Chapter 1: The Scope and Method of Economics

What is Economics?

Economics is the study of how individuals, firms, and societies make choices regarding the allocation of limited resources. It fundamentally addresses the problem of scarcity, which means that resources are available in limited quantities.

• Scarcity: A condition where resources are insufficient to satisfy all wants.

• Microeconomics: Focuses on individual decision-making, firm behavior, and market interactions.

• Macroeconomics: Deals with aggregate economic phenomena such as government policy, inflation, and GDP (not covered in microeconomics).

• Scarce Goods Examples: Water, cars, diamonds, celebrities (e.g., Beyoncé).

• Non-Scarce Good Example: Air (in most contexts).

• Poverty: An income threshold below which basic needs cannot be met; distinct from scarcity.

Five Foundations of Economics

• Incentives: Motivations for behavior, both positive (rewards) and negative (penalties). Incentives can have unintended consequences.

• Tradeoffs: Every choice involves giving up alternatives. Example: The opportunity cost of military spending is the value of alternative uses (e.g., hospitals, highways).

• Opportunity Cost: The highest-valued alternative forgone when making a choice.

• Marginal Thinking: Evaluating the benefit of one additional unit versus its cost. Marginal refers to the next unit.

• Trade: Specialization and exchange make all parties better off.

The Scientific Method in Economics

Economists use the scientific method to construct and test models:

1. Observe phenomena.

2. Develop hypotheses.

3. Construct models to test hypotheses.

4. Design experiments and collect data.

Models are simplified representations, often using ceteris paribus (holding other factors constant). Variables are classified as:

• Endogenous: Inside the model, controlled for.

• Exogenous: Outside the model, not controlled for.

Positive vs. Normative Analysis

• Positive Statements: Testable and verifiable (e.g., "The Nintendo Switch sold more consoles than the Playstation 4").

• Normative Statements: Opinions, not testable (e.g., "The Nintendo Switch has better games than other consoles").

Chapter 2: Scarcity and Choice

Opportunity Cost

Opportunity cost is the value of the next best alternative forgone when making a decision.

• Example: Choosing between bus and plane travel, factoring in monetary cost and time value.

Calculation Example:

• Bus: $100 + 16 hours × $8/hour = $228

• Plane: $200 + 6 hours × $8/hour = $248

• Find time value c where both options are equally attractive:

(per hour)

Production Possibility Frontier (PPF)

The PPF illustrates the maximum combinations of two goods that can be produced with fixed resources.

• Non-linear PPF: Increasing opportunity cost as more of one good is produced.

• Linear PPF: Constant opportunity cost.

• Investment in capital: Shifts the PPF outward, enabling more production in the future.

Comparative vs. Absolute Advantage

• Comparative Advantage: Ability to produce a good at a lower opportunity cost than others.

• Absolute Advantage: Ability to produce more output with the same resources.

• Specialization: Parties should specialize in goods where they have comparative advantage and trade for mutual benefit.

Example Table: Anna and Beth's Production Possibilities

Additional info: Anna has a comparative advantage in mowing lawns; Beth in washing dishes.

Chapter 3: Demand, Supply, and Market Equilibrium

Law of Demand

There is an inverse relationship between price and quantity demanded.

• If price increases, quantity demanded decreases.

• Demand curve shifts when factors other than price change (e.g., income, tastes, prices of related goods).

• Movement along the curve: Change in quantity demanded due to price change.

• Shift of the curve: Change in demand due to other factors.

Law of Supply

There is a direct relationship between price and quantity supplied.

• If price increases, quantity supplied increases.

• Supply curve shifts when input costs, technology, taxes/subsidies, or expectations change.

• Movement along the curve: Change in quantity supplied due to price change.

• Shift of the curve: Change in supply due to other factors.

Market Equilibrium

Market equilibrium occurs where quantity supplied equals quantity demanded (Qs = Qd).

• Invisible Hand: Market forces push prices toward equilibrium.

• If Qs > Qd: Price falls.

• If Qs < Qd: Price rises.

Example: Market for Roses

• Qd = 90 - 2p

• Qs = -30 + p

• Set Qd = Qs to solve for equilibrium price and quantity:

Chapter 5: Elasticity

Price Elasticity of Demand

Measures the responsiveness of quantity demanded to a change in price.

• Formula:

• Determinants: Number of substitutes, proportion of budget, time horizon.

• Elastic: Large change in Qd relative to price change.

• Inelastic: Small change in Qd relative to price change.

Methods of Calculating Elasticity

• Percentage Formula:

• Midpoint Formula:

Example Table: Tennis Passes in NYC

Revenue: 1 Day 2010 = $84,000; 1 Day 2011-12 = $105,000. Revenue increased, indicating inelastic demand.

Types of Elasticity

• Perfectly Inelastic: (e.g., emergency hospital care)

• Relatively Inelastic: (e.g., gas, electricity)

• Relatively Elastic: (e.g., apples)

• Unitary Elastic:

Income Elasticity of Demand

Measures how quantity demanded changes with income.

• Formula:

• Normal Good:

• Necessity:

• Luxury:

• Inferior Good:

Cross-Price Elasticity of Demand

Measures the responsiveness of demand for one good to the price change of another good.

• Formula:

• Substitutes:

• Complements:

Price Elasticity of Supply

Measures how quantity supplied responds to price changes.

• Formula:

• Perfectly Inelastic Supply: (e.g., oceanfront land)

• Relatively Inelastic Supply: (e.g., cellphone tower)

• Relatively Elastic Supply: (e.g., hot dog vendor)

Chapter 4: Demand and Supply Applications

Consumer and Producer Surplus

• Consumer Surplus (CS): Difference between willingness to pay and actual price paid.

• Producer Surplus (PS): Difference between price received and minimum price willing to sell.

• Total Surplus (TS):

Efficiency and Equity

• Efficient Outcome: Allocation maximizes total surplus; all buyers and sellers matched.

• Equity: Fair distribution of goods; sometimes considered by economists.

Taxes and Deadweight Loss

• Per-Unit Tax: Tax on each unit sold.

• Levy: Who is legally responsible for paying the tax.

• Incidence: Who actually bears the tax burden.

• Deadweight Loss (DWL): Lost surplus due to reduced economic activity from taxes.

• Tax Revenue: Added to total surplus.

• Tax Incidence Calculation:

% Consumers = % Producers =

Note: The side the tax is levied on does not affect incidence; relative elasticity determines who pays more.

Price Controls

• Price Ceiling: Legally imposed maximum price.

• Binding Price Ceiling: Below equilibrium price; causes shortages and potential black markets.

• Price Gouging: Illegal price increases during emergencies; acts as a price ceiling.

Example Table: Winners and Losers from Price Ceilings

Additional info: Price ceilings can lead to increased self-sufficiency, illegal markets, and discrimination.