INTERNATIONAL ECONOMICS NOTES

1ST SEMESTER

What is Economics?

In the economy we are faced with many decisions many involving an exchange sometimes using money as the
medium.

1. Households purchase final goods and services for final consumption and provide the
inputs into production – land labour and capital

2. The organizations which buy these factors and use them to produce goods and
services are referred to collectively as firms.

Land - all the natural resources of the earth

Labour - the human effort both mental and physical that goes into production

Capital - equipment and structures used to produce goods and services

Households buy goods and services from firms; firms use this money to pay for resources purchased from
households

(wages, rent, interest on capital and profit…)

When households receive income, some of the income is: saved (S) providing funds for financial institutions
taxed (T). The taxes can be used by the government in making purchases (G) such as education,health and
infrastructure…

Some products and services maybe purchased from other countries as Imports (M) And some services and
products maybe sold abroad as Exports (X). Some businesses will invest (I) in new capital.

Leakages are T + S + M Injections into the economy come from G, X and I.

The amount of interaction between households and firms – the amount of buying and selling which takes place,
represents the level of economic activity.

Economic activity is how much buying and selling goes on in the economy over a period of time

Economy refers to all the production and exchange activities that take place in a moment in time whether we
are talking about a local area, one country or a group of countries such as the European Union

The three big questions are:

◦ What goods and services should be produced?

◦ How should it be produced (see resources)?

◦ Who should get the goods and services produced?

◦ We have seen what the resources are…

But the question is: are these resources enough? Can all agents satisfy all their needs?...…

Economic Choice comes from Scarcity (Kıtlık)

◦ Both individuals and society as a whole have to make decisions related to how allocate scarce
resources

◦ Resources are scarce because they are less than people want and need – while needs are
potentially unlimited –

◦ Examples:

◦ Money…

◦ And time!...

◦ Scarcity means that society has limited resources and therefore cannot produce all the goods
and services people wish to have.

◦ Economics is the study of how society manages its scarce resources

Economic theory studies:

◦ How people make decisions – related to

◦ How much to consume, how much to save, how much work to offer, how much to produce…
 ◦ How people interact as buyers and sellers in markets, in which prices are determined and
quantities exchanged

◦ How the economy as a whole works –

◦ GDP, growth, unemployment, inflation… - Macroeconomics

Therefore, we can outline 10 main economic principles divided in three groups:

◦ How people make decisions

◦ How individuals interact

◦ How the economy as a whole works

People Face trade-offs

To get one thing, we usually must give up another thing – deciding means to choose between one thing or
another, in other words

There is no such thing as a free lunch…

Examples:

A student has to decide how much time to spend to study different subjects for an exam…

A family has to decide how much to spend of its monthly income for clothing or holidays…

A society has to decide how much to spend in national defence or social programmes…

There is a trade-off between EFFICIENCY and EQUITY. Efficiency means society gets the most that it can from its
scarce resources.

Equity means the benefits of those resources are distributed fairly among the members of society.

We’ll see many examples of this – one for all: taxes

Recognizing that trade-offs exist does not indicate what decisions should be made.

People have different opinions and belief sets.

But it helps to take better decisions

Opportunity Cost

Decisions require people to compare costs and benefits of alternatives – the cost of a choice is not always easy
to be determined What are the benefits and costs of going to university?

Benefits?

Costs?...
Food, lodging, transports, tuition fees…

But some of them are not costs of this particular choice… But one is really relevant

The value of the student’s time…could be working for pay instead of studying. The opportunity cost of an item
is what you have to give up to obtain that item.

Thinking at the Margin

Marginal changes are small, incremental adjustments to an existing plan of action. People make decisions by
comparing costs and benefits at the margin. Rational individuals make decisions by comparing (small) marginal
changes with respect to a given situation – criticisms…

Rent a small house or a house with an extra room – not, renting a house or living under a bridge…

Study for a master degree or leaving uni after undergraduate - not, not going to school at all…

An airline company decides to sell low cost lastminute tickets…

The benefit of the additional money obtained from the additional ticket is higher than the additional cost of
having an extra passenger (which is very low when the plan flights anyway…)

People Respond to Incentives (Teşvikler)

As rational people make rational decisions by weighing costs and benefits, marginal changes in costs or
benefits motivate people to respond…. The decision to choose one alternative over another occurs when that
alternative’s marginal benefits exceed its marginal costs!

When the price of a good rises, consumers will buy less of it because its cost has risen.

When the price of a good rises, producers will allocate more resources to the production of the good because
the benefit from producing the good has risen.

Therefore, public policies can create incentives or disincentives that alter behavior.

Examples:

Putting a price on plastic bags in supermarkets aims to encourage people to reuse bags

Price of parking… But Sometimes policymakers fail to understand how policies may alter incentives and
behavior Fines in schools or seat-belts... Another example: taxes…

Trade Can Make Everyone Better Off

Trade is not like a sports competition where one side gains and the other side loses. Trade allows people and
countries to specialize in what they do best. …and trade with others who are also specializing.

People gain from their ability to trade with one another. Competition results in gains from trading. The concept
of comparative advantage we’ll discuss below

Markets Can Be a Good Way to Organize Economic Activity

A market economy is an economy that allocates resources through the decentralized decisions of many firms
and households as they interact in markets for goods and services.
Households decide what to buy and who to work for Firms decide who to hire and what to produce.

In a pure market economy, where there is no government intervention, no one looks after the economic well-
being of society as a whole. Instead buyers and sellers are interested only in their own well-being.

Adam Smith made the observation that households and firms interacting in markets act as if guided by an
“invisible hand”, guiding self-interest into promoting society’s economic well-being.

How can this work?

Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it
(we’ll study it in the lecture on surplus)

Because households and firms look at prices when deciding what to buy and sell (lecture on supply and
demand), they unknowingly take into account the social costs of their actions.

As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a
whole.

However, when a government interferes in a market and restricts price from adjusting – economic policies like
price control or taxes (lecture)…

…decisions that households and firms make are not based on the proper information. Thus, these decisions
may be inefficient.

Governments Can Sometimes Improve Market Outcomes

Markets Can Be a Good Way to Organize Economic Activity. However there are relevant exceptions

Market failure occurs when the market fails to allocate resources efficiently. When the market fails
government can intervene to promote efficiency and equity.

Market failure may be caused by

an externality, which is the impact of one person or firm’s actions on the well-being of a bystander.

market power, which is the ability of a single person or firm to unduly influence market prices.

HOW THE ECONOMY AS A WHOLE WORKS

Macroeconomics and Microeconomics

Microeconomics is the study of how households and firms make decisions and how they interact in markets.

Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment and economic
growth

Micro: satin alan halk nasıl karar veriyor yani market araştırması

Macro: ekonominin mekanizmaları nasıl işliyor yani enflasyon işsizlik ekonomik büyüme vb.

Microeconomics and macroeconomics are closely intertwined. Because changes in the overall economy arise
from the decisions of millions of individuals.

An Economy’s Standard of Living Depends on its ability to produce goods and services

Economic growth - the increase in the amount of goods and services in an economy over a period of time.
Gross domestic product GDP (per head) - the market value of all final goods and services produced within a
country in a given period of time (divided by the population of a country)

GDP: Bir ülkenin belirli süre içerisinde ürettiği mal ve verdiği servislerin toplam market değerinin ülke nüfusuna
bölünmesi

An Economy’s Standard of Living Depends on its ability to produce goods and services

Standard of living - a measure of welfare based on the amount of goods and services a person’s income can
buy. (alım gücü)

Usually measured by the inflation-adjusted (real) income per head of the population.

a. Differences in living standards from one country to another are quite large.

b. Changes in living standards over time are also large.

Most variations in living standards are explained by differences in countries’ productivities.

Productivity is the amount of goods and services produced from each hour of a worker’s time.

Then, High productivity implies a high standard of living.

Policy makers need to raise productivity by improving education, training and investment in the latest
technology…

Note there are other measures used to measure well-being including people’s health and the environment they
live in…

Prices Rise When the Government Prints Too Much Money * ENFLASYON

Inflation is an increase in the overall level of prices in the economy.

One cause of inflation is the growth in the quantity of money. When the government creates large quantities of
money, the value of the money falls. High inflation imposes various costs on society.

Society Faces a Short-run trade-off Between Inflation and Unemployment

The Phillips Curve illustrates the trade-off between inflation and unemployment. It’s a short-run trade-off! The
Phillips Curve is important for understanding the business cycle.

Business cycle is the fluctuations in economic activity, such as employment and production.

Policymakers in governments and central banks can exploit this trade-off by using various policy instruments,
but the extent and desirability of these interventions is of continuing debate…

SUMMARY

1 When individuals make decisions, they face trade-offs among alternative goals.
2 The cost of any action is measured in terms of foregone opportunities.
3 People often make decisions by comparing marginal costs and marginal benefits.
4 People change their behavior in response to the incentives they face.
5 Trade can be mutually beneficial.
 6 Markets are usually a good way of coordinating trade among people.
7 Government can potentially improve market outcomes if there is some market failure or if the
market outcome is inequitable.
8 Productivity is the ultimate source of living standards.
9 Money growth is the ultimate source of inflation.
10 Society faces a short-run trade-off between inflation and unemployment.

Economic Methodology
Mainstream economics or neo-classical approach assumes that: Markets generate well-being. Decisions are
based on rationality with agents acting in self-interest.

Critics hold different views, in particular Neo-classical assumptions on rationality are wrong and what is
observed about human behavior does not conform to the predictions of the neoclassical view.

The Economist As A Scientist

The economic way of thinking . . .Involves thinking analytically and objectively. Makes use of the scientific
method.

 Let us consider now an important methodology problem – how economists deal with economic
problems

 How they adopt a scientific method,

 the role of assumptions…

 in the formulation of models

The Scientific Method

 The scientific method involves

 Devising theories (teori üretmek)

 Collecting data and

 Analysing the data in order to verify or refute theories

This is important! The theory is predictive - it is important that predictions based on the theory are
correct!

Theories

Theories can be used to explain a phenomenon and to make predictions. The economist observes an event,
formulates a theory to explain it, collects the data to verify it.
Example:

1- Observes inflation
2- Formulates a theory which explains the rise in the level of prices with a persistent increase of the
quantity of money
3- collects data…and so on

In the process, new theories come along, and old theories may be rejected…

 Falsifiability is a key concept in the scientific approach

 It refers to the possibility of a theory being rejected as a result of new observations or new data

 Things change, new information, experience or observations may be made which render the original
hypothesis redundant and subject to revision or refinement; this is a process which is never ending…

The following graph describes the problem, that is, the ALTERNATION OF THEORY AND EMPIRICAL WORK, each
refining each other, which is the basis of every scientific discipline.

Suggests, modifies

Tests, modifies

Theory organises knowledge and helps to predict behaviour in new situations.

In particular: it suggests which data are worth collecting and how to analyse new ones.

On the converse, data collection and analysis often reveal empirical regularities that are not explained by
existing theories – and these regularities lead to refinements of the theory
The alternation of theory and empirical work and their reciprocal refinement are the functioning mechanism
of each scientific discipline.

Economics is no exception.

The Role of Assumptions

Sometimes it is useful to simplify the real world. One important role of a scientist is to think imaginatively
about what assumptions could be made and to understand which assumptions are the most helpful ones to
make.

Example: to understand international trade, it may be helpful to start out assuming that there are only two
countries in the world producing only two goods.

Once we understand how trade would work between these two countries, we can extend our analysis to a
greater number of countries and goods.

Other examples: consumer behavior and bundles of goods…firms and production…

The art in scientific thinking is deciding which assumptions to make

Economists often use assumptions that appear somewhat unrealistic but will have small effects on the actual
outcome of the answer (see above)

…but they must be accurate and reasonable

Once we understand the model, we can begin to relax some assumptions…

Models

1. Most economic models are represented by diagrams and equations.

2. The goal of a model is to simplify reality in order to increase our understanding. This is where the use of
assumptions is helpful.

They are simpler than reality but that’s why they are useful – they must concentrate on what is more
relevant!

They omit many details

Allow us to see what’s truly important

Example:

Consider this map, which gives you the idea of where Torino is:
But if you want to go round the centre of the city THIS will be more useful

And if you need to find your way to the campus THIS will be more useful
While this would surely be of no use…

The goal of a model is to simplify reality in order to increase our understanding.

They are simpler than reality but that’s why they are useful – they must concentrate on what is more
relevant!

They omit many details

Allow us to see what’s truly important

Endogenous or Exogenous variables

A model will contain a number of variables. It is important to distinguish between

a. endogenous variable: a variable whose value is determined within the model.

b. exogenous variable: a variable whose value is determined outside the model.

Does a change in price, for example, cause a change in quantity demanded…?

or does quantity affect price?

Endogenous or Exogenous

In the first case – price determines quantity

Quantity is the endogenous variable while Price is the exogenous variable

Understanding the difference between endogenous and exogenous variables is important because it helps us
to separate out cause and effect. It is price which causes a change in quantity

Cause and Effect

Another Example: is a rise in the price level caused by an increase in the money supply or does an increase in
the money supply cause a rise in the price level?
Separating out cause and effect can be informed by statistical tests but is also subject to interpretation. It is
not always easy to establish cause and effect. Particularly when controlled experiments are not possible.

Inductive and deductive

A further distinction has to be made between

Inductive reasoning refers to the process of observation from which one can form patterns which provides
evidence for a hypothesis which may lead to a theory.

Deductive reasoning begins with a theory from which a hypothesis is drawn. The hypothesis is then subject to
observation and either confirmation or rejection. No approach is better than the other.

Important is the circular process of formulation, testing and refinement of theories, no uncritical acceptance
of the results of research.

Example of inductive reasoning: the fact you have seen the sun rising every morning does not mean it will rise
tomorrow…

However, people do believe that the sun will rise… This is INDUCTION

The general principle of induction is that BEHAVIOURAL REGULARITIES PERSIST in new situations, as long as the
relevant underlying conditions remain substantially unchanged.

It is THEORY wich suggests what is RELEVANT, and what is a substantial change, BUT THE PRINCIPLE ITSELF IS
AN AXIOM - NOT a DEDUCIBLE proposition.

Experiments in Economics

1. Economics is a science based on human behaviour, so it has not been considered possible to conduct
experiments in the way physical sciences can.

Empirical analysis can happen through the collection and analysis of natural data that exists such as wages,
prices, stock prices.

2. Laboratory type experiments in economics is where:

Data can be collected via observations on individual or group behaviour, or through questionnaires and
surveys, interviews and so on…

3. There are also field experiments…

WHY AN EXPERIMENTAL ECONOMICS?

• How could refinement be accomplished in the past?

• Traditionally – observation from naturally occurring economic phenomena were the only source of
data to stimulate revision of the theory.
 • If natural data were not present, no refinement was possible

Experimental methods have given access to new sources of data

• Data for empirical analysis can be drawn from several kinds of sources, each with different
characteristics, advantages, and dis-advantages. The key distinction is between:

Experimental data: deliberately created for scientific purposes under controlled conditions

“Happenstance” data: a by-product of uncontrolled processes.

• A further distinction is between:

Laboratory data: gathered in an artificial environment designed for scientific purposes

“Field data”: data gathered in a “natural” environment.

• Four combinations are possible.

The Economist As Policy Advisor

When economists are trying to explain the world, they are scientists. When economists are trying to change
the world, they are policy advisors.

Positive statements are statements that attempt to describe the world as it is. Called descriptive analysis.

Normative statements are statements about how the world should be. Called prescriptive analysis.

Note: Positive statements can be evaluated using data, while normative statements involve personal
viewpoints.

Positive or Normative Statements?

An increase in the minimum wage will cause a decrease in employment among the least-skilled. POSITIVE

Higher budget deficits will cause interest rates to increase. POSITIVE

The income gained from a higher minimum wage are worth more than any slight reductions in employment.
NORMATIVE

Governments should collect from tobacco companies the costs of treating smoking-related illnesses among the
poor. NORMATIVE
Why Economist Disagree

Economics is not a true science as it deals with human behavior. Economists may:

Disagree about the validity of alternative positive theories about how the world works or about the size of the
effects of changes in the economy on the behavior of households and firms.

Example: some economists feel that a change in the tax system that eliminates tax on income and creates tax
on consumption would increase saving.

However, other economists feel there would be little effect on saving. They may have different values and,
therefore, different normative views about what policy should try to accomplish.

Economists as Decision Makers

Economics could be said to be the science of decision-making. Economists identify costs and benefits of
decisions. Economists attach values to the costs and benefits.

If the benefits outweigh the costs, then the decision maybe warranted. Every day millions of decisions are
made by individuals, businesses and governments. Some will be rational, but others will not.

Summary
o Economists try to address their subjects with a scientist’s objectivity.

o They make appropriate assumptions and build simplified models in order to understand the world
around them.

o A positive statement is an assertion about how the world is.

o A normative statement is an assertion about how the world ought to be.

o When economists make normative statements, they are acting more as policy advisors than scientists.

o Economists who advise policy makers offer conflicting advice either because of differences in scientific
judgments or because of differences in values.

o At other times, economists are united in the advice they offer, but policy makers may choose to ignore
it.

S U P P LY A N D D E M A N D
M A R K E T F O R C E S O F S U P P LY A N D D E M A N D

In this lecture we’ll study the main components of the market economy

One of the founding elements of the market economy is the interaction between SUPPLY and
DEMAND. Supply and demand determine prices in a market economy and how prices, in turn,
allocate the economy’s scarce resources.
We’ll see, What we mean by supply and demand. How supply and demand interact in order to
determine prices and quantities of exchanged goods and services. How different factors which induce
changes in supply and demand induce changes in market price and quantities.

The Assumptions Of The Market Model

The terms supply and demand refer to the behaviour of people who respond to different economic
incentives as they interact with one another in markets

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

Markets can be local, regional, national, global, virtual, contrary to the notion of the market as a
physical place…

Markets can have different stucture according to the degree of competition mainly among producers

The Assumptions Of The Competitive Market Model

A competitive market is a market in which there are many buyers and sellers so that each has a
negligible impact on the market price

Competitive market

Characteristics of a perfectly competitive market:

All goods for sale are the same.

No buyer or seller can influence market price on their own, as they are so numerous.

Because buyers and sellers must accept the market price as given, they are often called "price
takers”.

General assumptions for efficient outcomes

The model of the market based on supply and demand, like any other model, is based on a series of
assumptions.

The model of supply and demand which leads to this ‘efficient’ outcome is based on the following:

Many buyers and sellers.

Identical (homogenous) goods.

Perfect information for all buyers and sellers.

Freedom of entry and exit.

Buyers and sellers act in self interest and independently

Demand

Demand is the amount of a good that buyers are willing and able to purchase at different prices, given
other factors which influence quantity demanded and are kept constant when a specific demand is
considered

The demand is the relation between price and quantity

Which is the direction of this relation?

Consumers respond to incentives….they tend to buy less when the price goes up…
 This inverse relation between price and quantity demanded is known as

Law of Demand - states that, other things being equal, the quantity demanded of a good falls when
the price of the good rises.

The ‘other things equal’ is VERY IMPORTANT

The Demand Curve: The Relationship between Quantity Demanded and Price

The Demand schedule is a table that shows the relationship between the price of a good and the
quantity demanded.

Graphically, individual demand curves are summed horizontally to obtain the market demand curve

Price of milk Quantity of Quantity of Quantity of

per litre (€) milk milk milk
demanded demanded demanded
(litres per (litres per (litres per
month) month) month)

Rachel Lars TOTAL

0.00 20 10 30

0.10 18 9 27

0.20 16 8 24

0.30 14 7 21

0.40 12 6 18

0.50 10 5 15

0.60 8 4 12

0.70 6 3 9

0.80 4 2 6

0.90 2 1 3

1.00 0 0 0
Shifts Versus Movements Along The Demand Curve

Ceteris paribus - other factors affecting demand are held constant so that we can analyze the effect of a change
in price on demand. Movement along the demand curve. Caused by a change in the price of the product.

A shift in the demand curve is caused by a factor affecting demand other than a change in price.

Changes In Quantity Demanded

A tax that raises the price milk results in a movement along the demand curve.

Movement Along the Demand Curve – a specification

Assume the price of milk falls.

◦ More will be demanded because of the income and substitution effects.

◦ The income effect. Assume that incomes remain constant then a fall in the price of milk
means that consumers can now afford to buy more with their income.
 ◦ The substitution effect. Milk is lower in price compared to other similar products so some
consumers will choose to substitute the more expensive drinks with the now cheaper milk.

Shifts in the Demand Curve - to the left or right.

A shift in the demand curve, Shifts caused by factors other than price.

1 Prices of related goods (substitutes and complements)

 Substitutes: two goods for which an increase in the price of one good leads to an
increase in the demand for the other (Coffee and tea, coca-cola and pepsi, jumpers
and hoodies....)

 Complements: two goods for which an increase in the price of one good leads to a
decrease in the demand for the other. (Ski and boots, petrol and cars….)

2. Income

◦ A lower income means that you have less to spend in total, so you would have to
spend less on some – and probably most – goods

◦ If the demand for a good falls when income falls or rises as income rises, the good is
called a normal good.

◦ If the demand for a good rises when income falls, the good is called an inferior good.

 Shifts caused by factors other than price (continued)

3) Tastes – they are considered as given, by cultural and personal

factors (demand for smoke, meat, bio products...)

4) Number of buyers (population)

5) Advertising

6) Expectations of consumers where demand is influenced by

expectations of future income and future prices – these can impact
on current demand

If I expect an increase in income…

If I expect an increase in price…

Supply

Quantity supplied is the amount of a good that sellers are willing and able to sell, given other factors
that are kept fixed when we consider a given supply

Supply is the relation between price and quantity supplied

Sellers respond to incentives - they produce more when the price increases – the relation is positive

Law of supply is the claim that, other things being equal, the quantity supplied of a good rises when
the price of the good rises
The Supply Schedule

Supply Schedule

◦ The supply schedule is a table that shows the relationship between the price of the good and
the quantity supplied.

Price of milk per litre (€) Quantity of milk supplied (litres per
month)

0.00 0

0.10 0

0.20 2

0.30 4

0.40 6

0.50 8

0.60 10

0.70 12

0.80 14

0.90 16

1.00 18

The Supply Curve

Supply Curve

◦ The supply curve is the graph of the relationship between the price of a good and the quantity
supplied.
Price of milk per litre (€) Quantity of milk supplied
(litres per month)

0.00 0

0.10 0

0.20 2

0.30 4

0.40 6

0.50 8

0.60 10

0.70 12

0.80 14

0.90 16

1.00 18

Market Supply versus Individual Supply

Market supply refers to the sum of all individual supplies for all sellers of a particular good or service.

Price of milk Quantity of milk Quantity of milk Quantity supplied

per litre (€) supplied by
Megan (litres supplied by Richard TOTAL
per month) (litres per month)
0.00 0 0 0
0.10 1 0 1
0.20 2 2 4
0.30 3 4 7
0.40 4 6 10
0.50 5 8 13
0.60 6 10 16
0.70 7 12 19
0.80 8 14 22
0.90 9 16 25
1.00 10 18 28
The Market Supply

Graphically, individual supply curves are summed horizontally to obtain the market supply curve.

Supply curve – movements along

Shifts in the Supply Curve

The supply curve shows how much producers offer for sale at any given price, holding constant all other factors
that may influence producers’ decisions about how much to sell.

When any of these other factors change, the supply curve will shift

1-Input prices. When the price of one or more of the factors of production increases, production of the good is
more expensive (irrespective of the prices), and less quantity is supplied.

2-Technology. Given the price level, an improvement in the technology – for instance a reduction of labour –
reduces costs and increases quantity supplied.

3-Expectations of producers about the future state of the market. If the producer expects an increase in the
price of the good, he can increase production to store it and sell it at higher prices in the future.

4-natural/Social Factors such as the weather and changing attitudes.

5-A change in the number of sellers in the market.

Change in Supply

A shift in the supply curve, either to the left or right.

Caused by a change in a determinant other than price.

Supply And Demand Together

Equilibrium Price

◦ The price that balances quantity supplied and quantity demanded.

◦ On a graph, it is the price at which the supply and demand curves intersect.

Equilibrium Quantity

◦ The quantity supplied and the quantity demanded at the equilibrium price.

◦ On a graph it is the quantity at which the supply and demand curves intersect.

Market demand and the sum of individual demands

Price of milk per litre Quantity of milk Quantity of milk Quantity of milk Quantity of milk
(€) demanded (litres per demanded (litres per demanded (litres per demanded (litres per
month) month) month) month)

Rachel Lars OTHERS TOTAL

0.00 20 10 2 32

0.10 18 9 2 29

0.20 16 8 2 26

0.30 14 7 3 24
0.40 12 6 5 23

0.50 10 5 4 19

0.60 8 4 4 16

0.70 6 3 5 14

0.80 4 2 5 11

0.90 2 1 6 9

1.00 0 0 6 6

Market Supply and the Sum of Individual Supplies

The Equilibrium of Supply and Demand

Price of milk per litre (€) Quantity of milk demanded Quantity of milk supplied
(litres per month) (litres per month)

TOTAL TOTAL

0.00 32 0

0.10 29 1

0.20 26 4

0.30 24 7

0.40 23 10

0.50 19 13

0.60 16 16

0.70 14 19

0.80 11 22

0.90 9 25

1.00 6 28

The Equilibrium of Supply and Demand

Price of milk per litre (€) Quantity of milk demanded (litres per Quantity of milk supplied (litres per
month) month)

TOTAL TOTAL

0.00 32 0

0.10 29 1

0.20 26 4

0.30 24 7

0.40 23 10

0.50 19 13

0.60 16 16

0.70 14 19

0.80 11 22

0.90 9 25

1.00 6 28
What Happens if the Market is NOT in Equilibrium?

Market Not in Equilibrium

Equilibrium
 Surplus

When price > equilibrium price

Then

quantity supplied > quantity demanded

There is excess supply or surplus

Suppliers will lower the price to increase sales, thereby moving toward equilibrium…

And the quantity demanded will increase

Market Not in Equilibrium

Equilibrium

Shortage

When price < equilibrium price

Then

quantity supplied < quantity demanded

There is an excess demand or shortage

Suppliers will raise the price (due to too many buyers demanding too few goods) without losing sales -
thereby moving toward equilibrium….

And the quantity demanded decreases…

Equilibrium

Law of supply and demand

◦ The price of any good adjusts to bring the quantity supplied and the quantity demanded for
that good into equilibrium.

Prices work as signals…

 The main function of price in a free market is to act as a signal to both buyers and sellers

 For buyers, price tells them something about the relative value of the benefit and the
opportunity cost of the purchase…
  For sellers, price acts as a signal in relation to the profitability (revenues and costs) of (extra)
production

Three Steps to Analyzing Changes in Equilibrium when demand and/or supply change

1 Decide whether the event shifts the supply or demand curve (or both).

2 Decide whether the curve(s) shift(s) to the left or to the right.

3 Use the supply and demand diagram to see how the shift affects equilibrium price and quantity.

Three Steps to Analyzing Changes in Equilibrium

Shifts in Curves versus Movements along Curves

◦ A shift in the supply curve is called a change in supply.

◦ A movement along a fixed supply curve is called a change in quantity supplied.

◦ A shift in the demand curve is called a change in demand.

◦ A movement along a fixed demand curve is called a change in quantity demanded.

But why there is an increase in price?!
But why there is an increase in price?
It requires more attention to see the definite change in price and quantity when BOTH curves shift

A Shift in Both Supply and Demand

If both curves shift, two cases are possible

The curves move in the same direction

The curves move in the opposite direction

In both cases the result depends on which curve shifts more

A Shift in Both Supply and Demand -

D increases, Supply decreases
A Shift in Both Supply and Demand (i)-
D increases, S decreases

The reason of the final effect on price ALWAYS DEPENDS on the existence
of SHORTAGE – OR SURPLUS
A Shift in Both Supply and Demand (ii) - D increases, S increases
Demand increases a little Demand equal to supply

Supply increases a lot

Price decreases Price remains equal

Quantity increases Quantity increases

Summary Table: What Happens to Price and Quantity When Supply or Demand Shifts?

Summary

1 Economists use the model of supply and demand to analyze competitive markets.

2 In a competitive market, there are many buyers and sellers, each of whom has little or no influence
on the market price.

3 The demand curve shows how the quantity of a good depends upon the price.

1 According to the law of demand, as the price of a good falls, the quantity demanded rises.
Therefore, the demand curve slopes downward.

2 In addition to price, other determinants of how much consumers want to buy include
income, the prices of complements and substitutes, tastes, expectations, and the number
of buyers.

3 If one of these factors changes, the demand curve shifts.

4 The supply curve shows how the quantity of a good supplied depends upon the price.
 1 According to the law of supply, as the price of a good rises, the quantity supplied rises.
Therefore, the supply curve slopes upward.

2 In addition to price, other determinants of how much producers want to sell include input
prices, technology, expectations, and the number of sellers.

3 If one of these factors changes, the supply curve shifts.

5 Market equilibrium is determined by the intersection of the supply and demand curves.

6 At the equilibrium price, the quantity demanded equals the quantity supplied.

7 The behaviour of buyers and sellers naturally drives markets toward their equilibrium.

8 To analyse how any event influences a market, we use the supply and demand diagram to examine
how the event affects the equilibrium price and quantity.

9 In market economies, prices are the signals that guide economic decisions and thereby allocate
resources.

Elasticity And Its Applications

Elasticity:

• Allows us to analyse supply and demand with greater precision.

• Is a measure of how much buyers and sellers respond to changes in market conditions, in particular
prices.

The Price Elasticity Of Demand

To know price elasticity is useful for sellers, who need to know how change in prices affect sales and revenues.

Policy makers, who need to know how changes in taxes and other policies may affect behaviour.

Price elasticity of demand is a measure of how much the quantity demanded of a good respond to a change in
the price of that good.

Price elasticity of demand is the percentage change in quantity demanded induced by a given percentage
change in the price.

Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the
percentage change in price.

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e
Example: If the price of an ice cream cone increases from €2.00 to €2.20 and the amount you buy falls from 10
to 8 cones, then your elasticity of demand would be calculated as:

(1 0  8 )
100 20%
10   2
( 2 .2 0  2 .0 0 )
100 10%
2 .0 0
Computing the Price Elasticity of Demand- Example 1

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e
 P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e
(1 0  8 )
100 20%
10   2
( 2 .2 0  2 .0 0 )
100 10%
2 .0 0
What’s going on?!

Using the Midpoint Method

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same
answer regardless of the direction of the change.

(Q 2  Q 1) / [(Q 2  Q 1) / 2 ]
P ric e e la s tic ity o f d e m a n d =
(P 2  P 1 ) / [(P 2  P 1 ) / 2 ]
Using the Midpoint Method

Example: If the price of an ice cream cone increases from €2.00 to €2.20 and the amount you buy
falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be
calculated as:

(10  8) 2
(10  8) / 2 0.22 x100 22%
 9    2.32
(2.20  2.00) 0.20 0.095 x100 9.5%
(2.00  2.20) / 2 2.10

Example 2 again…
What determines The Price Elasticity of Demand?

The determinants of price elasticity of demand:

◦ Availability of close substitutes.

Goods with very close substitutes tend to have a more elastic demand

Remember substitute goods…

◦ Necessities versus luxuries.

 Other things being equal, demand is more elastic, the less a good is – or is perceived to be - necessary

Think of, doctor’s visits and sailboat trips; bread and caviar…

But all this depends partly on consumer’s preferences…

Definition of the market.

• A limited definition of the product results in an higher elasticity, given the availability of close
substitutes...

• For example,a broadly defined good as food

• has a less elastic demand than

• a narrower category of goods, like biscuits

• …even more like chocolate biscuits…

• …because there are less substitutes.

Time horizon.

• The longer the time horizon, the more elastic the demand….

• Because consumers have more time to adapt to price change and find substitutes

• Example, demand for petrol….

The Price Elasticity of Demand

Demand tends to be more elastic:

◦ The larger the number of close substitutes.

◦ If the good is a luxury.

◦ The more narrowly defined the market.

◦ The longer the time period.

Example: Computing the Price Elasticity of Demand

The Variety of Demand Curves

Price Inelastic Demand

◦ Quantity demanded does not respond strongly to price changes.

◦ Price elasticity of demand is less than one.

Price Elastic Demand

◦ Quantity demanded responds strongly to changes in price.

◦ Price elasticity of demand is greater than one.

Different Demand Curves

Because the price elasticity of demand measures how much quantity demanded responds to the price

…it is closely related to the slope of the demand curve.

A good practical rule:

The flatter the demand curve, the higher its elasticity

The steeper the demand curve, the lower its elasticity

Perfectly Price Inelastic

Quantity demanded does not respond to price changes.

Perfectly Price Elastic

Quantity demanded changes infinitely with any change in price.

Unit Price Elastic

Quantity demanded changes by the same percentage as the price.

The Price Elasticity of Demand

Total Expenditure, Total Revenue and the Price Elasticity of Demand

Total expenditure is the amount paid by buyers, computed as the price of the good times the quantity
purchased.

Total revenue is the amount paid by buyers and received by sellers of a good.

Computed as the price of the good times the quantity sold.

TR = P x Q

Total Expenditure, Total Revenue and the Price Elasticity of Demand

With a price inelastic demand curve:

An increase in price….

…leads to a decrease in quantity that is proportionately smaller.

Thus, total revenue increases.

How Total Revenue Changes When Price Changes: Price Inelastic Demand
Total Expenditure, Total Revenue and the Price Elasticity of Demand

With a price elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is
proportionately larger.

Thus, total revenue decreases.

How Total Revenue Changes When Price Changes: Price Elastic Demand

Price Elasticity of a Linear Demand Curve

 The slope of a linear demand curve is constant, but the elasticity is not.

• At points with a low price and a high quantity, demand is inelastic.

• At points with a high price and a low quantity, demand is elastic.

 Total revenue also varies at each point along the demand curve.
Elasticity of a Linear Demand Curve

One can see the effect on total revenue of changes in price along a linear demand curve

when P increases along the elastic part, TR decreases

when P increases along the inelastic part, TR increases

Income Elasticity of Demand

Income elasticity of demand measures how much the quantity demanded of a good responds to a
change in consumers’ income.

It is computed as the percentage change in the quantity demanded divided by the percentage change
in income.

P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e
Types of Goods in relation to income

◦ Normal Goods

◦ Inferior Goods

Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for
inferior goods.

How do you expect the sign of the elasticity to be in these two cases?

>0 or <0?

Demand for goods consumers regard as necessities tends to be income inelastic.

◦ Examples include food, fuel, clothing, utilities, medical services…

Demand for goods consumers regard as luxuries tends to be income elastic.

◦ Examples include sports cars, furs, expensive foods…

Cross-Price Elasticity of Demand

Cross-price elasticity of demand measures of how much the quantity demanded of one good responds to a
change in the price of another good.

Substitutes…

have positive cross-price elasticities, while

complements…

have negative cross-price elasticities.

The Price Elasticity Of Supply

Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a
change in the price of that good.

When the ratio is bigger than 1 (>1), supply is elastic.

When the ratio is less than 1 (<1), supply is inelastic

When the ratio is equal to 1 (=1), percentage changes of price and quantity supplied are the same,
supply is unitary elastic
Determinants of Price Elasticity of Supply

 Time period.

◦ Supply is more price elastic in the long run than in the short run.

 Productive capacity and the ability of producers to change the amount of the good they produce.

◦ Supply of beach-front land is price inelastic (good somehow fixed in supply).

◦ Supply of books, cars, or manufactured goods is elastic…

◦ Size of the firm or industry (and their numbers).

◦ Mobility of the factors of production.

◦ Ease of storing stock or inventories.

How the Price Elasticity of Supply Can Vary

As for demand, elasticity of supply can vary along the curve

The explanation lies in the firm’s capacity for production

How the Price Elasticity of Supply Can Vary

As for demand, elasticity of supply can vary along the curve

The explanation lies in the firm’s capacity for production

When quantity is low, high elasticity is a sign that firms have excess capacity of production and can use
it to increase quantity produced

And supply is elastic

With the increase in quantity produced, excess production capacity is less and less and so is the ability
to increase quantity produced and supplied for a given increase in price…

Ora higher increase in price is needed to increase quantity (new machineries and plants)…

And supply is inelastic

The Price Elasticity of Supply

Different supply curves
The Supply Curve and Total Revenue

How Total Revenue Changes When Price Changes: Inelastic Supply

How Total Revenue Changes When Price Changes: Elastic Supply

Applications Of Supply And Demand Elasticity

Peak and off peak train travel

◦ Peak: Demand is price inelastic

Peak and off peak train travel.

Off peak: Demand is price elastic

 Peak and off peak train travel.

◦ Peak: Demand is price inelastic, so tickets are expensive.

◦ Off peak: Demand is price elastic, so in order to maximise revenues ticket prices are lowered.

Applications Of Supply And Demand Elasticity - Fall in farmers’ revenues.

Increased productivity in farming has led to…

Considerable rise in supply (large shift to the right), but…

…Only a small rise in inelastic demand

Lower prices for farmers and higher quantity…

Lower prices for farmers and higher quantity…

But to conclude this we only needed the previous lecture!…

In order to see the effects on welfare…

We must see the effects on revenue and income

These depend on the elasticity of demand!!!

 As the demand is inelastic…

Total revenue decreases

• This explain some policies of crop destruction or quotas…

• Supply decreases, prices increase

• As demand is inelastic…

• There is higher revenue and income….

Applications Of Supply, Demand, And Elasticity

1 Examine whether the supply or demand curve shifts.

2 Determine the direction of the shift of the curve.

3 Use the supply and demand diagram to see how the market equilibrium changes.

Summary

1 Price elasticity of demand measures how much the quantity demanded responds to changes in the
price.

2 Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the
percentage change in price.

3 If a demand curve is elastic, total revenue falls when the price rises.

4 If it is inelastic, total revenue rises as the price rises.

5 The income elasticity of demand measures how much the quantity demanded responds to changes in
consumers’ income.

6 The cross-price elasticity of demand measures how much the quantity demanded of one good
responds to the price of another good.

7 The price elasticity of supply measures how much the quantity supplied responds to changes in the
price.

8 In most markets, supply is more price elastic in the long run than in the short run.

9 The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the
percentage change in price.

10 The tools of supply and demand can be applied in many different types of markets.
 Revisiting The Market
Equilibrium
Does the model of supply and demand produce a result which is socially desirable?

Do the equilibrium price and quantity maximize the total welfare of buyers and sellers?

◦Market equilibrium reflects the way markets allocate scarce resources.

◦Whether the market allocation is socially desirable can be addressed by welfare economics.

Welfare Economic

Buyers and sellers receive benefits market – we’ll introduce a measure

from taking part in the of that benefit

An Efficient Allocation is a resource allocation where the value of the output produced by sellers equals the
value of that output for buyers.

◦The equilibrium in a market maximizes the total welfare of buyers and sellers and is therefore efficient.

Consumer and Producer Surplus

Consumer surplus measures economic welfare from the buyers’ side.

Producer surplus measures economic welfare from the sellers’ side.

Willingness to Pay

Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.

Willingness to pay is the maximum amount that a buyer will pay for a good.

◦It measures how much the buyer values the good or service.
Consumer Surplus

Therefore

The consumer surplus is the ADDITIONAL amount the consumer would be willing to pay in order to get the
good

beyond the market price he/she had to pay in order to get it

Simple example…

Suppose you are willing to pay 3000 euros for a good used car

You are lucky and you can find the car you want for 2000 euros…

If you pay a price of 2000, you will gain a surplus of 1000 = 3000 – 2000 .

We’ll show that…

1. We can use the demand the information on willingness to pay to derive curve…

2. we can use the demand curve to measure consumer surplus and…

3. Consumer surplus can be measured as the area below the demand curve and above the price.

We can use the information on willingness to pay to derive a demand curve… Check the table below

EXAMPLE 1
Four Possible Buyers’ Willingness to Pay – you are auctioning a guitar and 4 buyers show up…
 • The table shows the highest price each buyer is willing to pay for the guitar

• Each one is willing to pay less….

But at most a price equal but not higher

Suppose the auction takes place…

The price rises fast…

When it will be ≥ 800, Lisa will be willing to buy the guitar

Since Lisa was willing to pay more than he had to for the guitar, she derived some benefit from
participating in the market.

The difference between 1000 and 801 is her consumer surplus

EXAMPLE 2
There are 2 units on sale…

Suppose the auction takes place again for 2 units…

The price rises fast…

When it will be ≥ 700, Lisa and Paul will be willing to buy the guitars

Since the price is now lower, Lisa derives a higher benefit

Her consumer surplus is now 1000 - 701 instead of 1000 - 801…

We can derive a demand schedule from the table…

• Price Quantity

• If p > 1000 nobody buys the good 0 units

• If 800 < p < 1000 Lisa buys 1 unit

• If 700 < p < 800 Lisa and Paul buy 2 units

• If 500 < p < 700 Lisa and Paul and Claire buy 3 units

• If p < 500 Lisa, Paul and Claire and Leon buy 4 units

The Demand Schedule and the Demand Curve

The market demand curve depicts the various quantities that buyers would be willing and able to
purchase at different prices.

It is now possible to derive the demand curve but Which price do we choose among those in the
interval?

At any given quantity, the price given by the demand curve reflects the willingness to pay of the
marginal buyer.

That is

The consumer that would leave the market first if the price were any higher

For quantity 1 the price is = 1000, the willingness to pay of the marginal consumer Lisa

For quantity 2 the price is = 800, the willingness to pay of the marginal consumer Paul

……

For quantity 4 the price is = 500, the willingness to pay of the marginal consumer Leon

The Demand Schedule and the Demand Curve

2. Measuring Consumer Surplus with the Demand Curve

Measuring Consumer Surplus with the Demand Curve

Consumer surplus at a given price

can be measured

as the area below the demand curve and above the price.

The height of the demand curve is the buyer’s willingness to pay for the good, the value the buyer
attaches to it

The difference between this value and the market price is the buyer’s consumer surplus

The total area below the curve and above the price is the sum of the surplus of all the buyers in the
market

How a Lower Price Raises Consumer Surplus

The area below the demand curve and above the price measures the consumer surplus in the market

As price falls, consumer surplus increases:

Consider the li near demand curve

◦ Those already buying the product will receive additional consumer surplus because they are
paying less for the product than before (area BCDE).

◦ Some new buyers will enter the market and receive consumer surplus on these additional
units of output purchased (area CEF).