EC1002 Introduction To Economics PDF

Introduction to economics
O. Birchall assisted by D. Verry

EC1002
2016
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
O. Birchall, The London School of Economics and Political Science, assisted by D. Verry, The
London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
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Contents
Contents
Introduction............................................................................................................. 1
Introduction to the subject area...................................................................................... 1
Aims of the course.......................................................................................................... 1
Learning outcomes......................................................................................................... 2
Overview of learning resources....................................................................................... 2
Route map to the guide.................................................................................................. 4
Study advice................................................................................................................... 6
Use of mathematics........................................................................................................ 7
Examination advice........................................................................................................ 7
Block 1: Economics, the economy and tools of economic analysis......................... 9
Introduction................................................................................................................... 9
Scarcity........................................................................................................................ 12
Rationality.................................................................................................................... 13
The production possibility frontier (PPF)......................................................................... 13
Opportunity cost and absolute and comparative advantage........................................... 15
Markets........................................................................................................................ 16
Microeconomics and macroeconomics.......................................................................... 18
A note on mathematics................................................................................................ 18
Models and theory........................................................................................................ 19
Criticisms of economics ............................................................................................... 22
Overview...................................................................................................................... 22
Reminder of learning outcomes.................................................................................... 23
Sample examination questions...................................................................................... 23
Block 2: Demand, supply and the market.............................................................. 25
Introduction................................................................................................................. 25
Equilibrium................................................................................................................... 26
Demand and supply curves........................................................................................... 27
Shifts in the demand and supply curves......................................................................... 28
Consumer and producer surplus.................................................................................... 29
Overview...................................................................................................................... 32
Block 3: Elasticity ................................................................................................. 35
Introduction................................................................................................................. 35
Price elasticity of demand ............................................................................................ 36
Cross-price elasticity of demand.................................................................................... 39
Income elasticity of demand......................................................................................... 40
Price elasticity of supply................................................................................................ 41
Incidence of a tax ........................................................................................................ 41
Overview...................................................................................................................... 43
EC1002 Introduction to economics
Block 4: Consumer choice...................................................................................... 47

Introduction................................................................................................................. 47
Consumer choice and demand decisions....................................................................... 48
Utility maximisation and choice..................................................................................... 52
Income and price changes............................................................................................ 54
Deriving demand: The individual demand curve........................................................... 56
Deriving demand: The market demand curve............................................................... 58
Complements and substitutes....................................................................................... 58
Cash transfers versus transfers in kind........................................................................... 59
Overview...................................................................................................................... 60
Reminder of your learning outcomes............................................................................. 61
Block 5: The Firm I................................................................................................. 63
Introduction................................................................................................................. 63
Introduction to the firm................................................................................................ 64
The firms supply decision ............................................................................................ 64
Profit = Total revenue Total cost................................................................................. 69
Overview...................................................................................................................... 72
Block 6: The Firm II................................................................................................ 75
Introduction................................................................................................................. 75
Cost, production and output......................................................................................... 75
Overview...................................................................................................................... 81
Block 7: Perfect competition ............................................................................... 87
Introduction................................................................................................................. 87
Assumptions and implications....................................................................................... 88
The firms supply decision............................................................................................. 89
Industry supply curves................................................................................................... 92
Comparative statics ..................................................................................................... 93
Perfect competition and efficiency ................................................................................ 94
Overview...................................................................................................................... 95
Block 8: Pure monopoly......................................................................................... 99
Introduction................................................................................................................. 99
Perfect competition and perfect monopoly................................................................... 100
Monopoly analysis...................................................................................................... 100
Social cost of monopoly.............................................................................................. 105
Price discrimination.................................................................................................... 106
When can monopolies be justified?............................................................................. 107
Overview.................................................................................................................... 108
Reminder of learning outcomes.................................................................................. 108
Sample examination questions.................................................................................... 108
Block 9: Market structure and imperfect competition........................................ 111
Introduction............................................................................................................... 111
A theory of market structure....................................................................................... 112
Monopolistic competition........................................................................................... 113
ii
Contents
Oligopoly................................................................................................................... 114
Game theory.............................................................................................................. 115
Models of oligopoly.................................................................................................... 116
Block 10: The labour market................................................................................ 123
Introduction............................................................................................................... 123
The factors of production............................................................................................ 124
Analysis of the labour market...................................................................................... 125
Labour supply............................................................................................................. 127
Labour market equilibrium ......................................................................................... 128
Disequilibrium in the labour market............................................................................ 130
Wage discrimination................................................................................................... 131
Overview.................................................................................................................... 131
Block 11: Welfare economics............................................................................... 135
Introduction............................................................................................................... 135
Equity and efficiency................................................................................................... 136
Distortion of the market.............................................................................................. 141
Sources of market failure............................................................................................ 141
Overview.................................................................................................................... 145
Block 12: The role of government....................................................................... 147
Introduction............................................................................................................... 147
Government functions................................................................................................ 148
Taxation..................................................................................................................... 148
Public goods............................................................................................................... 150
Merit and demerit goods............................................................................................ 151
Transfer payments and income redistribution............................................................... 151
Principles of taxation.................................................................................................. 153
Local government....................................................................................................... 155
Impact of globalisation............................................................................................... 155
Political economy........................................................................................................ 155
Overview.................................................................................................................... 155
Block 13: Introduction to macroeconomics......................................................... 159
Introduction............................................................................................................... 159
Macroeconomic analysis............................................................................................. 160
The circular flow of income......................................................................................... 160
Measuring GDP.......................................................................................................... 161
Overview.................................................................................................................... 164
Sample examination questions ................................................................................... 165
Block 14: Output and aggregate demand........................................................... 169
Introduction............................................................................................................... 169
Components of aggregate demand: consumption and investment............................... 170
Equilibrium output...................................................................................................... 171
iii
The multiplier............................................................................................................. 173

Foreign trade: exports and imports.............................................................................. 176
Overview.................................................................................................................... 178
Block 15: Money and banking; interest rates and monetary transmission......... 181
Introduction............................................................................................................... 181
Money and banking.................................................................................................... 182
Interest rates and monetary transmission.................................................................... 185
Overview.................................................................................................................... 187
Block 16: Monetary and fiscal policy.................................................................. 191
Introduction............................................................................................................... 191
Monetary policy.......................................................................................................... 192
The IS-LM model........................................................................................................ 192
The policy mix............................................................................................................ 201
Overview.................................................................................................................... 203
Block 17: Aggregate demand and aggregate supply.......................................... 205
Introduction............................................................................................................... 205
Aggregate demand..................................................................................................... 206
Aggregate supply....................................................................................................... 207
Equilibrium inflation................................................................................................... 208
Wage rigidity.............................................................................................................. 209
Short-run aggregate supply......................................................................................... 209
Adjustment to demand shocks.................................................................................... 210
Overview.................................................................................................................... 212
Appendix 17a The AD curve: output and the price level............................................ 215
Appendix 17b Upwardly sloping SAS curves: output and the price level.................... 216
Block 18: Inflation............................................................................................... 217
Introduction............................................................................................................... 217
Money and inflation................................................................................................... 218
The Phillips curve and inflation expectations................................................................ 220
The costs of inflation.................................................................................................. 224
Controlling inflation.................................................................................................... 225
Overview.................................................................................................................... 225
Block 19: Unemployment.................................................................................... 229
Introduction............................................................................................................... 229
Rates of unemployment.............................................................................................. 230
Analysis of unemployment ......................................................................................... 233
Changes in unemployment......................................................................................... 235
Cyclical unemployment............................................................................................... 236
Cost of unemployment............................................................................................... 237
Overview.................................................................................................................... 238
iv
Contents

Block 20: Exchange rates and the balance of payments..................................... 241
Introduction............................................................................................................... 241
The exchange rate...................................................................................................... 242
The balance of payments............................................................................................ 244
Real and PPP exchange rates...................................................................................... 245
The current and financial accounts.............................................................................. 246
Long-run equilibrium.................................................................................................. 248
Overview.................................................................................................................... 248
Block 21: Open economy macroeconomics......................................................... 251
Introduction............................................................................................................... 251
The macroeconomy under fixed exchange rates........................................................... 252
Devalution of a fixed exchange rate............................................................................ 255
The macroeconomy under floating exchange rates....................................................... 256
Overview.................................................................................................................... 259
Block 22: Business cycles..................................................................................... 263
Introduction............................................................................................................... 263
Phases of the business cycle....................................................................................... 264
Theorising the business cycle...................................................................................... 264
Real business cycle theories........................................................................................ 267
Business cycle synchronisation.................................................................................... 268
Schools of macroeconomic thought............................................................................. 268
Overview.................................................................................................................... 270
Block 23: Supply-side economics and economic growth.................................... 273
Introduction............................................................................................................... 273
Supply-side economics................................................................................................ 274
Economic growth....................................................................................................... 275
Inputs to production................................................................................................... 276
Solow growth model.................................................................................................. 276
Romers model of endogenous growth........................................................................ 281
Costs of growth.......................................................................................................... 282
Overview.................................................................................................................... 282
Appendix 1: Syllabus........................................................................................... 285
Appendix 2: Outline of readings......................................................................... 287
Notes
vi
Introduction
Introduction
Introduction to the subject area
Every day people make decisions that belong within the realm of
economics. What to buy? What to make and sell? How many hours to
work? We have all participated in the economy as consumers, many of us
as workers, some of us also as producers. We have paid taxes. We have
saved our earnings in a bank account. All of these activities (and many
more) belong to the realm of economics. Households and firms are the
basic units of an economy and are concerned with the economic problem:
how best to satisfy unlimited wants using the limited resources that are
available? As such, economics is the study of how society uses its scarce
resources. Its aim is to provide insight into the processes governing the
production, distribution and consumption of goods and services in an
exchange economy.
The previous paragraph could be taken to imply that the realm of
economics is limited and clearly defined. However, if economics is
viewed as a way of thinking, or a set of tools that can be used to analyse
human behaviour and the world around us, then you will find that the
principles of economics can be applied to many different areas of life. The
scope is thus very broad, but the principles of analysis are well defined
and these are what you will become familiar with through undertaking
this course. Although the course provides some information that is
descriptive, such as how the banking system works, for example, its main
focus is on introducing models and concepts which are used as tools of
economic analysis. Concepts such as opportunity cost and approaches
such as marginal analysis can be widely applied and prove very useful in
understanding various aspects of society and peoples lives.
Studying economics doesnt just impart knowledge; it also develops
skills such as logical and analytical thinking and problem-solving skills,
which are useful beyond the formal study of economics. For some of you,
economics is not the main area of study, and you may not be intending
to pursue a career as an economist. However, we are sure that an
understanding of basic economic concepts will still prove useful to you in
whatever direction your studies and subsequent career may take.
Aims of the course

The course aims to:
introduce you to an understanding of the domain of economics as a
social theory
introduce you to the main analytical tools which are used in economic
analysis
introduce you to the main conclusions derived from economic analysis
and to develop your understanding of their organisational and policy
implications
enable you to participate in debates on economic matters.
Learning outcomes
At the end of the course and having completed the Essential reading and
activities, you should be able to:
define the main concepts and describe the models and methods used
in economic analysis
formulate real world issues in the language of economic modelling
apply and use economic models to analyse these issues
assess the potential and limitations of the models and methods used in
economic analysis.
Overview of learning resources

Textbooks
This subject guide follows the structure of the primary textbook (below)
and works through the parts of the textbook included in the syllabus
section by section, providing commentary, additional activities and
extending the material in some parts.
Primary textbook
Begg, D., G. Vernasca, S. Fischer and R. Dornbusch Economics. (London: McGraw
Hill, 2014) 11th edition [ISBN 9780077154516]. Referred to as BVFD.
The two supplementary textbooks below can be used to extend your

understanding and also provide an alternative approach which you may
find suits your own style. Although you are encouraged to make use
of these, you should check that you have a good understanding of the
material covered in the primary textbook and the subject guide, as this is
the required material for this course.
Supplementary textbooks
Lipsey, R.G. and K.A. Chrystal Economics. (Oxford: Oxford University Press,
2015) 13th edition [ISBN 9780198746577] international edition;
[ISBN9780199676835] UK edition. Referred to as L&C.
Witztum, A. Economics. (Oxford: Oxford University Press, 2005)
[ISBN 9780199271634]. Referred to as AW.
The material contained in the two supplementary textbooks (where it

goes beyond that contained in BVFD and the subject guide) is not directly
examinable and you are not required to purchase these texts. However,
if you are able to access them, you will find them beneficial and they
will enhance your understanding of the text and this guide. Both have
certain key advantages, for example, L&C contains very clear explanations
and is structured in a very logical way, while AW provides a deeper
understanding of the core concepts both philosophically and in terms of
the analytical approach.
How to use the subject guide

Each of the 23 blocks of the subject guide covers one or two chapters from
the primary textbook. The guide works through the textbook section by
section and you will find additional explanations, activities and questions
to aid and test your understanding. The subject guide has been designed
to accompany the textbook, so you should use them jointly and follow
the reading instructions listed throughout (e.g. Read sections 14.214.3;
answer the following questions to check your understanding etc.).
2
Introduction
One key aim of the guide is to encourage active engagement with the
material, as this is how you will really gain a good understanding. For
example, many of the models which will be covered in this course are
expressed graphically and the subject guide contains empty boxes where
you can practise drawing these graphs. It is very difficult to understand
and remember graphs just by looking at them, so you will need to practise
drawing them for yourself. For more complex graphs in later chapters,
you could even practise using blank paper and then, when you are
confident, draw the graph in the empty box in the subject guide. You are
also encouraged to actively undertake the other activities and questions
in the subject guide. Answers to these are available on the virtual learning
environment (VLE).
The subject guide and the primary textbook must be used together. The
guide will not make much sense without the textbook. Equally, do not be
tempted to neglect the guide and just focus on the textbook. You need to
be aware that the subject guide not only seeks to complement and clarify
the contents of the textbook, but also to extend it in certain places. For the
final examination, you will need to be familiar with the material in both
the textbook and the subject guide. The textbook chapters that are not
covered in the guide, and are not examinable, are: Chapters 11 (except
for section 11.9), 12, 26, 29. We hope that this guide will help you as you
work through the textbook and that you will find it useful in your studies.
Online study resources (VLE, Online Library)

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your
University of London email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you forget your login details at any point, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Electronic study materials: All of the printed materials which you
receive from the University of London are available to download, to
give you flexibility in how and where you study.
Discussion forums: An open space for you to discuss interests
and seek support from your peers, working collaboratively to solve
problems and discuss subject material. Some forums are moderated by
an LSE academic.
Videos: Recorded academic introductions to many subjects;

interviews and debates with academics who have designed the courses
and teach similar ones at LSE.
Recorded lectures: For a few subjects, where appropriate, various
teaching sessions of the course have been recorded and made available
online via the VLE.
Audiovisual tutorials and solutions: For some of the first year
and larger later courses such as Introduction to Economics, Statistics,
Mathematics and Principles of Banking and Accounting, audio-visual
tutorials are available to help you work through key concepts and to
show the standard expected in exams.
Self-testing activities: Allowing you to test your own
understanding of subject material.
Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time, and you should check the VLE
regularly for updates.
Answers on the VLE

Answers to the subject guide exercises can be found on the VLE. By far
the most beneficial approach is to attempt the questions and activities
yourself before you look at the answers. If, when you do look at them, you
discover that your own answer is incorrect, try to work out what led you to
that answer (to clear away your misconceptions) and furthermore, try to
understand why the given answer is in fact correct. This will help you to
gain a solid understanding.
Making use of the Online Library

The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (http://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team:
onlinelibrary@shl.london.ac.uk
Route map to the guide

The subject guide consists of 23 blocks an introductory block, and then
11 for microeconomics and 11 for macroeconomics. Throughout the guide,
chapter refers to the sections of the textbook, while block refers to the
sections of the subject guide. This is to avoid confusion for example,
when the guide says this concept will be explored further in Chapter 12, it
4
Introduction
should be clear to the reader that this refers to Chapter 12 of the textbook
(BVFD).
Breakdown of readings for each block:
Microeconomics
Block
10
11
12
Chapter
1, 2
6; 7.1, 7.2 and

7appendix
7.3
7.9
8.1
8.4
8.5
8.10
10
13
14;
11.9
Macroeconomics
Block
13
14
15
16
17
18
19
20
21
22
23
Chapter
15
16, 17
18, 19
20
21
22
23
24
25
27
28
Specific topics and concepts to be covered are as follows: This differs from
the syllabus only in the order that topics are listed. The full syllabus can be
found in Appendix 1.
Block 1
Introduction: The economic problem, production possibility frontiers,

opportunity cost, the role of the market, absolute and comparative advantage,
positive and normative economics, micro and macro economics, nominal and
real values, theory and models in economics
Microeconomics
Block 2
Demand, supply and the market: demand, supply, demand functions,

supply functions, equilibrium, consumer and producer surplus.
Block 3
Elasticity: price elasticity of demand, cross-price elasticity of demand, income

elasticity (normal, inferior and luxury goods), elasticity of supply.
Block 4
Consumer choice: rationality, utility, indifference curves, the budget

constraint, utility maximisation, substitution and income effects, substitutes and
complements.
Block 5
The Firm I: the firm, profit maximisation, marginal cost and marginal revenue,
technology and production functions, returns to scale, the law of diminishing
marginal returns, isoquants and isocost lines.
Block 6
The Firm II: cost functions, the distinction between the long and the short-run,
fixed and variable costs, behaviour of the firm in the long and in the short-run,
the firms supply function.
Block 7
Perfect competition: competitive industry, the competitive firm, entry and

exit, short-run and long-run equilibrium, some comparative statics.
Block 8
Pure monopoly: monopoly, price discrimination, natural monopoly,

supernormal profit, monopoly and competitive equilibrium compared.
Block 9
Market structure and imperfect competition: monopolistic competition

(differentiated products, the firms behaviour, the role of entry), oligopoly
(interdependence, game theory, reaction functions).
Block 10
Inputs to production: the labour market: the factors of production,

demand and supply of labour (profit maximisation and the demand for labour,
utility maximisation and the supply of labour), economic rent, monopsony,
factors affecting labour market equilibrium (unions, minimum wages).
Block 11
Welfare economics: general equilibrium, horizontal and vertical equity,

allocative and Pareto efficiency, market failures, externalities, Coase theorem.
Block 12
The role of government: government interventions, public goods, taxation;

the income distribution, the Gini coefficient and Lorenz curves.
Macroeconomics
Block 13
Introduction to macroeconomics: the problem of aggregation, the

circular flow of income, leakages and injections, national income accounting,
depreciation, value added and the NNP = Y identity, real and nominal gross
domestic product (GDP).
Block 14
Aggregate demand: actual and potential output, consumption, investment,

income determination, equilibrium, the multiplier, the paradox of thrift,
consumption and taxation, the government budget, automatic stabilisers (the
financing of government), the multiplier and taxation, the role of fiscal policy,
imports and exports, the multiplier in an open economy.
Block 15
Money and banking: the role of money, real balances, the liquidity
preference approach and the demand for money (liquid assets), commercial
banks and the supply of money (banks and the various multipliers), central
banks and monetary control, equilibrium in the money market.
Block 16
Monetary and fiscal policy: aggregate demand and equilibrium (IS),

equilibrium in the money market (LM), the IS-LM model, monetary and fiscal
policies in a closed economy.
Block 17
Aggregate demand and aggregate supply: Keynesian and classical

assumptions regarding wages and prices, aggregate supply in the long-run and
the short-run, the effects of exogenous demand and supply shocks.
Block 18
Inflation: inflation targeting, the Taylor rule, the quantity theory of money,
the Phillips curve in the long-run and the short-run, stagflation and the role of
expectations, costs of inflation
Block 19
Unemployment: types of unemployment, voluntary and involuntary

unemployment, causes of unemployment, private and social costs, hysteresis
Block 20
Exchange rates and the balance of payments: the foreign currency

market, exchange rate regimes, the balance of payments, capital mobility, the
rate of interest and the price of foreign currency
Block 21
Open economy macroeconomics: the effects of fiscal and monetary policies

under fixed and floating exchange rates with and without capital mobility
Block 22
Business cycles: trend path and business cycles, theories of the business
cycle, real business cycles
Block 23
Supply-side economics and economic growth: growth in potential

output, the steady state, technological progress, capital accumulation,
convergence, endogenous growth, policies to promote growth
Study advice
The British education system, possibly more than others, and economics as
a subject, possibly more than others, both emphasise understanding above
rote learning (learning by heart). It is very difficult (if not impossible)
to do well in economics examinations simply by rote learning. A much
better strategy is to try to gain a good understanding of the concepts and
the models. Although this may involve more work in the short term, the
final outcome will be much better, and the examination much easier. For
example, many of the models we will cover can be summarised in a single
graph or set of equations. You will need to be able to use these graphs to
demonstrate the effects of changes in the economic environment to which
the model relates. This is very difficult to do well through memorisation,
but if you understand why the different lines of the graph are drawn
in that particular way or what a particular equation represents, then
adjusting the graph or modifying the equations will become a relatively
simple and straightforward exercise.
6
Introduction
The textbook, which the subject guide accompanies, assumes that you
havent done any economics before and starts from the basics. It gives a
good explanation of all concepts and uses examples to make these new
concepts intuitive. It also includes material to stretch you, including
Maths boxes. You are required to really master this textbook, including
the Maths boxes and more challenging elements. If there are sections
which are difficult to understand at first, you may find that reading these
through several times is very helpful. In certain places, the subject guide
will also seek to extend the textbook if there are areas where it does not
go far enough. Although you will find the textbook approach of starting
at a fairly basic level very useful, you should expect the examination to
be quite rigorous. For example, examination questions are likely to be
similar to the hard questions in the review questions at the end of each
chapter. In this way, we hope to help you really lay a firm foundation of
understanding in economics, and at the same time demonstrate the high
standard that is expected of you as University of London students.
Use of mathematics
Economic models can be expressed in various ways, in words, in diagrams
and in equations. Although this course mainly uses diagrammatic
representations accompanied by words, simple equations can also be
a concise way of expressing an economic model, and you will need to
become familiar with this approach. At this stage, the maths involved
will be limited to simple algebra and elementary calculus. Some basic
mathematical techniques and ideas will be also introduced in the first
block. It is important to work through the Maths boxes in each chapter,
as these often provide a step-by-step explanation of the mathematical
approach to the models covered. The subject guide will also provide
further explanations where we think this will be helpful. Economics is
becoming an increasingly technical subject and, although the level of
mathematics required for this course is quite basic, we hope that you
will become confident in taking a mathematical approach to analysing
economic issues.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
Examination structure: The structure for the 201617 examination is
as follows:
Part I
worth 50 marks
30 multiple choice questions covering the entire syllabus in
microeconomics and macroeconomics. Candidates should answer
all 30 multiple choice questions.
Part II, Section A

worth 25 marks
three long response questions in microeconomics of which
candidates should answer one question.
Part II, Section B
worth 25 marks
three long response questions in macroeconomics of which
candidates should answer one question.
Further advice for multiple choice questions: Read the question
and each of the possible answers carefully, paying attention to words such
as not and never. Try to manage your time so you are able to check over
your answers again at the end.
Further advice for long-response questions: Marks are not
awarded for irrelevant material. For this reason, when you read a question,
it is best to spend some time thinking about your answer before you start
to write. Quickly writing everything remotely connected to the topic will
not impress the examiner. The best answers demonstrate that candidates
recognise the tools of analysis that are relevant to that question and they
are able to use them effectively to provide a well-reasoned answer.
You can find further guidance on examination technique in the annual
Examiners commentaries for the course which are available on the
University of London International Programmes website, and also in your
academic and study skills handbook, Strategies for success.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
Block 1: Economics, the economy and tools of economic analysis
Block 1: Economics, the economy and

tools of economic analysis
Introduction
This block covers the first two chapters of the textbook and is designed to
give you an introduction to economics and some help in starting to use
the tools of economic analysis. The concepts introduced in this block, such
as scarcity, opportunity cost and ceteris paribus (more on these below),
are absolutely essential to your understanding of economics. The more
thoroughly you work through the material in this block, the better your
foundation will be for all the material that follows.
So what is economics? The word economy comes from two Greek words
oikos (meaning house) and nemein (meaning manage) its original
meaning was household management. Households have limited resources
and managing these resources requires many decisions and a certain
organisational system. The meaning of the word economics has developed
over time. Today, economics can be defined as the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them. Furthermore, the key economic problem can
be defined as being to reconcile the conflict between peoples virtually
unlimited desires and the scarcity of available resources and means of
production.
These are the definitions provided in the core textbook (BVFD) and indeed
in many other textbooks. They are traditional definitions and have their
origins in an essay by Lionel Robbins (of the London School of Economics
and Political Science) written in 19321 in which he defined economics as
the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.
It is important to realise that this definition is not without its critics.
The textbook does not pretend to discuss in any depth the definition
of economics or the legitimate domain of economic investigation.
Those wishing to pursue the philosophical foundations of the nature of
economics could consult the collection of papers edited by Frank Cowell
and Amos Witztum,2 especially papers by Atkinson, Witztum, Backhouse
and Medema.
On a less philosophical note, if we were to follow the definition attributed
to Jacob Viner (an early member of the Chicago School and a teacher of
Nobel laureate Milton Friedman) that economics is what economists do,
the Robbins definition stated above would fall short of describing the way
in which the subject has evolved, in particular in its failure to reflect the
time and effort devoted today to empirical analysis.
Arguably, the definitions provided in the textbook apply more directly to
microeconomics than macroeconomics, the latter being more concerned
with the structure and performance of the aggregate economy and
such issues as growth, cycles, unemployment and inflation. However,
underlying these big issues is the behaviour of individual agents such as
consumers and firms. Recent developments in macroeconomics have been
concerned with establishing microeconomic foundations. So scarcity and
the rational responses to it are not absent from macroeconomics.
1
Lionel Robbins An
essay on the nature and
significance of economic
science. (London:
Macmillan, 1932, 2nd
edition 2014) p.16.
Cowell, Frank and

Amos Witztum (eds)
Lionel Robbinss essay
on the nature and
significance of economic
science: 75th anniversary
conference proceedings.
(London: Suntory and
Toyota International
Centres for Economics
and Related Disciplines,
2009) pp.1500.
Available at http://darp.
lse.ac.uk/papersdb/
LionelRobbinsConference
ProveedingsVolume.pdf
2
Although the definitions above may appear abstract, economics deals with
phenomena you will be very familiar with from your daily activities, and
provides tools and a language to analyse these. While it is not the only
language available, we hope it will prove useful to you.
Economics and the real world

One of the main reasons that BVFD was chosen as the textbook for the
course is that it combines the exposition of economic theory with liberal
use of actual data on many economic issues. Modern economics is a
subject which, at its best, does not theorise in a vacuum but addresses
issues of real world importance and attempts to make its concepts
and theories consistent with the facts. When economists make policy
recommendations these address issues of current importance and
concern. Furthermore, the effectiveness of economic policy is increasingly
subject to empirical evaluation. Sometimes this happens by piloting
a policy on a restricted scale before it is rolled out nationally. Almost
always government departments, private sector analysts and academic
economists attempt to evaluate the consequences of policy in the months
or years after implementation. If you pursue your study of economics to
a more advanced level you will learn how applied economists attempt
to test the relevance and accuracy of their theories and the success or
failure of economic policy using statistical techniques broadly known as
econometrics. However, even at this early stage of your study you should
attempt to familiarise yourself with actual facts about the economy and
think about what these imply for economic theory and the formation and
evaluation of economic policy. The statistics and policy discussions in
BVFD often (but not always) relate to the UK economy; we encourage you
to look for comparable examples wherever you live.
Learning outcomes
By the end of this block and having completed the Essential reading and
recognise economics as the study of how society addresses the conflict
between unlimited desires and scarce resources
describe ways in which society decides what, how and for whom to
produce
identify the opportunity cost of a decision or action
explain the difference between positive and normative economics
define microeconomics and macroeconomics
explain why theories deliberately simplify reality
recognise time-series, cross section and panel data
construct index numbers
explain the difference between real and nominal variables
build a simple theoretical model
plot data and interpret scatter diagrams
use other things equal to ignore, but not forget, some aspects of a
problem in order to focus on core issues.
10
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 1 and 2.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 1; UK edition,
Chapter1.
Witztum (AW), Chapter 1.
Synopsis of this block

This block introduces some of the key concepts in economics. First,
scarcity the idea that the means available to society (its labour force, its
capital stock, its natural resources, its technology) are insufficient to meet
all the wants (or the desired goods and services) of the people making up
that society. Related to scarcity is the concept of opportunity cost which
is the value of the best alternative that must be sacrificed. The concept of
scarcity gives rise to the production possibility frontier (PPF), which
shows the maximum amount of one good that can be produced given the
output of another good. The slope of the PPF is the opportunity cost. The
fact that different individuals and countries have different opportunity
costs of producing various goods gives rise to comparative advantage and
creates the possibilities for gains from trade.
In economics, people are assumed to behave rationally only taking a
course of action if its benefits outweigh its costs. Furthermore, people are
assumed to be motivated by self-interest. The idea of the invisible hand
describes how market forces allocate resources efficiently despite the
self-interested motivations of individuals. Markets resolve production and
consumption decisions via the adjustment of prices.
Economics can be divided into different sub groups and approaches.
Positive economics deals with facts about how the economy behaves
and with empirically testable propositions, while normative economics
involves subjective judgements. Microeconomics studies particular markets
and activities in detail, while macroeconomics deals with aggregates and
studies the economy as a whole system.
The interplay of data and theory/models in economics is very important.
Models are deliberate simplifications of reality which help organise how
we think about a problem. A key approach of economic analysis is to
abstract from various factors by holding them constant this is known
as ceteris paribus or other things equal. The second half of this block
examines the relationship between data and theory and also provides
guidance and instruction regarding key practical concepts and skills
such as index numbers, nominal and real variables, measuring change,
diagrams, lines and equations. Chapter 2 concludes by briefly addressing
some popular criticisms of economics and economists.
BVFD: read Chapter 1.
Sections 1.1 and 1.3 introduce the concepts of scarcity, opportunity cost, and efficiency.
These are not separate concepts but are all interrelated and can be demonstrated
using the production possibility frontier introduced in section 1.3. For a more detailed
introduction to these fundamental concepts, you can refer to AW Chapter 1.
Read section 1.1, concept 1.1 and case 1.1.
11
Scarcity
BVFD defines scarcity by saying: a resource is scarce if the demand for
that resource at a zero price would exceed the available supply. Since the
concepts of demand and supply have not yet been introduced to you, we
can also define scarcity by stating that the means available to society (its
labour force, its capital stock, its natural resources, its technology) are
insufficient to meet all the wants (or the desired goods and services) of the
people making up that society. This implies that for any one person to have
more of something, they or someone else must have less of something
else. In turn, this requires choice, both at the level of the individual agent
but also at the societal or collective level. How individuals and societies
cope with scarcity in relation to wants is central to economics. This course
concentrates on the market economy as the basic organisational principle
for coping with scarcity, but modified by governments to rectify market
shortcomings and to achieve distributional ends.
Opportunity cost
Related to scarcity is the concept of opportunity cost one of the key
concepts in economic analysis.
To cement your understanding of opportunity cost, complete the following
activity on this concept.
Activity SG1.1
a. Let us change the details of the problem in concept box 1.1. Suppose that there
were no jobs in the campus shop. The only job available, and this is the alternative
to going to the beach with your friends, is to work at the local fast food restaurant
clearing tables and washing dishes. This job also pays 70, but because of its general
unpleasantness you wouldnt do it unless you were paid at least 55. Should you go
to the beach or work at the fast food restaurant?
b. A high-end ladies fashion boutique purchases winter coats from a manufacturer at
a price of 300 per coat. During the winter the boutique will try to sell the coats at
a price higher than 300 but may not be able to sell all of the coats. Since they are
the latest fashion, no customers would be interested in buying the coats next season.
However, at the end of the winter, the manufacturer will pay the boutique 20% of the
original price for any unsold coats (and re-use the expensive fabrics they are made
from for the next years designs).
i. At the beginning of the year, before the boutique has purchased any coats, what
is the opportunity cost of these coats?
ii. After the boutique has purchased the coats, what is the opportunity cost
associated with selling a coat to a prospective customer? (You can assume the
coat will be unsold at the end of the winter if that customer doesnt buy the coat).
iii. Suppose towards the end of the winter the boutique still has a large inventory of
unsold coats. The boutique has set a retail price of 950 per coat. The marketing
manager argues that the boutique should cut the price to 199 to try to sell
the remaining coats before they become unfashionable at the end of the winter.
However, the general manager disagrees, arguing that would mean a loss of 101
on each coat. Which makes more economic sense the marketing managers
suggestion or the general managers argument?
BVFD: read section 1.2 and case 1.2.
This section raises various economic issues which you may be familiar with
through the news or other sources. It demonstrates what kinds of issues
economics deals with, although in the case of income distribution this is
12
often left to specialised courses. In each case, the authors demonstrate the
impact on the three key questions of what to produce, how to produce it
and for whom.
The global financial crisis of 200709 was a time of great disruption to
economies around the world and indeed to the world economy. As can
be seen in Figure 1.1 of the textbook, the US economy shrank at a faster
rate than had been seen since before the 1980s. The textbook will come
back to this period again and again to provide a fuller account of what
happened, why it happened, and how various countries reacted and to
use this period of recent economic history to illustrate and explain various
points of economic theory.
Rationality
BVFD: read concept box 1.2.
This concept box comes back to the idea of rationality, introduced in
section 1.1 of the textbook. In economics, people are assumed to act
rationally, using all available information to maximise their satisfaction.
In the real world, human behaviour is complex. The field of behavioural
economics examines human behaviour, especially when it appears to
depart from the assumption of rationality. Chapter two (covered in the
second part of this block) concludes with some criticisms of economics,
including the criticisms that people are not as mercenary as economists
think. In fact, depending on the task at hand, behaviour can be modelled
very simply, or in a more complex way to include various other factors,
including altruism. In some cases, even very simple models can go a long
way in explaining human behaviours. When these fail, more complex
elements can be included to make the model more realistic. Behavioural
economics indicates some ways that the simple assumption of rationality
can be extended to provide further insights into human behaviour.
The production possibility frontier (PPF)

BVFD: read section 1.3.
The production possibility frontier is one of the most basic and important
concepts in economics. It shows all the combinations of goods that can be
produced if the means of production are fully employed. It will come up
again in Block 7 when we discuss the perfect competition model of market
structure, Block 11 when we discuss welfare economics and also in Block
23 when we discuss economic growth.
The PPF: scarcity and desirability

The PPF is a boundary. It demonstrates scarcity in that any point beyond
the frontier is unattainable. Society cannot produce combinations that
lie outside the PPF because there are insufficient resources to do so. The
economic problem has been defined as reconciling scarcity with peoples
virtually limitless desires. These desires mean that people wish to have
more of everything as such, points above and to the right of the origin
are seen as better than points closer to the origin. If society produces at a
point on the frontier rather than inside it, society will be better off.
13
The PPF and efficiency

The statements above relate to the idea of efficiency. Points on the PPF
are productive efficient, while points within the curve are inefficient.
An efficient allocation of means of production is one which yields a
combination of outputs where it is not possible to increase the output of
one good without reducing the output of the other.3 Societies must also
choose not just any point on the PPF but a specific point. This relates to
allocative efficiency and will be discussed further in Block 11.
The PPF and opportunity cost

Society has a given amount of resources at its disposal and when the
economy is using these efficiently, using more resources to increase the
production of one good necessarily implies decreasing the production of
the other. This trade-off helps demonstrate the idea of opportunity cost.
The amount by which good B is reduced to increase the production of
good A is the opportunity cost of increasing the production of good A.
Moving along the PPF from one point on the curve to another shows how
much of one good must be given up to increase the production of the other
thus the slope of the PPF is the opportunity cost. The opportunity cost
can also be described as the real price of a good, since it represents the
amount of one good that must be sacrificed in order to attain more of the
other.
The shape of the PPF and marginal analysis

In economics, marginal analysis is very important. Marginal simply means
extra or additional and marginal analysis has to do with decision making
at the margin. Economists often analyse the effects of a one unit change
in something for example: how much better off will a consumer be if
they can purchase one additional unit of a good? How much extra profit
will a company earn by producing one additional unit of a good? How
much more can a company produce if they hire one additional worker?
Asking such questions helps to find the optimal level of (for example)
consumption and production, and you will come across this again and
again throughout the course. For example, Block 4 introduces the idea of
diminishing marginal utility: the first glass of lemonade you drink on a
hot day is very refreshing, the second is less so, and by the time you finish
the third, you may not want to drink any more lemonade for a while. In
this block, the shape of the PPF is linked to diminishing marginal returns:
in the example given in section 1.3, the first worker employed in the film
industry produces 9 units of output, the second produces 8 units, the third
produces 7 units and the fourth produces only 6 units. The fact that the
extra output each additional input can produce diminishes is one reason
why the PPF is concave toward the origin.
14
3
For simplicity, we
assume all goods in the
economy are grouped
into two groups, or
that it is a two-good
economy.
Activity SG1.2
In the box below, draw a production possibility frontier, clearly marking the regions of
inefficient production, efficient production and unattainable production. Illustrate how the
slope of the PPF represents opportunity cost. Why is the frontier concave to the origin?
Opportunity cost and absolute and comparative

advantage
The concept of opportunity cost can also help us to understand why people
(and countries) specialise in the production of certain goods and then
trade.
Let us expand a bit on the treatment of PPFs in the second part of section
1.3, dealing with the two individuals, Jennifer and John, making the two
goods, T-shirts (T) and cakes (C).
We can write, for Jennifer:
Number of T-shirts produced = (T-shirts produced per hour) * hours spent
on T-shirt production (LT).
Or
T=4LT
T
LT =
4
Similarly for Jennifer cake production can be written as:
C=2LC
C
LC =
2
Now, we are also told that Jennifer can work up to 10 hours, in T-shirt
and/or cake production. When she does work 10 hours:
LT +LC = 10
C
T
+
= 10
4
2
Be sure that you understand that for John we have the equation:
2T + C = 10
These equations will show the production possibilities for Jennifer and
John. They will help you in Activity SG1.3 which you should now attempt.
15
Activity SG1.3
a. Putting cakes on the horizontal axis and T-shirts on the vertical axis draw Jennifer and
Johns production possibility frontiers for a 10-hour working day.
b. In what way do these PPFs differ from that drawn in Figure 1.4? Why?
c. Write down the equations of these production possibility frontiers, making T (T-shirts)
a function of C (cakes).
d. What is the interpretation of the slope of these PPFs?
e. In your diagram what represents Jennifers absolute advantage in producing both
goods?
f. In your diagram what represents Johns comparative advantage in making cakes?
To cement your understanding of comparative advantage, complete the

following activity.
Activity SG1.4
Suppose there are two countries (M and W) and two goods (shoes and hats). The table
gives the labour requirements to produce a unit of each output in each country.
Country M
Country W
Shoes
10 labour hrs/unit of output
12
Hats
a. Which country has an absolute advantage in shoes? In hats?

b. Which country has a comparative advantage in shoes? In hats?
c. Assuming each country has 100 labour hours available, what will the total production
of shoes and hats be if each country specialises fully in the production of the good in
which it has a comparative advantage (presumably they would then engage in trade
with each other) compared to what they could produce in a situation with no trade if
they spent half their available labour on each good?
If you are interested in exploring these concepts in more detail you can
read Chapter 29 on Trade (which is optional and will not be covered in
this subject guide).
Markets
BVFD: read section 1.4 and case 1.3 and complete activity 1.1.
As noted above, economics can be defined as the study of how societies
make choices on what, how and for whom to produce. As such, economics
is concerned with the organisation of economic activities in a society and
the institutional arrangements that will provide optimal answers to the
questions above. These institutional arrangements can be thought of as
existing along a continuum from, on the one hand, command economies,
where decisions are made centrally by the government planning office, to,
on the other hand, free market economies where decisions are taken by
individual agents driven by self-interest but organised by market forces as
by an invisible hand.
This section begins to explain how free markets can often bring about
efficient outcomes. In subsequent blocks we will discuss in much greater
detail, and with more rigour, how market forces guide resource allocation.
Although it is true that centrally planned economies (command economies)
16
were riddled with inefficiencies, it would be incorrect to believe that all

non-planned economies are pure market economies. Today we all live in
mixed economies, in which governments play a major role. Subsequent
chapters (13 and 14) will analyse some of the reasons why markets fail
to allocate resources ideally, creating a potential role for the state to step
in. The actual extent of state intervention does, of course, differ quite
significantly across countries and how large the role of the state should be
is a highly contentious issue. Broadly speaking, governments can intervene
in the economy either to promote efficient resource allocation where
markets fail to achieve this end or to achieve more equitable outcomes
than markets generate if left to operate unhindered.
Positive and normative economics

This short section distinguishes in a quite traditional way between positive
and normative economics and you should be clear about the distinction.
There have been some quite eminent economists, such as the Swedish
Nobel Prize winner Gunnar Myrdal who rejected the positive-normative
dichotomy, claiming that normative values are inextricably intertwined
with so called objective or value-free economic analysis. Myrdal argued
that economists would be much better advised to state their values openly
and explicitly rather than pretend that they could be put to one side while
conducting positive analysis. This is not the orthodox view in the profession!
Returning to the treatment in BVFD, complete the following activity.
Activity SG1.5
Classify the following statements as positive or normative:
Inflation is more harmful than unemployment.
_______________________________________________________________
An increase in the minimum wage to 8 per hour would reduce employment by
0.5 percentage points.
_______________________________________________________________
The government should raise the national minimum wage to 8 per hour to help
reduce poverty in society.
_______________________________________________________________
An increase in the price of crude oil on world markets will lead to an increase in
cycling to work.
_______________________________________________________________
A reduction in personal income tax will improve the incentives of unemployed people
to find paid employment.
_______________________________________________________________
Discounts on alcohol have increased the demand for alcohol among teenagers.
_______________________________________________________________
The retirement age should be raised to 70 to combat the effects of our ageing
population.
_______________________________________________________________
17
Microeconomics and macroeconomics

Microeconomics takes a bottom-up approach to studying the economy
focusing on individual consumers, households and firms; while
macroeconomics takes a top-down approach, studying the economy as
a whole system and focusing on aggregates. One analogy that can be used
to describe the difference between macroeconomics and microeconomics
is the study of a rainforest. Macroeconomics studies the ecology of the
rainforest as a whole, while microeconomics studies individual plants and
animals that live there. Most professional economists tend to specialise in
either microeconomics or macroeconomics (indeed, they will specialise on
sub-fields within this broad dichotomy). As you work through the textbook
and the subject guide you may find yourself drawn either to micro or to
macro ahead of the other. That is natural. What you should not do at this
stage of your study of economics is unbalance your commitment of time
to the two halves; that is not a good strategy, either in terms of doing
well in examinations or of building a solid foundation for further study
of the subject. Blocks 11 and 12 cover welfare economics and the role of
the government. Welfare economics employs microeconomic techniques
to analyse welfare at an aggregate (economy-wide) level, and the role of
the government is both micro and macro as governments are involved in
specific markets but also attempt to manage the aggregate level of demand
and encourage economic stability and growth. For simplicity, blocks 11
and 12 are included in the first half of the course on microeconomics.
BVFD: read the Summary and work through the review questions.
BVFD: read Chapter 2.
A note on mathematics
In discussing the tools of economic analysis, this chapter, perhaps
surprisingly, has little to say in general terms about the role of mathematics
in economics. In its methods and approaches, if not its subject matter,
economics today is almost unrecognisable from the subject taught under
the same name 60 or 70 years ago. Of course, one wouldnt expect the
subject to stand still, but in this case the change has been dramatic. Today,
top universities require a high level of mathematical competence of their
students, even at undergraduate level (and even higher at postgraduate
level) while a cursory scan of the top economics journals might give the
impression that the subject is a branch of mathematics. It isnt. Correctly
used, mathematics in economics is a tool a means to an end not an
end in itself. Nevertheless, some have argued that the pervasiveness of
mathematics in modern economics has had damaging consequences both
on the development of the subject (with concentration on topics that lend
themselves to mathematical analysis and relative neglect of those that dont)
and on the ability of economists to communicate with non-economists,
often including those responsible for formulating economic policy.
Whether or not these criticisms are correct, it is highly unlikely that the
trend towards greater reliance on mathematical tools is likely to be reversed
in the near future. For those of you pursuing the subject beyond the
introductory level you will need to be prepared to use considerably more
18
mathematics. That said, the mathematical requirements of this particular

course are quite low. You need to be able to do basic arithmetic and algebra,
(including solving simultaneous equations) and you need to be able to read
and use graphs. Some of the Maths boxes in BVFD use calculus, including
partial differentiation and you should certainly try to understand this
material. Do not regard the mathematics boxes as optional extras.
Models and theory

BVFD: read the introduction to Chapter 2.
The introduction provides a brief but useful argument explaining why
models and theory are so important in economics. Sometimes students
of introductory economics complain that there is too much theory/too
many models. Why cant the subject just stick to the facts? But which
facts? And what can they tell us without guiding principles? On their own
the facts are silent. Teamed with appropriate models, however, they can
be eloquent. Broadly speaking, two key tools of economic analysis are
models/theory and data and they are best deployed in tandem. Sections
2.1 to 2.4 lay out some important issues relating to economic data, and
then the later sections of the chapter introduce economic models and
discuss how models and data are used together in economics.
BVFD: read sections 2.1 and 2.2 as well as concept 2.1.
Activity SG1.6
Index numbers: work through the following example to help you understand how index
numbers are calculated. Say we want to calculate inflation (a Retail Price Index) for
four specific goods. The index for each good is set at 100 for the first year. Work out the
percentage price change in each good (the first one is filled in for you).
Product
Price year 1
Index year 1 Price year 2
Index year 2
Bread
80p
100
120p
150
Cheese
260p
100
312p
Sausages
300p
100
390p
Toothpaste
100p
100
80p
TOTAL
400/4
Overall index
100
The change in the overall index is the average rate of inflation. What was the rate of
inflation for these four products?
Inflation between year 1 and 2 __________________________?
However, the products in the price index are not equally important and should not be
given an equal weighting in the calculation of the index. That is why Weighted Index
Numbers are often used.
Of the four products above, which do you think represents the lowest proportion of a
familys total spending? Which represents the highest?
If toothpaste represents a small proportion of each familys total spending, then we should
make the price change for toothpaste have a much smaller overall effect on the price index. To
do this we weight each price change to give it more or less importance in the overall index.
19
This has been done in the table below see if you can complete the last column:
Product
Weights Price
year 1
Index
year 1
Weighted Price
index
year 2
year 1
Index
year 2
Weighted
index
year 2
Bread
80p
100
400
120p
150
600
Cheese
260p
100
200
312p
Sausages
300p
100
300
390p
Toothpaste
100p
100
100
80p
TOTAL
10
Overall
index
1,000/10
100
Inflation between year 1 and 2 __________________________?

This figure is considerably higher than the original inflation figure. This is because the
products with the highest weights went up in price the most. The effect of the falling price
of toothpaste on the overall index was reduced because this item had a very small weight.
A weighted index gives a much better estimate of inflation, since it reflects which items
are most important to familys expenditure.
BVFD: read sections 2.3 and 2.4 and concept 2.2.
Activity SG1.7
You got a job in the year 2012 with a salary of 25,000. In 2014, you receive a 3,000
increase in your salary. CPI in 2014 with base year 2012 is 108. Calculate your real
income in 2012 and 2014 as well as the percentage changes in your nominal income and
your real income.
Economic models are a deliberate simplification of reality. Just the same
way that an architectural drawing shows all the important features of a
house without necessarily looking realistic, economic models abstract
from reality to clarify important features. This helps to simplify and clarify
the analysis of the problem at hand.
Economic models often use mathematics as the system of logic which ties
various parts of the model together.
Two terms which you should be familiar with are exogeneity and
endogeneity: Following the definitions provided in L&C (glossary),
an endogenous variable is a variable that is explained within a model or
theory. An exogenous variable influences endogenous variables, but is
itself determined by forces outside the model/theory. In the example of
a model of London Underground revenue, the number of passengers is
an endogenous variable, while factors such as bus fares and passenger
incomes are exogenous.
BVFD: read sections 2.6 and 2.7 and complete activity 2.1.
These sections, and 2.9 below, turn to the use of empirical evidence in
economics. They begin to give an intuitive feel for econometrics, the
application of statistical and mathematical techniques, often with the help
of computers, to economic data, in order to test hypotheses and/or forecast
20
the effects of changes in the economic environment on outcomes of interest

(quantity demanded, hours worked, inflation, unemployment, etc.).
Econometrics is a central and well developed aspect of the subject, which is
generally a required component of an undergraduate degree in economics.
However, it is not usually introduced at elementary level.
Fitting lines through scatter diagrams although the term is not provided
explicitly in this section, the description of how a computer, programmed
to apply defined statistical criteria, quantifies the influences of various
factors in a single model is describing multiple regression analysis.
The subsection Reading diagrams is very basic mathematics, not
econometrics. You need to be competent (and confident) in these basic
techniques to follow subsequent chapters of the textbook and this subject
guide. The following activity enables you to practise basic graphical
techniques.
Note: Figures 2.4 and 2.5 plot quantity on the vertical axis and price on
the horizontal axis. These are simply exercises to teach you techniques
for interpreting diagrams and finding the slope and intercept of a line. In
the following chapter, demand and supply diagrams will be introduced
typical demand and supply diagrams put price on the vertical axis and
quantity on the horizontal axis. Of course, the basic techniques of finding
the slope and intercept of the line will remain the same.
Activity SG1.8
Use the following functions to draw diagrams in the boxes below:
Q = 150 10P
Curve
Q = 50 + 20P
Curve
Slope =
Intercept =
Slope =
Intercept =

In economics, a Latin term is often used to indicate that other factors are
held constant, this term is ceteris paribus, which means other things the
same. This has to do with the conditions under which a theory holds. For
example, the market for one product is often studied under the assumption
that prices of other products are held constant. The purpose of this is not
to say that such factors are unimportant, but rather to focus on one effect
at a time. If many factors are allowed to vary simultaneously, the effects of
these can be difficult to disentangle. This section illustrates a technique of
showing the effect of two variables (fares and income in Figure 2.7) in a
two dimensional diagram. When we study the demand for a good we will
21
do something very similar; allowing changes in income to shift the whole

(downward sloping) relationship between price and quantity.
Regarding the relationship between economic theories and data, one
could ask the old question: what came first the chicken or the egg? In
fact, economic theories and empirical evidence (data) feed back on one
another. Someone may notice a certain relationship expressed in economic
data and develop a theory to explain this relationship. That theory will
then be tested by other data, from different time periods and different
contexts these data will either corroborate the theory, or lead to it being
modified or abandoned in favour of a theory that better fits the evidence.
Criticisms of economics
One criticism levied against economics which is mentioned briefly in this
section is that the actions of human beings cannot be reduced to scientific
laws. However, if we look at human behaviour in general, we can see
stable patterns on average even though the behaviour of individuals is
unpredictable. This has to do with the law of large numbers, a statistical
concept or law which states that as the number of individual cases
increases, random movements tend to offset each other, such that the
difference between the expected value and the actual value tends to zero.
That means the behaviour of a group of people is much more predictable
than the behaviour of certain individuals, because the odd things one
individual does tend to be cancelled out by the odd things that some other
individual does (this is discussed further in previous versions of L&C e.g.
Chapter 2 of the 12th edition).
More recently, economics has been criticised for failing to predict the
financial crisis and associated recession beginning in 200708.4 This led
to some damage to the reputation of the subject and to the status of the
profession. It is too early to say just how damaging this has been (there
doesnt seem to be any major decrease in the demand to study economics
at university or, broadly speaking, in the longer-term employment
prospects of economics graduates in either the private or public sectors).
One consequence of the crisis has been considerable self-examination of
the way in which the subject has been taught in the past and the first signs
of new pedagogical approaches can be detected in the revamping of some
introductory courses.
Overview
Economics analyses what, how and for whom society produces. The key
economic problem is to reconcile the conflict between peoples virtually
unlimited desires and the scarcity of available resources and means
of production. The PPF shows the maximum amount of one good that
can be produced given the output of another. The slope of the PPF is
the opportunity cost (of the good on the horizontal axis in terms of the
other). More generally, opportunity cost is the value of the best alternative
that must be sacrificed. The fact that different individuals and countries
have different opportunity costs of producing various goods gives rise to
comparative advantage and creates the possibilities for gains from trade.
22
4
Some economists
were prescient. Nouriel
Roubini (NYU. Stern
School of Business)
as early as 2006 was
predicting that the
US housing bubble
would burst, leading
to damaging loss of
consumer confidence
and ultimately to
recession. Widely
criticised for being too
pessimistic at the time
Roubinis forecasts were,
if anything, exceeded by
actual events. The link
provides some thoughts
of the Chairman of the
US Federal Reserve,
Ben Bernanke on the
implications of the crisis
for economics:
www.federalreserve.
gov/newsevents/speech/
bernanke20100924a.
htm
In economics, people are assumed to behave rationally only taking an

action if its benefits outweigh its costs. Furthermore, people are assumed
to be motivated by self-interest. The idea of the invisible hand describes
how, under certain conditions, market forces allocate resources efficiently
despite the self-interested motivations of individuals. Markets resolve
production and consumption decisions via the adjustment of prices.
There is a spectrum of government involvement in the economy from a
command economy to a free market economy. Most industrialised nations
have mixed economies.
Economics has many dimensions. Positive economics deals with facts
about how the economy behaves, while normative economics involves
subjective judgements. Microeconomics studies particular markets and
activities in details, while macroeconomics deals with aggregates and
studies the economy as a whole system.
The second half of this block examined the relationship between data
and theory and provided guidance and instruction regarding key practical
concepts and skills such as index numbers, nominal and real variables,
measuring change, diagrams, lines and equations. The interplay of data
and theory/models in economics is very important. Models are deliberate
simplifications of reality which help organise how we think about a
problem. Data can indicate a relationship that will later be theorised
about, and can also be used to quantify relationships and test existing
theories. A key approach of economic analysis is to abstract from various
factors by holding them constant this is known as ceteris paribus or other
things equal. Chapter 2 concludes by briefly addressing some popular
criticisms of economics and economists, such as the extent of disagreement
in the discipline (which in fact often relates more to normative than to
positive economics) and assumptions about human behaviour, which are
sometimes seen as oversimplified.
Reminder of learning outcomes

Now go back to the list of learning outcomes at the start of the block, and
be sure that they have been achieved.
Sample examination questions

Multiple choice questions
For each question, choose the correct response:
1. Every summer, New York City puts on free performances of
Shakespeare in Central Park. Tickets are distributed on a first-comefirst-served basis at 13.00 on the day of the show, but people begin
lining up before dawn. Most of the people in the lines appear to be
young students, but at the performances most of the audience appears
to be made up of older working adults (tickets can be transferred,
so the person picking up the tickets does not have to be the person
watching the performance). Which of the following concepts best
explains this fact?
a. Ceteris paribus.
b. Opportunity cost.
c. Marginal analysis.
d. Absolute advantage.
23
2. The output produced by Samuel and Roberto in 20 labour hours is

given below for wine and cheese. Choose the option with the correct
statement below.
Wine
Cheese
Samuel
Roberto
a. Samuel has an absolute advantage in both products and a

comparative advantage in cheese.
b. Roberto has an absolute advantage in both products and a
comparative advantage in cheese.
c. Roberto has an absolute advantage in cheese and a comparative
advantage in wine, while the opposite is true for Samuel.
d. Samuel has an absolute advantage in both products and a
comparative advantage in wine.
e. Roberto has an absolute advantage in both products and a
comparative advantage in wine.
Long response question

Use the production possibility frontier to illustrate the following concepts:
i. scarcity
ii. opportunity cost
iii. productive efficiency
iv. diminishing marginal returns.
24
Block 2: Demand, supply and the market

Introduction
The previous block introduced economics as the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them and described how societies adopt various
institutional arrangements to answer these questions as best they can. In
the societies we all live in, the role of the market is very important as a
means of answering these questions. Markets bring together buyers and
sellers and the mechanism of prices operates to coordinate the quantities
sellers wish to sell with the quantities buyers wish to buy. This chapter
examines demand and supply and the way they interact within markets to
determine quantities and prices.
The focus of this chapter, the demand and supply model, is perhaps the
iconic model of economics. Like all models it has its shortcomings and
knowing when it is appropriate to the analysis of a particular problem,
and when it is not, is something of an art. Some of the strengths and
weaknesses of this basic model will become clearer in subsequent chapters
of the text and blocks in this guide, but first you need to become familiar
with the basic workings of the model. Also postponed until later is the
analysis of the behaviour of individual consumers and individual firms
which lie behind demand and supply curves. It would also be possible to
start with the behaviour of these individual agents and then derive the
market demand and supply curves, however, experience suggests that
the power of supply and demand analysis in showing how prices and
quantities respond to changes in the economic environment can also be
experienced without all the detailed foundations being in place (as long
as they provided subsequently) and that this approach is often more
motivating than the reverse sequencing. The blocks of the subject guide
therefore follow the order of the textbook in firstly presenting the demand
and supply model and then showing later how demand and supply curves
are derived from the behaviour of individual consumers and firms.
Demand is the quantity of a product that buyers wish to purchase at any
given price, while supply is the quantity of a product that suppliers are
willing to sell at any given price. Demand and supply come together in a
market and this determines the price and quantity of goods sold. This will
be described in more detail in this chapter. Since we have all bought (and
maybe also sold) goods before, many of these ideas are quite intuitive.
Nonetheless, it is important to become familiar with the language
economists use to explain these ideas and the way that economics deals
with them. Graphical analysis is very important in economics and you will
need to become very comfortable with drawing demand and supply curves
and using them to demonstrate changes in various influential factors. You
will hopefully find this a very useful tool of analysis.
Learning outcomes
define the concept of a market
draw demand and supply curves (and inverse demand and supply
curves)
25
find equilibrium price and equilibrium quantity

describe how price adjustment reconciles demand and supply in a
market
analyse what shifts demand and supply curves
define reservation prices
describe consumer and producer surplus
analyse excess supply and excess demand
discuss the consequences of imposing price controls
discuss how markets answer what, how and for whom to produce
describe the functions of prices (to ration, to allocate).
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 3.
Further reading
Lipsey and Chrystal (L&C), Chapter 2.
Witztum (AW), sections 2.1 and 4.1.

This chapter introduces demand and supply and how these come together
in a market to determine equilibrium price and quantity. The factors that
underlie demand curves and supply curves are outlined, as is the way that
a change in one of these factors will lead to a shift in the relevant curve.
The concepts of consumer and producer surplus will also be introduced.
These exist because there are consumers who would be happy to pay
more than the market price, and suppliers who would be happy to sell for
less that the market price. The chapter will also show that allowing the
market to determine price (rather than having the government impose a
price) results in the maximum amount of consumer and producer surplus.
Through the readings and the exercises below, these ideas will now be
examined in further detail.
Equilibrium
BVFD: read sections 3.13.3.
Before turning to some activities which will help to consolidate your
understanding of the material in these sections it is worth elaborating
a little on the concept of equilibrium in economics. You will find that
this concept is central in economic theory (whether it is observable in
practice raises further issues which we do not address here) although
it has many interpretations; even in a basic course such as this you will
encounter more than one version. In microeconomics we are about to
look at the concept of equilibrium market price, later when we introduce
game theory we will encounter the concept of a Nash equilibrium and in
macroeconomics we will define equilibrium in terms of aggregate supply
and demand (as opposed to the supply and demand in the market for a
particular good or service), in terms of simultaneous goods and money
market equilibrium (IS-LM equilibrium) and in terms of the so-called
steady state (where capital, investment and output per worker are
constant) in growth theory. What is common in all these examples is that
the system being analysed is in some sense at rest there are no forces at
work generating further changes to the system. In the demand and supply
26
model, an equilibrium price is one where, simultaneously, consumers want

to buy just the amount that firms want to sell. At any other price one or
other of these groups would want to change the amount they buy or sell.
Usually when an economic system is not in equilibrium, there will be
incentives for the actors or agents in the model to change their behaviour
in ways that move the system towards equilibrium.1
Demand and supply curves

Activity SG2.1
Use the data in the following table to draw for yourself a demand curve, a supply curve, and
the whole market where demand and supply interact. Be careful to put price on the vertical
axis and quantity on the horizontal axis. What are the equilibrium price and quantity?
Price of a
Small Table ()
Quantity Demanded
(thousands)
Quantity Supplied
(thousands)
90
10
75
15
20
60
30
30
45
45
40
30
60
50
15
75
60
90
Demand Curve
Supply Curve
1
In more advanced
analysis, questions can
arise as to whether an
equilibrium exists in
the first place and, if it
does, whether it is stable
in the sense that, out
of equilibrium, forces
arise driving the model
being analysed back to
equilibrium. We do not
examine these issues
further on this course.
Demand and Supply
(Note: Although these lines are straight, they are still called demand and supply curves).
BVFD: read Maths box 3.1.
Maths box 3.1 introduces a simple mathematical way of describing the
demand and supply curves and finding equilibrium price and quantity. You
need to be familiar with this algebraic approach where the constants in
the supply and demand curves are given letters (here a, b, c, d) and where
they are expressed as numbers, as in the following activity.
Activity SG2.2
The direct demand function and direct supply function can be used to easily find the
equilibrium quantity and price. Use the following curves to find the equilibrium price and
quantity for noodles:
QD= 30 3/4P
QS= 5 + 1/2P
Equilibrium Price =
Equilibrium Quantity =
27
Although people generally talk about quantity as a function of price, when

it comes to drawing the graph, price is always drawn on the vertical axis,
so it is easier to work with the inverse demand function, where price is
expressed as a function of quantity demanded. For example:
Inverse Demand:
P = 20 QD
Inverse Supply:
P = 6 + QS
These equations are very useful for us to graph the demand and supply
curves, because we can easily read the key characteristics of the curves
straight off the relevant function. To graph the inverse demand function
P = a/b 1/b*QD (using the notation from Maths box 3.1), we can use
the fact that the intercept on the price axis is a/b and the gradient is 1/b.
Similarly, for the inverse supply function P = c/d + 1/dQS, the intercept is
c/d and the gradient is 1/d.
For example, if the inverse demand curve is P = 12 4QD, the demand
curve touches the vertical axis at P = 12 and slopes downward with a
slope of 4.
Activity SG2.3
Find the inverse demand and supply functions using the direct demand and supply
functions in the table below.
Demand/Supply Function
Demand
Q = 30 *P
Supply
QS= 5 + *P
Inverse Demand/Supply Function
and graph these in the following box:

Supply and Demand Curve
Shifts in the demand and supply curves

BVFD: read sections 3.43.7, including cases 3.1 and 3.2.
Activity 3.1 in is important, since it distinguishes between movements along a curve and
shifts in the curve itself. Complete the activity.
Activity SG2.4
For each event in the following table, identify whether this relates to demand or supply, in
what direction the curve would shift, and the effect on price and quantity. If you draw a
graph for each example, you will also see the movement along the other curve, resulting
in the new equilibrium price and quantity. The first line has been completed for you.
28
The market for sushi

Event
Which curve
shifts? Supply
or demand?
Direction? Effect on
price?
Effect on
quantity?
Movement along
the other curve
which direction?
The price of salmon

increases
Supply
Left
Lower
Demand, left
Higher
Sushi becomes more

popular in Europe
The price of similar
alternatives rises
Sushi sellers expect
the price of sushi to
rise in the future
New evidence reveals
sushi is not as healthy
as people had thought
New sushi machines
make production
more efficient
Consumer and producer surplus

BVFD: read section 3.8 and concept 3.1 on consumer and producer
surplus.
Imagine the following scenario:
The current price for a two-litre bottle of orange juice in my local grocery
store is 70p. Thats good news to me, because I was prepared to pay 1.20.
The store manager is happy to see me loading some cartons into my
trolley, because she knows the store would have been happy to sell them
for just 45p.
Im thinking: This is great! Im coming out 50p ahead on each carton!
Shes thinking: Fantastic! Im coming out 25p ahead on each carton!
So we are both enjoying a surplus.
The equilibrium price is set by the marginal consumer and producer who
were only willing to buy/sell for exactly 70p. Consumers who would
have been willing to pay more still just pay the equilibrium price and
enjoy a surplus. Producers who would have been willing to sell it for less
can still ask the equilibrium (market) price and also enjoy a surplus. The
efficient market outcome occurs where consumer and producer surplus are
maximised. We will come back to this later.
29
Activity SG2.5
1. The only four consumers in a market have the following willingness to pay for a good:
Buyer
Willingness to Pay
Sally
15
Simon
25
Susan
35
Shaun
45
If there is only one unit of the good and if the buyers bid against each other for the
right to purchase it, then the consumer surplus will be:
a. 0 or slightly less
b. 10 or slightly less
c. 30 or slightly less
d. 45 or slightly less.
NB: It may help to calculate the price first. Assume it is an open auction where each
bidder calls the price out aloud.
2. Examine the diagram below:
120
Supply Curve
100
80
60
Equilibrium
40
Demand Curve
20
100
Quantity
Figure 2.1: Supply and demand.

At the equilibrium price, the producer surplus is equal to:
a. 2,000
b. 4,000
c. 6,000
d. 10,000.
30
3. Here you see Anthonys demand curve for football matches (you can treat the demand
curve as being approximately linear).
P
8
6
10
Figure 2.2: Anthonys demand for football matches.

When the price per match falls from 8 to 6, his welfare:
a. Rises by 16
b. Falls by 16
c. Rises by 12
d. Falls by 12.
BVFD: read sections 3.9 and 3.10 as well as cases 3.33.5.
These sections will further develop your understanding of demand, supply and
equilibrium. You should read them carefully and try to think each point through. Can
you think of another market where price floors or ceilings have been imposed?
Activity SG2.6
Price floors and ceilings result in a loss of consumer and producer surplus, this is called a
deadweight loss. Can you calculate how much consumer and producer surplus is lost
due to the price ceiling in the diagram below? Has there also been a transfer of surplus
between consumers and producers?
Price
120
100
Supply Curve
80
Free Market Equilibrium
60
40
Excess demand
Demand Curve
20
Price Ceiling
50
100
Quantity
Figure 2.3: Loss of producer and consumer surplus due to a price ceiling.
BVFD: read the summary and work through the review questions.
31
Overview
Buyers and sellers come together in a market and exchange goods and
services. Demand (from buyers) and supply (from sellers) are key concepts
of economic analysis. Demand curves display the quantity that buyers
wish to buy at each price and generally slope downwards demand is
higher when the price is lower. Supply curves display the quantity that
sellers wish to sell at each price and generally slope upwards sellers
are prepared to sell more when the price is higher. The market clears
(and equilibrium is achieved) at the point where the demand and supply
curves intersect. Understanding what demand and supply curves represent
and what makes them shift is the most fundamental lesson from this
block. Price changes are represented by a movement along a curve,
shifts in the curves indicate changes in other factors, such as the price of
complements or substitutes or changes in consumers income (for demand
curves) and changes in technology and input prices (for supply curves).
Shifts in the demand or supply curves change the equilibrium price and
quantity. Inverse demand and supply curves (where price is expressed as
a function of quantity) can be useful for graphing the curves. The block
also introduces consumer and producer surplus and the fact that price
controls lead to a reduction in consumer and producer surplus, whereas
free markets optimise consumer and producer surplus. You need to be able
to calculate consumer and producer surplus and the loss involved due to
price controls.

Now go back to the list of learning outcomes at the start of the block and

1. An increase in consumer incomes would result in:
a. a decrease in demand for bread
b. a decrease in demand for diamonds
c. a decrease in demand for low-quality cars
d. an increase in demand for inter-city bus travel (compared to flying
or taking the train).
2. An increase in the price of chilli would lead to:
a. an increase in demand for Mexican food
b. a decrease in supply of Mexican food
c. an increase in the supply of Mexican food
d. a decrease in demand for other spices.
3. From the diagram below, the loss in consumer surplus due to the price
floor is:
a. 50
b. 100
c. 150
d. 200.
32

Price
50
Supply Curve
Excess supply
40
Price Floor
30
Free Market Equilibrium
20
Demand Curve
10
10
20
30
Quantity
Figure 2.4: Loss of consumer surplus due to a price floor.
4. Given the following inverse demand and supply curves:

P = 8 QD/2
P = 2 + QS
and assuming that price is fixed below the equilibrium price at 5, the
loss in producer surplus due to the price ceiling is:
a. 3.50
b. 4.50
c. 8
d. 9.
5. The demand curve for good A is given by:
Q AD = a bPA + cPB
Where PA is the price of good A, PB is the price of good B, and a, b, c
are positive constants. The supply curve for good A is also linear and is
upward sloping:
a. Goods A and B are complements.
b. Goods A and B are substitutes.
c. Goods A and B are unrelated in consumption.
d. The demand curve for good A is upward sloping.
6. The demand curve for good A is given by:
Q AD = a bPA + cPB
Where PA is the price of good A, PB is the price of good B, and a, b, c
are positive constants. The supply curve for good A is also linear and is
upward sloping. When the price of good B increases:
a. The quantity of A purchased falls and the price of A falls.
b. The quantity of A purchased increases and the price of A increases.
c. The quantity of A purchased increases and the price of A falls.
d. The quantity of A purchased increases and the price of A stays the
same.
7. Suppose that the price of Porto wine was 20 per litre in 2010 and 25
per litre in 2011. Ingrid observes that Margarets consumption of wine
rose from 1 litre per month in 2010 to 1.2 litres per month in 2011.
33
Ingrid concludes that Margarets demand for Porto wine has to be

upward sloping:
a. Ingrid is wrong: given the above information Margarets demand
for Porto wine has to be downward sloping.
b. Ingrid is right: given the above information Margarets demand for
Porto wine has to be upward sloping.
c. Ingrid is wrong: the above information is not enough to conclude
that Margarets demand for Porto is necessarily upward sloping.
Long response question

Suppose that the inverse demand and supply schedules for rental
apartments in the city of Auckland are as given by the following equations:
Demand: P = 2700 0.12QD
Supply: P = 300 + 0.12QS
a. What is the market equilibrium rental price per month and the market
equilibrium number of apartments demanded and supplied?
b. If the local authority can enforce a rent-control law that sets the
maximum monthly rent at $900, will there be a surplus or a shortage?
Of how many units will this be? And how many units will actually be
rented each month?
c. Suppose that the government decides to implement a policy to keep
out the poor. It declares that the minimum rent that can be charged is
$1,500 per month. If the government can enforce that price floor, will
there be a surplus or a shortage? Of how many units will this be? And
how many units will actually be rented each month?
d. Suppose that the government wishes to decrease the market
equilibrium monthly rent to $900 by increasing the supply of housing.
Assuming that demand remains unchanged, find the new equilibrium
quantity and the new inverse supply curve.
34
Block 3: Elasticity
Block 3: Elasticity
Introduction
The concept of elasticity is very important in microeconomics here we
devote a whole block to it! Elasticity has to do with responsiveness, for
example: how much does the quantity demanded of a good respond to
a change in the price of that good? For some goods, such as life-saving
medicine, peoples demand will not fall much even if the price increases
substantially, while for other goods, such as a particular chocolate bar,
the demand will respond to price much more, since if the price of one
chocolate bar goes up, people will generally be quite happy to purchase
another one (or a different kind of snack) instead. This chapter uses many
examples to make the concepts more intuitive, and also relies on graphs
and simple equations. Make use of the exercises in this block and in the
textbook to really master this concept and its applications.
Learning outcomes
describe how elasticities measure the responsiveness of demand and
supply
define and calculate price elasticity of demand
indicate the determinants of price elasticity
describe the relationship between demand elasticity and revenue
recognise the fallacy of composition
describe how cross-price elasticity relates to complements and
substitutes
define and calculate income elasticity of demand
use income elasticity to identify inferior, normal and luxury goods
define and calculate elasticity of supply
describe how supply and demand elasticities affect tax incidence.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 4.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 2; UK edition,
Chapter 3.
Witztum (AW), Chapter 2 section 2.4.

This block will explore the reasons why demand for certain goods
responds more or less to a change in price. Furthermore, we will also
explore how demand for a good changes in response to a change in the
price of another good, and also how it responds to a change in consumers
income. As well as the elasticity of demand, we will also examine the
elasticity of supply (i.e. how much producers supply decisions change in
response to a change in price). The implications of elasticity for a firms
total revenue, and for the effects of taxation shall also be examined.
35
Price elasticity of demand

BVFD: read section 4.1 of Chapter 4.
The formula for calculating price elasticity of demand (PED) is important and
also quite intuitive:
Price elasticity of demand = [% change in quantity] /
[% change in price]
As explained in Maths 4.2 this can be expressed using delta notation as:
PED =
Q P
P Q
where Q refers to quantity demanded and P to price. always means change

in, such that Q means change in quantity.
If the quantity demanded changes a lot in response to a change in price, we
say demand is responsive (or sensitive) to the price change, and the
demand is elastic. If the price can change a lot without really affecting the
quantity demanded, we say that demand is unresponsive (or insensitive)
to the change in price and demand for that product is inelastic.
Demand is elastic if the elasticity is more negative than 1.
Demand is inelastic if the price elasticity lies between 1 and 0.
This is represented in the sketch below:
inelastic
elastic
Figure 3.1: Defining elastic and inelastic demand.
When PED=0 demand is said to be perfectly inelastic and when PED=

we say demand is perfectly elastic.
While economists often discuss the absolute value of the elasticity (so if this
is between zero and 1, demand is said to be inelastic, and if it is greater than
1, demand is said to be elastic) we recommend you not to lose track of the
sign of the elasticity. As we shall see below for other elasticities (cross-price
elasticity, income elasticity), the sign has important implications. Nonetheless,
you will often see positive numbers for own-price demand elasticities this is
a shorthand and does not necessarily imply that the law of demand has been
violated.
The Greek letter eta () is often used to denote elasticity. For example, = 0
means that the price elasticity of demand is equal to zero and quantity
demanded will not change at all in response to a change in price.
Activity SG3.1
Consider your own buying habits. Rank the items below in terms of how responsive your
demand for these goods is to a change in their price:
Product
A nice pair of trousers
Rice
Bananas
Medicine
Holidays abroad
36
Rank of responsiveness
Block 3: Elasticity
BVFD: read Maths 4.1 and Maths 4.2.

There are various ways of calculating elasticity. Arc elasticity (Maths 4.1)
is used to find the elasticity between two different points of a demand
curve, in such a way that it is equal whether you analyse the change in
price as an increase or a decrease.
Point elasticity, on the other hand, describes the elasticity at a certain point
on the demand curve. Maths 4.2 on point elasticity uses calculus, however,
it also explains that the derivative of the direct demand function gives
the slope of the direct demand function at a given point. If the function is
Q
linear, the slope is constant for the whole curve, and corresponds to P in
the PED
formula above. The slope of a curve is straightforward and something you
can easily use without any knowledge of calculus.
One thing to be careful of is whether you are using the direct or the
inverse demand function (remember Block 2). For an inverse demand
function, use the inverse of the slope. For a direct demand function, you
can use the slope directly. That should be easy to remember!
That means that for an indirect demand function, the point elasticity is:
PED = 1/s * (P/Q), where s is the slope. For example: P = 20 Q/2 is an
indirect (or inverse) demand function. The slope of this is dP/dQ = 1/2.
In this case, you would use PED = (1/0.5) *(P/Q) = 2*(P/Q).
On the other hand, Q = 40 2P is a direct demand function. The slope of
this is dQ/dP = 2. (To check that the slope of the direct demand function
is equal
Q
P
-10
5
Q
P
to note that if P = 5, Q = 30. If P = 10, Q = 20. Therefore
= 2). In this case you would use PED = 2*(P/Q).
If you want to express the elasticity as a positive number, you will need to
use the absolute value (or just multiply the negative number by the minus
one, which is the same thing).
Activity SG3.2
Part A: Calculating an arc elasticity
Given the following information, calculate the elasticity of demand for the following
goods, expressing the elasticities as positive numbers
Initial Price and Quantity
New Price and Quantity
Good A
Good B
Good C
Good D
P0 = 4
P0 = 4
P0 = 5
P0 = 12
Q0 = 10
Q0 = 10
Q0 = 4
Q0 = 13
P1 = 5
P1 = 5
P1 = 2
P1 = 11
Q1 = 7
Q1 = 9
Q1 = 10
Q1 = 15
PED: value
PED: category
37
Part B: Calculating a point elasticity

Given the following information, calculate the elasticity of demand for the following
goods, expressing the elasticities as positive numbers:
PED = 1/s * (P/Q)
Slope = ____
Price
20
At X, PED =
At Y, PED =
16
At Z, PED =
Y
10
20
30
40
Quantity
Figure 3.2: Calculating point elasticities on a demand curve.
BVFD: read sections 4.24.4 and cases 4.1 and 4.2.

Activity SG3.3
The following table identifies some factors which act as determinants of demand
elasticity. Fill in the fourth column, which has been left blank, with a concrete example.
38
Factor
Example
Effect on demand elasticity
Necessity
People depend on
this
Demand is inelastic
Substitutes
There are many

similar products
available
Demand is elastic
Definition
Good defined very

narrowly
More elastic (because

there are more possible
substitutes)
Time-span
Tastes change/more
drastic adjustments
become feasible
Demand becomes more

elastic
The share of
your budget
Small items
Demand is inelastic
Good/Service
Block 3: Elasticity
Activity SG3.4
Use the boxes below to draw demand curves appropriate to each heading:
Perfectly elastic demand
Perfectly inelastic demand
=
Activity SG3.5
Total spending is the same as the firms revenue. Use the data below to decide, if you
were a manager, whether or not to make the price change in the following cases (you can
ignore costs for the purposes of this activity and just assume that an increase in revenue
is a good thing and a decrease in revenue is bad). For each case, calculate the demand
elasticity (using the arc method), decide whether or not to make the change, and then
check your answer by calculating total revenue before and after the price change.
a. Increasing the price from 6 to 7 will lead to a fall in sales from 10,000 to 8,000.
b. Increasing the price from 8 to 10 will lead to a fall in sales from 15,000 to 12,500.
c. Decreasing the price from 20 to 18 will lead to an increase in sales from 6,000 to
8,000.
This activity emphasises the relationship between elasticity and total
revenue. This is clearly explained in the textbook, but if you are not afraid
of a bit of algebra we can derive a useful formula linking the two:
TR = P * Q
TR QP + PQ
(This approximation depends on P and Q being small so that the
product PP is very small, or what is know as second order small)
Dividing by P
TR
P
but the second term is Q times PED so
TR
P
=Q+P
Q
P
= Q (1 + PED)
Remember that PED is negative and P is positive for a price increase and
negative for a price decrease. So, for example if demand is elastic, say 2,
and price falls, then the sign of TR is positive. If it is inelastic, say 0.3,
and price falls, then the sign of TR is negative.
Cross-price elasticity of demand

In Block 2, we discussed how a change in own-price leads to a movement
along the demand curve, while a change in the price of a related good
leads to a shift in the demand curve. An increase in the price of a
substitute good will shift the demand curve to the right; an increase in the
price of a complement will shift the demand curve to the left. Section 4.5
39
discusses the responsiveness of quantity demanded of a good (lets call this

good i) to a change in the price of a related good (which we can call good
j) this is known as cross-price elasticity of demand. The formulas
for calculating this are the same as for own-price elasticities, except that
you will use the original and new price of good j, and the original and
new quantity of good i. For example, using delta notation the cross-price
elasticity for good i with respect to the price of good j is:
Qi
Pj
Pj
Qi
Unlike the case of a downward sloping demand curve where PED was
always negative, the cross-price elasticity can be positive or negative
depending on how the goods are related in consumption (whether they
are substitutes or complements). The cross-price elasticity of demand is
negative for complements and positive for substitutes. If the price of good i
increases, people will demand less of good j if it is a complement to good i,
and more of good j if it is a substitute for good i. What would be the value
of the cross-price elasticity between two goods if they were completely
unrelated?
Activity SG3.6
Multiple choice question
A Bordurian lawyer explains: Smoking is a Bordurian tradition. If you had coffee, you had
cigarettes; if you had cigarettes, you had coffee. According to this statement, the cross-price
elasticity of the demand for coffee with respect to the price of cigarettes in Borduria is:
a. positive
b. negative
c. zero.
Income elasticity of demand

Activity SG3.7
Classify the following goods, based on their (hypothetical) income elasticity:
Good
Income elasticity
Car
2.98
Food
0.5
Margarine
0.37
Vegetables
0.9
Public transportation
0.36
Books
1.44
Type of good
Would you expect income elasticities for given goods to be broadly similar in different
countries? For example, would you expect the income elasticity of demand for public
transport to be similar in the USA and in Mali? Think about why or why not.
The formula for calculating income elasticity of demand is:
Percentage change in quantity demanded of good X divided by the
percentage change in real consumers income.
Using the delta notation and letting Q represent quantity of the good
40
Block 3: Elasticity
demanded and M represent real consumer income, income elasticity of

demand (IED) is given by the formula:
Q
Price elasticity of supply

BVFD: read sections 4.7 and 4.8 as well as Maths 4.3.
Activity SG3.8
For the following direct supply function, calculate and interpret the PES when Q = 10
and P = 2.5.
Direct Supply Function: QS = 5 + 2P
PES =
Activity SG3.9
Initially, the price of a tennis racket is 20. Demand is 30 and supply is 50. If the price
falls by 5, the quantity demanded rises to 40, the quantity supplied rises to 40, and the
quantity demanded of white cotton t-shirts rises from 70 to 100. Using the arc method,
calculate the own-price demand elasticity and the elasticity of supply for tennis racquets;
and the cross-price demand elasticity for white cotton t-shirts. Are white cotton t-shirts a
complement or substitute to tennis racquets?
Own price elasticity =
Cross-price elasticity =
Elasticity of supply =
Substitute or complement?
BVFD: Examine Table 4.11 this provides a simple but helpful summary
of the chapter up to section 4.8.
Make sure that you also understand section 4.7 which brings together ownprice, cross-price and income elasticities with reference to inflation.
Incidence of a tax
The key point of this section is that the incidence of the tax is not related
to the person who physically pays the money to the government. Rather,
whichever party (consumers or producers) is less price sensitive (either in
demand or supply) will bear the greater share of the burden of the tax.1
Suppose demand were perfectly inelastic, how would the burden of a sales
tax be shared between consumers and producers?
It is important to realise that a sales tax drives a wedge between the price
paid by consumers (sometimes called the demand price) and the price
received by producers (the supply price). In a simple supply and demand
diagram in the absence of taxes these two prices are, of course, the same.
Another point to consider is why goods such as cigarettes and fuel are
taxed so heavily. This isnt only a question of improving health or reducing
pollution consider the PED of these goods and the implications for
government tax revenues of taxing goods such as these.
This is summed up in an
expression which holds
for small taxes, but which
we do not prove here:
PES
D
=
S

PED
In words, the ratio of
the change in the price
the consumer pays (the
demand price) to the
change in the price that
the producer receives
(the supply price) is
equal to the ratio of the
price elasticity of supply
to the price elasticity of
demand.
BVFD: read Maths 4.4.

41
Activity SG3.10
Lets put Maths box 4.4 into practice using a numerical example. If:
QD = 30 4P
QS = 6 + 8P
t = 0.375 where t is a specific tax that has to be paid by suppliers.
Calculate
i. the equilibrium quantities with and without the tax
ii. the increase in the price paid by consumers and the fall in consumer surplus
iii. the fall in the price received by suppliers and the fall in producer surplus
iv. the tax revenue received by the government
v. the deadweight loss of the tax.
Activity SG3.11
Multiple choice question
Here you see the football fans demand curve d for televised football matches together
with the Football Associations (FA) supply curve s for such matches. The market for
televised matches clears where the two curves cross, hence when 10 matches are
televised for 6 each. Suppose now that the Government introduces a tax of 4 per
televised match. The figure shows that the number of televised matches falls from 10 to
6. For these 6 matches fans pay 8 but the FA earns only 4 as the difference goes into
the governments coffers.
P
S
8
6
d
4
2
0
10
Games per year
Figure 3.3: Demand and supply of televised football matches.

As a result of the tax:
a. The welfare of fans increases and the welfare of the FA decreases.
b. The welfare of fans decreases and the welfare of the FA increases.
c. Both fans and the FA lose welfare but the government raises enough tax revenues to
compensate them.
d. Both fans and the FA lose welfare and the government does not raise enough tax
revenues to compensate them.
e. Both fans and the FA gain welfare.
42
Block 3: Elasticity
BVFD: read the summary and work through the Sample examination
questions.
Overview
This block describes the concept of elasticity, explores how to calculate
elasticities and discusses the implications. Conceptually, elasticity has to
do with responsiveness, usually how much demand or supply responds to
a change in price or income. You need to know how to calculate arc and
point elasticities. The type of elasticities you need to be familiar with are
as follows: own-price demand elasticity (elastic if more negative than 1,
unit elastic if 1, inelastic if between 1 and 0; though in practice these
are often expressed as positive numbers using the absolute value), crossprice demand elasticity (generally positive for substitutes and negative for
complements), income elasticity of demand (negative for inferior goods,
larger than 1 for luxury goods) and supply elasticity (positive since the
supply curve slopes upwards). Elasticity has implications for total spending
on a product (which from the companys perspective is simply revenue):
If demand is elastic, a fall in price leads to an increase in revenue. It also
has implications for tax incidence the more price insensitive side of the
market (be it buyers or sellers) will bear a greater burden of the tax.


1. If demand for pork is given by: QD = 200 6P + 2Y, when the price of
pork is 8, a rise in consumers income from 100 to 150 leads to:
a. a fall in demand and an income elasticity of 0.14, pork is an
inferior good
b. a rise in demand and an income elasticity of 0.14, pork is a normal
good and a necessity
c. a rise in demand and an income elasticity of 7.08, pork is a luxury
good
d. a fall in demand and an income elasticity of 7.08, pork is an
inferior good.
2. Suppose that a firm currently charges a price of 100 per unit and
at this price its total revenue is 70,000. Suppose also that at this
price, demand is elastic. Now the firm raises its price by 2 per unit.
Explaining your answer, state which of the following quantities the
firm might sell after the price increase
a. 300
b. 600
c. 900
d. 1,200.
43
3. In Cte dIvoire the own-price elasticity of demand for beef is 1.91. If

the price of beef rises by 10 per cent, the quantity demanded of beef:
a. rises by more than 10 per cent
b. falls by less than 10 per cent
c. falls by more than 10 per cent
d. rises by less than 10 per cent.
4. When price elasticity of demand is greater than unity (in absolute
value), revenue will:
a. increase with an increase in price
b. decrease with a fall in price.
c. decrease with an increase in price.
d. remain unchanged with any change in price.
5. An estimation of demand facing a particular firm produced the
following information with regard to the elasticities of the demand
function for x:
Own price: 2; income: 1.5; cross price, y: 0.8; cross price z: 3.
Where x, y and z are goods and M is income. Therefore:
Select one:
a. If the price of x rose, your sales would fall but your total revenues
would increase.
b. If the price of x fell, your sales would increase and so would your
total revenues.
c. If the price of x fell, your sales would increase but your revenues
would fall.
d. If the price of x rose, your sales would increase and so would your
revenues.
6. With reference to the same information as in question 5:
Select one:
a. Commodities x and z are complements while x and y are gross
substitutes.
b. Commodities x and z are complements and so are x and y.
c. Commodities x and z are gross substitutes and so are x and y.
d. Commodities x and z are gross substitutes but x and y are
complements.
Long-response question:
1. a. Discuss the meaning of elasticity and the various types. What
determines the price elasticity of demand for a certain good? Who
is likely to find this information useful?
b. Assume that the market demand for barley is given by:
Q=1,900 4PB + 0.1M + 2PW
Where Q is the quantity of barley demanded, PB is the price of
barley, M is income (say per capita income of consumers) and
PW is the price of wheat. The prices of wheat and barley are each
200 (say s per tonne) and M is 1,000. The slopes for barley
demand, wheat demand and income are 4, 2 and 0.1 respectively.
44
Block 3: Elasticity
Calculate the own price elasticity of demand, the income elasticity

of demand and the cross-price elasticity of the demand for barley
with respect to the price of wheat.
c. Calculate and illustrate graphically the impact on welfare of a
specific tax of 37.5p per unit to be paid by suppliers when QD = 30
4P and QS = 6 + 8P. How do the welfare implications change if
the tax is paid by consumers instead of suppliers?
2. Interpret the following elasticities for petrol:
Demand elasticity: 0.39
Income elasticity: 1.2
Supply elasticity: 0.7
a. Do there appear to be good substitutes for petrol in the preferences
of buyers?
b. Does petrol appear to be a luxury or a necessity in the preferences
of buyers?
c. Do firms appear to have excess capacity in the petrol industry?
45
Notes
46
Block 4: Consumer choice

Introduction
This block introduces another two fundamental concepts in
microeconomics: indifference curves and the budget constraint. Indifference
curves illustrate a consumers preferences, while the budget constraint
shows what it is possible for them to consume, given a limited budget and
the prices they face. Put together, these concepts are used to determine the
consumers consumption decisions. In this way, we can see how the demand
curves you learned about in Block 2 are derived.
After studying the demand curve in Block 2, it is important to realise that
this curve is the direct result of the assumptions of rationality and individual
decision making as discussed in Block 1. This block, on consumer choice,
draws on the idea of opportunity cost as well as individual preferences to
derive the demand curve.
You will need a good understanding of the intuition behind the models
in this block. It is important that you gain a good grasp of them, because
we use an equivalent set of concepts in analysing how firms make their
production decisions (Block 5), and they are also used to determine
households labour supply (Block 10). As well as this, you will also need
to practise drawing the graphs in this chapter, since they will help to
understand the concepts, and since you may need to be able to reproduce
them for your exam. In particular, practise drawing the income and
substitution effects for normal and inferior goods, since many of the key
concepts are summarised in these graphs.
Learning outcomes
define the relationship between utility and tastes for a consumer
describe the concept of diminishing marginal utility
describe the concept of diminishing marginal rate of substitution and
calculate the marginal rate of substitution (MRS)
represent tastes as indifference curves
derive a budget line
explain how indifference curves and budget constraints explain
consumer choice
describe how changes in consumer income affect quantity demanded
describe how a price change affects quantity demanded
define income and substitution effects
show how the market demand curve relates to the demand curves of
individual consumers.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 5 including the appendix.
Further reading
Lipsey and Chrystal (L&C) international edition, Chapter 3; UK edition, Chapter 4.
Witztum (AW), Chapter 2.
47

The chapter starts by introducing the concept of utility, and the
assumptions that are commonly made by economists about utility. It then
explains indifference curves and the budget constraint and shows how
these are combined to determine the consumers choices. The impact of
changes in the consumers income and changes in price are examined in
detail, including the decomposition of the effects of price changes into
income and substitution effects. The chapter also demonstrates how
these ideas are used to derive the individual demand curve, and then the
market demand curve. The relationship to elasticity, particularly crossprice elasticity, is also discussed. Finally, the chapter explores whether the
consumer benefits more from cash transfers or transfers in kind.
Consumer choice and demand decisions

BVFD: read section 5.1 and concepts 5.1 and 5.2 of Chapter 5.
Utility
The concept of utility was introduced by Jeremy Bentham, in his 1789
book Principles of morals and legislation. He defined it as follows: By utility
is meant that property in any object, whereby it tends to produce benefit,
advantage, pleasure, good, or happiness, (all this in the present case comes
to the same thing) or (what comes again to the same thing) to prevent the
happening of mischief, pain, evil, or unhappiness to the party whose interest
is considered. The philosophy of utilitarianism (the greatest happiness
principle) was invented by Bentham and has been very influential. The
textbook defines utility much more simply as the satisfaction consumers
get from consuming goods (p.84). As you can read in the appendix to
Chapter 5, in the 19th century, economists believed that utility levels could
be measured, and used a unit of measurement called utils. Nowadays,
economists assume that utility is not measurable in this way, however, utility
is still a useful concept that underlies much of microeconomics.
Marginal utility
As discussed in Block 1, consumers and firms make decisions at the
margin. This idea is very important in relation to utility. The marginal
utility of a good or service is the extra utility a person gains from
consuming one more unit of that good or service.
Activity SG4.1
Linking the shape of the indifference curves to the assumptions regarding consumer tastes.
The various assumptions that lie behind indifference curves are reflected in certain
aspects of the shape of the curve. Match the assumption to the characteristic of the curve
and explain why.
Diminishing marginal rate of substitution
Lines never cross
Consumers prefer more to less

(non-satiation)
Any bundle is on some

indifference curve
Completeness
Indifference curves convex to the

origin (ICs look like smiles when
seen from the origin)
Transitivity
Downward sloping
The meaning and representation of preferences and hence the assumptions behind
indifference curves are discussed in detail in AW section 2.2.2.
48
The slope of the indifference curve is the marginal rate of

substitution
The marginal rate of substitution (MRS) between two goods, as you know
from the definition on p.86, measures the quantity of a good the consumer
must sacrifice to increase the quantity of the other good by one unit
without changing total utility. On p.88, in the paragraph discussing how
the slope of a typical indifference curve gets steadily flatter as we move to
the right, there is an important gem of information: The marginal rate of
substitution is simply the slope of the indifference curve. On the graph
below, the tangent T shows the slope of the indifference curve and the
MRS at point b.1
The figure and table below are analogous to L&C international edition:
Figure 3.2 and Table 3.2; UK edition: Figure 4.2 and Table 4.2, where
you can also find a good explanation of these concepts. The MRS is the
absolute value of the ratio of the change in clothing to the change in food.
Since these two changes always have opposite signs, the MRS (slope of an
indifference curve) is obtained by multiplying C/F by 1.
35
a
30
Clothing
1
Some textbooks define
the MRS as the slope of
the indifference curve,
that is as a negative
quantity, others as the
absolute value of the
slope (i.e. as a positive
quantity). This is simply
a matter of convention
and it doesnt matter
which convention is
followed, as long as one
is consistent.
25
20
15
10
5
0
10 15 20 25 30 35
Food
Figure 4.1: The marginal rate of substitution is the slope of the indifference
curve.
Movement Change in clothing Change in food Marginal rate of substitution

From a to b
12
(12/5)*1 = 2.4
From b to c
(5/5)*1 = 1.0
From c to d
(3/5)*1 = 0.6
From d to e
(2/5) * 1 = 0.4
From e to f
(1/5) * 1 = 0.2
Table 4.1
You should remember from Block 3 that (delta) means change.

Examining the movement from a to b and b to c etc. gives us a good
approximation of the slope of various sections of the curve. An even more
accurate way is to examine the change in utility due to a one unit change
in either of the goods: this gives us the marginal utility of each good at
a point on the curve. In fact, the MRS is given by MUC/MUF, (i.e. the
marginal utility of clothing at a certain point on the indifference curve,
divided by the marginal utility of food at that point, multiplied by 1).
We will come back to this again at the end of the block (as it is covered in
more detail in the third part of the appendix and Maths A5.1).
49
Figure 5.5 on p.90 of BVFD also helps to illustrate this idea, showing
indifference curves for people with different tastes. The glutton is more
willing to substitute films for food than the weight-watching film buff and
has a higher MRS. Drawing a tangent to any part of their indifference
curves shows that the slope of the gluttons indifference curve is steeper
reflecting his higher MRS between meals and films.
The slope of a typical indifference curve gets steadily flatter as we move to
the right, reflecting a diminishing marginal rate of substitution.
Clothing
For example:
Food
Figure 4.2: Changes in the slope of an indifference curve reflect a diminishing
marginal rate of substitution.
The slope of the tangent A shows the MRS of food for clothing at point a.
Similarly, the slope of the tangent B shows the MRS at point b. We can see
that the slope flattens as we move from a to b, reflecting a diminishing
MRS. At point a, the person has quite a lot of clothing and is willing to
substitute a fair bit of this for a certain amount of food. At point b, the
person has much less clothing but quite a lot of food and is only willing
to substitute a very small amount of clothing to gain the extra amount of
food. Going back to table 4.1, you can also see the diminishing MRS, as
the amount of clothing the person is willing to substitute for 5 additional
units of food continues to fall.
Activity SG4.2
Draw a map of indifference curves, marking out bundles and comparing them to each
other based on the following story: Mark likes jeans and cowboy boots. He is indifferent
between a bundle with 3 pairs of jeans and 2 pairs of cowboy boots (bundle A) and
a bundle with 2 pairs of jeans and 4 pairs of cowboy boots (bundle B). However, he
would prefer to have a bundle with 4 pairs of jeans and 5 pairs of cowboy boots (bundle
C). He is also indifferent between a bundle with 2 pairs of jeans and 1 pair of cowboy
boots (bundle D) and a bundle of 1 pair of jeans and 3 pairs of cowboy boots (bundle
E), although these last two options are his least preferred options. How do you think he
would feel about a bundle with 3 pairs of jeans and 3 pairs of cowboy boots?
Remember:
An indifference curve shows all the consumption bundles yielding a particular level of
utility.
Any point on a higher indifference curve is preferred to any point on a lower
indifference curve.
50
Indifference map
Budget constraint
Activity SG4.3
The slope depends only on the relative prices of the two goods. Draw budget constraints
for the following three price combinations, assuming a total income of 120.
A:
PX = 12
PY = 20
B:
PX = 10
PY = 20
C:
PX = 12
PY = 15
What is the interpretation of the slope of the budget constraint? It

represents the rate at which the consumer can substitute good x for good
y in the market, or the opportunity cost of x in terms of y. To see this,
suppose the consumer wishes to consume a little more x, x. This will
cost her xPx. Assuming she was spending all her income on x and y (on
her budget line) then she will have to reduce her expenditure on y by the
same amount. So xPx=-yPy, (i.e. the slope y/x=Px/Py).
BVFD: read Maths 5.1.
You should be familiar with the general form of the budget constraint used
in this section, (i.e. where pX is the price of good X, pY the price of good Y, x
the quantity of good X, y the quantity of good Y and M the money income
available to the consumer). Note that the first term on the left-hand side
of this equation is the consumers expenditure on X and the second term
is expenditure on Y. Since we assume that the consumer spends all her
income on these two goods, the amount spent on the two goods sums up
to M which is her income. One important point from this Maths box is that
the slope of the budget constraint is given by pX /pY i.e. the price ratio.
51
The figure in this Maths box shows how you can represent a general case,
where you dont have specific quantities and prices. The intercepts will
then be M/PY and M/PX respectively. This is likely to be how you will draw
a budget constraint most often.
Utility maximisation and choice

Indifference curves and the budget constraint together indicate the
choice a consumer will make to maximise their satisfaction. This can be
represented by the following diagram:
Step 1
Step 2
Preferences
(What the individual wants to do)
Budget Constraint
(What the individual can do)
Step 3
Decision
(Taking constraints into account, the individual attempts
to reach the highest level of satisfaction)
Figure 4.3: Consumer choice and the decision rule.
Decision rule
The point which maximises utility is the point at which the consumer
reaches the highest indifference curve that the budget constraint allows.
For the standard indifference curves we have been looking at, this
decision rule says that the consumer should choose the consumption
bundle where the slope of the budget line and the slope of the indifference
curve coincide. In other words, it is the point at which the indifference
curve is tangent to the budget constraint.
BVFD: read the first part of the appendix for Chapter 5 of, the material in
the appendix applies whether or not utility can actually be measured.
We can describe the consumers optimal decision using equations as
follows: At the chosen bundle, the marginal rate of substitution between
the two goods must equal their relative price, i.e. MRS =MUx/MUy =Px/
Py . Rearranging this gives MUX/PX= MUY/PY .
We can also describe their decision graphically, as follows: The consumer
choses the bundle where the indifference curve is tangent to their budget
constraint. The slope of the indifference curve (MRS = MUx/MUy) and
the slope of the budget constraint (Px/Py )must be equal. The tangency
thus implies MUx/MUy = Px/Py . Rearranging this gives MUX/PX=MUY/PY.
52
Good Y
M/Py
b
u0
M/Px Good X
Figure 4.4: A budget constraint and an indifference curve.
MUX/PX=MUY/PY has the intuitive interpretation that the marginal utility

derived from the last pound spent on X must be equal to the marginal
utility of the last pound spent on Y. Otherwise the consumer would adjust
their consumption pattern and increase their utility.
Imagine that MUX/PX > MUY/PY. This implies that the consumer derives
more utility from the last pound spent on good X than the last pound spent
on good Y. In this case, by consuming one pound more of good X and one
pound less of good Y, they can increase their utility level without spending
any more money. The consumer should continue to adjust their spending
in this way until MUX/PX=MUY/PY.
It is important to understand the intuitive explanation of the consumers
decision, as well as being familiar with the relevant equations and graphs.
Activity SG4.4
Jeremy has M and wants to buy some combination of books and shoes. Books cost PB
each and shoes cost PS per pair. Both of these goods are normal goods to him. Describe
graphically and in equations how he will decide on an optimal combination of the two
goods which will maximise his total utility. What is the intuition behind this?
53
Activity SG4.5
Draw budget constraints and possible indifference curves for the following scenario:
Susan buys cabbages and carrots. Cabbages cost 1 per kilo and carrots cost 0.80 per
kilo. Her income falls from 20 to 16. Carrots are a normal good, but cabbages are an
inferior good.
BVFD: read section 5.3 and cases 5.1 and 5.2.

Activity SG4.6
Page 98 contains a suggestion of two diagrams you should draw to check your
understanding, complete this in the boxes below:
A fall in the price of meals
An increase in the price of films
Income and price changes

Substitution and income effects
Decomposing the effects of a price change into income and substitution
effects is an important piece of economic analysis with many real world
applications. Case 5.1 shows one such application; others relate to the
effects of changes in wages on labour supply and changes in interest rates
on savings decisions. Remember:
The substitution effect is always negative.
The income effect is negative for normal goods and positive for inferior
goods.
For normal goods, the income and substitution effects reinforce each
other.
54
For inferior goods, the income and substitution effects work in

opposite directions.
For inferior goods, if the income effect dominates the substitution
effect, the good is called a Giffen good (in practice, these are very
rare).
Activity SG4.7
For a choice between Good X and Good Y, complete the graphs below, clearly indicating the
income and substitution effects in each case. You will find figures 5.14 and 5.16 helpful for
this activity, and you might want to repeat it a few times on a separate sheet of paper until
you are really comfortable with these concepts. The following order is generally best:
1. Draw the original budget line and indifference curve.
2. Draw the new budget line.
3. Draw the hypothetical budget line parallel to the new budget line and tangent to the
original indifference curve. This gives you the substitution effect.
4. Draw the new indifference curve (where you place this depends on what type of good it
is). This gives you the income effect.
Normal goods, price of X rises
Inferior good, price of X rises
Normal goods, price of X falls
Inferior good, price of X falls
NB: The method used in the textbook and in this activity to break a price change into
income and substitution effects follows an approach suggested by the economist John Hicks
and the effects are known as the Hicksian substitution and income effects. There is also an
alternative approach following the economist Eugen Slutsky. If you are interested to know
more about this, it is explained in AW 2.3.1. However, you are only required to know the
Hicksian approach (as in BVFD) for this course.
55
Deriving demand: The individual demand curve

In Block 2 we introduced demand and supply and learned about the
demand curve. Now we are able to derive the individual demand curve
from the choices of consumers.
Activity SG4.8
Derive the individual demand curve from the information in figure A. Can you now explain
why the demand curve is downward sloping?
Sunglasses
A
(Price per sandwich = p1)
e1
e2
e3
e4
Price-consumption curve
x1 x2 x3 x4
Sandwiches
Price per Sandwich
Sandwiches
Figure 4.5: Deriving the individual demand curve.

BVFD: read the second part of the appendix: deriving demand curves.
This explains why, for normal goods, a fall in price leads to an increase in quantity
demanded, due to both substitution and income effects.
Demand curves and consumer surplus

We have now shown the theoretical underpinnings of a downward sloping
demand curve. In particular we have gone beyond general statements such
as at lower prices existing consumers want to purchase more and new
consumers enter the market and shown that at each point on the demand
MU
curve consumers are maximising their utility by equating their MRS ( MU )
P
with the relative price ( P ) where x is the good on the horizontal axis and
y the good on the vertical axis. This enables us to give further intuition to
the price at any given quantity and to the whole demand curve.
x
56
To do this, we can put some numbers on a given utility maximising point

corresponding to a set of prices for x and y and a given income. For
example, let Px = 4, Py = 2 and income = 40. This is shown on the
diagram below. This diagram shows the consumers utility maximising
combination of x and y (x1, y1) at A in the upper panel and the demand
for x at Px = 4, Py = 2, M = 40 in the lower panel. How much is an
extra unit of x worth to the consumer at A/? At A, due to the tangency,
MRS = 2. This means our consumer would give up 2 units of y in order
to have another unit of x that is the meaning of MRS = 2; one unit of
x has the same value to her as 2 units of y. Since y costs 2 per unit, two
units of y are worth 4, an extra unit of x must also be worth 4 as an
extra unit of x is worth the same as two units of y at A. Another way of
saying this is that at A and A/ the consumers willingness to pay for
another unit of x is 4. So price can be interpreted as the willingness to
pay for an extra unit of the good, given income and prices of other goods.
Similarly, the demand curve can be interpreted as a willingness to pay
curve (its downward slope implying that the more x the consumer has, the
lower her willingness to pay for an extra unit). Although we do not do the
mathematics here, you can see intuitively that because price at a given x
represents the willingness to pay for a marginal unit of x, the area under
the demand curve up to that level of x shows the total willingness to
pay for that amount (the sum of the willingness to pay for each separate
unit). This also makes it easier to see that the consumer surplus (a concept
introduced in Block 2) at any given price and quantity is the difference
between the total willingness to pay for that amount minus what is
actually paid the prevailing price times the quantity.
y
20
y1
At A, MRS = Px/Py = 4/2 = 2
A
Indifference curve
x1
10
Px
A/
Demand curve for x
x1
Figure 4.6: Willingness to pay and consumer surplus.

57
Deriving demand: The market demand curve

The market demand curve is the horizontal addition of the demand curves
of all the individuals in that market. In the following activity we assume
that there are only three consumers, but the method can be applied to
much larger numbers; in such cases kinks in the market demand curve
would tend to be smoothed out.
Activity SG4.9
Consumer 3
12
12
12
12
2 4 6
5 10
Figure 4.7: Deriving the market demand curve.
Complements and substitutes

BVFD: read section 5.5 of and the part of 5.3 which addresses cross-
price elasticities of demand.
The section on complements and substitutes (section 5.5) introduces the
fact that goods are not always substitutes for each other, but may in fact be
complements. This means that if the demand for a good rises, the demand
for other complementary goods will rise as well.
You will remember from Block 3 that cross-price elasticities are negative
when two goods are complements and positive when two goods are
substitutes. The section on cross-price elasticities (in section 5.3) details
three factors which impact on income and substitution effects and can
make the cross-price elasticity for good Y either positive or negative
(responding to a change in the price of good X). These are: whether the
two goods are good substitutes for each other; the income elasticity of
demand of good Y; and good Ys share of the consumers total budget.
This section also shows that not all indifference curves are convex to the
origin as in Figures 5.2 and 5.3 of BVFD. How well the two goods can
be substituted for each other is reflected in the shape of the indifference
curves as follows:
Figure 5.20, LHS perfect substitutes indifference curves are straight
lines full substitution from one to the other if the price of one good
falls below the price of the other good.
Figure 5.18 good substitutes indifference curves are quite flat
large substitution effect of a price change.
Figure 5.17 poor substitutes indifference curves are very curved
small substitution effect of a price change.
58
PRICE
Consumer 2
PRICE
Consumer 1
PRICE
PRICE
Complete the fourth graph, showing the market demand curve. Why might the three
consumers have different demand curves?
Market demand
Figure 5.20, RHS perfect complements indifference curves are

perpendicular lines no substitution effect of a price change, the
consumer will consume more (or less) of both in the same proportion.
Activity SG4.10
Draw the indifference curves for perfect complements together with a budget line. Now
draw a new budget line for a change in the price of one of the goods. Indicate the income
and substitution effects (if any) of the price change.
Perfect complements
Activity SG4.11
Barbara likes peanut butter and jam together on her sandwiches. However, Barbara is very
particular about the proportions of peanut butter and jam. Specifically, Barbara likes 2
scoops of jam with each scoop of peanut butter. The cost of scoops of peanut butter and
jam are 50p and 20p, respectively. Barbara has 9 each week to spend on peanut butter
and jam. (You can assume that Barbaras mother provides the bread for the sandwiches.)
If Barbara is maximising her utility subject to her budget constraint, how many scoops of
peanut butter and jam should she buy?
Activity SG4.12
Suppose that a consumer considers coffee and tea to be perfect substitutes, but he requires two
cups of tea to give up one cup of coffee. This consumers budget constraint can be written as 3C
+ T = 10. What is this consumers optimal consumption bundle?
Cash transfers versus transfers in kind

Figure 4.8 below replicates Figure 5.21 from the textbook, but includes
indifference curves for the case where the consumer starts at e. If the
consumer receives a cash transfer, they may move to point c, where their
utility level is indicated by the curve u1. However, if they receive food
stamps (a transfer in kind), they cannot choose point c, and may move
instead to the feasible point B. At point B, their utility level is indicated by
the curve u0. This is clearly lower than the utility level the consumer could
have reached with a cash transfer. Furthermore, point B is not a tangency
solution: the slope of the indifference curve is not equal to the slope of the
budget constraint. This shows that non-tangency solutions may sometimes
arise from government policy, and also reaffirms the conclusion made
by the textbook: In so far as people can judge their own self-interest
people are better off, or at least no worse off, if they get transfers in cash
rather than transfers in kind (p.108).
59
Films
c
A
u1
u0
Food
Figure 4.8: Transfers in cash and in kind. Figure adapted by author from BVFD.
BVFD: read Appendix part 3 and Maths A5.1.

The section of the appendix entitled ordinal utility and indifference
curves introduces utility functions. As is written, although no one
really knows anyones utility function for any good, expressing utility
numerically through a utility function can be very useful. The maths
box shows how marginal utility can be found using the delta notation
or calculus. If you are familiar with calculus, you may find this makes
marginal analysis much easier. However, it is also possible to use the delta
notation to find marginal utility, or else this will be given to you, as per the
activity below.
Activity SG4.13
Calculate the optimal quantity of each of two goods (x and y) and the consumers total
utility given px = 1, py = 2, M = 80, and U(x,y) = xy, where MUx = y and MUy = x. How
would you represent this graphically?
BVFD: read the summary and work through the review questions in
Chapter 5.
Overview
This block started by introducing utility and indifference curves, as
well as the budget constraint. Indifference curves represent consumer
tastes, while the budget constraint shows the possibilities open to the
consumer, given their limited budget. Putting these together, we learned
the decision rule that determines consumer choice, under the assumption
that consumers maximise utility. In particular, we saw that consumers
will chose the bundle of goods such that MUX/PX = MUY/PY. Expressed
graphically, this means that the highest reachable indifference curve is
tangent to the budget constraint. We then explored how their choices are
affected by changes in income and prices, looking in particular at income
and substitution effects of a price change. This helped us identify normal
and inferior (and Giffen) goods. We also further examined complements
and substitutes. Understanding how consumers make choices lets us see
what lies behind the individual and market demand curves. Finally, the
analysis of budget constraints and indifference curves also made it possible
to evaluate the relative benefits of cash transfers versus transfers in kind.
60
Reminder of your learning outcomes

be sure that they have been achieved

1. The price of car transport is 30 cents per mile. The price of bus
transport is 60 cents per mile. The marginal utility of Marios last mile
of car transportation is 80 utils, and the marginal utility of his last mile
of bus transportation is 150 utils. Hence:
a. Mario is currently maximising his utility.
b. Mario could increase his utility by decreasing his consumption of
car transportation.
c. Mario could increase his utility by increasing his consumption of
car transportation.
2. If an agent has a utility function of the form u(x,y)=xy then:
a. They will be indifferent between (6,4) and (3,8).
b. They will prefer (6,4) over (5,5).
c. They will be indifferent between (6,4) and (5,5).
d. None of the above.
3. The slope of the demand for an inferior good is steeper than that of a
normal good because:
a. Income and substitution effects enhance each other.
b. Substitution effect for a normal good is greater than that of an
inferior good.
c. Income effect of a normal good is smaller in magnitude (absolute
value) than the income effect of an inferior good.
d. Income and substitution effects offset each other.
4. Judith spends all her money buying wine and cheese and wants to
maximise her utility from consuming these two goods. The marginal
utility of the last bottle of wine is 60, and the marginal utility of the
last block of cheese is 30. The price of wine is 3, and the price of
cheese is 2. Judith:
a. is buying wine and cheese in the utility-maximising amounts
b. should buy more wine and less cheese
c. should buy more cheese and less wine
d. is spending too much money on wine and cheese.
61
Long-response questions
1.a. Susan buys bread rolls and cheese. One bread roll costs 1 and
cheese costs 3 per 500g block. Susan has 12 income to spend on
bread and cheese.
i. Draw Susans budget constraint and a possible indifference
curve. Explain the assumptions behind the shape of the
indifference curve you have drawn.
ii. If the price of bread falls to 0.80 per loaf, how will this affect
her purchases? Answer in words and graphically, clearly
indicating income and substitution effects of the price change.
iii. If Susan only enjoys bread and cheese when she has 500g of
cheese for every bread roll that she eats, draw her indifference
curves. How much bread and cheese should she buy to
maximise her utility? Assume Susan has 12, one bread roll
costs 0.80 and cheese costs 3 per 500g block.
b. Now lets assume that Susan grows 100 potatoes each year and
all of her income comes from selling them. She spends all of her
income each year consuming potatoes and other goods. For Susan,
potatoes are a Giffen good, in that if her income is fixed in some
way (i.e. ignoring the fact that she sells potatoes and just fixing her
income at some value) her consumption of potatoes will rise when
their price rises. The price of potatoes falls and she consumes more
potatoes. Taking into account the fact that her income actually
comes from selling potatoes, explain how the last statement can be
consistent with those that precede it.
2. I consume two goods, ice cream and biscuits. I shop once a week,
spending 100, at either Sainsbury or Tesco (two well-known UK
supermarkets). Interestingly, Ive noticed that the bundle I purchase
when I visit Tesco costs more at Sainsbury. Similarly, the bundle I
purchase when I visit Sainsbury costs more at Tesco. And yet, I find
that I get the same utility from shopping at either store (i.e. the
Sainsbury shopping bundle gives me the same utility as the Tesco
shopping bundle). Explain how it is possible for all of these statements
to be true. (Hint: draw a single indifference curve and have me
maximise utility given a 100 budget and different prices in the two
stores).
62

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Introduction to economics

O. Birchall assisted by D. Verry

University of London International Programmes

EC1002 Introduction to economics

Block 4: Consumer choice...................................................................................... 47

EC1002 Introduction to economics

The multiplier............................................................................................................. 173

Reminder of learning outcomes.................................................................................. 238

EC1002 Introduction to economics

Aims of the course

EC1002 Introduction to economics

Overview of learning resources

The two supplementary textbooks below can be used to extend your

The material contained in the two supplementary textbooks (where it

How to use the subject guide

Online study resources (VLE, Online Library)

EC1002 Introduction to economics

Videos: Recorded academic introductions to many subjects;

Answers on the VLE

Making use of the Online Library

Route map to the guide

6; 7.1, 7.2 and

Introduction: The economic problem, production possibility frontiers,

Demand, supply and the market: demand, supply, demand functions,

Elasticity: price elasticity of demand, cross-price elasticity of demand, income

Consumer choice: rationality, utility, indifference curves, the budget

Perfect competition: competitive industry, the competitive firm, entry and

Pure monopoly: monopoly, price discrimination, natural monopoly,

Market structure and imperfect competition: monopolistic competition

Inputs to production: the labour market: the factors of production,

Welfare economics: general equilibrium, horizontal and vertical equity,

The role of government: government interventions, public goods, taxation;

EC1002 Introduction to economics

Introduction to macroeconomics: the problem of aggregation, the

Aggregate demand: actual and potential output, consumption, investment,

Monetary and fiscal policy: aggregate demand and equilibrium (IS),

Aggregate demand and aggregate supply: Keynesian and classical

Unemployment: types of unemployment, voluntary and involuntary

Exchange rates and the balance of payments: the foreign currency

Open economy macroeconomics: the effects of fiscal and monetary policies

Supply-side economics and economic growth: growth in potential

EC1002 Introduction to economics

Part II, Section A

Block 1: Economics, the economy and tools of economic analysis

Block 1: Economics, the economy and

Cowell, Frank and

EC1002 Introduction to economics

Economics and the real world

Block 1: Economics, the economy and tools of economic analysis

Synopsis of this block

EC1002 Introduction to economics

Block 1: Economics, the economy and tools of economic analysis

The production possibility frontier (PPF)

The PPF: scarcity and desirability

EC1002 Introduction to economics