Chapter 2: Thinking Like an Economist

(N. Gregory Mankiw – Principles of Economics, 9th Edition)

1. The Economist as Scientist

➤ The Scientific Method: Observation, Theory, and More Observation

• Economists use the scientific method to develop and test theories about how the
world works.

• Though they cannot conduct laboratory experiments, they use natural experiments,
historical data, and statistical analysis.

➤ The Role of Assumptions

• Assumptions simplify complex reality to make models easier to understand.

• The art in scientific thinking is deciding which assumptions to make.

o E.g., assuming "perfectly competitive market" or "rational behavior" can help

in focused analysis.

➤ Economic Models

• Models are simplifications of reality, used to improve understanding.

• Like maps, they omit many details to focus on what’s important.

2. Our First Model: The Circular-Flow Diagram

➤ Circular-Flow Diagram

• Visual model showing the flow of money, goods & services, and factors of
production between households and firms.

Key Components:

• Markets for Goods and Services → Households are buyers; Firms are sellers.

• Markets for Factors of Production → Firms are buyers; Households are sellers.

• Factors of Production include: Labor, land, and capital.

3. Our Second Model: The Production Possibilities Frontier (PPF)

➤ Production Possibilities Frontier (PPF)

• Graph showing the combinations of output that an economy can produce with its
available resources and technology.

Key Concepts:

• Efficiency: Points on the PPF represent efficient levels of production.

• Inefficiency: Points inside the curve show underutilization.

• Infeasibility: Points outside the curve are not attainable.

• Opportunity Cost: Slope of the PPF shows the opportunity cost of one good in terms
of another.

• Economic Growth: Outward shift of the PPF.

4. Microeconomics and Macroeconomics

➤ Microeconomics

• Study of individual decision-making units (households, firms, industries).

➤ Macroeconomics

• Study of economy-wide phenomena like inflation, unemployment, and economic

growth.

5. The Economist as Policy Adviser

Economists play two roles:

1. Scientists – trying to explain the world.

2. Policy Advisers – trying to improve it.

➤ Positive vs Normative Statements

• Positive Statements: Descriptive, based on facts, can be tested.

Example: "An increase in the minimum wage causes unemployment."

• Normative Statements: Prescriptive, based on values, cannot be tested.

Example: "The government should raise the minimum wage."

6. Why Economists Disagree

➤ Reasons Economists Disagree:

1. Different scientific judgments (e.g., different models or assumptions).

2. Different values (leading to different normative recommendations).

➤ Council of Economic Advisers

• A group of three economists appointed by the President to advise on economic

policy.

• Prepares the Annual Economic Report of the President.

7. Let’s Get Going

• While real-world economics is complex, learning economic thinking through models

and simplified assumptions helps us understand the big picture.

• This chapter sets the tone for analyzing real issues using economic tools.

Graphical Representations in Chapter 2:

1. Circular-Flow Diagram

2. Production Possibilities Frontier (PPF)

Chapter 3: Interdependence and the Gains from Trade

(Principles of Economics – N. Gregory Mankiw, 9th Edition)

1. Opportunity Cost and Comparative Advantage

➤ Opportunity Cost

• The opportunity cost of an item is what must be given up to obtain that item.

• This concept is central to understanding comparative advantage.

• Example: If you spend time making a good yourself, you lose the opportunity to buy
it from someone who could make it more efficiently.

2. Comparative Advantage and Trade

➤ Absolute Advantage

• The ability to produce a good using fewer inputs than another producer.

• A person can have absolute advantage in both goods, but not comparative
advantage in both.

➤ Comparative Advantage

• The ability to produce a good at a lower opportunity cost than another producer.

• Trade is based on comparative advantage, not absolute advantage.

Rule:
Each person should specialize in the good in which they have the comparative advantage.

Benefits of Specialization

• When two parties specialize in goods they produce at lowest opportunity cost and
trade, both can be better off.

• This results in gains from trade, allowing each to consume beyond their own PPF.

3. The Price of the Trade

➤ Terms of Trade

• For both parties to benefit, the price of the trade must lie between the two
opportunity costs.

Example:

• If farmer's opportunity cost of 1 ounce of meat is 2 ounces of potatoes

• And rancher's cost is 4 ounces of potatoes

A trade of 1 ounce of meat for 3 ounces of potatoes would benefit both.

➤ Both Parties Benefit

• By trading at a price between opportunity costs, each can get a good at a lower cost
than if they produced it themselves.

4. The Legacy of Adam Smith and David Ricardo

➤ Adam Smith

• In The Wealth of Nations (1776), Smith argued that specialization and free trade
increase productivity and wealth.

• He introduced the idea of absolute advantage.

➤ David Ricardo

• In Principles of Political Economy and Taxation (1817), Ricardo extended Smith’s work
by developing the concept of comparative advantage.

• He showed that even if one country is better at producing everything, there are still
gains from trade.

Ricardo’s Message:

• Trade is not a zero-sum game.

• Both nations can gain by specializing and trading based on comparative advantage.
Summary Insight

• Interdependence is beneficial.

• Comparative advantage explains how everyone can benefit through specialization

and trade.

• The concepts of opportunity cost, terms of trade, and the teachings of Smith and
Ricardo are fundamental to modern economics.

Chapter 4: The Market Forces of Supply and Demand

(Principles of Economics – N. Gregory Mankiw, 9th Edition)

1. Markets and Competition

➤ Definition of a Market

• A market is a group of buyers and sellers of a particular good or service.

• Buyers determine demand, sellers determine supply.

➤ Types of Markets

• Perfectly Competitive Market:

o Many buyers and sellers

o Homogeneous product

o No single buyer/seller affects the price

o Buyers and sellers are price takers

• Monopoly, Oligopoly, Monopolistic Competition are examples of imperfect

competition (covered in later chapters).

2. Demand

➤ Quantity Demanded

• The amount of a good that buyers are willing and able to purchase at a given price.

➤ Law of Demand

• Other things equal, as the price of a good rises, the quantity demanded falls, and vice
versa.

➤ Demand Schedule and Demand Curve

• Demand schedule: Table showing quantity demanded at various prices.

• Demand curve: Graph showing the relationship between price and quantity
demanded.

➤ Market Demand

• The sum of all individual demands for a good or service.

➤ Shifts in the Demand Curve

• A change in price → movement along the demand curve.

• A change in other factors → shift of the entire curve.

Factors that shift demand (Demand Shifters):

1. Income:

o Normal goods → ↑ income = ↑ demand

o Inferior goods → ↑ income = ↓ demand

2. Prices of related goods:

o Substitutes → ↑ price of one = ↑ demand for the other

o Complements → ↑ price of one = ↓ demand for the other

3. Tastes and preferences

4. Expectations about the future

5. Number of buyers

3. Supply

➤ Quantity Supplied

• The amount of a good that sellers are willing and able to sell at a given price.

➤ Law of Supply

• Other things equal, as the price of a good rises, the quantity supplied rises, and vice
versa.

➤ Supply Schedule and Supply Curve

• Supply schedule: Table showing quantity supplied at various prices.

• Supply curve: Graph showing the relationship between price and quantity supplied.

➤ Market Supply

• The sum of all individual supplies of a particular good.

➤ Shifts in the Supply Curve

• A change in price → movement along the supply curve.

• A change in other factors → shift of the entire curve.

Factors that shift supply (Supply Shifters):

1. Input prices (e.g., wages, materials)

o ↑ input prices = ↓ supply

2. Technology

o Improvements increase supply

3. Expectations about future prices

o If prices expected to rise, current supply may fall

4. Number of sellers

4. Supply and Demand Together

➤ Equilibrium

• The point where quantity demanded = quantity supplied.

• The equilibrium price is also called the market-clearing price.

• At equilibrium:

o No shortage or surplus

o Market is in balance

➤ Surplus (Excess Supply)

• When quantity supplied > quantity demanded

• Sellers lower the price to increase sales.

➤ Shortage (Excess Demand)

• When quantity demanded > quantity supplied

• Sellers raise the price due to high demand.

➤ Law of Supply and Demand

• The price of a good adjusts to bring the quantity supplied and quantity demanded
into balance.

5. How Prices Allocate Resources

• Prices are signals that guide resource allocation.

• In a market economy, prices coordinate decisions of buyers and sellers.

• They reflect both value to consumers and cost to producers.

Conclusion

• Supply and demand are the core forces of a market economy.

• Understanding how they interact helps us explain how prices are determined and
how markets work efficiently.

• This chapter lays the groundwork for more advanced economic analysis.

Graphical Representations in Chapter 4

1. Demand Curve

2. Shifts in Demand

3. Supply Curve

4. Shifts in Supply

5. Market Equilibrium
6. Shortage and Surplus
Chapter 5: Elasticity and Its Application – N. Gregory Mankiw, 9th Edition

Introduction

Elasticity measures how much one variable responds to changes in another variable. In economics,
it’s primarily used to measure how quantity demanded or supplied responds to changes in price.

1. The Elasticity of Demand

➤ Price Elasticity of Demand

• Definition: Measures how much the quantity demanded of a good responds to a change in
the price of that good.

• Formula:

Price Elasticity of Demand=%Change in Quantity Demanded%Change in Price\text{Price Elasticity of

Demand} = \frac{\% \text{Change in Quantity Demanded}}{\% \text{Change in Price}}

➤ Determinants of Price Elasticity

• Availability of close substitutes

• Whether the good is a necessity or a luxury

• Definition of the market (narrow or broad)

• Time horizon (more elastic in the long run)

➤ Elastic vs Inelastic Demand

• Elastic Demand: Elasticity > 1 → Quantity demanded changes a lot with price.

• Inelastic Demand: Elasticity < 1 → Quantity demanded changes a little with price.

• Unit Elastic: Elasticity = 1

➤ Total Revenue and Elasticity

• Total Revenue (TR) = Price × Quantity

• If demand is elastic, a price increase reduces TR.

• If demand is inelastic, a price increase increases TR.

2. Other Demand Elasticities

➤ Income Elasticity of Demand

• Measures how quantity demanded changes as consumer income changes.

• Formula:
Income Elasticity=%Change in Quantity Demanded%Change in Income\text{Income Elasticity} =
\frac{\% \text{Change in Quantity Demanded}}{\% \text{Change in Income}}

• Normal goods: Positive income elasticity

• Inferior goods: Negative income elasticity

➤ Cross-Price Elasticity of Demand

• Measures how the quantity demanded of one good responds to a change in the price of
another good.

• Formula:

Cross-
Price Elasticity=%Change in Quantity Demanded of Good 1%Change in Price of Good 2\text{Cross-
Price Elasticity} = \frac{\% \text{Change in Quantity Demanded of Good 1}}{\% \text{Change in Price
of Good 2}}

• Substitutes: Positive cross-price elasticity

• Complements: Negative cross-price elasticity

3. The Elasticity of Supply

➤ Price Elasticity of Supply

• Measures how much the quantity supplied of a good responds to a change in the price.

• Formula:

Price Elasticity of Supply=%Change in Quantity Supplied%Change in Price\text{Price Elasticity of

Supply} = \frac{\% \text{Change in Quantity Supplied}}{\% \text{Change in Price}}

➤ Determinants of Supply Elasticity

• Flexibility of sellers

• Time period (supply is more elastic in the long run)

➤ Types of Supply Curves

• Perfectly inelastic supply: Vertical curve (Elasticity = 0)

• Perfectly elastic supply: Horizontal curve (Elasticity = ∞)

• Unit elastic supply: Elasticity = 1

4. Application: The Elasticity and Taxation

➤ Impact of Taxes

• A tax on a good reduces quantity sold.

• Buyers pay more, and sellers receive less.

➤ Elasticity and Tax Incidence

• Tax Incidence: Refers to the distribution of tax burden between buyers and sellers.

• The side of the market that is less elastic bears more of the tax burden.

o If demand is inelastic and supply is elastic → Buyers bear more of the burden.

o If supply is inelastic and demand is elastic → Sellers bear more of the burden.

➤ Graphical Analysis

• Diagrams show the effect of tax shifting and how elasticity affects incidence.

Conclusion

• Elasticity is a critical tool in economics for analyzing supply, demand, and market changes.

• It helps understand total revenue, policy impact, and business decisions.

• Elasticity determines how much markets respond and who bears the burden of taxes.

• Graphical Representations in Chapter 5

Chapter 6: Supply, Demand, and Government Policies

(Principles of Economics – N. Gregory Mankiw, 9th Edition)

1. Controls on Prices

➤ Price Ceilings and Price Floors

Government sometimes sets price controls to regulate the economy, especially to protect buyers or
sellers.

Price Ceiling

A legal maximum on the price at which a good can be sold (e.g., rent control)

• Binding vs Non-Binding:

o If non-binding (above equilibrium) → no effect.

o If binding (below equilibrium) → causes shortages.

• Effects of Binding Price Ceiling:

o Shortages

o Long lines

o Rationing

o Black markets

• Real-World Example: Rent control policies.

Price Floor

A legal minimum on the price at which a good can be sold (e.g., minimum wage)

• Binding vs Non-Binding:

o If non-binding (below equilibrium) → no effect.

o If binding (above equilibrium) → causes surplus.

• Effects of Binding Price Floor:

o Surplus of goods/labor

o Unemployment in case of minimum wage

• Real-World Example: Minimum wage laws.

2. Evaluating Price Controls

Mankiw stresses that price controls often have unintended consequences:

• Lead to inefficiency.

• Create black markets.

• Policymakers need to understand market forces before applying such controls.

3. Taxes

Governments use taxes to raise revenue for public purposes and influence market outcomes.

How Taxes on Sellers Affect Market Outcomes

• Supply curve shifts left/upward.

• Higher equilibrium price and lower quantity.

• Buyers pay more, sellers receive less.

• The tax reduces market size.

How Taxes on Buyers Affect Market Outcomes

• Demand curve shifts left/downward.

• New equilibrium with lower quantity and lower price received by sellers.

• Buyers still pay more (including tax).

• Same result: tax wedge between what buyers pay and what sellers receive.

4. Elasticity and Tax Incidence

• Tax incidence refers to how the burden of a tax is distributed between buyers and sellers.

• The side of the market that is less elastic bears more of the tax burden:

o Inelastic demand: Buyers bear more.

o Inelastic supply: Sellers bear more.

• This idea connects back to Chapter 5 (Elasticity).

5. Case Studies

Mankiw includes examples to illustrate how price controls and taxes work in the real world:

Rent Control

• Designed to help the poor.

• In the short run: small shortage.

• In the long run: large shortage, deteriorating quality of housing.

Minimum Wage

• Increases income of low-skilled workers (if employed).

• But causes unemployment, especially among youth.

• Surplus of labor = unemployment.

Luxury Tax

• Imposed to target rich consumers.

• However, burden falls largely on suppliers (workers in the luxury industries) due to elastic
demand and inelastic supply.

Conclusion

• Government policies (price controls and taxes) can alter market outcomes.

• They may be well-intentioned but can lead to unintended consequences.

• Understanding supply, demand, and elasticity helps predict the effects of such policies.

Graphical Representations in Chapter 6