notes
Lesson-1
Introduction to Business Economics
Economics has been recognized as a special area of study for over a century. Virtually,
all four-year colleges offer courses in economics and most of them allow students to
major in the subject. Economists maintain high profiles in governments and have been
well represented among the highest appointees in the federal government of the United
States. The press reports on their doings and sayings, sometimes with praise and
admiration and sometimes with ridicule and scorn. Economics and economists are
words that almost everyone has heard of and uses. But what exactly is economics? A
very few people can give a good definition or description of what this field of study is
all about.
If ordinary citizens cannot give a good definition or description of economics, they can
be excused because economists also took long time to define their own field. In recent
years, the subject matter that economists have studied has expanded, making its
boundaries less defined. In recent years, for example, economic journals have published
papers on topics such as sex, crime, slavery, childbearing and rats. It is not surprising
that if one economist, in a lighter moment, suggested that economics can be defined as
“what economists do.”
Defining economics as “what economists do” does not tell anything which one did not
already know. A good definition should explain what it is that makes economics a
distinct subject, different from physics or psychology. One should not expect to find a
short definition that conveys the message with absolute clarity. No one should believe
that there is only one correct definition possible. Many good definitions are also
possible and each will focus on some important aspect of the subject. To use an
analogy, there is not one spot from which one can best view Niagara Falls. Each
viewpoint obscures some features and emphasizes on others. There are, ofcourse, some
spots that are clearly superior to others but people can disagree on deciding the best
amongst them.
Slide 1
Introduction to Economics
•The economic problem
•Opportunity cost
•Production possibility frontiers
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Slide 2
The Economic Problem
• Unlimited wants
• Scarce resources--
Land, labor, capital
• Resource use
• Choices
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Slide 3
The Economic Problem
1. What goods and services should an economy
produce? Should it emphasize upon agriculture,
manufacturing or services or should it be on sport
and leisure or housing?
2. How should goods and services be produced?
Labor intensive, land intensive, capital intensive?
Efficiency?
3. Who should get the goods and services
produced? And even distribution? More for the
rich or for those who work hard?
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Slide 4
Opportunity Cost
• It is the cost expressed in terms of the
next best alternative sacrificed
• Helps to get the true cost of decision
making
• Implies valuing different choices
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Slide 5
Production Possibility Frontiers
1. Show the different combinations of goods and services that
can be produced with a given amount of resources?
• No “ideal” point on the curve
• Any point inside the curve suggests that resources are not
being utilised efficiently
• Any point outside the curve means “not attainable with the
current level of resources”
• Useful to demonstrate economic growth and opportunity
cost
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Slide 6
Production Possibility Frontiers
Capital Goods
Consumer Goods
Yo
Xo
A
B Y1
X1
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Slide 7
Production Possibility Frontiers
Capital Goods
Consumer Goods
Yo
Xo
A
.B
C Y1
X1
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Slide 8
Positive and Normative Economics
• Health care can be
improved with more tax
funding
• Pollution control is
effective through a
system of fines
• Society ought to provide
homes for all
• Any strategy aimed at
reducing factory closures
in deprived areas would
be helpful
• Positive Statements
– Capable of being
verified or refuted by
resorting to fact or
further investigation
• Normative Statements
– Contains a value
judgement which
cannot be verified by
resort to investigation
or research
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What is economics?
One of the earliest and most famous definitions of economics is given by Thomas
Carlyle who in the early 19th century termed it as “dismal science.” Carlyle noticed the
anti-utopian implications of economics. Many of the utopians, people who believe that
a society of abundance without conflict is possible, believe that good results come from
good motives and good motives lead to good results. Economists have always doubted
this and it was the forceful statement of this disagreement by early economists such as
Thomas Malthus and David Ricardo that Carlyle reacted to.
Another definition of the early phase which is perhaps more useful is given by an
English economist, W. Stanley Jevons, who in the late 19th century wrote, “Economics
is the mechanics of utility and self interest.” One can think of economics as the social
science that explores the results of people acting on the basis of self-interest. There is
more to man than self-interest and the other social sciences, such as psychology,
sociology, anthropology and political science, attempt to tell about those other
dimensions of man. The assumption of self-interest underlies virtually every economic
theory.
At the turn of the century, Alfred Marshall’s “Principles of Economics” was the most
influential textbook of economics. Marshall defined economics as, “a study of mankind
in the ordinary business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of the material
requisites of wellbeing. Thus, it is on one side a study of wealth; and on the other, and
more important side, a part of the study of man.”
Many books of the period covered in their definitions something about the “study of
exchange and production.” These kinds of definitions revolved around economics based
topics. These definitions reflected upon processes involved in meeting people’s
material needs. Today, the economists do not use these definitions because the
boundaries of economics have expanded. Although exchange always remains at the
heart of economics yet the economists study more than exchange and production.
Most of the contemporary definitions of economics involve the notions of choice and
scarcity. Perhaps the earliest of these is given by Lionell Robbins in 1935. According to
him, “Economics is a science which studies human behavior as a relationship between
ends and scarce means which have alternative uses.” Virtually, all textbooks have
definitions that are derived from this definition. Though the words used differ from
author to author yet the standard definition is more or less the same. “Economics is the
social science which examines how people choose to use limited or scarce resources in
attempting to satisfy their unlimited wants.”
In other words “Economics is the science of choice, i.e. the science that explains the
choices that we make and how those choices change as we cope with scarcity.”
It should be noticed that scarcity is central in all the definitions.
Scarcity and Choice
Scarcity means that people want more than is available. Scarcity limits us both as
individuals and as a society. As individuals, limited income, time and ability keeps one
away from doing and having all that one might like. As a society, limited resources
(such as manpower, machinery and natural resources) fix a maximum on the amount of
goods and services that can be produced.
Scarcity requires choice. People should choose which of their desires they will satisfy
and which they will leave unsatisfied. When a person, either an individual or as a
society, choose more of something, scarcity forces him/her to take less of something
else. Economics is sometimes called the study of scarcity because economic activity
would not exist if scarcity did not force people to make choices.
When there is scarcity and choice, there are costs. The cost of any choice is the option
or options that a person gives up. For example, if you gave up the option of playing a
computer game to read this text, the cost of reading this text is the enjoyment which
you would have received playing the game. Most of the economics is based on a simple
idea that people make choices by comparing the benefits of option A with the benefits
of option B (and all other options that are available) and choosing the one with the
highest benefit. Alternatively, one can view the cost of choosing option A as the
sacrifice involved in rejecting option B. One chooses option A when the benefits of A
outweigh the costs of choosing A which are the benefits one loses when one rejects
option B.
The widespread use of definitions emphasizing choice and scarcity shows that the
economists believe that these definitions focus on a central and basic part of the subject.
This emphasis on choice represents a relatively recent insight into what economics is all
about. The notion of choice is not stressed in older definitions of economics.
Sometimes, this insight yields rather clever definitions. According to James Buchanan,
“An economist is one who disagrees with the statement that whatever is worth doing is
worth doing well.” Buchanan noticed that time is scarce because it is limited and there
are many things one can do with one’s time. If one wants to do all things well, one
should devote considerable time to each and thus, should sacrifice other things.
Sometimes, it is wise to choose to do something quickly so that one has more time for
other things.
What is a science?
Should we accept claims of economists who say they are scientists? To decide, we
should first know what science is.
Philosopher Karl Popper’s widely accepted definition of science says that a statement is
scientific only if it is open to the logical possibility of being found false. This definition
means that scientific statements are evaluated by testing them and by comparing them
with the world around us. A statement is non-scientific if it takes no risk of being found
false. It means that there can be no way to test a statement against observable facts or
events. Popper called this distinction the “line of demarcation.”
An implication of Popper’s definition is that one can never be completely sure that any
scientific theory is true. Accepted scientific theory is the only theory that has not yet
been contradicted by evidence, though the future may bring a contradiction. For
example, one cannot be absolutely sure about the statement, “The sun will rise in the
east tomorrow.” This statement is true because it is a scientific statement. One can
easily think of a logical possibility that would refute a statement, “A sunrise in the
west.” One can confidently reject this statement in a view that such an event will not
happen because the sun has always risen in the east. However, the fact that all previous
experiences have been consistent with the statement does not prove that the statement
will never be refuted.
Popper saw the growth of scientific knowledge as a process of conjecture and
refutation. Someone originally comes up with a way of explaining a set of facts, i.e. a
conjecture or guess or theory about how the facts are related. If further observation is
inconsistent with the theory, the theory is considered refuted and a new theory or
conjecture is found. In contrast, if the original explanation is non-scientific, it will
never be refuted and there will never be any need to change beliefs.
Most of the economists see their discipline as scientific in Popper’s sense of the world.
An economic theory makes statements about how facts fit together. There are
constantly new sets of facts arising that allow one to test the theory to see whether the
facts are similar to the predictions of theory. However, this process is more difficult for
economists than it is for physical scientists.
Unlike physical scientists, economists can almost never use controlled experiments to
gather facts with which to test theories. Rather they have to use whatever facts the
world gives them and rely on statistical procedures to draw conclusions. Though
statistical procedures let economists hold some variables constant to see the effect of
other variables just as a controlled experiment does yet they are subject to serious
limitations. If there are variables that a theory says are important but cannot be
measured or can be measured only imperfectly, statistical procedures may give
misleading results. The procedures also may fail if a theory is uncertain. The strength of
a properly done controlled experiment is that there is no need to list all the factors that
are controlled. The procedure is such that only one factor, or a small and known group
of factors, is different between the control and experimental groups. Given these
difficulties, it is not surprising that the controversy about whether a theory is supported
or rejected by the facts can last for many years in economics.
However, there is a minority of economists who do not see economics as scientific in
Popper’s sense. A group of economists called the Austrian school, for example, has
argued that economics starts with assumptions and economic theory is the logically
deduced result of those assumptions. If a theory does not fit the facts, one cannot
conclude that the theory is wrong. It is only inappropriate to apply the theory in that
particular situation because the initial conditions do not agree with the assumptions of
the theory.
Besides distinguishing between scientific and non-scientific statements, one can make a
positive/normative distinction.
Positive and Normative
Economists make a distinction between positive and normative which stands parallel to
the Popper’s line of demarcation. David Hume explained it well in 1739 and
Machiavelli used it two centuries earlier, i.e. in 1515. A positive statement is a
statement about “what is” and contains no indication of approval or disapproval. A
positive statement can be wrong. “The moon is made of green cheese” is incorrect but it
is a positive statement because it is a statement about “what” exists.
A normative statement expresses a judgment about whether a situation is desirable or
undesirable. “The world would be a better place if the moon were made of green
cheese” is a normative statement because it expresses a judgment about what ought to
be. It should be noticed that there is no way of disproving this statement. If one
disagrees with it, one has no sure way of convincing someone who believes the
statement made is wrong.
Economists have found the positive-normative distinction useful because it helps
people with very different views about what is desirable to communicate with each
other. Libertarians and socialists, and Christians and atheists may have very different
ideas about what is desirable. When they disagree, they can try to learn whether their
disagreement stems from different normative views or from different positive views. If
their disagreement is on normative grounds, they know that their disagreement lies
outside the realm of economics. So, any economic theory and evidence will not bring
them together. However, if their disagreement is on positive grounds, further
discussion, study and testing may bring them together.
Economists can confine themselves to positive statements but only a few are willing to
do so because such confinement limits what they can say about issues of government
policy. Both positive and normative statements should be combined to make a policy
statement. One should make a judgment about what goals are desirable (the normative
part) and decide a way to attain those goals (the positive part). Economists often see
cases in which people propose courses of action that will never get them to their
intended results. If the economists limit themselves to evaluate whether or not proposed
actions will achieve intended results, they confine themselves to positive analysis. One
should realize that although economists can speak with special authority on positive
issues yet even the best could be wrong. However, most of the economists prefer a
wider role in policy analysis and include normative judgments as well. On normative
issues, an economist cannot speak with special expertise. Addressing most of the
normative issues ultimately depends on how one answers the following question:
“What is the meaning of life?”
One does not study economics to answer this question. Most of the statements are not
easily categorized as purely positive or purely normative. Rather, they are like tips of
an iceberg with many invisible assumptions hiding below the surface. Suppose, for
example, someone says, “The minimum wage is a bad law.” Behind this simple
statement are assumptions about how to judge whether a law is good or bad (or
normative statements) and also beliefs about what are the actual effects of the minimum
wage law (or positive statements).
Unintended Consequences
The conventional definitions of economics ignore an important aspect of the field.
Economists are not interested in examining every case of actions based on costs and
benefits. They are interested only on those that have some sort of unexpected or
unintended consequences. Because people live in so complex systems that they cannot
fully understand them, their choices can have system-wide implications that they
themselves neither intended nor expected. Economics starts with individuals making
choices based on self-interest but it is primarily interested in how these actions affect
society as a whole. Do these choices lead to chaotic results or to harmonious ones?
The economists’ concern with unintended consequences of human choice and action
leads them to argue that good results do not necessarily come from good intentions and
good intentions do not necessarily lead to good results. In contrast, some parts of our
popular culture believe that intentions determine results. For example, people who try
to find a conspiracy behind all the world’s problems whether that conspiracy is of
communists, Jews, bankers, the CIA or multinational oil companies, start with a belief
that bad results come from bad people with bad intentions.
As like any other field of study, economics has a history and there are books that
attempt to trace the trail of economic thought back to its origins. Though the trail can be
traced back to the ancient Greeks yet it is a difficult trail to follow prior to 1776. In
1776, Adam Smith published The Wealth of Nations, a book that was clearly on
economics and that inspired a large number of books, pamphlets and articles in the next
50 years. Before this book, most of the ideas about economics were scattered in
writings that were mostly on politics or ethics or philosophy, not in books that were
clearly on economics. If one looks at the topics and theories that modern economics
textbooks contain and compares them to those things that Smith discussed, one is struck
by how little of contemporary economics comes directly from Smith. What comes from
Smith is a concern about and an interest in unintended consequences.
The most famous term in the The Wealth of Nations is “invisible hand.” Smith used this
term only once in the following quotation:
“...By directing that industry in such a manner as its produce may be of the greatest
value, he intends only his own gain, and he is in this, as in many other cases, led by an
invisible hand to promote an end which was no part of his intention. Nor is it always
the worse for the society that it was not part of it.”
Another quotation makes clearer that what unintended consequences the invisible hand
leads to:
“Every individual is continually exerting himself to find out the most advantageous
employment of whatever capital he can command. It is of his own advantage, indeed,
and not that of the society, which he has in view. But the study of his own advantage
naturally, or rather necessarily leads him to prefer that employment which is most
advantageous to society.”
Smith was not sophisticated in the level of economic theory that he used. He did not
understand the concepts that are considered basics at present, such as the model of
supply and demand. Alfred Marshall developed the modern treatment of supply and
demand a century after Smith. In his comprehensive survey of economic theory, Joseph
Schumpeter dismisses Smith as a theorist by saying, “The fact is that The Wealth of
Nations does not contain a single analytic idea, principle, or method that was entirely
new in 1776.”
Though the idea that there could be systematic unintended consequences was “in the
air” at the end of the eighteenth century, no one articulated it better than Smith.
Because he expressed so well the idea that these unintended consequences are of vital
importance for understanding how a society works, Smith has often been called “the
father of economics.” His book is concerned with a question that has aroused interest
among economists for two hundred years. The question is as follows:
“Under what conditions are actions based on self-interest beneficial to society?”
Many economic theories have been developed and improved in an effort to get better
answers to this question. The two most influential economists in the generation after
Adam Smith were David Ricardo and Thomas Malthus. Though they disagreed on
many things yet they were generally agreed upon the topic of population growth.
Malthus is best known for his writings on this topic. He believed that there was a
tendency for human populations to grow more rapidly than the food supply could be
increased. Land was fixed in amount and more food could be produced either by tilling
it more intensively or by adding less-productive land to tillage. In either case, an extra
hour of labor brought less than an average return of food. The implication of these two
different growth rates is clear-- eventually a segment of the population would face
starvation and this would cut the growth rate of population.
Malthus’ argument on population is related to possible unintended consequences.
Suppose a society aids its most needy members by giving them food. As a result, they
can survive and reproduce. Helping the poor would, according to Malthus’ argument,
increase population and in the future lead to even larger numbers on the verge of
starvation. Hence, charity would be self-defeating. All attempts to improve society
seem doomed to failure, according to a strict reading of the Malthusian argument and a
truly “dismal” conclusion, as Carlyle noted.
However, Malthus and Ricardo were wrong when they applied this argument to human
populations. The predictions they made did not occur. They underestimated both the
capability of technology to improve crop yields and the future of birth rates. As it
became apparent that they were wrong, economists lost their interest in the study of
population. It seemed that they did not have the unintended consequences to explore.
Since that time, economists have occasionally developed other clever theories with
intriguing possibilities of unintended consequences. This was done only to find that
they too were in conflict with real-world experience. One should keep this in mind that
one learns what contemporary economists believe. There is a possibility that today’s
secure truth may be tomorrow’s embarrassing mistake.
How to study Economics?
Agatha Christie wrote a series of mystery novels in which she challenged the readers to
outwit her fictional heroine, Miss Jane Marple. By the end of the book, a reader had the
same facts that Miss Marple had. But the facts do not speak for themselves. Rather, it
was Miss Marple’s ability to look at those facts in a special way or to see something
significant where most of the readers could not see anything which would let her solve
the mystery.
Facts in economics, as in an Agatha Christie novel, need to be organized in some way
before they can tell one about anything. By themselves, they are meaningless. Thus, the
study of economics involves more than a memorization of facts. Economics tries to
organize facts with its theory. A good theory tells about which facts are important and
which are not, and what is cause and what is effect. The study of economics involves
learning about how to organize facts the way economists do.
People who do not understand economics still try to make sense of the world around
them by trying to see the pattern in the facts they observe. Sometimes they use a “good-
versus-bad” model. In this model, there are two conflicting groups who are classified as
good people and bad people. These groups are usually involved in a zero-sum game--
one person’s gain is another’s loss. Further, evil motives possessed by the bad people
lead to bad results unless these people are in some way controlled. Good motives lead
to good results.
An example of a good-versus-bad viewpoint was expressed at a town meeting of a
small Indiana community during the winter of 1977. The meeting focused on the
natural-gas shortages that the community was facing. One citizen declared that the town
faced not an energy problem but a pricing problem. He noted that several years back,
there had been shortages of gasoline at 40 cents per gallon but no shortages at 60 cents.
Therefore, he declared that there could be a conspiracy at that time by oil companies to
increase prices and now it was the turn of the gas producers. The events he observed do
fit into a good-versus-bad framework. He saw a bad result. He saw a bad motive-- the
desire for profit seems to many people the same as greed or avarice. To connect motive
and result, he inferred the existence of a conspiracy.
Though a good-versus-bad model is sometimes appropriate (especially in small-group
situations) yet economists are very reluctant to use it. The economic model of supply
and demand gives a more sophisticated interpretation of the gasoline shortage-- one that
is depersonalized and unemotional with no bad groups involved. This model suggests
that, in case of shortage, one should search for government regulation of prices. The
model does not suggest that such regulation is something one should look for. Infact,
there were price restrictions in place at the time and such restrictions could lead to
shortages. The good-versus-bad view of the world is attractive because one is able to
understand the model at a very young age and because one sees the model used so often
as in fairy tales, in comic books, in movies and in television shows among other places.
As one knows how to use this model and because our culture discourages use of
alternative explanations such as fate or mystery, it is easy to fall back to this model if
one does not have a more sophisticated model to explain one’s world.
Economic issues affect every individual and most of the people have opinions on them.
These opinions may be based on a good-versus-bad view, some other non-economic
framework, or simply slogans that are often repeated. Often the hardest problem that
students have in learning about how economists interpret the world is to unlearn their
old and non-economic views.
Unlearning old ways of thinking can be difficult as a well-known example illustrates. In
the late 15th century, Christopher Columbus believed that by sailing a relatively short
distance to the West, he could reach Asia. Contrary to popular myth, it was Columbus,
not his critics who had an outdated view of the world. He believed that the world was
much smaller and that Asia was much larger than they actually are. His critics in their
guesses were much closer to the truth.
Columbus made four trips to the Caribbean but he never realized the significance of
what he had found. He died believing that he had found a short cut to the Far East.
Rather using the facts he had before him to alter and improve his ideas of world
geography, he insisted on keeping his old views and trying to make the facts fit in.
Economic education involves learning to see reality from new perspectives. Sometimes
these new perspectives may surprise you. They may even shock you. But if you take
some time to look at the reasoning behind these economic ways of looking at things,
you will find that they consist of carefully thought out and applied common sense.
Summary
Economics is essentially a subject that looks at choices, such as how individuals,
governments and businesses make the decisions and what are its consequences. It is
likely to be a strong likelihood that every issue raised in the class involves some form
of decision or choice. For example, if fines were the answer to poor attendance, the
choice would have been to remain absent and get fined or to attend the class and avoid
the fine. Then, the question would be how much of a fine is necessary for those who
choose to remain absent? All this can be precisely summarized through the figure 1.1
which is as follows:
Figure 1.1 The Economic Problem
Lesson-2
Scarcity, Choice and Efficiency
Slide 1
Production Possibilities
Frontier
„ Suppose there are only two goods...
… a production possibility frontier is a graph
showing the various combinations of the
output that can be produced when all
resources are being utilized in the most
(productively) efficient manner possible,
given the current level of technology
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Slide 2
Production Possibilities in a
Two-Good Economy
„ Consider an economy that produces
computers and cars
„ How can one illustrate the production
possibilities for this economy using a
graph?
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Slide 3
Quantity of
Computers
Produced
Quantity of
Cars Produced
3,000
0 1,000
A
C
Attainable and Unattainable
„ All points on or
inside the frontier
are attainable
„ Point A is attainable,
so is point B. Infact
B is better
„ Point C is
unattainable
Production
Possibilities
frontier
B
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Slide 4
Illustrating Concepts Using a
Production Possibility Frontier
‹ Scarcity
‹ Efficiency, Inefficiency and
Unemployment
‹ Opportunity Cost
‹ Economic Growth
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Slide 5
Quantity of
Computers
Produced
Quantity of
Cars Produced
3,000
0 1,000
A
C
Scarcity
„ All points on or inside the
frontier are attainable
„ Points A and B are attainable
„ At point C, more cars and
computers are being
produced than at A or B
But point C is unattainable.
Why?
„ Scarcity
„ Production possibilities are
bounded
B
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Slide 6
A
Quantity of
Computers
Produced
Quantity of
Cars Produced
3,000
0 1,000
Efficiency, Inefficiency and
Unemployment
„ All points on the PPF
are attainable if the
society uses all of its
resources in a
productively efficient
manner
„ But point A, which is
not on the frontier, is
also attainable
What is happening at A?
„ Waste
„ Unemployment
„ Inefficiency
Inside the
frontier
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Slide 7
Quantity of
Computers
Produced
Quantity of
Cars Produced
3,000
0 1,000
Opportunity Cost
„ Start at B1--
800 cars and 1500
computers
„ Suppose, you want to increase
the number computers to 2000
„ At point B2 you are producing
2000 computers and only 600
cars. To increase computer-
production by 500, you should
give up car-production by 200
„ The negative slope of the PPF
implies that whenever you
increase production of one
good…
…you will have to give up some
of the other good
Not possible
B1
1,500
B2
2,000
800 600
C
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Slide 8
3,000
0 1,000
Economic Growth-- Long Run
„ Over time an economy
can grow
„ More labor and capital
„ Technological progress
What happens to the PPF?
„ Shifts outward
„ Previously unattainable
levels of production…
…now become
attainable
1,500
4,000
Quantity of
Computers
Produced
Quantity of
Cars Produced
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Slide 9
A
Quantity of
Computers
Produced
Quantity of
Cars Produced
3,000
0 1,000
Economic Growth-- Short Run
„ Consider an economy at
point A
„ Recession
„ High unemployment
„ Suppose the central bank
cuts interest rates to bring
the economy out of
recession
„ The economy moves to B
„ Unemployment falls, output
increases
„ But production possibilities
are unaffected
B
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Slide 10
Why does the PPF bow
outward?
„ PPF does not necessarily have to be concave
„ But it is reasonable assumption
Why?
„ Because not all resources are equally suited at
producing the same good
„ Computer manufacturers make poor car makers and
vice-versa
„ Suppose, if more and more resources were diverted
into the production of cars say, computer
manufacturers would find themselves on the
automobile assembly line but their productivity would
be low
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Slide 11
Quantity of
Computers
Produced
Quantity of
Cars
Produced
3,000
0 1,000
B
Illustrating the Point
„ Suppose, one goes from A to B.
production of cars is virtually
unaffected but production of
computers falls by 750
„ Computer manufacturers are
lousy at making cars
„ PPF is steep
„ Suppose, one goes from C to D.
production of computers is
virtually unaffected but
production of computers
decreases by 250
„ Car makers are lousy at making
computers
„ PPF is flat
A 750
C D
250
As one moves up,
the slope of PPF
decreases
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Slide 12
Quantity of
Computers
Produced
Quantity of
Cars Produced
3,000
0 1,000
Linear PPFs
„ The slope of the PPF…
…measures the opportunity
cost of producing good X (in
this case cars) in terms of
good Y (in this case
computers)
„ If the PPF is linear, the
opportunity cost of
producing X in terms of Y is
constant at all levels of
production
„ This is unrealistic but linear
PPFs are easier to deal with
0
∆Y
∆X
Slope =
∆Y/∆X
B
A
Slope at A…
equals Slope
at B
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Slide 13
Marginal Rate of
Transformation
‹ The slope of the PPF is sometimes
called the marginal rate of
transformation of good X (in this case
cars) for good Y (in this case
computers)
‹ For linear PPFs, the MRTXY is constant
‹ For concave PPFs, the MRTXY (o/c of X
in terms of Y) increases with X
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Slide 14
Quantity of
Computers
Produced
Quantity of
Cars Produced
3,000
0 1,000
Measuring the Opportunity
Cost
What is the opportunity
cost of producing cars?
„ Pick any two points on
the PPF…
„ As one move from A to
B…
DY = -1800 and
DX = 600
Slope = -1800/600 = -3
„ O/C of 1 car is 3
computers
0
∆Y
∆X
Slope =
∆Y/∆X
B
A
200 800
2,400
600
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Slide 15
True or False
„ Because resources are scarce, society always
faces tradeoffs, consequently the PPF should
have a negative slope
„ This question is tricky
„ If a society faces tradeoffs, the PPF should
have a negative slope (and vice-versa)
„ But even if resources are scarce, a society
needs not to face tradeoffs (see next slide)
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Slide 16
Number of
Houses
Quantity of
Farmland
(acres)
500
0 1000
Positively Sloped PPF
„ Consider an island economy,
with limited land
„ The entire island is covered
by a forest
„ The island produces two
goods
„ Houses (made of wood)
„ Farm land (clearing forests)
„ The only way to produce
more houses is to clear more
farmland and vice-versa
„ Hence, the PPF has a
positive slope
„ But production possibilities
are still bounded
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Slide 17
Summary
„ A PPF shows all combinations of goods and services
that can be produced given available resources and
technology
„ The PPF is used to illustrate concepts such as scarcity
and opportunity cost
„ The slope of the PPF measures the o/c of producing
good X in terms of good Y
„ The curvature of the PPF reflects increasing
opportunity cost when substituting one type of
production for another
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Scarcity
Economics is the study of how economic agents or societies choose to use scarce
productive resources that have alternatives to satisfy wants which are unlimited and of
varying degrees of importance. The main concern of economics is the identification,
description, explanation and solution (if possible) of an economic problem. The source of
any economic problem is scarcity. Scarcity of resources forces the economic agents to
choose among alternatives. Therefore, an economic problem can be said to be a problem
of choice and valuation of alternatives. The problem of choice arises because limited
resources with alternative uses are to be utilized to satisfy unlimited wants which are of
varying degrees of importance. Had the resources like human, natural, capital, etc not
been scarce, there would have been no problem of choice and hence no economic
problem at all. Therefore, the root cause of all the economic problems is scarcity.
In other words, scarcity means wanting more than what is available. Scarcity limits us
both as individuals and as a society. As an individual, limited income, time and ability
keep one off from doing and having all that one might like. As a society, limited
resources such as manpower, machinery and natural resources fix a maximum on the
amount of goods and services that can be produced for you.
Scarcity is a central concept in economics. Resources scarcity is defined as a difference
between the desire and the demand for a good. This means that the collective desire of
individuals for goods and services exceeds the productive resources (natural, human and
capital) available to satisfy those desires. It means that scarce is good if people would
consume more of it if it were free. In other words, the things of value that people want
are virtually unlimited while the productive resources necessary to produce these things
are limited. Every society, rich or poor, should determine how to use the best of its scarce
productive resources to produce goods and services. This is the basic economic problem.
Following could be a suggestive list of desired goods and limited resources:
Economic goods (wants) Limited resources (scarcity)
Food Land
Clothing Cotton & other resources
National defense Human resource
Education No. of institutes, fee you can afford
Table 2.1
For example, you may want to own gold jewelery. However, the amount of gold
available is limited, so it is necessary to make choices as to how it should be allocated. In
a market economy, this is achieved by trade. Individuals trade resources between
themselves to reallocate resources to where they are most wanted. In a smoothly
operating market system, the rate of exchange between different resources, or price are
adjusted accordingly so that the demand is equal to the supply. One of the roles of the
economist is to discover the relationship between demand and supply and develop
mechanisms, such as pricing, incentives or penalties to achieve an optimal outcome in
terms of consumer welfare between supply and demand.
Scarcity is a relative concept. It can be defined as an excess demand, i.e. demand more
than the supply. For example, unemployment is essentially the scarcity of jobs. Inflation
is essentially scarcity of goods.
Choice
Because goods and services are scarce, choices have to be made. Scarcity is universal.
All individuals, households, business firms, communities and nations confront scarcity.
The fundamental economic problem is the inappropriate use of the limited resources to
produce the goods and services that are very valuable. Economics, therefore, can be
defined as the study of the choices which people make in order to cope with scarcity.
Economists study among other things that how societies perform the optimal allocation of
these resources.
Scarcity requires choice. People should choose which of their desires they will satisfy and
which they will leave unsatisfied. When a person, either an individual or as a society,
choose more of something, scarcity forces him/her to take less of something else.
Economics is sometimes called the study of scarcity because economic activity would not
exist if scarcity did not force people to make choices.
The resources (also called inputs or factors of production) that can be used to produce
goods and services are divided into four main categories which are as follows:
1. Land
The gifts of nature such as air, water, land surface and minerals lie beneath the earth’s
surface.
2. Labor
It is the time and physical or mental effort devoted to producing goods and services.
3. Capital
These are the goods made by people that are used to produce other goods and services
(factories, tractors, buildings, power plants, hand or power tools, machinery,
equipment, transportation networks, etc). Human capital is the knowledge and skill
people possess from education and vocational training. You are building human
capital right now as you work toward your degree.
4. Entrepreneurial Ability
It is the resource that organizes land, labor and capital. An entrepreneur is a person
who sets up a firm by combining all the factors of production in order to produce a
good or service. While labor receives wages or salaries for the work, an entrepreneur
expects to receive profits for his/her efforts.
Concept of Cost
One should be careful about utilization of each and every unit of scarce resources. To
decide whether to use an additional unit of resource, one needs to know the additional
output expected therefrom. Economists use the term marginal for such additional
magnitude of output. Therefore, marginal output of labor is the output produced by the
last unit of labor. Marginal revenue is the additional revenue generated by an additional
unit sold and marginal cost of production is the cost incurred for producing an additional
unit of output. While using the marginal concept, one should be careful of the nature of
relationship between the variables. In the above situation, labor, sales and output
produced are independent variables and output, revenue and cost are dependent variables.
In the same way, if sales depend on advertisement, you talk of “marginal sales of
advertisement’ but if the advertisement depends on the sales revenue, you talk of
“marginal advertisement of sales.”
The concept of marginalize assumes that an independent variable changes by a single
unit. In practice, an independent variable may be subjected to “chunk changes” rather
than unit changes. A contractor working on a turnkey project may change the labor
employed not by one, but by tens and hundreds. Similarly, the costs and benefits of
computerization are not subject to marginal analysis. In such situations, the concept of
incrementalism is more useful. In the above situations, we talk about incremental output
of labor and incremental costs and benefits of computerization respectively. Infact,
incrementalism is more general whereas marginalize is more specific. All marginal
concepts are incremental concepts but all incremental concepts need not be confined to
marginal concepts alone.
When there is scarcity and choice, there are costs. The cost of any choice is the option or
options that a person gives up. For example, if you gave up the option of playing a
computer game to read this text, the cost of reading this text is the enjoyment which you
would have received playing the game. Most of the economics is based on a simple idea
that people make choices by comparing the benefits of option A with the benefits of
option B (and all other options that are available) and choosing the one with the highest
benefit. Alternatively, one can view the cost of choosing option A as the sacrifice
involved in rejecting option B. One chooses option A when the benefits of A outweigh
the costs of choosing A which are the benefits one loses when one rejects option B.
The true cost of anything that is scarce is its opportunity cost, what is given up to get it.
In other words, the opportunity cost of an action is the highest valued alternative forgone.
Scarcity and Choice for a Single Firm
The Production Possibilities Frontier (PPF) shows the different combinations of various
goods that can be produced with the help of given available resources and existing
technology. The PPF marks the boundary between combinations of goods and services
that can be produced and combinations that cannot.
Different resources are not equally effective in producing different goods. Thus, along the
PPF, producing more quantity of one good has increased opportunity costs. Most of the
activities in the real world are subject to increase opportunity costs.
The opportunity cost of an action is the highest valued alternative forgone. On the PPF,
the opportunity cost of producing more of one good (e.g., soybeans) is the output of the
other good that needs to be forgone (e.g., wheat). The opportunity cost of a bushel of
soybeans is the number of bushels of wheat that should be forgone per bushel of
soybeans. Therefore, opportunity cost is a ratio. The opportunity cost of a bushel of
wheat is the inverse of the opportunity cost of a bushel of soybeans. The following table
shows the opportunity cost of producing wheat in the place of soybeans and vice-versa.
Opportunity cost of
Point Soybeans Wheat Soybeans Wheat
1 40 0
(38 - 0 / 40 - 30) =
38/10
-
2 30 38
(52 - 38 / 30 -20) =
14/10
(40 - 30 / 38 - 0) =
10/38
3 20 52
(60 - 52 / 20 -10) =
12/10
(30 - 20 / 52 - 38) =
10/14
4 10 60
(65 - 60 / 10 - 0) =
5/10
(20 - 10 / 60 - 52) =
10/12
5 0 65 -
(10 - 0 / 65 - 60) =
10/5
Table 2.2 Calculation of the opportunity cost
Scarcity and Choice for the Entire Society
Economic growth is the expansion in production. Two factors that cause economic
growth are as follows:
• Technological progress is the development of new goods and services and better
ways to produce goods and services
• Capital accumulation refers to the growth in a society’s capital resources
The greater the rate of capital accumulation and/or technological process, the more
rapidly the PPF expands, i.e. the more rapid is economic growth. The economic growth is
costly. The opportunity cost is incurred because resources are devoted to manufacture
capital goods and to develop new technologies rather than to produce goods for current
consumption. Nations that incur the cost of devoting more of their resources to capital
accumulation or technological change grow more rapidly than nations that choose not to
pay the cost and thus, devote fewer resources to such purposes.
The success of an individual, a firm or the entire nation depends on the effective
utilization of the resources.
The Concept of Efficiency
Efficiency is a relative term. It is never absolute. It is always relative to some criterion.
This can be seen when one asks if farms are more efficient in the United States or China.
The farming techniques in China are more efficient than those in the United States when
measured in terms of output per unit of land, output per unit of fossil fuel, or output per
unit of machinery. The farms in the United States are far more efficient in terms of output
per man-hour. The statement that farms in one country are more efficient than farms in
another makes no sense unless the criterion on which efficiency is measured is given. In
other words, “efficiency is the relationship between what an organization or an economy
produces and what it could feasibly produce.”
The criterion for economic efficiency is value. A change that increases value is an
efficient change and any change that decreases value is an inefficient change. A situation
that is economically efficient may be inefficient when judged on different criterion.
Value is subjective. A thing has value only if someone wants it. How can we know if
value is maximized? If there is some change that makes someone feel better off, but
making this change does not make anyone feel worse off, the original situation was not
one of highest value. Improvement was possible. When the highest value is reached, any
possible change that helps anyone harms someone else. This way of defining economic
efficiency called “pareto optimality” or “pareto efficiency” is named after Vilfredo
Pareto, an early mathematical economist.
Economists are interested in economic efficiency for two reasons, one positive and the
other normative. The positive reason is based on the observation that people search for
value. This search for value is vividly illustrated in the occupations of pimp, drug pusher,
and hit man. Any occupation, no matter how immoral or risky, if gives enough money, it
will attract people. On the theoretical level, this search for value is used in discussing
utility maximization and profit maximization. The search for value is the driving force of
market (and perhaps most non-market) economies. If there are situations in which there is
unexploited value, i.e. the value that is possible but which no one obtains, an economist
needs to explain why someone does not find a way to capture this value.
The normative reason stems from a desire to make policy recommendations. It is possible
to discuss some aspects of policy without normative assumptions. An economist can
predict, for example, whether a policy will or will not achieve the set goals. But
economists often want to do more. They often want to compare two policies or two
situations and decide which is better. To decide which is better requires some sort of
basis for ranking situations. Thus, if they want to ask whether government regulation of
utility prices, a tariff on steel, or a program to train unskilled workers helps society, the
economists need a criterion to base their answer. Economists generally use the criterion
of economic efficiency to evaluate situations, though they often supplement it with other
considerations because economic efficiency is not the only way to judge the relative
merits of two situations.
The value maximized in the notion of economic efficiency reflects the goals which
people have. The concept of economic efficiency treats all goals as equally valid. No
goals are considered better than other goals with one exception and that is “envy.”
Judging goals has been a central feature of the Judeo-Christian tradition. Generally, this
tradition has condemned as immoral goal seeking that emphasizes the narrowest
individualism such as hedonism. To be moral, people should take into consideration the
well being of some others as a goal, including family members and others who are
members of a community group.
Production efficiency means that more of one good cannot be produced without
decreasing the production of another good. Production efficiency occurs only when
production takes place on the frontier line. Because another good should be given up,
there is a tradeoff. If you are at a point 1 on table 2.2, production is inefficient because
there are unused or misallocated resources.
Resources are unused when they lie idle but could be working. For example, you can
leave some of the land used for the cultivation of soybeans idle or some workers might be
unemployed. Resources are misallocated when they are assigned to tasks for which they
are not suitable. For example, you can assign land best suited to soybean cultivation to
wheat cultivation, or assign skilled soybean workers to work in wheat cultivation. But
you can get more soybeans and more wheat from the same inputs (i.e. land and/or labor),
if you reassign them to tasks that closely match their skills.
If you produce at a point 2, 3 or 4, you can use your resources more efficiently to produce
more soybeans and more wheat or more of both soybeans and wheat.
Any individual, organization or an economy should know the answer to the five big
questions which are as follows:
The Five Big Questions
Every society needs to figure out what is referred in economics as the “how,” “what,”
“when,” “where” and “for whom” to produce.
1. How to produce or how to utilize its resources efficiently-- It is the choice among
different resource combinations and techniques used in the production of a good or
service. A good or service can be produced with different resource combinations and
techniques. The problem is which of these to use. Since resources are limited, when a
greater quantity is used to produce a particular good or service, less quantity is available
for the production of another good or service. The problem facing society is choosing the
right resource combination and production techniques so that the cost in terms of the
resources used for each unit of the good or service it decides to produce will be minimal.
“How to produce?” Because the price of a resource reflects its relative scarcity. The best
way to produce goods or service is to ensure the least money cost of production. If the
price of a resource rises relative to the price of others used in the production of the
particular good or service, producers will switch to another production technique-- the
one that uses less of the more expensive resource. The opposite holds true when the price
of resource falls relative to the price of others.
2. What to produce or what combination of goods and services to produce-- Since
resources are scarce, no economy can produce much goods or service as desired by
everyone. More of a good or service means less of others. So, society should choose
which goods and services to produce and in what quantities. “What to produce” is the
price mechanism which ensures that only those goods and services for which consumers
are willing to pay a sufficiently high price to cover at least the full cost of production will
be supplied by producers. A higher price induces producers to increase the quantity
supplied of a good. Alternatively, a fall in price will induce producers to decrease the
quantity supplied of a good.
3. For whom to produce-- The economy will produce those goods and services that
satisfy the wants of those consumers who can afford them. The higher the income of
consumers, the more the economy will be geared to produce those goods and services
they want and are willing to pay for them. “How much of each good to distribute to each
person” is the problem of how to divide up what has been produced among the
consumers, i.e. how many of the consumers’ wants can be satisfied. Scarcity ensures that
society cannot satisfy the wants of all its members.
4. When to produce-- The economy will produce the goods and services when they are
needed most. This is done in order to earn the maximum profit.
5. Where to produce-- This relates to the decision regarding the place of production to
yield maximum profit. For example, if you produce nearer to the raw material, the cost of
inputs will be less. If you produce nearer to the market, the cost of transportation of
output will be less.
All individuals, organizations and nations can produce all the goods and services required
by them but the point is who can produce it with minimum inputs and maximum outputs.
This is where the specialization starts.
Specialization and Comparative Advantage
People, businesses and nations can produce for themselves all the goods and services they
consume, or they can concentrate on producing one good or service (or, possibly, a few
goods or services) and then trade with others, i.e. exchange some of their own goods or
services for those of others. Specialization is the concentration on the production of only
one good or service, or a few goods or services.
The principle of comparative advantage states that each nation (or individual) should
specialize in the production of the goods or services in which they are more efficient (or
less inefficient). An individual or a nation has a comparative advantage in producing
something if he can produce it at a lower opportunity cost than anyone else. This stems
from the fact that people’s abilities differ and, as a result, different people have different
opportunity costs of producing a particular good or service.
It should be noted that it is not possible for anyone to have a comparative advantage in
everything. Thus, gains from specialization and trade are always available when
opportunity costs are different. Specialization requires a system of exchange to enjoy the
fruits of comparative advantage. A voluntary exchange should yield mutual gains, i.e. to
make both parties better off. This concept of exchange is the mother of markets.
Markets, Prices and the Coordination Tasks
Markets bring together buyers and sellers of goods and services. A market is any
arrangement that enables buyers and sellers to get information and to do business with
each other. Prices of goods and of resources, such as labor, machinery and land, adjust to
ensure that scarce resources are used to produce those goods and services that society
demands.
A large part of economics is devoted to the study of how markets and prices enable
society to solve the problems of how, what, when, where and for whom to produce, and
this is the coordinate task to find the optimum mix of the following:
1. What?
2. When?
3. Where?
4. How?
5. For whom?
The widespread use of definitions emphasizing on choice and scarcity shows that the
economists believe that these definitions focus on a central and basic part of the subject.
The emphasis on choice represents a relatively recent insight into what economics is all
about. The notion of choice is not stressed in older definitions of economics. Sometimes,
this insight yields rather clever definitions. According to James Buchanan, “An
economist is one who disagrees with the statement that whatever is worth doing is worth
doing well.” Buchanan noticed that time is scarce because it is limited and there are many
things one can do with one’s time. If one wants to do all things well, one should devote
considerable time to each and thus, should sacrifice other things. Sometimes, it is wise to
choose to do something quickly so that one has more time for other things.
Introduction to Production Possibility Frontiers
Scarcity necessitates choice. More of one thing means less of something else. The
opportunity cost of using scarce resources for one thing instead of something else is often
represented in a graphical form as a “production possibility frontier.” The opportunity
cost of producing (or consuming) one good is how much of the alternative good needs to
be sacrificed. Similarly, the per-unit opportunity cost tells us how much of a good is
sacrificed in order to gain one additional unit of an alternative good.
In other words, if a firm can produce two or more outputs or can produce output in two or
more periods, a production possibility frontier can describe the possible combinations of
output that can be attained for a given set of inputs.
If a firm can produce two or more outputs or can produce output in two or more periods,
a production possibility frontier can describe the possible combinations of output that can
be attained for a given set of inputs.
The Production Possibility Frontier (PPF) is a graphical representation which depicts all
the maximum output possibilities of two or more goods given a set of inputs (resources,
labor, etc). The PPF assumes that all inputs are used efficiently. It is normally drawn as
concave to the origin because the extra output resulting from allocating more resources to
one particular good may fall. This is known as the law of diminishing returns. It can
occur because factor resources are not perfectly mobile between different uses. For
example, re-allocating capital and labor resources from one industry to another may
require re-training, added to a cost in terms of time and also the financial cost of moving
resources to their new use. This cost is called opportunity cost. The formula for
calculating Per Unit Opportunity Cost (PUOC) is as follows:
Scarcity is the basis of many economic concepts because it constrains or limits the
behavior. Let us explore the notion of constrained behavior by starting with the simplest
sort of economic structure. Suppose you are alone on an island.
Now, each day you have enough time to produce 15 thousand bottles of wine or 15
thousand bushes of grain. Notice that you cannot have both, i.e. wine and grain. If you
use your time to produce wine, you do not have that time to produce grain. If you want
both wine and grain, you can devote some time to both. If, for example, you spend half of
the day producing wine and the other half for producing grain, you can have 7500 bottles
of wine and 7500 bushes of grain.
Wine
(thousands of bottles)
Grain
(thousands of bushels)
0 15
5 14
9 12
12 9
14 5
15 0
Table 2.3 Production possibility table
A list of all the possible combinations of wine and grain open to you makes up your
production possibilities. The production possibility frontier separates outcomes that are
possible for an individual (or a group) to produce from those which cannot be produced.
Because you cannot exchange, your production-possibilities frontier is also your
consumption-possibilities frontier. The consumption-possibilities frontier (sometimes
called the budget constraint) is the line indicating which outcomes are affordable and
which are not. Figure 2.1 illustrates the production-possibilities frontier and
consumption-possibilities frontier. The information in the table 2.3 is exactly the same as
the information in the figure 2.1. These are two different ways of presenting that
information.
Figure 2.1 Production possibility frontier
The slope of the frontier in the figure 2.1 measures the costs you are facing. In order to
get extra wine, you will have to sacrifice some grain and vice-versa. Notice that there is
no money involved. Cost does not depend on money but rather exists whenever there is
scarcity and choice. In economics, the cost of anything refers to whatever is given up in
order to get that thing. The cost of going to college, for example, includes not only the
money a person spends on tuition (which could be spent on something else) but also
includes the time spent in studying and going to classes. The value of this time can be
estimated by computing the amount of income a person could earn if he did not go to
college.
An example of a conventional PPF in the figure 2.1 shows the potential output of wine
and grains from a given stock of labor and capital. Combinations of the two goods that lie
within the PPF are feasible but point ‘a’ show an output that under-utilizes existing
resources or where resources are being used inefficiently. Combinations of the two goods
that lie on the PPF are feasible and can be produced by using all the available factor
inputs efficiently. In the figure 2.1, the combination of output shown by point ‘b’ is
unattainable as per the given current resources and the productivity of the available factor
inputs.
The PPF shows all efficient combinations of output for this island economy when the
factors of production are used at their full potential. The economy could choose to
operate at less than the capacity somewhere inside the curve, e.g. at point a. But such a
combination of goods would be less than what the economy is capable of producing. A
combination outside the curve, such as point “b,” is not possible since the output level
would exceed the capacity of the economy. The shape of this production possibility
frontier illustrates the principle of increasing cost. As more of one product is produced,
increasingly larger amounts of the other products should be given up. In this example,
some factors of production are suited to produce both wine and grain but as the
production of one of these commodities increases, resources better suited to the
production of the other should be diverted. Experienced wine producers are not
necessarily efficient grain producers and grain producers are not necessarily efficient
wine producers, so the opportunity cost increases as one moves toward either extreme on
the curve of production possibilities.
If you look at the table 2.3, you will see the importance of scarcity. You can think of the
production-possibilities frontier as the way economists visualize scarcity. Which of the
options will you choose? The favorite assumption of economists is that the individuals
base their actions on the costs and benefits that they see. Benefits depend on the goals
you have and the production-possibilities frontier has no information about them.
Shift in the PPF
The production possibility frontier will shift when:
a. There are improvements in productivity and efficiency (perhaps because of the
introduction of new technology or advances in the techniques of production).
b. More factor resources are exploited (perhaps due to an increase in the available
workforce or a rise in the amount of capital equipment available for businesses to
use).
In the example illustrated in figure 2.2, one can see the effects of a change in the state of
technology that allowed the wine producers to double their output for a given level of
resources. Further, suppose that this technique could not be applied to grain production,
i.e. resources allocated to grains are same as above. The real cost of wine will fall as there
has been a change in the opportunity cost. The impact on the production possibilities is
shown in the following diagram:
Figure 2.2 Shifted production possibility frontier
In the above diagram, the new technique results in wine production that is double of its
previous level for any level of grain production. Finally, if the two products are very
similar to one another, the production possibility frontier may be shaped more like a
straight line. Consider the situation in which only wine is produced. Let us assume that
two brands of wine are produced, brand A and brand B. These two brands use the same
grapes and production process and differ only in the name on the label. The same factors
of production can produce either product (brand) equally efficiently. Then, the production
possibility frontier would appear as follows:
Figure 2.3 Production possibility frontier for very similar product
It should be noted that to increase production of brand A from 0 to 3000 bottles, the
production of brand B has to be decreased by 3000 bottles. This opportunity cost remains
the same even at the other extreme where increasing the production of brand A from
12,000 to 15,000 bottles still requires brand B to be decreased by 3000 bottles. Because
the two products are almost identical in this case and can be produced equally efficiently
by using the same resources, the opportunity cost of producing one over the other
remains constant between the two extremes of production possibilities.
The PPF and Economic Efficiency
An efficient production point represents the maximum combination of outputs given
resources and technology. The PPF is a useful way of illustrating this idea. The economy
efficiency can be classified as follows:
i) Allocative Efficiency
An economy achieves allocative efficiency if it manages to produce a combination of
goods and services that people actually want. It is a condition achieved when resources
are allocated in a way that allows the maximum possible net benefit from their use. When
an efficient allocation of the resources has been attained, it is impossible to increase the
well being of anyone person without harming another person. For allocative efficiency to
be achieved, one needs to be on the PPF. This is because it is possible to raise output of
both goods and improve total economic welfare at points which lie within the frontier.
The definition of pareto efficiency is an allocation of output where it is impossible to
make one group of consumers better off without making another group at least as worse
off.
ii) Productive Efficiency
Productive efficiency is defined as the absence of waste in the production process. It is a
condition where any given level of output is produced at minimum cost. When the
production of two goods lies on the frontier or anywhere on the frontier, it is deemed to
be efficient production and production inside frontier is inefficient. Productive efficiency
requires minimizing the opportunity cost for a given value of output. When there is an
outward shift of the PPF perhaps due to improvements in productivity or advances in the
state of technology, the opportunity cost of production falls and society becomes more
able to produce more from given resources.
iii) Distributive Efficiency
Distributive efficiency requires people who value relatively the most (a ratio) of the
goods which the society produces to consume them relatively more. For example, if you
prefer apples to peanuts while someone else likes peanuts better than apples, your apple-
to-peanut consumption ratio should be greater than him/her. Distributive efficiency in
financial markets requires asset portfolios to reflect savers’ relative time horizons and
willingness to bear risk, and debt structures to reflect the sources and terms of funding
relatively best suited to the needs of economic investors, government agencies, or deficit
households. When an economy achieves economic growth leading to an outward shift in
the PPF, economists have concerns over the distribution of gains in output and whether or
not an improvement in average living standards has benefited the majority of consumers
or whether there has been an increase in inequality and relative poverty.
Comparative Advantage
Comparative advantage addresses a situation where two individuals or (in this case)
countries are able to benefit from specialization and trade. Given below is an example
involving two countries, country A and country X, where each country (first) attempts to
meet domestic demand by producing only what is needed and then another country
(second) follows the “Law of Comparative Advantage.”
Country A produces compact cars and luxury cars and is able to achieve the following
production possibilities:
A B C D E F G H I J
Compact cars 0 2 4 6 8 10 12 14 16 18
Luxury cars 9 8 7 6 5 4 3 2 1 0
Table 2.4 Ten different production/consumption choices (written as column/choice A
through column/choice J)
To meet domestic demand, country A needs to produce at point E (i.e. column E).
Moving from point E to point D, country A would have to give up producing two
compact cars in order to produce one more luxury car. Because this country is fully
employed, the only way to get more luxury cars is by taking workers out of compact car
production and putting them into luxury car production. Doing this between points D and
E causes two less compacts to be built. Therefore, the opportunity cost of that additional
luxury car is two compact cars.
Moving from point E to point F, country A needs to give up producing one luxury car in
order to produce two more compact cars. Therefore, the opportunity cost of each (1)
additional compact car is ½ of a luxury car.
If one considers any other pair of points, one will find that the opportunity is always the
same (for each good), no matter where one starts. This implies constant opportunity costs
and tells that the PPC here is a straight line.
Country X produces compacts and luxury cars as well. Their PPC relationship is as
follows:
Q R S T U V W X Y Z
Compact cars 0 1 2 3 4 5 6 7 8 9
Luxury cars 18 16 14 12 10 8 6 4 2 0
Table 2.5
To meet domestic demand in country X, it is necessary to produce at point W. If one had
to illustrate country A and X’s production possibilities on a graph, one would get the
following:
Calculating the opportunity cost here, we get:
Opportunity cost of each (1) additional compact car = 2 luxury cars
Opportunity cost of each (1) additional luxury car = 1/2 of a compact car
Compare the opportunity costs between countries.
For luxury cars:
(A) Opportunity cost of each 1 luxury car = 2 compact cars
(X) Opportunity cost of each 1 luxury car = 1/2 of a compact car
For compact cars:
(A) Opportunity cost of each 1 compact car = 1/2 of a luxury car
(X) Opportunity cost of each 1 compact car = 2 luxury cars
Country X gives up fewer compact cars when producing an additional luxury car while
country A gives up fewer luxury cars when producing an additional compact car.
Therefore, the opportunity cost of producing compact cars is lowest in country X and the
opportunity cost of producing luxury cars is lowest in country A.
When country A has a lower opportunity cost associated with producing something, A is
said to have a comparative advantage in producing that item. Therefore, A has a
comparative advantage in producing compacts while X has a comparative advantage in
producing luxury cars.
The Law of Comparative Advantage says, “By specializing in the production of a good
where a first country has a comparative advantage, the first country can trade with
another country (who specializes in something that the first country doesn't have a
comparative advantage in) and become better off.”
Suppose countries A and X specialize in where they have comparative advantage.
Country A switches from point E to point J while X switches from point W to point Q.
Country A
Domestic
Demand
Specialize
Country X
Domestic
Demand
Specialize
Compacts 8 18 Compacts 6 0
Luxury cars 5 0 Luxury cars 6 18
Table 2.6
Country A now has 10 more compact cars than needed domestically whereas X has 12
more luxury cars than needed domestically. Assume that these countries are willing to
trade on a one-for-one basis. Under that, A sends nine compact cars to X in exchange for
nine luxury cars as follows:
Country A
Before
Trade
After
Trade
Country X
Before
Trade
After
Trade
Compacts 8 9 Compacts 6 9
Luxury cars 5 9 Luxury cars 6 9
Table 2.7
Both of the countries got benefit from specialization and trade as they had more of each
goods after trade. By specializing and trading, these countries could “consume” compact
cars and luxury cars in amounts that would not be possible if these countries tried to meet
domestic demand alone. These countries are able to consume outside their PPC even
though they cannot produce outside of it. This is illustrated in the figure 2.4.
Figure 2.4
Country A’s PPC and Country X’s PPC are combined on the same graph. Consumption
occurs at point M, a point that lies along the (green) dotted consumption-possibilities
line. Point M exists outside of each country’s ability to produce. But according to the
Law of Comparative Advantage, point M does not exist outside of each country’s ability
to consume.
Definitions
1. Opportunity Cost
The opportunity cost of any good or activity is the value of the next best alternative
foregone and is also known as alternative costs or economic cost. Opportunity costs
include both implicit costs and explicit costs. The idea behind this is that anything
which one has to give up in order to carry out a particular decision is a cost of that
decision. This concept is applied again and again throughout modern economics.
2. Scarcity
According to modern economics, scarcity exists whenever there is an opportunity
cost, i.e. wherever a meaningful choice has to be made. Scarcity occurs because
resources are limited and cannot accommodate all of our unlimited wants.
3. Production Possibility Frontier
The production possibility frontier is the diagrammatic representation of scarcity in
production. A production possibility frontier (PPF) is a curve showing the various
combinations of goods that an economy could produce, assuming a fixed technology
and full employment and efficient resource utilization. The production possibilities
frontier is sometimes referred to as the production possibilities curve.
4. Comparative Advantage
It is a very important principle in itself. The law of comparative advantage is an
assertion that mutually beneficial trade can always take place between two countries
(or individuals) whose pre-trade cost and price structures differ. This law was first
elaborated by David Ricardo [1772-1823].
5. Discounting of Investment Returns
It is an another application of the opportunity cost principle that is very important in
itself. It tells how to handle opportunities that come at different times.
Lesson-3
Supplementary Reading-I
1. The Misconception of Scarcity
by Dr. Sam Vaknin
Also published by United Press International (UPI)
2. Malignant Self Love
by Dr. Sam Vaknin
3. Relationships with Abusive Narcissists
by Dr. Sam Vaknin
Are we confronted merely with a bear market in stocks or is it the first phase of a global
contraction of the magnitude of the Great Depression? The answer overwhelmingly
depends on how one understands scarcity.
It will be only a mild overstatement to say that the science of economics, such as it is,
revolves around the Malthusian concept of scarcity. Our infinite wants, the finiteness of
our resources and the bad job we too often make of allocating them efficiently and
optimally lead to mismatches between supply and demand. We are always forced to
choose between opportunities, between alternative uses of resources and painfully
mindful of their costs.
This is how the perennial textbook Economics (seventeenth edition) by Nobel
prizewinner Paul Samuelson and William Nordhaus defines the dismal science:
“Economics is the study of how societies use scarce resources to produce valuable
commodities and distribute them among different people.”
The classical concept of scarcity, i.e. unlimited wants vs. limited resources is lacking.
Anticipating much-feared scarcity encourages hoarding which engenders the very evil to
fend off. Ideas and knowledge are the inputs as important as land and water. These are
not subject to scarcity as work done by Nobel laureate Robert Solow and more
importantly by Paul Romer, an economist from the University of California at Berkeley,
clearly demonstrates. Additionally, it is useful to distinguish natural from synthetic
resources.
The scarcity of most of the natural resources (a type of “external scarcity”) is only
theoretical at present. Many resources are unevenly distributed and badly managed. But
this is man-made (“internal”) scarcity and can be undone by man. It is true to assume, for
practical purposes, that most of the natural resources, when not egregiously abused and
when freely priced, are infinite rather than scarce. The anthropologist Marshall Sahlins
discovered that primitive people had no concept of “scarcity.” They had only a concept of
“satiety.” He called them the first “affluent societies.”
This is because the number of people on Earth is finite and manageable while most
resources can either be replenished or substituted. Alarmist claims to the contrary, while
the environmentalists have been convincingly debunked by the likes of Bjorn Lomborg,
author of The Skeptical Environmentalist.
Equally, it is true that manufactured goods, agricultural products, money and services are
scarce. The number of industrialists, service providers, or farmers is limited as their life
span. The quantities of raw materials, machinery and plant are constrained. Contrary to
classic economic teaching, human wants are limited. According to it, “Only so many
people exist at any given time and not all them desire everything all the time. But, even
so, the demand for man-made goods and services far exceeds the supply.”
Scarcity is the attribute of a “closed” economic universe. But it can be alleviated either by
increasing the supply of goods and services (and human beings) or by improving the
efficiency of the allocation of the economic resources. Technology and innovation are
supposed to achieve the former and rational governance, free trade and free markets the
latter.
The telegraph, telephone, electricity, train, car, agricultural revolution, information
technology and biotechnology have all increased our resources, seemingly ex nihilo. This
multiplication of wherewithal falsified all apocalyptic Malthusian scenarios hitherto.
Operations research, mathematical modeling, transparent decision-making, free trade and
professional management help in allocating these increased resources to yield optimal
results.
Markets are supposed to regulate scarcity by storing information about our wants and
needs. Markets harmonize supply and demand. They do so through the price mechanism.
Money is, thus, a unit of information and a conveyor or conduit of the price signal as well
as a store of value and a means of exchange.
Markets and scarcity are intimately related. The former would be rendered irrelevant and
unnecessary in the absence of the latter. Assets increase in value in line with their
scarcity, i.e. in line with either increasing demand or decreasing supply. When scarcity
decreases, i.e. when demand drops or supply surges, asset prices collapse. When a
resource is thought to be infinitely abundant (e.g., air), its price falls to zero.
Armed with these simple and intuitive observations, one can now survey the dismal
economic landscape. The abolition of scarcity was a pillar of the paradigm shift to the
“new economy.” The marginal costs of producing and distributing intangible goods, such
as intellectual property are negligible. Returns increase rather than decrease with each
additional copy. An original software retains its quality even if copied numerous times.
The very distinction between “original” and “copy” becomes obsolete and meaningless.
Knowledge products are “non-rival goods,” i.e. can be used by everyone simultaneously.
Such ease of replication gives rise to network effects and awards first movers with a
monopolistic or oligopolistic position. Oligopolies are better placed to invest excess
profits in expensive research and development in order to achieve product differentiation.
Indeed, such firms justify charging money for their “new economy” products with the
huge sunken costs they incur. It includes the initial expenditures and investments in
research and development, machine tools, plant and branding.
To sum, though financial and human resources as well as content may have remained
scarce yet the quantity of intellectual property goods is potentially infinite because they
are essentially cost-free to reproduce. Plummeting production costs also translate to
enhanced productivity and wealth formation. It looked like a virtuous cycle.
But the abolition of scarcity implied the abolition of value. Value and scarcity are two
sides of the same coin. Prices reflect scarcity. Abundant products are cheap. Infinitely
abundant products are complimentary. Abundant money, an intangible commodity, leads
to depreciation against other currencies and inflation at home. This is why, the central
banks intentionally foster money scarcity.
But if intellectual property goods are so abundant and cost-free, why were distributors of
intellectual property so valued, not least by investors in the stock exchange? Was it
gullibility or ignorance of basic economic rules?
Not so. Even “new economists” admitted temporary shortages and “bottlenecks” on the
way to their utopian paradise of cost-free abundance. Demand always initially exceeds
supply. Internet backbone capacity, software programmers, servers are all scarce to start
with in the old economy sense.
This scarcity accounts for the stratospheric erstwhile valuations of dotcoms and telecoms.
Stock prices were driven by projected ever-growing demand and not by projected ever-
growing supply of asymptotically free goods and services. “The Economist” describes
how WorldCom executives flaunted the cornucopian doubling of Internet traffic every
100 days. Telecoms predicted a tsunami of clients clamoring for G3 wireless Internet
services. Electronic publishers gleefully foresaw the replacement of the print book with
the much heralded e-book.
The irony is that the new economy was self-destructive because most of its assumptions
were spot on. The bottlenecks were, indeed, temporary. Technology, indeed, delivered
near-cost-free products in endless quantities. Scarcity was vanquished. But at the same
cost, the amount of information one can transfer through a single fiber optic swelled 100
times. Computer storage catapulted 80,000 times. Broadband and cable modems let
computers communicate at 300 times their speed only 5 years ago. Scarcity turned to
glut. Demand failed to catch up with supply. In the absence of clear price signals, the
outcomes of scarcity and the match between the two went awry.
One innovation the “new economy” has wrought is “inverse scarcity.” It means unlimited
resources (or products) vs. limited wants. Asset exchanges in the world are now adjusting
to its harrowing realization that cost free goods are worth little in terms of revenues and
that people are badly disposed to react to zero marginal costs.
The new economy caused a massive disorientation and dislocation of the market and the
price mechanism. Hence, the asset bubble reverting to an economy of scarcity is our only
hope. If we do not do so deliberately, the markets will do it for us mercilessly.
Lesson-4
Tutorial
Multiple-choice Questions
1. From the viewpoint of economics, your college education can be thought of as an
investment in a factor of production. Which of the following factor is most appropriate?
a) Natural resources
b) Labor
c) Physical capital
d) Human capital
e) Entrepreneurship
2. A Production Possibilities Curve (PPC) illustrates the concept of scarcity. Which of the
following item will be most likely to result in a shift of the PPC outward, indicating the
ability to produce more goods?
a) An increase in population
b) A decrease in the price of steel
c) Reducing the federal debt
d) Signing a trade agreement with China
e) Making more consumption goods
3. Which of the following questions is outside the scope of economics?
a) What is the likely impact of the transfer of Hong Kong back to the
Chinese?
b) When a paper mill closes in a small southern town, who is most likely to
be out of work for a long time?
c) When you graduate from college, how might you best go about choosing a
job?
d) How should society balance the needs of the environment against the
needs of industry?
e) None of the above. All are within the scope of economic study.
4. The study of economics is generally divided into two major sub-divisions--
macroeconomics and microeconomics. Which statement is correct about the division?
a) Macroeconomics deals with unemployment, inflation, the budget deficit
and the trade deficit.
b) Macroeconomics deals only with individual markets.
c) All the topics in macroeconomics are bigger than those in
microeconomics.
d) Microeconomics is limited to the study of individual choices while
macroeconomics deals with group decisions.
e) Only macroeconomics deals with prices.
5. Which of the following is not a way we can use the study of macroeconomics?
a) To understand how a national economy works
b) To understand the grand debates over economic policy
c) To decide between two types of automobiles when we are buying a new
car
d) To make informed business decisions
e) To help decide which candidate for office is most likely to have a
successful economic policy
6. Which of the following is not a way we can use the study of microeconomics?
a) To understand how markets work
b) To understand the full impact of our trade deficit with Japan
c) To make personal or managerial decisions
d) To evaluate the merits of specific public policies
e) To help decide between two automobiles when we are buying a new car
7. The process of “thinking like an economist” involves three basic items. Which of the
following five does not belong to the process?
a) Economists use assumptions to simplify matters.
b) Economists deal only in items which have prices.
c) Economists explore the relationship between two variables, holding other
variables fixed.
d) Economists think in marginal terms.
e) Economists consider opportunity costs.
8. If a society is operating on its Production Possibilities Curve (PPC) with respect to
thousands of computers and numbers of space missions, and is producing 300,000
computers and 5 space missions in order to increase the number of space missions, it
should
a) Give up some computers
b) Produce more computers as well
c) Pay scientists more
d) Shift federal spending from military to science
e) Develop a new type of rocket
9. The problem of scarcity
a) exists only in market economies
b) could be eliminated if we could force prices to fall
c) means that there are shortages of some goods
d) exists because human wants exceed available resources
e) can be eliminated by government intervention
10. If Josiah is producing inside his Production Possibilities Curve (PPC), he
a) can increase production of goods with no increase in resources
b) is fully using his resources
c) is optimizing
d) is unaffected by costs and technology
e) can do no better than he is currently doing
11. The following table gives production possibilities for an economy that can produce
two goods, lobsters and boats. Graph the Production Possibilities Curve (PPC), according
to the information given in table 1.1 and putting lobsters on the horizontal axis. Use your
graph to answer the first four questions. As this economy produces more and more
lobsters, the slope of the PPC:
Lobsters Boats
A 0 10
B 100 9
C 200 7
D 300 4
E 400 0
Table 1.1
a) Increases
b) Is constant
c) Decreases
d) Cannot be determined
A) If the economy is producing at point C:
a) We can produce more lobsters and more boats.
b) We cannot produce any more lobsters.
c) We cannot produce any more boats.
d) We can produce more lobsters only by giving up some boats.
e) The economy is not efficient.
B) At point B, to get one more boat, this economy needs to:
a) Give up one lobster
b) Give up nine lobsters
c) Give up 100 lobsters
d) Increase the economy’s resources
e) Discover a new technology
C) If this economy is producing 50 lobsters and 8 boats, then:
a) the economy could produce more lobsters without giving up any boats
b) the economy could produce more boats without giving up any lobsters
c) the economy could produce more boats and more lobsters
d) the economy is not operating efficiently
e) all of the above
12. Economics is the study of which of the following:
a) Stock markets
b) Money
c) Self-interest
d) Scarcity
e) All of the above
13. Which of the following is not an example of a marginal decision?
a) Is it worth $2 to buy this extra slice of pizza?
b) If I study for one more hour, how much will it raise my grade?
c) If I hire ten workers to produce tables, what will be the average cost per
table?
d) If I drive slightly faster, what will be the change in my gasoline
consumption?
e) All of the above are marginal questions.
14. If Y = 200 + 2X, what is the slope of this line?
a) 100
b) 200
c) 2
d) 1/2
e) None of the above
15. If Y = 600 - 3X, what is the slope of this line?
a) -1/3
b) 1/3
c) 3
d) -3
e) 600
16. If Y = 600 - 3X, what is the vertical intercept?
a) 3
b) 200
c) 300
d) 600
e) None of the above
17. If Y = 600 - 3X, what is the horizontal intercept?
a) 100
b) 200
c) 300
d) 600
e) None of the above
2. Long Answer Questions
a) Looking at the world in which you find yourself in college, imagine a
typical class day. What examples of the factors of production are used to
produce the class? What are examples of natural resources, labor, physical
capital, human capital and entrepreneurship?
b) Write a short essay explaining how the market for textbooks works in your
campus. Explain what exactly takes place between you and the bookstore,
both at the beginning and at the end of the term.
c) Economists are often criticized for making assumptions. Why are
assumptions necessary? To think about this, you might consider an
assumption that is often made-- people are rational. Do you think that people
are rational and how could you construct a model of irrational behavior?
Would that be a better assumption to make?
Chapter-5
Supply and Demand-- Introduction
There is a famous saying that "learned economist" is the one who always answers "supply
and demand" in response to every question.
It is true that the "theory of supply and demand" is a central part of economics. It is
widely applicable, and is a model of the way economists try to think most problems
through, even when the theory of supply and demand is not applicable.
When people's actions are based on self-interest, they respond to incentives, i.e. to costs
and benefits. When the costs of an activity are raised or the benefits reduced, people do
less of the activity. Economists have found that they can use this simple idea of action,
based on costs and benefits, to construct a model (or theory) which explains how many
markets work. This model-- the model of supply and demand-- is perhaps the most basic
of the models economists use to explain the world around us.
Given the model's importance in the way modern economists think, it is surprising that
one does not find the model in the writings of Adam Smith, David Ricardo, Thomas
Malthus, or John Stuart Mill, though all of these pioneers in economics used the words
"supply" and "demand" frequently. The modern supply and demand model did not appear
until 1890 when Alfred Marshall published his Principles of Economics.
This group of readings explores economic terms and concepts that follow directly from
supply and demand curves, and which are important building blocks for other groups of
readings. It begins with the concept of elasticity which measures how people respond to
changes. An elasticity computation can be used whenever a measurable change in
something causes a measurable change in behavior. We will discuss the most commonly
used elasticity measures like price elasticity of supply and demand, income elasticity, and
cross-price elasticity. We will then see how value can be represented on a demand-curve
graph. We will also discuss the concept of marginal-- examining how marginal, total and
average revenue are related. Finally, we will discuss that elasticity and marginal revenue
are related by means of a simple equation.
Why does someone like Michael Jordan make more money per season than the rest of his
team combined? Why are diamonds expensive? Why do heart surgeons make more
money than sanitation workers? You probably guessed it right-- due to supply and
demand. We will look at supply and demand and how they interact in the marketplace to
determine the prices we pay for the goods and services we purchase.
Broadly, the learning objectives of this section are as follows:
1. To define demand, supply, inferior good, normal good, substitute, complement, law
of demand, price taker, price searcher, and market-clearing price.
2. To distinguish between changes in demand and changes in quantity demanded.
3. To distinguish between changes in supply and changes in quantity supplied.
4. To predict how changes in factors such as income, prices of substitutes, prices of
inputs etc. affect the supply and demand curves and equilibrium quantity and price.
5. To explain why we can treat the demand curve as positions of buyer equilibrium and
the supply curve as positions of seller equilibrium.
6. To compute price elasticities of supply and demand when the curves are given in the
form of a table.
7. To explain what is meant by when one says demand is elastic or inelastic.
8. To define income and cross-price elasticity, and explain what they measure.
9. To compute marginal revenue when total revenue is given, and vice versa.
10. To compute average revenue when total revenue is given, and vice versa.
11. To explain why marginal revenue is the slope of the total revenue curve.
12. To recognize the area that represents total revenue on a demand or supply graph.
The following slides will be the basis of our discussions in the following lessons:
Slide 1
Pricing is an extent
decision
z Profit = Revenue - Cost
z Definition: Demand Curves
are functions that relate the
price of a product to the
quantity demanded by
consumers.
z Demand Curves help us
make decisions to increase
profits by modeling revenue
» Particularly MR
» Should I sell another unit?
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Slide 2
Aggregate Demand
z Aggregate Demand: Each consumer
wants one unit.
z To construct demand, sort by value.
z Discussion: Why do aggregate
demand curves slope downward?
» Role of heterogeneity?
» How to estimate?
Pric
e Quantity
Revenu
e
Marginal
Revenue
12 1 12 12
11 2 22 10
10 3 30 8
9436 6
8540 4
7642 2
6742 0
5840-2
499-7
Aggregate Demand
0
2
4
6
8
10
12
14
0510
Quantity
Price
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Slide 3
Pricing Tradeoff
z Lower priceÎsell more, but
earn less on each unit sold
z Higher priceÎsell less, but
earn more on each unit sold
z Tradeoff created by
downward sloping demand
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Slide 4
Marginal Analysis
z Marginal analysis finds the right
solution to the pricing tradeoff.
» Also requires less information.
z Definition : The marginal
revenue (MR) is the change in
total revenue with an extra unit.
z Proposition : If MR > 0 , then total
revenue will increase if you sell
one more unit.
z Proposition : If MR > MC , then
total profits will increase if you
sell one more unit.
z Proposition : Profits are max.
when MR = MC
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Slide 5
Elasticity of Demand
z Motivation: Price elasticity is
used to do marginal analysis.
z Definition: Price elasticity =
(%change in quantity demanded)
÷ (%change in price)
» If |e| is less than one, demand is
said to be inelastic.
» If |e| is greater than one, demand is
said to be elastic.
» If |e| = 1, demand is said to be
unitary elastic.
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Slide 6
Other Elasticities
z Definition: Income elasticity =
(%change in quantity demanded) ÷
(%change in income)
» Inferior (neg.) vs. normal (pos.)
z Definition: Cross-price elasticity of
good one with respect to the price of
good two = (%change in quantity of
good one) ÷ (%change in price of
good two)
» Substitute (pos.) vs. complement
(neg.)
z Definition: Advertising elasticity =
(%change in quantity) ÷ (%change in
advertising)
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Slide 7
Describing demand
with price elasticity
z First law of demand: e < 0
(price goes up, quantity goes
down).
» Discussion: Do all demand
curves slope downward?
z Second law of demand: in
the long run, |e| increases.
» Discussion: Give an example
of the second law of demand.
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Slide 8
Describing demand
(contd.)
z Third law of demand: As
price increases, demand
curves become more price
elastic, and |e| increases.
» Discussion: Give an example
of the third law of demand.
Sugar Price
HFCS Quantity
HFCS
Price
HFCS Demand
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Slide 9
Estimating Elasticities
z Definition: Arc (price)
elasticity = [(q1 - q2)/(q1+
q2)] ÷ [(p1 - p2)/(p1 + p2)].
» Discussion: Price changes
from $10 to $8, quantity
changes from 1 to 2.
z Discussion: On a promotion
week for Vlasic, the price of
the Vlasic pickles drops by
25% and quantity increases
by 300%.
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Slide 10
Estimating Elasticities
(contd.)
z 3-Liter Coke Promotion
» Instituted to meet Wal-Mart
Promotion
Product Initial Final % change elas.
Price/bottleQ 3-liter 210 420 66.67% -3.78
P of 3-liter $1.79 $1.50 -17.63%
Price/bottleQ 2-liter 120 48 -85.71% 4.86
P of 3-liter $1.79 $1.50 -17.63%
Price/litre Q liters 870 1356 10.92% -3.50
P liters $0.52 $0.46 -3.12%
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Slide 11
Quick and Dirty
Estimators
z Linear Demand Curve Formula, e
= p/(pmax
-p)
z Discussion: How high would the
price of the brand have to go
before you would switch to
another brand of running
shoes?
z Discussion: How high would the
price of all running shoes have to
go before you should switch to a
different type of shoe?
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Slide 12
Market Share Formula
z Proposition: The individual brand
demand elasticity is
approximately equal to the
industry elasticity divided by the
brand share.
» Discussion: Suppose that the
elasticity of demand for running
shoes is –0.4, and the market share
of a Saucony brand running shoe is
20%. What is the price elasticity of
demand for Saucony running
shoes?
z Proposition: Demand for
aggregate categories is less
elastic than demand for the
individual brands in aggregate.
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Slide 13
Using Elasticities for
Prediction
z Discussion: The income elasticity of
demand for WSJ is 0.50. Real income
grew by 3.5% in the United States.
» Estimate WSJ demand
z Discussion: The 1998 real per-capita
median income in Arizona is $30,863;
and in Colorado is $40,706
» Estimate difference between per capita
consumption in Colorado and in Arizona.
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Slide 14
Elasticity and
Revenue
z Approximate relationship
» %∆Rev. = %∆P + %∆Q
» =%∆P(1+ %∆Q/%∆P)
» =%∆P(1+ e)
» =%∆Price(1 - |e|)
z Discussion: In 1980, Marion
Barry, Mayor of the District of
Columbia, raised the sales tax on
gasoline sold in the District by
6%.
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Slide 15
Elasticity and MR
z Proposition: MR = P(1 - 1/|e|)
» If |e| > 1, MR > 0.
» If |e| < 1, MR < 0.
z Discussion: If demand for Nike
sneakers is inelastic, should
Nike raise or lower price?
z Discussion: If demand for Nike
sneakers is elastic, should Nike
raise or lower price?
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Slide 16
Elasticity and Pricing
z MR > MC is equivalent to
»P(1 - 1/|e|) > MC
»P > MC/(1 - 1/|e|)
»(P - MC)/P>1/|e|
z Discussion: Elas. = –2, p =
$10 mc = $8, should you
raise price?
z Discussion: Mark-up of 3 liter
Coke is 2.7%. Should you
raise price?
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Slide 17
Elasticity and pricing
(contd.)
z Discussion: Sales people MR
> 0 vs. marketing MR > MC.
z Discussion: The Kentucky
legislature allows only one
race track to be open at a
time.
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