1. Common Sense Economics
Twelve Key Elements of Economics

2. Twelve Key Elements of Economics
1) Incentives Matter.
2) There is no such thing as a free lunch. (Milton
Friedman)
3) Decisions are made at the margin.
4) Trade promotes economic progress.
5) Transaction costs are an obstacle to trade.
6) Prices bring the choices of buyers and sellers
into balance.

3. Twelve Key Elements of Economics
7) Profits direct businesses toward activities that increase
wealth.
8) People earn income by helping others
9) Production of goods and services people value, not just
jobs, provides the source of high living standards.
10) Economic progress comes primarily through trade,
investment, better ways of doing things, and sound
economic institutions.
11) The “invisible hand” of market prices directs buyers and
sellers toward activities that promote general welfare.
12) Too often long-term consequences, or the secondary
effects, of an action are ignored.

4. Incentives Matter
• Economics rest on one simple principle
– INCENTIVES MATTER!!!
– What costs are associated with decisions?
– How do you make decisions?
– Why do you make those decisions?

5. Incentives Matter
• Two Important functions of incentives are:
1) To communicate information on the best things
to do and
2) To motivate people to do them.

6. Incentives Matter
• How do incentives affect the market?
– The Sellers
• An increase in price will cause an increase in amount
supplied
– The Buyers
• An decrease in price will cause an increase in amount
demanded

7. There is no such thing as a free lunch
• Reality is… “resources are limited, while the
human desire for goods and services is
virtually unlimited.”
– Scarcity is the condition in which human wants
are forever greater than the available supply of
time, goods, and resources
• Since we face scarcity, then we must choose our
resources wisely.

8. There is no such thing as a free lunch
• Opportunity Cost
– The best alternative sacrificed for a chosen action,
i.e. the next best alternative.
– It is expressed in terms of the most valuable
alternative that is sacrificed.
– What are some opportunity costs in your life?

9. There is no such thing as a free lunch
• Example of Opportunity Cost
• Please view the YouTube video:

10. Decisions are made at the margin
• Decisions are made at the margin
• Make choices where the benefits are greater
than the costs.
– MB (marginal benefit) > MC (marginal cost)
• Choices are made at the margin.
– They involve additions to, or subtractions from,
current conditions
– Decisions are made by evaluating “marginal”
effects of change

11. Trade Promotes Economic
Progress
• Why would we trade?
• Why do people agree to trade?
• They expect that it will improve their current
situation

12. Trade Promotes Economic
Progress
• Three Major Sources of Gains from trade:
1) Trade moves goods from people who value them
less to people who value them more
2) Trade makes larger outputs and consumption
levels possible because it allows each of us to
specialize more fully in things that we do best.
3) Voluntary exchange makes it possible for lower
per-unit costs by adopting mass production
methods.

13. Number Two- How do we get
Number Two- How do we get
larger outputs???
larger outputs???

14. Law of Comparative
Advantage
 Specialize in the task that you do better
 Law of comparative advantage
 Specialize in producing a good IF
 Lower opportunity cost of producing it
 Specialization and exchange
 Better off
 Absolute advantage
 Use fewer resources
 But does not have the lowest opportunity cost

15. Example of Comparative and
Example of Comparative and
Absolute Advantage
Absolute Advantage

16. Law of Comparative
Advantage
• It is about what productive actions you are
giving up, not about how good you are at each
action.
– It is possible that you can be the best at both
goods, but we are interested in the foregone
production that may be lost by you doing both
actions.

17. Number Three- lower costs
Number Three- lower costs

18. Economies of Scale
• A larger size often allows for larger, more
specialized machines and greater
specialization of labor.
• A larger scale of operation allows a firm to use
larger, more efficient machines to assign
workers to more specialized tasks.
• Production techniques such as assembly lines
can be introduced only if the rate of output is
sufficiently large.

19. Division of Labor
 Division of labor
 Specialization; Increased productivity
 Individual preferences; natural ability
 Experience
 No need to shift between tasks
 Laborsaving machinery
 Downside:
 Repetitive, tedious
 Routine tasks - robots

20. Transaction Costs are an Obstacle to
Trade
• Voluntary exchange promotes cooperation
and helps us get more of what we want.
• Is trade costly?
• Time, effort, and other resources
• Transactions Costs.

21. Transactions Costs???

22. Transaction Costs Are an Obstacle to
Trade
• How does the middlemen help?
• Would you like to kill your own meat?
• Knit your own sweaters??
• From the youtube video, what were the
transaction costs?
• Time!!!

23. Prices Bring the Choices of Buyers and
Sellers into Balance
• Market prices will influence the choices of both
buyers and sellers
• What happens when the price of a good
increases?
• The buyer tends to buy less (known as the law of
demand)
• The supplier tends to want more (known as the law of
supply)
• We will discuss the law of demand and law of
supply in more detail later in the chapter

24. Read I, Pencil and watch the short
video describing it!
This is what price does!!!

25. Profits Direct Businesses Toward
Activities That Increase Wealth
• When resources produce valuable good and
services then people are better off.
• What does profit and losses tell us about how
resources are allocated?
• The higher the marginal value, the greater the
amount supplied.

26. People Earn Income by Helping Others
• High earnings come from providing goods and
services that others value.
• How does Wal-mart help the average household?
• People seeking wealth notice people’s wants
for goods and services.
• Read the article “Profit-Friend or Foe” to help
understand this concept.

27. Production of Goods and Services People Value,
Not Just Jobs, Provides the Source of High Living
Standards
• Often government spending “crowds out”
private spending and no net increase in
employment is seen

28. Summary of Key Points 7-9
• The article entitled “Profit, Friend or Foe”
describes how the Key Points-7-9 relate to the
economy.
• Please read the article!!

29. Economic Progress Comes Primarily Through
Trade, Investment, Better Ways of Doing Things,
and Sound Economic Institutions
• How does this happen?
• Technological changes
• Better machines, roads, and communication
• Agricultural society, now service based

30. Economic Progress Comes Primarily Through
Trade, Investment, Better Ways of Doing Things,
and Sound Economic Institutions
• What’s important:
• Investments in productive assets and in the skills
of workers enhance our ability to produce goods
and service.
• Improvements in Technology spur economic
progress.
• Improvements in economic organization can
promote growth.

31. The Invisible Hand
• “Self-interest” will further the general
prosperity of a community or nation.
• How does this work?
• The “invisible hand” of market prices to promote the
goals of others.
• “…Adam Smith contends that pursuing one’s
own advantage creates an orderly society in
which demands are routinely satisfied without
a central plan.

32. The Invisible Hand
• The market price of a particular good or
service provides buyers and sellers with what
they need to know to bring their actions into
harmony with the actions and preferences of
others.
• What does the price tell about consumers and
sellers?
• Preferences, Sellers’ costs, location, and
circumstances in the market

33. Discussion of Demand and Supply
Discussion of Demand and Supply

34. The Law of Demand
The Law of Demand
The Law of Demand
• Law of Demand: the inverse ( or negative)
relationship between the price of a good and
the quantity consumers are willing to
purchase, other things held constant (ceteris
paribus).
 As the price of a good rises, consumers buy less.

35. The Law of Demand
The Law of Demand
• The demand curve allows you to find the
quantity demanded by a buyer at different
selling prices by moving along the curve

36. The Substitution Effect of a Price
Substitution Effect
Substitution Effect
Change
• What explains this “Law of Demand?”
– Lower Price= Greater Amount Consumer… Why?
– Substitution effect: The consumer will substitute a
cheaper good for a more expensive good.

37. Income Effect
• Income Effect: A fall in the price of the good
increases the consumers purchasing power.
– The consumer can now buy more with NO change
in their income level.

38. The Demand Schedule and
The Demand Schedule and
The Demand
Demand Curve
Demand Curve
• Demand: a curve or schedule showing the
various quantities of a product consumers
are willing to purchase at possible prices
during a specific period of time, other things
held constant.
– Demand is the quantity consumers are both
willing and able to buy at each possible price.

39. Market Demand Schedule
• A demand schedule is simply a table listing the
various quantities of something consumers
are willing to purchase prices
– Example of the demand schedule

40. Example of a Market Schedule
• Demand of Hula Hoops
Price (in Dollars)
Quantity Demanded (Hula Hoops)
$10.00
0
8.00
10
6.00
20
4.00
30
2.00
40

41. The Demand Curve Using the Schedule
• The demand curve is the plots of this table
– Example of demand curve using the demand
schedule

42. Demand Curve of Hula Hoops
Price of the
Hula Hoops
(measured
in dollars)
Quantity Demanded
of Hula Hoops

43. Market Demand
• The transition from the individual to the
market demand curve is done by totaling or
summing the individual demand schedules
(this is known as the horizontal summation of
demand).
– Example of horizontal summation

44. Horizontal Summation of Demand
+
= Market Demand
of Hula Hoops

45. Market Demand of Hula Hoops
• The market demand of hula hoops, is the
horizontal summation of the two individuals
demand for hula hoops (i.e. the summation of
quantity demanded at each individual price).

46. Market Demand of Hula Hoops
Price
(measured in
dollars)
Quantity Demanded of Hula Hoops

47. Changes in demand vs. changes in
quantity demanded
• A movement along the curve- CHANGES IN
PRICE ONLY
• Changes in quantity demanded
– Example of movement

48. Movement along the Curve
A movement from $8 to
$6 represents an
increase in quantity
demanded
A movement
from $8 to $10
represents an
decrease in
quantity
demanded

49. The distinction between changes in Quantity
Demanded and Changes in Demand
• Remember that price and quantity variables in
our model are subject to the ceteris paribus
assumption (other things held constant).
– IT IS VERY IMPORTANT TO REMEMBER THE
FOLLOWING:
– If you are dealing with price of the item it is a
movement along the curve, a change in quantity
demanded not DEMAND, NO SHIFT!!!!!!

50. Shifts of the Demand Curve:
1) Changes in consumer income
• Normal goods
• Inferior goods
2) Changes in the price of a related good
• Substitutes
• Complements
3) Changes in expectations- prices, income, or availability
of goods.
4) Changes in the number of consumers in the market
5) Changes in consumer tastes and preferences

51. Examples
• Income
– Normal goods: direct relationship
– Inferior goods: inverse relationship

52. Changes in Demand
• Most of us would consider steak to be a
normal good. Since, steak is a more expensive
meat as income increases then more
consumption of steak should occur.
• Thus, when consumer income increases, the
demand for steak increases.

53. Normal Good
D2
D1

54. Inferior Goods
• However, we could argue that Ramon Noodles
would be an inferior good, meaning as income
increases then the demand for Ramon
Noodles would decline.
• Thus, when income increases, then the
demand of Ramon Noodles will decrease.
– This would be a leftward shift of the demand
curve

55. Examples
• Related goods
– Substitute good: if the price of the substitutable
good decreases, then demand decreases for the
good of interest
– Complementary good: if the price of the
complement good increases, then demand
decreases for the good of interest.

56. Substitute goods
• Let’s assume that Pepsi and Coke are
substitute goods for one another.
• If the price of Pepsi increases, then what
happens to the demand of Coke?
– The demand for Coke will increase, because now
consumers will substitute Coke for Pepsi

57. Graph of Coke
Price
(measured in
dollars)
D2
D1
Quantity Demanded
of Coke (in millions)

58. Complementary Goods
• Complementary goods are goods that we buy
together, I think it is safe to say that peanut
butter and jelly are bought together.
• Thus, what would happen to the demand of
jelly, if the price of peanut butter increased?
– The demand for jelly would decrease.
• This is a leftward shift of the demand curve

59. Demand for Jelly
D2
D1

60. Supply
• Supply indicates how much producers are
willing and able to offer for sale per period at
each possible price, other things held
constant.

61. Law of Supply
• There is a direct (positive) relationship
between the price of a good or service and
the amount of it that suppliers are willing to
produce.
– Example of the supply curve
– When price increases, then the amount supplied
will increase.
– Why are sellers willing to sell more at a higher
price? Does this make sense?

62. Market Supply
• Again, it is the horizontal summation of the
quantity produced by the sellers
– Example of Horizontal Summation

63. Changes in Supply VS. Changes in
Quantity Supplies
• Increase or decrease in the price of the good
is a movement along the curve
• This is a change in “quantity supplied”
– Example here

64. Shifts of the Supply Curve
1) Changes in Technology
2) Changes in the Prices of Relevant resources
– Inputs into production.
3) Changes in the Price of Alternative Goods
– Other goods that the producer could produce
3) Changes in Producer Expectations
4) Changes in the Number of Producers

65. Markets
• A market is any arrangement in which buyers
and sellers interact to determine the price and
quantity of goods and services exchanged.
– Markets reduce transaction costs

66. Market Equilibrium
• The market is where the buyers and sellers
come together
• Equilibrium is no conflict between demand
and supply
– Quantity supplied= Quantity demand
– Example of the equilibrium
• This is the theory of how the price system
operates and it is the cornerstone of
microeconomic analysis

67. Exhibit 5(a)
Equilibrium in the Pizza Market
(a) Market schedules
Millions of pizzas per Week
Price per
pizza
$15
12
9
6
3
Quantity Quantity Surplus or
Demanded Supplied Shortage
8
14
20
26
32
28
24
20
16
12
Surplus of 20
Surplus of 10
Equilibrium
Shortage of 10
Shortage of 20
Effect on Price
Falls
Falls
Remains the same
Rises
Rises

68. Exhibit 5(b)
Equilibrium in the Pizza Market
(b) Market curves
S
$15
Surplus
Price per pizza
12
Above the equilibrium price:
QS>QD;
Surplus;
Downward pressure on P
c
9
Market equilibrium occurs at:
Price where QD=QS; Point c
6
Shortage
3
0
D
14 16 20 24 26
Millions of pizzas per week
Below the equilibrium price:
QD>QS;
Shortage;
Upward pressure on P

69. Economic Efficiency
• When a market reaches equilibrium, all the
gains from trade between the buyer and seller
have been fully realized and Economic
efficiency is met

70. Too Often Long-Term Consequences, or the
Secondary Effects, of an Action Are Ignored
• When the short-term benefits are greater
than the longer-term consequences.
• Policy
• Secondary Effects

71. Price Floors
 Price Floors
 Set above equilibrium P
 Minimum selling P
 Surplus
 Distort markets
 Reduce economic welfare

72. Price Ceilings
 Price Ceilings
 Set below the equilibrium P
 Maximum selling P
 Shortage
 Distort markets
 Reduce economic welfare

73. Exhibit 11
Price Floors and Price Ceilings
(b) Price ceiling for rent
(a) Price floor for milk
$2.50
Monthly rental price
Price per gallon
Surplus
S
S
$1,000
1.90
600
D
0
14 19 24
Millions of gallons per month
No effect if price floor is
set at or below equilibrium P
Shortage
D
40 50 60
0
Thousands of rental units per month
No effect if price ceiling is
set at or above equilibrium P