UNIT 1: WHAT IS ECONOMICS? BASIC CONCEPTS.

Economy is the study of the ways in which society manages scarce resources.
Scarcity means that the society has limited resources hence cannot produce all the goods
people wish to have.
What determines the allocation of resources?
Positive question: It asks for the description of how something is.
Most goods are allocated through markets. Therefore study of markets is at the core of
economics. A market is a place where buyers and sellers freely exchange goods.
Is the allocation of resources optimal?
Normative question: implies a value judgement (how should something be?).
Economists are typically concerned with efficiency. Most commonly employed concept
of efficiency is Pareto efficiency.
A situation is Pareto efficient if its impossible to make anyone better off without
making someone worst off.
Pareto efficiency is a very weak concept of what is desirable. No regard for equity,
justice, or liberty. (I have everything, you have nothing and I dont care).
Example 1: The marriage market.
Until recently, couples met mostly by chance. Now advantages in technology have
given us dating websites.
- How do economist answer questions?
Economics is a social science that studies decision-making in a world with scarce
resources. The scientific approach in economics consist of:
- Formulation of theories.
- Empirical analysis of data to test these theories.
METHODOLOGY IN ECONOMICS. The development of economic theory.
- The departure point is a set of assumptions (a model)
- The assumptions are combined (usually using maths or logic)
This delivers predictions, which can lead to:
+ New Theories
+ Empirical analysis
- Every model needs to be a simplification of reality.
Mathematics in economics.
- Advantages: Transparency (at least for insiders), logical consistency, and unexpected
conclusions.
- Disadvantages: Lack of transparency (for outsiders), can become end in itself, and
illusion of exactness.
THE PURE EXHANGE MODEL
A simple model can show how the free exchange can improve the welfare of
participants.
- Assumptions of the model:
Two people: Nerea and Carlos // Two goods: Oranges and onions
- Initial distribution: Nerea has got oranges and Carlos got onions.

- Preferences:
Nerea likes onions and shes willing to give up to 5 oranges for each onion.
Carlos likes oranges and hes willing to give up to 4 onions for each orange.
Questions:
Can they improve their situation by trading oranges for onions?
Would they be willing to exchange one onion for one orange?
Whats the interval of relative prices at which they would be willing to trade?
THE COMPARATIVE ADVANTAGE MODEL (CAM): To enrich the previous model
we will add some more assumptions.
The objective is to be able to understand who produces what. We relax the assumption
of the initial distribution and now we assume that both oranges and onions are available
in nature. Nerea needs an hour to pick either 10 oranges or 2 onions and Carlos needs an
hour to pick either 1 orange or 4 onions.
OPORTUNITY COST. The opportunity cost of an item includes everything you have to
give up in order to get that item. E.g.: Examples: going to university or being with your
current boyfriend/girlfriend.
So we can answer the following questions
Whats the opportunity cost of Nerea (in terms of oranges) of producing 1 onion?
Whats the opportunity cost of Carlos (in terms of onions) of producing 1 orange?
How many oranges would Nerea be willing to produce and trade for 1 onion?
How many onions would Carlos be willing to produce and trade for 1 orange?
- Specialization will be good for both! Nerea will pick only oranges and Carlos onions.
What if Carlos is so productive that he produces either 100 oranges or 400 onions per
hour? Still, it is better for Carlos to trade onions for oranges!
If an agent has a lower opportunity cost of one good in terms of the other good than
the other agent, the first agent has a comparative advantage in the production of the
first good.
In our example, Nerea has a comparative advantage in the production of
oranges and Carlos in the production of onions.
The main lessons of the CAM are:
Trade can improve the welfare of all the participants
Even in the case in which one very productive person (country)
exchanges with a considerably less productive one
What matters for the PATTERNS OF TRADE are the opportunity costs.
They determine the comparative advantages (vs. absolute advantages)
Questions related to the CAM:
Do you think Einstein should do his own tax declaration?
Is it good for the USA to trade with Ethiopia?
And for Ethiopia to trade with USA?

There are two fields in the economic science:

MICROECONOMICS studies the behavior of the individual units in each

economy (households and firms) and how they interact in markets. E.g.: Each
household decides what to consume, how much to work; each firm decides what
to produce, how many workers to hire. They interact in the market of each good
and in the labor market

MACROECONOMICS studies the interactions between the different markets

in an overall economy and the processes that affect the economy as a whole
Typical questions in macroeconomics are:
- What are the consequences of a higher government spending?
- What would be the evolution of unemployment?
- Why there is inflation (or deflation)?
- How does the average?

Summary:
1) Economics tries to understand how people choose and deal with scarcity
2) Study of markets central to economics
3) Positive vs. normative analysis
4) Pareto efficiency
5) Opportunity cost is the relevant way to measure the cost of something
6) Trade can make everyone better off
7) Comparative advantages are important in determining who produces what
8) Micro and macroeconomics

UNIT 2: THE DEMAND.

The market. A market refers to an institution in which buyers and sellers freely
exchange a good. Its got two sides:
- Buyers determine the demand for the good.
- Sellers determine the supply of the good.

Perfect competition.
The perfect competition model assumes that buyers as well as seller are price takers:
A buyer (or a seller, but specially buyers) is a price taker if s/he cannot influence the
price of the good that is bought/sold.
- When can we expect buyers and sellers to be price takers?
When there are many buyers and sellers interested in the same good (an homogenous
good).
We call this type of
market a competitive
Price
Quantity
market.
Other market structures:
Monopoly: single
Oligopoly:
few
Monopolistic
sellers but with
products.

100

90

80

70

seller.
sellers.
Competition: many
slightly
different

60
4
The demand. The demand
curve.
The
quantity
demanded is the
50
5
quantity of a good
that buyers are willing
(and able) to buy in
each
possible
40
8
circumstance
determined by various
factors such as
prices, availability of

other goods etc.

The demand curve is a function (or a graph) that shows us the demand as a
function of the price. (So it shows us when it changes)
Example of a demand curve:
Price (x10)

11
10
9
8
7
6
5
4
3
2
1

N of delivers

10

11

12

13

14

Ceteris Paribus
The demand curve is constructed under the assumption of ceteris paribus, which comes
from Latin, other things
being equal.
Price
Quanti
This means that the
demand curve is constructed only
ty
by looking at the effects
of changes in price. We keep all
other factors such as
prices of other goods, tastes
100
1
constant.

The law of the demand.

The law of the demand
relation between the price
the demand curve has a
- Individual and
To understand how the
consider two levels:
Individual demand
Market demand
Which is the sum of the
buyers in a market.
The individual
person.
Price
(x10)

demand

90

80

70

60

50

40

states that there is an inverse

and the quantity demanded, i.e.
negative slope.
market demand.
demand curve works we have to

individual demands of all the

corresponds

to

particular

N of delivers

Marginal utility.
The increase in the welfare of an individual resulting from an additional unit of a good
is called the marginal utility of the good.
We will measure this welfare increase in monetary units, i.e. euros.
E.g.: What is the marginal utility for an oyster?
CLUE: What do you prefer right now, X euros or an oyster?

Decreasing
marginal Number of MgU
For most of the goods, oysters
resulting
from
the
1
10
decreases as we consume
- Your first oyster 2
7
have already eaten 10
6
going to add less to your 3
That is, the marginal 4
3
decreasing in the number
already. This property
5
3
Number
MgU
utility) holds for the
of6 oyster
1
1

10

utility.
the
welfare
increase
consumption of a good
more of that good.
is very tempting. If you
oysters, an additional one is
welfare.
utility of an oyster is
of oysters you have eaten
(decreasing
marginal
majority of goods.
We can express the marginal utility
as a decreasing function of the
quantity of oysters.
MgU (in s)
N of
Delivers

For each price, an individual would compare the price with the marginal utility
generated by that unit.
Price and MgU
(in s)

Number of oysters
The MgU curve is the demand curve of a price taker individual.
Price and MgU
(In s)

Number of
oysters

MgU

10

Number of oysters

(Review graphics,
not completed)
CONCLUSION
If the Marginal Utility is decreasing, the individual demand will be decreasing.
The law of demand will hold.
Price and MgU (in
s)
Number of MgU
oysters
1

10

Number of oysters

The market demand.

The market demand is the total demand of all buyers in a market.
This can be calculated by summing all the individual demands at each price level. This
type of addition is called horizontal summation.

The market demand and

the horizontal summation
Market demand

The demand function in practice.

What happens when we study demands in an environment with many units?

11
10
9
8
7
6
5
4
3
2
1

11
10
9
8
7
6
5
4
3
2
1

9 10 11 12 13 14 15 16 17 18 19 20
11
10
9
8
7
6
5
4
3
2
1

9 10 11 12 13 14 15 16 17 18 19 20

1 2 3 4 5 6 7 8 9 1011121314151617181920212223242526272829303132333435363738394041424344454647484950

What happens when we study demands in an environment with many units? We

approximate the demand with a curve.

Market demand.
Does the law of demand hold in the case of market demand?
In general, the market demand is a decreasing function of its own price for two reasons:
Individual demands are decreasing functions of price.
At a lower price, there are more individuals demanding the good.
Factors that affect the demand: market price, consumers income, prices of other
goods
Quantity demanded and demand function.
If theres a change in demand due to the change in the price of a good, ceteris paribus
there will be a movement along the demand curve!

Change in the quantity demanded

Change in the quantity demanded:
Price of
photo
cameras

A change in the price of

cameras

D1
0

12

20

Quantity of photo cameras

Shifts in demand.
If there is a change in a factor that affects the demand other than the price of the good.
There is a shift in demand. Graphically, it looks like a shift in the demand curve (left or
right).

Shifts in demand
Price of
cameras

I ncrease in
demand

Decrease in
demand

D3

D1

D2

Quantity of cameras

The demand and consumers income.

Given an increase in income, the demand of a normal good increases.
Given an increase in income, the demand of an inferior good decreases.
Normal good:

Inferior good:

Demand and the prices of other goods.

- When a decrease in the price of a good reduces the quantity demanded of another
good, these two goods are called substitutes.

- When a decrease in the price of a good increases the quantity demanded of another
good, these two goods are called complements.
Complements or substitutes?
Determine if the following items are complements or substitutes.
Movies and theatre plays.
Movies and popcorn.
Cigarettes and cigars.
Computers and printers
Restaurant food and wine.
Goalkeepers and strikers.
Summary:
1) Introduction:
The market: Supply and demand
Competitive markets: price-taking.
2) Individual demand:
Marginal utility
From marginal utility to individual demand
3) From individual to aggregate demand
4) Movements and shifts:
Normal versus inferior goods.
Complements versus substitutes

UNIT 3: THE SUPPLY

What to outline?

The law of supply

Goals of a firm
- Firms as profit-maximizers
Different types of costs and individual supply
From the supply of the firm to the aggregate supply.
Shifts of the supply function.
The elasticity of supply (and elasticity of demand).

The quantity supplied: its the quantity of a good that sellers are willing (and able) to
sell in every possible circumstance (price of the good, price of factors of production).
Supply curve: function (or graph) that gives the supply for each price.

Example of a supply curve

Price (x10)

Price

Quantity

10

20

30

40

50

60

70

10

Number of deliveries

The law of supply states that there is a positive relationship between the price and the
quantity supplied,
E.g.: the supply curve has a positive slope.
Ceteris paribus:
The supply curve is drawn under the assumption ceteris paribus (remember,
from latin, other things equal).
It means that the supply curve is drawn keeping constant all the other things that
can influence the quantity supplied.
- Derivation of a supply curve:
In what follows we will study in detail the derivation of a supply curve. The first step is
to study the supply of an individual firm. Then, we will analyse the relationship between
the individual supply and the aggregate supply (or market supply).
- Firm as profit-maximizers:
Economists typically assume that firms seek to maximize profits. This assumption is not
always satisfied, especially in the short run (Maximization of market share,
Maximization of revenue, or Maximization of CEO ego).
Example:
For years, investors have complained that Amazon is chronically unprofitable.

As long as the company can grow its revenues, it can spend any profit it makes on new
lines of business that throw off more revenues.
- Economic vs. Accounting profit

- Fixed and variable costs:

Fixed costs are those costs that do not vary with the quantity of output produced.
Variable costs are those costs that do vary with the quantity of output produced.

Total costs

- Total costs:
7000
6000

Total Cost

5000
4000
3000
2000
1000
0
0

10

12

14

16

18

Units Produced

- Marginal and average costs:

The marginal cost is the increase in cost associated to producing one extra unit.
Average
cost is theand
totalaverage
cost for producing
Marginal
costsa number of units divided by the number of
units.
1200
1000

Costs

800
600
400
200
0
0

8
10
12
UnitsProduced
Average Cost
Marginal cost

14

- Marginal cost and decreasing marginal returns:

16

18

The curve of marginal cost is usually increasing because of the law of decreasing
marginal returns. If production is expanded by increasing the use of some resources
while others are kept constant, the LDMR is reasonable. There is a point at which the
fixed resources are overexploited and marginal costs start to increase. In reality
marginal cost curves often U-shaped.
- Aside: sunk costs
Sunk costs are costs that are irretrievable and therefore should not influence any future
decisions, whether in business of private life.
Example:
You have booked two trips for one weekend by accident, one for 50 and one for 100.
The trip for 50 would be slightly more fun.
Which one would you pick? How much each trip costs does not matter as you already
paid the price!

Marginal cost and supply curve

Units

Mg.C. Price (x10)

MgC,
Price

10

10

40

60

70

70

90

Number of
deliveries

- Aggregate supply:
Market
The aggregate
supply is the total quantity that all the firms or individuals want
supply
to sell at a given price.

The market supplycurve isthe horizontal sumof the

individual supplies
S. Firm 1

S. Firm 2

Market supply

2+3=5

In general the market supply curve has a positive slope because:

The individual supply curves have positive slope. When the price increases, more firms
enter the market.

Market supply
The market supplycurve is the horizontal sumof the
individual supplies
S. Firm 1

S. Firm 2

The market supply with many units:

Market supply

2+3=5

What
does this
step
mean?

- Determinants of supply:
Market price
Input Prices
Technology
Expectations
Number of producers
- Changes in the quantity supplied or movements along the supply:
Changes in the quantity supplied or movements along the supply curve arise when there
is a change in the market price of the product, other things equal.

Changes in the quantity supplied

O

Price

300

Anincreaseinthe
priceproducesa
movementalong
thesupplycurve

100

Quantity

- Supply shifts or changes

the supply (to the left or to the right) are caused by one of
Supplyin shifts
the other determinants (not the price).
S3
Price

S1

S2

Supply
reduction
Supply
increase

Quantity

- Changes in the quantity supplied and shifts in the supply curve:

- Shifts in the supply curve: Discuss how the following changes affect the supply curve
of deliveries:
The government puts a new tax on petrol.
Ikea limits the number of vans allowed in its parking lot.
There is a rise in the salary of van drivers.
A new bio fuel is invented which increases the efficiency of engines.
- Price elasticity of supply (and demand):
The price elasticity of supply is the percentage change in the quantity supplied when
the price changes by 1 %. It measures the response of the quantity supplied of a good to
a change in its own price. Everything we say about the price elasticity of supply can be
applied to the price elasticity of demand.
Price elasticity
The price elasticity of supply is computed as the percentage change in the quantity
supplied divided by the percentage change in the price.
P ric e e la s tic ity o f s u p p ly =

P e rc e n ta g e c h a n g e in q u a n tity s u p p lie d
P e rc e n ta g e c h a n g e in p ric e

The price elasticity of demand is calculated analogously.

- (Absolute) values elasticitys:
Perfectly elastic
ES =
Relatively elastic
ES > 1
Unit elastic
ES = 1
Relatively inelastic
ES < 1
Perfectly inelastic
ES = 0

1. Perfect inelastic supply:

An inelastic supply is equivalent to elasticity equal to zero:

An inelastic supply is equivalent to an elasticity smaller than one:

2. Unit elastic supply: is equivalent to an elasticity equal to one:

3. Elastic supply: is equivalent to an elasticity larger than one:

Price

Supply
1. A 25%
increase in
the price...

5
4

2. ... leads to a 100%

increase in quantity.

100

200 Quantity

Perfectly elastic supply

4. Perfectly elastic supply: is equivalent to an elasticity equal to infinity.
Price

1. Atanypriceabove4,
quantity suppliedis infinite.
Supply

4
2. Atexactly 4, producers
will supply anyquantity
3. Atany pricebelow
4,
thequantitysuppliedis
zero.

Quantity

Determinants of the elasticity supply:

- The elasticity of supply depends on the ability of the producers to change the quantity
they produce.
- The supply of land just in front of the beach is inelastic.
- The supplies of books, cars and industrial goods are elastic.
- Time horizon: the supply is in general more elastic in the long run (oil, etc.).
| Exercise: What determines the price elasticity of demand?
Application of elasticity concept:
What is the relationship between revenues of a firm and the price elasticity of the
demand of the good it produces?
- Example: Why can Wal-Mart reduce its prices and earn more money?
Summary:
The law of supply
Goals of a firm: firms as profit-maximizers
Different types of costs and individual supply
From the supply of the firm to the aggregate supply.
Shifts of the supply function.
The elasticity of supply (and elasticity of demand)

UNIT 4: MARKET EQUILIBRIUM

- Supply and demand together:

Equilibrium Price: price that equates the supply and the demand.
Equilibrium Quantity: quantity supplied and demanded at the equilibrium
price.

Supply and demand together

Demand schedule
Price

Supply schedule

Quantity

Price

Quantity

100

100

13

90

90

13

80

80

12

70

70

10

60

60

50

50

40

30

40

30

10

At 50, quantity demanded

is equal to the quantity

supplied!

Supply and demand together

Transport price
(x10)

Supply

9
8
7
6

Equilibrium

5
4
3
2

Demand

1
1

10

11
12
13
Transport quantity

Supply function: Qs = 1 + (4/5) p

Demand function: Qd= 10 - p

- Market equilibrium:
Is the market equilibrium a reasonable prediction? Excess supply puts downward
pressure on prices.

Market equilibrium
Price (x10)

Supply

9
8
7
6
5
4
3
2
1

Demand

Excess demand
1

10

11

12

13

Number of deliveries

- The price mechanism:

Tendency of the price to move towards a situation where supply and demand are equal
is known as the price mechanism. The price mechanism coordinates millions of
individual decisions.
What ensures that restaurants receive fresh ingredients every day?
Why are there enough people who are willing to collect rubbish, grow
rice, bury the dead, clean toilets
- The invisible hand:
The Scottish philosopher Adam Smith (1723-1790) was the first to describe the price
mechanism. In his book An Inquiry into the Nature and Causes of the Wealth of
Nations in 1776 Smith referred to an invisible hand that guides participants in the
market.
- Market outcomes:
Market equilibrium determines how markets assign scarce resources, like how much of
each good is produced or who will consume each good and how much.
A very important question: is the resource allocation determined by the market
desirable?
- Is the market equilibrium efficient?
Pareto-efficiency?
There are two ways to make consumers better off: Sell additional units at a sufficiently
low price or sell existing units at a lower price.
There are two ways to make sellers better off: Buy additional units at a sufficiently high
price or buy existing units at a higher price.

Is the market equilibrium efficient in the sense that we cannot increase the total
welfare of buyers and sellers? (Even if this would require making some buyers/sellers
worse off):
- Consumer surplus is a measure of the gains of buyers thanks to the existence of the
market.
- Producers surplus is a measure of the gains of sellers thanks to the existence of the
market.
- Consumer surplus:
We return to the market for deliveries and assume a price of 50. The number of
deliveries is three. But each delivery is worth more than the price. The difference
between the value of the good and what is paid for it is the consumer surplus.

If we are interested in the surplus of all consumers, we can make a similar computation,
but summing the surplus of all consumers:

Computations are simpler with linear demand functions:

- Producers surplus (or profit):

Lets again consider the example of deliveries and a price of 50. The quantity of
Producer
surplus (or profit)
deliveries is three. The area between the price and the horizontal axis gives us total
revenue.
Letsagain
consider the
example of
deliveriesand a
priceof 50. The
quan tyof
deliveries is
three.
The area
between the
priceand the
horizontal axis
givesus total
revenue.

Price (x10)

N of deliveries

Producers surplus (or profit)

The area under the cost curve (MgC) gives us the costs:
Lets again
Price (x10)
consider the
example of
deliveries and a
price of 50.
The quan tyof
deliveries is
three.

The areaunder
the cost curve
(MgC) givesus
the costs.

Producers surplus (or profit)

N of deliveries

The area between the price and the marginal cost (MgC) curve is the producer surplus.
If the supply
is the
market supply, this area is the total producer surplus.
The
area
Price (x10)
between the
price and the
marginal cost
(MgC) curve is
the producer
surplus
If the supplyis
the market
supply, this area
is the total

producer

Producers
surplus (or profit)
surplus

N of deliveries

With linear supply functions the computations are simpler:

With linear
Price (x10)
supply
func onsthe
computa ons
are simpler.

N of deliveries

- TOTAL SURPLUS:
Consumer surplus = value for the buyers amount paid by the buyers
Producer surplus = amount received by the sellers cost for the sellers
Total surplus = consumer surplus + producer surplus
Total surplus = value for the buyers cost for the sellers

- Efficiency in the market:

Total surplus is the sum of consumer and producer surplus.

Efficiency in the market

Price

9
8

Supply

7
6 Consume
r
Equilibriu
surplus
m price 5 Producer
4 surplus
3

Demand

2
1
1

3
4
5
6
7
8
Equilibrium quantity

10

11

12

13

Quantity

If the quantity produced decreases some units that before generated surplus cease to be
produced theres a reduction in total surplus:

Efficiency in the market

If the quan ty
produced
decreases
some units that
before generated
surplus cease to
be produced

Price

9
8

Supply

Consume
r
surplus

Equilibriu 6
m price
5

Producer

4 surplus

Thereisa
reduc onintotal
surplus!

Demand

3
2
1

10

11

12

Reduction of quantity

13

Quantity

If the quantity produced increases additional units are not valued highly enough to
relative cost. Theres a reduction in total surplus:

Efficiency in the market

If the quan ty
produced
increases
addi onal units
are not valued
highlyenough
rela ve to cost
Thereisa
reduc onintotal
surplus!

Price

9
8
7

Equilibriu 6
m price
5

Supply
Consume
r
surplus
Producer

4 surplus

Demand

3
2
1

Reduction of quantity

10

11

12

13

Quantity

- Market outcomes:
From previous points we can conclude that free competitive markets
1) Assign the goods supplied to the buyers that value the most, which is measured by
their willingness to pay.
2) Assign the demand for the goods to the sellers that can produce at the lowest cost.
3) Induce a quantity of goods that maximizes the total sum of consumer and producer
surplus.
- Criticism of maximisation of total surplus:
Willingness to pay and marginal utility are not the same.
Does a rich person get more joy out of a something just because they are willing to pay
more for it?
Consumers may not understand what they are buying. (Use of medication often decided
by doctor, who may have other interests apart from patient welfare.)
Its possible to sell more units without any buyer paying more than they want to and
without any seller selling below costs. (See exercise on problem set 1)
- Comparative statics:
How does a change in the exogenous conditions in the model affect the equilibrium
variables? For example, changes in consumer income, changes in technology, changes
in the prices of substitute goods

- Shifts of the curves versus movements along the curves:

A shift in the supply curve is called a change in supply.
A movement along a supply curve is called a change in the quantity supplied.
A shift in the demand curve is called a change in demand.
A movement along a demand curve is called a change in the quantity demanded.
- The changes in equilibrium:
The three main steps to analyse changes in equilibrium are:
1) Determine if the change leads to a shift in the demand or supply curve (or both).
2) Determine if the curve/s shift/s to the right or towards the left.
3) Check if these shifts affect the equilibrium price and quantity.
How does an increase in the demand affect the equilibrium?

How does a decrease in supply affect the equilibrium?

What happens to price and quantity if the supply and demand shift?

- Summary:
1) What outcomes does the market produce?
Market equilibrium
Excess supply or demand and the price mechanism
2) Are market outcomes good?
Pareto efficiency
Consumer surplus and producer surplus
3) Changes in equilibrium