Lecture 01

Principals of Economics
Economics
• Greek word ‘oikonomos’: one who manages a household
• Society faces many decisions like households
• Who will do what and how?
• Scarcity > Need for decision making
• Economics is the study of how society manages it’s scarce
resources
• How people make decisions
• How people interact with each other
• How economy works as a whole
• Economics works around some central ideas
How people make decisions

1. People face trade-offs

• Student > time (personal)
• Household > income
• Nation > Guns v butter
• Efficiency vs equality
How people make decisions

2. The cost of something is what you give up to get it

• Opportunity cost
• What is the cost of BUETing?
How people make decisions

3. Rational people think at the margin

• Systematically and purposefully do the best they can
• Marginal change: small increment of actions
• Diamond-water paradox
How people make decisions

4. People respond to incentives

• Incentive: induces to act
• Prices influence markets
• Tax and subsidies
• Unintended consequences, seat belt law
How people interact

5. Trade can make everyone better off

• Trade allows specialization
• Trade makes both parties better off
How people interact

6. Markets are good way to organize economic activities

• Market economy: allocates resources through
decentralized markets
• Invisible hand (Adam Smith)
• Market failure
How people interact

7. Govt. can sometime improve market outcomes

• Property rights and enforcing institutions
• Promote efficiency or equality
• Market failure: Externalities, Market power
• Promote equality
• Income tax, welfare systems
How the economy works as a whole

8. A country’s living standard depends on production

• Productivity
• More productive labor = high standard of living
• Implications for policy
• Education, Health, Technology > Productivity
How the economy works as a whole

9. Prices rise when govt. prints too much money

• Inflation: increase in the overall level of price
• More money > less valuable
How the economy works as a whole

10. Short-run trade off between inflation vs

unemployment
• Demand increases
• Business cycle: fluctuations of
production/unemployment in the economy
• Monetary, fiscal policies
Lecture 02
Principals of Economics
Economics as a science
• Economics tries to follow the scientific method
• Observe – Theorize/Hypothesize – Examine – Repeat
• Relies on natural experiments/historical data
• Relies on assumptions
• Uses simplified models to explain
• Diagrams and equations
The production possibilities frontier (PPF) model
• PPF: shows the combinations of output, economy can possibly
produce given available factors and technology
• Scarcity, efficiency, trade-off, opportunity cost, econ. growth
The production possibilities frontier (PPF) model
• PPF: shows the combinations of output, economy can possibly
produce given available factors and technology
• Scarcity, efficiency, trade-off, opportunity cost, econ. growth
Microeconomics & Macroeconomics
• Micro: the study of how households and firms make decisions and
how they interact in markets
• Macro: the study of economy wide phenomena, including inflation,
unemployment, and economic growth
• Answers different question but are interrelated
Positive economics vs Normative economics
• Positive: Descriptive. Describes the world as it is.
• Evidence based, can be verified with data.
• Normative: Prescriptive. Prescribes how the world should be.
• Value judgement based, depends on ethics/philosophy etc.
• Policies cannot be judged based on science alone
Lecture 03
Market Forces of Demand
and Supply

Google classroom code:

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Markets
• The terms supply and demand refer to the behavior of people
as they interact with one another in competitive markets
• Market: a group of buyers and sellers of a particular good or
service
• Can be highly organized or less organized
• Competitive market:
• many buyers and many sellers
• each has a negligible impact on the market price
• Buyers and sellers are price takers
Markets
• Different type of markets exist
• Perfect competition (many buyers, many sellers)
• Monopoly (1 seller, many buyers)
• Oligopoly (few sellers, many buyers)
• Monopsony (1 buyer, many sellers)
• Monopolistic competition (product is differentiated)
Demand

• Quantity demanded: amount of good buyers are willing and able

to purchase
• Law of demand: the claim that, other things equal (ceteris
paribus), the quantity demanded of a good falls when the price of
the good rises (negative relationship)
• Demand curve: shows the relationship between the price of a
good and the quantity demanded
Individual vs Market Demand
• The sum of all the individual level demand/supply for a particular
good or service
Shift in the demand curve
• Ceteris paribus! What if it doesn’t hold?
• At a given price, quantity demanded may change
• We call this: increase in ‘demand’ or decrease in ‘demand’
Shift in the demand curve
• Important factors that may cause shift in demand
• Income (normal good vs inferior good)
• Price of related goods (substitutes and complements)
• Taste
• Expectations
• Number of buyers
Two ways to reduce quantity demanded
Two ways to reduce quantity demanded
Supply curve
• Quantity supplied: amount of good sellers are willing and able to
sell
• Law of supply: the claim that, other things equal (ceteris paribus),
the quantity supplied of a good rises when the price of the good
rises (positive relationship)
• Supply curve: shows the relationship between the price of a good
and the quantity supplied
Supply curve
Individual vs Market Supply
• The sum of all the individual level demand/supply for a particular
good or service
Shift in the supply curve
• Important factors that may cause shift in supply
• Input prices
• Technology
• Expectations
• Number of sellers
Equilibrium
• A situation in which the market price has reached the level at
which quantity supplied equals quantity demanded
• Equilibrium price and equilibrium quantity
Equilibrium
• A situation in which the market price has reached the level at
which quantity supplied equals quantity demanded
• Equilibrium price and equilibrium quantity
Equilibrium
• A situation in which the market price has reached the level at
which quantity supplied equals quantity demanded
• Equilibrium price and equilibrium quantity
Moving into the equilibrium
• We began to see how markets work
• Markets allocate scarce resources through market mechanism
• Price determines who will produce how much and who will
consume
Lecture 04
Elasticity of Demand and
Supply

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Elasticity
• Law of demand and supply tells us the direction, elasticity tells
us magnitude
• Elasticity: a measure of the responsiveness of quantity
demanded or quantity supplied to one of its determinants
• Elasticity = Responsiveness
Price elasticity of demand
• The price elasticity of demand measures how much the
quantity demanded responds to a change in price
• Price elastic: [Link] responds more to price change
• Price inelastic: responds less
Price elasticity of demand
• Mid-point method of calculating elasticity
Price elasticity of demand
• Mid-point method of calculating elasticity
Price elasticity of demand
• What determines price elasticity?
• Availability of close substitutes
• Luxury goods vs. necessities
• Definition of markets
• Time horizon
Price elasticity of demand
• Elastic: >1 Inelastic: <1 Unit elastic: = 1
Price elasticity of demand
Total revenue and price elasticity of demand
• Total revenue (TR) = Price x Quantity
• When demand is inelastic (a price elasticity less than 1),
P and TR move in the same direction.
• When demand is elastic (a price elasticity greater than 1),
P and TR move in opposite directions.
• If demand is unit elastic (a price elasticity exactly equal to
1), TR remains constant when the price changes
Total revenue
and price
elasticity
of demand
 Elasticity of a
linear demand
curve
Other demand elasticities

• Income elasticity (IE) of demand: a measure of how much

the quantity demanded of a good responds to a change in
consumers’ income

• IE of normal good: positive

• IE of inferior good: negative
Price elasticity of supply
• A measure of how much the quantity supplied of a good
responds to a change in the price of that good
• Elastic? Inelastic?
• The price elasticity of supply depends on the flexibility of
sellers to change the amount of the good they produce
• A key determinant of the price elasticity of supply is the
time period being considered
• Supply is more elastic in the long run
• Formula to calculate supply elasticity?
 Supply curve with
different elasticities
 Supply curve with
different elasticities
Application of elasticity
• An Increase in Supply in the Market for Wheat due to
technology
Application of elasticity
• An Increase in Supply in the Market for Wheat due to
technology
Application of elasticity
• Policies to Reduce the Use of Illegal Drugs and Drug Related
Crimes
Application of elasticity
• Policies to Reduce the Use of Illegal Drugs and Drug Related
Crimes
Lecture 05
Consumer preference
Mankiw Chapter 21

Google classroom code:

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Consumer choice
• Financial resources are limited, you cannot buy everything
• We face trade-offs, how do we make decisions about them?
• How do consumers respond to changes in income/price?
Consumer preference: utility
• Utility: an abstract concept that measures the satisfaction or
enjoyment a consumer receives from a good or service
• Marginal utility: utility gained from one additional unit of
goods/service
• Law of diminishing marginal utility: marginal utility decreases as we
consume more of a good/service
Consumer preference: indifference curve
• Indifference curve: shows the consumption bundle that give the
consumer same level of satisfaction (utility)
• Slope of the indifference curve: Marginal rate of substitution (MRS)
• The rate consumer is willing to substitute one good for another
• Ratio of marginal utility of two goods
Properties of indifference curve
• Higher indifference curves (IC) are preferred to lower ones
• IC slopes downwards*
• ICs do not cross
• ICs are convex to the origin*

*usually
Properties of indifference curve
• Higher indifference curves (IC) are preferred to lower ones
• IC slopes downwards*
• ICs do not cross
• ICs are convex to the origin*

*usually
Budget constraint
• The limit on the consumption bundles a consumer can afford
• It shows the consumption bundles consumer can afford
• Slope = relative price, measures the rate of trading one good
for another
Budget constraint

• The limit on the consumption bundles a consumer can afford

• It shows the consumption bundles consumer can afford
• Slope = relative price, measures the rate of trading one good
for another
Consumer’s optimum
• Tangent of budget constraint and indifference curve
• MRS = relative price, utility maximization
• The equimarginal principal
Consumer’s optimum
• Tangent of budget constraint and indifference curve
• MRS = relative price
Change in income / price
Change in income / price
Income effect and substitution effect
• Change in price can be decomposed into two effects
• Income effect: increase in purchasing power, move to higher IC
• I’m richer, I should buy more x and y
• Substitution effect: change in price, movement along IC
• Good x is cheaper now, I should buy x more
Income effect and substitution effect
Income effect and substitution effect
Lecture 6-7
Firms and Production
Perloff. Chapter 06

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Firms’ decision making process
• What type of input to use?
• How much to produce?
• How large should the firm be?
The supply side
• Firm: an organization (economic unit) that converts inputs (land,
labor, capital) into outputs (goods and services)
• Industry: a collection of firm that produces similar goods/services
• Three broad categories of firm based on economic objective:
• Private . Public . Non-profit
• Ownership and management of firms
• Different ownership: legal structure of debt liability
• Owner and managers may have different objectives
• Firms want to maximize profit, profit = revenue - cost
The production function
Time and the variability of inputs
• Firm cannot adjust all factors quickly, some take longer
• Short run: a time so brief that at least one factor cannot be varied
practically (fixed input)
• Long run: a period of time lengthy enough so that all inputs can
be varied, all are variable inputs
• How long is the long run? Depends on the type of input
Production in the short run
Production in the short run
• Effect of extra labor: first output increases, then eventually falls
• MP crosses the AP curve at its peak
• Slope of line through origin of TP = Average product
• Slope of Total product at a point = Marginal product
Production in the
short run

Relationship between
• Total product (TP)
• Average product (AP)
• Marginal product (MP)
Law of diminishing marginal returns
• If only one input is increased, the marginal product of that input
will diminish eventually.
Production in the long run
• All inputs are variable
• Same output can be produced with different input-mix
Isoquant
Isoquant
Shape of the isoquant
• Depends on
substitutability
of inputs
MRTS (Marginal rate of technical substitution)
• The slope of an isoquant shows the ability of a firm to replace
one input with another while holding output constant = MRTS

• MRTS: the number of extra units of one input needed to

replace one unit of another input that enables a firm to keep the
output constant
MRTS (Marginal rate of technical substitution)
• MRTS = The Ratio of Marginal products of Labor and Capital

• As we replace capital with labor (shift downward and to the right along the
isoquant), the marginal product of capital increases—when there are few
pieces of equipment per worker, each remaining piece is more
useful—and the marginal product of labor falls, so the MRTS = MPL/MPK
falls in absolute value.
Returns to scale
• Returns to scale: how much output changes if a firm increases all its
inputs proportionately. The answer helps a firm determine its scale or size
in the long run.
• Increasing returns to scale (IRS): output increases more than proportionally
• Constant returns to scale (CRS): increases proportionally with input
• Decreasing returns to scale (DRS): increases less than proportionally
Lecture 8
Costs of Production
Mankiw Chapter 13

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Firms’ decision making process
• Cost is a key determinant for production and pricing
• Revenue
• Cost
• Profit = Revenue – Cost
Firms’ decision making process
• Costs as opportunity costs
• Explicit cost: require an outlay of money
• Implicit cost: don’t require an outlay of money
• Cost of capital as an implicit cost
• Foregone returns from the investment
Economic profit vs. accounting profit
Economic profit vs. accounting profit
Production and cost
• Remember:
• Production function?
• Short run? Long run?
• Marginal Product?
• Diminishing marginal product?
Production and cost
Production and cost
• Remember:
• Production function?
• Short run? Long run?
• Marginal Product?
• Diminishing marginal product?
Various measures of cost
• Fixed cost: costs that do not vary with quantity of output
• Variable cost (VC): it varies with quantity of output
• Average cost (AC): total cost divided by the total output
• Average fixed cost (AFC): ?
• Average variable cost (AVC): ?
• Marginal cost: ?
Cost curves and their shapes
• AFC
• AVC
• AC
• MC

*Efficient scale: the quantity of output that minimizes average total cost
Cost curves and their shapes
• AFC
• AVC
• AC
• MC

*Efficient scale: the quantity of output that minimizes average total cost
Short run AC & Long run AC

• A flatter U-shaped LRAC lies above (envelopes) the SRACs

Economies of scale / diseconomies of scale

• Due to specialization • Due to coordination

problems
Lecture 9
Firms in Competitive Markets
Mankiw Chapter 14

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Firms’ decision making process
• Think of the market for cooking gas and eggs
• Difference in market structure shapes the pricing and
production decisions of the firms that operate in these
markets.
• In this lecture, we examine the behavior of a firm in a
competitive market structure
Competitive market
• Competitive market: a market with
• many buyers and sellers
• trading identical products
• buyer and seller is a price taker
• Low barrier to entry and exit
• Also known as perfectly competitive market
Revenue of a firm
• Revenue
• TR
• AR
• MR
Profit maximizing condition
• Firm only decides the quantity produced, not the price (why?)
• Firms decision: How much to produce?
• Profit is maximum if: Marginal cost, MC = Marginal revenue, MR
Profit maximization
MC is the supply curve
• For a competitive firm MC IS THE SUPPLY CURVE
• Marginal cost = Marginal revenue [MC=MR]
Shutdown vs exit conditions
• Shutting down in the short-run vs exiting the market in the long run
• Shutdown if TR < VC or AR < AVC
• Exit if TR < TC or AR < ATC
Measuring profit and loss
Long run market supply

*
Increase in demand
In the long and
short run
Lecture 10
Monopoly
Mankiw Chapter 15

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Monopoly market
• Monopoly: a firm that is the sole seller of a product with out
close substitutes
• Price maker not price taker
• Need to decide both price and quantity
• Why not charge a million dollars then?

• Monopoly may not be the best choice for the society

Why monopolies arise
• Monopoly resources: A key resource required for production is
owned by a single firm.
• Government regulation: The government gives a single firm
the exclusive right to produce some good or service.
• The production process: A single firm can produce output at a
lower cost than can a larger number of producers (natural
monopoly)
Monopoly vs Competition
• What’s the difference?
• Demand curve or AR
• Marginal revenue (MR) is always less than price
Monopoly vs Competition
• What’s the difference?
• Demand curve or AR
• Marginal revenue (MR) is always less than price
Monopoly vs Competition
• What’s the difference?
• Demand curve or AR
• Marginal revenue (MR) is always less than price
Monopoly firm’s decision
• How much output? How much price?
• Decide output with: Profit maximising condition?
• Then decide price from demand curve
Monopoly firm’s profit
Monopoly and loss of welfare
• Consumer surplus and producer surplus
Monopoly and loss of welfare
• Monopoly and Deadweight loss
Price discrimination
• Selling to different buyers at different prices to maximize profit
• 1st degree price discrimination
• 2nd degree discrimination
• 3rd degree discrimination
Monopolistic competition?