Economics: Foundations and Models

Introduction to Economics

• Economics is the study of how individuals and societies make choices under conditions of scarcity and how those choices affect the allocation of resources.

• Scarcity refers to the limited nature of society’s resources relative to unlimited wants.

Key Economic Questions

• What goods and services will be produced?

• How will the goods and services be produced?

• Who will receive the goods and services produced?

Branches of Economics

• Microeconomics: Studies the behavior of individual households and firms and their interactions in markets.

• Macroeconomics: Studies the economy as a whole, focusing on inflation, unemployment, and economic growth.

Economic Agents

• Households: Supply labor and demand goods and services.

• Firms: Produce goods and services using inputs.

• Government: Regulates markets, redistributes income, and provides public goods.

Three Basic Economic Ideas

• People Are Rational: Decisions are made by comparing costs and benefits.

• People Respond to Economic Incentives: Changes in costs or benefits influence behavior.

• Optimal Decisions Are Made at the Margin: Marginal analysis compares additional benefits and costs.

Marginal Analysis

• Examines the additional benefit or cost of a small change in an activity.

• Example: Should a student study one more hour? Marginal benefit = improved grade; marginal cost = lost leisure time.

Trade-Offs and Opportunity Cost

• Trade-off: Giving up one thing to gain another (e.g., studying vs. socializing).

• Opportunity Cost: The highest-valued alternative that must be given up to engage in an activity.

Economic Models

• Simplified representations of reality used to understand economic behavior.

• Examples: Supply and demand model, production possibility frontier, circular flow model.

Model Building & the Production Possibilities Frontier (PPF)

Production Possibilities Frontier (PPF)

• The PPF shows the maximum combination of goods that can be produced given available resources and technology.

• Mathematical representation (for curved PPF):

Efficiency

• Productive Efficiency: Goods are produced at the lowest possible cost.

• Allocative Efficiency: Goods are produced in the quantities society values most.

Points on the PPF

• Inside the curve: Inefficient

• On the curve: Efficient

• Outside the curve: Unattainable

Increasing Opportunity Cost

• As production of one good increases, the opportunity cost rises due to resource specialization.

Economic Growth

• The PPF shifts outward when:

  • More resources become available

  • Technology improves

  • Education increases human capital

Positive vs. Normative Analysis

• Positive Statement: Fact-based, testable (e.g., "A minimum wage increase raises unemployment.").

• Normative Statement: Opinion-based, value judgment (e.g., "The government should raise the minimum wage.").

Comparative Advantage & Trade

Absolute and Comparative Advantage

• Absolute Advantage: Ability to produce more output with the same inputs.

• Comparative Advantage: Ability to produce at a lower opportunity cost.

Gains from Trade

• Trade allows both parties to consume more than they could without trade.

• Specialization increases productivity.

Terms of Trade

• The rate at which goods exchange between traders.

Why Trade Benefits Everyone

• Even if one country is better at producing everything, trade based on comparative advantage benefits both parties.

• Example: Country A produces computers at lower opportunity cost; Country B produces wheat at lower opportunity cost. Both specialize and trade.

Demand & Supply

Markets

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

Demand

• Demand: Relationship between price and quantity consumers are willing and able to buy.

• Law of Demand: Holding everything else constant, as price increases, quantity demanded decreases, and vice versa.

• Demand Curve: Downward sloping due to substitution effect, income effect, and diminishing marginal utility.

• Mathematical form:

Changes in Demand

• Change in Quantity Demanded: Movement along the demand curve due to price change.

• Change in Demand: Shift of the entire demand curve due to factors other than price.

• Demand Shifters (TIMER):

  • Tastes

  • Income

  • Market size

  • Expectations

  • Related goods

Types of Goods

• Normal Good: Demand increases when income increases.

• Inferior Good: Demand decreases when income increases.

Related Goods

• Substitute Goods: Used in place of each other (e.g., Pepsi and Coke).

• Complementary Goods: Consumed together (e.g., cars and gasoline).

Supply

• Supply: Relationship between price and quantity firms are willing to sell.

• Law of Supply: As price increases, quantity supplied increases, and vice versa.

• Supply Curve: Upward sloping because higher prices make production more profitable.

• Mathematical form:

Changes in Supply

• Change in Quantity Supplied: Movement along the supply curve due to price change.

• Change in Supply: Shift of the supply curve due to factors other than price.

• Supply Shifters (TRICK):

  • Technology

  • Resource prices

  • Number of sellers

  • Changes in taxes/subsidies

  • Expectations

Market Equilibrium

• Equilibrium: Point where quantity demanded equals quantity supplied.

• Equilibrium Price: Price at which the market clears.

• Surplus: Quantity supplied exceeds quantity demanded; price falls.

• Shortage: Quantity demanded exceeds quantity supplied; price rises.

Elasticity

Price Elasticity of Demand

• Measures responsiveness of quantity demanded to a change in price.

• Formula:

• Elastic Demand: (quantity changes more than price; e.g., luxury goods).

• Inelastic Demand: (quantity changes little with price; e.g., gasoline).

• Perfectly Elastic: Demand curve is horizontal.

• Perfectly Inelastic: Demand curve is vertical.

Determinants of Elasticity

• Availability of substitutes

• Necessity vs. luxury

• Share of income

• Time horizon

Total Revenue Test

• Total Revenue = Price × Quantity

• Formula:

• Elastic demand: Price ↑ → Revenue ↓

• Inelastic demand: Price ↑ → Revenue ↑

Income Elasticity of Demand

• Formula:

• Positive: Normal good

• Negative: Inferior good

Cross-Price Elasticity

• Formula:

• Positive: Substitutes

• Negative: Complements

Price Elasticity of Supply

• Formula:

Government Policies: Price Controls and Taxes

Price Controls

• Price Ceiling: Legal maximum price (e.g., rent control). Results in shortage.

• Price Floor: Legal minimum price (e.g., minimum wage). Results in surplus.

Tax Incidence

• The division of tax burden between buyers and sellers depends on elasticity.

Deadweight Loss

• Loss of economic efficiency when equilibrium outcome is not achieved.

Consumer and Producer Surplus

• Consumer Surplus: Difference between the highest price consumers are willing to pay and the price they actually pay. Graphically, area under demand curve above price.

• Producer Surplus: Difference between the price producers receive and the lowest price they would accept. Graphically, area above supply curve below price.

Deadweight Loss from Taxes

• Tax reduces total surplus by preventing mutually beneficial trades.

Key Vocabulary List