Chapter 1: The Scope and Method of Economics

1.1 Core Definitions

Economics is the study of how individuals and societies allocate scarce resources to satisfy unlimited wants. Scarcity is central: it exists when resources are insufficient to fulfill all desires at a zero price.

• Scarcity: Not enough resources to satisfy all wants at zero price.

• Factors of Production:

  • Land: Natural resources.

  • Labor: Human effort, both physical and mental.

  • Capital: Produced goods used for further production. Split into:

    • Physical capital: Tools, machinery, factories.

    • Human capital: Skills and education.

• Money is not capital: It is a financial asset, not a productive resource.

1.2 The Economic Problem

Scarcity forces societies to make choices. Three fundamental questions:

• What to produce?

• How to produce?

• For whom to produce?

Systems for answering these:

Market: Any place where buyers and sellers interact. Price: The key signal coordinating decisions.

1.3 Branches of Economics

• Microeconomics: Studies individual agents (households, firms) and markets.

• Macroeconomics: Studies aggregates (national income, employment, growth).

1.4 Positive vs Normative Economics

• Positive: Describes what is or will be; testable statements.

• Normative: Prescribes what should be; involves value judgments.

1.5 Economics as a Science

• Observation → Hypothesis → Testing → Modification

• Model: Simplified representation for prediction/explanation.

• Ockham's razor: Remove irrelevant details.

1.6 Key Assumptions

• People are rational

• Ex ante: Before the fact

• Ex post: After the fact

• Ceteris paribus: All else equal (used in drawing demand/supply curves)

1.7 Key Fallacies

• Post hoc ergo propter hoc: Confusing sequence with causation.

• Fallacy of composition: Assuming what's true for a part is true for the whole.

1.8 Criteria for Judging Outcomes

1.9 Marginalism and Sunk Cost

• Marginalism: Decisions based on additional costs/benefits.

• Efficient market: Profit opportunities are quickly eliminated.

1.10 Graphing Tools

• Slope:

• Linear equation:

• Time series graphs, curved lines (changing slope), simultaneous equations.

Chapter 2: The Economic Problem, Scarcity and Choice

2.1 Opportunity Cost and Sunk Cost

• Opportunity cost: Value of the best alternative forgone, including implicit costs.

• Sunk cost: Irrecoverable costs; should not affect decisions.

2.2 The Production Possibilities Frontier (PPF)

The PPF shows all efficient combinations of two goods that can be produced with fixed resources and technology.

• Assumptions: fixed resources, full employment, unchanged technology, specific time period.

• PPF is downward sloping (opportunity cost) and typically bowed out (increasing opportunity cost).

Law of Increasing Opportunity Cost: As more of one good is produced, the opportunity cost rises because resources are not equally suited for all production.

2.3 Slope of the PPF

• Marginal Rate of Transformation (MRT): Slope of the PPF; opportunity cost of producing one more unit of the good on the X-axis.

2.4 Reading the PPF

• PPF shifts outward with more resources or better technology.

• Growth in one good rotates the PPF outward along that axis.

2.5 Absolute and Comparative Advantage

• Absolute advantage: Producing more output with the same resources.

• Comparative advantage: Producing at lower opportunity cost.

2.6 Comparative Advantage: Worked Example

Steps for solving trade problems:

1. Identify format (output per resource or resource per output).

2. Determine absolute advantage.

3. Calculate opportunity cost for each country and good.

4. Identify comparative advantage (lower opportunity cost).

5. Find terms of trade (acceptable trading ratio between opportunity costs).

Terms of trade: between 0.5 and 1.5 cotton per wheat. Gains from trade are shown by consumption bundles outside the PPF.

Chapter 3: Demand, Supply, and Market Equilibrium

3.1 Market Structure

• Firms: Producers

• Households: Consumers

• Input markets: Households sell factors; firms buy.

• Output markets: Firms sell goods; households buy.

• Perfect competition: Many buyers/sellers, identical products, price takers.

3.2 Demand

• Quantity demanded: Amount buyers will purchase at a given price.

• Law of demand: As price rises, quantity demanded falls (inverse relationship).

• Substitution effect: Higher price leads buyers to switch to alternatives.

• Income effect: Higher price reduces real purchasing power.

• Demand schedule: Table of quantities at each price.

• Demand curve: Graph of the schedule (price on vertical axis).

• Market demand: Sum of individual demands at each price.

3.3 Shift vs Movement Along

• Movement along: Caused by change in own price (change in quantity demanded).

• Shift: Caused by other factors (change in demand).

3.4 Five Demand Shifters

• Income: Normal goods (demand rises), inferior goods (demand falls).

• Prices of related goods: Substitutes (demand rises with price of other), complements (demand falls with price of other).

• Tastes and preferences

• Expectations

• Number of buyers

3.5 Supply

• Quantity supplied: Amount firms will sell at a given price.

• Law of supply: As price rises, quantity supplied rises (positive relationship).

• Supply schedule/curve: Same as demand, but for sellers.

• Market supply: Sum of individual supplies at each price.

3.6 Five Supply Shifters

• Input prices

• Technology

• Number of sellers

• Prices of related products

• Expectations

3.7 Equilibrium

• Equilibrium: Price where Qd = Qs; no tendency to change.

• Excess demand (shortage): Price below equilibrium; Qd > Qs.

• Excess supply (surplus): Price above equilibrium; Qs > Qd.

• Price rationing: Allocation by willingness/ability to pay.

3.8 Equilibrium Algebra

• Set Qd = Qs, solve for P, substitute back for Q.

• Shortage: (price below equilibrium)

• Surplus: (price above equilibrium)

3.9 Comparative Statics: Single and Double Shifts

Double shifts: If both curves shift, one variable is indeterminate without knowing relative sizes.

Chapter 4: Demand and Supply Applications

4.1 Price Ceilings

• Price ceiling: Legal maximum price.

• Binding only if below equilibrium.

• Results: Shortage, non-price rationing (queuing, favoritism, coupons, black markets).

• Quantity traded = quantity supplied (short side determines market).

• Example: Rent control.

4.2 Price Floors

• Price floor: Legal minimum price.

• Binding only if above equilibrium.

• Results: Surplus, quantity traded = quantity demanded.

• Examples: Minimum wage, agricultural price supports.

4.3 Consumer and Producer Surplus

• Consumer surplus: Area below demand curve, above price, up to quantity traded.

• Producer surplus: Area above supply curve, below price, up to quantity traded.

• Total surplus: Maximized at equilibrium.

• Area calculation:

4.4 Deadweight Loss (DWL)

• DWL: Net loss of total surplus when quantity is away from equilibrium.

• Appears with binding ceilings/floors, taxes, quotas.

• Area:

4.5 Taxes

• Excise tax: Per unit tax; creates a wedge between buyer and seller prices.

• Effects: Price buyers pay rises, sellers receive falls, quantity traded falls.

• Tax revenue:

• DWL triangle appears beside revenue rectangle.

• Tax incidence: Burden depends on relative elasticity, not legal responsibility.

• More inelastic side bears more of the tax.

Chapter 5: Elasticity

5.1 Why Elasticity Exists

• Slope depends on units; elasticity is unit-free (ratio of percentage changes).

• Slope is not elasticity.

5.2 Price Elasticity of Demand

• Definition:

• Midpoint formula:

• Sign is negative; use absolute value for classification.

5.3 Classification of Elasticity

5.4 Elasticity Along a Linear Demand Curve

• Slope is constant, elasticity varies.

• Top left: infinite elasticity; midpoint: unit elastic; bottom right: zero elasticity.

• Vertical/horizontal curves: elasticity is constant everywhere.

5.5 Total Revenue Test

• Total revenue:

• If demand is elastic, price and TR move opposite.

• If inelastic, price and TR move together.

5.6 Determinants of Price Elasticity of Demand

• Availability of substitutes (more = more elastic)

• Share of budget (larger = more elastic)

• Luxury vs necessity (luxury = elastic, necessity = inelastic)

• Time horizon (longer = more elastic)

• Breadth of market definition (narrower = more elastic)

5.7 Income Elasticity of Demand

• Positive: normal good; negative: inferior good.

• >1: luxury; 0–1: necessity.

5.8 Cross Price Elasticity of Demand

• Positive: substitutes; negative: complements; zero: unrelated.

5.9 Elasticity of Supply

• Determinants: time, input availability, production flexibility, spare capacity.

• Perfectly inelastic supply: fixed quantity (e.g., land, unique art).

5.10 Elasticity and Tax Incidence

• More inelastic side bears more of the tax.

• Deadweight loss is larger when supply or demand is more elastic.

• Tax on perfectly inelastic good creates no deadweight loss.

Formula Sheet (Summary)

• Slope:

• Linear:

• Opportunity cost (output):

• Opportunity cost (hours):

• Terms of trade: strictly between opportunity costs

• Equilibrium: set Qd = Qs, solve for P

• Shortage:

• Surplus:

• Consumer surplus:

• Producer surplus:

• Total surplus: CS + PS

• DWL:

• Tax revenue:

• Midpoint elasticity:

• Elastic if , inelastic if , unit elastic if

• TR test: elastic means P and TR move opposite; inelastic means P and TR move together

• Income elasticity: positive = normal, negative = inferior

• Cross price: positive = substitutes, negative = complements

• Linear demand curve: elastic above midpoint, unit at midpoint, inelastic below

Key Graphs to Practice

1. Bowed out PPF (with inside/outside points, outward shift)

2. Straight line PPF for two-country trade

3. Demand and supply with equilibrium

4. Demand shift (new equilibrium)

5. Supply shift (new equilibrium)

6. Binding price ceiling (shortage measured)

7. Binding price floor (surplus measured)

8. Tax wedge (tax revenue, CS, PS, DWL labeled)

Additional info: These notes cover all foundational microeconomics concepts from scarcity and opportunity cost, through market equilibrium, price controls, surplus analysis, and elasticity. They are structured for exam preparation and include definitions, examples, formulas, and tables for comparison and classification.