principles review

Review Materials and Worksheets for Managerial Economics (Adkisson), ©Richard V. Adkisson 2007

Principles of Economics Review and Worksheets

The purpose of this packet is to provide a review of some basic math concepts and materials taught inPrinciples of Economics that are essential background knowledge for students in Economics 371. Mostof the economics concepts and models reviewed here are discussed in the first four or five chapters ofany good Principles of Economics textbook. The math concepts come from algebra and beginningcalculus. Make sure you understand this material within the first few days of class. Ask the instructorabout anything you don't understand.

WHAT IS ECONOMICS?

Economics, as it is treated in this class, is the study of how societies deal with the problem of scarcity. Scarcity is evident when a society wants to consume more goods and services than it has the capacity toproduce. The shorthand way of defining scarcity is to say that societies have unlimited wants butlimited resources. To decide how to allocate scarce resources among alternative uses is often referred toas the economic (or economizing) problem.

Resources fall into four categories: land (natural resources), labor (self explanatory), capital (goods usedto produce other goods), and entrepreneurial ability (the ability to organize resources into newproductive activities and the willingness to take the risk of doing so). Owners of each type of resourcereceive payments when they allow their resources to be used in production. Land owners receive rent,laborers receive a wage, capital owners receive interest (capital rental), and entrepreneurs receive aprofit.

To understand how economic choices are made is an important issue in economics. Since societies lacksufficient resources to produce everything they want, they must have a systematic way to decide how touse the resources they do have. A society's system for making these choices is called its economy. Anyeconomy must provide a systematic way to answer the three fundamental questions.

What to produce? Since no society can produce everything that its members want, the economymust provide a systematic way to decide which things the society will produce? (resourceallocation problem)

How to produce? Most things can be produced using any of several methods. The economymust provide a systematic way to decide which method to use. (technological choice problem)

For whom to produce? Since everyone cannot have everything they want, some or all membersof society will receive less of the things produced than they would like to have. The economymust provide a systematic way to decide who gets what. (income distribution problem)

History provides examples of at least three basic types of economies that societies have used to dealwith these questions. They are classified by the method used to answer the three fundamental questions.

Traditional Economies Answer the three questions in the same way they have been answered inthe past. (example: feudal societies)

Command Economies A central authority answers the three questions on behalf of society.(example: centrally planned economies of former USSR)


Market Economies The answers to the three questions evolve from the interaction ofindependent buyers and sellers in the marketplace. (example: U.S. and other capitalist orientednations)

Although it is useful to discuss these classifications, in reality, all economies are mixedeconomies. That is to say, they use some elements of all three methods of economic decisionmaking. For example, we might say that the U.S. has a mixed economy where many (but not all)economic decisions are made in markets.

In this course, as in many other economics courses, it is assumed that all economic decisions are madein markets. This assumption simplifies the analysis we will do and allows us to focus on the forcesthought to be the most influential in modern economies.

A COMMENT ON ECONOMIC INTERDEPENDENCE

All modern economies are characterized by a great degree of economic interdependence. Few (reallynone) of the people of the world produce all the things they consume. Most depend on others to producea large portion of the things they consume while they produce many things that they will neverconsume. In other words, there is a great deal of specialization and exchange that occurs in moderneconomies. People, towns, states, and countries specialize in certain types of production, producing farmore than they wish to consume, and exchange their surplus production for goods produced by otherpeople, towns, states and countries. People are willing to become economically interdependent becausespecialization and exchange leads to a more efficient use of resources and results in a higher materialstandard of living. At the same time, specialization and exchange creates a coordination problem, thedecisions of what to produce and what to consume are made separately. Without a good method tocoordinate production and consumption decisions, resources will be poorly used. One of the mainpurposes of this course is to explain how individual decisions work together in markets to solve thecoordination problem.

ECONOMIC MODELS

One of the things economists do is try to create models of economic behavior. Economic models aresimplified representations of real economic phenomena. Economic models can be expressed in at leastthree different ways. They can be expressed in words, graphs or equations. In this class, most of themodels we will explore will be in graphical form. Each model we discuss will be built upon a set ofsimplifying assumptions about economic behavior. For example, we will assume that "more is better"meaning that, other things equal, people prefer to have more stuff to less stuff. Another importantassumption that is often used in economics is that economic actors (people) are self interested and willmake economic decisions that serve their self interest, firms will seek to maximize profits andconsumers will seek to get the most possible satisfaction from their consumption of goods and services. We will mention many other assumptions during the semester. The use of assumptions helps to narrowthe focus of our analysis and thus makes it possible to focus on the things we are most interested in. However, be warned. The assumptions of the model define the context (real world situation) to whichthe model applies. Before using an economic model to analyze a real situation, one should always ask,"how well does the real world situation match the assumptions of the model?" Economic models can beuseful and important decision making tools, but only if care is taken in their application.

It is important in economics to understand the concept of cause and effect. Economists rely heavily on


conditional (if-then) statements, if this happens, then that happens. For example, an economist mightuse a model of supply and demand for pizza to analyze the pizza market and conclude that “if the priceof pizza goes up, ceteris paribus, consumers will buy less pizza.” Ceteris paribus means holding otherthings constant (other things like the price of soft drinks, the price of tacos, the income of consumers,etc...). Because economists must make many assumptions in their analyses, the list of “ifs” can be ratherlarge (if this, this, this, this, this, this, this, this, and this, then that). Sometimes many of the ifs areimplied rather than explicitly expressed. For this reason, it is important to know the assumptions thatare behind each model.

Economic models fall into two basic categories. Partial equilibrium models incorporate only one marketat a time. They ignore how changes in one market affect other markets. The typical supply and demandmodel (reviewed below) falls into this category. General equilibrium models incorporate two or moremarkets into the analysis at the same time. They try to capture the interrelationships among markets andwill always involve at least two goods and two prices. In this course, most, but not all, analysis is of thepartial equilibrium type..

There are two approaches to studying economics, microeconomics and macroeconomics. Both areimportant but we focus on microeconomic issues in this class.

Microeconomics is concerned with analyzing and explaining the behavior of the components ofthe economic system (households, firms, industries). For example, we might want to explainhow individual consumers/households make consumption choices, how firms decide what toproduce and how much to produce, or how markets produce price signals that help coordinatethe decisions producers and consumers .

Macroeconomics is concerned with analyzing and explaining the behavior of the economicsystem as a whole. For example, we might want to measure how much output is being producedin a year or what is happening to the price level (inflation, deflation). In addition,macroeconomics explores ways that the government might be able to influence the performanceof the economy through its fiscal policy (government policy on taxing and spending) and itsmonetary policy (central bank policy toward money supply and interest rate).

REVIEW OF GRAPHS AND GRAPHING

Some of the graphical models used in this class are simply expansions of the models you should befamiliar with from your study of principles of economics. Others will be new, but easy to understand, ifyou have a good grasp of basic graphing principles. Below you will find reviews of basic graphing andtwo basic economic models. The first model reviewed is the production possibilities curve (frontier)model. The second model reviewed is the simple model of a market (supply and demand).

GRAPHS

If you remember how you used the Cartesian coordinate system in algebra, you should have littleproblem understanding the graphical models we use here. This system is no more than twoperpendicular number lines on a two-dimensional plane and can be used to show relationships betweentwo variables, X and Y. Typically, values of the X variable are shown on the horizontal (flat numberline) axis and values of the Y variable are shown on the vertical (upright number line) axis of the graph. See Figure 2.


Figure 1

Each point on this two dimensional plane represents an ordered pair, (X, Y). For example, the point Hrepresents the ordered pair (2, 4) where X=2 and Y=4. The point C represents the ordered pair (-3, -3)where X= -3 and Y= -3. Note the characteristics of the ordered pairs in each quadrant.

Quadrant I Both X and Y are positiveQuadrant II X is negative, Y is positiveQuadrant III Both X and Y are negativeQuadrant IV X is positive, Y is negative

A variable is something that can take on different values. For example, in economics, price is a variablethat can take on many values. When variables are related to one another, they are usually classified asbeing either a dependent variable or an independent variable. The value of a dependent variabledepends upon the value of the independent variable (or of a set of independent variables). For example,a person’s weight (dependent variable) depends on many things (independent variables) like caloricintake, height, activity level, etc. When variables are related, a function can be used to describe therelationship between the variables. A function is a mathematical rule (equation) that relates one set ofvariables to another set of variables and assigns one unique value of the dependent variable to eachvalue of the independent variable. Discrete variables take on specific values, for example wholenumbers, 1, 2, 3, etc... within a range of numbers. Continuous variables can take on any value within arange, for example, 1, 1.1, 1.11, 1.111, 1.111, etc. Most variables used in this class are assumed to becontinuous and can therefore be represented by a continuous function. When a continuous function isgraphed, there will be no gaps in the graph.

Functional relationships with two variables (one dependent, usually Y, and one independent, usually X)can be easily graphed on the Cartesian coordinate system. For example, the line through points C and Bis the graph of the function, Y= aX - 2. This equation, or function, defines a positive (or direct), linearrelationship between the variables X and Y, as the value of X increases (decreases) the value of Yincreases (decreases). The line through points I and A is the graph of the function, Y=-X+1. Thisfunction defines a negative (or inverse), linear relationship between the variables X and Y, as the valueof X increases (decreases) the value of Y decreases (increases). The curve through points D, E, F, G,


and H is a graph of the function Y=X2. Note that in this case the relationship between X and Y isnonlinear. Note that for linear functions, the slope is a constant (it doesn’t change over the range of thefunction). For nonlinear functions the slope is a variable. The slope of a nonlinear function can befound by using simple calculus. The first partial derivative of a function (MY/MX) can be used to find theslope of a nonlinear function at any particular point. The second partial derivative of a function(M2Y/M2X) can be used to find whether the slope is increasing or decreasing at a particular point.

In addition to graphing relationships between variables (functions), we will sometimes divide the twodimensional plane (graph) into sets of points. For example, we could define the set of points in quadrantI (including the points on the axes) as the set of ordered pairs (X, Y) where X$0 and Y$0. We mightwant to divide this set into two subsets, one where X$0 and Y<3 and another where X$0 and Y$3. Thereason we might want to do this will become obvious later.

Having reviewed the general concept of graphing, it is important to point out several things about theuse of graphs in this class.

Because almost all of the variables discussed in economics have positive values, economistsoften use (and draw) only Quadrant I of the Cartesian coordinate system.

Often, the variables X and Y are renamed to represent more specific economic variables. Forexample, if we are interested in the relationship between the price of a good and the quantitydemanded of a good, the values on the horizontal axis will represent quantities of the good andthe values on the vertical axis will represent prices of the good.

In economics the actual numbers on the axes are often not as important as the type ofrelationship between the variables being discussed. For this reason, we will often draw a line orcurve to represent a functional relationship but will not show any particular values on the axes ofthe graph. Neither will we always define the specific equation that defines the relationship.

Graphs of linear functions are also called curves.

REVIEW OF BASIC ECONOMIC MODELS

PRODUCTION POSSIBILITIES CURVE

The production possibilities (frontier) curve is a basic economic model that captures the concepts ofscarcity, efficiency, opportunity cost, and economic growth. As mentioned above, the model usesquadrant I from the Cartesian coordinate system. In this model we assume that a society produces onlytwo goods, good X and good Y. When we label the axes in this way, we can think of the twodimensional space represented as a commodity space where each point in the space represents acombination (ordered pair) of some quantity of X and some quantity of Y. Note that an infinite numberof combinations of goods X and Y can be represented in this space.

Think of the production possibilities frontier as a constraint on society. Of all the (mathematically) possible combinations of the two goods, only some are possible to produce. After all, it takes resourcesto produce goods and services (in this case goods X and Y) and resources are limited. Therefore, thinkof the combinations of X and Y on, and below, the PPF as a society's production opportunity set (moregenerally its feasible set). Because of limited resources, society cannot produce just any combination of


Figure 2

X and Y. They must produce a combination in their production opportunity set (thus the model capturesthe concept of scarcity).

A society has the opportunity to produce any combination of goods in its production opportunity setbut, because of the "more is better" assumption mentioned above, we assume that a society not willpurposely choose to produce at a point below its PPF. To produce at a point below the PPF is to say thata society is either not using all of its resources, or it is not using its best (most efficient) technology. Ifmore really is better, a society will seek to produce as much with its resources as possible. That is, itwill choose to produce one of the combinations of X and Y on its PPF. The PPF shows all of thevarious combinations of two goods that can be produced assuming that society is using all its resourcesand its most efficient technology (thus the concept captures the concept of efficiency).

Once a society is producing at a point on its PPF it cannot increase the output of one good withoutdecreasing the output of the other good. Thus, this model also captures the concept of opportunity costs. The opportunity cost of good X is the amount of good Y that must be given up to produce one more X. The opportunity cost of good Y is the amount of good X that must be given up to produce one more Y.

The absolute value of the slope of the PPF at the point of production is the opportunity cost of good X interms of good Y. For example, if society was producing at a point on the PPF where the slope was -2,this would indicate that society must give up two units of Y to get one more unit of X. The reciprocal ofthe absolute value of the slope of the PPF gives the opportunity cost of Y in terms of X. In thisexample, society would have to give up 1/2 unit of X to get one more unit of Y.

We can talk of opportunity costs in three ways.

Constant Opportunity Costs - The opportunity cost of producing one more of good X (or goodY) is the same regardless of how much is already being produced (constant returns to scale). When there are constant opportunity costs the PPF will be linear (straight).

Increasing Opportunity Costs (shown in Figure 2) - The opportunity cost of producing a goodincreases as more and more of the good is produced (decreasing returns to scale). When thereare increasing opportunity costs the PPF will be concave to the origin of the graph (bowed out)


1 Remember, this is a very simple model. Notice that there is no government, financial,or external (international) sector. The purpose here is to gain an appreciation of how prices aregenerated and their role as economic signals.

as in the graph above.

Decreasing Opportunity Costs - The opportunity cost of producing a good decreases as more andmore of the good is produced (increasing returns to scale). When there are decreasingopportunity costs the PPF will be convex to the origin of the graph (bowed in).

Any time a society increases (or decreases) its resource endowment, or develops a more efficienttechnology, its PPF will shift to reflect the society's new production opportunity set. A shift outindicates that society's choices have expanded. A shift inward indicates that society's choices havecontracted. Outward movements of the PPF indicate economic growth and inward movements implyeconomic contraction.

Hopefully, by the end of this course, you will understand how a set of well-functioning markets willlead a society to the best possible choice when it chooses what to produce (from its limited choicesrepresented by its production opportunity set).

RESOURCE ALLOCATION THROUGH MARKETS

There are many different kinds of markets but, to keep things simple, we will concentrate on two basic markets, product markets and resource markets. Product markets are markets where finished goods andservices are bought by households and sold by firms. Resources markets are markets where land, labor,capital, and entrepreneurial ability are bought by firms and sold by households. The simplest model of amarket economy is the basic two sector, two market circular flow model.1 The diagram below is anexpression of this model.


Households are economic decision making units. They may contain a single person, family, or othergroup. The key is that they operate as a unit when making economic decisions. Households have twobasic decisions to make (a third will be discussed in class). Household members own resources andmust decide what quantity of resources they are willing to provide to firms (hours of labor, etc...). Theymust also decide what goods and services they are willing to consume and in what quantities they willconsume them. Households make supply decisions in the resource market and demand decisions in theproduct market.

Production takes place in firms. Entrepreneurs in firms have two basic economic decisions to make. They must decide what quantity (and what mix) of resources they are willing to buy. They must alsodecide what goods and services they are willing to produce and in what quantities to produce them. Firms make demand decisions in the resource market and supply decisions in the product market.

The prices of resources (wages, interest, etc...)are determined when buyers and sellers interact inresource markets. The prices of goods and services (PX and PY) are determined when buyers and sellersinteract in the product market. In turn, prices provide information to market participants that help themmake production and consumption decisions.

Refer to the circular flow diagram above. Households sell their resources in the resource market to earnincomes with which they buy the goods and services they wish to consume. When they pay for thegoods and services, firms receive revenue which they use to pay for the resources used when theyproduced the goods and services which they sell to the households. This is an example of economicinterdependence. There is a basic conflict here in that both households and firms behave in a selfinterested way. Utility maximizing households want high incomes (resource prices) and low prices forgoods and services. Profit maximizing firms want low costs (resource prices) and high revenues (pricesof goods and services). This conflict is what makes markets work.


THE MODEL OF A MARKET, SUPPLY AND DEMAND IN PRODUCT MARKETS

Resource markets are just as important as product markets but, because we primarily focus on productmarkets in this class, we will examine only product markets here. In market economies, prices aredetermined by the interaction of supply and demand. Consider the following definitions of supply anddemand.

Supply (expressed as a graph, an equation, or a table) tells us the various quantities of a particular goodor service that firms (sellers) are willing and able to sell at each price in a set of prices, other thingsequal. Mathematically, supply is a function (rule) that maps (relates) a set of quantities to a set ofprices, assuming that other variables (non price determinants of supply) are held constant.

Note: Several things (variables) will affect a producer’s willingness and ability to sell a good orservice in the market. For example:

Price of the good under considerationPrices of other goods that the producer could producePrices of resources (inputs)TechnologyProducers’ expectationsTaxes and subsidiesNumber of producers in the marketEtc. . .

All of these (except price of the good under consideration) are called non price determinants ofsupply or shift factors of supply.

In order to concentrate on the supply (price-quantity) relationship discussed above we mustassume that none of the non price determinants of supply change at the same time we examinethe price quantity relationship we refer to as supply. If one of the non price determinants doeschange it will change the price-quantity relationship. We call this a change in supply. Graphically, a change in supply will shift the supply curve to the left (decrease in supply) or tothe right (increase in supply).

A decrease in supply (leftward shift of supply curve) indicates that suppliers are willing and ableto sell fewer of the good or service at any price. For example, if the prices of resource inputsincreases, producers’ costs would increase and, at any given price, they would no longer bewilling and able to sell the same amount that they were selling before at the same price.

An increase in supply (rightward shift of the supply curve) indicates that suppliers are willingand able to sell more of the good or service at any price. For example, if they gain access to anew technology that allows them to use fewer resources in production, they will be willing andable to sell more goods than they were before, even at the same price.

Demand (expressed as a graph, an equation, or a table) tells us the various quantities of a particular goodor service that households (buyers) are willing and able to buy at each price in a set of prices, otherthings equal. Mathematically, demand is a function (rule) that maps (relates) a set of quantities to a setof prices, assuming that other variables (non price determinants of demand) are held constant.


Note: Several things (variables) will affect a consumer’s willingness and ability to buy a good orservice in the market. For example:

Price of the good under considerationConsumer’s tastes and preferencesIncomes of consumers (normal goods and inferior goods)Prices of other related goods (substitutes and complements)Consumer expectationsNumber of consumers in the marketEtc. . .

All of these (except price of the good under consideration) are called non price determinants ofdemand or shift factors of demand.

In order to concentrate on the demand (price-quantity) relationship discussed above we mustassume that none of the non price determinants of demand change at the same time we examinethe price quantity relationship we refer to as demand. If one of the non price determinants doeschange it will change the price-quantity relationship. We call this a change in demand. Graphically, a change in demand will shift the demand curve to the left (decrease in demand) orto the right (increase in demand).

A decrease in demand (leftward shift of demand curve) indicates that buyers are willing and ableto buy fewer of the good or service at any price. For example, if consumer incomes decrease,consumers would be willing and able to buy less of a good at any given price (assuming the goodis a normal good, see below).

An increase in demand (rightward shift of the demand curve) indicates that buyers are willingand able to buy more of the good or service at any price. For example, if there is a successfuladvertising campaign that convinces consumers that consumption of a good will improve theirlove life, consumers might become willing to buy more of the good at any given price.

IMPORTANT When we talk about a change in demand (or supply) we are talking about aresponse to one of the non price determinants of demand (or supply). A change in demand (orsupply) will be evident by a shift of the demand (or supply) curve. A change in quantitydemanded (or supplied) occurs when consumers (producers) respond to a change in the price ofthe good under consideration. Changes in quantity demanded (or quantity supplied) are simplymovements from one point to another point on the same demand (or supply) curve.


2 This assumes that X is a normal good. For normal goods, an increase (decrease) inincome will cause the consumer to buy more (less) of the good. For inferior goods, an increase(decrease) in income will cause the consumer to buy less (more) of the good. For many people,shrimp or steak might be normal goods while Ramen noodles or frozen burritos might be inferiorgoods.

Figure 4

GRAPHICAL MODEL OF A MARKET (SUPPLY AND DEMAND)

The graph below models the market for Good X.

Notice that demand is downward sloping indicating a negative (inverse) functional relationship betweenthe price of X and the quantity demanded of X (as the price of X goes down, consumers are willing andable to buy more of X, and vice versa). This is because of the income effect and the substitution effect.

The income effect is part of the reason for the inverse relationship between price and quantitydemanded. As a price goes down (other things staying the same) consumers’ real incomes (theamount of goods and services that can be purchased from one’s money income) increase. Thisincrease in income causes consumers to buy more of the good X because now they can affordto.2

For example, suppose you have an income of $250 per week and you have been spending it all onconsumption. If you are buying 10 gallons of gasoline every week and the price of gasoline drops by$.25 (everything else stays the same price) you will be able buy everything you bought before the pricechange and have $2.50 left to spend, part of which you may spend on more gasoline.

The substitution effect is another part of the reason for the inverse relationship between price andquantity demanded. As the price goes down (other things equal) the good becomes cheaper notonly in the dollar amount paid but it also becomes cheaper relative to (compared to) other goods. Because of this, consumers may buy more of the now relatively cheaper good and buy less ofsome substitute for the good. For example, if the price of hamburgers increases (decreases) you


might buy fewer (more) hamburgers and more (less) tacos or pizzas.

The demand curve in the graph above indicates that at price P1, quantity demanded is Q1. At price P3,quantity demanded is Q5 and at price P2, quantity demanded is Q4. Important: Remember that thisassumes that nothing else except price is changing. A change in any of the non price determinants ofdemand will change demand (shift the demand curve) and a new price-quantity relationship will beestablished. Other things equal, an increase in demand will drive the equilibrium price up and adecrease in demand will drive the equilibrium price down.

Notice that supply is upward sloping indicating a positive (direct) relationship between the price of Xand the quantity supplied of X (as the price of X goes up, producers are willing and able to sell more ofX, and vice versa). The main reason for this is explained by the law of diminishing marginal product.

To understand this, consider that there are two types of inputs in any productive process.

Fixed inputs are inputs which are used in the same quantity regardless of the level of output. Forexample, a factory building is a fixed input. Regardless of the level of output, the same buildingis used (and paid for). Because some inputs are fixed (at least in the short run) firms have fixedcosts that must be paid regardless of output.

Variable inputs are inputs that are used in different quantities as the level of output changes. Forexample, for most productive processes, labor is a variable input. As more (less) goods areproduced, more (less) labor is used. To the extent that a firm uses variable inputs, it will havevariable costs. Variable costs change with the level of output.

Realize that in the short run, the only way to increase the production of a good or service is to add morevariable inputs to the available fixed inputs.

And remember the following definitions.

Marginal product: “the amount of extra output produced when one more input is added to aproductive process.”

Marginal cost: “the increase in total costs when one more unit of a good or service is produced.” The law of diminishing marginal product states that “as more and more variable inputs are added to a setof fixed inputs, the marginal product of each additional variable input will eventually decline”. Forexample, as more and more workers (variable inputs) are put to work in a given factory building (fixedinput), the first workers hired will add more to production than the last workers hired. The factory isgetting crowded, more difficult to manage, etc... Assuming that each worker is paid the same wage, themarginal cost of producing a good will increase as more and more is produced in the short run.

Producers will be willing and able to sell a unit of a good in the market any time the extra revenue theyreceive from doing so (marginal revenue, often the price of the good) is enough to cover the marginalcost of producing the good. Because of the law of diminishing marginal product, marginal costsincrease as output increases. For this reason, producers will increase their output only when they areoffered a higher price, which will cover their higher marginal costs. Thus, we expect a positiverelationship between price and quantity supplied (upward sloping supply curve).


Figure 5

The supply curve in the graph above indicates that at price P1, quantity supplied is Q1. At price P3,quantity supplied is Q4 and at price P2, quantity demanded is Q5. Important: Remember that thisassumes that nothing else except price is changing. A change in any of the non price determinants ofsupply will change supply (shift the supply curve) and a new price-quantity relationship will beestablished. Other things equal, an increase in supply will drive the equilibrium price down and adecrease in supply will drive the equilibrium price up.

EQUILIBRIUM PRICE AND QUANTITY

Notice that in our previous example, at price P1, producers of X are willing and able to sell exactly thequantity of X that consumers of X are willing and able to buy at that price. The quantity supplied at P1equals the quantity demanded at P1. We call P1 the market-clearing price. At this price everyone whois willing and able to sell X sells all they want and everyone willing and able to buy X buys all theywant (at the market price). The market clearing price is also referred to as the equilibrium price becausethere is a tendency for the market price to move toward the equilibrium price whenever the market priceis different than the equilibrium price. Once the market price equals the equilibrium price, it tends tostay there until one of the non price determinants of demand or supply change. Consider the followingcases.

(See Figure 5) At price P2 we find a surplus (excess supply) of X in the market because, at this price,quantity supplied is greater than quantity demanded. At P2, sellers are willing and able to sell more ofX than buyers are willing and able to buy. As the surplus becomes evident to producers, they will beginto offer X for sale at a lower price and, at the same time, bring less to market (reduction in quantitysupplied). As the price drops, consumers who were not willing and able to pay price P2 begin to buy Xas the price drops (increase in quantity demanded). This adjustment will continue as long as there is asurplus of X in the market. The adjustment will stop when the market price has dropped to P1, theequilibrium price.


Figure 6

(See Figure 6) At price P2 we find a shortage (excess demand) of Y in the market because, at this price,quantity supplied is less than quantity demanded. At P2, sellers are willing and able to sell less of Ythan buyers are willing and able to buy. As the shortage becomes evident to producers, they will beginto ask a higher price for Y and, at the same time, bring more to market (increase in quantity supplied). As the price increases, consumers who were willing and able to pay price P3, but not a higher price, stopbuying Y as the price increases (decrease in quantity demanded). This adjustment will continue as longas there is a shortage of Y in the market. The adjustment will stop when the market price has increasedto P1, the equilibrium price.

IMPORTANT P1 will only be the equilibrium price for the case shown in the graph. If one of the nonprice determinants of supply or demand change (shifting the supply or demand curve) there will be anew equilibrium price. For example, if demand increases (demand curve shifts right) because of achange in tastes and preferences, the equilibrium price will increase. As the price of X adjusts upwardtoward the new equilibrium, producers increase their quantity supplied. The price increase sent a signalto producers that consumers wanted more Y.

PUTTING THINGS TOGETHER

Refer again to Figure 4 above. The prices shown in this graph (P1, P2, P3) were generated in marketsby the interactions of households (consumers) and producers. As prices change, consumers andproducers both transmit and receive important signals. Increasing prices tell producers to produce moreand consumers to consume less. Decreasing prices tell them the opposite. Besides clearing markets,changes in relative prices (Py/Px or Px/Py) signal the need to reallocate resources. For example,suppose consumer tastes and preferences changed such that the demand for X increased (price increases)and the demand for Y decreases (price decreases). The changing relative prices would tell producers toreallocate resources from Y production and toward X production.


Production Possibilities Curve Review (two pages)

Refer to the graph below and answer all of the questions that follow.

1. What two factors determine the position of asociety’s production possibilities curve?

2. Graphically, where is the societiesproduction/consumption opportunities set?

3. Define opportunity cost.

4. By looking at the production possibilitiesfrontier on the graph you can tell that thiseconomy experiences _______________opportunity costs. What does this mean?

5. If the PPF were straight instead of concave to the origin of the graph, we would say that this economyexperiences ___________________ marginal opportunity costs. What does this mean?

6. Which of the labeled points on the graph are included in the feasible production/consumptionopportunity set?

7. Which of the labeled points are not included in the feasible production/consumption opportunity set?

8. What is true at points A, B, C, D, and E that is not true at point H?

9. Point G represents a combination of beans and franks that has both more beans and more franks than arerepresented by point C. Suppose that, even though this is true society chooses to produce and consumethe combination represented by point C. If “more is better,” why would a society choose to do this?


10. Given the assumptions we talked about briefly in class, would a society ever voluntarily choose toproduce at point H? Why or why not?

11. If the slope of the PPF is -½ at point B, what is the marginal opportunity cost of franks at this point?

What is the marginal opportunity cost of beans at this point?

12. If the slope of the PPF is -2 at point D, what is the marginal opportunity cost of franks at this point?

What is the marginal opportunity cost of beans at this point?

13. Suppose that a NMSU researcher develops, and makes public, a new method to raise cattle and hogswhich allows them to gain weight with less feed. Describe what will happen to the PPF in this case.

14. Suppose that an NMSU researcher develops, and makes public, a new method for controlling theweather. Describe what will happen to the PPF in this case.

15. Suppose that this is the United States’ PPF and a large earthquake causes California to fall into theocean. Describe what will happen to the PPF in this case.

16. Describe society’s resource allocation decision at point A.

Describe society’s resource allocation decision at point E.

Is it likely that a society would voluntarily choose to produce and consume at either of these points?

Why or why not?

17. We discussed the “economic problem” in class. What is it and how does it relate to the PPF model?


Market Review Worksheet (two pages)

The graph below represents a simple graphical model of the market for shoe polish. The ticks on the verticalaxis are in intervals of one, the ticks on the horizontal axis are in intervals of 10. Add the proper labels for theX and Y axes (not the numbers on the ticks), the downward sloping curve, and the upward sloping curve.

What is the equilibrium price and quantity of shoe polish?

Why is it called an equilibrium and what condition is met at the equilibrium price that is not met at any otherprice?

What condition exists in the shoe polish market when the price is above equilibrium? Then what happens?


What condition exists in the shoe polish market when the price is below equilibrium? Then what happens?

What is the difference between a change in demand and a change in quantity demanded?

What is the difference between a change in supply and a change in quantity supplied?

How would each of the following affect demand or supply and the equilibrium price and quantity? In eachcase, identify which determinant of demand or supply has changed.

The price of leather shoes decreases (what kind of good is this?)

The price of canvas shoes decreases (what kind of good is this?)

Consumer incomes increase and shoe polish is a normal good (incomes decrease?)

Consumer incomes increase and shoe polish is an inferior good (incomes decrease?)

A famous and popular movie star says that men (or women) with shiny shoes drives him or her wild

Scientists at NMSU discover that shiny shoes cause skin cancer

The wage for factory workers increases (decreases?)

The price of tin decreases (increases?)

There is massive unemployment and many unemployed workers start shoe shine stands to make endsmeet.

A machine is invented that blends wax with dye faster and uses less energy to operate than the oldermachines

The price of moustache wax increases substantially


Circular Flow and the Role of Markets, Review Worksheet (two pages)

I Each number on the graph above indicates a sector, market, real flow, or monetary flow. If any two ofthem have been identified, you should be able to identify the other 10. I have identified two of theelements of the model below. Identify the others and note whether it is a sector, a market, a real flow, ora monetary flow.

1. ____________________ ______________________

2. ____________________ ______________________

3. ____________________ ______________________

4. ____________________ ______________________

5. ____________________ ______________________

6. ____________________ ______________________

7. _Households__________ ____Sector_____________

8. ____________________ ______________________

9. ____________________ ______________________

10. __Goods and Services__ _Real Flow_____________

11. ____________________ ______________________

12. ____________________ ______________________


The circular flow model on the other side of this sheet is the simplest representation of a market system. Itignores many important things like government, financial markets, flows of intermediate goods between firms,household production, and international markets. Still, it is useful as a starting point to talk about the role andfunctions of markets. The graph below has the government added. Think about it and try to identify theadditional flows.

A. ____________________

B. ____________________

C. ____________________

D. ____________________

E. ____________________

F. ____________________

G. ____________________

H. ____________________

III What is the role of markets in a market economy?

principles review

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