Introduction to Economics
Definition of social science and Economics
？ Social Science: The study of society and the way individuals interact within it.
？ Economics: the study of how society employs its finite resources in the attempt to satisfy
Definition of Microeconomics and Macroeconomics
？ Microeconomics: The study of individual economic units such as households and firms.
？ Macroeconomics: The study of the economy as a whole. (e.g. Inflation)
Definition of growth, development, and sustainable development
？ Economic Growth: An increase in real GDP or an increase in the quantity of resources.
？ Economic Development: A qualitative measure of a country's standard of living which takes
into account numerous factors such as education and health. The Human Development
Index is normally used to measure a country's economic development.
？ Sustainable development: The rate at which a country can develop without compromising
the needs of future generations.
'Positive and Normative Concepts
？ Normative Economics: Based on opinion. Uses words such as "should". The government
should make fixing unemployment its number one priority.
？ Positive Economics: Based on testable theories. For example, a hike in interest rates leads to
a fall in aggregate demand can be proven using data.
Know the concept of Ceteris Paribus.
？ Latin for all things being equal. Since Economics is basically the study of society, we have to
understand that there are thousands of variables present, and to control each one of these
variables is downright impossible. Thus we make everything else "ceteris paribus" in order to
see the effect of one aspect.
Know the concept of Scarcity
？ Scarcity is the observation that no resource is infinite.
？ Factors of Production
？ Factors of production are basic components or inputs which are required in the production of
goods and services.
？ Land: Gifts of nature, this includes everything on the land, under the land, above the land, or
in the sea. Oil is an example.
？ Labour: The human component hired to assist in producing a good or service. ？ Capital: Any man-made aid to production.
？ Entrepreneurship: Combines the other factors and takes risks recognizing the possibility of
gain from employing these factors in a specific way.
？ Factors of Payment (FoP):
？ Land: Rent
？ Labour: Wages
？ Capital: Interest
？ Entrepreneurship: Profit
The concept of Choice
？ Know the concept of Utility
？ Utility: The satisfaction gained from the consumption of a good or service. The demand curve
slopes downward because of the law of diminishing marginal utility. The marginal utility, or
extra happiness, we gain from buying an extra ice cream decreases with every ice cream we
buy at a fixed price.
？ Know the concept of opportunity cost
？ Opportunity cost: The cost of the next best alternative forgone. If I have $5.00 and can either
buy a tamogotchi or dinner, and I buy the tamogotchi, then the opportunity cost is the dinner I
could have bought.
？ Define Free and Economic Goods
？ Free good: A good with no scarcity, that has unlimited supply and therefore no price. A good
which has no opportunity cost associated with its consumption.
？ Economic Good: A good which is scarce and therefore has a possible opportunity cost.
Production Possibility Curves
Draw Diagrams showing opportunity cost, actual and potential output
Draw diagrams showing Economic growth and actual output
What are the basic economic questions?
？ What to produce?
？ How to produce it?
？ For whom to produce?
？ Free Market: A market where the forces of supply and demand decide the economic questions
and therefore where to allocate resources.
？ Command Economy: A market where the government or some central authority decides
where to allocate resources.
？ Mixed Economies: An economy consisting of both. Some decisions are made by market
forces while some other decisions are made by the government or some central authority. Advantages and Disadvantages of the Free Market
？ Resources allocated more efficiently by the price mechanism.
？ The profit motive is a great incentive, and forces producers to reduce costs and be innovative.
？ With no imperfections, the free market maximizes community surplus.
？ Market Failure- see Chapter II.
？ Monopolies and corruption - The natural goal of all firms is to attain monopoly, as this
eliminates competition, eliminating the associated costs and thus maximizing profit. If the
market structure does not include limiting social forces, financial forces will cause firms to
externalize costs such as pollution to gain monopoly. Union Carbide's gas leak in Bhopal is an
example of such an externalized cost.
Advantages and Disadvantages of a Planned Economy
？ The government can influence the distribution of income.
？ The government can determine which goods are supplied.
？ In order to function well, requires an enormous amount of information which is difficult to
？ No real incentive for individuals to be innovative. Goods are of poor quality since there is a
lack of profit motive.
？ May NOT lead to allocative efficiency or productive efficiency due to lack of competition and
？ Corruption - the government has the ability to abuse its absolute power.
？ The economy does not respond as well to supply and demand, firms are simply told to
produce a certain number of goods or services
Other important things to remember
Sectors of an economy:
？ Primary sector: Natural resources and raw materials.
？ Secondary sector: Manufactured goods.
？ Tertiary sector: The service sector, things like leisure, health, and sport.
？ Market: Convenient set of arrangements where buyers and sellers agree to exchange goods.
？ Definition of markets with relevant, local, national, and international examples
？ A place or situation where buyers and sellers communicate with exchange in mind.
Brief description of perfect competition, monopoly, and oligopoly as different types of market
structures and monopolistic competition using the characteristic
？ Perfect Competition: an industry structure in which there are many firms, none large enough
to influence the industry, producing homogeneous products. These firms are price takers.
There are no barriers to entry or barriers to exit.
？ Monopolistic Competition: an industry structure in which there are many firms, producing
slightly differentiated products. There are close substitutes for the product of any given firm.
Competitors have slight control over price. There are no barriers to entry or exit and success
invites new competitors.
？ Monopoly: an industry structure where a single firm produces a product for which there are
no close substitutes. Monopolists can set price, but are constrained by market discipline.
Barriers to entry and exit exist and in order to ensure profits, a monopoly will attempt to
？ Oligopoly: an industry structure in which there are a few firms producing products that range
from slightly differentiated to highly differentiated. Each firm is large enough to influence
this industry. Barriers to entry and exit are difficult, but exist.
？ Importance of price as a signal and as an incentive in terms of resource allocation
？ Definition of Demand
？ Demand is quantity of a commodity that will be bought at a given period of time at a given
price. What consumers are willing and able to buy at a price effects the demand for that good. ？ Law of demand with diagrammatic analysis:
？ The law of demand states that as a price of good or service rises, the quantity demanded will
fall. Concurrently, if the price of a good or service falls, the quantity demanded will increase. ？ Determinants of Demand
？ Function of demand: Qn= f[Pn, Y, (P1....Pn-1), T]
？ Price of a good: A change in the price of a good causes a movement along the demand curve. ？ Price of related goods
？ If the price of a substitute rises, demand will increase.
？ If the price of a compliment falls, demand will increase.
？ Income: An increase in income will cause an increase in demand for normal goods and a
decrease in demand for inferior goods.
？ Other macro factors: Change in the size and composition of a population, advertising,
？ Fundamental distinction between a movement along the demand curve and a shift of the
？ A movement along the demand curve is caused by a change in price. However, a shift of the
demand curve means that more is demanded at each price- this is caused by a change in any
of the determinants of demand (with the exception of price).
？ The demand curve is downsloping for several reasons, including the law of diminishing
marginal utility. The extra utility gained from the consumption of a good falls. Therefore, the
price must be lower for a person to purchase extra units of a given good. The income effect
states that as prices fall, real income increases. Consumers can therefore afford to consume a
greater quantity, providing a second reasons for the downsloping curve. A third reason is the
"substitution effect," whereby the falling price of a good makes that good cheaper in relation
to other goods (substitutes).
？ (HL) Exceptions to the law of Demand
？ Veblen goods: Veblen goods are named after the economist Thornstein Veblen and tie in with
his theory of conspicuous consumption. If price for a status good rises, then demand for that
good also rises.
？ Giffen goods: Giffen goods are goods which are absolutely vital for a person. This is usually
refers to staple crops such as rice in some parts of China and potatoes during the Irish potato
famine. As price for the good increases, individuals will be able to buy little of anything else
and instead spend their income purchasing staple crops.
？ Speculative goods: As share prices increases, so does the quantity demanded of shares, as
individuals predict further price increases.
？ Definition of Supply
？ Supply is the willingness and ability for producers to produce a good at a given price over a
given period of time.
？ Law of supply with diagrammatic analysis: A higher quantity of a good will be supplied at
a higher price. This is because producers can afford to supply extra units at a higher price
because it allows them to produce more before AC is greater than MC.
？ Determinants of Supply:
？ Function of supply: Qn= f(Pn,Pn1....P(n-1),F1...Fm,G,Tech) + Macro Factors ？ Price of substitute goods
？ Costs of the factors of production
？ Government Intervention: Taxes/Subsidies
？ New firms entering a market
？ Effect of taxes and subsidies: An indirect tax is a tax placed on each unit of a good.
Therefore the good become more expensive at every price by a certain value, and the supply
curve shifts upwards. A subsidy, or tax credit, has the opposite effect, namely it shifts the
supply curve downwards because the good is cheaper at every price.
？ Fundamental distinction between a movement along the supply curve and a shift of the
supply curve: As with a movement along the demand curve, a movement along the supply
curve is a change in quantity supplied resulting from a change in the good price. All other
determinants of supply will change the supply and so will shift the entire supply curve.
Supply and Demand
？ Interaction of Supply and Demand: When a good is placed on a market, it suddenly doesn't
begin to sell at its equilibrium price. What follows is a game of trial and error. Say a new pair
of jeans comes out on the market at $20.00 and it instantly becomes a success selling out
everywhere. Producers decide to produce more and charge it at $30.00. Now they're not
selling enough and have a surplus of stock. They reduce the price to $25 and they sell as much
as they make.
？ Diagrammatic analysis of changes in demand and supply to show adjustment of a new
？ Maximum Price: a maximum price that sellers may charge for a good or service. This is
usually set by the government. For example, concert tickets may have maximum prices. To be
effective, the maximum price (or price ceiling) must be set below the market clearing price. ？ Minimum Price a minimum price (or price floor) that sellers may charge for a good or
service. This again is usually set by the government. To be effective, it must be set above the
market clearing price.
？ Buffer stock scheme: A scheme in which the government tries to relegate the price level of a
good or service by buying the good up when demand is too low or selling off any surplus
when supply is too low. In the free market, commodities tend to fluctuate in price. ？ Buffer stock schemes tend to be very expensive. There are storage costs, the goods in question
might be perishable, and there is an opportunity cost made by the government in
？ Commodity agreements: Agreements between countries to attempt to stabilise commodity
prices. This may be done by a buffer stock scheme or placing a tariff on foreign goods. OPEC
is a good example of such an agreement.
Why do governments intervene in Agricultural markets
？ There has been a downward trend in agricultural markets: Thanks to more efficient
technology, there has been an increase in supply. The result has been lower prices as demand
has increased a bit. Moreover, the income elasticity of demand for food is inelastic. Someone
does not buy more apples because he has more money.
？ Agricultural prices are subject to fluctuations because of harvests, time lags in supply, and the
price elasticity of demand is very low. There are thousands of substitutes which are available.
If the price of beef goes up, individuals will switch to chicken instead. ？ Governments may wish to subsidize to prevent cheap imports from abroad in an effort to
protect domestic jobs.
？ Governments may wish to intervene by using buffer stocks, subsidies, or high fixed prices.
Price Elasticity of Demand
？ %Change in Quanity Demanded of Good A / %change in Price of Good A ？ Definition
？ The responsiveness of the quantity demanded of a good to a change in its price. ？ Possible range of values
？ PED > 1: Demand is elastic
？ PED < 1: Demand in inelastic
？ PED = 1: Demand is unit elastic
？ PED = 0: Demand is perfectly inelastic
？ PED = : Demand is perfectly elastic
？ Diagrams illustrating the range of values of elasticity
？ Varying elasticity along a straight-line Demand curve
？ Determinants of Price Elasticity
？ Closeness of substitutes
？ Luxury or necessity
？ Percentage of income spent on the good
？ Time Period
Cross Elasticity of Demand
？ The responsiveness of the quantity demanded of one good to a change in price of another.
？ %Change in QD of Good A / %Change in the Price of Good B
？ Significance of signs with respect to compliments and substitutes
？ A positive value signifies that the two goods are substitutes.
？ If the goods are complements, the value will be negative.
Income Elasticity of Demand
？ The responsiveness of the quantity demanded of a good to a change in income.
？ %Change in QD / %Change Y
？ Normal goods: When income increases, demand for normal goods increases as well. Positive
？ Inferior goods: When income increases, demand for this good falls. Negative YED.
Price Elasticity of Supply
？ The sensitivity of supply to a change in price.
%Change QS / %Change in Price.
？ Possible range of values:
PES > 1: Supply is elastic
PES < 1: Supply is inelastic.
？ Diagrams illustrating the range of values of elasticity:
？ Determinants of price elasticity of supply
？ Number of producers.
？ Spare capacity
？ Ease of storage
？ length of production period
？ time period of training
？ Factor mobility
？ How costs react
Applications of concepts of elasticity
？ PED and business decisions: the effect of price changes on total revenue.
？ PED may be important for businesses attempting to distinguish how to maximize revenue. For
example, if a business finds out its PED is very inelastic, it may want to raise its prices. If a
business finds that its PED is very elastic, it may wish to lower its prices. ？ PED may be important for a government to find the impact of a tax or subsidy. ？ PED and taxation
？ Governments may wish to know how a tax or subsidy will affect a good. ？ Cross-elasticity of demand:
？ Competitors may wish to know what will happen if there is a change in compliments, or
？ Significance of income elasticity for sectoral change (primary> secondary > tertiary) as
economic growth occurs.
？ Primary sector is generally income elasticity of demand inelastic. Just because a person's
income changes does not mean he will buy more tomatoes. However, secondary and tertiary
sectors tend to be income elasticity of demand elastic. A change in income will have a big
impact on quantity demanded of cars, or the demand for personal massages.
？ Flat rate and ad valorem taxes
？ A flat rate tax is a tax which is the same rate regardless of price or income. ？ Ad valorem taxes is a tax which is a percentage of the price of a good. The United States has
an ad valorem tax of ten percent.
？ Incidence of indirect taxes and subsidies on the producer and consumer