Chapter 1. Introduction: Markets and Prices
Microeconomics is the branch that deals with the behavior of individual economic units –
consumers, firms, workers, and investors – as well as the markets that these units comprise.
In economics, as in other sciences, explanation and prediction are based on theories. Theories
are developed to explain observed phenomena in terms of a set of basic rules and
assumptions. Microeconomics is concerned with both positive and normative questions.
Positive questions deal with explanation and prediction (you can verify and test), normative
questions with what ought to be (judgements).
Markets: the collection of buyers and sellers that, through their actual or potential
interactions, determine the price of a product or set of products. Economists are often
concerned with market definition – with determining which buyers and sellers should be
included in a particular market.
Market definition is important for two reasons:
• A company must understand who its actual and potential competitors are for the
various products that it sells or might sell in the future. It must also know the product
boundaries and geographical boundaries of its market, to set the price, determine
advertising budgets, and make capital investment decisions.
• Important for public policy decisions.
Significant differences in the price of a commodity create a potential for arbitrage: buying at
a low price in one location and selling at a higher price somewhere else.
A perfectly competitive market has many buyers and sellers, so that no single buyer or seller
has any impact on price. Some markets contain many producers but are noncompetitive;
individual firms can jointly affect the price, also known as cartels. In a perfectly competitive
market, the market price will usually prevail.
The nominal price of a good is its absolute price. The real price of a good is the price relative
to an aggregate measure of prices (price adjusted for inflation). The Consumer Price Index
(CPI) records how the cost of a large market basket of goods purchased by a “typical”
consumer change over time. Percentage changes in the CPI measure the rate of inflation in
the economy. The Producer Price Index (PPI) calculates how prices at the wholesale level
change over time. They measure cost inflation and predict future changes in the CPI. CPI is
used for consumers and PPI for businesses.
Chapter 2: The basics of Supply and Demand
The supply curve shows the quantity of a good that producers are willing to sell at a given
price. Slopes upward, because the higher the price, the more that firms are able and willing to
produce and sell. When production costs decrease, output increases (shift to the right).
Changes in price are represented by moves along the supply curve. The demand curve shows
,how much of goods consumers are willing to buy as the price per unit changes. Slopes
downward: consumers buy more if the price is lower.
Substitutes = an increase in the price of one good leads to an increase in the quantity
demanded of the other. Most consumers are willing to shift their purchases from one to the
other when prices change.
Complements = increase in the price of one good leads to a decrease in the quantity
demanded for the other. The goods tend to be used together.
Independent = two goods are independent if a change in the price of one good has no effect
on the quantity demanded of the other.
Equilibrium is the point where price equates the quantity supplied to the quantity demanded.
The market mechanism is the tendency in a free market for the price for the price to change
until the market clears (equilibrium).
A surplus is the situation in which the quantity supplied exceeds the quantity demanded.
Producers try to produce and sell more than consumers are willing to buy. To sell this,
producers need to lower prices until equilibrium reaches. A shortage occurs when quantity
demanded exceeds the quantity supplied.
Elasticity measures the sensitivity of one variable to another. It tells us the percentage change
that will occur in one variable in response to a 1-percent increase in another variable.
Price elasticity of demand:
Or
The price elasticity of demand is usually a negative number. When the price of a good
increases, the quantity demanded usually falls. When the price elasticity is less than 1,
demand is said to be price inelastic. When greater than 1, is it price elastic. The price elasticity
of demand for a good depends on availability of other goods that can be substituted. When
there are close substitutes, a price increase will cause the consumer to buy more of the
substitute. Demand will then be highly price elastic. No close substitutes will tend to have an
inelastic price.
The price elasticity of demand must be measured at a particular point on the demand curve
and will generally change as we move along the curve. This is easy to see for a linear demand
curve – in the form of:
, Q = a – bP.
For any price and quantity combination, the steeper the slope of the curve, the less elastic is
demand. Infinitely elastic demand (a) is the principle that consumers will buy as much of a
good as they can get a single price, but for any higher price the quantity demanded drops to
zero, while for any lower price the quantity increases without limit. Completely inelastic
demand (b) is the principle that consumers will buy a fixed quantity of a good regardless of
its price.
Demand for most goods usually rises when aggregate income rises (the total income of all
businesses, people, and governments in an economy). The income elasticity of demand is the
percentage change in the quantity demanded, Q, resulting from a 1-percent change increase
in income I:
The demand of some goods is also affected by the prices of other goods. A cross-price
elasticity of demand refers to the percentage change in the quantity demanded for a good
that results in a 1-percent increase in the price of another good.
The cross-price elasticities will be positive if the products are substitutes, because a rise in the
price of good A, leads to an increase in the quantity of good B demanded. If the products are
complements, the cross-price elasticity will be negative because the products tend to be used
together. An increase in the price of one tends to push down the consumption of the other.
Elasticities of supply are defined in a similar manner: the change in the quantity supplied
resulting from a 1-percent increase in price. This is usually positive because a higher price
gives producers an incentive to increase output. With respect to variables such as interest
Microeconomics is the branch that deals with the behavior of individual economic units –
consumers, firms, workers, and investors – as well as the markets that these units comprise.
In economics, as in other sciences, explanation and prediction are based on theories. Theories
are developed to explain observed phenomena in terms of a set of basic rules and
assumptions. Microeconomics is concerned with both positive and normative questions.
Positive questions deal with explanation and prediction (you can verify and test), normative
questions with what ought to be (judgements).
Markets: the collection of buyers and sellers that, through their actual or potential
interactions, determine the price of a product or set of products. Economists are often
concerned with market definition – with determining which buyers and sellers should be
included in a particular market.
Market definition is important for two reasons:
• A company must understand who its actual and potential competitors are for the
various products that it sells or might sell in the future. It must also know the product
boundaries and geographical boundaries of its market, to set the price, determine
advertising budgets, and make capital investment decisions.
• Important for public policy decisions.
Significant differences in the price of a commodity create a potential for arbitrage: buying at
a low price in one location and selling at a higher price somewhere else.
A perfectly competitive market has many buyers and sellers, so that no single buyer or seller
has any impact on price. Some markets contain many producers but are noncompetitive;
individual firms can jointly affect the price, also known as cartels. In a perfectly competitive
market, the market price will usually prevail.
The nominal price of a good is its absolute price. The real price of a good is the price relative
to an aggregate measure of prices (price adjusted for inflation). The Consumer Price Index
(CPI) records how the cost of a large market basket of goods purchased by a “typical”
consumer change over time. Percentage changes in the CPI measure the rate of inflation in
the economy. The Producer Price Index (PPI) calculates how prices at the wholesale level
change over time. They measure cost inflation and predict future changes in the CPI. CPI is
used for consumers and PPI for businesses.
Chapter 2: The basics of Supply and Demand
The supply curve shows the quantity of a good that producers are willing to sell at a given
price. Slopes upward, because the higher the price, the more that firms are able and willing to
produce and sell. When production costs decrease, output increases (shift to the right).
Changes in price are represented by moves along the supply curve. The demand curve shows
,how much of goods consumers are willing to buy as the price per unit changes. Slopes
downward: consumers buy more if the price is lower.
Substitutes = an increase in the price of one good leads to an increase in the quantity
demanded of the other. Most consumers are willing to shift their purchases from one to the
other when prices change.
Complements = increase in the price of one good leads to a decrease in the quantity
demanded for the other. The goods tend to be used together.
Independent = two goods are independent if a change in the price of one good has no effect
on the quantity demanded of the other.
Equilibrium is the point where price equates the quantity supplied to the quantity demanded.
The market mechanism is the tendency in a free market for the price for the price to change
until the market clears (equilibrium).
A surplus is the situation in which the quantity supplied exceeds the quantity demanded.
Producers try to produce and sell more than consumers are willing to buy. To sell this,
producers need to lower prices until equilibrium reaches. A shortage occurs when quantity
demanded exceeds the quantity supplied.
Elasticity measures the sensitivity of one variable to another. It tells us the percentage change
that will occur in one variable in response to a 1-percent increase in another variable.
Price elasticity of demand:
Or
The price elasticity of demand is usually a negative number. When the price of a good
increases, the quantity demanded usually falls. When the price elasticity is less than 1,
demand is said to be price inelastic. When greater than 1, is it price elastic. The price elasticity
of demand for a good depends on availability of other goods that can be substituted. When
there are close substitutes, a price increase will cause the consumer to buy more of the
substitute. Demand will then be highly price elastic. No close substitutes will tend to have an
inelastic price.
The price elasticity of demand must be measured at a particular point on the demand curve
and will generally change as we move along the curve. This is easy to see for a linear demand
curve – in the form of:
, Q = a – bP.
For any price and quantity combination, the steeper the slope of the curve, the less elastic is
demand. Infinitely elastic demand (a) is the principle that consumers will buy as much of a
good as they can get a single price, but for any higher price the quantity demanded drops to
zero, while for any lower price the quantity increases without limit. Completely inelastic
demand (b) is the principle that consumers will buy a fixed quantity of a good regardless of
its price.
Demand for most goods usually rises when aggregate income rises (the total income of all
businesses, people, and governments in an economy). The income elasticity of demand is the
percentage change in the quantity demanded, Q, resulting from a 1-percent change increase
in income I:
The demand of some goods is also affected by the prices of other goods. A cross-price
elasticity of demand refers to the percentage change in the quantity demanded for a good
that results in a 1-percent increase in the price of another good.
The cross-price elasticities will be positive if the products are substitutes, because a rise in the
price of good A, leads to an increase in the quantity of good B demanded. If the products are
complements, the cross-price elasticity will be negative because the products tend to be used
together. An increase in the price of one tends to push down the consumption of the other.
Elasticities of supply are defined in a similar manner: the change in the quantity supplied
resulting from a 1-percent increase in price. This is usually positive because a higher price
gives producers an incentive to increase output. With respect to variables such as interest
