Eco101 Principles of Economics PDF

School of Management Economics Department Principles of Economics "Economics 1" Dr. Fouad M. Eissa Head of Economics Department Modern University for Technology and Information...

School of Management Economics Department Principles of Economics "Economics 1" Dr. Fouad M. Eissa Head of Economics Department Modern University for Technology and Information (MTI) 0  Preface Economics exists as a discipline of study because the things that we value in our world are not available in a limitless supply. These things include, but certainly are not limited to, raw materials and resources, clean air and water, and all types of manufactured goods and services. If everyone in the world had all they could possibly hope for, there would be no need for economics. Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people. This text-book is written for readers and students who study business, accounting, marketing, information systems, financial institutions, and economics in Arabic and English. It provides readers and students with basic skills of handling topics of economics in the English language. This course includes eight chapters and questions for discussion at the end of each chapter, in order to help the student for the best understanding. I believe that instructor‘s skills will contribute a great deal to the overall usability of our text as part of a complete teaching/learning system. Dr. Fouad M. Eissa 1  Contents Chapter 1: Central Concepts of Economics 1.1 What is Economics? 1.2 Central economic problem - Scarcity and Choice 1.3 Macro and Microeconomics 1.4 Economic Goals 1.5 Marginalism – Benefits and Costs 1.6 Production Possibility Frontier (PPF) 1.7 Opportunity Cost 1.8 Economic Systems 1.9 Economic Role of Government  Questions for Review. Chapter 2: History of Economic Thought 2.1 Economic Thought Issues of the Past 2.2 Economic Thought Issues of the Present  Questions for Review Chapter 3: Demand and Supply 3.1 Introduction 3.2 The Demand 3.3 The Supply 3.4 Market Equilibrium 3.5 Shifts vs. Movement 3.6 Price Elasticity of Demand 3.7 Price Elasticity of Supply 2  3.8 Income Elasticity of Demand 3.9 Cross Elasticity of Demand  Questions for Review Chapter 4: Theory of Consumer Behavior 4.1 Introduction 4.2 Utility Theory 4.3 Law of Diminishing Marginal Utility 4.4 Indifference Preference Theory 4.5 Budget Line  Questions for Review. Chapter 5: Theory of Production 5.1 Production Function 5.2 Cost of Production 5.3 The Firm and Profit Maximization  Questions for Review. Chapter 6: Market Structure 6.1 Degrees of Competition 6.2 Perfect Competition 6.3 Monopoly Market 6.4 Oligopoly Market 6.5 Monopolistic Competition 6.6 Price Discrimination  Questions for Review. 3  Chapter 7: Distribution of Income 7.1 Definition of Income Distribution 7.2 Factors of Production 7.3 Computing of Income Distribution 7.4 Lorenz Curves and Gini Coefficients 7.5 Income Mobility. Questions for Review. Chapter 8: Overview of Macroeconomic 8.1 Introduction. 8.2 Goals of Macroeconomics. 8.3 National Income. 8.4 Business Cycle. 8.5 Inflation. 8.6 Unemployment.. 8.7 Money and Banking. 8.8 Macroeconomic Policy. 8.9 International Trade. 8.10 Economic performance and Growth  Questions for Review.  Glossary of Terms.  References. 4  Chapter One Central Concepts of Economics 5  Chapter One Central Concepts of Economics 1.1 What is Economics? Economics is the study of humanity‘s effort to satisfy unlimited wants by utilizing limited resources. The human science which studies the relationship between scarce resources and the various uses which compete for these resources. Most definitions of economics focus on scarcity and choice. To the economist virtually everything is scarce, not just diamonds or oil but bread and water. How can we say this? The answer is that one only has to look around the world to see there are not enough resources to give people all they want. Economics looks at people and production, markets and institutions, enterprise and exploitation, individual behavior and social relations, scarcity and choice, prosperity and poverty, power and free trade, national economic and globalization, efficiency and waste, crisis and growth, inequality and welfare, rent and reward, the creation and destruction of resources, the environment and the prospects for the economic future of humankind All other problems arise out of the problem of unlimited wants and limited resources, and all the most complicated relationships can be traced back to it. 6 Remember this definition well, and think about it as we proceed to consider some of the specific problems. This problem of using the scarce human and nonhuman resources to satisfy the infinite human wants is often called the basic economic problem. In order to begin our discussion of economics, we first need to understand the concept of scarcity and the two branches of study within economics: micro- economics and macroeconomics. 1.2 The Central economic problem "Scarcity and Choice" There are many specific economic problems (poverty, inflation, unemployment, etc.). However, if we use the term the economic problem we are referring to the overall problem of scarcity of resources. Hence, because they cannot have everything, individual and societies have to choose carefully when trying to make the best use of scarce resources. 1.2.1 Scarcity Scarcity, a concept refers to the tension between our limited resources and our unlimited wants and needs. For an individual, resources include time, money and skill. For a country, limited resources include natural resources, capital, labor force and technology. 7  Because all of our resources are limited in comparison to all of our wants and needs, individuals and nations have to make decisions regarding what goods and services they can buy and which ones they must forgo. For example, if you choose to buy one DVD as opposed to two video tapes, you must give up owning a second movie of inferior technology in exchange for the higher quality of the one DVD. Of course, each individual and nation will have different values, but by having different levels of (scarce) resources, people and nations each form some of these values as a result of the particular scarcities with which they are faced. So, because of scarcity, people and economies must make decisions over how to allocate their resources. Economics, in turn, aims to study why we make these decisions and how we allocate our resources most efficiently. Paul Samuelson noted that every economic society has to answer three fundamental questions arising from the economic problem: (what? how? and for whom?) - What goods are to be produced with the scarce resources (clothes, foods, cars and so on)? - How should we combine the resources to produce the goods and services that we want? 8 - For whom? Once we have produced goods and services we then have to decide how to distribute them among the people in the economy. 1.2.2 Economic goods and services Economic goods are those which are scarce in relation to the demand for them.  Wealth and Welfare An early definition of economics was that it is the study of wealth. By wealth the economist means all the real physical assets which make up our standard living (clothes, houses, food, roads, schools, hospitals, cars, oil tankers). Thus it is concerned not only with more economic goods but also with (public health, hours of work, law and order). Modern economics has tried to take account not only of the output of economic goods but also bad such as pollution and loss of pleasure from the natural environment.  Wealth and money Economics is not just about money as many people think. Indeed we could have an economy without money. Also, if we consider economics to be the study of wealth, it should be obvious that we could print twice as much money without the altering the real wealth of the economy. 9 1.3 Macro and Microeconomics There are two levels of analysis according to the approach or methodology at which the economist may derive laws concerning economic behavior. 1.3.1 Macroeconomics It deals either with the economy as a whole or with the basic subdivision or aggregates – such as the government, household, national income, inflation, unemployment and business sectors – making up the economy. An aggregate is a collection of specific economic units treated, as if they were one unit. Thus, we might find it convenient to lump together the over twenty million businesses in our economy and treat them as if they were one huge unit. In dealing with aggregates, macroeconomics is concerned with obtaining an overview, or general outline, of the structure of the economy and the relationships among the major aggregates constituting the economy. Macroeconomics speaks of such magnitudes as total output, total level of employment, total income, aggregate expenditures, the general level of prices, and so forth, in analyzing various economic problems. Macroeconomics examines the forest, not the tress. It gives us a bird‘s-eye view of the economy. Macro and microeconomics are the two vantage points from which the economy is observed. 10 Macroeconomics looks at the total output of a nation and the way the nation allocates its limited resources of land, labor and capital in an attempt to maximize production levels and promote trade and growth for future generations. After observing the society as a whole, Adam Smith noted that there was an "invisible hand" turning the wheels of the economy: a market force that keeps the economy functioning. 1.3.2 Microeconomics It deals with specific economics units and a detailed consideration of these individual units. At this level of analysis, the economist figuratively puts an economic unit, or very small segment of the economy, under the microscope to observe details of its operation. Here we talk of an individual industry, firm, or household, and concentrate on such magnitudes as the output or price of a specific product, the number of workers employed by a single firm, the revenue or income of a particular firm or household, or the expenditures of a given firm or family. In microeconomics we examine the trees, not the forest Microeconomics is useful in achieving a worm‘s-eye view of some specific component of our economic system. Microeconomics looks into similar issues, but on the level of the individual people and firms within the economy. It tends to be more scientific in its approach, 11 and studies the parts that make up the whole economy. Analyzing certain aspects of human behavior, microeconomics shows us how individuals and firms respond to changes in price and why they demand what they do at particular price levels. The market economy advocates forces within a competitive market, which constitute the "invisible hand", to determine how resources should be allocated. The command economic system relies on the government to decide how the country's resources would best be allocated. In both systems, however, scarcity and unlimited wants force governments and individuals to decide how best to manage resources and allocate them in the most efficient way possible. Nevertheless, there are always limits to what the economy and government can do. In microeconomics, supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium for price and quantity. 1.4 Economic Goals If economic policies are designed to achieve certain economic goals, then we need to recognize a 12 number of goals which are widely adopted in our own and many other societies. They include: A. Economic Growth The production of more and better goods and services, or more simply, a higher standard of living, is desired. B. Full Employment Suitable jobs should be available for all willing and able to work. C. Economic efficiency We want maximum benefits at minimum cost from the limited productive resources available. D. Price Level Stability Sizable upswings or downswings in the general price level, that inflation and deflation should be avoided. E. Economic Freedom Business executives, workers, and consumers should enjoy a high degree of freedom in their economic activities. F. An Equitable Distribution of Income No group of citizens should face stark poverty while others enjoy extreme luxury. 13 G. Economic Security: Provision should be made for those who are chronically ill, disabled, handicapped, laid off, aged, or otherwise unable to earn minimal levels of income. H. Balance of Trade We seek a reasonable balance in our international trade and financial transactions. 1.5 Marginalize - Benefits and Costs The economic perspective focuses largely on marginal analysis – decisions which compare marginal benefits and marginal costs. Marginal means ―extra‖, ―additional‖, or ―a change in‖. Most economic choices or decisions entail changes in the status quo. When you graduated from high school you faced the question of whether you should get additional education. Similarly, businesses are continuously deciding whether to employ more or fewer workers or to produce more or less output. In making such choices rationally, we must compare marginal benefits and marginal costs. Because of scarcity, any option or choice will entail both extra benefits and additional costs. Example: Your time is scarce. What will you do with, say, two ―free‖ hours on a Saturday afternoon? Option: Watch basketball game on television. 14  Marginal benefit: The pleasure of seeing the game. Marginal cost: Any of the other things you sacrifice by spending an extra two hours in front of the tube, including studying (economics, hopefully), jogging, or taking a nap. If the marginal benefit exceeds the marginal cost, then it is rational to watch the game. But if you perceive the marginal cost of watching the game to exceed its marginal benefits, then one of the other options should be chosen. 1.6 Production Possibility Frontier (PPF) Under the field of macroeconomics, the production possibility frontier (PPF) represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced. Production Possibility Frontier (PPF) is a curve that shows the different combinations of two goods that a country can produce during a specific period of time, when all its resources are fully and efficiently employed or used.  Assumptions of the PPF The PPF is based on these assumptions: 15  - The quantity of inputs (resources) is given. - Technological knowledge is given. - The country produces only two goods (or services). - Resources are employed fully and efficiently, this means if the country wants to produce more of one good; it must give up some of the other good. Example: A Schedule of alternative production possibilities of two goods (Chicken and fish). possibilities Chicken Fish (millions of tons) millions of tons) A 15 o B 14 1 C 12 2 D 9 3 E 5 4 F 0 5 The table shows the alternative production possibilities of the two goods (Chicken and fish) that the country can choose among them. At possibility A, all resources in the country are used to produce chicken, so the maximum output of chicken is 15 million tons and the output of fish is zero. If this country wants to produce additional units of fish it has to reduce its output of chicken to release enough 16 resources to be used in the production of the additional unit of fish as at point B. Let's turn to the chart below. Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present levels of resources. Figure: (1-1) As we can see, in order for this economy to produce more wine, it must give up some of the resources it uses to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would have to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A. As the chart shows, by moving production from point A to B, the economy must 17 decrease wine production by a small amount in comparison to the increase in cotton output. However, if the economy moves from point B to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represents the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production. Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there was a change in technology whiles the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources. 18  Figure: (1-2) When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology. An economy can be producing on the PPF curve only in theory. In reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo one choice for another, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly. 1.7 Opportunity Cost We can think about every choice as a tradeoff – an exchange – giving up one thing to get something else. Thinking about a choice as a tradeoff emphasizes cost as 19 an opportunity forgone or opportunity cost. Critically, the opportunity cost is the quantity of a good (or service) that has to be given up to produce one additional unit of another good or service. Opportunity cost is the value of what is foregone in order to have something else. This value is unique for each individual. You may, for instance, forgo ice cream in order to have an extra helping of mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can always change your mind in the future because there may be some instances when the mashed potatoes are just not as attractive as the ice cream. The opportunity cost of an individual's decisions, therefore, is determined by his or her needs, wants, time and resources (income). This is important to the PPF because a country will decide how to best allocate its resources according to its opportunity cost. Therefore, the previous wine/cotton example shows that if the country chooses to produce more wine than cotton, the opportunity cost is equivalent to the cost of giving up the required cotton production. Let's look at another example to demonstrate how opportunity cost ensures that an individual will buy the less expensive of two similar goods when given the choice. For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go 20 to the movies may be a cost that is too high for this person, leading him or her to choose the less expensive service. Remember that opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources. 1.8 Economic Systems There are four primary types of economic systems in the world: traditional, command, market and mixed. Each economy has its strengths and weaknesses, its sub- economies and tendencies, and, of course, a troubled history. 1.8.1 Traditional Economic System A traditional economic system is the best place to start because it is, quite literally, the most traditional and ancient type of economy in the world. There are certain elements of a traditional economy that those in more advanced economies, such as Mixed, would like to see return to prominence. Traditional economies still produce products and services that are a direct result of their beliefs, customs, traditions, religions, etc. Vast portions of the world still function under a traditional economic system. These areas tend to be rural, second- or third-world, and closely tied to the land, usually through farming. 21  However, there is an increasingly small population of nomadic peoples, and while their economies are certainly traditional, they often interact with other economies in order to sell, trade, barter, etc. Learn about the complexities of globalization and how it shapes economic relationships and affects cultures with this great class on the geography of globalization. Advantages and Disadvantages: Certainly one of the most obvious advantages is that tradition and custom is preserved while it is virtually non - existent in market / mixed economies. There is also the fact that each member of a traditional economy has a more specific and pronounced role, and these societies are often very close- knit and socially satisfied. The main disadvantage is that traditional economies do not enjoy the things other economies take for granted: Western medicine, centralized utilities, technology, etc. But as anyone in America can attest, these things do not guarantee happiness, peace, social or, most ironically of all, economic stability. 1.8.2. Command (central planned) Economic System In terms of economic advancement, the command economic system is the next step up from a traditional economy. This by no means indicates that it is fairer or an exact improvement; there are many things fundamentally wrong with a command economy. Centralized Control: The most notable feature of a command economy is that a large part of the economic system is controlled by a centralized power; often, a 22 federal government. This kind of economy tends to develop when a country finds itself in possession of a very large amount of valuable resource(s). The government then steps in and regulates the resource(s). Often the government will own everything involved in the industrial process, from the equipment to the facilities. Supposed advantages: You can see how this kind of economy would, over time, create unrest among the general population. But there are actually several potential advantages, as long as the government uses intelligent regulations. First of all, a command economy is capable of creating a healthy supply of its own resources and it generally rewards its own people with affordable prices (but because it is ultimately regulated by the government, it is ultimately priced by the government). Still, there is often no shortage of jobs as the government functions similarly to a market economy in that it wants to grow and grow upon its populace. 1.8.3. Market Economic System A market economy is very similar to a free market. The government does not control vital resources, valuable goods or any other major segment of the economy. In this way, organizations run by the people determine how the economy runs, how supply is generated, what demands are necessary, etc. Capitalism and Socialism: No truly free market economy exists in the world. For example, while America is a capitalist nation, our government still regulates (or attempts to regulate) fair trade, government 23 programs, moral business, monopolies, etc. etc. The advantage to capitalism is you can have an explosive economy that is very well controlled and relatively safe. This would be contrasted to socialism, in which the government (like a command economy) controls and owns the most profitable and vital industries but allows the rest of the market to operate freely; that is, price is allowed to fluctuate freely based on supply and demand. If you want to know how the global economy works and the role you play in it, check out this sweet class on Economics without Boundaries. Market Economy and Politics: Arguably the biggest advantage to a market economy (at least, outside of economic benefits) is the separation of the market and the government. This prevents the government from becoming too powerful, too controlling and too similar to the governments of the world that oppress their people while living lavishly on controlled resources. In the same way that separation of church and state has been to vital to America‘s social success, so has a separation of market and state been vital to our economic success. Yes, there is something wary about a system which to be successful must foster constant growth, but as a result progress and innovation have occurred at such incredible rates as to affect the way the world economy functions. 24 1.8.4. Mixed Economic System A mixed economic system (also known as a Dual Economy) is just like it sounds (a combination of economic systems), but it primarily refers to a mixture of a market and command economy (for obvious reasons, a traditional economy does not typically mix well). As you can imagine, many variations exist, with some mixed economies being primarily free markets and others being strongly controlled by the government. Learn more about an essential part of our economy with this free post on understanding the stock market. Disadvantages of a mixed economy: While a mixed economy can lead to incredible results (America being the obvious example), it can also suffer from similar downfalls found in other economies. For example, the last hundred years in America has seen a rise in government power. Not just in imposing laws and regulations, but in actually gaining control, becoming more difficult to access while simultaneously becoming less flexible. This is a common tendency of mixed economies. 1.9 Role of governments in the economy One important role of a government in an economy is to stabilize the economy. Most modern classical economists concede that if the stability of economies were to depend solely on forces of demand and supply, the scenario in the world today would be quite chaotic. 25 The government needs to formulate policies that govern how trade is going to be done within the country, as well as internationally. These rules are to be informed by the realization that sometimes - economic growth alone may not be all that a country needs. Ultimately, there needs to be, not just a larger economy, but better life for everyone. The level of government involvement may differ with circumstances. Usually, the government only comes in when it is really important that it does. To understand the role of government, it will be useful to distinguish four broad types of government involvement in the economy. First, the government attempts to respond to market failures to allocate resources efficiently. In a particular market, efficiency means that the quantity produced is determined by the intersection of a demand curve that reflects all the benefits of consuming a particular good or service and a supply curve that reflects the opportunity costs of producing it. Second, government agencies act to encourage or discourage the consumption of certain goods and services. 26 1.9.1 Responding to Market Failure The market maximizes net benefit by achieving a level of output at which marginal benefit equals marginal cost. That is the efficient solution. In most cases, we expect that markets will come close to achieving this result—that is the important lesson of Adam Smith‘s idea of the market as an invisible hand, guiding the economy‘s scarce factors of production to their best uses. That is not always the case, however. We have studied several situations in which markets are unlikely to achieve efficient solutions. In an earlier chapter, we saw that private markets are likely to produce less than the efficient quantities of public goods such as national defense. They may produce too much of goods that generate external costs and too little of goods that generate external benefits. In cases of imperfect competition, we have seen that the market‘s output of goods and services is likely to fall short of the efficient level. In all these cases, it is possible that government intervention will move production levels closer to their efficient quantities. In the next three sections, we shall review how a government could improve efficiency in the cases of public goods, external costs and benefits, and imperfect competition. 27 1.9.2 Public Goods A public good is a good or service for which exclusion is prohibitively costly and for which the marginal cost of adding another consumer is zero. National defense, law enforcement, and generally available knowledge are examples of public goods. The difficulty posed by a public good is that, once it is produced, it is freely available to everyone. No consumer can be excluded from consumption of the good on grounds that he or she has not paid for it. Consequently, each consumer has an incentive to be a free ride in consuming the good, and the firms providing a public good do not get a signal from consumers that reflect their benefit of consuming the good. Certainly we can expect some benefits of a public good to be revealed in the market. If the government did not provide national defense, for example, we would expect some defense to be produced, and some people would contribute to its production. But because free- riding behavior will be common, the market‘s production of public goods will fall short of the efficient level. The theory of public goods is an important argument for government involvement in the economy. Government agencies may either produce public goods themselves, as do local police departments, or pay private firms to produce them, as is the case with many government-sponsored research efforts. An important 28 debate in the provision of public education revolves around the question of whether education should be produced by the government, as is the case with traditional public schools, or purchased by the government, as is done in charter schools. 1.9.3 External Costs and Benefits External costs are imposed when an action by one person or firm harms another, outside of any market exchange. The social cost of producing a good or service equals the private cost plus the external cost of producing it. In the case of external costs, private costs are less than social costs. Similarly, external benefits are created when an action by one person or firm benefits another, outside of any market exchange. The social benefit of an activity equals the private benefit revealed in the market plus external benefits. When an activity creates external benefits, its social benefit will be greater than its private benefit. The lack of a market transaction means that the person or firm responsible for the external cost or benefit does not face the full cost or benefit of the choice involved. We expect markets to produce more than the efficient quantity of goods or services that generate 29 external costs and less than the efficient quantity of goods or services that generate external benefits. 1.9.4 Assessing Government Responses to Market Failure In each of the models of market failure we have reviewed here public goods, external costs and benefits, and imperfect competition, the market may fail to achieve the efficient result. There is a potential for government intervention to move inefficient markets closer to the efficient solution. Reviews the potential gain from government intervention in cases of market failure. In each case, the potential gain is the deadweight loss resulting from market failure; government intervention may prevent or limit this deadweight loss. 1.9.5 Merit and Demerit Goods In some cases, the public sector makes a determination that people should consume more of some goods and services and less of others, even in the absence of market failure. This is a normative judgment, one that presumes that consumers are not always the best judges of what is good, or bad, for them. 30  Merit goods are goods whose consumption the public sector promotes, based on a presumption that many individuals do not adequately weigh the benefits of the good and should thus be induced to consume more than they otherwise would. Many local governments support symphony concerts, for example, on grounds that the private market would not provide an adequate level of these cultural activities. Demerit goods are goods whose consumption the public sector discourages, based on a presumption that individuals do not adequately weigh all the costs of these goods and thus should be induced to consume less than they otherwise would. The consumption of such goods may be prohibited, as in the case of illegal drugs, or taxed heavily, as in the case of cigarettes and alcohol. A more fundamental reason for concern about income distribution is that people care about the welfare of others. People with higher incomes often have a desire to help people with lower incomes. This preference is demonstrated in voluntary contributions to charity and in support of government programs to redistribute income. A public goods argument can be made for government programs that redistribute income. Suppose that people of all income levels feel better off knowing 31 that financial assistance is being provided to the poor and that they experience this sense of well-being whether or not they are the ones who provide the assistance. In this case, helping the poor is a public good. When the poor are better off, other people feel better off; this benefit is nonexclusive. One could thus argue that leaving private charity to the marketplace is inefficient and that the government should participate in income redistribution. Whatever the underlying basis for redistribution, it certainly occurs. The governments of every country in the world make some effort to redistribute income. Programs to redistribute income can be divided into two categories. One transfer's income to poor people; the other transfers income based on some other criterion. A means-tested transfer payment is one for which the recipient qualifies on the basis of income; means-tested programs transfer income from people who have more to people who have less.  One role of government is to correct problems of market failure associated with public goods, external costs and benefits, and imperfect competition.  Government intervention to correct market failure always has the potential to move markets closer to efficient solutions, and thus reduce deadweight losses. 32  There is, however, no guarantee that these gains will be achieved.  Governments may seek to alter the provision of certain goods and services based on a normative judgment that consumers will consume too much or too little of the goods. Goods for which such judgments are made are called merit or demerit goods.  Governments redistribute income through transfer payments. Such redistribution often goes from people with higher incomes to people with lower incomes, but other transfer payments go to people who are relatively better off. 33  Questions for Review First: Multiple Choices 1. Which of the following is a public good? A) A lighthouse. B) A truck purchased by the military. C) An amusement park that charges admission. D) Electricity generated at High Dam. 2. Economics can best be defined as the study of how. A) Individuals decide to use scarce resources in an attempt to satisfy unlimited wants. B) To make money. C) The government should deal with unemployment and inflation D) To eliminate the problem of scarce resources E) To run a business 3. Because resources are scarce. A) Opportunity costs are zero. B) People must make choices among alternatives. C) All human wants and desires can be satisfied. D) Resource prices are fixed. E) Commodities are free. 34 4. A good economic theory. A) Have realistic assumptions. B) Contains as much detail as possible. C) Cannot be proven false. D) Predicts well. E) Can only be presented in mathematical terms. 5. In one week, Mohammed khan knit 5 sweaters or bakes 240 cookies. The opportunity cost per cookie for Mohammed is A) LE 5 B) 5 sweaters C) 48 sweaters D) 1/48 of a sweater E) 48 cookies 6. Adam Smith believed that people's pursuit of their own self-interests. A) tended to promote the general welfare B) required the government's "invisible hand" to keep the economy running smoothly C) might cause aggregate demand to be greater than aggregate supply D) would increase the wealth of a nation, which was the quantity of gold and silver it owned E) would decrease the wealth of a nation, which was its ability to produce goods and services 35 7. Current production at which point in Exhibit 0022 would lead to the largest outward shift in the production possibilities frontier in a later year? A) point a because this point represents a greater consumption level than point b. B) point b because this point represents greater total production than the other two points. C) point c because this point represents a greater consumption level than the other two points. D) point b because this point represents greater production of capital than point c. E) point c because this point represents greater production of capital than the other two points. 8. A major distinguishing feature between capitalism and socialist or command economies is that. A) with capitalism the average citizen is always wealthier than in socialist economies 36 B) decision making is typically decentralized in socialist economies and is centralized in capitalistic economies C) socialist countries all have red flags which capitalistic economies do not D) public ownership of resources with capitalism E) Decision making is typically decentralized under capitalism while it is centralized in command economies. 9. When drawing a production possibilities frontier, all of the following are usually assumed except one. Which is the exception? A) The quantity of resources is rapidly growing. B) Technology is fixed C) Resources can be shifted between productions of the two goods D) The production possibilities frontier is drawn for a particular time period E) Resources are fully and efficiently employed 10. The phenomenon of scarcity stems from the fact that. A. Most economies‘ production methods are not very good. B. In most economies, wealthy people consume disproportionate quantities of goods and services. C. Governments restrict production of too many goods and services. D. Resources are limited. 37  E. People are greedy 11. The opportunity cost of going to college is. A. The total spent on food, clothing, books, transportation, tuition, lodging, and other expenses. B. The value of the best opportunity a student gives up to attend college. C. Zero for students who are fortunate enough to have all of their college expenses paid by someone else. D. Zero, since a college education will allow a student to earn a larger income after graduation. E. None of the above 12. The opportunity cost of an item is. A. What you give up to get that item. B. The dollar value of the item. C. Usually less than the dollar value of the item. D. The number of hours needed to earn money to buy the item. E. None of the above 13. In a market economy, economic activity is guided by A. The government. B. Corporations. C. Central planners. D. The president E. Self-interest and prices. 38 14. Which of the following observations was made famous by Adam Smith in his book The Wealth of Nations? A. There is no such thing as a free lunch. B. People buy more when prices are low than when prices are high. C. No matter how much people earn, they tend to spend more than they earn. D. Households and firms interacting in markets are guided by an "invisible hand" that leads them to desirable market outcomes. E. None of the above 15. Which of the following is not among the reasons why we need the government? A. The government provides social welfare services for the poor and the needy B. The government provides public goods and services C. The government regulates markets when there is a market failure D. The government provides free food for everyone E. The government imposes laws and controls to protect competitiveness of the industry 16. An outward shift of the PPF means. A. Increased size of the government B. Economic growth C. More consumption D. More equality among citizens E. None of the above 39 17. The PPF of a nation shows. A. A. How much people consume B. B. How much production takes place with the existing resources C. C. The prices of products D. D. The population E. E. All of the above 18. Suppose a gardener produces both green beans and corn in her garden. If she must give up 14 bushels of corn to get 5 bushels of green beans, then her opportunity cost of 1 bushel of green beans is. A. a. 0.36 bushel of corn. B. b. 2.4 bushels of corn. C. c. 2.8 bushels of corn. D. d. 70 bushels of corn. E. e. 1 bushel of corn 19. What is the central economic problem? Economics is concerned primarily with: A. Money B. Determining corporate profits and losses C. The allocation of scarce resources. D. Balancing your checkbook. E. All of the above. 40 20. Which of the following statements applies to a mixed economy? A. There is confusion and a lack of organization B. The allocation of resources changes from production period to production period C. There are no real examples of truly mixed economies D. Mixed economies include aspects of both market and command economies E. None of the above statements apply 21. Which of the statements below does not apply to the production possibility frontier (PPF)? A. The PPF is closely related to the concept of scarcity B. Quantities of inputs are measured along the axes of the PPF. C. The PPF may shift over time. D. Movements along the PPF may occur as the allocation of resources changes. E. Technology may change the shape of the PPF. 22. Which of the following statements is false? When an economy is on its PPF: A. More of one product cannot be produced without sacrificing some of the order. B. Resources are fully employed. C. The economy is producing with productive efficiency. D. Consumers will have all that they need. E. A strike by workers will move the economy beneath the PPF. 41 23. Which of the following statements could be used to explain an outward shift in the production possibility frontier? A. There is an increase in technology B. The population of the country increases C. The country decides to postpone current consumption in favor of capital investment D. New natural resources are discovered under the ocean E. All of the above apply Second: Questions 1. What is the opportunity cost of seeing a movie? 2. Why should policymakers think about incentives? 3. What does the ―invisible hand‖ of the marketplace do? 4. Explain the two main causes of market failure and give an example of each. Second: True-and-False Questions 1. ( ) Economics studies the problem of scarcity. 2. ( ) Macroeconomics is the study of individual activities. 3. ( ) Microeconomics is the study of total aggregate of the whole society. 4. ( ) Scarcity means that we have limited resources relative to our unlimited wants. 5. ( ) Society can reach a point beyond its current production possibilities curve if economic growth occurs. 6. ( ) Any point on the production possibilities curve represents full employment. 42 7. ( ) Production possibilities curves never shift outward. 8. ( ) Economic growth is associated with an outward shift of the production possibilities curve. 9. ( ) Public goods are generally provided by the government. 10. ( ) To challenge scarcity, the society has to employ the resources efficiently. 11. ( ) The economic resources include natural resources, capital, labor and entrepreneur. 12. ( ) Spillover costs or benefits are examples of market failures. 13.( ) Most economists believe that the government should not become involved in the case of a market failure. 14. ( ) An excise tax on cigarettes will cause an increase in the price of cigarettes. 15. ( ) Opportunity cost is defined as the best alternative foregone. 16. ( ) Unless externalities or other market failures are present, the competitive market place is generally considered to be equitable. 17. ( ) Pure capitalism is characterized by private ownership and government economic decision making. 18. ( ) Liberals (economic left) generally value equity. 43  Chapter Two History of Economic Thought 44  Chapter Two History of Economic Thought 2.1 Schools of Thought The field of economics is organized into many different schools of thought, with differing views on the role of governments, firms individuals and how the markets and their participants operate. 2.1.1 Classical Classical economists hold that prices, wages and rates are flexible and markets always clear. As there is no unemployment, growth depends upon the supply of production factors. 2.1.2 Keynesian Keynesian economics was largely founded on the basis of the works of John Maynard Keynes. Keynesians focus on aggregate demand as the principal factor in issues like unemployment and the business cycle. Keynesian economists believe that the business cycle can be managed by active government intervention through fiscal policy (spending more in recessions to stimulate demand) and monetary policy (stimulating demand with lower rates). Keynesian economists also believe that there are certain rigidities in the system, particularly "sticky" wages and prices that prevent the proper clearing of supply and demand. 45 2.1.3 Monetarist The Monetarist school is largely credited to the works of Milton Friedman. Monetarist economists believe that the role of government is to control inflation by controlling the money supply. Monetarists believe that markets are typically clear and that participants have rational expectations. Monetarists reject the Keynesian notion that governments can "manage" demand and that attempts to do so are destabilizing and likely to lead to inflation. (Learn how Milton Friedman's monetarist views shaped economic policy after World War II. 2.1.4 New Keynesian The new Keynesian school attempts to add microeconomic foundations to traditional Keynesian economic theories. While New Keynesians do accept that households and firms operate on the basis of rational expectations, they still maintain that there are a variety of market failures, including sticky prices and wages. Because of this "stickiness", the government can improve macroeconomic conditions through fiscal and monetary policy. 2.1.5 Neoclassical Neoclassical economics assumes that people have rational expectations and strive to maximize their utility. This school presumes that people act independently on the basis of all the information they can attain. The idea of marginalism and maximizing marginal utility is attributed to the neoclassical school, as well as the notion 46 that economic agents act on the basis of rational expectations. Since neoclassical economists believe the market is always in equilibrium, macroeconomics focuses on the growth of supply factors and the influence of money supply on price levels. The New Classical School emphasizes the importance of microeconomics and models based on that behavior. New Classical economists assume that all agents try to maximize their utility and have rational expectations. They also believe that the market clears at all times. New Classical economists believe that unemployment is largely voluntary and that discretionary fiscal policy is destabilizing, while inflation can be controlled with monetary policy 2.2 Economic Issues of Economic Thought The questions of how to get the most out of limited resources and whose wants should be satisfied in the process have been asked for centuries. They have posed economic issues which have concerned private citizens and governmental leaders alike. 2.1 Economic Thought Issues of the Past As economists have worked on the issues that faced them, they have often been able to define underlying principles. These principles, in turn, have often helped later generations cope with similar problems. On occasion, as newer thinking gets closer to the truth and as newer problems arise; older principles are replaced with 47 new ones. Many great economists of the past have made lasting contributions to human knowledge by the way they coped with the problems of their own times. 2.1.1 Adam Smith (1723 – 1790) Adam Smith is often ranked as the founder of modern economics. He was a Scottish writer and teacher whose influence continues to be great. Smith‘s interests ranged over virtually all fields of human endeavor. His main point, however, was that a free economy could produce best if individual traders were left to do as their self-interest dictated in a competitive environment. This was rather unorthodox doctrine in a day when heads of governments usually felt that economic goals could be reached only through continuous administrative tinkering. The importance of Adam Smith‘s teaching is all the greater since he saw this flaw in the mercantilist policies of governments at the very time that the industrial revolution was taking shape. Smith was a contemporary of James Watt, and Smith‘s major book, The Wealth of Nations, was published in 1776. This was the period in which Watt‘s steam engine and many of the basic textile machines which served as springboards for industrialization were being invented. Thus, as Adam Smith pointed out the defects in the policies of his own age, he helped pave the way for the next. 48 2.1.2 Thomas Robert Malthus (1766 – 1834) In a period of rapidly growing population, the thinking of Thomas Robert Malthus still has clear relevance. Malthus lived in a world that was just beginning to feel the effect of advances in medicine and sanitation, which would lead to rapid population growth in the next two centuries. With new agricultural areas such as the United States opening up, Malthus reasoned out the relationships that might prevail among population, resources, and wages. He built on Adam Smith‘s concept of the operation of a price system in a competitive economy. Malthus combined, to an unusual degree, the ability to gather data from the world he lived in, the power to reason clearly, and the concern that always related economic matters to human affairs. 2.1.3 David Ricardo (1772 – 1823) Ricardo had several major interests, and he pursued them by building on the work of his predecessors. His name is most often associated with the ―iron law of wages‖, which concludes that workers‘ wages will stay at the level that permits only bare subsistence. This is an extension of Malthus‘s doctrine, which emphasized the pressure of population against the food supply, and it reflects Ricardo‘s concern with the economic interests of industrial workers. Ricardo also met a problem of his time with his theory of rent. He concluded that rent was not a cause of 49 high prices but was the result of high prices for goods produced on rented land. His concern with rent was timely in that it pointed toward the problems that would beset nations as population growth and industrialization continued. 2.1.4 William Stanley Jevons (1835 – 1882) The growth of industry in the 1800s enlarged markets and generally increased the complexity of the economic system. Jevons studied issues arising from such complex markets. His concept that an item‘s price is related to its utility, or its capacity to satisfy human wants, is a basic foundation of price theory. Although Jevons‘s famous conclusion that sunspots are related to the business cycle is no longer regarded as valid, his detailed investigation of the problem of prosperity and depression paved the way for later scholars. This was important, since the business cycle in industrial nations poses problems different in both kind and size from the fluctuations of simpler economies. 2.1.5 Alfred Marshall (1842 – 1924) Marshall stands in the tradition of the English classical economists we have just considered. He carried their theories, especially those related to the determination of price, to a high level of development. In particular, he showed how the price of a single seller, or monopoly, differs from that which results where there are many sellers, or competition. 50 2.1.6 John Maynard Keynes (1883 – 1946) By the year 1930, the Great Depression was under way, millions were out of work, and the whole want- satisfying power of the economy seemed to be breaking down. Keynes found that earlier economic thought – for example, theories about how prices are set offered few useful answers to help nations cope with massive economic breakdown. Keynes emphasized the need to consider overall spending, not merely spending for individual products. In doing this, he developed whole new branch of economics. The systems of thought that have arisen since the time of Keynes make possible a meaningful approach to the problems of unemployment, inflation, and economic growth. Like the earlier economists we have considered here, Keynes was willing to take a new look at the facts and issues of his own time. In doing so he, like them, made contributions that have remained useful far beyond his own time. 2.2 Economic Thought Issues of the Present In many ways the problems raised by the economists of the past are still very much with us. Governments still intervene in markets, as they did in Adam Smith's time. Population grows alarmingly in some parts of the world, as Malthus foresaw. Higher prices for farm crops were a factor in the rising value of farmland in the 1970s, as Ricardo's thinking suggested. 51 Jevon's studies of the details of the business cycle are repeated today in massive compilations of economic statistics. The individual prices Marshall studied still concern people, and we recognize that institutions, such as the unions Commons studied, affect them. Finally, we have yet to achieve the world of full employment without inflation that Keynes and his followers sought. The work of three American economists who won Nobel Prizes in the 1970s focuses on some of the most pressing concerns. Simon Kuznets was honored for his work on the measurement of national income; the gross national product (GNP) is a vital measure that concerns all citizens. Milton Friedman's Nobel Prize was mainly for his work on money. This is a very timely issue, since for centuries most money had some relationship to gold or other precious material. In the late twentieth century, money is produced mainly by governments, and Professor Friedman has studied the influence of money on prices and output. Herbert Simon showed how executives in major firms actually make decisions. As they make decisions allocating large amount of scarce resources, they consider not only prices and profits but also the satisfaction of people within the corporation. Professor Simon stresses the realities of the modern business world as a vital part of economics. 52  The following the issues concerned of the modern citizen has a big stake in economic principles and economic issues. Here are a few of the issues we face:  Can price controls do the best job of controlling inflation?  Should the tax on capital gains be cut to encourage investment?  How can farm prices be raised to cover the cost of production?  Should we raise tariffs to solve the problems of the deficit in the balance of trade?  Does the proposed increase in the minimum wage really help low-paid workers? At any given time, a few issues are very well known. Price-control laws and policies that raise gasoline prices are in this category. Most people have opinion on such things, even if they may not feel comfortable in fully stating their reasons. On the matters of a deficit in the balance of payments and the nature of current changes in the money supply, there is likely to be somewhat less depth of understanding. This criticism was given extensive nationwide publicity in newspapers and was probably seen by millions of people. It seems certain, however, that only a small minority of the population understood what the investment tax credit was all about. Even fewer may have been aware of the deep implication of this subject 53 for economic growth and the world's long-term economic welfare. It is good that such subject is argued, but it would be better if more of us could be informed participants in the discussion. If you study this book carefully, you will become one of those who do understand something of the many policies and big economic questions facing our nation and our world today. Economics will not tell you what to choose, although studying economic issues will help you to become better informed. Economics can help you to know about the costs involved in picking one alternative or another. Economics can also help you to know how to go about putting the chosen alternative into action. Choices rest on our choices rests on economic analysis. 54 Questions for Review: Multiple Choices: 1. Economics can best be thought of as: A) The study of making and spending money efficiently. B) The study of using limited resources to satisfy unlimited wants. C) The study of the motivations that underlie human patterns of consumption. D) A and B. 2. A great inventor who was Adam Smith's contemporary was: A) Thomas Edison B) Alexander Bell C) James Watt D) David Ricardo 3. The economist who stressed population was: A) Commons B) Malthus C) Marshall D) Smith 4. The economist who stressed labour unions was: A) Commons B) Malthus 55  C) Marshall D) Samuelson 5. The economist who stressed the problems of the 1930s was: A) Keynes B) Marshall C) Jevons D) Ricardo 6. Which economist did not receive a Nobel Prize in the 1970s? A) Friedman B) Keynes C) Simon D) None of the above. Questions: 1. What issues of the nineteenth-century economists remain current today? 2. Make a list of the ten leading current economic issues. 3. For a current economic issue, organize a debate that includes the best evidence on both sides that can be obtained. (Sample topic: "Wage and price controls should be used to lower inflation".) 56  Chapter Three Demand and Supply 57  Chapter Three Demand and Supply 3.1 Introduction Demand and Supply is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand. The relationship between demand and supply underlie the forces behind the allocation of resources. In market economy theories, demand and supply theory will allocate resources in the most efficient way possible. How? Let us take a closer look at the law of demand and the law of supply. 58  Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the goods, the standard graphical representation, usually attributed to Alfred Marshall, has price on the vertical axis and quantity on the horizontal axis, the opposite of the standard convention for the representation of a mathematical function. Since determinants of supply and demand other than the price of the goods in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as "shifts" in the curves). By contrast, responses to changes in the price of the good are represented as movements along unchanged supply and demand curves. 3.2 Demand 3.2.1 The Law of Demand (downward sloping demand) The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below - Figure (3.1) shows that the curve is a downward slope. 59  Figure (3.1) A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantities demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C). 3.2.2 Demand schedule The demand schedule is a table that shows the quantity of a good that consumers demand (willing and able to buy) at different prices, when other things held constant, during a specific period of time. 60 The following example shows the demand schedule for apples. Table no. (3-1): demand schedule for apples Points Price ($ per Quantity demanded box) (1000 of boxes per month) A 5 9 B 4 10 C 3 12 D 2 15 E 1 20 A demand schedule, depicted graphically as the demand curve, represents the amount of some goods that buyers are willing and able to purchase at various prices, assuming all determinants of demand other than the price of the good in question, such as income, tastes and preferences, the price of substitute goods, and the price of complementary goods, remain the same. Following the law of demand, the demand curve is almost always represented as downward-sloping, meaning that as price decreases, consumers will buy more of the good.  Types of goods 61  1. A normal good: is a good which its demand increases as income rises, and decreases as income falls. 2. An inferior good: is a good which its demand decreases as income rises, and increases as income falls. 3. Complementary goods: are any two goods or more that used together, e.g. cars and gasoline. 4. Substitute goods are goods that perform the same function, so they can be replaced for each other, such as beef and chicken. Just like the supply curves reflect marginal cost curves, demand curves are determined by marginal utility curves. Consumers will be willing to buy a given quantity of a good, at a given price, if the marginal utility of additional consumption is equal to the opportunity cost determined by the price, that is, the marginal utility of alternative consumption choices. The demand schedule is defined as the willingness and ability of a consumer to purchase a given product in a given frame of time. It is aforementioned, that the demand curve is generally downward-sloping; there may be rare examples of goods that have upward-sloping demand curves. Two different hypothetical types of goods with upward- sloping demand curves are Giffen goods (an inferior but staple good) and Veblen goods (goods made more fashionable by a higher price). 62  By its very nature, conceptualizing a demand curve requires that the purchaser be a perfect competitor—that is, that the purchaser has no influence over the market price. This is true because each point on the demand curve is the answer to the question "If this buyer is faced with this potential price, how much of the product will it purchase?" If a buyer has market power, so its decision of how much to buy influences the market price, then the buyer is not "faced with" any price and the question is meaningless. Like with supply curves, economists distinguish between the demand curve of an individual and the market demand curve. The market demand curve is obtained by summing the quantities demanded by all consumers at each potential price. Thus, in the graph of the demand curve, individuals' demand curves are added horizontally to obtain the market demand curve. The determinants of demand are: A. Income. B. Tastes & preferences. C. Prices of related goods and services. D. Consumers' expectations about future prices and incomes that can be checked. E. Number of potential consumers. 63 3.3. Supply 3.3.1 The Law of Supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at higher price increases revenue. The supple curve is the graphical representation of the supply schedule. Figure (3.2) A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantities supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. 64 3.3.2 Supply schedule A supply schedule is a table that shows the quantity of a good or service that producers are willing to supply and sell at different prices, when other things held constant, during a specific period of time. The following example shows the supply schedule for apple. Table no. (3-2): supply schedule for apples Points Price ($ per Quantity supplied Qs box) P (1000 of boxes per month) A 5 18 B 4 16 C 3 12 D 2 7 E 1 0 supply schedule relates the quantity supplied to price per unit of apple. Under the assumption of perfect competition, supply is determined by marginal cost. Firms will produce additional output while the cost of producing an extra unit of output is less than the price they would receive. 65  A hike in the cost of raw goods would decrease supply, shifting costs up, while a discount would increase supply, shifting costs down and hurting producers as producer surplus decreases. By its very nature, conceptualizing a supply curve requires the firm to be a perfect competitor, namely requires the firm to have no influence over the market price. This is true because each point on the supply curve is the answer to the question "If this firm is faced with this potential price, how much output will it be able to and willing to sell?" If a firm has market power, its decision of how much output to provide to the market influences the market price, then the firm is not "faced with" any price, and the question becomes less relevant. Economists distinguish between the supply curve of an individual firm and between the market supply curves. The market supply curve is obtained by summing the quantities supplied by all suppliers at each potential price. Thus, in the graph of the supply curve, individual firms' supply curves are added horizontally to obtain the market supply curve. Economists also distinguish the short-run market supply curve from the long-run market supply curve. In this context, two things are assumed constant by definition of the short run: the availability of one or more fixed inputs (typically physical capital), and the number of firms in the industry. 66  In the long run, firms have a chance to adjust their holdings of physical capital, enabling them to better adjust their quantity supplied at any given price. Furthermore, in the long run potential competitors can enter or exit the industry in response to market conditions. For both of these reasons, long-run market supply curves are flatter than their short-run counterparts. The Determinants of Supply are: A. Production costs: how many a goods costs to be produced. Production costs are the cost of the inputs, primarily labor, capital, energy and materials. Production costs depend on the technology used in production, and/or technological advances. B. Firms' expectations about future prices. C. Number of suppliers.  Time and Supply Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent. Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using 67 their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand. 3.4 Supply and Demand Relationship Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price. Imagine that a special edition CD of your favorite band is released for LE20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than LE20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied. If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after 68 the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at L.E20 was too high.  Market Equilibrium It is called equilibrium of supply and demand, combining the supply and demand schedules and curves together to determine the point where the quantity supplied equals the quantity demanded of apples. This point is the market equilibrium or point of market clearance. The price at this point is known as the equilibrium price or the market price. Table no. (3-3): Market Equilibrium (Quantity demanded equals quantity supplied) Points Possible Quantity Quantity State of Pressur Price demanded supplied market e on ($ per 1000 of 1000 of price box) boxes per boxes per month month A 5 9 18 surplus Downw ard B 4 10 16 surplus Downw ard C 3 12 12 equilibrium Normal D 2 15 7 Shortage Upward E 1 20 0 Shortage Upward It is shown from the above table no. (3-3) the following:  The equilibrium price = $ 3 per box of apple. 69   The equilibrium quantity = quantity supplied = quantity demanded = 12 box.  At price above the equilibrium price, there is supply surplus, i.e. Qs > Qd that put downward pressure on price to decrease until it reaches back the equilibrium price.  At prices below the equilibrium price, there is a Supply shortage, i.e. Qs < Qd that put upward pressure on price to increase until it reaches the equilibrium price. When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding. 70  Figure (3-3) As you can see on the chart, Figure (3.3) equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocated inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity. In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply. At the end the equilibrium is defined to be the price- quantity pair where the quantity demanded is equal to the quantity supplied, represented by the intersection of the demand and supply curves. But the market equilibrium: A situation in a market when the price is such that the quantity that consumers 71 demand is correctly balanced by the quantity that firms wish to supply. Price determination under perfect competition: The price is determined at the intersection of the market demand curve and the market supply curve of the product. So the perfectly competitive firm is a price taker and has no perceivable effect on that price. So the firm faces a horizontal or infinity elastic demand curve for the product. As in the following figure (3-4).  Determining Market Equilibrium Mathematically The equilibrium price and quantity can be determined algebraically as follows: 72 There are two functions as follows: Qd = a – bP (1) the demand function (equation). Qs = c + dP (2) the supply function (equation). Qs = Qd (3) the condition for market equilibrium. Where: a = the quantity demanded when P = 0 b = the slope of the demand function (curve) which negative. c = the quantity supplied when P = 0 d = the slope of the supply function (curve) which positive. Substituting for equations (1) and (2) into equation (3) gives: P = a–c P = the equilibrium price b + d Q = ad + bc Q = the equilibrium quantity b + d Example (3-1) Assume that the following functions of demand and supply of a certain good. Qd = 100 - 10P & QS = 20 + 10P 73  1. Find the slopes of the demand and supply functions. 2. Find the equilibrium price and quantity. Answer Example (3-1): 1. The slope of the demand function = dQd = - 10 dP The slope of the supply function = dQs = 10 dP 2. Substitute for the demand and supply functions in equilibrium condition equation and solve it as: Qd = Qs 100 - 10P = 20 + 10P 80 = 20 P Therefore, P = LE 4 Substituting P = 4 into the demand or supply function and solving for Q we have. Qd = 100 – 10P = 100 – 10 (4) = 60 units. QS = 20 + 10P = 20 + 10 (4) = 60 units. Example (3-2): Assume that the following functions are available data of an assumed firm in sub market in Cairo: Qdx = 625 – 5p (1) the demand function Qsx = 175 +5p (2) the supply function 74  How do you determine the equilibrium price and quantity of the commodity X, algebraically and graphically, illustrating the characteristics of perfect competition market? The comparative static analysis: Examines the likely effect on the equilibrium of a change in the external conditions affecting the market. Changes in market equilibrium: Practical uses of supply and demand analysis often center on the different variables that change equilibrium price and quantity, represented as shifts in the respective curves. Comparative statics of such a shift traces the effects from the initial equilibrium to the new equilibrium.  Partial equilibrium Partial equilibrium as the name suggests takes into consideration only a part of the market, ceteris paribus to attain equilibrium. A partial equilibrium is one which is based on only a restricted range of data, a standard example is price of a single product, the prices of all other products being held fixed during the analysis. The supply-and-demand model is a partial equilibrium model of economic equilibrium, where the clearance on the market of some specific goods is obtained independently from prices and quantities in other markets. In other words, the prices of all substitutes and complements, as well as income levels of consumers are constant. This makes analysis much 75 simpler than in a general equilibrium model which includes an entire economy. Here the dynamic process is that prices adjust until supply equals demand. It is a powerfully simple technique that allows one to study equilib- rium, efficiency and comparative statics. The stringency of the simplifying assumptions inherent in this approach make the model considerably more tractable, but may produce results which, while seemingly precise, do not effectively model real world economic phenomena. Partial equilibrium analysis examines the effects of policy action in creating equilibrium only in that particular sector or market which is directly affected, ignoring its effect in any other market or industry assuming that they being small will have little impact if any. Hence this analysis is considered to be useful in constricted markets.  Disequilibrium Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. The four basic cases of supply and demand are 1. If demand increases (demand curve shifts to the right) and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price. 76 2. If demand decreases (demand curve shifts to the left) and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price. 3. If demand remains unchanged and supply increases (supply curve shifts to the right), a surplus occurs, leading to a lower equilibrium price. 4. If demand remains unchanged and supply decreases (supply curve shifts to the left), a shortage occurs, leading to a higher equilibrium price. A. Excess Supply If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency. Figure (3.4) At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but 77 those consuming the goods will find the product less attractive and purchase less because the price is too high. B. Excess Demand Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it. Figure (4.5) In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium. 78 3.5 Shifts vs. Movement For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena: 3.5.1 Movements A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa. Figure (3.6) 79  Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa. Figure (3.7) 3.5.2 Shifts A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a piece of bread was LE2 and the quantity of bread demanded increased from Q1 to Q2, then there would be a shift in the demand for bread. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity 80 demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, bread suddenly became the only type of bread available for consumption. Figure (3.8) Conversely, if the price for a bottle of beer was LE2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is affected by a factor other than price. Table (1 ) : Variables that affect quantity demanded And a change in this variables 81  In summary, the demand curve shows what happens to the quantity demanded of a good when its price varies, holding constant all other determinants of quantity demanded. When one of these other determinants changes, the demand curve shifts. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price. 82  Figure (3.9) Table (2) : Variables that affect quantity supplied And a change in this variables  How Prices Allocate Resources The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the market price is above the equilibrium price, there is a surplus of the 83 good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise. In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price then determines how much of the good buyers choose to purchase and how much sellers choose to produce. 3.6 Elasticity of Supply and Demand Elasticity is a measure of the responsiveness of quantity demanded and quantity supplied to a change in price. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life. To determine the elasticity of the supply or demand curves, we can use this simple equation: Elasticity = (% change in quantity / % change in price) If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic. 84 3.6.1 Price Elasticity of Demand Price elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in price. We used the concept of price elasticity of demand to determine the change in demand as a result of the change in price. To compute price elasticity, it is defined as the percentage change in quantity demanded divided by the percentage change in price. Elasticity of Demand = Ed = Qd2 - Qd1 X P1 P2 - P1 Qd1 85 86 87 88  Total Revenue Test Total Revenue (TR) = P x Q Total Revenue and the price elasticity of demand are related. Here‘s the test: When price changes… – If TR changes in the opposite direction from price, demand is elastic. – If TR changes in the same direction as price, demand is inelastic. – If TR does not change when price changes, demand is unit-elastic. Price Elasticity of Demand is:  Inelastic when Ed < 1 Typical of necessities one must have.  Elastic when Ed > 1 Typical of luxuries one wants.  Unit elastic when Ed = 1 Price change does not change total revenue. Examples: Example no. (3-3): Suppose that price of text- book increased by 10 %, the result, the quantity demanded of books decreased by 5 %. 89 Compute: the price elasticity of demand, and determine the type of price elasticity of demand. Answer example no. (3-3): Percentage change in quantity demanded of product X Ed = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬ Percentage change in price of product X Ed = 5 % = - 0.5 10 % The type of price elasticity of demand is inelastic demand. Example no. (3-4): If the price of wood chair decreased from LE 100 to LE 80, the result was the quantity demanded increased from 500 chairs to 700 chairs monthly. Find: the price elasticity of demand, and determine the type of price elasticity of demand. Answer example no. (3-4): Ed = Qd2 - Qd1 X P1 P2 - P1 Qd1 Ed = 700 – 500 X 100 = -2 80 - 100 500 90 The type of price elasticity of demand is elastic demand, don't care about the Minus Sign.  Why Use Percentages in Measuring Elasticity 1. Because, using absolute changes, our choice of units would arbitrarily affect our impression of buyer responsiveness: - With a $1 reduction in the price of a bag of popcorn, consumers increase their consumption from 60 to 100 bags (a 1 unit price change causes a 40 unit quantity change). - If we change the monetary unit from dollars to pennies, now it appears that it takes a price change of 100 units to cause the 40 unit quantity change. 2. Because, using absolute changes, it would make little sense to compare the effects on quantity demanded of: - A $1 increase in the price of a $20,000 car with - A $1 increase in the price of a $1 soft drink  Factors Affecting Price Elasticity of Demand Determinants of price elasticity of demand refer to those factors affecting the elasticity of a given commodity. There are three main factors that influence a demand's price elasticity: 91 1. Availability of substitutes (Substitutability): Generally, the more substitute goods available, the greater the price elasticity of demand. 2. Consumer's income (Proportion of Income): Other things equal, the higher the price of a good relative to consumers‘ incomes, the greater the price elasticity of demand. 3. Luxuries versus Necessities: In general, the more a good is considered to be a ―luxury‖, the greater is the price elasticity of demand. 4. Time adjustments: Generally, product demand is more elastic the longer the time period under consideration. Consumers often need time to adjust to changes in prices. As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic. 92  Figure (3.10) Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price. Figure (3.11) 3.6.2 Price Elasticity of Supply Our analysis of demand elasticity is also applied to price elasticity of supply. However, this time elasticity of 93 supply measures the responsiveness of quantity supplied to change in the price of the product. It is the percentage change in quantity supplied divided by the percentage change in price. Price Elasticity of Supply = Es = Qs2 - Qs1 X P1 P2 - P1 Qs1 Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one. 94  Figure (3.12) On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one. Figure (3.13) Example no. (3-5): If the price of a product increased by 15 %, the quantity supplied would increase by 45 %. 95 Calculate the elasticity of supply, and determine the type of elasticity of supply. Answer Example no. (3-5): Percentage change in quantity Supplied of a product E s = ‫ـــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــــ‬ Percentage change in price of a product Es = 45 % = 3