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ECONOMICS
IN TERMS OF
THE GOOD, THE BAD
AND THE ECONOMIST

Matt McGee

3rd Edition
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Copyright ©2012 Matthew McGee
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First published in 2012 by IBID Press, Australia.

Library Catalogue:

1. Economics

2. International Baccalaureate

3. Matthew McGee

ISBN: 978-1-921917-02-8

All rights reserved except under the conditions described in the Copyright Act 1968 of Australia and subsequent
amendments. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any
form or by any means, without the prior permission of the publishers.

While every care has been taken to trace and acknowledge copyright, the publishers tender their apologies for
any accidental infringement where copyright has proved untraceable. They would be pleased to come to a suitable
arrangement with the rightful owner in each case.

Cover design by Crystallisation.

Published by IBID Press, PO Box 9, Camberwell, Australia.

Printed by Trojan Press

Associated website: http://www.goodbadecon.com/

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DEDICATION
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whiteboard pens! Buncey, you are a pillar of down-to-earth
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common sense and cheer – and somebody I’ve always wanted

Writing this book was an exercise in enduring opportunity to ask about the ‘Mile High Club’! Pat, we’ll crash your pub
costs – many of which were inflicted upon third parties in much more frequently now – get bigger bouncers.
the various countries where I visited friends only to abandon
them for my keyboard. I will spend years trying to thank the To Ilung and Suwarni; thank you so much for taking care of me!
following people:
To my wonderful students: I dare say we have broken most of
At first, second and third place, Little Bell; the Very Small the rules at least once – but since you are grade A human beings
Australian Female who forced me to get my act together all we did was have a laugh and get on with our work. I wrote
by making me food and to-do lists. Little Koala, I will never this book with you in mind, knowing full well that few teachers
comprehend how someone who is destined to forever view the in the world are lucky enough to have young people of your
world from 152.6 centimetres can be such a towering figure. calibre in their classes. The smuggled-in beer for my birthday
You stood your post and guarded the gates from demons on present was one of the highlights of my teaching life and that
the outside and fought off those within – and made sure there picture will be on the first page of the next edition! Under ‘The
were Snicker bars and cigars on my desk. You gave me time, Good’.
space and a continuum – and did the pyjama dance at the same
time. You cut a swathe through the thousands of little-things- Till alla därhemma i Sverige! Ja, jag kom hem till slut…och
to-do-popping-out-of-endless-boxes and let me have my cigar tillbringade alltför mycket smygtid med att försöka bli klar med
and computer time – as long as I finished my dinner. Nobody boken. Ni var så förstående och sade aldrig något. Vi hann ju
can ever love you like I do – or buy you as many watches. ändå äta kräftor, fiska gös och meta bäcköring! Stort tack Guy/
Ingela, Musen/Pernilla/Hermann och Lotta/Åke. Glenn och
To my editor; Rory, who is at the opposite end of the height Cissi; sätt på mobiltelefonen.
spectrum. With infinite kindness, patience and common sense,
you helped pull me out of a hole and never said anything To the incredible people at OSC: Kim flitted by, Keith acted
unsupportive or badgering. I still don’t understand how dad, Jo sweated efficiency, Clara forgot her bug jacket, Kostia
someone can know everything but it seems that you do. You was…Russian, Jacek spent money on pens – and I miss Gene,
also seem to find time to show me Australia in between bouts Jo, George and the Oxford crowd.
with computers and graphs. I owe you a great deal! Beer… I
owe you a few beers! Thank you Christian for my wonderful room, students, gym,
food during long evenings at school and very entertaining
To the incredible colleagues; Tom, I love you like a brother – laconic humour – and for not firing me. Thank you Julie for
even though my chances of getting fired increase by a factor of making sure I survived in the jungle – and for not telling
five every time we meet for coffee. Jon, you too are a brother – Christian to fire me.
and you are such that you make Tom look good! Ryan, another
brother, words cannot convey what I need to say, so I won’t – And, of course, to the Indonesian postal workers and customs
but you make Jon and Tom look good! I thank all three of you officers: May you CENSORED CENSORED CENSORED
CENSORED for coming by my room every so often to have CENSORED CENSORED CENSORED CENSORED
fun at my expense when I am under threat of getting fired for CENSORED CENSORED CENSORED (by kind colleagues
‘inappropriateness’ – or to get help stapling your ripped shirts wanting me to stay out of prison so they don’t have to cover my
together and to provide you with band aids (which you call classes).
‘plasters’ for some reason) after your wrestling matches between
classes. Katie, you are an eye in the maelstrom and we all pivot Matt McGee
around you – especially when you serenely make Bloody Marys
by the home pool! Adam, a real mate, you made sure things Åkers Styckebruk, Sweden, 19th of July 2012
worked and more importantly that we worked – and you skated
the fine line of diplomacy in the fracases! IB-Ian, you have been
a good mate, a teacher colleague…a rock – a BIG rock! Brett,
you cannot imagine what a sanctum sanctorum your humour
and civility has provided – and yes, I will continue to steal your
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Dear Colleague,
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Dear Student, Virtually every economics colleague I meet is either better

educated, more experienced, or a better teacher than I. I have
It won’t take you many pages of reading this book to realise that realised this for some time and therefore know that they could
I am a very happy man. I get to do what I love, and I love what have written a book as good – or better – than this one. To date
I do, which is warp young innocent minds with economics. there are some five textbooks written specifically for the IB and
There is nothing I want to do more than teach economics and you are thus not holding what is a book on economics – nor is
hopefully this comes out in the very personal style of writing I it the book on economics. It is my book on economics, which
use. means – for better or worse – that the examples and stories
are all done from a personal vantage point, and laced with my
This book has been written for you, not your teacher. The own rather pithy sense of humour. The personal outlook is
theory content is mainstream economics and in accordance intentional, as I wish to show our students that life indeed is
with the IB syllabus, but the style of writing is uniquely mine, applied economics. The stories, jokes and shoot-from-the-hip
and will naturally differ from other teachers in general and your comments are unfortunately inevitable – I simply don’t find
teacher in particular. It is most important that you realise this, anything worth taking that seriously. Especially myself.
and that this book – like so many others – doesn’t contain the
‘truth’ in any way, but merely one of many possible versions of I sincerely hope you are not put off by the personal style of
what we call reality. You and your teachers will both agree and writing and come to realise that while there is lots of nonsense
disagree with some of the content here, and that is exactly as it interspaced in the text, there is also a good deal of rather
should be! From disagreement comes discussion and debate. sensible and accessible economics. I have found that if one is
From debate comes argumentation. And from argumentation able to hook new and sometimes intimidating concepts onto
comes learning – to both sides hopefully. scenarios or events which people are familiar with, or can see
humour in, learning becomes easier. Economics is not boring
Life is fun and so is economics. In fact, I cannot separate the or other-worldly, so why should economics texts be that way?
two any longer – much to the irritation of anyone who tries to It is always easier to pull a piece of string across a table than
hold a serious conversation with me. I urge you not to regard push it.
economics as a subject confined to classrooms and complex
diagrams, but as an outlook on life and things happening Winston Churchill once said; “Criticism may not be agreeable,
around you. That is why I have put so many personal little but it is necessary. It fulfils the same function as pain in the
stories in here; to convince you that economics is just a way of human body. It calls attention to an unhealthy state of things”.
putting words to events and concepts thereby providing a little I, my editor and proof-reader at IBID have spent countless
order and structure. hours seeking out errors, omissions and mistakes, yet I alone
am ultimately responsible. There will naturally be mistakes
Two small pieces of avuncular advice: 1) Read! Read your in the text – either due to oversight or plain ignorance on my
textbook – whatever it is – and then read it again. Read part. You and your students would be of invaluable assistance
newspapers and economic literature on the side. Read blogs to me if you bring to my attention any and all errors in the
and net reports. Read studies and essays by others. When you text – and/or comment on the book in general. Write to me
read economics (or about economics!) you add to your active at matt@goodbadecon.com and the errors will be immediately
vocabulary in the language of our Dismal Science. 2) Look published and commented on in the “Errata” section of the
things up! Never take ‘truths’ at face value but LOOK THEM economics homepage; www.goodbadecon.com. I will answer
UP. You will be truly amazed at what you find out – as will your all serious correspondence.
teacher. If he/she is a good teacher then they too will look up
what you have found. This is called education. Yours,

Matt (matt@goodbadecon.com)

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USING THIS BOOK Throughout the book
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The structure of the book Numerous ‘Pop quizzes’ have been included in every section
and sub-section. These are of ‘Test your understanding of the
This book follows the IB syllabus to the letter – in fact, the issues above’ type, and to cut down on the size of the book, all
headings used herein are almost identical to the IB syllabus. I the answers will be housed and periodically updated at www.
have taken pains to divide the syllabus into ‘bite sized’ chapters, goodbadecon.com.
96 in all. Chapters 1 to 3 are introductory chapters with a few
words on basic terms and chapters 4 to 96 follow the syllabus Outside the box is where I have put non-syllabus concepts,
outline. It is definitely not necessary to follow the syllabus order theories and models. A little depth means that a certain syllabus
(in fact, many teachers don’t), yet I would recommend doing concept/theory is examined further and/or applied in greater
Section 1 initially, since the concepts therein are the basis for depth. Case studies bring up current and historical events
much of economic theory. pertaining to economics. Applied economics looks at specific
scenarios from an economic vantage point. All of these are
Section 1 (chapters 4 to 35) deals with the economic basics such really just ‘flesh on the bones’ of the core IB syllabus content,
as opportunity costs and the basic economic problems arising and are included merely to tweak interest and further illustrate
in societies. While this section might be considered a bit long, the linkage between our complex world and economic thought.
the intention is to give new students a breadth of examples Story time is mostly nonsense that I simply couldn’t resist
and illustrations to make the initial meeting with economics including. All of the content under the captions above is clearly
as easy as possible. I have taken care to extensively exemplify delineated from the core body of text.
and illustrate the use of perhaps the most important economic
model; supply and demand. Having a solid understanding At the end of all four syllabus sections – and many sub-sections
of how to use and apply the basic supply and demand model – I have included a number of short answer and extended
makes it easier to learn higher order concepts in later chapters. response questions. While short answer questions are not really
intended for SL, I have deliberately included short answer
Section 2 (chapters 36 to 62) deals with macroeconomics, and questions that are applicable to SL content. Data response
at this stage I have assumed students to be comfortable with questions have been left out completely, as I felt it better to cover
basic economic concepts, so I have somewhat limited the extent a wide range of issues in as little space as possible – this is easier
of explanatory text and increased the use of case studies and to do using short answer and extended response questions.
applied economics. Most schools have a battery of data response questions to use in
practice tests and I will continuously upload a variety of these
Section 3 (chapters 63 to 77) focuses on trade issues, and is on the Goodbadecon website. Paper 3 questions for higher
strongly linked to both micro/macro issues and development. level are found at the end of each relevant chapter and further
I have put great effort into finding examples and statistics of practice questions will be on our website.
recent date, and to use as many contextual examples as could
be fit in. Also on the website, there will be a section on examination
criteria, command terms used in exams and exam, extended
Section 4 (chapters 78 to 96) is development economics and essay and internal assessment guidelines and advice, together
builds heavily on concepts introduced in all other syllabus with some samples. And, in spite of my long-standing dislike of
sections. The ‘spread’ of development issues throughout the educational practices such as ‘keep it simple silly’ and ‘find the
syllabus is intentional, as IB economics puts major focus on basics really easily’, I have finally been badgered into including
development issues and emphasizes this by relating development a glossary. Such are the forces of demand.
to a number of issues throughout the syllabus.

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Contents
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1. Introduction to Economics 1

2. Introduction to Basic Economic Terms 5

3. Introduction to Basic Data Skills 15

4. Markets and Demand 21

5. Markets and supply 36

6. Market equilibrium 48

7. The Price Mechanism and Resource Allocation 65

8. Market Efficiency 69

9. Price Elasticity of Demand 75

10. Cross Price Elasticity of Demand 90

11. Income Elasticity of Demand 96

12. Price Elasticity of Supply 99

13. Government 107

14. Subsidies 118

15. Price Controls 125

16. Market Failure 137

17. Negative Externalities 141

18. Positive Externalities and Merit Goods 152

19. Lack of Public Goods 158

20. Common Access Resources and Sustainability 161

21. Asymmetric Information and Imperfect Competition 168

22. Production and Costs 171

23. Short Run Costs 178

24. Long Run Costs 185

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25. Theory of the Firm – Revenues and Profit 190
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26. Goals of Firms 196

27. Perfect Competition 201

28. Monopoly 213

29. Natural Monopoly 218

30. Monopoly vs. Perfect Competition 222

31. Monopoloistic Competition 229

32. Monopolistic Competition vs. Perfect Competition 234

33. Oligopoly 236

34. Collusive and Non-Collusive Oligopoly 239

35. Price Discrimination 245

36. Introduction to Macroeconomics - Economic Activity and the Circular Flow Model 253

37. Measuring Economic Activity – GDP and GNP/GNI 258

38. Calculating GDP and GNP in Nominal and Real Values 269

39. The business cycle 271

40. Aggregate Demand 277

41. Shifts in Aggregate Demand 282

42. Aggregate supply 286

43. Keynesian vs. Monetarist/New Classical View of LRAS 289

44. Shifting LRAS 296

45. Equilibrium in the Keynesian model 298

46. Equilibrium in the Monetarist/New Classical Model 301

47. The Keynesian Multiplier 307

48. Overview of main macro objectives – “Big 5 + 4” 313

49. Economic Growth 315

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50. Low Unemployment 325
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51. Types and Causes of Unemployment 331

52. Low and Stable Inflation 341

53. Causes and Consequences of Inflation and Deflation 352

54. Short and Long Run Phillips Curve 362

55. Equity in Distribution of Income 371

56. The Government Budget 385

57. The Role of Fiscal Policy 388

58. The Central Bank and Monetary Policy 401

59. The Role of Monetary Policy 406

60. The Role of Supply-Side Policies 415

61. Interventionist Supply-side Policies 417

62. Market-based Supply-side Policies 421

63. Free Trade 427

64. HL extension – Absolute and Comparative Advantage 434

65. Restrictions on Free Trade 443

66. Calculations of Effects of Tariffs, Quotas and Subsidies 466

67. Floating Exchange Rates 471

68. Exchange Rate Calculations 483

69. Government Intervention – Fixed and Managed Exchange Rates 486

70. The Structure of the Balance of Payments 497

71. Current Account and the Exchange Rate 506

72. HL extension – Implications of a Current Account Deficit/Surplus 509

73. Marshall-Lerner Condition and J-curve 519

74. Forms of Economic Integration 523

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75. Trade Creation, Trade Diversion and Economies of Scale 535
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76. Terms of Trade 539

77. Consequences of a Change in the Terms of Trade 543

78. Economic Growth and Economic Development 549

79. Characteristics of Less Developed Countries (LDCs) 558

80. The Millennium Development Goals 571

81. Measuring Development – Single Indicators 573

82. Measuring Development – Composite Indicators 580

83. Domestic Factors and Economic Development 585

84. International Trade and Economic Development – Problems in LDCs 591

85. Trade Strategies I – Import Substitution and Export Promotion 599

86. Trade Strategies II – Trade Liberalisation and the WTO 605

87. Trade strategies III – regional trade agreements (RTAs) 611

88. Trade strategies IV – Diversification of Exports 613

89. Foreign Direct Investment (FDI) and Multinational Corporations 615

90. Advantages and Disadvantages of FDI 618

91. Classification of Foreign Aid 627

92. Evaluation of foreign aid 632

93: Multilateral Development Assistance – IMF and the World Bank 638

94. The Role and Consequences of Foreign Debt 643

95. Market Orientated Policies 649

96. Governments and Intervention 653

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0
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Introduction to
Economics

Key concepts: 1. Economics is very cool! Yes, I know; it has a mathematical

foundation…and no; very few economists have ever
• What is economics? been arrested for tossing a TV out of hotel room after
• The good… an AC-DC concert. What I mean by “cool” is that our
• …the bad… field of study extends to virtually every aspect of society
• …and the economist and helps to explain (going from the mainstream to the

Y
ridiculous) why taxes on imports (known as tariffs) do
ou know that text at the beginning of books that we all not protect domestic jobs in the long run and whether
skip? Well, this is it. So, as a Read This! incentive, there Bon Scott is a more efficient singer than Brian Johnson.2
is a secret code baked into the first three chapters with
which you can login to the IBID site and win US$2,000.1 2. Economics is about real life and real events! It is not some
abstraction (= general concept) from the fuzzier parts
One of my many cheeky students was once introducing a new of TOK – it is largely uninteresting if the tree makes a
student around and had apparently warned the young lady sound falling in the forest when nobody is there to hear
about me. When they got to my class and had viewed the show it. We would instead look at how much value-added
for a few minutes, my student leaned over to the somewhat would be the case in making chop sticks out of the tree
shocked young lady to calm her; “Don’t worry. You get used or whether the resulting soil erosion would outweigh the
to him. It’s an acquired taste – it takes about three years.” To benefits to society of 100,000 bento box complements.
which the young lady replied “But we’re only in his class for
two years!?” Evil smile from my student, “Yupp! Welcome to 3. Putting 1. and 2. together I argue that a good grip on
economics.” economic terms and concepts has numerous personal
and societal benefits. Without stooping to Gekko’s ‘Greed
I’m a teacher. I teach. I love my students, my subject and my job is good’ credo (= statement of belief) the former might
– and all this will come across in this rather personal book for deal with realising that shares in the world leading Danish
IB students. In using this book you basically become one of my windmill producer Vesta will rise due to higher oil prices
students and thus get to read what all my new students in IB1 and the warm fuzzy feelings that come with being an
hear during the first class:
2 Singers in AC-DC. You think I’m making this up? Check out
“Who is the most efficient singer in AC/DC, Bon Scott or Brian
Johnson?”, University of Calgary archives at http://mpra.ub.uni-
1 You do realise I’m lying. Right? muenchen.de/3196/
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owner of shares in renewable energy companies. As for we went to Hacienda de los Morales in downtown Mexico City.
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societal issues, economics provided decision makers in Sitting around the table after dinner with a good cigar and
the UK government with sound arguments for spending Cognac, it struck me that this group of young people were one
around £1.2 billion in taxpayers’ money subsidising 100 of Mexico’s strong hopes for a better future. These “Zero-Point-
Vesta windmills, which were put in place in 2010 by the Two Percenters”, as I call them,5 would basically become the
Swedish firm Vattenfall in the largest offshore wind farm movers and shakers of tomorrow’s Mexico. I remembered how
off the coast of Kent in the UK.3 I introduced the topic to them some 1½ years earlier:

4. Finally, economics is not a “dismal science”4 but in fact a “Listen up people! Here’s the deal. First off, economics is the
most optimistic and heartening field of study. The basic study of us; as economists we are basically studying what we are,
facts are that in many respects humankind is increasingly how we have created societies and what drives us. In studying
better off; we live longer and healthier lives and have this we are gathering information in order to outline possible
immensely increased the opportunities, choices and solutions to very real problems and my key point here is that
abilities to lead better lives – noting of course that there economics is not an abstract study (= purely theoretical or
are some notable and distressing exceptions and that the hypothetical) of “numbers and money” but an applied science.
future is by no means certain. We look at reality with the intention of using information
gathered in order to construct models and theories useful in real
The Good… life, for example issues such as how to increase the production
of food and goods without causing irreparable damage to
the environment. Secondly, as I have said, economics is not a
“dismal science”6 but in fact rather an optimistic science. The
basic facts are that, despite the exceptions, life has got better for
most people as time has passed. My editor tell me that, when his
parents married, average life expectancy was 31 years. It is now
67 years. It is the exceptions to this progress that you must deal
with and thank god for a good education!”

…the Bad…
IB2 dinner at Hacienda Morales “Split the check
amongst yourselves while I finish my cigar, ladies
and gentlemen!”

The picture above is the one I use as my desktop on my

computer – mostly to remind myself how incredibly fortunate
I am. My IB2s and I decided that we needed a good meal so

3 This is the Thanet Offshore Windfarm which came into

operation in 2010. See http://www.energyboom.com/wind/
thanet-wind-farm-now-online-uk-once-again-world-leaders-
offshore-wind-energy, http://www.vattenfall.co.uk/en/thanet-
offshore-wind-farm.htm and http://www.telegraph.co.uk/
comment/columnists/christopherbooker/8025148/The-
Thanet-wind-farm-will-milk-us-of-billions.html “Left hand down a bit, there’s a break in the fumes
4 The term “dismal science” was apparently coined by Thomas ahead.”
Carlyle in the 19th century as an argument against economist’s
opposition to slavery! However, the term is often attributed to
Thomas Malthus of “The end is nigh” fame due to his prediction
in the late 19th century that the economics of population and 5 As they are undoubtedly part of the 0.2% wealthiest group of
food guaranteed that population would ultimately exceed humans ever to walk the face of the earth.
potential food production. No, it hasn’t happened – we produce 6 A quote commonly attributed to 19th century author Thomas
more food per capita today than ever before in the history of Carlyle who was referring to the economists Thomas Malthus
mankind. and David Ricardo.
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Anybody who’s read a newspaper has been bombarded by A standard textbook definition would be along the lines of
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the gloom and doom scenarios which seem to sell a lot of “Economics is about utilising and allocating scarce economic
papers. Decreasing natural resources together with increasing resources to achieve optimum output and/or utility”, and most
population gives us the core question of how the on-going of my colleagues would agree that three key concepts are at the
depletion of natural resources and rising populations can be heart of economics, namely scarcity, resource allocation and
met by increased efficiency in the production of food and the incentives.10
development of alternative energy sources. The future scenarios
are most uncertain but, as one single example, economists take The first two concepts deal with how societies use scarce
into consideration the prospect of a production peak for oil (it resources to produce the endless needs and wants in society.
already has according to the Energy Watch Group!7) and that The third issue is that of how people, firms and institutions will
decreasing oil production together with the depletion of natural act in accordance with these needs and wants; the willingness
resources might result in falling food and industrial production. and ability of households to save, work and start businesses;
Other notable issues facing our world are land/soil/air/water the willingness of firms to invest, produce and innovate; and
pollution, global warming, desertification, HIV/AIDS, poverty the willingness and ability of institutions to regulate such
levels, unemployment and so forth. transactions and provide safety nets. In keeping with my hard-
earned gunnery sergeant image, I simply say that economics is
…and the Economist about incentives – everything else is a footnote.11 I also make
sure that my bright-eyed and bushy-tailed younger students get
to hear me – at least once during the first week – that “…you’re
born, live through an endless series of trade-offs, and then you
die…”.

Basically, economics is the study of:

1. Trade-offs or opportunity costs (money going into arms

means less food)

2. Choices (why guns and not food)

3. Incentives (how do we get people to produce guns rather

“John Maynard Keynes, 1883 – 1946. ‘…a man of than food)
genius…//..who…had a world-wide influence on
the thinking both of specialists and of the general
public…’8” Chapter 2 deals with the basic economic problem which is
squarely centred on the three questions above and Chapter 3
So what do we do in economics? We study these issues from with basic data skills. These chapters are not part of the syllabus
the point of view of how societies’ wants and needs can be but I don’t want any student of mine to be ignorant of the most
met now and in the future. John Maynard Keynes, perhaps basic economic issues and ways of compiling/using data.
the most famous of all modern economists, claimed that
economics was the most difficult of sciences, as one needed to
be a mathematician, philosopher, politician and psychologist.9
7 The Guardian, 22 October 2007, “Steep decline in oil production
brings risk of war and unrest, says new study”
8 From The Times obituary, 22 April 1946 outside his regard.’ (See Essays in Biography. The Collected
9 Keynes’ exact words were: ‘...the master economist must possess Writings of John Maynard Keynes, Vol.X, Royal Economic
a rare combination of gifts... He must be a mathematician, Society. Published by MacMillan Press Ltd 1972.)
historian, statesman [and] philosopher - in some degree. He 10 Allocation is central to economic terminology. It means
must understand symbols and speak in words... He must study roughly, ‘placement’, or ‘the placing of ’.
the present in the light of the past for the purposes of the future. 11 Yes, I stole this from somebody. Economics doesn’t repeat
No part of man’s nature or his institutions must lie entirely itself, economists repeat each other.
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A Short Story of Economic
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Depression...

During the Great Depression in Australia during the 1930s

unemployment rate was high and many people were desperate
to get work. It was common for men to walk the roads in search
of work, often it was simply for their ‘keep’ which means food
and a bed. Their bedroll was referred to as a ‘matilda’ or ‘swag’
as in the song ‘Waltzing Matilda’.

The Photo shows a young man, Murray Greig, who decided

to ride his bike and he also constructed a trailer to carry his
belongings in search of work. He left his home in Melrose in
1935 at the age of 22 and headed east to Victoria and then
north through New South Wales and then Queensland. Motor
vehicles were not common and the roads were not well made
and subject to flooding and other damage. He often had to
carry his bike and belongings on his shoulders.

His work included tending stock, clearing land, breaking horses

and tractor driving. He was also quite successful in amateur bike
racing which supplemented his meagre income. He eventually
arrived in Queensland in 1939 where he spent about a year
cutting sugar cane before returning home. He then enlisted in
the War, serving overseas and then marrying, raising a family of
5 and being a successful farmer.

... and hope!

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2. Introduction to Basic Economic Terms
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Key concepts:
• Factors of production
• Scarcity
• Basic economic problem
• Opportunity cost
• Production possibility frontier (PPF)
• Positive and normative statements
• Utility and marginal utility
• Micro and macro

‘Sifnos’

Factors of production mean the whiteboard pen I use to fill the board when I am using

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it to produce education. Capital, as a term, is specific in that
e use the term ‘resources’ a great deal in the item must be used in the production of goods and not in
economics, and traditionally assign all economic simple consumption. One could say that capital is defined more
resources four headings; land, labour, capital and by usage than anything else. A guitar in my hands is simply
entrepreneurial spirit. These four groups constitute the factors a consumer good (and a mistake) while in the hands of Lady
of production used, to one extent or another, in the production Gaga it is a capital offence…sorry, that’s ‘capital’.
of all goods.
The entrepreneur is the person who brings the other three
Land is used in a wider sense, and covers not only the use of together and creates goods to fulfil wants and needs in society.
land for farming and space for factories, but to a wide variety of From Edison’s light bulb to Picasso’s painting Guernica all
natural resources such as oil, water, timber and ore. One often production necessitates the idea, drive, and ambition of an
uses the term raw material for these natural resources. Land entrepreneur to put land, labour and capital together and create
is also agricultural goods such as rapeseed and fish from the something. As a personal addendum, I would add education,
sea. All of the aforementioned resources are often referred to as training and experience to the four production factors above –
primary goods, (or primary commodities) and I often tell my this is commonly referred to as ‘human capital’. Human capital
students is that “If you can dig it up, chop it down or pluck it, is frequently considered of increasing importance in modern
it’s a primary good”. production.

Labour is pretty much self-explanatory but it is worthwhile to Definition: ‘Resources/factors of production’

note that it is often the element of labour that adds value to
The factors of production are commonly divided
all basic natural resources and transforms basic (simple) goods into land, labour, capital and entrepreneurial
such as silicon and oil into higher value goods such as silicon drive. These are the resources necessary to create/
chips and the plastic casing used in the computer I am using to supply goods and services in an economy.
write this.
or resources – just try to build a boat on a deserted island with
Capital is any man-made factor of production, such as a factory a stack of Yen!) ‘Capital’ is one of many terms with subject-
or machine.1 Yet the term is more far-reaching, as it can also specific meaning which also has other, wider, meanings outside
of economics. In its purest usage in economics capital is a man-
1 Be very careful in using the term ‘capital’ in economics! Very made factor of production, yet in a wider more general way
often the term is confused with ‘money’ – which is NOT a we use it to stand for financial or physical assets which can
factor of production. (Money is just a representation of goods generate income, such as property or shares in a company.
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In outlining the factors of production (land, labour, capital The basic economic problem that economics seeks to address
and the entrepreneur) available to the economic system, we has permeated all societies throughout history:
inevitably come upon the issue of scarcity which has a rather
specific meaning in economics as it goes to the very heart • What to produce?
of what economics is all about, namely the optimal use of • How to produce it?
resources. Scarcity means that all societies face the common • For whom to produce it?
problem of limited resources and how to best allocate these The first issue, ‘what’, deals with the allocation of resources to
resources to provide for our endless wants. make the goods that society wants. The issue can be as trivial
as ‘red shoes or blue shoes’ or as broad as the classic ‘Guns or
Scarcity is a universal problem, but does NOT necessarily mean butter’ question we shall look at in just a moment. The issue
that all peoples in all economies lack the same things! A most of ‘how’ deals with production methodology, organisation
valuable resource is water, which the Swedes have in abundance and technology. The final issue, ‘who’, is the wider issue of
in Sweden but has to be shipped in by tanker every day to the distribution, i.e. to whom the spoils of production go. All
Greek island of Hydra where I lived as a child. On the other societies have to deal with these issues, from the Aztec society
hand, on Hydra there is no lack of master stone-masons and which created the lookout tower up the hill here on Expat Street
marble, enabling marble sinks, counter-tops, tiles – we actually in Mexico City, to the centrally planned economy of Cuba
had a toilet seat made out of marble!2 When I think of it now, which made the excellent cigars I – but not the diners at the
the amount of marble we had there could have funded my table next to me – enjoy.
university studies.

This is my point; scarcity is an issue for all nations and has Definition: ‘The basic economic problem’
been for all time. It’s simply a matter of what is scarce and The enduring central issue of economics; how all
the reasons for this relative scarcity. Scarcity is defined by human societies, throughout time, are forced to
availability of resources, true, but also by our wants and desires, deal with the questions of what to produce, how
which are infinite. No matter what need is fulfilled, there is to produce it and for whom to produce.
always another lurking in the background and this is true in
all people. Naturally all these needs cannot be satisfied as there
are limits to society’s ability to satisfy them, the reason being Opportunity cost
that while our needs are seemingly endless the resources (land,
labour, capital…) used in satisfying them are quite definitely Resources are scarce and societies’ wants are endless; this
finite, or limited. Scarcity is what one might call a triumph of means making a choice which in turn means giving something
harsh reality of the inborn wants of man; all societies during up. An opportunity cost arises as soon as one alternative
all ages will have wrestled with the abundance of human wants, means giving up the next best available alternative. For example
the inability of the economic system to supply all wants, and the if my preference ranking (in descending order) in spending
resulting choices resulting from scarcity of available resources. $US10,000 is 1) a Blancpain watch; 2) 4 weeks vacation in
Cancun; 3) a new car, then in choosing the Blancpain my
Definition: ‘Scarcity’ opportunity cost is 4 weeks vacation – not the new car, because
my opportunity cost is the highest ranking – e.g. second best –
The excess of wants resulting from having limited
alternative I give up.
resources (land, labour, capital, and entrepreneurs)
– scarcity arises in satisfying the endless wants
of people using limited resources. Scarcity is a
universal problem for all economies – it is not
limited to “poor” countries.

2 Eh, a bit nippy during the winter.

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government) might face the decision of allocating funds
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Definition: ‘Opportunity cost’

towards new computers for the local public school or an all-
Opportunity cost is the option foregone in making expenses-paid fact-finding mission to Monaco for municipal
a choice of “Alternative A” over “Alternative B”.
councilmen and spouses. National government might have a
Assuming that all possible choices have been
choice between 15 new fighter jets and a new cancer research
ranked in order of preference, the opportunity
cost is the relinquishing of the second best centre. To phrase it in economic terminology, there are simply
possible alternative, i.e. the next best foregone too few resources (e.g. land, labour and capital) available to
opportunity of obtaining the highest ranked of all enable all wants to be taken care of. We are thus presented with
possible alternatives. The concept is fundamental interminable trade-offs at personal, municipal and national
in all subsequent economic concepts. level: the Blancpain or vacation; school computers or vaca…
em…fact-finding mission; fighter jets or health care. A trade-
off means mean an opportunity foregone.
The issue of ‘what/how/whom’ is naturally one of choices.
In some way, one has to choose between options. Let us use Production possibility frontier (PPF)
the learning tool of choice for Aristotle; the syllogism. A
syllogism is a set of factual statements ordered in a state of All economies face the same issues outlined in the basic
natural progression which all lead to an (inescapable?) logical economic problem of “what to produce…how…and for whom”,
conclusion. The classical syllogism is one where Aristotle and all economies face infinite wants and limited resources.
referred to his teacher Socrates:
Assume a small island economy, Sifnos, and the following:
1. ‘Man is mortal’

2. ‘Socrates is a man’ 1. the economy only has the resources to produce two
goods, pottery and tourist services
3. ‘Socrates will die’

The economic syllogism is somewhat less dramatic: 2. there is a known maximum output and the economy
can attain this level – i.e. the economy can fully utilise
1. People’s (or society’s) wants are infinite
all resources so there will be no unemployment or idle
2. Resources are finite machines
3. Choices must be made
3. there is no trade with other villages, thus production
We’d best comment on the above, primarily in order to explain equals consumption (much more on this in Section 4)
and perhaps defend the premises therein.3 Most people would
ultimately agree that, no matter what one has attained, one 4. that any given quantity of resources transferred from
always has an additional want. Mick Jagger couldn’t get no one sector to another are unequally productive, (or re-
satisfaction (and knew You Can’t Always Get What You want) – allocatable) – all resources used in the production
and he was a drop-out from the London School of Economics! of pottery are simply not equally productive in the
Fulfilling one’s desire for a new watch doesn’t mean that one production of tourist services.
wouldn’t want a vacation in Cancun and a new car to drive
there in. Even Bill Gates, who has earned millions in interest Figure 2.1 shows a few of the possible combinations of
alone during the time it has taken me to write this section, will output in the Syfnos economy. The PPF is drawn assuming
have unfulfilled wants.4 that all factors of production are fully utilised whereby any
combination of output within the PPF (point E) shows that the
The premise of endless wants and thus hard choices holds as economy is producing at a sub-optimal level, e.g. that there is
true for society as for the individual. A municipality (= local unemployment, idle capital or unused natural resources. Points
3 We will be using the term ‘premise’ rather often. A premise (pl. A to D make up the boundary of possible output (maximum
premises) is a basic assumption – often in a line of reasoning efficiency – see Pareto optimum, Chapter 7), and point F is
or argumentation where the premise must be included at the outside the PPF and thus impossible to attain.
outset in order for subsequent conclusions to hold true. For
example, my premise in writing this is that my students are
adequately versed in English.
4 Detractors may say that ‘world domination’ comes the closest.
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A The PPF goes from A → B → C → D. This is the boundary
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showing the different combinations of goods which Sifnos
B
can produce when producing at maximum efficiency and
5 all factors of production are utilised fully. For example,
PPF point A shows a combination of 600,000 hours of tourist
Tourism (100,000s of hours)

services and zero tonnes of pottery while point C shows

4 C 360,000 hours of tourism and 4,000 tonnes of pottery.

3 Point E is within the boundary of the PPF. At any of the

E endless combinations of output within the PPF, the
economy is not fully utilising factors of production – there
2 will be unemployment and/or idle machines.
F
1 Point F is outside the PPF – this is a combination of output
that is impossible to attain.
D
0
0 1 2 3 4 5
Pottery (1,000s of tonnes)

Figure 2.1 PPF for Sifnos – increasing opportunity costs

Figure 2.2 illustrates the issue of opportunity cost. Output ranges B to C along the PPF. It is immediately obvious that the cost
from 600,000 hours of tourism and zero pottery to 5,000 tonnes ratio has changed – the second 1,000 tonnes of pottery entails
of pottery and zero hours of tourism. Let us say that Sifnos is giving up the production of 40,000 hours of tourism service.
at point A, where the Sifnians are producing 600,000 hours of In other words, the opportunity cost of the second ‘batch’ of
tourism and nothing else. Moving to point B to produce the pottery is 40,000 tourism hours – twice the cost of the first
initial 1,000 tonnes of pottery entails giving up 20,000 hours of ‘batch’. Moving from point C to D we see how the opportunity
tourism service, which is thus the opportunity cost of the first cost of pottery production rises to 140,000÷1.8 ≈ 78,000 hours
tonne of pottery. The striking difference for the Sifnians will of tourism per tonne of pottery.
occur when they increase output of pottery further, from point

Moving from point A to point B increases output of

pottery by 1,000 tonnes but reallocates resources from
tourism – which decreases by 20,000 hours. The
A opportunity cost of the first 1,000 tonnes of pottery is
–20,000 6 B 20,000 hours of tourism.
–40,000 C

5
–140,000
Tourism (100,000s of hours)

Moving from point B to point C increases output of

D pottery by 1,000 tonnes but, having already reallocated
4
the best resources for pottery production, more resources
have to be taken from the tourism sector. The opportunity
3 cost of the second 1,000 tonnes of pottery rises to 40,000
hours of tourism.
PPF
–400,000 2

E
0
0 1 2 3 4 5
Pottery (1,000s of tonnes)
Figure 2.2 PPF for Sifnos – increasing opportunity costs
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Opportunity costs occur in economies because resources are Diagram (I)
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scarce. Increasing opportunity costs in production are due to

Increased use of unused
the fact that all resources are not equally re-allocatable or, to

Tourism
PPF factors moving the economy
use another phrase, factors are not perfectly mobile. When the towards the PPF – the
economy shows economic
Syfnians re-allocate limited (scarce) resources from tourist
growth.
services to pottery the best available resources (factors) in the
production of pottery will be used first. As additional factors are
taken from tourism, the economy is forced to use increasingly B
q1
less productive resources in the making of pottery and thus will
have to take increasing amounts of resources out of tourism A
production. Each additional unit of pottery will result in q0
increased opportunity costs.

In Figure 2.3 (I) at right, the economy shows economic growth Q0 Q1 Pottery
since actual output has expanded from point A to B.5 Our
model economy has just increased the production of both Diagram (II)
capital and consumer goods while the PPF remains in place. An increase in the quality or
This example of growth illustrates that unused resources have quantity of available factors of
been put into use For example, firms start utilising unused production increases potential
output (PPF0 to PPF1), and as these
machines and hire previously unemployed labourers. Note that Tourism
factors are put into use the
we are assuming that the quantity and/or quality of factors of PPF1 economy grows (point A’ to B’).
production remain the same so the PPF has not shifted. Points
B’
A to B could illustrate an economy recovering from recession –
previously unemployed labourers are hired and idle machinery
PPF0
is put to use. q’1
A’
Remember, the PPF is a purely hypothetical construct; we
have already taken into account all possible production q’0
circumstances such as technology, labour skills and quality of
raw materials in drawing the curve. That is why more or better
use of existing available resources illustrates growth in the PPF Q’0 Q’1 Pottery
without an associated shift in the PPF. Figure 0.3I. and Figure
0.3 II illustrate the effects on both potential output (the PPF Figure. 2.3 Economic growth – two possible
shifts outwards) and actual output/growth (point A’ to B’). The illustrations
increase in productive potential and subsequent actual growth
is the result of more and/or improved resources being put to
Changing the quality of the factors of
use. production

An increase in the quality of labour, such as education, training,

and experience, will inevitably result in the ability of labourers
to produce more goods during any given period of time.6 The
quality of land can entail new farming methods, high-yielding crop
types, or purer iron ore for making steel; improved capital, such as
production technology could render more widgets7 per hour and
6 Yet anyone having spent a summer working on an assembly
line, as I have, knows that one uses one’s experience and skill to
5 Note that ‘point to point’ movements in PPF diagrams are have longer breaks – not to produce more! I gleefully note that
grossly exaggerated. In Figure 2.3 I above, it appears as if both the firm in question went bankrupt.
consumer and capital goods have increased by 25%. Again, 7 A ‘widget’ is a fictitious/hypothetical product or ‘thing’.
keep in mind that the diagram is only a description and not a Economists use the term ‘widget’ to make up for a sad lack of
scaled representation of reality. fantasy and imagination in trying to conjure up good real-life
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Definition: ‘Positive’ and ‘normative’

widgets; and innovation in the production of capital goods in turn
means improved machines for consumer goods. Positive statements are based on facts or
evidence, free from value-laden and subjective
standpoints. They can be proved or disproved
Changing the quantity of the factors of using a scientific approach. Normative
production statements are based on norms, thus they are
subjective and biased – they can not be proved or
If there are more factors of production available, then potential disproved. “Man evolved from apes…”, a Darwinist
output has increased. Using available capital in the manufacture proposition, is a positive statement while “Man
of more capital increases potential output; adding more land (as was created by god…” is clearly a normative
the Dutch have done for hundreds of years by way of building statement.
dikes) adds to potential arable land; and an increase in the
labour force (for example a “baby boom” generation exiting
school or increased immigration) all mean that potential The aim of economic theory is to provide a basis for analyses
output has increased – and that actual output increases when which is as unburdened by normative statements as possible.
these resources are employed. Generally speaking, scientific research should be confined to
positive questions – i.e. questions or hypotheses which can be
either verified or falsified by looking at real life observations and
Positive and normative statements data. The stricter we are in our use of definitions, assumptions
and consequent models, the more we can weed out the more
Positive statements have nothing to do ‘positive attitude’ emotional aspects of economic conclusions. Economics as a
or such. A positive statement is one which does not contain science attempts to outline ‘good’ and ‘bad’ without resorting
subjective or opinionated elements but is based on facts that to subjective views. An economist aims to pose questions
can be proved or disproved. Examples of positive statements are that can be stated positively by defining ‘good’ and ‘bad’ in
‘Socrates is a man’ (see my ‘economic syllogism’ in the section on economic terms rather than moral terms and then answering
opportunity costs); ‘He was sentenced to death’; ‘Socrates was a the questions by examining facts and evidence.
convicted paedophile’; or perhaps even ‘Socrates was a woman’.
Note that nothing value-laden is included. It’s just stating facts Utility and marginal utility
– or ridiculous assertions as the last two are intended to show –
that can be tested by looking at data and facts as far as they are Utility refers to the usefulness perceived and satisfaction derived
known. Therefore ‘positive’ in no way means ‘good’, but rather from the consumption/use of a good. The perception of a
that there is no value judgement involved. So if I were to say good’s utility forms our preferences. The term springs from the
‘There are very few repeat-offenders amongst those who have Latin ‘utilitas’, meaning usefulness or applicability. Just think of
been executed’ I am actually using a positive statement. ‘utensils’!9

However, stating that ‘The death penalty is abhorrent (= Definition: ‘Utility’

objectionable) to a modern democratic country’ is a normative
Utility is the benefit/satisfaction/usefulness
statement, just as if one – like those who convicted him – were one gets from the consumption of a good. The
to say ‘Socrates was immoral’. The reason is that one would concept is quite obviously highly normative as
be standing on a platform of evaluation. Often this type peoples’ preferences vary greatly. My perceived
of statement is referred to as being ‘value-laden’, i.e. being usefulness will not be the same as yours.
burdened with moral/ethical values. One is using a certain
standpoint – religious, cultural or philosophical – to express the
value of something that cannot be refuted by logic or objective Utility is one of the classic abstract concepts, right up there with
reasoning. One is using a normative vantage point to express ‘quality’ and ‘happiness’. (In fact, I once bet one of my students
opinion.8 $US100 that he could not define ‘quality’ and he never got

products in textbook examples. 9 This translation was provided years ago by Pia Birgander, my
8 A norm is a rule or guideline arising from within the evolved incredible IB coordinator in Sweden. She knows about 18
standards of a society, e.g. “Socrates should be punished by languages, Latin being but one. Now, having her around is
being forced to drink poison!” utility – talk about useful!
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back to me. He has now graduated from the London School
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of Economics!). It simply defies any form of enumerative

measurement and appraisal, just like ‘love’ – try grading your Story-time! “You did what?!”
love for your boyfriend/girlfriend on a curve! The same goes for This was voiced loudly and almost in concert by a
utility; one simply cannot put the satisfaction one might feel, group of colleagues who had gathered for
say, from the consumption of chocolate into numerical values. evening grape juice (= wine) and
Picture yourself standing in front of long row of shop windows yummies at one of the houses
filled to the brim with goods. You are standing in front of a along Expat Street here in Mexico
certain shop window – and other people are standing in front close to the school we all work in.
of other windows. Why isn’t everybody at the same shop front?! Word had apparently spread that
I’d bought a new watch for some
ungodly sum and Marc – being a
stout Yorkshire lad with no
inhibitions whatsoever – handed
me my wine, glanced at my watch
and said “Ay, looks good! I used to see those all
over the place in the black markets in Vietnam”.
“You most certainly did not”, I growled. “This isn’t
a back-alley copy but the real thing – proudly
manufactured in Geneva by the Little Swiss Watch
Gnomes.”
By this time my friends in the know were all
grinning like possums eating the core out of a
Mexican cactus, waiting for Marc’s look when he
found out how much it cost. I can’t quote him
in print, but basically he said “You’re crazy!” It
took about 3.4 seconds for this to become the
consensus view and if their looks had taken on
physical action I would have left the party in a
straitjacket. Virtually everyone had different views
Simply, utility differs between prospective customers and this on “…the insane waste of money…” and “…what
steers preferences and therefore selective perception. While one could have gotten instead…”. The alternatives
perhaps you are fogging up the window of the Italian shoe shop, ranged from a new car to 4 weeks at a good hotel
your friend might be smearing nose grease on the armoured in Cancun or Acapulco. What they also all agreed
glass in front of the Swiss watch shop.10 on was that I shouldn’t wear it anywhere “risky” –
which in Mexico means “…anywhere outside the
house and/or near the police”.
The point of this story is that the satisfaction I
feel from wearing (e.g. consuming) the watch
is different from what the others would feel. I
derive such pleasure in owning fine mechanical
timepieces that I am prepared to pay a great deal
for them – and thus give up numerous other
goods. In economic language, I am spending
my income in such a way that I get maximum
pleasure from the goods I spend my money on
– I am maximising my utility. Any other option
would have added less to my overall sense of
satisfaction. By allocating my income towards the
consumption of a (-nother) watch, I added to my
10 Take it from an old person: don’t shop in pairs! The opportunity “happiness” the most. This is marginal utility, dealt
cost of looking at things which bore you out of your skull with next.
quickly becomes unbearable when you realise that you are
giving up your own valuable shopping time.
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Utility is at the heart of economic reasoning when it comes to Suddenly, through the shimmering heat waves and consequent
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analysing peoples’ wants and purchasing habits. As we shall mirages, you see a large parasol in the distance. You do a
see, utility explains why we buy a good in the first place – but high-speed shuffle towards it and coming closer discover
the concept does an even better job of explaining why we buy that it is real – you also see the painted sign with the legend
goods in the second place! Say what? ‘Second’ place? Well, stop ‘Mabogunje’s Finest Kind Cold Refreshments! All major credit
and think; have you in fact bought many single goods in your cards accepted!’ There are a number of bar stools set out in front
life-time? Are we not, in fact, constantly buying more goods, of a bar counter. You set yourself down on one of the stools in
i.e. another good rather than a good?! If so, then it should be of front of the smiling Mabogunje, slap your credit card on the bar
far greater interest for the social scientist to explain why we buy and order a beer. Mabogunje pulls the draft-lever a few times
an additional unit of a good rather than the first one, seeing as and sets an ice-cold pint of beer in front of you.
how recurrent purchasing is far more common than a ‘virgin’
purchase. Point in fact; I wasn’t buying a watch (see Story You start slow and end fast – just like a good opera. Indeed,
Time below) but another watch. Thus we need a concept which quaffing away there, you actually hear blissful choirs and feel
addresses the addition to utility caused by consuming one more like the injured Tristan being cured by Isolde. What sweet
unit of the good. This is marginal utility. satisfaction! ‘It ain’t over ‘til the Fat Lady sings’, you think and
order another beer…

Definition: ‘Marginal utility’ Whap! Mabogunje slaps another cold one on the counter and
whips your card through the register. Your initial thirst having
The addition to total utility (i.e. total benefit/
been satiated (=satisfied), you drink the next one with a bit more
satisfaction/usefulness or well-being) resulting
from the consumption of one more unit of a good. ease. It too is incredibly tasty – though it doesn’t quite give you
Ultimately choices are based on the perceived the lust-filled experience of the initial stein. Still, it’s satisfying
marginal utility of one more unit of a good. enough for you to want a third…which is, again, very tasty but
not quite in the same satisfaction-league as the previous. You
feel better and better after each additional beer – but not at
My favourite example of marginal utility – and one which lends the same rate. This continues through the 4th, 5th and 6th beer.
itself to immediate recognition and knowing laughter by every Each additional beer will add to your overall satisfaction – and
student I’ve had – is the ‘cold beer in the desert’ allegory (= inebriation – up to the 7th beer.14 Putting this little story into
comparison). Picture yourself marooned in the Kalahari with the traditional illustrative method of the economist, we get
nothing but the clothes on your back and your trusty credit tables and diagrams.
card securely tucked away in a Velcro pocket. You set off on
foot towards what you hope will be the nearest town. It’s 45° Total Marginal
Quantity
C in the shade – which would be fine if there was any shade.11 utility utility
But you are walking in the mid-day sun, which is hot enough to 0 0
→100
fry the niblets off a bronze elephant.12 Walk, walk, walk. Sweat, 1 100
→ 70
sweat, sweat.13 2 170
→ 45
3 215
→ 27
4 242
→ 15
5 257
→ 5
6 262
→ –3
7 259

Figure 2.4 Table of total and marginal utility

The table in Figure 0.4 above shows how total utility increases
– but that each additional beer adds to total utility less than the
11 The correct term for ‘°C’ is degrees Celsius – not ‘centigrade’. previous beer. Shakespeare was well aware of marginal utility
The scale was invented by the Swedish scientist Anders Celsius when he wrote “Can one desire too much of a good thing?” The
in 1742. (Source: http://www.astro.uu.se)
12 I dare not go into the subject of niblets. You are much too 14 This is when you inadvertently start crawling in the sand
young and innocent. violently sick or fall into a drunken stupor. Or both – in that
13 Or ‘Perspire, perspire, perspire’ if you are being polite. order.
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first beer renders total utility of 100, the second beer renders Marginal utility has wide applicability in the study of demand
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total utility of 170 – thus there is diminishing marginal utility patterns. It helps to explain consumption habits and patterns
since the second beer adds to total utility by 70 rather than an and also why goods such as diamonds – which are in no way
additional 100 units of utility. Note that one shows ‘movement’ necessities – are very dear, while water – which is an essential
– i.e. rate of change – by putting any marginal values between of life – is nowhere near as expensive as diamonds. I shall
the absolute values. For example, the second beer increases return to this classic economic conundrum in Section 2.2.
total utility from 100 to 170 which is shown in the table and in
Figure 1.8 below as a marginal utility value of 70 between the Micro and macro
total utility for beers number one and beer number 2. Figure 2.5
below shows how total utility increases – at a decreasing rate, Microeconomics centres on the forces working at the individual
i.e. diminishing marginal utility – up to the 7th beer. Swigging level, e.g. the individual firms’ and consumers’ (often bunched
the 7th beer confers negative utility, i.e. disutility, and you wind together in households) behavioural patterns and decision
up grovelling in the sand, proposing marriage to a cactus or making processes. Here economics focuses on the needs, desires
picking fights with claw-equipped nocturnal animals. Basically and buying habits of the individual consumer in conjunction
you’d be prepared to pay someone to drink the 7th beer! with the output capabilities of firms for particular products.
In short, microeconomics looks at firms’ outputs and pricing
Total utility (in consuming beer)
decisions and consumers’ purchasing decisions, for example
262 –3
257
+5 259 studying how firms react to increasing costs of production by
+15
242 raising the price and subsequently how consumer/household
+27 spending is adjusted when the price rises.
215
The diagram graphs
+45
the total utility in Withdrawing from the study of individual market participants
170 consumption of beer. in order to study the broad interaction of the aggregate (=
Each additional beer sum, combined, cumulative) of separate (micro) parts is the
+70 adds to total utility –
purview of macroeconomics. The four main issues here are
up to and including
100 the sixth beer. aggregate output (and thus economic growth), price level
(and thus inflation), labour markets (e.g. unemployment), and
finally foreign sector dealings (such as the balance of trade and
+100
exchange rates). Central to the study of macroeconomics is the
business cycle (also known as the trade cycle), which shows
total output in the economy over time – this is often put into
0 1 2 3 4 5 6 7 Quantity of beer
the context of variations in economic activity (recessions and
Marginal utility (of one more beer) expansions) and the links to macroeconomic policy.
The diagram graphs the
+100 marginal utility of
100 consuming an additional Definition: ‘Micro economics’
90 beer. The first beer renders Microeconomics is the field of economics dealing
80 100 units of utility, while
+70
each additional unit (pint)
with the relationships between individual
70
adds to total utility less components in the economy; firms, industries and
60
than the previous – this is consumers (households). This interplay is the basis
50 +45 diminishing marginal for individual markets.
40 utility. The seventh beer
30 +27 actually decreases total
utility, i.e. it renders Definition: ‘Macro economics’
20 +15
negative marginal utility of The sum total of all micro parts, the aggregate of
10 +5
–3. individuals’ and firms’ behaviour. The four main
0 –3
–10 1 2 3 4 5 6 7 Quantity of beer
areas of study are; 1) growth (increase in total
output); 2) price level (inflation); 3) labour market
(unemployment) and; 4) the balance in the foreign
Figure 2.5; Total and marginal utility of drinking sector (exports/imports, exchange rates).
beer in the desert
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Let us compare the two using a few examples: 6. The PPF shows the possible combinations of output in
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an economy. The boundary (frontier) is where all factors

Looking at how a firm reacts to increased demand for its are fully utilised. A shift outward of the PPF (economic
product is a micro-issue while studying the effects on all firms growth) is caused by an increase in the quality and/or
in the economy due to a general increase in demand is a macro- quantity of factors of production.
issue; the decision of a worker to work less due to lower wages
is micro while total hours of labour (and unemployment) is 7. Positive statements are statements which can be proven
macro; the effects on an industry (= group of firms producing or disproven. There is no evaluation or value-laden
similar goods) due to higher labour taxes is micro while element in such a statement.
the effect on total production in the economy due to taxes is
macro; government legislation aimed at monopolies is micro but 8. Normative statements are subjective. They cannot be
government legislation aimed at increasing taxes on profits for proven or disproven.
all firms is macro.
9. Utility is the benefit or satisfaction derived from
The distinction between the two areas is admittedly blurred, consuming a good. Marginal utility is the satisfaction
somewhat contrived and ultimately none-too-useful. I often derived from the consumption of one more good.
find the two areas overlapping and would be hard put to draw
a concrete line between them in many real life situations. 10. Microeconomics looks at the individual level of firms
Basically the difference isn’t vitally important unless an and households while macro looks at the aggregate
exam question addresses the issue… which is just the sort of (sum) of all households’’ and firms’ activities such as
statement designed to get me into a hefty argument with some unemployment, inflation and economic growth.
of my colleagues.15

Summary & revision

1. Economics deals with societal wants and the ability to
provide these wants using scarce resources (factors of
production – land, labour, capital and the entrepreneur).

2. Economics deals with the trade-offs we face every day,

ranging from the question of going to the movies or
doing homework to the use of government funds for
producing weapons or schools.

3. Resources are scarce since it is impossible to satisfy

endless societal wants.

4. The basic economic problem is what to produce, how to

produce it and to whom the goods will go.

5. For every use of resources there is an alternative use

– this gives rise to opportunity costs, i.e. the second
best alternative foregone (quantity of Good B) in the
production of a given quantity of Good A.

15 I answer all correspondence. Please write to me at matt@ibid.

com.au
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Key concepts:
• Models
• Correlation
• Causality
• Nonsense (spurious) correlation PUSD in JPY
160

• Indexes Qs = –800 + 25P(ex)

SUSD

80
Qd = 2,400 – 15P(ex)

DUSD

–1.0 –0.5 0 0.5 1.0 1.5 2.0 2.5

–0.8 1.2 2.4
Q/t (billions USD/day)

Y
ou will have to deal with data in economics, both in or theories which emerge will inevitably be limited in
writing your economic analyses for internal assessment applicability, but the basic strategy is to find correlation (=
and in your exams. Internal assessment comprises 20% a relationship or correspondence) between the variables
of your total grade and the data response questions 40% at SL being studied. We might see that consumption increases
and 30% at HL. This section takes a look at how models are as net incomes rise, e.g. positive correlation between the
built, some common types of economic data and how these two variables.
are frequently presented in tables and diagrams. One main
objective here is to get you to understand the difference between 3. Finally, one formulates a hypothesis based on any
correlation and causality as these concepts are very useful in patterns. For example, this might be; ‘Increased income
evaluating/criticising data which has been compiled (= put results in an increase in consumption’. One then tests
together) for you in tables and diagrams. Another objective is this by applying the model to other sets of data (such as
to clearly outline the difference between data based on stock the income and consumption figures over a longer time
and flow values. Finally, since so much economic data is given period or for another country) in order to see whether
in index form to enable comparisons between countries and the model has more general applicability. This means
over time, basic index series will be looked at. testing whether the results are generally consistent
with the theory being formulated. A key issue here is if
Models variable X causes a change in variable Y…or vice versa.
This is the issue of causality.
Models in economics are based on observations of real life and
then trends seen in data collected. Correlation
1. The first step is to organise reality in a rational manner When a set of data shows that there are visible and perhaps
by observation and subsequent gathering of data.1 predictable patterns in the variables in our data, we speak
It is most important to define the concepts that are of correlation. Note that high(-er) values for income and
being systematized; if we are studying income and the corresponding higher(-er) values for consumption is positive
effects on consumption then it is imperative to clearly correlation, while high(-er) values for income and low(-er)
outline whether we are looking at gross or net income, values for birth rates would show negative correlation.
including social benefits or not, what time period, which
population…etc. For example, one of the models used in macroeconomics
is the Phillips curve, which shows how inflation (rise in the
2. Step two is spotlighting aspects of the data in order to see general price level) and unemployment (percentage of working
whether any patterns emerge. Any and all models and/ population not holding a job) are related over a period of time.
Up to the 1960s in the US there was strong negative correlation;
1 It should be noted that many a cynical social scientist has
observed that ‘data is the plural of anecdote…if the anecdotes when unemployment (U) rose inflation (i) fell…or maybe
have been selected systematically’. I should say that when inflation rose unemployment fell!? In
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economic shorthand we would pose this as ‘∆U → ∆i’ and ‘∆i flow (causality) in regards to changes in income and subsequent
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→ ∆U’ respectively.2 changes in consumption and birth rates.

Causality The point to be made now is that if we were to study the

variables ‘consumption’ and ‘birth rate’ we might well find that
This is a common conundrum (mystery, problem) in economics there would be negative correlation; as total consumption rises
and indeed in all the social sciences; what causes what? Here, over a period of years, birth rates fall! This is where a good,
does the change in unemployment cause the change in inflation sceptical outlook on the use of statistics is absolutely vital. It
or the other way around? This chicken or egg problem is known is pretty obvious that increased consumption does not cause
as causality, which basically looks at the relationship between lower birth rates or vice versa, but that the two are in causal
variables and seeks to highlight which is the cause and which is contact with a common underlying variable; income. Figure 3.1
the effect.3 Let us look at a simple example. below illustrates the difference between the variables that are
correlated and the variables which show causal links.

Nonsense (spurious) correlation

Increased consumption (effect)
on
It is important to note that correlation is NOT the same as
e l ati
rr
Co

Nonsense Correlation
causality! Consider three variables; income, consumption and
on
birth rate. Standard economic theory shows that an increase in s ati
u
general incomes in a country will lead to higher consumption Ca
Increased
rates as any given percentage of income going towards income
consumption will necessarily mean higher consumption (cause) C
orr
as incomes grow. We have positive correlation between the ela
tio
variables income and consumption. Studies also show that Ca n
us
as incomes grow (on a national level) the birth rate markedly ati
on
falls – this means that there is negative correlation between
income and birth rates. Hence, a collection of data on birth Decreased birth rates (effect)
rates and consumption might show how birth rates fall when
Figure 3.1 Nonsense correlation
consumption in households rises – this would in all likelihood
be an example of ‘spurious’ or nonsense correlation. Correlation without causality is ‘spurious’ (= ‘fake’, ‘false’) or
‘nonsense’ correlation. There are some pretty far out examples
Thus, while there is correlation in all three cases above, one of studies which – in varying degrees of self-seriousness – find
would be on thin ice indeed in claiming that there is also strong correlation between a number of variables. One classic
causality in all pairs. In the case of income and consumption study in 1875 by the famous economist William Jevons found
most economists would agree that the increase in income causes correlation between sun-spots and the business cycle (see:
an increase in general consumption – a relatively clear example http://cepa.newschool.edu/het/profiles/jevons) while more
of cause and effect. Most studies would also show that increasing recent (jesting?) studies show positive correlation between the
incomes over time leads to a drop in birth rates (often measured amount of churches and violent crime! (See: http://www.selu.
as ‘live births per 1,000 women’) as higher tax revenues provide edu/Academics/Education) My personal favourite, however,
social welfare systems and pension funds which in turn enable is the classic study from 1950 showing an astoundingly strong
couples not to have to rely on having a good many children to (positive) correlation between the number of people classified
take care of them in times of need and old age. Rising incomes as ‘mental defectives’ and the number of radios in households
will cause lower birth rates. In other words, there is also a causal during the 1930s and 1940s.4 (See: http://www.sommestad.
2 In fact, the answer is probably neither! It is, instead, the com/text/essay)
underlying change in overall demand for goods and services
that causes both inflation and unemployment to change. See In these three examples, the answer to seeming correlation
Chapter 54. can be found in underlying, common variables. Sun spots
3 While this might seem rather trivial and straightforward,
might cause changes in weather patterns and thus crops which
I assure you it is not! Some of the most heated debates and
schisms (divisions, splits) between economic schools of 4 They must have been listening to an early version of rap music.
thought have arisen over this issue. Proto-rap, maybe.
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ultimately could lead to increased harvests and falling grain
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prices and, in turn, trigger a crisis. Churches are more frequent

Definition: ‘Correlation’
in highly populated areas and this often means cities – which
have higher crime rates than the countryside. As for radios and
When there is a visible pattern between variables
(X, Y, Z…), one speaks of correlation. If ∆↑X and
correlation to mental illness, the study was carried out during
∆↑Y there is positive correlation. If ∆↑X and ∆↓Y
a period of rapid societal change which would lead to the radio
there is negative correlation.
becoming a common household item and vast improvements
in diagnosing mental illness. Thus, in all three cases, seeming
Definition: ‘Causality’
correlation must in fact be explained by entirely different data.
When there is correlation and evidence that a
Final note on correlation/causality: As any number of my
change in one variable causes a change in another
variable, there is causality, e.g. if ∆X causes ∆Y.
colleagues delight in pointing out, it is a mainstay of the failings
of the dismal science of economics that it is often impossible to
actually definitely prove causality.5 Too often there are so many Definition: ‘Nonsense correlation’
underlying and parallel variables involved that it becomes If there is correlation without causality, one speaks
impossible to attribute (or even show) causality between a pair of nonsense or spurious correlation.
of variables. There are simply too many other possible influences
to attribute a degree of causality to any one variable. I strongly
recommend Chapter 4 “Where have all the criminals gone?”
in the book “Freakonomics”6, where the authors claim that the
remarkable decrease in crime rates in the US during the 1990s DEALING WITH EXAM QUESTIONS
had little or nothing to do with a “roaring economy”, harsher In data response questions you are often given
gun laws, increased use of the death penalty or new police tables, charts and diagrams. One neat way to
strategies but was clearly linked to the famous US abortion law show evaluation is to comment on any indications
(Roe v. Wade) from 1973! The authors make a case that mothers of correlation and causality. For example, in a set
who are socially disadvantaged – single parents with low of time-series diagrams for an economy showing
income – are strongly correlated with having children turning how export earnings (X) have increased, inflation
to crime. The dramatic increase in abortions during the 1970s (i) has increased and national income (Y) (money
meant fewer births in the very social groups where children value of all goods produced in an economy) has
were at worst risk of becoming criminals. The effect of this increased, one can use core economic theory to
comment on the correlation and even causality:
was that by the time the early 1990s rolled around, there were
“…as export revenue is part of national income,
far fewer early teens with the propensity to become criminals
increased exports cause an increase in national
and the crime rate began to fall. I hasten to point out that the income and the increased demand for exports
authors very quickly question their own results by stating the together with a causal link between income and
“…likeliest first objection…”, namely that there might NOT be consumption will drive up domestic prices in the
causality but simply correlation. They then use several statistical economy, i.e. inflation rises…”
methods to test their findings and indeed find causality.

Indexes

An index is a very clever way of adjusting data so that it becomes

5 One of my favourite colleagues, L.M., has the occasional HL easy to compare changes over time and/or between individual
math lesson in my classroom. Once, I was having a rant about firms/industries/countries etc. Two of the main indexes you
the Mexican traffic jams and the bungling traffic cops who will deal with in economics are for inflation (the consumer
showed up and actually made matters worse. L.M. said; ”Matt, price index, CPI) and comparisons of economic growth rates
you’re confusing the causal flows! It’s not the traffic jam that
(increase in GDP) between countries. It’s worth knowing how
causes the cops to show up – it’s the traffic cops showing up
who cause the traffic jams!” I don’t win a lot of points with L.M. an index is put together at the outset of studying economics, so
6 Freakonomics, Levit, Steven D., and Dubner, Stephen J., 2005 here is a simple – and childish! – example.
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In my childhood home in a place called Åkers Styckebruk,7
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Time Jan. 1996 Jan. 1997 Jan. 1998 Jan. 1999

Sweden, there is a well-scribbled and well-hacked doorpost
where countless children, grandchildren, friends, and Amanda’s
111 cm 114 cm 123 cm 133 cm
neighbourhood kids have marked their height during the past height
30 years. Careful scrutiny yields the name of my oldest friend, Change Period 1 ‘96-’97 3cms
Guy, several times and quite frequently Amanda – his daughter. during Period 2 ‘97-’98 9cms
Tempus fugit8 and all that. Here’s what Amanda’s marks on the period
(i.e. Period 3 ‘98-’99
doorpost look like: 10cms
growth)

Figure 3.2b Amanda’s growth 1996 to 1999 in

absolute values
January ‘99
Amanda 133cm If we want to compare Amanda’s growth rate to other kids
over the same period of time, it’s easiest to index her growth.
Using the first time period as the base year – the value that
all coming values will be compared with – we calculate:
January ‘98
Amanda 123cm Height at tn
__________
​    
​× 100
Height at t0

…where is the actual year and t0 is the base year value. This
gives us Figure 3.3 below.
January ‘97
Amanda 114cm Jan.
Time Jan. 1997 Jan. 1998 Jan. 1999
1996
January ‘96 Amanda’s
Amanda 111cm height – 100 102.7 110.8 119.8
indexed
(Jan 1996
​ 114  ​×100 )​ ​( ___
(​ ___ ​ 123  ​×100 )​ ​( ___
Amanda at 8!
as base ​ 133  ​×100 )​
111 111 111
year)

Figure 3.3 Amanda’s growth 1996 to 1999 –

indexed

Note that the rate of growth over the entire time period
is 19.8 percent. However the percentage change between
individual years is not a matter of deducting the index value
of the previous year from the value of the year in question. For
Figure 3.2a Growth rate and index example, the percentage increase between 1998 and 1999 is not
We see four specific points in time in Figure 3.2 above and 9% (119.8 – 110.8)! Percentage changes is calculated by taking
Amanda’s height at each specific time. The change in height the change in index value and dividing by the original value.
between the four points in time is, of course, growth. The rate So the percentage increase between 1998 and 1999 is [119.8 –
of change per time period is illustrated in a simple table below. 110.8] ÷ 110.8 × 100. This gives us a 8.1% increase in height
between 1998 and 1999.

Using Sweden’s GDP figures as a final example for the same

time period we can calculate growth rates using both absolute
7 Not pronounced ‘Acres of Stickybricks’. values and then an index series9:
8 ‘Time flies’. (And, according to my mother, gravity sucks.)
Amanda is now in her 20s and I cringe every time I get a
message from her on Facebook. Uncles really don’t want to 9 Swedish Bureau of Statistics, at http://www.scb.se/templates/
know what those cute little girls turn into when they grow up. tableOrChart____26651.asp
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Applying the same methodology as to Amanda’s growth.
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Year 1996 1997 1998 1999

Real 1. Economists use lots of models. These are based upon

GDP for
1,958 2,002 2,070 2,143 observations of real life; data collection; correlation
Sweden
Billion Billion Billion Billion analysis; formulating hypotheses; and finally testing the
(SEK =
SEK SEK SEK SEK model against reality.
Swedish
crowns)
Period 1 ‘96-’97 2. Correlation means that two (or more) variables show
Change 2.24% a pattern. For example we know that there is negative
during correlation between the price of a good and the quantity
Period 2 ‘97-’98
period sold over a period of time.
3.40%
(i.e.
growth) Period 3 ‘98-’99
3. Causality means that there is correlation and also that a
3.53%
change in the value of one variable causes a change in the
value of the other. If the price of ice cream decreases this
Figure 3.4 Economic growth rates for Sweden. will cause an increase in ice cream consumption.

4. When there is correlation but no causal relationship,

2,070 – 2,002
Example: period 2; ___________
​   ​  × 100 = +3.40%.
  one speaks of nonsense or “spurious” correlation. There
2,002
is 100% correlation between eating food and dying
Naturally the index series shows the same growth rates as when (ultimately) but eating food does not cause death.
we use the absolute values. Again, the cunning thing about
using indexes is that we can more easily compare Sweden’s 5. A very common method in economics to enable
growth rate over time and between, say, Sweden and the UK. comparisons over time and between groups is to index
I always urge my budding economists who write extended all data. The base period or value commonly has the
essays in economics to index data values in order to be able value 100 and all subsequent values of the index are in
to compare more easily. One of my more recent essays dealt comparison with the base value.
with the possibility of correlation between economic growth
and quantity of marriages in a municipality. By indexing all
values it became much easier to do an analysis of the strength
of correlation.10

10 This is called regression analysis and is best done having a math

teacher at your elbow or on speed dial. Incidentally, there is
indeed correlation betwen economic growth and quantity of
marriages! Positive or negative?!
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1.1 4. Markets and Demand

MICROECONOMICS
Key concepts: Definition and functions of
• Definition and function of markets markets
• Law of demand and correlation between price and Pick up the morning paper and flip to the classified ads. ‘Used
quantity demanded bicycle – call Adam.’ ‘Baby-sitter urgently needed! Call the
• How individual demand comprises market demand Svenssons!’ ‘Kittens! Call Sandy.’ ‘Change money at Sami’s – no
• Introduction to basic market model; downward commission!’ All of these fictitious ads are examples of markets
sloping demand curve in action. In each and every case, there is something being
• Movement along vs. shift of demand curve offered or asked for. Any replies will thus show the flip side of
• Non-price determinants of demand the coin; someone who wants the good or someone who can
supply the good.

HL extensions: Markets are well-established institutions and operate at all

• Linear demand function; Qd = a – bP levels of human interaction. When one thinks of ‘markets’, one
• Shifting the demand curve, e.g. a change in “a” often envisions stalls in an open square where goods are put out
• A change in the slope of the demand curve, e.g. a for sale and potential customers meander looking and perhaps
change in “b” buying. This traditional market place is a brilliant example, as
all the necessary prerequisites are in place; there are numerous

S
buyers (or customers) and numerous sellers (suppliers). Many
yllabus section 1 (Chapters 4 to 35) deals with how of the stalls will have similar goods and similar prices yet many
markets attempt to solve the basic economic problem. people will still circulate in the market, perhaps foregoing the
Consumers’ wants are paired-off with firms’ ability to wares offered at one stall in order to look at the same goods
satisfy those wants, creating the keystone of economic analysis: at another. Is that haggling I hear?! ‘..one dinar for this?! How
the supply and demand model. Then we look at market failings about two dinars for three?!’
such as over-consumption or under-consumption of goods such
as tobacco and health care respectively. Higher level students
will then go into greater depth concerning market outcomes
and the decision-making process within firms in ‘Theory of the
Firm’.

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You get the picture. An example could be from yesterday
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Definition: ‘Markets’ or from the Vikings celebrating their successful invasion of

A market is a situation where potential buyers York in 866; “Yah, Sven, plenty women to kill and cattle to
are in contact with potential sellers. It enables the rape! I’ll trade you one ox for two women.”1 A more recent
needs and wants of both parties to be fulfilled example is from any modern financial institution dealing with
whilst establishing a price and allowing an
international buying and selling of currencies on the Forex
exchange to take place.
(foreign exchange) market. The only real difference between
the two markets’ structures is that the buyers and sellers of
currencies are not in physical contact with each other – and
also that the Australian dollar is not bought at the business end
of a 4.5 kilo broadsword.
MICROECONOMICS

Market types
In the description of markets above it is implied that there are
a number of firms competing on the market for goods and
services. While this is often enough the case, there are a number
of instances where the degree of competition is considerably
lower, for a number of reasons. The competitive market has
many firms and a high degree of competition, whereas a
monopoly is at the other extreme; a single powerful firm and no
Market place at Chichen Itza, Mexico. Maya-Toltec style, competition. In between there is a ‘large fuzzy grey area’ where
900-1200 AD. we find markets characterised by a few large firms – oligopoly
– and high profile firms characterised by heavy advertising
Cut to an air-conditioned office equipped with wall to wall and brand-imaging – monopolistic competition. The following
computer screens and phones. 30 young men and women are figure arranges these four market structures according to four
glued to the screens – all the while talking in to multiple phones sets of criteria. (For greater depth on market structures – even
and feverishly taking notes. Cyber-dating? Nope. Just another for the ambitious SL student! – see chapters 22 – 35.)
day in the life of («blip» and AUD$250,000 were just transferred
to Tokyo) a foreign currency exchange office. 1 Or something to that effect. They weren’t too brainy those
Vikings. Too much salted herring.

Perfect competition Oligopoly Monopolistic competition Monopoly

Size/number of firms

Small & many Large & few Relatively many & small Single large

Barriers to entry

Low or none High Relatively low Very high

Homogeneous / heterogeneous goods

“Identical” Both homog. & non-homog. Non-homog. but similar “Unique”

Consumer sovereignty

High Low High Very low

Figure 4.1 Market structures and their characteristics

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The four criteria in Figure 4.1 above are in fact used as competitive market will empower consumers more than non-
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assumptions, as we are defining the market structure by competitive markets.

assuming that certain traits are fulfilled. The size and number
of firms has a powerful influence on the level of competition The shading in Figure 4.1 is not by accident. If you look at
and price, and therefore the power of the firm relative to the the characteristics of the perfectly competitive market and
consumer. Many firms will mean more competition and vice monopoly, you will see that they are each others’ opposites,
versa. The greater the number of firms that compete, the less being basically two extremes. Oligopolies and monopolistically
power any individual firm will have over market prices. competitive firms, on the other hand, portray very little
correspondence in terms of neatly following the arrows
Barriers to entry mean that it is difficult/costly for potential separating the two extremes. This ‘fuzzy grey area’ is the most
newcomers (firms) to enter the market. High barriers to entry difficult to characterise accurately and unfortunately this is the

MICROECONOMICS
are mainly of three types: area most of the real world winds up in. Also, don’t be fooled
by the neat figure; in reality there is a great deal of overlapping,
1. legalistic (for example the restrictions and regulations where an oligopoly is monopolistically competitive and could
governing banks and airlines, or not having certain also have elements of monopoly markets embedded. An
patent rights necessary for production); example would be Microsoft, Macintosh and Linux operating
systems.
2. financial (including difficulties in getting the funding
together to start a railroad company, or not having access Perfect competition
to raw materials); and finally
A perfectly competitive market is characterised by many
3. economic (newcomers would be producing small buyers and many sellers, all interacting in such a way so as
amounts which will mean high cost per unit whereas to provide the highest possible quantity at the lowest possible
existing firms would have much lower costs). The various price. As the goods are assumed to be 100% homogeneous,
forms of entry barriers compound the question of the only competitive element is price-competition, which in
competition, as high barriers to entry will allow existing turn empowers consumers and the market is demand-driven.
firms to act without giving too much consideration to the In providing this outcome there is no waste – all goods are
possibility of firms entering the market and increasing produced in order to fulfil market demand. This optimum
competition. outcome in terms of resource allocation is what is ‘perfect’
about the market structure. Agricultural goods like tomatoes
The degree of homogeneity and heterogeneity defines the and coffee and basic commodities such as iron and copper
composition or make-up of the good. Homogeneous means could be considered perfectly competitive market goods. The
‘same’ or ‘identical’ and in economics signifies whether a good remaining three market structures are commonly referred to as
has any number of identical (or close) substitutes or not; the ‘imperfect competition’.
potato is an oft-cited example. Heterogeneous is of course
the opposite; a good which is differentiated (= set apart, non- Oligopoly
homogeneous) from possible substitutes. It is relevant to note
that goods do not actually have to be physically different – it The main defining elements of an oligopoly are ‘few’ and ‘large’
is sufficient for us to perceive that goods are different – there – where there could well be several hundred firms but four
are many Taco restaurants but only one Mama Rosita’s! (See or five firms dominate the market. The dominant firms in an
monopolistic competition below.) oligopolistic market structure might have access to limited raw
materials, such as bauxite (for aluminium) and oil, creating
Finally, there is a question of the relative bargaining power entry barriers for other potential firms. Firms are often large
of consumers and firms. If consumers have a good deal of because of the necessity to produce very large quantities of
influence on prices and output, then consumer sovereignty goods to cover high costs of production and research and
is high. One would indeed expect to find this in competitive developments (R & D) – such firms are said to enjoy benefits of
markets where there are many firms. If, however, there is only scale (scale means size) where the cost per unit of output falls
one firm (supplier) then there are no substitutes available and as the firm increases in size. Examples of such oligopolies are
consumer sovereignty will be low. Regarding the empowerment pharmaceutical and car companies. There is also an incentive
of consumers as the ability to ‘cast votes’ on goods, then a for firms to collude (= cooperate), for example by agreeing to
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set identical prices or by dividing the market up geographically on all gas, water and TV/internet services in the country. The
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so as to avoid head-on competition. This type of behaviour is definition becomes a question of the degree of market power
frowned upon in most industrialised countries and severe legal for the firm, i.e. that monopoly firms have market power at
penalties are often set for collusive behaviour. the expense of consumers as there are no close substitutes and
thus scant competition. Firms have the power to set output and
Monopolistic competition price without taking competitive forces into consideration. In
the final analysis, consumer sovereignty in a pure monopoly
This is an increasingly common market structure where there situation is a bit like voting in the ex-Soviet Union; everyone
are a large number of firms producing similar goods which could vote freely but there was only one party.
are differentiated. The defining elements of monopolistic
competition are taken from perfect competition and monopoly
MICROECONOMICS

– hence the name. The market is competitive as entry barriers Law of demand
are low and potential firms will have access to attractive markets.
The market is also monopolistic, as goods are highly profiled – Part of the economic problem is that people have endless wants.
firms put a great deal of resources into marketing in order to However, simply wanting or desiring a good does not constitute
convince us that while there are many possible substitutes, there demand. Demand is more an activity than a state of mind, e.g.
is only one ‘Brand X’. This is known as branding and serves when you are actually willing to purchase a good at a certain
to create in the mind of the beholder that a particular good price. Demand in market terms is the quantity consumers are
or service is in some way different - e.g. superior - to others. willing and able to buy at a given price, not what they would
Standard textbook examples of monopolistically competitive like to have. I would most assuredly want a Patek Phillipe
firms are restaurants, hotels, car repair services and bakeries. wristwatch but I am not in the market for one (yet if you bought
One also often finds a number of markets which are largely this book I’m getting there). When consumers are both able and
monopolistically competitive but where there are a few large, willing to buy a good, economists speak of effective demand.
dominant firms; the markets for sports shoes and soft drinks
are notable examples. In reality therefore, the line between Recall from Chapter 3 the issue of correlation and causality. If
monopolistic competition and oligopoly is often blurred. we plot out effective demand for a normal good with price on
the Y-axis and quantity demanded on the X-axis, we would see
Monopoly negative correlation: when the price of a good falls the quantity
purchased of the good will increase. The starting point for our
Finally, the far end of the spectrum. Here the assumption in model of demand is positing (= proposing) that a rise in the
economic theory is that there is one firm only – a pure monopoly. price of a good will lead to lower quantity demanded for the
Examples of pure monopoly markets are postal services, state good – keeping all other variables constant. This is the law of
television and even oil companies (Pemex in Mexico) as seen demand, which states that ‘Ceteris paribus’, a change in price
in many countries. The concept of a pure private monopoly will lead to a change in the quantity demanded’.
doesn’t stand up to scrutiny in the real world particularly well
and I’d be hard put to find a specific example.2 The definition of
Definition: ‘Law of demand’
monopoly is a tricky one since it often depends on the definition
Ceteris paribus, a fall in the price for good X will
of the market in terms of both product and geographical area.
result in an increase in the quantity demanded for
Hence, de Beers might be considered a monopoly (see footnote
good X. An increase in the price of X will result in a
below) in the supply of raw diamonds but not in the market for decrease of quantity demanded.
diamond jewellery. Geographically speaking, local gas, water
The law of demand states that as long as all
and cable companies can have a regional monopoly but not other variables (income, price of other goods,
2 Diamonds are a possible example, where DeBeers has for over preferences) remain unchanged, then a fall in
70 years controlled some 50% to 90% of the total market for the price of a good will lead to an increase in the
raw diamonds – and the European Union, threatening a fine quantity demanded. This means that the demand
of up to 10% of de Beers global sales, prohibited the company’s curve is downward sloping and thus that quantity
method of controlling the market via intervention purchasing demanded is negatively correlated with price.
in 2006. (International Herald Tribune, Feb 22, 2006; “De Beers
loosens grip on diamond market”). Much of the definitional
difficulty here arises due to the complexity of the market. HL
will return to this issue in theory of the firm.
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Ceteris paribus Individual demand and market demand
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In scientific research in general and economic models in One of my favourite movies3 as of late is Despicable Me which
particular, one builds a model knowing that there are many at the time of writing has just left the big screen and hit DVD/
possible influences on the relationships one is looking at. In Blu-ray. I missed it on the big screen so,4 like a goodly many of
using our demand model to look at the effects of a change in my students, I bought it on DVD. My students and I all have our
the price of, say, gasoline (petrol), we would assume that a individual demand for DVDs and the sum of all demand here in
number of other influences on gasoline consumption would be Mexico City makes up the market demand. In other words, any
kept constant. Consumption of gasoline would be correlated to market demand is simply the aggregate of individual consumers’
several non-price determinants, such as households’ income, demand for the good. It is noteworthy that individual buyers
the average price of cars (complement goods), the average price can be Matt and his students (consumers), Wal-Mart (other

MICROECONOMICS
of public transport and so on. Assuming that there is no change firms) and the Naucali Youth Centre (government).
in income, car prices or public transport, we would see that a
fall in the price of gasoline would lead to an increase in gasoline If we hugely simplify the market and look at a small market
consumption. consisting of three IB students and their demand for DVDs
over a week, we get Figure 4.2 below. (MXN = Mexican pesos)
The assumption of ceteris paribus – ‘all else equal’ – is
almost always present in our economic models. It is virtually The market demand curve in this very simple example is made
impossible to leave out of our models as it raises the level of up of the three consumers which all have an effective demand
scientific trustworthiness by creating a more rigid framework for DVDs; Maria, Ana and Jesus. In keeping with the law of
of deductive reasoning, e.g. that a change in ‘X’ will lead to a demand, we see that a lower price will mean greater quantity of
predictable change in ‘Y’ as long as the situation is not muddied DVDs purchased each week. At a price of MXN150, the three
by an infinite number of other possible influences. consumers will purchase a total of 8 DVDs per week – which is
market demand (Dmkt). At a price of MXN50 market demand is
24 DVDs per week.5
Definition: ‘Ceteris Paribus’
3 Pause here for groans from my students...”...Matt, all your
Ceteris paribus is Latin and means “…all else
movies are favourites!” Yes, so?
remaining equal…” or “…all other things 4 I saw it on a long distance flight from Hong Kong at 03:00 in
remaining the same…”. This essential assumption the morning. I am sure the other passengers found my screams
allows economic models to predict outcomes of laughter very amusing.
and relationships with a degree of certainty and 5 Yes, I know this is hideously simple. When I explain this the
conviction simply by assuming that variables not first time in class, there’s always one of my kids who goes
addressed in the model are kept constant. “Duh!” However, keep in mind that the Maria’s, Ana’s and Jesus’
weekly allowance doesn’t change…nor does the price of movie
tickets…nor does the price of DVD players…nor anything else
which would affect weekly DVD demand of my students.

Individual demand curves for DVDs Market demand

curve for DVDs
150
P (MXN/DVD)

50
Dmkt
Maria’s D Ana’s D Jesus’ D
2 6 2 8 4 10 8 24
Q/t (DVDs/week) Q/t (DVDs/week) Q/t (DVDs/week) Q/t (DVDs/week)

Figure 4.2: Individual demand and market demand for DVDs in Naucalpan

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Downward sloping demand curve
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An increase in the price from

MXN100 to MXN150 causes a
In essence, we are painting a picture of the pattern of demand B movement along the demand
150 curve from A to B. This is termed a
for a good, where all possible prices are coupled to the quantities decrease in quantity demanded.
demanded. This gives us any number of possible combinations
of price and quantity demanded of DVDs, but for the sake of
100 A

P (MXN/DVD)
simplicity in Figure 4.3 below only three prices are mapped out.
There are two reasons for an increase in quantity demanded
when the price of a good falls; the income effect and the C
50
substitution effect. Dmkt
MICROECONOMICS

• Income effect: If your income remains the same

but prices rise, your real income has decreased and 8 16 24
consumers would have the propensity (= tendency) to Q/t (1,000s DVDs/week)
decreases their purchases of the good. In the same way, A decrease in the price from
a fall in the price of a good means that people who have MXN100 to MXN50 causes a
movement along the demand
a demand for the good are now richer in real terms, i.e. curve from A to C. This is termed
their income in terms of how much they can actually an increase in quantity demanded.
buy has increased – they buy more. If – ceteris paribus
– the price of DVDs falls from MXN100 to MXN50 the Figure 4.3: Market and downward sloping demand curve
quantity demanded increases from 16,000 DVDs per
week to 24,000.
• Substitution effect: Secondly, a fall in the price of a good
means that relatively speaking the price of alternative Movement along vs. shift of demand curve
goods has increased, so people will change their
purchasing behaviour and switch some expenditure In Figure 4.3 above, assume that the initial price is MXN100
to the (relatively) less pricey good. In simple terms, and thus that quantity demanded per week is 16,000 DVDs. If
consumers will substitute other goods with the lower the price increases to MXN150, then the quantity demanded
priced good. Thus, if the price of DVDs increases from falls from 16,000 DVDs per week to 8,000. This is shown by
MXN100 to MXN150 then consumers will, to a certain a movement along the demand curve, from point A to B,
extent, switch to substitutes (say cinema tickets or Blu- which means, using correct economic terminology, that ‘…the
Ray discs) since these substitutes are now relatively quantity demanded decreases...’ A decrease in the price from
cheaper – quantity demanded falls from 16,000 DVDs MXN100 to MXN50 is a movement along the demand curve
per week to 8,000. from point A to C – the quantity demanded has increased from
16,000 DVDs per week to 24,000. The demand curve extends
or contracts, i.e. any movement along the demand curve can
be referred to as an extension/contraction of demand. The
Definition: ‘Income and substitution effect’ curve is actually created by all the combined points of price and
Income effect: If, ceteris paribus, the price of a quantity demanded.
good falls, then consumers’ real income (income
in terms of how much they can actually buy) has A few comments on the simple relationship in Figure 4.3:
increased, so consumers buy more of the good.
Substitution effect: If, ceteris paribus, the price of a 1. The relationship between price and quantity demanded
good falls, then the price of the good in relation to is negative; any downward sloping curve shows that an
other goods (i.e. substitutes) will cause an increase increase in one variable (price) leads to a decrease in the
in consumption. (Relatively speaking the price of other variable (quantity) which is entirely in keeping
other goods has increased.)
with the law of demand. Note once again that in “moving
along” the demand curve we are assuming that all other
influences on demand are held constant, e.g. the ceteris
paribus condition.
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2. Have you noticed that we have put the independent is shown as a rightward shift in the demand curve from D0 to
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variable on the ‘wrong’ axis?!6 The norm is to put the D1 and referred to as an increase in demand. Conversely, if the
independent variable on the X-axis and the dependent price of Blu-ray discs were to decrease, then some consumers
variable on the Y-axis. As quantity is undoubtedly the would switch some expenditure to Blu-ray discs (a substitute)
dependent variable, we have ‘switched places’ in our and the demand for DVDs would decrease at all price levels –
model. the demand curve shifts left from D0 to D1. This is a decrease
in demand.
3. It is most important to keep firmly in mind that there is
a time-frame involved, here ‘1,000s of DVDs per week’.
Economists are notoriously sloppy and lazy for some
reason when it comes to including this rather important Exam tip; using the language

MICROECONOMICS
premise, and I urge you to include the time element in
your own diagrams. Not having a time frame (i.e. a time
of an economist
limit) would basically mean that the demand curve is set Ever wondered about the language that language teachers
in stone for all eternity! It is not; the demand curve is, as insist upon using? Me neither. Rather than saying ‘do-
we shall see, most dynamic over time. words’ they say ‘verbs’; rather than ‘thing-words’ they say
‘nouns’. They have an entire menagerie (= collection) of
Shifts in the demand curve terms that could just as soon be said in Martian as far as
I’m concerned. Unfortunately, economists are no different
As will be explained in some depth below, any change of the – something I will never admit to the face of a language
determinants of demand other than price, will serve to shift the teacher. We have an immense array of very subject-specific
demand curve. terms and concepts. The successful economics student
must incorporate them into his/her active vocabulary.
A decrease in the price of Blu-ray
discs (a substitute, i.e. a non-price Distinguishing carefully between ‘change in the quantity
variable of demand) leads to a demanded’ and ‘change in demand’ is an excellent place to
decrease in demand for DVDs. This
is shown by a leftward shift of the start.
demand curve.
Any change in the price will result in an increase or decrease
1 0 2 in the quantity demanded. An increase or decrease in
P0
P (MXN/DVD)

price means a movement along the demand curve. This is

referred to as a change in quantity demanded.

• changing the price does not change demand but the

D1 D0 D2
quantity demanded
Q1 Q0 Q2 • a change in the quantity demanded is a movement
Q/t (1,000s DVDs/week) along the demand curve
An increase in income (a non-price
variable of demand) leads to an
increase in demand for DVDs. This
Any change in a non-price variable will cause an increase
is shown by a rightward shift of the or decrease in demand at all price levels. An increase or
demand curve. decrease in demand means a shift of the demand curve.
This is referred to as a change in demand.
Figure 4.4: Market and downward sloping demand
curve for DVDs • changing a non-price variable (income, price of other
In Figure 4.4 above the original demand curve is D0. If incomes goods…etc) does not change quantity demanded but
increase (for those who are part of effective demand) we would demand
see that demand for DVDs increases at all price levels – this • a change in demand is a shift of the demand curve

6 This is the fault of one of the most influential textbook authors

in economics, Alfred Marshall (1842 – 1924). The story has it
that he simply made an error – which has stuck with us ever
since!
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A decrease in the price of Blu-ray
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discs (a substitute, i.e. a non-price

variable of demand) leads to a
In the coming model, a fundamental premise is that demand is decrease in demand for DVDs. This
is shown by a leftward shift of the
a function of many different variables, the main determinant

P (...)
demand curve.
being the price of the good. All other influences are non-price
determinants of demand which will shift the demand curve, the 1 0 2
main ones being; P0

1. income of consumers

2. price of other goods (substitutes and complements – D1 D0 D2

MICROECONOMICS

more on this later)

Q1 Q0 Q2
An increase in income (a non-price
Q/t (...) variable of demand) leads to an
3. changes in consumers’ tastes/preferences increase in demand for DVDs. This
is shown by a rightward shift of the
4. changes in consumers’ expectations/ hopes demand curve.

5. population changes – both in terms of size and structure Figure 4.5: Market and downward sloping demand curve
for DVDs
6. derived demand – e.g. where the demand for cars creates
demand for steel Income

It cannot come as a surprise that an increase in income would

Definition: ‘The demand function’ increase demand for a good. Just recall that our wants are
”QDx =∫ Px; Py; Y;….n ” The demand function reads endless! Thus, any furthering of the ability to satisfy those
“The demand for good X is a function of 1) the wants will mean that people will have an increased tendency
price of good X; 2) the price of good Y (substitute
to do. When demand increases for a good due to an increase in
or complement); 3) income (Y); 4) n – being tastes,
income, economists commonly refer to such goods as ‘normal’
population…etc. Our diagrammatic analysis links
the price to quantity. goods. (See income elasticity in Chapter 11.)

I do two weeks of teaching at the Oxford Study Courses

in England every Easter.8 The first time I did this I flew via
This book doesn’t permit going into the other 1,800 possible Stanstead Airport, which is a small and somewhat basic airport
influences on demand. Let us look at the six non-price unlike the larger Heathrow or Gatwick Airports. On returning
determinants above using a few real-world examples. Note that home I told my then wife9 that we were lucky that I flew via
in using the demand model, actual quantities and prices are Stanstead, as the wages I’d been paid were burning a hole in my
seldom used. The diagrams serve as illustrations rather than pocket; had I flown via Heathrow I probably would have spent
real-life depictions of actual data.7 (Figure 4.4 below covers all the entire week’s wages at the Tax Free shop on a new watch. Sad
six examples used – note that the axes would change depending but true. So, did I then save my increase in income? Nope. I was
on the good! Swiss watches would have Swiss Francs per watch surfing the Internet for Blancpain watches that very evening.
on the P-axis and thousands of watches per unit of time on
the Q-axis, whereas Caterpillar machinery would have average
price per machine on the P-axis and number of machines per
8 Basically, I’m greedy – and Blancpain watches aren’t given
time unit on the Q-axis.) away.
9 I seem to collect not only wrist watches but ex-wives. One
of my cheekier students plotted out my marriage habits and
then correlated my ups and downs with the business cycle. She
found correlation – the regression coefficient was 0.35! Maybe
7 Though it is strongly recommended that you include in your you should write me and ask about my marital status before
diagrams any numerical values given in the articles you will use buying any shares or property… Hmm, good extended essay
in internal assessment. material here. Write me and I’ll send you the data.
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What might cause an increase in general incomes in an one looks at these products, they are obviously competitors for
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economy? Perhaps a decrease in income taxes leaves people with my money. Should the price of Blu-Ray players increase there
higher disposable incomes. Or general increasing prosperity will be an increase in demand for Blu-Ray players (D0 to D2 in
gives the people in an economy higher wages and thus incomes. Figure 4.5) Note that, once again, we are assuming all else equal,
In any event, an increase in disposable income, (= income after i.e. there is no change in the quality or function of either good.
taxes and including any welfare benefits and such), will increase Consumers are simply substituting one good with another.
the demand for normal goods. In the example of Swiss watches,
this will cause a shift in the demand curve to the right, from D0 Other examples of substitute goods are rail travel and bus
to D2 in Figure 4.5, i.e. more watches are demanded at all prices. travel, apples and pears, or, to be most product-specific, Pepsi
(SFR = Swiss francs.) and Coke11 . (Many textbooks give tea and coffee as examples,
which I find to be utter nonsense – but then I am heavily

MICROECONOMICS
I’d best add a brief note on ‘abnormal’ behaviour within the addicted to coffee. Nothing substitutes coffee in my book.) A
context of the income effect. The goods exemplified above recent example of the power of substitutes arose in 2010 when
are normal goods as the norm (= custom) is for demand to demand for US grain rose more than 14% due to drought and
increase when income rises. However, it is possible that demand subsequent price increases in two of the largest grain producing
for some goods might actually fall when incomes rise simply countries, Russia and Ukraine.12
because a rise in income will change households’ preferences –
increased income could cause households to substitute certain Complement goods: Now, how would one go about buying one
goods with other, more preferred goods. Such goods are called of the DVD or Blu-Ray players? Being an economist, you would
inferior goods, possible examples of which are public transport look at the total (“bundle”) price of usage, in other words the
and potatoes. We return to this issue in Chapter 11. price of the player and the discs – either for recording or playing.
These two goods are in joint demand, commonly referred to as
complement goods. The two are a ‘package deal’ basically, as
one is useless without the other. Being complementary to each
other, a change in price of one good will affect demand for the
other. Should Blu-Ray discs increase substantially in price, one
can expect demand for Blu-Ray players to decrease (D0 to D1 in
Figure 4.5).

Other standard examples of complement goods are tennis

balls and tennis racquets, film and cameras, and staples and
staplers.13 Note that all complement goods are often not as ‘joined-
at-the-hip’ as my example, but are as often as not quite weakly
connected via preferences and habits.14 I often give the examples
of Cognac and cigars, strawberries and cream, and mustard and
pea soup. I bet that last one caught your attention. Yes, in Sweden

11 My students disagree with me most adamantly here! Me, I

Price of other goods failed the ‘Pepsi Challenge’.
12 “Wheat, Corn Stockpiles Dwindle After Russia’s Drought” BW
Substitute goods: When two goods are in competitive demand 25 – 31 Oct, 2010
they are said to be substitutes – and thus a rise in the price of one 13 How about tequila and writing economics?! Try reading the
good would cause an increase in demand for a substitute. There footnotes….
14 Here in Mexico, a bill clip holding one’s driving license and a
are a number of new formats for recording and viewing movies
100 peso note (circa USD9) are complement goods – if you
at home, the most recent are the formats Blu-Ray and HD DVD need to show your license to one of Mexico’s finest you’ll also
which look to compete with the standard DVD system.10 When need a “mordida”, i.e. a bribe to get you on your way. Commonly
the license and the bill are handed over together. Also, drinking
10 I actually wonder if Blu-Ray will take off – the picture is too and driving are not substitutes but complements. This is the
good! A goodly number of my students agree that the picture sort of comment that apparently caused my colleagues to start
sharpness is a bit staggering. I think my initial comment was betting on my life expectancy here. Nobody has me down for
something like “It’s too real…like viewing the world sober. I’m more than four years. When the colleagues say goodbye to me
not sure I need more reality.” on Fridays, they say it with depth and mean it.
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one customarily puts a dollop of mustard in one’s bowl of pea Please note that expectation is one of many possible variables
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soup. I added this example to illustrate the cultural dimension which will have an impact on demand. Expectations are
of many complement goods – just think of French fries with noteworthy in the light of stock market downturns during
ketchup (USA), French fries with vinegar (England) and French 2008/9. It doesn’t require a degree in rocket surgery to
fries with mayonnaise (Belgium). Here in Mexico, lime juice is understand that when people expect certain things to happen
a complement to…well, anything in the way of food!15 Oh, so is in the future, it can well affect their demand in the present.
chilli!16 As house buyers saw prices fall they held off on new house
purchases – which led to a decrease in demand. This has led to a
Tastes and preferences ‘self-fulfilling prophecy’. As housing prices fell, people expected
this to continue. As consumers waited for a further fall in
“The Atkins diet was a nightmare for the prices they actually held off on new housing purchases. This
MICROECONOMICS

consumer, but also for us.” (Guido Barilla, chairman

meant that demand fell… and that prices fell as an effect! This
of Barilla Pasta, Economist, Jan 20th 2007)
self-reinforcing negative feedback loop has proven immensely
Consumers are often persuaded to buy certain goods by peers, powerful for overall demand in the US economy since so much
fashion and advertising – and I’d hate to say which of these is of household wealth is tied to property. As (perceived) wealth
the strongest in terms of the Atkins diet. What if we instead of home-owners declines, so too will demand for goods.18
look at the amazing life expectancy of the Greeks who have one
of the highest average life spans in Europe – in spite of having Any time people expect things to happen within a foreseeable
one of the highest European proportions of smokers in the future time period, demand will be affected. If future prices
population and one of the lowest levels of physical exercise! The are expected to rise, peoples’ present demand might rise; if the
answer, according to research, lies in the use of healthy olive future value of shares on the stock market is expected to rise,
oil. A successful advertising campaign would increase demand speculators’ present demand for shares might rise; and if taxes
for olive oil, shifting the demand curve to the right (D0 to D2 in on property are expected to fall in the future, present demand
Figure 4.5). Our tastes can also change as the result of intellect for property might rise. A recent example of speculatively
rather than emotions; cigarette smoking is declining in most driven demand is the price of guns in the US during 2009 due
developing countries as the health issues become better known. to expectations that President Obama was going to pass stricter
legislation on arms sales.19 An extreme example of the power
Expectations of expectations occurred in Japan during the autumn of 2010
when the government passed laws for much higher taxes on
The strength of expectations is difficult to overestimate. So cigarettes and Japanese smokers hoarded billions of dollars
much of our behaviour is directly related to what we hope/ worth of cigarettes before the tax hike came into effect.20 This
expect/want to happen. Just imagine how house buyers would actually had an effect on national income – perhaps adding
react if a major highway were to be built right through the as much as 1.4 percentage points21 to national income.
neighbourhood they were looking at. Demand for the houses
would drop like a paralysed parakeet due to the expectation of
falling future property prices.17

15 I wonder if I can get away with including my favourite drink

recipe. I know; “Dear colleague, Take a dark beer (not the
English stuff – real beer) and pour into a large mug with two mention that the 2008-10 liquidity/credit/housing/stock
limes worth of juice and chili. Coat the rim of the mug with market crisis was strongly linked to speculative buying on the
salt and chili. Now you have a delicious “michelada cubana”!” housing market during the early 2000s.
Salud! 18 This is known as the “wealth effect” and has a very powerful
16 I love putting forth absolutely insane business ideas. One of influence on the macro environment.
these, which unfortunately came to me in an Energy Drink- 19 ‘Gun sales decline as fear of curbs fades’, Business Week May 24
induced vision blazed across the whiteboard while teaching – 30
and subsequently was worded out loud, was “chilli flavoured 20 “Japan enjoys a nice, if fleeting, nicotine buzz” Business Week,
condoms”. After the shrieks died down, one of the young ladies Oct 4 – 10
– with a look of complete seriousness – asked; “Em, Matt, 21 It is important that you understand the difference between
flavoured on the inside or outside?” God I’m old. “increase in 1.4%” and ”increase in 1.4 percentage points”. If
17 This example of a ‘self-fulfilling prophecy’ is a notable element GDP (national income) is projected to grow by 3.5% and there
in speculative behaviour and possibly resulting in an upward is an increase of 1.4%, then this means a GDP increase of
sloping demand curve – which is a HL concept. I should 3.549% (3.5 × 1.014). However, an increase of 1.4 percentage
30 points means 3.5 + 1.4, i.e. 4.9%.
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Population size and structure Putting the pieces together; oil and silicon
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An increase in population causing an increase in demand During 2007 and 2008, several economic commentators noticed
should be relatively plain. Yet there are also demand changes how the increase in oil prices led to an increase in demand for
caused by a change in the structure of the population. For silicon. Confused? It’s really quite simple and deals with some of
example, increased immigration will change the demand for the issues outlined above, namely substitutes and derived demand.
certain types of food; age structure will change the demand
for goods such as baby food or pensioners’ homes; income • As the price of oil increased dramatically, households
and wealth re-distribution in a country will affect demand for started to look to possible substitutes.
income sensitive goods, and so on.
• Oil is used in many industries, one of which is

MICROECONOMICS
Derived demand energy. As energy costs for households rose, possible
substitutes became more and more economically
When demand for a good, say cars, increases then factor inputs viable (= possible).
such as steel will see an increase in demand. We say that the
demand for steel is derived from the demand for cars. Derived • One of the substitutes for oil in the field of energy is
means ‘to be based on’ or ‘have its source in’. The concept is rather solar power. Thus, demand for solar panels increased
useful in understanding the interrelationship between goods drastically…
that don’t fall precisely into the category of complement goods.
Derived demand is commonly associated with production, • …and since silicon is used in the manufacturing of
where firms using any number of products as inputs will affect solar panels, the derived demand for silicon rose and
demand for said inputs. Continuing with the example, car led to a tenfold price increase during 2007/2008.
manufacturers use steel, rubber, plastic, glass…etc. A fall in the
demand for cars will affect car manufacturers’ demand for all
of these inputs. During 2009/’10, rampant increase in Chinese
demand for copper and iron from Australia and Brazil led to On a personal note, I saw the writing on the wall early on in 2007
increased demand for Caterpillar mining machinery from the and bought shares in Vesta, a Danish company manufacturing
US manufacturer – a clear example of derived demand.22 wind power generators. Sometimes you win. Then oil prices fell
drastically during 2009 and these shares bombed. Sometimes
One of my favourite examples of derived demand is currency, you lose.
say the Namibian dollar, the demand for which is derived from
the demand for tourism in Namibia; demand for Namibian
exports; and the demand for investment in Namibia. Note that
the causal flows can be reversed! Here in Mexico we receive
a great deal of American tourists and when the US dollar
appreciates (= increases in value compared to the Mexican
peso) American tourists get more pesos for their dollar.
Consequently, the US demand for hotels in holiday resorts such
as Acapulco increases.

22 “Stocks, copper rise, Treasuries drop..”, Business Week 1 Sept

2010
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HL extensions
HIGER LEVELSA LOW
P ($) Qd Calculation
0 4,000 Qd = 4,000-20 × 0; 4,000
M

50 3,000 Qd = 4,000-20 × 50; 3,000

In this HL section you will address a simple linear demand
100 2,000 Qd = 4,000-20 × 100; 2,000
function and learn how the demand curve shifts and changes 150 1,000 Qd = 4,000-20 × 150; 1,000
slope. 200 0 Qd = 4,000-20 × 200; 0

Linear demand function (Qd = a – bP)

The demand curve plots out how a change in price causes a It is conventional in Economics to plot Q (supply) on the
change in the quantity demanded. Since the demand curve is horizontal and P (price) on the vertical axis. To meet with the
downward sloping, price and quantity are negatively correlated. mathematical conventions of graphing functions, we will quote
MICROECONOMICS

We shall use the following form for our demand function: each function as a ‘P =’ function as well as a ‘Q =’ function so
that the slope may defined in the usual way as ‘rise over run’.
Qd = a – bP
Thus the demand function of this example:
Qd: quantity demanded
Qd = 4,000 – 20P
a; is the autonomous level of demand (e.g. unrelated to price
changes) – this is the Q-axis intercept may be transposed:

b: is the responsiveness of consumers to a change in price – this is 20P + Qd = 4,000 (by adding 20P to both sides)
the slope
20P = 4,000 – Qd (by subtracting Qd from both sides)
P: price
P = 200 – ¹/₂₀Qd (by dividing both sides by 20)
We basically see that Qd is a function (‘a result of a change in’)
the price of the good; ∆P → ∆Qd. Assume that our D function Using conventional mathematical theory, the slope of this curve
is Qd = 4,000 – 20P is – ¹/₂₀ meaning that for every increase in Q of 1 unit, there is a
reduction of price of ¹/₂₀ (or an increase of 1,000 in Q results in
• At P(0) Qd will be 4000 units a $50 reduction in price.
• At P(200) Qd is zero units

Qd = 4000 – 20P every unit increase in P

leads to a reduction of 20 units in Qd
P OR
+ 1600 units P = 200 – ¹/20Qd every unit increase in Qd
leads to a reduction of ¹/20 units in P
–80 units

Slope of P relative to Q =
–80÷1600 = –1/20

Slope of Q relative to P =
1600 ÷ –80 = –20

Figure 4.6

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Shifting the demand curve
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P Qd Calculation
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0 5000 Qd = 5,000-20 × 0; 5,000

50 4000 Qd = 5,000-20 × 50; 4,000

HIGER LEVEL
Recall that our demand function is Qd = a – bP. Any change in a
100 3000 Qd = 5,000-20 × 100; 3,000
non-price will shift the demand curve. Assuming that demand
150 2000 Qd = 5,000-20 × 150; 2,000
increases, this in fact means that quantity demanded increases
200 1000 Qd = 5,000-20 × 200; 1,000
at all price levels. This is a change in autonomous demand (‘a’).

Assume that the new D function is Qd = 5,000 – 20P…

Note that every incremental increase in price of $50 still leads to
or P = 250 – ¹/₂₀Qd a decrease in Qd of 1,000 units – e.g. the slope has not changed.

MICROECONOMICS
• At P(0) Qd will be 5,000 units

• At P(250) Qd is zero units

Qd
Qd =5
=4 ,00
,00 0–
0– 20P
20P or
or P=
P= 250
200 – ¹/
– ¹/ 20Q
20Q d
d

Figure 4.7
Changing the slope of the demand curve
Changing the slope from 20 to 15
So, our original demand function is Qd = a – bP which is Qd
P Qd Calculation
= 4,000 – 20P. If the slope changes from 20 to 15, e.g. Qd = 0 4000 Qd = 4,000-15 × 0; 4,000
4,000 – 15P … 50 3250 Qd = 4,000-15 × 50; 3,250
100 2500 Qd = 4,000-15 × 100; 2,500
o The slope becomes steeper 150 1750 Qd = 4,000-15 × 150; 1,750
200 1000 Qd = 4,000-15 × 200; 1,000
o The D-curve will intercept the P-axis at….23

23 Stick in Qd = 0 into the formula; Qd = 4,000 – 15P → 0 = 4,000

– 15P → 4,000/15 = 266.67
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Changing the slope from 20 to 30 and decreasing demand
HIGER LEVELSA LOW

If demand decreases and the slope also decreases…

P Qd Calculation
M

0 3000 Qd = 3,000-30 × 0; 3,000

• The new function is Qd = 3,000 – 30P (P = 100–¹/₃₀Qd) 50 1500 Qd = 3,000-30 × 50; 1,500
100 0 Qd = 3,000-30 × 100; 0
Any change in a non-P variable can affect both ‘a’ and ‘b’ in the D 150 -1500 Qd = 3,000-30 × 150; -1,500
function 200 -3000 Qd = 3,000-30 × 200; -3,000
Any change in a non-P variable can affect both ‘a’ and ‘b’ in the D
• A change in ‘a’ means that demand has changed … (i.e. function
a change in a non-P variable!)
• A change in ‘a’ means that demand has changed … (i.e.
• And a change in ‘b’ means a change in the responsiveness a change in a non-P variable!)
MICROECONOMICS

to a change in price (as in slope) • And a change in ‘b’ means a change in the slope of the
demand curve (this is related to the sensitivity of the
good in terms of a change in price – see price elasticity
of demand in Chapter 9)

Qd
=4
,00
0–
Qd 15
=4 Po
,00 rP
0– =2
20P 67
or –1
P= /15
200 Qd
– 1/
20Q
d
Qd
= 3,
000
–30
P or
P=
100
– 1/3
0Qd

Figure 4.8

POP QUIZ 4.1 ii. The P-intercept is ‘a’ / ‘b’; 200/2 = $100

iii. The slope is 2; for each $1 increase in price, Qd

Note that calculations such as you will do in supply and demand decreases by 2 units
will return several times in later sections.
2. Make a simple table showing the Qd when P=200, 150,
1. Assume a demand function of Qd = 200 – 2P. This tells 100, 50 and 0.
us that:
3. Illustrate these values (pairs) in a diagram, e.g. draw a
i. The Q-intercept, ‘a’, is 200 units demand curve.

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4. Draw a new demand curve based on the price of a 7. Market demand: sum of all individual demand
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complement decreasing – this leads to a 20% change in

HIGER LEVEL
demand for our good but no change in slope. 8. Downward sloping demand curve has two causes:

5. Draw another demand curve in the same diagram a. Income effect – a decrease in the price of a good
showing that the price sensitivity of the good increases, means real income rises for consumers who then
e.g. the slope changes. For each $1 increase in price, the can buy more of the good
Qd decreases by 3. (Q-intercept remains unchanged.)
b. Substitution effect – a decrease in the price of a
good (ceteris paribus) means that the relative price
of substitutes has risen so consumers substitute

MICROECONOMICS
a quantity of other goods for the lower priced

Summary & revision

alternative

9. A change in price leads to a movement along the demand

Demand curve

1. Markets are a very efficient way of satisfying wants/ 10. A change in a non-price variable affecting demand leads
needs in society and allocating resources via the price to a shift in the demand curve
mechanism. Decrease in demand Decrease in quantity
caused by a demanded caused by
non-price demand an increase in price
2. Four main market types are identified:
variable

a. Perfectly competitive markets – many small

firms producing homogeneous goods and low P D0
barriers to entry for other firms D1
D2
b. Oligopoly markets – a few large firms dominate
Decrease in Increase in
the market where entry barriers are high
demand demand

c. Monopolistic competition – many firms compete

on a market with relatively low barriers to entry
for differentiated (branded) goods

Q/t
d. Monopoly – one firm controls the market and Increase in quantity Increase in demand
barriers to entry are very high demanded caused by caused by a
a decrease in price non-price demand
3. Law of demand: an increase in the price of a good –
ceteris paribus – will lead to a decrease in the quantity
demanded NOTE:
This and several subsequent chapters refer to plotting graphs
4. Ceteris paribus: all else equal, nothing else changes and finding their slope. This topic is covered in more detail in
a free downloadable set of resources. To get these, go to the
5. Effective demand: the quantity of a good consumers are author’s website http://www.goodbadecon.com/
willing and able to purchase at different prices during a
given time period The resource can be found under ‘Slope’.

6. Individual demand: the willingness/ability of an

individual consumer/firm to buy goods at different
prices during a period of time
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Key concepts:
• Law of supply and correlation between price and quantity supplied
• How individual firms’ supply comprises market supply
• Introduction to basic market model; upward sloping supply curve
• Non-price determinants of supply
• Movement along vs. shift of supply curve

HL extensions:
MICROECONOMICS

• Linear supply function; Qs = c + dP

• Shifting the supply curve, e.g. a change in “c”
• A change in the slope of the supply curve , e.g. a change in “d”

Law of supply

O
ne of the hippie credos of my troubled childhood As so many issues in economics, this is intuitively obvious. An
was the T-shirt legend, ‘What if they gave a war and increase in the market price (for whatever reason) increases the
nobody came?’ This is like saying that a good has been propensity of suppliers to put the good on the market. There
provided but there is no demand for it whatsoever. There is no are a few simple reasons for this – all of which deal (once again)
such thing; in order to be able to refer to a market, there have to with the willingness and ability of suppliers to put goods on
be both willing buyers and willing sellers. One might actually the market. Just as was done in the section on the demand
say that demand creates supply. curve, it is necessary to clarify that supply is not the amount
that suppliers would like to supply, but rather the quantity they
The supply curve operates along the exact same parameters as intend to sell (= are willing and able to sell) during a given time
demand. A change in price will – ceteris paribus – result in a period.
change in the quantity supplied. As in the pattern of demand,
there is clear correlation as long as other influencing factors
remain the same. This is the law of supply, and differs from
demand in having positive correlation – when the price rises,
ceteris paribus, the quantity supplied increases and vice versa.

Definition: ‘Law of supply’

“Ceteris paribus, a rise in the price for good X will
result in an increase in the quantity supplied
of good X. A fall in the price of X will result in a
decrease of quantity supplied.”
The law of supply states that as long as all other
variables (the cost, availability and quality of
factors of production) remain unchanged, then a
rise in the price of a good will lead to an increase
in the quantity supplied.

Figure 5.1: Unwilling seller!

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Individual supply curves for DVDs Market supply
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Firm A Firm B Firm C curve for DVDs

SA SB SC Smkt
150
P (MXN/DVD)

50

2 6 2 8 4 10 8 24

MICROECONOMICS
Q/t (1,000s DVDs/week)

Figure 5.2: Individual supply and market supply for DVDs in Naucalpan

Individual firms and the market supply An increase in the price, ceteris
curve paribus, from MXN100 to MXN150
causes a movement along the

P (MXN/DVD)
supply curve from A to C. This is
Just as market demand is derived (= developed) from the termed an increase in quantity
individual demand curves, so too is the market supply curve. supplied.
Continuing with the simple example of a market for DVDs, let
us assume there are three firms on the market selling DVDs. C Smkt
150

In Figure 5.2, each of the firms has an individual supply curve.

A
Firm A is able and willing to put 2,000 DVDs on the market 100
at a price of MXN50 and 6,000 at a price of MXN150. The
supply curves for Firm B and C show, respectively, 2,000 DVDs
B
and 10,000 at these two prices. Summing up horizontally, the 50
market supply curve shows that firms on the market will supply
a total of 8,000 DVDs at a price of MXN50 and 24,000 at a price
of MXN150. 8 16 24
Q/t (1,000s DVDs/week)
A decrease in the price, ceteris paribus,
Upward sloping supply curve from MXN100 to MXN50 causes a
movement along the supply curve from
In Figure 5.3, if the price of DVDs rises from MXN100 to A to B. This is termed a decrease in
quantity supplied.
MXN150, the quantity supplied increases from 16,000 DVDs to
24,000 per week. This is in accordance with the law of supply; a
Figure 5.3: Market and upward sloping supply
higher price creates an incentive (the possibility of higher profit)
curve
for producers/suppliers to put more of the good on the market.
We once again use the ceteris paribus assumption when drawing Let’s look more closely at the issue of the upward slope of the
the supply curve. However, it is not incomes, preferences and supply curve for DVDs in Naucalpan, Mexico. It is almost
other goods’ prices that are kept constant (as we did in drawing intuitive that higher prices would cause existing stores to
the demand curve) but the price, availability and quality of increase available stocks of DVDs. There are two reasons for
production factors which we assume to be constant. (There this positive correlation.
are also various forms of government intervention which affect
supply. More later.) • The first is that a higher ticket price might add to
firms’ revenue (price times quantity), and perhaps also
additional to profit (total revenue minus total costs –
more in later chapters). Thus, if the market price rises
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suppliers will have an incentive to put more of the which means, using correct economic terminology, that ‘…
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good on the market. In the case of DVDs, sales outlets the quantity supplied increases...’ Accordingly, a decrease in the
(suppliers) will order more stocks of DVDs from price from MXN100 to MXN50 is a movement along the supply
regional wholesalers and put more DVDs on their curve from point A to B – the quantity supplied has decreased
shelves. from 16,000 DVDs per week to 8,000.
• The other reason why an additional quantity is supplied
at a higher price deals with the costs of producers. (A Shifts in the supply curve
key issue here are rising marginal costs, a HL concept
in Chapter 23, Theory of the Firm.) It is easy to As will be done in some depth further on, any change in the
understand that different suppliers have different cost price, availability, quantity and quality of factors of production
levels. If the market price is MXN100 and the cost to will cause a change in supply – e.g. a shift in the supply curve.
MICROECONOMICS

a supplier in getting hold of an additional DVD to sell Figure 5.4 below shows that any change in a non-price variable
is MXN101…then basically the supplier would lose off supply causes a shift in the supply curve.
MXN1 for an additional DVD and it would not be
provided. Now, if the market price rises to MXN102,

An increase in labour costs or
then the supplier would not only be willing but able to expectations of falling demand in
provide the additional DVD. the future (non-price variables of
supply) leads to a decrease in
supply for DVDs. This is shown by a
leftward shift of the supply curve.

WARNING !
P (MXN/DVD)
S1 S0 S2

Law of Supply P0

Important note: ‘Supply’ is NOT the same as ‘quantity in

existence’!!! It is most important that you understand at an
early stage that having 200 tonnes of cheese in a storage room is
not the same as 200 tonnes being on the market. You see, if the
producer of the cheese in question is simply storing the cheese Q1 Q0 Q2
then it is not actually offered on the market. It is not part of Q/t (1,000s DVDs/week)
supply. It will become part of supply if the market price of this An increase in income (a non-price
variable of demand) leads to an
cheese increases to the level where the producer decides that it increase in demand for DVDs. This
is not worth storing anymore and offers it for sale. is shown by a rightward shift of
the demand curve.

Thus: oil in an oil-field is NOT part of supply; oil in a cistern Figure 5.4: Shifting the supply curve for DVDs
which is offered to a petroleum company IS part of supply.
Schools of tuna fish are NOT part of supply; when tins of tuna
held in a warehouse are offered to the supermarkets they ARE Non-price determinants of supply
part of supply.
Just as in demand, there are “other variables” affecting supply
within the ceteris paribus assumption. These are non-price
determinants of supply. Any change in a non-price determinant
Movement along vs. shift of supply curve of supply means that the pattern of supply changes – shown
by a shift of the supply curve. Profit incentive and covering
In Figure 5.3 above, assume that the initial price is MXN100 increasing (marginal) costs explain why the supply curve is
and thus that quantity supplied per week is 16,000 DVDs. If upward-sloping and (just as in the pattern of demand) there are
the price increases to MXN150, then the quantity supplied a number of non-price determinants of supply, all of which will
increases from 16,000 DVDs per week to 24,000. This is shown shift the supply curve.
by a movement along the supply curve, from point A to C,
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Price of related goods: Producers will have any number of
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Definition: ‘Non-price determinants of supply’

possible producer substitutes (not to be confused with consumer
Any variable that changes the pattern of supply
substitutes!) such as DVDs and Blu-Ray discs. An increase
other than price is a non-price determinant of
in demand/price for Blu-Ray discs might cause suppliers to
supply. Changes in the price, availability, quality
and quantity of factors of production will all have reallocate (= shift) resources from the production of DVDs to
an effect on the supply of goods. Blu-Ray discs, causing the supply of (the producer substitute)
DVDs to decrease from S0 to S1 as shown in Figure 5.4.
The non-price determinants of supply can be divided into four
main categories: Another possibility is that producers have goods that are in
joint supply. An example would be gold and copper which
1. Changes in relevant market factors: these are costs of are often found in the same geological veins and pockets. An

MICROECONOMICS
factors of production; price of related goods (producer increase in the price of gold would lead to an increase in the
substitutes); firms’ expectations; and market entry/exit quantity supplied of gold (a movement along the supply curve
for gold) which in turn would increase the supply of copper,
2. Changes in availability/scarcity of factors of production: illustrated by the rightward shift in supply (S0 to S2) in Figure
these include reserves of natural resources; weather and 5.4, In a similar vein (pun intended), a decrease in the price
climate changes; natural disasters of beef would lead to a decrease in the quantity supplied of beef
(movement along the supply curve for beef) and therefore also
3. Changes in the quality/quantity of factors of a decrease in the supply of leather (shift left of the supply curve
production: factor inputs improve over time due to for leather).
improved production methods; technological advances,
and advances in materials • The expectations of firms: If firms expect a surge in
demand, such as seasonal demand for tourism, they
4. Market intervention (non-market variables) by might actually increase supply of, say, rental cars in
government such as taxes and subsidies. order to build a sizable stock for the coming increase
in demand. Figure 5.4 shows how anticipation of the
1. A change in relevant market factors tourist season in Cancun, Mexico, could lead suppliers
of rental cars to increase supply from S0 to S2.
Cost of factors of production: Any increase in costs to suppliers
will mean that the cost of producing goods will increase. This • Market entry/exit: If existing firms on a market are
lowers the ability and willingness of suppliers to put the goods making a profit, newcomers might be attracted. As
on the market (since they cannot influence the market price) firms enter the market, total supply of goods will
and producers will respond by decreasing output. Decreased increase. This is often the case for new products, where
raw material prices, lower labour costs and lower rents would all the success of the iPhone resulted in a rapid increase
cause production costs to decrease and supply to increase. Thus, in “copycat” (= similar, copied) products. In the same
if wages or salaries rise, then the workers used in production way, if an industry becomes less profitable then firms
become more costly whereupon producers will decrease output will leave the market, decreasing supply, for example
– e.g. the supply curve shifts left. Substituting ‘Swiss watches’ the decline in the Swedish ship-building industry in
for ‘DVDs’ in Figure 5.4 illustrates how an increase in labour the 1980s caused by far more competitive ship-builders
costs for Swiss watch manufacturers would cause a shift in the in Korea. (S0 to S1 in Figure 5.4).
supply curve to the left, from S0 to S1, i.e. fewer watches are
supplied at P0 and at all prices.1
2. A change in the availability/scarcity of factors
1 I did not use labour costs as an example randomly! Raw of production
material costs – even such precious metals as gold and
platinum – represent a fraction of the final value of a good • Availability and scarcity of factors: Any and all
Swiss watch. Perhaps the most complicated watch in the world, factors used in production are subject to relative
“Calibre 89” made by Patek Philippe for its 150th anniversary scarcity. Should factors become more available or
in 1989, contains 1728 parts, and had four people working on it
abundant, then the same market laws will apply to
for nine years (!) measured from initial research/design to final
completion. When I get the required USD6 million together them, i.e. scarcity will raise the price of any given factor
from book sales I’m going to get one. of production. Studies show that during the end of
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the decade, teachers in Sweden will be retiring at a again faced starvation according to the FAO3 due to lower than
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rate far beyond the rate of replenishment via teacher normal rains and poor harvests.
colleges. This will decrease the supply of teachers – and
hopefully raise the salaries of those of us who remain
in the profession2. As for tangible (= physical) goods,
3) A change in the quality/efficiency of factors of
suppose that the existing diamond mines in Botswana,
production
Namibia, South Africa and Russia start to peter out
(= diminish). This would mean that there would be • The quality of factors of production: Anything
less diamonds available no matter what we are willing which enables a producer/supplier to put more on the
to pay for them. While there is a nifty Swedish firm market without increasing costs means that supply
selling jewellery made from elk excrement, I don’t increases, i.e. the supply curve shifts to the right. Better
MICROECONOMICS

envision this being a viable substitute in the context production methods and/or a more educated and well-
of weddings. trained labour force would increase output during any
given time period. This is an increase in the efficiency
• Force majeure, unexpected events: Disruptions in use of factors – enabling the subsequent increase
such as earthquakes, fires, floods and other natural in productivity. Production techniques (division of
disasters can have significant effects on the supply labour for example), advancing technology (computer
of goods – not only agricultural goods but all goods assisted design and computer assisted manufacturing
needing transport. Look at the frequent disruptions to – CADCAM to name but one), new and improved
oil supply; every time there is a terrorist attack (Iraq; materials in production (any number of ceramics), and
blown up pipelines), flood (Mexico; workers can’t get of course anything dealing with increasing knowledge,
to the off-shore wells) or hurricane (Texas; destroyed research and development (R & D), education,
oil refineries) there is a resulting decrease in the supply training….etc.
of oil and petroleum products.
• Technology: Better tools, production processes,
materials, computer assisted design and computer
assisted manufacturing – CADCAM …etc, are all
elements of advancing technology which increase
output per unit of time, which is the same as increasing
supply. For example, it now takes General Motors in
North American an average of 24.4 hours to assemble
a vehicle – 6.4% shorter time than the year before.4

4. Market intervention – taxes and subsidies

In addition to the forces arising from within the market itself,
there are also forces which can be said to be imposed from
without, i.e. market intervention by government. Two common
Hurricane Frances gathers force in August 2004.
ways for governments to intervene are by imposing an indirect
The photo was taken from the International Space
Station. tax5 on goods or subsidising goods. An indirect tax – an
expenditure tax – such as value-added tax (VAT) on goods sold
In the same mode, an increase in the supply of factors will is a percentage increase of the sales price of the good and will
both increase availability and lower the costs for producers. in effect be an increase in costs for producers, thus decreasing
Just imagine how the discovery of new oil fields would help supply. A subsidy is the opposite, a payment to producers (often
suppliers all around the world by lowering the dependency on 3 Food and agricultural organization of the United Nations.
the oil cartel, OPEC. Another thing mentionable in this context 4 US carmakers’ efficiency rises..., Business Week 30 June 2003
is the effect of weather conditions on agricultural output. 5 Indirect taxes are taxes which indirectly go to government,
since VAT is paid to the suppliers who then in turn transfer
During 2008 tens of thousands of people in Ethiopia once
the taxes to government. A direct tax is income and profit
(corporate) tax, since this goes directly to government. We get
2 Maybe I should put in an advance order on a new Rolex. shafted either way.
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per unit of output, for example per tonne of wheat) which The price of oil is at P0 and rises to P1; the quantity supplied of
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lowers producers’ costs (HL: marginal costs) and also acts as oil increases to Q1. Now, assume that:
an incentive to produce more. This increases supply. (More in
Chapters 13 and 14.) 1. Oil production starts to reach maximum (short run)
output potential, and

2. Oil producers have a level of target revenue, i.e. an

Definition: ‘Indirect tax” and ‘subsidy’
aimed-for level of oil revenue.
An indirect tax such as an expenditure tax
is added to the price of the good and causes
Two forces kick in which in fact might cause oil suppliers to
suppliers to increase the price at all levels of
supply. The supply curve shifts left. decrease the quantity supplied; expectations of higher future oil

MICROECONOMICS
prices and limited investment alternatives.
A subsidy is a payment or money grant to
suppliers. This works as an incentive to produce
more and also lowers (marginal) costs of Expectations: Assume that suppliers are satisfied with the oil
production. The supply curve shifts right. revenues at P1. This is the area given by P1 × Q1. A rise in price
to P2 means that suppliers can in fact decrease quantity supplied
on the oil market (Q2) while retaining the target revenue. (The
loss of revenue – grey area – is equal to the gain in revenue

OUTSIDE shown by the green area.) If suppliers expect oil prices to remain
high or continue upwards, they have an incentive to hold off on
increasing capacity and supplies – they can sell less and still

THE BOX make at least the same revenue in the future.

Investment alternatives: Oil is a finite resource. Any oil left in

‘Mermaidomics’ revisited – the ground is a form of investment. Basically, by leaving the
oil in the ground and – in line with the expectations-based
‘backward bending’ S-curve?! argument above – betting on permanently higher oil prices,
During the speculative oil price shock of 2007/’08, several producers have “invested” in future oil revenues. As suppliers
economic commentators observed that oil suppliers in fact had are reaching maximum short run output levels at P1, increasing
an incentive to decrease output of oil as the price rose. This costs of extraction above P1 simply might lead suppliers to hold
seemingly contradicts economic theory, yet in fact it can be off on production increases.
explained quite logically.
With help from http://web.mit.edu/krugman/www/opec.html
S Revenue gain

P2

P1
P ($/barrel)

P0 Summary of supply shifts

Revenue loss
By now you should be accustomed to the methodology I use
in explaining concepts. I try to follow a ‘define – exemplify –
context’ formula, which I realise is both time consuming and
frequently tiresome. Therefore, I shall simplify the iteration of
Q0 Q1 changes in supply by using the nine additional examples used
Q/t (barrels/month) previously in a table below and labelling them accordingly in
Figure 5.6.
Figure: 5.5 Supply of oil

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1. A change in the relevant market factors
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Example: Effect: Supply will: In fig: 5.6

a) wages for road workers fall → cost of making roads falls supply curve for roads shifts right S0 to S2

b) price of steel rises → cost of making cars rises supply curve for cars shifts left S0 to S1

c) price of flour falls → cost of making bread falls supply curve for bread shifts right S0 to S2

2. A change in the availability/scarcity of factors of production

Example: Effect: Supply will: In fig:5.6
MICROECONOMICS

supply curve for health care shifts

d) fewer study medicine → fewer doctors in hospitals S0 to S1
left
e) pilots go on strike → fewer flights available supply curve for air travel shifts left S0 to S1
supply curve for electrical wire
f) new copper deposits found → more copper available S0 to S2
shifts right

3. A change in the quality/efficiency of factors of production

Example: Effect: Supply will: In fig:5.6
→ industrial production is
g) increased use of robots industrial supply curve shifts right S0 to S2
faster
supply curve for most goods shifts
h) better basic education → all labourers more efficient S0 to S2
right
→ most production more supply curve for most goods shifts
i) IT revolution S0 to S2
efficient right

4. Non-market variables, i.e. intervention

Example: Effect: Supply will: In fig:5.6
j) increased restrictions on → fewer sales outlets for
supply curve shifts to the left S0 to S1
cigarette sales cigarettes
→ firms must pay a portion of
k) taxes on gasoline are increased supply curve shifts to the left S0 to S1
sales revenue to government
→ milk producers have an
l) a subsidy is granted for the incentive to produce more
supply curve shifts to the right S0 to S2
production of milk milk and production costs
decrease

S1 S0 S2

a)
P (...)

b)
d) c)
f)
e)
g) Figure 5.6
j)
h)
k) i)
l)

Q/t (...)
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What we now need to do is put the supply and demand curves preferably equipped with a hot computer, cold bar, colour TV,
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together in the same diagram, in order to be able to analyse sofa and view. Or relieving me of the need to attend mind-
market behaviour. It bears repeating: nothing done so far has numbing teachers meetings in the study hall?!C Or extending
equipped you with the necessary tools to do a market analysis! all my vacations?! Or giving me complete and utter power over
For this you need supply and demand working together, not the all the language teachers at school?!
separate (purely explanatory!) graphs done thus far. Let’s put it
all together people. You get the drift. This would mean more hours taught at all price
levels. This is shown in Figure 5.8. If, for example, I accepted
a better office rather than an increase in pay, I would provide
additional teaching service at the same price – increasing
my supply from S0 to S1. As the price hasn’t changed, and the
Putting the

MICROECONOMICS
amount of teaching hours supplied has increased, supply has
pieces together increased I have increased my willingness to supply teaching
hours at all prices.

Wage negotiations
S0

P (= salary)
A few years ago I had a horrendous row with my (then) boss.A
What the issue boiled down to was my unwillingness to accept S1
more teaching hours and more students without a substantial
rise in my salary.B Being me, I used a great deal of harsh
language – most of it in print – and started to pack my bags and P0
empty my computer. I was simply not prepared to give up any
more of my increasingly valuable (i.e. scarce!) free time without
increased remuneration (=payment). One could say that my
opportunity costs of teaching additional classes were increasing
and that I wanted my income to match this increased cost. This
Q0 Q1
would render Figure 5.6 below. (We are assuming that my
Q/t (hours of teaching per year)
supply curve would be ‘normal’, i.e. I would supply more labour
at a higher salary.)
Figure 5.8: Matt’s supply of teaching hours
P (= salary)

S
A I have in fact more ex-bosses than ex-wives.

P1 B A wage means ”x dollars per hour”, i.e. an amount of

money per labour hour. A salary is not based on an
P0
hourly rate but is a fixed sum per month. Auto-workers
get wages, teachers get screwed salaries.

C No wait – I didn’t attend those anyhow. Oh well.

Q0 Q1
Q/t (hours of teaching per year)

Figure 5.7: Matt’s supply of teaching hours

Of course it is possible! My school could entice me to supply
more teaching hours without paying me more – i.e. change my
overall willingness, ability and propensity to supply teaching
hours. Any suggestions? Perhaps giving me my own office –
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HL Extensions
HIGER LEVELSA LOW

units – which is silly in realistic terms but simply shows that

the supply curve will have a positive value on the P-axis, e.g.
M

suppliers have a ‘minimum price’ before they supply any units

at all on the market.
Linear supply function; Qs = c + dP
2,000
We now do the other hand – the upward sloping S-curve. Same ​ c  ​; _____
The P-intercept is given by __ ​   ​  = 50.
d 40
type of formula but we use other letters so as not to confuse
things with the D-function. Also, we will need to calculate Thus suppliers demand a minimum of $50 to put any units on
equilibrium later on so we will need four different letters for the market (At P=$50 Qs is zero units.) The constant ‘d’ is 40 –
the parameters – two for the demand function and two for the this tells us that for every increase in price of $1, suppliers will
supply function. be able and willing to put an additional 40 units on the market.
MICROECONOMICS

Figure 5.9 illustrates the initial supply curve.

Qs = c + dP

Qs: quantity supplied (at a given price)

Original: Qs = -2,000 + 40P
P ($) Qs Calculation
c; autonomous level of supply (e.g. unrelated to price changes) 0 -2,000 Qs = -2,000 + 40 × 0; -2,000
25 -1,000 Qs = -2,000 + 40 × 25; -1,000
d: is the responsiveness of quantity supplied to a change in price 50 0 Qs = -2,000 + 40 × 50; 0
– this is the slope 75 1,000 Qs = -2,000 + 40 × 75; 1,000
100 2,000 Qs = -2,000 + 40 × 100; 2,000
P: price

Qs + 2,000
We basically see that Qs is a function (‘a result of a change in’) The equation Qs = -2,000 + 40P transforms to P = _________
​   ​  or
 
Qs
___ 40
the price of the good; ∆↑P → ∆↑Qs. Assume that our (linear) P = ​   ​ + 50. It is in this form that the graph can most easily be
40
supply function is Qs = -2,000 + 40P – at P=0 Qs will be -2,000 plotted with P on the vertical axis and Qs on the horizontal axis.

P Slope = Rise ÷ Run = 25 ÷ 1,0000 = 1/40

Qs = -2,000 + 40P or P = 50 + 1/40Qs

Rise = 25

Intercept Run = 1,000

on Qs-axis

Qs

Qs
Figure 5.9 Supply curve for the function P = ​ ___ ​  + 50 (or Qs = -2,000 + 40P)
40
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Shifting the supply curve, e.g. a change in c
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Supply decrease: Qs = -3,000 + 40P
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P ($) Qs Calculation
0 -3,000 Qs = -3,000 + 40 × 0; -3,000

HIGER LEVEL
Any change in c will result in a shift of the demand curve,
shown in Figure 5.10: 25 -2,000 Qs = -3,000 + 40 × 25; -2,000
50 -1,000 Qs = -3,000 + 40 × 50; 1,000
• Decrease; if supply decreases by 1,000 units at each 75 0 Qs = -3,000 + 40 × 75; 0
100 1,000 Qs = -3,000 + 40 × 100; 1,000
price level, then there is a leftward (parallel) shift of the
supply curve and the Q-intercept is -3,000. If supply
decreases by 50% at all prices Supply increase: Qs = -1,000 + 40P
P ($) Qs Calculation
3,000 __
o The P-intercept is _____
​   ​ 
40 d (  )
 ​ ​ c  ​  ​= $75 0 -1,000 Qs = -1,000 + 40 × 0; -1,000

MICROECONOMICS
25 0 Qs = -1,000 + 40 × 25; 0
• Increase; if supply increases by 1,000 units at each 50 1,000 Qs = -1,000 + 40 × 50; 1,000
75 2,000 Qs = -1,000 + 40 × 75; 2,000
price level, then there is a rightward (parallel) shift of
100 3,000 Qs = -1,000 + 40 × 100; 3,000
the supply curve and the Q-intercept is -1,000.

1,000 __
o The P-intercept is ​ _____
 ​ 
40 d (  )
 ​ ​ c  ​  ​= $25

s
1/ 40Q
5+
=7
rP Qs
0Po + 1/40
0 +4 = 50 s
-3,00 o rP 1/40Q
s= 40P 5+
Q
0+ =2
0 rP
-2,0 0 Po
Qs
= +4
00
= -1,0
Qs
-3,000

-1,000

Qs
-2,000

Figure 5.10 Shifting the supply curve

A change in the slope of the supply curve , o An increase in price of 25 → ∆↑Qs of 1,250
e.g. a change in d
o An increase in price of 50 → ∆↑Qs of 2,500
A change in d will of course result in a change in the slope,
Figure 5.11: o The Q-intercept is still -2,000 but the

• Assume that the new supply function is Qs = -2,000 +

2,000 __
P-intercept is _____
​   ​ 
50 d (  )
 ​ ​ c  ​  ​= $40
50P or P = ¹/₅₀Qs + 40
• A supply function of Qs = -2,000 + 20P or P = ¹/₂₀Qs +
o Basically, this tells us that for any change in P 100 increases the slope (from ¹/₅₀ to ¹/₂₀)
of $1, the Qs will increase by 50 units
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HIGER LEVELSA LOW

o A change in price of $1 causes an increase in

Supply increase in slope: Qs = -2,000 + 20P
Qs of 20 units
M

P ($) Qs Calculation
0 -2,000 Qs = -2,000 + 20 × 0; -2,000
o The Q-intercept is still -2,000 but the
25 -750 Qs = -2,000 + 20 × 25; -1,500
50 500 Qs = -2,000 + 20 × 50; -1,000
2,000 __
P-intercept is _____
​   ​ 
20 d (  )
 ​ ​ c  ​  ​= $100 75 1,750 Qs = -2,000 + 20 × 75; -500
100 3,000 Qs = -2,000 + 20 × 100; 0

Supply decrease in slope: Qs = -2,000 + 50P

P ($) Qs Calculation
The shift (∆c) and changes in slope (∆d) are of course caused by
0 -2,000 Qs = -2,000 + 50 × 0; -2,000
MICROECONOMICS

changes in the all the usual non-price determinants of supply

25 -750 Qs = -2,000 + 50 × 25; -750
50 500 Qs = -2,000 + 50 × 50; 500 such as a change in the price/availability of raw materials and
75 1,750 Qs = -2,000 + 50 × 75; 1,750 labour, market entry by firms, increases in productivity and
100 3,000 Qs = -2,000 + 50 × 100; 3,000 market intervention such as taxes and subsidies.

s
1/ 40Q
Qs 0+
1/2
0 =5
rP
0+ 40Po s
10 0 0+ + 1/50Q
P
=
= -2,0 P = 40
or Qs 50 P or
P
20 00 +
+ -2,0
00 Qs =
,0
-2
Q s=

Qs

Figure 5.11 Changing the slope of the supply curve

POP QUIZ 5.1

ii. The P-intercept will be negative (solving for Q = 0

1. Assume a supply function of Qs = 200 + 10P. This tells gives us a price of -20)
us that:
iii. The slope is 10; for each $1 increase in price, Qs
i. This is an inelastic supply curve – e.g. the supply increases by 10 units
curve intercept on the Q-axis will be a positive
value (at a price of zero quantity supplied is 200) 2. Make a simple table showing the Qs when P=0, $10, $20,
$30 and $40
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3. Illustrate these values (pairs) in a diagram, e.g. draw a b. Change in the price of producer substitutes.
SA LO

supply curve.

HIGER LEVEL
c. Expectations of firms.
4. Draw a new supply curve based on the price of raw
material decreasing – this leads to a 20% change in supply d. Market entry/exit by other firms.
for our good but no change in slope.
e. Government intervention (taxes and subsidies).
5. Draw another supply curve in the same diagram showing
that the slope changes. For each $1 increase in price, the
Qs increases by 8. (Q-intercept remains unchanged.)
Decrease in supply Increase in quantity

MICROECONOMICS
caused by a supplied caused by
non-price supply an increase in price
variable.

S1
P S0
Summary & revision S2

Decrease in Increase in
1. Law of supply: an increase in the price of a good – ceteris supply supply
paribus – will lead to an increase in the quantity supplied

2. Individual supply: the willingness/ability of an

individual firm to put goods on the market at different
prices during a period of time
Q/t
3. Market supply: sum of all individual supply curves Decrease in quantity Increase in supply
supplied caused by a caused by a
4. Upward sloping supply curve has two causes: decrease in price non-price supply
variable
a. Incentives – if the market price rises for a good
suppliers will have an incentive to put more of the
good on the market.
HL extensions
b. Increasing costs – as costs increase for producers
in putting additional units on the market, only 7. Linear supply function: (Qs = c + dP).
higher market prices will induce them to increase
the quantity supplied in that increasing (HL: 8. Shifting the supply curve (∆c).
marginal) costs may be covered.
9. Changing the slope of the supply curve (∆d).
5. A change in price leads to a movement along the supply
curve .

6. A change in a non-price variable affecting supply leads

to a shift in the demand curve, e.g.:

a. Change in price/availability/quantity or quality of

factors of production.

47