Introduction to Economics

Two branches of economics

Microeconomics: the behaviour of individual units

o Rational decision-making of people and firms
o Supply and demand

Macroeconomics: the behaviour of the whole system

o The activity of economic institutions, e.g. government
o Measurement of a whole economy

Some key concepts

The economic problem

We have unlimited wants but limited resources!

This gives rise to constant scarcity.

o Some kind of constraint on consumption is therefore required.

The market

Markets bring together:

o Individuals (who consume goods and services)
o Firms (which sell goods and services)

Under ideal conditions, the market produces and allocates goods and services
efficiently (i.e. with minimal waste).

The market appears to be so efficient at doing this that Adam Smith talked of an
invisible hand.
It is not from the benevolence of the butcher, the brewer, or the baker, that we
expect our dinner, but from their regard to their own self-interest. We address
ourselves, not to their humanity but to their self-love, and never talk to them of our
own necessities but of their advantages.

The economy is made up of many interacting markets.

Chemical
extraction

Plastics
Ink

Pens

Solvents
Labour
Books
Dyes

Writers

Money

Bartering has to get over the problem of the double coincidence of wants.

The use of money overcomes this.

Types of economic system

Planned
Competitive / Market / Laissez-faire
Mixed

Government intervention can take many forms:

o Ownership
o Regulation
o Taxation / subsidy

Tradeoffs

Individual:
o 15 minutes sleep or 15 minutes earlier to work
o Economics class or lunch

Societal:
o Efficiency or equity
o Health of education

Opportunity cost

This is the cost of one activity considered in terms of the best alternative (which has to
be foregone), e.g. buy a house, or put money in the bank

Decisions at the margin

Marginal means (roughly) considering the effects of one more.

o E.g. the marginal benefit of building a bridge is the extra benefit accrued just due
to that extra bridge (i.e. not the average benefit).

Diminishing marginal returns mean that we tend not to spend all our money on one
thing.
o E.g. you are much less likely to buy a chocolate bar if you have already eaten 3.

Rational Agency

Both individuals and firms are rational, in theory.

o Individuals seek to maximise utility.
o Firms seek to maximise profits.

Incentives can therefore affect peoples behaviour.

Supply and Demand

Quantity

Quantity demanded refers to the quantity that buyers are willing to purchase.

Quantity supplied refers to the quantity of a good that sellers are willing to offer.

Determinants of demand

Price of the product in question

Price of competing products
Consumer income
Tastes
Expectations
Size of the market

The Law of Demand

Ceteris paribus the quantity demanded of a good is inversely related to price.

Price

Quantity
demanded

NB while economic examples are typically stated in terms of price affecting demand
(and therefore you would expect price to be on the x-axis), in reality the variables are
interdependent. High demand can have a price reducing effect(?)

Determinants of Supply

Price of the product in question

Input price
Production technology
Expectations
Size of the market

The Law of Supply

Ceteris paribus the quantity supplied of a good is rises with price.

Price

Quantity
supplied

Economic efficiency

A system is Pareto-optimal when there is minimum waste, i.e.:

o There is no redundant capacity: you cant make anyone better off without
making someone else worse off.
o Productive and allocative efficiency come into this.

Maximum efficiency may not always be desirable; e.g. it may cause gross inequality.

Under normal conditions, the market should reach an equilibrium point of maximum
efficiency.

Equilibrium of Supply and Demand

The Equilibrium Point
Price
Supply
curve

Equilib
rium
price
Demand
curve

Quantity

Equilib
rium
quantit
y
equilibrium

When price and quantity reach this

point, we say that the market has
cleared. This equilibrium point is the point of maximum efficiency.

Changes in Supply and Demand

Increased demand (e.g. ice-cream in the summer): the demand curve moves right.
Increased supply (e.g. cheaper milk): the supply curve moves right.
Normally, both curves will move at the same time (e.g. in a heatwave, higher demand
will give rise to more production, but also higher maintenance cost of machines).

Price Distortion as a cause of inefficiency

Artificially high prices (e.g. through purchase tax) mean that demand wont meet supply
because the price as perceived by producers and consumers will be different.
This leads to inefficiency. Producers are producing less than is economical at a given
price, and consumers are consuming less than is utility-optimal.
Price
Supply
curve

Equilib
rium
price

Demand curve
without tax
Demand curve
with tax

Equilib
rium
quantit
y

Quantity

An analogous effect is produced by price subsidy.

Elasticity
Price Elasticity of demand

This means the extent to which the price of a good/service affects the quantity
demanded. The more price-elastic it is, the greater the effect of price.
o Price-elastic: all normal goods and most inferior goods
o Price-inelastic: necessities, e.g. petrol
For the purposes of raising revenue, it is clearly better to tax goods which are priceinelastic of demand.
NB: Price Elasticity of demand is not the same as the slope of the demand curve. The
technical definition of elasticity refers to percentage change => log-log relationship.

Income Elasticity of demand

This means the extent to which consumer income affects demand for a good/service.
You may imagine that the relationship is always a positive one, but it isnt!
o Positively (0-1) income-elastic: normal goods
o Very positively (>1) income-elastic: luxury goods. As incomes rise, the demand
for luxury goods increases disproportionately.
o Negatively income-elastic: inferior goods. As incomes rise, demand switches to
higher-quality goods.

Income and Substitution effects

These effects relate to individual preferences and how these relate to work and pay.
Increasing someones salary can motivate them to:
(i)
work more hours
(ii)
work fewer hours
Why? Lets examine the two effects:
o Substitution effect: an increase in pay causes an individual to work more
hours, because their work is worth more (autrement dit the opportunity cost of
leisure is higher).
o Income effect: an increase in pay causes an individual to work fewer hours,
because they have already reached their target level of income.
It can be hard to tell which effect will predominate! Consider:
Price
(i.e. wages)

Supply
curve

Incom
e
effect
predo
minant
Substituti
on effect
predomin
ant
Demand
curve
Quantity
(i.e. hours)

We call this a backward-bending supply curve.