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Now that you are enrolled in this economics course, you are probably wondering what it is all about. Every time you hear the word economics you probably think of money and buying things. While this is certainly an issue in any study of economics, it is but a small piece of a very intricate puzzle, which seeks expand our basic understanding of society and the millions of interrelationships that allow it to function. This course, even though it is only an introductory one, will give the student a broad understanding of economics as a social science. It is a science that begins with the most fundamental characteristics of human nature, and eventually culminates with issues as complex as government organizations trying to control trillion dollar economic systems.

Economics is nothing more than the quantification of common sense. Many of the things

that you will learn in this class are already deeply ingrained in your thoughts, common sense if you will. For example: You are already aware of the fact that some things cost much more than others but do you really understand why? Is it simply a rare product, or is there something else that we need to consider before making a guess at this explaining this phenomenon? This is at the very heart of economics, making informed attempts to explain events and actions within our economic system. This is why it is a science.

Though economics is a science, it is a social science and not a physical one such as chemistry

or physics. Above all else, economics deals with human beings and the systems that they create to survive in this rapidly changing world. On the social front, economics deals with many issues in daily life such as; taxes and why we pay them, the fact that some people are fabulously wealthy and others have barely enough to eat, that nine out of every ten new businesses will fail within the first five years of operation. This is just the beginning, so bring your mind and your talents. If you do, you will be rewarded with a wealth of information that will help you to make more informed decisions on many important issues in your life.

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PRINCIPLE ONE

AN INTRODUCTION TO ECONOMIC THOUGHT

In this first reading, we are concerned with the most basic concepts of economic thought: scarcity, unlimited wants, and

productive resources. It might be useful for you to think of these three concepts as the base of a pyramid. They form the broad

conceptual foundation upon which the entire pyramid rests. Without this base, the entire pyramid could never grow, so make sure that

you understand these concepts well and ask questions if you find it difficult.

To most people, the word scarcity means that something is rare or hard to find, and we usually associate this with a high

monetary price. It is essential that you do not think of scarcity in these narrow terms, you must expand your definition to make it

more economic in nature. In economics EVERYTHING IS SCARCE! Even if you think that those “penny fish” at the local Wal-Mart

are not scarce, they are. The key to understanding why this is true is for you to realize that making those “penny fish” or any other

product, for that matter, requires that a CHOICE must be made between one item and another. The reason for this will be much

clearer once you study the following ideas. For now, remember that everything is SCARCE!

Each and every day we are continually bombarded with countless advertisements and commercials on the radio, the Internet,

television, and newspapers. In addition to this we are also continually pestered with those endless offers for credit cards with low

interest rates to make buying feel “painless”. The combination of these two events is no accident, and the outcome is also somewhat

predictable. We are enticed to buy and given the ability to pay on credit, thus encouraging an increase in wants at a frenzied pace.

If we could all have a beach house with a jet to fly there, a yacht to sail on when we get there, and a maid and butler to take

care of everything, we would certainly take them all with no questions asked. In this simple example we see a few things worth

noting. First, our wants are ENDLESS. Second, we see two other economic concepts. The examples include wants that are classified

into two categories.

GOODS: These are actual tangible things that we buy such as: clothes, food, video games, and shoes.

SERVICES: These are intangible things that we buy such as: doctor visits, cleaning services, haircuts, or a day at the gym.

Unlimited wants would not be a problem if it were not for one very simple fact: There are approximately 290 million people

in the United States and some 6 billion worldwide. This sheer mass of numbers leads us to the next economic concept that will help us

to explain why everything is scarce in economics. Goods and services, contrary to some people’s notions, do not mystically appear

out of thin air. Each and everything that we want requires that many things be used to create it. In economics we call these things

used to produce goods and services THE FACTORS OF PRODUCTION. There are FOUR categories used to define the factors of

production, they are as follows:

1. LAND (Natural Resources): This factor is usually considered to be the raw materials that it takes to make something. Steel,

Oil, Wood and the like are examples. It is also the physical land that we live on.

2. LABOR (Human Resources): This is simply the human labor that it takes to create something. Carpentry, Sales Clerks, and

any other job that you can think of are all examples.

3. ENTREPRENEURSHIP: This is a little more difficult to create a specific definition for. One definition is simply the

initiative that people have to open up a business and make it work. Another might be someone who comes up with a new

product or service, and starts to sell it in the economy. The new opportunities for Internet companies are good recent

examples of entrepreneurs taking an idea from a dream to reality.

4. CAPITAL: Generally, all things considered capital are those used in the production of something else, be it a good or a

service. Throughout history, nations that invest in capital goods have higher growth rates and higher standards of living.

Capital is not always what it seems, either. If you buy a car to cruise around with friends, it is not a capital good. If you were

a traveling salesman however, the car would be a capital good because you need it to do your work. The following is a list of

the specific types of capital goods that are used in the economy.

A. PHYSICAL CAPITAL: These are the actual physical tools and other things that labor uses to make finished goods and

services with natural resources (“Land”). Examples: A computer used to do research for stock buying, a factory used to

produce cars, or a jetliner used by an airline to transport passengers, a hammer used by a carpenter, or a school used to

educate children to be productive members of the economy.

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B. HUMAN CAPITAL: Think of this as the SKILLS that workers bring to the economy. A college degree would be

included here as well as the skills that a plumber has to practice the trade. As we will see later, this is very important in

helping the economy to grow and prosper.

C. MONEY: Money is only considered capital if it is used to buy something that is used to make something else.

Companies spend billions of dollars every year on these types to things. As we will see later, this is a very important

part of the economy, and depends on many factors. People saving their money in the bank is very important, for this

money is often used by business to buy capital goods, without this saving, the ability to buy capital and grow an

economy would be limited.

Now that we have defined the different factors of production and differentiated between goods and services, we are ready to

combine these ideas together and solve our original puzzle. As we have seen, our wants are unlimited. Just the opposite, the factors

of production that we need to make all of the things that we need to meet these wants and needs are limited. There are a limited

number of workers with the necessary skills, a limited amount of money available to buy capital goods, and natural resources are

limited as well.

It should now be clear that there is a fundamental conflict between what we want and our ability to produce this unlimited

number of goods and services. Consider our earlier example of the beach house and all of the things that go with it. How could all

290 million Americans have a house the beach and a maid and a pilot? We simply do not have all of the resources to produce these

things. How can we all have a maid, if we did, there would be no one left to be a maid for anyone else. This is why economists

consider all things scarce. Since we cannot possibly meet ALL of the wants, we must choose among all of the things. We must

choose where we want to use the scarce resources that we have in order to keep the highest number of people happy.

Let us now go back to the pyramid analogy at the beginning of this reading. Now that you are aware of the importance of

scarcity and the choices that it makes necessary, this analogy should make a little more sense. All economic study is based on the fact

that we cannot have everything that we want all of the time. If the factors of production were not limited everyone would get

everything that they wanted, and we would have nothing to study in economics. Since they are limited, we see that economics is

basically the study of how people meet there wants and needs. It is really about survival, and the level at which we survive. Will we

be hunters and gatherers who simply live the most basic life imaginable? Or will we be a part of a much more complex society, where

we rely on millions of other people to make the things that we need to live a life of relative luxury?

There are examples of each of these types of economies in the world, and most actually lie somewhere between these two

extremes of basic and ultra complex. As we will see later, these are actually much more complex questions than they seem, and

require much more in-depth study.

EXIT QUESTIONS:

1. What is scarcity in economic terms, and how is it different than the usual sense in which you use the word? 2. Why do unlimited wants cause a problem in society, and why do they require us to make choices?

3. Do you think that the pyramid analogy is a fitting one for us to begin our study of economics with, and should

scarcity be at the base? Why or why not?

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PRINCIPLE TWO

COSTS, OPPORTUNITIES, UTILITY AND MAXIMIZING If there is one statement that can ever hope to sum up economics in a nutshell, it might sound a little something like this:

NOTHING IS COMPLETELY FREE! No matter what you have heard, the above statement is true. Anyone who would like to

challenge this statement is free to do so, but they normally find that once they develop the economic way of thinking, they will find

that it is hopeless to try to disprove the fact that NOTHING IS COMPLETELY FREE! If you learn nothing else in this class, please

leave here with this statement deeply embedded in your head. The main goal of this reading is to prove that, at least in economic

circles, this statement is indeed true.

In order for you to see why nothing is completely free, you must first understand the concept of “cost’ in terms other than the

one that you are familiar with. There are two main types of costs in economics, they are:

1. EXPLICIT: These are costs that you can actually see and count when you make an economic decision. If new

shoes cost $89, they have an explicit cost of $89. This is simple enough.

2. IMPLICIT: These are the “hidden” costs of making a decision. Think of these costs as something that is given up

in order to gain something else. If you take a new job for $30,000 per year and give up an old job that paid $25,000,

than the IMPLICIT cost of taking the new job is the $25,000 that you could have made if you stayed where you

were.

Economists have come up with an interesting term for the cost of making a decision, be it an economic one or not. The term

is OPPORTUNITY COST, and it simply means that if you want to do one thing, it ALWAYS costs you the opportunity to do

something else. A more concrete way of looking at this concept is to think of OPPORTUNITY COST as the next best alternative that

you gave up when you made a decision. There are no violations to this rule that any students have been able to prove, but feel free to

try anyway, economists are always open to new suggestions. Let us prove this concept through a little story.

Take the story of little Johnny who is in love with his girlfriend, and openly tells all of his friends that his love is true and FREE. This statement would give most economists a little chuckle, and they would quickly realize that Johnny has never taken an introductory economics class, for if he did he would realize that NOTHING IS FREE! In order for Johnny to fall in love and experience all of the joy that comes with it, he must spend time getting to know the lucky lady. Herein lies the falsehood behind his statement. If he must spend time with her, then he is giving up something else that he could be doing. It could be something as simple as missing the football game with his friends, but there is a cost nonetheless. Take another example that makes the issue a little clearer. Johnny COULD be working instead of falling in love, and if his job at the grocery store pays $7.25 per hour, this is the true cost of falling in love.

While the above example is indeed an extreme way to look at things in terms of costs, it is worth considering if you are to

develop the economic way of thinking. Within this example is the idea that nothing comes without some sort of TRADE OFF.

Something lost for something gained. If you buy concert tickets for the Dave Matthews Band show, you could have spent the money

on any number of other things. Thus, to go to the concert the next best alternative was lost. If that something was a night at work, the

opportunity cost of the concert is the income that you lost by not working PLUS any money that you spent to attend the concert.

Now that we have cleared up the notion that nothing is completely free, let us take it one step further. When calculating the

opportunity cost of something DO NOT forget to include both IMPLICIT and EXPLICIT costs. In going to the concert you lost your

wages, but you may have also met a new friend at work that night. Thus, you lost wages and the possible benefits of having a new

friend to do things with. While it would be very difficult to put a price on this friendship, there is still a cost associated with it. The

lesson learned in this reading should be that economists are always thinking of something in terms of what is costs, be the cost implicit

or explicit. A good example here would be whether to carry extra cash or leave the extra in the bank. If you carry it around, you are

losing interest that you could have gained. If you leave it in the bank, you may not have the cash when you need it. The choice is

yours, and neither is better than the other, however you must understand that both represent different options.

With all of these costs and choices to consider, as well as thousands of other issues on our mind at any given time, how do we

know what choice among the alternatives is the correct one? As you might have guessed, economists have devised a method to clarify

this issue as well. This is where the term UTILITY comes into play. When you think of UTILITY, think of it as the amount of

happiness that is gained by making a choice. This “happiness” can be measured in many different ways. In economics we often try to

measure happiness in terms of the monetary value that we are willing to pay for something. When you go to the mall and buy a new

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pair of shoes, you are doing so for a reason, not just to throw them in the closet and never look at them again. If the shoes cost $89,

and you actually purchase them, then you value the happiness of owning the shoes to be at least $89. If the same shoes were $100 and

you refused to buy them, then we know that your happiness gained would be less than $100. The idea of placing a monetary value on

happiness may seem a bit silly, but it is actually one of the most important concepts in economic study. Let us take a look at why this

is true.

Human beings are, we hope, rational creatures. This means that we can figure things out through reason and logic. Thus,

when we make economic decisions, we should actually have some sort of process in place to help us to make them. This process is

called COST/BENEFIT ANALYSIS. Cost/Benefit Analysis allows us to measure the cost of something against the value of the utility

that we will gain when we take the action. Let us use a non-monetary example to clarify this concept.

Little Jane can’t decide what to do on Friday. She wants to go out with her friends, but she would also like to go out with her boyfriend Little Johnny. How can we use economic thought to help her?

Jane has a difficult choice to make, but a little logic and reason should help her. All we need to know is some background

information on what Jane sees as costs and benefits in this example. Let us make a few assumptions. Jane’s friends want to go to the

mall for a little shopping and then to a party where many other friends will be, but Johnny will not be there. Johnny wants Jane to go

to a movie that Jane is not too interested in seeing, but might go just because Johnny wants to go. The information above should give

you what you need to help Jane, just think of costs and benefits. The benefits of going out with the girls are high: friends, shopping,

socializing, and a fun party. The benefits of going with Johnny on this night are low; Jane doesn’t really care about the movie that

much. In either example, the cost is the same, for her time is all that we are really concerned with. So what should Jane do? She

should go with her friends. The benefits of going with them are higher than going with Johnny, and the cost is the same.

In that above example we have also introduced you to another concept that human beings normally try to do whenever

possible. This concept is known as MAXIMIZATION. We try to MAXIMIZE the amount of utility that we receive and at the same

time try to minimize the costs that we have to pay for the utility. This behavior can explain many of the things that we do in our

everyday lives. Why do we prefer to go to a store when there is a sale going on, instead of when prices are higher? It’s simple; we get

more for our money. The most utility (benefit) for the least money (cost).

There is one more important thing for you to learn in this reading. Actually it is another simple rule for you to remember.

This rule assumes that people are always acting in a rational manner, and that they seek to MAXIMIZE their happiness (utility) all of

the time. This rule will aid you in making decisions, for it tells you when to and when not go ahead with economic decisions.

RULE: Economic logic tells us to buy something or make a decision as long as the UTILITY gained is greater than or equal

to the COST of making the decision. Never make a decision if the COST is greater than the BENEFITS of the decision. If

you think that a shirt will only give you $20 worth of fun and happiness and the shirt costs $45, DO NOT buy the shirt!

Think back to a statement that you read in an earlier section, “Economics is nothing more than the quantification of common

sense”. The above examples should allow you to see that this is very true. You are already aware of the rules and terms that you have

read in this section, all we have done is studied and thought about them in a formal sense and added some new vocabulary. Make sure

that you are very well versed in the terms and ideas in this reading. Just like the previous one, you will be expected to know these

ideas so that we can later apply them to many more complex situations. Just like learning how to write, you are now learning a new

way of thinking, and you have to practice it before you can become the master.

EXIT QUESTIONS:

1. What are the two types of costs, and how are they different than one another? Briefly explain an example in your life when you considered each of these types of costs.

2. What is opportunity cost in your own words? Give a recent example of when you had to consider opportunity cost in making a decision.

3. What is utility, and why do you think that it is so important for economists to place a value on utility?

4. What is the maximization rule? How does it always explain why we make the decisions that we do?

5. Think back to Jane’s problem. How would it be different if it were Little Johnny’s birthday? How can we now factor in the changing costs and the benefits, and would Jane make the same decision? Why or why not?

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PRINCIPLE THREE

PRODUCTIVITY, SEPCIALIZATION, INVESTMENT AND ECONOMIC GROWTH. The main goal of this reading is for you to recognize not only the importance of economic growth in our everyday lives, but

also to better grasp other elements that are pre-requisites if we are to expect real economic growth in a society. In the first reading,

you learned that nothing is free, and that there are also different types of costs associated with different things. Also, you should be

aware of scarcity and it’s overall importance in economic thought. In the last reading, we build on the ideas within the first by

examining cost benefit analysis and then utility. By combining the ideas in these two readings we see that economics provides us with

a method to calculate our decisions so that we get the most happiness for the least cost. The economy as a whole, which is simply the

combined decisions of millions of people, also has a way of ensuring that society gets the most utility for the least cost.

When you think of cost on the social level, you should not think simply in terms of dollars, rather you should think of all of

the productive resources that society possesses (Land, Labor, and Capital) as costs. Remember that society has a limited amount of

these available, and every time we produce one item, something else has been given up for that item. If we produce a new car, we

could have produced thousands of other items instead. The important thing here is that we chose the car, and that everything that we

could have used the resources for has been given up. Back to where we started, how can we as a SOCIETY get more output with the

resources that we have? Is it possible to have more cars and more computers with the limited resources that we have? Sure it is, but

there are a few things that you must understand before we explain exactly how. Consider the following example:

Take Johnny the old fashioned shoemaker. If we give him the tools that he needs, a factory to work in, and his skills, he can make 10 pairs in a given day. How would it be possible for him to make more shoes, and what would happen across society if he were to do so? Would we all be better off, or would Johnny be the only one to benefit?

Little Johnny and the questions that go with him are some of the most important in the history of economic thought. If you

can answer these questions and think of millions of “Little Johnny’s”, then you are on your way to seeing why the standard of living in

the United States is so high, and why that of Tibet is relatively low. We will learn a lot more about this later, but for now let’s keep it

simple. If Little Johnny can make 15 pairs of shoes instead of 10 pairs in the same amount of time, we would all be better off. The

logic is simple, if he makes more, then each takes him less time. Therefore, he could lower the price since it “costs” him less to

produce them. When he lowers the price, you and I benefit greatly because we get the same UTILITY at a lower cost. If we want to

maximize our happiness, than this scenario is a dream come true. This is what is meant by ECONOMIC GROWTH, on the individual

and social level. Economic growth means getting more output from each unit of societies productive resources. In the end we will all

benefit, for we will all get more for less. Remember though, we get more for less, not for free. It is important that you know what

economic growth does not rid us of scarcity, it simply makes scarcity less severe. Now let’s see how we can help little Johnny, and

society too.

The key to understanding economic growth is the concept of EFFICIENCY. EFFICIENCY is nothing more than getting

more output the same or a lesser amount of inputs. Let’s say you want to drive across the country and have two vehicles to do so with.

One is a big truck that gets 10 miles to the gallon; the other is a VW Rabbit diesel that gets 50 miles per gallon. Obviously, it would

be more EFFICIENT to take the rabbit, for it gets five times better gas mileage. Thus you would use a lot less fuel to get the job done.

Take this example from the individual to the social level, and let everyone drive VW Rabbits, and our oil supply will last a lot longer.

If we apply this example to “Little Johnny” we can further explore the concept of efficiency. Rather than primitive tools in a

primitive factory, let us give him power tools and pre cut pieces of leather, and he will produce many more shoes in a given amount of

time. In fact, why don’t we put him on an assembly line, and let him specialize in a specific task in shoe making, and he will be even

more efficient. As he becomes more efficient, the shoes will become cheaper due to less time involved in their production. This will

allow us to buy more shoes for less money. If we apply this idea to all things that we buy, everything will be cheaper, and we will all

be better off.

In the above example we see the key to economic growth in a society. To get more output from our resources we must be

more PRODUCTIVE. PRODUCTIVITY means that something is more efficient, and that we get more output from each unit of input.

How does this happen? Read the following terms and definitions, and the story that follows and you will be on your way to answering

this question.

1. DIVISION OF LABOR: This means dividing the completion of a job into the several basic tasks that it takes to

create something. Example: Let Little Johnny sew the sole to the shoe, rather than make the whole shoe.

2. SPECIALIZATION: This means that a worker specializes in a specific task in making something, or on a specific

career. By doing so, the worker knows the job better and can be more efficient. Example: Let doctors be doctors

and lawyers be lawyers, they will each specialize and do a better job.

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3. CAPITAL INVESTMENT: This means to buy more or better capital goods that are used in making other goods.

By investing in more and better types of these things, we make workers more efficient. Example: At grocery stores

we see those UPC scanners at the check out line. These make the job of totaling item prices much faster, and

require fewer workers to do the job. This should make the items cheaper, because fewer workers in the checkout

line waste less time. ATM machines do the same thing at banks.

4. HUMAN CAPITAL INVESTMENT: This when people invest time and energy in learning new skills and

information so that they can do a job more efficiently. A college education or other skills for the job are examples

here. This is important because it makes doing a job easier and more efficient. Again this should help all of us

because we can produce more in a days’ work, and buy things cheaper.

5. TECHNOLOGICAL PROGRESS: As technology progresses, so too does our ability to make the most of our

productive resources. Computers are a good example here, for they allow us to do more work than ever imagined

even ten years ago. Again, technology makes us all more efficient and productive, with the same end result.

The definitions and examples that you have just read can each explain how we can achieve economic growth, which will

allow all of us to make and buy more things for less money. When we can do this, we see that our STANDARD OF LIVING

increases and we all have more utility in our lives. The STANDARD OF LIVING is simply a measure of the amount of utility, either

psychological or material possession, that we have in a society. In the United States goods and services to buy surround us, and there

are many jobs for us to choose from. The opportunities seem endless indeed. If we go to Tibet however, we see that fewer people

work in industry and most are still on the farm. As a consequence, the amount of goods and services available are much more limited,

and their standard of living is lower than ours is. There are many other reasons for this, but we will save them for later.

There is one more concept that we must explore to complete our overview of economic growth and societies capacity to

produce the goods and services that meet our wants and needs. Hypothetically, it is possible to total all of the productive resources

that we have available and calculate how much total “stuff” we can produce. Rather than be precise in this measure, economists have

created a useful “picture” of this process. The term given to this measure is the PRODUCTION POSSIBILITIES FRONITER or

PPF. The PPF is a graphical representation of a societies' total ability to produce using ALL of its resources. This is the first graphical

measure that we will explore in this course, and economics makes use of many more. It is important that you fully grasp the use of

graphs in this course, for we will use many more in later studies. You will see a demonstration of the PPF and the details of how it

works in class, so for now, make sure that you remember generally what it measures and why it is important.

The PPF, as its name suggests, is the limit of a societies' productive capacity using all available resources. In economics we

simplify this concept by assuming that society can produce only two types of goods, capital and consumer goods. This is a very

unrealistic assumption, but it will make this concept much easier for you to understand.

CONSUMER GOODS: Those that are produced and are meant to be consumed, used up if you will.

CAPITAL GOODS: As you read earlier, these goods are used to produce other goods, both capital and consumer.

One very important thing that you must understand is that the production of more on one type of good, either capital or

consumer has drastic implications on our FUTURE ability to produce what we need to meet our wants and needs. The logic is simple.

Consumer goods are used in a short time, and thus cannot be re-used. This means that the resources used to make them are forever

gone, and cannot be used again. Capital goods, on the other hand, are used to make other goods. Therefore, if we produce more of

these we can have more of BOTH types of goods in the future. As a society, there is not one authority that decides how much of each

type of good will be produced. Instead, these decisions are made everyday by millions of people and businesses. Remember these

two simple rules:

A. More consumer goods today mean less consumer and capital goods tomorrow.

B. More capital goods today mean more capital and consumer goods tomorrow.

EXIT QUESTIONS:

1. Define economic growth in your own words and explain why it is so important in dealing with the problem of scarcity.

2. Define specialization and the division of labor. Provide and example of each, and explain why they are so important if we want economic growth.

3. Define the standard of living, and explain why economic growth allows it to rise. 4. What is the production possibilities frontier, and what does it measure?

5. What is the difference between capital and consumer goods?

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THE PRODUCTION POSSIBILITIES FRONTIER As mentioned above the Production Possibilities Frontier, or PPF, is our first graphical measure in the course. Below you

will see an example of a PPF and some things to note about the model. Take your time to study it and make sure that you are familiar

with what it measures, what can cause it to shift inward or outward, and what the different points related to the frontier mean with

respect to where the economy is performing.

ASSUMPTIONS OF THE PPF: The location of the actual PPF is based on two fundamental assumptions.

1. That the economy in question is using ALL of the land, labor, and capital that it has available

2. That the economy is using all of its resources at the most efficient level possible based on current technology and human

capital.

CAPITAL GOODS

POINT A

10 POINT E

POINT B

8 POINT C

4 POINT D

0 5 12 16 CONSUMER GOODS Now that you have seen an actual PPF, let us consider what this model measures and what it means in the big picture. This

model is HYPOTHETICAL and not representative of any specific economy in the world, it is just meant to get you to think in terms

of the broad picture. On the model above we need to note several important things that are highlighted by the model:

1. You will see that this economy has a choice of only TWO types of goods, Capital and Consumer. Also, as you move out

from the origin, you will see that the amount of each type of good increasing.

2. Look at Points A, B, and C. They all lie on the frontier (PPF 1) and all would be desirable places for the economy to be

because this means that all resources are being used at their most efficient levels possible. Note that neither Point A, B, or C

is any better than the others, they just represent the choices that the people within the economy are making.

3. Take a close look at what it means to move from Point A to B to C. You should see that the trade off of capital versus

consumer goods when moving between these points is INCREASING. Basically the OPPORTUNITY COST of each

additional unit of a good is INCREASING. Let us use Point A to B then B to C. From Point A to B you get 7 extra units of

consumer goods and give up only 2 units of capital goods to get them. If we look at Point B to C we see that you only get 4

extra consumer goods but that we must also give up 4 units of capital goods to get them. The trade off is now 1 to 1, much

higher than before. The reason for this is simple, when you move to the extreme ends of the frontier you are using resources

for purposes that they not well suited to. Think of using an aerospace engineer (labor) to raise wheat in Nebraska. She

PPF 1

PPF 2

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probably knows little about wheat farming, thus she is more inefficient than she would be at designing planes for Boeing!

Make sure that you clearly understand this concept before moving on.

4. Point D is attainable for the economy in question, but it is not desirable because this point represents an economic output

level where resources are going unused or that there is inefficiency in the economy. You do not want to be here!

5. Take a look at Point E. It lies beyond the frontier (on PPF 2) and would represent a consumer/capital good combination that

is not currently possible given the economies resources or level of efficiency. Things can be done to get here in the future,

but for now, the economy can only dream!

6. Take a close look at PPF 2. You should notice that is lies farther out than PPF 1. This implies that something has changed in

the economy, and that the economy can now have both MORE Capital and Consumer goods than it did before. This is the

ultimate goal of any economy, and is the best thing that can happen. Every member of the economy gets more stuff because

we have either more resources or higher levels of efficiency. There are only a few things that can do this, they are listed

below:

I. An increase in the amount of labor available (population growth).

II. An increase in the amount of natural resources available (discovering new energy sources).

III. An increase in the amount of CAPTIAL goods in the economy. (increases efficiency).

IV. An increase in the educational attainment of the population. (increases efficiency).

V. An increase in technology (increases efficiency).

7. Even if the frontier shifts from PPF 1 to PPF 2 the basic problem of scarcity is still not solved due to outward limits on what

we can do as a society with our resources. We may have made scarcity less of a problem but we still have not defeated the

overall problem, it will never go away.

10

PRINCIPLE FOUR

ECONOMIC SYSTEMS AND THEIR CHARACTERISTICS

Economics, like the rest of society, contains different systems. These systems are a collection of rules, values, laws, and

activities that can help to explain how different societies deal with the basic problem of scarcity. These rules, values and laws provide

a FRAMEWORK under which decisions are made, and these decisions shape our everyday lives in countless ways. Why is it that we

have thousands of products to choose from in the grocery store, and in other countries people raise or hunt all of the food that they

use? The answer to these and many other questions will become much easier to understand if you take the time to learn the

characteristics of the three main types of economic systems.

At the most basic social level, there are three questions that ALL economies must answer. The following THREE decisions

must be coordinated if people are to meet there wants and needs. Each type of economic system completes this task differently, and

with different degrees of success.

1. What will we produce?

2. How will we produce the goods that we want?

3. Who will get what is produced by the economy?

There are certain traditions that you probably take part in every year, maybe it is a family reunion on the same day every

year, or something that is always recited before you take part in the “big game”. Life is full of traditions, and they are usually

followed without question for one reason or another. Just like our lives, there are economic systems that rely on tradition to help

people to deal with decision making that helps to address the problem of scarcity. In TRADITIONAL ECONOMIES economic

decisions are made by tradition, through past practice over many generations. A good example of a traditional economy would be that

of the Indians of the Great Plains in the United States. They relied on the buffalo for all of their needs, and hunted them the same way

for hundreds of years, just as their forefathers did. The tribes followed the same rules as their ancestors before them, and they lived

for hundreds of years in this fashion. The rules and values in these types of economic systems rarely change, and are usually followed

without question. As you might expect, there are few if any of these types of societies left in the world today. We will look at the

reasons later, but for now you need simply be able to define a traditional economic system.

The second type of economic system is known as a COMMAND ECONOMY. In a command economy major economic

decisions are made by a central planning authority. Individual people make most of the day to day decisions, but the government

usually coordinates large-scale nationwide economic production. This concept is usually foreign to economic students in America,

and for good reason. The economy of the former Soviet Union is a good example of a command economy. The following should help

to clarify the basis for this type of economic system.

In the Soviet Union, before the 1990’s, there was generally only one type of automobile available to the general public. The

car was called a Latta, and was only available in three colors: red, white and black. Why would anyone settle for this you might ask?

The answer is simple; the government owned and controlled the only car manufacturer in the country. Not only did the government

own the company, but it also decided how many cars to produce, how much they would cost, where they would be sold, as well as the

colors that would be available. As you might imagine, this caused many problems for the consumer. Often, there were shortages of

cars, few if any options and colors to choose from, difficulty in delivering cars, and waiting lists to get a car. Why would any nation

try to undertake this difficult task you might wonder?

The answer to this question deals with scarcity, just as many others do. A nation only has so much land, labor, and capital to

use. The government of the former Soviet Union decided that the resources would best be used if the government were to control such

large-scale production. Cars weren’t the only example; many other large industries such as; steel, agriculture, oil, and coal were

controlled by the government. We will look at the shortcomings of this type of system later, for now make sure that you are aware of

the basic idea behind a command economy.

The third and final economic system that we are interested in is the MARKET ECONOMY. This is the basic format of the

American economy, and the one that you are the most familiar with. In this type of economic system INDIVIDUALS make many of

the day to day decisions that guide our economic life. A market is nothing more than a place where goods and services are sold. The

cafeteria is a good example, so too is the ticket scalper roaming the parking lot of a concert. Both of these examples provide a good or

service for sale, and therefore are considered markets, even if one is illegal.

The market economy has many advantages over the two other types of systems. It is in the market system that we see

economics in its purest form. People are able to meet their wants and needs in the way that they choose, by making their own

decisions. The following is a list of things that you should consider hallmarks of a market system.

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1. VOLUNTARY TRADE: In a market system, people must be allowed to trade VOLUNTARILY. If they are allowed to

do this, then they can always do what is best for them in order to meet their wants and needs. If trade is not voluntary,

then they may not be allowed to do what is best for them.

2. PERSONAL GAIN: People in market systems are seeking to better themselves through economic activity, and take

actions to ensure that they will receive the most benefit for the least cost. This may seem like greed, but if you think

about it, we often do our best work when we are doing something that directly benefits us.

3. INCENTIVES: A market system relies very heavily on a system of incentives to help people to make the best choices.

An incentive is nothing more than a reason for doing something. Economic incentives are very powerful, and a good

market system will reward those who understand how to best use incentives.

4. PRICE SYSTEM: A market system relies very heavily on the use of money and on a complex pricing system to

coordinate economic activity. Prices allow us to calculate the exact cost and benefits of making an economic decision,

and therefore make it much easier to estimate the value of something. This in turn allows us to meet our wants and needs

by getting the most benefit for the least cost.

5. INTERDEPENDENCE: In a market economy you will find that the people in the system are very DEPENDENT on

one another to meet their wants and needs. In order to be more efficient we must specialize, and when we specialize, we

must rely on others to create the things that we need for survival.

Now that you know a little about the main characteristics of a market economy, let us use an example to make it more

meaningful for you. In this example you will see how each of the items in the list above coordinate with one another to help you more

easily meet your wants and needs.

Let us assume that you want to eat a delicious steak for dinner tonight, and that the steak in the store has come all the way from Wyoming where the cow was raised. First, you do not raise the cow yourself and therefore you must be INTERDEPENDENT upon the rancher to give you what you crave. You want the steak for PERSONAL GAIN, you know that eating it will give you a large amount of utility. This utility acts a as INCENTIVE to further entice you to buy the steak in front of you. You must VOLUNTARILY TRADE money to the store in order to get the steak. Finally, the PRICING SYSTEM in our economy allows you to compare the price of the steak to the utility that you will gain from consuming such a nice cut of meat. In the end you decide to buy the steak, and thoroughly enjoy it when you eat it sizzling hot off of the grill.

The story above is a great illustration of how the market system functions. You have a want, and the market has an amazing

way of fulfilling it. How does this happen? It all happens because people are, first and foremost, interested in personal gain. It is this

that drives most of what we do. Think of the story above from the “other side of the coin”. Do you really think that the storeowner or

rancher cares who actually buys the steak? NO, they don’t! As long as someone buys it, both of these people gain utility from extra

income, and they can then buy what makes them happy. If more people want steaks the rancher and storeowner will gladly supply

more to the market, for each on they sell gives them extra utility.

Before we end the story of economic systems, let us return to something that we mentioned earlier in the reading that will

allow us to compare two different types of economic systems. In Russia, you could buy only one type of car, a Latta, in three colors

and with very few options. This was because the government controlled the means of production, and decided what the people should

and could drive. I would imagine that their level of utility was certainly lower than it could have been. What would happen to this

type of car in the market system? First, there would be other choices of car companies to choose from, ones with nicer more fun cars.

This would lead you to buy one that increased your utility by a lot rather than a little. Since you didn’t buy the Latta, the

company would lose the sale, and thus income and utility for the workers. Eventually, all people would cease to buy the Latta, and the

company would go out of business. It would be a harsh lesson indeed, but since the Latta failed to provide the utility that we wanted,

we do not voluntarily trade for it. What is the end result? It allows the resources that we could have used on the Latta to produce

other things that increase our utility by greater levels. The lesson learned here is that a MARKET SYSTEM more efficiently puts

resources to use where we need or want them the most.

There is one other thing that you need to know before we leave economic systems, there are no economic systems that exist

in their pure form. There are no purely TRADITIONAL, COMMAND, OR MARKET systems. All economies are mixed, each type

12

actually contains elements of all three types of systems. In America we have people who go fishing with their father to get some extra

food, we have a social security system for our retired years that is run by the government, and millions of different types of markets in

which goods and services are bought and sold. Indeed, we have elements of all three types of systems in our economy.

EXIT QUESTIONS: 1. Why do you think that there are fewer Traditional economies than any other type? 2. How are major production decisions made in a command economy, and why might this be a problem for today’s

large societies? 3. How are production and distribution decisions made in a market economy? 4. Why are prices such an important part of market economies? How do they help us to maximize our happiness? 5. Why is personal gain such an important part of a market economy?

13

PRICE DETERMINATION IN A MARKET ECONOMY:

PRICE

QUANTITY

THE INTERACTION OF SUPPLY AND DEMAND

AND MARKET INTERFERENCES

14

CETARIS PARIBUS

"ONE STEP AT A TIME"

One of the most useful terms in all of economics is indeed "Cetaris Paribus". The translation of this Latin phrase literally

means "all else remaining equal". This concept is very useful in all sciences, not just economics, and the reason is very simple.

Consider the bio-medical researcher who is conducting clinical experiments to study the effects of a new drug to treat a health

problem. They do experiments in small steps, changing only ONE variable at a time to test the results. For example, they may

give the patients a specific dose of the drug, and chart the results. Later, they may raise or lower the dose, then check the results.

Some patients are only given a placebo, or fake pill, and the results are charted. The point of all of this is to see how changing

only one variable affects the patient. If they would give the same patient different doses of the drug and a placebo all at the same

time it would be almost impossible to see what is actually happening, and the effectiveness of the drug could never be charted. In

your chemistry class you must consider several different variables when doing labs and mixing chemicals. The amount of each

chemical being used, the temperature, and the volume of the container are all important to the experiment. By changing only

ONE variable at a time you are able to see the results of the change.

In economics the concept of Cetaris Paribus is very important because we need to see how one change in the economy affects

prices in a particular market as well as other elements of the economy. Consider the following example to make it a little clearer:

Suppose that you are studying the world market for gasoline, and you noticed that there was a large increase in

the price of gasoline during the summer of 2004. If you wanted to get to the bottom of this you would have to isolate some different events in the economy individually, then look at their cumulative effects. There are four

main variables that you have to look at to explain this increase in the price of gasoline, by applying them to the

market ONE AT A TIME you should be able to see why gasoline prices rose so much in such a short period of time.

1. Due to tension in the Middle East, people were worried that oil shipments would be interrupted, and

the price of oil was being bid up due to feared future scarcity. (Supply)

2. America has not built a new oil refinery in over 10 years, and our ability to refine oil into gasoline was

stretched to the limit. (Supply)

3. People begin to drive much more in the summer months, beginning with the Memorial Day holiday, and many more people are driving poor fuel economy SUV's. (Demand)

4. The world economy, particularly China, was getting stronger and world demand for oil was driving up the price of oil on the world market. (Demand)

When we apply each of these variables one at a time we can see that it was inevitable that the price of gasoline

would rise dramatically. Each variable, be they supply or demand forces, was pushing price in the same

direction. This example is simple, but it would be more difficult if some forces were pushing in different directions. Let us assume that the world economy, instead of growing was in a recession. This would have the

opposite effect on oil and gasoline prices, but would it be enough to outweigh the other forces pushing prices upward? The only way to tell would be to apply it to the market and see what happened. So you see, applying

variables one at a time is indeed very important, especially when forces are working in the opposite directions on

a given market.

In the next few readings on supply and demand you will see that it is critical to use the concept of Cetaris Paribus to understand the interaction of supply and demand. You must isolate one change in the economy at a time, trace its effects, then apply other variables and trace their effects. Keep this concept in mind throughout the year, but especially during this unit, it will pay rich dividends to those who truly understand it.

15

DEMAND, PRICES, AND MARKETS

It’s all supply and demand said the cashier to the young lady, and with that the young girl was off to explain why he spent

$110of her fathers hard earned money on a pair of jeans from Abercrombie & Fitch. Supply and demand she thought; at least if I

have a real reason, especially one that an economist thought of, my dad shouldn’t get too mad at my relentless pursuit of finding ways

to waste his money. I’m sure that many students have echoed these very words in defense of squandering their parent’s money, but in

the case above, it is a justifiable reason to explain a high price paid for a good. While most people have heard the term before, supply

and demand is actually a much more complex system than the vast majority of society realizes. As we have already studied, scarcity

is the most fundamental problem in economics. Supply and demand is nothing more than a tool that we use to study this basic

problem. It allows us to see three things:

A. How will we produce to meet our wants and needs?

B. What will we produce to meet our wants and needs?

C. Who will get what is produced?

In our market system we use prices to answer all of these questions. Prices allow us to produce goods for the least amount of

money, to decide what people want, and to give different people the different things that they want or need. Prices allow us to

measure the opportunity cost of economic decisions, and in this sense they help us to use societies scarce resources where they are

needed the most.

Prices, what exactly are they, and how are they set in a market oriented economy like ours? Most people think that prices are

set almost entirely by the manufacturer or retailer of the goods that we buy. In some cases this is true, but there is certainly a lot more

to it than this. Before a company can set a price for something the usually do a considerable amount of research into the market that

they are about to enter. Most of this research is centered on the consumer and their willingness to spend money on a product. What

you have just read should help you to realize that as the old saying goes “It takes two to tango”. In other words it is not only the

supplier that sets prices, the consumer has a considerable input into this process too, even though they might not think so. It is this

idea that forms the basis for supply and demand.

In our economy the consumer forms the demand side of the market. The producers, be they large or small, form the supply

side of the market. The demander wants the goods for the LEAST amount of money; this is because they want to MAXIMIZE utility

for the least cost. The supplier, on the other hand, wants to sell for the highest price. This is true because they MAXIMIZE their

utility by making as much profit as possible. It is this interaction between the buyer and seller that sets prices in the economy. If

something is too expensive and does not sell, the supplier is forced to lower the price until the goods are sold. If something is too

cheap people will flock to buy it and raise the price, as the good becomes scarcer. This is what keeps the market continually moving,

and why prices are always changing. Now let us look more closely at each of the “players” in the economy.

DEMAND AND QUANTITY DEMANDED:

Demand is nothing more than a SET OF CONDITIONS that explain why we do or do not want to buy a product or service.

At times things are in high demand, at other times they are very low in demand. But, even if something has high demand, one thing is

always true. The more of something we buy, the less we are willing to pay for each additional unit of the same good. Consider this

example: If you go to the mall and buy a red shirt for $20 dollars, would you be willing to buy another of the exact same shirt for the

same amount of money? Probably not, but why? The reason is that the second shirt will not give you the same amount of utility as

the first because it is exactly the same product. This is the first economic LAW of the reading.

THE LAW OF DIMINISHING MARGINAL UTILITY: This law simply states that as we buy more of the same good, we get

less utility from each extra unit. How many times do you want to wear the same shirt, and would you even buy more than

one of them anyway?

This law is very important because it explains why we buy less of something as the price of the good or service rises. You

must ALWAYS REMEMBER that the relationship between PRICE and the QUANTITY of a good on the demand side of the

economy is INVERSE! This means that as price drops we buy more, and as it rises we buy less. It is this fact that forces companies

to think very hard before they price a good on the market, and also why we often see “2 for 1” sales in your favorite stores.

THE LAW OF DEMAND: Derived from the Law of Diminishing Utility, the Law of Demand states that we will only

demand a greater quantity of a good if the price that we pay for the good is lower. This makes perfect sense, for less utility

gained means that we will spend correspondingly less to get the utility. Think of a donut lover who is eating the first donut

versus the 10th

. He or she would certainly not pay as much of the 10th

as the first because they will be sicker and sicker after

each donut!

16

As you should have implied from what you have just read, price is very important in determining how much of something we

do or do not buy. But, you must understand that price only affects the QUANTITY DEMANDED of a good, and price DOES NOT

change any of the UNDERLYING REASONS that we buy goods or services. Think back to cost benefit analysis, when the price of a

good is changes, it only affects the cost, not the benefits. If the price of CD’s increases, you might buy a lesser quantity, but you still

enjoy music the same. Your love of music is the UNDERLYING REASON for buying music! Remember this rule:

RULE: Changes in price ONLY affect the quantity of a good demanded, not actual demand for a good. Now let us learn a

little about DEMAND for a product, and the reasons that we buy or do not buy products. Demand for a good, as previously

mentioned, is nothing more than a set of conditions that relates to a product that we wish to buy. It is very important that you realize

that the factors that affect demand are ALWAYS CHANGING. Specific conditions only exist for a short while, and are replaced by

different conditions. A simple example of this is right after you have just eaten a big lunch. Before lunch you had a set of ideas in

your head of what you wanted to eat, and these conditions told you how much to spend and what to eat. After lunch, you have an

entirely different set of conditions now that your appetite has been satisfied. Of the millions of things that affect DEMAND for a

good, most can be classified into one of the following categories:

1. CHANGE IN INCOME: As consumers incomes’ rise, they are willing to buy more of a good at ANY given price level.

The opposite is also true, as incomes fall, people are willing to buy less of all goods at any given price.

2. CHANGE IN POPULATION: As the population rises, people will buy more of a good at ANY given price. This is

true because there are simply more people to buy things.

3. EXPECTATIONS: Depending on what people EXPECT to happen, they may pay either MORE or LESS for a good. If

you expect gasoline to go up in price next week, you may fill up the tank today to avoid higher prices later. The opposite

is also true.

4. PREFERENCES: As consumers preferences for a good increase, they will buy more of the good at any given price

level. This is true because the good now provides more UTILITY than before, and thus a higher price will be paid. This

is the goal of advertising. Did you ever see a product such as Pepsi, when they give the can a “new look”, the product

has not changed, but the consumer now likes the look more, and should buy more of the good.

5. SUBSTITUTES: There are many goods that we can substitute for one another, and the relationship between these goods

has a very important effect on demand. Coca-Cola and Pepsi are a good example here. If the price of Coke rises, people

should buy more Pepsi at a given price. This is true because the substitute (Coke) is now more expensive, and we want

more Pepsi at its original price.

6. COMPLIMENTARY GOODS: There are many goods that we commonly use together with another good, and this

relationship is very important. Coffee and sugar are good examples of this. If the price of SUGAR rises, we will

DEMAND less coffee at any price. This is true because it is now more expensive to drink coffee the way that we want

it. Remember that nothing happened directly to the coffee market, but the change took place because of something that

happened in the sugar market!

Each of the examples that you have just seen are called the DETERMINANTS OF DEMAND. This means that they have the

power to actually change the entire conditions under which we demand goods and services. On a supply and demand graph this

means that we must change the ENTIRE DEMAND CURVE to show the effects of changes in one or more of these determinants.

Numbers 1,2,3and 4 are straight foreword, a change in any of these will change demand for a good DIRECTLY! Numbers 5 and 6,

substitutes and compliments, are more INDIRECT. This means that we must look at a change in one market and see how it affects a

RELATED MARKET. A related market is simply a market for one good that is in some way related to another market.

EXIT QUESTIONS: 1. Why are prices set by both producer and consumer in a market economy? 2. What is the difference between DEMAND and QUANTITY DEMANDED? 3. What is the Law of Diminishing Marginal Utility, and what relationship does it illustrate between price and quantity demanded? Do

you think that this relationship is always true? 4. Why is the demand for a good continuously changing? 5. Give a SPECIFIC example of how changing expectations could change the demand for a good. 6. What determinant of demand does advertising target, provide a SPECIFIC example for this one. 7. Provide THREE SPECIFIC examples of substitute goods in the economy. What is the relationship between a change in the price of

a substitute and demand for the original good? 8. Provide THREE SPECIFIC examples of complimentary goods in the economy.

What is the relationship between a change in the price of a complimentary good and demand for the original good?

17

THE GRAPHICS OF DEMAND

Now that you have read and understood the theory behind the demand side of the market, let us not turn to the graphical

models to show the relationships on the demand side of the market. Pay particular attention to the following items when studying the

graphs:

1. The axes on the graphs and what is measured on them. INTERNALIZE this information, never forget it, and your

confusion will certainly be limited!

2. The general slope of the demand curve and the reason for it.

3. The difference between MOVEMENT along a given demand curve and a SHIFT in the entire demand curve.

YOUR BASIC DEMAND SCHEDULE AND DERIVING THE DEMAND CURVE: The demand schedule is nothing more than

a Price and Quantity combination that tells how much people in a market will pay for different quantities of a good. Plotting these

Price and Quantity combinations on a graph and connecting the points creates a basic demand curve.

PRICE QUANTITY DEMANDED (COOKIES)

$1.00 1

.80 2

.60 3

.40 4

.20 5

PRICE

1.00

.80

.60

.40

.20

0 1 2 3 4 5 QTY. COOKIES

THINGS OF NOTE ON THE DEMAND CURVE DIAGRAM:

1. The relationship between PRICE and QUANTITY. People will only buy more of a good in a given market if

the price of the good decreases. (Law of Demand)

2. The DOWNWARD SLOPE of the demand curve. It will always look this way due to the laws of diminishing

marginal utility and demand.

3. That this is a general relationship for the entire market, not just for one person. What you are seeing here is a

basic representation of the behavior of all people who are in a market, individuals within the market may have a

personal demand curve that looks very different than the one shown above.

DEMAND

SCHEDULE

DEMAND CURVE

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FROM CHANGES IN PRICE AND QUANTITY TO CHANGES IN DEMAND: As you have seen in the demand reading, if

there is a change in only the PRICE of a good, there will be movement ALONG the given demand curve. Refer to the diagram above,

what will happen if market price goes from .60 to $1.00? There will be a lesser quantity demanded, thus movement along the same

demand curve. This occurs when there is NO CHANGE in the UNDERLYING CONDITIONS within the market. If there is a

change in the overall market for cookies for some reason, we would have to change the position of the entire demand curve. In the

following diagram you will see what happens if there is a change in DEMAND. We will use the same market for cookies to start

with.

THINGS TO LOOK FOR:

1. Notice the TWO different demand schedules, one for the old set of conditions and one for the new.

2. Note the change in the entire demand curve, it has SHIFTED, thus representing a new set of conditions.

3. Note the reason that is has shifted, a new demand schedule.

***ASSUME, FOR THE FOLLOWING EXAMPLE, THAT A STUDENT FOUND TWO DEAD FLIES IN A COOKIE

PURCHASED IN THE CAFETERIA AND THAT THIS INFORMATION SPREAD TO OTHERS THROUGHOUT THE

DAY.

PRICE QTY. DEMANDED (OLD) QTY DEMANDED (NEW)

1.00 1 0

.80 2 1

.60 3 2

.40 4 3

.20 5 4

PRICE

1.00

.80

.60

.40

.20

0 1 2 3 4 5 QTY. DEMANDED

WHAT DID WE FIND?: Once the students found out that the cookies may contain things that they do not want to eat, DEMAND

for cookies in the cafeteria fell. This is indicated by the new demand schedule from above. Students will buy less cookies at any

given price, for example if they were $1.00 each, they would buy none. Compare this to the original demand schedule, they would

have bought 1 cookie at this price, but since conditions have changes, they will buy none.

ON THE GRAPH:

1. Notice how the entire demand curve SHIFTED inward to represent the changing conditions, this is from the

new demand schedule.

2. Notice how the fact that the students will buy fewer cookies at any given price is shown here with a visual line.

3. Note that this was ONE change CETARIS PARIBUS, and does not factor in any other changes.

***Note that this would mean that the price of the cookies would have to be LOWERED to sell them, this is due to a decrease in

demand.

DEMAND

CURVE 1

NEW DEMAND

CURVE 2

19

THE BASICS OF SUPPLY: MAIN DETERMINANTS

Just as demand changes the prices of goods and services in the economy, the supply of a good has very powerful effects on

prices and availability of all of the things that we use to meet our wants and needs. You are much more familiar with the demand side

of the economy, so now it is time to give many of you your first taste of supply analysis. There are some basics that we need to

consider before we can see the effects of supply changes on prices and quantities of goods in the marketplace.

First, you must be aware of the fundamental difference between SUPPLY and QUANTITY SUPPLIED in a given market.

QUANTITY SUPPLIED is simply the amount of a good that will be supplied to the market at various price levels under a given set of

conditions. In the oil market, producers will supply different amounts of oil at different prices. In this way the market allow just the

right amount of its scarce resources to be used on oil production. If it were not for price, markets would never know how much of a

good to produce and we would end with either too much or too little of a good. There is another law that we must introduce at this

time. It is similar to the Law of Diminishing Marginal Utility, but it affects the supply side of the market, not demand.

THE LAW OF INCREASING COSTS: This economic law states that extra output of a good can only occur at higher

prices because inputs needed are becoming more scarce or that output is occurring at lower levels of efficiency, Cetaris

Paribus.

Thus, the relationship here is direct. If the price of the good rises, suppliers will supply a greater quantity of a good. The

logic behind this law is relatively simple because it is directly related to scarcity. As more of societies scarce resources (L,L,C) are

devoted to increased production, the price of these inputs rises. The only way that a producer can increase the Qty. Supplied is to pass

the increase in input prices on to the consumer. Consider a small company with a fixed size factory that has a maximum level of

output. If the company wants to produce more it must pay workers overtime and buy more inputs. In a limited size factory, more

workers or more tired workers mean crowding or more inefficiency. Thus, as you can see, the price of the good being created must

also rise.

THE LAW OF SUPPLY: Easily traceable to the law of increasing costs, the Law of Supply states that as the overall supply

of a good increases, the price of the good must rise to compensate for the increased cost of producing the good.

Now that we know a little more about the quantity supplied under a given set of conditions, let us look more closely at supply

itself. SUPPLY itself is nothing more than the set of conditions that form the foundation for production of a good. Economists are

interested in studying these conditions to see what happens if they change. Just like demand, Cetaris Paribus rules apply to supply.

What we want to do is simply change one or two of the conditions in the market and see what happens to QUANTITY and PRICE in

the given market. REMEMBER, changing a DETERMINANT of SUPPLY changes the ENTIRE market and producers will supply

more or less of a good AT ANY GIVEN PRICE! The following is a list of the DETERMINANTS OF SUPPLY, and a brief

description of each.

A. THE NUMBER OF FIRMS IN THE MARKET: As the number of firms increases so too does supply in the

entire market, the reverse is also true. If SUPPLY increases, the market price of the good or service will

DECREASE, the reverse is also true. Consider the market for personal computers. Apple and IBM used to

control the entire market; now that there are many companies that make these computers the price has fallen

dramatically.

B. THE PRICE OF INPUT GOODS: Inputs are used to make all goods and services. If the price of one or more

of these inputs rise, the SUPPLY of the good will decrease, the inverse is also true. As supply decreases the

price of goods will increase, the reverse is also true. The logic here is simple. If the price of oil rises, gasoline

companies will supply less gasoline at ANY GIVEN PRICE, this is because the price of oil has increased and it

is more expensive to produce each gallon of gasoline, so companies cut back production to compensate for the

higher input price.

C. TECHNOLOGY: As technology advances production becomes more efficient and scarce inputs create more

output than before. Thus, as technology increases, companies increase SUPPLY at any given price. By doing

so they decrease prices and compete with other companies better thus increasing sales. A simple example is

using robotics in car production. This decreases labor costs, and increases supply in the market. When this

happens we see more cars in the market and lower prices for these cars.

20

D. BUSINESS ENVIRONMENT: This is a broad category that includes many government regulations and taxes

that businesses are charged or have to comply with. If cleaning up the environment is a main goal of the

government, companies must “clean up their act”. This increases the cost of each good produced. Thus,

companies cut back supply because the current market price is not high enough to cover all of the costs to the

company.

E. PRICES OF RELATED OUTPUTS: Related outputs are nothing more than two or more goods that use the

same inputs in production. Take milk for example. You can make cheese, milk to drink, yogurt, or any other

number of items. If the price of one of these goods rises, more of the input will be used to create the item whose

price has risen. This means that the supply of the other goods MUST DECREASE.

If demand for yogurt drives up it’s price, dairy companies will use more milk for yogurt and less for cheese.

Thus, the SUPPLY of cheese will decrease and its price will rise to. You will notice in this example that it is

something in a related market that caused the change, not something in the cheese market, but rather, something

in the yogurt market.

Now that we have seen the determinants of supply, let us review the concepts that we have seen so far. PRICE only changes

the Quantity Supplied not the conditions under which SUPPLY is based. Secondly, a change in any of the DETERMINANTS of

supply will cause the entire supply of a good to change. This will cause the PRICE and QUANTITY in the market to change due to

something related to supply, and not in demand. Remember this:

A. An INCREASE in supply will cause the quantity in the market to increase, and the price of the good to DECREASE.

B. A DECREASE in supply will cause the quantity in the market to decrease, and the price of the good to INCREASE.

Just like demanders in the economy, suppliers are always faced with continuous changes in the conditions in the market.

They react in a predictable way to these changes in conditions, and always follow the rules that we have outlined above. When

suppliers react to these changes, they change the prices in the market that is being studied, and these price changes send important

signals to tell the market what we should and should not produce. Remember that ugly shirt that has been on the sale rack for the last

two months? Chances are that the shirt will no longer be produced unless there is a considerable change in the tastes of the consumer.

You can also be sure that when the price of computer chips decreases, the number of PC’s on the market will increase. This is due to

the fact that suppliers must always react in a way that is most favorable to the profits and sales of the business. Just like you they want

to maximize the amount of output that they can produce with each input.

EXIT QUESTIONS:

1. What is the Law of Increasing Costs, and what effect does it have on supply in a given market.

2. Re-read each of the determinants of supply. Create a specific example for each for each of these determinants and explain the effect of the change that you have created on PRICE and QUANTITY in the

given market.

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THE GRAPHICS OF SUPPLY

Now that you have studied the theory behind the supply side of the market and the elements of supply, let us turn to the

graphical side of supply. The general ideas behind the supply curve are the same as on the demand side, the difference comes in the

slope of the supply curve and the reasons for the change in slope. Below you will find a supply schedule for cookies in the cafeteria

and a graph that depicts this relationship.

PRICE QUANTITY SUPPLIED

.20 1

.40 2

.60 3

.80 4

1.00 ` ` 5

PRICE

1.00

.80

.60

.40

.20

0 1 2 3 4 5 QTY. SUPPLIED THINGS TO NOTE WITH THE SUPPLY CURVE:

1. The relationship between Quantity Supplied and Price. This is due to the Laws of Increasing Costs and Supply.

Firms will ONLY supply a greater quantity of a good if the price being offered for the good increases. This is

just the opposite of Demand.

2. The slope of the Supply Curve. It is always going to be upward sloping to some degree or another due to the

Price/Qty. Supplied relationship indicated in number one. This is very important because when we put supply

and demand together, you can see why prices rise when demand for a good rises.

3. Note that this is the overall supply for a given market and not just for one single firm in the market. This graph

represents the sum of all firms, an individual firms supply curve may look very different than that of the market

overall.

SUPPLY

SCHEDULE

SUPPLY

CURVE

22

FROM CHANGES IN QUANTITY SUPPLIED TO CHANGES IN SUPPLY:

As you have seen in the supply reading and the schedule/graph above, changes in the market price of a good will cause firms

to supply either a greater of lesser QUANTITY of a good. Now we will look at the implications of a change in the underlying

conditions of supply which will cause the entire supply curve to SHIFT either outward or inward. As with demand you must keep the

idea of Cetaris Paribus in mind and make only one change at a time to see the results of the change. Things to look for on this graph:

1. Note the two different supply schedules, one for the old conditions and one for the new.

2. Note that the entire curve has SHIFTED to represent the new conditions.

3. Note the reason that it has shifted.

***KEEPING WITH OUR COOKIE THEME, ASSUME THAT THE CAFETERIA HAS PURCHASED A NEW COOKIE

OVEN THAT CAN MAKE COOKIES TWICE AS FAST AS THE OLD ONE. YOU WILL SEE THE RESULTS ON THE

SUPPLY SCHEDULE BELOW.

PRICE QTY. SUPPLIED (OLD) QTY. SUPPLIED (NEW)

.20 1 2

.40 2 3

.60 3 4

.80 4 5

1.00 5 6

PRICE

1.00

.80

.60

.40

.20

0 1 2 3 4 5 6 QTY. SUPPLIED

THINGS TO NOTE: 1. The entire supply curve shifted OUTWARD due to the change in technology in the cafeteria.

2. That the firm will now supply more output at ANY given price due to the fact that it is cheaper to create each additional unit

of output.

3. In the end this will lower overall prices in the market because the supply of the good has increased. This is what is meant

when people say that increasing supply lowers prices.

SUPPLY

CURVE 1

NEW SUPPLY

CURVE 2

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EQUILIBRIUM: WHEN SUPPLY AND DEMAND MEET AND FALL IN LOVE (FOR NOW!)

If someone says that their equilibrium is off due to an inner ear infection the signs are readily visible, trouble keeping balance

and seeing straight. After the problem corrects itself, everything is back to normal. EQUILIBRIUM is a condition where there are

no changes in outside forces to push something in one direction or another, simply put, it is a state of natural balance. With supply

and demand, equilibrium is a state where there are no other outside forces acting to push either supply or demand in another direction,

thus prices will settle at a certain level UNTIL some force acts to change it. These forces have already been outlined in the S/D

readings as their determinants so you should be intimately familiar with them. (No need to review RIGHT!) Below you will see our

original supply and demand schedules in the cafeteria cookie market as well as a graph that illustrates where equilibrium will occur in

the market. Pay attention to the following items to better understand this concept:

1. At what price on the supply and demand schedules are quantity EQUAL to one another?

2. Where to the two curves intersect?

PRICE QTY. DEMANDED QTY SUPPLIED

.20 5 1

.40 4 2

.60 3 3

.80 2 4

1.00 1 5

PRICE

1.00

.80

.60

.40

.20

0 1 2 3 4 5 QUANTITY

THINGS TO NOTE:

1. Equilibrium occurs under this set of conditions at .60 and at 3 cookies both supplied and demanded. This is where the market

price would settle until some outside force pushes it to a different level.

2. If the cafeteria would try to set a price higher than this level there would be cookies that were not sold (surplus)

3. If the cafeteria would try to set a price lower than this there would not be enough cookies (shortage)

4. If we apply either of the changes in the market that we used for the supply and demand examples we would see one curve or

the other shift either inward or outward. This would set a new price and a new level of equilibrium. Try this with either

example that we used earlier and see what happens. Just plot out the other combinations, one at a time, on this graph and find

the new point of intersection.

DEMAND

CURVE

SUPPLY

CURVE

EQUILIBRIUM

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PRICE CEILINGS AND FLOORS:

INTERFERENCES IN THE MARKETPLACE

As we have seen so far, the market economy does a very good job of associating our level of utility with the costs of

producers, and is continually setting and re-setting prices in the economy. All of this activity takes place because of the millions of

combined decisions of consumers and producers in the economy, and serves as a stark reminder that our economy is always in motion,

and is always striving to allocate resources to the areas that place the highest value on them. While the market system does a good job

at this task, there are times when some goods are perceived to be too expensive, or when producers of certain goods need help just to

stay in business. It is times like these that we look to the government for help, and ask for some intervention on the part of the

government to solve the problem.

The minimum wage is a good example. It guarantees a certain wage to workers for each hour of labor that they provide.

Another example occurs in some of America’s largest cities, when citizens complain of rent being too high, and the government puts a

ceiling on rent so that people can afford to live in a particular area. While both of these ideas, particularly the minimum wage, may

seem like good ones; they are indeed interfering with very powerful forces. They act as limits that control some of the most basic

aspects of human nature, and in doing so, they can cause unintended consequences and impose unintended costs on the very people

that they seek to help. Let us now look at the two major tools that the government uses to try to cure some of the market systems’ ails.

A. PRICE CEILINGS: These are nothing more than maximum prices that the government sets for certain products that

society perceives as being too high. The government sets the maximum prices that people are allowed to charge for

something, and makes it illegal to charge more for these goods and services.

EXAMPLE: In New York City the local government has set a ceiling on the amount of money that a landlord can

charge for square feet of apartment space in certain areas of the city. The intent is to give the people affordable housing,

but it ignores some of the basic laws of supply and demand in doing so. Thus, it can create some unintended

consequences.

B. PRICE FLOORS: These are just the opposite of price ceilings, and this is when the government sets prices on

something that must be accepted as an absolute minimum. The intent is usually to help out a particular group of people

who are having trouble in a particular industry or area of the economy.

EXAMPLE: The minimum wage is the example that you are most familiar with. The intent is to guarantee people a

minimum level of income for hours worked so that they will be able to survive. High school students love the minimum

wage, yet it does have important consequences in job markets that the writers of such laws often do not consider, or at

least feel that the benefits of such laws will outweigh the costs.

OUTCOMES OF PRICE CEILINGS AND FLOORS: As mentioned above, government interference in markets often cause

unintended consequences due to their interference with the basic principles of supply and demand. Let us look at these outcomes with

a little supply and demand analysis.

P

EFFECTS OF A PRICE CEILING:

A. Increases the quantity demanded

B. Decreases the quantity supplied

C. Black markets and waiting lists often develop in the market

Q P

EFFECTS OF A PRICE FLOOR:

A. Decreases the quantity demanded

B. Increases the quantity supplied

C. Leads to overproduction and oversupply of a good in a market Q