Economics is a social science that studies how scarce resources are allocated to

satisfy needs and wants.

Microeconomics – this is concerned with the consumption, production and

distribution of goods and services, and focuses on individuals, firms and
government behaviour.

Macroeconomics – this focuses on the economy as a whole, in areas such as

national income, inflation, unemployment, growth, development, government
spending, and international trade.

Positive statements are based on facts. They can be verified by evidence.

Normative statements are based on opinion. They cannot be verified by

evidence. “Should” and “Ought” are usually used in normative statements.

Resources refer to all inputs used in the production process.

Goods are tangible things that are produced for consumers to satisfy their needs
and wants. Consumer goods are consumed for the purpose of satisfying needs
and wants. Capital goods are used in the production process to make a final good
or service. Milk is a consumer good if consumed as it is, but is a capital good if it is
used in the production of ice cream or punch.
 Services are intangible things that are used to satisfy needs and wants. They are
not physical. They can be experienced but not touched.

The Central Problem of economics is SCARCITY. Scarcity means “limited in

supply” and it is the direct result of limited resources and unlimited wants. It is
impossible to supply unlimited wants with limited resources so CHOICES have to
be made concerning the best way to use or allocate the resources. The presence
of choice means that some alternative uses for the scarce resources would not be
chosen. The next best alternative forgone is called the OPPORTUNITY COST. If the
different uses for the resources were prioritized and the number 1 priority was
chosen, then the number 2 on the list is the opportunity cost.

Scarcity, choice and opportunity cost can be demonstrated on a special graph

called the PPF – the Production Possibilities Frontier (or PPC – production
possibilities curve). It is an abstract curve used to demonstrate an economy’s
production capacity from its given resources. It shows all the possible
combinations of the two goods that can be produced from a country’s resources.

Assumptions:
Only 2 goods are produced.
Technology is fixed.
The PPF is concave to the origin.

Good Y
 Attainable and
efficient
Unattainable

100

80

PPF
60
Attainable but
inefficient

Good X
90 100 105
0

 Points above the frontier might be desired but they are not attainable
because there are just not enough resources to produce them. They are in
the realm of unlimited wants.
  Points below the frontier are attainable because there are enough
resources to produce them but they are inefficient because all resources
are not being used. More of both goods can be made if the country makes
full use of its resources.

 Points on the frontier show the combinations of goods/services that can be

made with full use of the country’s resources. There is full employment of
resources. These combinations are therefore attainable and efficient.
Efficiency is divided into two subgroups: productive efficiency (producing
the largest quantity of goods and services possible with given resources)
and allocative efficiency (choosing the best combination or best point on
the frontier out of all the combinations/points on the frontier to maximize
the well-being of everyone).

The PPF shows scarcity because it shows a limit to the amount of goods and
services that can be produced, and this limit is a direct result of limited resources.
So the curve itself demonstrates scarcity.
The PPF shows choice because only 2 goods can be produced from the country’s
resources and different combinations (or choices) are shown on and below the
curve.
The PPF shows opportunity cost because any change in production from one
point to another on the curve would necessitate giving up some of one good to
get more of the other. Increasing production from 60 units of Good Y to 80 units,
necessitates reducing production of Good X from 105 units to 100.
The opportunity cost can be calculated by using the concept of gradient from
mathematics.
change∈ y y 2− y 1 80−60 20
Gradient/slope = change∈ x = x 2−x 1 = 100−105 = −5 = -4

The slope is negative because less of one good has to be produced to have more
of the other good.

The concave shape of the PPF demonstrates decreasing opportunity cost. What
this means is that each time more of one good is produced, less of the other good
has to be given up than before. To increase production of Good Y from 60 to 80 (a
difference of 20), 10 units of Good X had to be given up. To further increase
production of Good Y from 80 to 100 units (the same difference of 20), only 5
further units of Good X had to be given up. This is less than the 10 from before.
The opportunity cost has decreased.
This can also be proven by calculating gradient:
To move from 60 to 80 units of Good Y, the gradient was -4. It was calculated
above.
To move from 80 to 100 units of Good Y, the gradient is now -2.
change∈ y y 2− y 1 100−80 20
Gradient/slope = change∈ x = x 2−x 1 = 90−100 = −10 = -2

Ignoring the minus sign, 2 is less than 4, therefore the opportunity cost
decreased.

There can be increasing opportunity cost if the PPF is drawn convex to the origin.
This means that more and more of one good has to be given up each time the
same amount of additional units of the other good are produced.
There can be constant opportunity cost if the PPF is drawn as a straight line. This
means that the same amount of one good has to be given up each time additional
units of the other good are produced.

Increasing returns to
scale Constant returns to scale

Scarcity causes all societies to face three basic questions:

 WHAT to produce?
 HOW to produce it?
 FOR WHOM to produce it?
Different societies answer these questions in different ways, leading to 4
categories of economic systems:
 Traditional economies
 Free market economies
 Planned economies
  Mixed economies

Economic System Features/Description/ Advantages Disadvantages The answers to the Examples

Characteristics 3 basic questions

Traditional/ It is run based on The three basic Indigenous tribes

Subsistence tradition and customs question are in Africa, Asia and
passed down through answered by the South America.
generations. tradition or
Subsistence activities customs.
include hunting,
fishing, farming, tool
making, and
agriculture.
Individuals have
assigned roles or
tasks to perform, and
there is unity among
community members.
New ways of doing
things are not
encouraged.

Free Market/Free All productive There is consumer No provision or The price No country is
Enterprise/ resources are owned sovereignty, since inadequate mechanism/market purely free
Market/Capitalist by private individuals. consumers decide provision of forces/demand and market. The U.S.A.
People are motivated what gets essential supply answer the comes close.
by personal gain. For produced (by what commodities basic economic
example: they demand). (called merit goods questions.
maximization of The profit motive and public goods).
profit is the main goal of businesses Market failure.
of business and encourages Unequal
maximization of innovation, distribution of
satisfaction is the inventions, and wealth.
main goal of technological Demerit goods get
consumers. development. produced, such as
The price mechanism Productive and alcohol and
(or the market allocative tobacco.
system) determines efficiency (together Economic
economic activity. they are called instability
This means that Pareto efficiency). sometimes, such as
demand and supply inflation and
determine economic recession.
activity.
 Goods and services
are distributed
according to
purchasing power.

Planned/Centrally All productive Allocative Imperfect The three basic China, Cuba, North
Planned/Command/ resources are owned efficiency is information may question are Korea.
Communist/Egalitarian by the state. pursued. cause some of the answered by the
The state makes all Full employment of state’s decisions state.
economic decisions. resources. not to be optimal.
Private individuals do Prevention of Lack of freedom of
not have any input. economic choice of
The well-being of the instability such as individuals in
society is generally inflation and economic matters.
the main goal of the recession. No productive
state. Equality is efficiency.
Full employment of achieved.
resources.
Goods and services
distributed equitably.

Mixed Some economic Some of the Some of the The three basic
decisions are made advantages of both disadvantages of questions are
by the state and free market and both free market answered jointly by
some by private planned and planned the state and
individuals. For economies. economies. private individuals.
example, the state
provides merit goods
and public goods that
the private sector
won’t.
Demand Theory

Consumers are groups of individuals who consume final goods and services.

Assumptions about consumers:

o Consumers are utility maximizers (they want to maximize satisfaction)
o Consumers are rational (they want the maximum satisfaction for the lowest
price).
Consumer demand (or market demand or just demand) refers to the total
quantity of goods and services that are purchased at a given price over a given
period of time.

Effective demand is the quantity of goods and services for which there is a desire,
willingness and ability to be purchased at a given price over a given period of
time.

Latent demand refers to the quantity of goods and services for which there is a
desire and willingness to be purchased, but not the ability, at a given price over a
given period of time.

There are two ways of describing consumer behaviour:

1. Marginal Utility Theory, also called the Cardinalist Approach because
cardinal numbers are used to represent consumers’ utility.
 2. Indifference Curve Theory, also called the Ordinalist Approach because
utility is ordered (ranked).

Marginal Utility Theory

Utility = satisfaction
The unit for measuring utility/satisfaction = utils
An individual can state how much satisfaction they get from the consumption of a
good or service by the number of utils. They can make up an arbitrary number of
utils.

Total Utility is the total satisfaction derived from consuming a good or service. It
is cumulative. It takes into account all the units of the good or service that are
consumed.

Marginal Utility is the additional satisfaction derived from consuming just one
additional unit of a good or service.
change∈total utility ∆ TU
MU = change∈the quantity of goods∨services = ∆ Q

Diminishing marginal utility occurs when consumption of more and more of a

good or service leads to lower levels of utility each time.

Consumers are concerned with the marginal utility per dollar ¿]

They equalize the marginal utility per dollar for every good or service that they
purchase. This is when CONSUMER EQUILIBRIUM is achieved. Therefore,
 MU MU MU
of good X = of good Y = of good Z etc
Price Price Price

Note that they must use up all of their income/budget.

If one good has a GREATER marginal utility per dollar than the other good, then
the consumer should consume MORE of it, till diminishing marginal utility causes
it to equalize with the other good.
If one good has a SMALLER marginal utility per dollar than the other good, then
the consumer should consume LESS of it, till it equalizes with the other good.

Limitation of marginal utility theory: the utils are arbitrary (or subjective). This
means that consumers can make up any number to represent satisfaction, and
different customers can make up different numbers to represent the same level
of utility. Therefore measuring utility accurately for comparison is difficult.

Indifference Curve Theory

The limitations of marginal utility theory led to the development of the

indifference curve theory. Utils are not needed. Consumers just need to order or
rank their satisfaction.

The analysis needs two parts: an indifference curve and a budget line (or budget
constraint).

Indifference Curves
 An indifference curve shows all the combinations of two goods or services
that give the consumer the same level of satisfaction so the consumer is
indifferent about which of the possible combinations to choose.
It is convex to the origin. Thus it has a negative slope. The slope is called the
marginal rate of substitution.
Two indifference curves will never intersect.
A higher indifference curve represents higher satisfaction. Higher
satisfaction is always preferred, since consumers are utility maximizers.
Thus every combination of goods or services on the higher indifference
curve are preferred to combinations on lower indifference curves.
Many indifference curves are called an indifference map.

The budget line

The budget line shows all the combinations of two goods or services that
the consumer can afford with a given budget/income.
The budget line is a straight line that slopes downward. The slope is called
the Price Ratio since it takes into account the prices of both goods/services.
The budget line can shift if (i) prices of the two goods/services change or if
(ii) income/budget changes. The budget line can pivot if the price of one
good/service changes while the price of the other remains the same.
 Good Y Good Y

Income
price of Y Income
price of Y

Income
price of Y

0 Good X Good X
0 Income Income
Income Income
price of X price of X price of X price of X

Consumer equilibrium occurs when the indifference curve is tangent to the

budget line. Lower indifference curves do not maximize utility and higher
indifference curves represent unaffordable combinations of goods and services.
The indifference curve that touches the budget line represents the combinations
of goods and services that give the highest utility and that can be afforded.
 Good Y

0
Good X

Individual Demand Curves

Both the Marginal Utility Approach and the Indifference Curve Approach reveal
something if the price of one good changes – the quantity demanded will change
also, in the opposite direction. That is, if the price of a good increases, the
quantity demanded will decrease, and vice versa. This gives rise to a downward
sloping individual demand curve. It shows the relationship between the price of a
good or service and the quantity demanded.

Price

P1

Demand

Quantity
0 Q1

The market demand curve is exactly the same and shows the sum of all the
quantities demanded by each individual in the market.

The demand curve is represented as a straight line for simplicity, but is closer to a
curve in real life. It illustrates the Law of Demand: that there is an inverse
relationship between price of a good/service or quantity demanded, ceteris
paribus. In other words, if price increases, quantity demanded will decrease, and
if price decreases, quantity demanded will increase. They move in opposite
directions.
Ceteris paribus is a Latin phrase that means “all other things constant.” In other
words, quantity demanded and price will behave this way only if nothing else is
influencing demand. We must allow price to be the only factor influencing
demand in order to observe this result. Other factors could cause a different
result to occur. So two situations emerge from this understanding:
(i) What happens when price changes but all other possible factors remain
the same?
(i) What happens when price remains the same but any of the other
possible factors changes?
To answer the first question: As seen before, when price changes, it causes
quantity demanded to change (in the opposite direction). Graphically, this is
shown as a movement along the demand curve. A movement to the right is called
an extension of demand and means that quantity demanded has risen. A
movement to the left is called a contraction of demand and means that quantity
demanded has declined.

Price

Contraction of Demand
(Quantity decreased)

P1

Extension of Demand
(Quantity increased)
 0 Quantity
Q1

To answer the second question: there are other things that affect quantity
demanded, even when the price does not change. These lead to a shift of the
demand curve. A shift to the right is called an increase in demand, and quantity
increases. A shift to the left is called a decrease in demand, and quantity
decreases.

Price

Increase in Demand
Decrease in Demand

P1

D2

D1
D3

Quantity
 0
Q3 Q1 Q2

The difference in language is subtle but important:

Factor that causes the change Jargon used
When price causes the change Extension, Contraction, Movement
along the demand curve, Quantity
demanded has changed
When any factor other than price Increase in demand, Decrease in
causes the change demand, Shift of the demand curve,
Demand has changed (leave out the
word “quantity”)

Determinants of Demand (factors that can cause the demand curve to shift):
 Changes in income
 Expectations of a price change
 Price changes of substitute goods or complementary goods
 Changes in the size or composition of the population
 Seasonal factors
 Advertising
 Changes in the distribution of income (from the rich to the poor, for
example)
 Government influences (such as taxes or legislation)
  Innovation (that causes obsolete or outdated goods to be replaced by
newer ones).

Elasticity of Demand
Elasticity of demand is a measure of the responsiveness of quantity demanded to
changes in any of the factors that affect it. The most widely examined type of
elasticity of demand is Price Elasticity of Demand (P.E.D.).
P.E.D. is a measure of the responsiveness of quantity of a good or service
demanded to changes in its price. In other words, if price changes, would there be
a big change or a small change or no change at all in the quantity that people
demand?

percentage change ∈quantity demanded % ∆ Q

P.E.D. = percentage change∈ price
= %∆P

∆Q original/ previous price

Alternatively, P.E.D. = ∆ P x original/ previous quantity

When given 2 prices and their resulting quantities demanded, calculate P.E.D.
using the formula above, then take its absolute value (meaning ignore the minus
sign and use only the digits), and find what category it belongs to from the table
below:

P.E.D. Result Degree/Category Meaning Interpretation Graph

of Elasticity
P.E.D. = 0 Perfectly price A change in A 1% change in
inelastic price would price will cause a
cause (P.E.D.) % change
absolutely no in quantity
 change in demanded.
quantity
demanded
P.E.D. ˂ 1 Price inelastic A change in A 1% change in
price would price will cause a
cause a less (P.E.D.) % change
than in quantity
proportionate demanded.
change in
quantity
demanded
P.E.D. = 1 Unitary Price A change in A 1% change in
elasticity price would price will cause a
cause exactly (P.E.D.) % change
the same in quantity
percentage demanded.
change in
quantity
demanded
P.E.D. ˃ 1 Price Elastic A change in A 1% change in
price would price will cause a
cause a greater (P.E.D.) % change
proportionate in quantity
change in demanded.
quantity
demanded
P.E.D. = ∞ Perfectly Price Quantity A 1% change in
Elastic demanded price will cause a
would change (P.E.D.) % change
by an infinite in quantity
amount even demanded.
with no change
in price.

Factors affecting P.E.D.

 Substitutes: the more substitutes there are for a good or service, the more
likely consumers would be to switch to the cheaper substitute. Therefore,
many substitutes = more price elastic demand, few or no substitutes = less
price elastic demand.
 Time: time is related to the point above. The more time that consumers
have to search for substitutes, the more price elastic demand would be.
Therefore, more time = more price elastic, less time = less price elastic.
  Income: the greater the amount of one’s income spent on the good or
service, the more a price change would evoke a response in you. Therefore,
good costs a high proportion of income = more price elastic demand, good
costs a low proportion of income = less price elastic demand.
 Addiction/Necessity: the more addictive or necessary for survival a good or
service is, the less a price change would affect quantity demanded.
Therefore, addictive good/necessity = less price elastic, non-addictive
good/non-necessity = more price elastic.

Importance of P.E.D.
If a good has price elastic demand, then price could be lowered and it would lead
to a greater than proportionate increase in quantity demanded, and hence
greater revenue. But if price is increased, the opposite would happen – loss of
revenue.
If a good has price inelastic demand, then price could be increased and it would
lead to an increase in revenue, but if price is lowered, it would lead to loss of
revenue. Businesses can determine which type of price elasticity of demand their
customers have and decide whether it is better to increase or decrease price in
order to raise revenue. Governments can also increase taxes on price inelastic
goods and services (alcohol, casinos, lotto etc) to raise revenue, but lower taxes
on price elastic goods and services.

Another type of elasticity of demand is Income Elasticity of Demand: a measure

of the responsiveness of quantity demanded to changes in income.
“Income” is represented by the letter Y.
 percentage change ∈quantity demanded % ∆ Q
Y.E.D. = = percentage change∈income
= %∆Y

It is the same formula as P.E.D. but price (P) is replaced by income (Y).
When Y.E.D. ˂ 0, the good or service is “inferior”
When Y.E.D. ˂ 1, the good is income inelastic
When Y.E.D. = 1, the good is unitary income elastic
When Y.E.D. ˃ 1, the good is “normal”

Importance of Y.E.D.
Business can pay attention to changes in their customers’ incomes, such as when
trade unions negotiate for higher wages, and determine whether or not their
demand will increase or decrease, based on whether the goods or services that
they provide are “inferior” or “normal”.

Another type of elasticity of demand is Cross Elasticity of Demand: a measure of

the responsiveness of quantity of a good demanded to changes in the price of a
different good (like a substitute or complementary good).
“Cross” is represented by the letter X.
percentage change ∈quantity of good A demanded % ∆ Qa
X.E.D. = = percentagechange ∈ price of good B
= % ∆ Pb

It is the same formula as P.E.D. but price (P) is for one good and Quantity (Q) is for
a different good.
When X.E.D. ˃ 0, the two goods are substitutes (like bmobile and digicel service)
When X.E.D. ˂ 0, the two goods are complementary (must be used together, like
shampoo and conditioner)
When X.E.D. = 0, there is no relationship between the two goods.
Importance of X.E.D.
Businesses can use cross elasticity of demand to calculate how much the demand
for their good or service would change by if the price of its substitute or
complement changes.