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Book Notes: “Principles of Microeconomics" - Part 2: How Markets Work (Mankiw)

This post is 2nd in a 7-part series of my personal notes outlining N. Gregory Mankiw’s economics textbook “Principles of Microeconomics” (8th Edition).


Index of Outlines for Principles of Microeconomics:
* Part 1: Introduction (Chapters 1-3)
* Part 2: How Markets Work (Chapters 5-6)
* Part 3: Markets and Welfare (Chapters 7-9)
* Part 4: The Economics of the Public Sector (Chapters 10-12)
* Part 5: Firm Behavior and the Organization of Industry (Chapters 13-17)
* Part 6: The Economics of Labor Markets (Chapters 18-20)
* Part 7: Topics for Further study (Chapters 21-22)


Part 2: How Markets Work

Chapter 4: The Market Forces of Supply and Demand

4-1 Markets and Competition

  • Market: A group of buyers and sellers of a particular good or service.
  • Buyers determine the demand for a product or service.
  • Sellers determine the supply for a product or service.
  • Markets can be highly organized or less organized.
  • An organized market is one in which buyers and sellers meet at a specific time and place and where an intermediary helps set prices and broker sales.
  • Competitive market: A market with many buyers and many sellers so that each has a negligible impact on the market price.
  • Factors necessary for a perfectly competitive market:

    1. The goods offered for sale are all exactly the same.
    2. The buyers and sellers are so numerous that no single buyer or seller has any influence over the market price.
  • Monopoly: A market with only one seller who can set prices.

4-2 Demand

  • Quantity demanded: Amount of a good buyers are willing and able to purchase.
  • Law of demand: The quantity demanded of a good falls when the price of a good rises (all other things being equal).
  • Demand schedule: A table that illustrates the relationship between the price of a good and the quantity demanded.
  • Demand curve: A graph of the relationship between the price of a good and the quantity demanded.
  • Example of a Demand Curve:
(Image from Wikipedia.org)
  • Market demand: Is the sum of individual demands for a given good or service.
  • Shifts in the demand curve can occur if something happens that alters the quantity demanded at any price.
  • Increase in demand: shifts the demand curve to the right.
  • Decrease in demand: shifts the demand curve to the left.
  • Key variables that can affect demand curve shifts:

    • Income: Lower income results in falling demand for normal goods and rising demand for inferior goods.
      • Normal goods: A good for which increased income leads to an increase in demand. Examples: Steak. If your income increases you may purchase and dine on steak more frequently.
      • Inferior goods: A good for which an increase in income leads to a decrease in demand. Example: Public transit. If your income increases you may be more inclined to take a taxi or buy a car.
    • Prices of related goods: Similar goods can affect demand for each other.
      • Substitutes: Two goods for which an increase in the price of one leads to an increase in the demand for the other. Example: Ice cream and frozen yogurt. If the price of frozen yogurt drops, demand for it will likely increase. More consumption of yogurt may result in less consumption of ice cream. Other examples: hotdogs vs. hamburgers, sweaters vs. sweatshirts, movie theaters vs. video streaming.
      • Complements: Two goods for which an increase in the price of one leads to a decrease in the demand for the other. Example: Hot fudge. If the price for hot fudge falls, you will buy more hot fudge. In addition, you will probably buy more ice cream since it is used with hot fudge. Other examples: gasoline and automobiles, computers and software, peanut butter and jelly.
    • Tastes: Taste is a historical, psychological and subjective characteristic that economists don’t try to explain. However, it must be accounted for and the impact of changing tastes can be examined by economists.
    • Expectations: Future expectations impact present-day economic decisions. Example: if you expect a forthcoming raise or a bonus you might alter your spending behaviors.
    • Number of buyers: The addition of more buyers into a market will increase the number of consumers. Similarly the subtraction of buyers also impacts the market. Consider macro trends like birthrates, immigration and deathrates (among other factors).
  • Case Study: Two ways to reduce the quantity of smoking demanded:

    1. Shift in the demand curve: For example, discourage overall smoking demand with warnings on cigarette packages. This shifts the demand curve to the left.
    2. Movement along the demand curve: A cigarette tax makes smoking more expensive. This doesn’t change the overall demand but reduces smoking by moving the amount of smoking along the demand curve.

4-3 Supply

  • Quantity supplied: The amount of a good that sellers are willing and able to sell.
  • Law of supply: Other things being equal, the quantity supplied of a good rises when the price of the good rises. When the price falls, the quantity supplied falls as well.
  • Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied.
  • Supply curve: A graph representing the relationship between the price of a good and the quantity supplied.
  • Example of a Supply Curve:
(Image from Quora.com)
  • Market supply: The sum of the supplies of all the sellers.
  • Shifts in the supply curve can occur if something happens that alters the quantity supplied:

    • Increase in supply: shifts the supply curve to the right.
    • Decrease in supply: shifts the supply curve to the left.
  • Key variables that can affect supply curve shifts:

    • Input prices: Inputs are the factors necessary for the production of a good or service. This can include material, time and labor. Example ice cream production inputs include cream, sugar, flavorings, ice-cream machines, buildings and workers. If the price of one or more of the inputs rises, producing ice cream becomes less profitable and firms supply less ice cream. Supply of a good is negatively related to the price of the inputs used to make the good.
    • Technology: Example: Automated machinery can reduce labor costs and boost production output.
    • Expectations: Future circumstances can impact current decision-making. For instance, if an ice cream supplier anticipates increased prices of sugar in the future, they might put some of their production into storage for the future and supply less ice cream today.
    • Number of sellers: Supply depends on the number of sellers. Should a current supplier retire or go out of business, it will impact the market supply. Similarly a new entrant might increase supply.

4-4 Supply and Demand Together

  • Equilibrium: A situation in which the market price has reached the level at which quantity supplied equals quantity demanded.
  • Equilibrium price: The price that balances the quantity supplied and the quantity demanded.
  • Equilibrium quantity: The quantity supplied and the quantity demanded at the equilibrium price.
  • Surplus: A situation in which quantity supplied is greater than quantity demanded.
  • Shortage: A situation in which quantity demanded is greater than the quantity supplied.
  • Law of supply and demand: The price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance.
  • Example of a Supply and Demand Curve and the point of equilibrium:
(Image from Wikipedia.org)

4-5 Conclusion: How Prices Allocate Resources

  • “Markets are usually a good way to organize economic activity.”
  • “In any economic system, scarce resources have to be allocated among competing uses.”
  • “Supply and demand together determine the prices of the economy’s many different goods and services.”
  • “Prices are the signals that guide the allocation of resources.”

Chapter 5: Elasticity and Its Application

5-1 The Elasticity of Demand

  • Elasticity: A measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants.
  • Price elasticity of demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.
  • Ask: Are consumers willing to buy less of a particular good if the price rises?
  • Elastic goods examples: Vacations, gasoline.
  • Inelastic goods examples: Food, salt, prescription drugs.
  • Some goods exhibit both elastic and inelastic characteristics depending on the time horizon (i.e. some goods are inelastic on a short-term basis and become more elastic on a long-term basis).
  • Factors that impact whether a good is elastic or inelastic:
    1. Availability of close substitutes: Goods with close substitutes are generally more elastic because consumers can switch from one good to a less expensive substitute.
    2. Necessities vs. luxuries: Necessities tend to be inelastic: consumers must purchase them no matter the price.
    3. Definition of the market: Elasticity of a market is contingent on the boundaries for that market. A narrow market is more elastic than a broad market because narrow markets are more easily substituted. Example: “Ice cream” is a narrow market category. Other sweets can be substituted for ice cream. Therefore ice cream is more elastic. “Food” is a broad market. Food is a necessity and is more inelastic.
    4. Time horizon: Goods can demonstrate more elastic demand over longer time horizons. Example: In the short-term, gasoline might be inelastic. Over the long-term, gasoline becomes more elastic as the market responds with more substitutes for consumers. For instance, fuel efficient cars or greater telecommuting options.
  • Computing the Price Elasticity of Demand
Price elasticity of demand = percentage change in quantity demanded / percentage change in price
  • Example: 10 percent increase in the price of ice-cream causes ice cream purchasing to fall by 20%. The PEoD is represented as 20 / 10 = 2. In other words, the change in quantity demanded is twice the size of the change in the price.
  • A larger price elasticity value implies a greater sensitivity to price changes for the quantity demanded.
  • The Midpoint Method is a better method for calculating percentage changes and elasticities. Author recommends using this method if elasticity calculations are necessary (however the formula is deemed unnecessary for this book so I am omitting from my notes). The formula can be found on page 92.
  • “Economists classify demand curves according to their elasticity.”
  • Demand is elastic when the elasticity is > 1 (quantity demanded moves proportionately to the price).
  • Demand is inelastic when the elasticity is < 1 (quantity demanded moves proportionately less than the price).
  • Unit elasticity: The term for goods with elasticities of 1.
  • Rule of thumb: “The flatter the demand curve that passes through a given point, the greater the price elasticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand.”
  • Memory trick: “Inelastic curves look like the letter ‘I’” (Example: a demand curve showing a vertical line would be inelastic because there is no change in the quantity demanded as the price, represented by the y-axis, increase or decreases).
  • Total revenue: the amount paid by buyers and received by sellers of a good. Computed as: price of the good times quantity sold (P*Q).
  • Elasticity effects total revenue depending on price elasticity of demand.
  • If demand is inelastic, then an increase of price causes an increase in total revenue (because quantity demanded, Q, is proportionately smaller than rise in P).
  • If demand is elastic, then an increase of price will cause a decrease in total revenue because Q is rising disproportionately compared to the rise in P.
  • “When demand is inelastic (< 1), price and total revenue move in the same direction: If the price increases, total revenue also increases.”
  • “When demand is elastic (>1), price and total revenue move in opposite directions. If the price increases, total revenue decreases.”
  • “If demand is unit elastic (=1), total revenue remains constant when the price changes.”
  • Elasticity along a linear demand curve:
    • At points with a low price and high quantity, the demand curve is inelastic.
    • At points with a high price and low quantity, the demand curve is elastic.
  • Income elasticity of demand: A measure of how much the quantity demanded of a good responds to change in a consumers’ income.
  • Cross-price elasticity of demand: A measure of how much the quantity demanded of one good responds to a change in the price of another good.

5-2 The Elasticity of Supply

  • Price elasticity of supply: A measure of how much the quantity supplied of a good responds to a change in the price of that good, commuted as the percentage change in quantity supplied divided by the percentage change in price.
  • Price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce.
    • Inelastic supply example: Beachfront land has an inelastic supply because it is difficult to produce more of it.
    • Elastic supply example: Manufactured goods like books and computers have elastic supplies because companies can run their factories longer in response to higher prices.
  • Key determinant to the price elasticity of supply is the time period being considered.
    • Supply is usually more inelastic in the short term (firms cannot quickly add new capacity/output).
    • Supply is usually more elastic in the long term (example: build more factories).
  • Computing the price elasticity of supply:
price elasticity of supply = percentage change in quantity supplied / percentage change in price
  • Example: An increase in the price of milk from $2.85 to $3.15 per gallon raises the amount of milk produced from 9,000 to 11,000 gallons per month.

    • Percentage change in price (using midpoint method) = (3.15-2.85) / 3.00 * 100 = 10%
    • Percentage change in quantity supplied = (11,000-9,000 / 10,000 * 100 = 20%– Price elasticity of supply = 20% / 10% = 2
    • The quantity supplied changes proportionately twice as much as the price.
  • The varieties of supply curves:

    • Perfectly inelastic supply when elasticity = 0 (a vertical line)
    • Inelastic supply when elasticity < 1 (a steep slope)
    • Unit elastic supply when elasticity = 1
    • Elastic supply when elasticity > 1 (a flatter slope)
    • Perfectly elastic supply when elasticity = infinity (a horizontal line)

5-3 Three Applications of Supply, Demand, and Elasticity

  • Case 1: Can good news for farming be bad news for farmers?

    • Background: Researchers develop a new hybrid of wheat that increases the yield per acre by 20%.
    • Exercise: Consider whether this development is a positive or negative development for farmers.
    • Questions to ask:
      1. Does the supply or demand curve shift?
      2. Consider the direction in which the curve shifts.
      3. Use a supply-and-demand diagram to see how market equilibrium changes.
    • Analysis:
      • New hybrid will affect the supply curve. Farmers can now supply more wheat (the supply shifts to the right).
      • The demand curve remains the same because consumers desire to buy wheat products at any given price is not affected by the introduction of a new hybrid.
      • The price of wheat will fall.– Food is generally inelastic. A decrease in price should cause total revenue (P*Q) to fall.
    • The result is that the price of wheat falls relatively substantially. The quantity of wheat sold rises only slightly.
    • In a competitive market, this kind of innovation increases per farmer efficiency which the market responds to by creating fewer farms (i.e. some farmers will leave farming altogether). Fewer farmers will be able to achieve greater output.
    • The dynamic above also helps explain the logic of farm subsidies where farmers are paid to leave their land fallow: it reduces the supply of farm products and results in higher prices.
  • Case 2: Why did OPEC fail to keep the price of oil high?

    • Background: During the 1970s, members of the Organization of the Petroleum Exporting Countries (OPEC) raised world oil prices to increase their income. OPEC accomplished this by jointly reducing the amount of oil they supplied. Oil prices rose more than 50% from 1973 to 1974. OPEC did the same thing again and from 1979 to 1981 the price of oil doubled. However soon after oil prices started to decline steadily and cooperation broke down and by 1990 prices were back to 1970 prices.
    • Exercise: Explore the differences in how demand behaves in the short-term and long-term.
    • Analysis:
      • Short-term: Supply and demand are relatively inelastic.
      • Supply is inelastic because quantity of known oil reserves and the capacity to extract and refine oil cannot be changed quickly.
      • Demand is inelastic because buying habits do not respond immediately to changes in price.
      • Long-term: Supply and demand becomes more elastic. Suppliers outside of OPEC increase oil exploration and extraction capacity (attracted by high prices). Consumers respond with conservation measures such as purchasing cars with higher fuel-efficiency.
  • Case 3: Does drug interdiction increase or decrease drug-related crime?

    • Background: Use of illegal drugs is a big problem. Drug use has adverse effects: addiction ruins lives of user and their families; addicts turn to crime to support their habit; government expenditures to minimize these activities are high.
    • Exercise: Examine the policy of drug interdiction through the tools of supply and demand. What happens if the government increases the number of agents devoted to the “war on drugs”?
    • Questions to ask:
      • Consider whether the supply or demand curve shifts.
      • Consider the direction of the shift.
      • How does the shift affect the equilibrium price and quantity?
    • Analysis:
      • Drug interdiction’s goal is reduced drug use but the direct impact is on the sellers of the drugs (supply side).
      • Restricting supply increases the costs of selling drugs.
      • Demand for drugs remains the same.
      • Use is likely inelastic so few addicts are likely to break habit in response to a higher price.
      • Drug interdiction raises the price of drugs proportionately more than it reduces drug use.
      • Drug interdiction likely increases drug-related crimes.
  • Some experts advocate policies that focus on the demand side of the equation. For example, reducing demand through educational programs.

  • Some experts argue that long-term effects will differ from short-term impacts. Higher prices over longer periods of time might discourage experimentation (due to higher barrier to entry).

Chapter 6: Supply, Demand, and Government Policies

6-1 Controls on Prices

  • Buyers of a good always want a lower price.
  • Sellers of a good always want a higher price.
  • Each party can influence the government to pass laws to alter the market by controlling the price of a particular good.
  • Price ceiling: A legal maximum on the price at which a good can be sold.
  • Price floor: A legal minimum on the price at which a good can be sold.
  • How price ceilings affect market outcomes:

    • If the government imposes a price ceiling that is above the equilibrium price, the price ceiling will have no effect and is considered not binding.
    • If the government imposes a price ceiling that is below the equilibrium price, the price ceiling is considered to be binding or as a binding constraint on the market. The result is a shortage of the quantity supplied.
  • Mechanisms for rationing goods in a shortage include:

    • A queue for demand (waiting for availability).
    • Selective distribution of goods (selling goods to preferred individuals or goods).
  • “Even though the price ceiling was motivated by a desire to help buyers, not all buyers benefit from the policy. Some buyers do get to pay a lower price..but other buyers cannot get any [of the good] at all.”
  • “When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers.”
  • Rationing mechanism are inherently inefficient. Lines waste time. Discrimination and seller bias is unfair and inefficient (the good may not go to the buyer who values it most highly).
  • “Free markets ration goods with prices.”
  • Case Study: Rent Control
    • Rent control is a common example of a binding price ceiling (government imposes a price ceiling that landlords may charge their tenants).
    • The goal of this policy is to help the poor by making housing more affordable.
    • Economists almost universally see rent control as a a highly inefficient way to help the poor.
    • Adverse effects of rent control occur over many years (which makes it difficult for general public to assess the costs/impacts).
    • Rent control, like all price ceilings, results in shortages of the underlying good (in this case housing).
    • Short-term: Rent control will stabilize or lower rental rates. The suppliers (landlords) cannot quickly adjust the supply. The demand and supply for housing is relatively inelastic.
    • Long-term: Buyers and sellers respond to market conditions as time passes.
    • Supply side impacts: landlords stop building new apartments and invest less in maintaining existing housing stock.
    • Demand side impacts: Low rents induce more people to move to the area with price controls.
    • Rent control upsets underlying free market incentives.
  • How price floors affect market outcomes:
    • If the government imposes a price floor that is below the equilibrium price, the price floor will have no effect and is considered not binding.
    • If the government imposes a price ceiling floor is above the equilibrium price, the price floor is considered to be binding or as a binding constraint on the market. The result is a surplus of the good.
  • Binding price floors cause a surplus.
  • Case Study: Minimum Wage

    • A minimum wage is the lowest price for labor that any employer may pay.
    • Consider the market for labor:
      • Workers determine the supply of labor.
      • Firms determine the demand.
      • With no government intervention, the wage normally adjusts to balance labor supply and labor demand.
      • If the minimum wage is above equilibrium, the quantity of labor supplied will exceed the quantity demanded. The result is unemployment.
      • Economy consists of many labor markets for different types of workers.
      • Highly skilled and experienced workers are not affected because their equilibrium wages are well above the minimum wage price floor.
    • Minimum wage has a significant impact on the market for teenage labor.
    • Teenagers are among the least skilled and experienced members of the labor force.
    • Many studies find that a 10% increase in the minimum wage depresses teenage employment by 1-3%.
    • Minimum wage alters the quantity of labor supplied. For teenagers this means more workers looking for jobs.
  • Economists generally oppose price controls because they see free, unfettered markets as the best means for organizing economic activity.
  • The job of market pricing is to balance supply and demand. When policymakers enact price controls they upset this balance.
  • In some cases, governments can improve market outcomes. This leads, in part, to continued attempts to enact price controls. In other cases, the government hurts the people they are trying to help.

6-2 Taxes

  • Governments uses taxes to raise revenue for public projects.
  • Important questions when considering a tax: Who bears the burden of a tax? Is it the buyers? Is it the sellers? Or do buyers and sellers share the burden?
  • Tax incidence: The manner in which the burden of a tax is shared among participants in a market.
  • The impact of taxes on sellers on market outcomes:

    • Hypothetical scenario: A local government passes a law requiring sellers of ice-cream cones to pay a flat tax of $0.50 for every cone sold.

    • Consider: How does this law affect buyers and sellers of ice cream?

    • Recommended analytical approach:

      1. Decide whether the law affects the supply curve or the demand curve.
      2. Decide which way the curve shifts.
      3. Examine how the shift affects the equilibrium price and quantity.
    • Immediate impact is on sellers. The tax is not directly levied on buyers so quantity demanded at any given price remains the same. Demand curve does not change. However, the tax on sellers makes the ice-cream business (at least via use of cones) less profitable, so it shifts the supply curve.

    • Tax on sellers raises the cost of producing and selling ice cream [with cones]. The supply curve shifts to the left.

    • Equilibrium price of ice cream shifts upward and the equilibrium quantity of ice cream cones will shift downward. Sellers sell less and buyers buy less.

    • The tax reduces the size of the ice-cream market.

    • Sellers are responsible for delivering the tax to the government, but the tax policy impacts both buyers and sellers.

    • Conclusions:

      • Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new equilibrium.
      • Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for the good and sellers receive less.
  • The impact of taxes on buyers on market outcomes:
    • Hypothetical scenario: Government passes a law requiring buyers to send $0.50 to the government for every ice-cream purchased.
    • Consider: How does this law affect buyers and sellers? (Use identical 3-step framework from prior section above)
    • The initial impact of the tax is on the demand for ice cream.
    • Supply curve is not immediately affected.– The tax shifts the demand curve for ice cream.
    • Buyers purchase less ice cream [cones] and demand is lowered.
    • The equilibrium price of ice cream falls.
    • Conclusions: Taxes levies on sellers and taxes levied on buyers are equivalent. Both parties will bear the burden.
  • Payroll taxes exhibit the basic lesson of tax incidence: “Lawmakers can decide whether a tax comes from the buyer’s pocket or from the seller’s, but they cannot legislate the true burden of a tax.”
  • “Tax incidence depends on the forces of supply and demand.”
  • How is a tax burden divided? Tax incidence is rarely shared equally.
  • A tax burden falls more heavily on the side of the market that is less elastic. (remember: elasticity measures the willingness of buyers or sellers to leave a market when conditions become favorable). When one side exhibits inelasticity, it means they have fewer substitutes and alternatives available.
  • In the example of payroll taxes most economists believe that labor is less elastic than demand. The result is that workers bear more of the burden of payroll taxes.

6-3 Conclusion

  • Economies are governed by two kinds of laws:

    1. The laws of supply and demand.
    2. The laws enacted by governments.
  • Price controls and taxes are commonly employed by governments with market economies.
  • “When analyzing government policies, supply and demand are the first and most useful tools of analysis.”


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