FARWESTERN UNIVERSITY

FACULTY OF ENGINEERING
1
MASTER OF SCIENCE DEGREE IN CONSTRUCTION PROJECT MANAGEMENT

ADVANCED ENGINEERING ECONOMICS

Lecture-8: Introduction to Basic

Economics (2)

Instructor: Surya R Acharya, PhD

suryaraj.acharya@gmail.com
 Syllebus item: UNIT 1
2
 Today’s contents
Big Picture
3
• Law of Diminishing Marginal Utility
o The more you consume, the less would be the incremental
satisfaction
• Law of Demand and Supply [Chapter 4]
• Market equilibrium [Chapter 6, selected]
o Consumer’s and Producer’s surplus
o Social loss due to ‘distortion’ in market equilibrium
• Elasticity (Demand and Supply) [Chapter 5]
o How demand and supply change with respect to price or
other relevant factors
• Applications and Examples
 Introduction to Economics
4

Reference
Principles of Economics, Ninth Edition
by N. Gregory Mankiw [Selected sections
of Chapter 4, 5, 6 and 8]
 Principle [Law] of Diminishing
Marginal Utility
5
Principle of diminishing marginal utility:
• The additional satisfaction a consumer gets from
one more unit of a good or service declines as
the amount of that good or service consumed
rises.
• The more of a good or service you consume, the
closer you are to being satiated—reaching a
point at which an additional unit of the good adds
nothing to your satisfaction.
• For someone who almost never gets to eat a
banana, the occasional banana is a marvelous
treat. (This was the case in Eastern Europe
before the
Copiedfall
from:of communism,
Krugman, when
Paul R., and Robin bananas
Wells. Economics. Worth
 Copied from: Krugman, Paul R., and Robin Wells. Economics. Worth
6 Publishers, 2013.
 The Law of Diminishing Marginal
Returns
7
• As the use of an input increases in equal increments (with
other inputs fixed), a point will eventually be reached at
which the resulting additions to output decrease.
• When the labor input is small (and capital is fixed), extra
labor adds considerably to output, often because workers
are allowed to devote themselves to specialized tasks.
Eventually, however, the law of diminishing marginal
returns applies: When there are too many workers, some
workers become ineffective and the marginal product of
labor falls.
• The law of diminishing marginal returns usually applies to
the short run when at least one input is fixed.
• In the long-run, all inputs can be increased. Law of
diminishing marginal
Copied from: Pindyck, return
Robert S. may or may
Microeconomics. not
Pearson, apply.
2013.
 Market
8

Source: Oxford
Dictionary
 Market
9
What Is a Market?
“A market is a place where two parties can gather to facilitate
the exchange of goods and services. The parties involved are
usually buyers and sellers. The market may be physical like a
retail outlet, where people meet face-to-face, or virtual like an
online market, where there is no direct physical contact
between buyers and sellers.”
“The term market also takes on other forms. For instance, it
may refer to the place where securities are traded—the
securities market. Alternatively, the term may also be used to
describe a collection of people who wish to buy a specific
product or service such as the Brooklyn housing market or as
broad as the global diamond market.”
https://www.investopedia.com/terms/m/market.asp
 Market
1
0
Understanding Markets
“Technically speaking, a market is any place where two or
more parties can meet to engage in an economic transaction
—even those that don't involve legal tender. A market
transaction may involve goods, services, information,
currency, or any combination of these that pass from one
party to another.”
“Markets may be represented by physical locations where
transactions are made. These include retail stores and other
similar businesses that sell individual items to wholesale
markets selling goods to other distributors. Or they may be
virtual. Internet-based stores and auction sites such as
https://www.investopedia.com/terms/
Amazon and eBay are examples of markets where
m/market.asp
transactions can take place entirely online and the parties
involved never connect physically.”
11
Market forces of supply and
demand
Slide contents drawn or copied from
Chapter 4, Principles of Economics by
N Gregory Mankiw.
 4-1 Markets and Competition
1
2
What is Market?
• A market is a group of buyers and
sellers of a particular good or service.
• The buyers as a group determine the
demand for the product, and the sellers
as a group deter- mine the supply of the
product.
• Highly organized (auction for
agricultural commodities) and less
organized (ice cream)
 4-1 Markets and Competition
1
3
What is competition?
• Competitive market: a market in which there are many
buyers and many sellers so that each has a negligible
impact on the market price
• Perfectly competitive market must have two
characteristics:
• The goods offered for sale are all exactly the same
• The buyers and sellers are so numerous that no single buyer or
seller has any influence over the market price.
• Buyers and sellers in perfectly competitive markets are
said to be price takers.
• Some markets have only one seller, and this seller sets the
price. Such a market is called a monopoly (price-maker)
• Many markets are not perfectly competitive. Yet, many of
the lessons that we learn by studying supply and demand
under perfect competition apply to more complex markets
as well.
 Quick Quiz
14
 4-2 Demand
1
5
The Demand Curve: The Relationship between
Price and Quantity Demanded
• Quantity demanded is a term used in economics to describe
the total amount of a good or service that consumers
demand (and are willing and able to purchase) over a given
interval of time.
• law of demand: the claim that, other things (income, price of
substitutes, taste etc) being equal, the quantity demanded of
a good falls when the price of the good rises.
 Demand schedule and demand
16
curve

demand schedule
a table that shows the relationship
between the price of a good and the
quantity demanded
demand curve
a graph of the relationship between
the price of a good and the quantity
demanded
 Market Demand versus Individual
Demand
1
7

The market
demand
• Time
• Geography/
scope
 Shifts in the Demand Curve
1
8
Because the market demand curve holds other things constant,
it need not be stable over time. If something happens to alter
the quantity demanded at any given price, the demand curve
shifts.
 What can shift the demand
curve?
1
9
• Mostly following variables can shift the
demand curve
o Income
o Prices of Related Goods
o Tastes
o Expectations
o No of buyers
• A curve shifts when there is a change in a
relevant variable that is not measured on
either axis.
 Copied from: Krugman,
Paul R., and Robin Wells.
Economics. Worth
Publishers, 2013.

20
 Some key words: definition
2
1
Normal good
a good for which, other things being equal, an increase in
income leads to an increase in demand
Inferior good
a good for which, other things being equal, an increase in
income leads to a decrease in demand
Substitutes
two goods for which an increase in the price of one leads to
an increase in the demand for the other
Complements
two goods for which an increase in the price of one leads to a
decrease in the demand for the other
 Shifts in the Demand Curve versus
Movements along the Demand Curve
22

• Demand refers
to
the demand sch
edule i.e.
the demand cur
ve
• The quantity
demanded is a
point on a single
demand curve
which
corresponds to a
specific price
 Quick Quiz
23
 4-3 Supply
2
4
The Supply Curve: The Relationship
between Price and Quantity Supplied
quantity supplied
the amount of a good that sellers are willing
and able to sell
law of supply
the claim that, other things being equal, the
quantity supplied of a good rises when the
price of the good rises
 Supply Schedule and Supply
Curve
2
5

supply schedule
a table that shows the
relationship between the price of
a good and the quantity supplied
supply curve
a graph of the relationship
between the price of a good and
the quantity supplied
 Market Supply versus
Individual Supply
2
6

Market Supply
as the Sum
of Individual
Supplies
 Shifts in the Supply Curve
2
7 Because the market supply curve is drawn holding
other things (input price, technology etc) constant,
when one of these factors changes, the supply
curve shifts.
 Shift of Supply Curve
2
8
• Variables that can shift the supply curve
o Input prices
o Technology
o Expectations
o Number of sellers
• Supply increases/decreases: Shift of
supply curve rightward/leftward
 Quick Quiz
2
9
 4-4 Supply and Demand
Together
3
0
equilibrium
a situation in which the market price has reached
the level at which quantity supplied equals quantity
demanded
equilibrium price
the price that balances quantity supplied and
quantity demanded
equilibrium quantity
the quantity supplied and the quantity demanded
at the equilibrium price
 The Equilibrium of Supply
and Demand
31

surplus
a situation in which quantity supplied is greater than quantity
demanded
shortage
a situation in which quantity demanded is greater than quantity
 Market Not in Equilibrium
32

law of supply and demand

the claim that the price of any good adjusts to bring the
quantity supplied and the quantity demanded of that good
into balance
 Analyzing Changes in Equilibrium
How a change in demand affects equilibrium
33
 Example: A Change in Market
Equilibrium Due to a Shift in Demand
(Fig 10)
3
4 Suppose that one summer the weather is very hot. How
does this event affect the market for ice cream? To
answer this question, let’s follow our three steps.
• The hot weather affects the demand curve by changing
people’s taste for ice cream. That is, the weather changes
the amount of ice cream that people want to buy at any
given price. The supply curve is unchanged because the
weather does not directly affect the firms that sell ice
cream.
• Because hot weather makes people want to eat more ice
cream, the demand curve shifts to the right. Figure 10
shows this increase in demand as a shift in the demand
curve from D1 to D2 . This shift indicates that the quantity
of ice cream demanded is higher at every price.
• At the old price of $4, there is now an excess demand for
ice cream, and this shortage induces firms to raise the
price. As Figure 10 shows, the increase in demand raises
the equilibrium price from $4 to $5 and the equilibrium
quantity from 7 to 10 cones. In other words, the hot
weather increases both the price of ice cream and the
quantity of ice cream sold.
 Analyzing Changes in Equilibrium
How a change in supply affects equilibrium
35
 Example: A Change in Market
Equilibrium Due to a Shift in Supply
(Fig 11)
3
6 Suppose that during another summer, a hurricane destroys part of
the sugarcane crop and drives up the price of sugar. How does this
event affect the market for ice cream? Once again, to answer this
question, we follow our three steps.
• The change in the price of sugar, an input for making ice cream,
affects the supply curve. By raising the costs of production, it
reduces the amount of ice cream that firms produce and sell at
any given price. The demand curve does not change because the
higher cost of inputs does not directly affect the amount of ice
cream consumers wish to buy.
• The supply curve shifts to the left because, at every price, the
total amount that firms are willing and able to sell is reduced.
Figure 11 illustrates this decrease in supply as a shift in the supply
curve from S1 to S2.
• At the old price of $4, there is now an excess demand for ice
cream, and this shortage causes firms to raise the price. As Figure
11 shows, the shift in the supply curve raises the equilibrium price
from $4 to $5 and lowers the equilibrium quantity from 7 to 4
cones. As a result of the sugar price increase, the price of ice
cream rises, and the quantity of ice cream sold falls.
 Analyzing Changes in Equilibrium
Shift in both Supply and Demand
37
 Example: Shifts in Both Supply
and Demand (Fig 12)
3
8 Now suppose that the heat wave and the hurricane occur during the
same summer. To analyze this combination of events, we again
follow our three steps.
• We determine that both curves must shift. The hot weather affects
the demand curve because it alters the amount of ice cream that
consumers want to buy at any given price. At the same time,
when the hurricane drives up sugar prices, it alters the supply
curve for ice cream because it changes the amount of ice cream
that firms want to sell at any given price.
• The curves shift in the same directions as they did in our previous
analysis: The demand curve shifts to the right, and the supply
curve shifts to the left. Figure 12 illustrates these shifts.
• As Figure 12 shows, two possible outcomes might result
depending on the relative size of the demand and supply shifts. In
both cases, the equilibrium price rises. In panel (a), where
demand increases substantially while supply falls just a little, the
equilibrium quantity also rises. By contrast, in panel (b), where
supply falls substantially while demand rises just a little, the
 Analyzing Changes in
Equilibrium
3 Summary
9
 Forces That Drive a Market to
Equilibrium
4
0
• A market equilibrium is not just an abstract
concept or a theoretical possibility: We observe
markets in equilibrium. The ability to buy as
much as you want of a good at the market price
is indirect evidence that a market is in
equilibrium.
• What really causes the market to be in
equilibrium? If the price were not at the
equilibrium level, consumers or firms would have
an incentive to change their behavior in a way
that would drive the price to the equilibrium
level.
• The equilibrium price is called the market
 4-5 Conclusion: How Prices
Allocate Resources
4
1
• Supply and demand together determine the prices of the
economy’s many different goods and services; prices in
turn are the signals that guide the allocation of resources.
• Economies are enormous groups of people engaged in a
multitude of interdependent activities.
o What prevents decentralized decision making from degenerating
into chaos?
o What coordinates the actions of the millions of people with their
varying abilities and desires?
o What ensures that what needs to be done is in fact done?
• The answer, in a word, is prices. If an invisible hand guides
market economies, as Adam Smith famously suggested,
the price system is the baton with which the invisible hand
conducts the economic orchestra.
42
43
 Summary
44
 Today’s contents
Big Picture
4
5
• Law of Diminishing Marginal Utility
o The more you consume, the less would be the incremental
satisfaction
• Law of Demand and Supply [Chapter 4]
• Market equilibrium [Chapter 6, selected]
o Consumer’s and Producer’s surplus
o Social loss due to ‘distortion’ in market equilibrium
• Elasticity (Demand and Supply) [Chapter 5]
o How demand and supply change with respect to price or
other relevant factors
• Applications and Examples
 Market Equilibrium
Consumer and Producer Surplus
4
6

Socail Surplus (a measure of social welfare)

= Cosumer surplus + Producer Surplus
 Consumer Surplus
4
7 • Willingness to pay: the maximum amount that
a buyer will pay for a good
• Consumer surplus: the amount a buyer is
willing to pay for a good minus the amount the
buyer actually pays for it
• Consumer surplus measures the benefit buyers
receive from participating in a market.
 Using the Demand Curve to
Measure Consumer Surplus
4
8
 Using the Demand Curve to Measure
Consumer Surplus
49
 What Does Consumer Surplus
Measure?
50

Consumer surplus is a good measure of

economic well-being, but there are exception
such as in the case of drug addiction.
 Quiz
51
 Producer Surplus
5
2
Cost and the Willingness to Sell
• Cost: the value of everything a seller must
give up to produce a good
• Each seller is willing to sell the good if the
price he would receive exceeds his cost of
producing the good.
 Using the Supply Curve to Measure
Producer Surplus
53
 Using the Supply Curve to Measure
Producer Surplus
54

The area below the price and above the supply

curve measures the producer surplus in a
market.
 How a Higher Price Raises Producer
Surplus
55

Producer surplus to measure the well-being of sellers

in much the same way as we use consumer surplus
to measure the wellbeing of buyers.
56
 Economics of Environmental
57
Protection

Cost

Benefi
t
 Welfare loss (loss in social surplus) due
to market distortion
5
8
Possible causes of market distortion
• Taxes
• Government intervention in pricing; rules
for
• Max price (price ceiling)
• Min price (floor price)
• Externalities
• Monopoly
• Others
 Effect of a Tax
Deadweight Loss
59

Source: Mankiw,
 Control on Prices
6
0
Price ceiling
• a legal maximum on the price at
which a good can be sold (house rent,
air fare etc)
Price floor
• a legal minimum on the price at
which a good can be sold (agricultural
products)
 How Price Ceilings Affect Market
Outcomes
6
1
 How Price Floors Affect
Market Outcomes
62
 Minimum Wage
63
 Today’s contents
Big Picture
6
4
• Law of Diminishing Marginal Utility
o The more you consume, the less would be the incremental
satisfaction
• Law of Demand and Supply [Chapter 4]
• Market equilibrium [Chapter 6, selected]
o Consumer’s and Producer’s surplus
o Social loss due to ‘distortion’ in market equilibrium
• Elasticity (Demand and Supply) [Chapter 5]
o How demand and supply change with respect to price or
other relevant factors
• Applications and Examples
 Elasticity
65

Source: Oxford
Dictionary
 Elasticity
6
6
• How would consumers respond to the higher
price of a good?
• It is easy to answer this question in a broad
fashion: People would buy less good. But we
might want a precise answer. By how much
would the sell of the good fall? This question
can be answered using a concept called
elasticity.
• Elasticity is a measure of how much buyers and
sellers respond to changes in market conditions.
When studying how some event or policy affects
a market, we can discuss not only the direction
of the effects but also their magnitude.
 5-1. The Elasticity of Demand
6
7
Elasticity
• a measure of the responsiveness of
quantity demanded or quantity
supplied to a change in one of its
determinants
Price elasticity of demand
• a measure of how much the quantity demanded
of a good responds to a change in the price of
that good, computed as the percentage change
in quantity demanded divided by the
percentage change in price
 The Price Elasticity of Demand and Its
Determinants
6
8
• Availability of close substitutes
• Necessities versus Luxary
• Definition of the market
• Time Horizon
 Computing Price Elasticity of
Demand
6
9
 Elasticity- Calculus
7
0

Microeconomics with Calculus

by
JEFFREY M. PERLOFF
 The Variety of Demand Curves
7
1
• Demand curves are classified according
to their elasticity.
• Elastic demand- when the elasticity is greater
than one
• Inelastic demand- when the elasticity is less
than one
• Unit elasticity- When the elasticity is exactly one
• Price elasticity of demand is closely
related to the slope of the demand curve.
The flatter the demand curve passing
through a given point, the greater the
price elasticity of demand. The steeper
 Demand curves with different
elasticities
7
2
7
3
 Total Revenue and the Price Elasticity
of Demand
7
4
• When demand is inelastic (a price elasticity
less than one), price and total revenue move in
the same direction: If the price increases,
total revenue also increases.
• When demand is elastic (a price elasticity
greater than one), price and total revenue move
in opposite directions: If the price increases,
total revenue decreases.
• If demand is unit elastic (a price elasticity
exactly equal to one), total revenue remains
constant when the price changes.
 Elasticity and revenue
7
5
7
6

The slope of a linear demand curve is

constant, but its elasticity is not.
 Other Demand Elasticities
7
7
 The Elasticity of Supply
7
8
Price elasticity of supply
• a measure of how much the quantity supplied
of a good responds to a change in the price of
that good, computed as the percentage change
in quantity supplied divided by the percentage
change in price
Determinants
• Flexibility of sellers to change the amount of
goods
• Time period being considered
7
9
 Price elasticity and supply
curve
8
0
 Applications of Supply, Demand, and
Elasticity
8
1
1. Can Good News for Farming Be Bad News
for Farmers?
 Why Did OPEC Fail to Keep the Price of Oil
High?
8
2
 Does Drug Interdiction Increase or
Decrease Drug-Related Crime?
8
3
 How Taxes on Sellers Affect
Market Outcomes
8
4

Implications The tax makes buyers worse off. Sellers get a higher
price ($3.30) from buyers than they did previously, but the effective
price after paying the tax falls from $3.00 before the tax to $2.80
with the tax ($3.30 – $0.50 = $2.80). Thus, the tax also makes
sellers worse off.
 How Taxes on Buyers Affect
Market Outcomes
8
5

Implications If you compare Figures 6 and 7, you will notice a

surprising conclusion: Taxes levied on sellers and taxes levied on
buyers are equivalent. In both cases, the tax places a wedge
between the price that buyers pay and the price that sellers
 Elasticity and Tax Incidence
8
6
 Elasticity and Tax Incidence
8
7

The two panels of Figure 9 show a general lesson about how the burden of
a tax is divided: A tax burden falls more heavily on the side of the market
that is less elastic. Why is this true? In essence, the elasticity measures
the willingness of buyers or sellers to leave the market when conditions
become unfavorable.
 Who Pays the Luxury Tax?
8
8
• Luxary goods- higher elasticity
• Burden fall less on buyers and more on
suppliers
• Buyers are rich but suppliers hire
workers from middle class
• Ultimately, the part of the burden shifts
to middle or lower class workers
• US Congress repealed most of the
luxury tax in 1993
 Elasticity and Tax incidence:
89
Calculus

Microeconomics with
Source:
Calculus
By JEFFREY M. PERLOFF
 Source:
Microeconom
ics with
Calculus
By JEFFREY M. PERLOFF

90
 Math/calculus of Demand,
91 Supply and Equilibrium
(optional)
Microeconomics with Calculus
by
JEFFREY M. PERLOFF
 Math of
demand
, supply
92
and
Equilibri
um

Microeconomics with
Calculus
by
JEFFREY M. PERLOFF
 Math of
demand
, supply
93
and
Equilibri
um

Microeconomics with
Calculus
by
JEFFREY M. PERLOFF
 Math of
94
demand,
supply and
Equilibrium

Microeconomics with
Calculus
by
JEFFREY M. PERLOFF
 Math of demand,
95 supply and
Equilibrium

Microeconomics with Calculus

by
JEFFREY M. PERLOFF
 Math of demand,
96 supply and
Equilibrium

Microeconomics with Calculus

by
JEFFREY M. PERLOFF
97 Appendix
Use of Mathematics in Economics
 Math in
Economic
98 s

Mathematics-
the key
instrument of
economic
analysis.

Milgrom, Paul (2000) Putting auction theory to work: The simultaneous

ascending auction Journal of Political Economy [Paul Milgrom won
Noble Prize in 2020]
99

DW Diamond, RG Rajan (2006) Money in a Theory of Banking, American

Economic Review,
 A Castells, A Solé-Ollé
(2005) The regional
allocation of infrastructure
investment: The role of
equity, efficiency and
political factors, European
Economic Review

10
0
10
1
102

Milgrom, Paul (1989) Auctions and bidding: A primer Journal of

Economic Eerspectives