Download pdf from investopida

EconomicsBasics

Tutorial

http://www.investopedia.com/university/economics/

Thanks very much for downloading the printable version of this tutorial.

As always, we welcome any feedback or suggestions.

http://www.investopedia.com/contact.aspx

Table of Contents

1) Economic Basics: Introduction

2) Economic Basics: What Is Economics?

3) Economic Basics: Production Possibility Frontier, Growth,

Opportunity Cost and Trade

4) Economic Basics: Demand and Supply

5) Economic Basics: Elasticity

6) Economic Basics: Utility

7) Economic Basics: Monopolies, Oligopolies, and Perfect Competition

8) Economic Basics: Conclusion

EconomicsBasics: Introduction

Economics may appear to be the study of complicated tables and charts,

statistics and numbers, but, more specifically, it is the study of what constitutes

rational human behavior in the endeavor to fulfill needs and wants.

As an individual, for example, you face the problem of having only limited

resources with which to fulfill your wants and needs, as a result, you must make

certain choices with your money. You'll probably spend part of your money on

rent, electricity and food. Then you might use the rest to go to the movies and/or

buy a new pair of jeans. Economists are interested in the choices you make, and

inquire into why, for instance, you might choose to spend your money on a new

DVD player instead of replacing your old TV. They would want to know whether

you would still buy a carton of cigarettes if prices increased by $2 per pack. The

underlying essence of economics is trying to understand how both individuals

and nations behave in response to certain material constraints.

We can say, therefore, that economics, often referred to as the "dismal science",

is a study of certain aspects of society. Adam Smith (1723 - 1790), the "father of

modern economics" and author of the famous book "An Inquiry into the Nature

and Causes of the Wealth of Nations", spawned the discipline of economics by

(Page 1 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

trying to understand why some nations prospered while others lagged behind in

poverty. Others after him also explored how a nation's allocation of resources

affects its wealth.

To study these things, economics makes the assumption that human beings will

aim to fulfill their self-interests. It also assumes that individuals are rational in

their efforts to fulfill their unlimited wants and needs. Economics, therefore, is a

social science, which examines people behaving according to their self-interests.

The definition set out at the turn of the twentieth century by Alfred Marshall,

author of "The Principles of Economics", reflects the complexity underlying

economics: "Thus it is on one side the study of wealth; and on the other, and

more important side, a part of the study of man."

EconomicsBasics: What Is Economics?

In order to begin our discussion of economics, we first need to understand (1) the

concept of scarcity and (2) the two branches of study within economics:

microeconomics and macroeconomics.

1. Scarcity

Scarcity, a concept we already implicitly discussed in the introduction to this

tutorial, refers to the tension between our limited resources and our unlimited

wants and needs. For an individual, resources include time, money and skill. For

a country, limited resources include natural resources, capital, labor force and

technology.

Because all of our resources are limited in comparison to all of our wants and

needs, individuals and nations have to make decisions regarding what goods and

services they can buy and which ones they must forgo. For example, if you

choose to buy one DVD as opposed to two video tapes, you must give up owning

a second movie of inferior technology in exchange for the higher quality of the

one DVD. Of course, each individual and nation will have different values, but by

having different levels of (scarce) resources, people and nations each form some

of these values as a result of the particular scarcities with which they are faced.

So, because of scarcity, people and economies must make decisions over how

to allocate their resources. Economics, in turn, aims to study why we make these

decisions and how we allocate our resources most efficiently.

2. Macro and Microeconomics

Macro and microeconomics are the two vantage points from which the economy

is observed. Macroeconomics looks at the total output of a nation and the way

the nation allocates its limited resources of land, labor and capital in an attempt

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 2 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

to maximize production levels and promote trade and growth for future

generations. After observing the society as a whole, Adam Smith noted that there

was an "invisible hand" turning the wheels of the economy: a market force that

keeps the economy functioning.

Microeconomics looks into similar issues, but on the level of the individual people

and firms within the economy. It tends to be more scientific in its approach, and

studies the parts that make up the whole economy. Analyzing certain aspects of

human behavior, microeconomics shows us how individuals and firms respond to

changes in price and why they demand what they do at particular price levels.

Micro and macroeconomics are intertwined; as economists gain understanding of

certain phenomena, they can help nations and individuals make more informed

decisions when allocating resources. The systems by which nations allocate their

resources can be placed on a spectrum where the command economy is on the

one end and the market economy is on the other. The market economy

advocates forces within a competitive market, which constitute the "invisible

hand", to determine how resources should be allocated. The command economic

system relies on the government to decide how the country's resources would

best be allocated. In both systems, however, scarcity and unlimited wants force

governments and individuals to decide how best to manage resources and

allocate them in the most efficient way possible. Nevertheless, there are always

limits to what the economy and government can do.

EconomicsBasics: Production Possibility Frontier (PPF), Growth, Opportunity Cost, and

Trade

A. Production Possibility Frontier (PPF)

Under the field of macroeconomics, the production possibility frontier (PPF)

represents the point at which an economy is most efficiently producing its goods

and services and, therefore, allocating its resources in the best way possible. If

the economy is not producing the quantities indicated by the PPF, resources are

being managed inefficiently and the production of society will dwindle. The

production possibility frontier shows there are limits to production, so an

economy, to achieve efficiency, must decide what combination of goods and

services can be produced.

Let's turn to the chart below. Imagine an economy that can produce only wine

and cotton. According to the PPF, points A, B and C - all appearing on the curve

- represent the most efficient use of resources by the economy. Point X

represents an inefficient use of resources, while point Y represents the goals that

the economy cannot attain with its present levels of resources.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 3 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

As we can see, in order for this economy to produce more wine, it must give up

some of the resources it uses to produce cotton (point A). If the economy starts

producing more cotton (represented by points B and C), it would have to divert

resources from making wine and, consequently, it will produce less wine than it is

producing at point A. As the chart shows, by moving production from point A to B,

the economy must decrease wine production by a small amount in comparison to

the increase in cotton output. However, if the economy moves from point B to C,

wine output will be significantly reduced while the increase in cotton will be quite

small. Keep in mind that A, B, and C all represent the most efficient allocation of

resources for the economy; the nation must decide how to achieve the PPF and

which combination to use. If more wine is in demand, the cost of increasing its

output is proportional to the cost of decreasing cotton production.

Point X means that the country's resources are not being used efficiently or,

more specifically, that the country is not producing enough cotton or wine given

the potential of its resources. Point Y, as we mentioned above, represents an

output level that is currently unreachable by this economy. However, if there was

a change in technology while the level of land, labor and capital remained the

same, the time required to pick cotton and grapes would be reduced. Output

would increase, and the PPF would be pushed outwards. A new curve, on which

Y would appear, would represent the new efficient allocation of resources.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 4 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

When the PPF shifts outwards, we know there is growth in an economy.

Alternatively, when the PPF shifts inwards it indicates that the economy is

shrinking as a result of a decline in its most efficient allocation of resources and

optimal production capability. A shrinking economy could be a result of a

decrease in supplies or a deficiency in technology.

An economy can be producing on the PPF curve only in theory. In reality,

economies constantly struggle to reach an optimal production capacity. And

because scarcity forces an economy to forgo one choice for another, the slope of

the PPF will always be negative; if production of product A increases

then production of product B will have to decrease accordingly.

B. Opportunity Cost

Opportunity cost is the value of what is foregone in order to have something else.

This value is unique for each individual. You may, for instance, forgo ice cream in

order to have an extra helping of mashed potatoes. For you, the mashed

potatoes have a greater value than dessert. But you can always change your

mind in the future because there may be some instances when the mashed

potatoes are just not as attractive as the ice cream. The opportunity cost of an

individual's decisions, therefore, is determined by his or her needs, wants, time

and resources (income).

This is important to the PPF because a country will decide how to best allocate

its resources according to its opportunity cost. Therefore, the previous

wine/cotton example shows that if the country chooses to produce more wine

than cotton, the opportunity cost is equivalent to the cost of giving up the required

cotton production.

Let's look at another example to demonstrate how opportunity cost ensures

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 5 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

that an individual will buy the least expensive of two similar goods when given

the choice. For example, assume that an individual has a choice between two

telephone services. If he or she were to buy the most expensive service, that

individual may have to reduce the number of times he or she goes to the movies

each month. Giving up these opportunities to go to the movies may be a cost that

is too high for this person, leading him or her to choose the less

expensive service.

Remember that opportunity cost is different for each individual and nation. Thus,

what is valued more than something else will vary among people and countries

when decisions are made about how to allocate resources.

C. Trade, Comparative Advantage and Absolute Advantage

Specialization and Comparative Advantage

An economy can focus on producing all of the goods and services it needs to

function, but this may lead to an inefficient allocation of resources and hinder

future growth. By using specialization, a country can concentrate on the

production of one thing that it can do best, rather than dividing up its resources.

For example, let's look at a hypothetical world that has only two countries

(Country A and Country B) and two products (cars and cotton). Each country can

make cars and/or cotton. Now suppose that Country A has very little fertile land

and an abundance of steel for car production. Country B, on the other hand, has

an abundance of fertile land but very little steel. If Country A were to try to

produce both cars and cotton, it would need to divide up its resources. Because it

requires a lot of effort to produce cotton by irrigating the land, Country A would

have to sacrifice producing cars. The opportunity cost of producing both cars and

cotton is high for Country A, which will have to give up a lot of capital in order to

produce both. Similarly, for Country B, the opportunity cost of producing both

products is high because the effort required to produce cars is greater than that

of producing cotton.

Each country can produce one of the products more efficiently (at a lower cost)

than the other. Country A, which has an abundance of steel, would need to give

up more cars than Country B would to produce the same amount of cotton.

Country B would need to give up more cotton than Country A to produce the

same amount of cars. Therefore, County A has a comparative advantage over

Country B in the production of cars, and Country B has a comparative advantage

over Country A in the production of cotton.

Now let's say that both countries (A and B) specialize in producing the goods with

which they have a comparative advantage. If they trade the goods that they

produce for other goods in which they don't have a comparative advantage, both

countries will be able to enjoy both products at a lower opportunity cost.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 6 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

Furthermore, each country will be exchanging the best product it can make for

another good or service that is the best that the other country can produce.

Specialization and trade also works when several different countries are

involved. For example, if Country C specializes in the production of corn, it can

trade its corn for cars from Country A and cotton from Country B.

Determining how countries exchange goods produced by a comparative

advantage ("the best for the best") is the backbone of international trade theory.

This method of exchange is considered an optimal allocation of resources,

whereby economies, in theory, will no longer be lacking anything that they need.

Like opportunity cost, specialization and comparative advantage also apply to the

way in which individuals interact within an economy.

Absolute Advantage

Sometimes a country or an individual can produce more than another country,

even though countries both have the same amount of inputs. For example,

Country A may have a technological advantage that, with the same amount of

inputs (arable land, steel, labor), enables the country to manufacture more of

both cars and cotton than Country B. A country that can produce more of both

goods is said to have an absolute advantage. Better quality resources can give a

country an absolute advantage as can a higher level of education and overall

technological advancement. It is not possible, however, for a country to have a

comparative advantage in everything that it produces, so it will always be able to

benefit from trade.

EconomicsBasics: Demand and Supply

Supply and demand is perhaps one of the most fundamental concepts of

economics and it is the backbone of a market economy. Demand refers to how

much (quantity) of a product or service is desired by buyers. The quantity

demanded is the amount of a product people are willing to buy at a certain price;

the relationship between price and quantity demanded is known as the demand

relationship. Supply represents how much the market can offer. The quantity

supplied refers to the amount of a certain good producers are willing to supply

when receiving a certain price. The correlation between price and how much of a

good or service is supplied to the market is known as the supply relationship.

Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the

allocation of resources. In market economy theories, demand and supply theory

will allocate resources in the most efficient way possible. How? Let us take a

closer look at the law of demand and the law of supply.

A. The Law of Demand

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 7 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

The law of demand states that, if all other factors remain equal, the higher the

price of a good, the less people will demand that good. In other words, the higher

the price, the lower the quantity demanded. The amount of a good that buyers

purchase at a higher price is less because as the price of a good goes up, so

does the opportunity cost of buying that good. As a result, people will naturally

avoid buying a product that will force them to forgo the consumption of something

else they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a

direct correlation between quantity demanded (Q) and price (P). So, at point A,

the quantity demanded will be Q1 and the price will be P1, and so on. The

demand relationship curve illustrates the negative relationship between price and

quantity demanded. The higher the price of a good the lower the quantity

demanded (A), and the lower the price, the more the good will be in demand (C).

B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be

sold at a certain price. But unlike the law of demand, the supply relationship

shows an upward slope. This means that the higher the price, the higher the

quantity supplied. Producers supply more at a higher price because selling a

higher quantity at a higher price increases revenue.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 8 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

A, B and C are points on the supply curve. Each point on the curve reflects a

direct correlation between quantity supplied (Q) and price (P). At point B, the

quantity supplied will be Q2 and the price will be P2, and so on.

Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of

time. Time is important to supply because suppliers must, but cannot always,

react quickly to a change in demand or price. So it is important to try and

determine whether a price change that is caused by demand will be temporary or

permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an

unexpected rainy season; suppliers may simply accommodate demand by using

their production equipment more intensively. If, however, there is a climate

change, and the population will need umbrellas year-round, the change in

demand and price will be expected to be long term; suppliers will have to change

their equipment and production facilities in order to meet the long-term levels of

demand.

C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to

show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20.

Because the record company's previous analysis showed that consumers will not

demand CDs at a price higher than $20, only ten CDs were released because

the opportunity cost is too high for suppliers to produce more. If, however, the ten

CDs are demanded by 20 people, the price will subsequently rise because,

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 9 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

according to the demand relationship, as demand increases, so does the price.

Consequently, the rise in price should prompt more CDs to be supplied as the

supply relationship shows that the higher the price, the higher the quantity

supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will

not be pushed up because the supply more than accommodates demand. In fact

after the 20 consumers have been satisfied with their CD purchases, the price of

the leftover CDs may drop as CD producers attempt to sell the remaining ten

CDs. The lower price will then make the CD more available to people who had

previously decided that the opportunity cost of buying the CD at $20 was too

high.

D. Equilibrium

When supply and demand are equal (i.e. when the supply function and demand

function intersect) the economy is said to be at equilibrium. At this point, the

allocation of goods is at its most efficient because the amount of goods being

supplied is exactly the same as the amount of goods being demanded. Thus,

everyone (individuals, firms, or countries) is satisfied with the current economic

condition. At the given price, suppliers are selling all the goods that they have

produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand

and supply curve, which indicates no allocative inefficiency. At this point, the

price of the goods will be P* and the quantity will be Q*. These figures are

referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the

prices of goods and services are constantly changing in relation to fluctuations in

demand and supply.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 10 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

E. Disequilibrium

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply

If price is set too high, excess supply will be created within the economy,

and there will be allocative inefficiency.

2. At price P1 the quantity of goods that the producers wish to supply is

indicated by Q2. At P1, however, the quantity that the consumers want to

consume is at Q1, a quantity much less than Q2. Because Q2 is greater

than Q1, too much is being produced and too little is being consumed. The

suppliers are trying to produce more goods, which they hope to sell in

hope of increasing profits, but those consuming the goods will purchase

less because the price is too high, making the product less attractive.

3. Excess Demand

Excess demand is created when price is set below the equilibrium price. Because

the price is so low, too many consumers want the good while producers are not

making enough of it.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 11 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

In this situation, at price P1, the quantity of goods demanded by

consumers at this price is Q2. Conversely, the quantity of goods that

producers are willing to produce at this price is Q1. Thus, there are too

few goods being produced to satisfy the wants (demand) of the

consumers. However, as consumers have to compete with one other to

buy the good at this price, the demand will push the price up, making

suppliers want to supply more and bringing the price closer to its

equilibrium.

4. F. Shifts vs. Movement

For economics, the “movements” and “shifts” in relation to the supply and

demand curves represent very different market phenomena:

1. Movements –

Like a movement along the demand curve, a movement along the supply

curve means that the supply relationship remains consistent. Therefore, a

movement along the supply curve will occur when the price of the good

changes and the quantity supplied changes in accordance to the original

supply relationship. In other words, a movement occurs when a change in

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 12 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

quantity supply is caused only by a change in price, and vice versa.

2. Shifts – A shift in a demand or supply curve occurs when a good’s quantity

demanded or supplied changes even though price remains the same. For

instance, if the price for a bottle of beer were $2 and the quantity of beer

demanded increased from Q1 to Q2, then there would be a shift in the

demand for beer. Shifts in the demand curve imply that the original

demand relationship has changed, meaning that quantity demand is

affected by a factor other than price. A shift in the demand relationship

would occur if, for instance, beer were all of a sudden the only type of

alcohol available for consumption.

Conversely, if the price for a bottle of beer were $2 and the quantity

supplied decreased from Q2 to Q1, then there would be a shift in the

supply of beer. Like a shift in the demand curve, a shift in the supply curve

implies that the original supply relationship has changed, meaning that

quantity supplied is affected by a factor other than price. A shift in the

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 13 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

supply curve would occur, if, for instance, a natural disaster caused a

mass shortage of hops: beer manufacturers would therefore be forced to

supply less beer for the same price.

Economic Basics: Elasticity

The degree to which a demand or supply curve reacts to a change in price is the

curve's elasticity. Elasticity varies among products because some products may

be more essential to the consumer. Products that are necessities are more

insensitive to price changes because consumers would continue buying these

products despite price increases. Conversely, a price increase of a good or

service that is considered less of a necessity will deter more consumers because

the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price

leads to a sharp change in the quantity demanded or supplied. Usually these

kinds of products are readily available in the market and a person may not

necessarily need them in his or her daily life. On the other hand, an inelastic

good or service is one in which changes in price witness only modest changes in

the quantity demanded or supplied, if any at all. These goods tend to be things

that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this

simple equation:

Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If

it is less than one, the curve is said to be inelastic.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 14 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

As we mentioned previously, the demand curve is a negative slope, and if there

is a large decrease in the quantity demanded with a small increase in price, the

demand curve looks flatter, or more horizontal. This flatter curve means that the

good or service in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as

quantity changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in

the amount supplied, the supply curve appears flatter and is considered elastic.

Elasticity in this case would be greater than or equal to 1.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 15 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

On the other hand, if a big change in price only results in a minor change in the

quantity supplied, the supply curve is steeper, and its elasticity would be less

than one.

A. Factors Affecting Demand Elasticity

There are three main factors that influence a demand’s price elasticity:

1. The availability of substitutes - This is probably the most important factor

influencing the elasticity of a good or service. In general, the more substitutes,

the more elastic the demand will be. For example, if the price of a cup of coffee

went up by $0.25, consumers could replace their morning caffeine with a cup of

tea. This means that coffee is an elastic good because a raise in price will cause

a large decrease in demand as consumers start buying more tea instead of

coffee.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 16 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

However, if the price of caffeine were to go up as a whole, we would probably

see little change in the consumption of coffee or tea because there are few

substitutes for caffeine. Most people are not willing to give up their morning cup

of caffeine no matter what the price. We would, therefore, say that caffeine is an

inelastic product because of its lack of substitutes. Thus, while a product within

an industry is elastic due to the availability of substitutes, the industry itself tends

to be inelastic. Usually, unique goods such as diamonds are inelastic because

they have few - if any - substitutes.

2. Amount of income available to spend on the good - This factor affecting

demand elasticity refers to the total a person can spend on a particular good or

service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income

stays the same, the income that is available to spend on Coke, which is $2, is

now enough for only two rather than four cans of Coke. In other words, the

consumer is forced to reduce his or her demand of Coke. Thus if there is an

increase in price and no change in the amount of income available to spend on

the good, there will be an elastic reaction in demand: demand will be sensitive to

a change in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up $2

per pack, a smoker, with very little available substitutes, will most likely continue

buying his or her daily cigarettes. This means that tobacco is inelastic because

the change in the quantity demand will have been minor with a change in price.

However, if that smoker finds that he or she cannot afford to spend the extra $2

per day and begins to kick the habit over a period of time, the price elasticity of

cigarettes for that consumer becomes elastic in the long run.

B. Income Elasticity of Demand

In the second factor outlined above, we saw that if price increases while income

stays the same, demand will decrease. It follows, then, that if there is an increase

in income, demand tends to increase as well. The degree to which an increase in

income will cause an increase in demand is called income elasticity of demand,

which can be expressed in the following equation:

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 17 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

If EDy is greater than one, demand for the item is considered to have a

high income elasticity. If however EDy is less than one, demand is considered to

be income inelastic. Luxury items usually have higher income elasticity because

when people have a higher income, they don't have to forfeit as much to buy

these luxury items. Let's look at an example of a luxury good: air travel.

Bob has just received a $10,000 increase in his salary, giving him a total of

$80,000 per annum. With this higher purchasing power, he decides that he can

now afford air travel twice a year instead of his previous once a year. With the

following equation we can calculate income demand elasticity:

Income elasticity of demand for Bob’s air travel is seven - highly elastic.

With some goods and services, we may actually notice a decrease in demand as

income increases. These are considered goods and services of inferior quality

that will be dropped by a consumer who receives a salary increase. An example

may be the increase in the demand of DVDs as opposed to video cassettes,

which are generally considered to be of lower quality. Products for which the

demand decreases as income increases have an income elasticity of less than

zero. Products that witness no change in demand despite a change in income

usually have an income elasticity of zero - these goods and services are

considered necessities.

EconomicsBasics: Utility

We have already seen that the focus of economics is to understand the problem

of scarcity: the problem of fulfilling the unlimited wants of humankind with limited

and/or scarce resources. Because of scarcity, economies need to allocate their

resources efficiently. Underlying the laws of demand and supply is the concept of

utility, which represents the advantage or fulfillment a person receives from

consuming a good or service. Utility, then, explains how individuals and

economies aim to gain optimal satisfaction in dealing with scarcity.

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 18 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

Utility is an abstract concept rather than a concrete, observable quantity. The

units to which we assign an “amount” of utility, therefore, are arbitrary,

representing a relative value. Total utility is the aggregate sum of satisfaction or

benefit that an individual gains from consuming a given amount of goods or

services in an economy. The amount of a person's total utility corresponds to the

person's level of consumption. Usually, the more the person consumes, the

larger his or her total utility will be. Marginal utility is the additional satisfaction, or

amount of utility, gained from each extra unit of consumption.

Although total utility usually increases as more of a good is consumed, marginal

utility usually decreases with each additional increase in the consumption of a

good. This decrease demonstrates the law of diminishing marginal utility.

Because there is a certain threshold of satisfaction, the consumer will no longer

receive the same pleasure from consumption once that threshold is crossed. In

other words, total utility will increase at a slower pace as an individual increases

the quantity consumed.

Take, for example, a chocolate bar. Let's say that after eating one chocolate bar

your sweet tooth has been satisfied. Your marginal utility (and total utility) after

eating one chocolate bar will be quite high. But if you eat more chocolate bars,

the pleasure of each additional chocolate bar will be less than the pleasure you

received from eating the one before - probably because you are starting to feel

full or you have had too many sweets for one day.

This table shows that total utility will increase at a much slower rate as marginal

utility diminishes with each additional bar. Notice how the first chocolate bar

gives a total utility of 70 but the next three chocolate bars together increase total

utility by only 18 additional units.

The law of diminishing marginal utility helps economists understand the law of

demand and the negative sloping demand curve. The less of something you

have, the more satisfaction you gain from each additional unit you consume; the

marginal utility you gain from that product is therefore higher, giving you a higher

willingness to pay more for it. Prices are lower at a higher quantity demanded

because your additional satisfaction diminishes as you demand more.

In order to determine what a consumer's utility and total utility are, economists

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 19 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.

turn to consumer demand theory, which studies consumer behavior and

satisfaction. Economists assume the consumer is rational and will thus maximize

his or her total utility by purchasing a combination of different products rather

than more of one particular product. Thus, instead of spending all of your money

on three chocolate bars, which has a total utility of 85, you should instead

purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of

milk, which has a utility of 50. This combination will give you a maximized total

utility of 120 but at the same cost as the three chocolate bars.

EconomicsBasics: Monopolies, Oligopolies and Perfect Competition

Economists assume that there are a number of different buyers and sellers in the

marketplace. This means that we have competition in the market, which allows

price to change in response to changes in supply and demand. Furthermore, for

almost every product there are substitutes, so if one product becomes too

expensive, a buyer can choose a cheaper substitute instead. In a market with

many buyers and sellers, both the consumer and the supplier have equal ability

to influence price.

In some industries, there are no substitutes and there is no competition. In a

market that has only one or few suppliers of a good or service, the producer(s)

can control price, meaning that a consumer does not have choice, cannot

maximize his or her total utility and has have very little influence over the price of

goods.

A monopoly is a market structure in which there is only one producer/seller for a

product. In other words, the single business is the industry. Entry into such a

market is restricted due to high costs or other impediments, which may be

economic, social or political. For instance, a government can create a monopoly

over an industry that it wants to control, such as electricity. Another reason for

the barriers against entry into a monopolistic industry is that oftentimes, one

entity has the exclusive rights to a natural resource. For example, in Saudi Arabia

the government has sole control over the oil industry. A monopoly may also form

when a company has a copyright or patent that prevents others from entering the

market. Pfizer, for instance, had a patent on Viagra.

In an oligopoly, there are only a few firms that make up an industry. This select

group of firms has control over the price and, like a monopoly, an oligopoly has

high barriers to entry. The products that the oligopolistic firms produce are

often nearly identical and, therefore, the companies, which are competing for

market share, are interdependent as a result of market forces. Assume, for

example, that an economy needs only 100 widgets. Company X produces 50

widgets and its competitor, Company Y, produces the other 50. The prices of the

two brands will be interdependent and, therefore, similar. So, if Company X starts

selling the widgets at a lower price, it will get a greater market share, thereby

This tutorial can be found at: http://www.investopedia.com/university/economics/

(Page 20 of 22)

Copyright © 2010, Investopedia.com - All rights reserved.

Investopedia.com – the resource for investing and personal finance education.