Training in Basic

Economics

ROSEMARIE G. EDILLON, PhD

Assistant Director-General
National Economic and Development Authority

Source: Google Images April 2014

A Short History of Economic Thought
1. Mercantilists (trade surplus; wealth is in gold)
2. Physiocrats (laissez faire; tableau economique)
3. Adam Smith (division of labor; invisible hand)
4. David Ricardo (comparative advantage; concept of nominal
and real output; concept of marginal product)
5. John Stuart Mill (concept of utility; early concept of demand
and supply; concept of homo economicus)
6. Alfred Marshall (marginalists; use of calculus; science of
human behaviour; diminishing marginal utility; supply and
demand)
7. Joseph Schumpeter (entrepreneurship; creative destruction;
business cycles)
8. John Maynard Keynes (fiscal policy)

Source: Samuelson and Nordhaus (1995)

What is Economics?

Economics – the study of the behavior of individuals,

community and societies in so far as they are involved in the
production and consumption of scarce goods (and services)

• goods are scarce

• resources must be used efficiently

Source: Samuelson and Nordhaus (1995)

 What is Economics?

A market is a mechanism by which buyers and sellers

interact to determine the price and quantity of a good or
service

Sources: Samuelson and Nordhaus (1995) and Google Images

 Economic Actors in the Market

Consumers (Households)
• buy goods and sell factors of production
• use income from sale of labor and other
inputs to buy goods from firms

Firms (Businesses)
• sell goods and buy factors of production
• base the prices of goods on the costs of
labor and property

Sources: Samuelson and Nordhaus (1995) and Google Images

 Economic Decisions faced by Households

• Consume good 1 or good 2 ?

• Work or not work ?
• Consume now or consume later?

Factors to consider
• Preferences (pleasure vs. pain; satisfaction;
utility; revealed preference)
• Budget constraint

Sources: Samuelson and Nordhaus (1995) and Google Images

MARGINAL UTILITY

Utility – the extent to which goods and services

are preferred by consumers

In the theory of demand, when we say that people maximize their utility,
this means they choose the bundle of consumption goods that they most
prefer.

Marginal Utility (MU) – increment to utility

in Economics, “marginal” “extra”

Source: Samuelson and Nordhaus (1995)

THE LAW OF DIMINISHING MARGINAL UTILITY

Law of Diminishing Marginal Utility – the amount of extra or marginal

utility declines as a person consumes more and more of a good

- as the amount of a good consumed increases, the MU of that

good tends to diminish
Source: Samuelson and Nordhaus (1995)
FUNDAMENTAL CONDITION OF MAXIMUM SATISFACTION
OR UTILITY

A consumer with a fixed income and facing given market prices of goods
will achieve maximum satisfaction or utility when the marginal utility of
the last peso spent on each good is exactly the same as the marginal
utility of the last peso spent on any other good.

MU good 1 = MU good 2
P1 P2
= Mu good 3
P3
= MU per P of income

The Demand Curve slopes downward because a higher price for

a good reduces the consumer’s desired consumption of that
commodity
Source: Samuelson and Nordhaus (1995)
Preferences: What the Consumer Wants
Indifference curve: Quantity
of Good M
shows consumption
bundles that give the
consumer the same
level of satisfaction B
A, B, and all other
bundles on I1 make A
the consumer equally I1
happy – he is
indifferent between
them. THE THEORY OF CONSUMER
Quantity
CHOICE of Good F10
Preferences: What the Consumer Wants
Indifference curve: Quantity
of Good M
• Downward sloping
• Higher indifference
curve means
higher level of C
D
utility I2
A
• Curves do not
I1
cross
I0
• Curves are convex
to the origin
Quantity
THE THEORY OF CONSUMER
CHOICE of Good F11
Budget Constraint: What the Consumer Can Afford

• Example:
Person A divides his income between two goods:
F and M.
• A “consumption bundle” is a particular combination
of the goods, e.g., 40 F & 300 M.
• Budget constraint: the limit on the consumption
bundles that a consumer can afford

THE THEORY OF CONSUMER

12
CHOICE
Quantity
of M
B

Slope = -4
C

A
Quantity
of F
 AA fall
fall in
in income
income
Quantity
of M
shifts
shifts thethe
budget
budget
constraint
constraint
down.
down.

An
An increase
increase in
in the
the price
price of
of
one
one good
good pivots
pivots the
the budget
budget
constraint
constraint inward.
inward.
Quantity
of F

Quantit
y of F
Quantity The
The optimum
optimum
of M
is
is the
the bundle
bundle most
most preferred
preferred
out
out ofof all
all the
the bundles
bundles he
he can
can
afford.
afford.
1200

B
600
A

C
D

150 300 Quantity

of F
 The Effects of an Increase in Income

An increase in Quantity
of M
income shifts the
budget constraint
outward.

B
If both goods are A
“normal,” then
more of both M and
F are bought.
Quantity
THE THEORY OF CONSUMER of F
CHOICE
 The Effects of a Price Change

Quantity
A change in price of M
rotates the budget
120
constraint initial
0
optimum
new
optimum
600
500

150 300 600 Quantity

350
of F
THE THEORY OF CONSUMER
CHOICE
Why does quantity demanded tend to fall as price
rises?
1. Substitution effect –
when the price of good
rises, the consumers
will substitute other
similar goods for it

2. Income effect – when

a price of good goes up,
consumers find
themselves poorer than
before, curbing their
consumption of this
good and other goods

Sources: Samuelson and Nordhaus (1995) and Google Images

 Law of Downward-Sloping Demand

P D

D
Q

When the price of a commodity is raised (and other things are held constant),
buyers tend to buy less of the commodity. Similarly, when the price is lowered,
other things being equal, quantity demanded increases
Sources: Samuelson and Nordhaus (1995)
 Factors that Influence Market Demand Curve

1. Average levels of income: as income rises, individuals tend to buy

more of almost everything, even if prices don’t change..

2. Prices and availability of related goods:

substitute goods – ones that tend to perform the same functions (e.g.,
red pencils and blue pencils, pens and pencils). Demand for good A
tends to be low if the price of substitute product B is low

complement goods – goods that are tend to be consumer together,

albiet not always (e.g., shoes and socks)

Source: Samuelson and Nordhaus (1995)

 Factors that Influence Market Demand Curve

4. Tastes or preferences – represent cultural and historical influence or

genuine psychological or physiological needs; may contain a large
element of tradition or religion.

5. Special influences – lexpectations on future economic conditions,

particularly prices; availability of MRT; quality of road and rail network;
etc.

Source: Samuelson and Nordhaus (1995)

 Why Does the Demand Curve Shift?

P D D1

D1
D
Q

Demand curve shifts when there are changes in the underlying factors
– An increase in demand causes a rightward shift in the demand curve
(means more quantities will be bought at every price)
– A decrease in demand causes a leftward shift in the demand curve
(i.e., less quantities will be bought at every price)
Source: Samuelson and Nordhaus (1995)
 Change in demand vs. a change in the quantity demanded

Change in demand Change in quantity demanded

(shift of demand curve) – one of the (moving to a different point on the
elements underlying demand curve same demand curve after a price
changed change) – other things were held
equal when price changed

D
P D’ P

A
B
D’
D
Q Q
Source: Samuelson and Nordhaus (1995)
MARGINAL PROPENSITY TO CONSUME

Marginal Propensity to Consume (MPC) – the extra amount that

people consume when they receive an extra dollar of income

response of consumption to changes in income

this is the slope of the consumption function, which measures the
change in consumption per dollar change in income

C
Consumption expenditure
∆C
∆DI

45⁰
DI Disposable income
Source: Samuelson and Nordhaus (1995)
MARGINAL PROPENSITY TO SAVE

Marginal Propensity to Save (MPS) – the fraction of an extra dollar of

income that goes to extra saving

Because the part of each dollar of income that is not consumed is

necessarily saved, MPS = 1 – MPC

e.g., if MPC is 0.85

MPC is 0.15

Source: Samuelson and Nordhaus (1995)

 Economic Actors in the Market

Consumers (Households)
• buy goods and sell factors of production
• use income from sale of labor and other
inputs to buy goods from firms

Firms (Businesses)
• sell goods and buy factors of production
• base the prices of goods on the costs of
labor and property

Sources: Samuelson and Nordhaus (1995) and Google Images

 Economic Decisions faced by Firms

• Produce good 1 or good 2 ?

• Hire more workers or buy more machines?
• Reinvest or declare dividends?

Factors to consider
• Demand and expectations of demand
• Available production technology
• Productivity of workers vs machines
• Cost of capital

Sources: Samuelson and Nordhaus (1995) and Google Images

 The Supply Curve

- Shows the relationship between the market price of a commodity and

the amount of that commodity the producers are willing to produce
and sell (other things held equal)

P S

Typical case of an upward-sloping

supply curve

Q
Source: Samuelson and Nordhaus (1995)
Factors Determining the Supply Curve

Assumption: Firms supply commodities for profit

and not for fun or charity

1. Cost of production

– When production costs for a good are low relative to the market
price, it is profitable to supply more

– When production costs for a good are high relative to the market
price, firms produce little and they switch to the production of other
products or may simply go out of business

Source: Samuelson and Nordhaus (1995)

Factors Determining the Supply Curve

Assumption: Firms supply commodities for profit

and not for fun or charity

a. Prices of inputs – changes in the price of labor, energy,

machinery, etc.

Oil price price of energy production lower

for firms cost supply

Sources: Samuelson and Nordhaus (1995) and Google Images

 Factors Determining the Supply Curve

Assumption: Firms supply commodities for profit

and not for fun or charity

b. Technological advances – changes that lower the amount of

inputs needed to produce the same quantity of output
(e.g., scientific breakthrough, better application of new technology,
reorganizing the flow of work)

Source: Samuelson and Nordhaus (1995)

Factors Determining the Supply Curve

Assumption: Firms supply commodities for profit

and not for fun or charity
2. Prices of related goods
- Goods that can be readily substituted for one another as outputs of
the production process
- e.g., auto companies make several car models, more demand for
one model could make the firm switch more of its assembly lines to
making this model, and supply of other models will fall
3. Government policy
- e.g., environmental and health considerations, taxes, minimum
wage laws, regulation politics, trade policies, etc.
4. Special influences
- e.g., weather on farming, spirit of innovation, market structure,
expectations about future prices, etc.
Source: Samuelson and Nordhaus (1995)
MARGINAL PRODUCT
Production Function
- relationship between the amount of input required and the amount of
output that can be obtained
- tells the maximum output that can be produced with a given amount
of inputs, defined for a given state of engineering and technical
knowledge

Total Product
- the total amount of output produced, in plysical units

Source: Samuelson and Nordhaus (1995)

MARGINAL PRODUCT
MARGINAL PRODUCT
- the extra product or output added by 1 extra unit of that input while
other inputs are held constant
- crucial for understanding how wages and other factor prices are
determined
Source: Samuelson and Nordhaus (1995)
The Law of Diminishing Returns

• We will get less and less extra output when we add additional doses of
an input while holding other inputs fixed.

• The MP of each unit of input will decline as the amount of that input
increases, holding all other inputs constant

- as more of an input such as labor is added to fixed amount of land,

machinery and other inputs, the labor has less and less of other
factors to work with

Source: Samuelson and Nordhaus (1995)

 Law of Diminishing Returns

• One Important Reason for the upward sloping supply curve:

 If society wants more of a good, then additional labor will have to be

added to the same limited land (or capital [other factors of
production]).
 Each new worker will be adding less and less extra product.
 The price needed to coax out additional output will therefore have to
rise.
 By raising the price of the said good, the consumers can persuade
the firms to produce and sell more of a good.

Source: Samuelson and Nordhaus (1995)

MARGINAL COST

Total Cost (TC) – represents the lowest total dollar expense needed to produce
each level of output q. TC as q

TC = FC + VC

FC = Fixed cost – represents the total dollar expense that is paid out even when
no output is produced

– unaffected by any variation in the quantity of output

VC = variable cost – represents expenses that vary with the level of output
(including raw materials, wages, and fuel) and include all costs that are not fixed

Source: Samuelson and Nordhaus (1995)

MARGINAL COST

MARGINAL COST – denotes the extra or additional cost of producing 1 extra unit
of output
Source: Samuelson and Nordhaus (1995)
Shift in Supply Curve
– There is a shift when there are changes in the factors that determine
the supply curve, other than the commodity’s own price
• Supply curve shifts right = • Supply curve shifts left =
supply increases when the supply decreases when the
amount supplied increases at amount supplied decreases at
each market price each market price

P S
S’
P S’
S

Q Q
Supply shifts vs. movements along the supply curve

Movement along the supply curve: price of that good changes

P

p’
p
Q
q q’

Shift of the supply curve: changes in the factors determining the supply
curve

S S’
P

Q
q q’
Source: Samuelson and Nordhaus (1995)
 The INVISIBLE HAND

“As every individual, therefore, endeavors as much as he can, both to employ his
capital in support of domestic industry, and so to direct that industry that its
produce may be of greatest value, each individual necessarily labours to render
the annual revenue of the Society as great as he can.”

“He generally, indeed, neither intends to promote the public interest, nor knows
how much he is promoting it. By preferring the support of domestic to that of
foreign industry, he intends only his own security; and by directing that industry
in such a manner as its produce may be of greatest value, he intends only his
own gain; and he is in this, as in many other cases, led by an invisible hand to
promote an end that was no part of his intention. Nor is it always the worse for
Society that it was no part of it. By pursuing his own interest, he frequently
promotes that of Society more effectively than when he really intends to
promote it.”
Adam Smith, “Wealth of Nations”
 The INVISIBLE HAND

PRICE – represents the terms at which people and firms voluntarily

exchange different commodities.

-Serves as signals to producers and consumers.

Prices coordinate the decisions of producers and consumers in a market.

higher price – reduce consumer purchases and encourage production

lower price – encourage consumption and discourage production

Prices are the balance wheel in the market mechanism

Sources: Samuelson and Nordhaus (1995) and Google Images

 Equilibrium of Supply and Demand

Supply and demand interact to produce an equilibrium

price and quantity or a market equilibrium

market equilibrium – that price and quantity where the forces of supply and
demand are in balance
P
Surplus
S surplus – excess of quantity
supplied over quantity demanded
P*
Equilibrium price shortage – excess of quantity
Shortage demanded over quantity supplied
D

q* Q
Equilibrium quantity
Source: Samuelson and Nordhaus (1995)
Equilibrium of Supply and Demand

Supply and demand intervals to produce an

equilibrium price and quantity or a market equilibrium
“equilibrium” - when supply and demand are in balance, there is no reason for
price to rise or fall as long as other things remain unchanged (ceteris paribus)

equilibrium price and quantity – level where the amount willingly supplied equals
the amount willingly demanded. There are no shortage or surpluses at the
equilibrium price

Sources: Samuelson and Nordhaus (1995) and Google Images

Effects of a Shift in Supply or Demand
Usefulness of the analysis of supply and demand

• Equilibrium prices and goods

• Predict the impact of changes in economic conditions on prices and quantities

Example: what happens to cornflakes manufacturing when the effect of Yolanda

typhoon raised up the price of corn?

S’ S
P

p’ E’
p E
D

q’ q Q

Sources: Samuelson and Nordhaus (1995) and Google Images

Source: Google Images

Effects of a Shift in Supply or Demand
What happens when there is a sharp increase in family incomes, so that everyone
wants to eat more cornflakes?

P
S

p’ E’

p E D’

D Q
q q’

Example: When the elements underlying demand or supply change, this leads to
shift in demand or supply and to change in the market equilibrium of price and
quantity
Source: Samuelson and Nordhaus (1995)
 Effects of a Shift in Supply or Demand

When prices or quantities change in the market, does that reflect a change on the
supply side or the demand side?

Shift of Demand Movement along Demand Curve

S S
S’
P P

p’ E’
D’ p E
p E p’ E”
D D
Q Q
q q’ q q’

Sometimes, looking at price and quantity simultaneously gives a clue about

whether it’s the supply curve that shifted or the demand curve
Source: Samuelson and Nordhaus (1995)
Simultaneous Shifts of Supply and Demand
- Most real world economic issues are much more complicated: involve several
forces acting at the same time, which must be sorted out
Example: what is the impact of immigration on wages?

LS
LS’
W

w E
w’ E’

LD
L
l l’

But is this what happens in reality?

Source: Samuelson and Nordhaus (1995)

 Simultaneous Shifts of Supply and Demand

Example: what is the impact of immigration on wages?

Immigration to growing cities
LS
W LS’

E
E’

LD
L
Possibilities:
- Some economists have suggested that immigrants are more likely to move to
cities where they can get jobs – where demand for labor is already rising because
of a strong local economy.
- Native-born residents move out when immigrants move in: possible that a wave of
new immigrants raise the population of a city, increasing the demand for labor.
Source: Samuelson and Nordhaus (1995)
How to isolate the impact of various factors?

Ceteris paribus or holding other things constant. The variable under

consideration is changed while all othe variables are held constant.

WHEN DOING A SUPPLY-AND-DEMAND ANALYSIS OF ANY

MARKET, YOU MUST TRY TO KEEP ALL OTHER THINGS EQUAL

Source: Samuelson and Nordhaus (1995)

ELASTICITY OF DEMAND AND SUPPLY
In order to turn supply and demand curves into truly useful tools, we
need to know how much supply and demand response to change in
price

• Elasticity – a way of quantifying how responsive supply and demand

are to changes in prices

Sources: Samuelson and Nordhaus (1995) and Google Images

PRICE ELASTICITY OF DEMAND

The price elasticity of demand measures how much the quantity demanded of
a good changes when its price changes. It is the percentage change in quantity
demanded divided by the percentage change in price

elastic demand - when the price elasticity of a good is high

- quantity demanded responds greatly to price change
- e.g., usually those with substitutes

inelastic demand - when the price elasticity of a good is low

- quantity demanded responds little to price changes
- e.g., usually necessities like food, fuel, etc.

Source: Samuelson and Nordhaus (1995)

PRICE ELASTICITY OF DEMAND

The length of time that people have to response to price changes also
plays a role.

SR: demand may be very inelastic

LR: demand is relatively more elastic

Economic factors determine the magnitude of price

elasticities for individual goods:

elasticities tend to be higher for luxuries, when

substitutes are available, and when consumers have more
time to adjust their behavior.

Source: Samuelson and Nordhaus (1995)

CALCULATING ELASTICITIES

Price elasticity of demand = ED

ED = percentage change in quantity demanded

percentage change in prices

ED > 1 price - elastic demand (1% change in price call forth more than a
1% change in quantity demanded)

ED < 1 price - inelastic demand (1% change in price evokes less than a 1%
change in quantity demanded)

ED = 1 unit - elastic demand (the percentage change in quantity is exactly

the same size as the percentage change in
price)
Source: Samuelson and Nordhaus (1995)
When Calculating Elasticities
1. We drop the minus signs from the numbers, treat all percentage
changes as positive
2. We use percentage changes and not actual changes – a change in
the units of measurement does not affect the elasticity
3. Denominator value is the average

ED>1 ED<1 ED=1

Perfectly inelastic demand: vertical demand curve
Infinitely elastic: horizontal demand curve
Note: slope is not the same as elasticity
Source: Samuelson and Nordhaus (1995)
TEN PRINCIPLES OF ECONOMICS
Ref: Mankiw 6e

• How people make decisions

1. People face tradeoffs.

2. The cost of something is what you give up to
get it.
3. Rational people think at the margin.
4. People respond to incentives.
TEN PRINCIPLES OF ECONOMICS

• How people interact with each other

5. Trade can make everyone better off.

6. Markets are usually a good way to organize
economic activity.
7. Governments can sometimes improve
economic outcomes.
TEN PRINCIPLES OF ECONOMICS

• The forces and trends that affect how the

economy as a whole works

8. The standard of living depends on a

country’s production.
9. Prices rise when the government prints too
much money.
[Link] faces a short-run tradeoff between
inflation and unemployment.
REFERENCES

Mankiw N. Gregory, 2007. Macroeconomics. New York: Worth Publishers

Samuelson, P.A., William D. Nordhaus. 1995. Economics. Boston, Mass:

Irwin/Mc GrawHill

Samuelson, P.A., William D. Nordhaus. Economics. 17th Ed. Online Resources

for Students: [Link]

Google Images