to try to anticipate the likely future
consequences of one's behavior before
choosing it—like driving with a suspended
driver’s license or choosing to take up
smoking.
• Actions have consequences—even
inactions, which are choices not to do
something or not to make changes, have
consequences—failing to study for an exam.
• In mainstream economics, to say that people
are rational is not to assume that they never
make mistakes. It is merely to say that they
do NOT make systematic mistakes.
• When economists talk of self-interest, they
are not just referring to satisfaction of
material wants but to a broader idea of
“preferences” that can easily encompass the
welfare of others.
• Because we assume that people want more
goods, it does not mean that economics also
presumes that people are selfish and greedy.
• People are willing to give up their money and
time for what they believe to be important
causes, revealing that charitable endeavors are
desirable goods.
• Self-interest is not the same as selfishness or
greed.
• We all face scarcity, because we cannot have all
of the goods and services that we desire.
• However, because we all have different wants
and desires, scarcity affects everyone differently.
part.
1.3 Economic Theory
• Theories are statements or propositions used to
explain and predict behavior in the real world.
• Because of the complexity of human behavior,
economists must abstract to focus on the most
important components of a particular problem.
• This is similar to maps that highlight the
important information (and assume away many
of the minor details) to help people get from
here to there.
• A hypothesis in economic theory is a testable
prediction about how people will behave or react
to a change in economic circumstances.
• For example, if the price of CDs increase, we
can hypothesize that fewer CDs will be sold.
• Empirical analysis, the use of data to test
hypotheses, is applied to determine whether a
hypothesis fits well with the facts. If an economic
hypothesis is supported by the data, we can
tentatively accept as an economic theory.
• Virtually all theories in economics are expressed
using a ceteris paribus (“holding everything
else constant”) assumption.
• An example of ceteris paribus: The theory that if
I study harder, I will perform better on a test
must carefully hold other things constant.
• These other things might include—what if you
studied so hard you overslept or you were too
sleepy to think clearly? Or what if you studied
the wrong stuff?
• Two main branches of economics:
• Macroeconomics, and
• Microeconomics.
• Macroeconomics is the study of the
aggregate, or total economy.
• It looks at economic problems as they
influence the whole of society, including the
topics of inflation, unemployment, business
cycles, and economic growth.
• Microeconomics deals with the smaller
units within the economy.
• It attempts to understand the decision
making behavior of firms
and households and their interaction in
markets for particular goods or services.
• Microeconomics looks at the trees;
Macroeconomics looks at the forest.
1.4 Positive and Normative Statements
• Positive statement--an objective testable
statement. Positive statements are attempts to
describe what happens and why it happens.
• Normative statement--a subjective non-testable
item about what should be or what ought to
happen. Normative statements are attempts to
prescribe what should be done.
• For example, should the government give “free”
prescription drugs to seniors? Or should the
government increase spending in the space
program?
1.5 Choices, Costs, and Trade-Offs
• If we had unlimited resources, and thus an

ability to produce all of the goods and services
anyone wanted, we would not have to choose
among those wants.
• We are all faced with the fact of scarcity, and as
a consequence, we must make choices.
• Because none of us can afford to buy everything
we want, each time we do decide to buy one
good or service, we reduce our ability to buy
other things we would also like to have.
part.
• People must choose.
• The cost of a choice is the values that must be

foregone.
• The highest or best foregone opportunity

resulting from a decision is called the
opportunity cost.
• “To choose is to lose.”
• “An opportunity cost is an opportunity lost.”
• To get more of anything that is desirable, you

must accept less of something else that you
also value.
part.
Opportunity Cost illustrations
• The opportunity cost of going to college must

include the opportunity cost of your time.
• The opportunity cost of rearing a child includes
the opportunity cost of the time spent in child
rearing, time that could be used pursuing a
career or volunteering at a local mission.
part.
1.6 Marginal Thinking
• Most choices involve how much of something to

do rather than whether or not to do something.
• Economists emphasize marginal thinking
because the focus is on additional, or marginal,
choices.
• Marginal choices involve the effects
of adding or subtracting from the current
situation.
part.
• The rule of rational choice is that individuals
will only pursue an activity if expected marginal
benefits are greater than expected marginal costs
[or E(MB) > E(MC)].
• Net benefits—the difference between the
expected marginal benefits and the expected
marginal costs
part.
• We can use the concept of marginal thinking to
evaluate pollution levels.
• We have to weigh the expected marginal
benefits of a cleaner environment against the
expected marginal costs of a cleaner
environment.
• Zero pollution levels would be far too costly in
terms of what we would have to give up.
part.
1.7 Specialization and Trade
• People are specializing when they

concentrate their energies on only one or a
few activities.
• This allows them to make the best use of (and
thus gain the most benefit from) their limited
resources.
part.
• If a person, a region, or a country can produce
a good or service at a lower opportunity cost
than others, we say that they have a
comparative advantage in the production of
that good or service.
• They can gain by specializing in the production
of the good in which they have a comparative
advantage.
part.
• The primary advantages of specialization are
that employees acquire greater skill from
repetition.
• They avoid wasted time in shifting from one
task to another.
• They do the types of work for which they are
best suited.
part.
• Trade, or voluntary trade, directly increases
wealth by making both parties better off (or
they wouldn't trade).
• It is the prospect of wealth—increasing
exchange that leads to productive
specialization.
part.
• Trade increases wealth by allowing
a person, a region, or a nation to specialize in
those products that it produces better and to
trade for the products that others produce
better.
• For example, the United States is better at
producing wheat while Brazil is better at
producing coffee.
• The U.S. and Brazil trade these goods with
each other.
part.
• Imagine Tom had 10 pounds of tea and
Katherine had 10 pounds of coffee. However,
Tom preferred coffee to tea and Katherine
preferred tea to coffee. Could both parties be
made better off through trade?
• If Tom traded his tea to Katherine for coffee,

both parties would be better off. Trade simply
reallocates goods and the voluntary exchange
increases wealth by making both parties
better off.
part.
THANK YOU FOR
ATTENTION!
part.
•PMME
Scarcity, Trade-
Offs
and Production
Possibilities
©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
2.1 Three Economic Questions
Every Society Faces
• Because of scarcity, certain economic

questions must be answered regardless of the
level of affluence of the society or its political
structure.
Three fundamental questions that inevitably must
be faced in a world of scarcity are:
• What is to be produced?
• How are these goods to be produced?
• For whom are the goods produced?
• In market-oriented economies, people “vote”
on economic affairs with their dollars.
• Consumer sovereignty describes how
individual consumers in market economies
determine what is to be produced.
• Economies are organized in different
ways to answer the question of what is to
be produced.
• Command economies rely on central

planning, where decisions about what is
produced is largely determined by a
government official or a committee associated
with the central planning organization.
• Market economies, on the other hand, largely
rely on a decentralized decision-making
process, in which literally millions of individual
producers and consumers of goods and
services determine what goods will be
produced.
• Most countries, including the United States,
have mixed economies in which the
government and private sector together
determine the allocation of resources.
• All economies, regardless of political structure,
must decide how, from several possible ways,
to produce the goods and services that they
want.
• For example, when digging a ditch,
a contractor must decide between many
workers using their hands, a few workers with
shovels, or one person with a backhoe.
• A decision must be made as to which method is
appropriate.
• The best method is the least-cost method.
• The best or "optimal" form of production will
vary from one economy to the next.
• Each nation tends to use the production
processes that conserve its relatively scarce
(and thus relatively more expensive) resources
and use more of its relatively abundant
resources.
• Labor intensive methods will be used where
capital is relatively scarce.
• Capital intensive methods will be used where
labor is relatively scarce.
• In every society, some mechanism must exist
to determine how goods and services are to
be distributed among the population.
• Who gets what?
• In a market economy, with private ownership
and control of the means of production, the
amount of output one is able to obtain depends
on one's income, which in turn, depends on the
quantity and quality of the scarce resources
that the individual controls.
• For example, Serena Williams‘s income
is very large because her skills are unique and
marketable.
• The movie Castaway and resource allocation.
• Chuck Noland finds answers to the what, how,
and for whom questions.
2.2 The Circular Flow Model
• Product markets are the markets for goods and
services.
• In the product market, households are buyers and
firms are sellers.
• Factor or input markets are where households
sell the use of their inputs (capital, land, labor and
entrepreneurship) to firms.
• In the factor markets, households are the sellers
and firms are the buyers.
• Wages, rents, interest and profit are the payments
for labor, land, capital and entrepreneurship.
The Circular Flow Diagram
Circular flow model example
• Suppose a teacher’s supply of labor generates
personal income in the form of wages (the
factor market), which she can use to buy
automobiles, vacations, food, and other goods
(the product market).
• Suppose she buys an automobile (product
market); the automobile dealer now has
revenue to pay for his inputs (factor market)—
wages to workers, purchase of new cars to
replenish his inventory, rent for his building,
and so on.
• Income flows from firms to households (factor
markets), and spending flows from
households to firms (product markets).
• This simple circular flow model shows how
households and firms interact in product
markets and factor markets and how the two
markets are interrelated.
2.3 The Production Possibilities Curve
• The economic concepts of scarcity, choice and
trade-offs can be illustrated by the use of a
production possibilities curve, which
represents the potential total output
combinations of any two goods for an
economy.
• That is, it illustrates an economy's potential for
allocating its limited resources for producing
various combinations of goods, in a given time
period.
• The production possibilities curve discussion
begins with a straight-line production
possibilities curve, with the goods being one's
grade in economics and one's grade in history.
Production Possibilities Curve: “Producing” Grades
in Economics and History
• On a production possibilities curve, we assume
that the economy has a given quantity and
quality of resources and technology available
to use for production.
• Using an example involving food and shelter
we can see a concave (bowed) production
possibilities curve.
• Each point represents the potential amounts of
food and shelter that can be produced in a
given time period, given the quantity and
quality of resources available.
Production Possibilities Curve: The Trade-Off
Between Food and Shelter
• The economy cannot produce beyond the
levels indicated by the production possibilities
curve during a given time period, because
there are not enough resources to produce that
output.
• However, it is possible to operate inside the
production possibilities curve.
• If an economy is operating inside its production
possibilities curve, it is not at full capacity, and
is operating inefficiently.
• The economy is not getting the most it can
from its scarce resources.
• As a result, actual output is less than potential
output.
• Most modern economies have resources that
are idle, at least some of the time.
• Unemployed resources create a serious
problem.
• For example, an unemployed coal miner who
is unable to find work at a “reasonable” wage,
or those unemployed in depressed times when
factories are already operating below capacity.
Clearly, the resources of these individuals are
not being used efficiently.
• It is not just labor resources that should be
most effectively used.
• All resources entering into production should
be used effectively.
• However, social concern focuses on labor, for
several reasons.
• Labor costs are the largest share of
production costs.
• Unemployed or underemployed laborers
may have mouths to feed at home, while
an unemployed machine does not.
• Efficiency requires society to use its resources
to the fullest extent—getting the most we can
out of our scarce resources; that is, there are
no wasted resources.
• If resources are being used efficiently, at a

point along a production possibilities curve,
more of one good or service requires the
sacrifice of another good or service as its cost.
• Efficiency does not tell us which point along
the production possibilities curve is best.
• But it does tell us that points inside the curve
cannot be best because some resources are
wasted.
• The production possibilities curve is not a
straight line.
• It is concave from below (that is, bowed
outward from the origin), reflecting increasing
opportunity costs of producing additional
amounts of a good.
Opportunity Costs for Cattle and Wheat
• The basic reason for increasing opportunity
cost is that some resources and skills cannot
be easily adapted from their current uses to
alternative uses.
• Easily adaptable resources are soon
exhausted and resources and workers that are
less well suited or appropriate (those with a
relatively greater opportunity cost) must then
be employed to increase output further.
Increasing Opportunity Cost and the
Production Possibilities Curve
2.3 Economic Growth and the Production
Possibilities Curve
• An economy can only grow with qualitative or
quantitative changes in the factors of
production–land, labor, capital and
entrepreneurship.
• Advancements in technology, improvements in
labor productivity
or new natural resource finds could all lead to
outward shifts of the production possibilities
curve.
• Economic growth means an outward shift in
the possible combinations of goods and
services produced illustrated by the production
possibilities curve.
• With growth comes the possibility to have more
of both goods than were previously available.
Economic Growth and Production Possibilities
• It is important to remember that increases in a
society's output do not make scarcity
disappear.
• Even when output has grown more rapidly
than population, so people are made better off,
they still face trade-offs.
• At any point along the production possibilities
curve, in order to get more of one thing, you
must give up something else.
Economic Growth and Production Possibilities Curve
• To generate economic growth, a society must
produce fewer consumer goods and more
capital goods in the present.
• They must sacrifice some consumption of
consumer goods in the present in order to
experience growth in the future.
• Investing in capital goods will increase the
future production capacity of the economy.
• So an economy that invests more and
consumes less now will be able to produce
and consume more in the future.
The Effects of a Technological Change on the
• Technological advance does not have to
impact all sectors of the economy equally.
• There is a technological advance in food
production but not in housing production.
• The technological advance in agriculture
causes the production possibilities curve to
extend out further on the horizontal axis
which measures food production.
• How do we produce more housing, when the
technological advance occurred in agriculture?
• Technological advance in agriculture allows us
to shift some of our resources out of agriculture
into housing.
• The production possibilities curve can be used
to illustrate the economic concepts of scarcity,
choice, opportunity costs, efficiency, and
economic growth.
• Scarcity is represented by the fact that
resource combinations outside the production
possibility curve are unattainable.
Guns and Butter
DEMAND AND
SUPPLY
 ©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
4.1 Markets
• A market is the process of buyers and sellers

exchanging goods services.
• Supermarkets, the New York Stock Exchange,
drug stores, roadside stands, garage sales,
Internet stores, and restaurants are all markets.
• Every market is different. Some markets are
local (such as housing or the market for
cement), but numerous others are global (such
as automobiles or gold).
• The important point about a market is not what
it looks like, but what it does–it facilitates
trade.
• Buyers, as a group, determine the demand
side of the market, whether it is consumers
purchasing goods or firms purchasing inputs.
• Sellers, as a group, determine the supply side
of the market, whether it is firms selling their
goods or resource owners selling their inputs.
• It is the interaction of buyers and sellers that
determines market prices and output through
the forces of supply and demand.
• In this chapter, we focus on how supply and
demand work in a competitive market.
• A competitive market is one in which a
number of buyers and sellers are offering
similar products and no single buyer or seller
can influence the market price.
• Because most markets contain a large degree
of competitiveness, the lessons of supply and
demand can be applied to many different types
of problems.
4.2 Demand
• According to the law of demand, the quantity

of a good or service demanded varies
inversely with its price, ceteris paribus.
• More directly, other things equal, when the
price of a good or service falls, the quantity
demanded increases.
• An individual demand schedule reveals the
different amounts of a particular good a
person would be willing and able to buy at
various possible prices in a particular time
interval, other things equal.
Elizabeth’s Demand Schedule for Coffee
• An individual demand curve is a graphical
representation that shows the inverse
relationship between price and quantity
demanded.
• It reveals the relationship between the price
and the quantity demanded, showing that
when the price is higher, the quantity
demanded is lower.
Elizabeth’s Demand Curve for Coffee
• Economists usually speak of the demand
curve in terms of large groups of people.
• The horizontal summing of the demand curves
of many individuals is called the market
demand curve for a product.
• The market demand curve shows the amounts
that all the buyers in the market would be
willing and able to buy at various prices.
Creating a Market Demand Curve
A Market Demand Curve
4.3 Shifts in the Demand
• A change in a good's price leads to a change

in quantity demanded, illustrated by moving
along a given demand curve.
• But price is not the only thing that affects the
quantity of a good people buy. The other
factors that influence the demand curve are
called determinants of demand, and they shift
the entire demand curve—a change in
demand.
Some possible demand shifters
• prices of related goods

• incomes of demanders
• number of demanders
• tastes of demanders
• expectations of demanders
• An increase in demand is represented by a
rightward shift in the demand curve.
• A decrease in demand is represented by a
leftward shift in the demand curve.
Demand Shifts
Substitutes
• A major variable that shifts the demand curve is
the prices of related goods.
• Two goods are called substitutes
if an increase in the price of one causes a
increase in the demand for the other good.
• The opposite also applies: Two goods are
called substitutes if a decrease in the price of
one causes an decrease in the demand for the
other good.
• For most people, good substitutes might
include: movie tickets and video rentals;
jackets and sweaters; 7-Up and Sprite; and
Nikes and Reeboks.
Substitute Goods
Complements
• Two goods are complements if an increase

in the price of one good causes a decrease in
the demand for the other good.
• The opposite is also true: Two goods are
complements if a decrease in the price of one
good causes an increase in the demand for
the other good.
• Complements are goods that “go together.”
• They are often consumed or used
simultaneously.
• For example: skis and bindings; hot dogs and
bun; motorcycles and motorcycle helmets;
DVDs and DVD players.
Complementary Goods
Income
• Generally the consumption of goods and

services is positively related to the income
available to consumers.
• As individuals receive more income, they tend
to increase their purchases of most goods and
services.
Income-Normal Good
• Other things equal, an increase in income
usually leads to an increase in demand for
goods (rightward shift).
• A decrease in income usually leads to a
decrease in the demand for goods (leftward
shift).
• Such goods are called normal goods.
• For example: CDs and movie tickets.
Income-Inferior Good
• Some goods exist for which rising (or falling)
income leads to reduced (or increased)
demand.
• These are called inferior goods. The term
inferior does not refer to the quality of the
good, but it merely shows that when income
changes demand changes in the opposite
direction (inversely).
• For example: thrift shop clothes, store-brand
products, and bus rides.
Normal and Inferior Goods
Number of Buyers
• The demand for a good or service will vary

with the size of the potential consumer
population—the number of buyers.
• An increase in the potential consumer
population will increase (shift right) the
demand for a good or service.
Consumer’s Preferences and Information
• Changes in fashions, fads, advertising, etc.

can change tastes or preferences.
• An increase in tastes or preferences for a
good or service will increase (shift right) the
demand for a good or service.
• While changes in preferences lead
to shifts in demand, much of the predictive
power of economic theory stems from the
assumption that tastes are relatively stable
over a substantial period of time.
Expectations
• An increase in the expected future price of a

good will increase (shift right) the current
demand for it.
• A decrease in the expected future price of a
good will decrease (shift left) the current
demand for it.
• Or if you expect to earn additional income in
the near future you may be more willing to dip
into your current savings to buy something
now.
Changes in Demand vs. Changes
in Quantity Demanded Revisited:
• If the price of a good changes, we say this

leads to a change in quantity demanded.
• If one of the other factors (determinants of
demand) influencing consumer behavior
changes, we say there is a change in
demand.
Possible Demand Shifters
Change in Demand Versus Change in Quantity Demanded
4.4 Supply
• The law of supply states that, other things
equal, the quantity supplied will vary directly
with the price of the good.
• According to the law of supply,
• the higher the price of the good, the greater
the quantity supplied,
• and the lower the price of the good, the
smaller the quantity supplied.
• The quantity supplied is positively related to the
price, because firms supplying goods and
services want to increase their profits, and the
higher the price per unit, the greater the
profitability generated by supplying more of that
good or service.
• Also, if costs are rising for producers as they
produce more units, they must receive a higher
price to compensate producers for their higher
costs.
• An individual supply schedule reveals the
different amounts of a product that a producer
is willing and able to supply at various prices in
a particular time interval, other things equal.
• An individual supply curve illustrates that
information graphically.
An Individual Supply Curve
• The market supply curve for a product is the
horizontal summation of the supply curves for
individual firms.
• It shows the amount of goods and services
suppliers are willing and
able to supply at various prices.
A Market Supply Curve
4.5 Shifts in the Supply Curve
• Changes in the price of a good lead to
changes in quantity supplied, which are
shown as movements along a given supply
curve.
• Changes in supply occur for other reasons
than changes in the price of the product itself.
• A change in any other factor that can affect
supplier behavior results in a shift of the entire
supply curve.
These other factors include:
• input prices
• prices of substitutes in production
• expectations
• number of suppliers
• technology
• taxes and subsidies
• weather
• An increase in supply shifts the supply curve
to the right.
• A decrease in supply shifts the supply curve to
the left.
Supply Shifts
• Higher input prices increase the cost of
production causing the supply curve to shift to
the left at each
and every price.
• Lower input prices decrease the cost of
production causing the supply curve to shift to
the right at each
and every price.
• The supply of a good can be influenced by the
prices of related products.
• Firms producing a product can sometimes use
their resources to produce alternative
products.
• Suppose a farmer’s land can be used to grow
either barley or cotton.
• If the farmer is currently growing barley and the
price of barley falls then this provides an
incentive for the farmer to shift acreage out of
barley and into cotton.
• Thus, a decrease in the price of barley will
increase the supply of cotton.
Substitutes and Complements in Production
• If producers expect a higher price in the future,
they will supply less now.
• They would prefer to wait and sell when their
goods will be more valuable.
• If producers currently expect that the price will
be lower later they will supply more now.
• Otherwise, if they wait to sell, then their goods
will be worth less.
• The market supply curve is the horizontal
summation of the individual supply curves.
• So an increase in the number of suppliers will
increase market supply.
• A decrease in the number of suppliers will
decrease market supply.
• Technological progress can lower the cost of
production and increase supply.
• Supply may also change because of changes
in the legal and regulatory environment in
which firms operate (e.g., safety and pollution
regulations.). If such changes increase costs,
they will decrease supply. If they decrease
costs, they will increase supply.
• An increase in costly government regulations,
taxes or adverse production conditions will
increase the cost of production, decreasing
supply.
• Subsidies, the opposite of a tax can lower the
cost of production and shift the supply curve to
the right.
• In addition, weather can affect the supply of
certain commodities.
• If the price of a good changes, it leads to a
change in its quantity supplied, but not its
supply.
• If one of the other factors influences sellers'
behavior, it leads to a change in supply.
Possible Supply Shifts
Change in Supply vs Change in Quantity Supplied
Bringing Supply
and
Demand
Together
©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
5.1 Market Equilibrium
Price and Quantity
• The market equilibrium is found at the point

at which the market supply and market
demand curve intersect.
• The price at the intersection of the market
demand curve and the market supply curve is
called the equilibrium price.
• The quantity at the intersection of the market
demand curve is called the equilibrium
quantity.
Market Equilibrium
• At the equilibrium price, the quantity
demanded equals the quantity supplied—the
amount that buyers are willing and able to
buy is exactly equal to the amount that sellers
are willing and able to produce.
• If the market price is at any other price, their
will be a shortage or a surplus.
Markets in Temporary Disequilibrium
• At a price greater than the equilibrium price, a
surplus, or excess quantity supplied, would
exist.
• Sellers would be willing to sell more than
demanders would be willing to buy.
• Frustrated suppliers would cut their price and
cut back on production, and consumers
would buy more.
• This would eliminate the unsold surplus and
return the market to equilibrium.
• At a price less than the equilibrium price, a
shortage, or excess quantity demanded,
would exist.
• Buyers would be willing to buy more than
sellers would be willing to sell.
• Frustrated buyers would compete for the
existing supply, causing the price to rise, and
producers to increase the quantity supplied.
• This would decrease the quantity demanded,
eliminate the shortage, and return the market
to equilibrium.
Shortages
The Market for Super Bowl Tickets
5.2 Changes in Equilibrium
Price and Quantity
• The demand and/or supply curves will shift

when one of the many determinants of
demand or supply (input prices, prices of
related products, number of suppliers,
expectations, technology, and so on)
changes.
• These changes (shifts) in the demand and
supply curves will lead to changes in the
equilibrium price and equilibrium quantity.
• An increase in demand results in a greater
equilibrium price and a greater equilibrium
quantity.
• Conversely, a decrease in demand results in
a lower equilibrium price and a lower
equilibrium quantity.
An Increase in Demand
• A decrease in supply results in a higher
equilibrium price and a lower equilibrium
quantity.
• Conversely, an increase in supply results in a
lower equilibrium price and a higher
A Decrease in Supply
• Very often, supply and demand will both shift
in the same time period.
• That is, supply and demand will shift
simultaneously.
• When supply and demand move at the same
time, we can predict the change in one variable
(price or quantity), but we are unable to predict
the direction of effect on the other variable.
• This change in the second variable, then, is
said to be indeterminate, because it cannot be
determined without additional information about
the relative changes in supply and demand.
• If the decrease in demand is greater than the
increase in supply, the equilibrium quantity will
decrease.
• If the increase in supply is greater than the
decrease in demand, the equilibrium quantity
will increase.
The Market for Aspen Rentals
Shifts in Supply and Demand
• Notice that the seasonal increases in demand
led to a shortage at the original (out of season)
price.
• When a shortage exists the price will rise until
the new equilibrium is reached. In this case,
at the intersection of the in-season demand
curve and the supply curve.
• An increase in supply decreases the
equilibrium price and increases the equilibrium
quantity.
• A decrease in demand decreases both the
equilibrium price and quantity.
• Taken together, they will decrease the
equilibrium price, but result in an indeterminate
change in the equilibrium quantity.
• It is also possible that both supply and demand
will increase (or decrease).
• As a result of technological breakthroughs and
new factories manufacturing flat screen LCD
televisions, the supply curve for LCD televisions
shifted to the right.
• But with rising income and an increasing number
of buyers, the demand increased as well.
• Both the increased demand and the increased
supply functioned to increase the equilibrium
quantity.
• The equilibrium price could have gone either
up or down depending on the relative sizes of
the demand and supply shifts.
• In the case of LCD televisions, we know that
the supply curve shifted more than the
demand curve, as a result, the equilibrium
price of LCD televisions has dropped over
time.
An Increase in the Demand and Supply of HD Televisions
The Effect of Changing Demand and/or Supply
• The eight possible changes in demand
and/or supply are presented, along with the
resulting changes in equilibrium price and
The Combination of Supply and Demand Shifts
College Enrollment and the
Price of Going to College
• How is it possible that the price of college

education has risen over the last 35 years, yet
many more students are attending college?
• Does this defy the law of demand?
• The answer is that demand and supply are
changing—demand is increasing and supply is
decreasing (costs are rising—maintenance,
new equipment, buildings and so on).
Market for College Education
5.3 Price Controls
• While non-equilibrium prices can occur
naturally in the private sector, reflecting
uncertainty, they seldom last for long.
• Governments, however, may impose non-
equilibrium prices for significant time periods.
• Price controls involve the use of the power of
the state to establish prices different from the
equilibrium prices that would otherwise prevail.
• The motivations for price controls vary with the
market under consideration.
• A price ceiling, or a legal maximum price, is
often set for goods deemed important to low
income households, like housing.
• A price floor, or a legal minimum price, may
be set on wages because wages are the
primary source of income for most people.
Price Ceilings: Rent Controls
• Under rent control the price (or rent) of an

apartment remains fixed over the tenure of an
occupant, except for allowable annual
increases tied to the cost of living or some
other price index.
• When an occupant moves out, the owner can
usually, but not always, raise the rent to a
near-market level for the next occupant.
Rent Controls
Results of Rent Controls
• Because living in rent controlled apartments is

a good deal, one which would be lost by
moving, tenants are very reluctant to move and
give up their governmentally granted right to a
below-market rent apartment.
• Because the rents received by landlords are
constrained at below market levels, the rate of
return on housing investments falls compared
to that on other forms of real estate not subject
to rent controls, reducing the incentives to
construct new rental housing.
• Where rent controls are truly effective, there is
generally little new construction going on and a
shortage of apartments that persists and grows
over time.
• Since landlords are limited in what rent they
can charge, there is little incentive to
improve or upgrade rental apartments in
order to get more rent.
• In fact, there is some incentive to avoid
routine maintenance, thereby lowering the
cost of apartment ownership to a figure
approximating the controlled rental price.
• Rent controls promote housing
discrimination.
• With rent controls, there are likely to be
many families wanting to rent a controlled
apartment, some desirable and some
undesirable, as seen by the landlord,
because the rent is at a below-equilibrium
price.
• The landlord can indulge in his “taste” for
discrimination in favor of “desirable” renters
without any additional financial loss beyond
that required by the controls.
Price Floors: The Minimum Wage
• Since 1938, the federal government has, by

legislation, made it illegal to pay most
workers an amount below a legislated
minimum wage (price for labor services).
Results of the Minimum Wage
• Because it would produce willing workers

who will be unable to find jobs, an increase in
the minimum wage would create additional
unemployment for low skill workers.
• The unemployment impact of the minimum
wage falls mainly on the least experienced,
least skilled persons, often teenagers,
holding the lowest paying jobs.
Unemployment Effects of a Minimum Wage
on Low-Skilled Workers
• They lose their jobs or are unable to get
them in the first place, and suffer a decline in
earnings, not a gain.
• Those who continue to hold jobs with the
same hours and working conditions after the
minimum wage is increased gain
substantially, and therefore are supporters of
efforts to increase the minimum.
• The analysis does not “prove” minimum
wages are “bad.”
• There is an empirical question of how much
unemployment is caused by minimum wages.
• Some might believe that the cost of
unemployment resulting from
a minimum wage is a reasonable price to pay
for assuring that those with jobs get a decent
wage.
• But they do impose a cost.
• It falls not only on low skilled workers and
employers, but also on consumers of products
that were made more costly by the minimum
wage.
• Most U.S. workers are not affected by the
minimum wage because in the market for
their skills. They earn wages that exceed the
minimum wage.
• In this case, the minimum wage is not
binding. This is shown in the next slide.
Unemployment Effects of a Minimum Wage
on Skilled Workers
Price Ceilings: Price Controls on Gasoline
• In 1973, the Organization of Petroleum

Exporting Nations (OPEC) reduced the
supply of oil.
• Because crude oil is a major input for
gasoline, this reduction in the supply of oil
caused a shift in the supply curve for
gasoline leftward.
• In an effort to prevent sharply rising prices,
the government imposed price controls on
gasoline in 1974.
• People now wanted to buy more gasoline
than was available at the controlled price.
Thus a shortage was developed.
Gasoline Price Ceiling
Unintended Consequences
• When markets are altered for policy reasons, it

is wise to remember that the actual results of
actions are not always as intended, as seen in
the cases of rent control and the minimum
wage.
• We must always look for unintended
consequences, the secondary effects of an
action that may occur along with the intended
effects.
• The unintended effects may sometimes
completely undermine
the intended effects.
The Costs of Production
• The Market Forces of Supply and Demand
– Supply and demand are the two words that
economists use most often.
– Supply and demand are the forces that make
market economies work.
– Modern microeconomics is about supply,
demand, and market equilibrium.
© 2007 Thomson South-Western

WHAT ARE COSTS?
• According to the Law of Supply:

– Firms are willing to produce and sell a greater
quantity of a good when the price of the good is
high.
– This results in a supply curve that slopes upward.

WHAT ARE COSTS?
• The Firm’s Objective

– The economic goal of
the firm is to
maximize profits.

Total Revenue, Total Cost, and Profit
• Total Revenue
• The amount a firm receives for the sale of its
output.
• Total Cost
• The market value of the inputs a firm uses in
production.

Total Revenue, Total Cost, and Profit
• Profit is the firm’s total revenue minus its total

cost.
• Profit = Total revenue - Total cost

Costs as Opportunity Costs
• A firm’s cost of production includes all the

opportunity costs of making its output of goods
and services.
• Explicit and Implicit Costs
• A firm’s cost of production include explicit costs
and implicit costs.
• Explicit costs are input costs that require a direct outlay
of money by the firm.
• Implicit costs are input costs that do not require an outlay
of money by the firm.

Economic Profit versus Accounting Profit
• Economists measure a firm’s economic profit as

total revenue minus total cost, including both
explicit and implicit costs.
• Accountants measure the accounting profit as
the firm’s total revenue minus only the firm’s
explicit costs.

Economic Profit versus Accounting Profit
• When total revenue exceeds both explicit and

implicit costs, the firm earns economic profit.
• Economic profit is smaller than accounting
profit.

Figure 1 Economists versus Accountants
How an Economist How an Accountant
Views a Firm Views a Firm
Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

PRODUCTION AND COSTS
• The Production Function

– The production function shows the relationship
between quantity of inputs used to make a good
and the quantity of output of that good.

The Production Function
• Marginal Product
• The marginal product of any input in the production
process is the increase in output that arises from an
additional unit of that input.

Table 1 A Production Function and Total Cost: Hungry
Helen’s Cookie Factory

• Diminishing marginal product is the property

whereby the marginal product of an input
declines as the quantity of the input increases.
• Example: As more and more workers are hired at a
firm, each additional worker contributes less and
less to production because the firm has a limited
amount of equipment.

Figure 2 Hungry Helen’s Production Function
Quantity of output
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
0 1 2 3 4 5 6 7
Number of Workers Hired
• Diminishing Marginal Product

• The slope of the production function measures the
marginal product of an input, such as a worker.
• When the marginal product declines, the production
function becomes flatter.

From the Production Function to the
Total-Cost Curve
• The relationship between the quantity a firm
can produce and its costs determines pricing
decisions.
• The total-cost curve shows this relationship
graphically.

Table 1 A Production Function and Total Cost: Hungry
Helen’s Cookie Factory

Figure 2 Hungry Helen’s Total-Cost Curve
Total
Cost
100
90
80
70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Quantity
of Output
(cookies per hour)
THE VARIOUS MEASURES OF
COST
• Costs of production may be divided into fixed
costs and variable costs.
– Fixed costs are those costs that do not vary with
the quantity of output produced.
– Variable costs are those costs that do vary with
the quantity of output produced.

Fixed and Variable Costs
• Total Costs
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
• TC = TFC + TVC

Table 2 The Various Measures of Cost: Thirsty Thelma’s
Lemonade Stand

• Average Costs
• Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces.
• The average cost is the cost of each typical unit of
product.

• Average Costs
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
• ATC = AFC + AVC

Average and Marginal Costs
Fixed cost FC
AFC  
Quantity Q
Variable cost VC
AVC  
Quantity Q
Total cost TC
ATC  
Quantity Q

Average and Marginal Costs
• Marginal Cost
• Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
• Marginal cost helps answer the following question:
• How much does it cost to produce an additional unit of
output?

Average and Marginal Cost
(change in total cost) TC

MC  
(change in quantity) Q

Thirsty Thelma’s Lemonade Stand
Note how Marginal Cost changes with each change in Quantity.
Quantity Total Marginal Quantity Total Marginal

Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10

Figure 3 Thirsty Thelma’s Total-Cost Curves
Total Cost
$15.00 Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Figure 4 Thirsty Thelma’s Average-Cost and Marginal-Cost
Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC
1.25 AVC
1.00
0.75
0.50
AFC
0.25
0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Cost Curves and Their Shapes
• Marginal cost rises with the amount of output

produced.
• This reflects the property of diminishing marginal
product.

• The average total-cost curve is U-shaped.

• At very low levels of output average total cost
is high because fixed cost is spread over only a
few units.
• Average total cost declines as output increases.
• Average total cost starts rising because average
variable cost rises substantially.

• The bottom of the U-shaped ATC curve occurs

at the quantity that minimizes average total
cost. This quantity is sometimes called the
efficient scale of the firm.

• Relationship between Marginal Cost and

Average Total Cost
• Whenever marginal cost is less than average total
cost, average total cost is falling.
• Whenever marginal cost is greater than average
total cost, average total cost is rising.

• Relationship between Marginal Cost and

Average Total Cost
• The marginal-cost curve crosses the average-total-
cost curve at the efficient scale.
• Efficient scale is the quantity that minimizes average total
cost.

Typical Cost Curves
• It is now time to examine the relationships that

exist between the different measures of cost.

Figure 5 Cost Curves for a Typical Firm
Note how
Marginal MCdeclines
Cost hits both
atATC
first and
and AVC
thenat their
Costs minimum
increases points.
due to diminishing marginal product.
$3.00 AFC, a short-run concept, declines throughout.
2.50
MC
2.00
1.50
ATC
AVC
1.00
0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output
Typical Cost Curves
• Three Important Properties of Cost Curves

• Marginal cost eventually rises with the quantity of
output.
• The average-total-cost curve is U-shaped.
• The marginal-cost curve crosses the average-total-
cost curve at the minimum of average total cost.

COSTS IN THE SHORT RUN AND
IN THE LONG RUN
• For many firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.
– In the short run, some costs are fixed.
– In the long run, all fixed costs become variable costs.
• Because many costs are fixed in the short run
but variable in the long run, a firm’s long-run
cost curves differ from its short-run cost
curves. © 2007 Thomson South-Western
Economies and Diseconomies of Scale
• Economies of scale refer to the property

whereby long-run average total cost falls as the
quantity of output increases.
• Diseconomies of scale refer to the property
whereby long-run average total cost rises as the
quantity of output increases.
• Constant returns to scale refers to the property
whereby long-run average total cost stays the
same as the quantity of output increases.

Figure 6 Average Total Cost in the Short and Long Run
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run
$12,000
10,000
Economies Constant
of returns to
scale scale Diseconomies
of
scale
0 1,000 1,200 Quantity of

Cars per Day
Summary
• The goal of firms is to maximize profit, which

equals total revenue minus total cost.
• When analyzing a firm’s behavior, it is
important to include all the opportunity costs
of production.
• Some opportunity costs are explicit while other
opportunity costs are implicit.

Summary
• A firm’s costs reflect its production process.

– A typical firm’s production function gets flatter as
the quantity of input increases, displaying the
property of diminishing marginal product.
– A firm’s total costs are divided between fixed and
variable costs. Fixed costs do not change when the
firm alters the quantity of output produced;
variable costs do change as the firm alters quantity
of output produced.

Summary
• Average total cost is total cost divided by the

quantity of output.
• Marginal cost is the amount by which total
cost would rise if output were increased by one
unit.
• The marginal cost always rises with the
quantity of output.
• Average cost first falls as output increases and
then rises.

Summary
• The average-total-cost curve is U-shaped.

• The marginal-cost curve always crosses the
average-total-cost curve at the minimum of
ATC.
• A firm’s costs often depend on the time
horizon being considered.
• In particular, many costs are fixed in the short
run but variable in the long run.

Thanks for
Summary
attention

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•PMME

The Role and

• Economics is primarily concerned with scarcity–

• If we had unlimited resources, and thus an

• The cost of a choice is the values that must be

• The highest or best foregone opportunity

• “To choose is to lose.”

• “An opportunity cost is an opportunity lost.”

• To get more of anything that is desirable, you

• The opportunity cost of going to college must

• Most choices involve how much of something to

• People are specializing when they

• If Tom traded his tea to Katherine for coffee,

• Because of scarcity, certain economic

• Command economies rely on central

• If resources are being used efficiently, at a

• A market is the process of buyers and sellers

• According to the law of demand, the quantity

• A change in a good's price leads to a change

• prices of related goods

• Two goods are complements if an increase

• Generally the consumption of goods and

• The demand for a good or service will vary

• Changes in fashions, fads, advertising, etc.

• An increase in the expected future price of a

• If the price of a good changes, we say this

• The market equilibrium is found at the point

• The demand and/or supply curves will shift

• How is it possible that the price of college

• Under rent control the price (or rent) of an

• Because living in rent controlled apartments is

• Since 1938, the federal government has, by

• Because it would produce willing workers

• In 1973, the Organization of Petroleum

• When markets are altered for policy reasons, it

© 2007 Thomson South-Western

• According to the Law of Supply:

© 2007 Thomson South-Western

• The Firm’s Objective

© 2007 Thomson South-Western

© 2007 Thomson South-Western

• Profit is the firm’s total revenue minus its total

• Profit = Total revenue - Total cost

© 2007 Thomson South-Western

• A firm’s cost of production includes all the

© 2007 Thomson South-Western

• Economists measure a firm’s economic profit as

© 2007 Thomson South-Western

• When total revenue exceeds both explicit and

© 2007 Thomson South-Western

© 2007 Thomson South-Western

• The Production Function

© 2007 Thomson South-Western

© 2007 Thomson South-Western

© 2007 Thomson South-Western

• Diminishing marginal product is the property

© 2007 Thomson South-Western

• Diminishing Marginal Product