Economics is a social science that studies how scarce resources are allocated to

satisfy needs and wants.

Microeconomics – this is concerned with the consumption, production and

distribution of goods and services, and focuses on individuals, firms and

government behaviour.

Macroeconomics – this focuses on the economy as a whole, in areas such as

national income, inflation, unemployment, growth, development, government

spending, and international trade.

Positive statements are based on facts. They can be verified by evidence.

Normative statements are based on opinion. They cannot be verified by

evidence. “Should” and “Ought” are usually used in normative statements.

Resources refer to all inputs used in the production process.

Goods are tangible things that are produced for consumers to satisfy their needs

and wants. Consumer goods are consumed for the purpose of satisfying needs

and wants. Capital goods are used in the production process to make a final good

or service. Milk is a consumer good if consumed as it is, but is a capital good if it is

used in the production of ice cream or punch.

Services are intangible things that are used to satisfy needs and wants. They are

not physical. They can be experienced but not touched.

The Central Problem of economics is SCARCITY. Scarcity means “limited in

supply” and it is the direct result of limited resources and unlimited wants. It is

impossible to supply unlimited wants with limited resources so CHOICES have to

be made concerning the best way to use or allocate the resources. The presence

of choice means that some alternative uses for the scarce resources would not be

chosen. The next best alternative forgone is called the OPPORTUNITY COST. If the

different uses for the resources were prioritized and the number 1 priority was

chosen, then the number 2 on the list is the opportunity cost.

Scarcity, choice and opportunity cost can be demonstrated on a special graph

called the PPF – the Production Possibilities Frontier (or PPC – production

possibilities curve). It is an abstract curve used to demonstrate an economy’s

production capacity from its given resources. It shows all the possible

combinations of the two goods that can be produced from a country’s resources.

Assumptions:

Only 2 goods are produced.

Technology is fixed.

The PPF is concave to the origin.

Good Y

Points above the frontier might be desired but they are not attainable

because there are just not enough resources to produce them. They are in

the realm of unlimited wants.

Good X

0

PPF

Unattainable

Attainable but inefficient

Attainable and efficient

10590

60

100

100

80

Points below the frontier are attainable because there are enough

resources to produce them but they are inefficient because all resources

are not being used. More of both goods can be made if the country makes

full use of its resources.

Points on the frontier show the combinations of goods/services that can be

made with full use of the country’s resources. There is full employment of

resources. These combinations are therefore attainable and efficient.

Efficiency is divided into two subgroups: productive efficiency (producing

the largest quantity of goods and services possible with given resources)

and allocative efficiency (choosing the best combination or best point on

the frontier out of all the combinations/points on the frontier to maximize

the well-being of everyone).

The PPF shows scarcity because it shows a limit to the amount of goods and

services that can be produced, and this limit is a direct result of limited resources.

So the curve itself demonstrates scarcity.

The PPF shows choice because only 2 goods can be produced from the country’s

resources and different combinations (or choices) are shown on and below the

curve.

The PPF shows opportunity cost because any change in production from one

point to another on the curve would necessitate giving up some of one good to

get more of the other. Increasing production from 60 units of Good Y to 80 units,

necessitates reducing production of Good X from 105 units to 100.

The opportunity cost can be calculated by using the concept of gradient from

mathematics.

Gradient/slope = change∈ ychange∈x = y2− y1

x2−x1 = 80−60100−105 = 20−5 = -4

The slope is negative because less of one good has to be produced to have more

of the other good.

The concave shape of the PPF demonstrates decreasing opportunity cost. What

this means is that each time more of one good is produced, less of the other good

has to be given up than before. To increase production of Good Y from 60 to 80 (a

difference of 20), 10 units of Good X had to be given up. To further increase

production of Good Y from 80 to 100 units (the same difference of 20), only 5

further units of Good X had to be given up. This is less than the 10 from before.

The opportunity cost has decreased.

This can also be proven by calculating gradient:

To move from 60 to 80 units of Good Y, the gradient was -4. It was calculated

above.

To move from 80 to 100 units of Good Y, the gradient is now -2.

Gradient/slope = change∈ ychange∈x = y2− y1

x2−x1 = 100−8090−100 = 20−10 = -2

Ignoring the minus sign, 2 is less than 4, therefore the opportunity cost

decreased.

There can be increasing opportunity cost if the PPF is drawn convex to the origin.

This means that more and more of one good has to be given up each time the

same amount of additional units of the other good are produced.

There can be constant opportunity cost if the PPF is drawn as a straight line. This

means that the same amount of one good has to be given up each time additional

units of the other good are produced.

Increasing returns to

scale Constant returns to scale

Scarcity causes all societies to face three basic questions:

WHAT to produce?

HOW to produce it?

FOR WHOM to produce it?

Different societies answer these questions in different ways, leading to 4

categories of economic systems:

Traditional economies

Free market economies

Planned economies

Mixed economies

Economic System Features/Description/

Characteristics

Advantages Disadvantages The answers to the

3 basic questions

Examples

Traditional/

Subsistence

It is run based on

tradition and customs

passed down through

generations.

Subsistence activities

include hunting,

fishing, farming, tool

making, and

agriculture.

Individuals have

assigned roles or

tasks to perform, and

there is unity among

community members.

New ways of doing

things are not

encouraged.

The three basic

question are

answered by the

tradition or

customs.

Indigenous tribes

in Africa, Asia and

South America.

Free Market/Free

Enterprise/

Market/Capitalist

All productive

resources are owned

by private individuals.

People are motivated

by personal gain. For

example:

maximization of

profit is the main goal

of business and

maximization of

satisfaction is the

main goal of

consumers.

The price mechanism

(or the market

system) determines

economic activity.

This means that

demand and supply

determine economic

activity.

There is consumer

sovereignty, since

consumers decide

what gets

produced (by what

they demand).

The profit motive

of businesses

encourages

innovation,

inventions, and

technological

development.

Productive and

allocative

efficiency (together

they are called

Pareto efficiency).

No provision or

inadequate

provision of

essential

commodities

(called merit goods

and public goods).

Market failure.

Unequal

distribution of

wealth.

Demerit goods get

produced, such as

alcohol and

tobacco.

Economic

instability

sometimes, such as

inflation and

recession.

The price

mechanism/market

forces/demand and

supply answer the

basic economic

questions.

No country is

purely free

market. The U.S.A.

comes close.

Goods and services

are distributed

according to

purchasing power.

Planned/Centrally

Planned/Command/

Communist/Egalitarian

All productive

resources are owned

by the state.

The state makes all

economic decisions.

Private individuals do

not have any input.

The well-being of the

society is generally

the main goal of the

state.

Full employment of

resources.

Goods and services

distributed equitably.

Allocative

efficiency is

pursued.

Full employment of

resources.

Prevention of

economic

instability such as

inflation and

recession.

Equality is

achieved.

Imperfect

information may

cause some of the

state’s decisions

not to be optimal.

Lack of freedom of

choice of

individuals in

economic matters.

No productive

efficiency.

The three basic

question are

answered by the

state.

China, Cuba, North

Korea.

Mixed Some economic

decisions are made

by the state and

some by private

individuals. For

example, the state

provides merit goods

and public goods that

the private sector

won’t.

Some of the

advantages of both

free market and

planned

economies.

Some of the

disadvantages of

both free market

and planned

economies.

The three basic

questions are

answered jointly by

the state and

private individuals.

Demand Theory

Consumers are groups of individuals who consume final goods and services.

Assumptions about consumers:

o Consumers are utility maximizers (they want to maximize satisfaction)

o Consumers are rational (they want the maximum satisfaction for the lowest

price).

Consumer demand (or market demand or just demand) refers to the total

quantity of goods and services that are purchased at a given price over a given

period of time.

Effective demand is the quantity of goods and services for which there is a desire,

willingness and ability to be purchased at a given price over a given period of

time.

Latent demand refers to the quantity of goods and services for which there is a

desire and willingness to be purchased, but not the ability, at a given price over a

given period of time.

There are two ways of describing consumer behaviour:

1. Marginal Utility Theory, also called the Cardinalist Approach because

cardinal numbers are used to represent consumers’ utility.

2. Indifference Curve Theory, also called the Ordinalist Approach because

utility is ordered (ranked).

Marginal Utility Theory

Utility = satisfaction

The unit for measuring utility/satisfaction = utils

An individual can state how much satisfaction they get from the consumption of a

good or service by the number of utils. They can make up an arbitrary number of

utils.

Total Utility is the total satisfaction derived from consuming a good or service. It

is cumulative. It takes into account all the units of the good or service that are

consumed.

Marginal Utility is the additional satisfaction derived from consuming just one

additional unit of a good or service.

MU = change∈totalutilitychange∈the quantity of goods∨services = ∆TU∆Q

Diminishing marginal utility occurs when consumption of more and more of a

good or service leads to lower levels of utility each time.

Consumers are concerned with the marginal utility per dollar ¿]

They equalize the marginal utility per dollar for every good or service that they

purchase. This is when CONSUMER EQUILIBRIUM is achieved. Therefore,

MUPrice

of good X = MUPriceof good Y = MUPrice

of good Z etc

Note that they must use up all of their income/budget.

If one good has a GREATER marginal utility per dollar than the other good, then

the consumer should consume MORE of it, till diminishing marginal utility causes

it to equalize with the other good.

If one good has a SMALLER marginal utility per dollar than the other good, then

the consumer should consume LESS of it, till it equalizes with the other good.

Limitation of marginal utility theory: the utils are arbitrary (or subjective). This

means that consumers can make up any number to represent satisfaction, and

different customers can make up different numbers to represent the same level

of utility. Therefore measuring utility accurately for comparison is difficult.

Indifference Curve Theory

The limitations of marginal utility theory led to the development of the

indifference curve theory. Utils are not needed. Consumers just need to order or

rank their satisfaction.

The analysis needs two parts: an indifference curve and a budget line (or budget

constraint).

Indifference Curves

An indifference curve shows all the combinations of two goods or services

that give the consumer the same level of satisfaction so the consumer is

indifferent about which of the possible combinations to choose.

It is convex to the origin. Thus it has a negative slope. The slope is called the

marginal rate of substitution.

Two indifference curves will never intersect.

A higher indifference curve represents higher satisfaction. Higher

satisfaction is always preferred, since consumers are utility maximizers.

Thus every combination of goods or services on the higher indifference

curve are preferred to combinations on lower indifference curves.

Many indifference curves are called an indifference map.

The budget line

The budget line shows all the combinations of two goods or services that

the consumer can afford with a given budget/income.

The budget line is a straight line that slopes downward. The slope is called

the Price Ratio since it takes into account the prices of both goods/services.

The budget line can shift if (i) prices of the two goods/services change or if

(ii) income/budget changes. The budget line can pivot if the price of one

good/service changes while the price of the other remains the same.

Consumer equilibrium occurs when the indifference curve is tangent to the

budget line. Lower indifference curves do not maximize utility and higher

indifference curves represent unaffordable combinations of goods and services.

The indifference curve that touches the budget line represents the combinations

of goods and services that give the highest utility and that can be afforded.

0

Incomeprice of Y

0

Incomeprice of Y

Good X

Good Y Good Y

Incomeprice of X

Good XIncomeprice of X

Incomeprice of Y

Incomeprice of X

Incomeprice of X

Individual Demand Curves

Both the Marginal Utility Approach and the Indifference Curve Approach reveal

something if the price of one good changes – the quantity demanded will change

also, in the opposite direction. That is, if the price of a good increases, the

quantity demanded will decrease, and vice versa. This gives rise to a downward

Good Y

Good X0

sloping individual demand curve. It shows the relationship between the price of a

good or service and the quantity demanded.

The market demand curve is exactly the same and shows the sum of all the

quantities demanded by each individual in the market.

The demand curve is represented as a straight line for simplicity, but is closer to a

curve in real life. It illustrates the Law of Demand: that there is an inverse

relationship between price of a good/service or quantity demanded, ceteris

paribus. In other words, if price increases, quantity demanded will decrease, and

if price decreases, quantity demanded will increase. They move in opposite

directions.

Price

Quantity

Demand

0

P1

Q1

Ceteris paribus is a Latin phrase that means “all other things constant.” In other

words, quantity demanded and price will behave this way only if nothing else is

influencing demand. We must allow price to be the only factor influencing

demand in order to observe this result. Other factors could cause a different

result to occur. So two situations emerge from this understanding:

(i) What happens when price changes but all other possible factors remain

the same?

(i) What happens when price remains the same but any of the other

possible factors changes?

To answer the first question: As seen before, when price changes, it causes

quantity demanded to change (in the opposite direction). Graphically, this is

shown as a movement along the demand curve. A movement to the right is called

an extension of demand and means that quantity demanded has risen. A

movement to the left is called a contraction of demand and means that quantity

demanded has declined.

Contraction of Demand (Quantity decreased)

Extension of Demand (Quantity increased)

P1

Price

To answer the second question: there are other things that affect quantity

demanded, even when the price does not change. These lead to a shift of the

demand curve. A shift to the right is called an increase in demand, and quantity

increases. A shift to the left is called a decrease in demand, and quantity

decreases.

Q1

0 Quantity

Decrease in Demand

P1

D3

D2

D1

Quantity

Price

Increase in Demand

The difference in language is subtle but important:

Factor that causes the change Jargon usedWhen price causes the change Extension, Contraction, Movement

along the demand curve, Quantity demanded has changed

When any factor other than price causes the change

Increase in demand, Decrease in demand, Shift of the demand curve, Demand has changed (leave out the word “quantity”)

Determinants of Demand (factors that can cause the demand curve to shift):

Changes in income

Expectations of a price change

Price changes of substitute goods or complementary goods

Changes in the size or composition of the population

Seasonal factors

Advertising

Changes in the distribution of income (from the rich to the poor, for

example)

Government influences (such as taxes or legislation)

Innovation (that causes obsolete or outdated goods to be replaced by

newer ones).

Q2Q10

Q3

Elasticity of Demand

Elasticity of demand is a measure of the responsiveness of quantity demanded to

changes in any of the factors that affect it. The most widely examined type of

elasticity of demand is Price Elasticity of Demand (P.E.D.).

P.E.D. is a measure of the responsiveness of quantity of a good or service

demanded to changes in its price. In other words, if price changes, would there be

a big change or a small change or no change at all in the quantity that people

demand?

P.E.D. = percentage change∈quantity demandedpercentagechange∈price = %∆Q%∆ P

Alternatively, P.E.D. = ∆Q∆P x original / previous priceoriginal / previous quantity

When given 2 prices and their resulting quantities demanded, calculate P.E.D.

using the formula above, then take its absolute value (meaning ignore the minus

sign and use only the digits), and find what category it belongs to from the table

below:

P.E.D. Result Degree/Category of Elasticity

Meaning Interpretation Graph

P.E.D. = 0 Perfectly price inelastic

A change in price would cause absolutely no change in quantity demanded

A 1% change in price will cause a (P.E.D.) % change in quantity demanded.

P.E.D. ˂ 1 Price inelastic A change in price would

A 1% change in price will cause a

cause a less than proportionate change in quantity demanded

(P.E.D.) % change in quantity demanded.

P.E.D. = 1 Unitary Price elasticity

A change in price would cause exactly the same percentage change in quantity demanded

A 1% change in price will cause a (P.E.D.) % change in quantity demanded.

P.E.D. ˃ 1 Price Elastic A change in price would cause a greater proportionate change in quantity demanded

A 1% change in price will cause a (P.E.D.) % change in quantity demanded.

P.E.D. = ∞ Perfectly Price Elastic

Quantity demanded would change by an infinite amount even with no change in price.

A 1% change in price will cause a (P.E.D.) % change in quantity demanded.

Factors affecting P.E.D.

Substitutes: the more substitutes there are for a good or service, the more

likely consumers would be to switch to the cheaper substitute. Therefore,

many substitutes = more price elastic demand, few or no substitutes = less

price elastic demand.

Time: time is related to the point above. The more time that consumers

have to search for substitutes, the more price elastic demand would be.

Therefore, more time = more price elastic, less time = less price elastic.

Income: the greater the amount of one’s income spent on the good or

service, the more a price change would evoke a response in you. Therefore,

good costs a high proportion of income = more price elastic demand, good

costs a low proportion of income = less price elastic demand.

Addiction/Necessity: the more addictive or necessary for survival a good or

service is, the less a price change would affect quantity demanded.

Therefore, addictive good/necessity = less price elastic, non-addictive

good/non-necessity = more price elastic.

Importance of P.E.D.

If a good has price elastic demand, then price could be lowered and it would lead

to a greater than proportionate increase in quantity demanded, and hence

greater revenue. But if price is increased, the opposite would happen – loss of

revenue.

If a good has price inelastic demand, then price could be increased and it would

lead to an increase in revenue, but if price is lowered, it would lead to loss of

revenue. Businesses can determine which type of price elasticity of demand their

customers have and decide whether it is better to increase or decrease price in

order to raise revenue. Governments can also increase taxes on price inelastic

goods and services (alcohol, casinos, lotto etc) to raise revenue, but lower taxes

on price elastic goods and services.

Another type of elasticity of demand is Income Elasticity of Demand: a measure

of the responsiveness of quantity demanded to changes in income.

“Income” is represented by the letter Y.

Y.E.D. = = percentage change∈quantity demandedpercentage change∈income = %∆Q%∆Y

It is the same formula as P.E.D. but price (P) is replaced by income (Y).

When Y.E.D. ˂ 0, the good or service is “inferior”

When Y.E.D. ˂ 1, the good is income inelastic

When Y.E.D. = 1, the good is unitary income elastic

When Y.E.D. ˃ 1, the good is “normal”

Importance of Y.E.D.

Business can pay attention to changes in their customers’ incomes, such as when

trade unions negotiate for higher wages, and determine whether or not their

demand will increase or decrease, based on whether the goods or services that

they provide are “inferior” or “normal”.

Another type of elasticity of demand is Cross Elasticity of Demand: a measure of

the responsiveness of quantity of a good demanded to changes in the price of a

different good (like a substitute or complementary good).

“Cross” is represented by the letter X.

X.E.D. = = percentage change∈quantity of good Ademandedpercentage change∈ priceof good B = %∆Qa%∆ Pb

It is the same formula as P.E.D. but price (P) is for one good and Quantity (Q) is for

a different good.

When X.E.D. ˃ 0, the two goods are substitutes (like bmobile and digicel service)

When X.E.D. ˂ 0, the two goods are complementary (must be used together, like

shampoo and conditioner)

When X.E.D. = 0, there is no relationship between the two goods.

Importance of X.E.D.

Businesses can use cross elasticity of demand to calculate how much the demand

for their good or service would change by if the price of its substitute or

complement changes.