Given the budget constraint, the theory of demand assumes a consumer seeks to reach the
maximum possible level of utility.
The budget line shows the maximum affordable quantity of one good for each given
quantity of the other good. The position of the budget line is determined by income and
prices alone. Its slope reflects only relative prices.
Because the consumer prefers more to less, he or she will always select a point on the
budget line. The consumer has a problem of choice. Along the budget line, more of one
good can be obtained only by sacrificing some of the other good.
Consumer tastes can be represented by a map of nonintersecting indifference curves.
Along each indifference curve, utility is constant. Higher indifference curves are preferred to
lower indifference curves. Since the consumer prefers more to less, indifference curves must
slope downwards. To preserve a given level of utility, increases in the quantity of one good
must be offset by reductions in the quantity of the other good.
Indifference curves exhibit a diminishing marginal rate of substitution. Their slope is flatter as
we move along them to the right. To maintain given utility, consumers sacrifice ever
smaller amounts of one good to get successive unit increases in the amount of the other
good.
Utility-maximizing consumers choose the consumption bundle at which the highest
reachable indifference curve is tangent to the budget line. At this point the market trade-off
between goods, the slope of the budget line, just matches the utility trade-off between
goods, the slope of the indifference curve.
At constant prices, an increase in income leads to a parallel outward shift in the budget line.
If goods are normal, the quantity demanded will increase.
A change in the price of one good rotates the budget line around the point at which none of
that good is purchased. Such a price change has an income effect and a substitution effect.
The income effect of a price increase is to reduce the quantity demanded for all normal
goods. The substitution effect, induced by relative price movements alone, leads consumers
to substitute away from the good whose relative price has increased.
In a two-good world, goods must be substitutes. The substitution effect is unambiguous.
With many goods, the pure substitution effect of a price increase also reduces demand for
goods that are complementary to the good whose price has risen.
A rise in the price of a normal good must lower its quantity demanded. For inferior goods,
the income effect operates in the opposite direction but rarely seems to dominate the
substitution effect. Demand curves slope downwards.
The market demand curve is the horizontal sum of individual demand curves, at each price
adding together the individual quantities demanded.
Consumers prefer to receive transfers in cash rather than in kind, if the two transfers have
the same monetary value. A transfer in kind may restrict the choices a consumer can make.
Economics analyses what, how and for whom society produces. The key economic
problem is to reconcile the conflict between people’s virtually unlimited demands with
society’s limited ability to produce goods and services to fulfil these demands.
The production possibility frontier (PPF) shows the maximum amount of one good that can
be produced given the output of the other good. It depicts the trade-off or menu of choices
for society in deciding what to produce. Resources are scarce and points outside the
frontier are unattainable. It is inefficient to produce within the frontier.
The opportunity cost of a good is the quantity of other goods sacrificed to make an
additional unit of the good. It is the slope of the PPF.
Industrial countries rely extensively on markets to allocate resources. The market resolves
production and consumption decisions by adjustments in prices.
In a command economy, decisions on what, how and for whom are made in a central
planning office. No economy relies entirely on command.
A free market economy has no government intervention. Resources are allocated entirely
through markets in which individuals pursue their own self-interest. Adam Smith argued that
an 'invisible hand' would nevertheless allocate resources efficiently.
Modern economies are mixed, relying mainly on the market but with a large dose of
government intervention. The optimal level of intervention is hotly debated.
Positive economics studies how the economy actually behaves. Normative economics
recommends what should be done. The two should be kept separate. Given sufficient
research, economists could agree on issues in positive economics. Normative economics
involves subjective value judgements. There is no reason why people should agree about
normative statements.
Microeconomics offers a detailed analysis of particular activities in the economy. For
simplicity, it may neglect some interactions with the rest of the economy. Macroeconomics
emphasizes these interactions at the cost of simplifying the individual building blocks.
