Economic Units and Circular Flow

Basic Economic Units

• A firm transforms resources (inputs) into products (outputs).
• Firms serve as the primary producing units within a market economy.
• An entrepreneur organizes, manages, and assumes the risks of a firm.
• Entrepreneurs take new ideas or products and turn them into successful businesses.
• Households are the consuming units in an economy.

Circular Flow of Economic Activity

• Economic activity's circular flow highlights connections between firms and households.
• It takes into account both input and output markets.

Input and Output Markets

• Output or product markets are markets where goods and services are exchanged.
• Input markets concern the exchange of resources, like labor, capital, and land, used to produce products.
• Payments flow counterclockwise, opposite the physical flow of resources, goods, and services.

Input Markets

• Labor markets comprise households supplying work for wages, and firms demanding that labor.
• Capital markets entail households supplying savings for interest or future claims, and firms asking for funds to buy capital goods.
• In Land markets, households supply land or real property in return for rent.

Household Demand

• Household demand is determined by the product price.
• Household income, and the prices of related products are key determinants.
• Household preferences have a significant impact on demand
• The households' expectations about income, wealth, and prices affect demand
• The population size also has an impact

Quantity Demanded

• Quantity demanded refers to the amount of a product a household will purchase in a given period.
• This assumes the household can buy all it wants at the current market price.

Demand Schedules and Curves

• A demand schedule is a table that reveals the amount of a product a household is willing to buy at different prices.
• Demand curves are derived from these demand schedules.
• A demand curve is a graph that illustrates how much of a product a household is willing to buy at different prices.

Law of Demand

• The law of demand establishes an inverse relationship between price and the quantity of a good demanded (ceteris paribus).
• Demand curves slope downward to represent this relationship.
  • Ceteris Paribus holds all other things constant.
• Demand curves intersect the X-axis (quantity) because of time limitations and marginal utility.
• Demand curves intersect the Y-axis (price) due to limited incomes and wealth.

Income and Wealth

• Income Includes wages, salaries, profits, interest, rents, is measured as a flow
• Wealth, is net worth, (assets minus liabilities) and is measured as stock

Related Goods and Services

• Normal Goods: Demand rises as income increases, and falls as income decreases.
• Inferior Goods: Demand falls when income rises.
• Substitutes: Goods serve as replacements for each other; demand for one increases when the price of the other rises. P1↑, D2↑
• Complements: Goods that "go together"; a decrease in the price of one leads to increased demand for the other, and vice versa. P1↓, D2↑

Demand Shifts

• A change in demand differs from a change in quantity demanded.
• Quantity demanded changes due to a price change.
• Changes in demand determinants (excluding price) cause a demand change or a demand curve shift.
• With demand shifts, demand increases and the Quantity also increase.

Increased Demand

• Increased demand shifts the demand curve to the right
• Quantity demanded increases when the demand curve shifts right due to price level.

Supply Schedules and Curves

• A supply schedule is a table showing how much product firms will supply at different prices.
• Quantity supplied is the number of units a firm will offer at a specific price during a time period.
• A supply curve illustrates on a graph how much on a product a firm will supply at different prices.
• The law of supply establishes a positive relationship between price and quantity supplied (ceteris paribus).
• The price of a good/service, and the cost of producing it are key determinants for supply.
• Supply curves have a positive slope.
• Change in production costs (price of required inputs, labor, capital, land), technology, and prices of related products all affect supply.

Supply Shifts

• Change in price of good indicates change quantity supplied
• Change in non price determinants indicate change in supply

Market Supply

• Market supply aggregates the supply of a service from all firms in a market or industry.
• Market supply involves the horizontal summation of individual firms' supply curves.

Market Equilibrium

• Market operation depends on the interaction between buyers and sellers.
• Equilibrium indicates a situation where supply equals demand.
• At equilibrium, there isn't any pressure for the market price to change.
• Quantity supplied equals quantity demanded only in equilibrium; buyer and Seller wishes do not align at at any other price point.

Market Disequilibrium

• Excess demand is were Quantity demanded exceed quantity supplied.
• Excess supply is where quantity supplied exceeds quantity demanded.
• When demands exceeds supply the price tends to rises to restore equilibrium.
• When supply exceeds demand, the price tends to fall to restore equilibrium.

Changes in Demand and Supply

• Higher demand leads to both higher equilibrium prices and higher quantities.
• Higher supply leads to lower equilibrium prices and higher quantities.
• Lower demand leads to lower prices and quantities exchanged.
• Lower supply leads to higher prices and lower quantities exchanged.

Impact of simultaneous changes in supply and demand

• When both supply and demand increase, quantity will increase.
• The direction in which the market price will move depends on the relative magnitude of the shifts in supply and demand.

Concept of Elasticity

• Elasticity is the ratio of the % increase in quantity to the % increase in what affects it.
• Price Elasticity of Demand is based upon the ratio between a % change in quantity demanded due to a corresponding % change in price.
• Elastic demand schedules are those whose computed elasticities are numerically greater than one (e > 1 ).
• A change in price results in a more than proportionate change in quantity demanded for elastic goods.
• With unitary elasticity, percentage change in price equals resulting percentage change in quantity demanded (e = 1).
• With Inelastic demand, elasticity is numerically less than one; a change in price is accompanied by a less than proportionate change in quantity demanded. (e < 1)