Production Possibilities and Opportunity

Cost
We do not produce outside
the PPF because it is
unattainable.
We do not produce inside the
PPF because we could have
produced more with the
same amount of resources.
We will only produce at
points on the PPF.
Which combination of Pizza and
Cola on the line should we choose
to produce at?

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DEMAND AND SUPPLY

What makes the prices of oil and gasoline double

in just one year?
Will the price of gasoline keep on rising?
Are the oil companies taking advantage of people?
Some prices rise, some fall, and some fluctuate.
This chapter explains how markets determine
prices and why prices change.
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Market and Prices

A market is any arrangement that enables buyers and
sellers to get information and do business with each other.
A competitive market is a market that has many buyers
and many sellers so no single buyer or seller can influence
the price.
Ex: fast food market
Counter-Ex: Smart phone market

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Market and Prices

The money price of a good is the amount of money
needed to buy it.
The relative price of a good is the ratio of its money price
to the money price of the next best alternative good.
Ex: the money price of coffee is $1 a cup, the money price of gum is
50 cents a pack,
what is the relative price of one cup of coffee in terms of gums?
To calculate the relative price, we can divide the money price of coffee
by the money price of gum.
The relative price of a cup of coffee is 2.

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Market and Prices

What is relative price essentially?
The relative price of a good is an opportunity cost.
Ex: the money price of coffee is $1 a cup, the money price of gum is
50 cents a pack, what is the opportunity cost of one cup of coffee?
In order to buy one cup of coffee, we need to give up 2 packs of gums,
therefore the opportunity cost of one cup of coffee is two packs of
gum.
The relative price of a cup of coffee is 2.

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Market and Prices

Calculate the relative price using price index

The money price of a basket of all goods is called a price index.

A price index is the average price of all goods and services in the
basket.
Ex: Consumer Price Indexes (CPI), Producer Price Index (PPI) or
Wholesale Price Index(WPI)
We divide the money price of coffee by the price index.
Ex: Suppose the price index is 2, the money price of coffee is $1 a cup,
what is the relative price of a cup of coffee?
The relative price of a cup of coffee is $0.5.

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Demand
If you demand something, then you
1. Want it,
2. Can afford it, and
3. Have made a definite plan to buy it.
Wants are the unlimited desires or wishes people have for
goods and services. Demand reflects a decision about
which wants to satisfy.

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Demand
The quantity demanded of a good or service is the amount
that consumers plan to buy during a particular time period, and
at a particular price.
Ex: suppose you buy one cup of coffee a day at a price of $1,
what is the quantity of coffee demanded per week at this price?
What determines the quantity demanded of one cup of coffee per
week?
To economists, the most important factor is the price!
To study the relationship between the quantity demanded of a good and its
price, we keep all other influences on buying plans the same (for example,
your income).

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Demand
The Law of Demand
The law of demand states:
Other things remaining the same, the higher the price of a
good, the smaller is the quantity demanded; and
the lower the price of a good, the larger is the quantity
demanded.

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Demand
The law of demand results from:
1. Substitution Effect
When the relative price (opportunity cost) of a good or
service rises, people seek substitutes for it, so the
quantity demanded of the good or service decreases.
Ex: suppose the price of an energy bar rises from $1.5 to $3
and the price of a bottle of energy drink is the same. How do
quantity demanded of bars change and why?
People now substitute energy drinks for energy bars, because
energy drink becomes relatively cheaper. So we buy less
energy bars.

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Demand
2.Income Effect
When the price of a good or service rises relative to income,
people cannot afford all the things they previously bought, so
the quantity demanded of the good or service decreases.
Ex: suppose the price of an energy bar rises from $1.5 to $3 and the
price of a bottle of energy drink is the same. How do quantity demanded
of bars change and why?
With the same income, people now cannot afford as much energy bars
as before, so we buy less energy bars.
Now suppose the price of an energy bar falls from $1.5 to $1, what would
happen and why?

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Demand
Demand Versus Quantity Demanded
The term demand refers to the entire relationship between the
price of the good and quantity demanded of the good.
Ex: the quantity demanded of coffee is 2 cups per day at a price of $2, 3
cups per day at a price of $1.5

The quantity demanded of a good or service is the amount

that consumers plan to buy during a particular time period, and
at a particular price.
Ex: the quantity demanded of coffee at a price of $2 is 2 cups per day.

Demand is the relationship between two variables, while

the quantity demanded is just a number!

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Demand
Figure 3.1 shows a demand curve for energy bars.

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Demand
Demand Curve
Demand curve shows the relationship between the
quantity demanded of a good and its price when all other
influences on consumers planned purchases remain the
same.
The distinction between demand and quantity demanded
on the demand curve:
Demand is illustrated by the entire curve, while quantity
demanded refers to a point on the demand curve!

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Demand
How can we illustrate the law
of demand on the demand
curve?
A rise in the price, other things
remaining the same, brings a
decrease in the quantity
demanded and a movement up
along the demand curve.
A fall in the price, other things
remaining the same, brings an
increase in the quantity
demanded and a movement
down along the demand curve.
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Demand
Willingness and
Ability to Pay
A demand curve is also a
willingness-and-ability-to-pay
curve.
Ex: when 5 million bars are
available each week, the highest
price that people are willing to pay
for the last bar is $2.50.

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Demand
Why is a demand curve also a willingness-and-ability-to-pay
curve?
Suppose the highest price that people are willing to pay for the last bar
is $2.50 when 5 million bars are available each week,
If the firm sets the price higher than $2.50, it cannot sell that much bars;
if the price is lower than $2.50, then it can sell more then 5 million bars.
Therefore, saying that someone is willing to pay at most $2.50 for the 5
millionth bar is equivalent to say the quantity demanded at the price of
$2.50 is 5 millions per week.
Willingness to pay and the law of demand

The smaller the quantity available, the higher is the price that
someone is willing to pay for the last unit.

2012 Pearson Addison-Wesley

The Economic way of thinking

Choices respond to incentives
An incentive is a reward that encourages an action or a
penalty that discourages one.
People make choices by looking at the incentives they face.
What are the incentives people face when making buying
plans?
People want the most pleasure for themselves, yet
resources are scarce.
Incentives act as the key to reconcile the paradox.

2012 Pearson Addison-Wesley