Choice, markets and elasticity
Basic Economic Concepts and the Economic Problem
Independent economic foundations connect scarce resources, competing uses, opportunity cost and positive versus normative reasoning. Numerical examples below supply their own fictional assumptions; no official paper weighting or regional curriculum equivalence is claimed.
Scarcity, choice and opportunity cost
- Scarcity concerns limited resources relative to competing uses. A market shortage means quantity demanded exceeds quantity supplied at the prevailing price; it can persist and need not arise only from a price control. Do not use them interchangeably.
- Opportunity cost is the value of the next best alternative forgone, which may be valued in physical or monetary terms. Money paid is not automatically the entire opportunity cost.
- Free goods exist only where the quantity available exceeds wants at zero price; even beach access in Cyprus carries an opportunity cost in land use or maintenance.
- Every agent faces the cost: the state's opportunity cost of a new highway is the school or hospital not built.
The production possibility frontier (PPF)
- A point on the curve is productively efficient; inside the curve means unemployed or inefficiently used resources; outside is unattainable with current resources and technology.
- A straight-line PPF indicates constant opportunity cost (resources are perfectly substitutable). A concave PPF indicates increasing opportunity cost as resources are switched into uses for which they are less suited.
- The PPF shifts outward with more or better resources or improved technology. A biased shift reflects improvement specific to one good.
Methodology
- Positive statements are testable against evidence; normative statements rest on value judgements. A sentence containing a figure can still be normative if it includes 'should'.
- Microeconomics examines individual markets and agents; macroeconomics examines aggregates such as output, the price level, unemployment and the balance of payments.
Worked example
A fictional farm has a straight-line frontier with intercepts 400 litres of milk and 2 tonnes of grapes per season. Increasing milk from 300 to 400 litres sacrifices 100/400×2=0.5 tonnes, or 500 kg, of grapes:5 kg per extra litre. At the supplied prices of 1.20 currency units per litre of milk and 300 per tonne of grapes, the extra milk earns 120 but sacrifices grape revenue 150. Under this narrow revenue comparison, grapes are preferred at that margin; actual costs or other objectives would require additional data.
Traps that cost marks
- Defining opportunity cost as the money paid rather than the alternative forgone.
- Confusing a movement along the PPF (reallocation of given resources) with an outward shift (growth).
- Describing a point inside the PPF as unattainable; it is attainable but inefficient.
- Labelling a normative claim positive because it quotes a statistic.
Demand, Supply and Market Equilibrium
Demand and supply diagrams are conditional models. Use the stated curve shapes and other-things-equal assumptions to distinguish an own-price movement from a shift, calculate an equilibrium and interpret a hypothetical policy.
Demand
- The law of demand states an inverse relationship between price and quantity demanded over a period, ceteris paribus.
- Non-price determinants shift the curve: income (normal versus inferior goods), tastes and advertising, prices of substitutes and complements, population size and age structure, expectations of future prices, distribution of income.
- A change in the good's own price moves you along the curve; it changes quantity demanded, not demand.
Supply
- Supply is directly related to price because higher prices cover rising marginal costs.
- Shift factors: input costs (fuel, animal feed, wages), technology, taxes and subsidies on producers, number of firms, weather and seasonality, expectations.
Equilibrium and comparative statics
- Equilibrium is where quantity demanded equals quantity supplied. Above it, a surplus drives price down; below it, a shortage drives price up.
- Demand rises: price and quantity both rise. Supply rises: price falls, quantity rises. Both shifting together leaves one variable indeterminate: if both rise, quantity certainly rises but price may rise, fall or stay put.
Price controls
- A binding price ceiling below equilibrium creates a shortage, queues, black markets and reduced quality - rent controls on old buildings are a standard example.
- A binding price floor above equilibrium creates excess supply in the standard model; a particular support scheme may include public purchase or storage, as with agricultural support prices.
Worked example
Demand is Qd = 100 − 5 P and supply Qs = 10 + 5 P. Setting them equal: 100 − 5 P = 10 + 5 P, so 90 = 10 P, P = €9 and Q = 55. A successful advertising campaign shifts demand to Qd = 120 − 5 P. Now 120 − 5 P = 10 + 5 P, giving P = €11 and Q = 65. The shift raises price by €2 and quantity by 10 units; the higher quantity is a movement along the existing supply curve, not a shift of supply.
Traps that cost marks
- Shifting demand when the scenario changes the good's own price.
- Forgetting ceteris paribus: if an input cost changes, demand does not shift.
- Claiming price is always indeterminate when two curves shift; it is only indeterminate when the shifts pull price in opposite directions.
- Confusing a shortage at a controlled price with scarcity.
Elasticity and Consumer/Producer Behaviour
Elasticity compares proportional responses rather than changes in unlike units. State whether a question uses an initial-base finite calculation, midpoint arc elasticity or a point derivative, then distinguish revenue from profit.
Price elasticity of demand
- PED = percentage change in quantity demanded ÷ percentage change in price. For an ordinary downward-sloping demand curve the point coefficient is negative; use its absolute magnitude for the usual classification, with any exceptions or finite-change convention stated. |PED| > 1 elastic, < 1 inelastic, = 1 unit elastic, 0 perfectly inelastic, infinite perfectly elastic.
- Determinants: availability of substitutes, proportion of income spent, necessity versus luxury, time horizon, habit or addiction, and how broadly the good is defined.
- Revenue rule: if demand is elastic, a price cut raises total revenue; if inelastic, a price rise raises total revenue. Revenue is maximised at unit elasticity.
- Tax incidence: the burden falls more heavily on the side of the market that is more inelastic.
Income, cross and supply elasticities
- YED positive = normal good; above 1 = luxury; negative = inferior good.
- XED positive = substitutes; negative = complements; near zero = unrelated.
- PES depends on spare capacity, time period, factor mobility and storability. Supply is more elastic in the long run.
Consumer and producer behaviour
- Marginal utility diminishes as consumption rises; in a smooth interior optimum where both goods are purchased, the usual marginal condition is MUx/Px = MUy/Py. Corner solutions and other constraints require separate analysis.
- A price fall pivots the budget line outward, producing an income effect and a substitution effect.
- Consumer surplus is the area between the demand curve and the price paid; producer surplus the area between price and the supply curve. Together they measure welfare, which is why market-failure questions use them.
Worked example
A bakery initially sells 500 loaves at 2.00 each, so revenue is 1,000. After price rises to 2.20, it sells 450 and revenue is 990: a fall of 10, not unchanged revenue. Initial-base finite changes give−10%/+10%=−1, but that convention must not be treated as proof of an exact finite-change unit-elastic revenue result. Midpoint changes are−50/475 and 0.20/2.10, giving arc elasticity about−1.105. That magnitude exceeds one and is consistent with the observed revenue fall. A point-elasticity rule is local; specify the convention and range before applying it.
Traps that cost marks
- Reporting elasticity as a percentage; it is a ratio of percentages and has no units.
- Confusing steepness of a straight-line demand curve with elasticity: elasticity changes along a linear curve even though slope does not.
- Applying the revenue rule in reverse, claiming a price rise raises revenue when demand is elastic.
- Assuming the tax is fully passed on to consumers regardless of elasticities.