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Econ notes for midterm
Chapter 1
Three Key Economic Ideas
People are rational: They use available information to achieve their goals.
Rational consumers and firms weigh costs and benefits to make the best decisions.
Example: Apple chooses iPhone prices to maximize profit.
People respond to economic incentives: Actions change as incentives change.
Examples: Cash for Clunkers program, COVID-19 stimulus checks.
Incentives can have unintended consequences: Changes to the Federal Student Loan Program may incentivize colleges to increase tuition.
Students might borrow more, knowing they may not have to repay it all.
Optimal decisions are made at the margin: Most decisions involve doing a little more or less of something.
Marginal cost (MC) and marginal benefit (MB): The additional cost or benefit of a small amount extra of some action.
Marginal analysis: Comparing marginal benefits and marginal costs.
The Economic Problem That Every Society Must Solve
Every society must answer three questions:
What goods and services will be produced?
How will the goods and services be produced?
Who will receive the goods and services produced?
Scarcity leads to trade-offs: Producing more of one good or service means producing less of another.
Trade-off: The idea that, because of scarcity, producing more of one good or service means producing less of another good or service.
Opportunity cost: The highest-valued alternative that must be given up to engage in an activity.
Example: Increased space exploration funding might mean less funding for cancer research.
Firms choose different production methods:
Example 1: Music production: Hire a great singer vs. using Auto-Tune.
Example 2: Manufacturing: Use more machines or move to a location with cheaper labor.
Distribution of goods and services:
In the U.S., people with higher incomes obtain more goods and services.
Tax and welfare policies affect income distribution, leading to debates about the desirability of redistribution.
Centrally planned economy: The government decides how economic resources will be allocated.
Market economy: Decisions of households and firms determine the allocation of economic resources.
Mixed economy: Most economic decisions result from the interaction of buyers and sellers in markets, but the government plays a significant role in the allocation of resources.
Market economies promote:
Productive efficiency: Every good or service is produced at the lowest possible cost.
Allocative efficiency: Production is in accordance with consumer preferences; every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.
Voluntary exchange: A situation that occurs in markets when both the buyer and the seller of a product are made better off by the transaction.
Each transaction improves the well-being of buyer and seller; transactions continue until no further improvement can take place.
Caveats:
Markets may not immediately be efficient.
Governments might interfere with market outcomes.
Market outcomes might ignore the desires of people not involved in transactions, like avoiding pollution.
Equity: The fair distribution of economic benefits.
Trade-off between efficiency and equity: policies that promote equity, such as income taxes, may reduce efficiency by discouraging work and investment.
Economic Models
Economists use models to analyze economic events and government policies.
Steps to build an economic model:
Decide on assumptions.
Formulate a testable hypothesis.
Use economic data to test the hypothesis.
Revise the model if it fails to explain the economic data well.
Retain the revised model to help answer similar economic questions in the future.
Economic models make behavioral assumptions:
Consumers maximize well-being.
Firms maximize profits.
Hypothesis: A statement about an economic variable that may be correct or incorrect.
Economic variable: Something measurable that can have different values, such as the number of people employed in manufacturing.
Most economic hypotheses are about causal relationships.
Statistical methods are used to evaluate hypotheses using relevant data.
Difficult to establish causality.
Economists accept and use an economic model if it leads to hypotheses that are confirmed by statistical analysis.
Positive analysis: Analysis concerned with what is.
Normative analysis: Analysis concerned with what ought to be.
Economists mostly perform positive analysis; but positive analysis alone is usually not enough to decide what to do.
Economics as a social science studies individuals' actions and how they affect outcomes.
Governments use economic analysis for policy decisions.
Economic theory can identify winners and losers from a tariff. Economic analysis can estimate the dollar amounts gained and lost, and economists generally discourage tariffs.. However, policymakers may value the well-being of some groups more, which is a normative judgment.
Microeconomics and Macroeconomics
Microeconomics: The study of:
How households and firms make choices.
How they interact in markets.
How the government attempts to influence their choices.
Macroeconomics: The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.
Economic Skills and Economics as a Career
Economists can describe how choices are made, explain the consequences, and advise on better decisions.
Economics majors develop decision-making skills.
Many CEOs of large corporations majored in economics.
Economics majors earn higher-than-average incomes.
Self-selection: Future high earners may be more attracted to fields like economics.
Important Economic Terms
Technology: The processes a firm uses to produce goods and services.
Capital: Manufactured goods that are used to produce other goods and services.
Pay close attention to terms defined in class and in the textbook!
Appendix: Using Graphs and Formulas
Graphs and formulas help analyze economic situations.
Bar graphs and pie charts show market share data.
Time-series graphs: can be influenced by truncated scales.
Two-dimensional grid: Price of pizza (y-axis) and quantity of pizza (x-axis).
Slope of a line: Change in value on the vertical axis divided by the change in value on the horizontal axis.
\text{Slope} = \frac{\Delta y}{\Delta x}
Example: When the price of pizza decreases from $14 to $12, the quantity of pizza demanded increases from 55 to 65 per week. So, the \text{Slope} = \frac{(\$12 - \$14)}{(65 - 55)} = \frac{-2}{10} = -0.2
Showing three variables on a graph: Demand curve for pizza.
Positive relationship: As one variable increases, the other increases.
Negative relationship: As one variable increases, the other decreases.
Graphs and cause and effect: can be hazardous.
Linear relationships: Represented by a straight line.
Non-linear curve: Has different slopes at different points.
Formula for a percentage change:
\text{Percentage change} = \frac{\text{Value in the second period} - \text{Value in the first period}}{\text{Value in the first period}} \times 100
Example: U.S. real GDP increased from $19,610 billion in 2021 to $20,018 billion in 2022. Therefore, the \text{Percentage change} = \frac{\$20,018 - \$19,610}{\$19,610} \times 100 = 2.1\%
Area of a rectangle: \text{Area} = \text{Base} \times \text{Height}
Area of a triangle: \text{Area} = \frac{1}{2} \times \text{Base} \times \text{Height}
Summary of using formulas:
Understand the economic concept.
Use the correct formula.
Make sure the number calculated is economically reasonable.
Chapter 1 summary
1.1 Three Key Economic Ideas
Rationality: People make decisions using available information to achieve their goals.
Economic Incentives: Individuals and firms respond to economic incentives consistently.
Marginal Analysis: Optimal decisions are made by comparing marginal benefits and marginal costs. Continue an activity until marginal benefit equals marginal cost.
Market: A group of buyers and sellers of a good or service facilitating trade.
Obesity and Health Insurance
Obesity is linked to diseases like heart disease and diabetes, posing a major health problem.
Body Mass Index (BMI) is used to measure weight relative to height; a BMI of 30 or more indicates obesity.
Obesity rates have increased significantly; explanations include high-calorie diets, lack of exercise, and less physical activity in jobs.
Health insurance may create an incentive to gain weight by reducing the costs of obesity.
Research indicates people with health insurance are more likely to be overweight; private insurance increased BMI by 1.3 points, while public insurance increased it by 2.3 points.
The formula for calculating BMI is: BMI = (Weight \, in \, pounds/Height \, in \, inches^2) \times 703
1.2 The Economic Problem That Every Society Must Solve
Societies face trade-offs because of limited resources.
Trade-off: Producing more of one good or service means producing less of another.
Opportunity Cost: The highest-valued alternative given up to engage in an activity.
Societies must answer three questions:
‘ What goods and services will be produced?
How will the goods and services be produced?
Who will receive the goods and services produced?
A. What Goods and Services Will Be Produced?
Determined by choices of consumers, firms, and government, each entailing an opportunity cost.
B. How Will the Goods and Services Be Produced?
Firms choose production methods, often balancing workers and machines.
C. Who Will Receive the Goods and Services Produced?
Largely depends on income distribution; a policy question is whether the government should intervene to equalize income.
D. Centrally Planned Economies versus Market Economies
Centrally Planned Economy: Government allocates economic resources.
Market Economy: Decisions of households and firms in markets determine resource allocation.
Income in a market economy is determined by payments for what one sells; higher training and longer hours generally result in higher income.
E. The Modern “Mixed” Economy
Increased government intervention since the Great Depression aims to raise incomes and address environmental and social goals.
Mixed Economy: Combination of market-driven decisions and government intervention.
F. Efficiency and Equity
Market economies tend to be more efficient than centrally planned economies.
Productive Efficiency: Goods/services produced at the lowest possible cost.
Allocative Efficiency: Production aligns with consumer preferences; marginal benefit equals marginal cost.
Voluntary Exchange: Transactions in markets benefit both buyer and seller.
Inefficiency can arise from government interference or environmental damage.
Equity: Fair distribution of economic benefits; trade-off between efficiency and equity.
College Football Attendance
Declining attendance is attributed to rising ticket prices and increased opportunity costs.
Opportunity cost includes ticket price plus the value of alternative activities.
Increased TV broadcasts and improved at-home viewing experiences raise the opportunity cost of attending games.
Colleges are trying to counter this by reducing ticket prices and improving stadium amenities.
1.3 Economic Models
Economic Model: Simplified version of reality used to analyze real-world situations.
Steps to develop a model:
Decide on assumptions.
Formulate a testable hypothesis.
Test hypothesis with economic data.
Revise the model if it fails.
Retain the revised model.
A. The Role of Assumptions in Economic Models
Models are simplified using assumptions, including behavioral assumptions about consumer and firm behavior.
B. Forming and Testing Hypotheses in Economic Models
Economic Variable: Measurable quantity with different values.
Hypothesis: Statement about an economic variable that may be correct or incorrect.
Hypotheses are tested using statistical analysis, and models are accepted if their hypotheses are confirmed.
C. Positive and Normative Analysis
Positive Analysis: Concerned with what is.
Normative Analysis: Concerned with what ought to be.
Economics primarily uses positive analysis to measure costs and benefits.
D. Economics as a Social Science
Economics studies individual actions and human behavior across various contexts.
Economists influence government policies on the environment, health care, and poverty.
1.4 Microeconomics and Macroeconomics
Microeconomics: Studies choices of households and firms, their interactions in markets, and government influence.
Macroeconomics: Studies the economy as a whole, including inflation, unemployment, and economic growth.
1.5 Economic Skills and Economics as a Career
Economics analyzes choices made by individuals, businesses, and governments.
Businesses, government agencies, and nonprofits hire economists.
Economics majors earn about 33% more than all majors early in their careers.
1.6 A Preview of Important Economic Terms
Brief overview of terms: firm, entrepreneur, innovation, technology, goods, services, revenue, profit, household, factors of production, capital, and human capital.
Appendix: Using Graphs and Formulas
Graphs simplify and concretize economic ideas.
Types of graphs: bar graphs, pie charts, and time-series graphs.
Coordinate grids have vertical (y-axis) and horizontal (x-axis) axes.
Graphs of Two Variables
Graphs show the relationship between two variables, such as price and quantity on a demand curve.
A. Slopes of Lines
Slope indicates how much the y-axis variable changes as the x-axis variable changes.
Slope is constant for a straight line and measured as slope = \frac{\Delta y}{\Delta x}, also known as rise over run.
Taking into Account More Than Two Variables on a Graph
Changing other variables shifts the demand curve.
A. Positive and Negative Relationships
Relationships can be negative (e.g., price and quantity demanded) or positive (e.g., income and consumption).
B. Determining Cause and Effect
Inferring cause and effect from graphs can be misleading due to omitted variables or reverse causality.
C. Are Graphs of Economic Relationships Always Straight Lines?
Few relationships are linear, but linear approximations can be useful.
D. Slopes of Nonlinear Curves
Slope at a point on a nonlinear curve is measured by the slope of the tangent line at that point.
Formulas
A. Formula for a Percentage Change
\text{Percentage change} = \frac{\text{Value in the second period} - \text{Value in the first period}}{\text{Value in the first period}} \times 100
B. Formulas for the Areas of a Rectangle and a Triangle
Area of a rectangle: Base \times Height
Area of a triangle: \frac{1}{2} \times Base \times Height
C. Summary of Using Formulas
Understand the economic concept.
Use the correct formula.
Ensure the result is economically reasonable.
Chapter 2
2.1 Production Possibilities Frontiers and Opportunity Costs
Production Possibilities Frontier (PPF): A curve showing the maximum attainable combinations of two goods that can be produced with available resources and current technology.
PPF is a positive tool: It shows "what is," not "what should be."
Points on the PPF are attainable.
Points below the PPF are inefficient.
Points above the PPF are unattainable with current resources.
Opportunity cost: The highest-valued alternative that must be given up to engage in an activity.
Increasing Marginal Opportunity Costs: Some resources are better suited to one task than another; the more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity.
Economic growth: The ability of the economy to increase the production of goods and services, represented by shifts in the PPF.
2.2 Comparative Advantage and Trade
Trade: The act of buying and selling.
Specialization and Gains from Trade: Individuals and countries can benefit from trade by specializing in what they are relatively good at.
Absolute advantage: The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources.
Comparative advantage: The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.
The basis for trade is comparative advantage, not absolute advantage.
Individuals, firms, and countries are better off if they specialize in producing goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading.
2.3 The Market System
Market: A group of buyers and sellers of a good or service, and the institution or arrangement by which they come together to trade.
Two key groups in the modern economy:
Households: Individuals who provide factors of production (labor, capital, natural resources, etc.).
Firms: Entities that purchase factors of production from households and use them to create goods and services.
Four Factors of Production:
Labor: All types of work.
Capital: Physical capital such as computers, buildings, and machine tools.
Natural resources: Land, water, oil, iron ore, etc.
Entrepreneurial ability: The ability to bring together the other factors of production to successfully produce and sell goods and services.
Factor market: A market for the factors of production.
Product market: A market for goods or services.
Circular-flow diagram: A model that illustrates how participants in markets are linked.
Households provide factors of production to firms.
Firms provide goods and services to households.
Firms pay money to households for factors of production.
Households pay money to firms for goods and services.
Free market: One with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed.
Market Mechanism: Markets with flexible prices allow the collective actions of households and firms to signal the relative worth of goods and services.
How the Market Mechanism Works:
If consumers switch to electric cars, firms will charge more for them.
The self-interest of firms will lead them to produce more electric cars.
This happens organically with flexible prices, without central control.
How the Market Mobilizes Knowledge: Local knowledge is critical for adapting to changing conditions, happening faster in market systems than in centrally-planned economies.
Role of the Entrepreneur: An entrepreneur operates a business, bringing together factors of production to produce goods and services and contribute to economic growth.
Legal Basis of a Successful Market System:
Protection of private property: Individuals or firms have exclusive rights to their property, including the right to buy or sell it.
Enforcement of contracts and property rights: Important for transactions across time, requiring an independent court system.
Trade-offs, Comparative Advantage, and the Market System Notes
Trade-offs, Comparative Advantage, and the Market System
Brief Chapter Summary and Learning Objectives
2.1 Production Possibilities Frontiers and Opportunity Costs, page 29
Use a production possibilities frontier to analyze opportunity costs and trade-offs.
The model of the production possibilities frontier is used to analyze the opportunity costs and trade-offs that individuals, firms, and countries face.
2.2 Comparative Advantage and Trade, page 30
Describe comparative advantage and explain how it serves as the basis for trade.
Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than other producers.
2.3 The Market System, page 31
Explain the basics of how a market system works.
Markets enable buyers and sellers of goods and services to come together to trade.
Key Terms
Absolute advantage, p. 30: The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources.
Circular-flow diagram, p. 31: A model that illustrates how participants in markets are linked.
Comparative advantage, p. 30: The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.
Economic growth, p. 30: The ability of an economy to produce increasing quantities of goods and services.
Entrepreneur, p. 31: Someone who operates a business, bringing together the factors of production—labor, capital, and natural resources—to produce goods or services.
Factor market, p. 31: A market for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability.
Factors of production, p. 31: Labor, capital, natural resources, and other inputs used to make goods and services.
Free Market, p. 31: A market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed.
Market, p. 31: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.
Opportunity cost, p. 29: The highest-valued alternative that must be given up to engage in an activity.
Product market, p. 31: A market for goods—such as computers—or services—such as medical treatment.
Production possibilities frontier (PPF), p. 29: A curve showing the maximum attainable combinations of two goods that can be produced with available resources and current technology.
Property rights, p. 31: The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.
Scarcity, p. 29: A situation in which unlimited wants exceed the limited resources available to fulfill those wants.
Trade, p. 30: The act of buying and selling.
Chapter Outline: Ford Faces a Trade-Off at Its Dearborn, Michigan Plant
In 2022, only 6 percent of cars, SUVs, minivans, and pickup trucks sold in the United States were electric.
Ford Motor Company's best-selling and most profitable vehicle is its F-150 pickup truck.
In 2022, Ford assembled both gasoline-powered F-150 pickup trucks and all-electric F-150 Lightning pickup trucks in its River Rouge complex in Dearborn, Michigan.
Ford’s managers face a trade-off: Should Ford increase the resources it uses to produce the F-150 Lightning?
Doing so might lower the cost of producing that model, allowing the firm to reduce its price while still earning a profit.
Or should the firm devote those resources to produce the F-150, its best-selling vehicle?
2.1 Production Possibilities Frontiers and Opportunity Costs
Learning Objective: Use a production possibilities frontier to analyze opportunity costs and trade-offs.
Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants.
Goods and services are scarce, as are the resources used to make goods and services.
A production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of two goods that can be produced with available resources and current technology.
A. Graphing the Production Possibilities Frontier
All combinations of products on a production possibilities frontier are efficient because all available resources are being used.
Combinations inside the frontier are inefficient because maximum output is not obtained from available resources.
Points outside the frontier are unattainable given the firm’s current resources.
Opportunity cost is the highest-valued alternative that must be given up to engage in an activity.
B. Increasing Marginal Opportunity Costs
A production possibilities frontier that is bowed outward illustrates increasing marginal opportunity costs, which occur because some workers, machines, and other resources are better suited to one use than to another.
Increasing marginal opportunity costs illustrate an important concept: The more resources already devoted to any activity, the smaller the payoff to devoting additional resources to that activity.
C. Economic Growth
Economic growth is the ability of an economy to produce increasing quantities of goods and services.
Economic growth can occur if more resources become available or if a technological advance makes resources more productive.
Growth may lead to greater increases in production for one good than another.
2.2 Comparative Advantage and Trade
Learning Objective: Describe comparative advantage and explain how it serves as the basis for trade.
Trade is the act of buying and selling.
Trade makes it possible for people to become better off by increasing both their production and their consumption.
A. Specialization and Gains from Trade
PPFs show the combinations of two goods that can be produced if no trade occurs.
We can also use PPFs to show how you can benefit from trade even if you are better than someone else at producing both goods.
B. Absolute Advantage versus Comparative Advantage
Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources.
If the two individuals have different opportunity costs for producing two goods, each individual will have a comparative advantage in the production of one of the goods.
Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.
Comparing the possible combinations of production and consumption before and after specialization and trade occur proves that trade is mutually beneficial.
C. Comparative Advantage and the Gains from Trade
The basis for trade is comparative advantage, not absolute advantage.
Individuals, firms, and countries are better off if they specialize in producing the goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading.
2.3 The Market System
Learning Objective: Explain the basics of how a market system works.
In the United States and most other countries, trade is carried out in markets.
A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.
A product market is a market for goods—such as computers—or services—such as medical treatment.
A factor market is a market for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability.
Factors of production are labor, capital, natural resources, and other inputs used to make goods and services.
A. The Circular Flow of Income
A circular-flow diagram is a model that illustrates how participants in markets are linked.
The diagram demonstrates the interaction between firms and households in both product markets and factor markets.
B. The Gains from Free Markets
A free market is a market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed.
Adam Smith is considered the father of modern economics.
His book, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, was an influential argument for the free market system.
C. The Market Mechanism
A key to understanding Adam Smith’s argument is the assumption that individuals usually act in a rational, self-interested way.
This assumption underlies nearly all economic analysis.
D. How the Market Mobilizes Knowledge
The efficient functioning of an economy requires the processing of enormous amounts of knowledge.
This knowledge is local and known by only a few people.
The knowledge concerns the best way to respond to changes a firm faces in its ability to make and sell its products.
The economy needs this knowledge to provide the most efficient answers to what goods and services should be produced, how they will be produced, and who will receive the goods and services that are produced.
A market system does a better job of using such knowledge than does a government-run, centrally planned economy.
The ability to mobilize knowledge is a key way in which a market system provides better outcomes that does government central planning.
E. The Role of the Entrepreneur in the Market System
Entrepreneurs are an essential part of a market economy.
An entrepreneur is someone who operates a business, bringing together the factors of production—labor, capital, and natural resources—to produce goods or services.
Entrepreneurs often risk their own funds to start businesses and organize factors of production to produce those goods and services that consumers want.
F. The Legal Basis of a Successful Market System
The absence of government intervention is not enough for a market economy to work well.
Government has to provide a legal environment that allows markets to operate efficiently.
Property rights are the rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.
To protect intellectual property rights, the federal government grants patents to inventors.
A patent grants the exclusive right to produce and sell a new product for 20 years from the date the patent is filed.
Books, films, and software receive copyright protection.
Under U.S. law, the creator of a book, film, or piece of music has the exclusive right to use the creation during the creator's lifetime.
The creator’s heirs retain this right for 70 years after the death of the creator.
Extra Solved Problem 2.3 Adam Smith’s “Invisible Hand”
The late economist Alan Krueger argued that Adam Smith was concerned that the invisible hand would not function properly if merchants and manufacturers convinced the government to issue regulations to help them.
a. What types of regulations might merchants and manufacturers seek from the government?
b. How might these regulations prevent the invisible hand from working?
Solving the Problem
Step 1: Review the chapter material.
This problem is about how goods and services are produced and sold and how factors of production are employed in a free market economic system as described by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations, so you may want to review the section “The Gains from Free Markets.”
Step 2: Answer part (a) by describing the economic system in place in Europe in 1776.
At the time, governments gave guilds—associations of producers—the authority to control production.
The production controls limited the output of goods such as shoes and clothing, as well as the number of producers of these items.
Limiting production and competition led to higher prices and fewer choices for consumers.
Instead of catering to the wants of consumers, producers sought favors from government officials.
Step 3: Answer part (b) by contrasting the behavior of merchants and manufacturers under a guild system and in a market system.
Because governments in a guild system gave producers the power to control production, producers did not have to respond to consumers’ demands for better quality, greater variety, and lower prices.
In a market system, producers who sell poor quality goods at high prices suffer economic losses; producers who provide better quality goods at low prices are rewarded with profits.
Therefore, it is in the self-interest of producers to address consumer wants.
This is how the invisible hand works in a free market economy but not in most of Europe in the eighteenth century.
Extra Analyze the Concept An Elementary Case of Copyright
The U.S. Congress provides copyright protection to authors to give them an economic incentive to invest the time and effort required to write books.
While a book is under copyright, only the author—or whoever the author sells the copyright to—can legally publish a paper or digital copy of the book.
Once the copyright expires, however, the book enters the public domain, and anyone is free to publish the book.
Copies of classic books written in the 1800s, such as Mark Twain’s Huckleberry Finn and Charles Dickens’s Oliver Twist, are available from many publishers that do not have to pay a fee to the authors’ heirs.
Arthur Conan Doyle was a doctor in England when he published his first story featuring the detective Sherlock Holmes in 1887.
Anyone who wants to publish any of the Sherlock Holmes stories that Doyle wrote from 1887 through the end of 1922 is free do so.
But the last 10 Sherlock Holmes stories that Doyle wrote from 1923 to 1927 remain under copyright protection.
Doyle’s heirs argue that because the author continued to develop the personalities of Sherlock Holmes and his companion Dr. John Watson in the 10 stories that remain under copyright protection, the characters cannot be used in new books, films, or television shows without payment.
Doyle’s heirs have asked anyone who wants to include Holmes in a new work to pay them a fee of $5,000 per use.
The producers of two Sherlock Holmes films starring Robert Downey, Jr., and the producers of the television series Sherlock, starring Benedict Cumberbatch, and Elementary, starring Jonny Lee Miller, agreed to pay the fee, as have most authors of books using Holmes as a character.
In 2011, when Leslie S. Klinger published A Study in Sherlock, a collection of new stories involving Sherlock Holmes, his publisher insisted that he pay the usual fee to Doyle’s descendants.
But two years later, when Klinger decided to publish another collection, In the Company of Sherlock Holmes, he decided that rather than pay the fee he would sue Doyle’s descendants, hoping the federal courts would rule against their copyright claims.
Federal Appeals Judge Richard Posner—who is also an economist—eventually ruled in favor of Klinger.
He argued that copyright law did not allow authors or their heirs to require fees for the use of characters from stories in the public domain.
He also noted that, “the longer the copyright term is, the less public-domain material there will be and so the greater will be the cost of authorship, because authors will have to obtain licenses from copyright holders for more material.”
As a result of this ruling, for the first time since 1887, anyone can use Sherlock Holmes as a character in a book, television show, or movie without having to pay a fee.
Extra Analyze the Concept Managers at Feeding America Use the Market Mechanism to Reduce Hunger
Charitable giving doesn’t seem to have much to do with markets.
When donors give money, clothing, or food to a charity, they typically don’t expect anything in exchange—beyond a possible tax deduction.
In 1979, retired businessman John van Hengel started Feeding America.
This charity collects donations of food from farmers, supermarkets, food processing plants, and governments and distributes the food to thousands of food pantries and food programs operated by churches, schools, and community centers around the country.
These programs give the donated food away free or at a very low price to low-income families.
By 2004, Feeding America was providing 1.8 billion pounds of food per year to millions of low-income people, but the organization’s managers realized that they could serve even more people if they could operate more efficiently.
In particular, the managers were concerned that food was sometimes not allocated in ways that were consistent with the needs of local food programs.
For example, potatoes might be shipped to food programs in Idaho—the country’s leading potato growing state—or milk might be shipped to food programs that lacked the refrigeration capacity to keep it fresh long enough to distribute.
In 2005, Feeding America asked Canice Prendergast, Don Eisenstein, and Harry Davis, professors at the University of Chicago’s Booth School of Business, to design a more efficient way of allocating food to local food programs.
Feeding America had been allocating food by calculating how many low-income people lived in an area and then shipping a target number of pounds of food to food programs in the area.
All food, whether fruit, bread, milk, or pasta, that weighed the same was treated the same in making allocations to local food programs.
The food programs were not allowed to choose which foods they wanted to receive.
Because Feeding America provided on average only about 20 percent of the total food donations local food programs received, it might ship food—for example, bread and breakfast cereal—the local program already had, while failing to ship food, such as fruits and vegetables, that the program needed.
The business professors advising Feeding American proposed changing the food allocation system to one that resembled a market.
Each food program was given a number of “shares” that they could use in bidding against other food programs for the types of food that best met the needs of the low-income people using their program.
In addition, any local program that had surplus food was allowed to sell it to other local programs in exchange for shares.
Although this new system does not involve money, it operates like a market—in which consumers determine prices by competing against each other in buying goods.
Goods for which consumers have a greater preference tend to have higher prices than goods for which consumers have a lesser preference; for instance, in supermarkets, organic produce often sells for a higher price than nonorganic produce.
Similarly, food programs turned out to have a stronger preference for fresh fruits and vegetables than for pasta.
Under the previous system, a pound of fresh fruit would have been treated the same as a pound of pasta in calculating how much food Feeding America would allocate to a local program.
But when under the new system local food banks were allowed to bid for food with shares, the price of a pound of fruit or vegetables was 116 times higher than the price of a pound of pasta.
Because under the new system food is allocated in a way that more closely fits the needs of local food programs, Feeding America is able to provide food to thousands more low-income people than was possible under the old system.
In addition, because less food is wasted, people and organizations have been willing to donate more food to the program.
Finally, Feeding America’s managers have used the knowledge of which types of foods local food programs prefer to guide the types of food they ask companies to donate.
For instance, in addition to fruits and vegetables, programs are willing to pay more shares for peanut butter and frozen chicken because these foods are easy to store.
Even many critics of using a market mechanism to allocate food donations eventually embraced the system, including the director of one Michigan food program whose initial reaction was: “I am a socialist. That’s why I run a food bank. I don’t believe in markets.”
The success of Feeding America’s revised procedures for allocating food donations shows how powerfully market mechanisms can increase efficiency and raise living standards.
Extra Economics in Your Life & Career: Economists Express Their Agreement on Free Trade
Tariffs are taxes governments impose on imports.
During the summer of 2017, fifteen former leaders of the White House Council of Economic Advisors signed a letter to then President Trump urging him not to place tariffs on imports of steel into the United States.
The letter notes that “Among us are Republicans and Democrats alike, and we have disagreements on a number of policy issues. But on some policies, there is near universal agreement. One such issue is the harm of imposing tariffs on steel imports.”
Those who endorse tariffs and other barriers to free international trade believe that such barriers protect domestic industries and the jobs of their employees.
Questions:
(a) Why do many economists, including those who have served for both Republican and Democratic administrations, support free trade policies and oppose tariffs and trade barriers even if these barriers are designed to protect domestic workers from losing their jobs?
(b) What types of jobs would be most vulnerable to job losses due to competition from imports?
Answers:
(a) As you learned in this chapter, countries are better off if they specialize in producing goods and services in which they have a comparative advantage and trading with other countries for other goods and services.
Tariffs prevent countries from taking full advantage of the benefits from free trade.
The argument that economists who have worked for both Democratic and Republican governments made is based on positive economic analysis (analysis concerned with what is) rather than normative analysis (analysis concerned with what ought to be).
Ben Bernanke, former chair of the Federal Reserve Board, has cited a study that examined the effect of international trade on income in the United States since World War II:
“… the increase in trade… has boosted U.S. annual incomes on the order of 10,000 per household.
The same study found that removing all remaining barriers to trade would raise incomes anywhere from 4,000 to 12,000 per household.”
(b) Another study cited by Bernanke found that the 21 occupations in the United States that were most vulnerable to imports from foreign firms were primarily for relatively low-wage positions.
In general, the greater the skill requirements for the job you hold, the less vulnerable you will be to losing your job due to competition from imports.
. Where Prices Come From: The Interaction of Demand and Supply
3.1 The Demand Side of the Market
Variables influencing demand:
Begin by investigating how buyers behave, referring to this as market demand, the demand by all the consumers of a given good or service.
Demand Schedule:
A table showing the relationship between the price of a product and the quantity of the product demanded.
Demand Curve:
A curve that illustrates the relationship between the price of a product and the quantity of the product demanded.
Quantity Demanded:
The amount of a good or service that a consumer is willing and able to purchase at a given price.
Law of Demand:
States that, holding everything else constant (ceteris paribus), when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.
Qd = f(P), where Qd is the quantity demanded and P is the price.
Explanations for the Law of Demand:
Substitution Effect:
When the price of a good falls, consumers substitute toward the good whose price has fallen, making it more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power.
Income Effect:
Consumers have more purchasing power, which is like an increase in income.
The change in the quantity demanded of a good that results from the effect of a change in the good’s price on a consumer’s purchasing power, holding all other factors constant.
Ceteris Paribus Condition:
The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant.
Shifting the Demand Curve:
A change in something other than price that affects demand causes the entire demand curve to shift.
A shift to the right is an increase in demand.
A shift to the left is a decrease in demand.
As the demand curve shifts, the quantity demanded will change, even if the price doesn’t change.
The quantity demanded changes at every possible price.
Variables That Shift Market Demand:
Income:
An increase in income increases demand if the product is normal and decreases demand if the product is inferior.
Normal Good: A good for which the demand increases as income rises and decreases as income falls (e.g., new clothes, restaurant meals, vacations).
Inferior Good: A good for which the demand increases as income falls and decreases as income rises (e.g., second-hand clothes, instant noodles).
Prices of Related Goods:
An increase in the price of related goods increases demand if products are substitutes and decreases demand if products are complements.
Substitutes: Goods and services that can be used for the same purpose (e.g., Big Mac and Whopper, Ford F-150 and Dodge Ram, reusable water bottles and bottled spring water).
Complements: Goods and services that are used together (e.g., Big Mac and McDonald’s fries, left shoes and right shoes, reusable water bottles and gym memberships).
Tastes:
If consumers’ tastes change, they may buy more or less of the product.
Example: If influencers successfully advertise reusable water bottles, they affect consumers’ tastes, increasing demand for reusable water bottles.
Population and Demographics:
Demographics: The characteristics of a population with respect to age, race, and gender.
Increases in the number of people buying something will increase the amount demanded.
Example: An increase in the elderly population increases the demand for medical care.
Expected Future Prices:
Consumers decide which products to buy and also when to buy them.
Future products are substitutes for current products.
An expected increase in the price tomorrow increases demand today.
An expected decrease in the price tomorrow decreases demand today.
Example: If you found out the price of gasoline would go up tomorrow, you would increase your demand today.
Natural Disasters and Pandemics:
Temporary disruptions to economic activity can happen via natural disasters or pandemics.
Natural Disaster: A hurricane, flood, or similar act of nature that causes damage to stores, factories, or office buildings.
Pandemic: A situation in which a disease becomes sufficiently widespread as to significantly affect economic activity.
Example: The Covid-19 pandemic reduced the demand for goods that required people gathering (restaurants, concert tickets, etc.) but increased the demand for computing equipment to work from home.
Change in Demand vs. Change in Quantity Demanded:
A change in the price of the product being examined causes a movement along the demand curve, which is a change in quantity demanded.
Any other change affecting demand causes the entire demand curve to shift, which is a change in demand.
3.2 The Supply Side of the Market
Market Supply:
The decisions of firms about how much of a product to provide at various prices.
Supply Schedule:
A table that shows the relationship between the price of a product and the quantity of the product supplied.
Supply Curve:
A curve that shows the relationship between the price of a product and the quantity of the product supplied.
Quantity Supplied:
The amount of a good or service that a firm is willing and able to supply at a given price.
Law of Supply:
States that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.
Qs = f(P), where Qs is the quantity supplied and P is the price.
Shifting the Supply Curve:
A change in something other than price that affects supply causes the entire supply curve to shift.
A shift to the right is an increase in supply.
A shift to the left is a decrease in supply.
As the supply curve shifts, the quantity supplied will change, even if the price doesn’t change.
The quantity supplied changes at every possible price.
Variables That Shift Market Supply:
Prices of Inputs:
Inputs are anything used in the production of a good or service.
For a reusable water bottle, this includes plastic, labor, and transportation services.
An increase in the price of input decreases the profitability of selling the good, causing a decrease in supply.
A decrease in the price of an input increases the profitability of selling the good, causing an increase in supply.
Technological Change:
A firm may experience a positive or negative change in its ability to produce a given level of output with a given quantity of inputs.
Examples:
A new, more efficient way of producing water bottles would increase their supply.
Governmental restrictions on how much workers are allowed to work might decrease the supply of water bottles.
Prices of Related Goods in Production:
Many firms can produce and sell alternative products: substitutes in production.
Example: An Illinois farmer can plant either corn or soybeans. If the price of soybeans rises, that farmer will plant (supply) less corn.
Sometimes, two products are necessarily produced together: complements in production
Example: Cattle provide both beef and leather. An increase in the price of beef encourages more cattle farming, which increases the supply of leather.
Number of Firms and Expected Future Prices:
More firms in the market will result in more products available at a given price (greater supply).
If a firm anticipates that the price of its product will be higher in the future, it might decrease its supply today in order to increase it later.
Fewer firms \rightarrow supply decreases.
Natural Disasters and Pandemics:
Less of a good will be supplied due to disruptions in production
Example: During hurricanes and floods, some manufacturing plants will be damaged and forced to shut down. The result will be fewer units supplied.
Change in Supply vs. Change in Quantity Supplied:
A change in the price of the product being examined causes a movement along the supply curve, which is a change in the quantity supplied.
Any other change affecting supply causes the entire supply curve to shift, which is a change in supply.
3.3 Market Equilibrium: Putting Demand and Supply Together
Market Equilibrium:
A situation in which quantity demanded equals quantity supplied.
Recall that markets with many buyers and sellers are perfectly competitive markets; a market equilibrium in one of these markets is called a competitive market equilibrium.
Competitive Market Equilibrium:
Occurs where quantity demanded equals quantity supplied in a market with many buyers and sellers.
Surplus:
A situation in which the quantity supplied is greater than the quantity demanded.
Sellers will compete among themselves, driving the price down.
Shortage:
A situation in which the quantity demanded is greater than the quantity supplied.
Sellers will realize they can increase the price and still sell as many water bottles, so the price will rise.
Price Determination:
Price is determined by the interaction of buyers and sellers.
Neither group can dictate price in a competitive market (i.e., one with many buyers and sellers).
However, changes in supply and/or demand will affect the price and quantity traded.
3.4 The Effect of Demand and Supply Shifts on Equilibrium
Predictions with Demand and Supply Graphs:
Predictions about price and quantity in our model require us to know demand and supply curves.
Typically, we know price and quantity but do not know the curves that generate them.
The power of the demand and supply model is in its ability to predict directional changes in price and quantity.
Increase in Demand:
If reusable water bottles are a normal good, as income rises, demand shifts to the right.
Equilibrium price rises.
Equilibrium quantity rises.
Increase in Supply:
When a new producer enters the market, more water bottles are supplied at any given price—an increase in supply.
Equilibrium price falls.
Equilibrium quantity rises.
Simultaneous Shifts in Demand and Supply:
Over time, it is likely that both demand and supply will change.
For example, as new firms enter the market for water bottles and incomes increase, we expect:
The supply curve will shift to the right, and
The demand curve will shift to the right.
Equilibrium quantity will rise, but the effect on the equilibrium price is not clear.
If demand shifts more than supply: equilibrium price and quantity both rise.
If supply shifts more than demand: quantity rises, but equilibrium price falls.
Without knowing the relative size of the changes, the effect on the equilibrium price is ambiguous. It is possible, but unlikely, that the equilibrium price will remain unchanged.
Shifts of a Curve vs. Movements Along a Curve:
Suppose an increase in supply occurs.
Equilibrium quantity will increase, and
Equilibrium price will decrease.
The decrease in price will cause a movement along the demand curve but not an increase in demand.
The demand curve already describes how much of the good consumers want to buy at any given price.
When the price change occurs, we just look at the demand curve to see what happens to how much consumers want to buy.
Chapter 3: Where Prices Come From: The Interaction of Demand and Supply
3.1 The Demand Side of the Market
Variables Influencing Demand:
Price: The most important factor affecting demand.
Income:
Normal Good: Demand increases as income rises and decreases as income falls.
Inferior Good: Demand increases as income falls and decreases as income rises.
Prices of Related Goods:
Substitutes: Goods used for the same purpose. A decrease in the price of a substitute shifts demand to the left; an increase shifts demand to the right.
Complements: Goods used together. A decrease in the price of a complement shifts demand to the right; an increase shifts demand to the left.
Tastes: Subjective elements influencing consumer decisions. Increased taste shifts demand to the right; decreased taste shifts demand to the left.
Population and Demographics: Characteristics of a population (age, race, gender) that influence demand.
Expected Future Prices: Expectations of future price changes affect current demand.
Natural Disasters and Pandemics: Events that can significantly impact demand.
Perfectly Competitive Market:
Many buyers and sellers.
All firms sell identical products.
No barriers to new firms entering the market.
Demand Schedules and Demand Curves:
Demand Schedule: A table showing the relationship between price and quantity demanded.
Quantity Demanded: The amount a consumer is willing and able to purchase at a given price.
Demand Curve: A curve showing the relationship between price and quantity demanded.
Market Demand: The demand by all consumers of a given good or service.
Law of Demand:
Holding everything else constant, when the price of a product falls, the quantity demanded increases, and when the price rises, the quantity demanded decreases.
Explanations for the Law of Demand:
Substitution Effect: Change in quantity demanded due to a change in relative price, holding purchasing power constant.
Income Effect: Change in quantity demanded due to the effect of a change in price on consumer purchasing power, holding all other factors constant.
Ceteris Paribus Condition:
The requirement that when analyzing the relationship between two variables, other variables must be held constant.
Change in Demand vs. Change in Quantity Demanded:
Change in Demand: A shift in the entire demand curve due to a change in a variable other than price.
Change in Quantity Demanded: A movement along the demand curve due solely to a change in the product's price.
3.2 The Supply Side of the Market
Variables Influencing Supply:
Price: The most important factor affecting supply.
Prices of Inputs: If the price of an input rises, the supply curve shifts to the left. If the price of an input declines, the supply curve shifts to the right.
Technological Change: Positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs.
Prices of Related Goods in Production:
Substitutes in Production: Alternative products a firm could produce. If the price of a substitute in production increases, the supply of the product will shift to the left.
Complements in Production: Goods produced together. An increase in the price of a product will cause the supply curve for its complement to shift to the right.
Number of Firms in the Market: Entry of firms shifts supply to the right; exit shifts supply to the left.
Expected Future Prices: Expectations of future price changes affect current supply.
Natural Disasters and Pandemics: Events that can significantly impact supply.
Quantity Supplied:
The amount of a good or service that a firm is willing and able to supply at a given price.
Supply Schedules and Supply Curves:
Supply Schedule: A table that shows the relationship between the price of a product and the quantity of the product supplied.
Supply Curve: A curve that shows the relationship between the price of a product and the quantity of the product supplied.
Law of Supply:
Holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.
Change in Supply vs. Change in Quantity Supplied:
Change in Supply: A shift in the entire supply curve due to a change in a variable other than price.
Change in Quantity Supplied: A movement along the supply curve due solely to a change in the product's price.
3.3 Market Equilibrium: Putting Demand and Supply Together
Market Equilibrium:
A situation in which quantity demanded equals quantity supplied.
Competitive Market Equilibrium: A market equilibrium with many buyers and sellers.
Surpluses and Shortages:
Surplus: Quantity supplied is greater than quantity demanded. Firms cut prices to increase sales.
Shortage: Quantity demanded is greater than quantity supplied. Firms raise prices due to excess demand.
Demand and Supply Both Count:
Neither consumers nor firms can dictate the equilibrium price alone.
3.4. The Effect of Demand and Supply Shifts on Equilibrium
Shifts in Demand:
Increase in demand (rightward shift) leads to higher equilibrium price and quantity.
Decrease in demand (leftward shift) leads to lower equilibrium price and quantity.
Shifts in Supply:
Increase in supply (rightward shift) leads to lower equilibrium price and higher equilibrium quantity.
Decrease in supply (leftward shift) leads to higher equilibrium price and lower equilibrium quantity.
Simultaneous Shifts in Demand and Supply:
The effect on equilibrium price and quantity depends on the relative magnitudes of the shifts.
Curve Shifts vs. Movements along Curves:
Price changes resulting from shifts in demand or supply do not cause further shifts in the curves themselves.
Chapter 6: Elasticity: The Responsiveness of Demand and Supply
6.1 The Price Elasticity of Demand and Its Measurement
Definition: Elasticity measures how one economic variable responds to changes in another.
Price Elasticity of Demand: Measures the responsiveness of quantity demanded to a change in price.
Calculated by dividing the percentage change in quantity demanded by the percentage change in price.
*Slope vs. Elasticity: Slope is sensitive to units, making elasticity a better measure.
A. Measuring the Price Elasticity of Demand
The price elasticity of demand is always negative, but we often compare absolute values.
B. Elastic Demand and Inelastic Demand
Elastic Demand: Percentage change in quantity demanded > percentage change in price (elasticity > 1).
Inelastic Demand: Percentage change in quantity demanded < percentage change in price (elasticity < 1).
Unit-Elastic Demand: Percentage change in quantity demanded = percentage change in price (elasticity = 1).
C. Computing Price Elasticities
Calculating elasticity between two points yields different values for price increases vs. decreases.
D. The Midpoint Formula
Midpoint Formula: Used to ensure a single elasticity value between two points.
Uses the average of initial and final quantities and prices.
Formula: Price\ Elasticity\ of\ Demand = \frac{\frac{Q2 - Q1}{(Q2 + Q1)/2}}{\frac{P2 - P1}{(P2 + P1)/2}}
Where Q1 and P1 are the initial quantity and price, and Q2 and P2 are the final quantity and price.
E. When Demand Curves Intersect
The flatter curve is more elastic (smaller slope in absolute value).
The steeper curve is less elastic (larger slope in absolute value).
F. Polar Cases of Perfectly Inelastic and Perfectly Elastic Demand
Perfectly Inelastic Demand: Quantity demanded is completely unresponsive to price (elasticity = 0).
Vertical demand curve.
Perfectly Elastic Demand: Quantity demanded is infinitely responsive to price (elasticity = ∞).
Horizontal demand curve.
G. The Many Uses of Elasticity: An Example from Law Enforcement Policy in Denmark
Efficient allocation of resources requires policies that provide the most deterrence per dollar cost.
Expansion of DNA database in Denmark:
A 1 percent higher detection probability reduces crime by 2 percent.
6.2 The Determinants of the Price Elasticity of Demand
Five key determinants:
A. Availability of Close Substitutes
Most important determinant.
More substitutes → more elastic demand.
Fewer substitutes → less elastic demand.
B. Passage of Time
The more time passes, the more elastic the demand becomes.
C. Luxuries versus Necessities
Demand for a luxury is more elastic than for a necessity.
D. Definition of the Market
The more narrowly defined the market, the more elastic the demand.
E. Share of a Good in a Consumer’s Budget
The larger the share, the more elastic the demand.
F. Some Estimated Price Elasticities of Demand
Estimates vary depending on data and time period.
6.3 The Relationship between Price Elasticity of Demand and Total Revenue
Total Revenue: Total amount received from selling a good or service (price * quantity).
Inelastic Demand: Price and total revenue move in the same direction.
Price increases, total revenue increases.
Price decreases, total revenue decreases.
Elastic Demand: Price and total revenue move in opposite directions.
Price increases, total revenue decreases.
Price decreases, total revenue increases.
Unit Elastic Demand: Change in price is offset by a proportional change in quantity, leaving revenue unaffected.
A. Elasticity and Revenue with a Linear Demand Curve
Elasticity is not constant along most demand curves.
At high prices and low quantities, demand is elastic.
At low prices and high quantities, demand is inelastic.
6.4 Other Demand Elasticities
Two other important demand elasticities:
Cross-price elasticity of demand.
Income elasticity of demand.
A. Cross-Price Elasticity of Demand
Measures the responsiveness of the quantity demanded of one good to a change in the price of another good.
Formula:
Cross-Price\ Elasticity\ of\ Demand = \frac{\%\ Change\ in\ Quantity\ Demanded\ of\ Good\ A}{\%\ Change\ in\ Price\ of\ Good\ B}
Substitutes: Positive cross-price elasticity (price of one good increases, demand for the other increases).
Complements: Negative cross-price elasticity (price of one good increases, demand for the other decreases).
B. Income Elasticity of Demand
Measures the responsiveness of the quantity demanded to changes in income.
Formula:
Income\ Elasticity\ of\ Demand = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Income}
Normal Good: Quantity demanded increases as income increases.
Necessity: Income elasticity is positive but less than 1.
Luxury: Income elasticity is greater than 1.
Inferior Good: Quantity demanded decreases as income increases.
6.5 Using Elasticity to Analyze the Disappearing Family Farm
From 1950 to 2022, the number of farms decreased significantly.
Rapid growth in farm output and low price and income elasticities made family farming difficult.
Increased wheat production led to a substantial decline in prices because:
Demand for wheat is price inelastic.
Income elasticity of demand for wheat is low.
6.6 The Price Elasticity of Supply and Its Measurement
Measures how much quantity supplied increases when price increases.
A. Measuring the Price Elasticity of Supply
The responsiveness of the quantity supplied to a change in price.
Formula:
Price\ Elasticity\ of\ Supply = \frac{\%\ Change\ in\ Quantity\ Supplied}{\%\ Change\ in\ Price}
Due to the law of supply, price elasticity of supply is positive.
Inelastic Supply: Elasticity < 1
Elastic Supply: Elasticity > 1
Unit Elastic Supply: Elasticity = 1
B. Determinants of the Price Elasticity of Supply
Depends on firms' ability and willingness to alter production with price changes.
Supply is inelastic in the short term, more elastic in the long term.
C. Polar Cases of Perfectly Elastic and Perfectly Inelastic Supply
Perfectly Inelastic Supply: Vertical supply curve.
Perfectly Elastic Supply: Horizontal supply curve.
D. Using Price Elasticity of Supply to Predict Changes in Price
When demand increases, the amount that price increases depends on the price elasticity of supply.
Inelastic supply leads to a larger price increase than elastic supply.
The Price Elasticity of Demand and Its Measurement
Definition of Elasticity: Elasticity is a measure of how much one economic variable responds to changes in another economic variable, based on percentage changes in the variables.
Price Elasticity of Demand: The responsiveness of the quantity demanded to a change in price.
Price\, elasticity\, of\, demand = \frac{Percentage\, change\, in\, quantity\, demanded}{Percentage\, change\, in\, price}The price elasticity of demand is a negative number because price and quantity change in opposite directions on the demand curve.
Elastic Demand: Demand is elastic if its price elasticity of demand is larger (in absolute value) than 1. A 10% increase in price would result in a greater than 10% decrease in quantity demanded.
Inelastic Demand: Demand is inelastic if its price elasticity of demand is less than 1.
Unit-Elastic Demand: Demand is unit-elastic if the price elasticity of demand is exactly equal to 1. A given percentage change in price produces the same percentage change in demand.
Midpoint Formula: Used to calculate percentage changes to ensure the elasticity from point A to B is the same as from B to A.
Percentage\, change = \frac{QB - QA}{(QA+QB)/2} \times 100Midpoint Formula for Elasticity:
Price\, elasticity\, of\, demand = \frac{\frac{Q2 - Q1}{(Q1 + Q2)/2}}{\frac{P2 - P1}{(P1 + P2)/2}}Solved Problem Example:
Price of Coca-Cola cut from $1.50 to $1.30 per bottle.
Sales increase from 2,000 to 2,500 gallons per day.
Average quantity = 2,250
Average price = $1.40
Percentage change in quantity demanded = 22.2%
Percentage change in price = -14.3%
Price elasticity of demand = -1.6
Demand is price elastic in this range since 1.6 > 1.
A vertical demand curve is perfectly inelastic, meaning quantity demanded does not change as price changes, so elasticity is zero.
A horizontal demand curve is perfectly elastic, meaning quantity demanded is infinitely responsive to price changes, so elasticity is infinite.
6.2 The Determinants of the Price Elasticity of Demand
Availability of Close Substitutes: More substitutes lead to more elastic demand.
Gasoline has few substitutes, so its price elasticity of demand is low.
Nikes have many substitutes, so their price elasticity of demand is high.
Passage of Time: Elasticity is higher in the long run than the short run because people can adjust their buying habits more easily.
If the price of gasoline rises, people may buy a more fuel-efficient car or move closer to work over time.
Luxury vs. Necessity: Price elasticity of demand is higher for luxuries.
Milk and bread are necessities, so demand is less sensitive to price.
Definition of the Market: The more narrowly defined the market, the more elastic is demand.
Demand for jeans in general might be inelastic, but demand for a specific brand of jeans can be elastic.
Share of a Good in a Consumer’s Budget: Goods that are a small portion of the budget tend to have very inelastic demand.
6.3 The Relationship between Price Elasticity of Demand and Total Revenue
Total revenue: The total amount of funds a seller receives from selling a good or service, calculated by multiplying price per unit by the number of units sold.
If demand is relatively price inelastic, decreasing the price will not gain enough additional customers to compensate for the lost revenue, so overall revenue goes down.
If demand is relatively price elastic, decreasing the price will gain many additional customers, more than compensating for the lost revenue, so overall revenue goes up.
6.4 Other Demand Elasticities
Cross-Price Elasticity of Demand: The percentage change in the quantity demanded of one good divided by the percentage change in the price of another good.
Measures the strength of substitute or complement relationships between goods.
Substitutes have a positive cross-price elasticity of demand.
Complements have a negative cross-price elasticity of demand.
Unrelated goods have a cross-price elasticity of zero.
Income Elasticity of Demand: A measure of the responsiveness of the quantity demanded to changes in income, measured by the percentage change in the quantity demanded divided by the percentage change in income.
Normal goods have a positive income elasticity of demand.
Inferior goods have a negative income elasticity of demand.
6.5 Using Elasticity to Analyze the Disappearing Family Farm
Rapid increases in farm productivity have led to a large shift to the right in the supply curve for wheat.
Income elasticity of demand for wheat is low, so demand for wheat increased little over time.
Demand for wheat is also inelastic, so the large shift in the supply curve and the small shift in the demand curve resulted in a sharp decline in the price of wheat.
6.6 The Price Elasticity of Supply and Its Measurement
Price elasticity of supply: The responsiveness of the quantity supplied to a change in price, measured by dividing the percentage change in the quantity supplied of a product by the percentage change in the product’s price.
The time period is critically important for determining the price elasticity of supply.
If a supply curve is a vertical line, it is perfectly inelastic (elasticity of supply equals zero).
If a supply curve is a horizontal line, it is perfectly elastic (elasticity of supply equals infinity).
Knowing the price elasticity of supply can help predict the effect that a change in demand will have
10.1 Utility and Consumer Decision Making
Utility: The enjoyment or satisfaction people receive from consuming goods and services.
Marginal Utility (MU): The change in total utility from consuming one more unit of a good or service.
Law of Diminishing Marginal Utility: Satisfaction decreases as more of a good/service is consumed.
Budget Constraint: The limit on consumer spending due to income.
Rule of Equal Marginal Utility per Dollar Spent: Consumers maximize utility by making sure that the last unit of each good consumed provides equal utility per dollar. This requires two conditions:
Spending all available income.
Equalizing marginal utility per dollar across all goods.
If the rule doesn't hold (e.g., more utility per dollar from Coke than pizza), utility can be increased by shifting spending until the rule is satisfied.
Income Effect: Change in quantity demanded due to altered purchasing power from a price change.
Substitution Effect: Change in quantity demanded due to a change in relative prices.
10.2 Where Demand Curves Come From
Market demand curves slope downward due to income and substitution effects.
For normal goods, both effects increase quantity demanded when the price falls.
For inferior goods, the income effect reduces quantity demanded when the price falls, working against the substitution effect.
The rule of equal marginal utility per dollar (MU/P) is used to analyze consumer decisions when prices change.
Extra Solved Problem
Jake has $20 to spend on chicken wings and chili dogs.
The initial price of wings is $4, and chili dogs is $2.
After the price of chili dogs inceases to $4 each Jake adjusts based on MU/P to maximize utility.
10.3 Social Influences on Decision Making
Social factors influence consumer choices.
Celebrity Endorsements: Increase demand if consumers believe celebrities use or are knowledgeable about the product.
Network Externality: Usefulness of a product increases as more people use it.
Can lead to consumers sticking with inferior technologies due to switching costs and path dependence, possibly causing market failure.
Fairness: Consumers value fair treatment and may react negatively to perceived unfair price increases, even if it reduces profits.
Firms might avoid raising prices during high demand to maintain customer satisfaction.
Uber's surge pricing model has faced criticism because consumers perceive price increases due to demand surges as unfair, compared to price increases due to cost increases.
Framing prices as discounts rather than surge pricing may mitigate negative perceptions.
10.4 Behavioral Economics: Do People Make Rational Choices?
Behavioral Economics: Studies situations where people's choices don't appear economically rational.
Opportunity Cost: The value of the next best alternative that is foregone.
Sunk Cost: A cost that has already been incurred and cannot be recovered.
Consumers often make mistakes:
Ignoring nonmonetary opportunity costs.
Failing to ignore sunk costs.
Being unrealistic about future behavior.
Endowment Effect: People value goods they own more highly than goods they don't own.
People often have inconsistent preferences over time, leading to issues like overeating.
Nudges: Using behavioral insights to guide people toward better decisions (e.g., automatic enrollment in 401(k) plans).
Anchoring: Consumers often relate—or anchor—a product's value to another known value, especially when uncertain about its true worth.
Extra Solved Problem
Automatically enrolling employees in 401(k) plans increases participation rates because opting out requires confronting the inconsistency between short-term spending and long-term savings goals.
Employees may remain at the default savings rate (e.g., 3%) even if they would have chosen a higher rate initially, due to inertia and the intention to increase savings later.
Extra Apply the Concept
Vaccination:
Nudges, such as a video, financial incentives, and convenient links, were tested to increase COVID-19 vaccination rates.
The tested nudges did not significantly raise vaccination rates in a study with Medicaid recipients.
Appendix: Using Indifference Curves and Budget Lines to Understand Consumer Behavior
Consumer preferences rank combinations of goods by utility.
Preferences are assumed to be transitive: If A is preferred to B, and B to C, then A is preferred to C.
Indifference Curve: Shows combinations of goods that provide the same utility.
Consumers are indifferent between bundles on the same curve.
Curves further to the right represent greater utility.
Marginal Rate of Substitution (MRS): Rate at which a consumer will trade one good for another.
MRS decreases as an indifference curve becomes less steep (convex).
Indifference curves cannot cross, as it would violate transitivity.
Budget Constraint: Limits spending based on income.
Represented by a downward-sloping line; bundles on or inside the line are affordable.
Slope equals the negative ratio of prices.
Utility maximization occurs at the tangency between the budget line and the highest attainable indifference curve.
Demand curves slope downward because a price drop allows consumers to reach higher indifference curves, increasing quantity demanded.
The substitution effect of price change is measured by finding a point along the same indifference curve I1 and it's the change in consumption of pizza along I1.
The income effect of price change is measured by finding change in consumption from the tangency of the line parallel to the new budget line and I1 to the tangency of the new budget line and I2
Increased income shifts the budget line outward, allowing consumption on a higher indifference curve.
At optimal consumption:
MRS equals the ratio of prices.
Rate at which a consumer is willing to trade goods equals the rate at which they can trade them.
Marginal utility per dollar spent is the same for every good.
Rational Decision-Making
People are rational and use available information to achieve their goals, making decisions that maximize their utility.
Rational consumers and firms weigh costs and benefits to make optimal choices, such as Apple setting iPhone prices to maximize profit.
Example: A firm may analyze market trends and consumer preferences to adjust pricing strategies effectively.
Economic Incentives
Economic incentives influence behavior; individuals and firms change actions based on incentives.
Examples include government programs like Cash for Clunkers and COVID-19 stimulus checks that encourage consumer spending.
Unintended consequences can arise, such as increased tuition due to changes in the Federal Student Loan Program, leading students to borrow more.
Marginal Analysis
Optimal decisions are made at the margin, where individuals compare marginal costs (MC) and marginal benefits (MB).
Marginal cost refers to the additional cost incurred from producing one more unit, while marginal benefit is the additional satisfaction gained.
Marginal analysis helps in determining the point at which the benefit of an action equals its cost, guiding decision-making.
The Economic Problem That Every Society Must Solve
Fundamental Economic Questions
Every society must address three core questions: What goods and services will be produced? How will they be produced? Who will receive them?
Scarcity necessitates trade-offs; producing more of one good means producing less of another, highlighting the concept of opportunity cost.
Example: Allocating funds to space exploration may reduce funding for cancer research, illustrating opportunity cost.
Production Methods and Distribution
Firms choose different production methods based on cost-effectiveness, such as hiring skilled labor versus using technology like Auto-Tune in music production.
Distribution of goods and services often correlates with income levels, leading to debates on income inequality and redistribution policies.
Economic systems vary: centrally planned economies rely on government decisions, while market economies depend on individual choices.
Efficiency and Equity
Market economies promote productive efficiency (lowest cost production) and allocative efficiency (production aligns with consumer preferences).
Voluntary exchange benefits both buyers and sellers, enhancing overall welfare in transactions.
However, markets may not always be efficient, and government intervention can sometimes distort outcomes, raising equity concerns.
Economic Models and Analysis
Building Economic Models
Economists use models to analyze events and policies, starting with assumptions and formulating testable hypotheses.
Testing hypotheses with economic data allows for model revision, enhancing future analyses.
Behavioral assumptions include consumers maximizing well-being and firms maximizing profits.
Types of Economic Analysis
Positive analysis focuses on what is, while normative analysis addresses what ought to be, with economists primarily engaging in positive analysis.
Economic theory helps identify winners and losers in scenarios like tariffs, although policymakers may prioritize certain groups based on normative judgments.
Statistical methods are crucial for evaluating hypotheses and establishing causal relationships.
Economic Models
Economic models are simplified representations of reality used to analyze complex economic situations.
Developing a model involves making assumptions, formulating hypotheses, testing them with data, and revising the model as necessary.
Assumptions and Hypotheses
Assumptions simplify models, including behavioral assumptions about consumers and firms.
Economic variables are measurable quantities that can take on different values, and hypotheses are statements about these variables that can be tested.
Positive vs. Normative Analysis
Positive analysis focuses on what is, while normative analysis deals with what ought to be, with economics primarily using positive analysis to evaluate costs and benefits.
Microeconomics and Macroeconomics
Microeconomic Principles
Microeconomics studies individual choices made by households and firms, and their interactions in markets.
It examines how government policies influence these choices, impacting market dynamics and consumer behavior.
Understanding microeconomics is essential for analyzing specific market outcomes and consumer preferences.
Macroeconomic Overview
Macroeconomics looks at the economy as a whole, addressing issues like inflation, unemployment, and economic growth.
It provides a broader context for understanding economic trends and their implications for policy-making.
Macroeconomic indicators are vital for assessing overall economic health and guiding government interventions.
Important Economic Terms and Concepts
Key Economic Terms
Technology refers to the processes used in production, influencing efficiency and output.
Capital is defined as manufactured goods used to produce other goods and services, playing a crucial role in economic growth.
Understanding these terms is essential for grasping economic principles and their applications.
Using Graphs and Formulas
Graphs and formulas are tools for analyzing economic situations, with bar graphs and pie charts illustrating market data.
The slope of a line in a graph represents the rate of change, calculated as
Slope=ΔxΔy
.
Formulas for percentage change and area calculations are fundamental for economic analysis, aiding in data interpretation.
Understanding Markets and Health Issues
The Concept of Market
A market is defined as a group of buyers and sellers of a good or service that facilitates trade, impacting supply and demand dynamics.
Markets can be physical locations (like farmers' markets) or virtual platforms (like e-commerce websites).
The interaction between buyers and sellers determines prices and availability of goods and services.
Obesity and Health Insurance
Obesity is linked to serious health issues such as heart disease and diabetes, making it a significant public health concern.
Body Mass Index (BMI) is a key metric for assessing obesity, with a BMI of 30 or more indicating obesity. The formula for calculating BMI is:
BMI=(Weightinpounds/Heightininches2)×703
The rise in obesity rates can be attributed to factors like high-calorie diets, sedentary lifestyles, and reduced physical activity in workplaces.
Health insurance may inadvertently incentivize weight gain by lowering the financial burden associated with obesity-related health issues.
Research shows that individuals with health insurance are more likely to be overweight, with private insurance increasing BMI by 1.3 points and public insurance by 2.3 points.
Economic Problems and Resource Allocation
The Economic Problem
Societies face trade-offs due to limited resources, necessitating choices about production and consumption.
Opportunity cost is defined as the highest-valued alternative that is forgone when making a choice.
Societies must answer three fundamental questions: What goods and services will be produced? How will they be produced? Who will receive them?
Production Decisions
The goods and services produced are determined by consumer preferences, firm decisions, and government policies, each with associated opportunity costs.
Production methods are chosen by firms, balancing labor and machinery to optimize efficiency.
Income distribution plays a crucial role in determining who receives the produced goods and services, raising questions about government intervention.
Economic Systems
Centrally Planned Economies rely on government allocation of resources, while Market Economies depend on household and firm decisions.
In a market economy, income is influenced by the value of goods and services sold, with higher education and longer working hours typically leading to higher income.
The Mixed Economy combines market-driven decisions with government intervention to address social and environmental goals.
Microeconomics vs. Macroeconomics
Microeconomics
Microeconomics examines the choices of households and firms, their interactions in markets, and the influence of government policies.
It focuses on individual market dynamics and consumer behavior.
Macroeconomics
Macroeconomics studies the economy as a whole, addressing issues like inflation, unemployment, and overall economic growth.
It provides a broader perspective on economic performance and policy implications.
Graphical Analysis and Formulas
Using Graphs in Economics
Graphs are essential tools for visualizing economic relationships, such as demand and supply curves.
Types of graphs include bar graphs, pie charts, and time-series graphs, each serving different analytical purposes.
Understanding Slopes and Relationships
The slope of a line in a graph indicates the rate of change between two variables, calculated as
slope=ΔxΔy
.
Relationships can be positive (e.g., income and consumption) or negative (e.g., price and quantity demanded).
Formulas for Economic Calculations
Key formulas include those for percentage change:
Percentage change=Value in the first periodValue in the second period−Value in the first period×100
.
Area calculations for geometric shapes are also relevant, such as the area of a rectangle:
Base×Height
and a triangle:
21×Base×Height
.
Production Possibilities and Trade
Production Possibilities Frontier (PPF)
The PPF illustrates the maximum combinations of two goods that can be produced with available resources and technology.
Points on the PPF are attainable, while those below are inefficient and those above are unattainable.
Comparative Advantage and Trade
Trade is driven by specialization and comparative advantage, where individuals or countries focus on producing goods at lower opportunity costs.
Absolute advantage refers to the ability to produce more of a good with the same resources, while comparative advantage is about lower opportunity costs.
Comparative Advantage
Definition and Importance
Comparative advantage refers to the ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than competitors, making it a crucial concept in economics.
It serves as the foundation for trade, emphasizing that trade is beneficial when parties specialize in goods where they hold a comparative advantage rather than an absolute advantage.
For example, if Country A can produce wine at a lower opportunity cost than Country B, while Country B can produce cheese more efficiently, both countries benefit from trading wine for cheese.
This principle encourages specialization, leading to increased overall production and consumption in the economy.
Historical context: The concept was popularized by economist David Ricardo in the early 19th century, illustrating how nations can benefit from trade even if one is more efficient in producing all goods.
Case Study: The trade relationship between the U.S. and China, where each country specializes in different sectors, maximizing their economic output.
Trade-offs and Opportunity Costs
Trade-offs are the alternatives that must be given up when making a decision, closely linked to the concept of opportunity cost.
Opportunity cost is defined as the highest-valued alternative that must be sacrificed to engage in an activity, crucial for understanding economic choices.
For instance, if a farmer decides to grow corn instead of wheat, the opportunity cost is the amount of wheat that could have been produced.
The production possibilities frontier (PPF) is a graphical representation that illustrates these trade-offs and opportunity costs, showing the maximum attainable combinations of two goods.
Increasing marginal opportunity costs indicate that as production of one good increases, the opportunity cost of producing additional units rises, reflecting resource allocation efficiency.
Example: A PPF curve that shows the trade-off between producing cars and trucks, where moving resources from truck production to car production results in higher opportunity costs.
The Market System
Market Definition and Structure
A market is defined as a group of buyers and sellers of a good or service, along with the institutional arrangements that facilitate their trade.
The modern economy consists of two key groups: households, which provide factors of production, and firms, which purchase these factors to create goods and services.
The four factors of production include labor, capital, natural resources, and entrepreneurial ability, each playing a vital role in the economy.
Factor markets are where the factors of production are bought and sold, while product markets are where goods and services are exchanged.
The circular-flow diagram illustrates the interactions between households and firms, showing how money and resources flow in an economy.
Example: Households provide labor to firms, which in turn produce goods that households purchase, creating a continuous cycle of economic activity.
Market Mechanism and Flexibility
The market mechanism refers to how supply and demand interact to determine prices and allocate resources efficiently in a free market.
Flexible prices allow the market to respond to changes in consumer preferences and resource availability, signaling the relative worth of goods and services.
For instance, if there is a surge in demand for electric cars, firms will increase production in response to higher prices, demonstrating the self-regulating nature of markets.
Local knowledge is essential for adapting to changing market conditions, often leading to faster responses in market systems compared to centrally-planned economies.
Entrepreneurs play a critical role in the market system by combining factors of production to innovate and meet consumer needs, driving economic growth.
Example: The rise of tech startups in Silicon Valley illustrates how entrepreneurial ventures can rapidly adapt to market demands and technological advancements.
Production Possibilities and Economic Growth
Production Possibilities Frontier (PPF)
The PPF is a curve that shows the maximum combinations of two goods that can be produced with available resources and technology, illustrating concepts of efficiency and trade-offs.
Points on the frontier represent efficient production levels, while points inside indicate inefficiency, and points outside are unattainable given current resources.
The shape of the PPF can indicate increasing marginal opportunity costs, where reallocating resources from one good to another results in higher opportunity costs.
Economic growth can shift the PPF outward, indicating an increase in an economy's capacity to produce goods and services due to resource availability or technological advancements.
Example: A country investing in education and technology may experience economic growth, allowing it to produce more of both consumer and capital goods.
Graphical representation: A PPF graph showing the trade-off between consumer goods and capital goods, with shifts indicating growth.
Economic Growth and Its Implications
Economic growth is defined as the ability of an economy to produce increasing quantities of goods and services over time.
Growth can result from an increase in resources, such as labor and capital, or from technological advancements that enhance productivity.
The implications of economic growth include improved living standards, increased employment opportunities, and greater overall wealth in society.
However, growth can also lead to trade-offs, such as environmental degradation or income inequality, necessitating careful policy considerations.
Historical context: The Industrial Revolution marked a significant period of economic growth, transforming economies from agrarian to industrialized.
Example: The rapid economic growth in China over the past few decades has lifted millions out of poverty but also raised concerns about environmental sustainability.
Determining Cause and Effect
Inferring Cause and Effect from Graphs
Inferring cause and effect from graphs can be misleading due to omitted variables or reverse causality, which can lead to incorrect conclusions about relationships between variables.
It is crucial to consider external factors that may influence the observed data, as they can skew interpretations.
For example, a rise in ice cream sales may correlate with an increase in drowning incidents, but the underlying cause is the warmer weather, not a direct relationship between the two.
Understanding the context of data is essential for accurate analysis, especially in economic studies where multiple variables interact.
Are Graphs of Economic Relationships Always Straight Lines?
Few economic relationships are linear; however, linear approximations can simplify complex relationships for analysis.
Nonlinear relationships can provide more accurate representations of real-world scenarios, such as diminishing returns in production.
Economists often use linear models for ease of calculation, but they must be aware of their limitations and the potential for misinterpretation.
Slopes of Nonlinear Curves
The slope at a point on a nonlinear curve is determined by the slope of the tangent line at that point, which reflects the rate of change.
Understanding the slope is vital for analyzing marginal changes in economics, such as marginal cost and marginal benefit.
Nonlinear curves can illustrate concepts like increasing or decreasing returns to scale, which are important in production theory.
Formulas and Economic Concepts
Formula for a Percentage Change
The formula for calculating percentage change is:
Percentage change=Value in the first periodValue in the second period−Value in the first period×100
This formula is essential for understanding growth rates in economics, such as GDP growth or inflation rates.
Accurate calculation of percentage changes helps in comparing economic performance over time.
Formulas for Areas
Area of a rectangle:
Area=Base×Height
Area of a triangle:
Area=21×Base×Height
These formulas are fundamental in economics for calculating areas under curves in graphical representations, such as consumer surplus and producer surplus.
Summary of Using Formulas
Understanding the economic concept behind the formula is crucial for correct application.
Using the correct formula ensures accurate results, which are essential for sound economic analysis.
Results must be economically reasonable; unrealistic outcomes indicate a misapplication of the formula or misunderstanding of the underlying concepts.
Production Possibilities and Opportunity Costs
Production Possibilities Frontier (PPF)
The PPF is a curve that shows the maximum attainable combinations of two goods that can be produced with available resources and current technology.
It serves as a positive tool, illustrating 'what is' rather than 'what should be', helping to visualize trade-offs in production.
Points on the PPF represent efficient production, while points below indicate inefficiency, and points above are unattainable given current resources.
Opportunity Cost
Opportunity cost is defined as the highest-valued alternative that must be given up to engage in an activity, a key concept in economic decision-making.
Understanding opportunity costs helps individuals and firms make informed choices about resource allocation.
For example, if a farmer decides to grow corn instead of wheat, the opportunity cost is the profit that could have been earned from wheat.
Increasing Marginal Opportunity Costs
Increasing marginal opportunity costs occur because some resources are better suited for one task than another, leading to diminishing returns.
The PPF is typically bowed outward, reflecting that as more resources are allocated to one good, the opportunity cost of producing additional units increases.
This concept is crucial for understanding resource allocation and efficiency in production.
Comparative Advantage and Trade
Understanding Comparative Advantage
Comparative advantage is the ability to produce a good or service at a lower opportunity cost than competitors, forming the basis for trade.
It differs from absolute advantage, which is the ability to produce more of a good using the same resources.
Specialization based on comparative advantage allows individuals and countries to increase overall production and consumption.
Trade and Specialization
Trade enables individuals and countries to benefit from specialization, leading to increased efficiency and economic growth.
By focusing on what they do best, producers can trade for other goods and services, enhancing overall welfare.
For example, a country that specializes in technology can trade for agricultural products, benefiting both parties.
The Market System
The market system is defined as a group of buyers and sellers of a good or service, facilitating trade and economic activity.
Key components include households, which provide factors of production, and firms, which produce goods and services.
The circular-flow diagram illustrates the interactions between households and firms, highlighting the flow of goods, services, and money in the economy.
Understanding Trade and Its Benefits
The Concept of Trade
Trade is defined as the act of buying and selling goods and services, facilitating economic interactions.
It enhances individual and collective welfare by increasing production capabilities and consumption options.
Trade allows for specialization, where individuals or entities focus on producing goods they can create most efficiently.
Specialization and Gains from Trade
Specialization leads to increased efficiency and productivity, allowing for greater output of goods.
The Production Possibility Frontier (PPF) illustrates the maximum combinations of two goods that can be produced without trade.
Even if one party is more efficient in producing both goods, trade can still be beneficial if comparative advantages exist.
Absolute vs. Comparative Advantage
Absolute advantage refers to the ability to produce more of a good with the same resources compared to others.
Comparative advantage is when a party can produce a good at a lower opportunity cost than others, leading to mutually beneficial trade.
Understanding these concepts is crucial for analyzing trade dynamics and economic efficiency.
The Market System and Its Mechanisms
Basics of Market Systems
A market is defined as a collection of buyers and sellers interacting to exchange goods and services.
Product markets deal with tangible goods, while factor markets involve the inputs used in production, such as labor and capital.
The market system is essential for the allocation of resources and distribution of goods.
The Circular Flow of Income
The circular-flow diagram models the interactions between households and firms in both product and factor markets.
It illustrates how money flows through the economy, highlighting the interdependence of economic agents.
This model helps in understanding the dynamics of income generation and expenditure in an economy.
The Role of Free Markets
Free markets operate with minimal government intervention, allowing for efficient production and distribution of goods.
Adam Smith's seminal work, The Wealth of Nations, argues for the benefits of free markets and the 'invisible hand' guiding economic activity.
The assumption of rational self-interest among individuals is foundational to economic analysis in free markets.
The Role of Knowledge and Entrepreneurship in Markets
Mobilizing Knowledge in the Economy
Efficient economies require the processing of vast amounts of localized knowledge to respond to market changes.
Market systems are better equipped than centrally planned economies to utilize this knowledge effectively.
The ability to adapt and innovate based on local knowledge is crucial for economic success.
The Entrepreneurial Function
Entrepreneurs are vital in a market economy, combining resources to create goods and services.
They take risks to start businesses, responding to consumer demands and market opportunities.
The entrepreneurial spirit drives innovation and economic growth, making it a key component of market systems.
Legal Framework Supporting Market Systems
The Importance of Legal Structures
A successful market economy requires a legal framework that supports property rights and market operations.
Property rights allow individuals and businesses to control their resources, fostering investment and economic activity.
Intellectual property rights, such as patents and copyrights, incentivize innovation by protecting creators' rights.
Copyright and Its Implications
Copyright laws provide authors with exclusive rights to their works, encouraging creative investment.
Once copyright expires, works enter the public domain, allowing free access and use by the public.
The case of Arthur Conan Doyle illustrates the complexities of copyright duration and the rights of heirs.
Copyright and the Use of Sherlock Holmes
The Copyright Controversy
Doyle’s heirs require a fee of $5,000 for the use of Sherlock Holmes in new works, impacting authors and producers.
Notable adaptations include films starring Robert Downey, Jr. and television series like Sherlock and Elementary, all of which complied with the fee.
Leslie S. Klinger’s legal battle against Doyle’s heirs highlights the tension between copyright and public domain.
Federal Appeals Judge Richard Posner ruled in favor of Klinger, emphasizing that characters in the public domain cannot be monetized by heirs.
The ruling allows unrestricted use of Sherlock Holmes since 1887, marking a significant shift in copyright law.
This case illustrates the broader implications of copyright duration on public access to cultural works.
Implications of the Ruling
The ruling opens the door for new creative works featuring Sherlock Holmes without financial barriers.
It raises questions about the future of copyright law and its impact on creativity and innovation.
The decision reflects a growing sentiment against prolonged copyright terms that limit public access.
Authors and creators can now freely explore and reinterpret the character of Sherlock Holmes.
The case serves as a precedent for future copyright disputes involving public domain characters.
It highlights the balance between protecting creators' rights and ensuring public access to cultural heritage.
Feeding America and Market Mechanisms
Overview of Feeding America
Founded in 1979 by John van Hengel, Feeding America collects and distributes food donations to low-income families.
By 2004, the organization was distributing 1.8 billion pounds of food annually, but faced challenges in efficient allocation.
The initial allocation method was based on population numbers, leading to mismatches in food supply and local needs.
The organization sought to improve efficiency by consulting with economists from the University of Chicago.
The new system introduced a market-like mechanism for food allocation, allowing food programs to bid for food types.
This approach increased the efficiency of food distribution and reduced waste, benefiting more low-income families.
Market Mechanism Implementation
The new allocation system allowed food programs to use shares to bid for food, resembling market dynamics.
Programs with surplus food could sell it to others, creating a competitive environment for food distribution.
Preferences for certain food types, such as fresh produce, were reflected in the bidding process, leading to better matches with local needs.
The price differential between food types (e.g., fresh fruit vs. pasta) illustrated varying demand and preferences.
The system resulted in less food waste and encouraged more donations from organizations.
Critics of market mechanisms in charity began to support the new system due to its effectiveness.
Economics of Free Trade
The Case Against Tariffs
Tariffs are taxes on imports that can hinder free trade and economic efficiency.
A letter from former White House Council of Economic Advisors urged against steel tariffs, highlighting bipartisan agreement on the issue.
Economists argue that tariffs protect domestic industries but ultimately harm consumers and the economy.
Free trade allows countries to specialize in goods where they have a comparative advantage, enhancing overall welfare.
The positive economic analysis supports the idea that free trade leads to higher incomes for households.
Historical data shows that increased trade has significantly boosted U.S. household incomes since World War II.
Vulnerable Job Sectors
Jobs most at risk from imports are typically low-wage positions, as identified in studies cited by economists.
The impact of competition from foreign firms can lead to job losses in specific sectors, particularly manufacturing.
Understanding which jobs are vulnerable helps policymakers address the challenges posed by globalization.
The need for retraining and support for affected workers is crucial in a transitioning economy.
The discussion around free trade and job security remains a contentious issue in economic policy debates.
Balancing free trade benefits with domestic job protection is a key challenge for policymakers.
The Impact of International Trade on Income
Overview of Trade Effects
Ben Bernanke, former chair of the Federal Reserve Board, highlighted the significant impact of international trade on U.S. incomes since World War II.
A study cited by Bernanke indicates that increased trade has raised U.S. annual incomes by approximately $10,000 per household.
The same study suggests that eliminating remaining trade barriers could further increase incomes by $4,000 to $12,000 per household.
This underscores the economic benefits of trade liberalization and its potential to enhance living standards.
The findings reflect broader economic trends where trade can lead to greater efficiency and resource allocation.
Historical context: Post-World War II era marked a significant expansion in global trade, influencing domestic economies.
Vulnerability of Occupations to Trade
Bernanke also referenced a study identifying 21 U.S. occupations most vulnerable to foreign imports.
These occupations are primarily low-wage positions, indicating a correlation between job skill level and vulnerability to trade competition.
Higher skill requirements generally correlate with lower vulnerability to job loss due to imports.
This highlights the importance of education and skill development in mitigating the adverse effects of globalization.
Case Study: The manufacturing sector has seen significant shifts due to international competition, affecting low-skilled labor disproportionately.
Historical context: The rise of globalization in the late 20th century has reshaped labor markets, necessitating adaptation in workforce skills.
Understanding Demand in Economics
Demand Fundamentals
Demand refers to the consumer's willingness and ability to purchase goods and services at various prices.
Market Demand: The total demand from all consumers for a specific good or service.
Demand Schedule: A tabular representation showing the relationship between price and quantity demanded.
Demand Curve: A graphical representation illustrating the demand relationship, typically downward sloping due to the Law of Demand.
Quantity Demanded: The specific amount consumers are willing to buy at a given price, influenced by various factors.
Law of Demand and Its Explanations
The Law of Demand states that, ceteris paribus, a decrease in price leads to an increase in quantity demanded, and vice versa.
Mathematical Representation:
Qd=f(P)
, where
Qd
is quantity demanded and
P
is price.
Substitution Effect: Consumers will substitute cheaper goods for more expensive ones, affecting demand dynamics.
Income Effect: A price drop effectively increases consumer purchasing power, leading to higher demand for the good.
Ceteris Paribus Condition: This principle emphasizes that other factors must remain constant when analyzing price-demand relationships.
Factors Influencing Demand
Various factors can shift the demand curve, leading to changes in market demand.
Income: An increase in income raises demand for normal goods and decreases demand for inferior goods.
Prices of Related Goods: The demand for a product can increase if the price of a substitute rises or decrease if the price of a complement rises.
Tastes and Preferences: Changes in consumer preferences can significantly impact demand, as seen with trends influenced by advertising.
Population and Demographics: An increase in population or changes in demographic characteristics can lead to increased demand for certain goods.
Expected Future Prices: Anticipation of future price changes can influence current demand, as consumers may buy more if they expect prices to rise.
Supply Dynamics in Economics
Supply Fundamentals
Supply refers to the total amount of a good or service that firms are willing to sell at various prices.
Market Supply: The collective supply from all firms in the market for a specific good or service.
Supply Schedule: A table showing the relationship between price and quantity supplied.
Supply Curve: A graphical representation of the relationship between price and quantity supplied, typically upward sloping due to the Law of Supply.
Quantity Supplied: The specific amount that firms are willing to sell at a given price, influenced by various factors.
Law of Supply and Its Implications
The Law of Supply states that, ceteris paribus, an increase in price results in an increase in quantity supplied, and vice versa.
Mathematical Representation:
Qs=f(P)
, where
Qs
is quantity supplied and
P
is price.
This relationship indicates that higher prices incentivize producers to supply more of a good, reflecting production costs and profitability.
Factors Influencing Supply
Several factors can shift the supply curve, leading to changes in market supply.
Prices of Inputs: An increase in input prices (e.g., raw materials, labor) can decrease supply, while a decrease can increase it.
Technological Change: Innovations can enhance production efficiency, increasing supply.
Prices of Related Goods in Production: Changes in the profitability of alternative products can affect supply decisions.
Number of Firms: An increase in the number of firms in a market typically increases supply, while fewer firms decrease it.
Expected Future Prices: Anticipation of future price changes can lead firms to adjust current supply levels.
3.1 The Demand Side of the Market
Variables Influencing Demand
Price: The most significant factor affecting demand, where a decrease in price typically leads to an increase in quantity demanded and vice versa.
Income: Differentiates between normal goods (demand increases with income) and inferior goods (demand increases as income decreases).
Prices of Related Goods: Includes substitutes (goods used for the same purpose) and complements (goods used together), affecting demand shifts based on their price changes.
Tastes: Subjective preferences that can shift demand; increased preference leads to a rightward shift, while decreased preference leads to a leftward shift.
Population and Demographics: Characteristics such as age, race, and gender that influence overall demand in the market.
Expected Future Prices: Anticipations of future price changes can lead consumers to adjust their current demand.
Demand Schedules and Demand Curves
Demand Schedule: A tabular representation showing the relationship between price and quantity demanded, illustrating how demand varies with price changes.
Demand Curve: A graphical representation of the demand schedule, typically downward sloping, indicating the inverse relationship between price and quantity demanded.
Market Demand: The total demand from all consumers for a specific good or service, aggregating individual demands.
Law of Demand: States that, ceteris paribus, as price decreases, quantity demanded increases, and vice versa, highlighting the fundamental behavior of consumers.
Substitution Effect: Describes how consumers will replace more expensive items with cheaper alternatives, affecting quantity demanded.
Income Effect: Reflects how changes in price affect consumer purchasing power, influencing the quantity demanded.
Change in Demand vs. Change in Quantity Demanded
Change in Demand: Refers to a shift in the entire demand curve due to factors other than price, such as changes in consumer preferences or income.
Change in Quantity Demanded: A movement along the demand curve resulting solely from a change in the product's price, illustrating the law of demand.
Ceteris Paribus Condition: The assumption that all other variables remain constant when analyzing the relationship between price and quantity demanded.
Graphical Representation: Changes in demand are shown as shifts of the demand curve, while changes in quantity demanded are movements along the curve.
Examples: A rise in consumer income may shift the demand curve for normal goods to the right, while a price increase leads to a movement up along the same curve.
Implications for Businesses: Understanding these concepts helps firms predict consumer behavior and adjust their strategies accordingly.
3.2 The Supply Side of the Market
Variables Influencing Supply
Price: The primary factor affecting supply; higher prices typically incentivize producers to supply more of a good.
Prices of Inputs: Changes in the cost of production inputs can shift the supply curve; higher input prices shift the supply curve left, while lower prices shift it right.
Technological Change: Innovations can enhance production efficiency, shifting the supply curve to the right as firms can produce more at lower costs.
Prices of Related Goods in Production: Includes substitutes and complements in production; changes in their prices can affect the supply of the primary good.
Number of Firms in the Market: An increase in the number of firms typically shifts the supply curve to the right, while firm exits shift it left.
Natural Disasters and Pandemics: These events can disrupt production, leading to a decrease in supply.
Supply Schedules and Supply Curves
Supply Schedule: A table that illustrates the relationship between the price of a product and the quantity supplied, showing how supply varies with price changes.
Supply Curve: A graphical representation of the supply schedule, usually upward sloping, indicating a direct relationship between price and quantity supplied.
Law of Supply: States that, ceteris paribus, an increase in price results in an increase in quantity supplied, and a decrease in price results in a decrease in quantity supplied.
Market Supply: The total supply from all producers in the market for a specific good, aggregating individual supply curves.
Graphical Analysis: Understanding shifts in the supply curve versus movements along the curve is crucial for analyzing market behavior.
Examples: A rise in the price of a substitute in production may lead to a leftward shift in the supply curve for the original product.
Change in Supply vs. Change in Quantity Supplied
Change in Supply: A shift in the entire supply curve due to factors other than price, such as changes in production technology or input costs.
Change in Quantity Supplied: A movement along the supply curve resulting solely from a change in the product's price, illustrating the law of supply.
Graphical Representation: Changes in supply are depicted as shifts of the supply curve, while changes in quantity supplied are movements along the curve.
Implications for Producers: Understanding these concepts helps producers make informed decisions about production levels based on market conditions.
Examples: A technological advancement may shift the supply curve to the right, while an increase in input costs may shift it to the left.
Market Dynamics: Recognizing the difference between these changes is essential for predicting market behavior.
3.3 Market Equilibrium: Putting Demand and Supply Together
Market Equilibrium
Definition: Market equilibrium occurs when the quantity demanded equals the quantity supplied, resulting in a stable market price.
Competitive Market Equilibrium: A specific type of market equilibrium characterized by many buyers and sellers, where no single entity can dictate prices.
Surplus: A situation where quantity supplied exceeds quantity demanded, leading to downward pressure on prices as sellers compete to sell their excess inventory.
Shortage: A situation where quantity demanded exceeds quantity supplied, resulting in upward pressure on prices as sellers recognize the opportunity to increase prices.
Price Determination: Prices are determined by the interaction of supply and demand; neither buyers nor sellers can unilaterally set prices in a competitive market.
Market Adjustments: The market naturally adjusts to reach equilibrium through changes in price and quantity traded.
The Effect of Demand and Supply Shifts on Equilibrium
Predictions with Demand and Supply Graphs: Understanding the shapes of demand and supply curves allows for predictions about price and quantity changes in the market.
Increase in Demand: If demand for a good increases (e.g., reusable water bottles), the demand curve shifts right, leading to higher equilibrium price and quantity.
Increase in Supply: An increase in supply (e.g., new producers entering the market) shifts the supply curve right, resulting in lower equilibrium price and higher quantity.
Simultaneous Shifts: When both demand and supply increase, equilibrium quantity will rise, but the effect on price depends on the relative shifts of the curves.
Ambiguous Price Effects: If demand shifts more than supply, both price and quantity rise; if supply shifts more than demand, quantity rises but price falls.
Graphical Analysis: Visualizing these shifts helps in understanding the complex interactions in the market.
Shifts of a Curve vs. Movements Along a Curve
Understanding Shifts: An increase in supply shifts the supply curve right, increasing equilibrium quantity and decreasing equilibrium price.
Movement Along the Demand Curve: A decrease in price leads to a movement along the demand curve, indicating how much consumers want to buy at the new price.
Demand Curve Stability: The demand curve itself does not shift with price changes; it reflects consumer behavior at various price points.
Graphical Representation: Distinguishing between shifts and movements is crucial for accurate market analysis and predictions.
Examples: A price drop in water bottles may lead to increased quantity demanded without shifting the demand curve itself.
Market Implications: Understanding these concepts is vital for businesses to strategize pricing and production effectively.
Understanding Market Equilibrium
Market equilibrium occurs when the quantity demanded equals the quantity supplied, resulting in a stable market price.
Competitive market equilibrium involves many buyers and sellers, ensuring no single entity can dictate prices.
The equilibrium price is determined by the intersection of the supply and demand curves, reflecting the market's balance.
Surpluses and Shortages
Surplus occurs when the quantity supplied exceeds quantity demanded, leading firms to lower prices to stimulate sales.
Shortage arises when quantity demanded surpasses quantity supplied, prompting firms to raise prices due to excess demand.
Both surpluses and shortages indicate market inefficiencies that can lead to adjustments in price and quantity.
The Role of Demand and Supply in Equilibrium
Neither consumers nor firms can solely dictate the equilibrium price; it is a result of their interactions in the market.
Changes in either demand or supply can shift the equilibrium point, affecting prices and quantities in the market.
Effects of Demand and Supply Shifts on Equilibrium
An increase in demand (rightward shift) results in higher equilibrium price and quantity, while a decrease (leftward shift) leads to lower equilibrium price and quantity.
An increase in supply (rightward shift) lowers equilibrium price and raises quantity, whereas a decrease (leftward shift) raises price and lowers quantity.
Simultaneous shifts in demand and supply can complicate predictions about equilibrium changes, depending on the magnitude of each shift.
6.1 The Price Elasticity of Demand and Its Measurement
Definition and Importance of Elasticity
Elasticity measures the responsiveness of one economic variable to changes in another, crucial for understanding market dynamics.
Price elasticity of demand specifically assesses how quantity demanded responds to price changes, guiding pricing strategies.
Measuring Price Elasticity of Demand
Calculated by dividing the percentage change in quantity demanded by the percentage change in price, providing a clear measure of responsiveness.
The price elasticity of demand is typically negative, but absolute values are often used for comparison.
Types of Demand Elasticity
Elastic Demand: When the percentage change in quantity demanded exceeds the percentage change in price (elasticity > 1).
Inelastic Demand: When the percentage change in quantity demanded is less than the percentage change in price (elasticity < 1).
Unit-Elastic Demand: When the percentage changes in quantity demanded and price are equal (elasticity = 1).
The Midpoint Formula for Elasticity
The midpoint formula provides a consistent elasticity value between two points, avoiding discrepancies in calculations.
Formula:
PriceextElasticityextofextDemand=(P2+P1)/2P2−P1(Q2+Q1)/2Q2−Q1
This formula uses averages of initial and final quantities and prices to yield a single elasticity value.
6.2 The Determinants of the Price Elasticity of Demand
Key Determinants of Elasticity
Availability of Close Substitutes: More substitutes lead to more elastic demand; fewer substitutes result in less elastic demand.
Passage of Time: Demand becomes more elastic over time as consumers find alternatives.
Luxuries vs. Necessities: Luxury goods tend to have more elastic demand compared to necessities.
Market Definition and Budget Share
The more narrowly defined the market, the more elastic the demand tends to be, as consumers have more alternatives.
A larger share of a good in a consumer's budget results in more elastic demand, as price changes significantly impact purchasing decisions.
Estimated Price Elasticities of Demand
Estimates of price elasticity can vary based on data sources and time periods, reflecting changing consumer behavior and market conditions.
6.3 The Relationship between Price Elasticity of Demand and Total Revenue
Total Revenue and Demand Elasticity
Total Revenue (TR) is calculated as price multiplied by quantity sold (TR = Price * Quantity).
Inelastic Demand: Price increases lead to higher total revenue, while price decreases lead to lower total revenue.
Elastic Demand: Price increases result in lower total revenue, while price decreases lead to higher total revenue.
Elasticity and Revenue with Linear Demand Curves
Elasticity is not constant along most demand curves; it varies with price and quantity levels.
At high prices and low quantities, demand is typically elastic; at low prices and high quantities, demand is usually inelastic.
6.4 Other Demand Elasticities
Cross-Price Elasticity of Demand
Measures the responsiveness of the quantity demanded of one good to a change in the price of another good.
Formula:
Cross−PriceextElasticityextofextDemand=% Change in Price of Good B% Change in Quantity Demanded of Good A
Positive cross-price elasticity indicates substitutes; negative indicates complements.
Income Elasticity of Demand
Measures the responsiveness of quantity demanded to changes in income.
Formula:
IncomeextElasticityextofextDemand=% Change in Income% Change in Quantity Demanded
Normal goods have positive income elasticity; necessities have elasticity less than 1, while luxuries have elasticity greater than 1.
6.5 Using Elasticity to Analyze the Disappearing Family Farm
Historical Context and Economic Impact
From 1950 to 2022, the number of family farms decreased significantly due to economic pressures.
Rapid growth in farm output combined with low price and income elasticities made family farming increasingly difficult.
Increased wheat production led to price declines, as demand for wheat is price inelastic and income elasticity is low.
6.6 The Price Elasticity of Supply and Its Measurement
Understanding Price Elasticity of Supply
Measures how much quantity supplied increases in response to price increases, reflecting producers' responsiveness.
Formula:
PriceextElasticityextofextSupply=% Change in Price% Change in Quantity Supplied
Due to the law of supply, price elasticity of supply is always positive.
Determinants of Price Elasticity of Supply
Depends on firms' ability and willingness to adjust production levels in response to price changes.
Supply is generally inelastic in the short term but becomes more elastic in the long term as firms adjust.
Polar Cases of Supply Elasticity
Perfectly Inelastic Supply: Represented by a vertical supply curve, indicating no change in quantity supplied regardless of price changes.
Perfectly Elastic Supply: Represented by a horizontal supply curve, indicating infinite responsiveness to price changes.
Price Elasticity of Demand
Definition and Formula
Price elasticity of demand measures the responsiveness of quantity demanded to price changes, calculated as:
Priceelasticityofdemand=PercentagechangeinpricePercentagechangeinquantitydemanded
The elasticity is typically negative due to the inverse relationship between price and quantity on the demand curve.
Understanding elasticity helps businesses and policymakers make informed decisions regarding pricing strategies.
Types of Demand Elasticity
Elastic Demand: Occurs when the absolute value of price elasticity is greater than 1. A 10% price increase leads to a greater than 10% decrease in quantity demanded.
Inelastic Demand: Price elasticity is less than 1, indicating that quantity demanded is less responsive to price changes.
Unit-Elastic Demand: Price elasticity equals 1, meaning percentage changes in price and quantity demanded are equal.
Midpoint Formula
The midpoint formula ensures consistent elasticity calculations regardless of direction:
Percentagechange=(QA+QB)/2QB−QA×100
For elasticity:
Priceelasticityofdemand=(P1+P2)/2P2−P1(Q1+Q2)/2Q2−Q1
This formula is particularly useful for calculating elasticity between two points on a demand curve.
Solved Example
Example: Price of Coca-Cola drops from $1.50 to $1.30, increasing sales from 2,000 to 2,500 gallons.
Average quantity = 2,250, Average price = $1.40.
Percentage change in quantity demanded = 22.2%, Percentage change in price = -14.3%.
Price elasticity of demand = -1.6, indicating elastic demand since 1.6 > 1.
Determinants of Price Elasticity of Demand
Key Determinants
Availability of Close Substitutes: More substitutes lead to higher elasticity. For example, gasoline has few substitutes, making its demand inelastic, while branded sneakers like Nikes have many substitutes, resulting in elastic demand.
Passage of Time: Elasticity increases over time as consumers adjust their habits. For instance, rising gasoline prices may lead consumers to buy fuel-efficient cars in the long run.
Luxury vs. Necessity: Luxuries tend to have higher elasticity compared to necessities like milk and bread, which have inelastic demand.
Market Definition and Budget Share
Definition of the Market: Narrowly defined markets tend to have more elastic demand. For example, demand for a specific brand of jeans can be elastic, while demand for jeans in general is often inelastic.
Share of a Good in a Consumer’s Budget: Goods that constitute a small portion of the budget tend to have inelastic demand, as consumers are less sensitive to price changes.
Total Revenue and Price Elasticity
Relationship Overview
Total Revenue: Calculated as price per unit multiplied by the number of units sold. Understanding elasticity helps predict how total revenue changes with price adjustments.
If demand is inelastic, lowering prices may decrease total revenue as the increase in quantity sold does not compensate for the lower price.
Conversely, if demand is elastic, lowering prices can increase total revenue as the increase in quantity sold more than offsets the price drop.
Other Demand Elasticities
Cross-Price and Income Elasticity
Cross-Price Elasticity of Demand: Measures the responsiveness of quantity demanded of one good to the price change of another. Positive for substitutes, negative for complements, and zero for unrelated goods.
Income Elasticity of Demand: Indicates how quantity demanded changes with income changes. Normal goods have positive elasticity, while inferior goods have negative elasticity.
Consumer Decision Making and Utility
Utility Concepts
Utility: Satisfaction derived from consuming goods and services. Marginal utility (MU) is the additional satisfaction from consuming one more unit.
Law of Diminishing Marginal Utility: As consumption increases, the additional satisfaction from each additional unit decreases.
Budget Constraint: Limits consumer spending based on income, requiring consumers to make choices about their consumption.
Maximizing Utility
Rule of Equal Marginal Utility per Dollar Spent: Consumers maximize utility by ensuring the last unit of each good consumed provides equal utility per dollar spent.
If the rule is not satisfied, consumers can increase utility by reallocating their spending.
Behavioral Economics and Decision Making
Behavioral Insights
Behavioral Economics: Examines how psychological factors influence economic decisions, often leading to irrational choices.
Nudges: Subtle policy shifts that encourage people to make decisions that are in their broad self-interest, such as automatic enrollment in retirement plans.
Endowment Effect: People value items they own more than equivalent items they do not own, leading to inconsistent preferences over time.
Indifference Curves and Budget Lines
Understanding Consumer Preferences
Indifference Curves: Graphical representations of combinations of goods that provide the same level of utility. Curves further to the right indicate higher utility.
Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade one good for another, which decreases as more of one good is consumed.
Budget Constraints and Utility Maximization
Budget Constraint: Represents the combinations of goods that a consumer can afford, depicted as a downward-sloping line.
Utility maximization occurs at the tangency point between the budget line and the highest attainable indifference curve, where MRS equals the price ratio.
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