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Library and Archives Canada Cataloguing in Publicati on

Ragan, Ch ristopher
Microeconomics I Ch ristopher T.S. Ragan. - 14th Ca nad ian ed.
Includes index.
ISBN 978-0-321-79487-1
L Mic roeconomics-Textbooks. 2. Microeconomics-Canada-Texrbooks. l. Tide.
HB172.R35 20 13 338.5 C20 I2· 906726- 1

IS13N 978-0-32 1-79487- 1
PART 1 What Is Economics? 1 PART 5 Factor Markets 307
Ch,1 pter 1 Economic Issues and Concepts Chapter 13 How F,1ctor Markets Work 307
Chapter 2 Economic Theories, Data, and Chapter 14 Labou r Markets 337
Gn1phs 32 Chapter 15 In terest Rates and the
Capital Marker 360
PART 2 An Introduction to Demand
and Supply 55 PART 6 Government In the Market Eco nomy 384
Chap ter 3 Demand, Supply, and Price 55 Chapter 16 Marker Failu res and Covern ment
Chapte r 4 Elas ticity 81 lnrervenrion 384
Chapter 5 Markets in Action '103 Chapter 17 The Economics of Envi ronmental
Protection 417
PART 3 Consumers and Producers 124 Chapter ·18 Taxation and Public Expenditure 445
Chapter 6 Consumer Behaviour 124
Chapter 7 Producers in the Shorr Run 153 PART 12 Canada In the Global Economy 823
Chapter 8 Producers in the Long Run 177 Chapter 33 The Gains from lntcmation::l!I
Trade 823
PART 4 Market Structure and Chapter 34 Trade Policy 847
Efficiency 200
Chapter 9 Competitive Markets 200
Chapter 'I 0 Monopol)•, Carrels, and Price Mathematical Notes M-1
Discrimination 227 Photo Credits C-1
Chapter 'I 'I Imperfect Competition and Timclinc of Crear Economists T-1
Strategic Behaviour 254 Index 1-1
Chapte r '1 2 Economic Effi ciency and Public Common Abbreviations Used in the Text CA -1
Policy 281

List of Boxes xi 2.3 Economic Data 40
Additional Topics on MyEconLab XI I Index Numbers 40
To the Instructor xiii Graphing Economic Data 43
To the Stude11t XVII I 2.4 Graphing F.conomic Theori es 45
Features of This Edition X IX Func(ions 45
Supplements XXI Graphing Functions 46
Ackn owledgements XXll l A Fina l Word 50
Abouc rhe Aurhor XXIV Summary 50
Key Concepts SJ
Stu dy Exercises 51
What Is Economics? 1
Chapter 1 Economic Issues and Concepts 1
An Introduction to Demand and Supply 55
.I. I What Is F.conomics? 4
Resources 4 Chapter 3 Demand, Supply, and Price 55
Sc;ircity and Choice 4 3.1 Demand 56
Four Key E.conomic Problems 8 Quantity Dc111andcd 56
Economics and Government Policy 9 Quantity De111anded and Price 58
l.2 The Complc.xity of Modern Demand Schedules and Demand
Economics 10 Cmvcs 59
The Nature of Market Economies ll 3.2 Supply 64
The Decision Makers and Their Quantity Supplied 64
Choices 13 Quantity Supplied and Price 64
Production and Trade 1.5 Supply Sd1cdulcs and Supply Curves 6.5
1.3 Is T here an Alternative co die 3.3 The Determination of Price 68
Markee Economy? 17 The Concept of a Market 68
Types of Economic Systems 18 Market Equilibrium 70
The Great Debate 19 Changes in Market EquilibriL11n 7'l
Government in the Modern Mixed Relative Prices and "1flation 73
Economy 22 Summary 76
Summary 23 Key Concepts 78
Key Concepts 23 Study Exercises 78
Study Exercises 24 Chapter 4 Elastlclty 81
Appendix 10 Chapter 1 4.1 Price Elasricfry of Demand 82
A Refresher to Graphing 26 The Measurement of Price
Displaying Poinrs on a Graph 26 Elasticity 83
Linear Curves 27 What Determines Elasticity
Non-Linear Curves 29 of Demand? 86
A Final Wo rd 31 Elasticity and Total Expenditure 88
4.2 Price Elasticity of Supply 90
Chapter 2 Economic Theories, Data,
Determinants of Supply Elasticity 91
and Graphs 32 4.3 An lmporcanc Example Whe1·c
2.1 Positive and Normative Statements 33 F.lasciciry Matters 92
Disagreements Among Economists 34 4.4 Other Ocmand Elasticities 95
2.2 Building and Testing Economic Income Elasticity of Demand 96
Theories 36 Cross Elasticity of Demand 98
What J\rc Theories? 36 Summary 99
Testing Theories 37

Key Concepts 100 Dimi nishing Ma rginal Ra te of

Study Exercises 100 Substitutio n 144
Chapter 5 Markets In Action 103
The Indifference Map 145
5.1 The Interaction Among Markets 104 6A.2 The Budget Linc 146
5.2 Government-Controlled Prices 105 Properties of the Budget Li nc 146
DiscqL1ilibriL1m Prices '1 06
The Slope of the Budget Linc 146
Price Floors '106
6A.3 The Consumer's Uti lity-Maxi mizing Choices 147
Price Ceilings 107
The Consumer's Reaction tu a
5.3 Rent Contt.·ols: A Case Study
Change in Income 148
of Price Ceilings The Consumer's Reaction to a
The Predicted F.ffecrs of Rent Change in Price 148
Controls '110
6A.4 Deriving the Demand Curve 149
Who Gains and Who Loses? 112 Income and Substiwtion
Po lie)• Altcrnatives 113 Effects 150
Study Exercises 15·1
5.4 An hmoducrion to Market Efficiency 113
Demand as "Value" and Supply Chapter 7 Producers In the Short Run 153
as "Cost" '1 14 7.1 What Arc Firms? 154
E.conQmic Surp lus and Marker Organization of Firms 154
Efficienc)' 'l 15 Financing of Firms 155
Ma rket Efficiency and Price Conrrols 11 7 Goals of Firms 155
One Final Application: 7.2 Producrion, Costs, and Profits 157
Output Qu<> tas '11 8 Production 157
A Cautionary Word 'l 19 Costs and Profits 158
Summary 120 Profit-Maximi:Ging Output 160
Key Concepts 121 Time Horizons for Decision Making 161
Study Exercises 121 7 .3 Production in the Short Run 162
Total, Average, and Marginal
PART 3 Produ cts 162
Consumers and Producers 124 Diminishing Marginal Product 164
The Ave rage-Marginal
Chapter 6 Consumer Behaviour 124
Relationship 166
6. 1 Marginal Utility and Consumer 7.4 Coses in the Short Run 166
Choice 125 Defining Short-Ru n Costs 167
Diminishing Marginal Utilit)' '125
Shorr-Ru n Cost Curves 168
Urility Schedules and Graphs '126
Capacity 172
Maximizing Utility '1 26
Sh ifts in Short-Run Cost Curves
The Consumer's Demand Curve '1 29
Summary 173
Marker Demand Curves '1 29 174
Key Concepts
6.2 Income and Substitution Effects Snidy E.xcrciscs 174
of Price Changes 130
The Substitution Effect 'l 31 Chapter 8 Producers In the Long Run 177
The Income Effect '1 31 8.l T he Long Run: No Fixed Factors 178
The Slope of the Demand Curve '1 32 Pro fit M..iximiza tion and Cose
6.3 Consumer Surplus 134 Minimization 178
The Concept '134 Long-Run Cost Curves 181
The Paradox of Value '1 36 Shifts in LRAC Curves 185
Summary 138 8.2 The Very Long Run: Changes
Key Concepts 139 in Technology 186
Study Exercises 139 'lcchnological Change 186
Firms' Choices in che Very Long Run 189
Appendix co Chapter 6 Summary 191
Indifference Curves 143 Key Concepts 191
6A.1 Indifference Curves '143
Snidy e xercises 192

Appendix to Chapter 8 10.3 Price Oibcrim ination 241

lsoquant Anal)•si!. 195 When Is Price Discrimination
8A. l Isoqu:mrs 195 Possible? 243
An Isoquant Map 196 Different Forms of Price
8A.2 Cobl Minimiiation 197 Discrimination 243
The Pri11ciplc of Substi tution 197 The Consequences o( Price
Discrimination 248
Summary 249
PART 4 Key Concepts 250
Market Structure and Efficiency 200 Srudy Exercises 250
Chapter 9 Competitive Markets 200 Chapter 11 Imperfect Competition and
9. 1 Marker Srrucrure and Firm Strategic Behaviour 254
Behaviour 201 I I.I The Structure of the Canadian
Compccicivc Marker Strucmre 201 Economy 255
Competitive Behaviour 201 Industries wirh Many Small Firms 255
The Significance of Market lndusrrics wirh a Few Large Firms 255
Structure 202 Industrial Concentration 256
9.2 The Theory of Perfect Competition 202 11.2 What Is Imperfect Competition? 257
The Assumptions of Perfect Firms Choose Their Products 258
Competition 202 Firms Choose Their Prices 258
The Demand Curve for n Perfectly No11 Price Competition 259
Competitive Firm 203 Two Market Structures 259
Total, Average, and Margi11al 11.3 Monopolistic Competition 260
Revenue 205 The Assumptions of Monopolistic
9.3 Short-Run Decision> 206 Compcrinon 260
Should the Firm Produce At All? 206 Predictions of rhe Theory 261
I low Much Should the Firm 11.4 Oligopoly and Game Theory 263
Produce? 208 Profit Maximization Ts Complkntcd 263
Short-Run Supply Curves 210 The Basic Dilemma of Oligopoly 264
Shorr-Run Eq uilibrium in a Some Simple Ga me Theory 265
Competitive Market 211 Extensions in Carne Theory 268
9.4 Long-Run Decisions 215 11.5 Oligopoly in Practice 268
Entry and Exit 215 Types of Cooperative Behaviour 268
Long-Run Equilibrium 218 Types o( Competitive Behaviour 269
Changes in Technology 220 The Importance of Entry B::irrier& 272
Declining Industries 222 Oligopoly and the Economy 274
Summa ry 223 Summary 276
Key Concepts 224 Key Concepts 277
Study Exercises 224 Study Exercises 277
Chapter 10 Monopoly, Cartels, and Price Chapter 12 Economic Efficiency and
Discrimination 227 Public Polley 281
10.1 A Single-Price Monopnlist 228 12.1 Producrivc and Allocative Efficiency 282
Revenue Co11cepts for a Productive Effici ency 283
Monopolist 228 Allocative Efficiency 284
Shurr-Run Profit Maxirniz::ition 230 Which Marker Structures Arc
Entry Barriers and Long-Run Efficient? 286
Equilibrium 233 Allocative F.fficiency and
The Very Long Run and Creative Toral Surplus 289
Destruction 234 A lloca ri vc F.fficienC)' and
10.2 Cartels as Monopolico 237 Market Failure 291
The Effects of Cartcl1£ation 238 12.2 Economic Regulation to Promote
Problems That Cartels Face 239 Efficiency 293

Regulation of Natural Monopolies 294 Chapter 15 Interest Rates and the Capita! Market 360
Regulation of Oligopolies 297 15.1 A Brief Overview of the
12.3 Canadian Compcticion Policy 299 Capical Markee 361
The Evolution of Canadian Policy 299 15.2 Present Value 362
Recent Reforms 301 The Present Value of a
Future Challenges 302 Single Futu re Payment 363
Sununary 302 The Present Value of a Stream
Key Concepts 303 of Future Paymen ts 364
Study Exercises 303 Conclusions 366
15.3 Investment Demand 367
The Firm's Demand for Capi tal 367
PART 5 The Economy's Demand for
Factor Markets 307 Tnvcstmcnt 371
Chapter 13 How Factor Markets Work 307 1.5.4 The Supply of Saving 371
13.1 Income Distribution 308 Saving and Cu rre nt Income 372
A Glim pse of the Theory Ahead 310 Saving and Expected Future Tncome 372
13.2 T he Demand for Factors 311 Saving and the Interest Rate 373
Marginal Reven ue Product 311 The Economy's Supply of Saving 373
The Firm's Dcma11d Curve l5.5 Investment, Saving, and the
for a Factor 314 Interest Rate 374
The Market Demand Curve F.quilibrium in the Capital Market 374
fur a Factor 316 Changes in the Capita l-Market
13.3 The Supply of Factors 317 E.quilibrium 376
The Supply of F::tctors to the Economy 318 Long-Run Trends in the
The Supply of Factors to a Capital Ma rket 378
Particular Industry 320 Summa ry 380
The Supply of Factors to a Key Concepts 381
Particular Firm 322 Study li..xc rciscs 381
13.4 T he Operntion of Factor Markets 322
Differcmials in Factor Prices 323 PART 6
Policies to Promote " Pay Eq uit)1 " 326 Government In the Market Economy 384
Economic Rene 327 Chapter 16 Market Failures and Government
A Final Word 331 Intervention 384
Summary 332
16.1 Basic Functions of Govcrmm.:nt 385
Key Concepts 333 16.2 The Case for Free Markets 387
Study Exnciscs 33.3 Automatic Coordination 387
Chapter 14 Labour Markets 337 Jn nov:ltion and Growth 388
14.1 Wage Differentials 338 Dceentralization of Power 389
Wage Differentials in Competitive 16.3 Market Failures 390
Ma rkets 338 Market Power 391
Wage Differentials in Ex tcrna Ii tics 391
No n-competi tive Markets 343 Non-rival rous and
Legislated Minimum Wages 346 Non-cxcludablc Goods 393
14.2 Labour Unions 348 Asymmetric Information 397
Collective Bargaining 349 Summa ry 399
Unanswe red Questions 352 l6.4 Bl"Oader Social Goals 40 1
14.3 The "Good Jobs-Bad Jobs" Debate 352 Income Distribution 401
Six Observations 354 Prefe rences for Pu blic Provision 402
A Mixed Blessing? 355 Protecti ng Individua ls from Others 403
Summary 356 Paternalism 403
Key Concepts 357 Social Responsibility 404
Study Exercises 357 F.conomic Growth 404

t\ General Pri nciple 405 Sc:ope of Government Activity 468

16.5 Government l111crvcntion 405 Evolution of Policy 468
The Tools of Government Summary 469
Intervention 406 Key Concep1s 470
The Costs of Government Study Exercises 470
Interven uon 406
Government Pailure 409 PART 12
I low Much Should Government Canada In the Global Economy 823
Intervene? 4 11
Summary 412 Chapter 33 The Gains from International Trade 823
Key Concep1s 413 33.1 The Gains from Trade 824
Study Exercises 413 Interpersonal, Interregional, and
lnrcrnational Trade 825
Chapter 17 The Economics of Environmental lllustr:lting the G:iins from Trade 826
Protection 417 The Gains from Trade wi th
17.l The Economic Ra1iunalc for Variable Costs 829
Rcgulaling Pollu1ion 418 Sources of Comparati ve t\dvant:igc 832
Pollution as an E.xtcrnality 41 8 33.2 The Determination of Trade P:merns 835
The Optimal Amoun t o ( Pollution The Law of One Price 835
Abatement 41 9 The Pattern of foreign Trade 836
17.2 Poll111ion-Con1rol Policies 421 Ts Comparative Adva ntage
Direct Con1rols 42l Obsolete? 837
Emissions Taxes 423 The Terms o( Trade 839
Tradable Pollution Permits: "Cap Summ:uy 843
and Trade" 424 Key Concepts 843
U11ccrtai11ty and the Choice Study Exercises 844
Between Emissions Taxes and Chapter 34 Trade Policy 847
"Cap and Tradctt 427 Free Trade or Protection? 848
17.3 The F.conomic Challenge of Global The Case for Free Tracie 848
Clima!c Change 429 849
The Case for Protection
Greenhouse-Gas Fmissions 429 Invalid Arguments for l'rotecnon 852
·n1c C.1sc for Global Collccrivc Acrion 431 34.2 Methods 0£ l'rotcc1ion 855
Fnergy Use, GOP, and Tariffs 855
Greenhouse Gas F.missions 433 Quotas and Voluntary Export
Significant Policy Challenges 436 Rcm1crions (VER~) 856
Summary 440 Tariffs Versus Quot:b: t\n t\ppliearion 857
Summary 441
Trade-Remedy Laws :ind Non-tariff
Key Concepts 441
Barriers 858
Srudy Exercises 442 Curren! Trade Policy 860
Chapter 18 Taxation and Public Expenditure 445 The GATT and 1hc WTO 860
18.1 Taxation in Canada 446 Regional Trade Agreements 86 1
Progressive 'foxes 446 Trade Creation a11d Trade Diversion 863
The Canadian Tax Sysrcm 447 The North American Free Trade
18.2 Eval11a1ing 1he Tax System 451 Agreement 864
Taxa tion and fa1uiry 451 Summary 868
Taxarion and Efficiency 453 Key Concepts 869
18.3 Public E.xpcndi1urc in Canada 457 Study Exercises 869
Govcrnmcnr Purch:.tscs and
Transfers 457 Mathematical Notes M-1
Canadian " Federalism" 458 Photo Credits C-1
Canadian Social Programs 460 limeline o( Great Economists T- 1
18.4 Evalua1ing the Role of Govcrnmcn! 467 Index 1-1
Public Vcrsu~ Pnva1c Sector 467 Common Abbreviations Used in the Text CA- I
\fA Applylng Economic Concepts
'1-1The Opportunity Cost of You r University 15.·1 The Capital Ma rket and
Degree 6 Macroeconomics 380
2-1 Where Economists Wo rk 35 '16-'l The World's Endangered Fish 395
3-1 Why Apples But Not iPhones? 69 16-2 Used Cars and the Market for " Lemons" 400
5-1 Minim um Wages and Unemployment 108 17-1 An Open Letter to rhe Leaders of
7-1 Ts ft Socially Responsible to Maximize Canada's Federal Political Parties 438
P rofi t~? 156 18-l Poverty Traps and the Negative
7-2 Th rec Examples of Diminishing Rew ms 165 Income Tax 465
8-'IThe Significance of Productivity Growth 187 33-l Two Examples of Absolute and
8-2 The Remarkable Evolution in Personal Comparative Advantage 83'1
Bank ing 190 :n -2 Comparative Ach•antage and Clobal
9-1 Why Small Firms Arc Price Takers 204 Supply Chains 840
9-2 The Parable of the Seaside Inn 214 34 -1 Dues the WTO Du Mu re Ha rm
10-1 Entry Barriers fo r Irish Pu bs During Than Good? 862
the Booming 1990s 235 34 -2 The Transformation of Canada's
12-1 Confidence, Risk, and Regulatio11 in International Trade 864
Canadian Banki ng 300 34-3 Canadian Wine: A Pree-Trade Success
13-1 Ri!:ing Income Inequality in Cam1cla Srory 867
and Other Developed Countries 312

1.-J Lessons from History

1-1 The Failll rc of Ccnrral Planning 20 11 -1 Explicit Cooperntion in OPEC 270
3-1 Ice Storms, Hurricanes, and Economics 74 13-1 David Ricardo a11d "Economic Rent" 329
8-1 Jacob Viner and tlie Clever Draftsman '185 '14-'l Tl1e Development of Unions in Canada 350
10-1 Creative Destrnction Tli rough History 236 34-l Tracie Protection ;rnd R eces~ion 854

~J Extensions In Theory
3-1 The Distinction Between Stocks and Plows 57 '12-2 Innovation and Imperfect Competi tion 292
3-2 The Algebra of Market E.quilibrium 76 15-l Inflation and Inte rest Rates 375
4- 1 The Algebra of Tax Incidence 94 16-1 Arrhur Okun's "Leaky Rucket" 402
4-2 The Terminology of Elasticity 96 18-'1 Who Rea lly Pays the Corporate Income
7-1 Idle Capital Equipment and Plat Cost Tax? 448
Curves 171 33-l The Gains from Trade Mo re Cenera lly 830
11 -1 The Prisoners' Dilemma 267
12·'1 Allocati ve Efficiency and the Distribution
of l ncomc 288

CHAPTER 1 Challenges Facing the Developing CHAPTER 12 Ontnrio's Troubled Electricity Sector
CHAPTER 13 Docs Government Support of Specific
CHAPTER 2 (low Economists Choose Their Theories Industries Really Create Jobs?
What the S&PrrSX Reall y Measures CHAPTER 14 The Puz:tle of Interindustry Wage
Differentials in Canada
A Brief Introduction co Graphing
CHAPTER 15 The U.S. I lousing Collapse and the
CHAPTER 3 Economic Data and the ldenrification financial Crisis of 2007-2008
A Beginner's Guide to the Stock Market
A Primer on the Market for Crude Oil
ln ves1men1 and Saving in Globali1,cd
CHAPTER 4 Some Further Details J\ hour Demand Financial Markets
lntcresr Rares and rhe Extraction of
Who Really Pays for Payroll Taxes? Namra I Resources
CHAPTER 5 Linkages Between Markets CHAPTER 16 Externalities and the Coase Theorem
When Rent Concrols Work a11d When I low Excessive Regulation Hob bles
They Don't Devclopmcnc
Agriculmre and chc Farm Problem Charging for Garbage by the Bag
CHAPTER 6 Whar Makes People I lappy? A Markee for S02 Emissions in the
Do Taxes Discourage Work Effort and United Srates
Saving? The Politics of Market-Based
CHAPTER 1 Multinational Enterprises and Foreign Environmental Policies
Direcr Investment CHAPTER 18 Debure More Healchy than Hcalch Care
Do Pirms Really Maximize Profits? Who Arc Canada's Poor?
CHAPTER 8 Explaining Different Concepts of The Eco11omic and Fiscal Challenges of
Efficiency Population Agi11g
Undemanding and Addressing Canada's Whac h the Ralanccd Budget Multiplier?
l'rocluccivicy Challenges
CHAPTER 33 Who Arc Can:ida's Trading P:ircncrs?
CHAPTER 9 An Example of Loss MinimiLarion as
Profit Maximi1~1rion Docs Tlurd-World Growth I !arm First·
World Prosperity?
The Long-Run Jndu~cry Supply Curve
CHAPTER 34 The Continuing Saga of Softwood
CHAPTER 10 The Bartle over Online Prescription I .um ber
Fann Subsidies and the World Trade
CHAPTER 11 The Nature of G l o ba l iz~1tio11 Orga nization
A Sequential Game in Fibre Optics
Oligopoly and Contestable Markets

Economics is a living discipline, changing and evolv-
ing in response co developmenrs in che world economy
I Current Economic Issues
and in response co che research of many chousands of
economises chroughouc che world. Through fourceen In wricing che fourceench edition of M icrocconom-
edicions, Microeco110111ics has evolved wich che disci- ics, we have cried co reflccc che major economic issues
pline. Our purpose in chis edicion, as in che previous chac we face in che e::irly twenty firsc cenrnrr.
chirreen, is co provide scudencs wich an incroduccion
co che major issues facing rhe world's economies, Living Standards and Economic Growth
co che mechods char economises use co srudy chose
issues, and co che policy problems char chose issues One of the most fu ndament:il economic issues is
cre:ice. Our tre::irment is everywhere guided br three chc dccermination of overall living ~til n dards. Adam
imporranc principles: Smith wondered why &ornc countries bcc(nnc wealthy
while others rc mnin poor. Though we have learned
much abo ut chis topic in the p:isc 240 yca ri. since
1. Economics is sci<mtific, in rhe sense char it pro- Adam Smith's landmark work, economises 1·ecognize
gresses through rhe syscemacic confronrnrio n chac there is sci II much we du noc know.
of rheor)' by eviclern.:e. Ncirher cheory nor darn The imporcance of cechnologica l drn ngc in decer-
alone c::in tell us much ::ibour che world, bur com- mining increases in overall living st:rnclarcls is a theme
bined they cell us a great de::il. char perrneaces both rhc microeconomics and macrn-
economics halves of chis book. Chapter 8 explores
2. Economics is 11sef11/, ::ind it should be seen by
scudencs co be so. An understanding of eco- how firms de::il with technologic::il chonge at che
nomic cheory combined wich knowledge abour micro level, and how changes in their economic envi-
ronment lead them co create new produces :rnd new
che economy produces many imporcanr insights
produccion processes. Chopters I I an<l 12 discuss
about economic policy. Alrhough we scress these
insights, we :ire also careful co point out cases in how imperfeccly eompecicive firms ofcen compete
through cheir innovocive praccices, and che impor-
which coo liccle is known ro support strong state-
tance for policym::ikers of designing compecirion
mencs about public policy. Appreciating what is
noc known is :is imporr:inc :is learning what is policy co keep chese proccices as energecic as possible.
known. \Y/e ore convinced ch::ic no ocher incroduccory
economics cexcbook places as much emph::isis on
3. We strive :ilw:irs to be ho11est with our read- tec.:hnologic.::il change :ind economic growth os we
ers. Although we know th:it economics is not do in this book. Given the importance of continuing
alwars e:isy, we do nor ::ipprove of glossing growth in living scancl:irds and undersea 11ding where
over difficult bits of ::in::ilrsis without letting chat growth comes from, we believe this emphasis is
renders see wh:it is h:ippeni ng and what has appropriate. We hope you agree.
been :iss111Tied. We t:ike whatever space is
needed to explain why economists draw their Flnanclal Crisis, Recession, and Recovery
conclusions, rat her than just asserting the
cond usion&. We :i lso tnke p::i ins to ovoid sim- The collapse of U.S. housing prices in 2007 led to
plifyi ng mnuers so much chat students wo uld a global fi nancial crisis the likes of which had not
have to un l e~rn what they have been caughc if been witnessed in a century, and perhaps longer. A
they conci 1111e rhci r srucl)' beyond the introduc- deep recession, experienced in many coun tries, fol -
wry C<Jur&c. In shore, we h::ivc cried to follow lowed quickly on irs heels. These dramatic events
Albert Einstein 's advice: reawakened many people ro rwo csscnti<ll fact~ about
economi c~. Fir&r, modern economics can a11d do go
Everylhiug s/Jo11/d he made as simple as possible, into recession. Thi~ essential fact h:id pcrhap~ been
/Jut 11cJ/ si111p/el'. forgotten by many who had become complacent a ftcr


more than two de..:ades of economic prosperity. Sec· winds shifted aga in with the arriva l of the fi narn.;ial
ond, Finan..:ial markets are crucia l to the operation crisis and global recessio n in 2008, which led gov·
of modern economies. Li ke an electricity system, the ernmencs che world over to ta ke some unprecedented
details of financial markets are a myste ry to most actions. Many soon argued chat we were observing
people, and the system itself is often ignored whe n the "end of laissez-fa ire" and witnessing the rew rn of
it is functio ning properly. But when fi nancial mar· "big government." But was chat really crue?
kets ..:ease to work smoothly and interest rates rise Tlas the f1111damenta/ role of government changed
while credit flows decline, we arc all reminded of their significantly over the pasc 35 years? In order [() under-
importa nce. ln this sense, the financial crisis of 2007- stand the role of government in che economy, students
2008 was like a global power fa ilure fo r the world must understand the benefits of free markets as well
economy. as the situations that cause markets to fai l. T hey must
The financ ial crisis had micro causes and macro also understand that governments often interve ne in
consequences. The challenges of appropriate regula- the economy fu r reasons related more co equit)' chan
tion for fi nancial and nonfina ncial firms arc explored to efficienq 1.
in Chapters 12 and 16. The market for financial In chis fourteenth edition of Mic.roec.011omics, we
capital and the determination of interest rates arc continue ro incorporare rhe discussion of government
examined in Chapter 15. And debates regarding policy as ufren as possible. Here are bur a few uf rhe
the apprupriare rule uf che guvernmenc i11 a marker many examples that we explore:
economy occur rhru ughour rhe book, incl uding i11
• tax incidence (in Chapter 4)
Chapters I, 5, 16, and 18.
• che effects of minimum wages and ren~ controls
(in Chapter .5)
Globallzatlon • economic regulation and competitio n poliq 1
Enormous 1:hanges have occurred throughout the (in Chapter 12)
world over the lase few decades. Flows of trade and • pay equi ty policy (in Chapter 13)
investment !between countries have risen so dra· • environ mental policies (in Chapter ·t 7)
matically that it is now common to speak of the • rhe disincentive effects of income taxes (in
"globaliz.ation" of the world economy. Today it is no Chapter 18)
longer possible to study any economy without taking • trade policies (in Chapter 34)
into account developments in the rest of the world.
Throughout its history, Canada has been a
trading nariun, and our policies relating to interna-
tio nal trade have ofcen been ac che centre of poli tica l
I The Book
debates. International trade shows up in many parts
uf chis cexcbuok, buc ic is che exclusive focus of cwu Economic gruwrh, financial crisis and recession, glo-
cha peers. Cha peer 33 discusses the theory of chc gains balizariun, and the rule of government are pressing
fro m trade; Cha pter 34 explores trade policy, with an issues of rhe day. Much of our smdy of economic
emphasis on NAFTA and the WTO. principles and the Canadian economy has been
The furces uf glubalizatiun are with us ru scay. In shaped by these issues. In addition ru specific cov-
chis fourteenth edition uf Microeco11omics, we have erage of growth and internationally orienred rupics,
do11e our besr ro ensure char srudents are made aware growth and globalizarion appear nacurally rhrough-
of the world ourside Canada and how events else- ouc the book in rhe trearmem of many copies once
where in the wurld affecr rhe Canadian ecunumy. thought co be emirely "domestic."
Most cha peers of Microeco11omics con rai n some
discussion of economic policy. We have rwo main
The Role of Government goals in mind when we present rhese discussions:
Between 1980 and 2008, the political winds shi fted
in Canada, the United States, and man)' ocher coun· 1. We aim [() give students practice in using cco·
tries. Political pa rties char previously advocated a nomic the01·)1, because appl)1ing theo ry is both a
greater nJle fo r government in the economy argued wonderfully effective teaching method and a reli-
the benefits of limited government. But the poli tical able test of students' grasp of theory.

2. We want co introdllce students co the major poli..:y ..:artels. Chapter ·1·1 deals with monopolistic compe·
issues of the day and to lee them discover that few ti tion and oligopol)', which are the market structures
policy debates are as "black and white" as they most commonly found in Canadian industries. Stra-
often appea r in the press. tegic behaviour plays a central part in the analysis of
this chapter. The first half of Chapter 12 deals with
Buth guals refl ect our view chat students should see rhc effidcnc)' of competition and the inefficicnc)' of
economics as useful i11 helpi11g us ru unders tand and monopol)'. The last half of the chapter deals with regu-
deal with rhe wurld around us. lation and competition polic)'·
Part 5 begins with Chapter 13, which discusses
rhe general principles of factor pricing and how factor
Structure and Coverage
prices arc influenced b)' fa cto r mobility. Chapter 14
To open Parr I, Cha prer I begins wirh an informal then examines the operation of labour markets,
presentation of six major issues of the day. We then addressing issues such as wage differentials, discrimi-
introduce scarcity and choice, and chis leads co a dis- nati<Jn, labour uni<JnS, and the "good jobs-bad jobs"
cussion of the market as a coordinating device. Fina 11)', debate. Chapte r J 5 discusses investment in physical
we turn to alternative economic sysrems. Compari- capital, rhe role uf rhe inreresr rare, and rhe uveralI
sons with command economies help cu esta blish what functioni ng uf capital markers.
a marker economy is by showi11g what it is not. The The first chapter uf Pare 6 (Chapter 16) provides
Appendix ro Chaprer 1 provides a useful refresher a general discussion of market success and marker
on graphing. Chapter 2 makes the importanc disrinc- fail ure and ouclines rhe argumenrs for and againsr
tion berween positive and normative inquiries and guvernmenr inrervention in a market economy. Chap-
goes un cu an incruducrury discussion uf che cunsrruc- ter 17 deals with enviru11mencal regulaciu11, with a
rion and resting of economic rheories. derailed discussion of market-based policies and a11
Parr 2 deals wi rh demand and supply. Afrer incro- imroduccion ro che issue of global climate change.
ducing price derermination and elasticity in Chapters 3 Chapter 18 analyzes mxes, public expendicure, and
and 4, we apply chese cools in Chapter 5. The case the mai n elemenrs of Canadian social policy. These
srudies are designed ro provide practice in applying the rh ree chapters expand on rhe basics of microeconomic
rools racher d1an ro give fu ll coverage of each case pre- analysis by providing cm renc illus(racious of rhe rel-
sented. Chapter 5 also has an inrnicive and thorough evance of economic (heory to contemporary policy
creacmenc of economic val ue and marker efficiency. situatio ns.
Pare 3 presenrs the foundations of demand and We hope yo u fi nd rhis menu boch arcraccive
supply. Tlhe theory of consumer behaviour is devel- and challenging; we hope srudencs find che ma(erial
oped via marginal ucility theory in Chap ter 6, which stimulating and enlightening. Man)' of t he messages
also provides an introduction co consumer surplus of economi..:s a re complex- if e..:onomi..: unde rstand·
and an irn tuitive discussion of income and substi- ing were only a matter of common sense and simple
tu tion effects. The Appendix to Chapter 6 covers observation, there would be no need for professional
indifference curves, budget lines, and the derivation economises and no need fo r textbooks like this one.
of demand curves using indifferen..:e theory. Chapter 7 To understand e..:onomics, one must work hard. \Vork·
introduces the firm as an institution and develops ing at this book should help readers gain a better
shore-run costs. Chapter 8 covers long-run costs and understanding of the world around them and of the
the principle of substitution and goes on co consider policy problems faced by all levels of govern ment.
shi fts in cost curves due to technological change. The Furthermore, in today's globalizcd world, the return
latter topic is seldom if ever covered in the micro part w education is large. We li ke tQ chi nk chat we have
of clemen tary te xtbooks, yet applied work on firms' contributed in some small pan ro the understanding
responses to changing economic signals shows it to that increased investment in human capital by the
be extremcl)' important. next generation is necessary to restore incomes to the
The first two chapters of Part 4, Chapters 9 and rapid growth paths chat so beneficed our parents and
10, present the standard the<Jrics of perfect compeci- our peers. Perhaps we ma)' even contribute w some
tion and monopoly with a thorough discussion of price income-enhancing accumulation of human capital b)'
discrimination and some treatment of international some of our reade rs.

Substantive Changes to Part 3: Consumers and Producers

This Edition In Chapter 6, we have clarified the discussion of the
condition fur utilit)' maximization, and the material
on individual and market demand curves is now in
We have revised and updated che entire rexc wirh the main rext rather tha n in an optional box. Chap-
guidance from an exrensive series of formal reviews ter 7 examines the shore run theory of the firm; we
and orher feedback from both users and nonusers say more about the role of bank lending, have bec-
of rhe previous editions of this book. As always, we cer explanations for diminishing returns, and che
have striven very hard ro improve the ceachabilitr box on flat cosc curves has been improved. We have
and readabi lit)' of the book. \Vic have focu&cd the expanded and clarified our discussion in Chapter 8
di~cu~sions i;o that c:11:h major point is emphasized of che principle of substicution and have added a new
as clearl y a~ pos~ible, without discrac:ring che reader discussion on che imporram:e of produccivi cy growth
with no11C'1'>Cntial point1>. 1\dditi1111al TofJics, avail- in drivi ng long-run living standards.
able on M )'EconLab (www.m)'cconlab.rnm), address
theoretical, empirica l, and poliq1di&cu&sions chat arc Part 4: Market Structure and Efficiency
interesting but optional. (i\ complete liMing of the Tn Cha pter 9 on perfect competition, we have
Additional Topics is provided fo llowing the Cunrencs improved our discussion of whether firms should pro-
afcer rhe Lise of Boxes.) As in rccenc editions, we have duce at all, che concept of che shut down price, and
kepr all cme marcrial in the main parr of rhe rexc. the meaning of loss minimi7,arion. 111 Chap[er I0, we
Three rypes of boxes (A ppl)•ing Economic Cunceprs, have clarified the comparison of price :rnd m::irginal
Lessons from Histuq•, and Extensions in Theuq•) are cost for determining efficicnt:y. \Vic have added Potash
used tu show examples or extensions rhar can be and Canpotex as an example of an at:cive cartel, and
skipped wirhour fea r of missing an essemial concept. car prices between Canada and the United Stares as
Bur we chink ir wo uld be a shame co ski p coo many an example of price discrimination. In Chapter I I,
of chem, as there are many inreresting examples and we have streamlined the discu~sion of monopolis-
polk)' discussions in rhese boxes. tic competition, including an improved di~cus~ion of
\Ylhar follows is a brief listing of rhe main changes shore-run profiti. and lo~<.e<.. We have al~o added a new
char we have made ru rhe textbook. discus~ion about how profir maximization among
oligopoli~t~ involve~ perception'> of rivals' re~ponscs
and have included a new discussion about exrensiuns
Part 1: What Is Economics?
beyond simple game rheur)'· In Chapter 12, we have
Chaprer I has been significanrlr rewritten and rear- clarified rhe discussion abuur regularion uf nacural
ranged. We now begin with a brief discussion of six monopolies and we have added a new box on the reg-
ker issues in the Canadian and world economies, and ularion of Canadian banks mocivare<l by the need cu
chen rum co examine resoun:es and scardrr, coordi- reduce risks and enhance scabiliC)'. \Vie have updated
nacion in markets, and alternative economic systems. che discussion of Canadian cumpeciciun pulic)', includ-
We have added a di~cu ~~ion of the role of economic ing rhe recenr example of rhe proposed joim venrure
polic)'. In Cha pter 2, we have improved our discussion between Air Canada and United Conrinenral.
of the nacurc of theories, ca u~acion, and predictions,
and we have added a new box dist:ussing where econ- Part S: Factor Markets
omists gee jobs and what kinds of work they do. Chapter 13 begins with a seccion on income disrribu
rion, and we have added a new box 0 11 rising income
Part 2: An Introduction to Demand and Supply inequality in Canada and rhc ocher OECD economies,
In Chapter 3 on the basics of demand and supply, and why ic matrers. We have also cnrire ly rewri t-
we have added a new box explaining why rhe model ten and shortened rhc discussion of a firm's demand
works well for commodities (like apples) bur not so for a factor of production, and wha t determines che
well for differentiated produces (like il'hones). Chap· elascicicy of factor demand. Jn Chapter 15, we have
ter 4 on elasrit:ity begins with rhc ex::unple of rhe effect improved our discussion of what events ch:inge a
of the 20 I I Libyan war on the price of oil. We have firm's demand fo r capital, and why honsehold saving
also streamli ned rhe discussion of supplr elascicicy. is relaced co che interest rate.

Part 8: Government in the Market Economy we have reworked and clarified our disc ussion of rhe
In Chapter 16, we have improved our discussion case for protection. We have shortened the discussion
and diagram explaining the meaning of positive and of countervailing duties but expanded the discussion
negative extemalities. We have improved the box and exa mples of notional treatment in NAFTA. We
on che marker for lemons and also our explanation have also streamlined our dis,ussion of the ongoing
of rcnr sceki ng. We have also deleced rhe old mare- WTO Doha round. Our mcnti<m of the new Tr:ins
ria I on ineffkient public choices and the box on the Pacifie Partnership now leads us w a new box on the
Arrow Impossibility Theorem, which many reviewers ongoing drive to diversify Canada 's trade.
thought was too advanced. Jn Chapter 17 on environ-
menral regulation, we have improved our discussion
of direct controls, including a passage about when
ther are effective. We also have several changes in the If )'ou arc moved to write to u~ (and we hope 1h:1t
section on climate change, including a new discus- )'OUwill be!), plea~e du. You can ~end an)' comment~
sion of the state of play after the Kyoto Protocol. Tn or question\ regarding the text (or an)' of rhc ~ upplc­
Chapter I 8, we have improved our discussions of the mcntarr m:itcrial, ~m:h as the Instructor's Ma1111al,
CST, the di~incen tive effects of taxation, rhc fu nding the Study G111de, the TestGen, or the wcb-b:i~cd
paths for CST and CTTT, and rhc derails ~urrounding Additional TcJfJics) to:
the OAS and the Child Tax Bcnefi ts. Christopher Ragm1
Deµt1rt111e11t of l::co11omics
Part 12: Canada In the Global Economy McGill U11i11ersity
Ch:iprer 33 on rhe gains from international rracle has 855 Sherbrooke St. West
been upd:Hed and revised, bur there is nu subs1:mrial Mo111real, Quebec HJA 2T7
change co irs srrucrure or messages. In Chaprer 34, 1•-mail: chr1stopher.raga11@mcJ.:1/
Welcome to what is most likely your first book about argumem co verbal or geometric exposition, these may
microeconomics! You are about co encounter what is prove usefu l. Ochers may disregard chem.
for most people a new way of thinking, which often In chis edition of rhe book, we have incorporated
causes people co see things differently than they did many elements co help you review material and pre-
before. But learning a new way of chinking is not pare for examinations. A brief descripcion of all the
always easy, and you should expect some hard work feacures in chis book is given in the separace section
ahead. We do our best ro be as clear and logical as char follows.
possible and ro illustrate our argumems whenever We encourage you co make use of MyEconLab
possible with current and interesting examples. chat accompanies chis book (W\
Yoll must develop your own technique for study· at the outset of yollr swdies. MyF.conLab contains a
ing, but the fo llowing suggestions may prove helpful. wealth of valuable resources to help yo u. MyEcon-
Begin by carefu lly considering the Learning Objec· Lab provides Sollltio ns to Selected Study Exercises.
tives at the beginning of a cha pter. Read the chapter It also incllldes many additional practice qllestions,
itself relatively quickly in order to get the genera l some of which are modelled on Study Exercises in
idea of the a rgument. At this first reading, you may the book. MyEconLab also contains many Additional
want to skip the boxes and any footnotes. Then, after Topics-these represent material written especia lly
reading the Summary and the Key Concepts (at the for this textbook and include many inte resting theo·
end of each chapter), reread the chapter more slowl)', rctical, empirical, and policy discussions. You can also
making sure chat yt1u understand eac:h seep tJf the find animations tJf some of the key figures in che ccxt,
argument. marked with the S)'mbol 1$} below the figure mun-
With respect to the figures and tables, be sure you ber, as well as an electronic version of che textbook.
understand how the conc:l usions that arc stated in For more details about MyEconLab, please sec the
boldface ac the beginning of eac:h c:apcion have been description on p. ii.
reached. You should be prepared to spend rime on dif- We strongly suggest you make use of the excel-
ficult sections; occasionally, you ma)' spend an hour lent Study Guide written expressly for chis text. The
on onl)' a few pages. Paper and pencil arc indispens- Study Guide is closely integrated with the book; it
able equi pment in your reading. Ir is best to fo llow offers practice questions and exercises chac will tesc
a di fficulr argument by building yo ur own diagram and rein force your understanding of che concepts and
while che argument unfolds rather than by relying 011 analytical techniques stressed in each chapter of the
che fin ished diagram as ic appears in che book. cext and will help you prepare for your examinations.
The end-of-chapter Study Exercises require you co Explanaciu11s are provided fur the answers tu many
practise usi1'1lg son1e of che concepts char yo u learned of che Mulriple-Choice Questions cu facilirace your
in che chapter. These will be excellenc preparation for independent scudy. Being able ro solve problems and
your exams. Tu provide you with immediate feedback, co cummunicace and interpret your resulcs are impor-
we have pusced Suluciuns cu Selected Study Exercises canc goals in an intruductur)' course in ecunumics. The
on MyEconLab ( We strongly Study Guide can play a crucial role in your acquisition
advise char you should seek ro understand economics, of these skills.
nor co memorize ic. Over the years, the book has benefited greatly
The red numbers in square brackets in che cexc from commems and suggestions we have received
refer ro a series of machen1acical noces char are found from students. Please fee l free to send your comn1encs
starting on page M-'I at the end of the book. For chose ro Good luck, and we
of you who like mathematics or prefer mathematical hope you enjoy yo ur course in economics!

We have made a careful cfforc wich chis edition co incorporacc fca cures chac
will faci li~ace che ceaching and learning of economics.
• A set of Learning Objectives at the beginning of each chapter, correlated
co the Chapter Outline, clarifies che skills and knowledge co be learned in
each chapter. These same learning objectives are used in the chapter sum-
maries, as well as in the Study Guide. __ .._.. ..._......._...
.··--·-·--...___ ·-----
·------- ._

• Major ideas are highlighted with a yellow background in the rexr.

• Key ccrms arc boldfaced where chcy arc defi ned in chc body of chc ccxc and
chey arc restated with their dcfi nicions in the margins. Jn che index at the
back of the book, each kC)' term and the page reference co i t~ definicion
arc boldfaccd.
• \~lebl i n ks
co usefu l Internee addresses are given in the margins. Each web-
link presents a URJ. address, along wi th a brief description of the material
available there. Some links are co government home pages where yo u can
obtain much addi tional data. Other links are co organizations such as
OPEC, the UN, and the WTO.

~-=...-:::...-~-·--·----· .

• The colour scheme for figiires consistently uses the same colour for each
type of curve. For example, alI demand curves are blue and all supply
curves are red.
• A caption for each figure and cable summarizes the underlying economic l'~j,~
J: l. I' .

----. ---
reasoning. Each caption begins with a boldfaced scacement of the relevant /

economic conclusion.

• Applying EcoMmic Concepts boxes demonstrate economics in action,

providing examples of how cheorecical material relates w issues of cm-
re nr inceresr.
• Excensions in Theory boxes provide a deeper creacmem of a theoretical
topic char is discussed in the text.
• Lessons from Hiscory boxes contai11 discussions uf a parricular policy
de bace or empirical finding char ra kes place in a hiscorical comexr.
• Photographs wirh short captions are inrerspersecl rhroughouc rhe chaprers
co illuscrace some of che arguments.


• Chapter Summaries are organized using the same numbered heading as

found in the body of the chapter. The relevant I.earning Obje..:tive (LO)
...,.......... _ ... ;;£..7·:3.~. ....
numbers are given in red next to each heading in the summary.
• Key Concepts are listed near the end of each cha peer.
~·--·- ..... .....
.:=;:~-==-·: -..
- E:·c~..:.~-z~
...- -.... -...a.-

• A set of Study Exercises is provided fo r each chapter. These ofte n quan·

e•••ep14;1 titative exercises requi re the student to analyze problems by means of
computations, graphs, or explanations.

• A set of Mathematical Notes is presenced in a separate section near the

end of che book. Because marhemarical noracion and derivations are nor
_...................... . .
........ . , ... ,., .. ,.,.
.,_ ...... _...........
·-. necessary w underscand che principles of economics buc are more helpful
in advanced work, chis seems w be a sensible arrangemem. References in
.. _...... _.... ;E:Ti0:~!~~

.......... _. ........ _..•

the text co these mathematical notes are given by means of red numbers in
i::~';=~t~:~~r:;::-: square brackets.
=. ::~~?.~~
...... .,J

' '" '~ ..

~:-~:~: ~ .. ..... -:-:::-:"/
.~":::·.:.: ~:

, ~
.... . . . ·*-·· ..-.. _.;::.=.:::;.,".'x.:.::.:
•·• O • I t •

• •


- _.-... .,_,
" ......·-·..-•-
.... ·-- . "·-·-···-·-
......... ~ -··•"'
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...- ...
_., ...-··-··- . ..
r.-:::-..:........ - -...··- !i~'X.';..":.i: ;-.~
·~:::'i ~:.::.:

• A Timclinc of Great Economists, extending from the mid-seventeenth

11r111llne Of Economi.&li ccncur)' co the late twentieth century, is presented nea r the end of the
book. Along chis rimeline we have placed brief descriptions of che life and
works of some greac economises, mosc of whom che reader will encouncer
in rhe textbook. The rimeline also includes some major world evems cu
give readers an app reciation of when these economises did cheir work.
• For convenience, a list of rhe Common Abbreviations Used in the Text is
given on che final page of rhe rexc.
A c:omprehensive sec of supplemencs has been carefully
prepared to assisc studcncs and instructors in using this
I Study Guide
new edition.
A robust Study Guide, wrictcn by Paul T. Dickinson

I MyEconlab
and Guscavo lndarc, is available for microeconomics
(978-0-32'1-82840-8). le is designed for use either in
the classroom or by studencs on their own. The Study
Guide uffers addicional study support and rein fo rce-
The mo111enc you know. rne11c for each cext chapter. It is closely i11Cegrated
Educators know ic. Scudents know it. Tc's that wirh rhe rexcbook; offeri11g relevanr exercises for each
inspired moment when something chat was difficult chapter. Tu facilirate independenc scudy, explanariuns
co understand suddenly makes perfect sense. Our are provided for abuuc 70 percem of the answers cu
MyLab produces have been designed and refined with the Additional Mulciple-Chuice Questiom. For each
a single purpose in mind-to help educators creace chapter, che Study Guide provides rhe fu~luwing help-
that moment of unde rstanding with their scudents. ful macerial:
My EconLab delivers proven results in helping
individual studencs succeed. It provides engaging cxpc- • Learning Objcccives marchi ng chose in che ccxtbook
ricm:es that pers<malizc, stimulate, and measure learning • Cha peer Overview
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xxll SUP l'LEM ~ N TS

I Instructor's Resource CD-ROM These insrru1.:ror supplements are also available

for download from a password-prorecced section of
Pearson Education Canada's on line catalogue (www.
The lllstructol''s Resource CD-ROM (978·0·32 I· Navigate co your book's
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• An lnscruccor's Manual (in borh Word and PDF for-
mat) wricten by Chriscopher Ragan. Ir indudes full
solurions co all rhe Srudy Exercise~.
• A Computeri1ed Testbank (J>earson TestGen)
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Ragan.The testb:rnk consists of 4000 multiple-choice CourscSmart goes bcrond traditional expeccations-
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like w chank three individuals wich whom we worked Christopher Ragan

About the Author
Chris Raga n received Professor Raga n's resea rch focuses mainly on
his 13.A. in economics the design and implementation of macroeconomic
From the University policy in Canada. He has been privileged to serve the
of Victoria, his M.A. fede ral govern ment in Ottawa as Special Advisor co
from Quee n's Uni ver- the Governor of the Bank of Canada and as the Clif-
sit)', and his Ph.D. from ford Clark Visiting Economist at the Depa rtmcnt uf
the Massachusetts Finance. I le currcncl y serves on the Moneta ry Poliq 1
Institute of Technology Council of the C.D. II owe Institute, where he also
in Cambridge, Massa- holds the David Dodge Chair in Monetary Policy.
chusecrs in 1990. I le Chris Raga n used the third edition of chis text-
then joined the Depart- book as an undergraduate stude nt in 198 1 and joined
ment of Economics Richard Li psey as a co-author in '1997 for the book's
at McGill University nin th edition. Fur several editions, Lipsey and Ragan
in Montreal, where he has ta ught graduate courses in worked diligentl y tu mai ntai n the book's reputa tion
macruecu11umics and i11Cernatiunal fina11ce and under- as the clearest and must comprehensive intruducrury
graduare cuUJrses in macroeconomic theory and policy, economics rexrbook in Ca11ada. Although Professor
currem economic issues, and fi nancial crises. Over rhe Ragan is now rhe sole lisred author, chis fourteenth
years he has caught principles uf economics (micro and edition of Economics srill uwes much cu the dedica-
macru) cu thousands uf srudencs at McGill and main- riun uf previous aurhurs, including Richard Lipsey,
tains a rep ucarion rn1 campus as being "super-excited" Douglas Purvis, and Gordrn1 Spal'ks.
about economics. In 2007, Chris Ragan was awarded
che Noel Fieldhouse Teaching Awa rd frum McGill fu r
reaching excellence.

About the Cover

The cover image of this edi tion is an aerial dra wing of the bustling port of Collingwood, Ontario, by artist Steve
Mi;Donald. Steve is an established Canadian artist and fou ndi ng member of the accla imed collei;tive Drawnon-
wa rd. The colle<.:tive has been the subject of awa rd-wi nning documentaries shown on CRC, Rravo, and TVO,
profiled fo r die artis ts' unique bond with Canada's landscape. For more info rmation, visit


After studying this chapter you will be able to

1.1 WHAT IS ECONOMICS? 1 explain the importance of scarcity, choice, and opportunity
cost. and how all three concepts are illustrated by the
production possibilities boundary.

1.2 THE COMPLEXITY OF MODERN ECONOMIES 2 view the market economy as self-organizing in the sense
that order emerges from a large number of decentralized
3 explain how specialization gives rise to the need for trade,
and that trade is greatly facilitated by money.
4 identify the economy's decision makers and see how their
actions create a circular flow of income and expenditure.

1.3 IS THERE AN ALTERNATIVE TO THE MARKET ECONOMY? 5 see that all actual economies are mixed economies,
having elements of free markeLS, tradition, and government

MANY of the challenges we face in Canada and around problem and its ~ol uti ons will be tremendous; popula-
che worlcl are primarily economic. Some are moscly tion aging in Canada and ocher developed countries
environmental, social, or political, but with many issues will have consequences fo r the structu re of our soci-
there is also a significant economic dimension. Wars and eties, but it will also have significant economic effeccs;
civil unrest througho ut hiscory have often had economic and the existence of poverty, whether in Canada or in
roocs, with antagonists competing fo r control over vital the much poorer nations of the world, most certainly
resources; global climate change is a phenomenon that has economic causes and consequences. We begin by
engages the attention of the scientific and environmental discussing several issues chat arc currently of pressing
communiries, but the economic implications of boch che concern, boch inside and outside of Canada.

Productivity Growth Productivity growth lies at the heart of the long-te rm i1ncrease in
Canadians' average living srandards. Pwducriviry is a measure uf how much uurp ur (ur
income) is produced by one hour of work effort, and it has been rising gradually over
(he past cenrnry. In recem years, however, produc(iVi(y grow(h has been slowing in Can-
ada, and economises in universities and governments have been examining the cause of
che slowdown and also examining whac policies, if any, might reverse chis trend. If your
living srandards arc w improve over your lifetime as much as your grandpare nts' did
over theirs, Canada's rate of productivity growth wi ll need to increase signi fican tl y.

Population Aging The average age of the Canadian population is steadily rising, due both
cu a lung-rerm decline in ferci liry and cu aii increase in average life-expecra11cy. This popu-
lation aging has several effects. First, since people evenmally retire as they approach their
"golden years," there will be a decline in (he grow(h ra(e of Canada's labour force. As a
result, some fi rms and industries will find it more difficu lt to fi nd workers, and wages
are likely to rise as a result. Second, since our publicly funded health-care syscem rends co
spend much more on seniors than it docs on Canadians under the age of 55, there will be
a significant increase in public health-care spending as a share of the total size of the econ-
omy. This will puc new and difficulr demands on govemmencs' fiscal posicions, and force
chem either to increase tax rates or reduce spending in order to balance their budgets. This
same demographic problem is being encountered in muse developed commies.

Climate Change Climate change is a global phenomenon char will have importanr
implications for mosc nations on Earch. The long-cerm increase in the emission of
greenhouse gases-caused largely from (he burning of fossi l fuel s such as oil, coal,
and natural gas-has led to an accumulation uf these gases in che acmusphere and is
contri buting to a long-term increase in Earth's average temperature. The rise in temper·
alure is leading cu the melting of polar ice caps, a slow increase in sea level, a creeping
expansion of the world's great dese rts, and reductions in agricultural produc[ivicy. Par-
ticularly troubling is that much of the burden of cl imate change appears co be fal ling
on developing coun tries char arc lease able co bear the burden. Global climate change
presencs a challenge for the design of better econom ic policy, aimed at reducing green-
house-gas emissions with our und uly slowing the growth of material living scanda rds. Ir
also presents a challenge for global diplomacy, aimed at gerring all counrries- rich and
poor- involved in a collective effort of reducing their emissions.

Global Ananclal Stablllty The collapse of rhe U.S. housing rnarket in 2007- 2008 led co
the fa ilure of several major fin ancial institutions and caused a global financia l crisis.
The largest and most synchron ized worldwide recession in over 70 years fo llowed in
its wa ke. Many clements came together to ca use these events, including new mortgage
practices, innovative financial inscrumencs, expansionary monecar}' policy, regu lation
in the fina ncial seccnr, and ma.ny ochers. The crisis led most of the world's major
governments co intervene consuderably in their economies- by providing assistance
cu their financial inscitutiuns, by directl y expanding expendicures un goods and

servii;es, a nd by providing liqllidity to their finan<.: ial markets. T:\y 2010 most of these
economies had emerged from recession and were on rheir way ru healrhy economic
recove ries. However, it was then clear chat governments needed to play a role in
redesigning their financial syscems co reduce che likeluhood chac similar evencs would
occur in the future. The quest fo r "financial stability" has become a polic)' imperative
in many councries.

Rising Government Debt The aggressive government respo nse to the global financ ial
crisis led w massive new public spending in an effon ro dampen che effecrs of che reces-
sion. These increases in government spending, however, cook place when the re<.:ession
was causing a decline in governmenc tax revenues. As a resulc, govemmencs' budgec
deficits increased fo r several years, and government debt in most countries increased
significantly between 2008 and 2012. Even by 2010 it had become clear rhar govern-
ment debt in some European countries (especia lly Greece, Portugal, Ireland, Italy, and
Spain) was so high that bondholders were no longer prepared to purd1ase new govern·
menc bo11ds or renew rheir exisci11g holdings of bo11ds. The resulting upward spike in
interest rates made it almost impossible for these countries co ca rry out their regular
business witho uc special financial assistance from ocher governmems or from the lnrer-
national Monetary Fund. The political te nsions created among European governments
threatened to spell the end of Europe's common currency, the euro. The European
"sovereign debt crisis" is scill la rgely un resolved.

Globallzatlon Canada is a small nation chat relics significancly on trade with the rest of
che world for ics prospericy. We sell our lumber and oil and beef co rhe world, as we do
our cngin.ecring and legal and fi nancial services. /\s consumers we buy a wide variety
of produces from the rest of the world, incl udi ng coffee, leather shoes, and fine wi ne;
our firms also buy many inpurs from abroad, including machine cools, sofrware, and
some specialized raw materials. ln short, inte rnadona l trade and the ongoing process
of globalization are crucial co Canada's economic prosperiry. Yee globalization also
presents some challenges. /\ decision co reduce ta ri ffs on imported goods generates
overall benefits for Canada, bur ic also generates cemporary coses for chose Canadians
who arc displaced from their previously protected occupations. And greater competi-
tion for Canadian firms from chose in developing coun cries leads co overall increases in
domestic living standards, as Canadians now have access to cheaper goods. I Iowevcr, ic
may also lead to a decline in some middle-level jobs in Canada that get replaced slowly
with jobs in expanding sectors.

These six issues are only a small sample of the many economic issues chat confront
Canada and orher counrries. To undersrand any of chem ir is necessary co have a basic
understanding of economics-how markers work, how prices arc determined, in what
sense markets sometimes fai l co work well, and how government policy can be used to
improve outcomes. These arc che main topics of this book. There is a lot to learn, and not
many weeks in your college or universiry course. So, lee's gee scarred ac che very beginning.

11.1 What Is Economics?

These issues wuuld nur marrer much if we lived in an ecunumy uf SLu.;h plenry char rhere
was always enough ro fully sarisfy everyone's wants. If we could always gee all che goods
we wanted, it wouldn't be so important to be more productive in our work. Rapid
gruwch i11 health-care spe11di11g would 11ut be such a problem if governments had 11u
li mits on what they could spend, or if there were not problems associated with high
levels of govcrnmcnr debt. And cherc would be no need co rradc with ocher rnu ntrics if
Canada cuuld easily and cheaply produce cuffee, clothing, electronic cumpunencs, and
all chose ocher things chat we currencly import from fore ign lands. Bur such an economy
wirh unlimited products is impossible. Wh),i
The shore answer is because we live i11 a world of scarcity. Compared with the
desires of individuals for produces such as berrer food, clothing, housing, education,
holidays, health care, and entertainment, the cx isring supplies of resources arc clearly
i11adequare. They are sufficie1ir cu produce only a small fraccio11 of rhe goods a11d ser-
vices rhac we desire. This scarciry gives rise ro rhe basic economic problem of choice. If
we ca nnot have everything we want, we must choose what we will and will nut have.
One definition of eco11omi.cs comes from rhe grear economise Alfred Marshall
(1842- 1924), who we will encounter ar several poims in chis book: "Economics is a
study of mankind in the ordinaq1 business of life." A more informative definition is

Economics is the study of the use of scarce resources to satisfy unlimited human

Scarcity is inevita ble and is centra l co economic problems. What are society's
resources? Wh)' is scarcity inevita ble? What arc the conseque nces of scarcit)1 ?

A society's resources are ofce11 divided in to die three broad categories of land ,
labour, and capital. t a11d includes all natura l endowments, such as arable land,
fores ts, lakes, crude oil , and minerals. Labour includes al l mental and physical
human resources, includ ing ent repreneurial capacity and management skill s. Caf)ita l
includes all manufactu red aids co production, such as cools, machinery, a nd bu il d-
factors ol producUon Resources
ings. Economists call such reso urces factors of production because they are used to
used to produce ~<><ls and produce the things d1ac people desi re. We divide what is produced inco goods and
services; frequently divided Into services. Goods arc tangible (e.g., cars and shoes), and services arc intangible (e.g.,
the basic categories of land,
haircuts and education).
labour, and capital.
People use goods and services to satisfy many of their wants. The act of ma king them
goods Tangible commodities, is called production, and the act of using chem co satisfy wants is called consumption.
wch as cars or shoes.
Goods are valued for the services they provide. for example, a car helps to satisfy its
services Intangible owner's desires fo r transportation, mobility, and possibly status.
oommoditles, such as haircuts
or medical care.

producUon The act ot making Scarcity and Choice

goods or serllices.
For almosc all of che world's 7 billion people, scarcity is real and ever-presem. As we
consumption Ti'iu act of using
goods or serlllccs to satisfy said earlier, relative co our desires, existing resources are inadequate; the re are enough
wants. ru prnduce only a fracrio11 of rhe goods and services char we wane.

But aren't the advanced industrialized nations rich enough that s..:arcity is nearl y
banished? After all, they arc "affluent" societies. Whatever affl uence ma)' mean, how-
ever, ir does nur rnea n rhe end uf the problem uf scarcity. Canadian fa milies rhar earn
$75 000 per year, the average after-tax income for a Canadian fa mi ly in 20'13 but a
princely amo un t by world standards, have no trouble spending it on things that seem
useful tu chem, and chey wu uld certainly have no tro uble cu1wincing yuu that their
resources are scarce relative to their desires.
Because resources arc scarce, all societies face the problem of deciding what co
produce :rnd how much each person will consume. Sucieries differ in who rnakes che
choices and how they are 111ade, but the need to choose is co111mon to all. Just as sca r-
city implies the need for choice, so choice implies chc existence of cost. A decision to
have more of one thing requires a decision co have less of something else. The less of
"something else" can be thought of as the cost of having more of that "one thing."

Scarcity implies that choices must he made, and makinKchoices implies the existence
of coses.

Opportunity Cost To see how choice implies cost, we look first at a trivial example and
then at one that affects all of us; both examples involve precisely the same fu ndamental
Consider rhe choice David faces when he goes our fur pizza and beer wirh his
friends. Suppose rhar he has only $16 for che niglH and rhar each beer coses $4 and each
slice of pizza costs $2. Since David is both hungry and thirsty, he would like to have
4 slices of pizza and 3 beers, bur chis would cosr
$20 and is cherefore unaccainable given David's
FIGURE 1·1 Choosing Between Pizza and Beer
scarce resources of $'16. There are several com-
binacions, however, char are accainable: 8 slices of
pizza and 0 beers; 6 slices of pizza and 1 beer; 4
4 slices of pizza and 2 beers; 2 slices of pizza and
3 beers; and 0 slices of pizza and 4 beers. A Unattainable

- Cc[ one eo1nbinacions
David's choices are illumaced in figure 1-1,
which graphs the combinations of beers and slices
uf pizza char David considers buying. The m11n-
~ 2
extra beer

bers of slices of pizza are shown 0 11 che horizon- z"
tal axis; the num bers of beers are shown on the
verrical axis. The duwnwarcl-sloping line cunneccs
che five possible combinarions of beer and pizza 0 2 3 4 5 6 7 8
that use up all of David's resources- $16. This is Slices of Pin 1
David's budget line. Notice that puinr A shuws a
combinacion- 4 slices of pizza and 3 beers- char Limited resources rorcc a choice among competing ahcrna-
civcs. Given a roral of $ 16 to spend on $2 slices of pizza and
lies outsid!e the line because ics total cost is more $4 beers, some choices arc un:maina blc, such as point A .
rha n $16. Point A is unattainable ru David. If T he five p<)i nrs on rhe g/cen li ne show all comb irl:ttions rhar
David could buy fractions of a beer and of a slice :arc anainablc by spend ing rhc $ 16. If it we re possible to buy
of pina, all points that lie on or inside the line pans o f a bee r a nd pa rts of a slice of pizza, then all co mbina-
would be attainable combinations. t ions o n the line and in the 14Ceen area wou ld be attainable. If
t he entire $ 16 is to be spent, rhe choice between more pizza
In chis secring David can ask himself, "Whac an d more beer involves an opportunity cost. T he slope of the
is the cost of one beer?" One answer is that the green line reflects opportuni ty costs. T he opportunity cost of
cosr is $4. An equivalem answer, ass umi11g rhac une extra slice of pizi.a is half of a beer; the opporrtuniry cost
he wanred co spend all of chis $ l 6 on rhese rwo CJ f o ne cicrra beer is two slices of pizza.
items, is that the cost of one beer is the two slices


The Opportunity Cost of Your University Degree

The opportun ity cost of choosing one thing is wh3f must chosen instead-yo ur best altern:1tive to attending
be given up as rhc bcsr altcrnarivc. Compuring rhc oppor- unive1·siry.
tun ity cost of a college or un iversity education is a good Suppose rhat your best altcrnarivc ro arrending uni-
example ro ill ustrate which facrors are included in the com- versity w:ts ro gee :t job. In th is c:tsc, the opportu nity cost
putation of opportunity cost. You may also be surprised to of your university degree musr include the ea rn ings that
learn how expensive your university degree reall)• is!• you would have received had you taken that job. Sup-
Suppose tha t a bachelor's degree requ ires four years pose that your (after-tax) annual earn ing,~ would have
of study and that each year you spend $6000 for tu ition been $25 000 per yca1; for a rotaI of $100000 if you had
fees- approximately the ave1·agc at Canadia n unive1·si- stayed at thar job for fou r years. To the direct expenses of
tics in 200-and ::1 fu rther$ J500 per yea r for books and $30000, we musr therefore add $'100000 for the earnings
materials. Docs this mean that the cost of a univc1·siry that you gave up by not tak ing a job. This brings the true
education is only $30000? Unforru narcly nor; rhc rruc cosr of your university degree-rhc opporrunicy cost-up
cosr of a un iversity degree w :t student is much higher. to $1300001
The key point is rha r the opportuniry cost of a uni- Notice that the cost of food, lodging, clothing, and
versity education docs not include just the out-of-pocket other living expenses did not ente r the calcularion of the
expenses cin tu ition and books. You must aJs(i take oppo rni niry cost in th is exam ple. The living expenses
into consideration what you are forced to gi11e up by musr be incurred in eirher casc- wherher you arrcn d
choosing ro attend university. Of course, if you were nor university or get a job.
srudyi ng yo u co uld have done an y one of a number of If rhe opportunity cost of a degree is S<) high, why
things, but the relevant one is the 0 11e you would have do students choose ro go to universiry? Maybe srndents

of pizza he muse give up co gee ic. In face, we say in chis case char rwo slices of p izza is che
oppo1·t11nity cost o f one beer, since they are the opportunity David must give up to get
one excra beer.

Every ti me a cho ice is made, opportunity costs are incurred.

As simple as ic may seem, rhe idea of uppum111iry cusc is une uf rhe ce11Cral ins ights uf
op1>01tunlty cost The cost of economics. Here is a precise defi ni tion: The oppo~tun ity cost of using resou rces for acer-
using 1usoul'C<ls for a ccnaln ta in purpose is the benefit given. up t;y 1wt 11si11g them in. the best alternative way. That is,
purposu, muasured by lllu bcncnt
!ll\/l?n up by not usin.g them In
ic is rhe cosc measured in terms of ocher goods and services rh ac co uld have been obta ined
their best eltematlve use. instead. Tf, for example, resources that could have p roduced 20 km o f road are best used
instead to produce one hospita l, the opportun ity cost of a hospita l is 20 km of road;
looked ar che ocher way round, rhe opporrun iry cosc of 20 km of road is one hospita l.
See Applying cconomic Concepts 1-1 for an example o f oppo rcunicy cosc char
should seem qui te fa milia r to you: the opportu ni ty cost of getting a university degree.

Production Possibilities Boundary A Ithough David's choice between pizza and beer
may seem co be a trivial consumption decision, the natu re of the decision is the same
whatever the choice being made. Consider, for example, the choice that an y conn try
must face between p roduc ing mi litary goods (such as ships, ta nks, and guns) and civilian
goods (such as food, clothing, and housing).
If resources are fully and efficiencly employed, ic is noc possible co have more of boch.
However, as the govern menc cues defe nce expendimres, resources needed co produce civil-
ian goods will be freed up. The opportun ity cost of increased civilian goods is therefore

sim ply enjoy lc:irning :ind thus :ire prep:ircd to incur the
high cosr co be in the univer·sicy environm ent. Or· maybe rhcy
believe char a universiry degree will significantly increase
their future c:t rning potenti:tl. In Ch:tprer 14 we wi ll see
cha t chis is rn1c. In this case, they arc giving up fou r years
of earnings at one salary so th at they can invest in building
their· skills in the hope of enjoyi ng many more ye:m in the
futu re at a co nsiderably higher salary.
Wh atever the rcMon for :1 ttcndi11g college or un iver-
sity, the recognition that a post-secondary degree is very
ex pensi ve should convince students to make the best use of
their rime whi le they arc there. Read on !

•This box consiJ crs only the cost / (J the st11dc11t of " uni versity
Jcgree. For reasons that will he J iscusscd in Jctail in Part Six
The opporWttity cost to a11 ittdi11id11a/ co111p/cti11g a 1111i11ersity of [his hook, provincial govt'rn111t'nCs ht:ivil )r subsidize poSC·
degree in Canada is large. It i11c/11des the direct cost of t11ition secondary education in Canada. Hecnuse of this subsidy, the cost
a11d books as well as t/Je eam i11gs forgo11c while alle11di11g to society of n lll1iversiry degree is ge11ernlly much higher 1ht1n rhe
university. cost to a11 individual srudenc.

rhe forgone milirary oucpuc. Or, if we were considering an increase in milicary oucpuc, rhe
opporruni cy cost of increased military output would be the forgone civilian goods.
The choice is ill usrrared in Figure 1-2. Because resources are scarce, some
combinac.ions- rhose rhar would require more rhan rhe coral available supply of
resources fo r their production-cannot be atc:ained. Tlhe negatively sloped curve on the
graph divides rhe cumbinarions char can be acrained from chose rha r cannoc. Poincs above
and co rhe righr of rhis curve cannm be arrained because rhere are nor enough resources,
points below and to the left of the curve can be atc:ained without using all of the available
resou rces, and poincs on che curve can just be ;mained if all rhe available resou rces are used
efficiently. The curve is called the pt'oduction possibilities boundary. (Sometimes "boundary" l)n>duc:tion PO<SSlbllltles boundary
is replaced with "curve" or "frontier.") It has a negative slope because when all resou rces are ACUl\itl s11<1>11ng ~1-.011 alu.'tllatll/e
combinations of commodities
being used efficiendy, producing more of one good requires producing less of ochers. can jusl be altained it alt available
resouiws are used efficiently;
It Is lhe boondllry betWCoo
I\ production possihilities houndary illustrates three concepts: scarcity, choice, and attalnablo and unattalnablo outpUl
opportunity cost. Scarcicy is indicated by the unatcainahlc combinations outside comtinatlons.
the boundary; choice, by the need to choose among the alternative atrainablc points
along the houndary; and opportunity cost, hy the negative slope ol: the houndary.

The shape of che production possibilities boundaa-y in Figure 1-2 implies that an
increasing amounr of civilian producrion musr be given up ro achieve equal successive
increases in milicary production. This shape, referred r.o as concave co the origin, incli-
cates that the opportu ni ty cost of either good increases as we increase che amount of it
char is produced. A scraighr-line boundary, as in Figure 1-'I , indicares (hac (he opporcun-
ity cosr of one good srays conscanr, no matrer how much of it is produced.

The concave shape in Figure 1-2 is the way economists usu-

AGURE 1·2 A Production Possibilities Boundary all)1 draw a coun t1')"s production possibilities boundary. The
shape occurs because each factor of production is noc equally
Unotrai11nblc useful in producing all goods. To see why differences among
e <'0111bi1101io11s factors of production arc so important, suppose we begin at
• poinc c in Figure 1-2, where mosc resources are devoced co
the production of mi litary goods, and then consider gradually
shifting more and more resources coward chc production of
civilian goods. We mighr begin by shifting nmrienc-rich land
chat is particularly well suited to growing wheat. This land may
f not be very useful for making military equipment, but it is very
• useful for making cenain civilian goods (like bread). This shifr
:' Attainnhlc
of resources will therefore lead to a small reduction in mil-
: combinations itary output but a substantial increase in civi lian output. Thus,
'' ' (he opporrnnicy cos( of producing a few more unirs of civilian
goods, which is equal to the forgone military output, is small.
Q uantity of Military Goods But as we shift more and more resou rces towa rd the produc-
(ion of civilian goods, and therefore move along r11e produc-
The negatively sloped boundary shows the com- tion possibilities boundary towa rd point a, we must shift more
binarions chat arc attainable when all resources
arc used efficiently. The producrion possibilirics and more resources that arc actually quite well suited to the
boundt1ry scparares rhc arrt1int1blc co111bint1tions produc(ion of military oucpur, like aerospace engineers or rhe
of goods, such as a, b, c, and d, from unatr:tin- minerals needed to make gunpowder. As we produce more and
ablc cort1bin:ttions, such :ts e and ( Points"· b, more civilian goods (by devoting more and more resou rces to
and c rcp1·csenr full and c(ficienr use of S<)ciecy's producing chem), rhe amount of military oucpur char must be
resources. Poinc d represents either inc(ficicnt
use of resources or failure rouse all rhe available forgone to produce one extra unit of civi lian goods rises. That
resources. If producrion changes from poinr n is, the opportunity cost of producing one good rises as more of
ro point b, an opporrunit)' cosr is involvcd.111c char good is produced.
opporrunicy cost of producing !:;x more mi litary
goods is rlne necessary reduction in the produc-
tion of civilian goods equa l to l\y. Four Key Economic Problems
Modern economies involve mi llions of complex production
and consumption activities. Despite this complcxit)', however,
che basic decisions chac muse be made are noc very differenc from chose chac were
made in ancient and primitive economies in which people worked with few tools and
bartered with thei r neighbours. Nor is the essence of rhc decisions in modern, com-
plex economies differenr from chose in current-day developing economies, where many
people stniggle for their daily survival. In all cases, sca rcity, opportu ni ty cost, and the
need fo r choice play crucial roles. Whatever the economic S)'Stem, whcrher modern or
ancient or complex or primicive, chere are four key economic problems.
1. What Is Produced and How? This quesrion concerns the allocation of scarce reso ur-
resource allocation The ces among alterna(ive uses. This resource allocarion determines the quantities of various
allocation 01 an economy's goods char are produced. Choosing cu produce a particular combination of gouds means
scarce resourtes among
alternative U51!5.
choosing a particular allocarion of resources among the i11duscries or regions producing
che goods. What derermines which goods are produced and which ones are nur?
Furthermore, because resou rces are scarce, it is desirable chat they be used efficiently.
I fence, it matters which of the available methods of production is used to produce
each of che goods. Whar decerm in es which merhods of produc(ion ger used and which
ones do not? Any economy must have some mechanism by which these decisions about
resource allocation arc made.

ls there some combination of the production of goods

chat is "better" than ochers? Jf so, ~hou l d govern men cs tr)' to FIGURE 1-3 The Effect of Economic Growth
airer che pacrern uf pruduccion in chis direcciun? Cuuld rhey on the Production Possibilities
ad1ieve this if they tried? Boundary

2. What Is Consumed and by Whom? Economises seek co under-

srand whac decermines rhe discribucion of a narion's rocal
oucpuc among its people. Who gees a loc, who gees a liccle,
and why? Should governmencs care abo uc chis distribu-
tion of consumption and, if so, whac cools do rhey have co
bmmd•~ J
Prnduction possibilities

alter it?
If production takes place on the production possibilities
boundary, rhen how abouc consumption? Will che economy possihilitic.'
consume exactly the same goods th~H it produces? Or will boundnry
the counc1fs ability to trade with ocher countries permit brforr~
the economy ro consume a different combinacion of goods?
3. Why Are Resources Sometimes Idle? Somerimes large 11 um-
bers of workers who wo uld like co have jobs are unable co
find employers co hire chem. Ac che same cime, che managers
and owners of offices and faccories could operare ac a higher 0
Qua111icy of Milicary Coods
level uf acciviry-rhar is, chey could produce mure gouds and
services. For some reason, howeve1; chese resources- land, Economic growth shifts the boundary out ward
labour, and faccories-l ie idle. Thus, in cerms of Figure 1-2, and makes it possible to produce more of all prod-
che economy somecimes operaces inside ics production pos- ucts. Rcforc growth in productive capacity, po ints
sibilicies bounda r·y. <1,b, and c were on the production possibilities
Why are resou rces sometimes idle? Should governments r
boundary and points e and were unattainable.
Afte1· g1·owrh, points e and f' and manr orhc1· pre-
wurry abuuc such idle resou rces, or is chere sume reason co viously unarcainablc combinations arc acrainablc.
believe rhac such occasional idleness is necessary for a well-
functioning economy? Ts there anything governments can do
co reduce such idleness?
4. Is Productive Capacity Growing? The capacity co produce goods and services grows
rapidly in some countries, grows slowly in ochers, and actually declines in ochers. Growth
in productive capacit)1 can be represented by an outwa rd shift of the production possi-
bilities boundar)', as shown in Pigure 1-.3. Jf an ecQnQm)''S capacity to produce g<Jods and
services is growing, some combinations rhar arc unatca inablc today will become attain-
able in die fucure. Whac are the decerminams of such growth? Are chere some undesirable
side effects of growch? Can guvernmencs do anything cu influence economic growch?

Economics and Government Policy

Questions relating co whac is produced and how, and what is consumed and by whom, fa ll
microeconomics The st\Jdy of
wichin the realm of microeconomics. Microeconomics is che scudy of che causes and conse- the causes e~d consequences
quences of the allocation of resou rces as it is affected by the workings of the price S)1srcm and ol lho allocallun ol rusourcts as
governmem policies char seek ro influence ic. Questions relacing co rhe idleness of resou rces It Is allcctcd by Ilic workings of
the price system.
and the growth of rhe economy's producrive capacicy fall within the real m of macroeconom-
ics. Macroeconomics is the study of the determi nation of economic aggregates, such as total macroeconomics The st\Jdy ol
ourput, rocal employmenr., interest rares, the price level, and rhe race of economic growth. llw dottrmlnadun of ucunumlc
aggregales such as lolal oolput,
The design and effecciveness of governmenc policy is relevanc co discussing all four the price leve-1, emplO)lll1ent, end
economic problems. When asking what combination of goods and services is produced in erowth.

the economy, and whether some <.:ombina tions might be better than others, government
policy en ter~ the discu~sion . Jn later ch apter~ we will examine situations ca lied market
failures, which arise when free markers lead ro roo much of some goods being produced
(like pollution) and coo little of ochers (like national parks). Jn such situations, govern·
mcnc policy could be used to altc1: the allocation of the economy's resources in such a wa)'
as ro make sodery as a whole becrer off.
When asking who gees co consume che economy's output, it is natural co discuss the
fairness regarding the distribution of consum ption across individuals. Do free markets
lead ro fa ir ourcomes? Can we even decide objecrively whar is fair and what is unfair?
And if we could, what kind of government polii;ies could be used co improve the distri-
bution ? We will sec throughout this bnok that many government policies arc designed
wirh fairness in mind. We will also encounrer an ongoing debare abour how much rhe
government should cry co improve the fai rness of market outcomes. Some argue that it is
reasonable to do so; others argue that attempts to improve fairness often lead to reduc-
tions in marker efficiency rhar impose large cosrs on society.
Government policy is also pa re of the discussion of why a na tion's economic resou rces
arc someti mes idle and what can be done to reduce such idleness. For example, when the
Canadian economy enrered a major global recession in 2009, the federal and provincial
governments increased their planned spending significantl y in an anempc co dampen die
decline in aggregate output and rise in unemployment chat was then occurring. Other
counrries did rhe same. Some critics argued rhar such "fiscal stimulus" packages could nor
increase overall output and income, since che increase in government spending would sim-
ply displace private spending. Ochers argued that recessions arc caused large))' by a reduc-
tion in private spending, and char an increase in government spending can be an effective
temporary replacement to help sustain the level of economic activity. Such debates lie at
the heart of 111acroccono111ic policy, and we have much tu say about them in chis book.

11.2 The Complexity of Modern Economies

If you want a litre of milk, yo u go co yo ur local grocery score and buy it. When the
grocer needs more milk, he orders it from the wholesaler, who in turn gets it From the
dairy, which in turn gers ir from rhe dairy farmer. The dairy farmer buys carrle feed and
electric mi lking machines, and he gees power co nm all his equipment by putting a plug
into a wall outlet where the clectricit)' is supplied as he needs it. The 111ilking machines
are made from pans manufactured in several different places in Canada, rhe United
States, and overseas. The parts themselves are made from materials mined and smelted
in a dozen or 111orc countries.
As ic is wirh rhe milk you drunk, so ic is wirh everything else rhac you buy. When you
go co che approp riate score, what you wa ne is normally on the shelf. Those who make these
produces find that all the required components and materials arc available when they need
them- even chough chese things typically come from many different pares of the world
and are made by many people who have no direct dealings with one another.
Yo ur own tra nsactions arc only a small pare of chc re111arkably co111plex set of
rransacrions rhar ta kes place every day in a modern economy. Shi pments arrive daily
at our ports, railway terminals, and airports. These shi pments ini;lude raw mate rials,
such as iron ore, logs, and oil; parts, such as automobi le engines, transistor~, and circuit

boards; tools, sud1 as s..:rewdrivers, lathes, and digging equipment; perishables, sud1
as fresh flower~, coffee beans, and fruit; and alI kinds of manufactured goods, suc h as
washing ma..:hines, compucers, and cell phones. Railways and rrucking lines rnove chese
goods among thousands of different destinations within Canada. Some go dire..:tly to
consume rs. Others arc used by local firms to manufacture thei r produces-some of
which wil I be sold domescically and ochers exporced eo ocher coun tries.

The Nature of Market Economies

An economy is a sysrem in which scarce resources-such as labour, land, and capiral-
are allocared among competing uses. Decisions mus t be made abouc which goods are
produced and which arc not; who works where and at what wage; and who consumes
which goods at what rimes. Alrhough each of these individual de..:isions may seem sim-
ple, the enti re ..:ombinacion is remarkably complex, especially in modern societies.

Self-Organizing Early in the development of modern economics, choughcfuI observers

wondered how such a complex set of dealings gets organized. Who coordinates rhe
whole sec of efforts? Who makes sure rhac all the acrivi ries fir coged1er, providing jobs
co produce che things char people wane and delivering chose things co where they are
wanted? The answer is, surprisingly, no one!

i\ i.:reat insii.:hc of earl y economists was that an econom y based on free-market

transactions is self-organizing.

A ma rket e..:onomy is self-organizing in che sense that when

individual consumers and producers ace independe ntl )' co pursue
their own self-interests, responding to pri..:es dererm ined in open
markets, t he collective out..:ome is ..:oordinaced- there is a "spon-
ta neous economic order." In char order, li ccrall)' thousands of
millions of cra11saccio11s and acciviries fir together to produce che
things tha t people want within the constraints set by ~he resour..:es
tha t arc a.vailablc to the na tion.
The greac Scottish economise and political philosopher Adam
Smith ('1 723- 1790), 1 who was the First to develop this insight fu lly,
put it this way:
Tl is not from the benevole11ce of the butcher, the l1rewer, or the
bake~. that we expect our dinner, but from their regard to their
own interest. We address ourselves, not to their humanity b11t to
their self-love, a11d never talk to them of our ow1111ecessities but
of their advantages. /\dam Smith wrote J\n Inqui ry into the
Na ture and Ca uses of the Wealth of Nations
Smirl1 is nor saying rhac benevolence is unimportant. Indeed, he i11 1776. Now referred to by most people sim-
praises it in many other passages of his book. He is sayi ng, however, ply as The Wealth of Nations, it is considered
that the nnassivc number of economic interactions char charactcri:i:e to be the begi1111i11g of modem economics.

TiiroL•gho11 r chis book, we cncounrcr many grcar economises fcoon rhc pasr whose ideas shaped rhc disci-
pline of economics. At rhe back of the book you will find a timeline rhar begins in rhe 1600s. Ir corHains brief
discussions o f mn ny of rhcsc rhinkcrs nnd plnccs them in their hisroricnl conrcxc.

a modern economy cannot all be motivated by benevolence. Although benevolence does

motivate ~ome of our actions, often the very dramatic ones, the vast majority of our
everyday actions are mocivaced by self-inceresc. Self-inceresc, noc benevolence, is therefore
the foundation of economic order.

Efficiency Another great insight, which was hinted ac by Smich and fu lly developed
ove 1~ the nexc cencury and a half, was rhac rhis spontaneously generated economic
order is relacively efficient. Loosely speaking, efficiency means chac rhe reso urces
available co che nation are organized so as ro produce rhe various goods and services
char people wane co pu rchase and co produce chem wirh rhe lease possible amount
of reso urces.
An economy organized by free markets behaves almost as if it were guided by
"an invisible hand," in Smith's now-famous words. This docs not literally mean that
a supernarurnl presence runs a marker economy. Instead ir refers ro rhe relarively effi-
cient order chac emerges spontaneously out of che many independent decisions made by
those who produce, sell, and buy goods and services. The key co explaining th is market
behaviour is char chese decision make1·s all respond ro rhe same sec of prices, which are
determined in markets chat respond co overa ll conditions of national scarcity or plenty.
Much of this book is devoted to a detailed elaboration of how this market orde r is
generated and how efficiencly rl1ar job is done.
That free markets us ually generate relatively efficient omcomes does nor mean char
rhcy arc always efficient or chat everyone views the outcomes as desi rable or even fair.
Free markers sometimes fai l co produce efficient outcomes, and rhese fa ilures ofren pro-
vide a motivation for government inte rvention. Jn addition, many market outcomes may
be efficient but perceived by many to be quite unfa ir. For example, we will sec that an
efficiem labour marker may nonecheless lead co large differenrials in wages, wirh some
individuals receiving low incomes while others receive enormous incomes. So, while a
central aspect of economics is tlhe study of how markets allocate resources efficientl y,
much emphasis is also placed on whar happens when markecs fai l in various ways.
Incentives and Self-Interest Lyi11g ac the hearc of n1odern economies are incentives and
self-interest. Individuals generally purs ue rheir own self-inceresr, buying and sell ing
whar seems besc for them and cheir fa milies. They purchase produces char [hey wane
racher chan chose chey dislike, and chey buy chem when ic makes sense given cheir cime
and fina11cial co11scraints. Similarly, che)' sell products, includi11g cheir own labour ser-
vices, in an acrempc co improve cheir own economic siruarion. When making such deci-
sions abour whar ro buy or sell and ar whar prices, people respond ro incentives. Sellers
usually wane co sciI more when prices are high because by doi ng so chey have command
over more resources char can be used co purchase che things rhey wane. Similan·ly, buyers
usually wanr ro buy more when prices are low because by doing so rhey are becrer able
co use their scarce reso urces co acquire the many things rhey desire.
With self-interested buyers and sellers responding to incentives when determining
whac rhey wane co buy and sell, rhe overall markec prices and qua ntities are deter-
mined by rheir collective inreracrions. Changes in their preferences or productive abil-
ities lead to changes in their desired transactions and thus to fluccuacions in market
prices and q uan ricies.
The millions of markec rrarnsaccions occurring on a daily basis in a modern econ-
omy are governed by a sec of inscicucions largely created by govern ment. Mose often
chese inscirucions are so much a parr of che fabric of our sociery chac we barely nocice
rheir exisrence, bur rheir importance should nor be ignored. The mosc imporranr
of these instimtions are pri vate property, the freedom co enter into contracts, and the

rule of law. The natures of private property and contracwal obligations are defined by
laws passed by legislatures and enforced by the police and the courts.

The Decision Makers and Their Choices

Three broad groups of decision makers uperare in any economy. The firsr group is
consumers. Sometimes we chink of consumers as being individuals and sometimes we
chink in cerms uf families or households. Consumers purchase various kinds of guuds
and services wich rheir income; chey usually earn rheir income by selling cheir labour
services co their employers. Sometimes their income is earned by renting out the land or
buildings or machines char rhey own .
The second group of decision makers is producers. Producers may be firms rhat are
interested in earning profi ts ur they may be non-profit or charitable organizations. Jn
any case, producers hire workers, purc hase or renc various kinds of macerial inpucs and
supplies, and chen produce and sell cheir produces. In rhe cases of charitable organiza-
tions, chei r produces are ofte n distrib uted fo r free.
The chird group of decision makers is government. In Canada, rhis group includes
che federal, provincial, cerricorial, and municipal governmencs. Like producers, govern-
mencs hire workers, purchase or rent material and supplies, and produce goods and
services. Unlike muse producers, howeve1; guvernmencs usually provide cheir goods and
services ar no direct cosc co che final user; cheir operacions are financed nor by revenue
from the sale of their produces but instead by the ca.xes they collect from individual
consumers and producers. In addiriun tu producing and providing many goods and
services, govemmems creace and enforce laws, and design and implemenc regulacions
chat must be followed by consumers and producers.
How Are Decisions Made? How do consumers, producers, and governments make deci-
sions? Thinking abuuc how governments make decisio111s is not straightforward. Indeed,
it is not uncommon to hear Canadians say something like "How could the govern-
ment possibly do somethi ng so stupid?" As we will see in later chapte rs, however, there
is usually a sensible explanation fo r why a government makes the decisions that it
docs, rhn ugh it is often nor clear un til you chink carcfu lly about what the government's
objectives really arc. We will examine government policies in detail at many points
througholllt this book.
Fur now, lee's focus un how consumers and producers make rheir decisions. Econo-
mises usually assume char consumers' and producers' decisions are both "maximizing"
and "ma rginal." What docs this mean?
Maximizing Decisions. The important ass umption chat economises usually make about
how these two groups make their decisions is chat eve ryone cries co do as well as pos-
sible for himself or herself. Jn the ja rgon of economics, people are assumed to be maxi-
mizers. When individuals decide how many factor services to sell to producers and
how many products co buy from them, they are assumed to make choices designed to
maximize their well-being, or utility. When producers decide how many factor services
to buy from individuals and how many goods to produce and sell to them, they arc
assumed to make choices designed co maxi mize their profits. We explore the details of
uti lit)' and profit maximization in late r chapters.
Marginal Decisions. Firms and consumers who are trying co maximi1.e usually need co weigh
the costs and benefits of their decisions at the margi11. f or example, when you consider
buying an additional pair of shoes, you know the marginal cost of the shoes- chat is,

how mud1 you must pay to get them- and you need to compare that <.:ost to the marginal
benefit tha t yo u will receive-the extra satisfa..:tion you get from having chose shoes. Tf you
are trying to maxi mize your utility, you will buy the new pair of shoes only if you think
that the benefit to you in terms of extra utility exceeds the marginal cost.
Similarly, a producer atremp ti ng to maximize irs profits and considering whether to
hi re an extra worker must determine the marginal cost of rhe worker- the extra wages
and benefits that must be paid- and compare it to the marginal benefit of the worker-
the increase in sales revenues the extra worker will generate. A produ..:er inrerested in
maximizing its profi r will hire rhe exrra worker only if rhe benefit in terms of extra
revenue ex..:eeds the cost in te rms of extra wages.

In order to achieve their objectives, maximizing consumers and producers make

marginal decisions; they decide whether they will be made better off by buying or
selling a little more or a linli: less of any given product.

Voting in an election is an example in which de..:isions are not made on a. marginal

basis. When you voce in a Canadian federal election, you have only one vote and you
must s upport one party over the ochers. When you do, you
vote fo r everything that party stands fo r, even though you
may p refer to pick and choose elements from each party's
FIGURE 1·4 The Circular Flow of Income political platform. You cannot say "I vote for the Liberals
and Expenditure on iss ue A and fo r rhe Conservatives on issue B." You musr
make a total, rather than a marginal, decisio n.

nw rkccs The Flow of Income and Expenditure fi gu re '1-4 shows the
basic decision ma kers and the fl ows of income and expendi-
tu re tha t the>' set up. Indi viduals own facto rs o f produc-
tion. T hey sell che services of these factors co producers
and receive payments in return. These arc their incomes.
Producers use the facrur services char rhey buy ro make
goods and services. They sell rhese ru individuals, recei ving
payments in return. These are rhe incomes of producers.
These basic flows of income and expendi tu re pass through
Facmr ma rkers. Individuals sell rhe services of rhe faccur rhac rhey
own in what are collectively ..:ailed facto r mark ets. When
you gee a part-ti me job duri11g un iversity, you are parci..:i-
The red line shows the now of goods and scrvi· paring in rhe facror market. Producers sell rhei r ourpurs
ccs; th e blue line shows the payments made to of goods and services in what are colleccively cal led goods
purchase these. Factor services flow from indi· markets. When yo u purchase a hair..: ur, an airpla ne ticket,
viduals who own the foctors (includi ng thei r or a new pair of shoes, for example, you are parcidparing
own labour) through fa ctor n1arkets to fi rms
th at use tlhcn1 to make goods and services. in rhe goods ma rker.
T hese goods and se rvices then fl ow rhrough T he pri..:es that are de termined in these markets deter-
goods markets ro rhose who consume them. mine chc incomes that arc earned. People who get high
Money payments flow from firms ro individ· prices for cheir fa ccor services earn high incomes; those
ua ls through factor markets. T hese payments who get low prices earn low in..:omes. The distribution
become the income of individuals. When th ey
spend th is income buying goods and services, of incom e refers to how che nation's coca I income is dis-
money flows through goods markets back to cribured among irs citizens. This is largely determined by
producers. the price that each type of factor servke receives: in fa..: tor

Production and Trade

Individual producers decide which guuds cu produce and huw cu produce rhem. Pro-
duction is a very complex process in any modern economy. For example, a typical car
manufactmcr assembles a product out of thousands of individua l parts. le makes some
uf these pares itself. Muse are subcontracted cu pares man ufacturers, and many of che
major pares manufacturers subcontract some of their work ro smaller· firms. The same
is true fo r producing consumer electronics, clothing, home appliances, fu rniture, fash-
ion accessories, cleaning pruducrs, resraur::rnr meals, a11d must other produces yuu can
imagine purchasing. Such complex production displays rwo characteristics noted lung
ago by Adam Sm ith-specialization and the division of labour.

Specialization Jn ancient hunter- gatherer societies and in modern subsistence economies,

most people make most of the things chey need for themselves. However; from the rime chac
people first engaged in settled agriculture and some of them began to live in towns, people
have specialized in doing particular jobs. Artisan, soldier, priest, and government official
were some of chc earliest specialized occupations. Economises call this allocation of differ-
ent jobs to different people the specialization of labour. There arc two fundamenta l reasons speclallzaUon of labour The
why specialization is extraordinaril)' efficient compared with universal self-sufficiency. SPecialization of individual
workers In the productloo of
First, individual abilities differ, and specialization al lows individuals cu du what they pa111oolar goods or services.
can do relatively well while leaving ever)•thing else ro be done by others. Even when
people's abilities arc unaffected by the act of specializing, the economy's total production
is greater whe11 people specialize than when chey all cry cu be self-sufficier1r. This is true
for individuals, buc ir is also crue for entire countries, :ind ir is one of rhe most funda-
mental principles in economics: the principle of comparative advantage. A muc h fuller
discussion of comparative advanrage is found in Chaprer 33, where we discuss rhe gair1s
from international trade.
The second reason why specialization is more cf~ic:i ent than self-sufficiency cQn-
cerns changes in people's abilities char occur because they specialize. A person who
concentrates on one activity becomes better at it tha n1could a jack-of-all-trades. This
is called teaming by dning, and it was a factor much stressed by early economises;
research shows char ic is imporranr in many modern industries.
The Division of Labour Throughout mosr of history each artisan who specialized in mak-
ing some product made che whole of that product. But over the last severa I hu ndred
yea rs, man)' rcdrnical adva nces have made it efficient to organize production methods
into large-scale firms organized around what is called the division of labour. This term division of labour The breaking
refers co s pecialization within che producrion process of a parricular produce. up of a prodlllcllon process Into
a series of specialized tasks,
Mass Production. In a mass-production factory, work i:. divided into high!)' specialized eaell done by a different worker.
casks by using specialized machinery. Each individual repeatedly docs one or a few small
casks char represe nt only a small fraction of chose necessary co produce any one produce.
Flexible Manufacturing. Two recent changes have significant!)' altered the degree of spe-
cia lization fo und in many modern production processes. First, individual artisans have
rccen rl y reappeared in some lines of production. They arc responding co a revival in che
demand for indi vidually crafted, rarher rhan mass-produced, produces. Second, many
manufacturing operations are being reorganized along new lines called fl exible manu-
facturing, which was pioneered b)1 Japanese car manufacturers in rhe micl- t 950s. Ir has
led back co a more cr:afr-based form of organization within che factory. In chis tech-
nique, employees work as a ream; each employee is able ru do every ream member's job
ra rher chai n only one very specialized cask ar one poinc on rhe assembly line. However,

even these workers are practising the division of labour- but the division is not as fine
as it is i11 mass produ..:tion.

Money and Trade People who specialize in doi ng only one thing must sadsfy most of
their wa nts by consuming thi ngs made by other people. Jn ea rl y societies the exd1ange
of goods and servi..:es took pla..::e by simple mutual agreement among neighbours. Tn
the course of time, however, trading became centred on particular gatheriing places
called markets. For example, the French markets or trade fairs of Champagne were
known th roughout Europe as early as the eleventh ccntur)'· Even now, man)' small
towns in Canada have regular nnarket days. Today, however, the term "market" has a
much broader meaning, refcrrirng to any institutions that allow buyers and sellers to
transact with each other, which could be by meeting physically or by trading over the
Internet. Also, we use the te rm " market economy" to refer to a society in which people
~peci alize in productive activities and meet most uf their mate rial wa nts through volun-
ta ry market tra nsactions with other people.

Specialization must be accompanied by trade. People who produce only one thing
must trade most of it to obtain all the other things they wa nt.

barter An economic system In Early trading was by means of barter, rhe trading of goods directly for ocher goods.
which ~ods and services are Bur barter is costl y in terms of rime spem searching om satisfactory exchanges. If a
traded directly lor olher goods
end 5ervices.
farmer has wheat but wa nts a hammer, he must find someone who has a hammer
and wa ms wheac. A successfu l l>arcer transaction thus requires what is called a double
coi11cide11ce of wa11ts.
MonC)' eliminates the cum bersome system of barte r b)1 separating the tra nsactions
involved in the exchange of produces. If a farmer has wheat and wanes a ham mer, she
merely has w find someone who wa nts wheat. The farmer ta kes money in exchange.
Then she finds a person who wa nts to sell a hammer and gives up the money fo r the

Money greatly facilitates trade, which itself facilitates specialization.

Globalization Marker economies constantl y change, largely as a res ult of rhe develop-
ment of new technologies and che new patterns of production and trade char result.
Many of che recent changes are referred to as globalizatio11, a cerm often used loosely co
mean the increased importa nce of in rernacional era de. Internacional era de is, however, a
very old phenomenon. The usu a I pattern over most of the last 200 years was ma nufac-
tu red goods being sent from Europe and North America co the rest of the world, with
raw materia ls and primary products being sent in retu rn . What is new in the last few
decades is the globali7.acion of manufacwring. Assembly of a product may ta ke pla..:e in
the most industrialized coun tries, but the hundreds of component parts are man ufac-
tu red in doze ns of different coumtries and delive red co the assembly plane "just in ti me"
for assembly.
Two major causes of globa lization arc the rapid reduction in tra nsportatio n costs
and the revol ution in in formation rechnology char have occurred in rhe past 50 years. The
cost of moving products around the world fell greatl y over the last half of the twentieth
c:encu ry because uf c:oncaineri£ation and the increasingsize uf ships. Our ability to transmit

and analyze data irn.;reased even more dramatica lly, wlhile the costs of doing so
decreased equally dra matically. For example, today $1000 buys an u ltra -~l im
cablec ur lapcup cumpucer chac has che sarne curn pucing puwer as a "main-
fra me" computer that in ·1970 cost $"10 million and filled a large room. This
revol utio n in in fo rmation and communication tedrnology has made it possible
cu cuui:diuiace ecu11umic cransaccions around rhe wurld in ways chac were dif-
ficul t and costly 50 yea rs ago and qui te impossible 100 years ago.
Globalization is as important fo r consumers as it is for producers. For
example, as sume tasces become universal co yo u11g people, spread by ever-
increasing access to foreign television stations and global social netwo rks,
we can sec the same clothes and hear the same music in virtually all big T/Je revolut ion in shipping c/lld
cities. McD011ald's res raura11rs are as visible in Moscow or Beijing as in i11 computer teclm o/of<y IJCIS
Londo n, New York, Vancouver, or Montrea l. Many other brands are also drastically reduced co1111m111i-
catio11 a11d tra11sportatio11 costs.
known around the world, such as Louis Vuittun, I lilfi.gcr, Gucci, Rolcx, N ike, Ti?is red11ctio11 i11 costs lies at
Cuca-Cola, Kellogg's, t-leinz, Nestle, Mulsun, Tuyoca, Rolls-Royce, Sony, and the heart of globalizatio11.
Mi ts ubishi .

Through the ongoing process of globalization, national economies are ever more
linked to the global economy, in which an increasing share of jobs and incomes is

Glo ba lization comes with challenges, however. As Canadian firms relocate

productio n fac iIi ties co countries where coses are lower, domesric wo rkers are laid
off and nn ust sea rch for new jobs, perhaps needing ret raining in the process. The
location of produc tion faci li ties in countries with luwcr envi ronmental or human-
rig hrs records raises di fficult questions abour the standards char should be fol-
lowed by Canadia n-owned firms in foreign lands. A1ncl firms often use the th rea t of
relocation in an attempt to extract financial assistance from governments, placing
chose govern me n rs in di fficult positions. These concerns have led in recent years co
"anti-globalization protests" that have ra ised aware ness of some of the costs asso-
ciated wich the process of glo balization. We have mo re co say abo ut these issues in
Chap ters 33 and 34.

1.3 Is There an Alternative to

the Market Economy?
1~~~ ~~~~~~~~~~~~~-

In chis chapter we have discussed che elemems of an economy based on free-marker

transactions- what we call a market economy. Are there any alternatives to this type
uf economy? The answer is nu in une sense and yes in another. We answer nu because
che modern economy has no practical al ternative to reliance on market dece rminacion
fo r many of its transactions. We answer yes because not all transactions cake place in
free ma rkets even in rhe muse market-orie11ted society. To gu further we 11eed cu identify
va rious cypes of economic systems.

Types of Economic Systems

It is helpfu l to distinguish three pure types of economies, called traditional. command.
and free-market economies. These economies differ in the way in which economic
decisions are coordinaced. Bm mo acrnal economy fies neady into one of chese chree
categories- all real economies coma in some elements of each type.
traditional economy An Traditional Economies A traditional economy is one in which behaviour is based
economy in ~~ l ch t>ehaviour is primarily on tradition, custom, and habit. Young men follow their fathers' occ.:upa·
bas~ mostlyon tradition.
tions. Women do what their mothers did. There is little change in the pattern of goods
produced from year to year, other than those imposed by the vaga ries of natu re. The
techniques of production also follow traditional patterns, except when che effects of an
occasional new invention arc felt. f inal!)', production is allocated among rhc members
according to long-established traditions.
Such a system works best im an unchanging environ ment. Under such scacit cun-
clicions, a syscem chac does noc concinually require people co make choices can prnve
effective in meeting economic arnd social needs.
Traditional systems were common in earlier times. The feudal system, under which
most people in medieval Europe lived, was a largely cradicional sociecy. Peasancs, ani-
sans, and most others living in villages inherited rheir positions in chat society. They
also usually inherited their specifie jobs, which they handled in traditional ways.
Some elemems of cradirional economies persist today. In some cases, che rradicional
behaviour is natural and probably desirable, as when a child with considerable exper-
tise ra kes over a successful fa mily business. In other sicuatiuns, the cradicional behav-
iour is che res ult of a resis tance to change and fear of less familiar and more ris ky career
paths. In these cases, the traditiCJnS may clash with the change that is a hallmark of a
modern and dynamic economy.
Command Economies In command economics, economic behaviour is determined b)'
some central authority, usually the government, which makes most of the necessary deci-
sions on what to produce, how to produce it, and who gets to consume which products
and in whac quantities. Such economies are characterized by rhe centra/izatio11 of deci-
sion maki1lg. Because centralized decision makers usually creace elaborate and complex
command economy An plans fu r rhe behaviour char rhey wane co impose, the cerms command eco11omy and
ucunumy In which 1most centrally plan11ed economy are usually used synonymously.
economic decision~ are made
The sheer quanciry of data required for che cemral planning of an emire modern econ-
hy a central planning authority.
omy is enormous, and the task of analyzing it to produce a fully integrated plan can hardly
be exaggerated. Moreover, the plan must be continually modified co rake account nor only
of current data bur also of furnre trends in labour supplies, cechnological developmems,
and people's tastes for various goods and services. This is a notoriously difficult exercise,
nor lease because of the unavailability of all essential, accurace, and up-cu-dace information.
Thircy years ago, more chan one-third of che world's population lived in coun tries
that relied heavily on central plan ning. Today, after the fa ll of the Berlin Wa II and the
cullapse of the Suviec Union, rhe num ber of such countries is small. Even in countries
in whic.:h cencral planning is che proclaimed system, as in Cuba, increasing amouncs of
market de termination are gradually being permitted.

Free-Market Economies In the chi rd rype of ec.:onomic.: system, the decisions about
free-market economy An resource allocation are made W'ithout any central di rection. Instead, they result from
economy in ~ich 1most
economic decisions. are
inn umerable independent decis ions made by individual producers and w nsumers.
made bv private households Such a system is known as a frc1..:-markct economy or, more simply, a market economy.
and firms. Jn such an economy, decisions relating to che basic economic issues arc deccmlralized.

Despite the absence of a central plan, these many decentralized decisions are nonethe·
less coordinated. The main coordinating device is the set of market-determined prices-
which is why free -market systems are often ca lled price S)'Stems.
In a pure marker economy, all chese decisions are rnade by buyers and sellers acci ng
chrough un hi ndered markers. The governmem provides che background of defin ing
property rights and protecting citizens agai nst fo reign and domestic enemies but,
beyond char, markers decermine all resource allocariun and income discribucion.

Mixed Economies Economics that arc fu lly traditional ur fu lly centrally plan ned or
wholl)' frcc·markcc arc pure types chat arc useful for studying basic principles. When
we look i11 deta il at any actual econOITI)', however, we discover that its economic behav-
iour is the result of some mixture of central control and market dete rmination, with a
certai n amou nt of traditional behaviour as well.

In practice, every economy is a mixed economy in the sense tha t it comhines signifi- mll<Ald economy An uconumy
cant dcmems of all three systems in detcrminin~ economic behaviour. In which some economic
decisions are marle by flnns and
households and some by the
Furthermore, within any economy, the degree of the mix varies from sector to sector.
f or example, in some planned cconornics, the command principle was used more often to
determine behaviour in heavy-goods indumies, such as steel, than in agriculture. Farmers
were often given substantial freedom to produce and sell what they wanted in response
to varying ma rket prices.
When economises speak of a particular economy as being cen·
trally pla1nned, we mean only that the degree of the mix is weighted
heavily toward the command principle. When we speak of one as
being a market economy, we mean only chat rhe degree of the mix is
weighted heavily towa rd decentralized decision making.
Although no countr)' offers an example of either system working
alone, some economies, such as chose of Canada, the United Stares,
France, and Hong Kong, rely much more heavily on market de..:isions
than others, such as the economics of China, North Korea, and Cuba.
Yer even in Canada, che command principle has some sway. Crown
corporations, legislated minimum wages, rules and regulations for
environmental protection, quotas on some agricultural outputs, and
resrricrions on che imporc of some icems are jusr a few examples.

The Great Debate

As we saw earlier, in 1776 Adam Smich was one of che first people
to analyze the operation of markets, and he stressed the relative
efficiency of free-market economies. A cencury lacer, a nocher great
economist and policical philosopher, Karl Marx (1818- J 883), argued
that although free·market economies would indeed be successfu l
in prudu..:ing high levels of oucpuc, they could nut be relied un co
ensure chat this output would be fa irly discribured among citizens.
He argued the benefits of a centrally planned system in which the Ka·rl Marx argued that free-market eco110111ics
could 11.ot be relied 011 to e11s11re an equitable
government could ensure a more equi table clistributiu11 of output. distribution of iizcome. I le nd11ocated a system
Beginning with rhe Soviet Un ion in the early ·1nos, many nations of ctmtral plm111i11g i11 which go11em111ent owns
adopted systems in which conscious government central planning most of the means of productio11.

replaced the operation of the free market. For al most a i;entury, a great debate then raged
on the relative merit~ of command economics vc r~us market economics. Along with the
Soviet Union, che councries of Eastern Europe and China were <.:ommand economies for
much of the twentieth century. Canada, the United Scates, and most of the countries of
\Vescern Europe were, and still arc, primarily market economics. The apparent successes
of rhe Sovier Union and China in che 1950s and 1960s, including che abiliry ro mobilize
considerable resou rces into heavy industries, suggested co many observers chat the ..:om·
mand principle was at least as good for organizing economic behaviour as the market
principle. Over rhe long run, however, planned economies proved robe a fai lure of such
disastrous proportions that they seriously depressed the living standards of their citizens.
During the last decade of the twentieth century, mnst nf the wnrld's centralliy planned
economies began rhe difficulr rransirion back coward freer markers. These rransirions
occurred at different paces in different coumries, bm in most cases the initial few years
were characterized by significant declines in output and employment. Twenry years later;
howeve1; moscof rhe "rransirion" economies are experiencing growrh rares above rhe ones
they had in their fina l years as centrally planned economies. Living standards are on the rise.
Lessons from Tlistory '/- / discusses in more deta il why the centrall)' planned econ-
omies fai led. This fail ure suggesrs rhe superiority of decemralized markers over cenrrally


The Failure of Central Planning

crea ting the woup of co untries that became known as the
Easrcrn Bloc or the Soviet Bloc.
Despite rhe successful geogra phic spread of commun-
ism, rhc Sovicr system of centra l economic planning had
many difficulties. By 1989, communism had collapsed
th roughout Central an d Eastern Europe, and the cconoitric
sysrcms of form erly communise counrries began rhe dif-
ficult transition from centrally planned to nrarkct econ-
omics. Although political issues played an cno1·mous r<)lc
in these events, rhe economic changes generally co nfirmed
rhe su periority of a marker-oriented price system over ce n-
rral plan ning as a method of orga nizing eco nomic acriviry.
The failure of central planning had many ca uses, but four
were pa r:ticularl y significam.
T/Je fall of tf1e Berli11 Wall in November 1989 was tf1e
/;cgi1111i11g uf t/Je c11d uf t/Je Soviet system of ce11tral Failure of Coordination
pla1111i11g. In rhc centrally planned eco nomies, a body of plan·
ners attempted to coordinate all the economic decisions
The Rolshcvik Revolution in 19 17 in Russia brought the about produ ction, investrncnt, trade, an d co11sumption
world irs fi rsr example of a large-scale communise sociery. char were likely ro be made by producers and consum-
With the rise to power of Joseph Stalin and the creation of ers throughout rhe country. Without the use of prices to
the Soviet Union in 1922, communism and ce1mal economic signa l 1·clarivc sca rcity and abundance, ce ntral plann ing
planning began rhcir spread throughour Easrern and Cen tra l generally proved impossible to do with any reasonable
Europe. This sprc:td of central planr1ing was :tccclcr:ttcd by deg1·cc of success. Borrlenccks in pmducrion, shol'tages
the Soviet Un ion's role following rhe Second World War in of some goods, and glurs of others plagued the Soviet
''liberating" several cotrrltrics from Nazi domination, thus economy for dcc3dcs.

planned ones as mechanisms for allo..:ating an economy's scar<.:e resour<.:es. Put another
way, it demonstrates the superiorit)' of mixed economics with substantial clements of
market dererrninariun uver fu lly planned ..:urnmand econurnies. However, it dues 1101
demonstrate, as some observers have asserted, the superiority of completely free-market
economics over mixed economics.
There is nu guai:a nree char cumplerely free markers will, un their uwn, handle such
urgent matters as ..:ontrolling pollution, providing publi<.: goods (like national defence),
or preventing financial crises, such as occurred in 2008-2009 in most of chc developed
coun tries. Indeed, as we will see in lacer chaprers, muclh economic rheoi:y is devoted co
expla ining why free markets often fail co do these things. Mixed economies, with sig-
nificant clements nf governmen t inte rvention, arc needed co do these jobs.
Furrhermore, acceptance of che free marker over cennal planning does not provide an
excuse to ignore a coumry's pressing social issues. Ac..:eptance of the benefits of the free mar-
ke t Still leaves plenty of scope to dcbare the most appropriate levels and types of government
policies di:recced ac achieving specific social goals. Ir follows rhac rhere is srill considerable
room for disagreement abom the degree of the mix of market and government determina-
tion in any modern mixed econom)'-room enough to accommodate such divergent views
as could be expressed by conservative, liberal, and modern social democratic panies.

Failure of Quality Control and even when ir did occur, new jobs were usuall y found for
Central plann ers could moniror the number of units prn· all who lost theirs. Although the hip.h level of security was
duccd by any factory, rewa rd plants th at exceeded thei r attractive ro many people, ir proved impossible ro provide
productiotl ta rgets, and punish those that fell short. Fae· sufficient incentives for reasonably hard and efficient work
rory managers opcraring under rhcsc conditions would unde1· such condirions.
meet rhci r quotas by whatever means were ava ilable, and
once the goods passed our of thei1· factory, what happe ned Environmental Degradation
to chem w::is someone else's he:ulache. Fulfilling producrion plans became rhe all-embracing 11oal
In mal'kct economics, poor qua liry is punished by low in centrally planned economics, to the excl usion of most
sales, and rerailcrs soon give a signa l ro factory managers other considerations, includi ng the environment. As a result,
by shifting their purchases ro other suppliers. The incen· environmenral degradarion occurred in rhc Soviet Union
rives rh at obviously flow from such private-sector pu rchas· and the countries of Eastern Europe on a scale unknown in
ing discretion were generall y absent from centrally planned advanced Western nations. A particulady distu1·bing example
eC()nomics, where pt11·ch;1scs and s;1lcs were org;1 nized b)' (only one of many) occurred in Central Asia, where high
the body o f planners, and prices and profits were not used quoras for cocron ourpur led to indiscriminare use of pcsri-
to signal customer satisfaction or dissatisfaction. cidcs and irrigation. Birth defects became very common, and
the vast Aral Sea was more than three-quarters dr.:iincd, ca us·
Misplaced Incentives ing major cnvironmcnral effects.
In market economics, relative wages and salaries provide This failure to protect the envi ronm ent stemmed from
incenrives for labour ro move from place ro place, and rhc rhe p1·essui·e ro fulfil l p1·oduction plans and che absence of a
possibility of losing one's job provides an incentive to work ~ pol itical marketplace" where citizens could express their
di ligently. This is a harsh mechan ism chat punishes job losers preferences for rhc environment. Imperfect rhotJgh the sys·
with loss of income (although social programs provide floors rem may be in dcmocraric ma rker economics-and in some
to the an1ount of economic punishn1ent that can be suf· p:i rticul:ir cases it h:is been quite poor- thei1· record of
fcrcd). In centra lly planned economics, workers usual ly had environmental prorecrion has been vastly better rhan rhar
complete job security. lr1dustrial ur1cmploymenr was rare, of the cen trally planned economics.

So, the first answer to the question about the existern.;e of an alte rnative to the
market econom)1 is no: There is no practica l alccrnativc to a mixed system with major
reliance on markets buc some government presence in moscaspects of che economy. The
second answer is yes: Within the framework of a mixed economy there are substantial
alternatives among many clifferenc ancl complex mixes of free-market and govern ment
decerminacion of economic life.

Government in the Modern Mixed Economy

Markee economies in coday's advanced industrial coun tries are based primarily on vol-
umary cransaccions between individual buyers and sellers. l'rivace individuals have rhe
right to buy and sell what they want, to accept or refuse wo rk chat is offered co them,
and w move where chey wanr when chey wane.

Key institutions arc private propcrt)' and freedom of contract, hoth of which must
be maintained by active govcrnmcnr policies. The govcrnmenr creares laws of own-
ership and contract and then provides the instinnions, such as police and courts,
to enforce these laws.

Jn modern mixed economics, governments go well beyond these important basic func-
rions. They incervene in markec rransacrions co correcr what economists call market failures.
These are well-defined situations in which free markets do not work well. Some products,
called public goods, arc usually not provided at all by markers because their use cannot usu-
ally be restricted co chose who pay for them. Defence and police protection are examples of
public goods. In other ..:ases, private producers or consumers impose coses called externalities
on those who have no Sa)' in the transaction. This is the case when factories pollute the ai r
and rivers. The public is harmed but plays no pare in che transacrion. Jn yec orher cases, finan·
cial institutions, such as banks, mortgage companies, and investment houses, may indulge in
risk)' activities that threaten the health of the enti re economic s)1Stcm.111csc market fai lures
explain why governments sometimes intervene co alcer the allocation of resources.
Also, important issues of equity arise from letting free markets determine people's
inc:omcs. Some people lose their jobs bcc:ausc fi rms arc reorganizing co bcrnmc more
efficienc in che face of new technologies. Orhers keep rheir jobs, buc che markec places
so little value on their services thac chey face economi..: dep rivation. The old and the
chronically ill may suffer if their past circumstances did not allow chem to save enough
to support rhemselves. For many reasons of rhis sort, almosc everyone acceprs some gov-
ernment intervention co redistribute income. Care must be taken, however, noc co kill the
goose that lays the golden egg. By caking too much from higher-income people, we risk
eliminating rheir incenrives to work hard and produce income, some of which is ro be
redistributed co chose in need.
These arc some of the reasons chat all modern economics arc mixed economics. Through-
out most of rhe C\ventieth cenrmy in advanced industrial societies, rhe mix had been shift-
ing coward more and more government participation in decisions about the allocation of
resources and the distribution of income. Starting in the earl y 1980s, a worldwide movement
began co reduce rhe degree of government parricipation in economies. Wirh rhe 011sec of the
global financial crisis of 2008-2009, howeve1; there has been some movement back coward
a greater involvement of government in the economy. These shifcs in the marker/government
mix, and the reasons for chem, are some of the major issues that will be srudied in this book.


1.1 What Is Economics? LO 1

• Scal'ciry is a fundamenra l pl'oblem faced by al l economies. • A pl'oducrion possi bilities bou ndary shows all the com-
Not enough resources arc avai lable to produce all the binations of 1-1oods that can be prod uced by an economy
goods and services that people would like to consun1e. whose resources arc fu ll )' and cfficicnrlr em plorcd.
• Scarcity makes ir necessa ry ro choose. All socieries muse Movement from one point co another along rhc bound-
have :t 1't1ech:tnism for choosing wh:tr goods and services ary req uires a rea llocation of resources.
wil l be produced and in whar quantities. • Four basic questions must be an swered in all eco n-
• The concept of opportunity cost emphasizes the prob- omics: Wh at is produced and how? Wh at is consumed
lem of scarcity and choice by measuring rhc cosr of and hy whom? Why al'e l'esourccs sometimes idle? Is
obtaining a un it of one product in te rms of the num ber productive capacity growi ng?
of units of other products that could have been obtai ned • Issues of governn1enc policy enter into discussions of all
instead. four qucsrions.

1.2 The Complexlty of Modern Economies LO 2, 3, 4

• A 111a1·ker economy is self-organizi ng in the sense rhar • The inrernction of consu mers and producers tlwough
when individual consum ers and producers act independ- goods and factor markets is illustrated by th e circular
ently w pursue thei r own self-interest, responding to flow of incon1e and expenditu re. Individual consun1crs
prices determi ned in open markers, the collective our- sell factor services to producers and thereby ea rn th eir
con1e is coordinated. incon1c. Si rt1ila rly, producers earn thei r irnco1t1c by scll-
• lncenrives and sclf-intel'eSt play a central l'Ole for all inp. p.oods and services to individual cons~1mers.
groups of decision makers: consumers, producers, and • Modern economics arc based on th e specialization
g()vcrnmcnts. :rnd division of labour, which necessit:ltc th e exch:rnge
• Individual consu mers arc assu med to make rhei r deci - {trading) of goods and se rvices. Excha nge rakes place in
sions in an effort w maxim ize thei r wel l-being or utility. n1arkecs :ind is facil itated by the use of mon ey.
Producers' decisions arc assumed to be designed to • Driven by the ongoi ng rcvolurion in transportation
maxim ize their profi ts. and communica tions tcchnolop;y, th e world economy is
rapidly global izing.

1.3 Is There an Alternatlve to the Market Economy? LO 5

• We car1 distinguish th ree pu re types of economics: its citizens. All these countries arc now movi ng toward
traditional, command, and free-marker. In practice, al l greater market determination and less state comm and in
economics arc mixed economics in that their economic their economics.
behaviou r l'esponds ro mixes of tradition, gove rnment • Governments play an im pol'tanr role in modern mixed
com mand, and price incentives. economics. They create and enforce impo rtant back-
• In the lace 1980s, events in Eastern Eu rope and the ground institutions such as private property and
Soviet Union led to the general acceptance th at the freedom of contract. They inte rvene to co rrect marker
system of fully centrally planned economics had fo iled fai lures. They also redistribute incon1e illl the interests
t() p1·oducc minim:llly :lcccpt;1blc living sta nd;1rds fo1· of equity.

Resources lnccnrivcs and sclf-i nccrcst Trad itional economics
Scar·city and the need for· choice Specializa tion Command economies
Choice and opportunity cost The division of labour Free-market economics
Production possi bilities boundary Trade and mon ey Mi"cd economics
The self-o rgan izi ng economy Globa lization


Make the grade with MyEconLah: Study Exercises marked in red can be found on
MyEconLab MyEconLab. You can practise them as often as you want, and most feature step-by-step
guided instructions to help you find the right answer.

1. Fill in rhc blanks co make rhe following srarcmcncs correct. a. If rh c economy is ar poinr A, how many ronnes of
cloth ing :rnd how 1t1any ronnes of foocU :ire bei ng
a. The rhree Aeneral ca rep.ories of any economy's produced? Ar point B? Ar poi nt C?
reso urces arc , , and b. Whar do we know abour rhe use of resources when
Economists refer to these resources as the _ __
rh c economy is ar poinr /\? J\t poinr B? At poinr C?
of pro ducrion.
c. If rhe economy is at poinr IJ, whar is the opportunity
b. Wh en we use any resource, rhc bcnefir given up by cosr of p1·oduci ng one more tonne of food? What is
nor using it in irs best alternarive way is kn own as rh c oppo rruniry cosr of producing one more tonn e
rhe of char resource. of clothing?
c. The conce pts of scarcity, choice, and opporrun iry d. What do we know a bout the use of r(;Sou rccs at
cost ca n be illustrared by a curve known as rhe poinr D? How would ir be possible for rhc economy
to produce :tt poinr D?
d. When looki np. at a production possibilities bound·
ary, any poinr char is ourside rh e boundary dcm· 4. Choiccland has 250 workers and produces only rwo
onstra res . The slope of the goods, X and Y. Ll bour is rhc only focror of produc·
prod uction possi biliries bound ary demonstrates tio n, bur so me workers :l•'e better suited ro p1·oduci ng
X th an Y (and vice versa). The cable below shows rhe
e. J\ stra ight-line producrion possibilities boundary maximum levels of ourpur of each good possible from
(PP B) indicares chat rhe opporruniry cosr of each various levels of labour inpur.
good is , no marrer how much of char good
is produced. A PPR char is conca ve to the origin indi· Number of Annual Number of Annual
cares rh ar a(n) amounr of one good muse Workers Producrion Workers Producri on
be given up to produce more of the other good. Producing X of X Producing Y of Y
f. Consider an economy produci ng rwo goods, A an d
B, wirh a PPB rhar is concave ro rhc origin. As rhe 0 0 250 1300
eco nom y produces more of good J\ and less of good so 20 200 .1 200
B, irs opportunity cosr of producing A _ __ 100 45 150 900
2. Explai n rl1e rl1ree eco nomic conceprs illusrrared by rl1e 150 60 100 600
producrion possibilities boundary.
200 70 50 350
3. Consider an cconon1y that produces only food and cloth·
inA. lrs producrion possibiliries boundary is shown below.
250 75 0 0
a. Dr:tw the production possibilities boundary for
~ 8 D
"' Choiccland on a scale diag1·am, wirh the p1·oducrion
7 • of X on the horiion tal axis and rhe production of Y
~ 6 on the vertical ax is.
-c b. Compute the opportunity cost of producilllg an extra
0 5
....µ..0 4
15 un irs of X if rhe economy is inirially producing
: /\ 45 units of X and 900 units of Y. How docs th is
i'i .3 ·-··-··•··-··-··-··- compare ro the opporruniry cosr if rhe economy were
a 1
initially producing 60 units of X and 600 units of Y?
c. If rhe economy is produci ng 40 unirs of X and 600
unirs of Y, wha r is rhe opportunity cosr of producinp.
0 23 4 5 6 7 8 an cxna 20 units of X?
Tonnes of Cloching per Year d. Su ppose now char rhe rechnology assoc iared wirh
producing good Y improves, so rhar th e max in1um

level of Y that can be produced from any given level there were only two goods call thcn1 X and Y. But we
of l:ibou r inpu r increases b)' I0 percenr. Explain {or all know that any economy produces man)' more than
show in a dia11ram) what happens ro the production just two goods. Explain wh)' the insights il lustrated in
possibilirics curve. Figure I· 2 on page 8 arc more general, :ind why the
assumption of only rwo goods is a usefu l one.
5. E'<plain wh)' a 1cchnolog1cal 1111provcmcnt in the pro-
duct11>n of one good means rhar :i country can now pm· 9. What is the difference bcrwccn m1c1oeconomics and
duce more of ot/Jer goods rhan it did previously. I linr: macroeconomics?
D1aw a counny's producnon poss1b1hties boundary ro
10. For rach of the following situations, explain how :i ch:ingc
help :inswer this question.
in the sratcd "price~ i& l1kclr to affccr )'our mccnt1ves
6. Consider your decision wherher ro go skiing for rhe regarding rhe srarcd decision.
weekend. Suppose transportation, lift tickers, and
a. rhc price of ski-lift tickets; your decision to purchase
accom mod:ition for rhe weekend cost $300. Suppose
a ski-lift ticker
also that restauranr food for rhe weekend wi ll cost $75.
b. the hou rly wai::e for your weekend job; the decision
F1nolly, suppose you hove o weekend job that you will
to nor work and 11.0 skiing on the weekend instead
have to miss if you 110 skiini::, wh ich pays you $ 120 {after
rax) for the one weekend day that you work. Whnt is the
c. rhe va lue of a speeding ticker; your decision ro speed
on rhe hii:hway
opp<ll'runity cosr of 11oin11 skii ng? Do you need any other
information before computing the opportunity cost? d. rhe weii:hr of your course 11.rade arrachcd ro :in :issign·
mcnr; your decision to work hard on that assignment
7. Suppose you :1 r1CI a friend arc stranded on :111 is la nd e. the level of tuiti on fees at your college or un iversi ty;
and rnusr gather firewood an d ca tch fis h co survive. you r decision to attend th at collc1-1e or un ivcrsiry
T hrough experience, you know rh at if each of you
spends an enrire day on ei ther ~1criv i ty, the result is 11. State and explai n two reasons why the specialization of
given in the foll owi ng rnble: labour is more efficient than un iversal self-sufficie ncy.
12. Consider the morkct for doctors' services. In what way has
Fish Firewood {bundles) this market r:ikcn 3dV311t:1ge of rhe spccialit.:.1.lion of bbour?
You 6 3 13. List the four ma in types of economic systems and their
m3in attributes.
Your friend 8 2
14. As we said in the rcxt, the aver.111e forn1 ly income in C:1n-
You and your friend decide char )'Ou should each spc· :1d:1 is abour $75 000 per )'Car. Imagine a hypot11cric31
cialize so rhar one person carchcs fish while the ocher world m which all Canadian fan11hcs had this income.
gathers firewood. Bur who &hould do which r:isk? a. In such a world, would poverty C'<ISt in C:inada?
a. What is rhe opporrun1f)' cosr for ) 'OU to gather an b. In such a world, would scarcif)• exist in Canada?
add1t1onal bundle of firewood? What is )'our friend's c. Explain the difference between poverty and scarcif)'.
oppominif)• cosr of gathering an extra bundle of 15. Comment on the following statement: ~one of the m)'S-
firewood? tcrics of semantics is why the government managed
b. Assuming that you and your friend specialize, what economics ever came tc> be called pl:inncd and rhc mar-
allocarion of rlsks maximizes rora l ourpur for your ker economics unplanned. It is rhe former rhar arc in
one day of joint effort? chronic chaos, in which bu)'Cl'S stand 111 line hoping to
c. Suppose you both decide to work for two days buy some toi ler paper or so3p. Ir is the latter that are
accordini: rn rhe allocnrion in parr {b). Whar is rhe ir1 reasonable cquilibriu111-whcrc if you wo nl a bar of
rorn l amount of ou tput? What wou ld ir have been soa p or a srcak or :i shirr or a c:11; you can ,110 io the Stl11'c
had i•ou chosen the reverse alloca tion of tasks? an d find that the item is magic:i ll y there for you to buy.
8. In this chaptc l' we used a simple idea of a produc- Ir is the liberal eco nomi es thar rcflecr ~ highly sophis-
ti on possibil ities boundary to il lustrate the concepts ricated planning system, and the govcrnmcnr-ma11c1gcd
of sca rcity, choice, :111d opportun ity cosr. We assumed ccononi ies that arc prin1itivc and unp lanned."
This appendix is a refresher un the basic graph- a1t<l we call che 3 and che 2 che courdmates uf puinc
ing cechniques you saw in high school machemacics. A. The usual practice in graphing is co lisc che x-axis
Economist11 use Af:iphs co illu\trnte cheuries and show coordinate first and the y axis coordinate second.
daca, and you will see man)' grnphs throughuuc chis In che same way, we can read poilll B(2, - 2), point
cUL1rse. Here, we review che mosc basic concepcs for C(-1,-2), and point D( 4, 3).
those who need review. Any poin t on a graph is simply a visual rep-
resencarion of cwo num bers. Fur example, point A
represents the numbers 3 and 2. For che graph co
Dlsplaylng Points on a Graph be meaningfu l tu us, however, the num bers must cell
us something. Lee's cake an example fro 1n econom-
Coordinate Space A graph begins with two num ber ics and plo[ a graph with che in formacion from che
lines, one horiw ntal and one vertica l. We call the hori- table in Figure 2 that shows how much Kacie s:wes at
zuncal numl>er line the x axis because we ofcen label various levels uf income (buch measured i11 dollars).
che variable displayed along chis axis x. We call che Each poinc on the graph now represents a particular
vertical num ber line they axis bec:wse we often label level of income and the associated level of saving, or
che variable displayed :ilong chis axis y. In Figure I an income-saving cumbinacion. For example, poinc
che x axis displays che number line horizoncally from C shows cha[ ac an income of $30 000, Kacie saves
-5 co 5 with intervals of I. The y axis displays che $5000. Tc is also easy co see when looking ac chis
number line vertically from -3 co 3, also wich intervals graph char when Kacie's level of income goes up, her
of I. We have now creaced a cwo-dimensional space level of saving goes up.
chat is called a coordi11atc space. Nocice chac each incremenc indicaced on che x axis
Now look at poinc A in che figure. Poinc A repre- is 10000 and rhe incremenc on che y axis is only 5 000.
sencs cwo numbers: 3 on che horizoncal, or x. axis and We adjust the scale~ on the axes to fit the information
2 on the vertical, or y, axi ~. We write point A as (3, 2) we wane cu graph. 111 Figure I we called each inter-
val 1 on boch axes, and in Figure 2 we called each
interval on the x axis I0 000 :md each interval on
cite )' axis 5 000. Imagine crying Lu graph Canadian
AGURE 1 nacional income, which is in che range of $·1.7 crilliun,
y O'l'ltt or
on a graph using interv:ils of $ 1 or even $10 000.
l l(-~. 3) \'Crtll31 Q'l'IS The resulring gra ph would hnve tu be enormous, and
• J"
A(J, 2) would noc be helpful in displaying chc in formacion.
l • Therefore, we choose 1he ~cales on each axis co be~c
I • display che speci fie dam we are considering.
-5 -4 -3 -l I 0 l J '' S x nxis ••r
Variables Our gra ph in Figure 2 now visua lly repre-
I •
nxis sents the relatitmship between chc 1wo variables, income
C'(- 1,-l) . - l and saving. Variable is the word we use co describe
-J - the items on the axes tu which we are givins numeric
values; in this case, income and saving. The i11depe11d-
e11t variable, in chis case income, is represenred on the


15 000 . .'( y
independent dependent
IQ 000
• v:\riablc
Kati e's Inco me
Katie's Saving
Jl 5 000 . •
fl 10 000 -5 000
:>..: 0 10000 20000 30000 40000 20 000 0
-5 000 . •A 30 000 s 000
40 000 lO 000
Katie's Income ($}

horizontal axis (che x axis) and rhe dependent vari-

able, in chis case saving, is represented on the vertica l FIGURE 3
axis (che y axis). (Though rhis is che usual way cu draw
a grap h, you will lace r see char economises are some· 12
cimes accused of doi ng it backward- see foocnoce 3 11
un page 71 i11 Chapter 3.) VI

8 a positive, o r
7 di re<.'t relati1)nship
Linear Curves ·~ s
When cwo variables move, eicher i11 che same or in ""' J
opposite clireccions, we can plor rhe daca poincs on a 2
graph and join their poincs ro form a curve. If joining
che poincs gives us a srraighc line we call ic a linear 0 2 3 4 5 6
curve andl we say char x and y have a linear relatio11- Nurn litr of Toppings
ship. /\ relacionship in which che two variables move
in che same direccion is called a positive. or direct,
relacionsl\ ip-when one variable goes up, che ocher relacio nship. j oining che poincs gives us an upward·
goes up. A relationship in which the two variables sloping straight line, so we call this a positive, linear
move in opposite directions is called a negative, or relationship.
inverse, relationship-when one variable goes up, rhe
other goes down. A Negative Relationship f igure 4 shows cwo vari·
ables, che price of cickecs for a universiry baske r·
A Positive Relationship Figure 3 shows rwo variables, ball game and the num ber of people who choose to
the number of pizza toppi ngs and che total price of purchase tickets and attend the game. (In Cha peer 3
a pizza. A cheese pizza has zero toppings and coses we describe such a relacionship as a demand curve
$5; each additional copping coses $1.50. The two for basketball tickets.) The two variables move in
va riables, number of toppings and price of pizza, opposite directions-chis is a negative, or inverse,
move in [he same di rection- as the num ber of top· relations hi p. Joining the points gives us a downward-
pings (rhe x variable) goes up, che price of che pizza sloping straight line, so we call this a negative linear
(they variable) goes up-so chis is a positive or direct relariuns hi p.


6y rise - 500
1\: slope=- =- =- - = - 5
fJ.x run 100
~- 14 600 fJ.v rise 200
.., _
" "' 12
a negative, or
inverse relationship
IJ: slope= -=- =-
fJ.x run
=- - = 0.4
~ lS I0
o:l "
0 .!.! 8 o•
13 r- 6
400 "'II ''• :• oO
4 ~:
ii : ' N
l JOO ' : II
: ~
_________________ : 02
0 500 I 000 I500 2000 2500 200
Run = 500
Actendan~e at Game
Run= IOO

0 100 200 JOO 400 500 600 x axis

Slopes of Linear Curves The slope of a line cells us
how much the )' variable changes whenever the
x va riable changes. For example, rhe slope of the A linea r curve has the same slope over che enti re
straight line in Figure 3 cells us how much the price length of the curve.
of pizza changes (the change on the)' axis) when the
number of toppings changes (rhe change on the x Infinite and Zero Slopes Figure 6 shows cwo extreme
axis). The slope is defined as die change in the val ue cases char we see ufren in ecunumics. Fur rhe hori-
on the vertical axis divided b)' the change in the value 7.ontal line, we calculate the slope as rise/run -
on the horizontal axis. It is commonly refe rred to as 6.y / il x = 0/oo. We say tharrhe run, or t.x, is co beca use
the " rise over the run ." We ca n wri te a desc ri ption of rhe linear curve exrends ru infinicy. Zero divided by
slope in a few ways: infinity is 1.ero. Remember chat the fl atter is the curve,
the smaller is the slope. I !ere is the extreme case of a
rise change in va lue on vertica l axis fl ar curve; rhe slope is zero. For rhe ve rrica l line, we
Slope "" - . . - .
run chani:;c 111 val ue on honzunta I axis calculate the slope as rise/run = t. y/ 6.x - oo/0.
Jnfinit)' divided by :1.ero is infi nity. Remember that the
il y
The lasr rerm uses che Greek letter delca, 6, which
y sl ope = ~
means "the change in." For Figure 3, the slope of the
curve is $ 1.50 per cupping, indicating rhar each extra
copping increases rhe price of che pizza by $ ·
Figure S shows the cak ulation of slopes for two
linear cui:ves. (Work chruugh each uf chese calcula- slope= 0
rions and rhen draw various linear curves of yo ur
own and practise ca lculating their slopes. Try using
differenr uni cs and intervals un rhe axes and see if chis
affects rhe slope.) Norice char rhe upwa rd-sloping
curve has a positive slope and the downward-sloping
curve has a negative slope. Also no tice chat rhe
sreeper rhe line, upward- or downward-sloping, x
the higher the absolute num ber value of the slope.

steepe r is the curve, the higher is the slope. This is the The slope of the line is 0.5. Verify this by cakulating
extreme case of a steep curve; the slope is infi ni te. 6.y/ 6.x between any two points on che line. Between
Understanding the concept of che slope of a li11e is poincs C and D, for example, the D.)' (or the rise) is 1
crucial when studying economics. Fconomists are inter· and the /'o..x (or the run) is 2. So the slope of the linear
estcd in how much one variable changes in response co curve is 6.y/ 6.x = 1/2 = 0.5.
a cha11ge in anochei: variable, and it is the slope of the The equation for a downwa rd-sloping linear
curve thac tells them this. curve wo rks the same way. In Figure 7 we plot the
linear curve, B, given by rhe rela rionship between rhe
Equation of a Linear Curve A linear curve is a visual x and y variables in Table B of Figure 7. T he equation
represenrncion of rhe linear relationship berween cwo for chis linear curve is y = 8 - 4x . Once agai n, prove
variables. The same relationship can also be described this ro yourself by calculating y for various levels of x.
in an equation. The general equation for a linear curve is The y inte rcept for chis line is 8 and the slope is - 4.
Notice, of course, that the slope of the downward-
y =a I bx, sloping linear curve is negari ve.
where)' is the dependent variable and x is the independ-
enr variable. The Jeerer a represems d1e y intercept, or
che point at which the line intersects the y axis. The Non-Linear Curves
letter b represents the slope of the line.
All the curves we have looked at so far have been
In Figure 7 we plot the linear curve, A, given by straight lines-they have been linear curves. (Su d1ey
che relationship between che x and y variables in Table haven't really been ''<.;u rves" at a II!) However, not
A of Figure 7. The equation fo r this linear curve is
all relations between two economic va riables can be
graphed as a straight line. Mure ufren, the relation
y = 2 + 0.5x
is non-linear. Tn a non-linea r relationship between
Prove this to yourself by calculating y fo r any value of x and y, each unit change in x docs no t alwa ys bring
x. f or example, whe n x = 3, y == 2 + 0.5(3) == 3.5. about the same change in the y variable. Figure 8
When x=7,y = 2 r 0.5(7) = 5.5.Theyintercepcof shows four curves, two with positive slopes and two
chis line is 2, and thus the line inte rsects they axis at 2. wi rh negative slopes.

Table A Table B
y x y x y

0 2.0 0 8
2.5 .25 7
2 3.0 .50 6
3 3.5 .75 5
.s 4 4.0 1.00 4
4 5 4.5 l .25 3
6 5.0 1.50 2
7 5.5 1.75
8 6.0 2.00 0
9 6.5

0 2 J 4 s 6 7 8 9 10 x HJ 7.0

Curves A and T:\ both show positive relationshi ps Since the slope of the curve is conti nuously
between x and )1- the slopes arc both positive. /\s changing, we must measure the slope at s{Jecific
x increases, so does y. Curve A, however, becomes points along rhe curve. To do so, we simply draw a
fl atter as x increases, and curve R becomes steeper straight line tangent co the curve at the point at which
as x increases. Similarly, curves C and D both show we want co measure the slope. A line is ta ngent co a
negacive rela ri onshi ps berween x and y- boch slopes curve if ir couches but does not intersect rhe curve ar
are negative because in each case, as x increases, y chat point. The slope of chis cangenc line then cells
decreases. Curve C becomes flacccr as x increases us the slope of chc curve at the point of tangency.
and curve D becomes sceeper as x increases. i:igure 9 shows rhe calcularion of rhe slope ar rh ree
points along a downward-sloping curve like our
Slopes of Non-Linear Curves Examine curves /\, B, C, curve C in Figure 8.
and D in Figure 8 ru see how y changes in response cu Consider the slope of the curve at point A. The can-
a one·unit change in x, ar various levels of x . You will gcnc ro the curve at point /\ has a )' intercept at 50 and
sec that for curves A and C, the change in y becomes an x inrercepr at l 0.Thus rhe slope of rhe rangenr line is
smaller as we move along rhe x axis. We can describe 6.y/ 6. x - - 50/ 10 - - S. Thus the slope of the curve
the slopes of curves A and C as starting our steep and ac point A is -5. Now consider the slope of the curve at
becoming flatte r as x increases. for curves B and D, poinr C. The ra ngenr line co poinr C has an x inrercepr
however, che change in y becomes larger as we move of 50 and a )' inte rcept of 'I 0. The slope of the tangent
along rhe x axis. We can describe the slopes of curves line is 6.)1 / 6. x = - I0 / SO = - 0.2. Therefore che slope
B and D as scarri ng our flat and becoming steeper as of the curve ar point C is 0.2. Thus, alchough che slope
x increases. The slopes of rhese non-linear curves are of the curve is always negative, its slope falls (in abso·
changing as we move along the curve. How do we lute value) from 5 at point A to 0.2 at point C.
measure che slope of a curve when che slope is differ-
enr ac each poinc along rhe curve?
Remember chat we measured die slope of a
stra ight line by choosing two points on the line and FIGURE 9
dividing rhe change in y by che change in x. Doing che y
same thing to measure the slope of a non-linea r curve,
however, would give us the slope of the line connecting so
che cwo specific puims char we chose on che curve buc 45
would not give us che slope of the cmve itself.

35 Av - 50
• - 10 •-5

y 25


I0 · - - •
...... ~.: - - -~!.","'"• - .
5 ' ... --.... ...... -.. .. -.......

0 I0 IS 20 2S 30 3S 40 4S SO x

We le;ive it to you to draw more non linear curves A Final Word

(like rnrvc~ A, B, and D in f-igurc 8) and compute the
slopes at various poincs along each curve. Fur each Graphing can be intimidating, but a Ii trle practice
comput::itfon, simply draw a straight line rn ngent to goc~ a long war. Br working rour way carefully
the rnrvc, and then compute the slope uf the tangent thro ugh che various parts of chis seccion, plus the
line. This will give you rhe slope of rhe non-linear graphing questions in the Study Exercises ::it the end
curve at tl1c point of tangcucy. of Clrnp tcr 2, you will soon be comforcablc wirh che
basics of graphing.

After studying this chapter, you will be able to

2.1 POSITIVE ANO NORMATIVE STATEMENTS 1 distinguish between positive and normative statements.

2.2 BUILDING AND TESTING ECONOMIC THEORIES 2 ex.plain why and how economists use theories to help
them understand the economy.
3 understand the Interaction between economic theories
and empirical observation.

2.3 ECON OMIC DATA 4 ldentiFy several types of economic data, Including Index
numbers, time-series and cross-sectional data, and scatter

2.4 GRAPHING ECONO MIC THEORIES 5 see that the slope of a line on a graph relating two
variables shows how one responds lo a small change
in the other.

IF you follow che news, whecher online, TV, newspaper, or Economics is a social sdem:e, and in chis chapter we
radio, you are likely co hear the views of economists being explore what it means to be "scientific" in the study of
discussed- about debr crises, unemploymenc, arremprs economics. Along the way we will learn much abour
to reform the; health-care system, environmental policy, theo ries, predictions, data, cescing, and g1·aphing-
changes co corporate income-tax races, or a myriad of economisrs use all of these cools and rechniques in
other issues. Where do economisrs' opinions come from? their attempt ro understa nd the economic world. We
Are rhey supported by hard evidence, and if so, why do begin wirh rhe imporranr disrincrion between positive
economises somecimes disagree wirh each ocher over and normative sratemenrs.
important issues?

I 2.1 Positive and Normative Statements

fa:unumiscs give rwu broad rypes uf advice, called nonnative and positive. Fur example,
chey sometimes advise that rhe government oughc co cry harder co reduce unemployment.
When they say such things, chC)' arc giving normative advice; in chis case, cher arc mak-
i11g judgements abour the value uf the various things rhac rhe guvernmenr could du wirh
its limited reso urces and abouc che coses and benefits of red ucing unemploymenc. Advice
chat depends on a val ue judgement is normarive- ic cells ochers what cl1e)1 ought to do.
Anorhei: rype uf advice is illustrated by rhe srarernenr " If rhe guverl11'ne11r wanes ru
reduce urnemploy menc, reducing unemployment insurance benefits is an effeccive way
of d<Jing so." This is p<JSitive advice. Tc docs not rely on a judgement about the value of
reducing rn1empluymenr. Instead, rhe expert is saying, "If ch is is what you wane co do,
here is a way co do ic."
Norm ative statements de pend on val ue judgcmcnl:'S and cannot be evaluated solely normative stotoment A
by a recourse cu fates. In cuncrasc, positive statements do not involve val ue judgemencs. statement about what ought
to be as OllPOsed to what
They are scaremenrs abour maccers of face, and so disagreemencs abour chem are appro- actually Is.
priately deal t with b)' an appeal to evide nce. The distirnction between positi ve and nor-
macive is fundamental co sciencific progress. Much of che suctess of modern stiente positive statement Astatement
depends on the abiliry of scienrisrs co separate rhei1· views on what does happen in rhe about what a-ctually Is (was. or
wlll be), as opposed to llllat
world from their views on what they would like to happe11. For example, uncil the eighc- ought to be.
eench cenw ry almosc everyone believed char Eanh was only a few chousand years old.
Evidence rhen began co accum ulate char Earth was bil.lions of years old. This evidence
was hard for most people to accept, since ic ra n counter to a litera l reading of many reli-
gious cexcs. Many did nor wane co believe rhe evidence. Nevertheless, scienriscs, many
of whom were religious, conti nued cheir resea rch because rhey refused co allow cheir
fee lings abo ut what tl1C)' wanted to believe to affccc their sciencific search for the cru th.
Eventually, all scientists and mosr members uf the public came cu accept char Earth is
abouc 4 billion years old.

Distinguishing what is actually true fro m what we wo uld like to be true requires
disti nguishing between positive and no rmative statements.

Examples of both t)'pes of statements arc given in Table 2- 1. All fi ve positive scare-
menrs in che cable are assertions about che nacure of rhe world in which we live. In
contrast, the five normacive stacements involve value judgements. Nocice cwo things
about the positive/normative discinction. Firsc, posicive statements need not be true.
Scatemenc C is almost cercainly false, and yec ic is positive, nut normative. Second,
the incl usion of a value judgement in a statement does not necessaril)' make the state-
ment itself normative. Statement D is a posicive statement abouc the value judgemcncs
chat people hold. We could conduce a survey cu check if people really du prefer low
unemployment co low inflatio n. We could ask chem and we could observe how they
voted. There is no need for che economist to rel)' on a value judgement cu check chc
validi ry uf che sracemenc icself.
We leave yo u co anal)'7.e the remai ning eight state ments to decide precisely why
each is either posicivc or normaci vc. Remember to apply the two ccscs. Firsc, is chc scate-
menc only abu uc actual ur alleged faces? If su, ic is a posicive one. Secu11d, are value
judgements necessary co assess the truth of the statement? Tf so, it is normative.

TABLE 2·1 Positive and Normative Statements

Posirive Norma rive
A Raising interest rotes encourages people to save. F People shou ld be encouraged to save.
B High rates of income t:ix encourage people ro evade G Gove rnmen ts should arrange taxes so that people
paying raxes. ca nn ot avoid payi ng them.
C Lowering the price of cigarerrcs leads people H The gove rnment shou ld raise the tax on cigarettes
ro smo ke less. ro discou rage people from smoking.
D 111e majority of chc population would prefer a policy char Unemp loyme nt is a more imporra nc social problem
reduced unemplwmcnc ro one char reduced inAarion. than infbti<)n.
E Govern ment financial :issisrance ro commercial banks J Gove rnment should not spend taxpayers' money on
is ineffoccivc ar p1·cvenring job losses. supporting commercial hanks.

Disagreements Among Economists

Economises ofcen disagree wich one anmher in public discussions, frequencly because of
poor communication. The adversaries fail to define their terms or d1eir points of refer·
ence clearly, and so chey end up "arguing pasc" each ocher, wich che only cercain resulc
being chac che audience is left confused.
Another source of disagreement seems from some
economists' fa ilure to acknowledge the fu~ I state of
their ignorance. There are many points on which che
evidence is fa r from conclusive. Info rmed judgements
arc required co cake a position on even a purely posi·
cive question. In such cases, a responsible econom ist
makes clear the extent to which his or her view is
based on judgements about the relevant faces.
Many ocher public disagreemencs are based on
the positive/normative distinction. Oifferem econo·
mists have different values, and these normative
views play a large pare in mosc discussions of pub·
lic policy. Many economists stress the importance
of individual responsibility and argue, for example,
chac lower employmenc insura nce benefi rs wouId be
Economists often dis(1gree with one another i11 the 111edfr1 or al desirable because people would have a greater incen·
co11(ere11ces, but their debates are more often about normative
issues tha11 positive ones.
cive ro search fur a job. Ocher economisrs srress rhe
need for a generous "social safety nee" and argue rhar
higher employment insurance benefits are desirable because human hards hip would be
reduced. In such debaces, and rhere are many in economics, ic is che respon.sibiliry of
che economise co scare clearly whac pare of the proffered advice is normacive and whac
. ..
pare 1s pos1c1ve.
Because che world is complex and because no issue can be seeded beyond any doubc,
economises rarely agree unanimously on an issue. Nevercheless, there is an impressive
amount of agreement on many aspects of how che economy works and what happens
when governmencs incervene cu alcer ics workings. A survey published in che American

F.conomic Review, perhaps the most infl uential eco11omics journal, showed strong
agreement among economises on many propositions, including "Rent control leads
co a housing shortage" (85 percent yes), "Tariffs usually reduce economic welfare"
(93 percent yes), "T.arge government budget defi cits have adve rse effects on the economy"
(83 percent yes), and "A minimum wage increases uncmplo)1 ment among young wo rkers"
(79 pei:ce11c yes). Notice char all these are posirive rarher rhan normative sraremenrs. Ocher
examples of these areas of agreement will be found in many places throughout this book.
Whether chey ag ree or disagree with one another, economises arc in demand in
many secrurs of che economy. See Applying Economic Concepts 2- 1 for a discussion of
the many organizations that employ economists.


Where Economists Work

This cha pter discusses rhe theoretical and empirical Co nference Boa rd of Canada. Al l of these independent
tools tha t economists use. After reading th is mate ri al, and non-prnfit organizations hire economists ro study
you mi14ht wo nder where economists find jobs and what economic issues and th en write an d edit the economic
kind of work they acrua lly do. The skills of economises pu blica tions that address them.
arc demanded in many parts of the economy by gov- Private and pub lic (crown) corporations in many
ernments, private and crow n corpo rations, non-profit sectors of the economy also hire eco norn ists in a va riety
organiza tions, and univcrsicics. of positions. Economists ar Ca nadian Pacific Railway
In Ottawa an d the provincial and territoria l ca p- monito r how changes in wo rld commodity prices wi ll
ita ls, economists arc hired in most governm ent depart· lead to changes in Ca nadia n resource production and
ments ro ana lyze the effects of govern ment policies an d thus co changes in che demand for chci r rail cransporc
to design ways to im prove rhose policies. Ar Fi nance services. Economises at Manitoba Hydro study the lin k
Ca nada, economists design and analyze the income-tax between economic growth and elcctricicy de mand co
system and the effects of current spending proya ms. hel p the fi rm with its long-run investment decisions.
At Environme nr Canada, rhcy help design an d cvaluare Those :Jt Exp()1't Dcvclo pmcnr C:Jru da exami ne h()W
policies aimed at reducing water and ai r pollution. At economic and policical risks in various councries influ·
lndusn·y Canada, rh ey srudy the sou1·ces of p1·oducrivi ry ence the demand fo r the products of CanadiM export·
growth and design policies ro enco urage inn ovation in crs. Economises at Bombardie r arc hired to dctcnnine
the priva te sector. At the Bank of Ca nada, economises how ongoing negotiatio ns withi n the Wo rld Trade
researc h rhc link between intcrcsc rares, chc aggregate Orga niza tion wi ll affect tariff levels in va rious coun·
dcn1and fo r goods and services, and the rate of increase tries and how these changes will affect the demand for
in prices. They also moniror developments in chc 11lobal Bomba rdier jets.
economy and thei r effects on the Ca nadian economy. Sta- Finall y, many economists arc hired by univcrsi-
tistics C rnad ;1 em pk)ys nuny economists to design 111cth· tits all over the world to teach Students like you and to
ods of colleccing and an alyzing data coveri ng all aspeccs conduce 1·esea1·ch on a wide variety of economic ropics.
of Canadian society. Some of this resea rch is theoretical and some is empir-
The analysis of economic policies also cakes pb cc in ical, using dara ro rest economic rhco rics. Other aca·
independent research organizations, often called "th ink demic economists focus their resea rch on chc des ign an d
ra nks." The C. D. Howe lnsrirure in TOl'onro is one of im plementation of better economic policy, an d often
Ca nada's bcsr-kn own rh ink ranks, and it regularl y pub· spend considerable time imcracting wirh rhc eco nomists
lishcs l'apers on topics rangi ng from moneta ry policy em ployed by government departmen ts.
and the stare of public pensions co rhe effects of immi- Training in economics prnvidcs useful analytical
gration and the challenges in reforming Ca nada's policies skills that arc va lua ble for lea rning about the workings
for foreign devclopmcnr assisrancc. Orher think ranks of a complex ccono111ic world. There is 110 shorrnge of
include the Institute for Research on Public Policy, the demand for people who can thin k clearly and an alytic·
Ca nadian Centre for Policy Altern atives, the Fraser lnsri· al l)' abo ut eco nomic issues. This cou rse could wel l be the
ture, the Centre for che Scudy of Living Standards, and che sra rr of a great career for you. Srudy hardl

I 2.2 Building and Testing Economic Theories

The economic world is complex. Many things are changing at the same time, and it
is difficult to distinguish cause from effect. Economists who arc observing the world
carefully, however, see regulari ties in rhe data- for example, rhar unemploymem rends
to rise when natio nal income slows, or that periods of higher inflation ofren follow
periods of ver)' low interest races. Jn order co becccr understand such regula ri ties in chc
dara, and co identify rhe likely causes and effects, economists develop theories, which
they sometimes call models. Theories are used to both expla in events that have already
happened and ro help predict evems rhar might happen in rhe future.

What Are Theories?

Theories arc constructed to explain things. For example, cconmnisrs may seek to
explain what determines che qu.anciL )' of eggs boughr and sold in a particular month
in Manitoba and the price at which they are sold. Or they may seek to explain what
determines the quantity of oil bought and sold around the world on a particular day
and rhe price ar which ir is rraded. As parr of rhe answer ro such quesrions, eco11omisrs
have developed theo ries of demand and supply- theories that we will swdy in detail in
the next three chapters. These a11Jd all other theories arc distinguished by their variables,
assumptions. and predictions.
variable Ally well-defined Item, Variables The basic clements of an)' theory arc its varia bles. A variable is a well-defined
such as the price or quantity of item, such as a price or a quanricy, that can rake on different possible values.
a commodity, that can take on
various S(ICClfic values.
Jn a theory of the egg market, the variable quantity of eggs might be defi ned as the
number of cartons uf 12 Grade A large eggs. The variable price of eggs is the amount uf
money chat must be given up co purchase each carcon of eggs. The particular values taken
by chose two variables might be 20 000 cartons per week at a price of $2.60 in .rr uly 20·11 ,
18 000 car cons per week ac a priice of $2. 75 in Jul y 20 12, and 19 500 cartons per week
ac a price of $2.95 in July 2013.
There are two broad categories of variables chat are important in any theory. An
endogenous variable Ava~able endogenous variable is one whuse value is decermined within che theory. An e..xoger1011s
tllat Is explained w11111n a theory. variable infl uences che endogenous variables buc is itself decermined outside rhe theory.
Sometimes calle-0 an induced
variable or a dependent variable.
To illustrate the difference, the price of eggs and the quantity of eggs are endogenous
variables in our cheory of che egg marker- our theory is designed ro explain [hem. The
exogenousvariable Avariable
scare of rhe weather, however, is an exogenous variable. Ir may well affect rhe num ber of
that is determined outside the
theOfy. Sometimes called an
eggs consumers demand or producers supply, but we can safely assume chat the state of
auronomous varlsbte or an the weather is nor influe11ced by che marker for eggs.
lndcpcnacnr var/able.
Assumptions A cheory's assumptions concern motives, directions of causation, and the
condi tio ns under which che cheory is meanc ro apply.
Motives. The theories we scudy in this book make the fundamental assum ption that
cvcr)1one pursues his or her ow11 scif-intcrcst when making economic decisions. Indi-
viduals arc assumed to strive to maximize cheir utility, while firms arc assumed to cry
co maximize cheir profits. Noc only are rhey ass umed co know what chey wanr, buc we
also ass ume char chey know how cu go about getting it wichi n the constraints they foce.
Direction Of Causation. When economises assume that one va riable is related co anothe r,
the)' arc usually ass uming some causal link between the two. For example, when the
amoun t of wheat that producers want to supply is assumed to increase when the qua lit)'

of their fertilizer improves, the causation nms from the quality of fertilizer to the supply
of wheat. Producers supply more wheat because they n1ow have access to better fertil-
izer; they are not ass umed to get access to better fertilizers as a result of their increased
supply of wheat.
Conditions Of Application. Assumptions are often used to spec i~, the conditions under
which a theory is meant to hold. For example, a theo ry that assumes there is "no gov·
ernment" usually does not mean literally the absence o f government but only that the
theory is meant to apply when governments are not significantly affecting the siwation
being studied.
Alrhuugh assumpcim1s are an essential pare uf all theories, scudencs are ufcen con-
cerned abo ut chose chat seem unrealistic. An example will illustrate some of che issues
involved. Much of the theory that we are going to study in this book uses the assump·
ciun rhac owners uf firms arcempc co make as much money as chey can-rhac is, cu
maximize their profits. The assumption of pro fie maximizacion allows economises co
make predictions about the behaviour of firms, such as "firms will supply more output
if rhe mal"kec price i11creases."
l'rofic maximizarion may seem like a racher crude assumprion . Surely, for example,
the managers of Firms sometimes choose to protect the environment rather tha n pur·
sue certain highly polluting bur profitable opporcunicies. Dues chis nor discredit rhe
assumprion of profit maximizarion by showing ir co be unrealisric?
The answer is no; to make successful predictions, the cheOI')' does not require that
managers be solely and un waveringly morivared by che desire cu maximize profirs ac
all rimes. All char is required is char profirs be a sufficiently imporranr considerarion
that a theory based on the assumption of profit maximization will lead to explanations
and predictions char are subscanrially correcc. le is noc always appropriate ro criticize
a theory because ics assumptions seem unrealistic. A good cheory abscracrs in a useful
way; a poor theory does not. Tf a theory has ignored some genuinely importa nt factors,
ics prediccions will usually be concradicced by che evidence.

All theory is an abstracrion from realiry. If ir were nor, it would merely dupli-
cate rhc world in all irs complexity and would add licrlc ro our undcrsrnnding
of ir.

Predictions A theory's predictions are rhe proposicio11s chat can be deduced from ic.
They are often ca lled hypotheses. For example, a prediction from a theory of the oil
marker is chat a rise in che world price for uil will lead Canadian uil producers eo
produce and supply more oil. Anorher prediction in che same marker is chat a deci-
sion b)' the member~ of the OPEC cartel to reduce their an nual output of oil will lead
cu an increase in che world price. The economic logic behind such predictions will be
explained in several chapters of this book; for· now we can proceed to see how econo-
mists test suc h predictions or h)•porhescs.

Testing Theories
A cheory is reseed by confronring irs predictions wirh evidence. For example, is an
increase i111 the world price of oil actually fo llowed by an increase in oil production by
Canadian producers? A rheory ceases co be useful whern iccannoc predicr beccer chan an
alcernacive cheory. When a cheory consiscenrly fai ls co predict becrer chan an available
alternative, it is either modified or replaced.

The old question "Which ca me First: the chicken or the egg?" is often raised when
discussing economic theories. In rhe fi rst instance, it was observation chat preceded
economic theories; people were not born with economic theories embedded in their
minds. TTowever, once economics was esta blished as a scientific line Qf inquiry, theor-
ies and evide11ce inreracced with each ocher. le has now become impossible cu say rhar
one precedes the ocher. Tn some cases, empirical evidence may suggest inadequacies
chat require the development <Jf better theories. In other cases, an inspired guess may
lead to a cheory char has lictle current empirical support but is subseque11tly found to
expla in many observations. This interaction between theory and empirica l observation
is illustrated in Figure 2-1.

RGURE 2-1 The Interaction Between Theory and Empirical Observation

Defirnricln• and
ahour hchavoour )- --< The cxisnng rhcory ·~
mo<l1fic<I in l1ghr of
the newly acquired
empirical knowlc<lgc

/\ process of
logica l deduction

Empirica l ohscrvanon
and re.mng of the theory

l either
Conclusion: The theory Joe> or
<k)es n()[ prnvide a be11er If the theory is in conflict
explanation of the facr> than wirh rhc evidence
alrcrnarivc competing theories or

If the thec;o-y pas>es the

cest, no c:onsequent nc:cion is The theory is discarded
nece>sa1 y, although the in favour of n superior
rheory should be subjecred co1npeting theory
ro connnucd scrutiny

Theory and observation arc in continuous interaction. St:ming (:It the to p left) with the assumptions of a theo ry and
the defini ti ons of relevant tern1s, th e theo rist deduces by logical ana lysis everything that is in1plied by the assu111ptions.
These i111plications arc the predictions or the hypotheses of tk theory. The theory is then tested by confronting its pre-
dictions with evidence. If the theo ry is in conflict with facts, it will usua lly be amended to make it co nsistent wid1 those
facts (thereby 111aking ir a berre1· theo1·y), or it will be discarded, ro be replaced by a superior rheory. The process then
begi ns again: The new or a111ended rheory is subjected firsr ro logical analysis and then ro empi1·ical resting.

The S·cientific approach is central to the study of economics: Empirical observa-

tion leads to the construction of theories, theories generate specific predictions,
and the predictions arc tested hy more detailed empirical olm:rvation.

Rejection Versus Confirmation An importa nt pa rt of che scientific approach consists

uf creating a cheury chat will explain some ubservacio n. A theory designed cu explain
observadon X will typically generate a prediction abo ut some other observable vari-
ables, Y and Z. The prediction about Y and Z can be tested and may be rejected by
the darn. If the prediction is rejected, the value uf the rheory is brought inru question.
The alte rnative to chis approach is to create a theory and then look for confirmi11g
evidence. Such an app roach is ha£a rdous because the world is sufficiently complex
that some con firm ing evidence can be found fur any theory, nu matter how unlikely
the theory may be. For example, fl ying saucers, the loch Ness monster, fo rtu ne telling,
and ascro log)' all have their dcvucces who can quote confirmi ng evide nce in spice of
rhe fai lure of man)' attempts tu discover systematic, objective evidence uf these things.
Statlstlcal Analysis Must theories generate a prediction of rhe form "If X increases,
then Y will also increase." A specifie example is "lf national income rises, rhe level of
employment will rise." Statistical analysis can be usecU tu test such predictions and to
estimate rhe numerical values of rhe function char descri bes rhe rela tionship. In pracrice,
the same daca can be used simulraneously w resr whether a relationship exists and, if ir
docs exist, to provide an cscimacc of the magnitude of that relationship.
Because economics is primarily a non-laboratory science, it lacks the controlled
experimemrs central co such sciences as physics and chemistry. Economics must therefore
use millions of uncontrolled "experiments" that arc going on eveq1da)' in the marketplace.
Households are deciding whar ru purchase given changing prices and incomes, fi rms are
deciding what co produce and how, and governments are involved in rhe economy ch rough
their various taxes, subsidies, and regulations. Because all these activities can be observed
and recorded, a mass uf data is cunri nually being produced by che economy.
The variables char interest economises- such as rhe level of employment, rhe price
of a DVD, and the output of automobiles-a rc generall y influenced b)1 many forces
char vary simulcaneously. If economises are tu resc their cheuries abo ut relations among
specific variables, they mus t use srariscical techniques designed for situations in which
ocher things ca1mot be held constant. Fortunatel)', such ceclrniques exist, although their
ap plication is usually neither simple nor scraighrfu rwaa·d.
Lacer in chis chap ter we provide a discussion of some graphical tec hniques for
describing data and displa)'ing some of the more obvious relationships. Further exam-
ination uf daca involves techniques scuclied in elernencary statistics courses. Mure
advanced courses in econometrics deal wich che array of techn iques designed co cesc
economic h)'potheses and co measure economic relations in che complex circumstances
in which economic evidence is ufce11 generated.
Correlation Versus Causation Suppose you wane co test your theory's prediction rhac "If
X im:reases, Y will also increase." You are looking fur a Ctlusal relationship from X ro Y,
because a change in Xis predicted co cause a change in Y. When you look ac the data, sup-
pose you find chat X and Yarc posicivel)' correlated-that is, when X rises, Yalso tends to
rise. Is yo ur rheory supported? Ir mighc appear char way, bur rhere is a pocenrial problem.
A finding that X and Y are positively correlated means onl y that X and Y tend to
move together. This correlation is co11sistenl wich the theor)1 char X causes Y, but it is

not direct evidence of this causal relationship. The causality may be in the opposite
di rectio n-from Y to X. Or X a.nd Y ma)' have no direct causal connection; they ma)'
instead be jointly caused by some thi rd variable, Z.
Here is an example. Suppose your theory predicts that individuals who get more
education will earn higher incomes as a rcsulc-che causa lity in chis theory rnns from
education ro income. In the dara, suppose we fi nd that education and income are
positively correlated (as they are). This should not, however, be ta ken as d irect evi-
dence fur chc causal predictio n. The data arc certai nly consistent with that chem')', bur
they are also consistent with others. For example, individuals who grow up in higher-
income households may "buy" more education, just as they buy mo re clothes or encer-
cainmcnc. In chis case, income causes education, ra ther than the other wa y around.
Another possibility is char education and income are positively correlated because
the personal characteristics that lead people to become more educated-ability and
rnocivacinn-are the same characteristics chat lead to high incomes. In chis case, the
causal rela tionship ru ns fro m personal characceriscics ro borh income and education.

Most economic predictions involve causality. Economists must take care when
testing predictions to distinguish between correlation and causality. Corrcla-
tiort cart establish that the data are cor1sistent with the theory; establishing the
likelihood of causality usually requires advanced statistical techniques.

I 2.3 Economic Data

for data on the Cafladian Economises use real-world observa tions co cesc their cheories. For example, did the
economy 8nd many 01her quan- amoum char people saved lase year rise-as rhe theory predicts it should have-when a
tifiable aspects of Canadian life.
see SrarlsUcs C8n8da's webs/re:
la rge tax cue increased their after-tax incomes? To cesc chis prediction we need reliable \. daca for people's incomes and cheir savings.
Policical sciemisrs, sociologiscs, amhropologisrs, and psychologists ofcen collect
fo r themselves the data they use to formulate and test their theories. Economists are
unusual among social scienriscs in mai nly using darn collecred by ochers, ofren govern-
mem sratiscicians. In economics there is a division of labour between colleering daca
and using them to test theories. The advantage is that economists do not need to spend
much of cheir scarce resea rch rime collecting rhe dam chey use. The disadvancage is char
they are often nor as welI informed about the limicarions of che daca collected by others
as they would be if they had collected the data themselves.
Afcer dara are cullecred, chey can be displayed in various ways, many of which we will
see lacer in chis chapte r. They can be laid out in tables. They can be displayed in va rious types
of graphs. And when we are interested in relative movements rather than absolute ones, the
dara can be expressed iii index numbers. We begin with a discussion of imlex numbers.

Index Numbers
Economises frequentl y look at data on prices or quantities and explore how specific vari-
ables change over ri me. For example, chey may be interesced in comparing che ri me paths
of outp ut in two industries: steel and newsprint. The problem is that it may be difficult
to compare the ti me paths of the two diffe rent variables if we just look at the " raw" data.

Table 2·2 shows some hypotheti..:al data fo r the

volume of outp ut in the steel and newsprint indus· TABLE 2-2 Volume of Steel and Newsprint Output
cries. Because che cwo variables are measured in dif·
ferent units, it is not immediately d ear which of the Volume of
two variables is more volatile or which, if cith c1~ has Volume of Srecl Newspri nr
aii upward or a dow1 1wai:d crend. Yc:.t1· (rh ous:.tnds of ronncs) {thous:rnds of rol ls)
It is easier to compare the two paths iF we fo..:us 2004 200 3200
on relative rather than absolu te changes. One way w 2005 2 10 3 100
do chis is co cunsrrucc sorne i1tdex numbers. 2006 225 3000
2007 2 15 320 0
How to Bulld an Index Number We sra rr by ra king rhe 2008 250 3 100
value of rhe variable ar some poinr in rime as rhe 2009 220 3300
"base" with which the val ues in other periods will be 2010 265 3 100
compared. We call rhis rhe base period. In rhe present 20 11 225 3300
example, we choose 2004 as rhe base year for bmh 2012 255 3 1()0
20 13 230 320 0
series. We then ta ke the output in each subsequent
20 14 245 3000
yea r, called rhe "given yea r," divide ir by rhe ourpur
in rhe base year, and rhen mukiply rhe resulr by I 00. Comptll'ing the tim e pachs of two darn series is diffi-
This gives us an index number for the outp ut of steel cult when absohuc numbers arc used. Sin ce srccl our·
and a sep:arare index num ber for the output of news- pur and ncwspri nr ourpur have quire differenr absolure
print. For each index number, rhe value of ourpur in nu mbers, ir is difficulr ro derccr which rime se ries is
more volatile.
the base yea r is equal to I00. The details of rhe ca ku·
lacions are shown in Table 2-3.
An i 1~dex number simply expresses rhe value of some series in any given yea r as Index number A measure of
a percentage of its value in the base yea r. For example, the 20"14 index of steel outp ut somo vartablc, cunvcntlonally
e•pressed relative to a base
of 122.5 cells us char sreel outp ut in 2014 was 22.5 percent greater chan in 2004. In period, which is assigned lho
conrrasr, che 2014 index fo r newsprint output of 93.8 cells us char newsprint ourpur lllllue 100.
in 20'14 was only 93 .8 per,ent of the output in 2004- that is, outp ut was 6.2 per,ent

TABLE 2-3 Constructing Index Numbers

Steel Newsprint
Year Procedure Index Procedu re Index
2004 (200/200) x 100 = 100.0 (3200/3200) X I00 = 100.0
2005 (2 10/200)x 100 105.0 {3 100/3200 ) x 100 96.9
2006 (225 /200) X I00 11 2.5 (3000/3200) x 100 93.8
2007 (2 15/200)X 100 107.5 (3200/3200) x 100 100.0
2008 (250/200)X 100 125.0 (3 100/3200 ) x 100 96.9

2009 (220 /200) X I00 110.0 (3300/3200 ) x 100 I0 3.1
20 10
20 11
(265 /200) X I00
(225 / 200) X I00 ..... 132.5
{3 100/3200) x 100
(3300/3200) X I 00
20 12 (255/200)X 100 127.5 {3 100/3200) x 100 = 96.9
20 13 (230/200)x 100 = 11 5.0 {3200/3200) X I 00 100.0
20 14 (245 /200) X I00 122.5 (3000/3200) x lOO 93.S

Index numbers arc calcul:11ed by dividing the value in the given year by the value in the
base year and multiplying the result by 100. The 20 14 i1ukx number for steel tel ls us th:.\t
steel output in 20 14 was 22.5 percent grea ter than in the base year, 2004. The 20 14 index
number for newsprint tells us tha t newspri nt output in 20 14 was 93.8 percent of th e out·
put in the base yea r, 2004.

lower in 20'14 than in 2004. The results in Table 2-3 allow us to compare the relative
fl uccuacions in rhe rwu series. le is ap parent frum che val ues i11 che cable char che uuc-
puc of sceel has shown significantly more percencage variabilicy chan has che oucpuc of
newsprint. This is also clear in Figure 2-2.
The fo rmu la of any i11dex number is
Value of index Absuluce value in given period
. . x 100
in any given period Absolute value 111 base penod
Care must be cake11, however, when using index numbers. The index number always
tells yo u the percentage change compared wi th the base yea r, but when comparing an
index number across non-base )'Cars, rhe percentage change in chc index number is
not given by che absuluce difference in rhe values uf rhe index number. Fur example, if
yo u want to know how much steel output changed from 2008 to 20'10, we kn1ow from
Table 2-3 chat che index num ber fu r scccl output increased from '125.0 co 132.5. Bue
chis is 11oc an increase of 7.5 percenc. The percentage increase in steel oucpur is com-
puted as (132.5 - 125 .0)/125 .0 - 7.5/125.0 - 0.06, or 6 percent.
More Complex Index Numbers Perhaps rhe mosr famous index number used by econo-
mists is the index of average prices- the Consumer Price Jndex (CPT). This is a price
index of che average price paid by consumers fur the rypical basker of guods char rhey
buy. The inclusion of che word "average," however, makes rhe Cl'! a more complex
index number than the ones we have constructed here.
Wich whac yuu have jusc learned, you cuu ld cunscrucc separate index num bers
for rhe price of beef, rhe price of coffee, and the price of orange juice. Bm to gee rhe

RGURE 2·2 Index Values for Steel and Newsprint Output






2004 2005 2006 2007 2008 2009 20 I0 20 1 I 201 2 20 1J 20 14

Comparing the lime paths of two variables is much easier when index numbers are used. Since both index numbe1·s are equal
ro I00 in the hMe year, relative volatility and trends become clear. Srecl output is clea rly more volatile in pc1·centage terms
than newsprint ourput. Steel outpur also has an upward trend, whereas newsprint output appears to have lirrlc or no trend.

Consllmer f> ri..:e Index, we need to ta ke the average of these separate price indexes (pills
thousands of others fo r the goods and services we have ignored he re). But it cannot be a
sirn ple average. lnscead, it rnusr be a weighted average, in which the weight assigned ru
each price index refle..:ts the relative importance of that good in the typical consumer's
basket of goods and services. For example, since the typical consumer spends a ti ny
fraction of income on sai:di11es bur a much larger fraction of income on housing, rhe
weight Q I] the "sardines" pri..:e index in the CPT is very small and the weight on the
"housing" price index is very large. The res ult is that even huge swings in che price of
sai:dines have negligible effeccs on che CPI, whereas much more modesr changes in rhe
price of housing have noticeable effects on che CPI.
We will spend much more ri me discussing rhc Consumer Price Index when we
cross·seellonal data A set of
srudy macroeconomics beginning in Chapcer 19. Fur now, keep in mind rhe useful ness
observations made at tile same
of the simple index numbers we have constructed here. They allow us co compare the Umo across soveral different
ri me paths of different variables. units (such as households,
firms, or countries).

Graphing Economic Data time.series data Asot

of observations made at
/\ single economic variable, such as unemployment, national income, or the average successive periods of time.
price of a house, can come in rwo basic forms.
scatter diagram A ~ap11
showing two variables, one
Cross-Sectional and Time-Serles Data The firsc is called cross-sectional dam, which means measured on tile horizontal and
the other on the vertical axis.
a number of differenr observations on one variable all caken in different places at rhe same Each point rcpiesents the values
point in time. Figure 2-.3 shows an example. The va riable in the figure is the average selling of the varlablos tor a par1lwlar
price of a house. Ir is shown for each of rhe ren Canadian pwvinces in April 20 12. unit of observation.
The second type of dara is called
time-series data. Tt refe rs to observations
of one variable ac successive poinrs in
cime. The dara in Figure 2-4 show rhe FIOURE 2·3 A Cross-Sectional Graph of Average House Prices for
unemployment race fo r Canada from Ten Canadian Provinces, 2012
1978 cu 2 012. (Nuce chac che Canadian
550 000
unemploymenc rare is simply a weighred
500 000
average of the 13 provincial and ter-
rirorial unemploymenc races, where rhe 450 000
weighc for each region is char region's 400 000 ..
labour fo rce as a fraction of the total
Canadian labour force.) Time-series ..
~ 350 000 I -
graphs are quire useful in economics
because we often want to know how
i8 300 000

250 000
-- - I•

- . -
specifie economic numbers are changing
200 000 I•

over cime. As is d ear in f igure 2-4, che 150000 I

Canadian unemployment rate is rela-
cively vulacile over lung periods of time, 100 000 I• . .
bur in recent years ic has been low by his· so 000
to ri..:al standards. o ~~·.......~·.......~·.......~·.......~·~~·~~·~~· ~~·~......
llC /\ti SK Mfl ON QC NH NS ·pE NL
Scatter Diagrams J\nochcr way data can
be presenred is in a scarcer diagram. le is (Source: Ada pted from M LS® St:uistics ©20 12 The Ca n::idian Rc:tl
designed to show the relation between Estate Assucia tiun; t/nati ona l·a veragc·p rice-map)
two different variables. To plot a scatter

RGURE 2·4 A Time-Series Graph of the Canadian Unemployment Rate, 1978-2012






78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
Source: A1u1ual avern~e of monthly, seasonall y adj usted data from Statistics Canada, CANSIM Ta ble 282-0087; both
sexes, 15 yea rs :111d over)

RGURE 2·5 A Scatter Diagram of Household Income and Saving

l louschold Annual Income Annual Saving

$ 70 000 $ 10 000
~ 15
2 30 000 2 500 ..!!
100 000
60 000
12 000
3 000
.. "t:l
Vl c

·- - - - -
- ~
-··- - -
.• s
5 80 000 8 000 ~ •9 ' 4
7 ~2
10 000 500
' 6 ·~ 8
6 'E.
7 20 000 2 000 0 20 40 60 80 100
8 50 000 2 000 (thouso nds of doll ors)
9 40 000 4 200
10 90 000 8 000

Saving 1ends to rise as income rises. The rable shows rhe amou nt of income earned by ten selected households together
wirh the amounr they saved during the same year. The sca tter diagram plots rhe income and saving for rhe ten house·
holds lisred in the table. The number on each doc refers co the household in rhe corresponding row of the ta ble.

diagram, values of one variable arc measured on the hori:wntal axis and values of the
second variable are measured on rhe vertical axis. Any poinr on rhe diagram relares a
speci fi c val ue of one variable to a corresponding specific value of the other.
The data plotted on a scatter diag ram may be either cross-sectiona l data or
rime-series daca. An example o f rhe former is shown in Figure 2-5. The cable in

the figu re shows data for the income and saving of ten households in one pa rticu·
la r yea r, a nd these data arc plotted on a scatter diag ram. Each poi nt in the figure
represents one household, showing its income and its saving. The positive relation
between the two stands out. The higher the househo ld's income, the higher its sav·
ing te nds to be.

I 2.4 Graphing Economic Theories

Theories are built on assu mptions about relationshi ps between variables. For example,
the qua ntity of eggs demanded is assumed to fall as the price of eggs rises, and the coral
amount an individual saves is assu med to rise as his or her income rises. How can such
relations lbe expressed?

When one variable, X. is related to another variable, Y, in such a way that to every
value of X there is only one possible value of Y, we say that Vis a f1111ction of X.
When we write chis relation down, we are expressing a f11n.ctio11al relation between
che cwo varia bles.
Here is a specific but hypothetical example. Conside r the relation between an indi·
vidual's a11n ual income, which we denote by rhe symbol Y, and rhe amount chat per-
son spends on goods and services duri ng che year, wl\ich we denote by che symbol C
(for consLJmption). Any particular example of the relation between C and V can be
expressed several ways: in words, in a cable or schedule, in a mathematical equation,
or in a graph.

Verbal Statement. When income is zero, the person will spend $800 a year (either by
borrowing the money or by consuming past savings), and for every extra $ I of income
the person will increase expenditu re by 80 cents.

Schedule. This cable shows selected values of the person's income and consumption.

Annual Income Consumption Reference Letter

$ 0 $ 800 p
2 500 2 800 If
5 000 4 800 r
7 500 6 800 s
10 000 8 800

Matllematical Equation. C = $800 ~ 0.8 Y is rhe equacion. of rhe relation jusc described in
words and displayed in che rable. As a check, you can firs t see chac when Y is zero, C
is $800. Further, you can see that every time Y increases by $1, the level of C increases
by 0.8($ 1 ), which is 80 cencs.
Graph. Figure 2-6 shows rhe poinrs from che preceding schedule and the line repre-
sencing di e equation given in die previous paragraph.

Comparison of rhe values on the graph wirh rhe values

AGURE 2·6 Income and Consumption in the schedule, and with rhe values derived from the cqua-
rion jusr sr:ircd, shows rhar rhese are alrernarive expressions
of the s:ime relation between C and Y. All four of rhese
modes of expre~sion refer to the same relation between the
person's consumption cxpendicur·e and income.

Graphing Functions
Di ffe renc fu ncrions have differenr graphs, and we will
meet many of rhese in subsequent chapters. Figure 2 6
is an example of a relaciun in which the C\Vo variables
move rogecher. When income goes up, consumpcion goes
up. In such a relation rhe cwo variables are positively
0 2 000 6 000 10 000 related ru ead1 ocher.
lnco111e ($) Figure 2·7 gives an example of variables char move
Consumption expe nditure rises as income rises. The
in opposite directions. As the :imoun t spent on reducing
fig11rc graphs lhc schedu le and the equ ation for the poll ution goes up, rhc amount of remaini11g pollution
hypothct ic~1 1 funcrional relatio n discussed in rh c rcxr. goes down. In such a relarion rhe rwo variables are
11cgati11cly related ro each other.
Borh of rhese graphs are srraighr lines. '11 such cases
rhe variables are li11early related ro each ocher (eirher
AGURE 2·7 Linear Pollution Reduction posicively or neg:irively).

~ The Slope of a Straight line Slopes are imporranr in eco·

. r; 6 nomics. They show you how much one variable changes
c c
c 0 s as the ocher changes. The slope is defined as che amu um
=0 .....0
" w
4 of change in rhe variable measured on che verrical axis
.... J
per unicchange in che variable measured on the horizon
.5 ~
.5 ral axis. Jn rhe case of Figure 2-7 ic cells us how man)'
~ .§ tonnes of polluriu11, symbolized by /', are removed per
"' - 0 I 2 J 4 5 6 7 8 9 10 11 12
d!ollar spent on reducing pollution, symbolized by F,,
Exprnditurr 0 11 Reducinj\ Pollu1ion, I'
Consider moving from poinr A w puinc Bin che figure. If
(thousands of dollars) we spend $2000 more on dea n-up, we reduce pollmiun
b r 1000 ronnes. This is 0.5 tonnes per dollar spenr. On
Pollution a~ a linear function of dean-up cxpcndi· che graph che excra $2000 is indicared b)' A£, che arrow
ll1rc. Between points A and R it costs $2000 to
reduce pollution by I000 tonnes. The cost of pollu· i11dicaring chac £ rises br 2000. The 1000 ronnes of pol
non reducr1on is the same elsewhere on the line. The lucion reduccion is indic:ited by AP, rhe arrow showing
slope of the line, 0.5, indicates that 311)' $ I expendi- char pulluciun fa lls br I 000. (The Greek uppercase lercer
tu re on pollution clean -up reduces ll1c amount nf delca, A, srands for "rhe change in.") To ger rhc amounc
pollurio n by 0.5 ronncs. o f pollution reduction per dollar of expenditure, we
1111erely divide one by Lhe ocher. In symbols chis is t:. f'/AE.

If we lcr X stand for whatever variable i~ measured on the horizontal axis and
Y for whatever variahlc is measured on the vertical axi\, the slope of a ~traiKht
line is ~ Y/~ X.1 1 1 1

Red numbers 111 square brackets indicate mathematical note~ that are found 111 a separate sectton at che
back of the lx)Ok.

The equa tio n of the line in Figure 2·7 can be computed in two steps. First, note
that when E = 0, the amount of remaining pollution, P, is equal to 6 (thousand tonnes).
Thus, rhe line meets the vertical axis (E = 0) when P equals 6. Second, we have already
seen that the slope of the line, fj.P/ fj. F,, is equal to -0.5, which means that for every
one·unit increase in E, I' fa lls by 0.5 uni t. \Y/e can rhus Stace the equation of rhe line as
I' = 6 - (0.5)E
where both P and E arc expressed as thousands of unitS (tonnes and dollars, respectively).

Non-linear Functions Although it is sometimes convenient to simplify a real relation

be[ween cwo variables by assuming chem cu be linearly relared, rhis is seldom rhe case
over dieir whole range. Non-linear relations are much more common than linear ones.
Tn the case of reducing pollution, it is usuall)' quite cheap to eliminate the first units
uf pull urion. Then, as rhe envirunmenr gers cleaner and cleaner, che cosr uf furcher
clean·up cends to increase because more and more sophisticated and expensive methods
need co be used. As a resule, f igure 2·8 is more realistic than f igure 2· 7. Inspection of
Figure 2·8 shows that as more and more is spent, the amo unr of pollurion reduction
for an add itional $1 of dea n·up expendiw re gets smaller and smaller. This is shown
b)' che diminishing slope of che curve as we move rightward along ic. For example, as
we move from puinc A cu point B, an increase in expendirure uf $1000 is required cu
reduce po llution by 1000 tonnes. Thus, each tonne of pollution reductio n coses $·1. 'R ue
as we move from point C (where we have already reduced pollution conside rably) to
point D, an extra $6000 muse be spent in order tu reduce pollution by 1000 cunnes.
Ead1 tonne of pollution reduction therefore costs $6.
Economists call the change in pollution when a bit more or a bic less is spent on d ean·
up rhe marginal change. The figure shows char the slope uf che curve at each point measures

RGURE 2·8 Non-linear Pollution Reduction

* "-
c! "
' C::

-I di'{I
- - - t:" -

~ ~
4 I I
"""O I "' I
·ac: c:
~ 3 I +l I
l}.f. =+1.75
E _g
- --i- -i- - - - - - -
0:: - 1 I D
~ I -------·
I I dE I
_ I J I I I _l ..!_I I I I I I l_ I
0 l 2 J 4 5 6 7 8 9 lO l1 l2 lJ 14 15 16
Expcndini rc 0 11 Poll ution Reduction, ~;
(thousands of doll ars)

Poll ution as a non-linear function of clean-up expenditure.. The slope of the curve changes as we move along it. Between
poinrs A and B, it costs $ 1000 to reduce pollution by I 000 tonnes. Between points C and D, it cosrs $6000 to reduce
pollucion by I000 to nnes. Ar poinc Z, the slope of rhe curve is equal ro the slope of rhe straight line ta ngent to rhe curve
ar point Z. The slope of rhc ta ngent line is - 0.75/ 1. 75 = - 0.43.

this marginal , hange. Tt also shows that in the type of

FIGURE 2·9 Increasing Production Costs curve illustrated, the marginal change per dollar spent
is diminishing as we spend mo re on reducing poll ution.
There is always a payoff to more expendicure over the
500 -
ra nge shown in the figure, but the payoff di nninishcs as
more is spenc. This relation can be described as dimin·
ishing marginal 1·csfJ01·1sc. We will meet such relations
many times in what follows, S<J we emphasize now
J.50 rhar diminishing marginal response does nor mean
chat the total response is diminishing. Tn Figure 2-8,
300 :~
, L\Q I
the total amoun t of pollution conti nues to fall as mn re
I} I
and more is spenr on clean-up. Bm di mi nis hi ng mar·
ginal response does mean chat the amount of pollution
_ _z.1l +65 II
I I reduced per dollar of expenditure gets less and Jess as
18() rhe coral expenditure rises.
I /3 I I
150 I I Figure 2-9 shows a graph in which the marginal
100 I response is increasing. The graph shows the relation·
~I I ship becween annual production coses and annual om·
+10 I I I
I._..,_.,I I I put for a fi rm chat makes hockey sticks. Notice chat
the rnorc sticks produced annually, the higher the firrn's
0 I0 20 30 40 50 60 coses. This is shown by rhe posirive slope of rhe line.
A1111 uul Number of H<X'key Scicks l'ro<luced, Q
(chousn nds)
Notice also that as more and more hockey sticks are
produced, the extra amount that the firm must pay
Production costs in crease at an increasing rate as annual ro produce each exrra stick rises. for exampie, as rhe
outpm rises. From point A to poinr 8, an extra ann ual fi rm moves from point A to point B, annual costs
ourput of LO 000 hockey sticks increases a nnual costs
by $30 000. Each extra stick costs $3. From point C to
rise by $30 000 in <Jrdcr (() increase its annual out·
point D, :1 11 extra output of I0 000 hockey sticks increases pm by 10 000 hockey sticks. Each exrra stick costs
annua l costs by $ 150 000. Each extra hockC)' stick then $3 ($30 000/10 000 - $3 ). Rut when the firm is pro·
costs $ I.5. T his is :l c:1sc of incre:lsing m:lrgin:ll cost. At ducing man)' more hockey sticks, such as at point C,
point Z, rhc slope of the curve is equal co the slope of rhc ics faccory is closer co ics capacity and ic becomes more
scraigh t line ca ngenr ro the cu rve at poinr Z. The slope of
the tangen t line is 65/8 = 8. 13.
costly to increase produi;tion. Moving from point C to
point D, the firm's annual C<JMS increase by $150 000 in
order ru increase ics annual ourpuc by 10 000 hocke)'
sticks. Each extra stick chen coses $15 ($ 150 000/10 000 = $15).This figure illustrates a case
of iizcrc:asi11g marginal cost, a characccristic uf production that we will sec often in this book.
Figures 2-8 and 2-9 show char wich non-linear functions the slope of the curve chan·
ges as we move along the ' 1irve. For example, in Figure 2-8, the slope of the curve fa lls
as the expendicurc on pollution dea n-up increases. In Figure 2-9, the slope qf the curve
increases as rhe volume of producrion increases.
How, exactly, do we measure the slope of a curved line? The answer is thac we use the
slope of a straight line /a11ge11t to that curve at the point that interests us. For example, in
figure 2-8, if we wanr ro know the slope of che curve at poinr Z, we draw a srraighc line that
touches che curve only ac point Z; this is a tangent line. The slope of chis line is - 0.75/ 1.75 =
- 0.43. Similarly, in figure 2-9, the slope of the curve at point Z is given by the slope of the
scraighc line cangenc co rhe curve ar poinr Z. The slope of chis line is 65/8 = 8.13.

For non-linear functions, rhe slope of che curve changes as X changes. T here·
fo re, the marginal response o f Y to a change in X depends on the val ue of X.

Functions with a Minimum or a Maximum So fa r, all the grap hs we have shown have
had either a positive or a negative ~l ope over their emire range. But man)' relations
change di recrions as rhe indepe ndenr variable increases. For example, consider a firm
that is attempting to maximize its profits and is trying to determine how much output
to produce. The firm ma)' Find that its unit production costs arc lower tha n the market
price of cine good, and so ir can increase irs profir by producing more. Bue as ir increases
its level of production, the fi rm's unit costs may be driven up because the capacity of
the facto!")' is being approached. Evcntuall)', the firm may find chat extra output will
acrually cosr so much char irs profits are reduced. Th is is a relationship char we will
swdy in detail in lace r chapters, and it is illustrated in Figure 2-'IO. Notice that when
profits arc maximized at pnint A, the slope of the curve is zero (because a tangent to the
curve ac poinc A is horizonral), and so che marginal response of profits co ourpur is zero.
Now consider an example of a function with a minimum. You probably know that
when yo u drive a car, the fuel consumption per kilome[re depends on your speed. Driv-
ing very slowly uses a IQ( of fuel per kilomecre cravelled. Driving very fas c also uses a
lot of fue l per ki lometre travelled. The best fuel efficiency- die lowest fue l consumption
per kilometre travelled-occurs at a speed of approximate!)' 95 kilometres per hour. The
relacionsh ip beC\11/een speed and fuel consumpcion is shown in Figure 2-l 1 and illuscraces

FIGURE 2·10 Profits as a Function of Output FIGURE 2·11 Average Fuel Consumption as
a Function of Speed

A Straillht line
400 ri'!ngenr ro
rhc curve nt
poinr A
.. ~ ~

- 0
JOO :2
u: 200
0 ~
.. "
... 0
~ tangent to
4- the curve at
point A

~ 2-
0 I 000 2000 I 3000 4000 5000
0 20 40 60 80 1100 120 140 160
Annual Level of Output 95
Prori ts rise and then eventually foll as outpu t (kilometres ptr hour)
ri ses. When the firm is producinl( fewe r than
2500 units annua lI)', the marginal 1·es po11sc of Average fuel consumption falls and then rises as speed
profit t<) outpur is positive-rhar is, an increase increases. Average fuel consum ption in litres per kilon1ctrc
in ourpur leads roan increase in profit. Beyond trnvellcd is min imized at point A at a speed of :lfll}J'OXimarely
2500 un irs annually, the margina l response 95 kilometres pc1· hot11· (km/h). At speeds less than 95 km/h,
is negative- an increase in output leads ro rhc marginal response is negative-that is, an increase in speed
a redu ction in profit. At point A, profits arc reduces fuel consumption per ki lometre. At speeds above
111aximized and the marl(inal response of 95 km/h, the marginal response is positive-an increase in
profit to output is zero. Beca use the tangent at speed increases fuel consumption per kilometre. At 95 km/h,
point A is horizo ntal, the slo pe of the curve is the margina l response is zero and fuel consumption per kilo-
zero at thar poin t. 111ctrc is

a forn.:tion with a minimum. Note that at point A the slope of the curve is zero (because
a tange nt to the curve at point ;\ is horizonta I), and so the marginal res/1onse of foci
consumption co speed is zero.

At either a minimum or a maximum of a function, the slope of the curve is

zero. T hen:fnn:, at the minimum or maximum, the marginal response of Y Lo
a change in X is zero.

A Final Word
We have done nrnch in this chapre r. We have discussed why econon1isrs develop rheories
(or models) co help them understand the world. We have also discussed how they test
their rheories and how rhere is a co11rin ual back-and-forrh process berween empirical
resting of predicrions and refining rhe theory. Finally, we have devored co1.1siderable
ti me and space co exploring the many ways that data can be displayed in grap hs and
how economisrs use graphs ro illusrrate rheir theories.
Many scudenrs find themselves intimidared when they are first confronred with all
the details about gra phing. But try not co worry. You may not yet be a master of all the
graphing rechniques rhar we have discussed in rhis chapter, bur you will be smprised ar
how quickly it all falls into place. And, as is true for most skills, there is no subsriture
for practice. Jn the next three cha pters we will encounter man)' graphs. But we will Start
simply and then slowly attempt more complicated cases. We are confidenr char in the
process of learning some basic economic theories you will get enough practice in graph-
ing that you will very soon look back at this chapter and rcali:tc how straightfo rward
it all is.


2.1 Positive and Normative Statements LO 1

• A key co the success of scientific inquiry lies in sepa rat· from normative sraccmcnts abouc how one would like
ing positive sraccmcnrs abouc the way the world works the world co work.

2.2 Building and Testing Economic Theories LO 2, 3

• Theories (sometimes called models) arc designed co • Economises make use of scaciscical analysis when cescing
ex plain an d predict whac we sec. A theory consists of a cheir theories. They muse cake care co make the discinc-
scr of defi nitions of the variables ro be discussed, a set tion between correlation and ca usation.
of assumprions about how things behave, and the condi- • The progress of any science lies in find ing ben er cxplan-
tions unde r wh ich rhe theory is mea nr ro apply. acions of cvcncs than arc 11ow avail:t blc. Thus, in any
• A cheory provides prediccions of che cypc " If one cvc nr developing scie nce, one musr expect ro disca rd some
occurs, th en another event will also occur." existing theories and replace them with demonstrably
• Theo ries arc reseed by chec king chcir predictions :igainsc supc1°i(J1' :Jlrcl'll:Jtives.
evidence. In economics, ccscing is almosc always done
using the dara produced by che world of ordinary events.

2.3 Eco:nomlc Data LO 4

• Index num bers express economic series in relative forn1. same time. Time-series graphs show obse1·vations on
Values in each period arc expressed in relatio n to th e one variable taken over time. Scatter diagrams show
val ue in th e base period, which is given a val ue of I00. many poi nts, each of which refers to specific observa -
• Economic data can be graphed in clucc different ways. tions on two diffe rent variables.
Cross-sectional gra phs show observa tions ta ken at the

2.4 Graphing Economic Theories LO 5

• A functional relation can be expressed in words, in a When the variable is meas ured on the vertical axis of a
schedule givi ng specific va lues, in a marh emarical equa- diagram, irs marginal 1·esponsc at a specific poinr on rh e
tion, or in a gra ph. cu rve is measured by the slope of the li ne at that point.
• A graph of two varia bles has a positive slope when they • Sonic functions have a ma ximun1 or mini11'11.11H poin t. At
borh increase or decrease together and a negative slope suc h poi nts, the marginal response is ze ro.
when they move in opposite directions.
• The margi nal response of a va ri;ible gives the amount
it changes in response to a change in a seco nd variable.

Positive and nonnative sra remenrs CoHelation versus causa rion Positively and negatively sloped curves
Endogenous and exogenous variables l'unctional rclatitons Marginal responses
Theories and models Positive and negati ve relations Max im um and minim um va lues
Variables, assum ptions, and predictions betwee n variables


Make the grade with MyEco nLab: Study Exercises marked in red can b e fou nd on
MyEconlab MyEconlab. You can practise them as often as you want, and most feature ~tep-by-stcp
guided instrnctions to help you find the right answer.

1. Determine whether each of the followi ng statements is 2. What arc some of the positive and normaci ve issues that
positive or normative. lie behind the disagreements in rhc following cases?
a. The government should impose stricter regulations a. Economists disa)l.rec on whether the govern ment of
on rhe banking sector co avoid future financial crises. Canada should try to stim ulate the economy in the
b. Financial aid co develo ping countries has no impact next six months.
on per ca pita GDP in those coumries. b. European and No rth Ame.rican negotiators dis-
c. Tuition fee incre:iscs :it Canadi:in universities lc:id ag1·ee over rhc dcsi r:ibility of reducing Eul'(Jpc;1 n
to red uced access for low-income students. farm subsidies.
d. Ir is unfa ir that CaMdians have universal access to c. Economists argue about the merits of a voucher
hea lth c:irc but not to dental ca re. system that al lows parents to choose th e schools
e. Canadians cu rrently have too much perso nal debt. thei r children wi ll attend.

d. Econo111is1s dcba1c l he use of a two-tier medical th:it there is a rdalionship between A

S)•sce111 in Ca1uda (whereby health care continues and B.
ro be publicly provided, bur individuals arc
6. Use the app1·opriare graph-11111e·se1ies, cross-sccrional,
pe11ni11ed ro be 1reared by docrnrs who bill rhc
or scacrer diagram-co illustrate the economic data pro·
pacicnt dirccrli•-an approach known as "cxcra
vidcd 111 each part below.
e. F.conon11s1s dcba1e rhc costs of global climate a. The Canad1an·dollar price of one U.S. dollar (1hc
change and rhe relative merics of carbon caxes ·exchange rate") in 20 I I:
and other policies to reduce greenhouse gas
cmis~i on~.
f. Pol1C) makers disagree abour rhc cxrenr ro which Januar)' o.994
financial markers need ro be regulated. February 0.988
March 0.977
3. In rhe followini:: examples, idencify rhe exogenous April 0.958
(o r independent) variable and the endogenous (or May 0.968
dcpcndcnr) varbblc.
June 0.977
a. The amount of rainfal l on the CaMdian prai ries Ju ly 0.956
dcrermincs rhe amount of wheat produced in Augusr 0.982
C:rnadla. September 1.003
b. When che world price of coffee increases, there is Ocrobcr 1.01 9
n chnni::c in the pl'ice of your cu p of coffee ar Tim November 1.026
I lorrons. Occc111bcr 1.024
c. If student loans were no longer ava ilable, there
wou kUbe fewer swdc111s a11cndin11 univcrsily. b. A con1p:1riso11 of averap,c hou~c hol d cxpcndilur·cs
d. An inc:rcasc in the tax on i;asolinc leads people to across provinces in 20 I 0:
drive more fuel-efficient veh icles.
4. Economists somerimes nuke e:ich of rhe following Bl'irish Columbia $72 486
assumptions when rhey construct models. Discuss Alberta 84 087
some situations in which each of l hcse assumptions Sasbrchewan 69 237
might be a useful simplification in order ro think about Maniroba 66 330
some aspect of rhc real world. Ontario 74 521
a. Earth is Aar. Quebec 61 536
b. There arc no d1Hcrcnccs berween men and women.
New Brunswick 59 943
c. There is no tomorrow. Nova 5coria 61 907
d. There arc onli· rwo periods: rhis year and nexr year. Prince Edward Island 58 194
e. A country produces only rwo rypcs of goods. Newfoundland and Labrador 60 139
f. People arc wholly selfish.
c. Per capita 11rowrh rates of real GDP :111d inve~t·
5. Fill in rhe bl ank~ ro make the fol lowing st:mmenrs mcnr rares for variou~ counmes, averaged over the
corrccr. period 1950-2009:
a. Economises have designed to better
explain and prcdicr rhc behaviour we observe in
i\vera~c J\vera11e
the world around us. Growrh Rate I1wesr111c11r Race
b. A va ri able, ~uch 35 price or quantity, that is deter· Counrq' (%per yc:1r) (%of GDP)
mined wil'11in :1 theory is known as a(n) _ __
va riable. A va ri able that is dcte rrnined oucsidc chc C:rnad;i 2.0 18.2
thcorr is k11 ow11 as a( n) va ri able. Auscria 3. 1 22.0
c. When, based 011 a theory, we claim rh ar "If A Ja1w1 4.0 16.6
occu rs, then 13 wi ll fol low," we :1rc 111:1king a Un ircd Srnrcs 1.9 18. 1
that ca11 then be tcsrcd by _ __ Un ircd Kini;do111 2.0 14.5
obscrvarion. Spain 3.4 23.0
d. If we observe that when variable A dccrc:ises,
Norw:1y 2.8 17.4
variable B also decreases, we can say rhar rhc rwo Sourh Korea 5. 1 27.2
varbbles arc . We cannor necessarily say Iceland 2.7 28.0

7. u~c the following figure fO answer the questions below. a. The baS( )'car ·~ 2000. Construct a physics text·
y ~ . ,-Y- ~ book price index.
I t I t I t I I
b. What is the pcrccnrap.e increase in the price of the
.: '
I inc H
8 - ---:--- - ~- ---:--- -{ · --·~-- --:- ...... ~ -- --~-
book between the base year and 2005?
7 ~ .,.,. : ' c. What is the pcrccnrage increase in the price of the
. . .

6 ·---:- --- ~ ----:---- ~----' ......:....... ~-- .... ~ ..

book from 2007 to 20 IO?
d. Arc the dara lisred above timc·scrics 01· c1·oss·
. ' • sectional data ? Explain why.
11. Suppose you w:tnr to crea te a price index for th e price
4 of pizza across scvcrnl Canadian university ca111puscs,
:is of March I , 2013. The d:na arc as fol lows:

l Univcrsiry Price per Pizza

Dalhousie $6.50
Laval 5.95
M el.ill 6.00
0 1345678 Queen's 8.00
a. Is rhc slope of Linc A positive or ne11:1tivc? Lin c B? W:ircl'loo 7.50
b. Calcul:.ue the slope of Linc A. Write the equation Manitoba
dcscribinp. rhe line in th e form Y .. mX I Ii, where Saskatchewan S.?S
111 is th e slope of the line and u
is a constant term. Cal11ary 6.25
c. C:i lculatc the slope of Linc 8. Write the equation UBC 7.25
describing the line in the form Y • 111X ~ /J, where Vi ctoria 7.00
111 is the slope of the line and u is a constant term.

8. Suppose the relationship between the government's tax a. Using Calp.ary as rhc -base universit)'," construct
revenue (T) and national income ( Y) is represented by the Canadian 11n1vcrsit)• piua price index.
the fo llowing equation: T I0 + 0.2SY. Plot this rel a· b. At which u111vcrs1ry is pw~ the most c"<pcnSl\'C, and by
tionship on a scale diagram, with Yon the horizontal what pcrccnrage is rhc price higher than in Calµry?
axis and Ton the vertical axis. Interpret the equation. c. At which university is pizza the least expensive, and by
what perccnta)lc is the price lower than in Calµry?
9. Consider the following rluec specific functions for a d. /\re the data listed above time-series or cross·
fun ction:i l relation between X and Y: sectional d:1r:1? Exp lain why.
i) Y n SO I 2X
12. For each of the functional relations listed below, plot
ii) Y - 5o + 2x + o.o5x2
the relation~ on a scale diagram (with X on rhc hori
iii) v.. so+2x - o.osx2 zont:tl axis and Yon the vcrrical axis) and co111pute the
a. For the values of X of 0, I0, 20, 30, 40, and 50, sl(lpc of the line.
plot X and Yon a scale dia11ram for e:tch specific
function. Connect these points with a smooth line. a. Y - 10+3X
b. for each function, state whether the slope of the b. Y 20 + 4X
line is constant, increasing, or dccrcas1np. as rhe c. Y 30 + 5X
value of X increases. d. Y 10 + SX
c. Describe for each function how the mar11inal
13. Suppose we divide Canada into three regions: the
change in Y depends on the value of X.
Wcbt, the Ce ntre, and the East. Each region hos an
10. Suppose you want to create a price index for the price of unemployment r::m , defined as rhe number of peo ple
a pan<cubr physics textbook ovc1· ten yca1·s in your uni· unc111pluycd, ex pressed as a fraction of tha t rc11io11's
versit)' bookstore. The price of the book on September I labour force. The rnblc t'11ar follows shows c~ch 1·cgion's
of each year is as follows: unemployment rntc and the size of its labou r force.
Yc:tr Price($) Year Price ($)
2000 85 2006 120 Rq:ion Rate Labour Force
200 1 87 2007 125
2002 94 2008 127 West 5.5% 5.3 1111ll1on
2003 104 2009 127 Centre 7.2% 8.4 million
2004 11 0 20 10 130 East 12.5% 3.5 1111111011
2005 I 12

a. Co1t1putc an une1t1ployn1enr r:HC for C:111:id:i using 14. Oraw three gra phs in which the dependent vari able
a simple average of rhe rares in the rliree regions. Is increases at an increasi ng ra te, at a constant rate, and
this tl1e "right" unemployment rate for Ca nada as at a dimi nishing rate. Then draw three graphs in wh ich
:i whole? Expbin why 0 1· why ll(Jt. it dcc1·c3scs lt lll incrc:lsing, const:lnr, lnd diminish·
b. Now compure an uncmploymenr rate for Ca nada ing rare. State a real relation rhat each of rh ese graphs
using weights thtit reflect the size of thtit region's might describe, other than the ones given in the text of
labou r force as a proportion of rhe overall Canadian rh is chapter.
labour force. Explain rhe di fference in this uncmploy·
1t1cnt r:i re from the one in p:irt (a). Is this a " better"
measure of Ca nadian uncmp loymcnr? Explain why.
After studying this chapter, you will be able to

3.1 DEMAND 1 list the factors that determine the quantity demanded of a
2 distinguish between a shift of the demand curve and a
movement along the demand curve.

3.2 SUPPLY 3 list the factors that determine the quantity supp lied of
a good.
4 distinguish between a shift or the supply curve and a
movement along the supply curve.

3.3 THE DETERMINATION OF PRICE 5 explain the forces that drive market price to equlllbrlum,
and how equilibrium price is affected by charnges in
demand and supply.

WE are now ready to swdy the important qllestion of rhe quanricies chat are boughr and sold . Finally, we
huw markets wurk. The answer leads us cu develop a examine how rhe price S)'Stcm allows che economy to
simple model of supply and demand. And though there respond to changes in demand and supply. The con·
is much more co economics rhan just demand and ceprs of demand and supply help us co un derscand che
supply (as many following chapte rs will illustrate), this price system's Sllccesses and fa ilures, and the conse-
is an essemial scarcing point fo r underscanding how a quences uf many guvernmenr policies.
market economy functions. This chapter deals with rhc basic clements of
As a firs r seep, we need ro understand what derer- demand, supply, and price. In rhe nexr cwo chaprers
mincs rhc demand fo r and rhc supply of particular we use the rhcor)' of demand and suppl)' to discuss
produces. Then we can see how demand and sup· such issues as cigarecce raxes, legislated minimum
ply rugerher determine rhe prices uf produces and wages, renr cunrruls, and che burden uf payroll caxes.

I 3.1 Demand
Whar derermines rhe de mand fur any given pruducr? Huw have Canadian cunsumers
responded co che recenc declines in che prices of smarcphones and lapcop compucers?
I low will they respond to the next sudden change in the price of gasoline or coffee?
We scare by developing a cheory designed cu explai11 rhe demand fur sunne typical

Quantity Demanded
The tota l amoun t of any particula r good or service that consumers want to purchase
quantity demanded The in sume rime periud is called rhe quantity demanded uf char pruducr. Ir is impurcanr cu
amount of a good or service that nocii;e cwo things about chis <.:on<.:epc.
consumers want to purchase
du1lnesome time pe1lod .
First, quantity demanded is a desired quantity. Ir is the amou nt that consumers
want cu purchase when faced wich a particular price of che pruducr, urher pruduccs'
prices, their incomes, thei r tastes, and everything else that might matter. Tt may be dif-
fere nt from the amo un t that consumers actually succeed in purchasing. If suffic ient
quantities are nuc available, rhe amuun r char consumers want tu purchase may exceed
the amount chat they a<.:tually purchase. (For example, thin k of standing in line co
purchase tickets w a show, only to find out chat the show is sold Qut before you gee to
rhe head uf rhe li11e.) Tu distingu ish rhese cwu concepts, rhe rerm quantity demanded
is used to refer to desi red purchases, and such phrases as quantity bought or quantity
exchanged arc used to refer to actua I purchases.
Second, quanriry demanded refers ro a flow of purchases, expressed as so much
per period of time: 'I mi ll ion units per clay, 7 mi ll ion per week, or 365 mi ll ion per yea r.
For example, being told that the quantity of new cars demanded (at current prices) in
Canada is 50 000 means 11orhi11 g unless you are also ruld rhe periud of cime involved.
For a coun try as large as Canada, 50 000 cars demanded per day would be an enor-
mous rate of de mand, whereas 50 000 per yea r would be a vCr)' small rare of demand.
The impurranr disrincrion berwee11 stocks and flows is discussed in Extensions in
Thco1·y 3- ·1.
The total amoun t of some [)roducc that consumers in the relevant market wane co
buy in a given rime period is influenced by rhe following imporranr variables: l2J

• Product's own price

• Consumers' income
• Prices of ocher produces
• Tastes
• Population
• Expectations about the fuw re

We will discuss rhe separate effecrs uf each uf these variables lacer in rhe chaprer.
For now, we focus on the effe<.:ts of dia nges in the product's own prii;e. But how do we
analyze the distinct effect of changes in one variable when all arc likcl)' to be changing
at unce? Since chis is difficulr tu du, we consider rhe influence uf the variables une at a
time. To do chis, we hold all but one of chem constant. Then we let the selected variable

The Distinction Between Stocks and Flows
An imporranr conccprua l issue rh ar arises frequcnrly in rhe flow pcrsisrs. We cannor add rhe stock of I00 lirrcs of
econom ics is rhe distitiction between stock and (low vari- water in the tub to the flow of I 0 litres per minute to ger
ables. Economic rhco rics use borh, :Jnd it t:Jkcs :l lirtlc I .I 0 lin·es. The new srock of WJter will depend on how
practice to keep them straight. long th e flow pcrsisrs; if it lasrs for 20 minurcs, rhc new
As noted in the text, a flow varia ble has a time srock wil l be 300 lirres; if the flow persisrs for 60 rn in-
dimcnsion- ir is so much per 1111it of time. For exam ple, urcs, rhe new stock will be 700 lirrcs (or rhc rub will
the quantity of Gra de A laq;:c eggs purchased in Edmon - overflow!).
ton is a fl ow va ri able. No useful informarion is conveyed The amounr of income earn ed is a fl ow; ir is so much
if we arc told that the number pu rchased was 2000 dozen per year or per month or per hour. The amoun t of a con-
eggs unless we arc also told rh e period of rime ovc1· which stune1·'s expcndirure is also a flow-so much spenr per
these purchases occurred. Two thousnnd dozen eggs per week or per month or per year. The amount of money in
hou r wo uld indicate a much rn ore active market in eggs a bank account (earned, perhaps, in the past but un spent)
rhan wou ld 2000 doze n eggs per monrh. is a stock- jusr so many rhousands of dollars. The key
In contrast, a stock vnriable is a variable whose test is alwnys whether a time dinrcnsion is required to
value has mea ning at a jloi11t i11 time. Thus, the number give the va riable meaning,
of eggs in th e egg producer's warehouse on a parricular
day- for example, I 0 000 dozen eggs on September 3,
20 13-is a srock variable. Al l rh osc eggs arc rh crc ar one
time, arid they remain there unti l something happens ro
change the stoc k held in rhe warehouse. The stock vari-
able is just a number ar a poinr in rime, not a rate of fl ow
of so much pe1· un it of rime.
The terminology of stocks and flows ca n be under-
stood using an analogy ro a bathrub. Ar any moment, the
rub holds so much warcr. This is rhc stock. and ir ca n be
rt1casurcd in rernrs uf the vo lun1c of w:itcr, say, I 00 litres.
There mighr also be water fl owing inro the rub from rhe
rap; th is flow is measured as so much wate r per unit rime,
s:iy, I0 Iitrcs per minute.
The disrincrion berwecn stocks and flows is imporr-
ant. fo ilurc to keep thcnr straight is a common source
of confusion :ind even error. Nore, for example, rhar The a11101mt of water behind t/Jc dam al a11y time is tlic
a srock va riable and a flow variable cannot be added stock of water; the amow1t moving tlirough t/Je gate is the
togethe1· withour specifying some time period for wh ich flow, which is 111cas1tred per mlit of time.

vary and scudy how its change affects quanrity de manded. We can do the same for each
of die mhier variables in turn, and in d1is way we can come to understand the import-
ance of each variable.
Holding all other variables constant is ofren described by the expressions "other
things being equa l," "od1er things given," or the equivalem l.atin phrase, ceteris pari·
bus. Whem economists speak of the influence of the price of gasoline on the quancity of
gasoline demanded, ceteris parib11s, they refer co what a change in the price of gasoline
would do to the quantity of gasoline demanded if all other variables that infl11e11ce the
demand (or gasoline did not change.

Quantity Demanded and Price1

We are inte rested in studying the relationship between the quantity dema nded of a prod-
uct and that product's price. This requires that we hold all other influences constant
and ask, "How will che quamicy demanded of a produce change as ics price changes?"

A basic economic hypothesis is that che price of a produce and the quantity
demanded are related negatively, other things being equal. That is, the lower the
price, the higher the quantity demanded; the higher the price, the lower the quam ity

The great Bri tish econom ise Alfred Marshall (1842- 1924) called chis fundamen -
tal relation rhe " law of demand ." In Chapter· 6, we will derive the law of demand as
a prediction that fo llows from illlorc basic assumptions about the behaviour of indi-
vidual co11sumers. For now, lee's simply explore why chis relationship seems reason-
able. Produces are used to satisfy desires and needs, and there is almost always more
tha n one product char will sacisfy an)' desire or need. Jlunger ma)' be alleviated by
eari11g mear or vegetables; a desire fur gree11 vegetables ca11 be satisfied by broccoli
or spinach. The desire for a vacation may be sacisfied by a crip co the ocean or co che
mountains; the need co get there may be sarisfied by different airlines, a bus, a car, or
a crai11. For any general desire or 11eed, chere are almost always ma11y differenc prod-
uces char wi11 satisfy ir.
Now consider what happens if income, tastes, population, and the prices of all
ocher products rema in constant and the price of only one produce changes. As the
price goes up, rhac produce becomes an increasingly expensive means of satisfying a
desire. Many consume rs will decide to switch wholly or
parrl)' to ocher produces. Some consumers will stop buy-
Last-Minute DEALS
f' :r (_
111 I I 1(1! At UJ 1
JJ '~(_ nJJ1
ing ic alcogecher, mhers will buy smaller amouncs, and
stil I others may continue to buy the same quantity. But
MOllU l llGt!IS
the overall effect is that less will be demanded of the
I-. OM!t for L•• V e.o•• Trev.ltre I TAVtt l •c11•.-11 ~ produce whose price has risen. As meac becomes more
lCIJIGli l 1111'.c Ill LKUJLJ NLXI o'• L LKLNLJ
expensive, fo r example, some cons umers will switch to
• 1 1 I•
meat substitutes; others may forgo meat at sc>me meals
.... and eac less meac ar ochers. Taken cogecher as a group,
II ·-·- consumers will wa nt to buy less meat whe n its p rice rises.

··· ~~~·- Conversely, as the price goes down, the product

becomes a cheaper way of satisfying a desire. Households
'"""" -·· will dema nd more of it. At the same time they will buy
less of simila r products whose prices have not falle n and
as a resulc have become expensive relative to rhe prod-
••• Ll C~ in question. For example, when the price of toma-
Challxes i11 prices lead most co11s11m.ers to alter their toes fa lls, man)' shoppers will switch to tomatoes and cut
choices. Por example, as prices for hotel rooms fall, 11aca· rheir purchases of other vegetables chat are now relatively
tio11ers may /;e more likely lo t<ike weekend trips. more expensive.

1 In this chapter we explore a product's demand curve for the ma rket as a whole-what we often call the
market demand curve. In Chapter 6 we discuss how this market demand curve is derived by adding up, or
11f1t;rcf111ti11f1, th< demands of difftre111 individual~.

Demand Schedules and Demand Curves

A demand schedule is one way of showing the relationship between quantity demanded demand schedule A tahle
and che pa·ice of a produce, ocher things being equal. Ir is a cable showing rhe quanciry Showing the reladonshlp
between Quantltv demanded
de manded ar various prices. and lhc price or a commodity,
The cable in Figure J -'I shows a hypothedcal demand schedule for apples. 2 Tt lists the other lhings being equal.
quantity of apples that would be demanded at various prices, given the assumption that
all ocher variables are held consrnnr. We should nore in parricular chat average house-
hold income is assumed to be $50 000 per year because later we will want to see what
happens when income changes. The table gives the quantities demanded for five selected
prices, but in fact a separate quanrity would be demanded at every possible price.
A second method of showing the relationship between quantity demanded and
price is to draw a graph. The five price-quanti ty combinations shown in the ta ble arc
plotted in figure 3-1. Price is plocred on che vertical axis, and che quamity demanded is
plotted on the horizontal axis.
The curve drawn through these puinrs is called a demand curve. le shows the quan- demand curve The iraphical
ciry char consumers would like ro buy at each price. The negative slope of rhe curve repreSEntedon of Ille relationShip
~tween ~uantity demanded and
indicates that the quanti ty demanded increases as the price falls . Each point on the Ille price of a commodity, other
dema11ll curve indicates a si11gle price-qua11til)' curnbi11ariu11. The dema11ll curve as a tilings bling uqual.
whole shows something more.

FIGURE 3·1 The Demand for Apples

A Demand Schedule for App les A Demand Curve for Apples

Qua ntity Deman ded
(rhou~a nd s of bushels 120
per year when avcragc
Reference Price annual income is i'.i] 100
-... ""'
Poi nt ($ per bushel) $50 000)
u 20 110
1l ~
0 ""
v 40 85 ·c:
... 0
WI 60 65 3
x 80 50 D
y 100 40 0 20 40 60 80 100 120 140
Quantity of Apples
(thousands oi bushels pe1· yenr)
Boch the table and the graph show che weal quantity of apples chat would be demanded at various priccs, ceteris
parib11s. For exam ple, row W indicares rhar if rhe pl'icc of apples we1·c $60 1)C1' bushel, consumc1·s wou ld desi re ro
purchase 65 000 bushels of apples per year, holding conscanr the values of rh e other variables char affect quanriry
demanded. The demand curve, labelled D. relates quantity of apples demanded ro rhc price of apples; irs negative slope
indic::trcs that quantity demanded increases as price fa lls.

2 W/c rcali1.c chat apples arc nor a very exciting product ro discuss, an,l many swdcnrs wonder why we do
not instea d use cell phones, resrn uranr meals, or cars as our hyporhcrica l exa mple, The model of demand
and supply, howcvcr, licst applies to products thn t arc demanded hy mn ny consumers and suprilicd by many
producers, each of which offers for sa le n vim1ally identical (''homogeneous") version of the product. For this
reason, we l1nve chosen a simple agricultural product, but we could have illusrrared che same principles with
beef, wheat, copper, newsprint, oil, and a whole hosr of what cco110mists call "comn1odiri<s."

The demand curve represents the relationship between quan tity demanded and
price, ocher things being equal.

\Vhen economists speak of demand in a particula r market, they are referring not
jusc to che particular quantity being demanded ac che moment (i.e., not just to one point
0 11 the demand curve) bm to the entire demand curve- to die relationshi p between
desired purchases and all the possible prices of the produce.
demand Tlltl entire rclat1ons111p The te rm demand therefore refers to the enti re relationship between the quantity
between the quanlicy of a demanded of a product and the price of that prod uct. In contrast, a single point on
oommodity lllat buyers want to
purchase and the price of that
a demand schedule or curve is t he quantity demanded at that point. This distinction
commodity, other lllfngs beln& between "demand" and "quantiicy demanded" is an extremely important one and we
equal. will examine it more closely lacer in chis chapter.

Shifts In the Demand Curve The demand curve is drawn wich che assum ption chat
everything except t he product's own price is being held constant. Bue what if other
things change, as they often do? For example, consider a n increase in average
household income wh il e the price of apples remai ns constan t. If consume rs spend
some of t heir extra income on apples, the new quanricy demanded cannot be rep re-
sented by a point o n the o riginal dema nd curve. Tc muse be rep resented on a new
demand curve chat is co chc right of che old curve. Thus, a rise in income chat ca u se~
mo re apples rube dema nded at each price shifts rhe dema nd curve fur apples ru rhe
right, as shown in Figure 3-2. This shift illustrates the operation of a n importa nt
genera l rule.

FIGURE 3·2 An Increase In the Demand for Apples

Demand Schedules Demand Curves
Quantity r>cruandcd Quantity Demanded
(thousands of bushels (thousands of bushels 120 \
per yea r when average
an nua l income is
per yea r when average
annual income is
(I\] 100 - \ V'
bushel) $50 000) $60 000)
..!:( "'
g: ..6 80 \ X'
p Do
11 0u
85 v
11 5 V'

:; g_
~ ~
·~ ~
""" 0
_.' .,

' U'
65 w
50 x
40 y
95 W'
80 X'
70 y•

0 20 40 60 80 JOO 120 J40


100 Quantity of Apples

(tlH1usanJs of bushels per year)
An increase in annual household income increases the quantity demanded at each price (for ;ill normal goods). This
is show n by the rightwa rd shift in the dema nd curve, from Doro D1. When average income rises from $50 000 ro
$60 000 per yea r, quantity demanded ar a price of $60 pe1· bushel rises from 65 000 bus hels per yea r to 95 000 bushels
per yea r. A simi lar rise occurs ar eve ry other price.

A demand curve i~ drawn with the assumption that everything except the product's
own price is held constant. A change in any of the variables previously held con-
stant will shift the demand curve to a new position.

A demand curve caii shifc in rwu importa11r ways. 111 rhe firsr case, more is desired
at each price-the demand curve shifts rightward so chat each price corresponds to a
higher quantity than ir did before. In rhe sec:<Jncl case, less is desired at eac:h price-die
dema11d curve shifcs lefcward so thac each price corresponds co a lower quancicy chan
it did before.
Lee's now consider five important causes of shi fts in the demand curve.
1. Consumers' Income. If average income rises, consumers as a group can be expected to
desi re more of most products, other things being equal. Goods for which the quantity
de manded increases when income rises are called normal goods; goods for which the
quantity demanded falls when irn.:ome rises are called inferior goods. The te rm normal
goods refl ects economists' empirical finding that the de mand fo r mosc goods rises when
income rises. We therefore expect chat a rise in average w nsumer income shifts rhe
de mand curve for most produces to the right, indicating that more will be demanded at
any given price. Such a shi ft is ill ustrated in figure 3-2.
A change in che distribution of income can also lead co changes in de mand. In
particula1; a change in the distrib ution of income will cause an increase in the de mand
fo r produces bought most b)' consumers whose incomes increase and a dec rease in
che demand for produces boughc mosc by consumers whose incomes decrease. If, for
example, che govern mem increases che child cax credit and ac che same cime raises basic
tax races, income will be transferred from lwuscholds without children to hm1seholds
wich children. Demands for produces more heavily bought by persons wichour children
will decline, while de mands for products more heavily bought by households wich chil-
dren will increase.
2. Prices of Other Goods. We saw char rhe 11egacive slope of a product's de mand curve
occurs because che lower ics price, che cheaper che pl'-Oducc becomes relative ro ocher
products chac can satisfy che same needs or desires. T hese ocher produces are called
substitutes in consumption. Another way fur the same change ro come about is chac substitutes In consumption
che price of che subsciruce produce rises. For example, apples can become cheap relative Goods that can be used in place
of anolher to satisfy similar
co oranges either because che price of apples falls or because the price of ora nges rises.
needs or desires.
Eicher change will increase the amoum of apples chac consumers wam co buy as some
consumers substitute away from oranges and coward apples. Thus, a rise in che price of
a subscicure for a produceshifts rhe demand curve for che produce co che righc. More will
be demancled ac each price.
Complements in consumption are prod uces chat rend co be used joincly. Cars and gas- complement• In consumption
oline are complements; so are gulf dubs and gulf balls, amd airplane fl ights ro Calgary and Goods that tend to be
consumed toj!ether.
ski-lifr tickets in Ban ff. Because complemems rend co be consumed cogerhe1; a fall in the
price of one will increase the quantity demanded of both products. Thus, a fa ll in the price
of a complement for a produce will shifc thac product's demand curve ro che righc. Mure
will be demanded ar each price. for example, a fall in che price of airplane trips co Calgary
will lead to a rise in the demand for ski-lift tickets in Ranff, even though che price of chose
lifr rickets is unchanged. (The demand curve for ski-lift rackets will shift ru che righc.)
3. Tastes. Tastes have a powerfu l effect on people's desired purc hases. A change in castes
may be long-lasting, such as the shi ft from typewri te rs to computers, or it may be a

short-lived fad as is common with many electronic ga mes, such

FIGURE 3·3 Shifts in the Demand Curve as the lacest versions of Need for Speed or Just Oance. Tn eicher

\x . ,... ,
case, a change in tastes in favo ur of a produce shi fcs the demand
Dz o, curve w the right. More will be demanded at each price. Of
course, a change in tastes against some product has the opposite
\ An increase
effect and shi fcs the demand curve to rhc lcfc.
\ 4. Population. If there is an increase in population with purchas-
, -- ing power, the demands fo r all the products purchased by the
'' ' new people will rise. Thus, we expecc char an increase in popula-

(-,,, .
A <lccrcasc '
'' '

tion wiII shift rhe demand curves for mosc produces co rhe righc,
indicating char more will be demanded at each price.
5. Expectations about the Future. Our discussion has so far focused
in dc1na nd
on how changes in the current value of variables may change
demand. Bue ic is also true chat changes in people's ex{Jecta·
Quanciry per Period tio11s about future values of variables may change demand. For
example, suppose you arc thinking about buying a vacation
A rightwa rd shifr in the demand curve from property in a small rown in Nova Scotia, and yo u have learned
D0 to D 1 indicates an increase in demand; chac in rhe near fucure a large high-cech firm will be moving ics
a leftward shift from Do to Di indicates a
decrease in demand. An increase in demand head office and several hundred employees co chis same small
mea ns that more is demanded at each price. ruwn. Since rheir futui:e muveme11c incu yu ui: ruwn will pi:ub-
Such a ri)l.htward shift can be caused b)' a rise ably increase the demand fur housi11g and drive up che future
in income, a rise in rhc price of a subsrirute, a price of houses, chis expecrarion will lead you (and ochers like
fall in rhe price of a com plcmenr, a change in you) cu increase your demand today so as co make the purchase
tastes that favours that product, an increase before che price rises. Thus, che demand curve fo r houses will
in population, or the anticipation of a future
event rhat will increase the price.
shi ft cu cbe righc roday in an riciparion of a future evem.
/\ decrease in demand means that less Figure 3-3 the changes char cause demand
is demanded at each price. Such a lefrward curves to shi fc.
shifr can be ca used by a fa ll in incon1c, a fal l
in rhc price of a substitute, a rise in th e price Movements Along the Curve Versus Shifts of the Whole Curve
of a com1) lemem, a change in rasres that Suppose you read in coday's newspaper rhac a sharp increase in
disfavours th e prnduct, a decrease in popu· che world price Qf coffee beans has been caused by an increased
btion, or rh c antic ipation of a future even t
that will dec rease the price.
worldwide demand for coffee. Then rom urruw yuu read rhar
che rising price of coffee is reducing rhe cypical consumer's pur·
chases of coffee, as sh<Jp pers switch to other beverages. The
rwo srories appear ro concradicc each ocher. The firsr associates
a rising price wich rising demand; che second associaces a rising price wirh declining
de mand. Can both statements be true? The answer is yes-beca use the two statements
acrually refer ro differenr rhings. The firsr describes a shi ft in rhe demand curve; rhe
second descri bes a movemenr along rhe dema nd curve in response co a change in price.
Consider first the statement char rhe increase in rhe price of coffee has been caused
by an increased demand for coffee. This sraremenr refers ro a shifr in rhe demand curve
for coffee-in chis case, a shift co rhe righr, indicaring more coffee demanded ar each
price. This shifc, as we will sec lacer in chis chapre1; will increase che price of coffee.
Now consider che second sraremenr-rhar less coffee is being boughr because of irs
rise in price. This refers co a movemem along rhe new demand curve and reflects a change
between cwo specific quantities demanded, one before the price increased and one afcerward.
Possible explanations fo r rhe rwu stories are as fo llows:

1. A rise in population and income in coffee-drinking countries shifts the demand

curve fo r coffee co the righc. This, in curn, ra ises che price of coffee (for reasons we
will soon swdy in decail). This was rhe firsc newspaper srory.

2. T he rising price of coffee is ca using each individu al household to .:ut back

on its coffee purchases. The cutback is represented by an upward movement
to che left along che new demand curve fur coffee. This was the second news-
paper story.
To prevenr che cype of confusion caused by our cwo newspaper stories, economises
use a specialized vocabulary to distinguish between shifts of demand curves and move-
menrs along demand curves.
We have seen chat "demand" refers co che entire demand curve, whereas "quanciry
demanded" refers to a particular point on the demand curve. Economists rese rve the change In demand A change In
the quantity demanded at each
cerm change in demand co describe a change in the quan tity demanded ac every price. possible pnC<J ol lllc commodity,
Thar is, a change in demand refers co a shift of the enri re demand curve. The cerm represented l>y a Shin In t110
change in quantity demanded refers to a movement from one point on a demand curve whole demand curve.
cu another poinc, either un rhe same demand curve ur un a new one. change In quantity demanded
Achange In Ille spcclflc
quannty of the good demanded,
represented lby a chango from
A change in quantity demanded can result from a shift in the demand curve with
one point on a demand curve
che price cons1an1, from a movement along a given demand curve due to a change to another point. either on the
in the price, or from a combination of the two. [J] original demend curve or on a
new one.

We consider these three possibilities in AG URE 3.4 Shifts of and Movements Along the Demand Curve
[ LI rl1 .

An in.:rease in demand means that the

whole demand curve shifts to the right; at any
given price, an increase in demand causes an
increase in qua ntity demanded. For example,
in f igure 3-2 on page 60, che shi ft in the
demand curve fur apples frurn Do cu D 1 repre-
sencs an increase in demand, and at a price of
$40 per bushel, quantit)' demanded increases
from 85 000 bushels cu 11 5 000 bushels, as
indicated by che move from V co V'.
A m(JVement down and to the right
alung a demand curve represe nrs an increase
in quanriry demanded. For example, in
Figu re 3-2, with the demand for apples Qun11 tity
given by che curve D 1, a11 increase in price
from $40 co $60 per bushel causes a move- An increase in demand means that the demand curve shifts to
ment along D I from v· co W'' and quantity the right, and hence quantity demand ed will be higher at each
demanded decreases from I 15 000 bushels p1·ice. A l'ise in pl'icc causes a movement upward and to the left
along che demand curve, and hence quanticy demanded will fall .
to 95 000 bushels.
The demand curve is origina lly D0 and price is p0 , wh ich means
Whem there is a change in dema nd and that quantity demanded is Q0 . Suppose demand increases ro
a change in the price, rhe overall change in D u, which means chat at any particular price, there is :i larger
qua nti ty demanded is the net effect of the shift quantity demanded; for example, at Po, quantity demanded is
in the demand curve and the movement along now Q1• Now suppose the price rises above Po· This causes a
movement up and co the left aloni;: Di, and quantity demanded
che new dema nd curve. Figure 3-4 shows the fa lIs below Q·1• As the figure is drawn, th e quantity dema r1ded
combined effect of an increase in demand, ar the new price P2 is less than Q 1 bur greater than Q0 . So in
shown by a rightward shift in the whole chis case rhe combined effect of rhe increase in demand an d che
dema nd curve, and an upwa rd movement co rise in price is an increase in quantil}' demanded from Qo co Q2•
the left along the new demand curve caused

by an increase in price. The increase in demand

causes an increase in quantity demanded at the
ini cial price, whereas che movement along che new
demand ..:urve ..:a uses a de..: rease in the qua ntity
demanded. Whether quantity demanded rises or fa lls
overall depends on che relative magn icucles of these
two ..:hanges.

I 3.2 Supply
What determines che supply of any given produce?
A rise i11 the price of wlm ll , other thi11JlS bei11g eq11al, wi/l /e{td
farmers to pltwt less of other crops and plant more wheat.
Why do Canadian oil prodL11;ers extra..:t and sell more
uil when rhe pri..:e uf uil is high? Why du Canadian
caccle ranchers raise and sell more beef whe n che price of catcle-feed fa lls? We start by
developing a theory designed to expla in the supply of some typical produ..:c.

Quantity Supplied
The amount of some good or service chat producers want co sell in some ti me
quanUty supplied The amount period is cal led che quantity supplied of chac produce. Quanricy supplied is a
or a commodity thal producers flow; it is so much per unit of ti me. Nore also that qua ntity suppl ied is the
want to sell during some lime
~enod .
amou nt chat producers arc wil li ng co offer for sale; it is not necessari ly the
amuu nc chac chey s ucceed in sel ling, wh ich is expressed by quantity sold ur quan-
tity exchanged.
As a general rule, an)' event chat makes production of a specific product more
prufirable will lead firms cu supply mure uf ir. The quantity supplied of a product is
in fl uen..:ed by the followi ng key variables: [4J

• Product's uwn price

• Prices of inputs
• Tcdmolog)'
• Some government taxes ur subsidies
• Prices of other products
• Number of suppliers

The situation with supply is the sa me as chat with demand: T here are severa l
influencing variables, and we will not gee fa r if we Cf)' co discover what happens
when rhey al l change at the sa me rime. Again, we use rhe conve11ienr ceteris pari-
bus assumption to study the in fluence of the variables one at a time.

Quantity Supplied and Price

We begin by holding all other influences ..:onstant and ask, "How do we expect the total
quan tity of a product supplied to vary wi th its own price?"

A basic economic hypothe~is i~ that the price of the product and the quantit y
supplied are related positively. other things being equal. That is, the higher the
product's own price, the more its producers will supply; the lower the price, the less
its producers will supply.

In larer chapte rs we will de rive chis hypo thesis as a prediction from more basic
assumptions abouc che behaviour of individual profit-maximizing fi rms. For now we
simpl)' nuce chat as rhe pruducc's price rises, producing :and selling chis produce becomes
a more profirable activity. Firms interested in increasing cheir profit will therefore
choose to increase their production.

Supply Schedules and Supply Curves

The general relationship just discussed can be ill ustraced b)' a supply schedule, which supply schedule A t8ble
shows the relationship between quantity supplied of a product and the price of the showlne 111e reladonshlp
bctwt'Cn quanU!)' supplied and
produce, ocher things being equal. The cable in Figure 3-5 presencs a hypothetical sup- the price of a commodity, olller
ply schedule fo r apples. things being equal.
A supply curve, the graphical representa tion of the suppl)' schedule, is illustrated
supply curve The graphical
in Figure 3-5. Each point on rhe supply curve represents a specific price-quancicy com- representsdon of the
bination; however, the whole curve shows something more. rclatlonShlp butwcun quar;llty
When economises make statements about the conditions of supply, thC)' arc not supplied andl lho prlco of a
commodity, other things being
referring jusc cu rhe particular quanciry being supplied ac che mumenr- chac is, nut
to just 0111e point on the supply curve. Instead, they are referring to the entire supply

FIGURE 3.5 The Supply of Apples

A Supply Schedule for Apples A Supply Curve for Apples
Price Supplied (thousa nds 120
Reference ($ per of bushels
Poi nt bushel) ~·car) "'il 100
u 20 20 Q, ..c 80
< t
II 40 45 0 0.
w 60 65 " t: 60
80 80 ·~ ~0
x "'"
:!'!. 40
y 100 95

0 20 40 60 8<) 1<)0 120 140

Quancity of Apples
{thousands of bushels per year)

Both the table and the graph show the quantities that producers want to sell at various prices, ceteris [Jarilms. For
exa mple, row t11 indicares cliac if che price of a pples we re $60 per bushel, producers would wa ne ro sell 65 000 bushels
per year. T he supply curve, labelled S, relares quanriry of apples supplied ro che price of apples; ics positive slope ind i-
caces that quantity supplied inc reases as price increases.

The sup ply curve represencs che rclacionship becween quancicy supplied and price,
other things being equal; its positive slope indicates that qua ntity su pplied increases
when price increases.

cllrve, to the complete relationsh ip between des ired sales and all possible prices of the
supply The entire relationship Supply refers to the enrire relationshi p between the quanrity supplied of a product
between the quantity of some and the price o f that product, other things being equal. A single point on t he SL1pply
commodity thst nroducers wish
curve refer~ to chc qua11tity suf;p/ied at that price.
to sell end the nrice of thst
commodity, other thlni:s being
equal. Shifts In the Supply Curve A shift in the supply curve means that at each price chere is
a change in rhe quantity supplied. An innease in rhe quantity supplied at each price is
shown in Figure 3-6 . T his change appears as a rightwa rd shift in the supply curve. 1n
contrast, a dec rease in the quantity supplied at each price would appear as a leftward
shi fr. For supply, as for demand, chere is an impurcanr general rule:

A change in any of the variables (other than che produ cc's own price) thac affeccs
the quantity su pplied will shift the supply curve to a new position.

Lee's now consider che possible causes of shifts in supply curves.

1. Prices of Inputs. All things rhac a firm uses ro pruduce irs outputs, sud1 as materials,
labour, and machines, are called rhe firm's inputs. Ocher thi ngs being equal, che higher
che price of any input used cu make a produce, rhe less prufir there will be frum making
that product. We expect, rhe refore, chat the higher rhe price uf any i11put used by a firm,
the less rhe firm wilI produce and offer fur sale ac any given price of the produce. A rise

FIGURE 3-6 An Increase in the Supply of Apples

Supply Schedules Supply Curves

Quantity Supplied Quantity Supplied
{thousands of bushels {thousands of 120 So SI
Price per year before bushels pe r yea r after ~

($ per bushel) innovation) innovation) ~ -5, 100 , ' y'
Q. "
So S1
,I x·
Q. .D
J_ -( ~ 80
20 ,, so o~
40 45 v 75 v'
~ ~
·C ~
, , ttl

Q. 0

, ,,,.
60 65 ti/ 95 iv' ~ 40 u , ; v'
80 80 x I I Ox'
20 II
100 95 y 125 y'

0 20 40 60 80 100 120 140

Quanricy of Apples
(rhousa ollls of hushcls pee year)
A cost-saving innovation increases the quantity sup plied at each price. This is shown by rhe righ rward shifr in die sup-
ply curve, from S0 ro S1• As a rcsulr of a cost-saving innova rion, the quantity that is supplied ar a price of $ 100 per
bushel rises from 95 000 ro 125 000 bushels per yea r. A similar rise occurs at every price.

in the price of inpll ts therefore shifts the Sllpply curve to the left, indicating that less
will be supplied at any given price; a fa ll in the price of inputs makes production more
profirable and therefore shifts the supply curve to the right.

2. Technology. /\t any time, what is prodllcCd and how it is produced depend on what
is known. Over time, knowledge changes. The enormous increase in production per
worker that has been going on in industrial societies fo r about 200 yea rs is due
largely to im proved methods of production. The Industrial Revolution is more than
a historical event; it is a present realit)'· Discoveries in chemistry have led to lower
coses of produccio11 for well-established products, such as paints, and co a large
variety of new produces made of plastics and synthetic fibres . Such inventions as
si licon chips and fibre optics have radically changed produces, such as cell phones,
computers, and surgical devices, and che consequenc development of smaller com-
puters has revol utionized che production and lowered che coses of countless ocher
non-eleccrnnic produces.
Any technological innovation char decreases the amoum of inputs needed per unit
of output reduces production coses and hence increases the profits chat can be earned
ac any given price of che produce. Because increased proficabilicy leads co increased
willingness co produce, this change shifrs che supply curve ro che righc.
For producers of agricultural products, extreme weather events are similar to a
deceriorarion in technology because chey reduce che amount of oucpuc char can be pro-
duced wirh a given amoum of land, labour, and ocher inpucs. Agriculcural production
generally depends on specific weather conditions, and extreme deviations from normal
can lead co dramaric reductions in ourpur. Droughrs, floods, hurricanes, rornados, and
early froscs are a few examples of extreme weather evenrs thac usually reduce the sup·
ply of agr icultural products.

3. Government Taxes or Subsidies. We have just seen chat anything increasing firms' cQsts
will shift che supply curve to the left, and anything dcc:reasing firm s' coses will shift the
supply curve to the right. As we will sec in later cha pters, governments often levy spe-
cia l taxes on the production of specific goods, such as gasoline, cigarettes, and alcohol.
These caxcs make the produc:ti<m and sale Qf chese goods less profitable. The result is
chat rhe supply curve shifcs ro che left.
For ocher goods, governmencs often subsidize producers- char is, chey pay pro-
ducers a specific amount for each llnit of the good prodllced. This often occu rs for
agricll lcural produces, especially in che Uni ced Scares and che European Un ion. In
such sicuarions, the subsidy increases che profirabilicy of production and shifts the
supply curve to the right. For example, environmental concerns have led the U.S.
and Canadian governmenrs in recenr years ro provide subsidies for rhe production
of biofuels. These subsidies have caused the supply curve for biofuels ro shift to the

4. Prices of Other Products. Changes in the price of one product may lead to changes in
che supply of some ocher product because chc two products arc eithe r substitutes or
complenumts in the production process.
A prairie farmer, for example, can plane his fie ld in wheat or oars. If rhe mar-
ket price of oats fall s, thus making oar production less profitable, the fa rmer will be
more incl incd to plant wheat. In this case, wheat and oats arc said to be substitutes
in production- for every extra heccare planced in one crop, one fewer hectare can be
planted in the other. Jn this example, a reduction in the price of oats leads to an increase
in the suppl)' of wheat.

An excellent example in wh·id1 two products are complements in production is oil

and natural gas, which arc ofte11 fo und together below Ea rth's surface . If the market
price of oil rises, producers will do more drilling and increase cheir production of oil.
But as more oil wells are drilled, the usual outcome is that more of both natura l gas
and oil arc discovered and then produced. Thus, the rise in rhc price of oil leads to an
increase in rhe supply of che complemenrary producr- nacu ral gas.
5. Number of Suppl/crs. For given prices and cechnolugy, rhe coca I amuunr uf any produce
supplied depends un rhe num ber of firms producing char produce and offering ir fur
sale. If prufics are being earned b)' current firms, chen more firms will chuuse cu encer
chis industry and begin producing. The effect uf rhis increase in rhe number uf suppliers
is cu shifc rhe supply curve ro rhe righr. Similarly, if che exisring firms are losimg money,
d1ey will evencually leave che iudum·y; such a reduction in che number of suppliers
shifts che supply curve co che lefc.
Movements Along the Curve Versus Shifts of the Whole Curve As wirh demand, ic is
imporcanc co distinguish movements along supply curves from shi fts of rhe whole curve.
change In supply A change In Economises reserve rhc rcrm change in supply to descri be a shift of rhe whole supply
the quantity supplied at each curve-char is, a change in che quanricy char will be supplied ar every price. The rerm
possible price ot tlw commodity,
represented by a sli lll In tho
change in quantity supplied refers co a movemenc fro m one poinc on a supply curve
whole supply curve. to another point, either on the same supply curve or on a new one. Jn other words, an
increase in supply means rhar rhe whole supply curve has shifted ro rhe righr, su rhar
change In quantity supplied A
change In tile weclflc quantity
rhe qua ncicy supplied ar any given price has increased; a movemenc up and ro rhe righr
supplied, roprusuntcd by a along a suppl)' curve indicates an increase in the quantity supplied in response ro an
change hum one point on a increase in rhe price of che produce.
supply curve to another point,
either on the origin~! wpply
curve or on a new ()Ile. A change in quantity supplied can result from a change in ~ upply with the price
constant, a movement along a given supply curve because of a change in the price,
or a combination of the two.

An exercise you mighc find useful is cu cunscrucc a diagram similar co Figure 3-4
(see page 63 ), emphasizing rhe difference between a shifc of che supply curve and a
movement along the supply curve.

I 3.3 The Determination of Price

So fa r we have considered demand and supply separately. We now come to a kc)' ques-
tion: How do rhe rwo forces of demand and supply inte ract cu determine prit:e? Before
considering dlis question, you should know dlat the demand-and-supply model does
not apply ro all markets. Sec /\ fJ1Jlyi11g Economic Co11ceµts 3- 1 for a discussion of wh)'
the model in chis chaprer applies well cu apples but nut cu more incerescing produces,
such as iPhones.

The Concept of a Market

Originally, the term market designated a physical place where produces were bought
and sold. We still use the cerm chis way co describe such places as Granville Island Mar·
ket in Vancouver, Kensington Market in Toronto, or Jean Talon Market in Monrreal.


Why Apples But Not !Phones?

The demand-and-supply model that we have developed restrictions. Hydro Quebec is rhe sole producer of clec-
in rhis cluprcr docs not apply ro the nw·kcrs fo r all rriciry in the province of Quebec and scrs rhe price char
goods and services, and there is a good reaso n why our consun1crs pay. In contrast, most producers of frui ts and
example rhroughour rhc chapre1· has been apples and nor, vegetables arc very small relarive to rhc size of the marker
fo r example, il'honcs,, brand-name clothing, or even and have no ability to infl uence the m:.uket p1·icc.
textbooks. Three conditions must be satisfied in order for The rhi1·d assumprion ensures rhar there will be a
price dc:rerm inarion in a marker to be well described by single price in the ma rket because producers have no
the den 1and·and·supply model. ability to di(fere11li<1te their product from those of other
producers. This condirion is satisfied in ma11y markers
I.There must be a large number of consun1crs of the for commodities- steel, alun1inum, copper, wheat, oil,
product, each one small relative to the size of natu ral gas, lumber, newsprint, beef, pork, ere. Bur ir is
the market. 11ot satisfied in the markers for many consumer prod-
2. There must be a large number of producers of the ucrs such as smarrphones and mhe1· electronic devices,
product, each one small relative to the size of cars and moto rcycles, clothing, and fasr food and other
the n1arkcr. restaura11t meals. In these cases, each producer sells a
3. Producers must be selling identical 01· ''homoge- differenr version of rhc producr and spends considera ble
neous" ve rsions of rhe product. advertisi ng resources trying to convince co nsum ers to
pu1·chase thei1· version. In rhese markets, differentiared
The first assumption ensures chat no single con- products sell at different prices.
sumer is la rge eno ugh to influence the n1arket price When all three conditions arc sa tisfied, eco nomists
th rough thei r buying actions. This is satisfied in most use the demand-and-supply model ro explain the deter-
markers, although there arc important exceptions. For mination of 1t1a1·kcr price and quantity. This 1t1odcl has
example, Ca nadian provincial govcrnmenrs arc dom· proven ro be very successful in explaining outcomes in
inane purchasers of prescri ption drugs in Canada, and markets such as oil, steel, copper, wheat, soybeans, beef,
their market power tends to keep prices below what rhey pOl'k, newsprint, lumber, foreign cul'rcncics, financial
would orhcrwisc be. assets like stocks and bonds-and apples!
The second assumption ensures that no single So be careful when you try to apply the demand-
producer is large enough ro influence the marker price and-supply model. It works ve ry wel l in desc ribing the
through th eir selling actions. There arc many markets in events in many markets, but not so wel l for others. Later
which this is nor true. For example, De Beers controls rhe chapters in rh is book will examine the more com plex
sale of a la rge frnction of the world 's rough diamonds, markets for wh ich we need a mo re advanced model.
an d thus it ca n alter th e n1arket price th rough its sales

Once developed, however, rh eories of market behaviour were easily exrended ro cover
produces, such as wheat or oil, that ca n be purchased a nywhe re in the wo rld at a price
chat ce to be un ifo rm the world over. Today we can also buy and sell items in ma r-
kers rh ar exist onli ne-cons ider the aucri on services provided by eBay or the almost
limitless list of products available from Amazon (i n1: lud ing a weddi ng chape l and a
UFO detecto r! ). The idea chat a market muse be a single geographi c location whe re
consu mers 1:an go co buy so mething became obsolete long ago.
For present pu rposes, a market may be defined as existing in any situation (sud1 market ArT-J situstion in which
as a physiical place or an electronic medium) in which buyers and sellers negotiate the buye1$ and sellers can negotiate
tile oxehange ol goods or
exdiange of goods or se rvices. sorvtcos.
lnc.lividual markets differ in the degree of competition among the va rious buyers and
sellers. In che next few cha pters we will examine markets in which the num be r of buy-
ers and sellers is sufficiencly large rhat no one of rhem has any appreciable influence on
the market p rke. This is a rough c.leFi nicion of what economises 1:all pcl'fectly competitive

markets. Starting in Chapter ·10, we will consider the behaviour of markets in which there
arc small num bers of either sellers or buyers. But our initial thcoq1 of markets, based on
rhe inceracrion of demand and supply, will be a very good des..:riprion of rhe markers for
such things as wheat, pork, newsprint, coffee, copper, oil, and many other commodities.

Market Equilibrium
The cable in Figure 3-7 brings wgerher rhe demand and supply schedules from
Figures 3- 1 and J -5. The quantities of apples demanded and supplied at each price
can now be compared.
There is only one price, $60 per bushel, at which rhe quamity of apples demanded
equals the quantity supplied. Ac prices less than $60 per bushel, there is a shortage of
apples because che quanrity demanded exceeds che quanrity supplied. This is a situation
excess dem~ nd A sltusUon of excess demand. Ar prices grearer rhan $60 per bushel, rhere is a surpl us of apples
In whleh, at the glvC'n prioo, because che quantity supplied exceeds che quantity demanded. This is a situation of excess
quantity demanded exceeds
quantity supplied.
supply. This same srory can also be ruld in graphical rerms. The quanriries demanded and
supplied ac any price can be read off che rwo curves; che excess supply or excess demand
exce.. supply A situation
is shown by the horizontal distallce between the Cll rves at each price.
in which, at the give-n price,
quantity supplied exceeds To examine che decerminaciun uf markec price, lee's suppose firsc char che price is
quantl()' demanded, $'!00 per bushel. Ac chis price, 95 000 bushels are offered for sale, bur only 40 000
bushels arc demanded. There is an excess supply of 55 000 bushels per year. Apple sellers
are then likely co cue their prices cu ger rid uf this surplus. And purchasers, observing rhe
srock of unsold apples, will begin ro offer less money for rhe produce. In ocher words,
excess supply causes downward pressure cm price.
Now consider che price uf $20 per bushel. Ar chis price, chere is excess demand.
The 20 000 bushels produced each year are snapped up quickly, and 90 000 bushels
of desired purchases c:ann<Jt be made. Rivalry between would-be purchasers may lead
chem tu offer more rhan rhe prevailing price ro ourbicl oche1~ purchasers. Also, sellers
may begin ro ask a higher price for rhe quanriries rhac rhey do have co sell. In ocher
words, excess demand causes upward pressure n11 price.
Finally, consider rhe price uf $60. Ar chis price, producers wane cu se II 65 000
bushels per year, and purchasers wane ro buy rhar same quantity. There is neirher a
shortage nor a surplus of apples. There arc no unsatisfied bu)'crs to bid the price up,
nor are rhere unsatisfied sellers co force che price down. Once rhe price uf $60 has been
reached, therefore, rhere will be no tendency for ic ro change.
Equilibrium implies a sra tc of resc, or balance, between opposing forces . The
equlllbrlum price The ptlce equilibrium price is the one roward which rhe actual markec price will rend. Once
at which quantity demanded escablished, ir will persist unril ic is disrurbed by some change in marker condirions char
equals quantity supplied. Also
called the m8rl<et·cle8rlng price.
shifts the demand curve, the sup ply curve, or both.

The price at which the quantity demanded equals the quantity supplied is called the
equilibrium price, or rhc marker-clearing price. 151
dlsequlllbrlum prtce Aprice at
v.tileh quantity dem3ndod docs
not equal quantity supplied. Any price at which the market does noc "clear"- chac is, qllancicy demanded does not
dlsequlllbrlum Asituation In a
equal quantity supplied-is called a disequilibrium price. Whenever the re is either excess
market In which there Is excess demand or excess supply in a marker, rhac marker is said robe in a srace of disequilibrium,
demand or excess supply. and the market price will be changing.

FIGURE 3·7 Determination of the Equilibrium Price of Apples

* De ma nd a nd Supply Sche du les

Excess Dema nd
(+) or Excess ~"
De ma nd a nd Supply Curves

Price (th ousands of (tho usands of Supply(- ) ..6
($per bushels per bushels per (to nn es per g_ 100
bushel ) yea r) year} )'Ca r) l::
p D s D- S ~ 80
20 11 0 20 ~90 ~ 60
40 85 45 +40 Q.
60 65 65 0 ..: 40
80 50 80 - JO
100 40 95 - 55 D

0 20 40 60 80 100 J20 140

Quantity of Apples
(thousands of bushels per year)
The equilibrium price corresponds to the intersection of the demand and supply curves. At any price above $60, there is
excess s.upply a nd thus downward pressure on price. J\ t any price below $60, there is excess demand a nd thus upward
pressure o n price. Only at a price of $60 is there no pressure for price to change. Equi li brium occurs at point E, at a
price of $60 and quantity exchanged equal tO 65 000 bus hels.

Figure 3-7 makes ic clear char che equilibrium price occurs where rhe demand and
supply curves incersecc. Below chac price, chere is excess demand and hence upward pres-
sure on the existing price. Above chac price, there is excess supply and hence downward
pressure on che existing price. 3

Changes in Market Equilibrium C4mmodldes & Futures

Price (US$) Chg Prlce(IJS$) Chg
Changes in any of the variables, other than price, Cn1dellll Oll.57 0.27 l.11mbftr 202.50 -HO
chac i11fl ue11ce quanricy demanded ur supplied Nalural G11 2.816 0.041 r..... 2400.00 ·3100
ilo•tlng Oil 3.1244 00071 Corn 820.25 2 00
will cause a shift in the demand curve, the sup- r..1d 1642.70 0.20 Soybeans 1727.50 5 00
Silver 20.48 0.014 0.t 303.25 3 75
pl)' curve, or both. There arc fo ur possible shifts: r_.- 3.4566 O.OCl.t!l u.. C.ttle t2U75 0 15
an increase in demand (a righcward shi fc in rhe Pllltinom
1524.10 18.30 Wood Pulp 806.00
75, 175
3 50
02~ . 75 5.~fl L.f.anHDgs
de mand curve), a decrease in demand (a leftward
shi ft in the demand curve), an increase in sup- Ma11y commodities like those listed here are actively traded in
ply (a rigluwa rd shifc i11 rhe supply curve), and a international markets a11d their equilibrium prices fluctuate daily.
decrease i 11 supply (a leftward shift in the supply Source: "Co111111oditics & Fururcs," TMX Money, rmx.quotc-
curve) . res.php. Accessed Augusr 22, 20 12.

.lWhen economises grnph a demand (0 1· supply) curve, chey puc che varit1ble to be explt1i1m l (che depend·
enc variable) on rhe horiioncal axis and che explanacory variable (che independem vari able) on the venical
axis. This is "backward" co whac is usuall y done in mathematics. The rational explanacion of whac is now
cronomiscs' odd practkc is bu ried in che hiscory of economics and daces back co Alfred Marshall's Principles
of Economics (1890) 161. For hctcer or worse, Marshall's scheme is now used by all eco nom ises, although
nlathcn1atic:i :ins never fuil to \VOndcr :\t this cxa n1plc o f the odd \Vay s of cconon1ists.

FIGURE 3·8 Shifts in Demand and Supply Curves


t> I ts Po
·c; J: P1
0.. /Jo

0 0 Qi Qo Q,
Qua nriry Quanciry
(i) The effect of shifts in the dem~ nd curve (ii) The effect of shifts in the supply curve

Shifts in either· demand 01· supply cur·ves will gcnernlly lead to changes in cquilihrfom p1·ice and quantity. In p;11·r (i),
suppose the origin al demand and supply curves arc D0 and S, which inrcrsccr ro produce equ ili brium ar Eo, with a price
of Po and a qua miry of Qo. An in crease in demand shifts the demand curve ro D" raking the new equ il ibrium ro E 1 •
Price rises rn p 1 and quantiry rises to Q 1• Srarcing ar E0 , a decrease in demand shifcs the demand curve ro D21 raking
the new equil ibrium ro E2. Price falls ro /J2 and quantity falls to Q1.
In part (i i}, the original demand nnd supply curves arc D and So, which intersect to produce equil ibrium at Eo, with
::1 price of µ0 and a quantity of Q 0 . An increase in suppl)' shi fts the supply Cl11·vc ro Si, raking the new cqui libriun1 to
E,. Price falls to />1 and quantity rises to Q1 . Starring at Eo, o decrease in St1pply shifts the St1pply cu rve fror11So to S2,
rak ing th e new equilibrium to E2. Price rises ro P2 and quanc iry fall s rn Q1.

Tu discover rhe effects uf each uf rhe possible curve shifts, we use rhe merhud
comparatlve statics. The known as comparative srarics.4 Wirh rhis merhod, we derive predicrions abour how rhe
dcrlvatlon of prcdlcmons by ,.,.,dogenous variables (equilibrium price and quancity) will change following a change
analyzing lhe effecl of a change
In some exogenous variable on
i11 some exoge11011s variable (rhe variables whose cha11ges cause shifrs in rhe dema11d and
the equilibrium. supply curves). We srarr from a posirion of equilibrium and rhen inrroduce rhe change
to be studied. We then determine the new equilibrium position and compare it with the
original one. The difference berween rhe rwu pusirions of equilibrium muse resul r from
rhe change char was inrroduced, because everyrhing else has been held consranr.
The changes caused b)' each of the fo ur possible curve shifts arc shown in
Figure 3-8 . Srudy rhe figure carefully. Previo usly, we had given rhe axes specific labels,
but because it is now intended co apply to any product, the horizontal axis is simply
labelled "Quantity." This means quantity per period in whatever units outpl.llt is meas-
ured. "Price," rhe vertical axis, l'l11eans rhe price measured as dollars per unit of quanrity
for the same product.
The effects of the four possible curve shifts arc as fo llows:

1. An increase in de mand causes an increase in both the equilibrium price and the
equili brium quantity exchanged.
The rcnn storic is used because we arc not concerned wirh rhc acrna l 1>arh by which the 111arkc1 goes from
the first equilibrium posirion 10 the seco nd. or wi1h the time ta ken to reach 1hc second equilibriu m. Analysis
of these movements would be described as dy11a1111c analysis.

2. A decrease in demand causes a decrease in both the equilibrium price and the
equilibrium quantity exchanged.
3. t\n increase in supply causes a decrease in the equilibrium price and an increase in
the equili brium quan ri ry exchanged.
4. A dec1:ease in supply causes an inc1:ease in the equili brium price a11d a deci:ease in
the equilibrium quantity exchanged.
Demonstrations of these effects are given in the caption to Figure 3-8. The intuitive
reasoning behind each is as follows:

·1. An i1Jcrease in demand (the demand curve shifts to the right). An im;rease in
demand creates a shortage at the ini tial equilibrium price, and the unsatisfied buy·
ers bid up the price. This rise in price causes a larger quantity to be supplied, with
the result that at the new equilibrium more is exchanged at a higher price.
2. A decrease in demand (the demand curve shifts to the left). A decrease in de mand
creates a surplus at the initial equi li brium price, and the unsuccessful sellers bid
the price down. As a result, less of the produce is s upplied and offered for sale. Ar
the new equi librium, both price and quantity exchanged are lower than they we re
3. An i11crease in supply (the supply curve shifts to the right). An increase in supply
creates a surplus ar rhe ini tial equili brium price, and rhe unsuccessful suppliers
force the price down. This drop in price increases the quantity de manded, and the
new equi librium is at a lower price and a higher quantit)' exchanged.
4. A decrease in supply (the supply curve shifts to the left). t\ decrease in supply cre-
ates a shortage at the initial equilibrium price rhar causes rhe price to be bid up.
This ~ i se in price redllces the qlla ntity demanded, and the new equilibrillm is at a
higher price and a lower quantit)' exchanged.
B)' using the tools we have learned in this chapter, we can link many real-world
events rhar cause demand or supply i:urves to shi fr and th us lead to changes in marker
prices and qllantities. Lessons from Histo·ry 3-'/ shows how we can llSe demand-and-
supply analysis to examine the effects of two major weather shocks: Quebec's 1998 ice
storm and Hurricane Karri11a in 2005.
Ollr discussion of demand, Sllpply, and market eqllilibrillm has expla ined why
equilibrium price and quantity arc found at the intersection of the demand and supply
curves. We have shown diagrams (Figures 3-7 and 3-8) illusrraring this in rhe general
case. Bue we have not presented a specific algebraic.: example of demand and sllpply and
"solved" preciscl)' fo r the equi libri um price and quantity. Sec Extensions in Theory 3-2
fur an algebraic soluriun ru a specific model uf demand and supply.

Relative Prices and Inflation

The rhem·y we have developed explains how individual prices are determined by
the fo rces of demand and SL1pply. To facilitate matters, we have made ceteris pari-
bus ass um ptions. Specifically, we have ass umed rhe constancy of all prices except
rhe one we are studying. Does this mean that our theory is inapplicable ro an
inflationa ry world in which all prices are rising at the same ti me? Fortunately, the
answer 1s nu.


Ice Storms, Hurricanes, and Economics

He1·e a1·e two simple exam ples of the demand-:rnd· all stores in the g1·earer Monn·eal area we1·e sold out of
supply model in action. 13orh examples show how the such generato rs, and the prices for newly ordered units
weather-something that changes in unpredictable increased sharply.
:ind often drama ti c ways-can have significant effects Furthermore, the shortages :ind price increases for
on ei th er che demand or the suppl)' of va rious prod· generators were not confined to the area directly hit b)'
ucrs, with obvious imp lications for the observed ma1'- rhe ice scor111. As it became clear rhat rhere was an excess
kct price. demand for generators in Quebec, sellers in other parts
of rhe counrry began ro divcn their supply toward Que·
The Weather and a Demand Shock bee. This reduction in supply caused shorrages, and thus
rn Januarr I ~98, Quebec, Eastern Ontario, and parts price increases, in other parts of the country, as fa r nwa)'
of rhe northeastern Un ited Stares were hit by a massive as Edmonron.
ice storm. So unprecedented wns this storm in its mngni·
rude that many electric power systems we re devasraccd. The Weather and a Supply Shock
I Jomes and businesses in the Montreal area went with· In late August 2005, I lu rricanc Katrina emerged from
out power for as long as fou r weeks. rhe Caribbean, gathered srrengrh as it Cl'Qssed rhe Gulf
This electric power sho rtage had many economic of Mexico, and unleashed its fu ry on New Orleans,
effects, including lost factory production, dan1age tO Louisiana. The damage tO New Orlea ns was massive,
many businesses, rh e dearh of far111 livesrock, and the dis· especially after the levee holding back Lake Pontchar-
placement of thousands of peo ple into shelters. Another tra in broke an d much of the city was fl ooded. Katrina
effecr of the powe1· shol'tage, as soon as it became clear was rh en rhe worsr narura l disaster in U.S. history;
rh:ir it wou ld last for more than just a few hours, was a the cost of the damngc to buildings, bridges, houses,
sudd en and substantia l increase in the dcn1and for port· and other infrastructure was esrin1ated to be close to
able gas-powered gene rato rs. Within just a few days, U.S.$125 billion.

T he price of a product is the amount of money tha t must be spe nt to acq uire one
absolute price The amount of un it of that product. This is called the ahsoluce price or m cmey price. A relative price is
money mat must be spent to che ratio o f cwo absolme prices; i[ exp r·esses che pt' ice o f one good i11 cern1s of (re)a[ive
acquire one unit of .a commodity. to) another.
Also called money price.
We have been reminded several rimes char what matte rs fo r demand an d supply
relaUve price The retlo of the is rhe price of rhe produ ce in qu.esrion relath1e to the prices of other products; char is,
money price of one commodity
what ma tters is the relat ive p ri ce. For exa mple, if the price o f carrots rises wh ile the
lo tho munuy prlcu vi anud1or
comrnod~y; that Is, a ratio of prices of ocher vegetables a rc constant, we expect consumers to reduce thei r quan tity
two absolute ~rices. demanded of carrors as chey su bsricuce coward rhe consumpri on of orher vegetables.
Jn this case, the relative p ri ce of ca rrots has increased. Bm if the p ri ces of carrots and
all ocher vegetables arc risi ng at the same race, the relative price of ca rrc>tS is con·
scant. In chis case we expect no subscicucion co cake place between carrots :and ocher
In an inflationary wo rl d, we arc often in terested in the price of a give n prod uct
as ic relates co the average price of all od1er produces. If, durin g a period when all
p ri ces were increasi ng by an average o f 5 percent, the price o f coffee inc reased by
30 percent, then the price of coffee increased relative co the prices of other goods as a
whole. Coffee became relatively expensive. Howeve r, if coffee had increased in price by

HLil'ric:rnc K:min:1 had :in instant effect on the world

market for oil. Over short peri ods of tim e, the world demand
curve for oil is relatively steep, reflecting the fact that users
of oil initia11ly reduce their purch:ises only slightl y when the
price rises.
Hurricane Karrina interruprcd the local production
and distribution of oil, thereby causi ng a temporary red uc-
rion in world supply. Several large oil rigs in the Gulf of
Mexico we re damaged and we re shur down or opcraring
well below th ei r ca paci ty fur several weeks. ln addition, the
major pipelines char rransporr chis oil from rlic Gulf pores
to th e in lamd refi neries were also seriously damaged. For
both reasons, rhc supply ctu·vc fo,· oil shifeed co rhe lcfr.
An d give n th e relatively steep demand curve, th is reduction
i11 supply ca used a sha rp increase in the equi librium price.
The price per barrel of oil, wh ich had averaged roughly
U.S.$40 c:1rlier th at yea r, reached U.S.$70 on August 29, H11rrica11c Katri11t1 in August 2005 damaged several oil
and sraycd above U.S.$65 fo1· about a month. As rhc 1·igs platforms operating i11 tl1a Gulf of Me~·ico, " w siug a
and pipelines were repaired, and Gu lf-area oil production temporary reduction i11 the s11pJJly of oil.
bega n co app1·oach its pre-Karrina levels, rhc supply curve
shifted back ro rh e righr and rhc price rernrn ed ro levels
between U.S.$55 and U.S.$60 per ba rrel.

30 pen:ent when other prices increased by 40 percent, then the relative price of coffee
would have fallen . Although the money price of coffee increased substantially, coffee
became relatively cheap.
In this cha pter we have been ass uming that changes in a particular price occur
when all other prices arc constant. We can easily extc11Jd the analysis to an inflationar y
sercing by reme mbering rhar any force rhar raises rhe price of one proclucr when orher
prices remain constant will , given general inflation, raise the price of that product fa ster
than the price level is rising. For example, consider a change in tastes in favour of cof-
fee rhar raises irs price by 5 percem when orher prices are consranr. The same change
would raise its price by 8 percent if, at the same time, the general price level were rising
b)' 3 percent. In each case, the price of coffee rises 5 percent relative to the average of
all prices.

In microeconomics, whenever we refer to a change in the price of one prod uct, we

mean a change in that product's relarive price, that is, a change in rhe price of rhar
product relative to the prices of all other goods.


The Algebra of Market Equilibrium

This box presen ts an algebra ic model of demand and it. We know that in equilibrium quantity demanded equals
supply and the merhod for derern1 ining rh e equili b- qu antity supplied, or Q1J = Qs. We call the equilibrium
rium price and quanriry. For si mp licity, we assum e rhat quantity Q•. Bu t we also know that in equi librium the
the demand and supply curves arc linea r relationships price paid by the consumers will equal the price received
between price and quantity. by the pl'Oduce1·s- th:ir is, there is only one equili brium
Co nsider the following demand and supply curves: price, wh ich we call p•. Purring these two facts tov;cthc1;
we know that in cqui libriun1
Demand: QD = 11bp -
Demand: Q• = a - bp •
Supply: Q~ - c + dp
Su pply: Q• = c + dp•
where pis rhc price, Q1J is quanciry demanded, Q~ is quan·
tity supplied, and a, b, c, and d arc positive constants. Both
relationsh ips arc plotted in the accompanying fi11.urc. SuppIy:
Q = c + d/1
What is the inrcrprerarion of the deman d curve and
how do we plot ir? First, at a price of zero, consun1- 1!.
crs will buy a units- this is the horizontal intercept of
the demand curve. Second, at a price of 11/b, consu111- "
c1·s will buy zcrn un irs, so a/b is the ver·rica l intercept of
the demand cu rve. Finally, rhc slope of the demand cu rve
is - I /b; the quantity dc111a11ded increases by b t1t1irs for p·=~
,, + d
every $ 1 rhat price fa lls.
What is th e inrcrprcration of the supply curve, and
how do we plot ir? Firsr, if rhe price is zer·o, supplier·s will
sell c units-this is th e horizonta l intercept of th e supply
curve. Second, for every$ I increase in price, the quantity
supplied increases by d un its. Thus, the slope of the sup-
ply curve is 1/d. 0 c Q• = ad+ch ti

Given these demand and su pply curves, the market b+d Qunnciry
equilibrium can be determined in two ways. The first is to
co11strucr a sc:.ilc :rnd plot the two curves :.iccul" We now have two equations and rwo unknown vari -
arcly. If you do this carefu ll y, you wil l be ab le ro read rhe
ables(/>" and Q•) and can proceed ro solve the system of
equi libriu m price and quanriry off the diagram. Rut you r equations. Since Q• from the demand curve equ als Q•
diagram will h:ive ro be very accu rate for this to work! from the supply curve, it follows that
A mo re precise method is to use algebra to solve
for the equilibrium price and quantity. Herc is how we do a /1/1* - c I dp*


3.1 Demand LO 1, 2
• T he amoum of a product that consumers wanr ro pur- • The relationship between quantity demanded and price
chase is called q ut111l ily demc111ded. It is a fl ow ex pressed is represented graphically by a dema nd cu rve that
as so much 1x:1· pel'iod of rime. Ir is derern1ined by tasres, shows how much will be demanded at each marker
income, tlte product's own price, the prices of oth er price. Quantity dem:.inded is assumed to incrc:.ise as the
producrs, chc size of the population, and expectations pr·ice of the product fa lls, other th ings held consranr.
about the futu re. Thus, dema nd curves arc nega tively sloped.

This implies Q0 = 18 - 3p
a - c = ( b + d)µ• Q~ = 2 ~ Sp

wh ich can be solved for p• to get The equilibrium cond ition is that QD • QS • Q• . And
a- c when quantity is equal to g-, price wil l be equal to µ• .
p* - - - Thus, in equilibri um we will have
This is rhe solu tion for the equili brium marker price. Q* = 18 3p•
By substituting this value of p• back into eit/Jer the demand
Q* = 2 +Sp•
curve or the supply curve (it docsn 't matter which), we get
rhe solution for Q•: Since Q• from rhe demand cu rve obviously equals Q•
b(a c) from the supply curve, we have
Q* - a - [Jp• = a - ---'--.:...
(b I d) 18 - Jp• = 2 + Sp•
which can be sin1plified to which can be solved for p• ro gcr
Q• = a( b + d] b(a - c) Sp• - 16
(b + d) (b + d) p• = 2
wh ich ca n be fu rther sim plified ro Putting this va lue of p•• back into chc demand curve
(ad + be ) we get
g· = b +d
Q• - 18 - 3(2)
We now have the precise sol urions fo r the equilibrium Q· - 12
price :ind qu:intity in this mark et. Notice that the solu·
rions for p• and Q" naturally depend on those (cxogen· We have therefore solved for the equil ibrium price and
ous) varia bles that shift the demand and suppl y curves. For quantity in this specific numerical model of demand and
cx:unplc, an increase in demand for the p1·oduct wou ld be supply.
reflected by an increase in a. This would shift the demand Masteri ng che algebra of demand and supply rakes a
curve to the right, incrcasi n)l. both p• and Q•, A decrease in little practice, but is worth the effort. If you wou ld li ke to
supply wou ld have :1 different effect. It would be reflected praccisc, try the Study Exe rcises at the end of th e chap·
by a decrease in c th at would shift the supply cu rve to the rer (and Chapters 4 and 5) chat deal wi th the algebra of
left, leading roa n increase in p* and a reduction in Q•. demand and supply.
Now let's do the same thin~ but wi th even more
specific demand and supply curves. Suppose we have rhe
following relationships:

• A shift in a demand curve represents a change in the • le is importan t ro make the distinction between a
quantity demanded at each price and is referred to as a movement along a demand curve (caused by a change
chauge .in demand . in the prnd ucc's pr·ice) and a shift of a demand curve
• J\n increase in demand mea ns the demand curve shi fts (caused by a change in any of th e other determina nts of
ro the right; a decrease in demand n1eans the demand demand).
curve shifts ro th e left.

3.2 Supply LO 3, 4
• The Jmount of J good that p1·oducc1·s wish ro sell is own price, the costs of inputs, the number of suppliers,
called quantity supplied. It is a fl ow expressed as so government taxes or subsidies, the state o f technology,
much per period of tin1e. It depends on th e product's and prices of ocher· pr·oduccs.

• T he relatio nship between quanciry suppl ied and price • An increase in supply n1ea ns th e suppl)' curve shifts ro
is represented graphica lly by a supply curve char shows the righ t; a dec rease in supply mea ns rhe supply curve
how much will be supplied ar each marker price. Qu,111 - shifts to the left.
tiry supplied is assumed to increase as th e price o f rhc • Ir is important ro m;ike rh c disrincrion betwee n ;i
produce inc reases, orher things held consranr. Thus, sup- movement along a supply curve (caused by a cha nge
ply curves arc positively sloped. in rhe product's price) and a shifr of a supply curve
• A shifr in the supply curve indicates a change in rhe (caused by a change in a ny of th e och er determinants
quantity supplied ar each price and is referred ro as a o f supp ly).
change i11 supply.

3.3 The Determination of Price LO 5

• T he equilibrium price is the price at wh ich th e quantity supply. An increase in demand raises both eq uilibri um
demanded equals rh c qu antity suppl ied. Ar any price price and equi librium quantity; a dec rease in demand
below eq ui librium, there wil l be excess demand; at a ny lowers borh. An increase in suppl y raises eq uilibri um
price ::ibovc equilib1·ium, rhc1·c will be excess supply. qu;i nrity bur lowers cqu ilib1·ium price; a dcc1·casc i11
Graphica lly, equil ibrium occurs where the deman d a nd supply lowers equilibrium quan tity bur raises eq ui lib-
supply curves intersect. rium price.
• Price rises when there is excess dema nd and fa lls when • The abso lute price o f a product is its price in terms o f
th ere is excess supply. Thus, th e actual market price mon ey; its relative price is its price in relatio n ro other
wi ll be pushed roward the eq ui librium price. Wh en ir is pl'Oducrs. In an inflationary period, a rise in rhe relative
reached, rhere wi ll be neirh cr excess demand nor excess price o f o ne produce means chat its abso lute price rises
supply, and rhe price will nor change unril either rhe by more than rhe ave1·age of al l prices; a fall in irs 1·ela-
supply curve or the demand curve shifrs. rive price means char its absolute price rises by less than
• By usi ni; the method of compM<1tii1e statics, we can rhc averai;c of all prices.
determi ne rhe effects of a shift in either demand or

Srock and flow varia bles Change in quantity demanded versus Equ ili brium, equil ibri um price, and
Ceteris paribus or ''other things change in demand discqui libriunr
being equal" Quanrity suppl ied Comparative statics
Quantity deman ded Supply schedu le and supply curve Relative price
Demand sched ule and demand Change in quantity s upplied versus
cu rve change in supply


Make the grade with MyEconLab: Study Exercises marked in red can be found on
MyEconlab MyEconLab. You can practise them as often as you want, and most feature step-by-step
guided insrrucrions ro help you find rhe righr answer.

1. fill in rh e blanks co co111plere the srarc111ents about a b. Consider the 111arker for Ca nadian softwood lu111 -
supply-and -demand model, as applied i11 the fol lowing bcr (a 11orn1al good). If, ceteris p<1rilms, a verage
situation s. incomes in ()()th Canada and rhe Un ited States rise
over severa l yea rs, the curve for lumber
a. Consider the marker for cement in Toronto. If, cet- will shift ro rhc , ind icaring a(n) _ _ __
cris paribus, ha lf rhe producers in chis marker shut
down, the curve for cement will shift to
the , ind icaring a(n) in _ __

c. Consider the 111arkc1 for Quebec art isanal cheeses. 3. Classify rhc cffccrofcach of rhe foll owin11:u (i) a decrease
If, ceteris pari1J11s, rhe price of imporred cheeses in rhc den13nd for fi~h or (ii) a dccrca~c in the quanriry
from France rises si11n1ficanrly, rhe curve of fish dcm:indcd. lllusrrare each diap.rammaricall)'.
for Quebec chee~es will shift ro rhe , indi-
a. The govcrnmcnr of Canada clo~es the Atlantic cod
carin11 a(n) in - - -·
d. Consider rhe marker for milk in the United States.
If cetcris parilms, the U.S. govcrnmcnr decreases b. People buy less fish bee:iusc of a rise in fish prices.
subsidies ro dai11· farmers, rhe curve for c. The Carholic Church relaxes 1rs ban on eating meat
nulk will shifr 10 rhc , indicating a(n) oo Frida)'s.
Ill d. The price of beef falls and, as a rcsulr, consumers
e. Consider the world marker for shipping conraincrs. bu)' more beef and less fish.
If, ceteris parib11s. rhe price of steel (a major input) e. Fears of mercury poisoning lead loc:ils ro shun fish
nscs, the cu1 vc for shipping conraincrs caught in nearby lakes.
wi lI shifr ro rhc , indicaring a(n) f. Ir is generally alleged rhat eating fish is bcncr for
in one's health rhnn e;iring meat.
I. Co nsider the market for hot do11 buns. If, celeris 4. Arc rhc fol lowin11 rwo observations inconsistent?
pari/111s, rhc price of wieners doubles, rhe
curve for hot do14 buns wi ll shift to the _ __ a. Risi ng dcrn:ind for hou~i ng causes prices of new
indie:iting a(n) in _ __ homes ro sonr.
b. Many fami lies refuse ro bL1y homes as prices become
2. The followin11 rablc shows hypoth etica l dcrl1:lnd prohibitive for rhcm.
schedules for sugar for th ree scpa r:ite months. To help
make the distinction between chan14es in demand and 5. Fo1· each of rhc followinA srnrcmcn LS, dcrcrmine
changes in quo miry dc1mndcd, choose rhe word ing ro whether rhcrc has been a change in supp ly or a chanAC
nrnke each of thc following srarcmcnts correct. in quantity supplied. Dr~w :1 dcm~nd-:rnd-supply di:i·
gram for each siruarion ro show cirhcr ~' movcmenr
:ilong the suppli• c11rvc or a shift of the supply curve.
Quanrity Demanded
for Sugar (in kilo11rams) a. The price of Canadi:in-wown peaches skyrockers
Price/kg Ocrober November Decem ber during :in unusua lly cold su111n1cr thot reduces the
$1.50 11 000 size of rhe peach harvesr.
10 500 13 000
b. An incrc:isc in income leads ro an increase in rhe
I. 75 10 000 9 500 12 000
price of fam1ly-rc~1auranr n1cals, and to :in increase
2.00 9 000 8 500 II 000
in rhcir sales.
2.25 8 000 7 500 10000
c. TechnoloAical imp1ovcrnenrs in clecrron1c publish-
2.50 7000 6 500 9 000
ing lead ro price reducrions for c-books and an
2.75 6 000 5 500 8 000 increase in e-book s:iles.
3.00 5 000 4 500 7000 d. A low·c:irb d1er becomes popubr nnd leads ro
3.25 4 000 3 500 6 000 a rcducrion in rh c price of bread and less bread
3.50 3 000 2 500 5 000 being sold.
a. When rhe price of sugar rises from $2.50 to $3.00 6. The following din11ram describes rhe hyporherical
the month of Ocrober rhcrc is :i(n) (111crease/
111 dem:ind and supply for canned run a in Canada 1n 20 13.
decrease) in (de111a11d forlq11a11tity de111a11ded of)
sugar of 2000 ki:. 4.50
b. We co n say that the dc111and curve for suga r in
Dece mber shifrcd (to t/Jc rig/Jt!to the left) of Novcm· - 4.00
bcr's dcn1a11d curve. T his represents a(n) (i11crease/ G J.SO
decrease) in demand for SUA:lr. ~ J.00
c. An increase in th e demand for suga1· means thar I
quantity demanded ar each price has (i11creased! ~0 2.50 I
decreased), while a decrease in dcn1and for suga r c:!. 2.00 I
me.a ns tliar quamir)' demand ed at eac h price has ·~ 1.50 ----1---'------ /)
(i11cm1scdldccrct1sed). 0..
d. In ~he monih of Occcn1bcr, a price change for suga r 1.00
from $3.50 to $2.75 per kilogr:im would mc:in 0.50 I I I
3cl1an11e in (de111a11d forlq11a11tity de111a11ded of)
sugar of 3000 kg. 0 2 J 4 5 6 7 8 'I 10 11 12
e. Plot the duce dem:ind schedules on a gr:iph :ind Quantity (1111llion1 of con•)
label each demand curve to indicarc wherhcr iris rhc
demand for Ocrober, November, or December.

a. Suppose the price of :t c:t11 of cun:t is $4 .00. Wh:tt is these events in the copper market, and explain how e:tch
the quamiry demanded? What is the quanriry sup· event shifts either rhe demand cu rve or the supply cu rve.
plied? At th is price, is there a shortage or a surplus?
10. Consider the world market for wheat. Suppose the1·e
By wl):tt :tmounr?
is a major fa ilure in Russia's wheat crop because of a
b. Suppose rh e price of a can of runa is$ I .SO. What is
severe drou) Ex plain rhe likely effect 011 the equi-
rhe qunnrity demanded? What is rhc qunnrity sup-
librium p1·ice and quantity in rhe wo l'l d wheat marker.
plied? Ar rhis pr·icc, is there :t shonage or a surplus ?
Also explain why Canadian wheat farmers certainly
By whar amounr?
benefit from Russia's droughr. The following diagrams
c. What is the eq ui librium price and qu:tnrity in rhis
provide :.1 sm:ring point for your ana lysis.
s s
7. Co nsider households' demnnd for chicken me:tt. for
each of rhe events listed below, srn tc and ex plain the
likely effect on rhc demand for chicken. How would
each CVClilt be ill ustrated in :t dbgran1?
a. A medical study reports that eating chicken reduces
the likelihood of suffering fron1 particular types of
hearr problems. D
b. A widespread bovine disease leads to an increase in
the pr·icc of bed. Quanciry of Whcac Quo nti ty of Whcac
c. Average household income increases. (thousands of ronnes) (mi llions of to1111es)
Canada Wo,.ld
8. Co nsider the world marker for a pa rticular qua lity of
coffee bea ns. The following table shows the de111:1nd 11. This question requires you to solve a su pply-and-
and supply schedu les for this marker. demand model algeb raicall y. Letting p be t he price of
rhe product, suppose rhe demand and su pply functions
Price Quantity Qu:tntiry for some product arc given by
(per Dcm:tndcd Supplied
kilogram) (m illions of ki lograms per yea r) Q') - 100 3p
$2.00 28 10 Q~ - I 0 ~ 2p
$2.40 26 12 a. Plot both the demand curve and the supply curve.
$3.10 22 13.5 b. Wh:it is the condition for equilibrium in tlhis 111:1rket?
$3.50 19.5 19.5 c. imposi ng rhe condition for equilibrium, sol ve
$3.90 17 22 for the cqui libriun1 price.
$4.30 14.5 23.5 d. Substitute the cqui libriurll price into either the
a. Plot the demand and supply schedules on a diagram. demand or the supply function to solve for the
b. Identify the amount of excess demand or supply equil ibrium quantity. Check to make sure you ger
associ::ned with ench price. rhe same answer whether you use the demand func-
tion or th e supply function.
c. Identi fy the eq uilibrium price in this market.
e. Now suppose there is an increase in demand so
d. Suppose that :t collection of n:ttional governn1ents
that rhe new demand function is given by
we re somehow able to set a minimum price for
coffee equal to $3.90 per kilo)l.ram. F.xplai11 the Q0 = 180 - 3p
outcome in rh c world coffee nur·kct.
Com pure th e new equ ilibrium price and quantity. ls
9. Ea rly in 2,01 1, the world price of copper rc:tchcd a record your· r·esulr consistent wirh the ''law" of demand?
high of over $l0 000 per tonne. Two events :tppcared to f. Now suppose th:lt with the new dem:rnd curve in
lie behind this high price. First, China's rapid econon1ic place, there is an increase in supply so that the new
growth and the massive building of infrastrncrure. supply function is gi ven by Qs .. 90 ~ 2/J. Compute
Second, an explosion closed:\ major Chile:in port used the new equilibrium price :ind quantity. Is you r
for shipping a substantial fraction of the world's copper resu lt consistent with the "law" of supply?
output. Use a demand-and-supply diaw-am to illustrate

After studying this chapter you will be able to

4.1 PRICE ELASTICITY OF DEMAND 1 explain what pri ce elasticity of demand is and how it is
2 explain the relationship between total expenditure and
price elasticity of demand.

4.2 PRICE ELASTICITY OF SUPPLY 3 explain what price elasticity of supply is and how it is

4.3 AN IMPORTANT EXAMP LE WH ERE ELASTI CITY MATTERS 4 see how elasticity of demand and supply determine the
effects of an excise tax.

4.4 OTHER DEMAND ELASTICITIES 5 measure the income elasticity of demand and be able to
distinguish between normal and inferior goods.
6 measure cross elasticity of demand and be able to distin-
guish between substitute and complement goods.

THElaws of demand and supply predicr rhe clirecrion of of oil led to an immediate increase in the world pric:c,
changes in eqllilibrillm price and qllantity in response from $'100 co $120 per ba rrel, which persisted llnci l
co various shifrs in demand and supply curves. For Libya's production returned co more normal levels
ma ny purposes, however, it is not enough to know after the end of the civil war. How can we explai n
merely wherher price and qua nriry rise or fall; ir is also why the increase in rhe price of oil in chis situation
important to know by how muc:h each changes. was 20 percent rather tha n .50 percent or only .5 per-
ror example, during rhe 20 11 civil war in Libya, cent? As we will see in chis chapter, rhe shapes of che
that counny's oil production was sharply reduced fo r de mand and supply curves determine the sensitivity
over six months. As a result, global oil production of prices and quancities co various economic shocks.
fell by over 1.5 million barrels per day, a decline of Precise measures of rhese sensitivities are provided by
just unde r 2 percent. This drop in the wo rld supply what are called the elasticity of demand and supply.

I 4.1 Price Elasticity of Demand

Suppose chere is a decrease in clhe supply uf sume fa rm crup-chac is, a lefrward shifr
in che supply curve. We saw in Figure 3-8 (see page 72) when we examined the laws
of supply and de mand that such a dec rease in supply will cause the equilibrium price
ru rise and the equilibrium qua11city cu fo ll. Bue by huw much will each change? The
answer depends on whac is called the price elasticity of demand.
Loosely speaking, demand is said co be elastic when quantity de manded is quite
responsive ru changes in price. When qua ntity demanded is relatively un responsive cu
dianges in price, dema nd is said co be inelastic.
The importance of elasticity is ill ustrated in Figure 4-'l. The two parts of the fig-
ure have che same initial equil ibrium, and rhac equili brium is disturbed by che same
leftward shi ft in che supply curve. Bur che demand curves are different in rhe rwo
parts of the figure, and so rhe sizes of the changes in equilibrium price ancl quantity
are alsu different.
Parr (i) of rigure 4-1 illusrr·a[es a case in which che quanriry char consumers demand
is quire responsive to price changes-chat is, demand is relatively elastic. The reduction
in supply pushes up che price, buc because rhe quantity demanded is qui re responsive co
changes in price (demand is elastic), only a small change in price is necessary to restore

FIGURE 4-1 The Effects of a Supply Shift with Two Different Demand Curves


Quantity Qunmity
(i) Relatively el astic dema nd (ii} Relatively inelastic demand

The more 1·esponsive the quanti1y demanded is to changes in pr·ke, 1hc less the change in equililll'ium price and the
greater the change in equilibrium quantity resulting fro m any given shift in the supply cmve. Boch pal'fs of rhc figure
arc drawn to chc sa me scale. They show the same inicia) equil ibri um, E0, and che same shifc in the supply curve, from
50 to S1• In each pa rt, initial equi libri um is at price Po and output Qo an d the new equi libri um, Ei. is at µ 1 and Q 1•
In part (i}, th e effect of the reduction in supply is a slight rise in the price and a large decrease in quantity. In part (i i),
the effect of the identica l reduction in supply is a large increase in th e price and a relatively srnall decrease in quantity.

Part (ii) of Figure 4· ·1 shows a case in whid1 the quantity dema nded is quite
unresponsive to price changes-that is, dema nd is relMivcly inelastic. As in part (i), the
decrease in suppl)' ac che origi11al price causes a shorcage char increases che price. How·
ever, in this case the qua ntity dema nded by consumers does not fall much in response
to the rise in price (demand is inelastic). The result is clhat equilibri um price rises more,
a11d equilii brium qua11Cicy fa lls less, chan in rhe fim case.
In both cases shown in Figure 4 . ·1, the shifts of the supply curve are identical. The
sizes of the effects on the equilibrium price and quantit)' arc different onl)' because of
che differenr elasriciries of demand.

The Measurement of Price Elasticity

In Figure 4-1, we were able cu say char rhe demand curve in pan (i) showed more
respo nsiveness co price changes rhan rhe demand curve in part (ii) because two condi·
tions were fulfilled. First, both curves were drawn on the same scale. Second, the initial
equilibrium prices and quanriries were che same in both parts of the figure. Lee's see
why chese conditions matter.
First, by drawi ng borh Figures on the same scale, we saw that the de mand curve
char looki;d sceeper actually did have che larger absoluce slope. (The slope of a demand
curve tells us the amount by which price must change to cause a unit change in quanrity
dema nded.) If we had drawn the two curves on diffe rent scales, we could have con·
eluded 11uthi11g abouc which demand curve actually had the greacer slope.
Second, because we scarred from the same price-quantity equilibrium in both parts
of the figure, we did nor need to distinguish between percentage changes and ahsolute
changes. [f rhe initial prices and quanriries are rhe same i11 borh cases, rhe larger abso·
lute change is also che larger percencage change. However, when we wane ro deal with
different initial price-quantity equilibria, we need to decide whether we arc intercscccl
in absolure or perce11tage changes.
To see why rhe difference becween absolme and percentage change marcers, con·
sider the changes in price and qua ntity demanded fo r three different products: cheese,
T-shirrs, and coffee machines.The information is shown
in Table 4.·1. Should we conclude char the demand for
coffee machines is not as responsive to price changes
TABLE 4·1 Price Reductions and Corresponding
as rhe demand for cheese? After all, price curs of $2 Increases In Quantity Demanded for
cause quire a large increase in die quamiry of cheese
Three Products
demanded, but only a small increase in the quantity
demanded of coffee machines. Ir should be obvious rhar
Inc rease in
a $2 price reduction is a large price cur for a low-priced Quanriry
product and an insignificant price cut for a high-priced Reduction Demanded
produce. nn Table 4-1, each price reduction is $2, bm Commod ity in Price (per monrh)
they are c:learly differenr proportions of the respecti ve
Cheese $2 per kilogram 7500 kilograms
prices. It is usuall)' more revealing to know the /)erce11t· T-sliirts $2 per shirr 25 000 shires
age change in the prices of rhe various products. Coffee machines $2 per m:ich inc 500 m:ich incs
for similar reasons, knowing che quanciry by
which dema nd changes is not very revealing unless For each of the three prnducts, the data show the change
the initial level of demand is also known. An increase in quantity demanded resulting from the same absolute
fall in price. The dat:t arc fairl y un informative about the
of 7500 kilogra ms is quite a significam change if che responsiveness of quantity demanded to prrice because
quantity fo rmerly bought was 15 000 kilogra ms, but they do not tel l us either the original price or the original
ic is insignificanc if che quantity formerly boughr was quantiry demanded.
-io miIlion kilograms.

TABLE 4·2 Price and Quantity Information Underlying Data ofTable 4· 1

Original New Ave rage Origi nal New Average

Product Unit Price ($) Price($) Price ($) Quantity Qu:inriry Quantity
Cheese kilogram 5.00 3.00 4.00 116 250 123 750 120 000
T-shirts shirt 17.00 15.00 16.00 187 500 2 12 500 200 000
Coffee mach ines machine 8 1.00 79.00 80.00 9 750 10 250 10 000
These data provide the appropriate context for the data given in Table 4-1. The t::1ble rcl:ms the $2-per·unit price
reduction uf each product ro the actual prices and quantities den1ancled.

Table 4-2 shows the original and new levels of price and quantity. Note chat it also
shuws che average price and average quantity. These averages will be necessar)' fur uur cum-
pucacion of elascicicy.
prlco clastlclty of d•mand (•J) The price elasticity of demand, che measure of responsiveness of the quanrit)' of a
A mcesvrc of the pwducr demanded cu a change i11 chat product's price, is symbolized by rhe Greek letter
responsiveness of Quentlty
demende<J to a change In tile
eta, 'I). Tc is defined as follows:
commodity's own p!loo.
Percentage change in quantity demanded
'I) = Percenrage change in price
This measure is called che price elasricicy of demand, or simply demand elascicicy.
Because rhe variable causing rh e change in quanriry demanded is rhe product's own
price, che term own-price elaslic.ity of demand is also used.
The Use of Average Price and Quantity in Computing Elasticity Table 4-3 shows che
percentage changes fur price and quantity using the data fro m Table 4-2. The caption
in Table 4-3 srresses char che demand elasricicies are compured by using changes in
price and quantity measured in te rms of the average values of each. Averages are used
co avoid the ambiguity caused by the fact that
when a price ur quantity changes, the change is
TABLE 4·3 Calculation of Demand Elasticities a different percentage of che original value than
it is of the new value. rur example, the $2.00
(I ) (2) (3) change in rhe price of cheese shown in Table 4-2
Pcrccnt:tgc Percentage FJascicity rep resents a 40 percent change in the original
Decrease in Increase in of Demand price qf $5 .00 but a 66.7 percent change in the
Product Price Quanriry (2} + ( 1) new price of $3.00.
Cheese 50.0 6.25 0.1 25
Using average values for price and quantity
T-shins 12.5 12.5 1.0 means chat the measured clascicicy of demand
Coffee machines 2..5 .5.0 2.0 berween any rwo poinrs on rhe demand curve,
call chem A and B, is indepe nde nt of whether
Elasticity of demand is the percenta11e change in quantity the movement is from J\ to B or from B co A. Tn
demanded divided by the percentage change in price. The che example of cheese in Table 4-2 and 4-3, che
percentage changes arc based on average prices and quanti-
ties shown in Ta ble 4-2. For example, rhe $2.00-per-kilogram
$2.00 change in the price of cheese is unambigu-
decrease in the price of cheese is 50 percent of rhe average ously 50 percent of the average price of $4.00,
price $4.00. A $2.00 change in rhe price of coffee machines is and rhar percencage applies co a price increase
only 2.5 pcrcem of th e average price per mach ine of $80.00. from $3.00 to $5.00 or co a price decrease from
$5.00 co $3.00.

Once we have computed the average prices and quantities as in Table 4·2, the alge·
braic formula for price elasticity is straightforward. Suppose we have an initial price of
Po and an ini tial qua ncit>' of Qo. We then consider a new price of p 1 and a new quantity
of Q1 (both price-quantity combinations lie on the demand curve for the product). The
fo rmula for price elasticit>' is then

~Q Q1 - Qo

11 = -
~p Pi - Po
p p

where 75 is the average price and Q is the average quantity. Jn the case of cheese from
Table 4·2, we have

7500/120 000 0.0625

11 = 2.0/ 4.0- = 0.5 = 0· 125

as shuwn in Table 4-3. Notice chac elascicicy is 1111it free- even chuugh prices are meas·
ured in dollars and quantity of cheese is measured in kilograms, the elasticity of demand
has no units.
We leave it cu yo u cu use chis formula cu confirm che price elascicicies fu r T-shirts
and coffee machines shown in Table 4·3. [7]

Interpreting Numerical Elasticities Because de mand curves have negacive slopes, an

increase in price is associated with a decrease in qua mity demanded, and vice versa.
Because che percenrage changes in price and quanciL ] ' have opposite signs, de ma11d elas-
cicicy is a negacive number. However, here we will ignore che negative sign and speak
of the measure as a positive number, as we have done ·in the illustrative calculations in
Table 4-3. Thus, che more responsive che quan ricy demanded co a change in price, rhe
grearer che elascicicy and che larger is 17.
The numerical value of demand elasticity can va ry from zero to infini ty. First con-
sider che excreme cases. Elascicicy is zero when a change in price leads co 110 change
in quanri ry demanded. This is che case of a vercical demand curve, and ic is qui re rare
because ic indicates chat consumers do nm alter their consumption at all when price
changes. Ac che ocher exrreme, elascicicy is very large whe11 even a very small change
in price leads co an enormous change in quanricy demanded. In chese sicuacions, rhe
de mand curve is very fl at, almost horizontal. (Jn die ra re limidng case, die de mand
curve is perfeccly horizo11cal and elasriciry is i11 fi nice.) Mose of realicy lies berween rhe
excremes of vertical and horizontal demand curves. We divide this "realistic" range of
lnelastfc demand Following a
elasticities into two regions. given percentage change inprice,
When rhe percenrage change in quanciry demanded is less rhan che percentage there Is a smaller percentaee
change in price (elasticity less than 1), chere is said to be inelastic demand . When the change In QuantltY demanded;
percentage change in quantity is greater than the percentage change in price (elasticity clasticltY lcss 11\an 1.
greacer chan 1), chere is said cu be elastic demand. The dividing line becween chese cwu elastic demand Following
cases ocCL1rs when the percentage change in qua ncicy demanded is exaccly equal co the a given percenta![ll change
In price. there is a greater
percentage change in price, and so elasticity is equal to 1. Here we say that de mand
11ercenuige change in QuantilY
is unit elastic. This imporca11c cerminulugy is summarized in pare A uf Extensions in demanded; elasticltv greater
Theory 4-2, which is fou nd on page 96. than 1.

FIGURE 4·2 Elasticity Along a Linear Demand Curve


11 /\~= l\Q/Q= IO/lO = S

I A11/p 2110
9 _L __ fl
8 I
::'.!. 7 - 1- - - T - - ~=l\Q/~= 1 0/JO = I
.~ I I I AfJ/p 2/6
.,_ 6 I I I
5 _1 ___ .J.._ --1-- - D
4 I I
3 I - r- - ·~·AQ/~• l0/50 • O.l
I IAf1/11 2/2
_ 1___ T _
I r
- -1- - - +-- - 1- - - ,

0 5 10 15 20 25 30 35 40 45 50 55 60
Qun11 riry DemanJeJ

Moving down a linear demand curve, price clasti cily foil s coniinuonsly, even though the
slope is cons1an1. In the in terva l between poi nts A and B, the percenrnge change irn quan·
tiry is I 00 (6Q = IO and Q = I 0) and the pe1·cencage change in pl'ice is 20 (6p - 2 and
7i - 10). The pl'ice elasriciry over rhis in terva l of the demand curve is then 100/ 20 - 5.
The same absolute changes ·in price and quantity occur over the inrcrvals CD an d EF.
but cb sticiry differs beca use rhese absolme changes represent di fferent pe rcentage chan·
i;cs. Between points C and D, price elasticity is equal to I. Between points E and 1; price
elasticity is equal co 0.2. Note ch at elasticity approaches infinity as we get closer to where
the demand curve intersects the vertical axis; elasticity approaches iero as we p.ct closer to
where the demand curve intersects the horizomal axis.

A demand curve need nor, and usually does nor, have che same elasciciry over ics
whole lengch. Figure 4-2 shows char a negacively sloped linear demand curve does nor
have a constant elasticity, even though it docs have a constant slope. A linca r demand
curve has conscanc elascicicy only when ic is venical ur horizoncal. Figure 4-3 illuscraces
chese two cases, in addicion to a chi rd case of a panicular 11011-linear demand curve char
also has a constant clascicicy.

What Determines Elasticity of Demand?

Elascicicy of demand is moscly decermined by che availability of substitutes and che time
period under consideracion.
Availability of Substitutes Some products, such as margarine, broccoli, Dell PCs, and
Toyota cars, have quite close substitutes- butter, other green vegetables, Toshiba PCs,
a11d Mazda cars. A change in the price of these products, with the prices of the sub-
stitutes remaining constant, ca111 be expecced co cause much substiwcion. A fa ll in

prii;e leads consumers to buy more of the product

and less of the substitutes, and a rise in price leads FIGURE 4-3 Three Demand Curves with
cunsurners tu buy less of the pruducr and rnure uf the Constant Elasticity
A rel aced point concerns product definition. o, (11=0)
Pruducrs defined mure broadly, such as all fouds ur
all i;lothi 111g or all methods of transpo rtatio n, have
ma ny fewe r satisfacwry substitutes tha n do prod-
ucts defined much more narrowly. A rise in their
prices i;a11 be expected ro .;a use a smaller fa 11 in ...
~ /'o
quantities demanded than wnuld be the case if close
subsricures were available. Fur example, rhere are
far more substitutes for Diet Pepsi tha n there are
for the broader categories of diet colas, soft drinks,
or all beverages. As a res ulr, rhe demand elasricicy
for Diet Pepsi is signifi cantly higher than for bever- 0 Qo
ages overall. Q uantity

Each of these demand curves has a conmint clas1icity.

Products with close substitutes tend to have D·1 has zero clnsticity: The quantity demanded is equal
elastic demands; products with no dose suhsti- to Qo, independent of the price. D2 has infinite elasticity
at the price Po: A small price incrense fron1 Po decreases
ll1tcs tend to have inelastic demands. Narrowly quantity demanded fron1 an indefinitely large amount to
defined products have more elastic demands zero. D; has unit clasticiry: A given percenragc increase
than do more broadl y defined products. in p1·ice brings an equal percencage decrease in quanricy
demanded at all points on the curve; it is a rccrangular
hyperbola for wh ich price rimes quantity demanded is
a constnnt.
Short Run and Long Run Demand elasticiry also depe nds
cu n grear extenc on che rime period being considered.
Because it cakes time to develop satisfactory substitu tes, a demand that is inelastic
in the short run may prove to be elastic when enough time has passed. A dra matic
example of rhis principle occurred in 1973 when che Organizacion of che Pecroleum
Exporting Countries (OPEC) shocked the world with its sudden and large increase in
the price of oil. At that time, the sho rt-run dema nd for oil proved to be highly inelastic.
Large price increases were mec in che shore ru n by very small reducrions in quanciry
demanded. Tn this case, the sho re run lasted for seve ral years. Gradually, however, the
high price of oil led to such adjustme nts as the development of smaller, more fue l-
efficienc cars, economizing on hearing oil by install ing more efficient insulariun, and
replai;ing fuel oil in many industrial processes with ocher power sources, such as coal
and hydroelectricity. The long-run elasticity of de mand, relating the change in price to
the change in quanricy demanded after all adjustmenrs were made, turned our ro have
an elasti<.:ity of mud1 more than ·1, altho ugh the long-ru n adj ustments took as mud1 as
a decade to work out. 1

Note that rhe dramatic increase in the world price of oil that occurred between 2002 and 2008, as wel l as
the even more dramatic decline from 2008 co 2009, docs not illustrate the same points about the elasticity
o( demand for oil ns th< OPEC-rdnw.J events from th< 1970s. In the earlier period, th< dominant ec:o110mic
shocks were (OPEC-induced) shil'cs in the suppl)' of oil which led to movement along n more-or-less stable
demand curve. l'rorn 2002 rn 2009, in contrast, rhe dominant shocks were changes in the world demnnd for
oil t1nd thus movemems along a more-or-less srnble supply nirve.

The res ponse to a price change, and tlm~ the 111easu1·ed price elas-
cicicy of demand, will tend co be greater the longer the time span.

For products for which substitutes only develop over [ime, it is

helpful co idenci fy two kinds of demand curves. A short-mn demand
curve shows the immediate response of quantity demanded co a change
in price. The /o11g-mn dema11d curve shows the response of quantit)'
demanded cu a change in price afrer enough rime has passed ru develop
or switch co substiwte products.
Figure 4-4 shuws the short-run and long-run effects of an i11creasc in
Because most people cm111ot ensi/y or supply. In the short run, the supply increase leads cu a movement down
c111ickly change the size of car 1hey drive
or 1heir 111elf1od of tra11sportcllio11, 1he the relatively inelastic short·rnn demand i;urve; ic thus 1.:auses a large fall
de111a11d for gasoline is much less elastic i11 in price but onl y a small increase in quantity. In the long run, demand
the short rtm than in the long run. is more elastic; thus long-run equili brium has price and quan ri ty above
those chat prevail ed in short-run equili brium.

RGURE 4·4 Short-Run and Long-Run Elasticity and Total Expenditure

Equilibrium Following an
Increase In Supply We know chat quantity demanded i11creases as price falls,
but what happe ns to the total expenditure on char product?
Tt cums out that che response of total expenditure depe nds
on the price elasriciry of demand.
To see rhe relationship berween the elasricit)' of
demand and weal expenditure, we begin by nQting chat
coral expenditure at any poinc on rhe demand curve is equal
ro price rimes quanri ry:

Total expenditure = Price x Quantity

Bei;ause prii;e and quantity move in opposite di rections

along a dema nd curve, the diange in total expenditure is
0 QoQs Q, ambiguous if all we know abo ut rhe demand cu1've is rhat
Quantity ic has a negarive slope. The change in roral ex:pendimre
The magnitude of the changes in the equilib- depends on the relative i;hanges in the price and quanti cy.
rium price and quantity following a shift in sup- As an example, consider a price decline of I 0 percent. If
ply depends on the time allowed for demand to quanri cy dema nded rises by more rha n lO percem (elastic
adjust. The initial equilibrium is at Eo, with price dema nd), then the quantity change will dominate and total
Po and qu~rntity Qo. Supply then increases and
expenditure will rise. In contrast, if quantity demanded
the supply curve shifrs fru111 So to SI·
l111n1cdiately followi ng the increase in sup· increases by less rhan 10 percent (inelas tic demand), rhen
ply, the rel eva nt demand curve is rhe shon-run the price diange will dominate and tota l expenditure will
cu1·vc Os, :and the new equilibrium immediatel y fa ll. If quanriry demanded increases by exacrl y ·1 0 percent
followi ng the supply shock is £5. Price fal ls (unic elastic demand), then the two percentage changes
sharply co PS· and quanciry rises only to Qs. In exactl y offset each other and total expenditure will remain
the long run, the demand curve is the more elastic
one given by D1., and equi libriu m is at l-t. The unchanged.
long-run equilibrium price is PL (greater than Ps), Vigure 4-5 illustrates rhe relationship between elasti·
and qu anci t)' is Q1, (Jl,rca tcr than Q5 ). city and total expendiwre; it is based on the linear demand
curve in Figure 4-2. Tomi expendiru re at ead1 of a number

FIGURE 4·5 Total Expenditure and Quantity Demanded

Price($) Quantity Demanded Expenditure($)

12 ~
1 () demand: ,, > J

12 0 0 8 , /Unit clastk demand: '1 = I

10 10 100 ~ ~""
8 20 160 ·~ 6
6 30 180 ?<-
4 40 160
2 50 100 2
0 60 0 Oe ma11d
() I0 20 JO 40 50 60 Quantity
I Demanded
The change in wtal expenditure on a product in I
response lO a change in price depends on 1he elasli- I
city of demand. The table and graph are based on the I
Elastic I Inelastic
demand curve shown in Figure 4-2. For qu:u1ritics
demanded rhar arc less rhan 30, clasriciry of demand ... de mand: ,, > 1I dema nd: 'l < I
El 200 I
is grea ter than I, and hence any increase in quantity :;;;
demanded will be proportionately larger than the fa ll
in price that caused it. In char range, roral expenditure ~ 150
"E" 100
increases as price fal ls. For quantities greater than
30, elasticity of demand is less than I, and hence any
incrcast in quantity demanded wi ll be proportion - i.:: 50
ate ly sma ll er· rh:in the fal l in price rh:ir c:iused it. In
that range, tota l expenditure decreases as price falls.
The maximum of tota l expenditu re occu rs whe re rhc 0 J0 20 JO 40 50 60 Quan city
elasticity of demand equa ls l. Dcma11dcd

of points on the dema nd curve is calculated in the table, and the ge neral re lationshi p For information on OPEC and its
8Ctivities, see I\.
between total expenditure and quantit)' dema nded is shown b)' che plotted curve. Tn che
figure we see char expenditure reaches irs maximum whe n elascicicy is equal co ·1. [SJ
Our earlier example of the '1973 O PF.C·induced increase in the world price of oil
can be used to ill ustrate this re lationship between elas cicit)', price, and tota l expendi-
cure. As che OPEC countries acred cogecher co resrricr supply and push up rhe world
price of oil, qua ntity demanded fell, but only by a small percentage- much smaller than
the percentage increase in price. World dema nd fo r oul (at lease in the shore ru n) was
very inelascic, and rhe resulc was char coral expendirure on oil increased dramatically.
T he OPEC oil producers, the refore, experienced an eno rmous increase in income.
The W<Jrlcl wheat market pr<Jvidcs another example. This market is srnmgly infl u-
enced by wearher condirions in rhe major whear-producing commies. If one major
wheat-producing coun try, like Russia, suffers a significant failu re in its wheat crop,
the world supply curve fo r wheat shifts to che left and the equ ili brium world price
rises. Because rhe wol'ld demand for wheac is inelasric, rhe world's coral expendicllt'e on
wheat wil I rise. Tn chis case, even though many individual Russian wheat producers will
be W<J rse off because their crop failed, the total inrnmc of the world's wheat producers
will incl'ease. One ocher observation is releva nt: Wheac producers in orher co uml'ies,
like Canada, benefit by selling thei r (u nchanged) crop at a higher world price. And the

less elastic the world dema nd fo r wheat, the more the price will rise as a res ult of the
Russian crop fa ilure, and thus the more Canadia n wheat farme rs will benefit.

I 4.2 Price Elasticity of Supply

1>rloe elastlclty of supply ('ls) The concepr of elasriciry can be applied co supply as well as co demand. Price elasticity
A moasuru ul !ho of supply measures the responsiveness of the quantity supplied to a change in the prod·
rcsponslVtmcss ol ~uanUty
supplied lo a change in !he
ucr's price. Ir is dcnored 7/s and c.lcfined as follows:
product's own price.
Pcrcc11tage change in qua ntity supplied
tJ =
s Percentage change in price

This is often called suf;p/y elasticity. The supply curves considered in this chapter
all have posirive slopes: An increase in price causes an increase in qua nriry supplied.
Such supply curves all have positive elasticities because price and quantity change in
the same direction.
Figure 4-6 shows a simple linear supply curve co illusrrare rhe measuremenr of sup-
ply elasticity. Between points A and B, the change in price is $ '1.50 and the average price
is $4.25. Between the same two points, the change in
quantity supplied is 20 unirs and rhe average quan-
ti ty is 40 units. The value of supply elasticity between
ROURE 4·6 Computing Price Elasticity of Supply points J\ and B is therefore

'ls = dQI~ = =~ = I .4 l !::iQ/Q 20/40 0.5

7 10/40 71s - -~P/1;- = 1.50/4.2.5 - 0.353 = 1. 42
~pip l.~0/4.25 0.35.3 s
As was che case wich dema nd, care must be caken
5 -----~ f~ when computing supply elasticity. Keep in mind that
;;; even rhuugh rhe supply curve may have a consranr
" .3.5 I
.lit slope, rhe measure of supply elasticity may be differ-

.3 I
I ent at diffe rent places on the curve. When ris > ·1, sup·
l I pl)' is said to be elastic:; when ris < I, supply is said tQ
I be inelastic.
I Some important special cases need to be noted.
If the supply curve is ve rtica l-the quantity supplied
0 10 20 JO 40 so 60 does nor cha11ge as price changes-chen elasticiry of
Quanricy Supplied supply is zero. A ho rizonta l supply curve has an infin-
ite elasticity of supply: There is one critica l price at
Suppl y elasti city is computed using average price and which ourpur is supplied bur where a small drop in
average quantity supplied. Between points I\ and 8, th e
elasticity of supply is 1.42. The sa me approach shown price will reduce the quantity that producers are will-
here can be used ro compute elasticity between any two ing to supply from an indefinitely large amou nt co
poincs on t he supply Clll've. zero. Between rhese rwo extremes, elasticiry of supply
va ries with the shape of the supply curve. 2

2 Here is a11<lChcr special case that is ofttn puzzlini; ar fi rst glance. Co11sidcr a linear su1>ply curve: rhnc hcgins
nr th< origin. It is easy m show that th< elasticity of supply along such a curve is always l - 110 matter how
steep the supply ~urve is! See Study Exert•ise # I 0 on page J0 I to explore this further.

Determinants of Supply Elasticity

Recause much of the treatment of demand elasticity ca rries over to supply elascicicy, we
can cover the main poinrs quickly.
Substitution and Production Costs The case of subsricuticm can va ry in production as
well as in consumption. If the price of a product rises, how much more can be pro-
dm:ed profitably? This depends in part on how easy it is for prodm:ers to shift fro m
the produ.ccion of ocher products co che one whose pri ce has risen. If agricultu ral land
and labo ur can be readily shi fted from whear cu canula, fur example, the suppl)' of each
crop will be more elastic than if they cannot. Or if a facto ry that produces snowmobiles
can easily be refitted co produce Jct Skis, then the supply of each product will be mo re
elastic tha11 if the factory and equipme11t could nor be easily modi fied.
Supply elasticity also depends on how costs behave as out-
put is varied. Jf rhe costs of producing a unit of output rise
rapidly as output rises, rhen rhe stimulus tu expand produc-
tio n in response to a rise in price will quickly be choked off RGURE 4·7 Short-Run and Long-Run
b)' increases in coses. Jn this case, supply will tend t<J be rather Equilibrium Following an
inelastic. Jf, however, the cosrs of producing a u11i t of output Increase in Demand
rise only slowly as production increases, a rise in price chat
raises profics will elicit a large increase in quantity s upplied
before ehe rise in coses puts a hale co che expansion in output.
ln this case, suppl y will te nd to be rather elastic.
Short Run and Long Run As wirh demand, length of ri me for /is
response is importa nt. Tc may be difficult to change quantity
supplied in response cu a price increase in a matter of weeks
or months buc easy co do so over years. An obvious example
relates to oil production. New oil fie lds can be discovered,
wells drilled, and pipelines built over years bur nor in a few
months. T hus, the elasticity of oil supply is much greater over
five year~ than over one yea r.
As with demand, it is useful tu make rhe distinction between
the shore-run and rhe long-run supply curves. The short-nm sup-
ply curve shows the immediate response of quantit)' supplied 0 Q,
tu a cha11ge in price given produce1·s' current capacit}' tu pw-
duce the good. The long-run supply curve shows rhe response The siie of the changes in the cquili b·
of quanri t)' supplied w a change in price after enough cime has rium price and quantity following a shift in
passed ru allow producers ru adj ust their productive capacity. demand depend s on the rime frame of the
analysis. The initial equilibrium is ar E0,
with p1·icc Po and quantity Q0 . Demand then
increases such that the demand curve shifts
The long-run supply for a product is more elastic rhan rhe from Do to D I·
short-run supply. Immediately fol lowing the demand shift,
the relevant supply curve is the short-run
curve Ss. so thar the new equilibrium immedi·
Figure 4-7 illumaces ehe short-run and long-run effects :11cly following rh c demand shocl< is at E5.
of an increase in demand. The immediate effect of the shift in Price rises sharpl)' ro p5, and quanriry 1·iscs
<)nly to Qs. In rhc lt)ng rnn, rhc supply curve
demand is a sharp increase in price (Po to Ps) and only a modest is the more elastic one given by S1,. The long·
increase in quamiry (Qo co Qs). The inabilicy of firms co change run equilibrium is at £1,; price is p1, (less than
their productive capacity in the short run in response to the Ps) and quantity is Qi, (greater than Qs).
increase in demand means char rhe marker-clearing res ponse is

mostly an increase in price. Over time, however, as Firms are more able to irn,;rease their
capacity, the consequences of the demand shi ft fa ll more on quantity and less on price.
A recent example of chis price and quancicy behaviour is found in che worlcl oil mar-
ket in the years between ·1~98 an1d 2008. Recause of relatively rapid rates of economic
gwwrh in many cuunrries, and especially i11 rhe large emerging markers uf China and
India, che world demand for oil was growing significancly. During chis period, however,
most oil producers were ac or close to cheir produccion limits: The number of oil-produ-
cing wells could increase only wirh coscly new exploracion and drilling, and each acrive
well delivered a daily flow of oil rhac was difficulr ro increase. Producers' inabiliry co
easily expand oil production in che short term means char che short-run supply of oil
is qui re inelastic. As a resul r, rhe increase in demand led ru sharp price increases-from
abour U.S.$'15 per barrel in 1998 ro jusr under U.S.$150 per barrel in micl-2008.
Over time, howeve1; co the extent chat oil producers are able co increase their
explorarion and drilling accivicies, rhe high price should induce a larger increase in
quanriry supplied. In ocher words, rhe long-run supply of oil can be expecced co be more
elastic than the shore-run supply. Tf no other significant changes occur in the world oil
marker, rhe effecr of rhis new oil production should be co reduce oil prices from rhe very
high levels observed in 2008. (As ic curned our, che price dropped sharply in lace 2008
because of the onset of a major world recession, bur since then prices have risen again,
rh uugh nur ru rhe very high levels observed in 2008.)

4.3 An Important Example Where

Elasticity Matters

So far, chis chapter may have seemed fa irl)1 cough going. We have spent much time
examining price elasciciry (uf burh demand and supply) and huw cu measDre ir. Bur
why should we care about this? Tn this section, we explore the important concept of
tax incidc11cc and show chat cla scicity is crucial to determining whether consumers or
producers (or burh) end up bearing che burden of excise raxes.
The federal and provincial governments in Canada levy special sales taxes called
excise tax A tax on the sale of a excise taxes Qn many go<Jds, such as cigarettes, alcohol, and gasoline. Ac chc point of
partlc11lar commodl'ty. sale uf che produce, che sellers collecr che rax un behalf uf che government and rhen
remit the tax collections. When the sellers write their cheques to the government, these
firms feel chat they arc the ones paying the whole tax. Consumers, however, argue that
they are che ones who are shouldering che bmde11 uf che cax because rhe tax causes che
price of the product to rise. Who actually bears the burde n of the tax?
tax Incidence The location of The question of who bears the burden of a tax is ca llcd the question of tax incidence.
the hurden of a wx-that Is, the A scraighrforward application of demand-and-supply analysis will show char cax inci-
Identity of the uldm:ate bearer
ol lhe tax.
dence has nothing to do with whether the government collects the rax directly from
consumers or from firms.

The burden of an excise cax is distributed berween consumers and sellers in a man-
ner char depends on the relative elasticities of supply and demand.

Lee's consider a case where the governmem imposes an excise tax on cigarettes.
The analysis begins in Figure 4-8. To simplify the problem, we analyze the case where

there is initially no ta x. The equilibrium without taxes

is ill ustrated by the solid supply and demand curves. AGURE 4·8 The Effect of a Cigarette Excise Tax
What happe11s whe11 a tax of t dollars per pack of ciga-
rettes is introduced? With an excise ta x, the price paid
b)' the cons umc1~ called che consmner price, and the
price ultimately received by rhe seller, called the seller .....,
price, must differ by the amount of the tax, t. :..
In ter ms of the figure, we can anal)'ZC the effect of & ''"
the cax by considering a new supply curve S' chat is "'
above the original supply curve S by the amount of the
5 /'o
ta x, l'. Th is reduction in suppl)', caused by the impos- ~
ition of the excise tax, will cause a movement along ~

0 P,
the demand curve, reducing the equilibrium quantity. "u
Ar this new equilibrium, E 1, the consumer price rises to
p, (grea[Ct" rhan p0 ), rhe seller price falls co Ps (less rhan
p0), and [he equilibrium quanti ty falls co Q 1. Notice
that the difference between the consumer price and the 0
seller price is exaccly the amount of the excise rax, t.
Note also that the qua nti ty demanded at the con- Pttl'ks of Cignrecies
sumer p rice is equal to the quantity supplied at the seller
price, a condition chat is required for equilibrium . As The burden of an excise tax is shared by consumers
and producers. The original sup ply and demand curves
shown in the figure, compared with the original equi • fo r cigarettes arc given by the solid lines Sand D; cqui·
libri um, the consumer price is higher and the seller price librium is at Eo with price Po and quantit)' Qo. When
is lower, although in each case the change in price is an excise tax of l per pack is im posed, th e suppl y curve
less tha n the fu ll extent of the excise tax. The difference shifrs up ro the dashed line S', which lies above rhe
between /JO and Pc is the amoun t of the tax that the con- Miginal supply cu1·vc by rhc ;imounr of the rax, 1. The
new equili brium is ;it E1• The tax increases the con·
sumer ends up paying; the difference between Po and Ps sumer price but by less than the full am ount of th e tax,
is the amo unt of the tax the seller ends up paying. The an d reduces the seller price, also by less than the full
burden of the excise tax is shared between consumers amoum of the tax. The tax also reduces t he equilib-
and sellers in proportion co rhe rise in price co consum- rium quantity exchanged.
ers relative to the fall in price received by sellers.

After the imposition of an excise tax, the difference hctwecn the consumer and seller
prices is equal to the tax. In the new equilibrium, the quan tity exchanged is less than
that exchanged before the imposition of the tax.

The role of the relative elasticities of supply and demand in determining the inci-
de nce of die excise cax is illustrated in Figure 4-9. In pare (i), de mand is inelastic rela-
ti ve to supply; as a result, the fall in quantity is quite small, whereas the price paid by
consumers rises by a Imost the fuII extent of the ta x. Because neither the price received
by sellers nor the quamity sold changes very much, sellers bear litcle of the burden of
the tax. In part (ii), supply is inelastic relative to de mand; in this case, consumers can
more easily substitu te away fro m cigarettes. There is little change in the price, and
hence they bear little of the burden of the cax, which fa lls mostly on suppliers. Notice
in Figure 4-9 that the size of the upward shift in supply is the same in the two cases,
indicati ng the same tax in both cases.

\'\lhen demand is inelastic relative to supply, consumers bear most of the hurdcn of excise
rnxcs. When supply is inelastic rclarivc to demand, prod uccrs bear most of chc burden.

AGURE 4 ·9 Elasticity and the Incidence of an Excise Tax

s !!
v fJr

0 Q , Qo
0 Q, Qo
Packs of Cigarettes Packs of Cigarctccs
(i) Inelastic demnnd, elastic supply (ii) Inelastic supply, elastic demand

The distribution of the burden of an excise tax between consumers and producers depends on the relative elasticities of
supply and demand. In both parts of the figwc, th e initial supply and demand curves arc given by Sand D; th e initial
equ ilibrium is at F.0 with equi librium price Po and qu antiry Q 0 . A r:1 x of t per pack of ciga rettes is imposed, causing the
supply curve to shi ft up by the an1ount of the tax to S'. The new cquilibriu1t1 is at F, 1• The consumer price rises to Pv
the seller price fol ls top,, and th e qu:rntity fa lls ro Q1• Sellers be:lr little of the burden of the t;JX in the first cose (and
consum ers bear a loc), whereas consumers bear lirde of rh e hurden i11 the second case (and sellers bear a loc).


The Algebra of Tax Incidence

It is straightforward to show precisely the burden of an When the market is in equilibrium, Q'> - Q\ and
excise rax by using algebrn ro solve for the equilibrium price so we can equate Q1> from cquarion ( I) with Qs from
and quantity. Suppose the demand-and-supply model of the equation (5). This gives us
n1a rket is given by the following two linear equations.
(I) QI) - a - hp, Demand ctu·vc a - bp" = c - dt + dpc
( 2) Q,~ = c + dp, Supply curve
This equation allow~ us to ~olvc for th e equilib rium
Where Q1J is quantity demanded ar the consumer price, consumer price, Pc•.
Pn and Cf is quantity supplied at the seller price, /J,. The
presence of an excise ta x oft dol lars pe r un ir implies char
the price received by the seller, p,, must bet dol lars less
rhan rh e price paid by the consume1; p,:
This solution fill' />c• c::in now be substituted h:lck
(3) T', - P.. into rhc demand curve, equation ( I ), to solve for the
We can subsricure equa rion (3) inro (2) ro exp1·ess equilibriu m quantity, Q*.
the supply curve in terms of the consumer price:
b (a c I dt )
(4) Q1 - c + d (Pc - t) Q• - (/ - hp/ - a - b i d
(Id + be bd
(5) <;;f - C - dt ~ dJlc b+d b +i

Now we can examine who reall y pays for cigarette tax increases (or tax increases
on gasoline and alcohol). T he de mand for cigarettes is inelastic both overall and n:la-
cive cu supply, suggesring chat che burden uf a cigarecce cax is burn e mo re b)1 consume rs
chan by p rod ucers. T he de mand fo r gasoli ne is also ine lastic, but much more so in the
short run than in the lo ng run. (In the long run, drivers can change their d riving hab its
:rnd impruve che efficiency uf cheir vehicles, buc i11 rhe shurr ru11 such changes are very
costly.) T he supply of gasoline, given wo rl d trade in petroleum and petroleum produces,
is elastic relative co dema nd. T he re latively inelastic d·cmand and elastic suppl)' im ply
char che b urden of gasoline raxes fa lls musrl y on cons ume rs.
F,;y;tcnsions in Thco1·y 4-'/ shows how to work ch ro ugh the algebra of de mand and
supply in the presence of an excise tax.

I 4.4 Other Demand Elasticities

T he pri ce of the p rod uct is not the only importa nt va ri ab le determining the quantity
demanded for that product. Changes in income and changes in the prices of other
products also lead ro changes in qua ntity de manded, a nd elasticity is a useful concept
in measuring their effects.

Now compare these solutions for Pr• and Q• ro the We can therefore express the equi librium consumer
case where there is no tax, t - 0. This exercise reveals arid seller prices iri the presence of on excise tax irn rcrn1s
what we al ready know from Figu res 4·8 and 4·9-rhar of p":
the excise ta x increases the equilibrium consun1er price
and reduces rhe equilibrium quantity from rhe levels rhar
we would observe in the absence of rhc excise tax.
(8) p/ - p• + b : d'
Who bears rhe burde n of rhe excise cax? To answc1· b
this question, we must examine both the equilibri um (9) P: - p• - b i d'
consun1er and seller prices, p,•and p, •.We just saw chat
a- c d These solutions for p/ and p," show precisely how
(t>) p/ = b+d +b+ d' rhe burden of the excise tax depends on rhe slopes of the
and weals<> know that Pc' - I - p, •. Ir follows that demand and supply curves. For exam ple, consider a small
value of d. which reflects a rel atively steep supply curve.
a c d The small value of d means chat Pc• is only a liccle above
(7) p• = - +- t - t
' b+d b+d p", whereas p, • is considerably below p•; rlrns, when the
a c b supp ly curve is relatively steep, sellers bear more of the
= --- t burden of rhe rax. In conrrasr, consider a small val ue of
b+ d b+d
b, wh ich reflects a relatively srccp demand curve. The
Nore diar when t = 0, rhe equilibriu m price in this small value of b means that p,* is only a little belowµ•;
n1odcl, for both consumers and sellers, is but p/ is considerably above/>"; thus, consumers bear
a- c more of rhe burden of rhe tax when rhe de mand curve is
. = - -
b+d rel acivcl y sccep.

Income Elasticity of Demand

An important determinant of demand is the income of che customers. The responsive-
Income elMtlcfty of' demand ness of de mand co changes in income is termed the income elasticity of demand and is
( ~y) Ameasure of tile
symbolized 'T/ y.
responsiveness of quanUty
demande<l to a change in l'ercenrage change in quamiry demanded
income. 'Tlv - perc:cntagc cIiangc
. .111 .111c:omc

nonnaf good A good for 1'11llch For most goods, increases in income lead to increases in demand- their income elasticity
quantity demanded rises is positive. These are called normal goods. Goods for which demand decreases in response
as income rises-its income
elastlclty Is POSltlve.
w a rise in income have negative income elasticities and are called inferior goods.
The income elasticity of normal goods can be greater tha n I (elastic) or less than I
Inferior good A good fur ~1llch
quantity demanded falls as
(inelastic), depending cm whether the percentage change in quantity demanded is greater or
Income rises- Its Income less than the percentage change in income that brought it abouc. le is also comnnon to use
elsstlclty Is negative. the terms income·clastic and incomc·inelastic co refer co income elasticities of greater or less
than 1. (See F.xtension.s in Theory 4-2 fur a summary uf the differenr elasticicy cuncepts.)


The Terminology of Elasticity

Numerical Measure
Term of F.las1icity Verbal Description
A. Price c'lasticity of demand (supply)
Perfectly or completely 0 Qu::iintity demanded (supplied) docs not change as
inelastic price changes.
lnclasric Between 0 and I Quainriry demanded (suppl ied) changes by a smal ler
percentage than docs price.
Un ir elastic Quainrity demanded (supplied) cha nges by exactly the same
pcrccnrage as docs price.
Elastic Greater th an I but Qua nti ty demanded (suppl ied) changes bra larger percent·
less rhan in fi niry age t han does price.
Perfectly, completely, or Infin ity Purchasers (sellers) arc prepared to buy (sell) al l they can at
infinitely elastic some price and non e at all at a higher (lower) price.
B. Income elasticity of demand
In ferior good Nega rive Quantity demanded decreases as income increases.
Normal good Positive Quanrity demanded increases as income increases:
lrlcomc·inclastic Less th an I l.ess than in proportion co inco me increase
lncome-clasric G1·earer rhan More rhan in proportion ro income increase
C. Cross elasticity of demand
Substimre Posirive Price increase of a subsrirure leads roa n increase in quanriry
demanded of th is good.
Complcmenc Ncga rivc Price i11crcasc <)fa co mplcmenr leads ro a decrease in
quantity demanded of this good.

How the demand fo r goods and servi..:es rea<.:ts to dianges in in..:ome has import·
ant economic dfcces. In most Western countries during the twentieth ccntur)1, eco·
numic growrh caused che level of incurne ro double every 20 ru 30 )'ears. This rise in
in..:ome was shared to some extent by almost all citizens. As they found their in..:omes
increasing, chey increased their demands fo r most produces. In che fi rsc pare of char
century, however, che demands fur sume pwducrs (such as fuod a11d basic clurhing)
we re income-inelastic, whereas che demands fo r durable goods (such as ..:ars and TVs)
were im:ome-clastic. As a result, chc de mand for food and clothing grew less rapidly
rhan did che demand for cars and TVs. Larer in rhe cenrury, as incornes wse srill furrher,
the income elasticity of demand fo r manufactured durables fell while chat for services
(such as resta ura nt meals and entertainment) increased. During this perind the ongoing
income growrh led che dema11d for services ro grow more rapidly chan rhe demand for
du rable goods.
In some developing countries, where per capita incomes coday arc close co those
of rhe Wescern narions ac rhe beginning of che rwenrierh cenrury, ic is che demands for
du rable manufactured goods char are increasing mosc rapidly as income rises. Jn futu re
years (assuming char chc current growth of income cc111[inucs), chcsc same countries will
likely experience rhe same shifc in demand coward services char was experienced by rhe
Western coun tries in die lase pare of die twentieth cemury.
The umevcn impact of the growth of income on the demands for different prod-
ucrs has imponam effecrs on rhe parrem of employmenc. Fur example, in Wesrern
coumries, employment in agricultu re fell during die first pare of the cwentiedi century,
while employment in manufacturing rose. Jn the lase ha lf of the century, employment
in manufacru ring fell gradually whereas empluymenc in services increased rapidly (and
employment in agriculcure conti nued its grad ual decline). \Ve will see many ocher con·
sequences of these demand shifts lacer in this book.
Luxuries Versus Necessities Different products typically have diffe rent income elasti-
cities of dema11d. Fur example, empirical studies find that basic food items- such as
vegetables, bread, and cereals- usually have positive i1ncome elascicicies less than 'I (so
an increase in income of 10 percent leads to an increase in quantity demanded of less
chan 10 percenr). Such goods are ofcen called necessities. In cunrrasr, more expensive necessities ProduclS for Wlllch
foods-such as prime cuts of meat, prepared meals, and wine-usually have positive the Income e1astlclty of demand
Is positive hut less than I.
income elasticities greater tha n I (so an increase in income of 'I 0 percent leads eo an
increase in quanciLl' demanded of more chan I 0 perce11r). These prnducts are often
called lu:.---uries. luxuries Products fOl which the
Income elastl city of demand Is
positive and gicater man 1.
The more necessary an item is in the consumption pattern of consumers, the lower
is its income elasticity.

Income elascicicies fur any one produce also vary wich che level of a consumer's
income. When incomes are low, consumers may eac almost no green vegetables and
consume locs of starchy foods, such as bread and pasta; whe n incomes arc higher, chey
may ear clheap curs of mear and more green vegerables along wirh rheir bread and pasra;
when incomes are higher sti ll, they are likely co eat higher-quality and prepared foods
of a wide variety.
The disrincrion between luxuries and necessiries helps co explain differences in
income elasticities. The case of restaura nt meals is one example. Such meals are almost
alwa)1S more expensive, caloric fo r caloric, than meals prepared at home. Tt would

'. ~··'r'.\}) thus be expected that at lower incomes, restaurant mea Is would
..... ' .
be regarded as an expensive luxury but that the demand fur chem

. ,. ~ t'
,. (!Jp~
(.hl'aJll would expand substantially as consumers became richer. This is
actually what ha ppens.

";'"f e~n ·~ ~

l''l ' it ~ ~ Nurice chac both necessicies and luxu ries have pusicive income
. ... •"'... ll U.I.
~~ u
. . ' . elasticities a11d thus are normal goods. Tn contrast, inferior goods
~·· • • i.: - "' ~ 4
have a nega.tive income elasticity because an increase i.n income
' :::
I t·.. ' j,1.·_. accually leads co a reduction in quantity demanded. An example

I ' of an inferior good for some consumers might be ground beef
or pac kages of instant noodles; as consumers' incomes rise, thC)1
reduce their demand fur these products a11d consume more uf
Substitute products have a positive cross elasti· higher-quality ite ms.
city; mt increase in the price of one leads to an
increase i11 dema11d for the otl1er.

Cross Elasticity of Demand

cross cla!>1lclty of d omand The responsiveness of quanricy demanded co changes in che price of another prnducc is
(•1xrl Ameasure or the called che cross elasticity of demand. Tt is denoted T/xv and defined as fo llows:
responsiveness of tlhe quantity
of one commodity ilemanded to Percentage d1ange in qua nti ty demanded of good X
changes In tile price of anotl1er T/xv =
commodity. Pei:ce11cage change in pi:ice uf good Y
The change in che price of good Y causes che demand curve for good X co shift. If
X and Y are substitmes, an increase in the price of Y leads co an increase in the demand
for X. If X and Y are complemenrs, an increase in the price of Y leads cu a reducciun
in demand for X. In eithe r case, we are holding che price of X constant. We therefore
measure the change in the qua ntity demanded of X (at its unchanged price) by measur·
ing the shift uf the demand curve fur X.
Cross elasticity can vary from minus infinity ro plus infinity. Complememary prod-
ucts, such as cars and gasoline, have negative cross elasticities. A rise in the price of
gasoline will lead cu a decline in the demand fur cars, as some people decide tu du
wichouc a car and ochers decide noc ro buy an additional car. Subsciruce produces, such
as cars and public transport, have positive cross elasticities. A rise in the price of cars
(relative tu public transport) wi II lead ro a rise in the demand for public transport as
some people shift from cars w public tra nsporc.

The positive or negative signs of cross clasricirics cell us whether goods arc subsri-
cuccs or complcmcnrs.

Measures of cross elasticity sometimes prove helpful in defining whether producers

of similar produces are in rnmpericiun wirh each urher. Fur example, glass boccies and
aluminum cans have a high cross elasticity of dema nd. The producer of boccies is chus in
competition with the producer <>f cans. If the bottle company raises its price, it will lose
subsranrial sales ro the can producer. In cuncrasc, men's shoes and women's shoes have a
low cross elasticity, and chus a prnducer of men's shoes is noc in dose competition with
a producer of women's shoes. Tf the former raises its price, it will not lose many sales
co che laccer. Knowledge of cross elasricicy can be imporcanc in maccers of competition
fJo/icy, in which the issue is whether a firm in one industry is or is not competing with
firms in another industry. We discuss competition policy in more deta il in Chapter 12.


4.1 Price Elasticity of Demand LO 1, 2

• Price elastic ity of demand is a measure of the extent to demand is elastic-the percentage change in quantity
which the quantity demanded of a product responds to demanded is grea ter than the percentage change in price.
a change in its price. Represenred by the symbol 71, it is • The main determinanc of demand elasticity is the
defined as availabil ity of substitutes for the product. Any one of
a group of close substitutes will have a more elastic
Percentage change in quantity demanded demand than will th e group as a whole.
71 = - -
Pcrcentagc cha nge in price • ltc1ns th;tt have few substitutes in the shor·r 1·t111 rend
to develop man )' subsrirnres when consumers and pro-
• The pc1·ccnragc changes arc usually calculated as rhc ducers have rin1c tO adapt. Therefore, demand is more
change divided by the average value. Ebsricity is defined elastic in the long run than in the short run.
to be a positive number, and it can va ry from zero to • Elasticity and total expend iture arc related. If elasticity
infin ity. is less than I, total expe ndicure is positiveUy related with
• Wh en elasticity is less than I, demand is inelastic- th e price. If elasticity is greater than I, total expenditure
percentage change in qu:rnrity demanded is less than rhe is negatively rel ated with price. If elasticity is I, total
percentage change in price. Whcn elasticit)' exceeds I, expenditure docs not change as price changes.

4.2 Price Elasticity of Supply L03

• Elasticity of supply measures th e extent to wh ich the • Supply rends to be more cbstic in the long run than in
quantity supplied of some product changes when the the short run because it usually ta kes time fo r producers
price of tl1ac produce changes. Represented by the sym- to airer chcir ourpuc in response to price changes.
bol 'I),, it is defined as
Percencage chan~e in quantity supplied
'IJs -
Percentage change in price

4.3 An Important Example Where Elasticity Matters LO 4

• The distribution of rh c burden of an excise tax between more elastic demand is relative to supply, the more of
consum ers and producers depends on chc rclacivc elasti- rhc burden of an excise tax tails on producers.
cities of supply and dcn1and for the product.
• The less elastic demand is relative to supply, the more of
the burden of an excise tax fal ls on the consumers. The

4.4 Other Demand Elastlcltles LO 5, 6

• Income elastici ty of demand is a measure of the exte nt ro • Cross elasticity of demand is a n1casurc of the extent to
wh ich the quantity demanded of so me product changes wh ich the quantity demanded of one product changes
as income changes. Represented by the sym bol 71y, it is when the price of a different product changes. Repre-
defined :is sented by the symbol 1/XY· it is defined as
Percentage change in quantity de111andcd Percentage change in quantity demanded of good X
1/y - 1/xy =
Per·centage change in inco me Percentage change in price of good Y

• The income elasticity of deman d for a product wil l usu- • It is used to define products that are subsrirures fo r one
all y clu.ngc as income va1·ics. A pr()duct th::lt h:ls a high another (positive cross elasticity) and products that arc
income elasticity at a low income may have a low or complements for one another (negative cross elasticity).
negati ve income elasticity ar higher incomes.

Price elasticity of demand Elasticity of supply Normal j\oods and inferior goods
Inelastic and perfectly inelastic Short-run and long-nin respo nses co Lu)(IJries an d necessiries
demand shifts in dema nd and supply Cross elnsticity of dema nd
Elastic and infinitel y elastic demand The burden of an excise tax Substitutes and co mplements
Relationshi p between deman d clasci- Consumer price and seller price
city an d rot::il expenditure Income elasticity of demand


Make the grade wirh MyEconLah: Study Exercises marked in red can be found on
MyEconlab M yEcon Lab. You can practise them as ofren as you want, and most feature srep-by-step
guided instructions to help you find the dght answer.

1. Fill in th e blan ks to make the fo ll owing scatemenrs a. Fill in the table and calculate the price elasriciry
co rrect. of deman d over each price range. lk sure to use
a. When a lO percent change in the price of a good average prices and quantities when computing the
bri ngs about a 20 pe1·cenr change in irs quan - percentage changes.
tity demanded, the price elasticity of demand is b. Plot rhe demand curve and show rhe elasriciries
_____ . We ca n say that demand for this over the different ra nges of the curve.
good is __ . c. Exploin why der11and is r11ore elastic nt the higher
b. Wh en a I0 pcrccnr change in rhe price of a good prices.
brings about a 4 percent change in its quan - 3. Suppose the market for frozen oran14e juice is in eq ui-
tity demanded, the p1·ice elasrici ry of demand is librium at a price of $2.00 per can and :t quanrity of
- - - - -· We can say rhat demand for th is 4200 ca ns per mon th . Now suppose that at a price of
good is _ _ _ __ $3.00 per can, quantity demanded fal ls to 3000 cans
c. Wh en a I 0 pc1·cenr ch:rngc in rhc p1·icc of a good per month and quantity ~uppl icd increases to 4500
brings abouc a I0 percent cha nge in irs quan - cans per month.
tity demanded, the price elasticity of demand is
. We can say that demand for chis a. Draw rh c appropriate diagram for: th is ma rker.
good is _ _ _ __ b. Calculate rhe price clasriciry of demand for frozen
orange juice between th e prices of $2.00 and $3.00.
2. A hypothetical demand schedule for comic books in a Is rh c dcm:ind elastic or inelastic?
small town is provided below. c. Calculate the elasriciry of supply fo1· frozen orange
juice between the prices of $2.00 nnd $3.00. Is th e
Percenc supply elastic or inelastic?
Tomi Percent Clrnnge in Elnsticiry d. Explain in gcner:tl what focrors wou ld :tffecr the
Quantity Expcn· Change Qu:intiry of elasticity of demand for frozen orange juice.
Price Demanded diture in Price Demanded Demand e. Explain in genera l what factors wou ld affect che
$11 l
elasticity of supply of frozen orange juice.
9 3 4. Frnm the fol lowing quotations, what, if anything, can
7 5 you co nclude abou t elasticity of demand ?
5 7
a. ~Good weather resulted in record wheat harvests
3 9
and sent wheat prices rumbling. The result has been
disasrrous for many whear farmers."

b. "R,iclership always went up when bus fo res came per kilogran" s:tlcs of tea in Canada incrc:tsed fro1t1
down, but the increased patronage never was enough 7500 kg per month to 8000 kg per month .
to prevent a decrease in overall reven ue." d. An increase in the world demand for pulp (used in
c. «/\s th e price of cell phones fell, producers found producing newsprint} increases the price by 14 per·
rh ei1· revenues soa ring." ce nt. Annua l Canad ian p1·oduccio11 increases from
d. "Coffee ro me is an essential good- I've just gotta 8 million tonnes to 1 l million tonnes.
have it no matter what rhe price."
9. The foll owing cable shows rhe demand schedule for
e. "The soaring price of condominiums docs little to PlayStation video games.
cu rb the strong demand in Vancouver."
5. Interpret the following smtemen ts in terms of the rcl- Quantity
ev;i nt ebsticiry conce pt. Price Demanded Tot:tl
a. "As fuel for tractors has become more expensive, (per unit) (per year) Expenditure
many farmers have shifted from plowing thei r A $30 400 000
fields to no-till farming. No-till acreage increased B 35 380 000
dramatically in the pasr 20 yea rs." c 40 350 000
b. ''Fertilizer makers brace for a dismal year as fertil - D 45 320 000
izer prices soa r." E 50 300 000
c. «When formers arc hurting, small towns feel th e F 55 260 000
pain." G 60 230 000
d. "The development of the Alberta oil sands II 65 190 000
ma y bring prosperi ty to many north ern Alberta
merchants." a. Com pute total ex penditure for each row in the
6. What would you predict about the relative price ta ble.
elasticity of den1and for each of the following items? b. Pl()t the demand curve and the rnral cxpcnditu1·e
Explain your 1·easoning. curve.
c. Com pute th e price elasticities of demand between
a. food points A ;ind B, B and C, C and D, ::rnd so () II.
b. vegcrn blcs d. Over whar range of prices is che demand for video
c. lea{)' vegeta bles gam es elastic? Explain.
d. leaf)' vegeta bles sold at your loc:tl supern1arket e. Over what range of prices is the demand for video
e. lca{y vci;:ctables sold at your local supermarket on ga mes inelastic? Ex plain.
10. Consider th e following straight-line SU))ply curves. In
7. Su ppose a sta mp dealer buys rhe only two existing each c:tse, p is the price (rncasured in doll ars per unic)
copies of a stamp ar an auction. After the pu rchase, and Qs is the quantity supplied of the product (meas-
the dc:tler goes to the front of the roon1 and burns ured in thousands of units per n1onrh).
one of the stam ps in front of th e shocked audi -
ence. Wh M must the dealer believe in order for this i) p = 2Qs
to be a wea lth-maximizi ng acrion? Explain with a ii) p • 4Q 5
demand-and-supply diagram. iii)p = 5Qs
iv)p = IOQ.s
8. For each of the following cvencs, stare the relevant
elasticity concept. Then compute the measure of elas- a. Plot each supply curve on a scale diagram. In each
ticity, using average prices and quanrirics in your cal- case, plot point A (w hich corresponds to price equal
culations. In all cases, assume that these arc ceteris to $20) and point B (wh ich corresponds ro price
pt1rilms changes. equal co $40).
b. For each supply curve, compu te the price cl:tsticity
a. When the price of movie tickets is reduced from of supply between poi nts A and B.
$ 14.00 to $ I 1.00, ticker sales increase from 1200
c. Explain why rhe slope of a supply cu rve is not the
to "1350.
sa me as the elasticity of supply.
b. As average household income in Ca nad a increases
by I 0 percent, Mrnual sales of BMWs increase from 11. This is a challenging question intended for those stu-
56 000 to 67 000. dents who like mathematics. It will hel p you work
c. After a major fail ure of Brazil's coffee crop sent through rh e issue of rax incidence. (See Exte11sio11s i11
coffee prices up from $3.00 per kilogrnm to $4.80 Tl1eory 4-1 on pages 94-95 if yo u get stuck! )

Co11sider the rnarkct for gasoline. Suppose the 111arkct c. Now suppose the govern1t1c11t irnposes a tax of 14
dema nd a nd supply curves arc as given below. ln each ccnrs per litre. Show how rhis affects rh e marker
case, quantity refers to mil lions of litres of gasol ine per eq uilibrium. What is the new "consumer price" and
month; p1·ice is the p1·ice per lin·c (in cents). what is the new "prnd ucc1· p1·ice"?
Demand: p = 80 - SQD d. Co111purc rhe rora l reve nue raised by the gasol ine
tax. Wha t share of this tax revenue is "paid" by
Supply: /l = 24 + 2(f co nsu111ers, and whar share is "paid" by produce rs?
a. Plor rhc demand and supply cu rves 011 a scale (l lint: lf the consum er price were unchanged from
diagram. the pre-tax cqui libri un1, we wou ld say that co n-
b. Comp ute the equi libri um price and quantity. sumers pay none of the tax.)

After studying this chapter, you will be able to

5.1 THE INTERACTIO N AMO NG MARKETS 1 explain why individual markets are not isolated from the
rest of the economy and how changes in one market
typically have repercussions In other markets.

5.2 GOVERNMENT-CONTROLLED PRICES 2 describe how the presence of legislated pri ce ceilings and
price floors affect equlllbrlum price and quantity.

5.3 RENT CONTROLS: A CASE STUOY OF PRICE CEILI NGS 3 compare the short-run and long-run effects of legislated
rent controls.

5.4 AN INTRODUCTION TO MARKET EFFICIENCY 4 explain why government interventions that cause prices
to deviate from their market-clearing levels tend to be
Inefficient for society as a whole.

OVER rhe past rwo chaprers, we have developed rhe markers. Por example, when we examined che mar-
model of demand and supply that yo u can now use ket for apples, we made 110 mention of the ma rkets
ro analyze individual markers. A full undersranding of fo r milk, TVs, or labou r services. Jn other words,
che basic rheory, however, comes only wich practice. we viewed che marker fur apples in isolarion from
This chapter will provide some practice by analyzing all other markets. Ru t this was onl y a simpli fi ca ·
several examples, i11cludi11g minimum wages, renr tion. In ch is chapter's opening section we noce thar
controls, and output quotas. the economy shoul d not be viewed as a series of
Before examining rhese cases, however, we begin isolaced markers. Racher, che economy is a complex
the chaprc r by discussing how various market~ arc system of in ccr-rclaccd markccs. The implication
relared co one another. In Chap re r·s 3 and 4, we used of rhis complex scrucru1·e is char evenrs leading ro
che sin1ple demand-and-supply model cu describe a changes in one marker typically lead ro changes i11
single ma rkec, ignoring what was going on in other ocher markets as well.

I 5.1 The Interaction Among Markets

Suppose an advance is made rhac reduces rhe cusr uf exrracring narural gas. This rechn u-
logical improvemenr would be rep resenred as a rightward shifr in che supply curve for
natural gas. The equilibrium price of natura l gas wo uld fall and there wo~ild be an
increase in rhe equilibriu m quancicy exchanged.
How would ocher· markers be affecced? As nacural-gas fi rms expanded their pro·
duction, rhcy would increase their demand for rhc entire ra nge of goods and servi-
ces used fur rhe exrracrion, processing, pum ping, and disrriburiun uf narural gas. This
increase in demand would cend co raise che prices of rhose icems and lead che producers
of chose goods co clevore tn<Jre resources to their production. The natural-gas firms
would also increase rheir demand for labour, si11ce more workers wo uld be requi red cu
drill fo r and exrracc more narural gas. The increase in demand for labour would rend
ro push wages up. Firms char hire similar workers in ocher industries wo uld have co
pay higher wages cu re rain rheir workers. As a result, profits of chose fi rms would fa ll
and chey wo uld employ fewer workers, chus free ing up che excra workers needed in che
narural-gas industry.
There would also be a direcr effecr on consumers. The reducrion in rhe equili brium
price of narn ral gas would gene race some subscicurion away from ocher· fue ls, such as oil
and propane, and coward rhc now-lower-priced natural gas. Such reductions in demand
would re nd co push down rhe price of oil and propane, and producers of chose fuels
would devore fewer resources ro cheir produccion.
Jn shore, a cechnologica I improvement in che nacural-gas induSCI')' wo uld have
effeccs in many ocher markers. Bue rhere is noching special abour che nawral-gas indus-
cry. The same would be crue abouc a change in almosc any market you can chink of.

No market or industry exists in isolation from the economy's many other markets.

A change in one market wil l lead co d ianges in many ocher markets. The induced
changes in chesc other markers will, in curn, lead to changes in rhe fi rsc markec. This is
whar economises call feedback. In rhe example of rhe natural-gas indusrry, rhe reduc-
tion in the price of nawral gas leads consumers co reduce their demand for oil and
pwpane, rhus driving duwn rhe prices of rhese urher fuels. Bu r when we draw any given
demand and supply curves fo r nacural gas, we assume char che prices of all other goods
arc constant. So, when the prices of oil and propane fall, che feedback effect on the nae·
ural-gas marker is co shi ft rhe de111a11d curve for naru ral gas co rhe left (because natural
gas is a subsricure for boch oil and propane).
Predicting che precise si7.e of chis feedback effect is difficult, and che analysis of
rhe natural-gas industry-or any ocher i11dusrry-would certainly be much easier if we
could simply ignore ir. Bur we cannoc always ignore such feedback effeccs. Economises
make a discinccion between cases in which che feedback effects are small enough char
they can safely be ignored, and cases in which chc feedback effects arc large enough char
ignoring chem would significancly change che analysis.
partlnl·equlllbrlum analysis The Partial-equilibrium analysis is che analysis of a single marker in sicuacions in
analysis ol a single mall<ut In
Isolation, l!ll'oring any feedbacks
which the feedback effects from other markers arc ignored. This is che t )1 pc of analy-
that may oome lrom Induced sis chat we have used so far in rhis book, and it is che mosc common type of analysis
changes in other mall<ets. in microeconomics. For examp le, when we examined die market fo r ciga rettes at

the end o f Chapter 4, we ignored any potential feedback effe<.::ts that could have
come from the market for alcohol, coffee, or many other goods or services. Tn this
case, we used partial-equil ibrium analysis, focusing 0111)1 un the market for ciga-
rettes, beca use we assumed that the changes in the ciga rette market would produce
small enough changes on the other markets that the feedbac k effects from che other
markets wo uld, in turn, be suffic ie11tly di ffused that we cuuld safely ignore rhem.
This suggests a general rule celli ng us when pa rtial-equi li brium analysis is a legitim-
ate method of analysis:

If a specific market is quite small relative to the entire ecor10my, changes ir1 the
market will have relatively small effects on other markets. The feedback effects on
the original market will, in turn, he even smaller. In such cases, partial-equilihrium
analysis can s ucces~full y be used to analyze the original market.

When economises srudy all markets cogecher, rather than a single marker in isola-
tion, they use what is <.::ailed general-equilibrium analysis. This is more complkated general·equlllbrlum
than pa rtial-equ ilibrium anal)•sis beca use the economist not onl)' must consider what analysts Tho analysis of
all the economy's marl<els
is happe ning in each individual market bur also must (ake inco acco un t how events in simultaneously, recognizing lhe
each market affect alI the other markets. Interactions emong the various

General -equilibrium analysis is the study of how all markets function together, tak-
inK into account the various relatio nships and feedback effects amonK individual

As you go on w learn more microeconomics in this and lacer chapters, you will encoun-
ter mostl y parcial-equilibri um analysis. The book is writcen this way incentionally- it is
easier to learn about the basic ideas of monopoly, competi tion policy, labour unions, and
environme mal policy (as well as many ocher wpics) by rem icring our a(tenrion w single
markecs. But keep in mind that many ocher markecs are " behind the scenes," linked co the
individual markets we choose to Study.
We now go on to examine the effects of govern mem -concrolled prices. These appear
prominentl y in labour markets and rental housing markets.

.I 5.2 Government-Controlled Prices

In a number of imporranr cases, governments fix che price ac which a produce must be
bought and sold in the domestic market. Here we examine the genera l consequences of
sud1 policies. Later, we look ar sume specific examples.
In a free market che equilibrium price equates che quanci ry demanded wich (he
quantity s upplied. Government price co11trols are policies that attempt to hold che price
ar some disequilibrium val ue. Some controls hold rhe ma rker price below its equilib-
ri um value, th us crea(ing a shortage at (he controlled price. Ocher controls hold price
above its equi libri um value, th us creati ng a surplus at the controlled price.

Disequilibrium Prices
RGURE 5·1 The Determination of Quantity
Exchanged in Disequilibrium When controls hold the price at some disequil ibriium value,
what determines the quantity actually traded on the mar-
ker? This is nm a quescion we have co as k when examining
•s a free market because the price adj usts to equate quan·
•• • cicy de manded wich quancicy supplied. Bue chis adj ust·
•• ••
"' .

•• mem cannm cake place if che governmenc is controll ing
the price. So, in this case, what dete rmines die quantity
•• actually exchanged?
•• ••
.. • ... • • D
The key co che answer is che face chac any voluntary
market transaction requires both a willing buyer and a
0 wirning seller. So, if quancicy demanded is less chan quan-
ti ty supplied, demand will dete rmine the amount acrnally
exchanged, while the rest of the quantity supplied will
In discq uiaibrium, quantity exchanged is deter· remain in che hands uf rhe unsuccessfu l sellers. Conversely,
min ed by the lesser of quantity demanded and if quanriry de manded exceeds quantity supplied, supply
quantity suppli ed. J\r c, the marker is in cqu ili b·
rium , with quantity de manded eq ual to quantity
wirn determine the amount actually exchanged, while the
supplied. For any price below p0 , the quantity resc of the qua11tity de ma11ded will rep rese11t unsatisfied
excl1angcd will be determined by rhe supply curve. de mand of would-be buye rs. Figure 5-1 illustrates che gen-
For· any pr ice above p0 , the q uantity exchanged era ~ conclusion:
wil l be determined by the dcr11and curve. Thus,
the solid p-0rrions of rhe S and D curves show the
actual quam itics exchanged ar differenr discqu il ib· At any disequilibrium price, quantiiy exchanged is
num pnccs. d ecermined by che lesser of q uanticy demanded or
quantiiy supplied.

Price Floors
Govern ments sometimes establish a price floo r, which is
the minimum permissible price tha t can be charged for
a particular good or service. A price fl nor chat is set at
RGURE 5·2 A Binding Price Floor ur below che equili brium price has nu effect because the
free-market equi librium re mains attainable. If, however,
the price fl oor is set above the equilibrium, it wilil raise the
price, in which case it is said co be bi11di11g.
Price fl oors may be esta blished by rules that make it
illegal to sell the product below the prescribed price, as
in che case of a legislated minimum wage. Or the govern-
mem may establish a price floor by an nouncing that it
will guarantee a certa in price by bu)'ing an)' excess supply.
Such gua rantees are a fearn re of many agriculcural sup-
port policies.
O Q, Qo Q2 The effects of a binding price fl oor arc illustrated in
Q unncity Figure 5-2, which establishes the foll owing key resulc:

A binding price floor leads to excess supply. T he

free·nurkct cquilib1·ium is at E, with price p0 an d Binding price lloors lead to excess suppl y. Either an
qua11riry Qo. The gove rnment now esrablishcs a unsold surplus will exist, or someone (usually the ~ov·
binding prrice fl oor ar p 1 • The resulr is excess sup· ern men t) mus t enter the market and buy thi: excess
ply equal to Q1Q2. supply.

The consequences of excess supply differ from product to product. If the product
is labour, subject to a minimum wage, excess supply translates into people without jobs
(unemployment). If rhe producr is whear, and more is produced rhan can be sold ro
consumers, the surplus wheat will accumulate in grain elevators or government ware·
houses. These consequences may or ma)' not be worthw hile in terms of the ocher goa ls
achieved. Bue worrhwhile or nor, chese consequences are inevicable in a compericive
market whenever a price floor is set above the market-dearing equilibrium price.
Why might the government want co incur these consequences? One reason is that the For lnformatJon on various
people wh.o succeed in selling rheir produces ar rhe price fl oor are becrer off rhan if rhey had labour·market pollcles In
Canada. see HRSDC's website:
to accept the lower equilibrium price.Workers and fa rmers are among the politically active, Then cl/ck on
organized groups who have gained much by persuading the government tn establish price "PfQ{Jrams and Polle/cs\
fl oors rhar enable rhem ro sell rheir goods or services ar prices above free-marker levels. lf
the demand is inelastic, as it often is for agricultural products, producers earn more income
in total (even though they sell fewer uni ts of the product). The losses arc spread across the
large and diverse secof consumers, each of whom suffers only a small loss.
AfJp/ying P.conomic ConcefJts 5-1 examines che case of a legislated minimum wage
in more derail, and explains rhe basis of rhe often-heard claim that minimum wages
increase unemploymenr. We discuss che effecrs of min imum wages in grearer derail in
Chapter '14 when we examine various labour-marker issues.

Price Ceilings
A price ceiling is rhe maximum price ar which cerrain
goods and services may be exchanged. Price ceilings on
oil, natural gas, and re ntal housing have been frequent ly
imposed by fede ral and provincial governments. If the AGURE 5·3 A Price Ceiling and Black-Market Pricing
price ceiling is set above rhe equilibrium price, ir has
no effect because the free-market equili brium remains
attainable. If, however, the price ceiling is set below the
free-market equilibrium price, che price ceiling lowers
the price and is said to be binding. The effects of binding
price ceilin1gs are show11 in Figure 5-3, which esrablishes
the fo llowing conclusion:

Binding price ceilings lead to excess demand, with

rhc quantity exchanged being less than in rhe frce- D
market equilibrium.
0 Qo Q ,
Allocating a Product In Excess Demand Free markets elim· Qunncity
inate excess demand by allowing prices cu rise, the reby
A binding price ceiling causes excess demand and
allocating the available supply among would-be pur· invices a black market. The equi libl'ium poinr, E, is
chase rs. Because this adjustmcnt cannot happen in the ac a price of Po and a quanriry of Q0 . If a price ceil-
presence of a binding price ceiling, some ocher methud ing is sec at pi, chc quantiry demanded will rise to
of allocation must be adopted. Experience suggests what Q 1:tnd the qu:intity supplied wi ll fo ll to Q.2. Quan-
we c:a n expect. tity ::tc:tually exc:han11cd will be Q2. But if ::tll the
If srores sell rheir available supplies on a first-come, avai lable supply of Q2 were sold on a black market,
the price co consumers would rise co P2· Because
first-served basis, people will rush to stores that are sa·id black n1arkercers buy at the ceiling price of P1 and
cu have scocks of rhe produce. Buye 1~s may wair hou1~s co sell at the black-ma1·ket p1·ice of p 2, their profits are
ger inro rhe srore, only co fi nd rhac supplies are exhausred rep1·cscnrcd by rh e shaded area.
before they can be served. This is why standing in lines


Minimum Wages and Unemployment

All Canadian governments, provincial, territorial, and Supply of labour, h:.tvc lcgisbrcd minimum w:lgcs. For those indus-
tries covered by provincial or territorial legislation (which
includes most indumies excepr banking, a irl ine~, lruck-
ing, and railw:.tys), the minimum wage in 20 12 r:.tngcd
from a low of $'1.50 per hour in Saskatchewa11 to a high
of $ 11.00 per hou r in Nunavut. This box examines rhe
effects of implementing a minimum wage in a competitive
laboui· ma~kct and p1·ovides a basis for understanding the
often-heard cl:.tim that minimum w:.tges to an increase
in uncmploymcnc.
The accompanying figmc shows the demand and
supply curves for labour services in a fully con1petirivc
marker with Employment on rhc ho ri zo ntal axis and
I lourly Wage Rate on the vertical axis. In the absence
of any lcgisbrcd mi nimu m wage, the cquilib1·ium in rhc
labour ma rker would be a wage equal to wo and a level 0 E, E0 E2
of employment equal to E0 . E111ploy111cnc
Now suppose the government introduces a min-
imum wage equal to Wmiu that is greater than wo. The

became a way of Iife in the cenrrally planned economies of the Soviet Union and East-
ern Europe, in which price controls and product shortages were pervasive.
In marker ecunumies, "firsc-cume, first-served" is ufren rhe basis fur allocating
tickers ro concerts and sporting events when promoters set a price at wh ich demand
exceeds the supply of available seats. In these cases, ticket "scalpers" often buy blocks
uf tickers and rhen resell rhem ar market-cleari11g prices. Storekeepers (and some ticker
sellers) often respond ro excess demand by keeping goods "under rhe counter" and sell-
ing only to customers of their own choosing. Whe n sellers decide to whom they will and
sellers' preferences Allocetion will 11or sell rheir scarce supplies, allocation is said ro be by sellers' preferences.
of commodities In excess If rhe government dislikes rhe allocation of products by long line-ups or by sellers'
demand by decisions ol tho
preferences, it can choose to ration the product. To do so, it prints only enough ration
couput1s cu match rhe qua11ciry supplied ar rhe price ceiling and rhen discribures rhe
coupons ro would-be purchasers, who rhen need borh money and coupons ro buy rhe
product. The coupons may be distributed equally among the population or on the basis
of some criterion, such as age, fam ily scacus, or occupation. Rationing of chis sore was
used by Canada and many mher coumries during bmh rhe first and Second World Wars.

black mar1<ct A situation In Black Markets Price ceilings usualliy give rise tn black markets./\ black marker is any marker
v.tilch ~orls arc sold at prices in which cransaccions (which are themselves legal) rake place ac prices char violate a legal
that violate e 1eea11price control.
price control.

Binding price ceilings always create the potential for a black market because a
profit can be made by buying at the controlled price and selling at the (illegal)
black-market price.

mud1 of the product will be sold only to those who can afford the black-market price,
which will often be well above the free-market equi li brium price.

To the extent that hinding price ceilings give rise to a hlack market, it is likely that
the government's objectives mo1iv.11ing the impo~ition of the price ceiling will be

The market for health care in Canada is an importa nt example in whid1 market·
clearing prices arc not charged; instead, the price is controlled at zero and the services
are rationed by customers havi ng co wait their curn robe served. No black market has
arisen, although when some Canadians travel to the Uni ted States and pay cash for
health-care services that they caninQt get quickly enough in Canada, Qr when they pay
cash for rhe limired services provided by Canadian private clinics, rhe effecrs are similar
to chose chat occur in a black market. Even though there is not enough of the product
available in che public system rn satisfy all demand at the rnntrnlled price of zero, many
people's sense of social jusrice is sarisfied because healrh care, ar lease in principle, is
free ly and equally available co everyone. Tn recent years, there has been a great deal
of debate regarding potential reforms to Canada's health-care system; we discuss this
clebare in more derail in Chaprer 18.

I 5.3 Rent Controls: A Case Study of Price Ceilings

For long periods over the past lhundred yea rs, rent controls existed in London, Paris,
New York, and many ocher large cities. In Sweden and Brirai n, where rent conrrnls
on apa rtments existed for decades, shorrnges of renrnl accommodations were chronic.
When rent controls were inicia.ccd in Toronto and Rome, severe housing shortages
developed, especially in chose areas where demand was rising.
Rent controls provide a vivid illustration of the short· and long·cerm effects of chis
type of ma rket intervention. Note, however, that the specifics of rent-control laws vary
greatly and have changed significantly since rhey were fim imposed many decades ago.
Jn particular, cmrenc laws often permit exemptions for new buildings and allowances
for maintenance costs and inflation. Moreover, in many countries rent controls have
evolved inro a "second generation" of legislation that focuses on reg11/ati11g the rental
housing market rathe r than simp ly controlling the price of rental accommodation.
In chis section, we confi ne ourselves co an ana lysis of rent controls that a rc aimed
primarily ar holding rhe price of renral housing below the free-market equi li brium
value. Tc is chis "first generation" of rent controls that produced dra matic results in
such cities as London, Paris, New York, and Toronto.

The Predicted Effects of Rent Controls

Binding rent controls are a speci fic case of price ceilings, and therefore Figllre 5-J can
be used co predict some of their effects:

1. There will be a shorrage of remal housing in (he sense that quamicy demanded will
exceed quantity supplied. Snnce rents are held below their free·markec levels, the

increased wage has two effects. First, by increasing the a result of the wage increase, shown in the figure as the
cost of bbour services ro firms, rh c minimum w:igc quanriry E1Eo.
reduces the level of employment to E1• The second effect These arc the effects of minin1un1 wages in a com·
is to increase the quanciry supplied of labour services ro peririvc labour marker-one in whi ch rh erc arc many
E2. Thus, the clear effect of the binding minimum wage, firms and many wo rkers, none of whom have the
as seen in the figure, is ro gcnern te uncmploymenr- powe r ro influc11ce rhc marker wage. In Chaprcr 14 we
workers rhar want a job in rhis marker bur are unable ro will examine non·co mpcririvc labour markers, and we
gcr one-equal ro the amount E:1E:2. will th en sec that minimum wages may hove a differ·
Whom docs rhis policy bencfir? And whom docs ir enc effecc on rhc markcc. This diffcrenc behaviou r of
h::1rm? The owners of firms arc clearl y m::1dc worse off competitive ::ind non-competitive markets in rhc pres·
since rh ey arc now required ro pay a higher wage rhan cncc of minimum wages probably accounts for the
before th e minimum wage was imposed. They respond disagreements among econom ists and policymakers
co this increase in costs bi• reducing their use of labour. rega rd ing th e effects of n1in i1t1um-wagc legislation .
Some (bur nor al l) workers arc made better off. The wo rk· Umi l we proceed co char more advanced discussion,
ers who arc lucky enou)l.h to keep their jobs-E 1 workers however, rhe analysis of a competitive labour n1ar-
in rhc figure-get a higher wage rhan before. The shaded kcc in rhis box prnvidcs an cxccllcnr cxallllplc of rhc
area shows rhe red iscribucion of income away from firms economic effects of a binding price fl oor in specific
and towa1·d these forrunace wo1·kers. Some wo1·kers a1·c ci 1·ct11nsra nccs.
h::1rmed by the policy-the ones who lose their jobs ::is

Figure 5-3 illuscraces che exrreme case, in which all rhe available supply is sold on a
black markec. We say chis case is extreme because there are law-abiding people in every
society and because governmencs ordinarili• have at least some power to enfo rce their
price ceiliugs. Altho ugh some unics of a produce subject co a binding price ceiling will
be sold on the black market, it is unlikely chat all of chat produce will be.
Docs rhe ex istence of a blac k market mean chac the goa ls sought by impos·
ing price ceili ngs have been rhwarred? The answer depends on what the goals are.
Three of the goa ls chat governments often have when imposing a price ceiling are
as fo ll <Jws:

1. To restrict production (perhaps co release resources for ocher uses, such as wartime
milita ry production)
2. To keep specific prices down
3. To satisfy notions of equi ty in the consumption of a produce that is tempo rar·
ily in short supply (such as building supplies innmcdiatcly followi ng a natu ral
When price ceilings are accompanied by a significam black marker, it is not clear
chat any of these objectives are achieved. First, if producers are willing to sell (illegally)
at prices above the price ceiling, nothing restricts them to the level of output of Q2 in
Figure 5-3. As long as rhey can receive more chan a price of p., they have an incencive co
increase their production. Second, black markets clearly frustrate the second objecdve
since rhe actual prices are nor kept down; if quanricy supplied remains below Qo, then
che black-markec price will be higher than rhe free-marke[ equilibrium price, p0 . The
chi rd objective may also be chwarted, since with an active black markec it is likely chat

ava ila ble qllantity of re nral housing will be less than if free·ma rket rents had been
cha rged.
2. The s horrage will lead co alcernacive allocation schemes. Landlords may allocace
by sellers' preferences, or the government may intervene, often through sec:urity-
of-ren ure laws, which protect tenants from evictio11 and thereby give rhem priority
over prospective new tena nts.

3. Black markets will appear. For example, landlords may (illegall y) req uire tenants
to pay " key money" equal to the difference in value between the free-ma rket and
the controlled rents. In the absence of securi ty-of-ten ure laws, landlords may force
tenants out when their leases expire in order co extract a large entrance fee from
new tena nts.
T he unique featu re of rem comrols, however, as compa red with price comrols in
general, is that they arc applied to a highly durable good that provides services to consum-
ers for long periods. Once built, an aparcmem can be used for decades. As a result, che
immediate effects of rent control are typically quite diffe rent from the long-term effects.
T he shore-run supply response to the imposition of re nt controls is usually qu ite
limiced. Some conversions of aparcmenr un ics ro condominiums (char are noc covered
by the rernt-control legislation) may occur, but the quan·
tity of apartments docs not change much. The sho rt-ru n
supply cun·ve for rental housing is quite inelastic. FIGURE 5·4 The Short-Run and Long-Run Effects of
In the long run, however, the supply response to Rent Controls
rent cont ro ls can be q ui te dramatic. If the expected
rate of return from building new rencal housing foils
significantly below what can be earned on other invest·
me nts, funds wi ll go elsewhere. New constructio n will
be haired, and old bui ldings will be converted co other s,
uses o r will simply be left to dete ri orate. The long·
run supply curve of renta l acco mmodations is
Figure 5-4 ill ustrates the housing sho rtage that
wo rsens as time passes under rcnc contro l. Because the
shore-run supply of ho using is inelastic, the controlled
re nt causes only a mode rate housing shortage in the
sho rt run. Indeed, most < Jf the sho rtage comes frum an
increase in che q uantiry demanded rather rhan from a Qua nriry of Rcnral i\"on11nodario11s
reductio n in quantity supplied. As cime passes, how-
ever, fewe r new apartments arc built, more conversions Rent control causes housing shortages that worsen
as time passes. The free ·m:Hkct cquilibr·ium is '\C
take place, and older buildi11gs are nor replaced (a11d point E. The conrrollcd rent of r., forces renrs below
not repaired) as they wear out. As a result, the quantity thei r free-ma rker equilibrium value of r 1. The shorr-
supplied s hrinks steadily and the extent of the housimg run supply of housing is shown by the perfectly
shorcage worsens. inelastic curve S,s. Thus, quantity supplied remains
Along with the growing housing shortage comes at Q1 in the short run, and the housing shortage
is Q1Q2• Over tirne, the quantity supplied shrinks,
an increasingly inefficient use of renra l accom modation as shown by the lor1g-run suppl)' curve Si,. In the
space. Exisci11g re11a11cs will have an i11cencive ro sray long run, there arc only Q3 units <)f 1·c1HJI JCC<)m-
where they are even tho ugh their fam ily size, location modations supplied, fewer than when controls were
of emplo)•mc nt, or economic circumstances may change. insriruted. The long-run housing shorrag-c of Q3Q2
Since they cannoc move wichouc givi ng up cheir low-re nc is larger than rhe initial shortage of Q1Q2·
ac1:ommodation, some may ae1:ept lower-paying jobs

nearby silllply to avoid the necessity of moving. Thus, a situatio n will arise in which
existing tenants wilI hang on to accommodation even if it is poorly suited to their
needs, while individuals and fa milies who are newly encering che housing marker will
be unable co fi nd any rental accommodation except at black·lllarkec prices.
The province of Ontario instituted rent controls in '1975 ancl cightencd chem on
ac least rwo subsequenr occasions. The concrols permicred significanc increases in rencs
only where these were needed co pass on cost increases. As a resulc, the restrictive effects
of re nt controls were fe lt mainly in areas whe re demand was increasing rapidly (as
opposed co areas where only coses were increasing rapidly).
During the mid- and lace-'l 990s, che population of Onta rio grew substantially but
the stock of rental housing did n<Jt keep pace. A shortage developed in the rental-housing
marker, and was especially acure in Merro Toronco. This growing housing shorrage led
the Conservative Onrario government in '1997 co loosen renc controls, in particular
by allowing landlords to increase the rent as much as they saw fit but only as tenants
vacated the apattment. Noc surprisingly, rhis policy had boch crirics and supporcers.
Supporters argued char a loosening of controls would encourage the constrnction of
apa rtments and thus help to reduce the housing short-
age. Cricics argued char landlords would harass existi ng
tena nts, fo rcing chem to move out so that rents could
be inc reased fo r incoming te nants. (Indeed, this behav-
iour happened in renc-conrrolled New York Cicy, where
a landlo rd pleaded guilty to hiring a "hie man" co kill
some tenants and sec fires to the apartments of others to
scare chem ouc so char rencs could be increased!)
Rene control still exists in many Canadian p rovinces,
and the govCrnlllCnts place limits on the annua l rate of
increase of rents. In Ontario in 2012, for example, the
maximllm allowable increase was 3.1 pen.;ent, although
landlords could apply to the regulatory body fur permis-
Perhaps the most strikin.11 effect of rent control is the /o11.11- sion co have a larger increase.
term decline in the a11101111t a11d quality of rental lw11sin}I.

Who Gains and Who Loses?

Existing renancs in rem-concrollecl accommodacions are the principal gainers from a
policy of rent control. As the gap between the controlled and the free-market rencs
grows, and as rhe scock of available housing falls, chose who are still lucky enough co
live in rem-controlled housing gain more and more.
Landlords suffer because they do not gee the race of rewrn they expected on their
invescments. Some landlords are large companies, and ochers are wealchy individuals.
Neither of these groups attracts great public sympathy, even though rhe rental compan·
ies' shareholders are noc all ric h. But some landlords are people of modest means who
may have put their reciremenc savings inru a small apa rtment block or a house or cwo.
They find chat the value of their savings is di minished, and sometimes they fi nd chem·
selves in the ironic positio n of subsidizing te nants who are far better off than they are.
The ocher important group of people who suffer from renc concrols are potential
future tenants. The housing shortage will hurt some of chem because the rental housing
they will requi re will not exist in the fu w re. These people, who wind up livi ng farther
from their places of employmenr and srudy or in apa rtments otherwise inappropriate

to their siw ations, are invisible in debates over rent control because they cannot obtain
housing in the rent-controlled jurisdiction. Thus, rent control is often Sta ble politically
even when it causes a long-run housing shortage. The 1.:urrenr tenanrs be11efir, and chey
outnum ber the current landlords, while the potential tenants, who are harmed, are
nowhere co be seen or heard.

Policy Alternatives
Most rent controls today arc meant to protect lower-income tenants, not onl)' against
"prufiree ring" by landlords in rhe face of severe loca l shorrages bur alsu againsr che
steadily rising cost of housing. The market solution is to let re nts rise sufficiently to
cover the rising costs. If people decide that tlie)' cannot affo rd the market price of
aparcmencs and will noc rent them, cunscrucciun will cease. Given whac we kn uw abu uc
consu111er behaviour, however, it is more likely that people will make agonizing choices,
both to economize on housing and to spend a higher proportion of total income on it,
which mean consuming less housing and less of urher things as well.
If governments do not want to accept chis market solution, there are 111any things
they can do, but tl1e)1 cannot avoid the fundamental fact that the opportuni ty cost of
guud housing is high. Binding renr cuncruls create ho using shurcages. The shurcages
can be removed onl y if the government, at taxpayer expense, either subsidizes housing
productiun or produces public housing directly.
Alrernacively, che guvernmenc ca11 make housing mure affordable cu lower-i11cume
households by providing income assistance directly to these households, thereby giv-
ing chem access w higher-quality housing rhan thC)' rnuld otherwise affo rd. Whatever
policy is ndu pred, it is imporra1ir cu recug11ize chat providing grearer access ro renral
accommodations has a resource cost. The costs of providing additional housing cannot
be voted our of exiscencc; alI that can be d<Jnc is co tra nsfer rhe rnscs from one sec of
persu11s co anocher.

I 5.4 An Introduction to Market Efficiency

ln chis chapcer we have seen che effeccs of governmenrs imervening in compeciri ve mar-
kers by secting price fl oors and price ceilings. Jn both cases, we noted that the impos-
icion of a controlled price generares benefits for some individuals and coses fo r ochers.
For example, in che case of che legislated minimum wage (a price floor), fi rms are made
worse off by the minimum wage, but workers who recain dieir jobs are made bener
uff. Ocher wo rkers, rhuse unable cu recain rheir jobs ac rhe higher wage, may be made
worse off. In rhe example of legislated rem comrols (a price ceiIing), landlords are
made worse off by che rent controls, but some tenants are made better off. Those cen-
ancs whu are nu longer able cu find an aparcmenc when renrs fo ll are made wu rse off.
ls ir possible to derermine rhe overall effecrs of such policies, rather chan jusc die
effects on specific groups? For example, can we say that a policy of legislated minimum
wages, while harming firms, nunecheless makes society as a whole beccer off because
it helps workers more than it harms fi rms? Or can we conclude that the imposition of
re nt controls makes society as a whole better off because it helps te nants more than it
harms landlords?

To address such questions, economists use the concept of market efficiency. We will
explore this concept in more detai l in later chapte rs, but for now we simply introduce
rhe idea and see how it helps us understand rhe overall effecrs of price controls. We
begin by caking a slightly different look at market demand and supply curves.

Demand as "Value" and Supply as "Cost"

In Chaprer 3 we saw char rhe marker demand curve for any prnducr shows, for each
possible price, how much of that product consumers want to purchase. Similarly, we
saw char rhe marker supply curve shows how much producers wane co sell ac each pos-
sible price. Bm we can rum rhings around and view rhese curves in a slighrly differenr
way- by stardng with any given quantity and asking about the price. Specifi cally, we
can consider rhe highesr price clime consumers are willing to pay and rhe lowesc price
chat producers are 111illi11g to accept for any given unir of rhe produce. As we will see,
viewing demand and supply curves in chis manner helps us chink about how society
as a whole benefits by producing and consuming any given amuunr uf sume p roduce.
Lee's begin by conside ring rhe marker de mand curve for pizza, as shown in pare (i)
of Figure 5·5. Each point on the demand curve shows the highest price consumers are
willing cu pa)' fur a given pizza. (We assume fo r simpliciry char all pizzas are idencical.)
Ac poinr A we see char consumers are willing to pay up ro $20 for rhe 1OOch pizza, and
at point B consumers are willing to pay up to $ '15 fo r the 200th pizza. Tn both cases,
rhese maximum prices reflect the value cu11sumers place un char particu lar pizza. In
general, for each pizza, the price on the de mand curve shows rhe value to consumers
from consuming that pizza.

A GU RE 5·6 Reinterpreting the Demand and Supply Curves for Plua

20 20

15 15
~ !::'.?.
·c; ~
"" JO "'" 10

5 s

0 JOO 200 JOO 400 0 100 200 JOO 400

Q uantity Quantity
{i) Dtmand (ii) Supply

For each piva, the price on che demand curve shows the value consum ers receive from consuming thac piiia; the ·price on
the supply curve shows che additional cost to firms of producing that piu.a. Each point on the demand cu rve shows the
maximum price consumers arc willing ro pay ro consume rhat unit. T his maximum p1·icc 1·cflccrs the va lue diat consum·
crs get from rlur un ir <)f rhc p1·oducr. Each point on rhc su pply cu rve shows rhc minimum pr·icc firn1s ar·c willing t<) accept
fo r producing and selling char un it. This minimum price reflects the additional cosrs incurred by producing that un ir.

The reason the de mand curve is downward sloping is chat not all consumers are
the same. Some consumers value pizza so highl)1 that d1q1 arc willing to pay $20 fo r a
pizza; others are prepared cu pa)' onl)' $10, while surne value pizza su little that they are
prepared co pay only $5. There is nothing special about pizza, however. What is trne fo r
the clemancl for pizza is true fur the demand fo r any ocher product:

For each unit of a product, the price on the market demand curve shows the value
LO consumers from consuming that unit.

Now Ice's consider the market suppl)' curve for pizza, shown in part (ii) of f igure 5-5.
Each puinr un die market supply curve shuws che lowest price fi rms are willing w
accept co produce and sell a given pizza. (We maincain our simplifying assu mption chat
all piuas arc identical.) At point E firms arc willing to accept a price no lower than $5
fur rhe 1OOch pizza, and ar point F firms are will ing co accept a price 110 lower than $10
for the 200d1 pizza. The lowest acceptable price as shown on the supply curve reflects
the additional cost firms incur to produce each given pizza. To sec this, consider the
pruductiun uf the 200rh pizza ac puinr F. If rhe firm's cural cuscs increase by $10 when
chis pizza is produced, the firm will be able to increase its profits as long as it can sell
that pizza at a price greater than $10. If it sells the pizza at an)' price below $ I0, its
profits will decline. If it sells the pizza at a price uf exactl y $ 10, its profits will neither
rise nor· fa lI. Thus, for a profit-maximizing firm, the lowest acceptable price for the
200th pizza is $'10.
The reason char rhe supply curve is upward sloping is char nut all producers ai:e the
same. Some are so good at producing pizzas (low·cusc producers) rhar rhey would be
willing to accept $5 per pizza; others arc less easil)' able en prnclucc pizzas (high-cost
producers) and hence wo uld need ro receive $15 in order ro produce and sell rhe identi-
cal pizza. What is rrue for rhe supply of pizza is rrue for rhe supply of ocher produces:

For each unit of a product, the price on the market supply curve shows the lowest
acceptable price ro &ms for selling that unir. This lowest acceptable price reflects
the additional cost to fi rms from p roducin~ that unit.

Economic Surplus and Market Efficiency

Once the demand and supply curves are pur rogether, the equilibrium price and quanriry
can be dete rmined. This brings us to the imporcant concept of economic surplus, We con-
tinue with our pizza example in Figure 5-6, which shows the demand and supply curves
together. Consider a quamiry of 100 pizzas. For each one of chose 100 pizzas, the value co
consumers is given by the height of the demand curve. The additional cost to firms from
producing each uf these 100 pizzas is shown by the height of the supply curve. Fur the emi re
JOO pizzas, the difference between the value ro consumers and the additional coses co firms
is called economic surplus and is shown by the shaded ar·ea CD in the figure.

For any Kiven quantity of a product, the area below the demand curve and above
the supply curve shows the economic surplus associated with the production and
consump tio n ol' that product.

What does this economii; surplus represent? T he e<.:onomic surplus is the net va lue
that society as a whole n:ceivcs by producing and consuming these 100 pizzas. Jr arises
because firms and consumers have caken resou rces chac have a lower value (as shown
by the height of the supply curve) and transformed them into something vallued more
highly (as shown by che heighc of che demand curve). To puc ic differcncly, chc val ue
from consuming rhe 100 pizzas is grearer rhan rhe cost of rhe resources necessary co
produ<.:e chose ·100 flour, yeast, tomato sau<.:e, cheese, and labour. Thus, che aa
of producing and consuming those I00 pizzas "adds value" and genera res benefits fur
society as a whole.
We are now ready to introd ui;e the w ni;ept of market effii;ieni;y. Jn late r d iaprers,
afte r we have explored consume r and Firm behavio ur in greater detail, we will have a
more de railed discussion of efficiency. for now, we simply inrrod uce rhe concepr and
see how it relates to the imposition of govern ment price controls.
Economists say that a ma rket fo r any specific
produce is efficiem if che quanri ty of the prod uce
RGURE 5-6 Economic Surplus in the Pizza Market produced and consumed is sud 1 that the eco-
nomic surplus in that marker is max imized. Note
char chis refers to the total surplus but nor its
Total shaded areas arc distribution between consumers and p roducers.
For example, as we will sec in the next section,
20 the removal of a binding sec of renr controls will
increase to tal surp lus and thus improve the effi-
ciency of the market. i\t the same time, however,
<;; 15 some te nants will be made worse off while some
"';;' l 2.50 landlords will be made better off. T he fact that
10 tota I surp lus has increased means that, at least
in principle, it wou Id be possible fo r t hose who
gain to compensate those who lose so that every-
s one ends up being better off. When economists
say chat "societ)' gains" when market efficiency
is enhanced, even though these <.:ompensations
0 100 200 250 JOO 400 rarely occur, t here is an im plicit va Jue j udgemcnt
Quu11riry being made chat the benefics co rhuse who gai n
outweigh the costs to those who lose.
For any qu antily of pinas, the area below the demand curve Lee's ap pl)' this concept of cfficicnc)' cu che
and above rthe supply curve shows rhe economic surplus gen-
erated hy the production and conmmption of those pizzas. pizza marker shown in Figure 5-6 and ask, Whar
The demand curve shows the v:iluc co nsum ers place on level of pi1,7.a productio n and consumption is effi-
eac h addirional pizza; rhc supply curve shows rhc addirional cient? Consider the quancicy of ·100 pizzas. J\r
cosr associared wirl1 produc ing eac h pizza. For exam ple, rh is quanri ry, the shaded area <D shows rhe rora l
consumers value the IOOth pizza at $20, whereas the addi- economic surplus that society receives from pro-
tional cost to firms of producing char lOOch pizza is $5. The
economic surplus gcncr:ucd by producing and consuming ducing and consuming 'I 00 pizzas. But if outpu t
this IOOch piu.j is therefore $ 15 ($20 - $5) . Fo r any range were co increase beyond 100 pizzas, more eco-
of qu:rntiry, the sh:ldcd ;i1·e:1 between the cur·ves over th;ir nomic surp lus wo uld be generated because the
range shows rhe eco nomic surplus gencrarcd by producing val ue placed by consumers on additiona l pizzas is
and consumi ng rhosc pizzas. greater than che additional coses associated with
Economic surp lus in rhe pi zza ma rker is maximized-
and rhus marker efficiency is achieved-at rhe free-marker their production. Specifically, if produc tion and
equilibrium qunntiry of 250 pizzns nnd price of $ 12.50. Ar consum ption we re co increase co 200 pizzas, addi-
chis point, torn( economic surplus is rhe sum of rhc three tional economic surplus would be ge nerated, as
shaded arcns. shown by shaded area~. Contin uing this logic,
we sec that the amoun t of economic s urplus is

maximized when the qllantity is 250 llni ts, and at that qllantity the total economic
surplus is equal to the sum of areas CD, (2), and (].
Whac wo uld happen if che quanricy of pizzas were ro rise fu rther, say co 300 unirs?
For any beyond 250, the value placed on these pizzas by consumers is less than
che additi onal coses associated wirh cheir pruducci011. Jn chis case, producing che lase
50 pizzas would acrually decrease rhe amou nr of economic surplus in chis markec
because society would be ca king highly valued resou rces (flour, cheese, etc.) and trans·
funn ing rhem inro pizzas, which are valued less.
In oun'. example of rhe pizza marker, as long as rhe price is free ro acljus r ro excess
de mands or supplies, the equi libri um price and quantity will be determined where che
dema nd and supply curves fur pizza incersecr. Jn Figure 5-6, rhe equili brium quan ricy
is 250 pizzas, rhe quanri cy char maximizes che amounr of economic surplus in rhe pizza
ma rket. Jn other words, the free inte raction of demand and supply will res ult in market
efficiency. This resulr in rhe pizza marker suggests a more general rule:

A compecirive markec will maximize economic surplus and therefore be efficient

when price i~ free to achieve its market-clearin~ equilibrium level. 1

Market Efficiency and Price Controls

At the beginning of this section we asked whether we could determine if society as
a whole is made better off or worse off as a result of the government's imposition of
price fl oo rs or price ceilings. Wirh an undema nding of economic surplus and marker
efficiency, we are now ready co consider these qllestions.
Let's begin with the case of a price floo r, as shown in part (i) of Figure 5-7. The
free-markec equi libri um is shown by point£, with price Po and quanciry Q 0. When rhe
govern ment imposes a price floo r at Pi. the quantity exchanged fa lls to Q1• In the free·
market case, each of the units of output between Qo and Q1 generates some economic
surplus. Bue when che price floor is pur in place, rhese unirs of rhe good are no longer
produced or consumed, and thus they no longer generate any economic surplus. The
purple shaded area is called rhe deadweight loss caused by rhe binding price floor, a11d
ir represenrs rhe overall loss of economic surplus ro society. The size of rhe deadweighr
loss reflects the extent of market i11e(ficie11cy.
The case of a price ceiling is shown in part (ii) of Figure 5-7. The free-market
equi libriu m is again shown by poinr £. wirh price Po and quanciry Q0 . When rhe
government imposes a price ceiling at p2 , the quancicy exchanged falls co Q 2. Jn the
free-market case, each uni t of outp ut between Q 0 and Q2 generates some economic
surplus. Bur when che price ceiling is imposed, chese unics of che good are no longer
produced or consumed, and so they no longer generate an y economic surplus. The
purple shaded area is the deadweight loss and represents the overall loss of surplus
co society caused by rhe policy. The size of che deadweighc loss refleccs rhe exrenc of
market in efficiency.

The imposition of a binding price ceiling or price lloor in an otherwise free and
competitive market leads to market inefficiency.

In Parr 6 oi' chis book, we will see some i111porranc exceptions to chis rule when we discuss "marker failures."

RGURE 5·7 Market Inefficiency with Price Controls

Rcduccion in economic Retluccion in economic

surplus caused hy the s surplus caused by tht s
prke noor p1·ice ceiling

~ pfl l
/>1 f----.,j--~--.......~--

Quaiitity Quantity
(i) Binding price floor (ii) Binding price ceiling

Rinding price fl oors ;ind price ceilings in compelitive mnrkets lead to u reduclion in overall economic surplus andl 1hus IO
market inefficiency. In both pa rts of the figu re, the free· markcr eq uil ibri um is at point F. with price Po and quantity Qo.
In part (i), die imroducrion of a price floor at p 1 reduces quanriry to Q 1• In pan (i i), the introduction of a price ceiling ar
p2 1·educes quantity ro Q2. In boch pa rrs, the purple shaded area shows the reduction in ove1·all econom ic su rplus- rhe
deadweighc loss-c1·eaced by rhe price fl oor or ceiling. Boch outcomes display marker inefficiency.

Tt is worth repeati ng a central point: binding price floo rs and price ceilings do
more tha n merely redistribute a given amount of economic surplus between buye rs and
sellers. They also lead to a red L~ction in the quamity of the product tra nsacted and a
reduction in total economic surp lus. Society as a whole receives less econom ic surplus
as compared with the free-ma rket case.

One Final Application: Output Quotas

Before ending this chapter, it is usefu l co consider one final application uf government
inte rventio n in a competitive ma rket, and to examine the effects 0 11 overall economic
surplus and marker efficiency. !Figure 5-8 illustrates rhe effects of inrruduci 11g a sys-
tem of output quotas in a competitive markec. Outpur quoras are common'ly used in
Canadian agriculcure, especia lly in the markets for milk, butter, and cheese. Output
quuras are sometimes used i11 or'1er inclusrries as well; for example, rhey are ofren used
in large ciries co regulate rhe number of raxi drivers.
The equilibrium in the free-ma rket case is at point P, with price /Jo and quantity Q0.
Whe n the gnvernmenr introduces an output quota, it restricts tntal output nf this prod-
uce co Q 1 unirs and chen distribuces quocas- "licences co produce"- among rhe pro-
duce rs. With output restricted to Q1 units, the market price rises to p 1, the price that
consume rs arc willing to pay for chis quantity of the product. The purple shaded area-
the deadweighc loss of the ompu t quota- shows the overall loss of economic surplus as
a result of the quota-induced output restriction.
One interesting consequence of the use of output quotas relates to the marker value
of the quoras themselves. When quoca systems are used, fi rms initially issued quotas by
the government are usually permitted to buy or sell quotas co each other or co new firms
interested in ente ring the industry. The quota itself simply provides the holder permission

to produc·e and sell in that industry, but the market value

of the quota reflects the profitabilit)' of that production. FIGURE 5·8 The Inefficiency of Output Quotas
As yo u can see frurn Figure 5-8, che uucpuc resrricciun
created by the quota leads to an increase in the product's
price. If demand For che product is inelastic, as is che case Maximum output
;/level under che quota s
in the dairy markets where quotas are cummu11ly used,
total income to producers rises as a result of the reduction
in output. (Refer back to figure 4-5 in Chapter 4.) But
since cheir output fa lls, firms' producriun coses are also
reduced. The introduction of a quota system therefore
leads to a rise in revenues and a fall in production costs-
a clear benefit for producers! Noc surprisingly, individual
producers are often prepared to pay a high price to pur·
chase quotas from ocher producers because having more
quotas gives chem che ability cu produce more ompuc.
There is a catch, however: producers muse incur
a very high cost in order to purchase the quotas. For
example, an average dairy farm in Ontario or Quebec Quami1y
has about 90 cows and produces abo ut 2300 litres of
milk per day. The rnarkec value of the quota required to
produce chis amoun t of mil k is approximately $2.2 mil- Binding output quotas lead to a reduction in out-
put and a reduction in overall economic smplus.
lion. The ownership of a quota therefo re represents a The free-marker equilibrium is ar poinr E wich
considcra blc asset fo r chose producers who were lucky price Po and quantity Q 0• Suppose the govcrnmcnr
enough w receive it (fur free) when it was initially issued then restricts total quantity to Q1 by issuing output
by the govern ment. l3m for new producers wa nting to quor:is to firms. The m:irket price rises to p 1• The
get into the industr)', the need to purchase an expensive purple shaded area shows the reduction in overall
economic surplus- the dcadweighr loss- created
quota represents a considerable obstacle. These large by the quota system.
costs from purchasing the quota offset the benefits fro m
selling the product at the (q uota-induced) high price.

A Cautionary Word
In chis chapcer we have examined che effeccs of governmenc policies cu conrrol prices in
otherwise free and competitive markets, and we have shown chat such policies usually
have cwu results. Fim, chere is a rediscrib ucion berwee11 buyers and sellers; one gwup is
made becrer off while rhe ocher group is made worse off- ac lease as far as rhe economic
value of production is concerned. Second, the re is a reduction in the overall amo unt of
economic surplus generared in rhe marker; rhe result is chac rhe omcome is i11efficiem
and sociery as a whole is made worse off.
The finding that government inte rvention in otherwise free markets leads to ineffi-
ciency should lead one cu ask why governmcnr would ever inrervene in such ways. The
answer in many simacions is char che governmenr policy is mocivaced by che desire co
help a specific group of people and that the overall costs are deemed to be a worthwhi le
price cu pay ro achieve che desired effect. For example, legislated minimum wages arc
ofcen viewed by politicians as an effecrive means of reducing poverry- by increasing
the wages received by low-wage workers. The costs such a policy imposes on Firms, and
on society overall, may be viewed as coses worth incurring co redis tribute economic
surplus coward low-wage workers. Similarly, che use of output quoras in certain agri-
cultu ral markets is sometimes viewed by politicians as an effective means of increasing
income cu specific farmers. The coses chat such quota systems impose on consumers,

and on society as a whole, may be viewed by some as ac<.:eptable <.:osts in achieving a

redistribution of economic surplus towa rd these fa rmers.
In advocating chese ki nds of policies, ones chac rediscribute economic surplus buc
also reduce the total amoun t of economic surplus ava ilable, policymakers are mak-
ing normative j uclgements regarding which groups in society deserve to be helped at
rhe expense of ochers. These judgemencs may be informed by a careful srudy of which
groups are must genuinely in need, and they may also be driven by political cunsidera·
cions that the currenc governme nt deems important en ics prospects fo r re-election . Tn
eirher case, rhere is norhing necessarily "wrong" abour rhe governmenr's decision ro
inte rvene in these markets, even if these interventions lead to inefficiency. Not surp ris-
ingly, however, decisinns like this arc often controversial and hotly debated.
The job of rhe economise is ro carefully analyze rhe effecrs of such policies, rak-
ing care to identify both the distributional effects and the implications for the overall
amo unt of economic surplus generated in the market. This is positive analysis, empha-
sizing rhe actual effecrs of rhe policy racher rhan whac mighc be desirable. These ana-
lytical results can then be used as inputs to the decision-making process, where they will
be combined with normative and political considera tions befo re a fi nal policy decision
is reached. In many pares of chis cexrbook, we will encouncer policies cha r govern-
ments implement (or conside r implementi ng) to alter market outcomes, and we will
exarnine the effects of those policies. A full understanding of why specific policies arc
implemenred requires paying arrenrion to the effects of such policies on both che overall
amount of economic surplus and the distributio n of that surplus.


5.1 The Interaction Among Markets LO 1

• Partial-eqt1ilibrium ana lysis is the scudy of a single • Parrial-cqui librium analysis is appropriate when the
market in isolation, ignoring events in other markets. marker bei ng exa mined is sn1all relative to the enti re
Gcneral-cq uilibrium ana lysis is the study of all markets economy.

5.2 Government-Controlled Prices LO 2

• Government price conrrols arc policies rhar acrempc co be sold, 01· rhe government musr seep in and buy the
ho ld rhe price of some good or service at some disequi- surplus.
libri um value- a value that could not be mainta ined in • Rinding price ceilings lead to excess demand an d pro-
rh e absence of rhe governm ent's inrervemion. vide a strong inccnrivc for black marketeers ro buy ar
• A binding price fl oor is scr above the equi librium price; the controlled price and sell at the higher free-mark et
a binding price ceiling is scr below the equilibrium price. (illegal) price.
• llinding price floors lead to excess supply. Either the
potencial sellers arc lefr with quanti ties that ca nnot

5.3 Rent Controls: A Case Study of Price Celllngs LO 3

• Rent controls arc a form of price ceiling. The major con- • Beca use th e supply of rclltal housing is much more
sequence of binding rent con trols is a shortage of ren tal elastic in the long run rhan in rhe short run, the exrcnr
accommodations and the al location of rental housi ng by of the housing shortage caused by rent conrro ls worsens
sellers' preferences. OVCI' rime.

5.4 An Introduction to Market Efficiency L04

• Demand curves show consum ers' willinp;ness to pay for co thac quantity) shows the economic surplus p;cncraccd
each uflir o( rh c product. For any given quanrity, die by rhe producrion and consumption of rho~e units.
area below rhc demand curve shows the overall va lue • Economic surplus is a common measure of market effi-
l11at co1
1sumcrs place on rhac quantiti• of the producr. ciency. A marker's surplus is maximized when the quamity
• Supply curves show rhc lowest price prnduccrs arc pre- exchanged is determined by chc inrerscccion of the demand
pared ro accept in order to produce and sell each unir of and supply curves. 'l'his outcome is said to be efficient.
rhe producr. This lowcsr acceprable price for each addi - • Policies rhar inrervene in ocherwisc free and comperirive
tional unit reflects the firm's costs required to produce markets-such as price floors, price ccili.n14s, and out-
each additional 11nir. put quot;is- i;cncrall y lead to a reductio n i11 the rotal
• For any p;iven quanrity exchanged of a producr, che area amoum of economic surplus generaced in chc marker.
below the demand curve and :tbovc die supply curve (up Such policies arc inefficient for society overall.

Gcner:il-cq llilibrillm :111:1lysis Black m:u·kcts Economic surplus
Parcial-cq ui librium analysis Rent controls Market efficiency
Price controls: fl oors and ccilin,As Shorr-run and long-run supply curves Inefficiency of price controls and
Alloc:icion by sellers' preferences of rent:d accommodations oucpur quotas


M:1ke the gmde with MyEconU.1b: Study Exercises marked in red can be found on
MyEconLab MyEcooLab. You can practise rhem as often as you want, and most feature step-by-step
guided instructions to help you find the right answer.

1. Consider che market for straw hats on a tropical island. b. Suppose the government believes that no islander
The demand and supply schedules a1·e given below. shou ld have co pay more rhan $3 for a hat. The gov-
crnn1cnt can achieve this by i111posi ng a _ _ __
Price($) Qu:intiry Demanded Quanticy Supplied c. Ar rhe p,ovcrnmcnt·controllccl price of $3 th ere will
be a of hats.
I 1000 200 d. Suppose now rhat rhc governmcnr believes rhc island's
2 900 .300 hac makers arc not paid enou14h for their hats and
3 800 400 that isbndcrs should p;)y no less rh:in $6 for a hat.
4 700 500 They can achieve chis by imposing a
5 600 600 e. At chc new govcrnmcn r-controllcd prricc of $6 chcrc
6 500 700 wil l be a of hats.
7 400 800 2. The fol lowing questions are abouc resource al location
8 300 900 in rh c presence of price ceilings and price floors.
a. The equilibrium price for scraw h:ics is _ _ _ __ a. 1\ binding price ceiling leads to excess dcm:ind.
The equilibrium qu;incicy demanded ;ind qu;1nrity What arc some methods, ocher rhan price, of ;1llo·
supplied is _ _ _ __ eating th e available supply?

b. A binding price floor leads ro excess su pply. How Whar is the highest level ar wh ich such o ceiling
might the govcrn menr deal with th is excess supply? could be sec in order to have any cffecr o n the mar-
c. Why migh t rhe governmcnr choose ro imp lemenr a ker? Explain )'OLLI' answer.
price ceiling? c. Suppose the maximum rental price is set equal to
d. Why rnighr rhc government choose to implemenr a $500 per month. Describe rhe effect on quantity
price floor? dem:in dcd, supplied, and cxch:inged in the rc ntal-
housing mark et.
3. Co nsider the marker for so nic product X rhat Is rcprc·
d. Suppose a black rn:trkct develops in the presence
senced in rhe demand-and-supp ly diagra m.
of the rent contro ls in pa re (c) . What is the black-
rn arkct price that wou ld cxisr If all of the quantity
/J supplied wc1·e sold on the black marker?
5. Explain and show in a diai;ran1 why the short-run
effects oi re m control arc likely ro be less significanr
rhan the long-nm cffccrs.
6. In cities experiencing rapid growth , like Calgary and
Saskatoon, ir is often cloiincd rhar the "overheated"
rea l estare marker puts housi ng our of reac h of ordin-
p• ary Ca nadians. Not surprisingly, governmen ts often
dcbarc l\1)W bcsr ro deal wirh rhis issue. Wh <> bca1·s the
heaviest cost when rcnrs arc kept artifidally low by
each of rhc follow ing means?
a. legislated ren t controls
b. a subsid y to tenants equal ro some fractiton of thei r
0 rent
c. the provision of public housing wh ich is made
avail:iblc at bclow-111:.irket rents
a. ~up pose the governmen t decides to im pose a price
f1001· at p 1• Descri be how this affccrs price, q ua11· 7. Consider the marker for burriros in a hyporh erical
riry, and marker efficiency. Can adian city, blessed with thousands of smdcnrs ~111d
b. ~upposc the jl.ovcrnmcnt decides ro impos~ a pdcc dozens of smal l burrito srands. The demand and sup-
floor ar P2· Descri be how this :1ffccts price, quan· ply schedules arc shown in rh c table.
rity, and marker efficiency.
c. Sup pose the government decides ro impose a price Quanriry QuMtity
ceiling ar p,. Describe how this affects price, quan· Dema nded Supplied
tit)', and market efficiency. Price ($) (rhousn nd~of burritos per monthl
d. Suppose rhc government decides to impose ;1 price
ceiling ar P2· Describe how this affects price, quan -
0 500 125
riry, and market efficiency.
1.00 400 175
1.50 .350 200
4. Consider the market for rental housing in Yourtown. 2.00 300 225
T he demand :rnd supply schedu les for rcnral h<l usi ng 2.50 250 250
arc given in rh c table. 3.00 200 275
3.50 ISO 300
Price Quanrity Demanded Quantity Supplied 4.00 100 32.5
($ per momh ) (th ousands of unirs) (rhous:inds of unirs) .5.00 0 375
11 00 40 80
1000 a. Graph rhc demand a11d supply curves. What is the
50 77
free-market equilibrium in rhis marker?
900 60 73
b. Whar is rh c rota l eco nomic surplus in thi s market
800 70 70 in the free-1t1:1rkcr C{1uilibriu111? What arrea in your
700 80 67
diagra m represents this economic surplus?
600 90 65 c. Suppose the local governmenr, our of co ncern fo1·
500 100 60 the students' welfare, enforces a price ceiling on
a. In a Free market for rcnra l housing, what is the burriros ar a p1·icc of$ I .SO. Show in yo ur diagram
~quilibrium price and quanriry? the effect on price and quantity exchanged.
b. Now suppose the µovcrn111cnt in Yourtown decides d. Are srudenrs better off as a resu lt of th is policy?
ro impose :1 ceiling on chc mo nrhly renta l pl'ice. Explain.

e. What happens to over:1ll economic surplus in this 10. This question rcl ~rcs to the section Link:1gcs Hclwccn
marker as a result of the price ceiling? Show th is in Markets found on the MyEconL:ab (www.mycconlab.
the dia14r:un. com). In 1994, the Quebec and Ontario governmen ts
~ip,n i(icanrly red uced thei r excise t:ixes on ciga1·ccces,
8. Consider the market for mil k in Saskatchewan. If p is
bur Manitoba and Saskatchewa n left tlhcirs in place.
the price of 111ilk (ccnrs per litre) and Q is th e q11a11-
This led to cigarette sn1uAAli r1g between provinces that
tity of litres (i11 millions per month), suppose rh:u rhc
linked the provinci:il m3rkers.
demand and supply curves for milk arc given by
a. Draw a simple dema nd-and-supply diagram fo1·
Demand: /J - 225 - 1SQI>
the "E:isrcrn" marker :ind a scp:irarc one for the
Supply: p - 25 1 3SQ'i "Western" market.
a. Assuming rh crc is no governmenr interven tion in b. Suppose rhac ciga rette ra xes a1·c reduced in che
rh is marker, what is the cquil ib1•ium price and easte rn market. Show the immediate effecrs.
quantity? c. Now suppose rh ar dl(' supply of ciga retrcs is
b. Now suppose th e government guarantees mi lk (illegall y) 111obilc. Explain :ind show what happens.
producers a price of $2 pc1· litre and promises to d. Wh at limits th e extent of smuAAling that will tak e
buy any amoun t of mi lk thar the producers cannot place in chis si ruacion ?
sell. What arc th e quantity demanded and quantit)' 11. Consider a sim ple dema nd·and-supply model of a com-
supplied ar chis guaranteed price? petitive la bou r marker in a sma ll town. The dcm3nd
a. How mu ch milk would the govcrnmcnr be buying and supp ly curves for labour arc given l;y
(per monrh ) with this system of price supports?
d. Who pays for the mil k that the government buys? Demand: w - 18 - 31.D
Who is helped by this policy and wh o is harmed? Supply: tll - 3 I 2Ls
9. This question Is related to the 11se of output quotas in whc1·c 111 is the wage ($ per hour) :ind L is rhc numbc1·
che milk marker in chc previous question. SL1ppose rhc of hours of employment (measured in thousa nds of
govemmcm used a quom system i1mcad of dirccr price hours per month).
suppo rts ro assist milk pmduccrs. ln parricula1; ir issued
a. Plot the demand an d supp ly curves to scale.
quotas to existing mil k producers for 1.67 mi llion li tres
b. Solve for the equilibri um level of w and L in chc
of mi lk per 111onth.
case of no governmcm i11rcrvention.
a. If mi lk production is exactly equal to rhe amount c. Now suppose char the town co uncil imposes a min-
of quoras issued, whar price do consumers pay for imum wage equal to $10 per hour. What is the new
mi lk? level of crnploymcnr?
b. Compa red with the direcc price contro ls in the pre- d. Identify in yo ur diagram the area th:it is the dead·
vious question, whose inco1t1c Is highc1· under th e weight loss. Compute its size, measured in thou-
qoora sysrcm? Whose is lower? sa nds of dollars per month.
After studying this chapter you will be able to

6,1 MARGINAL UTILITY AND CONSUMER CHOICE 1 describe the difference between marginal and total utility.
2 explain how utility-maximizing consumers adjust their
expenditure until the marginal utility per dollar spent is
equalized across products.

6.2 INCO ME AND SUBSTITUTION EFFECTS OF PRICE CHA NGES 3 understand how any change in price generates both an
income and a substitution effect on quantity demanded.

6.3 CO NSUMER SURPLUS 4 see that consumer surplus Is the "bargain" the consumer
gets by paying less for the product than the maximum
price he or she is willing to pay.
5 explain the •paradox of value:·

IMAGINE that you stop at a corner store with a $20 bill in some detai l why demand curves arc negatively
in yollr pockec, looking fo r lace-nighc snacks ro have sloped- and also discuss rhe rare siruarions in
while you arc Studying. Yo u musr choose how co divide which demand curves might be positively sloped.
this $2U bet"-veen Frozen burritos and bottles of your The chird and final seccion examines an imporcanc
favourite juice. How du you make this decision? implicacion of having ncgacivcly sloped demand
Jn this chapter we look at how economisrs analyze curves and inrroduces the concept of consumer
such problems-the cheory of consumer behaviour. surplus, which is pare of rhe economic surplus chac
Nor surprisi ngly, economists thi nk about consumers we discussed in Chapter 5. As you wi ll see in lacer
as caring bo rh abour che prices of che goods and che chaprers, consumer surplus is useful in showing chac
satisfaction they get from the goods. free and competitive markets often gcneracc cffi-
The first rwo sections of rhe chaprer explore rhe cienc ouccomes.
underpinnings of consumer behaviour and explain

I 6.1 Marginal Utility and Consumer Choice

Consumers make all kinds of decisiuns-chey choose co drink coffee ur cea (ur neicher),
ro go ro che movies, ro go out for· dinner, and to buy top-of-the-line (or not so good)
compurcr equi pment. As we discussed in Chapter l, cc:<Jno111isc~ assume chat in making
their choi(;es, i:onsurners are motivated ro maximize rheir ucilit)', the rural sarisfoi:cion utility The satisfaction lha1
that they derive from che goods and services char they (;Onsume. a cof\Su1ner r~oeives from
eonsumln& some 8000 or
Although ucility cannot be measured direc:dy, ic is still a useful c:on.:ept. You know chat service.
you derive sacisfacciun-or uciliry-from eating a good meal, listening cu musk, buying
new shoes, or taking a walk through a pa rk. And we need some way to think Jbouc how
you as a consumer make your decisions. i\s we will sec in chis chapter, it is po$sible co
co11strncr a usefu l theory of consumer behaviour based 011 rhe idea of utility maximizatio11.
Tn developing our theory of consumer behaviour; we begin b)' considering the consump·
tion of a single produce. Ir is useful to distinguish between rhe consumer's weal utility, total utlllty lihe total satisfaction
whid1 is the fu ll sarisfacciun res ulring from rhe consumprion of rhar produce by a co11- resulting from the CQllS\lmption
of a given commodity by a
sumer, and the consumer's marginal utility, which is the additional satisfaction resulting consumer.
fro m consuming one more unit of thac product. For example, the tutal utility of con-
suming five boccies uf frui r juice per day is che ru ral sacisfaccion char chose five juices m0rglnal uUlity The addlUonal
salislacdon obtained horn
provide. T he marginal utility of the fifth juice consumed is the additional satisfaction consuming one eddltlooel unh
provided by rhe consum ption of char fifth juice each da)'. 1 of a common lty.

Diminishing Marginal Utility

The central hypothesis of utility theory, often called the law of di111inishi11g mal'ginal
utility, is as follows:

1"he utiliry char any consumer derives from successive m1its of a particular prodllct
consum.ed over some period of time diminishes as total consumpcion of the product
iucreases (holding consmm the conswnpcion of aU ocher produces).

Conside r your utility from using clean water, for drinking, bathing, washing yo ur
dishes or clothes, and all its other purposes. Some minimum q1Jantity is very importa nt
and )' OU would, if necessa1')', give up a considerable sum of money ro obtain that qua n·
city of water. Thus, your marginal miliry of that basic quantity of water is very high.
You will, of course, consume more than this bare min imum, but your marginal utility
of success ive litres of water used over a period of time wil l decline steadily.
We will consider evidence fo r this hypothesis later, but you can convince yo urself
that it is at lease reaso nable by asking a few questions. I low much money would be
needed co induce you co reduce your consum prion of water by one lirre per week? The
answer is very little. How muc h would induce )'OU to reduce it by '' second litre? Ry
a third litre? To onl)1 unc litre consumed per week? The answer tt> the la$t question is
quite a lot. The fewer lirres you are already using, the higher the margi11al mil icy of one
more litre of water.

1Tcchnknll y, incremental utility is mea~ured over u discrece interval, such a• from four juices ro five juices,
whereas mnrf),innl utility is a rare of chani.:e measured over a 11 infinitesimal intavul. l-lowever, rn11u11011 usn11e
applies che IV<)rd mar.~i11al when the Ilise uuic is iuvolved, eve11 if 3 011e-t111ic change is uor i1ifiniresi111nl.['I)

Utility Schedules and Graphs

[n Figu re 6- l we make the assumption that uti liry can be measured, and tlms the di f·
Ferenc amo unc of uciliry received fro n·1 consuming differe nr uni rs can be compared.
This is a helpful ass um pcion in allowing us co see che imponanr difference berween
tocal and marginal uci lity. The figure ill ustrates the ass umptions that have been made
abo U[ urilit)', using Alison's daily consum pcion of fruir juice as an example. The
table shows rhar Alison's ro ta! urilicy rises as she drinks more bordes of juice per
day. However, the milicy chat she gees from each additional juice per day is less than
char of rhe previous one-char is, her marginal uci li ry declines as rhe quan riry she
consumes rises. [101
The data are graphed in the two pares of Figure 6· 1.

Maximizing Utility
As already noced, economises assume rhar consume1.·s rr)' ro make themselves as well off
as rhey possibly can in rhe ci rcunnsra nces in which they find themselves. Tn other words,

FIGURE 6·1 Alison's Total and Marginal Utlllty from Drinking Julee


Number of
Borries <)f Juice .~ 80
Alison Drinks Alison's Alison's ::>
per Day ' l:'oml Uri liry Maq.1,i nal Utility Ol
w 60
0 0 <I>
JO> ·c
I 30 40
65 15 ~
10• 20
4 75
5 83 s
6 89 6
4 i 6 8 10
7 93 0 4
8 96 Quantity of Juice
9 98 (bortlcs of juice per tiny)
10 99

.~ 30
Tocal utilil y rises, l>ut ma1·ginal ucility declines, as consumption
increases. The marginal utillr)' of 20, shown :is rhe second cnn1' in
the th ird column, arises because Alison's tota l utility increases from
30 to 50-a difference of 20-wirh consumption of rhe seco nd

·"' 10
juice. To indicate that the marginal uriliry is associated wirh the "0
chan ge from one level of consumption to another, th e figures in ~
the third coh1111n Mc rccorikd between thi: rows of the values in the 0 2 4 6 8 10
second column. Qunnci1y of Juice
(borrles of juice per <lny)

consumers seek to maximiie their total utility subjecr to the constraints they face- in
pa rtic ular, their income and chc marker prices of various produces.
The Consumer's Decision Now char we have examined the concepts of coral utility and
marginal uriliry, we are ready ro answer rhe question posed ac rhe beginning of rhe
chapter: H ow can consumers decide to allocate their consumption of juice and burritos
in such a way as w maxi mize their utility? Of course, we could as k the same question
abour any cwo goods, or any num ber of goods, bur we will focus on juice and burriros
to keep the example simple.
The ucilicy-maximizing consumer should consume juice and burritos co the point
ar which che marginal ucilicy per dollar spent on the lase juice is jusr equal cu rhe mar-
ginal uti lity per dollar spent on the lase burrito. Tn chis way, the consumer's utility will
be maximized.

A utility-maximizing consumer aUqcaccs expenditures so chat the marginal utility

obtained from the lasr dollar spenr on each producr is equal.

l et's consider an example. Imagine char Alison's L1tilicy from the last dolla r spent
oil juice is rhree ti mes her utility fro m the lase dollar spe11c oil burricus. In chis case,
Alison can1 increase her total utility by spending less on burri tos and spending more
on juice.
If Alisun wanrs cu maximize he1· utility, she will conti nue ro swirch her expendirurc
from burritos to juke as long as her lase dollar spent on juice yields more utility than
her las t dolla r spent on burritos. This switc hing, however, reduces the quantity of bur-
ri ros consumed and, given che law of diminishing margi nal uciliry, raises che ma rginal
uti lity of bnrritos. At the same ti me, swicching increases the quantity of juice consumed
and thereby lowers the marginal uti lity of juice.
Evencually, cbe marginal utilities will have cha111ged enough so chat the urili ry
received from the lase dollar spenr on juice is just equal co the utility received from the
last dQllar spent on burricos. At chis point, Alison gains nothing from further switches.
(Jn face, switching fu rther would reduce her coral uciliry.)
So much fo r the specific example. What can we say more generally abo ut utility
maximization? Suppose we denote the marginal utility of the last uni t of produce X
by MUx and its price by fJ X· l ee MUy and py refer, respectively, cu rhe marginal util-
ity of a second produce Y and irs price. The marginal uciliry per dollar spent on X will
be MUx/J!x. For example, if the last unit of X increases ucilit)' by 30 and cosc1. $3, ics
marginal uciliry per dollar is 30/3 = 10. lf che last unic of Y increases uciliry b)' 10 <111d
coses$ J, its marginal utility per dollar is I0/1= 10. Wirh chese n11m bers, the marginal
ucilicics from the lase do llar spent 0 11 X and Y arc equal.
The condicion required fur a consumer co be maximizing ucilicy, fo r any pair of
produ~cs, is

MUx = MUy (6- l)

fJx fJy

This equation says chat a utility-maximizing consumer will allocate expenditure so chat
che utility gained from the lase dolla r spent on one produce is equal cu rhe ma rginal util-
ity gai ned from the lase dolla r spent on any ocher procUucr.

This is the fu nda mental equation of marginal utilit)' theory. With only '' given
amount of income co spend, a consumer demands each good up co the poinc at which
che 111argi11al ucilicy per dollar sp enc on ic is che same as che marginal ucilicy per dol-
lar spent on every other good. When this <.:ondition is met for all goods, the consumer
cannot increase utility Further br reallocati ng expenditure. That is, utility wi ll be maxi-
mized. (Of course, if she gees more income co spend, she can raise her coca! ucilicy by
bu)'ing more of each good.)
An Alternative Interpretation If we rearra nge che rerms in Equation 6- 1, we can gain
additional insight into consumer behaviour.
MUx Px
MUy Pv

The right side of chis equacion its che relative price of che cwo goods. le is decennined
by che market and is beyond Alison's control. She reacts to these market prices but is
powerless ti) change them. The left side is the relative ability of the two goods co add co
Alison's utility. This is within her control because in detennining the quami~i es of dif-
ferent goods to buy, she also determines their marginal utilities. (If you have difficult)'
seeing wh)', look again at f igure 6- 1.)
If the rwo sides of .Equation 6-2 are not equal, Alison can increase her cucal utility
by rearranging her purchases of X and Y. Suppose that the price of Xis $4 and the price
of Y is $2. The right-hand side of Equation 6-2 is then /Jx//>v = 4/2 = 2. Remember that
Alison can do nothing ru change rhe righc-hand side of chis equation-the prices are
determined in the market and are beyond her control. Suppose also that Alison is wr·
rcntly purchasing X and Y such thac che marginal utility fo r X is 12 and the margina l
utility fur Y is 4. The lefc-hand side of Equacion 6-2 is chen MUx/MUv = 12./4 = 3. In
chis case MUx/MUv > Px//Jy. Alison <.:an increase her tota l utility b)' increasing her pur·
chases of X (which have a high MU) and reduci ng her purchases of Y (which have a low
MU) unril the rario MUx/MUy is equal ru 2, rhe same as rhe rario of rhe prices. Ar chis
point Alison cannot increase her· total utility an)' further by rearranging her purchases
hecwcen chc two produces.
Cor1sider whar Alison is doing. She is faced with a set of prices rh::ic she ca11nuc
change. She responds ro these prices and maximizes her· uri licy by adjusting {he things
char she can change-chc quantities or the various goods that she purchases-unti l
Equation 6-2 is satisfied for all pairs of pruducrs.
Is This Realistic? le may seem u11realisci<.: ru argue chat consumers maximize ucilicy in
che precise way we have described. After all , noc many of us scand in che aisles of a
score and compuce rarios of marginal urilitics and prices. Keep in mind, though, that
urilicy rhcury is used by economises ro predi<.:t how consumers will behave when faced
with such evems as changing prices and incomes. As long as consumers seek ro do the
best thC)' can fo r thc mse l vc~ with their limiced resources, the consumer's actual thought
process dues nor concern us. The theory is not meant ro be a description of how they
rea<.:h their de<.:isions but is rather a convenienr way of discovering the implications of
their maximizing behaviour. Like man)' theories, utility-maximization theory leads to
predictions chat can be rested empirically. Economists continue to use the rheor)' of
utility maximization because ics predii:riuns are ra rely rejected by the daca. One of the
most importa nt of these predictions is that consumers who ace as if the)' arc following
a rule like Equacion 6-2 have negacivel)' sloped demand curves for goods and services.
In rhe nexc se<.:cion we derive chis resulr.

The Consumer's Demand Curve

To derive the consumer's de mand curve for a product, we need co ask what happe ns
when there is a change in the price of that product. As an example, let us derive Alison's
dema nd curve for fruic juice. Consider Equation 6-2 and lee X represen t juice and Y rep-
resent all other products take11 together. 1n this case, rhe price of Y is interp reted as rhe
average p.-ice of all urher produces. What will Alison do if, wich all ocher prices re main-
ing constant, there is an increase in rhe price of juice? Alison cannot avoid suffering
some loss in uriliry- whereas her income is uncha nged, it costs more co buy each juice
and the same tu buy each unit of everything else. She might decide tu spend less on
everything else and increase her spending on juice in order co hold her juice consump-
tion constant. Rut she can do better than char. To see why, notice thac when che price of
juice rises, che right side uf Equation 6-2 increases. Bue, until Alison adjusts consump-
tion, the left side is unchanged. Thus, after che price changes bm before Alison reacts,
the fo llowing siwacion exists:

MU uf juice Price uf juice

< .
MU of Y Price of Y
What dues Alisun do cu resto re the equality? The hypothesis uf diminishing
margina l uci lity tells us that as she buys fewer boccies of juice, the marginal utility
of juice wi ll rise and thcrcb>' increase chc ratio on rhc left side. Thus, in response
co an increase in rhe price of juice, with all ocher prices constant, Alison reduces
her consLJmption of juice until the marginal utility of juice rises sufficiently chat
Equation 6-2 is resto red. (Sec Scudy Exercise #5 0 11 page 140 C<J work through a
specific numerical example.)
This analysis leads co the basic prediction of de mand theory:

A rise in the price of a produce (with all ocher determinants of demand held con-
stant} leads each consumer co reduce the quantity demanded of the produce.

Market Demand Curves

U this is what each consumer does, it is also what all consumers taken cogecher do.
Thus, che theory of consumer behaviour chac we have considered here predicts a nega-
tively sloped market demand curve in addition w a negatively sloped demand curve for
each individual consumer.
As we firscsaw in Chapter 3, marker demand curves show the relationship between
the product's price and che amo unc demanded by all consumers cogether. The market
de mand curve is the horizontal sum of the de mand curves of individual consumers. Tc
is the hori zonta l sum because we wane co add quantities demanded at a given price,
and quan cities are measured in the horizomal direction on a conve11tio11al demand
f igure 6-2 illustrates a marker made up of uni)' two consumers: Arun and Bashira.
Ar a price of $3, Arun purchases 2 uni ts and Bashira purchases 4 uni ts; ch us, together
they purchase 6 uni ts, yielding one point on the market demand curve. No matter how
man)' consumers arc involved, the process is the same: Add the quantities demanded by
all consumers at each price, and the result is the market demand curve.

FIGURE 6·2 Market and Individual Demand Curves

~ ~
~ ~
6 -------------- 6 I
3 3 3 -'----
' I
0 2 0 1.5 4 0 1..5 6
Q unnciry Q unnciry Quantit y
(i) Aru n (ii) Bashirah (iii ) J\run and Bashirah

The market demand curve is the hori zo ntal sum of th e individual demand curves. Ar any given price, the quanriry
dema nded by Arun is added ro rhc quanriry demanded by Bashira ro yie ld rhc coral quanriry demanded by rhc marker.
l loweve r large the number of consu mers in the marker, the derivation of the marker demand curve follows th e same
summation process.

6.2 Income and Substitution

Effects of Price Changes

We have jusr seen che relarionship berween che law of diminishing marginal utility
and the slope of che consume r's demand curve for some produce. Here we con-
sider an alternative method for thin ki ng about the slope of an individual's demand
curve. This alrernarive mechod can also be used co chink abouc rhe slope of a marker
demand curve.
Let's consider Tristan, a student who loves to car- and especially loves to cat
ice cream. A fall in the price of ice cream affects Trisca11 in rwo ways. First, it pro-
vides an incentive co buy more ice cream (and less of orher things) because earing
ice cream is now a cheaper wa)' to sacisf)' some of his cravings. Thus, a n·ed uccion
in rhe pr:ice of ice cream-which, with all ocher prices co11scanc mea11s a fall in the
relative price of ice cream- leads Triscan co substitute away from orher prod uccs
coward ice cream.
Second, because che price of ice cr:eam has fallen, Tristan has more purchasing
real Income Income expressed power or real income available co spend on all produces. Suppose the price of pre-
In ttrms ul !ho purchasing powur mium ice cream fe ll from $.5 to $4 per li tre and Tristan was in the habit of eacing
of money lnoomc-thal Is. !he
quanllly of goods and serllices
half a licre of ice cream a day. ln che course of a 30-day munch, Triscan could keep
that can be P1Jrchased with the his ice cream habir unc hanged buc save $15, money ehac would be available for any
money Income. purpose-more ice cream, blueberry muffins, rounds of mini golf, or photocopies of
yo ur economics nuces.
Lee's now explore rhese ewo separaee effeces in a linle more derail.

The Substitution Effect

To isolate the effect of the change in relative price when the price of ice cream fa lls, we
can consider what wo uld happe n if we also reduce Tristan's mo ne)' income to resto re
che original purchasing power. Suppose Trisran's uncle sends him a momhl y allowance
for ice cream, and when the price of ice cream falls, the allowance is reduced by $'15 so
that Trista n can buy just as much ice cream-and everything else-as he could befo re.
Trisran's purchasing power will be unchanged. If his behaviour re mains unchanged,
however, he will no longer be ma ximizing his utility. Recall that utility maximization
requires t hat the ratio of margi na l utility to price be the same for all goods. Jn our
example, wi th no change in behaviour, che quanti ties (and hence marginal ucilicies) and
the prices of all goods other than ice cream are unchanged. The quantity of ice cream
is also unchanged, but the price has Fallen. To maximi:i:e his uti li ty afte r the pri ce of ice
cream falls, Tristan muse therefore increase his consum ption (reduce his margi nal util-
ity) of ice cream and reduce his consumption of other goods. Jn othe r words, he must
substitute away frum ucher guuds and ruward ice cream.
When purchasing power is held constant, the cha nge in che quantity demanded
of a good whose relative price has changed is called the substitution effect of the price substJtutlon effect The change
cha11ge. 2 In tile quantity ot a good
demanded resulting from a
change in ils relatiw price
(holding real Income constant).
The substitution effect increases the quanti ty demanded of a good whose price has
fallen and reduces the quantity demanded of a good whose price has risen.

The Income Effect

To examine the substitution effect, we reduced Trisrau's money income following the
price reduction so that we could see the effect of the relative price change, holding
purchasing power constant. Now we wane to see che effect of che change in purchasing
power, holding relative prices co11sta11t at their new value. To do chis, suppose that after
Tristan has adjusted his purchases to the new price and his reduced income, he then
calls his un1cle and pleads cu have his allowance restored cu its original (higher) amount.
Tristan's uncle agrees, and Tristan's money income is retu rned ro its original level. If
we assu me that ice cream is a no rmal good, Tristan will increase his consumption of
ice cream (even beyond rhe increase we have already seen as a resulc of the subsricurion
effect). The change in the quantity of ice cream demanded as a result of Tristan's reac-
tion to increased real income is ca lied the income effect. Income effect The change in the
quantlt.Y of a good demanded
resulting trom a Chango In real
The income effecr leads consumers to buy mo re of a prnducr whose price has Income (holding rclatlvo prices
fallen, 11rovided that che produ ce is a normal good.

Nocice char rhe size of rhe income effect depends on rhe amounc of income spenr on
the good whose price changes and on the amount by which the price changes. In our
example, if Tristan were initiall y spending half of his income on ice cream, a reduction

2 This measure, which isolates the substitution effect by h<lkli ni; the consumer's purchnsini; p<lwer constant,
is k11ow11 as che Slutsky effe<:c. A related bur slightly difiere11t measure that holds the eo11sumds level of util·
ity <'Onscant is Jist•ussed in the append ix ro this d rnpter.

in the pri..:e of ice cream from $5 to $4 would be equiva lent to a ·10 percent in..:rease
in real income (20 percent of 50 percent). Now consider a di ffe rent case: The price of
gasoline falls by 20 percent. for a consumer who was spending 5 per..:enr of in..:ome on
gas, chis is equivalent to a ·1 percent in..:rease in real in..:ome (20 percent of 5 per..:enc).

The Slope of the Demand Curve

We have now divided Triscan's reaction co a change in che price of ice cream inco a
subsdcudon effect and an income effect. Of course, when the price changes, Tristan
moves direccly from rhe initial cunsum prion paccern co rhe final one; we do nur observe
any "halfway" consum ption pacrern. However, by breaking rhis movemenc inro two
pares for analytical purposes, we are able to swdy Tristan's total change in qua ndcy
dema nded as a response ru a change in relative prices plus a response ru a change in
real income.
What is true fo r Tristan is a lso true, in general terms, for all consumers. The sub·
sricurion effecr leads consumers ru increase rheir demand for goods whose prices fall.
The income effe..:r leads consumers ro buy more of all normal goods whose pri..:es fall.
Putti ng the income and subscicucion effects together gives the followi ng statement
of che law of demand:

Recause of the combined operation of the income and subscirucion effects, the
demand curve for any normal good will be negatively sloped. T hus, a foll ·in price
will increase the quantity demanded.

Figure 6-3 illustrates how the combination of the substitution effe..:c and che income
effect determines rhe slope of any demand curve. In each part of the figure, we begin at
poim A with che price p0 • We chen consider a reduccion in the price cop 1• ln each case,
che substitution effect (shown by the green arrow) increases the quantity demanded.
In each case rhere is also an income effecr (rhe red arrow), bur che size and sign of
the income effect differs in each case. The sum of the income and substitucion effeccs
determines the total effect of the price change and thus how overall quantity demanded
respo nds co rhe price reduction. Nore char all normal goods have negarively sloped
dema nd curves. The same is true for most inferior goods. The figure illustrates why in
the case of an inferior good the income effect muse be very strong in order to generate a
posirively sloped demand curve. This is a very rare case in economi..:s, bur there is some
interesting history behind it.

Giffen Goods Great interest was generated by the apparent refutation of clhe law of
demand by the English ernnomist Sir Robert Giffc n ('1837-·19·10). I Ic is alleged to have
observed that when a rise in rhe price of imported wheat led to an increase in rhe price
of bread, members of the 'British working class increased their consumption of bread,
suggesting that their demand curve for bread was positively sloped.
As is clear in figure 6-3, rwo things must be true in order for a good to have a
Giffen good M Inferior good positively sloped de mand curve- a so-called Giffen good. First, the good muse be an
lot which Ille Income ellcct inferior good, meaning that a reduction in real income leads households to purchase
oulweigtls lhe substitution effect
so that the demand curve is
more of that good. Second, che good muse rake a large proportion of roral luousehold
~ositively slo!l<lrl. expendiwre and therefore have a large income effect. Bread was indeed a dietary staple
of the British working classes du ring the nineteenth century. A rise in the price of bread

FIGURE 6·3 Income and Substitution Effects of a Price Change

For a nMmnl gO<)d, [he For nl<)S[ inferior gO<)ds, for n few inferior goods-
income and subs[itmion the income effect only Gi ffen goods- the income
effects work in the sa me pnrcin Ily offsets the /\ effect outweighs the
substitution effect. sulmirntion effect
I Substitution effect Substitution effect
R , i / _:"'"""'''"'""''
Pi - - -T,_-......_ /11 ~I
I I '\ i
lncon1c I '-i- lnt·ome
I effect DI I cffw
0 0 0
Q uantity Demanded Q uanti ty Demanded Q uantity Demanded

(i) Nonnal goo,t (ii) Inferior good (iii) (In ferior) Giffen good

Demand curves for inferior goods arc negatively sloped un less the income effect outweighs the substitution effect.
In each of the diagrams, the initial price is µ0 and the initial quantity demanded is Qo. Thus, A is a point on al l
duce demand cttrvcs. For al l three goods, a price reduction to µ 1 creates a su bstitution effect that increases quantity
demanded to QJ.
For norn1al goods in pa rt (i), the reduction in price increase~ real income and leads ro a fu rther increase in quantit)'
dcnundcd. T he income effect is shown as the incre:ise from QJ ro Q1. T he rora l effect of the price cha nge is the1'Cfo1·e
the change from Qo to Q1> an d poi nt B is on th e negatively slo ped demand curve.
For inferior goods, the price reduction causes an i1lcrease in rea l income that leads to a reduction in quantity
demanded. If the good makes up a small fraction of the consumer's total expenditure, which is the case fo r most goods,
then thi s income effect will be small. In pa rt (ii), the income effect reduces quantity demanded from QJ
to Q·1, and so the
total effect of the price change is the change from Qo to Q1• In this case, the income effect docs not fully offset the substitu-
tion effect ::ind so the dem::ind curve is sti ll ncg::itivcly sloped th rough point B. In part (iii), the income effect is. very l::irge,
reducing quantity den1anded from QJ to Qi. an d the overa ll change is therefore a reduction in quantit)' demanded fron1
Q0 to Q 1. In this cJsc the demJ nd cur·ve is positively sloped tlll'ough point B. This is the cJsc of ;J Giffen good.

would therefore cause a large reductio n in people's rea I in come. Th is co uld lea d people
co eat more bread (and less meat) in order to consume enough calories to stay alive.
T hough possible, sud1 cases are al l buc unknown in the m odern wo rl d, fo r in all but the
poorest socie ties, typical households do not spend large pro po rtions of the ir incomes
on any single inferior good.
Conspicuous Consumption Goods Thurscein Veblen (1857-1929), in The Theory of the
Leisure Class. nored that some products were consumed nor for rheir intrinsic qualiries
bur because they had "snob appeal." I Jc suggested char the more expensive such a com-
modiry became, rhe greater might be irs ability to confer srarus on irs purchaser.
Consumers mighr value diamonds, for example, precisely because everyone knows
they arc expensive. Thus, a fall in price might lead chem ro srop buying dia mo nds and
co swirch to a more sarisfacrory object of conspicuous consumptio n. They may behave
in the same way with respect co luxury cars, buying rhem because they are expensive.
Docs th is Sort of behaviour violate ou r basic theo ry of util ity maxim iza ti on?

Two comments are in order. First, in a <.:ase where individuals

appear to buy more good~ at a higher price because of the high /;rice,
there is acrually something else going on char explai ns the apparenc
violation of the law of demand. What really appeals co su..: h individ-
uals is that other people think they paid a high price-this is the basis
for the "snob appeal." Bur such snobs would scill buy more at a lower
pri<.:e (and hen..:e still have negatively sloped demand ..:urves) as long as
chey were absol utely sure diac other people thC)ught chey had paid che
high price. As one advercising slogan for a discount deparcmenr srore
puts it, "Only you know how liccle you paid."
Second, even if such conspicunus consumers do exist, it is still
unlikely that the market demand curve is positively sloped. The rea-
son is easy to discover. The fact chat countless lower-income ..:on-
sumers wo uld be glad to buy diamonds or BMWs only if these
commodities were sufficiently inexpensive suggests that positively
sloped de mand curves for a few individual wealthy households are
much mo re likcl)' tha n a positively sloped 1narket demand curve for
the same commodity.

Some people buy 11ery exp1111si11e product.s

because t/Jeir extreme prices confer status 011
the purchaser. But holdi11~ this stat11s co11-
s1an1, people 1µ011ld still probably buy more tll
I 6.3 Consumer Surplus
lower prices, suggesting a downward-sloping
de111a11d curve. Our discussion of consumer behaviour has led us to a better under-
standing of demand curves and how they are derived. Ac the heart
of our dis..: ussion has been the ..:oncepc of utility and che law of diminis hing ma rginal
uti lity.
In this section we introduce the important concept of consumer surplus. which
requires that we make a clear distinction between marginal and total utility. Under-
standing chis difference will help us ro resolve a famous paradox in the histor)' of
economic theory.

The Concept
Jmaginc yourself facing an eichcr/or choice concerning some pa rticular produce, say,
ice cream: You can have the amo un t yo u are now consuming, or you ..:an have none
of it. Suppose yo u would be willing co pay as much as $100 per month for the eight
litres of gourmet ice cream chat you now consume, rather tha n do without it. Further,
suppose you actually buy chose eight litres fur only $40 instead of $100. What a
ba rgain! You have pa id $60 less tha n the most you were will ing to pay. A.:tually this
sort of bargain occurs ever)' da)' in the cconom)'· Indeed, it is so common that the $60
consumer surplus The "saved" in this example has been given a name: consumer surplus. Consumer surplus
difference between 1he total
value that consumers place
is the differe nce between the tota l va lue that consumers place on all the units con-
on all un~s consumed of a sumed of some produce and the pa)'menc they actually make to purchase that amount
commodrty and the payment of rhe product.
that tlrny actually maku Lo Consumer surplus is a dire..:t ..:onsequen..:e of negatively sloped demand ..:urves.
purchase that amount of the
This is easiest co understand if yo u chi nk of an individual's demand curve as show-
ing his or her will ingness to pay for successive units of the product. (You may recall
our dis..:ussion of chis point in Chapte r 5.) To ill ustrate the ..:oncepc, suppose we have

FIGURE 6-4 Moira's Consumer Surplus on Milk Consumption

Lito·cs of Amounr Moi ra Is Moira's Consumer

Mi lk Mo ira Will ing co Pay co Surplus If She 6.00 -
Consu111es per Obrain This Acrua lly Pays ~

Weck Litre $ 1.00 per litre '5"'

Fi1·sr $6.00 $5.00
Second 3.00 2.00 j 4.00 -
Th ird 2.00 1.00 ..~
Fou rth 1.60 0.60 -"'
0 2.00 -
- >--
1-- pri.ce
"" J.00 1--t--t--t---t--+---.-=-'----

Ninth 0.50 - n_
Tench 0.40 - I I JI
0 I 2 3 4 S 6 7 8 9 10
Litres nf Milk
Consumed per Week

Consu111er surplus on each unit consumed is che difference between the market price and the maximun~ price thac
the c-0nsumc1· is willing co pay to ohcain chac unic. The rable shows rhe value rhar Moira puts on succcssi vc litres of
mi lk consumed each week. Her negatively sloped dema nd curve shows thac she wou ld be will ing co pay progressively
s111al ler a111ounrs for each add itiona l unic consumed. If th e 111arket price is $ 1.00 per litre, Moira will buy six lirres of
mi lk per week and pay the amount in the dark shaded area. The total va lue she places on these six li tres is th e enrire
shaded area. I kr consumer surplus is the light shaded area.

inrerviewed your classmace Moira and displayed rhe informacion from rhe in terview
in the table in Figu re 6-4. Our first question to Moi ra is, "Tf yo u were drinking no
milk ar al l, how much would yo u be willing cu pay for one lirre per week?" Wich nu
hesirariorn she replies, "$6.00." We chen ask, " If yo u had already consumed char one
litre, how much would you be wi lling to pay for a second litre per week?" After a bit
of thoughc, she answers, "$3.00." Adding one Ii ere per week with each question, we
discover rhac she would be willi ng co pay $2.00 co ge( a rhi rd (i(re per week and $l.60,
$'1.20, $'1.00, $0.80 , $0.60, $0.50, and $0.40 fo r successive litres from (he fo urth to
che cenrh licre per week.
The sum of che values (hac she places on each licre of milk gives us che total value
chat she places on all cen litres. Tn chis case, Moira valllles the 10 litres of mi lk per week
at $17.10. This is the amuum char she would be willing ro pay if she faced rhe either/or
choice of 10 litres or none. This is also rhe amounc she would be willing co pay if she
were offered the mi lk one litre at a time and dia rged the maximum she was willing to
pay fo r each litre.
However, Moira does not have ro pay a differem price for each li(re of milk she
consumes each week; she can buy all she wants at the prevailing market price. Suppose
che price is $ 1.00 per litre. She will buy six licres per week because she values che sixrh
li(re jusc a r (he markec price bur all earlier litres at higher amounts. She does not buy a
seventh litre because she values it at less than the market price.
Because Moira values che first litre ac $6.00 but gees ic fur $ 1.00, she makes a
"profit" of $5.00 on that licre. Berween her $3.00 valuation of the second litre and

what she has to pay for it, she cllears a "profit" of $2.00. She clears a "profit" of $'1.00
on the thi rd litre and so on. T his "profit," which is shown in the thi rd column of the
cable, is Moira's consumer surplus on each licre of milk.
We ..:an ..:alculate Moira's total ..:onsumer surplus of $8.80 per week by summing
her surpl us on each litre that she ac tuall y purc hases; we can calculate t he same total by
fim summi ng whac she would be willing co pay for all six lirres, which is $14.80, and
then subtra..:ti ng the $6.00 that she a..:tuall y does pay.

for any unit consumed, consumer surplus is the difference between the maximum
amounr the consumer is prepared to pay for char unic and chc price the consumer
actually pays.

The data in the first two colu mns of the ta ble give Moi ra 's demand curve fur
milk. Ir is her demand curve because she will go on buying licres of milk as long as she
va lues each litre at least as muc h as the ma rket price she must pay fo r it. \Vhen the
market price is $6.00 per litre, she will buy onl y one litre; when it is $3.00, she will
buy rwu licres; and so on. T he cocal val uation is che area below her demand cu rve, and
consumer surplus is the part of the area that lies above the price line. T hese areas are
shown in Figure 6-4.
Figure 6-5 shows chat the same relations hip holds
fo r the smooth ma rkec demand curve chat indkaces the
RGURE 6-5 Consumer Surplus for the Market total amoun t that all consumers would buy at each price.
Figure 6-4 is a bai: chart because we allowed Moira cu
va ry her ..:onsumpcion only in discrete units of one litre
at a ti me. I lad we allowed her to vary her consumption
of milk one d rop ac a ri me, we could have traced our a
contin uous curve similar to che one shown in Figure 6-5.

price The market demand curve shows the valuation that
/>o consumers place on each unir of rhc produce. For
any given quantity, the area under the demand curve
0 Qo and above the price line shows the consumer surplus
Quantity Consumed per Period received from consuming chose uni ts.
Total consumer surplus is che area under the demand
curve and above the price line. The area under the The Paradox of Value
demand cu1·vc shows rhc roral val uation rhar con·
st11nc rs pb cc <)ll :lll un irs consumed. Ft)r example, rhc
roral value rhar consumers place on Qo unirs is rhe Consumer surpl us is an important concept. It will prove
enrire shad!ed area under rhe demand curve up to Q0 . useful in lacer chapters when we evaluate che perform·
Ar a marker price of P<» the amount paid for Qo un its a nee of the market system. 3 For now, howeve1; we discuss
is the dark shaded area. I lcncc, consumer surplus is a n example in which the concept of consumer surplus
the light shaded area. helps us co understand apparently paradoxical market
0 L1 t1.:omes. The distin1.:tion between total value and mar·
gina I value is crucial.
Early economises, scruggling wich the problem of what determines the relative
prices of produas, encounte red what they called the paradox of value. Many ncccssa r)'
Indeed, consumer suq>lus is 1>art of what, in Chaprer S, we called c~'Onomic suq>lus when we discussed
market cffiden9'. We will rewrn ro a dcrniletl discussion of market cffide119• in Chapter l2.

prodllcts, such as wate r, have prices that are low <.:ompared with the prices of luxL1 ry
prodllcts, such as dia monds. Wate r is necessary to our existence, whereas diamonds arc
used rnoscly for luxury purposes and are nor in an)' way essenrial ro life. lsn'r ic odd,
then, that wate r is so cheap and diamonds are so expensive? As it too k a long ti me to
resolve chis ap parent paradox, it is not surprising chat even today, similar confusions
cloud ma11y poli..:y discussions.
The first step in resol ving this pa radox is to use the distinction between the total
and marginal values of any produce. We have seen al ready that the area under the
dema nd curve is a meas ure of rhe total value placed on all che unirs rhar rhe con-
sumer consumes. For example, for all consumers toge ther, the tota l value of consum-
ing Qo unirs is rhe entire shaded area (light and dark) under the demand curve in
Figure 6-5.
What about the marginal value that consumers place on one additional uni t? This
is given by the produc t's market price, which is /lo in Figure 6-5. Facing a marker price
of p0 , each consumer buys all the units that he or she val ues at Po or greater but does
not purchase any uni ts val ued at less than p0 . Therefore, each consumer val ues the last
unit consumed of any produce at its market price.
The second seep in resolving the paradox is co recognize tha t supply plays jusc
as importa nt a role in determining market price as does demand. Earl y economists
thought the price or "value" of a product depended onl y on its use by consumers-that
is, by demand. But we now know chat supply aspects are just as importa nt- including
the costs o f production, the number of producers, and so on.
Given this joint importance of supply and de mand, it is easy to imagine a situa-
tion in which two products, such as water and dia monds, have very different market
prices (and hence marginal values) even if their respective prices do not reflect the
total va lue consumers place on the two goods. Figure 6-6 resolves the diamond-
water paradox.
The resol ution of the paradox of value is that a good that is very plentiful, such as
water, will have a low price and will thus be consumed to the point where all consumers
place a low val ue on die last unit consumed, whecher o r not they place a high value on
their total consumption of the produ..:t. 'Ry contrast, a product that is relatively scarce
in the marketplace will have a high market price, and con~u m pt i on will therefore Stop
at a poinr where consumers place a high val ue on che last unir consumed, regardless of
the value that they pla..:e on their total consumption oF the good.

Because the market price of a product depends on hoth demand and suppl y,
cherc is nothing paradoxical in there being a produce on which consumers place
a high total value (s uch as wate r) selling for a low price and hence having a low
111arf{i11al value.

The same paradox exists in many markets, includi ng la bour markets. As we all
know, professional hockey players earn many ri mes more rhan nu rses and docto rs, even
though most consumers pro bably place mor·e coral val ue on healch care than rhey do
on sports entertainment. But top-quality hockey players have a set of skills that are in
much sho rter supply chan even highly skilled medical professionals, and chis diffe rence
in supply helps co explai n their different incomes. We have much more co say about rhe
operation of labo ur markets in Cha peers lJ and H .

ROURE 6·6 Resolving the Paradox of Value

Small consumer surplus

from diamonds. High prkc
mean~ hii;h maq;inal value.
Large ro11su111er
surplus from wa ccr.
LO\v pric( 1neans IO\V
n1arginal v:i luc.

Quancicy Quantity
(i) Water (ii) Oiamonds

Th e m arkcc pr ice of a prnduct docs noc just reflect the total value th at consumers place on that prnduct; sup ply also
maucrs. The graph presents hypothetical demand curves for warer and diamonds. The tota l va lue rhat co nsumers place
Qw units of warer, as shown by rhe rotaI shaded area under rhe demand curve, is grear. The coral va lue char consum-
0 11
ers place on Qr1 un its of diamonds is shown by the total shaded area under th e demand curve for diamonds. This is
clearly less than the total val ue placed on water.
The large supply of water makes water plen tiful an d makes wa ter low in price, as shown by Pw in pa rt (i) of the
figure. The relativel y low supply of dian1onds 1t1akcs dian10111ds sca rce an d keeps dia1t1onds high in p1·ice, as shown by
Pd in p;11·t (ii) of the figure. The high tot:ll v:.ilue for w:.ite1; com bi ned with its low J)l'ice, lc;1ds to :l l:u·gc co11sumc1· surp lus
for water. For diamonds, the low total va lue and high price lead to a small consumer surplus.


6.1 Marginal Utlllty and Consumer Choice LO 1, 2

• Marginal uti lity theory distinguishes betwee n rh e roral MUx MUv

utility from the consumption of all un its of some prod- Px Pv
uct and the incrcn1ental (or margina l) utility derived
from consuming one more unir of the product.
• The basic assumption in marginal util ity theory is that • Demand cu1·ves have nep.ative slopes because when
rhe urilicy consumers de1·ive (ovc1· some given rime pc1·iod) the price of one product falls, each consumer responds
from the consumption of successive units of a product by increasing purchases of that product sufficiently to
dimi nishes as the number of units consumed increases. restore the ra tio of chat producr's margi nal uril iry to its
• Consum ers arc assumed to make their decisions in a way now lower price (lvlU/p) to the same level achieved fo r
that 1t1aximizcs their utility. Utility-1t1aximizing consum· al l orher products.
crs make their choices such that the utilities derived from • Market deman d cu rves for any product ::ure derived
the last dollar spent on each product arc equal. Fo r two b)' hori zontal ly summ ing al l of the individual den1and
go()ds X and Y, utility wi ll be maximized when curves for that prod uct.

6.2 Income and Substitution Effects of Price Changes LO 3

• A change in rhc price of a producr gcnerares borh an increase in rhc consumer's real income and thus ro an
inco me effect and a substitution cffecr. The su bsriturion increase in purchases of all normal goods.
effect is rhc reaction of th e consumer ro rhc change in • The combined income and subsrirution cffccrs ensure
relative prices, with pu rchasi ng power (real income) held that the quan ti ty demanded of an y norn1al good
conscant. The substiturion effect leads the consumer ro will increase when its price falls, other th ings being
increase purchases of the producr whose rclarive price equal. No rmal goods, therefore, have ncgarivcl y sloped
has fo llen. dcm:rnd curves.
• The income cffccr is rhc rcacrion of rh c consu mer ro rhc • An inferior good wi ll have a negarive ly sloped dema nd
change ·in purchasing power (real income} rhat is caused curve un less rhe income cffecr is strong e111ough to out-
by the p1·ice change, holding relative p1·iccs consra m weigh rhc subsrirmion effccr. This si tuarion is very rare
ar their new level. A fall in one price wil l lead ro an and is called a Gi ffen good.

6.3 Consumer Surplus L04, 5

• For each unit of a product, consume r surplus is the dif- • It is im porrant ro distinguish between tota l and mar-
ference between whar consumers would be wi ll ing to gi nal values because choices concerning a bir more and
pay fo r th at unit and wha t co nsun1crs actually pay for a bit less cannot be predicted fron1 a l<11ow ledge of
th ar un it. rural va lues. The pa radox of value invo lves confusion
• Cot1sun 1er surplus arises beca use demand curves arc between tora l val ue atid margina l val ue.
neg:ltivcly sloped :Jnd co nsumers purchase units of a • P1·iec is 1·cl::1rcd f(J rhc ma1·gin:ll v:J luc that eonsumc1·s
product up to the poi nr where the value of the marginal place on having a bir more or a bir less of some product;
unit consumcd- rhc margi nal va lue-equals the ma1·ker it bears no necessa ry relationship ro th e rota l va lue rhar
price. On all un irs before rhc margi nal unir, consumers consumers place on all of the un its consumed of rhat
val ue rhe prod ucr more rhan rhe price and hence th ey prod uct.
ea rn consumer surplus.

Total utiliry and marginal uril iry Slope of the demand curve Giffen goods and conspic uous
Utility maximizarion Market and ind ividual demand co nsumption goods
Equaliry of MU/p across differenr curves Consum er surplus
goods Income effect an.d suhsritution effeer The pa radox of va lue


Make the grade wi th M yEcon Lab: Study Exercises marked in red can b e found on
MyEconlab M yEconLab. You can praccise them as often as you want, and most feature step-by-step
guid ed instructions to help you find the right answer..

1. Fil l in the bla nks to make the following sta tements good ____ as rota l consumption of the good
correc t. increases.
b. A uriliry-maximizing consumer will all ocarc expendi-
a. Urility th eo ry is b:.tsed <Jn the hypothesis th e
ture such rhar rhe per dollar spenr on
received from each add irional unir of rhe
each product is for all products.

c. An eq uation that represents a utilit)'·n1ax in1izini; Rupert is wi lling to pay fo r e:ic h successive pizza
pa ttern of consum ption of two goods, A and B, is pe r week.

d. Marginal utility analys is tells us that a rise in the Rupert's Willi ngness to Pay
price Qf a good, ceteris paribus, leads each con·
sumer to reduce the of the good. This, in First $ 18
turn, predicts a demand curve. Second $ 16
2. The tab le below shows how Brett's uti lity inc reases Third $ 13
as the ll'lu mber of avoca dos he consu111es (per Fou rth $9
month) increases. Brett's util ity is measu red in utils, Fifth $4
a nan1e chat economists invented to desc ribe un its Sixth $0
of uti li ty.
a. Suppose Rupert were co car five pizzas per week.
What is the total va lue Rupert wou ld place on his
Avocados 'fotal Utility Ma rgina l Utility five weekly pizzas?
(in urils) (in uti ls) b. If the market price is $ 10 per pizza, how many piz-
Zero 0 zas will Rupert buy and cat per week?
Firsr 100 c. If rhe ma rket price is $ I0 per pizza, what is the
Second 185 weekl y consun1er surplus that Rupert gets frorn
Third 245 eating pizza?
Fourth 285 5. Sally consumes only two goods, shoes an d ''everything
Fifth 3 15 else." For five di fferent shopping trips (each with dif·
Sixth 335 fcrcn t prices), the prices and Sall y's marginal utilities
Seventh 345 arc show11 below.
Eighth 350
Shoes Everything Else
a. Plot Brett's tota l utility on a scale diagram, with
uti ls on the vertical axis and the number of avo· MU Price($) MU Price($)
cad os (per month) on the horizo ntal axis. Tri p I 125 250 so 100
b. Compute the marginal utili ty for eac h avocado and Tri p 2 100 200 50 100
fill in the table. Tri p J 75 150 50 100
c. Plot the n1argina l uti lity on a scale diagram, with Tri p 4 50 100 50 100
uri ls on the vertical axis and rhe number of avo· Tri p 5 25 50 50 100
cados (per mon th) on the horizonta l axis. (Make
sure co plot marginal utility at the midpoin ts a. Is Sally maximizi ng her tota l utility on each shop·
between units.) ping trip? Explai n why or why not.
d. Explain why it is reasona ble that Brett's utility b. Us ing wh:it you h:ivc lea rned in this chapter about
increases by sn1allcr and s111allcr amoun ts for each margi na l utility, explai n how the number of shoes
successive avocado consumed. consumed is changing as their price changes.
3. In each of the CMCS listed below, identify whether c. Can )' OU detect the shape of S:illy's dcn1and cu rve
Claudia 's expenditure on each prod uct should rise or for shoes from the data shown in rhc ra blc?
fa ll in order to maximize her uti lity. 6. Su ppose there is a I0 percent increase in the prices of
the following products. Kee ping in mind how large a
M;irgi1ul M;irgin:i l fraction of a typical consumer's budget these items arc,
Utility of Utility of ex plain whether you think the incon1e effect in each
Price of X X (u nits of Price of Y (u nits of case wou ld be small or large, and why.
Case ($) util ity) y ($) utility) a. salt
b. jeans
A ]0 2 5 3
c. ca nned vegetables
B U2 4 4 2 d. gasoline
c 3 .I 6 2 e. 1111111-vans
D 4 2 4 2 f. renta l apartments
E 8 4 4 3 g. Iuxury ca rs
h. cell phones
4. Rupert reall y loves pizza, but he cventu:illy tires I. vacations to Cuba
of it. The ta ble below shows the highest price that j. fee fo r one·day ca r rentals

7. Use rhc followini.:d1ogra111 ofa111arkcr for porrcd plants 9. Sec the diogrJ111s ot rhc bottom of rhc page. Consider
to answer the questions below about consumer surplus. rhc supply·:ind-dcmand di:igrams dcpicring the m:ir·
kers for X and Y. respectively. In rhe m::irkcr for good
X, supply is pcrfecrl) cl:isnc, 111dicat111g rhar producers
arc prepared to supply anr amount of X at price Pu·
a. In the marker for X. demand 111crcascs from Do
to 0 1• Ei<pla1n what h3ppens t0 rhe coral value
that consumers place on X.
b. Ei<plain how the mcreasc m dem;md for X airers
rhc marginal value th at consumers place on X.
c. In the market for Y. a technological improvement
/'o causes supply to increase from So to S1o causing
price ro fa ll from Po tu µ 1. Ei<plain what happens
ro rhe coral value rhar consume1s pl.ace on a given
qu:rnrir)• of Y.
d. Explain why the increase in supply leads con-
sumerb ro reduce 1hcir 111argino l va lue of Y
even rhough rhere h:is been no change in th eir
preferences regarding Y (and thus no shifr in the
D demand cu1·ve).
10. Consider the marker for some product. T he dem:ind
0 and supply curves :ire Aiven by:
Demand: p 30 4Q1'
n. Whh dc111ond curve [) ond supply cu rve So, rhe
equil ibrium price :\lld qu:llltiry in chis marker arc Supply: p 6 I 2Q~
Po and Ou· At the price Pu. what is rh c area char a. Plot the demand and supply cu rv es on a scale
repre~cnr~ coral consumer su rplt1s in th is marker? diagra m. Compu re rhe equi librium price (p•) and
(Use rhc letter poinr l::tbcls co describe rhe area.) quantity (Q•).
b. Now suppose supply in creases co SI· Determine the b. Show in the d1:114ram the coral value rh:n consum·
new equilibrium price and quanrity. What is the ers place on Q• units of the good.
area that now represents total consumer surplus? c. What is the value th:ir consumers place on an
c. Ar the new lower price, whar is the area char rcprc· additional unit of the good?
scnts the mcrea ed consumer surplus earned on the d. Now suppose that production costs foll, and thus
original units purchased? the marker supply curve sl11fts to a new posu1on
d. At me new lower price, what is rhe area diat represents given by p - 2 + 2Q5. ! low do consumers now
consw11cr surplus earned on the new unn:s purchased? value :111 additional u1111 of the good ?
8. In wh at situations do rhe substirurion effect and the e. F.i<plain wh>• consumers' mar11inal value has
income effect work in the same direction to produce a fallen even thou11h there ha s been no ch:inge
downw;ird-slopi n11 demand curve? In whar siruarions in thei r preferences (and thus no clrnngc in the
do they have opposing cffecrs? demand curve).

,___ \
\ ~

, , ,,
I s,

, ,,
, ,
1-----+--- -,---- S0 , ,
' ' ' ..
/) I
Q.___ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
Quonuty of X QuGnti i:y of Y

11. Using n1Mgina l utility th eory, discuss why newspaper a. What would be the 1t1argina l value of such services
publishers arc prepa red to use vendi ng mach ines rhat consumed by each Canad ian if rhc governm ent
al low customers to pay for one newspaper and remove provided the necessa ry resources to satisfy all
scvc1·;il, whcrc;is c:rndy ;ind s()ft-drink pr()duccrs use dcm:1lld?
vending machines that allow customers to remove b. How does your answer ro pa rt (a) re late co rhe coral
only the single producr that is pu rchased. vnluc that Ca nadians proba bly pbce on 111cdic:al
12. Many medical and hospital services in Canada arc
p1·ovided ar zero direct cost ro al l Canadians and ai·c
financed our of genera l gove rnment revenues.
In Chaprer 6, we covered some basic material con· Of course, rhere are combinarions of rhe cwo
cerning rhe theorr of demand; here we extend the products ocher chan those enumer:ited in the table
treatment of demand cheoq• b)' considering in more that will give I lugh the same level of ucilit)'. All of
dernil che assumpcions abouc consumer behaviour chese co111bi1rncions are shown in Figure 6A 1 by the
char underlie the theory of demand. smooth curve char passes through the poinrs plot·
The history of demand cheor)' has seen cwo major red from rhe cable. This curve, called an indifference
breakthroughs. The firsr was marginal ucilicy cheory, curve, shows all combinarions of produces char yield
which we used in Chapter 6. By distinguishing total Hugh the same utility.
and margi nal values, chis cheoqr helped co explain rhe
so-called paradox of value. The second breakthrough
came wich indifference theory, which showed chat che The consumer is indifferent between the combi-
stringent assumption of measurable uti lity (required nati on~ indicated by any two point~ on one indif-
for marginal uciliry rheory) could be dispensed wirh. ference curve.
Indifference theory is based on the much weaker
assumption char consumers can alwars say which of
rwo consumption bundles they prefer wichouc having Any poincs above che curve show combinations
co say by how much chey prefer ic. of food and clothing that I !ugh prefers to point\ on
chc curve. Consider, for example, che combinacion
of 20 unics of food and 18 units of clothing, rcprc
scnced by point g in Figure 6A- 1. 1\lchough it may
I 6A.1 Indifference Curves nut be obvious chat this bundle muse be preferred co
bundle a (which has more .:lothing buc less food), it is
obvious rhat it will be preferred to bundle c because
Suppose Hugh currently has avail:ible some specific boch less doching and less food are represemecl
bundle of goods, say, 18 uni rs of clothing and I 0 unirs at c than at g. Inspection of the graph shows ch:it any
of food. Now offer him an alcernacive bundle of, say, point above rhc curve will be superior to MHT1e points
13 uni rs of doching and 15 uni cs of food. This alternative on che curve in che sense char ic will contain boch
combinacion of goods has 5 fewer uniri. of clothing and more food and more clothing chan chose points on
5 more unirs of food chan che first one. Whecher Hugh the curve. I lowcver, because all points on the curve
prefers chis new bundle depends on d1e relative valua· are equal in I lugh's eyes, any point above rhc curve
tion that he places on 5 more units of fond and 5 fewer must be superior to a II points on the curve. Ry a simi·
units of clorhing. If he values rhe extra food more than lar arg ument, all points below and (() the left of the
chc forgone cloching, he will prefer the new bundle co the curve rep resent bundles char are inferior co bundles
original one. If he values the extra food le~s rh ~ n the for- represented by points on the curve.
gone dorhing, he will prefer che original bundle. If Hugh
vQlues the exrra food the same as che forgone clothing,
he is said to be indifferent between the two bundles. Any point above an indifference curve i' preferred
Suppose char after much rrial and error, we have to an)' point along chac same indifference curve;
idenrified sever:il bundles between which Hugh is indif· any poinc on chc curve is preferred to :iny poinc
ferent. In ocher words, all bundles give him equal sati~fac­ below it.
rion or uriliry. Tiiey are shown in rhe table in Figure 6A· 1.

RGURE 6A·1 Hugh's Indifference Curve

Alrcrn:tcivc Bundles (;iving Hugh Equ:tl Urilicy

~ Indi fference curve
Bundle Cloth ing Food t JO
(I 30 5 ~
b 18
'd .s 20
10 20 il
e 8 25 0

f 7 30 0

·~ 10

0 10 lO JO
Quantity of Food per Weck

Th is indifference curve shows co mbinations of food and clothing that yield equal utili ty and between which H ugh is
in differem. The smooch curve rh rough rh e poinrs is an indifference curve; all combin arions on ir give Hugh equal uril iry.
Poi nt g a bo ve the li ne is a preferred combinati on to any poi nr on the li ne; point h below the line is an inferior combina·
tion to any point on the line. T he slope of the line T gives the marginal rate of substituti on at point b. Moving down
rhc indifference curve from b to(. rh e slope flo ttcns, showing rh M the 1t1orc food and the less clothing Hugh has, the
less willing he is to sacrilice fu rther clothing to get n1o re footl.

Diminishing Marginal Rate of Consider a case in which Hugh has a loc of cloth·
Substitution ing and only a lictle food. Common sense suggests char
he rnight be willing to give up quite a bic o:f plentifu l
How much clmhing would Hugh be willing w give clmhi ng w gee one more unic of scarce food. lt sug·
up to get one more unit of food but to keep his mil- gescs as well that if Hugh had little clothing and a loc
icy unchanged? The answer ro chis quescion measures of food he wo uld be willing co give up only a litcle
whac is called Hugh's marginal ra(e of subs(i(mion of scarce clmhing ro gee one more unit of already plenti·
clmhing for food. The marginal race of substicucion fut food.
(MRS) is (he amounc of one produce chac a consumer This example illuscraces che hypothesis of dimin-
is willing to give up co gee one more unit of anocher ishing marginal ra(e of substiturion. The less of one
produce. product, A, and the more of a second produce, n, that
the consumer has already, che smaller the amount of A
that che consumer will be wiIling co give up ro get one
The first basic a ss umption of indi fference th eo ry
additional unit of n.The h)'pothcsis Sa)'S chat the mar·
is tha t the algebraic value of the MRS between ginal race of subscicucion changes when rhe amoun ts
two goods is always negative. of rwo products consumed change. The graphical
expression of this hypothesis is that an)' indiffer·
A negaci ve MRS means char cu increase cunsum p· ence curve becomes flaccer as rhe consumer moves
tion of one produce, Hugh is prepared co decrease downward and co the right along che curve. In figure
consumption of a second product. The negative val ue Figure 6A· I, a movement downward and C<J the righc
of che margimal race of subsricurion is imlicaced graph· 111ea11s rhac Hugh is consuming less clothing and more
ically by che negative slope of indifference curves. food. The decreasing steepness of the curve nneans chat

Hugh is willing to sacrifice less and less clothing to get that will give Hugh equal utility. ff the points indicat·
each addit ional unit of food. ll 1 J ing all of these combinations arc connccced, they will
fo rm anorher indifference curve. This exercise can be
repeated many ti mes, and we can thereby generate
Diminishing MRS is the second basic as~umption
many indifference curves fo r I !ugh. The farther an)'
of indifference cheory.
indiffei:ence curve is from che origin, che highei: will be
the level of Hugh's utility given by any of the points on
The hypo thesis of diminishing marginal ra te the curve.
of substitmion is illustrated in Table 6A-1 , which is A sec of indifference curves is called a11 in diffei:ence
based on the example in Figure 6A-1. The lase column map, an example of which is shown in Figure 6A-2.
of the ta ble shows the rate at which TTugh is prepared le specifics the consumer's castes by s howing his
cu sacrifi ce unics of clothing per uni t of food obtai ned. race of s ubscicucion betwee n che cwo producrs fu r
At fi rst, H ugh will sacrifice 2.4 units of clothing co get every possible level of curre nt consumption of chese
I unit more of food, but as his consum ption of cloth- produces.
ing di minishes and his consumption of food increases,
Hugh becomes less and less willing to sacrifice further
clothing for more food. When economises say that a consumer's castes
arc given, they do not mean that the consu.mcr's
current consumption pattern is given; rather, they
The Indifference Map mean that the consumer's entire indifference map
IS ~t\lell.
So far, we have constructed only a single indifference
curve for I Iugh. I Towcvcr, Starting at any ocher point in
figure 6A-l , such as g, there will be ocher combinations
AGURE 6A·2 Hugh's Indifference Map

TABLE 6A-1 Hugh's Marginal Rate of Substitution

Between Clothing and Food -'""
( I) (2) Ma1·gina l

Change Change Race of ]""

in i 11 Substitution 0
Movement Cloch ing Food (1 )+ (2)
From a co b 12 5 2.4 i:-
From b to c
From c ro d
Fro m d roe 2 s 0.4
Fron1 e ro ( I 5 0.2
The maq;;inal rate of substitllCion of clothing fo1· Quoncity of Food per Week
food declines (in absolllCe value) as the quantity of
food increases. This table is based on Figure 6A- I.
When 1lugh moves from a to b, he gives up 12 units An indifference map consists of a set of indifference
of cloth ing and gains 5 units of food; he remains at curves. All points on a particular curve indica te alter-
the same level of overa ll utilit)'. At point a, Hugh is native combinations of food and clothi ng that give
prepared to sacrifice 12 units of clothing fo r 5 un its of I lugh equal uti lity. The farther the curve is from the
food (i.e., 12/5 = 2.4 un ics of cloching per unit of food origin, the higher is the level of uti lity it represents.
obrained). Wh en he moves from b to c, he sacrifices For example, l 5 is a higher indifference curve th an
5 units of cloth ing for 5 units of food (a rate of sub- 14, which mea ns tha t al l che points on 15 give Hugh a
stitution of l un it of cloth ing for each unit of food). highe1· level of utility than do th e points on 14 .

J 6A.2 The Budget Line Properties of the Budget Line

The budget line has several important properties:
Indifference curves illustrate consumers' tastes. Tu
develop a complete theory of their choices, we must 1. Poinrs on the budget line indicate bundles of prod-
also illustr:itc rhc availa ble ::ilec rn ~ Li vcs. These :lrc uces that use up the consumer's entire income.
shown ns the solid line ab in Figure 6A-3. Thar line, (Try, for example, the point 20C. 20/1.)
called a budget line, shows all the combinations of
2. Poinrs becween rhe budget line :ind che origin
food and clOl'hing chat I !ugh c:11n buy if he ~pends a
indicace bundles of produces rhar cosc less than
fixed amuunr uf money, i11 this case his emire money
rhe consumer's income. (Try, for example, the
income of $720 per week, at fixed prices of rhe puinr 20C. IOF.)
producl~ (in this ca~c, $ 12 per unit for clothing and
$24 per unic fur food). 3. Points above che budget line indicate curnbinacions
of products rhar cosr more ch:in che consumer's
income. (Try, for example, the point 30C. 40F.)

FIGURE 6A·3 Hugh's Budget Line

The hudgct line shows all rnmhination~ of product~
that arc available to 1hc con~umcr Kivcn his monC)'
income and the prices of the goods that he purcha~cs.

I We can also show Hugh's alcemarives with an
~ nudger l111c equacion that uses symbols to express the information
I I contained in the budget line. Let E stand for I lugh's
I I money income, which must be equal co his coral expen-
I diture on food and clorhing. If Pf and Pc represent the
I moner price~ uf food and clothing, respecrivcl)', :md
I f and C represem rhe qua nti ties of food and cloching
I ,, that Hugh chooses, then his spending on food is eq ual
to /Jf' times r:. a11d his spending on clothing is equal to
0 10 20 Jo 40
Pc rimes C. Thus rhe equation fur rhe budget line is
Quancicy of Food pe1 Week, 1'
E - P1 x F + Pc x C
The budget line shows chc quantitic' of goods nvail-
ahle to a consumer given money income nnd the prices
of goods. Any poinr in this diagram indicates a com- The Slope of the Budget Line
bination (or bundle) of so much food and so much
clothing. t>omt xi. for example, indicates 40 units of Look ngain ac Hugh's budget line in Figure 6t\-3. The
clorhini: and IO umts of food per week. vercical intercept is 60 units of clothing, ancl the hor
With ;111 1ncurnc of $720 a week and prices of izuntal imer\'.ept is 30 units uf fuud. Thus the slope
$24 per unit for food and $ 12 per unit for clotlung, is equal to 2. The min us sign means char increases in
I lugh's budget line is a/J. This line sl1ows all the com-
hinarions nf F and C av:iibblc ro him if he spends the Hugh's purchases of one of the goods muse be acco m
entire $720 per week. He could spend all this money panied by dec:reases in his purchases of che ocher. The
income on clothing and obtai n 60 units of clorhing numerical value of rhe slope indica res how muc h of
:111d 1ero food each week. Or he could i:o ro the other one good muse be given up co obtain an additiona l unit
extreme and purchase only food, buyini: JO units of of che ocher; in our example, rhe slope of 2 mea11s that
/• and ieru units of C. 1Iui:h could also choose an
1ntcrmcdiatc pos11ion :1nd consun1c some of both Hugh must forgo rhe purchase of 2 units of clothing to
good~ for example, spending $240 to bu)' I 0 units acquire I exrra unir of food.
o( F and $480 to bur 40 urlus of C (poinr xi). Points Recall char in Chapter 3 we concrasred che
above the budi:cr line, such as x1, arc nor :trtain:iblc. absoluce, or money, price of a produce with its reln-
cive price, which is che ratio of its absolucc price co

that of some other product or group of products. One by the straight line, and the curves from the indifference
importa nt point is that the relative price determines ma p arc abo shown. Any point on the l1udgct line is
che slope of che budget line. In cerms of our example acrainable, but which puint will Hugh accuall)' chouse?
of food and clothing, the slope of che budget line is Because Hugh wa nes to maximize ucilicy, he wants
determined by the relative price of food in terms of to reach the highest attainable indifference curve. lnspec:·
clorhing, PF/Pc; wirh che price of food (PF) ar $24 per ciu11 uf Figure 6A-4 shows char if Hugh pui:chases any
unit and the price of clothing (pc) ac $ ·12 per unit, che bundle on the budget line at a point cut by an indiffer-
slope of tlhe budget line (in absolute value) is 2. l12J ence curve, he c:an reach a higher indifference curve. Only
The significance of rhe slope of Hugh's budger line when rhe bundle purchased is such rhac rhe indifference
fo r food and clothing is thac it re Aects his opporcu· curve is ta ngent to the budget line is it impossible for
nity cost of fnocl in te rms of clothing. To increase fond I !ugh to reach a higher curve by altering his purchases.
consumprion while mainraining expenclirure consranr,
Hugh mu:sc move along che budget Iine and therefore
The cons umer's utility is maximized at the point
consume less clothing; chc slope of the budget line
de rermines how much clorhing he muse give up w where an indifference curve is tangent to the bud·
gee line. Ac that point, the consumer's margi nal
obtain an additio nal unit of food.
race of substitution for the two goods is equal to
the relative prices of the two goods.
The opportunity cost of food in terms of clothing
is measured by the (absolute value of the) slope of
the budget li ne, which i~ equal to the relative price
ratio, /1F//1c. RGURE 6A·4 Hugh's Utility-Maximizing Choice

In che example, wirh fixed income and wirh rhe
relacive price of food in cerms of clothi ng (pp/pc) equal 60
to 2, I !ugh must fo rgo the purchase of 2 units of cloth- ,,.
ing ro acquire 'I exrra unic of food . The opporru nicy ~~ 50
cosc of a unit of food is ch us 2 units of clothing. Notice &
that the relative price (in our example, PF/Pc - 2) is c.c
~ 40
consisrenr. wirh an infinire number of absolure prices. 0
If fip= $40 and pc; - $20, it is still necessa ry to sacrifice 0
0 30
2 units of clothi ng to acquire I unit of fond. 4 Thus rel-
ari ve, nor absolure, prices derermine opporcunicy cosr. ·=~ 20
GA.3 The Consumer's
Utility-Maximizing 0 5 10 15 20 25 30 35
Quantity of Food pe1· Week
The consumer's utility is maxi mi zed a1 A, where an
indifference curve is tangent to the budget line. Hugh
An indifference map describes che preferences of a con- has a mone y income of $720 per week and faces
sumer, and a budget line describes the possibilities avail- money p1·iccs of$ .1 2 per· unit for clorhi11g ~ nd $24 per
unit for food. A combina tion of un its of clothing and
able co a consumer. To predicr whac a consumer will food indicated by point a on 11 is attaina ble but, by
accually do, both sets of information must be combined, movi ng along the budget line, Hugh can reach higher
as is done in Figure 6A·4. I lugh's budget line is shown ind ifference curves. The same is true at b on /2 and at
con 1,. Ar A. however, where an indifference curve
Of course, wich a given income, Hugh ca11 afford much less of is rangenr ro the budgcr line, Hugh c:rnnor reach a
(1 4)
each at chese higher money prices, but the opportunity cost of food higher curve by moving along the budget line.
in terms of clothing remains unchanged.

The intu iti ve explanation fo r this result is that if

I Tugh values goods diffcrcntl)1 from the way the mar- FIGURE 6A·5 Income-Consumption Line
ker does, there is room fo r profitable exchange. Hugh
can give up some of the good that he val ues relatively
less than the market docs and ta ke in return some of
rhe good char he val ues relatively more chan che mar- ...
ket does. When he is prepared to exchange goods at
the same race as chey can be traded on the market,
rhere is no furrher opportunity for him co raise uri licy

by substiw ti ng one product fo r the other.


The theQry thus proceeds by supposing chat I !ugh c

is presenred wich marker prices rhac he cannot change
and then by analyzing how he adjusts to these prices l
by choosing a bundle of goods such that, at the mar-
gin, his ow1l subjecrive val uation of rhe goods coin- 0
Quantity of Food p« W<ek
cides with the valuations given by market prices.
We will now use this theory to predict the typical The income-consumption line shows how the con-
consumer's response co a change in income and in prices. sumer's purchases react to a change in money income
with relative prices being held constant. Increases in
I lugh's money income cause a parall el outwa rd shift
The Consumer's Reaction to a of his budget line, moving his utility-n1axi miii ng point
from A to R ro C. By joinir1g all the utiliti1·maxin1izing
Change in Income poinrs, Hugh's income- consumption line is rrnced our.

Achange in Hugh's money income will, cctcris paribus,

shift his budget line. For example, if Ilugh's income
doubles, he w ill be able ro buy rwice as much of borh FIGURE 6A·6 Hugh's Price- Consumption Line
food and clothing compared with any combination on
his previous budget line. I Iis budget line will therefore
shift our parallel co itself co indicate chis expansion in -"' (I
his consumption possibilities. (The fact that it will be 8
~ Pricc-co11s11 rnpcion
a pa rallel shi ft is established by the previous demon- ...
Cl. lin<
stra tion rhac che slope of the budget line depends only
on the relative prices of the two products.) ~""
For each level of I Iugh's income, there will be a
urilicy-maximizing poinc at which an indifference curve ...0
is tangent to the relevant budget line. Each such utiliry- c
maximi'ling position means that I Iugh is doing as well rl

as possible ar char level of income. If we move rhe budget =

line through all possible levels of income and if we join
up all the utility-maximizing points, we will trace out
what is called an income-consumption line, an example
of which is shown in Figure 6A-5. This line shows how
" '
Qun11tiri1 of Food per Week

I Tugh '~ cons umption bundle changes as his income 111c pric<-' -consurnption line shows how the con·
changes, with relative prices being held constant. sumer's purchases react to a change in one pri ce with
money income and other prices being held constant.
Decreases in the price of food (with rnoncy inco me and
The Consumer's Reaction to a the price of clothing held constall[) pivot Hugh's bud·
get line from au to ac to t1d. Hugh's uriliry-111axi mizi ng
Change in Price bundle moves from A m B m C. By joining all the
utiliry·rn:.t)(imizing points, a price-consumption line is
We already know that a change in the relative prices traced out, showing that Hugh purchases mo re food
of the two goods changes the slope of the budget line. a nd less cloth ing as the price of food fal ls.
Given the price of clothing, for each possible price of

food there is a different utility·maxi mizing consump·

tion bundle for TTugh. If wr.: connect these bundles, FIGURE GA·7 Derivation of a Consumer's Demand Curve
at a given money income, we will trace ouc a price-
consumption line, as shown in Figure 6A·6. Notice
that in this example, as che relative prices of food and
cloching change, che quanri cies of food and clothing
chat Hugh purchases also change. Tn particular, as Price-consumption
the price of food falls, T!ugh bu)'S more food and less

6A.4 Deriving the Demand

0 600
What ha ppens to che consumer's demand for some 1200 2200
Gasoline (lirres per momh}
producr, say, gasoli ne, as che price of rhac prnducr
(i) l'ri~c-consu mprion line
changes, holding constam the prices of all ocher
If chere were only cwo produces purchased by
consumers, we could de rive a de mand curve for one of
the products from the pri r.:L~consumption line like the
one we showed for Hugh in Figure 6A-6. When chere
are many produces, however, a change in the price
of one product genera lly causes substitu tion toward
(or away from) all ocher goods. Thus, we would like
to have a simple way of representing the individual's
castes in a world of many products.
In pare (i) of Figure 6A-7, a new cype of indif-
ference map is plotted in which litres of gasoline per
month arc measured on the horizontal axis and the
value of all ocher goods consumed per rno11 th is plotted 0 600
on the vertical axis. We have in effect used "everything 1200 2200
but gasoline" as che second produce. The indifference Gasoline (litres per month}
cui:ves in chis figure then show che race ac which the (ii ) Dcma 11cl curve
consumer is prepared to substitute gasoline for mone)'
(which all ows him tQ bu)' all ocher goods) at each level Every point on the prkc-consumption line corre-
of consumprion of gasoline and of all ocher goods. sponds to both a price or the product and a quan-
tity demanded; chis is chc information rcqui1·cd fo1· a
To illustrate the deri vation of demand curves, demand curve. In pan (i), rhe consumer has a money
we use rhc numerical example shown in Figure 6/\-7. income of $4000 a nd alrcrnarively faces prices of
The consumer is assumed co have an afrer-rax money $ l.50, $1.00, an d $0.50 per litre of gasoline, choosing
income of $4000 per month. This level of money income posirions A, B, a nd C at each price. The information
is plotted on the vertical axis, showing that if the con- for litres of gasoline demanded ar each price is rhen
plotted in part (ii ) to )'icld the consumer's demand
sumer consumes no gasoline, he can consume $4000 curve. The three points a, b, and c in part (ii) corre·
worth of m her goods each month. When gasoline costs spond to the points A, B. and C in part (i).
$ 1.50 per litre, the consumer could buy a maximum of
2667 Ji(res per monrh. This se( of choices gives rise co
the innermost budget line. Given the consumer's tastes, Next, let the price of gasoline fa ll co $1.00 per
urilit)' is maximi"tcd at point A, consuming 600 litres of litre. N ow the maximum possible consumption of
gasoline and $3100 worch of ocher producrs. gasoline is 4000 lirres per mon rh, giving rise co rhe

midd le blldget line in the fi gllre. The <.:onsumer's whereas in part (ii) the price of gasoline is plotted
utility is maxi mized, as alwa)'S, at the point where explicitl y on the ve rtical axis.
che new budget li ne is tangent co an indi fferen<.:e
cu rve. At this point, B, the consumer is i;onsum·
ing 1200 litres of gasoline per month and spendi ng Income and Substitution Effects
$2800 on all ocher goods. Finally, lee che pri<.:e fa ll
to 50 i;encs per licre. The consumer can now buy a The price-consump tion line in pare (i) of Figure 6A-7
maximum of 8000 litres per