Core Economic Principles and Market Concepts

Posted on Apr 3, 2025 in Economics

1. People Face Trade-offs

Efficiency: The property of society getting the maximum benefits from its scarce resources.

Equality: The property of distributing economic prosperity fairly among the members of society.

2. The Cost of Something Is What You Give Up

Opportunity Cost: Whatever must be given up to obtain some item, or the last best alternative forgone.

3. Rational People Think at the Margin

Rational decision-making involves comparing marginal benefits and marginal costs: Marginal Benefits ≥ Marginal Sacrifice.

4. People Respond to Incentives

Incentive: Something that induces a person to act, i.e., the prospect of a reward or punishment.

5. Trade Can Make Everyone Better Off

People gain from their ability to trade with one another, allowing for specialization and greater variety.

6. Markets: A Way to Organize Economic Activity

Markets usually allocate resources efficiently through the interactions of many buyers and sellers. However, market failures can occur:

• Externality: The impact of one person or firm’s actions on the well-being of a bystander.
• Market Power: The ability of a single person or firm to unduly influence market prices.

7. Governments Can Sometimes Improve Market Outcomes

Government intervention can potentially improve market outcomes:

• To promote efficiency: Address market failures (e.g., externalities, market power).
• To promote equality: Address disparities in economic well-being through policies like taxes and welfare.

8. Standard of Living Depends on Production

A country’s standard of living depends on its ability to produce goods and services.

Productivity: The amount of goods and services produced from each unit of labor input.

9. Prices Rise with Excessive Money Printing

When the government prints too much money, the value of money falls, leading to inflation.

Inflation: An increase in the overall level of prices in the economy.

10. Short-Run Trade-off: Inflation vs. Unemployment

Society faces a short-run trade-off between inflation and unemployment (often illustrated by the Phillips Curve).

Note: In the long run, when expectations adjust to reflect the actual situation, this trade-off may not hold.

Supply and Demand Change Effects

Production Possibilities Frontier (PPF)

The Production Possibilities Frontier (PPF) is a graph showing the various combinations of output that the economy can possibly produce given the available factors of production (resources) and the available production technology.

• If the opportunity cost per unit remains constant, the PPF is a straight line.
• If the opportunity cost of a good rises as the economy produces more of that good (due to specialized resources), the PPF is bow-shaped (concave).

Market Definition

A market is a system or arrangement where buyers and sellers interact with each other, settle on a price, and transactions take place at this price.

• A competitive market is one with many buyers and sellers, where each has a negligible effect on the market price.

Demand Concepts

Demand is defined as the desire for a commodity backed by the ability and willingness to pay.

Demand is always referenced concerning a specific:

• Price
• Place
• Time

Law of Demand

The Law of Demand states that, ceteris paribus (other things remaining the same), the higher the price of a good, the smaller the quantity demanded, and vice-versa. There is an inverse relationship between price and quantity demanded.

Supply Concepts

The quantity supplied of any good is the amount of a commodity that sellers are willing and able to sell at a particular price, particular place, and particular time.

Law of Supply

The Law of Supply states the claim that, ceteris paribus (other things being equal), the quantity supplied of a good rises when the price of the good rises, and vice versa. There is a direct relationship between price and quantity supplied.

Price Elasticity of Demand (PED)

Price elasticity of demand (PED or E_p) measures how much the quantity demanded of a good responds to a change in the price of that good. It will typically have a negative value due to the inverse relationship between price and quantity demanded (Law of Demand), though the negative sign is often dropped by convention when discussing elasticity levels.

Types of Price Elasticity:

• Perfectly Inelastic (E_p = 0): Quantity demanded does not respond at all to price changes.
• Relatively Inelastic (0 < |E_p| < 1): The percentage change in quantity demanded is smaller than the percentage change in price.
• Unitary Elastic (|E_p| = 1): The percentage change in quantity demanded is equal to the percentage change in price.
• Relatively Elastic (|E_p| > 1): The percentage change in quantity demanded is greater than the percentage change in price.
• Perfectly Elastic (|E_p| = ∞): Quantity demanded changes infinitely with any change in price (buyers are only willing to pay one specific price).

Calculating PED and Revenue

Price Elasticity of Demand (PED) = (% Change in Quantity Demanded) / (% Change in Price)

Midpoint Formula (Arc Elasticity):

PED = [(Q₂ – Q₁) / ((Q₁ + Q₂) / 2)] / [(P₂ – P₁) / ((P₁ + P₂) / 2)]

Total Revenue (TR) = Price (P) × Quantity (Q)

If demand is elastic (|E_p| > 1), then the % change in Q > % change in P. A price decrease increases TR; a price increase decreases TR.

If demand is inelastic (|E_p| < 1), then the % change in Q < % change in P. A price decrease decreases TR; a price increase increases TR.

Types of Demand Elasticity

Elasticity measures the responsiveness of demand to changes in its determinants:

• Price Elasticity of Demand: Responsiveness to the commodity’s own price.
• Income Elasticity of Demand: Responsiveness to changes in consumer income.
• Cross-Price Elasticity of Demand: Responsiveness to changes in the price of related commodities (substitutes or complements).