Session 1

Basic Economic principles

Fundamental economic problem:

Scarcity: the limited nature of society’s resources (e.g. land, labor,

capital)

Economics: the study of how society manages scarce resources

The Economy: all the production and exchange activities that take place
every day

What do economists’ study?

- How people make decisions

o Work, buy, save, invest, produce
- How people interact with one another
- Analyze forces and trends that affect the economy as a whole
o Growth in average income
o Fraction of the population that cannot find work
o Rate at which prices are rising

MICRO VS. MACRO

- Microeconomics
o The study of how households and firms make decisions and how
they interact in Markets
- Macroeconomics
o The study of economy-wide phenomena, including inflation,
unemployment, and economic growth

Individual Decision Making

1. People face tradeoffs

a. Follows from the principle of scarcity
b. We must compromise. Compare the costs and benefits of your
decisions
c. “there is no free Lunch”
i. Ex: how to allocate time, family, income, profit, national
income…?
ii. Efficiency: ability to make a maximum with a minimum of
Means
iii. Equity: distribution of production uniformly
2. Opportunity Cost
a. What to give up to get something or the value of the benefits you
give up
b. Linked to the difficult measure of the cost of a decision
c. Ex. The opportunity cost of getting a higher education should
include not just the tuition fee, but also the forgone opportunities
such as working and earning wages
3. Thinking at the Margin
a. Rational people assumption
b. Framework reasoning that simplifies decision-making
c. Marginal decisions by considering the marginal benefit and
marginal cost
i. Whether to spend an extra hour playing video games?
ii. Whether to eat an extra cookie?
4. People respond to incentives:
a. Incentive:
i. Something that induces a person to act
ii. Higher price
1. Buyers – consume less
2. Sellers – produce more
iii. Public policy
1. Subsidies to EVs
2. Carbon tax

Interactions among agents

5. Trade can make everyone better off

a. Specialization and trade
i. Self-sufficient vs specialization
ii. Individuals, families
iii. Countries? Why trade wars?
6. Markets are usually a good way to organize economic activity
a. Everyone in the market make choices based on self interest
b. Markets and Market economy
i. Market as a type of institution: various forms of markets
ii. Product markets, labor markets, stock exchanges, online
marketplace, bitcoin markets, financial markets…
iii. Firms and the boundary of markets
iv. Market economy
1. Allocate resources through decentralized decisions of
many firms and households as they interact in
markets for goods and services
2. Guided by prices and self interest
3. Adam smiths “invisible hand”
4. Centrally planned economy and government
intervention
7. But sometimes, we need the government to improve market outcomes
a. Market failures
i. A SITUATION IN WHICH A MARKET FAILS TO ALLOCATE
RESOURCES EFFICENTLY
b. Sources of market failures
i. Unclear property rights
1. Property rights: the ability of an individual to own
and exercise control over scarce resources
2. Intellectual property rights
ii. Externalities (negative and positive externalities)
1. One’s actions affect the wellbeing of bystanders
iii. Market power
1. The ability of a single economic actor to have a
substantial influence on market prices, e.g.,
monopoly
2. Antitrust legislation
3. Equality (market can not handle inequality problems
-> government intervention)
4. Labor protection
5. Human rights …
c. Market failures justify government intervention, but there is also
government failure
i. limited information
ii. Agency problem

The economist as a scientist

The study of economics relies on the Scientific Method

- Developing models that explain some part of the world

- Drawing testable hypotheses from the predictions of the Model
- Testing them using data to see how closely the model matches what
we actually observe

Economic models:
The circular flow

The production possibilities frontier

- It is worthwhile noting that simply obtaining statistically significant

relations from the empirical tests does not suffice
- Correlation does not imply causality
o E.g.->
 1- people enter campus daily 9:00 am
 2- Everyday it rains at 9:00 a.m.
 =>Ppl walking into campus =/= Rain
- Natural experiments/ quasi experiments provide opportunities for
casual inference
o Easy, in theory, but in reality its much more complicated
(observe communities where certain policies/ circumstances are
in effect)
- POSITIVE VS. NORMATIVE ANALYSIS
o Positive statements: (objective statements-> it is raining))
 Attempt to describe the world as it is
 Descriptive
 Confirm or refute by examining evidence
o Normative Statements (Subjective statements -> it should be
sunny)
 Attempt to prescribe how the world should be
 Perspective
o Economists may disagree
 Validity of alternative positive theories about how the world
works
o Economists may have different values
 Different normative views about what policy should try to
accomplish

The Market Forces of Supply and Demand

Markets and Competition

- Supply and demand

o The forces that make market economies work
o Refer to the behavior of people as they interact in COMPETITIVE
MARKETS
- Market
o A group of buyers and sellers of a particular good or service
 Various forms
o Buyers as a group
 Determine the demand for a product
o Sellers as a group
 Determine the supply of the product
- Competitive market
o A market in which there are many buyers, and many sellers,
price and quantity are determined by all buyers and sellers as
they interact in the marketplace

DEMAND

- “demand”
o Relationship between the price of a good and quantity demanded
o Quantity demanded: amount of good that buyers are willing and
able to purchase (at a given price)
- Law of demand
o Other things equal ????
o When the price of a good rises, the quantity demanded of the
good falls
o When the price falls, the quantity demanded rises
 Price Demand
1. Individual demand
a. An individuals demand for a product
b. Recall: demand is a relation between the price of a good and the
quantity demanded
c. So, what is an individual’s demand?
i. Demand schedule: a table
1. Price on the left | quantity on the right
ii. Demand curve: a graph
1. Price on the Vertical axis
2. Quantity on the horizontal axis

Y-Values
4
2
0
0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6
a.
b. Blue line = demand curve
2. Market Demand
a. Sum of all individual demands for a good or service
i. @ 2.00$ Nicholas demands 3 ice cream cones and Sarah 4
-> quantity demanded @ 2$ is 3+4=7
b. Market demand curve
i. Sum the individual demand curves horizontally
ii. Total quantity demanded of a good varies
3. MOVEMENTS along the demand curve vs. SHIFTS in the demand curve
a. Movements along:
i. On a given demand curve, when there is a change in price,
quantity demanded changes
ii. Direction of change: law of demand
b. Shift in the demand curve:
i. An incident that increases/ decreases the quantity
demanded at EVERY PRICE
4. Demand shift
a. Shifts in the demand curve
i. Increases in demand
1. Change that increases the quantity demanded at
every price
2. Demand curve shifts right
ii. Decreases in demand
1. Change that decreases the quantity demanded at
every price
2. Demand curve shifts left
b. Variables that can shift the demand curve
i. Income, price of related goods, tastes, number of buyers,
expectations
c. Income
i. Normal good
1. Other things constant
2. An increase in income leads to an increase in
demand
ii. Inferior good
1. Other things constant
2. An increase in income leads to a decrease in demand
d. Prices of related goods
i. Substitutes: two goods where an increase in the price of
one, leads to an increase in the demand for the other
(tulips and magnolias)
ii. Complements: two goods where an increase in the price of
one, leads to a decrease in the demand for the other
(coffee and creamer)
e. Expectations about the future
i. Expect an increase in income tomorrow
1. Increase in current demand
ii. Expect higher prices tomorrow
1. Increase in current demand
f. Number of buyers, increases
i. A larger market
ii. Advertising
iii. Digital vs physical stores

VARIABLES THAT INFLUENCE BUYERS

Price of the good itself -> movement along the demand curve

Income -> shifts demand curve

Prices of related goods -> shifts the demand curve

Tastes -> shifts the demand curve

Expectation -> shifts the demand curve

Number of buyers -> shifts the demand curve

Elasticity and its Application

- Elasticity: How sensitive supply and demand is
o Measure of the responsiveness of quantity demanded or quantity
supplied to change one of its determinants (e.g. price, income)
1. Price elasticity of demand
a. How much the quantity demanded of a good responds to a
change in the price of that good ( think trampoline)
b. ELASTIC DEMAND (perfectly elastic demand: price elasticity of
demand = ∞)
i. Quantity demanded responds substantially to changes in
price
c. INELASTIC DEMAND (low sensitivity % of the Demand when price
changes) (perfectly inelastic demand: price elasticity of demand
= 0)
i. Quantity demanded responds only slightly to changes in
price
d. Determinants of price elasticity of demands
i. Availability of close substitutes: more elastic demand
ii. NECESSITIES VS LUXURIES
1. Necessities: inelastic demand
2. Luxuries: elastic demand
iii. NARROW VS BROAD MARKETS
1. Narrow (think niche -> e.g. vinyl shop): more elastic
demand
2. Broad (think clothing): more inelastic demand
iv. TIME HORIZON (gas prices: short term -> ppl will pay; long
term -> ppl find substitutes like EV’s)
1. Demand is more elastic over longer time horizons
2. Computing the price elasticity of demand
a. Percentage change in quantity demanded / percentage change in
price
b. Use absolute value (e.g. |-2%| => 2%)
percentagechange ∈quantity demanded
c. price elasticity of demand=
percentage change ∈ price
d. MIDPOINT METHOD
i. Two points: (Q1, P1) and (Q2,P2)
Q2+Q 1
(Q 2−Q1)/[ ]
2
ii. price elasticity of demand=
( P 2−P 1)/[P 2+ P 1
2 ]
e. Q2= New quantity; Q1= initial quantity -> same goes for price
f. Perfectly inelastic demand -> | (vertical)
g. Perfectly elastic demand -> (horizontal)
h. If the percentage increase in price = percentage decrease in
quantity demanded, then it is unit- elastic
i. If the percentage increase in price > percentage decrease in
quantity demanded, then it is inelastic
j. If the percentage increase in price < percentage decrease in
quantity demanded, then it is elastic
k. The flatter the demand curve, the greater the price elasticity of
demand
l. Determinants of price elasticity of demand
i. Availability of close substitutes
1. Goods with close substitutes: more elastic demand
3. Total revenue (TR)
a. Amount paid by buyers and received by sellers of a good
b. Price of the good times the quantity sold ($xQS)
i. If demand is inelastic, TR increases
ii. If demand is elastic, TR decreases
c. Inelastic demand (elasticity<1)
i. P and TR move in the same direction-> if price goes up, so
does total revenue
d. elastic demand (elasticity>1)
i. P and TR move in opposite directions -> if price goes up
total revenue goes down
e. Unit elastic demand (elasticity = 1)
i. Total revenue remains constant when the price changes
4. Elasticity along the demand curve
a. Linear demand curve
i. Constant slope
1. Rise/Run
ii. Different price elasticities
1. Points with low price and high quantity
a. Inelastic demand
2. Points with high price and low quantity
a. Elastic demand
3. “Halfway point” unit elasticity
5. Other types of elasticity of demand
a. Income elasticity of demand
i. How much the quantity demanded of a good respond to a
change in consumers’ income
ii. Percentage change in quantity demanded/ percentage
change in income
b. Normal goods
i. Necessities have a smaller income elasticity
c. Luxuries have a larger income elasticity
d. Inferior goods have a negative income elasticity
e. Cross-price elasticity of demand
i. How much the quantity demanded of one good responds to
a change in quantity demanded of another good
ii. Percentage change in quantity demanded of the first
good /percentage change in price of the second good.
iii. Substitutes
1. Goods typically used in place of one another
2. Positive cross-price elasticity
iv. Complements
1. Goods that are typically used together
2. Negative cross price elasticity