General Economic

Concepts
 Economy
• Economy: Process of Production and Consumption
• Four Pillars of Economy:
Economy
Production
Consumption
Distribution
Accumulation
 Economics
• Oikonomia: Household management
• Economics: ‘Economics is the science which studies human
behaviour as a relationship between ends and scarce means
which have alternative use’ Robbins.
• The problem of allocation of scarce resource.
• Economics is the study of how societies use scarce resources to
produce valuable goods and services and distribute them
among different individuals.
• Efficiency: Economic efficiency requires that an economy
produce the highest combination of quantity and quality of
goods and services given its technology and scarce resources.
• Effective use of society’s resources in satisfying people’s wants
and needs.
 Two branches of Economics
•Microeconomics: Individual, Firm.
Studying Individual’s Utility, Firm’s production and cost
of production, Income of factors of production, etc

•Macroeconomics: Overall performance of the

economy.
Learning about National Income, Aggregate Demand,
Economic Growth, etc.
 Positive vs Normative Economics

•Positive Economics: What it is?? What has

happened?? What is happening??
•Normative Economics: How it should be??
 TEN Principles of Economics

 Principle 1: People Face Trade-offs :

 To get something that we like, we usually have to give up
something else that we also like. Making decisions requires
trading off one goal against another.
 Principle 2: The Cost of Something Is What You Give Up to
Get it:
 Because people face trade-offs, making decisions requires
comparing the costs and benefits of alternative courses of
action. In many cases, however, the cost of an action is not
as obvious as it might first appear.
 Principle 3: Rational People Think at the Margin:
 Economists normally assume that people are rational.
Rational people systematically and purposefully do
the best they can to achieve their objectives, given
the available opportunities.
 Principle 4: People Respond to Incentives
 Incentivesare crucial to analyzing how markets
work. A higher price in a market provides an
incentive for buyers to consume less and an
incentive for sellers to produce more. As we will see,
the influence of prices on the behavior of consumers
and producers is crucial for how a market economy
allocates scarce resources.
 Principle 5: Trade Can Make Everyone Better Off :
 Trade allows countries to specialize in what they do best and
to enjoy a greater variety of goods and services.
 Principle 6: Markets Are Usually a Good Way to Organize
Economic Activity
 market economy an economy that allocates resources
through the decentralized decisions of many firms and
households as they interact in markets for goods and
services
 Principle 7: Governments Can Sometimes Improve Market
Outcomes
 Principle 8: A Country’s Standard of Living Depends on Its Ability to
Produce Goods and Services
 What explains these large differences in living standards among
countries and over time? The answer is surprisingly simple. Almost all
variation in living standards is attributable to differences in countries’
productivity—that is, the amount of goods and services produced by
each unit of labor input.
 Principle 9: Prices Rise When the Government Prints Too Much Money
 inflation an increase in the overall level of prices in the economy.
What causes inflation? In almost all cases of large or persistent
inflation, the culprit is growth in the quantity of money. When a
government creates large quantities of the nation’s money, the value
of the money falls.
Principle 10: Society Faces a Short-Run
Trade-off between Inflation and
Unemployment
Understanding
Economy
•The Problem of Scarcity and Choice
•Basic Economic Problems
•Production Possibility Frontier (PPF)
•Opportunity Cost
 Economics
• Oikonomia: Household management
• Economics: ‘Economics is the science which studies human
behaviour as a relationship between ends and scarce means
which have alternative use’ Robbins.
• The problem of allocation of scarce resource.
• Economics is the study of how societies use scarce resources to
produce valuable goods and services and distribute them
among different individuals.
• Efficiency: Economic efficiency requires that an economy
produce the highest combination of quantity and quality of
goods and services given its technology and scarce resources.
• Effective use of society’s resources in satisfying people’s wants
and needs.
 Two branches of Economics
•Microeconomics: Individual, Firm.
Studying Individual’s Utility, Firm’s production and cost
of production, Income of factors of production, etc

•Macroeconomics: Overall performance of the

economy.
Learning about National Income, Aggregate Demand,
Economic Growth, etc.
 Positive vs Normative Economics

•Positive Economics: What it is?? What has

happened?? What is happening??
•Normative Economics: How it should be??
 Basic Economic Problems

•1 What to produce and in what

quantities?
•2 How to produce?
•3 For whom to produce?
Production Possibility Frontier (PPF)
 Production possibility set
•Production possibility set: The set of outputs
that are feasible given the technology and
the amount of inputs.
•PPF: Graphic representation of alternative
production possibilities facing an economy.
 Production Possibility Frontier (PPF)

The production-possibility
frontier (or PPF ) shows the
maximum quantity of goods
that can be efficiently
produced by an economy,
given its technological
knowledge and the quantity
of available inputs.
 Production Possibility Frontier (PPF)
• Production Possibility Curve
• Transformation Curve
• Marginal rate of transformation: how much of one good
can be produced by sacrificing other good.
• Slope of the PPF measures the marginal rate of
transformation.
Economic Growth and PPF
 Pareto Efficiency
Pareto efficiency: An
Economic state where
resources can not be
reallocated to make one
individual better off
without making at least
one individual worse off.
Pareto Set: the set of
pareto efficient bundles
given the amounts of good
1 and good 2 available.
 Opportunity Costs

In a world of scarcity, choosing one thing

means giving up something else. The
opportunity cost of a decision is the value
of the good or service forgone.
CIRCULAR FLOW OF INCOME AND
EXPENDITURE
 Introduction
• The circular flow of income forms the basis for all the
macroeconomic models of the economy.
• It is helpful to the essential concepts like national
income, aggregate demand and aggregate supply.
• The circular flow of income describes the movement of
goods or services and income among the different sectors
of the economy.
• It illustrates the interdependence of the sectors and the
markets to facilitate both real and monetary flow.
 Real Flow
• The real flow refers to the flow of factor services and
flow of goods and services.
• The flow of factor services from the households to the
firms and the flow of goods and services from firms to
the household is the real flow.
• The flow of factor services generates money flows in the
form of factor payments which the firms pay the
household and similarly the household need to pay the
firms for the flow of goods and services.
 Monetary Flow
• The movement of the money/cash payment from one sector to
the other sector corresponding to the real flow is referred to as
the monetary flow.
• Thus, the income of one sector becomes the expenditure of the
other
• The supply of goods and services by one sector becomes the
demand of the other sector.
• The real flow and monetary flow move in a circular manner in
an opposite direction.
• A continuous flow of production, income and expenditure is
known as the circular flow of income.
 The four macroeconomic sectors
1. The household sector
• This sector includes all the individuals in the economy.
• The primary function of this sector is to provide the
factors of production.
• The factors of production include land, labour, and
capital.
• The household sectors are the consumers who consume
the goods and services produced by the firms and in
return make payments for the same.
2. The Firm Sector
•This sector includes all the business
entities, corporations and partnerships.
•The primary function of this sector is to
produce goods and services for sale in the
market and make factor payments to the
household sector.
3. The Government Sector
•This sector includes the center, state, and local
governments.
•The prime function of this sector is to regulate the
functioning of the economy.
•The government sector has both revenue as well as
expenditure.
•The government earns revenue from tax and non-
tax sources and incurs expenditure to provide
essential public services to the people.
4. The Foreign Sector
•This sector includes transactions with the rest of the
world.
•Foreign trade implies net exports (exports minus
imports).
•Exports include goods and services produced
domestically and sold to the rest of the world
•Imports include goods and services produced
abroad and sold domestically.
 The Three Markets
1. The Goods Market
In this market the goods and services are exchanged
among the four macroeconomic sectors.
The consumers are the household, government and
the foreign sector.
The producers are the firms.
2. The Factor Market
•The factors of production are traded
through this market.
•For the production of final goods and
services, the firms obtain the factor
services and make payments in the form
of rent, wages and profits for the services
to the household sector.
3. The Financial Market
•This market consists of financial institutions
such as banks and non-bank intermediaries
who engage in borrowing (savings from
households) and lending of money.
 The Circular Flow of Income in a Two Sector Model
• In this model, the economy is assumed to be a closed economy
• Consists of only two sectors, i.e., the household and the firms.
• A closed economy is an economy that does not participate in
international trade.
• The household sector is the only buyer of the goods and
services produced by the firms and it is also the only supplier
of the factors of production.
• The household sector spends the entire income on the purchase
of goods and services produced by the firms implying that
there is no saving or investment in the economy.
• The firms generate income by selling the goods and
services to the household sector.
• Households earns income by selling the factors of
production to the firms.
• Thus, the income of the producers is equal to the income
of the households is equal to the consumption
expenditure of the household.
• The demand of the economy is equal to the supply.
• In this model, Y = C
• where, Y is Income and C is Consumption.
The Circular Flow of Income in a Two-Sector
Model
 The Circular Flow of Income in a Two- Sector Model with
Saving and Investment
• In the above model, we assumed that the household sector spends its
entire income and that there is no saving in the economy.
• In practice, the household sector does not spend all its income; it saves
a part of it.
• The saving by the household sector would imply monetary withdrawal
(equal to saving) from the circular flow of income.
• This would affect the sale of the firms since the entire income of the
household would not reach the firm implying that the production of
goods and services would be more than the sale.
• Consequently, the firms would decrease their production which would
lead to a fall in the income of the household and so on.
• There is one way of equating the sales of the firms with the
income generated.
• If the saving of the household is credited to the firms for
investment then the income gap could be filled.
• If the total investment (I) of the firms is equal to the total saving
(S) of the household sector then the equilibrium level of the
economy would be maintained at the original level.
• The equilibrium condition for a two-sector model with saving
and investment is as follows:
The circular flow of income in a two sector
model with saving and investment
 The circular flow of income in a three sector
model
• The three sector model of circular flow of income highlights the role
played by the government sector.
• This is a more realistic model which includes the economic activities of
the government however; we continue to assume the economy to be a
closed one.
• There are no transactions with the rest of the world.
• The government levies taxes on the households and the firms and it also
gives subsidies to the firms and transfer payments to the household
sector.
• Thus, there is income flow from the household and firms to the
government via taxes in one direction and there is income outflow from
• If the government revenue falls short of its expenditure, it is also
known to borrow through financial markets.
• This sector adds three key elements to the circular flow model, i.e.,
taxes, government purchases and government borrowings.
The circular flow of income in a three sector
model
• In this model, the equilibrium condition is as follows:
• Y=C+I+G
• Where, Y = Income; C = Consumption; I = Investment and G =
Government Expenditure
• In a closed economy, aggregate demand is measured by adding
consumption, investment and government expenditure.
• Aggregate demand is defined as the total demand for final goods and
services in an economy at a given time and price level.
• Aggregate supply is defined as the total supply of goods and services
that the firms are willing to sell in an economy at a given price level.
 The circular flow of income in a four sector
model
• This is the complete model of the circular flow of income that
incorporates all the four macroeconomic sectors.
• Along with the above three sectors it considers the effect of foreign
trade on the circular flow.
• With the inclusion of this sector the economy now becomes an ‘open
economy’.
• Foreign trade includes two transactions, i.e., exports and imports.
• Goods and services are exported from one country to the other countries and
imports come to a country from different countries in the goods market.
• There is inflow of income to the firms and government in the form of payments
for the exports.
• There is outflow of income when the firms and governments make payments
abroad for the imports.
• The import payments and export receipts transactions are done in the financial
market.
The circular flow of income in a four sector
model
• In this model, the equilibrium condition is as follows:
• Y = C + I + G + NX
• NX = Net Exports = Exports (X) – Imports (M)
• Where, Y = Income; C = Consumption; I = Investment; G =
Government Expenditure; X = Exports and M = Imports.
Leakages and injections in the circular flow of
income
• The flow of income in the circular flow model does not always remain
constant.
• The volume of income flow decrease due to the leakages of income in
the circular flow and similarly, it increases with the injections of
income into the circular flow.
leakages
• Referred to as an outflow of income from the circular flow model.
• Leakages are that part of the income which the household withdraw from the circular flow and is not used to
purchase goods and services.
• This part of the income does not go to the goods market.
 Three main leakages

• Saving: It is that part of the income that is not used by the household to purchase of
goods and services or pay taxes. It is kept with the financial institutions like banks
that can be lend further by the banks to the firms for investment or capital expansion
purposes.
• Taxes: Tax revenue is the income paid by the household and firms to the government.
It flows to the government rather that the goods market.
• Imports: Import payments are made to the foreign sector for the good and services
bought from them. This is an outflow of income from the economy.
• Leakages reduce the volume of income from the circular flow of
income.
• Leakages = S + T + M
• Where, S = Saving; T = Taxes; and M = Imports
injections
• An injection is an inflow of income to the circular flow.
• The volume of income increases due to an injection of income in the
circular flow.
 Three main injections

• Investment: It is the total expenditure by the firms on capital expansion. It flows to the
goods market.
• Government Expenditure: It is the total expenditure of the government on goods and
services, subsidies to the firms and transfer payments to the household sector. Transfer
payments are government payments like social security schemes, pensions, retirement
benefits, and temporary aid to needy families etc.
• Exports: Export receipts are the payment made by the foreign sector for the purchase of
domestic goods. It is an inflow of income from the foreign sector to the financial market.
• Injections = I + G + X
• Where, I = Investment; G = Government Expenditure; and X =
Exports
• Balance of leakages and Injections in an open economy is:
•S+T+M=I+G+X
Law of Demand
 Quantity Demanded
The quantity demanded of any good is
the amount of the good that buyers
are willing and able to purchase.
Demand means desire backed by
willingness and ability to pay.
 Law of Demand

Other things being equal, when

the price of a good rises, the
quantity demanded of the good
falls, and when the price falls, the
quantity demanded rises.
 Demand Schedule

Atable that shows the relationship

between the price of a good and
the quantity demanded
 Demand Curve
A graph of the relationship
between the price of a good and
the quantity demanded
Law of Demand
 Reasons for downward-sloping
demand
 Quantity demanded tends to fall as price rises for
two reasons:
1. Substitution effect: occurs because a good
becomes relatively more expensive when its price
rises. When the price of good A rises, I will generally
substitute goods B, C, D, . . . for it.
2. Income effect: when a price goes up, I find myself
somewhat poorer than I was before.
 Market Demand versus Individual
Demand
 Market
Demand: the sum of all the individual
demands for a particular good or service.
Market Demand
Shifts in Demand
 Shifts in Demand
Variables that can shift the demand curve:
 Income
 Prices of related goods:
Related Goods: Substitutes and Complements
 Tastes
 Expectations
 Number of buyers
 Population
Shifts in the Demand Curve versus
Movements along the Demand Curve
Law of Supply
 Quantity Supplied
The quantity supplied of any good or
service is the amount that sellers are
willing and able to sell.
 Law of Supply

Other things being equal, when the

price of a good rises, the quantity
supplied of the good also rises, and
when the price falls, the quantity
supplied falls as well.
 Supply Schedule

Atable that shows the relationship

between the price of a good and the
quantity supplied, holding constant
everything else that influences how much
of the good producers want to sell.
 Supply Curve
A graph of the relationship between
the price of a good and the quantity
supplied
The supply curve slopes upward
because, other things being equal, a
higher price means a greater quantity
supplied.
Law of Supply
Market Supply versus Individual
Supply
Market Supply
Shifts in Supply
 Reasons for Shifts in Supply
Variables that can shift the supply
curve:
1. Input Prices
2. Technology
3. Expectations
4. Number of Sellers
5. Government policy
Market Equilibrium
 Equilibrium
•Equilibrium: a situation in which the market
price has reached the level at which quantity
supplied equals quantity demanded.
•Equilibrium price: the price that balances
quantity supplied and quantity demanded.
•equilibrium quantity: the quantity supplied
and the quantity demanded at the equilibrium
price
Market Equilibrium
Disequilibrium, Surplus and Shortage
 Surplus and Shortage
•Surplus: a situation in which quantity
supplied is greater than quantity
demanded.
•Shortage: a situation in which quantity
demanded is greater than quantity
supplied.
 Change in Equilibrium
•A Change in Market Equilibrium Due to a
Shift in Demand
•A Change in Market Equilibrium Due to a
Shift in Supply
•Shifts in Both Supply and Demand
A Change in Market Equilibrium Due to a Shift in
Demand
A Change in Market Equilibrium Due to a Shift in
Supply
Shifts in Both Supply and Demand
 Price Ceiling and Price Floor

•Price Ceiling: a mechanism of price

control where the price for a good is
prevented from rising above a certain
level.
•Price Floor: a method of price control
where the price of a good is prevented
from falling below a certain level.
Price Elasticity of Demand
 Elasticity
•Elasticity: A measure of the responsiveness of
quantity demanded or quantity supplied to a
change in one of its determinants
•Price elasticity of demand: A measure of how much
the quantity demanded of a good responds to a
change in the price of that good, computed as the
percentage change in quantity demanded divided
by the percentage change in price.
Price elasticity of demand
The Midpoint Method
(d) Perfectly Inelastic (e) Perfectly Elastic
• Perfectly Elastic Demand: Elasticity equals infinity
• Perfectly Inelastic Demand: Elasticity equals zero
• Inelastic demand: Elasticity is less than one
• Elastic demand: Elasticity is greater than one
• Unit Elastic demand: Elasticity is one
Elasticity of linear demand curve

Elasticity =
Lower Segment/Upper
Segment
 Problem
• Suppose the price of a commodity falls from Rs. 6 to
4 per unit and due to this the quantity demanded of
the commodity increases from 80 units to 120 units.
Find out the price elasticity of demand.
• A consumer purchases 80 units of a commodity when
its price is Rs. 1 per unit and purchases 48 units when
its price rises to Rs. 2 per unit. What is the price
elasticity of demand for the commodity?
Total Revenue and the Price Elasticity of
Demand
Total Revenue and the Price Elasticity of
Demand
 The Price Elasticity of Demand and Its
Determinants
•Availability of Close Substitutes
•Necessities versus Luxuries
•Definition of the Market
•Time Horizon
Elasticity of Demand and
Supply
 Goods
• Normal Goods: When price rises, quantity demand
declines.
• Inferior goods: When income rises, quantity demand
declines.
• Giffen Goods: When price rises, quantity demand
increases. (Exception to law of demand). Law of demand
does not hold true in case of Giffen goods.
 Income Elasticity of Demand
• Income elasticity of demand: how much the quantity
demanded of a good responds to a change in consumers’
income, computed as the percentage change in quantity
demanded divided by the percentage change in income.
 Income Elasticity of Demand
• Normal goods: Higher income raises the quantity demanded.
Because quantity demanded and income move in the same
direction, normal goods have positive income elasticities.
• Inferior goods: Higher income lowers the quantity demanded.
Because quantity demanded and income move in opposite
directions, inferior goods have negative income elasticities.
• Necessities tend to have small income elasticities because
consumers choose to buy some of these goods even when
their incomes are low.
• Luxuries tend to have large income elasticities because
consumers feel.
 Cross-price elasticity of demand
• Cross-price elasticity of demand a measure of how
much the quantity demanded of one good responds to
a change in the price of another good, computed as the
percentage change in quantity demanded of the first
good divided by the percentage change in price of the
second good.
 Cross-price elasticity of demand
• Whether the cross-price elasticity is a positive or negative
number depends on whether the two goods are substitutes or
complements.
• Substitutes are goods that are typically used in place of one
another. The cross-price elasticity is positive for substitutes.
• Complements are goods that are typically used together, such
as computers and software. In this case, the cross-price
elasticity is negative, indicating that an increase in the price of
car reduces the quantity of petrol demanded.
 Price elasticity of supply
• A measure of how much the quantity supplied of a good
responds to a change in the price of that good,
computed as the percentage change in quantity supplied
divided by the percentage change in price.
 Price elasticity of supply
•(a) Perfectly Inelastic Supply: Elasticity Equals 0
•(b) Inelastic Supply: Elasticity Is Less Than 1
•(c) Unit Elastic Supply: Elasticity Equals 1
•(d) Elastic Supply: Elasticity Is Greater Than 1
•(e) Perfectly Elastic Supply: Elasticity Equals
Infinity
 Applications of Supply, Demand, and Elasticity
• 1. Can Good News for Farming Be Bad News for Farmers?
 Applications of Supply, Demand, and Elasticity
• 2. Why Did OPEC Fail to Keep the Price of Oil High?
 Applications of Supply, Demand, and Elasticity
• 3. Does Drug Interdiction Increase or Decrease Drug-Related Crime?
Consumer and Producer
Surplus
 Willingness to pay
• Willingness to pay: the maximum amount that a buyer will pay for a good
 consumer surplus

•Consumer surplus: the amount a buyer is

willing to pay for a good minus the amount
the buyer actually pays for it.
Using the Demand Curve to Measure
Consumer Surplus
How a Lower Price Raises Consumer Surplus
How Price Affects Consumer Surplus
 Producer Surplus
• Cost: the value of everything a seller must give up to produce a good
• producer surplus: the amount a seller is paid for a good minus the seller’s cost of
providing it.
Using the Supply Curve to Measure Producer
Surplus
How Price Affects Producer Surplus
Market Efficiency
 Market Efficiency
•Efficiency: the property of a resource
allocation of maximizing the total surplus
received by all members of society.
•Equality: the property of distributing economic
prosperity uniformly among the members of
society.
Consumer and Producer Surplus in the Market
Equilibrium
The Efficiency of the Equilibrium Quantity
Production Function
 The Modern Times: Introducing Feeding Machine
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 The Theory of Production
•Price of commodity : Demand and Supply
interaction.
•Supply depends upon cost of production. Cost of
Production is dependent on (1) the physical
relationship between inputs and output and (2)
the prices of inputs.
•Production: Transformation of inputs into outputs.
 The Theory of Production
• Production Function: Relation between input and Output.
• Theory of Production : Study of production function.
The production function specifies the maximum output that
can be produced with a given quantity of inputs. It is defined
for a given state of engineering and technical knowledge.
➢ Law of variable proportions
➢ Laws of returns to scale
 Factors of production
•Land, Labour and Capital
•Short run vs Long run
Short run: A period in which firms can adjust production by changing variable factors such as
materials and labor but cannot change fixed factors such as capital.
Long run: The long run is a period sufficiently long that all factors including capital can be
adjusted.

•Fixed factor vs Variable factor

 Returns to a Factor
• Law of diminishing returns or law of variable proportions : Study of
the production function when the quantities of some inputs are kept
constant and the quantity of one input is varied.
• Returns to a factor: How output changes when the amount of a
variable factor changes.
• It is relevant for the short-run production function.
• Short-run production function:

Q = f ( L, K )
Q is output, L is Labour, and K is capital.
 Total Product, Average Product and Marginal Product
• Total Product (TP): Amount of total output produced by a given
amount of variable factor keeping the quantity of other factors
fixed.

• Average Product (AP):

Q
AP =
L
• Marginal Product: Addition to the total product by the employment
of an extra unit of a factor. The marginal product of an input is the
extra output produced by 1 additional unit of that input while
other inputs are held constant.
Q
MPL =
L
TP, MP, and AP
 Law of Variable Proportions

• When the quantity of one factor is varied and other factor is kept constant, the
proportion between the variable factor and the fixed factor is altered. The ratio
of variable factor to the fixed factor increases as the quantity of variable factor
increases. In this law we study the effects of variations in factor proportions on
the output. Hence, law of variable proportions.

• Assumptions of the law of variable proportions:

➢ State of technology is given and unchanged.
➢ There must be some inputs whose quantity is kept fixed
➢ There must be possibility of varying the proportions
Law of Variable Proportions
 Three Stages of the Law of Variable Proportions
• Stage 1 : Stage of Increasing Returns
➢ Total product (TP) increases at an
increasing rate
➢ Average product(AP) increases
throughout
➢ Marginal product(MP) of fixed
factor is negative
• Stage 2: Stage of Diminishing Returns
➢TP increases at a diminishing rate
➢AP declines
➢MP also declines but remains positive
• Stage 3: Stage of Negative Returns
➢TP declines
➢AP decreases
➢MP becomes negative
 Causes of Increasing, Diminishing and Negative Returns
• Causes of Increasing Returns:
➢Fixed factor is effectively utilized. Efficiency of fixed factor increases. Efficiency of
variable factor increases because of division of labour.

• Causes of Diminishing Returns:

➢Scarcity of the fixed factor
➢Indivisibility of the fixed factor
➢Imperfect substitutability of the factors

• Causes of Negative Returns

➢Excessive variable factor relative to fixed factor. MP of variable factor is negative.
THE EFFECT OF TECHNOLOGICAL
IMPROVEMENT
 Returns to Scale
•All inputs are variable factors.
•The effects of scale increases of inputs on
the quantity produced.
•Case for Long run
 Types of Returns to Scale
• Constant returns to scale: denote a case where a change in all
inputs leads to a proportional change in output. For example, if
labor, land, capital, and other inputs are doubled, then under
constant returns to scale output would also double.
• Increasing returns to scale: (also called economies of scale) arise
when an increase in all inputs leads to a more-than-proportional
increase in the level of output.
• Decreasing returns to scale: occur when a balanced increase of all
inputs leads to a less-than proportional increase in total output.
Problem
COST CONCEPTS
 Costs
•Total Cost: The amount that the firm pays to buy
inputs.
•Explicit Cost: Input costs that require an outlay of
money by the firm.
•Implicit Cost: Input costs that do not require an
outlay of money by the firm. Ex. Use of own
buildings, land, etc.

Total Cost = Explicit Cost + Implicit cost

 COSTS
• Sunk Cost: Expenditure that has been made and cannot
be recovered.
• Historical Cost: The price at which capital goods were
originally purchased and a given percentage of the
original price is taken as depreciation which is charged
to current costs of production per year.
• Opportunity Cost: The cost associated with
opportunities that are forgone by not putting the firm’s
resources to their best alternative use.
 COSTS
•Fixed Costs (FC) : costs that do not vary with the
quantity of output produced. Fixed costs are
expenses that must be paid even if the fi rm
produces zero output. Sometimes called
“overhead” or “sunk costs,” they consist of items
such as rent for factory or office space, interest
payments on debts, salaries of tenured faculty,
and so forth. They are fixed because they do not
change if output changes.
 COSTS
• Variable Costs (VC): costs that vary with the quantity of output
produced.

• Total Costs (TC): Fixed costs + Variable costs

• Average Cost (AC) or Average Total Cost (ATC) :

AC or ATC = TC/Q
Q is unit of output.
• Average Fixed Cost (AFC): FC/Q
• Average Variable Cost (AVC): VC/Q
 COSTS
• Marginal Cost: Marginal cost sometimes called
incremental cost is the increase in cost that results from
producing one extra unit of output. Because fixed cost
does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or
the increase in total cost that results from an extra unit
of output.
COSTS
COST in the Short Run
The Relation between AC and MC:
• Whenever marginal cost lies
below average cost, the
average cost curve falls.
• Whenever marginal cost lies
above average cost, the
average cost curve rises.
• When average cost is at a
minimum, marginal cost
equals average cost.
COSTS : Summary
Price Ceilings and Price Floors

Elasticity and Taxation

 Price Ceilings and Price Floors
• When government does intervene in a market either to prevent the price of some good or
service from rising “too high” or to prevent the price of some good or service from falling “too
low”.

• The demand and supply model shows how people and firms will react to the incentives that
these laws provide to control prices

• Laws that government enact to regulate prices are called price controls.

• Price controls come in two flavors.

• A price ceiling keeps a price from rising above a certain level (the “ceiling”), while a price floor
keeps a price from falling below a given level (the “floor”).

• price ceiling - a legal maximum on the price at which a good can be sold
• price floor - a legal minimum on the price at which a good can be sold
Price Ceilings
• A price ceiling is a legal maximum price that one pays for some good or service.
• A government imposes price ceilings in order to keep the price of some
necessary good or service affordable.
• Price ceilings are enacted in an attempt to keep prices low for those who need
the product.
• However, when the market price is not allowed to rise to the equilibrium level,
quantity demanded exceeds quantity supplied, and thus a shortage occurs.
• Those who manage to purchase the product at the lower price given by the price
ceiling will benefit, but sellers of the product will suffer, along with those who
are not able to purchase the product at all. Quality is also likely to deteriorate.
 A Price Ceiling Example—Rent Control
• The original equilibrium (E0) lies at the
intersection of supply curve S0 and
demand curve D0, corresponding to an
equilibrium price of $500 and an
equilibrium quantity of 15,000 units of
rental housing.

• In this market, at the new equilibrium E1,

the price of a rental unit would rise to
$600 and the equilibrium quantity would
increase to 17,000 units.

• The new equilibrium would be at E1—

unless a price ceiling prevents the price
from rising. If the price is not permitted
to rise, the quantity supplied remains at
15,000. However, after the change in
demand, the quantity demanded rises to
19,000, resulting in a shortage.
• Suppose that a city government passes a rent control law to keep the price
at the original equilibrium of $500 for a typical apartment.

• the horizontal line at the price of $500 shows the legally fixed maximum
price set by the rent control law. However, the underlying forces that
shifted the demand curve to the right are still there. At that price ($500),
the quantity supplied remains at the same 15,000 rental units, but the
quantity demanded is 19,000 rental units.

• In other words, the quantity demanded exceeds the quantity supplied, so

there is a shortage of rental housing.

• One of the ironies of price ceilings is that while the price ceiling was
intended to help renters, there are actually fewer apartments rented out
under the price ceiling (15,000 rental units) than would be the case at the
market rent of $600 (17,000 rental units).
 Buyers of any good always want a lower price while A Market with a Price Ceiling
sellers want a higher price,
How Price Ceilings Affect Market Outcomes

The government imposes a price ceiling of $2.

Because the price ceiling is below the equilibrium
price of $3, the market price equals $2. At this
price, 125 cones are demanded and only 75 are
supplied, so there is a shortage of 50 cones.

Because of this excess demand of 50 cones, some people

who want to buy ice cream at the going price are unable
to do so. In other words, there is a shortage of ice cream.
Notice that even though the price ceiling was motivated
by a desire to help buyers of ice cream, not all buyers
benefit from the policy. Some buyers do get to pay a
lower price, although they may have to wait in line to do
so, but other buyers cannot get any ice cream at all.
When the government imposes a binding price ceiling
on a competitive market, a shortage of the good arises,
and sellers must ration the scarce goods among the
large number of potential buyers
It shows the gasoline market after an increase in the
price of crude oil (an input into making gasoline) shifts
the supply curve to the left from S1 to S2 .
• In an unregulated market, the price would have
risen from P1 to P2 . The price ceiling, however,
prevents this from happening.
• At the binding price ceiling, consumers are willing to
buy QD , but producers of gasoline are willing to sell
only QS .
• The difference between quantity demanded and
quantity supplied, QD – QS , measures the gasoline
shortage.

this shift in supply would have raised the equilibrium

price of gasoline from P1 to P2 , and no shortage would
have resulted. Instead, the price ceiling prevented the
price from rising to the equilibrium level. At the price
ceiling, producers were willing to sell QS , but consumers
were willing to buy QD . Thus, the shift in supply caused
a severe shortage at the regulated price.
 Price Floors

• A price floor is the lowest price that one can legally pay for
some good or service.
• Price floors are sometimes called “price supports,” because
they support a price by preventing it from falling below a
certain level.
 In the absence of government intervention, the price would adjust so that the quantity
supplied would equal the quantity demanded at the equilibrium point E0, with price P0
and quantity Q0.

• However, policies to keep prices high for

farmers keeps the price above what would
have been the market equilibrium level—the
price Pf shown by the dashed horizontal line in
the diagram. The result is a quantity supplied
in excess of the quantity demanded (Qd).
When quantity supplied exceeds quantity
demanded, a surplus exists.

• However, a price floor set at Pf holds the price

above E0 and prevents it from falling. The
result of the price floor is that the quantity
supplied Qs exceeds the quantity demanded
Qd. There is excess supply, also called a
surplus.
 How Price Floors Affect Market
Outcomes
the government imposes a price floor of $4, which is
above the equilibrium price of $3. Therefore, the market
price equals $4. Because 120 cones are supplied at this
price and only 80 are demanded, there is a surplus of 40
cones.

• Just as the shortages resulting from price ceilings can

lead to undesirable rationing mechanisms, so can the
surpluses resulting from price floors.
• The sellers who appeal to the personal biases of the
buyers, perhaps due to racial or familialties, may be
better able to sell their goods than those who do not.
• By contrast, in a free market, the price serves as the
rationing mechanism, and sellers can sell all they want
at the equilibrium price.
To examine the effects of a minimum wage, we must
consider the market for labor.

This shows the impact of a binding minimum

wage. Because the minimum wage is a price
floor, it causes a surplus: The quantity of labor
supplied exceeds the quantity demanded. The
result is unemployment.

Thus, while the minimum wage raises the incomes of

those workers who have jobs, it lowers the incomes of
workers who cannot find jobs.
➢ For instance, the government can make housing more affordable by
paying a fraction of the rent for poor families. Unlike rent control, such
rent subsidies do not reduce the quantity of housing supplied and,
therefore, do not lead to housing shortages.

➢ Similarly, wage subsidies raise the living standards of the working poor
without discouraging firms from hiring them. An example of a wage
subsidy is the earned income tax credit, a government program that
supplements the incomes of low-wage workers.

Although these alternative policies are often better than price

controls, they are not perfect. Rent and wage subsidies cost the
government money and, therefore, require higher taxes.
 ✓ All governments—from national governments around the world to local
governments in small towns—use taxes to raise revenue for public
projects, such as roads, schools, and national defense.

✓ Because taxes are such an important policy instrument and affect our lives
in many ways,

Tax incidence -
the manner in which the burden of a tax is shared among participants in a
market
Elasticity and Tax Incidence
❑ The analysis, or manner, of how a tax burden is
divided between consumers and producers is called
tax incidence.

❑ Typically, the tax incidence, or burden, falls both on

the consumers and producers of the taxed good.
❑ Only rarely will it be shared equally

❑ If demand is more inelastic than supply, consumers

bear most of the tax burden, and

❑ If supply is more inelastic than demand, sellers bear

most of the tax burden.
An excise tax introduces a wedge between the price paid by
consumers (Pc) and the price received by producers (Pp).

The vertical distance between Pc and Pp is the amount of

the tax per unit. Pe is the equilibrium price prior to
introduction of the tax.

(a) When the demand is more elastic than supply, the tax
incidence on consumers Pc – Pe is lower than the tax
incidence on producers Pe – Pp.

(b) When the supply is more elastic than demand, the tax
incidence on consumers Pc – Pe is larger than the tax
incidence on producers Pe– Pp.

(c) The more elastic the demand and supply curves, the
lower the tax revenue.
 How Taxes on Sellers Affect Market
Outcomes
➢ When a tax of $0.50 is levied on
sellers, the supply curve shifts
up by $0.50 from S1 to S2 .
➢ The equilibrium quantity falls
from 100 to 90 cones. The price
that buyers pay rises from
$3.00 to $3.30.
➢ The price that sellers receive
(after paying the tax) falls from
$3.00 to $2.80.
➢ Even though the tax is levied on
sellers, buyers and sellers share
the burden of the tax.
• Taxes discourage market activity. When a good is taxed,
the quantity of the good sold is smaller in the new
equilibrium.
• Buyers and sellers share the burden of taxes. In the
new equilibrium, buyers pay more for the good, and
sellers receive less.
 How Taxes on Buyers Affect Market
Outcomes
➢ When a tax of $0.50 is levied
on buyers, the demand curve
shifts down by $0.50 from D1
to D2 .
➢ The equilibrium quantity falls
from 100 to 90 cones. The
price that sellers receive falls
from $3.00 to $2.80.
➢ The price that buyers pay
(including the tax) rises from
$3.00 to $3.30.
➢ Even though the tax is levied
on buyers, buyers and sellers
share the burden of the tax.
In panel (a), the supply curve is elastic, and the demand
curve is inelastic. In this case, the price received by
sellers falls only slightly, while the price paid by buyers
rises substantially. Thus, buyers bear most of the
burden of the tax.

In panel (b), the supply curve is inelastic, and the

demand curve is elastic. In this case, the price received
by sellers falls substantially, while the price paid by
buyers rises only slightly. Thus, sellers bear most of the
burden of the tax.
A tax burden falls more heavily on the side of the market that is less
elastic.

A small elasticity of demand means that buyers do not have good

alternatives to consuming this particular good. A small elasticity
of supply means that sellers do not have good alternatives to
producing this particular good. When the good is taxed, the side
of the market with fewer good alternatives is less willing to leave
the market and, therefore, bears more of the burden of the tax.
Long Run Cost
COST in the Short Run
The Relation between AC and MC:
• Whenever marginal cost lies
below average cost, the
average cost curve falls.
• Whenever marginal cost lies
above average cost, the
average cost curve rises.
• When average cost is at a
minimum, marginal cost
equals average cost.
 Cost in the Long run
• long-run average cost curve (LAC): Curve relating
average cost of production to output when all inputs,
including capital, are variable.
• short-run average cost curve (SAC): Curve relating
average cost of production to output when level of
capital is fixed.
• long-run marginal cost curve (LMC) Curve showing the
change in long-run total cost as output is increased
incrementally by 1 unit.
Cost in the Long run
When a firm is producing
at an output at which the
long-run average cost LAC
is falling, the long-run
marginal cost LMC is less
than LAC. Conversely,
when LAC is increasing,
LMC is greater than LAC.
The two curves intersect
at A, where the LAC curve
achieves its minimum.
Cost in the Long run The long-run average
cost curve LAC is the
envelope of the short-
run average cost curves
SAC1 , SAC2 , and SAC3
. With economies and
diseconomies of scale,
the minimum points of
the short-run average
cost curves do not lie
on the long-run
average cost curve.
 Economies of scale
• Economies of scale: Situation in which output can be doubled for less
than a doubling of cost.
1. If the firm operates on a larger scale, workers can specialize in the
activities at which they are most productive.
2. Scale can provide flexibility. By varying the combination of inputs
utilized to produce the firm’s output, managers can organize the
production process more effectively.
3. The firm may be able to acquire some production inputs at lower
cost because it is buying them in large quantities and can therefore
negotiate better prices. The mix of inputs might change with the
scale of the firm’s operation if managers take advantage of lower-
cost inputs.
 Diseconomies of Scale
• Diseconomies of scale Situation in which a doubling of output
requires more than a doubling of cost.
1. At least in the short run, factory space and machinery may
make it more difficult for workers to do their jobs effectively.
2. Managing a larger firm may become more complex and
inefficient as the number of tasks increases.
3. The advantages of buying in bulk may have disappeared
once certain quantities are reached. At some point, available
supplies of key inputs may be limited, pushing their costs up.