CHAPTER 1

Economics  For whom are goods produced?

- Study of how societies use scarce resources to Types of economy/ Ways of organizing an economy
produce valuable goods & services and  Market Economy
distribute them among different individuals - Most economic questions are settled by
- Explains the differences in state of welfare the market mechanism
- Explains why people trade - Decisions are made in markets, where
- Examines how government policies can be individuals or enterprises voluntarily agree
used to pursue goals such as growth to exchange goods and services, usually
 Utility –objective measure of well-being through payments of money and
 Happiness – subjective measure bargaining
- Studies the behavior of economic agents - System of prices, of markets, of profits and
 Consumer maximizes individual’s utility or losses, of incentives and rewards
happiness determine the what, how, and for whom
 Firm : profit - Firms produce the commodities that yield
 Government : social welfare the highest profits (the what) by the
- Towards the pursuit of benefits – welfare, techniques of production that are least
happiness costly (the how). Consumption is
- Uses models as representations (simplification determined by individuals' decisions about
of the world) in explaining the behavior how to spend the wages and property
- Fundamental problem: How to use scarce incomes generated by their labor and
resources efficiently property ownership (the for whom)
- 2 basic subfields: - The extreme case of market economy, in
 Microeconomics which the government keeps its hands off
- Concerned with the behavior of economic decisions is called a laissez-faire
individual identities such as markets, economy (‘leave us alone’)
firms, and households  Command Economy
 Macroeconomics - A central identity (Government) makes
- Views the performance of the most economic (production and
economy as a whole distribution) decisions
- Main objective: improve living conditions of - The government answers the major
people; increase welfare economic questions through its ownership
‘Scarcity’ of resources and its power to enforce
- Limited amount of goods & services relative to decisions
desires; constraints - Ex. Communism
‘Efficiency’  Mixed Economy
- Maximum extent possible; Most effective use - When an economy does not fall
of a society’s resources in satisfying people’s completely into either of the two polar
wants and needs categories
Logical Fallacies - Government oversees the functioning of
 Post hoc Fallacy (non sequitur) the market, regulates interaction through
- Making conclusions just because two creation of laws; controls pollution
events occur in sequence - Most societies today operate mixed
(Event X Event Y) economies
- The first event caused the second event
 Failure to hold other things constant (ceteris  Faced with the undeniable fact that goods are
paribus) scarce relative to wants, an economy must decide
 Fallacy of composition (generalization) how to cope with limited resources.
- What is true for a part is true for the whole  It must choose among different potential bundle of
goods (the what), select from different techniques
Three Fundamental Economic Problems of production (the how), and decide in the end who
 What goods to produce and how much? will consume the goods (for whom)
 How to produce? ‘Inputs’
 - Commodities or services used to produce ‘Opportunity Cost’
goods and services - In a world of scarcity, choosing one thing
- Also called as the factors of production means giving up something else (trade-off)
 Land - Value of the next-best good or service that is
- Natural resources; Relatively fixed forgone
 Labor - Can be illustrated using PPF
- Human time spent in production ‘Efficiency’
 Capital - Economy’s resources are being used as
- Form the durable goods of an economy effectively as possible to satisfy people’s
- Produced in order to produce yet desires
another goods - One important aspect of overall economic
‘Outputs’ efficiency is productive efficiency
- Various useful goods or services that result Productive Efficiency
from the production process and are either - Occurs when an economy cannot produce
consumed or employed in further production more of one good without producing less of
Production Possibility Frontier (PPF) another good
- Shows the maximum quantity of a pair of - The economy is on its production-possibility
goods that can be efficiently produced by an frontier (efficient), rather than inside
economy, given its technological knowledge (inefficient)
and the quantity of available inputs Why study economics?
- Reflects the menu of choice for the economy - To understand how the powerful ideas of
- It is a visual device for showing what types of economics apply to the central issues of human
goods are available in what quantities societies
- Being on the PPF means that producing more
of one good inevitably requires sacrificing SUMMARY
other goods  Goods are scarce because people desire much
- Application: more than the economy can produce
 Private goods vs Public goods  Economic goods are scarce, not free, and society
Poor countries can afford little of public must choose among the limited goods that can be
goods but with economic growth, public produced with its available resources
goods take a larger share of output  Every society must answer three fundamental
 Current-consumption goods vs capital questions: what, how, and for whom
By sacrificing current consumption and  Societies answer these questions in different
producing more capital goods, a nation’s ways: command & market
economy can grow more rapidly, making Command economy is directed by centralized
possible more of both goods in the future government control; Market economy is guided
by an informal system of prices and profits in
which most decisions are made by private
individuals and firms; all societies are mixed
economies with varying combinations of the two
 PPF shows how the production of one good is
traded off against the production of another good
 The value of the good or service forgone is the
opportunity cost
 Productive efficiency occurs when production of
one good cannot be increased without curtailing
production of another good; This is illustrated by
the PPF
 Points outside the frontier (I) are infeasible or
 Societies are sometimes inside their PPF because
unattainable
of macroeconomic business cycles or
 Any point inside the curve (U) indicates that
microeconomic market failures
the economy has not attained productive
efficiency
 CHAPTER 2
Market Economy The Dual Monarchy
- No single individual or organization or - Tastes as expressed in the dollar votes of
government is responsible for production, consumer demands
consumption, distribution, or pricing - Resources and technology
- Individuals and firms engage in voluntary trade
coordinated by a system of prices and markets
Market
- Mechanism through which buyers and sellers
interact to determine prices and exchange
goods and services or assets
- May be centralized (stock market) or
decentralized (most)
- Central role: determine prices
Price
- Value of the good in terms of money
- Represents the ‘terms of trade’ – the value at
which exchange occurs
- Serve as signals to producers and consumers
 If consumers want more of any good, the
price will rise, sending a signal to
producers that more supply is needed
Circular Flow of a Market Economy
- Coordinate the decisions of producers and
- Product Markets: flow of outputs; Factor
consumers in a market
Markets: markets for inputs or factors of
 Higher prices tend to reduce consumer
production
purchases and encourage production
- Consumers buy goods and sell factors of
 Lower prices encourage consumption and
production; Firms sell goods and buy factors of
discourage production
production
- The balance wheel of the market mechanism
- Consumers use their income from the sale of
Market Equilibrium
labor and other inputs to buy goods from firms;
- Represents a balance among all the different
Firms base their prices of goods on the costs of
buyers and sellers
labor and property
- Price at which buyers desire to buy exactly the
- Prices in goods market are set to balance
quantity that sellers desire to sell (supply &
consumer demand with firm supply; Prices in
demand)
factor markets are set to balance household
How Markets Solve the Three Economic Problems
supply with business demand
 What goods and services will be produced is
Invisible Hand
determined by the money votes of consumers
- Private interest can lead to public gain when it
in their daily purchase decisions; Firms are
takes place in a well-functioning market
motivated by the desire to maximize profits –
mechanisms
net revenues, or the difference between total
- Under perfect competition and with no market
sales and total costs
failures, markets will squeeze as many useful
 How things are produced is determined by the goods and services out of the available
competition among different producers resources as is possible. Otherwise, the
- Keep costs at a minimum by adopting the remarkable efficiency properties of the
most efficient methods of production invisible hand may be destroyed
- Technological advancements Market Failure
 For whom things are produced depends on the - Markets do not always lead to the most
supply and demand in the markets for factors efficient outcome
of production - Monopolies, imperfect competition,
- Factor markets determine wage rates, land externalities
rents, interest rates, and profits : factor
prices Modern Economy
 - Elaborate network of trade that depends on - Promote equity by using tax and expenditure
specialization and an intricate division of labor programs to redistribute income toward
- Make extensive use of money – yardstick for particular groups
measuring economic values and is the means - Foster macroeconomic stability and growth –
of payment reducing unemployment and inflation while
- Use vast stocks of capital encouraging economic growth – through fiscal
‘Specialization’ and monetary policy
- Occurs when people and countries concentrate ‘Efficiency’
their efforts on a particular set of tasks  Perfect Competition
- Use to best advantage the specific skills and - A market in which no firm is or consumer
resources that are available is large enough to affect the market price
- Allows the intricate network of trade - Invisible hand doctrine applies
‘Division of labor’ - Produces an efficient allocation of
- Dividing a production into a number of small resources, economy lies on its PPF
specialized steps or tasks ‘Inefficiency’
*Specialization and trade are the key to high living  Imperfect Competition
standards - Occurs when a buyer or seller can affect a
Money good’s price
- Allows people to trade their specialized - Society may move inside its PPF
outputs for the vast array of goods and services - Leads to prices that rise above cost and to
produced by others consumer purchases that are reduced
- Means of payment in the form of currency and below efficient levels
checks used to buy things - Too high price, too low output
- Lubricant that facilitates exchange - Monopolist: A single supplier who alone
- Acts as a matchmaker between buyers and determines the price of a particular good
sellers or service
- Government controls money supply through - Gov’t’s role: encourage competition
their central banks  Externalities (Spill-over Effects)
Capital - Occur when firms or people impose costs
- A produced and durable input which is itself an or benefits on others outside the
output of the economy marketplace
- Machines, buildings, computers, software, … - Gov’t’s role: intervene in markets
- Has to be produced before you can use it  Public Goods
‘Poverty trap’ - Polar case of a positive externality
- Low incomes and few productive outlets for - Commodities which can be enjoyed by
their savings, save and invest little, grow slowly everyone and from which no one can be
*Economic activity involves foregoing current excluded
consumption to increase our capital. Investing enhances - Ex. National defense
the future productivity of our economy and increases - The cost of extending the service to an
future consumption additional person is zero (non-rivalry)
Property Rights - Impossible to exclude individuals from
- Bestow on their owners the ability to use, enjoying it (non-excludability)
exchange, paint, dig, drill, or exploit their Taxes
capital goods - Where government’s revenues to pay for
Capitalism its public goods and for its income-
- Ability of individuals to own and profit from redistribution programs come from
capital - The price we pay for public goods
- Difference from prices is that taxes are not
Governments voluntary: Everyone is subject to the tax
- Increase efficiency by promoting competition, laws ; we are all obligated to pay for our
curbing externalities, and providing public share of the cost of public goods
goods ‘Equity’
 - Markets do not necessarily produce a fair government regulates social conditions and
distribution of income. A market economy may provides pensions, health care, and other
produce unacceptable inequalities in income necessities for poor families
and consumption Socialism
- The resulting income distribution may not - State owns, operates, and regulates much of
correspond to a fair outcome the economy
- Market mechanism: Goods follow money votes
and not the greatest need SUMMARY
- Even the most efficient market system may  Markets are mechanisms through which buyers and
generate great inequality sellers meet to trade and to determine prices and
- Tools the government can use to reduce quantities for goods and services
income inequality: Redistribute income  Invisible hand of markets would lead to the optimal
 Progressive taxation economic outcome as individuals pursue their own
- Taxing large incomes at a higher rate self-interest
than small incomes  Some key features of a modern economy:
- Impose heavy taxes on wealth or on Specialization and the division of labor among
large inheritances to break the chain people and countries create great efficiencies;
of privilege increased production makes trade possible; money
 Transfer payments allows trade to take place efficiently; and a
- Money payments to people sophisticated financial system allows people's
- Provides a safety net to protect the savings to flow smoothly into other people's
unfortunate from privation capital.
 Subsidy  The rules that define how capital and other assets
- Subsidize consumption of low-income can be bought, sold, and used are the system of
groups by providing food stamps, property rights
subsidized medical care, and low-cost  Government may step in to correct market failures;
housing Roles: ensure efficiency, correct unfair distribution
- Role of econ: analyze the costs and benefits of of income, promote economic growth and stability
different redistributive systems, impact of  Imperfect competition, such as monopoly,
different tax systems; more efficient way of produces high prices and low levels of output
reducing poverty Gov’t: Regulate businesses or put legal antitrust
‘Macroeconomic growth and stability’ constraints on business behavior
- Fluctuations : business cycles – high inflation &  Externalities arise when activities impose costs or
unemployment bestow benefits that are not paid for in the market
- Through fiscal and monetary policies, place
government can influence the level of total Gov’t: regulate these spillovers (air pollution) or
spending, the rate of growth and level of provide for public goods (public health)
output, the levels of employment and  Gov’t on unequal distribution of income: Can alter
unemployment, and the price level and rate of the pattern of incomes (for whom) generated by
inflation in an economy market wages, rents, interest, and dividends; Use of
- Fiscal policies: power to tax and power to taxation to raise revenues for transfers or income-
spend support programs that place a financial safety net
- Monetary policy: determining supply of money under the needy
and interest rates; affect investment in capital  Gov’t: Macroeconomic policies for stabilization and
- Macroeconomic policies to promote long-term economic growth include fiscal policies (of taxing
objectives: economic growth and productivity and spending) along with monetary policies (which
- Econ growth: growth in a nation’s total output affect interest rates and credit conditions)
- Productivity: output per unit input; efficiency
 An efficient and humane society requires both
with which resources are used halves of the mixed system – market and
Welfare State government. Operating a modem economy without
- Is one in which markets direct the detailed both is like trying to clap with one hand
activities of day-to-day economic life while
 CHAPTER 3
Consumer sovereignty operating through dollar votes  Prices and availability of related goods
determines what gets produced and where the goods - Substitute goods: demand for Good A
go, but technologies influence costs, prices, and what tends to be low if the price of
goods are available substitute product B is low
Theory of Supply & Demand  Tastes or Preferences
- Shows how consumer preferences determine - A variety of cultural and historical
consumer demand for commodities, while influences, trends
business costs are the foundation of the supply  Special influences
of commodities - Seasons,
- Changes in supply and demand drive changes Shifts in Demand Curve
in output and prices - When there are changes in factors other than a
Demand Schedule good’s own price which affect the quantity
- Relationship between price and quantity purchased
demanded - A change in demand
- The higher the price, the fewer units - Demand increases (decreases) when the
consumers are willing to buy quantity demanded at each price increases
Demand Curve (decreases)
- Graphical representation of the demand Movements along Curve
schedule - Change in quantity demanded
Law of downward-sloping demand - Occurs after a price change alone
- When the price of a commodity is raised (and
other things are held constant), buyers tend to Supply Schedule
buy less of the commodity. Similarly, when the - Shows the relationship between its market
price is lowered, quantity demanded increases price and the amount of that commodity that
- Quantity and price are inversely related. producers are willing to produce and sell, other
- P  Q  things held constant
- Reasons: Supply Curve
 Substitution Effect - Upward sloping
- When the price of a good rises, consumers Reason: Law of diminishing returns
will tend to substitute other goods for the Determinants of Supply:
more expensive good in order to satisfy  Cost of production
their desires more inexpensively - When production costs for a good are low
- Ex. As the price of beef rises, I eat more relative to the market price, it is profitable
chicken for producers to supply a great deal
 Income Effect - When production costs are high relative to
- When a price goes up, I find myself price, firms produce little, switch to the
somewhat poorer than I was before production of other products, or may
because I cannot buy the same quantity of simply go out of business
goods as before - Determined by the prices of inputs and
Market Demand Curve technological advances which are changes
- Found by adding together the quantities that lower the quantity of inputs needed
demanded by all individuals at each price to produce the same quantity of output
- Obeys the law of downward-sloping demand  Prices of related goods
Determinants of Demand: - If the price of one production substitute
 Average income of consumers rises, the supply of another substitute will
- As people’s incomes rise, individuals decrease
tend to buy more of almost  Government policy
everything, even if prices don’t change - Trade policies
 Size of the market  Special influences
- Measured by the population - Weather
- A growth in population increases Shifts in Supply
demand
 - When changes in factors other than a good’s  Supply falls  demand curve shifts to the left 
own price affect the quantity supplied Price  Quantity 
- Supply increases (decreases) when the amount Immigration
supplied increases (decreases) at each market - Shifts the supply curve for labor to the right
price and pushes down wages
Rationing by the purse
Market equilibrium - By determining the equilibrium prices and
- Comes at that price and quantity where the quantities, the market allocates or rations out
forces of supply and demand are in balance the scarce goods of the society among the
- At the equilibrium price, the amount that possible uses
buyers want to buy is just equal to the amount - The marketplace, through the interaction of
that sellers want to sell supply and demand, does the rationing
- No tendency for the price to rise or fall, as long - What: those who have the most dollar votes
as other things remain unchanged have the greatest influence on what goods are
Equilibrium Price produced
- Also called the market-clearing price - For whom: The power of the purse dictates the
- Denotes that all supply and demand orders are distribution of income and consumption
filled, the books are cleared of orders, and - How: decided through the help of supply and
demanders and suppliers are satisfied demand

SUMMARY
 A market blends together demands and supplies.
Demand comes from consumers who are spreading their
dollar votes among available goods and services, while
businesses supply the goods and services with the goal of
maximizing their profits
 A demand schedule shows the relationship between the
quantity demanded and the price of a commodity, other
things held constant, which is depicted graphically by a
demand curve
 Law of downward-sloping demand: Quantity demanded
falls as a good's price rises
 Influences behind the demand schedule: average family
incomes, population, the prices of related goods, tastes,
and special influences. When these influences change,
the demand curve will shift.
 The supply schedule (or supply curve) gives the
 Market equilibrium price and quantity come at the relationship between the quantity of a good that
intersection of the supply and demand curves producers desire to sell – other things constant – and
 Shortage: When the price is too low, quantity that good's price
demanded exceeds quantity supplied; price tends  Quantity supplied generally responds positively to price,
to move upward due to competition among buyers so the supply curve is upward-sloping
for limited goods  Elements affecting supply other than the good’s price:
production cost (determined by the state of technology
 Surplus: When the price is too high, quantity
and by input prices), prices of related goods, government
supplied exceeds quantity demanded; price tends policies, special influences
to move downward  Equilibrium: at the intersection of the supply & demand
Effect of a shift in supply or demand curves
 Demand rises  demand curve shifts to the right  Equilibrium Price: Price at which the quantity demanded
 Price  Quantity  just equals the quantity supplied
 Demand falls  demand curve shifts to the left  Above equilibrium: QS > QD : surplus; downward pressure
Price  Quantity  on price
Below equilibrium: QS < QD : shortage; upward pressure
 Supply rises  demand curve shifts to the right 
on price
Price  Quantity   Shifts in the supply and demand curves change the
equilibrium price and quantity
 CHAPTER 4
Price elasticity of Demand - At the top of the line, a very small percentage
- Measures how much the quantity demanded price change induces a very large percentage
of a good changes when its price changes quantity change, and the elasticity is therefore
- Sensitivity to price changes extremely large.
- Price elasticity of demand = ED
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
- High: elastic – its quantity demanded responds
greatly to price changes (Goods with ready
substitutes, luxuries, when consumers have
more time to adjust their behaviors)
- Low: inelastic – quantity demanded responds
little to price changes (Necessities, goods with
few substitutes, for the short run)
- Ex. Gasoline: In the short run, demand may be Elasticity vs Slope
very inelastic but in the long run, consumers - remember not to confuse the elasticity of a
can adjust behavior to the higher price of curve with its slope
gasoline) - Linear demand curves start out with high price
- Determined by the economic characteristics of elasticity, where price is high and quantity is
demand low, and end up with low elasticity, where
- Categories: price is low and quantity is high
 Price-elastic Demand - it is not true that a steep slope for the demand
- 1% change in price  > 1% change in curve means inelastic demand or that a flat
quantity demanded slope signifies elastic demand
 Price-inelastic Demand - The slope is not the same as the elasticity
- 1% change in price  < 1% change in because the demand curve's slope depends
quantity demanded upon the changes in P and Q, whereas the
 Unit-elastic Demand elasticity depends upon the percentage
- %change in quantity=%change in price changes in P and Q (exceptions: polar cases of
- Implies that total expenditures on the completely elastic and inelastic demands)
commodity (which equal P X Q) stay Total Revenue
the same even when the price - equal to price times quantity (or PX Q)
changes  When demand is price-inelastic, a
Calculating Elasticities price decrease reduces total revenue.
- Drop the minus signs from the numbers,  When demand is price-elastic, a price
thereby treating all percentage changes as decrease increases total revenue.
positive  In the borderline case of unit-elastic
- Percentage changes in price and demand demand, a price decrease leads to no
rather than absolute changes; A change in the change in total revenue.
units of measurement does not affect the The Paradox of the Bumper Harvest
elasticity - The good weather and bumper crop have
- Use of averaging to calculate percentage lowered their and other farmers' incomes
changes in price and quantity - answer lies in the elasticity of demand for
-
∆𝑄 ∆𝑃
ED = 𝑄1+𝑄2 ÷ 𝑃1+𝑃2 Where 1- original, 2- new foodstuffs
(
2
) (
2
) - The demands for basic food products tend to
Rule for Calculating the Demand Elasticity be inelastic; for these necessities, consumption
 We can calculate the elasticity as the ratio of changes very little in response to price
the lower segment to the upper segment at the - farmers as a whole receive less total revenue
demand point. For example, at point B, the when the harvest is good than when it is bad
lower segment is 3 times as long as the upper - The increase in supply arising from an
segment, so the price elasticity is 3. abundant harvest tends to lower the price. But
 Price elasticity is relatively large when we are the lower price doesn't increase quantity
high up the linear DD curve demanded very much
 - A low price elasticity of food means that large - Setting maximum or minimum prices in a
harvests (high Q) tend to be associated with market tends to produce surprising and
low revenue (low P X Q) sometimes perverse economic effects
Price Elasticity of Supply Minimum Wage
- responsiveness of the quantity supplied of a - sets a minimum hourly rate that employers are
good to its market price allowed to pay workers
- percentage change in quantity supplied divided - As the minimum wage rises above the market-
by the percentage change in price clearing equilibrium at M, the total number of
- Vertical supply curve: completely inelastic jobs moves up the demand curve, so
supply; fixed supply – zero elasticity employment falls
Horizontal supply curve: completely elastic - The gap between labor supplied and labor
supply demanded represents the amount of
Intermediate case: percentage quantity and unemployment
price changes are equal; unit-elastic - Minimum wage is an inefficient way to transfer
- Factors affecting: productive capacity, time buying power to low-income groups; they
period (short run – inelastic; long-run – elastic) would prefer using direct income transfers or
government wage subsidies rather than
Long-Run Relative Decline of Farming gumming up the wage system
- Demand for farm products tends to grow more
slowly than the impressive increase in supply SUMMARY
generated by technological progress. Hence,  Price elasticities of demand for individual
competitive farm prices tend to fall. Moreover, goods are determined by the economic
with price-inelastic demand, farm incomes characteristics of demand.
decline with increases in supply  Tend to be higher when the goods are luxuries,
- Crop restrictions: Shifts the supply curve up when substitutes are available & when
and to the left & because the demand for food consumers have more time to adjust their
is inelastic, crop restrictions not only raise the behavior, and lower for necessities, for goods
price of crops but also tend to raise farmers' with few substitutes, and for the short run
total revenues  A pure number, involving percentages; it
- inefficient: the gain to farmers is less than should not be confused with slope.
the harm to consumers  The general rule for elasticities is that the
Impact of a Tax elasticity can be calculated as the ratio of the
- ‘Incidence’: ultimate economic effect of a tax length of the straight-line or tangent segment
on the real incomes of producers and below the demand point to the length of the
consumers segment above the point
- Gasoline tax: the consumer bears most of the  Impact of a price reduction on total revenue:
burden, with the retail price rising, because elastic demand – increase; inelastic demand –
supply is relatively price-elastic whereas decrease; unit-elastic – no effect
demand is relatively price-inelastic  The incidence of a tax denotes the impact of
- Subsidies: Rather than to discourage the tax on the incomes of producers and
consumption of a good, it is used to encourage consumers. In general, the incidence depends
production upon the relative elasticities of demand and
- key to determine the incidence of a tax is the supply
relative elasticities of supply and demand - A tax is shifted forward to consumers if
 demand is inelastic relative to supply, as in the demand is inelastic relative to supply.
the case of gasoline, most of the cost is - A tax is shifted backward to producers if
shifted to consumers supply is inelastic relative to demand.
 if supply is inelastic relative to demand, as  Government’s intervention
is the case for land, then most of the tax is Ceilings : excess demand; floors : excess supply
shifted to the suppliers
Minimum Floors and Maximum Ceilings
 CHAPTER 5
Consumer behavior commodity; this shows why demand curves
- Explained in terms of the premise that people slope downward
choose those goods and services they value Ordinal utility
most highly - consumers need to determine only their
‘Utility’ preference ranking of bundles of commodities,
- Denotes satisfaction - Does not require that we know how much A is
- Refers to how consumers rank different goods preferred to B
and services - Dimensionless
Marginal Utility Substitution Effect
- denotes the additional utility you get from the - When the price of a good rises, consumers will
consumption of an additional unit of a tend to substitute other goods for the more
commodity expensive good in order to satisfy their desires
Law of diminishing marginal utility more inexpensively
- the amount of extra or marginal utility declines - Firms: produce a given amount of output at the
as a person consumes more and more of a least total cost
good - When consumers substitute less expensive
- Total utility ( U) enjoyed increases as goods for more expensive ones, they are
consumption ( Q) grows, but it increases at a buying a given amount of satisfaction at lower
decreasing rate cost
- implies that the marginal utility (MU) curve Income Effect
must slope downward; total utility curve must - When a price rises and money income is fixed,
look concave, like a dome real income falls because the consumer cannot
Total Utility afford to buy the same quantity of goods as
- sum of all the marginal utilities that were before
added from the beginning - the change in the quantity demanded that
Assumptions: arises because a price change lowers consumer
- Each consumer maximizes utility, which means real incomes
that the consumer chooses the most preferred ‘Real income’
bundle of goods from what is available. - actual quantity of goods that your money
- Consumers have a certain income and face income can buy
given market prices for goods. Income elasticity
Equimarginal principle - percentage change in quantity demanded
- A consumer will achieve maximum satisfaction divided by the percentage change in income,
or utility when the marginal utility of the last holding other things constant
dollar spent on a good is exactly the same as - High income elasticities: demand for these
the marginal utility of the last dollar spent on goods rises rapidly as income increases.
any other good - Low income elasticities: weak response of
- If good A costs twice as much as good B, then demand to increases in income
buy good A only when its marginal utility is at Market demand
least twice as great as good B's marginal utility - obtained by summing up the quantities
- A law of rational choice demanded by all the consumers
Marginal utility of income Inferior goods
- The common marginal utility per dollar of all - for which purchases may shrink as incomes
commodities in consumer equilibrium increase because people can afford to replace
- Measures the additional utility that would be them with other, more desirable goods
gained if the consumer could enjoy an extra Substitutes
dollar's worth of consumption - If an increase in the price of good A will
increase the demand for substitute good B
𝑀𝑈𝑔𝑜𝑜𝑑1 𝑀𝑈𝑔𝑜𝑜𝑑2 Complements
=
𝑃1 𝑃2 - An increase in the price of good A causes a
- A higher price for a good reduces the decrease in the demand for its complementary
consumer's desired consumption of that good B.
Independent goods
 - a price change for one has no effect on the increases, the marginal utility of the last unit
demand for the other consumed tends to decrease
Merit goods  To maximize utility, a consumer must satisfy the
- whose consumption is thought intrinsically equimarginal principle that the marginal utilities of
worthwhile the last dollar spent on each and every good must
Demerit Goods be equal
- whose consumption is deemed harmful  The market demand curve for all consumers is
Paradox of Value derived by adding horizontally the separate
- How is it that water, which is essential to life, demand curves of each consumer
has little value, while diamonds, which are  The substitution effect occurs when a higher price
generally used for conspicuous consumption, leads to substitution of other goods for the good
command an exalted price? whose price has risen
- Answer: diamonds are very scarce and the cost  The income effect is the change in the quantity
of getting extra ones is high, while water is demanded of a good because the change in its price
relatively abundant and costs little in many has the effect of changing a consumer's real income
areas of the world  Income elasticity is the percentage change in
- The total utility from water consumption does quantity demanded of a good divided by the
not determine its price or demand. Rather, percentage change in income
water's price is determined by its marginal  Goods are substitutes if an increase in the price of
utility, by the usefulness of the last glass of one increases the demand for the other
water  Goods are complements if an increase in the price
- The more there is of a commodity, the less is of one decreases the demand for the other
the relative desirability of its last little unit  Goods are independent if a price change for one
- it is the large quantities that pull the marginal has no effect on the demand for the other
utilities so far down and thus reduce the prices  it is the tail of marginal utility that wags the market
of these vital commodities dog of prices
Consumer Surplus
 Consumer surplus is the excess of total value over
- The gap between the total utility of a good and
market value
its total market value
- reflects the benefit we gain from being able to
- arises because we "receive more than we pay
buy all units at the same low price
for"
- area between the demand curve and the price
- because we pay the same amount for each unit
line
of a commodity that we buy, from the first to
 The indifference Curve depicts the points of equally
the last
desirable consumption bundles. The indifference
- we pay for each unit what the last unit is worth
contour is usually drawn convex (or bowl-shaped)
- we would have been willing to pay more than
in accordance with the law of diminishing relative
the market price for each of the earlier unit
marginal utilities
 When a consumer has a fixed money income, all of
SUMMARY which she spends, and is confronted with market
 In the theory of demand, we assume that people prices of two goods, she is constrained to move
maximize their utility, which means that they along a straight line called the budget line or
choose the bundle of consumption goods that they budget constraint (Y=Qgood1xP1 + Qgood2xP2)
most prefer  Equilibrium is at the point of tangency, where the
 Utility denotes the relative satisfaction that a slope of the budget line (the ratio of the prices)
consumer obtains from using different exactly equals the slope of the indifference curve
commodities (the substitution ratio or the ratio of the marginal
 Marginal utility is the additional satisfaction utilities of the two goods)
obtained from consuming an additional unit of a  At every point of tangency, the marginal utility per
good dollar is equal for every good
 The law of diminishing marginal utility states that  By comparing the new and old equilibrium points,
as the amount of a commodity consumed we trace the usual downward-sloping demand
curve