6.2: Other Demand Elasticities

6.2.1: Cross-Price Elasticity of Demand

Learning Objective

Use the cross elasticity of demand to describe a good

Key Points

• Complementary goods have a negative cross-price elasticity: as the price of one good increases, the demand for the second good decreases.
• Substitute goods have a positive cross-price elasticity: as the price of one good increases, the demand for the other good increases.
• Independent goods have a cross-price elasticity of zero: as the price of one good increases, the demand for the second good is unchanged.

Key Terms

substitute

A good with a positive cross elasticity of demand, meaning the good’s demand is increased when the price of another is increased.

Complement

A good with a negative cross elasticity of demand, meaning the good’s demand is increased when the price of another good is decreased.

The cross-price elasticity of demand shows the relationship between two goods or services. More specifically, it captures the responsiveness of the quantity demanded of one good to a change in price of another good. Cross-Price Elasticity of Demand (E_A,B) is calculated with the following formula:

The cross-price elasticity may be a positive or negative value, depending on whether the goods are complements or substitutes. If two products are complements, an increase in demand for one is accompanied by an increase in the quantity demanded of the other. For example, an increase in demand for cars will lead to an increase in demand for fuel. If the price of the complement falls, the quantity demanded of the other good will increase. The value of the cross-price elasticity for complementary goods will thus be negative .

Complements

Two goods that complement each other have a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls.

A positive cross-price elasticity value indicates that the two goods are substitutes. For substitute goods, as the price of one good rises, the demand for the substitute good increases. For example, if the price of coffee increases, consumers may purchase less coffee and more tea. Conversely, the demand for a substitute good falls when the price of another good is decreased. In the case of perfect substitutes, the cross elasticity of demand will be equal to positive infinity .

Substitutes

Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises.

Two goods may also be independent of each other. In this instance, if the price of one good changes, demand for the other good will stay constant. For independent goods, the cross-price elasticity of demand is zero : the change in the price of one good with not be reflected in the quantity demanded of the other.

Independent

Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant.

6.2.2: Income Elasticity of Demand

Learning Objective

Analyze the characteristics of the income elasticity of demand.

Key Points

• The income elasticity of demand is the ratio of the percentage change in demand to the percentage change in income.
• Normal goods have a positive income elasticity of demand (as income increases, the quantity demanded increases).
• Inferior goods have a negative income elasticity of demand (as income increases, the quantity demanded decreases).

Key Terms

Superior Good

A type of normal good. Demand increases more than proportionally as income rises.

Necessary Good

A type of normal good. An increase in income leads to a smaller than proportional increase in the quantity demanded.

The income elasticity of demand (YED) measures the responsiveness of demand for a good to a change in the income of the people demanding that good, ceteris paribus. It is calculated as the ratio of the percentage change in demand to the percentage change in income:

If an increase in income leads to an increase in demand, the income elasticity of that good or service is positive. A positive income elasticity is associated with normal goods. In contrast, if a rise in income leads to a decrease in demand, the good or service has a negative income elasticity of demand. A negative income elasticity is associated with inferior goods.

In all, there are five types of income elasticity of demand :

Income Elasticity of Demand

Income elasticity of demand measures the percentage change in quantity demanded as income changes.

• High income elasticity of demand (YED>1): An increase in income is accompanied by a proportionally larger increase in quantity demanded. This is typical of a luxury or superior good.
• Unitary income elasticity of demand (YED=1): An increase in income is accompanied by a proportional increase in quantity demanded.
• Low income elasticity of demand (YED<1): An increase in income is accompanied by less than a proportional increase in quantity demanded. This is characteristic of a necessary good.
• Zero income elasticity of demand (YED=0): A change in income has no effect on the quantity bought. These are called sticky goods.
• Negative income elasticity of demand (YED<0): An increase in income is accompanied by a decrease in the quantity demanded. This is an inferior good (all other goods are normal goods). The consumer may be selecting more luxurious substitutes as a result of the increase in income.

6.2.3: Calculating Elasticities

Learning Objective

Calculate price elasticity of demand with the midpoint method

Key Points

• When changes in price and quantity are big, the arc elasticity or point elasticity formulas provide a more accurate elasticity coefficient than the basic elasticity formula.
• The arc elasticity captures the responsiveness of one variable to another between two given points.
• The midpoint method can be used if just two points on the demand curve are known. You do not need to know the function relating price and quantity demanded to use this method.
• The point elasticity captures the change in quantity demanded to a tiny change in price. To calculate the point elasticity, you must have a function for the relationship between price and quantity.

Key Terms

Arc elasticity

The elasticity of one variable with respect to another between two given points.

Point elasticity

The measure of the change in quantity demanded to a very small change in price.

The basic formula for the price elasticity of demand (percentage change in quantity demanded divided by the percentage change in price) yields an accurate result when the changes in quantity and price are small. As the difference between the two prices or quantities increases, however, the accuracy of the formula decreases. This happens because the price elasticity of demand often varies at different points along the demand curve and because the percentage change is not symmetric. Instead, the percentage change between any two values depends on which is chosen as the starting value. For example, when the quantity demanded increases from 10 units to 15 units, the percentage change is 50%. If the quantity demanded decreases from 15 units to 10 units, the percentage change is -33.3%. Two alternative elasticity measures can be used to avoid or minimize the shortcomings of the basic elasticity formula.

The midpoint method calculates the arc elasticity, which is the elasticity of one variable with respect to another between two given points on the demand curve . This measure requires just two points for quantity demanded and price to be known; it does not require a function for the relationship. The midpoint method uses the midpoint rather than the initial point for calculating percentage change, so it is symmetric with respect to the two prices and quantities demanded. The arc elasticity is obtained using this formula:

Arc Elasticity

To calculate the arc elasticity, you need to know two points on the demand curve. The calculation does not require a function for the relationship between price and quantity demanded.

Suppose that the price of hot dogs changes from $3 to $1, leading to a change in quantity demanded from 80 to 120. The formula provided above would yield an elasticity of 0.4/(-1) = -0.4. As elasticity is often expressed without the negative sign, it can be said that the demand for hot dogs has an elasticity of 0.4.

The point elasticity is the measure of the change in quantity demanded to a tiny change in price. It is the limit of the arc elasticity as the distance between the two points approaches zero, and hence is defined as a single point. In contrast to the midpoint method, calculating the point elasticity requires a defined function for the relationship between price and quantity demanded. The point elasticity can be calculated with the following formula:

In the formula above, dQ/dP is the partial derivative of quantity with respect to price, and P and Q are price and quantity, respectively, at a given point on the demand curve.

6.3: Price Elasticity of Supply

6.3.1: Definition of Price Elasticity of Supply

The price elasticity of supply is the measure of the responsiveness in quantity supplied to a change in price for a specific good.

Learning Objective

Differentiate between the price elasticity of demand for elastic and inelastic goods

Key Points

• Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable: 
• The impact that a price change has on the elasticity of supply also directly impacts the elasticity of demand.
• Inelastic goods are often described as necessities, while elastic goods are considered luxury items.
• The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly inelastic.

Key Terms

demand

The desire to purchase goods and services.

supply

The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.

luxury

Something very pleasant but not really needed in life.

In economics, elasticity is a summary measure of how the supply or demand of a particular good is influenced by changes in price. Elasticity is defined as a proportionate change in one variable over the proportionate change in another variable:

The price elasticity of supply (PES) is the measure of the responsiveness in quantity supplied (QS) to a change in price for a specific good (% Change QS / % Change in Price). There are numerous factors that directly impact the elasticity of supply for a good including stock, time period, availability of substitutes, and spare capacity. The state of these factors for a particular good will determine if the price elasticity of supply is elastic or inelastic in regards to a change in price.

The price elasticity of supply has a range of values:

• PES > 1: Supply is elastic.
• PES < 1: Supply is inelastic.
• PES = 0: The supply curve is vertical; there is no response of demand to prices. Supply is “perfectly inelastic.”
• PES =
   (i.e., infinity): The supply curve is horizontal; there is extreme change in demand in response to very small change in prices. Supply is “perfectly elastic.”

Inelastic goods are often described as necessities. A shift in price does not drastically impact consumer demand or the overall supply of the good because it is not something people are able or willing to go without. Examples of inelastic goods would be water, gasoline, housing, and food.

Elastic goods are usually viewed as luxury items. An increase in price for an elastic good has a noticeable impact on consumption. The good is viewed as something that individuals are willing to sacrifice in order to save money. An example of an elastic good is movie tickets, which are viewed as entertainment and not a necessity.

The price elasticity of supply is determined by:

• Number of producers: ease of entry into the market.
• Spare capacity: it is easy to increase production if there is a shift in demand.
• Ease of switching: if production of goods can be varied, supply is more elastic.
• Ease of storage: when goods can be stored easily, the elastic response increases demand.
• Length of production period: quick production responds to a price increase easier.
• Time period of training: when a firm invests in capital the supply is more elastic in its response to price increases.
• Factor mobility: when moving resources into the industry is easier, the supply curve in more elastic.
• Reaction of costs: if costs rise slowly it will stimulate an increase in quantity supplied. If cost rise rapidly the stimulus to production will be choked off quickly.

The result of calculating the elasticity of the supply and demand of a product according to price changes illustrates consumer preferences and needs . The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly inelastic.

Price elasticity over time

This graph illustrates how the supply and demand of a product are measured over time to show the price elasticity.

Perfectly Inelastic Supply

A graphical representation of perfectly inelastic supply.

6.3.2: Measuring the Price Elasticity of Supply

The price elasticity of supply is the measure of the responsiveness of the quantity supplied of a particular good to a change in price.

Learning Objective

Calculate elasticities and describe their meaning

Key Points

• The price elasticity of supply = % change in quantity supplied / % change in price.
• When calculating the price elasticity of supply, economists determine whether the quantity supplied of a good is elastic or inelastic.
• PES > 1: Supply is elastic. PES < 1: Supply is inelastic. PES = 0: if the supply curve is vertical, and there is no response to prices. PES = infinity: if the supply curve is horizontal.

Key Terms

mobility

The ability for economic factors to move between actors or conditions.

capacity

The maximum that can be produced on a machine or in a facility or group.

The price elasticity of supply (PES) is the measure of the responsiveness of the quantity supplied of a particular good to a change in price (PES = % Change in QS / % Change in Price). The intent of determining the price elasticity of supply is to show how a change in price impacts the amount of a good that is supplied to consumers. The price elasticity of supply is directly related to consumer demand.

Elasticity

The elasticity of a good provides a measure of how sensitive one variable is to changes in another variable. In this case, the price elasticity of supply determines how sensitive the quantity supplied is to the price of the good.

Calculating the PES

When calculating the price elasticity of supply, economists determine whether the quantity supplied of a good is elastic or inelastic. The percentage of change in supply is divided by the percentage of change in price. The results are analyzed using the following range of values:

• PES > 1: Supply is elastic.
• PES < 1: Supply is inelastic.
• PES = 0: Supply is perfectly inelastic. There is no change in quantity if prices change.
• PES = infinity: Supply is perfectly elastic. An decrease in prices will lead to zero units produced.

Factors that Influence the PES

There are numerous factors that impact the price elasticity of supply including the number of producers, spare capacity, ease of switching, ease of storage, length of production period, time period of training, factor mobility, and how costs react.

The price elasticity of supply is calculated and can be graphed on a demand curve to illustrate the relationship between the supply and price of the good .

Supply and Demand Curves

A demand curve is used to graph the impact that a change in price has on the supply and demand of a good.

6.3.3: Applications of Elasticities

In economics, elasticity refers to how the supply and demand of a product changes in relation to a change in the price.

Learning Objective

Give examples of inelastic and elastic supply in the real world

Key Points

• To determine the elasticity of a product, the proportionate change of one variable is placed over the proportionate change of another variable (Elasticity = % change of supply or demand / % change in price).
• For elastic demand, a change in price significantly impacts the supply and demand of the product.
• For inelastic demand, a change in the price does not substantially impact the supply and demand of the product.
• Economists use demand curves in order to document and study elasticity.

Key Terms

elastic

Sensitive to changes in price.

supply

The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.

inelastic

Not sensitive to changes in price.

demand

The desire to purchase goods and services.

Example

• If the per gallon price of water increases from $10 to $11, there is a 10% increase in price. As a result of the price increase, the demand for water drops from 100 gallons to 99 gallons of water per day, which is a 1% decrease. In this case, the price increase of water is inelastic because it does not substantially impact the supply and demand (there is only a 1/10 change in demand).

In economics, elasticity refers to the responsiveness of the demand or supply of a product when the price changes.

The technical definition of elasticity is the proportionate change in one variable over the proportionate change in another variable. For example, to determine how a change in the supply or demand of a product is impacted by a change in the price, the following equation is used: Elasticity = % change in supply or demand / % change in price.

The price is a variable that can directly impact the supply and demand of a product. If a change in the price of a product significantly influences the supply and demand, it is considered “elastic.” Likewise, if a change in product price does not significantly change the supply and demand, it is considered “inelastic.”

For elastic demand, when the price of a product increases the demand goes down. When the price decreases the demand goes up. Elastic products are usually luxury items that individuals feel they can do without. An example would be forms of entertainment such as going to the movies or attending a sports event. A change in prices can have a significant impact on consumer trends as well as economic profits. For companies and businesses, an increase in demand will increase profit and revenue, while a decrease in demand will result in lower profit and revenue.

For inelastic demand, the overall supply and demand of a product is not substantially impacted by an increase in price. Products that are usually inelastic consist of necessities like food, water, housing, and gasoline. Whether or not a product is elastic or inelastic is directly related to consumer needs and preferences. If demand is perfectly inelastic, then the same amount of the product will be purchased regardless of the price.

Economists study elasticity and use demand curves in order to diagram and study consumer trends and preferences. An elastic demand curve shows that an increase in the supply or demand of a product is significantly impacted by a change in the price . An inelastic demand curve shows that an increase in the price of a product does not substantially change the supply or demand of the product .

Inelastic Demand

For inelastic demand, when there is an outward shift in supply and prices fall, there is no substantial change in the quantity demanded.

Elastic Demand

For elastic demand, when there is an outward shift in supply, prices fall which causes a large increase in quantity demanded.

5.2: Theory of Consumer Choice

5.2.1: Introducing the Budget Constraint

Learning Objective

Discuss the role of the budget set and indifference curve in determining the choice that gives a consumer maximum satisfaction

Key Points

• Consumers analyze the optimal way in which to leverage their purchasing power to maximize their utility and minimize opportunity costs through employing trade-offs.
• The way economists demonstrate this arithmetically and visually is through generating budget curves and indifference curves.
• Budget curves indicate the relationship between two goods relative to opportunity costs, which defines the value of each good relative to one another.
• Indifference curves underline the way in which a given consumer interprets the value of each good relative to one another, demonstrating how much of ‘good
  ‘ is equivalent in utility to a certain quantity of ‘good
  ‘ (and vice versa).
• Through utilizing these economic tools, economists can predict consumer behavior and consumers can maximize their overall utility based upon their budget constraints.

Key Terms

Trade-offs

Any situation in which the quality or quantity of one thing must be decreased for another to be increased.

utility

The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.

Example

• Pretend you have $100 to spend on food for the month. You have a wide variety of options, but some will provide you with higher opportunity costs than others. You could purchase enough bread, rice, milk and eggs to feed yourself for the full month or you could buy premium cut steak and store-prepared dinners by the pound (which would last about one week). The opportunity cost of the former is the high quality foods which have the convenience factor of already being prepared for you while the opportunity cost of the latter is having enough food to feed yourself for the entire month. In this circumstance the decision is easy, and the trade off will be sacrificing convenience and high quality food for the ability to have enough food on the table over the course of the whole month.

The concept of budget constraints in the field of economics revolves around the idea that a given consumer is limited in consumption relative to the amount of capital they possess. As a result, consumers analyze the optimal way in which to leverage their purchasing power to maximize their utility and minimize opportunity costs. This is achieved through using budget constraints, which represent the plausible combinations of products and/or services a buyer is capable of purchasing with their capital on hand.

Trade-offs

To expand upon this definition further, the business concept of opportunity cost via trade-offs is a central building block in understanding budget constraints. An opportunity cost is defined as the foregone value of the next best alternative in a given action. To apply this to a real-life situation, pretend you have $100 to spend on food for the month. You have a wide variety of options, but some will provide you with higher opportunity costs than others. You could purchase enough bread, rice, milk and eggs to feed yourself for the full month or you could buy premium cut steak and store-prepared dinners by the pound (which would last about one week). The opportunity cost of the former is the high quality foods which have the convenience factor of already being prepared for you while the opportunity cost of the latter is having enough food to feed yourself for the entire month. In this circumstance the decision is easy, and the trade off will be sacrificing convenience and high quality food for the ability to have enough food on the table over the course of the whole month.

Budget Curves and Indifference Curves

Understanding these trade-offs underlines the true function of budget constraints in economics, which is identifying which consumer behaviors will maximize utility. Consumers are inherently equipped with an infinite demand and a finite pool of resources, and therefore must make budgetary decisions based on their preferences. The way economists demonstrate this arithmetically and visually is through generating budget curves and indifference curves.

Budget curves: This indicates the relationship between two goods relative to opportunity costs, which defines the value of each good relative to one another. For example, on the figure provided a quantity of 5 for ‘good
‘ is identical in price (economic value) as a quantity of 7 for ‘good
‘. This demonstrates the trade-off ratio between the two available products or services. It is important to keep in mind that prices and valuations of goods are constantly changing, and that the ratio between any two goods is not fixed over the long-term for most products/services.

Budget Curve

A budget curve demonstrates the relationship between two goods relative to opportunity costs, essentially deriving the relative value of each good based on quantity and utility. Keep in mind that moving from one point on the in to another is trading off ‘
‘ amount of one good for ‘
‘ amount of another.

Indifference curves: Indifference curves underline the way in which a given consumer interprets the value of each good relative to one another, demonstrating how much of ‘good
‘ is equivalent in utility to a certain quantity of ‘good
‘ (and vice versa). Any point along the indifference curve will represent indifference to the consumer, or simply put equivalent preference for one combination of goods or the other. In the figure it is clear that the budget curve has been included in conjunction with the indifference curves, which allows insight as to the ideal actual quantity of each good is optimal for this specific consumer.

Indifference Curves

Indifference curves are designed to represent an equal perception of overall value in a given basket of goods relative to a specific consumer. That is to say that each point along the curve is considered by the consumer of equivalent value despite alterations in the quantity of each good, as these trade-offs are consider of equal value and thus indifferent.

Through utilizing these economic tools, economists can predict consumer behavior and consumers can maximize their overall utility based upon their budget constraints.

5.2.2: Mapping Preferences with Indifference Curves

Learning Objective

Describe the indifference curves for goods that are perfect substitutes and complements

Key Points

• Indifference curves illustrate bundles of goods that provide the same utility.
• An economist can derive conclusions based upon the properties of the illustration. In framing these implications it is useful to identify the two potential extremes of substitute goods and complementary goods.
• The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which consumers will act when posed with a decision between various products and services.
• The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which consumers will act when posed with a decision between various products and services.

Key Terms

substitute

A good with a positive cross elasticity of demand, meaning the good’s demand is increased when the price of another is increased.

Complement

A good with a negative cross elasticity of demand, meaning the good’s demand is increased when the price of another good is decreased.

A critical input to understanding consumer purchasing behaviors and the general demand present in a given market or economy for specific goods and services is the identification of consumer preferences. Consumer preference varies substantially from individual to individual and market to market, requiring comprehensive economic observation of consumer choices and behaviors. One of the primary tools leveraged by economists mapping consumer preferences is the indifference curve, which illustrates a series of bundled goods in which a consumer is indifferent. A consumer would be just as happy with any combination of Good X and Good Y on the curve . This could synonymous to saying baskets of goods that provide the same utility.

Indifference Curve

A consumer will be just as happy with any combination of Good X and Y on indifference curve I1, though s/he will prefer any bundle on indifference curve I2 or I3.

These indifference curves, when mapped graphically alongside other curves, is called an indifference map. A key consideration in creating any indifference map is what relative preferences should be isolated. While it is possible to create a complex array of preference maps to compare more than two products/services, each specific standard indifference map will be about creating a benchmark between two. For example one could compare relatively similar goods/services (i.e. apples vs. oranges) or dramatically different goods/services (i.e. university training vs. automobile purchasing). These two items being compared represent the x and y axis of a indifference map. A consumer will always prefer to be on the indifference curve farthest from the origin.

Implications of Indifference Maps

After constructing the required inputs to generate a comprehensive indifference map, an economist can derive conclusions based upon the properties of the illustration. In framing these implications it is useful to identify the two potential extremes that can be outlined via with indifference curves:

• Perfect Substitutes: To understand what a indifference curves will look like when products are perfect substitutes, please see . These lines are essentially perfectly straight, and that demonstrates that the relative utility of ‘Good X’ compared to that of ‘Good Y’ is equivalent regardless of the amount in question. It is reasonable to assume in this scenario that purchasing all of one or all of the other will not decrease the overall satisfaction of the consumer. Perfect substitutes are often homogeneous goods. A consumer with no preference between Burger King and McDonald’s, for example, might consider them perfect substitutes and be indifferent to spending all of their fast food money on one or the other.
• Perfect Complements: The opposite of a perfect substitute is a perfect complement (see ), which is illustrated graphically through curves with perfect right angles at the center. These right angles, and the subsequent straight horizontal and vertical lines, demonstrate that ‘Good X’ and ‘Good Y’ are inherently tied to one another and that the consumption of one is dependent upon the consumption of the other. An example of complementary goods might be university tuition and academic textbook purchases, an automobile and automobile insurance, or a cable and a television.

Combining an understanding of these inputs with the extremes demonstrated an indifference map, economists are able to draw meaningful conclusions regarding consumer choices and purchasing behaviors in the context of two goods. The comparison between the goods demonstrates the relative utility one has compared to another, and the way in which consumers will act when posed with a decision between various products and services.

Perfect Substitute Indifference Curve

In this particular series of indifference curves it is clear that ‘Good X’ and ‘Good Y’ are perfect substitutes for one another. That is to say that the utility of one is identical to the utility of the other across all quantities represented on the map.

Perfect Complement Indifference Curve

The perfect right angle in this series of indifference curves implies that the utility of ‘Good X’ and ‘Good Y’ are entirely interdependent. This is to say that in order to enjoy one good it is necessary to also have the other.

5.2.3: Properties of Indifference Curves

Learning Objective

Analyze the properties that are common to many indifference curves

Key Points

• The concept of an indifference curve is predicated on the idea that a given consumer has rational preferences in regard to the purchase of groupings of goods, with a series of key properties that define the process of mapping these curves.
• Indifference curves only reside in the non-negative quadrant of a two-dimensional graphical illustration (or the upper right).
• Indifference curves are always negatively sloped. Essentially this assumes that the marginal rate of substitution is always positive.
• All curves projected on the indifference map must not intersect in order to ensure transitivity.
• Nearly all indifference lines will be convex, or curving inwards at the center (towards the bottom left).

Key Terms

Transitive

Having the property that if an element $x$ is related to $y$ and $y$ is related to $z$, then $x$ is necessarily related to $z$.

utility

The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.

Indifference curves trace the combination of goods that would give a consumer a certain level of utility. The indifference curve itself represents a series of combinations of quantities of goods (generally two) that a consumer would be indifferent between, or would value each of them equally in regards to overall utility. Indifference curves allow economists to predict consumer purchasing behaviors based upon utility maximization for a bundle of goods within the context of a given consumer’s budget constraints and preferences.

Properties of Indifference Curves

The concept of an indifference curve is predicated on the idea that a given consumer has rational preferences in regard to the purchase of groupings of goods, with a series of key properties that define the process of mapping these curves:

• Indifference curves only reside in the non-negative quadrant of a two-dimensional graphical illustration (or the upper right). This assumes that negative quantities are meaningless – one can’t consume a negative amount of a good.
• Indifference curves are always negatively sloped. This is based on the assumption that a consumer is always better off consuming more of a good, so as quantity consumed of one good increases, total satisfaction would increase if not offset by a decrease in the quantity consumed of another good. This also assumes that the marginal rate of substitution is always positive.
• All curves projected on the indifference map must also be transitive to ensure that if
  is preferred to
  and
  is preferred to
  ,
  is not also preferred to
  . This is manifested in indifference curves that never intersect. 
• Nearly all indifference lines will be convex, or curving inwards at the center (towards the bottom left). This demonstrates that increasingly high quantities of one good over another have a cost in respect to their overall utility per unit (diminishing returns). It is technically possible for indifference curves to be perfectly straight as well, which would imply that the two goods are identical (perfect substitutes).

Combining these various properties, one can highlight a number of critical implications of consumer purchasing behavior and the concept of utility. Consumers naturally desire a bundle of goods that is varied (hence the convex curves for most comparisons) in order to maximize their utility. Similarly, all indifference curves will naturally identify diminishing rates of substitution as the quantity increases for a certain good compared to another, and can create demand projections of prospective supply.

5.2.4: Impact of Income on Consumer Choices

Learning Objective

Break down changes in consumption into the income effect and the wealth effect

Key Points

• The basic premise behind the income effect is that varying income levels will determine different quantities and balanced baskets along the provided indifference curves for any two goods being compared.
• These differences in quantity reflect the increase or decrease an a given individual’s purchasing power, thus the income effect could be summarized as the increase in relative utility captured by a consumer with more monetary power.
• Income effects on consumer choice grow more complex as the type of good changes, as different product and services demonstrate different properties relative to both other products/services and a consumers preferences and utility.
• The four key types of goods to consider are normal goods, inferior goods, complements and substitutes.

Key Terms

Inferior goods

A good that decreases in demand when consumer income rises; having a negative income elasticity of demand.

Income Effect

The change in consumption choices due to changes in the amount of money available for an individual to spend.

Wealth Effect

The change in an individual’s consumption choices due to changes in perception of how rich s/he is.

Consumer choices are predicated on various economic circumstances, and recognizing the relationship between these circumstances and an individual’s purchasing behavior allows economists to recognize and predict consumer choice trends. One of the central considerations for a consumer in deciding upon their purchasing behaviors is their overall income or wage levels, and thus their budgetary constraints. These budgetary constraints, when applied to a series of products and services, can be optimized to capture the most utility for the consumer based on their purchasing power.

Income from a Consumer Theory Perspective

The simplest way to demonstrate the effects of income on overall consumer choice, from the viewpoint of Consumer Theory, is via an income-consumption curve for a normal good(see ). The basic premise behind this curve is that the varying income levels (as illustrated by the green income line curving upwards) will determine different quantities and balanced baskets along the provided indifference curves for the two goods being compared in this graph. These differences in quantity reflect the increase or decrease an a given individual’s purchasing power, thus the income effect could be summarized as the increase in relative utility captured by a consumer with more monetary power.

Income-Consumption Curve

Simply put, increases or decreases in income will alter the optimal quantity (and thus relative utility) of a given basket of goods for a specific consumer.

The wealth effect differs slightly from the income effect. The wealth effect reflects changes in consumer choice based on perceived wealth, not actual income. For example, if a person owns a stock that appreciates in price, they perceive that they are wealthier and may spend more, even though they have not realized those gains so their income has not increased.

Effects of Income on Different Goods

Income effects on consumer choice grow more complex as the type of good changes, as different product and services demonstrate different properties relative to both other products/services and a consumers preferences and utility. As a result, it is useful to outline the differences in income effects on normal, inferior, complementary and substitute goods:

• Normal:A normal good is a good with incremental increases or decreases in utility as quantity changes, demonstrating a predictable and simple linear relationship as income increases or decreases. demonstrates a graphical representation of the effects of income changes upon preference map.
• Inferior:Inferior goods, or goods that are less preferable, will demonstrate inverse relationships with income compared to normal goods. That is to say that an increase in income will not necessarily result in an increase in quantity for the inferior good, as the consumer derives minimal utility in purchasing the inferior good compared to other goods. Inferior goods are often sacrificed as income rises and consumers gain more choice/options. This can be represented in .
• Complementary: Complementary goods are goods that are interdependent in consumption, or essentially goods that require simultaneous consumption by the consumer. An example of this would be like purchasing an automobile and car insurance, the consumption of one requires the consumption of the other. As income increases, these will increase relative to one another (as a ratio). demonstrates this concept in graphical form.
• Substitutes: Perfect substitutes are essentially interchangeable goods, where the consumption of one compared to another has no meaningful impact on the consumer’s utility derived. Substitutes are goods that a consumer cannot differentiate between in terms of the need being filled and the satisfaction obtained. Income increases will thus affect the consumption of these goods interchangeably, resulting in increase in the quantity of either or both.

In merging Consumer Theory and consumer choices with income level, the primary takeaway is that an increase in income will increase the prospective utility that consumer can acquire in the market. Understanding how this applies in a general fashion, alongside the specific circumstances dictating specific types of goods, it becomes fairly straight-forward to predict consumer purchasing behaviors at differing income levels.

Income Levels and Inferior Goods

This graph demonstrates the inverse relationship between income and the consumption of inferior goods. As income rises, the quantity consumed of ‘X1’ decreases. This illustrates increased variance in consumer choice as income rises.

Income Effect on Complementary Goods

In this graphical depiction of income increases, the consumption of these two goods are complementary and thus interdependent.

5.2.5: Impact of Price on Consumer Choices

Learning Objective

Construct the demand curve using changes in consumption due to price changes

Key Points

• For normal goods or services, demand is illustrated with a downward sloping curve, where the quantity on the x-axis will generally increase as the price on the y-axis decreases (and vice versa).
• As the demand curve implies, price is the central driving force behind a decision to purchase a given product or service.
• A critical consideration of product/service pricing is the price elasticity of a given good, which indicates how responsive demand is to a change in price.
• Using demand curves, economists can project the impact of a price change on the consumer choices in a given market.
• The quantity demanded may change in response to both to shifts in demand (and the creation of a new demand curve, as demonstrated in and movements along the established demand curve.

Key Term

elasticity

The sensitivity of changes in a quantity with respect to changes in another quantity.

In almost all cases, consumer choices are driven by prices. As price goes up, the quantity that consumers demand goes down. This correlation between the price of goods and the willingness to make purchases is represented clearly by the generation of a demand curve (with price as the y-axis and quantity as the x-axis). The construction of demand, which shows exactly how much of a good consumers will purchase at a given price, is defining of consumer choice theory.

Deriving Overall Demand

The generation of a demand curve is done by calculating what price consumers are willing to pay for a given quantity of a good or service. For normal goods or services, demand is illustrated with a downward sloping curve, where the quantity on the x-axis will generally increase as the price on the y-axis decreases (and vice versa). The quantity demanded may change in response to both to shifts in demand (and the creation of a new demand curve, as demonstrated in ) and movements along the established demand curve. A demand shift usually takes place when an external factor increases or decreases demand across the board, while a movement upwards or downwards on the curve is indicative of a change in the good’s price.

Demand Shifts

This graph demonstrates a shift in overall demand in the market, where the generation of a new parallel demand curve is required to accurately represent consumer choices.

As the demand curve implies, price is often the central driving force behind a decision to purchase a given product or service. Consumers must weigh the overall utility they can capture by making a purchase and benchmark that against their overall monetary resources to optimize their purchasing decisions. This practice regulates the price companies can set for their products and services, as the income effects and the prospective substitutions (substitution effect) will drive consumer purchase towards purchases that create the most value for themselves.

Price Elasticity

A critical consideration of product/service pricing is the price elasticity of a given good, which indicates how responsive demand is to a change in price. Price elasticity is essentially a measurement of how much any deviations in price will drive the overall quantity purchased up or down, underlining to what extent consumer purchasing decisions will be dictated by pricing. The figure pertaining to price elasticity shows how the slope of the demand curve will change depending on the degree of price sensitivity in the marketplace for a good. A highly elastic good will see consumers much less likely to purchase when prices are high and much more likely to purchase when prices are low, while a good with low elasticity will see consumers purchasing the same quantity regardless of small price changes.

Price Elasticity

As this graph demonstrates, the slope of the demand curve will vary as a direct result of how elastic consumer purchasing behaviors will be compared to price changes.

Using demand curves, economists can project the impact of a price change on the consumer choices in a given market.

5.2.6: Deriving the Demand Curve

Learning Objective

Explain how Giffen goods violate the law of demand

Key Points

• The derivation of demand is a useful tool in this pursuit, often combined with a supply curve in order to determine equilibrium prices and understand the relationship between consumer needs and what is readily available in the market.
• The inherent relationship between the price of a good and the relative amount of that good consumers will demand is the fulcrum of recognizing demand curves in the broader context of consumer choice and purchasing behavior.
• Generally speaking, normal goods will demonstrate a higher demand as a result of lower prices and vice versa.
• Giffen goods are a situation where the income effect supersedes the substitution effect, creating an increase in demand despite a rise in price.
• Neutral goods, unlike Giffen goods, demonstrate complete ambivalence to price. That is to say that consumer swill pay any price to get a fixed quantity.

Key Terms

Derivation

The operation of deducing one function from another according to some fixed law, called the law of derivation, as the of differentiation or of integration.

Giffen good

A good which people consume more of as only the price rises; Having a positive price elasticity of demand.

The law of demand in economics pertains to the derivation and recognition of a consumer’s relative desire for a product or service coupled with a willingness and ability to pay for or purchase that good. Consumer purchasing behavior is a complicated process weighing varying products/services against a constantly evolving economic backdrop. The derivation of demand is a useful tool in this pursuit, often combined with a supply curve in order to determine equilibrium prices and understand the relationship between consumer needs and what is readily available in the market.

Deriving Demand Curves

Despite a wide array of prospective goods and services in a constantly altering economic environment, the law of demand pursues the derivation of a demand curve for a given product that benchmarks the relative prices and quantities desired by consumers in a given marketplace. The inherent relationship between the price of a good and the relative amount of that good consumers will demand is the fulcrum of recognizing demand curves in the broader context of consumer choice and purchasing behavior.

Generally speaking, normal goods will demonstrate a higher demand as a result of lower prices and vice versa. The derivation of demand curves for normal goods is therefore relatively predictable in respect to the direction of the slope on a graph (see ). The downward slope represented in this figure underline the critical principle that a given price point will reflect a given quantity demanded by a given marketplace, allowing suppliers and economists to measure the value of a product/service based on a price/quantity analysis of consumer purchasing behaviors.

Deriving the Demand Curve (Normal Goods)

This illustration demonstrates the way in which economists can identify a series of prices and quantities for goods demanded, which ultimately represents the overall demand curve for a given product/service.

One important consideration in demand curve derivation is the differentiation between demand curve shifts and movement along the curve itself. Movement along the curve itself is the identification of what quantity will be purchased at different price points. This means that the factors that underlie consumer desire for the product remains constant and consistent, but the quantity or price alters to a new point along the established curve. Alternatively, sometimes external factors can shift the actual demand for a given good, pushing the demand curve outwards to the right and up or inwards down and left. This represents a substantial change in the actual demand for that product, as opposed to a quantity or price shift at a fixed demand level.

Exceptions: Giffen Goods and Neutral Goods

With the concept of general demand curves in mind, it is important to recognize that some goods do not conform to the traditional assumption that higher prices will always demonstrate lower demand. Giffen goods and neutral goods break this rule, with the former demonstrating an increase in demand as a result of a price rise (see ) and the latter demonstrating indifference to price in regards to the quantity demanded (illustrated as a completely vertical demand curve):

Demand Curve for Giffen Goods

Giffen goods are essentially goods that demonstrate an increase in demand as a result of an increase in price, generally considered counter-intuitive in traditional economic models. This graph illustrates the derivation of a demand curve for these goods.

• Giffen Goods – Giffen goods are a situation where the income effect supersedes the substitution effect, creating an increase in demand despite a rise in price. Goods such as high-end luxury items like expensive fashion often demonstrate this type of counter-intuitive trend, where the high price of an item is attractive to the consumer for the sake of displaying wealth.
• Neutral Goods – Neutral goods, unlike Giffen goods, demonstrate complete ambivalence to price. That is to say that consumers will pay any price to get a fixed quantity. These goods are often necessities, defying the standard law of demand due to the fact that they must be purchased regardless of price/situation. A good example of this is water or healthcare, where not getting what is required will have dramatic consequences.

5.2.7: Applications of Principles on Consumer Choices

Learning Objective

Explain the labor-leisure tradeoff in terms of income and substitution effects

Key Points

• Economics assumes a population of rational consumers, subjected to the complexities of modern economics while they attempt to maximize the utility obtainable within their income range.
• The income effect says that a consumers overall income level will have an effect on the quantities of goods that consumer will purchase.
• The substitution effect, similar to the income effect, identifies ways in which consumer purchasing power will alter the relative quantities of goods/services purchased by consumers at varying income levels and budgetary constraints.
• Combining the substitution effect and the income effect, one can derive an overall labor-leisure trade-off based on a given consumers purchasing power (income) relative to the price of necessary bundles of goods (substitution effect).
• A rational consumer will begin to work less hours after meeting their consumption requirements in order to capture the value of leisure (and enjoy their income in a meaningful way).

Key Terms

substitution effect

The change in demand for one good that is due to the relative prices and availability of substitute goods.

purchasing power

The amount of goods and services that can be bought with a unit of currency or by consumers.

Income Effect

The change in consumption resulting from a change in real income.

Economics assumes a population of rational consumers, subjected to the complexities of modern economics while they attempt to maximize the utility obtainable within their income range. Central principles to analyzing consumer actions and choices are income effect and the substitution effect, which ultimately generate a labor supply to illustrate the labor-leisure trade-off for consumers.

Income Effect

The income effect needs two simple inputs: the average price of goods and the consumer’s income level. This creates a relative buying power, which will play a substantial role in the quantity of goods purchased. Predicting consumer choice requires inputs on consumer purchasing power and the goods in which they are deciding between. In we are comparing ‘Good X’ and ‘Good Y’ to identify how a change in income will alter the overall amount of each good would likely be purchased along a series of indifference curves (see Boundless atom on ‘Indifference Curves’). This graphical representation of a consumer’s income (I) and budget constraints (BC) underlines the variance in quantity of ‘Good X’ and ‘Good Y’ that will be demanded dependent upon income circumstance. Naturally, a higher income will result in a shift towards increase in quantity for many consumable goods/services.

Income Effects on Consumption and Budget Constraints

This graphical representation of a consumers income(I) and budget constraints (BC) underlines the variance in quantity of ‘Good X’ and ‘Good Y’ that will be demanded dependent upon income circumstance. Naturally, a higher income will result in a shift towards increase in quantity for many consumable goods/services.

Substitution Effect

The substitution effect is closely related to that of the income effect, where the price of goods and a consumers income will play a role in the decision-making process. In the substitution effect, a lower purchasing power will generally result in a shift towards more affordable goods (substituting cheaper in place of more expensive goods) while a higher purchasing power often results in substituting more expensive goods for cheaper ones. This shows the relationship between two graphs, pointing out how the substitution effect identifies the relationship between the price of a given good and the quantity purchased by a given consumer. As the bottom half of the figure implies, a higher price will dictate a lower quantity consumer for ‘Good Y’, while a lower price will create a higher quantity. This translates to the graph above as the consumer makes choices to maximize utility when comparing the price of different goods to a given income level, substituting cheaper goods and more expensive goods dependent upon purchasing power.

Substitution Effect

This two-part graphical representation of the substitution effect identifies the relationship between the price of a given good and the quantity purchased by a given consumer. As the bottom half effectively highlights, a higher price will dictate a lower quantity consumer for ‘Good Y’, while a lower price will create a higher quantity. This translates to the graph above as the consumer makes choices to maximize utility when comparing the price of different goods to a given income level.

Types of Goods

One additional important component of consumer choice is the way in which different goods demonstrate different reactions to income alterations and price changes:

• Income Changes: When income changes rises or falls, consumption of certain types of goods will have a positive or negative correlation with these changes. With normal goods, an increase of income will correlate with a higher quantity of consumption while a decrease in income will see a decrease in consumption. Inferior goods, on the other hand, will demonstrate an inverse relationship. A rise in income will cause a decrease in their consumption and vice versa.
• Price Changes: When price rises or falls, consumption of certain types of good will either demonstrate positive or negative correlations to these shifts in regard to quantity consumed. Ordinary goods will demonstrate the intuitive situation, where a rise in price will result in a decrease in quantity consumer. Inversely, Giffen goods demonstrate a positive relationship, where the price rises will result in higher demand for the good and high consumption.

Labor Supply Curve

These concepts of income versus required monetary inputs (prices) for goods/services generates a relationship between how much an individual will choose to work and how much an individual can take in terms of leisure time. Simply put, desired labor and leisure time are dependent upon income and prices for goods. The relationship between the number of hours worked and the overall wage levels results in something of a boomerang effect, with hours worked as the x-axis and wages as the y-axis.

Graphically represented, the labor supply curve looks like a backwards-bending curve , where an increase in wages from W1 to W2 will result in more hours being worked and an increase from W2 to W3 will result in less. This is primarily due to the fact that there is a certain amount of capital attained by consumers where they will be satisfied with their monetary utility, at which point working more has diminishing returns on their satisfaction. A rational consumer will begin to work less hours after meeting their consumption requirements in order to capture the value of leisure (and enjoy their income in a meaningful way).

Labor Supply Curve

The concept of labor supply economics is most efficiently communicated via the following graphical representation. This graph demonstrates the relationship between hours work and overall wage rates, demonstrating the shift in utility as wages increase.

To apply this to the concept of different types of goods above, one can view wage rates and leisure time as consumer goods. Depending on which point on the backwards-bending curve we are on, the trade-offs and thus the consumer decision will change. If a worker choose to work more when the wage rate rises, leisure is an ordinary good.

4.2: Producer Surplus

4.2.1: Market Power

Learning Objective

Summarize the relationship between market power and a firm’s supply decision

Key Points

• Firms with market power are said to be “price makers. ” They can raise prices and change the quantity supplied of goods and services without hurting profits. Market power often exists when there is a monopoly or oligopoly.
• Firms with limited to no market power are said to be “price takers. ” They cannot raise their prices or change the quantity supplied of goods and services without hurting profits. Perfectly competitive firms are examples of price takers with no market power.
• Market power is determined by the number of producers in the market, the size of each firm, barriers to entry in the market, and availability of substitute goods. Firm size and market size alone do not dictate market power.
• Market power is often measured with concentration ratios or the Herfindahl-Hirschman Index, but these are not perfect measures.

Key Terms

market power

The ability of a firm to profitably raise the market price of a good or service over marginal cost. A firm with total market power can raise prices without losing any customers to competitors.

contestable market

An imperfectly competitive industry subject to potential entry if prices or profits increase.

concentration ratio

The proportion of total industry output produced by the largest firms (usually the four largest).

Herfindahl-Hirschman Index

A measure of the size of firms in relation to the industry and an indicator of the amount of competition among them.

Market power is a measure of the economic strength of a firm. It is the ability of a firm to influence the quantity or price of goods and services in a market. A firm is said to have significant market power when price exceeds marginal cost and long run average cost, so the firm makes economic profits. Such firms are often referred to as “price makers. ” In contrast, firms with limited to no market power are referred to as “price takers. “

Determinants of Market Power

A firm usually has market power by virtue of controlling a large portion of the market. However, market size alone is not the only indicator of market power. Other factors that affect a firm’s market power include:

• Number of producers
• Size of firms in the market

The numbers and size of firms determine the extent that firms can withstand pressures and threats to change prices or product flows. However, being a large firm does not necessarily equal market power. For example, while conglomerates may be very large, they may play only small roles in many different markets and have no ability to influence prices in any of them.

• Barriers to entry

Barriers to entry determine how contestable the market is. Even highly concentrated markets may be contestable markets if there are no barriers to entry or exit, which limits a firm’s ability to raise its price above competitive levels.

Common barriers to entry include control of a scarce resource, increasing returns to scale, technological superiority, and government-imposed barriers.

• Availability of substitute goods

Greater availability of substitute goods will weaken a firm’s market power.

Relationship between Market Power and Firm Behavior

A firm’s market power influences its behavior. For example, market power gives firms the ability to engage in unilateral anti-competitive behavior. Some of the behaviors that firms with market power are accused of engaging in include predatory pricing, product tying, and creation of overcapacity or other barriers to entry . If no individual participant in the market has significant market power, then anti-competitive behavior can take place only through collusion, or the exercise of a group of participants’ collective market power.

Google Logo

In 2012, the U.S. Federal Trade Commission opened an antitrust probe against Google’s search practices. Google allegedly used its market dominance to promote its own products over competitors’ products in web searches.

A monopoly, a price maker with market power, can raise prices and retain customers because the monopoly has no competitors. If a customer has no other place to go to obtain the goods or services, they either pay the increased price or do without.

An oligopoly may also be a price maker with market power, as firms may be able to collude and control the market price or quantity demanded.

A perfectly competitive firm, a price taker with no market power, cannot raise its price without losing its customers.

Measurement of Market Power

Measurement of market power is often accomplished with concentration ratios or the Herfindahl-Hirschman Index (HHI).

Concentration Ratios

The concentration ratio is the proportion of total industry output produced by the largest firms (usually the four largest). This measure of market power relates the size of firms to the size of the market. For monopolies, the four firm concentration ratio is 100 percent, while the ratio is zero for perfect competition.

Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index (HHI) is a measure of the size of firms in relation to the industry, and an indicator of the amount of competition among them. The HHI is calculated by summing the squares of the percentage market shares of all participants in the market. The HHI for perfect competition is zero; for a monopoly, it is 10,000.

For example, if a market consists of five firms with market shares of 40, 20, 20, 15, and 5 percent each, the HHI is 2650 (
).

Measurement Problems

The use of the concentration ratio or the HHI to measure market power is not perfect. A high concentration ratio or large firm size is not the only way to achieve market power. Many smaller firms acting in unison can achieve the same result. Additionally, the measurements do not convey the extent to which market power may be concentrated in a local market.

4.2.2: Defining Producer Surplus

Learning Objective

Define producer surplus

Key Points

• Producer surplus can be thought of as the extra money, utility, or benefits the producer receives by selling a product at a price that is higher than its minimum acceptable price.
• The minimum acceptable price for producers is represented by the supply curve.
• Graphically, producer surplus is the shaded region just above the supply curve, but below the equilibrium price level.

Key Term

producer surplus

The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.

Producer surplus is the difference between what price producers are willing and able to supply a good for and what price they actually receive from consumers. It is the extra money, benefit, and/or utility producers get from selling a product at a price that is higher than their minimum accepted price, as shown by the supply curve.

Economic Surplus

Producer surplus is the shaded area directly above the supply curve, up to the equilibrium point. Consumer surplus is the shaded area directly under the demand curve, up to the equilibrium point.

For example, above, the equilibrium price is
. However, at
, the producers are willing to sell one unit of a commodity for a price that is lower than
. The resulting rectangle from
on the
-axis, to its intersection with the supply curve, up to the level of
is the producer surplus at price level
.

Similarly, at
, the producers are willing to sell two units of a commodity at a price that is still lower than
. The rectangle from
on the
-axis, to its intersection with the supply curve, up to the level of
is the new producer surplus at price
. The total producer surplus at
is the first rectangle at the
price, plus the new rectangle from the
price.

This process is repeated for every price level up to the equilibrium price. To find the resulting total producer surplus, all of the rectangles for the individual price levels are added together, and the total area is the total producer surplus. Below, the total producer surplus is made of all three pink rectangles – the surpluses at price levels of
,
, and
– added together.

Producer surplus

In the figure, producer surplus at different prices is represented by the pink rectangles.

4.2.3: Impact of Changing Price on Producer Surplus

Learning Objective

Examine producer surplus in terms of changes in demand, supply, price, and price elasticity

Key Points

• Changes in the equilibrium price are directly related to producer surplus, other things equal. As the equilibrium price increases, the potential producer surplus increases. As the equilibrium price decreases, producer surplus decreases.
• Shifts in the demand curve are directly related to producer surplus. If demand increases, producer surplus increases. If demand decreases, producer surplus decreases.
• Shifts in the supply curve are directly related to producer surplus. If supply increases, producer surplus increases. If supply decreases, producer surplus decreases.
• Price elasticity of supply is inversely related to producer surplus. If supply is completely elastic, it is drawn as a horizontal line, and producer surplus is zero. If supply is completely inelastic, it is shown as a vertical line, and producer surplus is infinite.

Key Terms

producer surplus

The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.

price elasticity of supply

A numerical measure of the responsiveness of the quantity supplied of a product to a change in the price of the product alone.

Producer surplus is affected by many different factors. Changes in the price level, the demand and supply curves, and price elasticity all influence the total amount of producer surplus, other things held constant.

Changes in Price

Changes in price are directly associated with the amount of surplus a producer will receive. Graphically, the producer surplus is directly above the supply curve, but below the price. Other things equal, as equilibrium price increases, the amount of potential producer surplus and the number of goods supplied increases. Lower prices result in lower potential producer surplus and goods supplied: with a lower equilibrium price, the producer surplus triangle will be smaller.

Economic Surplus

The producer surplus is directly above the supply curve and is shaded in blue.

Demand Curve

Shifts in the demand curve are directly related to the amount of producer surplus. If demand decreases, and the demand curve shifts to the left, producer surplus decreases. Conversely, if demand increases, and the demand curve shifts to the right, producer surplus increases.

At an initial demand represented by the “Demand (1)” curve, producer surplus is the blue triangle made of
,
, and
. When demand increases, represented by the “Demand (2)” curve, producer surplus is the larger gray triangle made of
,
, and
.

Producer Surplus and the Demand Curve

If the demand curve shifts out, producer surplus increases, as seen by size of the gray triangle.

Supply Curve

Similarly, shifts in the supply curve are also directly related to the amount of potential surplus. Decreases in the supply curve will cause decreases in producer surplus. Increases in the supply curve will cause increases in producer surplus.

At an initial supply represented by the “Supply (1)” curve, producer surplus is the blue triangle made of
,
, and
. If supply increases, represented by the “Supply (2)” curve, producer surplus is the larger gray triangle made of
,
, and
.

Price Elasticity of Supply

Price elasticity of supply is the relationship between price and quantity changes. It measures how quantity supplied is affected by changes in price. When supply is elastic, producers can increase production without much price or cost change. When supply is inelastic, producers cannot change production easily.

When supply is perfectly elastic, it is depicted as a horizontal line. Producer surplus is zero because the price is not flexible. Producers cannot provide a higher price than market price.

When supply is perfectly inelastic, it is depicted as a vertical line. Producer surplus is infinite because the price is completely flexible.

3.2: Supply

3.2.1: The Law of Supply

Learning Objective

Explain the Law of Supply

Key Points

• Quantity supplied moves in the same direction as price.
• The supply curve is an upward sloping curve.
• Producers are willing to increase production at higher prices to increase profit.

Key Terms

surplus

That which remains when use or need is satisfied, or when a limit is reached; excess; overplus.

shortage

a lack or deficiency

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

The law of supply is a fundamental principle of economic theory. It states that an increase in price will result in an increase in the quantity supplied, all else held constant.

An upward sloping supply curve, which is also the standard depiction of the supply curve, is the graphical representation of the law of supply. As the price of a good or service increases, the quantity that suppliers are willing to produce increases and this relationship is captured as a movement along the supply curve to a higher price and quantity combination.

The Law of Supply

Supply has a positive correlation with price. As the market price of a good increases, suppliers of the good will typically seek to increase the quantity supplied to the market.

The rationale for the positive correlation between price and quantity supplied is based on the potential increase in profitability that occurs with an increase in price.

All else held constant, including the costs of production inputs, the supplier will be able to increase his return per unit of a good or service as the price for the item increases. Therefore, the net return to the supplier increases as the spread or difference between the price and the cost of the good or service being sold increases.

The law of supply in conjunction with the law of demand forms the basis for market conditions resulting in a price and quantity relationship at which both the price to quantity relationship of suppliers and demanders (consumers) are equal. This is also referred to as the equilibrium price and quantity and is depicted graphically at the point at which the demand and supply curve intersect or cross one another. It is the point where there is no surplus or shortage in the market .

Law of Supply and Law of Demand: Equilibrium

The law of supply and the law of demand form the foundation for the establishment of an equilibrium–where the price to quantity combination for both suppliers and demanders are the same.

3.2.2: Supply Schedules and Supply Curves

Learning Objective

Explain the price to quantity relationship exhibited in the supply curve

Key Points

• The supply curve plots the quantity that is willingly supplied at any given price.
• The individual supply curves can be summed by quantity provided at a specific price to achieve an aggregate supply curve.
• The supply curve is upward sloping in the short run.

Key Terms

aggregate

A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

Supply is the amount of some product that producers are willing and able to sell at a given price, all other factors being held constant. In general, supply depicts a positive relationship between the price of a good or service and the quantity that the producer is willing to supply: if a supplier believes it can sell the product for more, it will want to make more of the product. As a result, as the price of a good or service increases, suppliers increase the quantity available for purchase.

A supply schedule is a table that shows the relationship between the price of a good and the quantity supplied. The supply curve is a graphical depiction of the supply schedule that illustrates that relationship between the price of a good and the quantity supplied .

The Supply Schedule and Supply Curve

The supply curve is a graphical depiction of the price to quantity pairings presented in a supply schedule. The supply schedule is a table view of the relationship between the price suppliers are willing to sell a specific quantity of a good or service.

The supply curves of individual suppliers can be summed to determine aggregate supply. One can use the supply schedule to do this: for a given price, find the corresponding quantity supplied for each individual supply schedule and then sum these quantities to provide a group or aggregate supply. Plotting the summation of individual quantities per each price will produce an aggregate supply curve.

In theory, in the long run the aggregate supply curve will not be upward sloping but will instead be vertical, consistent with a fixed supply level. This is due to the underlying assumption that in the long run, supply of a good only depends on the fixed level of capital, technology, and natural resources available.

The supply curve provides one side of the price-to-quantity relationship that ensures a functional market. The other component is demand. When the supply and demand curves are graphed together they will intersect at a point that represents the market equilibrium – the point where supply equals demand and the market clears.

3.2.3: Market Supply

Learning Objective

Identify the market conditions that yield a market supply curve.

Key Points

• A supply curve is the graphical representation of the supplier’s positive correlation between the price and quantity of a good or service.
• The supply curve can only be attributed to a depiction of a perfectly competitive market due to the unique attributes of perfect competition: firms are price takers, no single firm’s actions can influence the market price, and ease of exit and entry.
• The market supply curve is derived by summing the quantity for a given price across all market participants (suppliers). It depicts the price-to-quantity combinations available to consumers of the good or service.

Key Term

Supply curve

A graphical representation of the quantity producers are willing to make when the product can be sold at a given price.

A supply curve is the graphical representation of the supplier’s positive correlation between the price and quantity of a good or service. As a result, the supply curve is upward sloping . Market supply is the summation of the individual supply curves within a specific market.

Market Supply

The market supply curve is an upward sloping curve depicting the positive relationship between price and quantity supplied.

The market supply curve is derived by summing the quantity suppliers are willing to produce when the product can be sold for a given price. As a result, it depicts the price to quantity combinations available to consumers of the good or service. In combination with market demand, the market supply curve is requisite for determining the market equilibrium price and quantity.

By its very nature, conceptualizing a supply curve requires the firm to be a perfect competitor, namely requires the firm to have no influence over the market price. This is true because each point on the supply curve is the answer to the question “If this firm is faced with this potential price, how much output will it be able to and willing to sell? ” If a firm has market power, its decision of how much output to provide to the market influences the market price, then the firm is not “faced with” any price, and the question is meaningless.

The attributes of a competitive market signal that the price is set external to any firm. Therefore, production in the market is a sliding scale dependent on price. As price increases, quantity increases due to low barriers to entry, and as the price falls, quantity decreases as some firms may even opt out of the market.

The supply curve can be derived by compiling the price-to-quantity relationship of a seller. A seller could set the price of a good or service equal to zero and then incrementally increase the price; at each price he could calculate the hypothetical quantity he would be willing to supply. Following this process the seller would be able to trace out its complete individual supply function. The market supply curve is simply the sum of every seller’s individual supply curve.

3.2.4: Determinants of Supply

Learning Objective

Identify the factors that affect the supply of a good

Key Points

• Supply is the quantity of a good or service that a supplier provides to the market.
• Suppliers will shift production for non-price changes related to the determinants of supply and will slide production levels across the supply curve for price related movements.
• Innumerable factors and circumstances could affect a seller’s willingness or ability to produce and sell a good.

Key Terms

incentive

Something that motivates, rouses, or encourages.

intervention

The action of interfering in some course of events.

Supply is the quantity of a good or service that a supplier provides to the market. Innumerable factors and circumstances could affect a seller’s willingness or ability to produce and sell a good. Some of the more common factors are:

• Good’s own price: An increase in price will induce an increase in the quantity supplied.
• Prices of related goods: For purposes of supply analysis, related goods refer to goods from which inputs are derived to be used in the production of the primary good.
• Conditions of production: The most significant factor here is the state of technology. If there is a technological advancement related to the production of the good, the supply increases.
• Expectations: Sellers’ expectations concerning future market conditions can directly affect supply.
• Price of inputs: If the price of inputs increases the supply curve will shift left as sellers are less willing or able to sell goods at any given price. Inputs include land, labor, energy and raw materials.
• Number of suppliers: As more firms enter the industry the market supply curve will shift out driving down prices. The market supply curve is the horizontal summation of the individual supply curves.
• Government policies and regulations: Government intervention can take many forms including environmental and health regulations, hour and wage laws, taxes, electrical and natural gas rates and zoning and land use regulations. These regulations can affect a good’s supply.

Suppliers will change their production levels along the supply curve in response to a price change, so that their production level is equal to demand. However, some factors unrelated to price can shift the production level. For example, a technological improvement that reduces the input cost of a product will shift the supply curve outward, allowing suppliers to provide a greater supply at the same price level.

Determinants of Supply

If the price of a good changes, there will be movement along the supply curve. However, the supply curve itself may shift outward or inward in response to non-price related factors that affect the supply of a good, such as technological advances or increased cost of materials.

3.2.5: Changes in Supply and Shifts in the Supply Curve

Learning Objective

Distinguish between shifts in the supply curve and movement along the supply curve

Key Points

• A change in the price of a good or service, holding all else constant, will result in a movement along the supply curve.
• A change in the cost of an input will impact the cost of producing a good and will result in a shift in supply; supply will shift outward if costs decrease and will shift inward if they increase.
• A change in the expected demand for a good or service will result in a shift in supply; supply will shift outward if enthusiasm is expected to increase and will shift inward if there is an expectation for consumers preferences to change in favor of an alternate good or service.

Key Term

Non-price changes

Shocks, either exogenous or endogenous, that affect the positioning of the supply curve.

Price changes and movement along supply curve

If the price of the good or service changes, all else held constant such as price of substitutes, the supplier will adjust the quantity supplied to the level that is consistent with its willingness to accept the prevailing price. The change in price will result in a movement along the supply curve, called a change in quantity supplied, but not a shift in the supply curve. Changes in supply are due to non-price changes.

Non-price changes and shifts of the supply curve

If production costs increase, the supplier will face increasing costs for each quantity level. Holding all else the same, the supply curve would shift inward (to the left), reflecting the increased cost of production. The supplier will supply less at each quantity level.

If production costs declined, the opposite would be true. Lower costs would result in an increase in output, shifting the supply curve outward (to the right) and the supplier will be willing sell a larger quantity at each price level. The supply curve will shift in relation to technological improvements and expectations of market behavior in very much the same way described for production costs.

Technological improvements that result in an increase in production for a set amount of inputs would result in an outward shift in supply.

Supply will shift outward in response to indications of heightened consumer enthusiasm or preference and will respond by shifting inward if there is an assessment of a negative impact to production costs or demand .

Supply Shifts

A shift in supply from S1 to S2 affects the equilibrium point, and could be caused by shocks such as changes in consumer preferences or technological improvements.

3.3: Market Equilibrium

3.3.1: Clearing the Market at Equilibrium Price and Quantity

When a market achieves perfect equilibrium there is no excess supply or demand, which theoretically results in a market clearing.

Learning Objective

Define market equilibrium

Key Points

• The interdependent relationship between supply and demand in the field of economics is inherently designed to identify the ideal price and quantity of a given product or service in a marketplace.
• A market clearing, by definition, is the economic assumption that the quantity supplied will consistently align with the quantity demanded.
• Market clearing requires a variety of assumptions which simplify the complexities of real markets to coincide with a more theoretical framework, most centrally the assumptions of perfect competition and Say’s Law.
• While this concept of market clearing resonates well in theory, the actual execution of markets is very rarely perfect. The concepts of consolidated markets and ‘sticky’ markets reduces the accuracy of these models.

Key Terms

Say’s Law

The idea that money is perishable.

Incumbents

A holder of a position as supplier to a market or market segment that allows the holder to earn above-normal profits.

Opportunity cost

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

Example

• A textbook example of a monopoly was the Da Beers family, who owned the vast majority of diamond mines worldwide. Through effectively controlling the diamond market supply (via owning the mines), and warehousing the diamonds in a way to substantially alter the available supply, it became reasonably easy for Da Beers to charge prices in excess of what a reasonable equilibrium would be.

The interdependent relationship between supply and demand in the field of economics is inherently designed to identify the ideal price and quantity of a given product or service in a marketplace. This equilibrium point is represented by the intersection of a downward sloping demand line and an upward sloping supply line, with price as the y-axis and quantity as the x-axis . At perfect equilibrium there is no excess demand (represented by ‘A’ in the figure) or excess supply (represented by ‘B’ in the figure), which theoretically results in a market clearing.

Equilibrium Pricing

This chart effectively highlights the various basic implications of a simple supply and demand chart. The equilibrium point is where market clearing will theoretically occur.

Market Clearing Assumptions

A market clearing, by definition, is the economic assumption that the quantity supplied will consistently align with the quantity demanded. This definition requires a variety of assumptions which simplify the complexities of real markets to coincide with a more theoretical framework, most centrally the assumptions of perfect competition and Say’s Law:

• Perfect competition is a market where the price determined for a given good or service is not affected by external forces or competition in a way that allows incumbents (companies) to attain market influence.
• Say’s Law hinges on the concept that capital loses value over time, or that money is essentially perishable. The simplest way to view this law is interest rates. When you invest or owe money, that capital accrues interest due to the fact that there is an opportunity cost in not investing that money elsewhere. This opportunity cost creates the assumption that money will not go unused.

Combining these two assumptions, in a perfectly competitive market the amount of a product or service that is supplied at a given price will equate to the amount demanded, clearing the market of all goods/services at a given equilibrium point.

Theory and Practice

While this concept of market clearing resonates well in theory, the actual execution of markets is very rarely perfect. Markets demonstrate consistent shifts of supply and shifts of demand based on a wide spectrum of externalities. Even in static markets there is competitive consolidation that allows companies to charge differing price points than that of the equilibrium. The concept of monopolies provides a good example for this experience, as monopolies (see example) can control price and quantity simultaneously.

Another classic criticism of market clearing is the way in which the labor market functions. In the 1930’s, during the worst depression recorded in the United States, the labor market did not clear the way economic theories of market clearing would assume it would. Instead, there seemed to be what John Maynard-Keynes (father of Keynesian Economics) called ‘stickiness,’ which preventing the market from normalizing. The importance of raising these concerns is the understanding that while the concept of market clearing, equilibrium and supply/demand charts are highly useful in understanding the basic functioning of markets, reality does not always conform with these models.

3.3.2: Impacts of Surpluses and Shortages on Market Equilibrium

The existence of surpluses or shortages in supply will result in disequilibrium, or a lack of balance between supply and demand levels.

Learning Objective

Infer the outcomes of departures from equilibrium using the model of supply and demand

Key Points

• Surpluses, or excess supply, essentially indicates that the quantity of a good or service exceeds the demand for that particular good at the price in which the producers would wish to sell (equilibrium level).
• In a perfectly competitive market, excess supply is equivalent to the quantity available in the market beyond the equilibrium point of intersection between supply and demand. This will result in a shift in market equilibrium towards lower price points.
• Shortage is a term used to indicate that the supply produced is below that of the quantity being demanded by the consumers. This disparity implies that the current market equilibrium at a given price is unfit for the current supply and demand relationship.
• In a perfectly competitive market, a shortage in supply will ultimately result in a shift in the equilibrium point, transitioning towards a higher price point due to the limited supply availability.

Key Terms

Disequilibrium

The loss of equilibrium or stability, especially due to an imbalance of forces.

surplus

That which remains when use or need is satisfied, or when a limit is reached.

shortage

Not enough or not sufficient for a given demand.

In the analysis of market equilibrium, specifically for pricing and volume determinations, a thorough understanding of the supply and demand inputs is critical to economics. Surpluses and shortages on the supply end can have substantial impacts on both the pricing of a specific product or service, alongside the overall quantity sold over time. Shifts such as these in the supply availability results in disequilibrium, or essentially a lack of balance between current supply and demand levels. Surpluses and shortages often result in market inefficiencies due to a shifting market equilibrium.

Surpluses

Surpluses, or excess supply, indicate that the quantity of a good or service exceeds the demand for that particular good at the price in which the producers would wish to sell (equilibrium level). This inefficiency is heavily correlated in circumstances where the price of a good is set too high, resulting in a diminished demand while the quantity available gains excess. There are substantial business risks inherently built into the concept of surpluses, as the general outcome will be either selling off inventory at sub-par prices or leftover unsold inventory. In both scenarios businesses will be forced to minimize margins or incorporate losses on that particular good. Governmental intervention can often create surplus as well, particularly through the utilization of a price floor if it is set at a price above the market equilibrium .

Price Floor

A price floor ensures a minimum price is charged for a specific good, often higher than that what the previous market equilibrium determined. This can result in a surplus.

In a perfectly competitive market, particularly pertaining to goods that are not perishable, excess supply is equivalent to the quantity available in the market beyond the equilibrium point of intersection between supply and demand. In this theoretical scenario the equilibrium point will transition towards a lower price point due to the increased supply, which will in turn motivate consumers to purchase a higher quantity as a result. This allows the economic model of the market to correct itself.

Shortages

Inversely, shortage is a term used to indicate that the supply produced is below that of the quantity being demanded by the consumers. This disparity implies that the current market equilibrium at a given price is unfit for the current supply and demand relationship, noting that the price is set too low. It could also indicate that the desired good has a low level of affordability by the general public, and can be a dangerous societal risk for necessary commodities. Indeed, Garrett Hardin emphasized that a shortage of supply could also be perceived as a ‘longage’ of demand, as the two are inversely related. From this vantage point shortages can be attributed to population growth as much as resource scarcity.

In a perfectly competitive market, a shortage in supply will ultimately result in a shift in the equilibrium point, transitioning towards a higher price point due to the limited supply availability. This will prioritize who receives the good or service based upon their willingness and ability to pay a premium for the specific item in demand, leveraging those along the demand curve who are at higher levels with higher ability and willingness to pay.

3.3.3: Changes in Demand and Supply and Impacts on Equilibrium

Alterations to overall supply or demand dictate the cross-section or equilibrium, ascertaining price and volume for a product or service.

Learning Objective

Illustrate how changes in supply or demand impact the market equilibrium

Key Points

• The interdependent relationship between the supply of a given product or service and the overall demand exercised by interested parties generates a theoretical equilibrium point, dictating the average market price and purchase volume relative to that price.
• Markets are in constant flux as demands and supplies are subjected to varying driving forces and influences. These shifts play a critical role, altering market equilibrium price points and volumes for products and services.
• Demand shifts can be caused by a wide variety of factors, but largely revolve around drivers of consumer behavior and circumstances.
• Supply shifts, similar to demand shifts, can ultimately be a result of a wide variety of externalities. Scarcity, or the lack of availability for a particular material, is a core driving force for overall supply.
• Due to a demand curve’s sloping downward and a supply curve’s sloping upwards, the curves will eventually cross at some point on any supply/demand chart. This point of equilibrium serves as a price and quantity tracking point.

Key Terms

equilibrium

A condition in which competing forces are in balance.

scarcity

An insufficiency or lack of availability; a shortage.

The interdependent relationship between the supply of a given product or service and the overall demand exercised by interested parties generates a theoretical equilibrium point, dictating the average market price and purchased volume relative to that price. In a static market it would be reasonable to assume that prices and volumes would remain fairly predictable and consistent relative to the population, but realistic markets are not static. Instead, markets are in constant flux as demands and supplies are subjected to varying driving forces and influences. These shifts play a critical role in altering market equilibrium price points and volumes for products and services, requiring constant vigilance and adaptation by providers and consumers. To better understand market variations, it is useful to examine how changes in supply and demand may occur, as well as the impacts and implications of these changes.

Demand Shifts

Demand shifts are defined by more or less of a given product or service being required at a fixed price, resulting in a shift of both price and quantity. As would be assumed, an increase in demand will shift price upwards and volume to the right, increasing the overall value of both metrics relative to the prior equilibrium point . Alternately, a decrease in demand will shift price downwards and volume to the left, decreasing both measurements to realign equilibrium with a reduced demand.

Demand Shifts

In this graph, the demand curve (red) has been affected by an increase in demand. This consequently increases price at a given volume.

Demand shifts can be caused by a wide variety of factors, but largely revolve around drivers of consumer behavior and circumstances. Demand shifts can therefore often be affected by economic factors such as average spending power per person in a given economy or overall average income. Demand can also be affected by cultural changes, demographic shifts, availability of substitutes, environmental factors and concerns (e.g. climate change), politics, and advances in science (e.g. declining demand for unhealthy foods). Demand is particularly malleable in respect to goods that are not necessities, thus are desired or not based upon sociological norms.

Supply Shifts

Supply shifts are defined by more or less of a particular product/service being available to fulfill a given demand, affecting the equilibrium point by shifting the supply curve upwards or downwards. A supply shift to the right, indicating more availability of the specified product or service, will create a lower price point and a higher volume assuming a fixed demand. Alternately, a decrease in supply with a consistent given demand will see an increase in price and a decrease in quantity. This is an intuitive theory underlining the fact that scarcity is relevant to the willingness to pay.

Supply Shifts

In this supply and demand chart we see an increase in the supply provided, shifting quantity to the right and price down. More of a given product, assuming the same demand, will result in lower price points at the equilibrium.

Supply shifts, similar to demand shifts, can ultimately be a result of a wide variety of external factors. As discussed above, scarcity plays a critical role in pricing and thus controlling supply is often even considered a strategic play by companies in specific industries (most notably industries like precious stones, rare earth metals, etc.). Supply shifts can also be a result of technological advances, over-utilization or consumption, globalization, supply-chain efficiency, and economics. For example, the discovery of a new gold deposit, acts as a shock to the supply of gold, shifting the curve right.

Equilibrium

In combining these two potential shifts, equilibrium is constantly subjected to both factors resulting in supply shifts and factors resulting in demand shifts. Due to the demand curve sloping downward and the supply curve sloping upwards, they inadvertently will cross at some given point on any supply/demand chart. This cross-section, or equilibrium, serves as a price and quantity tracking point based upon the consistent inputs of overall demand and supply availability. Any change in either factor will result in immediate impact on equilibrium, balancing the new demand or supply with a corresponding volume and appropriate average price point.

3.4: Government Intervention and Disequilibrium

3.4.1: Why Governments Intervene In Markets

Governments intervene in markets when they inefficiently allocate resources.

Learning Objective

Identify reasons why the government might choose to intervene in markets.

Key Points

• The government tries to combat market inequities through regulation, taxation, and subsidies.
• Governments may also intervene in markets to promote general economic fairness.
• Maximizing social welfare is one of the most common and best understood reasons for government intervention. Examples of this include breaking up monopolies and regulating negative externalities like pollution.
• Governments may sometimes intervene in markets to promote other goals, such as national unity and advancement.

Key Term

inefficient market

An economy where social optimality is not acheived; an economy where resources are not optimally allocated

Governments intervene in markets to address inefficiency. In an optimally efficient market, resources are perfectly allocated to those that need them in the amounts they need. In inefficient markets that is not the case; some may have too much of a resource while others do not have enough. Inefficiency can take many different forms. The government tries to combat these inequities through regulation, taxation, and subsidies. Most governments have any combination of four different objectives when they intervene in the market.

Maximizing Social Welfare

In an unregulated inefficient market, cartels and other types of organizations can wield monopolistic power, raising entry costs and limiting the development of infrastructure. Without regulation, businesses can produce negative externalities without consequence. This all leads to diminished resources, stifled innovation, and minimized trade and its corresponding benefits. Government intervention through regulation can directly address these issues.

Another example of intervention to promote social welfare involves public goods. Certain depletable goods, like public parks, aren’t owned by an individual. This means that no price is assigned to the use of that good and everyone can use it. As a result, it is very easy for these assets to be depleted. Governments intervene to ensure those resources are not depleted.

Macro-Economic Factors

Governments also intervene to minimize the damage caused by naturally occurring economic events. Recessions and inflation are part of the natural business cycle but can have a devastating effect on citizens. In these cases, governments intervene through subsidies and manipulation of the money supply to minimize the harsh impact of economic forces on its constituents.

Socio-Economic Factors

Governments may also intervene in markets to promote general economic fairness . Government often try, through taxation and welfare programs, to reallocate financial resources from the wealthy to those that are most in need. Other examples of market intervention for socio-economic reasons include employment laws to protect certain segments of the population and the regulation of the manufacture of certain products to ensure the health and well-being of consumers.

Former President Bill Clinton signing welfare reform

Former President signing a welfare reform bill. Welfare programs are one way governments intervene in markets.

Other Objectives

Governments can sometimes intervene in markets to promote other goals, such as national unity and advancement. Most people agree that governments should provide a military for the protection of its citizens, and this can be seen as a type of intervention. Growing a large and impressive military not only increases a country’s security, but may also be a source of pride. Intervening in a way that promotes national unity and pride can be an extremely valuable goal for government officials.

3.4.2: Price Ceilings

A price ceiling is a price control that limits how high a price can be charged for a good or service.

Learning Objective

Define price ceilings.

Key Points

• For a price ceiling to be effective, it must be less than the free-market equilibrium price.
• The purpose of a price ceiling is to protect consumers of a certain good or service. By establishing a maximum price, a government wants to ensure the good is affordable for as many consumers as possible.
• Rent control is an example of a price ceiling.

Key Terms

free-market equilibrium price

The price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers

Price ceiling

An artificially set maximum price in a market.

A price ceiling is a price control that limits the maximum price that can be charged for a product or service. Generally ceilings are set by governments, although groups that manage exchanges can set ceilings as well. The purpose of a price ceiling is to protect consumers of a certain good or service. By establishing a minimum price, a government wants to ensure the good is affordable for as many consumers as possible .

US Poster for Price Ceilings

Governments often impose price ceilings in times of war to ensure goods are available to as many people as possible.

An example of a price ceiling is rent control. These regulations require a more gradual increase in rent prices than what the market may demand. This regulation is meant to protect current tenants. Without rent control, there could be situations where the demand for housing in an area could cause rent prices to make a substantial jump. Unable to afford the new, significantly higher rent, a majority of the neighborhood’s tenants may be forced to move out of the neighborhood. Rent controls limit the possibility of tenant displacement by minimizing the amount by which rent can be increased.

By definition, however, price ceilings disrupt the market. By setting a maximum price, any market in which the equilibrium price is above the price ceiling is inefficient. There will be excess demand because the price cannot increase enough to clear the excess.

For a price ceiling to be effective, it must be less than the free-market equilibrium price. This is the price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. It is also the price that the market will naturally set for a given good or service. If the price ceiling is higher than what the market would already charge, the regulation would not be effective. As a result, a government will do significant research into the current market conditions for a good before setting a price ceiling.

3.4.3: Price Ceiling Impact on Market Outcome

A binding price ceiling will create a surplus of supply and will lead to a decrease in economic surplus.

Learning Objective

Explain how price controls lead to economic inefficiency

Key Points

• A price ceiling has an economic impact only if it is less than the free-market equilibrium price.
• An effective price ceiling will lower the price of a good, which decreases the producer surplus. The effective price ceiling will also decrease the price for consumers, but any benefit gained from that will be minimized by the decreased sales due to the drop in supply caused by the lower price.
• If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the greatest number of consumers.
• Prolonged shortages caused by price ceilings can create black markets for that good.

Key Terms

Price ceiling

An artificially set maximum price in a market.

black market

trade that is in violation of restrictions, rationing or price controls

A price ceiling will only impact the market if the ceiling is set below the free-market equilibrium price. This is because a price ceiling above the equilibrium price will lead to the product being sold at the equilibrium price.If the ceiling is less than the economic price, the immediate result will be a supply shortage. As you can see from the chart below, a lower base price means less of a good will be produced. The quantity demanded will increase because more people will be willing to pay the lower price to get the good while producers will be willing to supply less, leading to a shortage.

Price Ceiling Chart

If a price ceiling is set below the free-market equilibrium price (as shown where the supply and demand curves intersect), the result will be a shortage of the good in the market. The dead weight loss, represented in yellow, is the minimum dead weight loss in such a scenario. If individuals who value the good most are not capable of purchasing it, there is a potential for a higher amount of dead weight loss.

A price ceiling will also lead to a more inefficient market and a decreased total economic surplus. Economic surplus, or total welfare, is the sum of consumer and producer surplus. Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest that they are willing pay. Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least they would be willing to sell for. An effective price ceiling will lower the price of a good, which means that the the producer surplus will decrease. While the effective price ceiling will also decrease the price for consumers, any benefit gained from that will be minimized by decreased sales caused by decreased available supply for sale from producers due to the decrease in price. This translates into a net decrease total economic surplus, otherwise known as deadweight loss. This loss is signified in the attached chart as the yellow triangle.

Rationing

If a ceiling is to be imposed for a long period of time, a government may need to ration the good to ensure availability for the greatest number of consumers. One way the government may ration the good is to issue ticket to consumers. A government will only allow as much of good to be out in the marketplace as there are available tickets. To obtain the good, the consumer must present the ticket and the money to the vendor when making the purchase. This is generally considered a fair way to minimize the impact of a shortage caused by a ceiling, but is generally reserved for times of war or severe economic distress.

Black Market

Prolonged shortages caused by price ceilings can create black markets for that good. A black market is an underground network of producers that will sell consumers as much of a controlled good as they want, but at a price higher than the price ceiling. Black markets are generally illegal. However these markets provide higher profits for producers and more of a good for a consumers, so many are willing to take the risk of fines or imprisonment.

3.4.4: Price Floors

A binding price floor is a price control that limits how low a price can be charged for a product or service.

Learning Objective

Define Price Floors.

Key Points

• For a price floor to be affect the market, it must be greater than the free-market equilibrium price.
• Price floors above the equilibrium price will induce a surplus.
• The federal minimum wage is an example of a price floor.

Key Terms

free-market equilibrium price

The price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers

price floor

A mandated minimum price for a product in a market.

A price floor is a price control that limits how low a price can be charged for a product or service. Generally floors are set by governments, although groups that manage exchanges can set price floors as well. The purpose of a price floor is to protect producers of a certain good or service. By establishing a minimum price, a government seeks to promote the production of the good or service and ensure that the producers have sufficient resources to go about their work.

For a price floor to be effective, it must be greater than the free-market equilibrium price. This is the price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. It is also the price that the market will naturally set for a given good or service. If the price floor is lower than what the market would already charge, the regulation would serve no purpose. Since the price is set artificially high, there will be a surplus: there will be a higher quantity supplied and a lower quantity demanded than in a free market . As a result, a government will generally do significant research into the current market conditions for a good or service before setting a price floor.

Price Floor

If a price floor is set above the equilibrium price, consumers will demand less and producers will supply more.

An example of a price floor is the federal minimum wage. In this case the suppliers are employees and employers are the consumers. The federal government has established a price that all employers must pay their workers. Obviously employers can pay more than that amount, but they cannot pay less. The purpose of setting this floor is to ensure that all employees make enough money from their jobs to provide for their basic needs.

History of the Federal Minimum Wage

History of the federal minimum wage in real and nominal dollars. The federal minimum wage is one example of a price floor.

3.4.5: Price Floor Impact on Market Outcome

Binding price floors typically cause excess supply and decreased total economic surplus.

Learning Objective

Show how price floors contribute to market inefficiency

Key Points

• A price floor is economically consequential if it is greater than the free-market equilibrium price.
• Price floors lead to a surplus of the product.
• Supply surplusses created by price floors are generally added to producer’s inventory or are purchased by governments.
• Consumer surplus is the gain obtained by consumers because they can obtain a product for a lower price than they would be willing to pay.
• Producer surplus is the benefit producers get by selling at a price higher than the lowest price they would sell for.

Key Terms

free-market equilibrium price

The price established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers

price floor

A mandated minimum price for a product in a market.

A price floor will only impact the market if it is greater than the free-market equilibrium price. If the floor is greater than the economic price, the immediate result will be a supply surplus. As you can see from , a higher base price will lead to a higher quantity supplied. However, quantity demand will decrease because fewer people will be willing to pay the higher price. This will lead to a surplus of supply.

Surplus from a price floor

If a price floor is set above the free-market equilibrium price (as shown where the supply and demand curves intersect), the result will be a surplus of the good in the market.

A price floor will also lead to a more inefficient market and a decreased total economic surplus. Economic surplus, or total welfare, is the sum of consumer and producer surplus. Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest that they are willing pay. Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least they would be willing to sell for. An effective price floor will raise the price of a good, which means that the the consumer surplus will decrease. While the effective price floor will also increase the price for producers, any benefit gained from that will be minimized by decreased sales caused by decreased demand from consumers due to the increase in price. This translates into a net decrease total economic surplus, otherwise known as deadweight loss.

Since well designed price floors create surpluses, the big issue is what to do with the excess supply. The first option is to let inventories grow and have the private producers bear the cost of storing it. The other option is for the government that set the price floor to purchase the excess supply and store it on its own. The government could then sell the surplus off at a loss in times of a food shortage.

3.4.6: Introduction to Deadweight Loss

Deadweight loss is the decrease in economic efficiency that occurs when a good or service is not priced at its pareto optimal level.

Learning Objective

Define deadweight loss

Key Points

• Deadweight loss can be caused by monopolies, binding price controls, taxes, subsidies, and externalities.
• When deadweight loss occurs, it comes at the expense of consumer surplus and/or producer surplus.
• Deadweight loss can be visually represented on supply and demand graphs as a figure known as Harberger’s triangle.

Key Terms

Pareto optimal

Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.

deadweight loss

A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.

Deadweight loss is the decrease in economic efficiency that occurs when a good or service is not priced and produced at its pareto optimal level. When output is at its pareto optimal point, the price, production, and consumption of a good cannot be altered for one person’s benefit without making at least one other worse off. In a perfectly competitive market, products are priced at the pareto optimal point.

When deadweight loss occurs, it comes at the expense of either the consumer economic surplus or the producer’s economic surplus. Consumer surplus is the gain that consumers receive when they are able to purchase a product for less than the price they are willing to pay; producer surplus is the benefit producers receive when the sell a product for more than they are willing to sell for. While price controls, subsidies and other forms of market intervention might increase consumer or producer surplus, economic theory states that any gain would be outweighed by the losses sustained by the other side. This net harm is what causes deadweight loss.

Deadweight loss can be visually represented on supply and demand graphs . Known as Harberger’s triangle, the deadweight loss equals the area within the following three points:

Deadweight loss

This chart illustrates the deadweight loss created when a price floor is instituted on the market for a good. The amount of deadweight loss is shown by the triangle highlighted in yellow. This area is known as Harberger’s triangle.

• where the supply and demand curve intersect, otherwise known as the free market equilibrium;
• the point on the supply curve where the y-coordinate equals the non-pareto optimal price;
• the point on the demand curve where the y-coordinate equals the non-pareto optimal price.

Example – Price Ceilings and Deadweight Loss

The chart above shows what happens when a market has a binding price ceiling below the free market price. Without the price ceiling, the producer surplus on the chart would be everything to the left of the supply curve and below the horizontal line where y equals the free market equilibrium price. The consumer surplus would equal everything to the left of the demand curve and above the free market equilibrium price line.

With the price ceiling, instead of the producer’s surplus going all the way to the pareto optimal price line, it only goes as high as the price ceiling.The consumer surplus extends down to the price ceiling, but it is limited on the right by Harberger’s triangle. In this case, the reason for that limitation is due to quantity produced. The consumer would purchaser more of the product at the ceiling price, but the producers are unwilling to supply enough to meet that demand because it is not profitable. As a result all of the goods that might have been produced and consumed if the good was priced optimally are not, representing a net loss for society.

3.4.7: Arguments for and Against Government Price Controls

Many argue that price controls ensure resource availability, but most economists agree that these controls should be used sparingly.

Learning Objective

Justify the use of price controls when certain conditions are met

Key Points

• The main appeal of governmental imposed price controls is that they can ensure that citizens can purchase what they need in times of national economic hardship.
• Well designed price controls can ensure that basic staples are affordable, minimize the possibility of shortages, and prevent price gouging when shortages occur.
• By keeping prices artificially low through price ceilings, economists argue that demand is increased to a point where supply cannot keep up, leading to a shortage in the controlled product.
• Price floors often lead to surpluses, which can be just as detrimental as a shortage.

Key Terms

Price control

A law that sets the maximum or minimum amount for which a good may be sold.

staple

A basic or essential supply.

When unemployment is especially high or when there is a shortage of goods, it can be difficult for people to get what they need at an affordable price. The main appeal of government imposed price controls is that they can ensure that citizens can purchase what they need in times of national economic hardship .

USFA Depression Price Fixing Poster

During the depression the US government fixed prices on basic staples, such as food, to ensure people would be able to obtain their basic necessities.

Well designed price controls can do three things. First, these regulations can ensure that a basic staple, such as food, remains affordable to most of a country’s citizens. Second, regulation can protect the producers of a good and ensure that they get sufficient revenue. This in turn limits the possibility of shortages, which benefits consumer. Finally, when shortages occur, price controls can prevent producers from gouging their customers on price.

Generally price controls are used in combination with other forms of government economic intervention, such as wage controls and other regulatory elements.

While price controls may appear to be a sound decision in theory, most economists believe these controls should be used sparingly. By keeping prices artificially low through price ceilings, consumers demand a higher quantity than producers are willing to supply, leading to a shortage in the controlled product. As Nobel Prize winner Milton Friedman said, “We economists do not know much, but we do know how to create a shortage. If you want to create a shortage of tomatoes, for example, just pass a law that retailers can’t sell tomatoes for more than two cents per pound. Instantly you’ll have a tomato shortage. “

Price floors often lead to surpluses, which can be just as detrimental as a shortage. One of the best known price floors in the minimum wage, which establishes a base line per hour wage that must be paid for work. As a result, employers hire fewer employees than they would if they could pay workers lower than the minimum wage. As a result the supply of workers is greater than the amount of work, which creates higher unemployment.

3.4.8: Taxes

Governments use its tax systems to raise funds for its programs and influence its citizens’ economic actions.

Learning Objective

Categorize types of taxes into ad valorem taxes and excise taxes

Key Points

• A good tax system should be efficient, understandable and equitable. It should also allocate the costs of public services to those who use it, although that principle is hard to execute in practice.
• A direct tax is assessed on a person’s income. Indirect taxes are assessed on an individual’s participation in certain activities, such as making a purchase.
• The three types of tax systems are proportional, progressive, and regressive.
• Ad valorem and excise taxes are two types of indirect taxes.

Key Terms

progressive

Increasing in rate as the taxable amount increases

regressive

Whose rate decreases as the amount increases.

Taxes are the primary means for governments to raise funds for its programs and to pay off its debts. It can also be used to influence its citizens’ financial behavior. . Choosing the right set of rules that have all of the elements of a good tax system can be a challenge for any government.

tax

Taxes are a tool used by governments to raise money and influence their citizens’ economic choices.

Elements of a Good Tax System

• Efficient: A tax system should raise the necessary revenues without unduly burdening the taxpayer.
• Understandable: A tax system should be easily understandable by the average citizen who has to pay the tax.
• Equitable:The tax burden should be distributed equitably among a nation’s citizens. Generally, this means that those that are wealthier should pay more.
• Benefit Principle: Generally, the people who use public services should pay for them with higher taxes. However this principle is difficult to enforce in practice.

Two Types of Tax Systems

1. Direct Taxation: A direct tax is assessed on the income of the taxpayer and is generally collected before the taxpayer collects his wages.
2. Indirect Taxation: An indirect tax is an avoidable tax assessed on certain activities, such as purchasing goods or services. Examples of an indirect tax include sales tax and VAT (value added tax).

Types of Tax Structures

• Proportional Tax: Otherwise known as a flat tax, a flat tax rate is applied to all earned income regardless of how much the taxpayer earns. So a person making $20,000 would pay the same rate as a person making $120,000, but would pay significantly less in real dollars.
• Progressive Tax: The more a person earns, the higher the tax rate. Generally in a progressive tax system, income is divided into “brackets. ” For example, assume a tax system divides earners into people two groups. Those who earn less than $100,000 pay 10% and people who earn $100,000 or more pay 20%. A person earning $20,000 would have to pay 10%, or $2,000, while a person who earns $120,000 would have to pay 20%, or $24,000.
• Regressive Tax:In a regressive tax system, poorer families pay a higher tax rate. Although a regressive tax system is never explicitly used, some claim a sales tax is a type of regressive tax. Since high income earners spend a lower proportion of their income on goods and services in comparison to low income earners, the rich tend to pay proportionally less sales tax.

Ad Valorem vs Excise Tax

Ad Valorem (or Value Added) and Excise Taxes are types of indirect taxes. Both are generally assessed on the sale of goods. These two taxes differ in three ways:

1. An excise tax typically applies to a narrower range of products, such as gasoline, tobacco, and alcohol.
2. An excise tax is typically heavier than an ad valorem, accounting for a higher fraction of a product’s retail price.
3. Excise taxes are typically a fixed fee per unit, meaning that the government earns its revenue based on volume sold. Ad valorem taxes are proportional to the price of the good, so the government earns revenue based on the value of the good or service being sold.

3.4.9: Taxation Impact on Economic Output

Tax incidence falls mostly upon the group that responds least to price, or has the most inelastic price-quantity curve.

Learning Objective

Analyze how changes in taxes affect the price of a good for sellers and buyers

Key Points

• When supply is inelastic and demand is elastic, the tax incidence falls on the producer.
• When supply is elastic and demand is inelastic, the tax incidence falls on the consumer.
• Tax incidence is the analysis of the effect a particular tax has on the two parties of a transaction; the producer that makes the good and the consumer that buys it.
• A marginal tax is an increase in a tax on a good that shifts the supply curve to the left, increases the consumer price, and decreases the price for the sellers.

Key Terms

elastic

Sensitive to changes in price.

Tax incidence

The effect a particular tax has on the two parties of a transaction.

Tax incidence is the effect a particular tax has on the two parties of a transaction; the producer that makes the good and the consumer that buys it. The burden of the tax is not dependent on whether the state collects the revenue from the producer or consumer, but on the price elasticity of supply and the price elasticity of demand. To understand how elasticities influence tax incidence, its important to consider the two extreme scenarios and how the tax burden is distributed between the two parties.

Inelastic supply, elastic demand

Because supply is inelastic, the firm will produce the same quantity no matter what the price. Because demand is elastic, the consumer is very sensitive to price. A small increase in price leads to a large drop in the quantity demanded. The imposition of the tax causes the market price to increase and the quantity demanded to decrease. Because consumption is elastic, the price consumers pay doesn’t change very much. Because production is inelastic, the amount sold changes significantly. The producer is unable to pass the tax onto the consumer and the tax incidence falls on the producer .

Tax Incidence of Producer

When supply is inelastic but demand is elastic, the majority of the tax is paid for by the consumer. Since quantity demanded drops significantly in this scenario, the producer is forced to sell less.

Elastic supply, inelastic demand

Consumption is inelastic, so the consumer will consume the same quantity no matter the price. The producer will be able to produce the same amount of the good, but will be able to increase the price by the amount of the tax. As a result, the entirety of the tax will be borne by the consumer.

Similarly elastic supply and demand

Generally consumers and producers are neither perfectly elastic or inelastic, so the tax burden is shared between the two parties in varying proportions. If one party is comparatively more inelastic than the other, they will pay the majority of the tax.

Increasing tax

If the government increases the tax on a good, that shifts the supply curve to the left, the consumer price increases, and sellers’ price decreases. A tax increase does not affect the demand curve, nor does it make supply or demand more or less elastic. This potential increase in tax could be called marginal, because it is a tax in addition to existing levies.

1.2: Individual Decision Making

1.2.1: Scarcity Leads to Tradeoffs and Choice

Learning Objective

Give examples of economic trade-offs.

Key Points

• Scarce resources diminish as they are used and almost all resources are scarce.
• In order to use a scarce resource, you are inherently using the resource for one purpose and not an alternative.
• The cost of using a resource is called the opportunity cost: the value of the next best alternative that you could be using the resource for instead.

Key Terms

Scarce

Insufficient to meet demand.

Opportunity cost

The value of the best alternative forgone.

A fundamental concept in economics is that of scarcity. In contrast to its colloquial usage, scarcity in economics connotes not that something is nearly impossible to find, but simply that it is not unlimited. For example, the number of available hours in a day is a scarce resource: there is a finite amount of time available to you to do work, hang out with friends, and relax. Most resources are scarce in most situations.

Since resources tend to be scarce, anyone that uses the resource has to make a decision about how to use it. Suppose, for example, that you are a drink manufacturer. To produce a beverage, you have to use some scarce resources: the plastic for the bottle, the workers’ time, a machine to fill the bottles, etc. If you choose to make one bottle of water, you have chosen to not make a bottle of soda . Your scarce resources force you to make a choice and a trade-off producing one product or another.

Tradeoffs

Since resources are scarce for a drink manufacturer, it must make a tradeoff between producing bottles of water and bottles of soda.

Like producers, consumers also have to make choices. Often, consumer must choose between current consumption (“I want to buy an ice cream”) and future consumption (“I should rather save my money so I can buy an ice cream tomorrow”). Since consumers’ resources such as time, attention, and money are limited, they must choose how to best allocate them by making tradeoffs.

The concept of trade-offs due to scarcity is formalized by the concept of opportunity cost. The opportunity cost of a choice is the value of the best alternative forgone. In other words, if you can only produce bottles of soda and water, the opportunity cost of producing a bottle of water is the value of producing a bottle of soda. Similarly, there is an opportunity cost in everything: the opportunity cost of you reading this is what you could be doing with your time instead (say, watching a movie). When scarce resources are used (and just about everything is a scarce resource), people and firms are forced to make choices that have an opportunity cost.

1.2.2: Individuals Face Opportunity Costs

Learning Objective

Distinguish between explicit costs and opportunity costs

Key Points

• The opportunity cost is the value of the next best alternative foregone.
• Every decision necessarily means giving up other options, which all have a value.
• The opportunity cost is the value one could have derived from using the same resources another way, though this is not always easily quantifiable.

Key Term

Opportunity Costs

The value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources.

When individuals make decisions, they are necessarily deciding between taking one course of action over another. In doing so, they are choosing both what to do and, by extension, what not to do. The value of the next best choice forgone is called the opportunity cost. In other words, the opportunity cost of a course of action is the value the of the option that the individual chose not to take.

Individuals face opportunity costs in both economic and non-economic decisions. One of the easiest way to imagine an individual’s opportunity costs is to imagine a student who decides to study. By choosing to study, the student is implicitly choosing to not go to a party, hang out with friends, or catch up on some much-needed sleep . In this example, the opportunity cost is not easily expressed in dollars and cents, but is just as real.

Opportunity Cost

By choosing to go to spend time and money on things like classes and computers, you are necessarily choosing not to spend it on something else, like going on vacation. This is an opportunity cost.

Rational individuals will try to minimize their opportunity costs. By doing so, individuals are maximizing the amount that they can get out of their resources (time, money, effort, etc.). This makes sense: individuals should seek to get the most and give up the least.

As economic actors, individuals face opportunity costs as well. For example, suppose you decide to purchase a new computer. You could have chosen to spend your money on books or rent or a spring break trip; whichever one of those options is most valuable to you (beside purchasing a new computer) is the opportunity cost.

Such logic applies for every economic decision: purchasing one good means that an individual has chosen to spend resources one way instead of another. Opportunity costs are an important consideration for economists and business people, but are faced by individuals even when they are not making classically economic decisions.

1.2.3: Individuals Make Decisions at the Margins

Learning Objective

Apply the concepts of marginal analysis and utility to decision-making

Key Points

• The marginal cost or benefit is the amount that a decision will change the total cost or benefit from where it is currently.
• Individuals will make choice that maximizes the net marginal benefit (marginal benefit – marginal cost).
• While total or average cost and benefit are important, provided enough resources, individuals will look only at the net marginal benefit.

Key Terms

marginal cost

The additional cost from taking a course of action.

marginal benefit

The additional benefit from taking a course of action.

When individuals make decisions, they do so by looking at the additional cost and benefit of the decision. The cost or benefit of the single decision is called the marginal cost or the marginal benefit. This is different from the total or average: net marginal benefit (marginal benefit minus marginal cost) is the amount that total benefit will change due to the single decision. For example, if the cost of making 9 pieces of pizza is $90 and the cost of making 10 pieces is $110, the marginal cost of producing the tenth piece of pizza is $20. In theory, individuals will only choose an option if marginal benefit exceeds marginal cost.

Marginal and Total Utility

Marginal utility is the amount that a certain action will change total utility. Individuals use net marginal utility to make decisions.

Let’s take an example. Suppose you are buying a car and have three choices:

1. Car A, which costs $10,000
2. Car B, which costs $12,000
3. Car C, which costs $15,000

The prices represent the marginal costs of each car; purchasing the car will add the cost of the car to your total costs. Also suppose Car A provides you $15,000 worth of utility, Car B provides $15,000, and Car C provides $25,000. Those utilities, in dollar terms, are the marginal benefit of each car.

In order to make the decision, you look at the marginal cost and marginal benefit of each car. By subtracting the cost from the benefit, Car A offers $5,000 of marginal benefit, Car B offers $3,000, and Car C offers $10,000. Obviously, Car C is the best choice because, at the margins, it offers the most benefit to you.

Note that you are concerned not with your total or average cost and benefit (assuming no resource or other external restrictions), but with the marginal cost and benefit. As a decision maker, you want to know how much the decision will change your current state, so you look at the margins, not the overall picture. That is not to say that things like the total cost are unimportant, but that, assuming there are enough resources, individuals will look at the marginal change each option will provide to his/her life or to the firm and chose the one with the greatest net marginal benefit.

Marginal Benefits and Costs for Pollution

The tools of marginal analysis can illustrate the marginal costs and the marginal benefits of reducing pollution. When the quantity of environmental protection is low (quantity
) and pollution is extensive, there are cheap and easy ways to reduce pollution, and the marginal benefits of doing so are quite high. At
, it makes sense to allocate more resources to fight pollution.

However, as environmental protection increases, the cheap and easy ways of reducing pollution decrease, and pollution can only be reduced with costly methods. In other words, the largest marginal benefits are achieved first, followed by decreasing marginal benefits. As the quantity of environmental protection increases to
, the gap between marginal benefits and marginal costs decreases. At point _, the marginal costs will exceed the marginal benefits. At this level of environmental protection, society is not allocating resources efficiently, because too many resources are being given up to reduce pollution.

Marginal Costs and Marginal Benefits of Environmental Protection

Reducing pollution is costly—resources must be sacrificed. The marginal costs of reducing pollution are generally increasing, because the least expensive and easiest reductions can be made first, leaving the more expensive methods for later. The marginal benefits of reducing pollution are generally declining, because the steps that provide the greatest benefit can be taken first, and steps that provide less benefit can wait until later.

1.2.4: Individuals Respond to Incentives

Learning Objective

Predict how pay incentives will influence a person’s work performance

Key Points

• Price is one of the main incentives studied in economics. Price incentivizes producers to supply a certain amount, and consumers to purchase a certain amount.
• Economics is mainly concerned with studying remunerative incentives (those that concern material reward).
• Individuals, firms, and governments all change incentives in hopes of encouraging desired outcomes.

Key Terms

Incentive Structure

The cumulative set of promised rewards and/or punishments that encourage actors to make a set of decisions.

incentive

Something that motivates an individual to perform an action.

An incentive is something that motivates an individual to perform an action. The study of incentive structures is central to the study of all economic activities (both in terms of individual decision-making and in terms of cooperation and competition within a larger institutional structure).

Perhaps the most notable incentive in economics is price. Price acts as a signal to suppliers to produce and to consumers to buy. For example, a sale is nothing more than a store providing an incentive to potential customers to buy. The lowering of the price makes the purchase a better idea for some customers; the sale seeks to persuade individuals to change their actions (namely, to buy the product).

Sales are Incentives

Sales are incentives for consumers to buy, because firms know consumers generally respond to lower prices by purchasing more.

Similarly, the increase in price acts as an incentive to suppliers to produce more of a good. If suppliers think they can sell their products for more, they will be inclined to produce more. The price acts, therefore, as an incentive to customers to buy and suppliers to produce.

Types of Incentives

Incentives come in many other forms, however. Broadly, most incentives can be grouped into one of four categories:

• Remunerative incentives: The incentive comes in the form of some sort of material reward – especially money – in exchange for acting in a particular way. Wages, prices, and bribery are all examples of remunerative incentives. This is the type of incentive that is typically associated with economics.
• Moral incentives: This occurs when a certain choice is widely regarded as the right thing to do, or as particularly admirable, or where the failure to act in a certain way is condemned as indecent. Societies and cultures are two main sources of moral incentives.
• Coercive incentives: The incentive is a promise of some sort of punishment if the wrong decision is made. For example, the promise of imprisonment is a coercive incentive for people to not steal.
• Natural Incentives: Things such as curiosity, mental or physical exercise, admiration, fear, anger, pain, joy, the pursuit of truth, and a sense of control of people or oneself can cause individuals to make certain decisions.

Economics is mainly concerned with remunerative incentives, though when discussing government regulations, coercive incentives often come into play. By manipulating incentives, individuals (as well as businesses and governments) hope to encourage some behaviors and discourage others.

Incentives and Performance

Companies leverage incentives-based strategies to drive performance and optimize employee decision-making and behaviors through meaningful reward systems. While there are both advantages and drawbacks to this type of approach, remunerative (financial) incentives are highly attractive options for employers in a variety of industries and businesses. Providing incentives such as variable income, where an individual can obtain more personal rewards for successfully creating a product or making a sale, often drives up production for highly motivated employees.

An example of this would be a manufacturing facility making widgets. The floor manager shifts the wage system from an hourly wage perspective to a straight piece rate system. The more widgets a worker creates, the higher his or her prospective income will be. Under this incentive system less productive workers may stay the same, but highly productive workers will respond by increasing their production. 

1.3: Interaction of Individuals, Firms, and Societies

1.3.1: Introducing the Firm

Firms allow an economy to operate more efficiently and reduce the transaction costs of coordinating production.

Learning Objective

Explain the importance of private companies and firms in the economy

Key Points

• Firms generally appear and become prevalent as an alternative to individual trade when it is more efficient to produce in a non-market environment.
• Limited liability separates the management of a firm from its ownership, allowing companies to raise money easily because owners do not need to risk everything in the case of bankruptcy.
• Most industries experience increasing returns to scale up to a point, which means that more goods can be produced using fewer resources.
• According to Ronald Coase, the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism.

Key Terms

increasing returns to scale

The characteristic of production in which output increases by more than the proportional increase in inputs.

firm

A business enterprise, however organized.

“Firm” is simply another word for company or business. The basic economic marketplace consists of transactions between households and firms. Firms use factors of production – land, labor, and capital – to produce goods that are consumed by households. They may be organized in many different ways – corporations, partnerships, sole proprietorships, and collectives are all examples of firms. Economists who study the theory of the firm attempt to describe, explain, and predict the nature of a firm, including its existence, behavior, structure, and relationship to the market.

The Evolution of the Firm

Not all markets and societies involve firms. In many medieval cities, most production was done by individual craftsmen who were loosely organized into guilds, or by tenant farmers who rented family-sized plots of land. Transactions took place primarily between individuals.

Firms generally appear and become prevalent as an alternative to individual trade when it is more efficient to produce in a non-market environment. For example, in a labor market, it might be too difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. While the advantages of consolidation for efficiency are potentially many and varied, the underlying concept is that integrating operational paradigms enables potential synergy via the construct of a firm.

Firms also allow economic growth, not only for the firm but for the broader society in which it resides. Through separating the business from the individual(s) who starts it, the funding, insurance and liability of a firm can function independently of a person. The separation of a firm from the individual also allows more specifically applicable regulations and laws, broader accumulation of investment capital and more complex strategic alliances. While the detailed implications of a firm and it’s relationship with individuals and society are complex, the important takeaway is that firms play an integral role in economic structure.

The Firm

Organizing production under firms reduces the transaction costs of coordinating production in the market.

The Transaction Theory of the Firm

According to Ronald Coase, people begin to organize their production in firms when the transaction cost of coordinating production through the market exchange is greater than within the firm. He notes that a firm’s interactions with the market may not be under its control (for instance because of sales taxes), but its internal allocation of resources are: “Within a firm, … market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur … who directs production.” He asks why alternative methods of production (such as the price mechanism and economic planning), could not either achieve all production, so that either firms use internal prices for all their production, or one big firm runs the entire economy.

For Coase the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. These include discovering relevant prices (which can be reduced but not eliminated by purchasing this information through specialists), as well as the costs of negotiating and writing enforceable contracts for each transaction (which can be large if there is uncertainty). Moreover, contracts in an uncertain world will necessarily be incomplete and have to be frequently re-negotiated. The costs of haggling about division of surplus, particularly if there is asymmetric information and asset specificity, may be considerable. Organization into a firm can considerably reduce these costs.

1.3.2: Trade Leads to Gains

Producers and consumers trade because the exchange makes both parties better off.

Learning Objective

Explain why parties trade.

Key Points

• The benefit of exchange to producers is measured by the profit the producer makes. The benefit of exchange to a consumer is measured by net utility gained.
• Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay.
• Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least that they would be willing to sell for.
• An allocation of resources is Pareto efficient when it is impossible to make any one individual better off without making at least one individual worse off.

Key Terms

utility

The ability of a commodity to satisfy needs or wants; the satisfaction experienced by the consumer of that commodity.

consumer surplus

The difference between the maximum price a consumer is willing to pay and the actual price they do pay.

producer surplus

The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.

Producers and consumers trade because the exchange makes both parties better off. The benefit of exchange to producers is measured by the amount of profit – that is, the difference between the average cost of producing an item and the price received for that item. The benefit of exchange to a consumer is measured by net utility gained. This is measured by taking the difference between the maximum price a consumer is willing to pay and the actual price they do pay. To understand this, imagine purchasing a car. You would be willing to pay up to $15,000 for a car in good condition, but you are able to buy one for only $12,000. Since you value the car at $3,000 more than you paid for it, $3,000 is the benefit that you gained from the transaction.

Economists refer to these benefits from exchange as producer and consumer surplus. Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay. Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least that they would be willing to sell for.

The amount of consumer and producer surplus that is gained from a transaction can be seen on a standard supply and demand graph. Consumer surplus is the area (triangular if the supply and demand curves are linear) above the equilibrium price of the good and below the demand curve. This reflects the fact that consumers would have been willing to buy a single unit of the good at a price higher than the equilibrium price, a second unit at a price below that but still above the equilibrium price, etc., yet they in fact pay just the equilibrium price for each unit they buy.

Likewise, in the supply-demand diagram, producer surplus is the area below the equilibrium price but above the supply curve. This reflects the fact that producers would have been willing to supply the first unit at a price lower than the equilibrium price, the second unit at a price above that but still below the equilibrium price, etc., yet they in fact receive the equilibrium price for all the units they sell. The sum of consumer and producer surplus is called economic, or social, surplus, and reflects the total amount of benefit received by society when consumers and producers trade.

Consumer and Producer Surplus

Consumer surplus is the area between the demand line and the equilibrium price, and producer surplus is the area between the supply line and the equilibrium price.

Exchange and Pareto Optimality

An allocation of resources is Pareto efficient when it is impossible to make any one individual better off without making at least one individual worse off. For example, imagine that two individuals prefer peanut butter and jelly sandwiches to a sandwich with only peanut butter or only jelly. A distribution in which Individual A has all of the peanut butter and individual B has all of the jelly is not Pareto efficient, because both parties would be better off if they shared their resources.

Similarly, an action that makes at least one party better off without making any individual worse off is called a Pareto improvement. Any transaction in a free market always produces a Pareto improvement because it makes consumers and/or producers better off without making either party worse off (if this were not the case, the consumer and/or the producer would refuse to participate in the transaction in the first place). It is commonly assumed that outcomes that are not Pareto efficient are to be avoided, and if a Pareto improvement is possible it should always be implemented.

One way to look at whether a transaction is a Pareto improvement is to ask whether it increases consumer or producer surplus without decreasing either party’s surplus. Lowering an item’s price without changing the quantity sold, for example, may increase consumer surplus, but is not a Pareto improvement because producers suffer negative consequences.

1.3.3: Thinking about Efficiency

An efficient market maximizes total consumer and producer surplus.

Learning Objective

Define economic efficiency.

Key Points

• Economists assume that firms seek to maximize their profits – defined as the difference between total revenue and total cost – while consumers seek to maximize their utility – which is roughly defined as the total satisfaction gained from goods, services, or actions.
• An efficient allocation of resources maximizes total consumer and producer surplus.
• Because they produce efficient outcomes, the seemingly haphazard workings of the marketplace can promote the common good.
• Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds.

Key Terms

producer surplus

The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.

consumer surplus

The difference between the maximum price a consumer is willing to pay and the actual price they do pay.

Every economic transaction has a buyer and a seller who will only participate is she is receiving at least a minimum benefit. These benefits are represented as consumer surplus and producer surplus, respectively. In , both types of surpluses are displayed graphically. An efficient market maximizes total consumer and producer surplus.

Consumer and Producer Surplus

Consumer and producer surplus are maximized at the market equilibrium – that is, where supply and demand intersect.

The market shown in is one without any distortions such as regulations, taxes, or an inability for buyers to meet sellers. It is subject to what Adam Smith described as the invisible hand: if the price is anything except the equilibrium price, market forces will eventually return the market price to equilibrium .

Not all markets are efficient. There are a number of reasons why a market may be inefficient. Perhaps most well known is inefficiency caused by government intervention. Governments can institute any number of policies that prevent markets from achieving the free market equilibrium price and quantity: taxes raise prices, quotas limit the quantity sold, and regulations affect the supply and demand curves. Market inefficiency can also be caused by things such as irrational market actors and barriers to transactions, such as an inability for buyers and sellers to find one another.

Economists often seek to maximize efficiency, but it is important to contextualize such aims. Efficiency is but one of many vying goals in an economic system, and different notions of efficiency may be complementary or may be at odds. Most commonly, efficiency is contrasted or paired with morality, particularly liberty, and justice. Some economic policies may be seen as increasing efficiency at a cost to other goals or values, though this is certainly not a universal tradeoff. For example, taxation will always cause some inefficiency in markets, but many individuals believe that the benefits of programs such as Social Security and public schooling are worth the loss in efficiency.

1.3.4: The Function and Nature of Markets

In a free market, the price and quantity of an item are determined by the supply and demand for that item.

Learning Objective

Summarize the defining characteristics of a free market economy

Key Points

• A market is defined as a system or institution whereby parties engage in exchange. A market economy is an economy in which decisions regarding investment, production, and distribution are based on supply and demand, and prices of goods and services are determined in a free price system.
• In a perfectly competitive market there are many buyers and sellers so no individual actor may affect a good’s price; there are no barriers to exit or entry; products are homogeneous; and all actors in the economy have perfect information.
• Changes to the market supply and market demand will cause changes in the equilibrium price and quantity of the good produced.
• When markets are perfectly competitive, the equilibrium outcome of trade in the market is economically efficient. This means that the market is producing the largest net gain possible for society, given consumers’ utility functions and producers’ production functions.

Key Terms

equilibrium

The condition of a system in which competing influences are balanced, resulting in no net change.

market economy

An economy in which goods and services are exchanged in a free market, as opposed to a state-controlled or socialist economy; a capitalistic economy.

In economics, a market is defined as a system or institution whereby parties engage in exchange. A market economy is an economy in which decisions regarding investment, production, and distribution are based on supply and demand, and prices of goods and services are determined in a free price system. The major defining characteristic of a market economy is that decisions on investment and the allocation of producer goods are mainly made through markets. This is the opposite of a planned economy, where investment and production decisions are embodied in a plan of production.

A free market is a market structure that is not controlled by a designated authority. Free markets may have different structures: perfect competition, oligopolies, monopolistic competition, and monopolies are all types of markets that may exist in a capitalist economy. The most basic models in economics assume that markets are free and experience perfect competition – there are many buyers and sellers so no individual actor may affect a good’s price; there are no barriers to exit or entry; products are homogeneous; and all actors in the economy have perfect information.

Market Equilibrium

In a free market, the price and quantity of an item is determined by the supply and demand for that item. The market demand function describes the amount of a good that all consumers will purchase at a given price, while the market supply function expresses the amount that producers will supply at a given price. Consider the market for computers. At a price of $1,200, the market may demand 8,000 computers, while producers are willing to supply 15,000 computers. This is not the equilibrium price because at $1,200, supply exceeds demand. In order to reach equilibrium, the price must drop, causing demand to rise and supply to fall until the two are equal. This can be expressed graphically by drawing the market supply function and the market demand function and finding the point where the two curves intersect .

Market Supply and Demand

The market equilibrium exists where the market demand curve and the market supply curve intersect.

Changes to the market supply and market demand will cause changes in the equilibrium price and quantity of the good produced. For example, if a new technology is invented that allows producers to manufacture cars more efficiently, supply will rise and the market supply curve will shift to the right. The new market equilibrium will have a higher number of cars sold at a lower price. When markets are perfectly competitive, the equilibrium outcome of trade in the market is economically efficient. This means that the market is producing the largest net gain possible for society, given consumers’ utility functions and producers’ production functions.

1.3.5: Markets are Typically Efficient

A perfectly competitive market with full property rights is typically efficient.

Learning Objective

Define efficient markets.

Key Points

• A market has productive efficiency when units of goods are being supplied at the lowest possible average cost.
• A market has allocative efficiency if the price of a product that the market is supplying is equal to the value consumers place on it.
• It is important to note that achieving economic efficiency is not always the most important goal for a society. A market can be perfectly efficient but highly unequal.
• A smoothly functioning market requires that producers possess property rights to the goods and services they produce and that consumers possess property rights to the goods and services they buy.

Key Term

Pareto efficiency

The state in which no one can be made better off by making another worse off.

An efficient market maximizes total consumer and producer surplus; there is no deadweight loss . An economic system is said to be more efficient than another (in relative terms) if it can provide more goods and services for society without using more resources. In absolute terms, a situation can be called economically efficient if:

Economic Inefficiency

A sign of economic inefficiency in a market is the presence of deadweight loss.

1. No one can be made better off without making someone else worse off (commonly referred to as Pareto efficiency),
2. No additional output can be obtained without increasing the amount of inputs, and
3. Production proceeds at the lowest possible per-unit cost.

Economists refer to two types of market efficiency. A market has productive efficiency when units of goods are being supplied at the lowest possible average cost. This condition is satisfied if the equilibrium quantity is at the minimum point of the average total cost curve. For example, if a farm can produce 10,000 bushels of corn with 20 employees, but is currently producing 10,000 bushels with 25 employees, it is not achieving productive efficiency.

A market has allocative efficiency if the price of a product that the market is supplying is equal to the value consumers place on it. This is equivalent to saying that the marginal cost of an item is equal to its price. If a market is not allocatively efficient, then it is creating too much of something that consumers value less than other goods, or not enough of something that consumers value more. A market that produces 500 loaves of bread but only one gallon of milk is probably not allocatively efficient.

As you study economics further, it is usually safe to assume that markets are efficient unless you’re dealing with a distortion (e.g. regulations, imperfect information sharing).

It is important to note that achieving economic efficiency is not always the most important goal for a society. A market can be perfectly efficient but highly unequal, for example. If 1% of the population controls virtually all the income, then the market will efficiently allocate virtually all of its production to those same people. While this is economically efficient, many would argue that it is not desirable. Efficient markets may have negative effects on those that exist outside of the market; for example, the energy market may cause environmental harm that is not captured in the economic notion of efficiency.

1.3.6: Government Intervention May Fix Inefficient Markets

Governments can intervene to make a market more efficient when a market failure, such as externalities or asymmetric information, exists.

Learning Objective

Discuss the role of government in addressing common market failures

Key Points

• Economic efficiency occurs under the following conditions: competitive markets with accurate exchange of information and mobile resources, in which individuals bear the full costs and benefits of their transactions.
• The criteria for economic efficiency are rarely fully met.
• If a transaction affects individuals not involved in the transaction (either positively or negatively), that transaction is said to have an externality. 
• Governments can intervene by taxing negative externalities or subsidizing positive externalities.
• Free markets will generally produce less than the optimal amount when a good is nonexcludable and nonrivalrous, which means that a government can make the market more efficient by producing the public good itself.

Key Terms

public good

A good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.

externality

An impact, positive or negative, on any party not involved in a given economic transaction or act.

free rider

One who obtains benefit from a public good without paying for it directly.

In an efficient market, firms can produce goods at the lowest possible cost while individuals can access the goods and services they desire, all while utilizing the least resources possible. A market can be said to be economically efficient if it has certain qualities:

• perfectly competitive
• mobile resources
• accurate and freely available information
• individuals directly receive the costs and benefits of their transactions

Market failure is the name for when a market is not efficient; that is, when it deviates from one or more of the above conditions. However, in reality no market is perfectly efficient. In general, minor inefficiencies do not dramatically affect society. But when society is adversely affected by economic inefficiency, such as when a monopoly firm raises prices to a point where people cannot afford a basic good, the government will sometimes intervene.

Consider the problem of externalities, the phenomenon of when a transaction occurs that affects people who were not directly involved. For example, when a coal plant producing electricity causes pollution, there is a transaction between the company and the resident who purchases the product. But if you live near the coal plant and suffer from asthma due to the smog it produces, you are encountering a negative externality. You had no choice in the transaction, but are experiencing its effects.

Externalities are an example of economic inefficiency, since those involved in the economic transaction do not bear the full costs of the transaction. In this case, governments can intervene by taxing the transaction and using the money to negate the harmful effects or to compensate those affected by the negative externality. Similarly, when a transaction produces positive externalities, efficiency is achieved when the government subsidizes the transaction. Education is an example of a transaction that has a positive effect on society.

Another case in which markets do not operate efficiently on their own is the market for public goods. Public goods are nonrival, which means that more than one (and sometimes many!) individual can use the good at one time. They are also nonexcludable, which means that their use cannot be prevented. For example, consider a beautiful fountain in a public park. The company that built the fountain cannot force people to pay money in order to enjoy it, since its in a public area; and since one person looking at the fountain doesn’t prevent others from looking at it, it is a nonrival good.

Free markets will generally produce less than the optimal amount when a good is nonexcludable and nonrivalrous, which means that a government can make the market more efficient by producing the public good itself. By using tax revenue, governments can avoid the problem of free riders and produce an efficient quantity of public goods even when the free market cannot.

National Defense as a Public Good

National defense is a classic example of a good that is nonexcludable and nonrivalrous. It will be under-produced unless the government provides it.

1.3.7: Full Economy Interactions

Variables that describe the full economy, such as GDP and unemployment, are determined by the decisions of individual economic actors.

Learning Objective

Explain how the macroeconomy is the sum of many individual economic actors’ decisions.

Key Points

• Macroeconomists combine the demand of all consumers in a market (aggregate demand) and the supply from all producers in a market (aggregate supply) to look at the way these groups interact on a large scale.
• Just as the choices made by individual consumers and producers can be aggregated to describe an entire industry, their combined effects can also influence a nation’s overall economic activity.
• GDP is measured by adding together all the production undertaken by a nation’s firms. Individual firms affect GDP every time they choose to produce more or less. Consumers affect GDP whenever they increase or decrease demand for goods.

Key Terms

inflation

An increase in the general level of prices or in the cost of living.

aggregate

A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.

In the most basic economic model, the economy consists of interactions between households, which provide labor and purchase goods, and firms, which employ labor and produce goods . Macroeconomics studies the aggregate effects of the actions of many individual households and firms. While microeconomists might study how a market with one producer and one consumer reaches equilibrium, macroeconomists combine the demand of all consumers in a market (aggregate demand) and the supply from all producers in a market (aggregate supply) to look at the way these groups interact on a large scale.

Circular Flow

The economy consists of interactions between firms and households.

Consider the market for CDs. Each individual consumer has a demand function for CDs that determines how many he will buy at a particular price – for example, one consumer may only buy a single album if they cost $15 each, but would buy two if the price dropped to $10 each. Likewise, each producer has a production function that determines how many CDs it will produce at a given price; it may produce 10,000 CDs if they can be sold for $10, but will increase production to 12,000 if the price rises to $15. In order to understand the entire market for CDs, economists add the demand of all consumers at each possible price, creating an aggregate demand curve, and the total quantity supplied by producers at each possible price, creating an aggregate supply curve. The point at which these two curves intersect shows the market equilibrium for CDs.

The Macroeconomy

Just as the choices made by individual consumers and producers can be aggregated to describe an entire industry, their combined effects can also influence a nation’s overall economic activity. Macroeconomists study a variety of these effects, but three are central to macroeconomic research:

• Gross domestic product (GDP) – the size of an entire economy’s output – is measured by adding together all the production undertaken by a nation’s firms. Individual firms affect GDP every time they choose to produce more or less. Consumers affect GDP whenever they increase or decrease demand for goods.
• Inflation occurs when many individual consumers increase demand for a good, raising the equilibrium price for the economy as a whole.
• Unemployment rises when firms choose to produce less or when consumers decrease their demand at a given price.

1.4: Basic Economic Questions

1.4.1: Production Outputs

A firm’s production outputs are what it creates using its resources: goods or services.

Learning Objective

Identify how suppliers determine what and how much to supply

Key Points

• The profit-maximizing amount of output occurs when the marginal cost of producing another unit equals the marginal revenue received from selling that unit.
• Output are the quantity of goods or services produced in a given time period, by a firm, industry or country.
• There are four types of market scenario that a firm may encounter when making a production decision: economic profit, normal profit, loss-minimizing condition, and shutdown. The firm should always produce unless it encounters a shutdown scenario.

Key Terms

fixed costs

A cost of business which does not vary with output or sales; overheads.

average total cost

Average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q).

variable cost

A cost that changes with the change in volume of activity of an organization.

marginal cost

The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. Additional cost associated with producing one more unit of output.

Production outputs are the goods and services created in a given time period, by a firm, industry or country. These goods can either be consumed or used for further production. Production outputs can be anything from crops to technological devices to accounting services. Producing these outputs incur costs which must be considered when determining how much of a good should be produced.

Determining what to produce and how much to produce can be difficult. Microeconomics assumes that firms and businesses are profit-seeking. This means that above all else they will produce goods and services to the degree that maximizes their profits. In economic theory, the profit-maximizing amount of output in occurs when the marginal cost of producing another unit equals the marginal revenue received from selling that unit . When the product’s marginal costs exceeds marginal revenue, the firm should stop production.

Production Conditions

A firm will seek to produce such that its marginal cost (MC) is equal to marginal revenue (MR, which is equal to the price and demand). It is not produced based on average total cost (ATC).

Once a firm has established what its profit-maximizing output is, the next step it must consider is whether to produce the good given the current market price. There are several key terms to be familiar with prior to addressing this question.

• Fixed costs are those expenses that remain constant regardless of the amount of good that is produced. For example, no matter how much of a good you produce, you will still have to pay the same amount of rent for your factory or storage units.
• Variable costs are only those expenses that are directly tied to the production of more units; fixed costs are not included.
• Opportunity costs are the cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the cost equals the most valuable forgone alternative.
• Average total cost is the all expenses incurred to produce the product, including fixed costs and opportunity costs, divided by the number of the units of the good produced.

There are four different types of conditions that generally describe a firm’s profit as described in :

• Economic Profit: The firm’s average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
• Normal Profit: The average total cost equals the price at the profit-maximizing output. In this case, the economic profit equals zero. In this scenario, the firm should produce of the product.
• Loss-minimizing condition: The firm’s product price is between the average total cost and the average variable cost. The firm should still continue to produce because additional sales would offset a portion of fixed costs. If the manufacturer stopped production, it would sustain all the fixed costs as a loss.
• Shutdown: The price is below average variable cost at the profit-maximizing output. Production should be shutdown because every unit produced increases loss. The revenue gained from sales of these products do not offset variable and fixed costs. If it does not produce goods, the firm suffers a loss due to fixed costs, but it does not incur any variable costs.

1.4.2: Production Inputs and Process

Labor, capital, and land are the three necessary inputs for any production process.

Learning Objective

Explain the use of capital and labor in production

Key Points

• Capital, otherwise known as capital assets, are manufactured goods that are used in production of goods or services.
• Cash is not included in capital in terms of a production input. Homes and personal automobiles are also not included in capital because these items are not directly tied to the production of goods or services.
• Labor is a measure of the work done by human beings to create a manufactured output.

Key Terms

labor

The workers used to manufacture the output.

capital

Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).

input

Something fed into a process with the intention of it shaping or affecting the outputs of that process.

The process of production generates output, otherwise referred to as good and services. Production processes require three inputs: land, capital and labor. Land is simply the place where you produce your product, whether it is a factory or a farm, and may included capital if the output being created is a service. In most scenarios, the inputs in the production process are primarily capital and labor.

Capital

Capital, otherwise known as capital assets, are manufactured goods that are used in production of goods or services. Control of these assets are the primary means of creating wealth. Included in capital is anything that has been manufactured that can be used to enhance a person’s ability to perform economically useful work. For a caveman, a stick or a stone would have been considered capital. For a post-industrial worker, a laptop, computer, and cellphone would be considered capital .

Girls running warping machines in Loray Mill, Gastonia, N.C. by Lewis Hine, 1908.

Any tool or machine that could be used to improve someone’s ability to work would be included in capital.

In regards to production, it also is important to know what capital is not. While capital may refer to funds invested in a business in other disciplines such as accounting, cash is not included in capital in terms of a production input in economics. Homes and personal automobiles are also not included in capital because these items are not directly tied to the production of goods or services.

Labor

Labor is a measure of the work done by human beings to create a manufactured output. Producers demand labor because it aids in producing output which can then be sold. In production, a worker will only be hired when the marginal revenue s/he brings in exceeds or equals the marginal cost of hiring that worker. The cost of one worker is the wage.

The value of labor varies based on the skills and talents that the individual worker brings to that job. If the job involves designing and building a computer, an engineer’s labor is more valuable than a tailor. If the job requires the manufacture of a suit, an employer would prefer the tailor. Other elements that influence the perception of the value of a specific type of labor in production include the amount of training necessary to execute the task and the barriers to conducting that type of work.

1.4.3: Production Recipients

The process of producing and distributing a good or service is called a supply chain, and it is composed of many economic actors.

Learning Objective

Identify the market actors involved in taking a product from the original producer to the consumer

Key Points

• Supply chains vary based on industry, the resources of the manufacturer, and market conditions.
• The purpose of a supply chain is to act as an integrating function that links major business functions and processes into a cohesive business model.
• Typical steps in a supply chain include: extraction of raw materials; acquisition of components; production; inventory; transportation; wholesaler; and retailer.

Key Term

supply chain

A system of organizations, people, technology, activities, information and resources involved in moving a product or service from supplier to customer.

A supply chain is a system of organizations, people, activities, information and resources involved in moving a product or service from supplier to customer. The company’s supply chain illustrates the total process of transforming raw materials into a finished product, and then selling that finished product to consumers .

Supply Chain

This represents the typical supply chain for a computer. The right half of the chart represents the steps it takes from producing the final product to the consumers.

The purpose of a supply chain is to act as an integrating function that links major business functions and processes into a cohesive business model. When designed well, a supply chain is able to respond to shifts in demand and changes in the marketplace. Based on these shifts, the supply chain is able to alter production levels accordingly so that supply can meet demand so that the firm is able to maximize its profit.

Supply chains vary based on industry, the resources of the manufacturer, and market conditions. Some typical elements and actors in a supply chain include:

• Extraction/Acquisition of Raw Materials or Components. Before the production of a good can be initiated, you need to have all of the necessary elements. These elements could be unrefined raw materials that the company transforms into components or pre-assembled parts. A firm may have subsidiaries or divisions that obtain raw materials or it might acquire those elements from a third party.
• Production. This is the process that transforms the elements acquired from the prior step into the finished good. Economic actors involved in this step include product designers, assembly-line workers, and floor management.
• Inventory. Once the good is completed, it is generally placed into a centralized inventory location while decisions are made by inventory managers and a firm’s sales division.
• Transportation. Finished goods must be transported to stores and other locations where consumers can obtain the good. Depending on the type of business, goods may be transferred to smaller regional inventory depots, merchants, or directly to a consumer.
• Wholesaler. A wholesaler is someone who sells a good to smaller stores, who in turn sells the good to consumers.
• Retailer. The retailer buys the product in bulk and sells individual or smaller groups of units to the end consumer.

1.4.4: Differences Between Centrally Planned and Market Economies

The key difference between centrally planned and market economies is the degree of individual autonomy.

Learning Objective

Compare the characteristics of capitalist and socialist economic systems

Key Points

• A pure planned economy has one person or group who controls what is produced; all businesses work together to produce goods and services that are planned and distributed by the government.
• Planned economies have several advantages. Ideally, there is no unemployment, and needs never go unfulfilled; because the government knows how much food, medicine, and other goods is needed, it can produce enough for all.
• Realistically, these systems tend to suffer from large inefficiencies and are overall not as successful as other types of economic systems.
• A pure market economy is one perfectly free of external control. Individuals are left up to themselves to decide what to produce, who to work for, and how to get the things they need.
• Because there is no regulation ensuring equality and fairness, market economies are burdened with unemployment, and even those with jobs can never be certain that they will make enough to provide for all of their needs.
• Because they do not need to wait for word from the government before changing their output, companies under market economies can quickly keep up with fluctuations in the economy, tending to be more efficient than regulated markets.

Key Terms

Centrally planned economy

When the government is responsible for setting the amount produced.

autonomy

Self-government; freedom to act or function independently.

market economy

An economy in which goods and services are exchanged in a free market, as opposed to a state-controlled or socialist economy; a capitalistic economy.

While there are many different variations of national economies, the two dominant economic coordination mechanisms are centrally planned and market based. Before you can analyze any national economy, you need to understand these two opposing viewpoints on how to run an economy. The key difference between the two is the amount of individual autonomy within the two systems.

Centrally Planned Economy

A pure planned economy has one person or group who controls what is produced; all businesses work together to produce goods and services that are planned and distributed by the government. These economies are also called command economies because everyone must follow specific guidelines set up by the controlling authority. The reason behind this type of planning is to make sure that everything needed is produced and that everyone’s needs are fulfilled. Since most peoples’ needs are provided for in a centrally planned economy, compensation is primarily morally based. Most assets are owned by the state.

Planned economies have several advantages. Ideally, there is no unemployment and needs never go unfulfilled. Because the government knows how much food, medicine, and other goods is needed, it can produce enough for all. But achieving these outcomes depends on the group that organizes production and distribution to accurately identify what the consumers will need, determine what it would take to meet those goals, and anticipate all possible situations. This means there are a lot of opportunities to make a mistake. Realistically, these systems tend to suffer from large inefficiencies and are overall not as successful as other types of economic systems.

V.I. Lenin

The Soviet Union, as established by V.I. Lenin, is an example of a country that tried to establish a pure centrally planned economy.

Market Based Economy

A pure market economy, or capitalist system, is one perfectly free from external control. Individuals may decide what to produce, who to work for, and how to get the things they need. They are compensated with material goods for their work, and most assets are privately owned. This type of economy, though it may be chaotic at times, allows people to change along with the shifting market conditions to maximize their profits. Although they avoid many of the inadequacies of planned economies, market economies are not free of their own problems and downfalls. Perhaps the greatest problem is that business firms may refuse to produce goods that unprofitable for them. For instance, in 2000 there was a shortage of tetanus vaccine in the United States. Because it was expensive to make, most companies were unwilling to start production themselves, leaving only one firm struggling to keep up with demand. In a planned economy, this shortage would not happen because the government would boost production of the vaccine if it were needed.

Because there is no regulation to ensure equality and fairness, market economies may be burdened with unemployment and even those with jobs can never be certain that they will make enough to provide for all of their needs. Despite these and other problems, market economies come with many advantages, chief among which is speed. Because they do not need to wait for word from the government before changing their output, companies under market economies can quickly keep up with fluctuations in the economy, tending to be more efficient than regulated markets. Also, individuals have more freedom and opportunities to do the jobs they want and to profit by them.

1.4.5: Mixed Economies

A mixed economy is a system that embraces elements of centrally planned and free market systems.

Learning Objective

Explain the characteristics of a mixed economy

Key Points

• Most of the means of production in a mixed economy are privately owned in a mixed economy.
• The government strongly influences the economy through direct intervention in a mixed economy, such as through subsidies and regulation of the markets.
• Most government intervention in mixed economy is limited to minimizing the negative consequences of economic events, such as unemployment in recessions, to promote social welfare.

Key Terms

mixed economy

A system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies.

monopoly

A market where one company is the sole supplier.

A mixed economy is a system that embraces elements of centrally planned and free market systems. While there is no single definition of a mixed economy, it generally involves a degree of economic freedom mixed with government regulation of markets. Most modern economies are mixed, including the United States and Cuba. Countries hope that by embracing elements of both systems they can gain the benefits of both while minimizing the systems disadvantages.

In general, most of the means of production in a mixed economy are privately owned. There are some exceptions to this general rule, such as some hospitals and businesses. The mostly private ownership of all means of production allows the market to quickly respond to changing circumstances and economic factors. As a result, the market is generally the dominant form of economic coordination. However, to mitigate the negative influence that a pure market economy has on fairness and distribution, the government strongly influences the economy through direct intervention in a mixed economy. Different ways a government directly intervenes in an economy include:

• granting a business a monopoly,
• granting a subsidy to a sector,
• creating and enforcing regulation,
• direct participation in the market , or
• providing money and other resources segments of its populations, such as through a welfare program.

Most government intervention in mixed economy is limited to minimizing the negative consequences of economic events, such as unemployment in recessions, to promote social welfare.

While mixed economies vary based on their degree of government intervention, some elements are consistent. Generally, individuals in mixed economies are able to:

• participate in managerial decisions,
• travel,
• buy and sell items privately,
• hire and fire employees,
• organize organizations,
• communicate, and
• protest peacefully.

However, the government in mixed economies generally subsidizes public goods, such as roads and libraries, and provide welfare services such as social security. These governments also regulate labor and protect intellectual property.

1.5: Economic Models

1.5.1: Math Review

Mathematical economics uses mathematical methods, such as algebra and calculus, to represent theories and analyze problems in economics.

Learning Objective

Review basic algebra and calculus’ concepts relevant in introductory economics

Key Points

• Using mathematics allows economists to form meaningful, testable propositions about complex subjects that would be hard to express informally.
• Algebra is the study of operations and their application to solving equations. It provides structure and a definite direction for economists when they are analyzing complex data.
• Concepts in algebra that are used in economics include variables and algebraic expressions.
• Calculus is the mathematical study of change. Economists use calculus in order to study economic change whether it involves the world or human behavior.
• In economics, calculus is used to study and record complex information – commonly on graphs and curves.

Key Terms

variable

something whose value may be dictated or discovered.

quantitative

Of a measurement based on some number rather than on some quality.

As a social science, economics analyzes the production, distribution, and consumption of goods and services. The study of economics requires the use of mathematics in order to analyze and synthesize complex information.

Mathematical Economics

Mathematical economics is the application of mathematical methods to represent theories and analyze problems in economics. Using mathematics allows economists to form meaningful, testable propositions about complex subjects that would be hard to express informally. Math enables economists to make specific and positive claims that are supported through formulas, models, and graphs. Mathematical disciplines, such as algebra and calculus, allow economists to study complex information and clarify assumptions.

Algebra

Algebra is the study of operations and their application to solving equations. It provides structure and a definite direction for economists when they are analyzing complex data. Math deals with specified numbers, while algebra introduces quantities without fixed numbers (known as variables). Using variables to denote quantities allows general relationships between quantities to be expressed concisely. Quantitative results in science, economics included, are expressed using algebraic equations.

Concepts in algebra that are used in economics include variables and algebraic expressions. Variables are letters that represent general, non-specified numbers. Variables are useful because they can represent numbers whose values are not yet known, they allow for the description of general problems without giving quantities, they allow for the description of relationships between quantities that may vary, and they allow for the description of mathematical properties. Algebraic expressions can be simplified using basic math operations including addition, subtraction, multiplication, division, and exponentiation.

In economics, theories need the flexibility to formulate and use general structures. By using algebra, economists are able to develop theories and structures that can be used with different scenarios regardless of specific quantities.

Calculus

Calculus is the mathematical study of change. Economists use calculus in order to study economic change whether it involves the world or human behavior.

Calculus has two main branches:

• Differential calculus is the study of the definition, properties, and applications of the derivative of a function (rates of change and slopes of curves) . By finding the derivative of a function, you can find the rate of change of the original function.
• Integral calculus is the study of the definitions, properties, and applications of two related concepts, the indefinite and definite integral (accumulation of quantities and the areas under curves) .

Calculus is widely used in economics and has the ability to solve many problems that algebra cannot. In economics, calculus is used to study and record complex information – commonly on graphs and curves. Calculus allows for the determination of a maximal profit by providing an easy way to calculate marginal cost and marginal revenue. It can also be used to study supply and demand curves.

Common Mathematical Terms

Economics utilizes a number of mathematical concepts on a regular basis such as:

• Dependent Variable: The output or the effect variable. Typically represented as
  , the dependent variable is graphed on the
  -axis. It is the variable whose change you are interested in seeing when you change other variables.
• Independent or Explanatory Variable: The inputs or causes. Typically represented as , ,
  , etc., the independent variables are graphed on the
  -axis. These are the variables that are changed in order to see how they affect the dependent variable.
• Slope: The direction and steepness of the line on a graph. It is calculated by dividing the amount the line increases on the
  -axis (vertically) by the amount it changes on the
  -axis (horizontally). A positive slope means the line is going up toward the right on a graph, and a negative slope means the line is going down toward the right. A horizontal line has a slope of zero, while a vertical line has an undefined slope. The slope is important because it represents a rate of change.
• Tangent: The single point at which two curves touch. The derivative of a curve, for example, gives the equation of a line tangent to the curve at a given point.

1.5.2: Assumptions

Economists use assumptions in order to simplify economics processes so that they are easier to understand.

Learning Objective

Assess the benefits and drawbacks of using simplifying assumptions in economics

Key Points

• Neo-classical economics employs three basic assumptions: people have rational preferences among outcomes that can be identified and associated with a value, individuals maximize utility and firms maximize profit, and people act independently on the basis of full and relevant information.
• An assumption allows an economist to break down a complex process in order to develop a theory and realm of understanding. Later, the theory can be applied to more complex scenarios for additional study.
• Critics have stated that assumptions cause economists to rely on unrealistic, unverifiable, and highly simplified information that in some cases simplifies the proofs of desired conclusions.
• Although simplifying can lead to a better understanding of complex phenomena, critics explain that the simplified, unrealistic assumptions cannot be applied to complex, real world situations.

Key Terms

simplify

To make simpler, either by reducing in complexity, reducing to component parts, or making easier to understand.

assumption

The act of taking for granted, or supposing a thing without proof; a supposition; an unwarrantable claim.

As a field, economics deals with complex processes and studies substantial amounts of information. Economists use assumptions in order to simplify economic processes so that it is easier to understand. Simplifying assumptions are used to gain a better understanding about economic issues with regards to the world and human behavior .

Simple indifference curve

An indifference curve is used to show potential demand patterns. It is an example of a graph that works with simplifying assumptions to gain a better understanding of the world and human behavior in relation to economics.

Economic Assumptions

Neo-classical economics works with three basic assumptions:

1. People have rational preferences among outcomes that can be identified and associated with a value.
2. Individuals maximize utility (as consumers) and firms maximize profit (as producers).
3. People act independently on the basis of full and relevant information.

Benefits of Economic Assumptions

Assumptions provide a way for economists to simplify economic processes and make them easier to study and understand. An assumption allows an economist to break down a complex process in order to develop a theory and realm of understanding. Good simplification will allow the economists to focus only on the most relevant variables. Later, the theory can be applied to more complex scenarios for additional study.

For example, economists assume that individuals are rational and maximize their utilities. This simplifying assumption allows economists to build a structure to understand how people make choices and use resources. In reality, all people act differently. However, using the assumption that all people are rational enables economists study how people make choices.

Criticisms of Economic Assumptions

Although, simplifying assumptions help economists study complex scenarios and events, there are criticisms to using them. Critics have stated that assumptions cause economists to rely on unrealistic, unverifiable, and highly simplified information that in some cases simplifies the proofs of desired conclusions. Examples of such assumptions include perfect information, profit maximization, and rational choices. Economists use the simplified assumptions to understand complex events, but criticism increases when they base theories off the assumptions because assumptions do not always hold true. Although simplifying can lead to a better understanding of complex phenomena, critics explain that the simplified, unrealistic assumptions cannot be applied to complex, real world situations.

1.5.3: Hypotheses and Tests

Economics, as a science, follows the scientific method in order to study data, observe patterns, and predict results of stimuli.

Learning Objective

Apply the steps of the scientific method to economic questions

Key Points

• The scientific method involves identifying a problem, gathering data, forming a hypothesis, testing the hypothesis, and analyzing the results.
• A hypothesis is simply a prediction.
• In economics, extensive testing and observation is required because the outcome must be obtained more than once in order to be valid.
• Cause and effect relationships are used to establish economic theories and principles. Over time, if a theory or principle becomes accepted as universally true, it becomes a law. In general, a law is always considered to be true.
• The scientific method provides the framework necessary for the progression of economic study.

Key Term

hypothesis

An assumption taken to be true for the purpose of argument or investigation.

Economics, as a science, follows the scientific method in order to study data, observe patterns, and predict results of stimuli.

There are specific steps that must be followed when using the scientific method . Economics follows these steps in order to study data and build principles:

Scientific Method

The scientific method is used in economics to study data, observe patterns, and predict results.

1. Identify the problem – in the case of economics, this first step of the scientific method involves determining the focus or intent of the work. What is the economist studying? What is he trying to prove or show through his work?
2. Gather data – economics involves extensive amounts of data. For this reason, it is important that economists can break down and study complex information. The second step of the scientific method involves selecting the data that will be used in the study.
3. Hypothesis – the third step of the scientific method involves creating a model that will be used to make sense of all of the data. A hypothesis is simply a prediction. What does the economist think the overall outcome of the study will be?
4. Test hypothesis – the fourth step of the scientific method involves testing the hypothesis to determine if it is true. This is a critical stage within the scientific method. The observations must be tested to make sure they are unbiased and reproducible. In economics, extensive testing and observation is required because the outcome must be obtained more than once in order for it to be valid. It is not unusual for testing to take some time and for economists to make adjustments throughout the testing process.
5. Analyze the results – the final step of the scientific method is to analyze the results. First, an economist will ask himself if the data agrees with the hypothesis. If the answer is “yes,” then the hypothesis was accurate. If the answer is “no,” then the economist must go back to the original hypothesis and adjust the study accordingly. A negative result does not mean that the study is over. It simply means that more work and analysis is required.

Observation of data is critical for economists because they take the results and interpret them in a meaningful way. Cause and effect relationships are used to establish economic theories and principles. Over time, if a theory or principle becomes accepted as universally true, it becomes a law. In general, a law is always considered to be true. The scientific method provides the framework necessary for the progression of economic study. All economic theories, principles, and laws are generalizations or abstractions. Through the use of the scientific method, economists are able to break down complex economic scenarios in order to gain a deeper understanding of critical data.

1.5.4: Economic Models

A model is simply a framework that is designed to show complex economic processes.

Learning Objective

Recognize the uses and limitations of economic models

Key Points

• Many models use mathematical techniques in order to investigate, theorize, and fit theories into economic situations.
• Economic models have two functions: 1) to simplify and abstract from observed data, and 2) to serve as a means of selection of data based on a paradigm of econometric study.
• Creating a model has two basic steps: 1) generate the model, and 2) checking the model for accuracy – also known as diagnostics.
• Examples of the uses of economic models include: professional academic interest, forecasting economic activity, proposing economic policy, presenting reasoned arguments to politically justify economic policy, as well as economic planning and allocation.

Key Terms

deductive

Based on inferences from general principles.

diagnostics

The process of determining the state of or capability of a component to perform its function(s).

qualitative

Based on descriptions or distinctions rather than on some quantity.

Economic Models

In economics, a model is defined as a theoretical construct that represents economic processes through a set of variables and a set of logical or quantitative relationships between the two. A model is simply a framework that is designed to show complex economic processes. Most models use mathematical techniques in order to investigate, theorize, and fit theories into economic situations.

Uses of an Economic Model

Economists use models in order to study and portray situations. The focus of a model is to gain a better understanding of how things work, to observe patterns, and to predict the results of stimuli . Models are based on theory and follow the rules of deductive logic.

Economic model diagram

In economics, models are used in order to study and portray situations and gain a better understand of how things work.

Economic models have two functions: 1) to simplify and abstract from observed data, and 2) to serve as a means of selection of data based on a paradigm of econometric study. Economic processes are known to be enormously complex, so simplification to gain a clearer understanding is critical. Selecting the correct data is also very important because the nature of the model will determine what economic facts are studied and how they will be compiled.

Examples of the uses of economic models include: professional academic interest, forecasting economic activity, proposing economic policy, presenting reasoned arguments to politically justify economic policy, as well as economic planning and allocation.

Constructing a Model

The construction and use of a model will vary according to the specific situation. However, creating a model does have two basic steps: 1) generate the model, and 2) checking the model for accuracy – also known as diagnostics. The diagnostic step is important because a model is only useful if the data and analysis is accurate.

Limitations of a Model

Due to the complexity of economic models, there are obviously limitations that come into account. First, all of the data provided must be complete and accurate in order for the analysis to be successful. Also, once the data is entered, it must be analyzed correctly. In most cases, economic models use mathematical or quantitative analysis. Within this realm of observation, accuracy is very important. During the construction of a model, the information will be checked and updated as needed to ensure accuracy. Some economic models also use qualitative analysis. However, this kind of analysis is known for lacking precision. Furthermore, models are fundamentally only as good as their founding assumptions.

The use of economic models is important in order to further study and understand economic processes. Steps must be taken throughout the construction of the model to ensure that the data provided and analyzed is correct.

1.5.5: Normative and Positive Economics

Positive economics is defined as the “what is” of economics, while normative economics focuses on the “what ought to be”.

Learning Objective

Contrast normative and positive statements about economic policy

Key Points

• Positive economics is a branch of economics that focuses on the description and explanation of phenomena, as well as their casual relationships.
• Positive economics clearly states an economic issue and normative economics provides the value-based solution for the issue.
• Normative economics is a branch of economics that expresses value or normative judgments about economic fairness. It focuses on what the outcome of the economy or goals of public policy should be.
• Positive economics does impact normative economics because it ranks economic polices or outcomes based on acceptability (normative economics).

Key Terms

normative economics

Economic thought in which one applies moral beliefs, or judgment, claiming that an outcome is “good” or “bad”.

positive economics

The description and explanation of economic phenomena and their causal relationships.

Positive and normative economic thought are two specific branches of economic reasoning. Although they are associated with one another, positive and normative economic thought have different focuses when analyzing economic scenarios.

Positive Economics

Positive economics is a branch of economics that focuses on the description and explanation of phenomena, as well as their casual relationships. It focuses primarily on facts and cause-and-effect behavioral relationships, including developing and testing economic theories. As a science, positive economics focuses on analyzing economic behavior. It avoids economic value judgments. For example, positive economic theory would describe how money supply growth impacts inflation, but it does not provide any guidance on what policy should be followed. “The unemployment rate in France is higher than that in the United States” is a positive economic statement. It gives an overview of an economic situation without providing any guidance for necessary actions to address the issue.

Normative Economics

Normative economics is a branch of economics that expresses value or normative judgments about economic fairness. It focuses on what the outcome of the economy or goals of public policy should be. Many normative judgments are conditional. They are given up if facts or knowledge of facts change. In this instance, a change in values is seen as being purely scientific. Welfare economist Amartya Sen explained that basic (normative) judgments rely on knowledge of facts.

An example of a normative economic statement is “The price of milk should be $6 a gallon to give dairy farmers a higher living standard and to save the family farm. ” It is a normative statement because it reflects value judgments. It states facts, but also explains what should be done. Normative economics has subfields that provide further scientific study including social choice theory, cooperative game theory, and mechanism design.

Relationship Between Positive and Normative Economics

Positive economics does impact normative economics because it ranks economic policies or outcomes based on acceptability (normative economics). Positive economics is defined as the “what is” of economics, while normative economics focuses on the “what ought to be. ” Positive economics is utilized as a practical tool for achieving normative objectives. In other words, positive economics clearly states an economic issue and normative economics provides the value-based solution for the issue .

Debt Increases

This graph shows the debt increases in the United States from 2001-2009. Positive economics would provide a statement saying that the debt has increased. Normative economics would state what needs to be done in order to work towards resolving the issue of increasing debt.

1.6: Differences Between Macroeconomics and Microeconomics

1.6.1: Macroeconomics

Macroeconomics is the study of the performance, structure, behavior and decision-making of an economy as a whole.

Learning Objective

Define macroeconomics and identify the main users of macroeconomics

Key Points

• For most macroeconomists, the purpose of this discipline is to maximize national income and provide national economic growth.
• The most common macroeconomic topics of study for national entities are sustainability, full employment, price stability, external balance, equitable distribution of income and wealth, and increasing productivity.
• Macroeconomists hope that their models help address two key areas of research: the causes and consequences of short-run fluctuations in national income (otherwise known as the business cycle) and what determines long-run economic growth.

Key Terms

Macroeconomics

The study of the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets.

deflation

A decrease in the general price level, that is, in the nominal cost of goods and services.

inflation

An increase in the general level of prices or in the cost of living.

Macroeconomics is the study of the performance, structure, behavior and decision-making of an economy as a whole . Macroeconomists focus on the national, regional, and global scales. For most macroeconomists, the purpose of this discipline is to maximize national income and provide national economic growth. Economists hope that this growth translates to increased utility and an improved standard of living for the economy’s participants. While there are variations between the objectives of different national and international entities, most follow the ones detailed below:

Circulation in Macroeconomics

Macroeconomics studies the performance of national or global economies and the interaction of certain entities at the these level.

• Sustainability occurs when an economy achieves a rate of growth which allows an increase in living standards without undue structural and environmental difficulties.
• Full employment occurs when those who are able and willing to have a job can get one. Most economists believe that there will always be a certain amount of frictional, seasonal and structural unemployment (referred to as the natural rate of unemployment). As a result, full employment does not mean zero unemployment.
• Price stability occurs when prices remain largely stable and there is not rapid inflation or deflation. Price stability is not necessarily zero inflation; steady levels of low-to-moderate inflation is often regarded as ideal.
• External balance occurs when exports roughly equal imports over the long run.
• Equitable distribution of income and wealth among the economy’s participants. This does not, however, mean that income and wealth are the same for everyone.
• Increasing Productivity over time throughout the national economy.

To achieve these goals, macroeconomists develop models that explain the relationship between factors such as national income, output, consumption, unemployment, inflation, savings, investment and international trade. These models rely on aggregated economic indicators such as GDP, unemployment, and price indices.

On the national level, macroeconomists hope that their models help address two key areas of research:

• the causes and consequences of short-run fluctuations in national income, otherwise known as the business cycle, and
• what determines long-run economic growth.

1.6.2: Microeconomics

Microeconomics deals with the economic interactions of a specific person, a single entity or a company; it is the study of markets.

Learning Objective

Define Microeconomics, Identify the main users of microeconomics

Key Points

• One of the major goals of microeconomics is to analyze the market and determine the price for goods and services that best allocates limited resources among the different alternative uses.
• Microeconomics assumes businesses are rational and produce goods that maximize their profit.
• The science of microeconomics covers a variety of specialized areas of study including: industrial organization, labor economics, financial economics, public economics, political economy, health economics, urban economics, law and economics, and economic history.

Key Terms

microeconomics

That field that deals with the small-scale activities such as that of the individual or company.

Scarcity

an inadequate amount of something; a shortage

Microeconomics deals with the economic interactions of a specific person, a single entity, or a company. These interactions, which mainly are buying and selling goods, occur in markets. Therefore, microeconomics is the study of markets. The two key elements of this economic science are the interaction between supply and demand and scarcity of goods .

Supply and Demand Graph

Microeconomics is based on the study of supply and demand at the personal and corporate level.

One of the major goals of microeconomics is to analyze the market and determine the price for goods and services that best allocates limited resources among the different alternative uses. This study is especially important for producers as they decide what to manufacture and the appropriate selling price. Microeconomics assumes businesses are rational and produce goods that maximizes their profit. If each firm takes the most profitable path, the principles of microeconomics state that the market’s limited resources will be allocated efficiently.

The science of microeconomics covers a variety of specialized areas of study including:

• Industrial Organization: the entry and exit of firms, innovation, and the role of trademarks.
• Labor Economics: wages, employment, and labor market dynamics.
• Financial Economics: topics such as optimal portfolios, the rate of return to capital, and corporate financial behavior.
• Public Economics:the design of government tax and expenditure policies.
• Political Economics: the role of political institutions in policy.
• Health Economics: the organization of health care system.
• Urban Economics: challenges faced by cities, such as sprawl, traffic congestion, and poverty.
• Law and Economics: applies economic principles to the selection and enforcement of legal regimes.
• Economic History: the history and evolution of the economy.

1.6.3: Key Differences

Microeconomics focuses on individual markets, while macroeconomics focuses on whole economies.

Learning Objective

Recognize questions addressed by microeconomics and macroeconomics

Key Points

• Microeconomics and macroeconomics both focus on the allocation of scarce resources. Both disciplines study how the demand for certain resources interacts with the ability to supply that good to determine how to best distribute and allocate that resource among many consumers.
• Microeconomics studies the behavior of individual households and firms in making decisions on the allocation of limited resources. Another way to phrase this is to say that microeconomics is the study of markets.
• Macroeconomics is generally focused on countrywide or global economics. It studies involves the sum total of economic activity, dealing with the issues such as growth, inflation, and unemployment.
• There are some economic events that are of great interest to both microeconomists and macroeconomists, but they will differ in how and why they analyze the events.

Key Terms

Macroeconomics

The study of the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets.

microeconomics

The study of the behavior of individual households and firms in making decisions on the allocation of limited resources.

inflation

An increase in the general level of prices or in the cost of living.

Stemming from Adam Smith’s seminal book, The Wealth of Nations, microeconomic and macroeconomics both focus on the allocation of scarce resources . Both disciplines study how the demand for certain resources interacts with the ability to supply that good to determine how to best distribute and allocate that resource among many consumers. Both disciplines are about maximization: microeconomics is about maximizing profit for firms, and surplus for consumers and producers, while macroeconomics is about maximizing national income and growth.

Adam Smith, Founding Father of Economics

Adam Smith’s book, Wealth of Nations, was the basis of both microeconomic and macroeconomic study.

The main difference between microeconomics and macroeconomics is scale. Microeconomics studies the behavior of individual households and firms in making decisions on the allocation of limited resources. Another way to phrase this is to say that microeconomics is the study of markets.

In contrast macroeconomics involves the sum total of economic activity, dealing with the issues such as growth, inflation, and unemployment. Macroeconomics is the study of economies on the national, regional or global scale.

This key difference alters how the two approach economic situations. Microeconomics does consider how macroeconomic forces impact the world, but it focuses on how those forces impact individual firms and industries. While macroeconomists study the economy as a whole, microeconomists are concerned with specific firms or industries.

Many economic events that are of great interest to both microeconomist and macroeconomists, though they differ in how they analyze those events. A shift in tax policy would interest economists in both disciplines. A microeconomist might focus on how the tax might shift supply in a specific market or influence a firm’s decision making, while the macroeconomist will consider whether the tax will translate into an improved standard of living for all of the economy’s participants.

13.2: Effective Informative Speaking

13.2.1: The Goals of an Informative Speech

Learning Objective

List the goals of an informative speech

Key Points

• One of the goals of an informative speech is to enhance the understanding of the audience.
• Another goal of an informative speech is to maintain the interest of the audience.
• A final goal of an informative speech is for the audience to remember the speech.

Key Terms

goal

A result that one is attempting to achieve.

inform

To communicate knowledge to others.

An effective informative speech requires the speaker to aim for a series of goals. And similar to a soccer match, hitting these goals increases the likelihood of a successful speech. The main goals for an informative speech are to help explain a specific subject and to help the audience remember the knowledge later.

Setting Goals

You need to determine a series of goals in order to create a successful informative speech.

A poster at the United Nations Headquarters in New York City, New York, showing Millennium Development Goals.

One of the goals, perhaps the most essential goal that drives all informative speeches, is for the speaker to inform the audience about a particular topic. In order to aim for this specific goal, a speaker should consider how best to package the complex understanding that they have cultivated of the topic, from personal experience and research, into an easily communicable form for the audience.

A final, significant goal an effective informative speech is to make the audience remember. Most memorable speeches have emotional appeals that audiences continue to talk about long after the speech is delivered, and sometimes even after the life of the speaker. To make sure that the information contained in a speech is remembered by the audience, the deliverer of an informative speech should combine organization, repetition and focused visualizations to increase the effectiveness of the speech and the likelihood that the audience will leave informed.

One way to help an audience remember the details of an informative speech is to maintain the interest of the audience. The challenge of an informative speech is delivering information in a neutral way that does not bore the audience. Unlike persuasive speeches, which rely heavily on emotional appeal, informative speeches have to demonstrate why the audience should care about the information contained in the speech without compromising a neutral tone.

13.2.2: Scoping Your Speech

Learning Objective

Explain how to effectively scope an informative speech

Key Points

• Every piece of information in a speech should relate to the speech topic, purpose, and thesis simultaneously.
• Audiences have a hard time following or understanding speeches that are too broad in scope (that is, speeches that include too much irrelevant or tangential information).
• By keeping all of the information relevant as he or she develops your speech, the speaker’s job becomes easier by keeping all supporting information on point.

Key Term

scope

The extent of the area or subject matter that something deals with or to which it is relevant.

Some speeches contain such a wide range of information that the audience is left wondering what the speaker was trying to communicate. A speech with a scope that is too broad complicates the audience’s ability to retain information. Properly scoping your speech allows the speaker to narrow down what the speech will cover, thus increasing its ability to inform the audience.

Scope Out a Specific Target

Every piece of information in a speech should be relevant to the topic, purpose and thesis. If it’s only a tangent, it doesn’t belong in the speech.

Scope refers to the extent of the area or subject matter that something deals with or to which it is relevant. The key word here is relevance; the speech should not go in so many different directions that none of those directions relate to the original purpose and thesis of the speech.

One way to effectively scope a speech is to think of the question: “What information do I want my audience to know at the end of the speech? ” Use the answer to this question as a focal point for everything else to be included in your speech. Everything included then must be relevant to your purpose and thesis. Anything superfluous or extraneous is only going to broaden the scope and take the speech away from that ultimate goal.

The evidence and supporting arguments should not only be related tangentially; there should be direct lines of relevance to every piece of information included in your speech.

Scoping a speech is not only helpful for the audience, but is also to the benefit of the speaker. Keeping the speech on point and focused makes it easier for the speaker to build more credible, reinforced arguments. By narrowing the scope of the speech, the speaker improve the speech’s ability to effectively communicate essential information to the audience.

13.2.3: Tailor Complexity to Your Audience

Learning Objective

Apply knowledge of your audience when composing your speech

Key Points

• Consider the audience that will be hearing your speech.
• Tailoring the complexity of the speech to your audience means considering how best they receive information.
• Considering how much information your audience already knows should help you tailor the complexity of your speech.

Key Term

complexity

The state of being complex; intricacy; entanglement.

Overview

The main goals for an informative speech are to help explain a specific subject and to help the audience remember the knowledge later. To achieve these goals, a speaker should consider how best to package the complex understanding that they have cultivated of the topic, from personal experience and research, into an easily communicable form for the audience.

Complexity

One way to deliver an effective informative speech and ensure that the audience leaves your speech informed is to tailor the complexity of the speech to the specific audience.

Consider the Audience

The speaker should tailor the complexity of the speech to the specific audience.

An audience listens to a speech.

Never presume that your audience has a lot of background knowledge on your subject, but also don’t assume they know nothing. The audience is an integral part of public speaking; not only will they hear your speech, but they should be an important component that informs the writing of the speech as well. Consider, for example, if you are preparing to deliver an informative speech on the topic of cloning to an audience of geneticists. Their professional training will have given them an extensive understanding of DNA. Because of this, you would want to tailor the complexity of the speech to match the knowledge that the audience already possesses, meaning that the speech could contain lots of technical terms with little explanation because the audience will already understand what those terms mean.

Conversely, consider delivering a speech on the same topic to an audience of college students. This audience, even if they have taken biology classes, will not possess the same expertise knowledge that professionals do. Therefore, you would want to tailor the complexity of your speech to the knowledge of the students, using fewer technical terms and more general explanations.

13.2.4: Demonstrate the Relevance of the Topic

Learning Objective

Choose a topic that is relevant to your audience

Key Points

• You can make a topic relevant by choosing a timely topic.
• Another way to make a topic relevant is to tell the audience why they should care about the particular subject of your speech.
• Making a topic relevant for your audience increases the likelihood that they will remember the information contained in your speech.

Key Term

relevant

Not out of date; current.

Overview

Informative Speaking is a speech meant to inform the audience. This speech can take on topics ranging from the newest, high-tech inventions from around the world that hope to cure cancer, to more light-hearted topics. The topic should be one that is timely and interesting.

In order to improve the likelihood that the audience will walk away informed by your speech, you should make your topic relevant. The topic of an informative speech should be one that is timely. This means that what was a good topic for a speech for Teddy Roosevelt is probably no longer going to be a good topic for a speech given now. A relevant topic is one that is appropriate for the contemporary period. This is because the information that an informative speech contains should be the most recent, whether this information is statistical data or just the state of the conversation around a particular topic.

Choose a Relevant Topic

Although Theodore Roosevelt was a great speaker, giving a speech about him today might not be relevant.

Another way to consider how to make the topic of a speech relevant is to consider the audience who will hear your speech. Ask yourself, “What topic would the audience find interesting or useful? ” If you feel committed to a particular topic, then begin thinking about how you can demonstrate why the topic is relevant to your audience. Doing this requires that you articulate why they should care about your chosen topic. But remember that an informative speech should try to communicate this in an unbiased way that does not rely heavily on emotional appeals.

13.2.5: Make Connections

Learning Objective

Explain how to make connections in your speech

Key Points

• Make connections among your ideas so you can connect the ideas into meaningful groups for your main points.
• Make connections between your interests and the audience interests to motivate attention during your speech.
• Make connections with transitions to show relationships and join ideas together.
• Make connections with signpost transitions to help the audience organize ideas by numbering the main points, such as first, second, etc.
• Make connections by using previews before main points and use internal summaries to connect one idea to what is coming next.

Key Terms

connection

The point at which two or more things are connected; a feeling of understanding and ease of communication between two or more people.

signpost

A particular type of transition in the form of a brief statement that indicates where the speaker is in the speech, such as “first” and “finally,” or that calls attention to a key idea, such as “now remember this.”

transitions

Words or phrases that allow the reader to understand how adjacent parts of a communication are connected.

Make connections like the old time switchboard operator.

In order to make your informative speech effective, you can think of yourself as the old time switchboard operator and make connections!

Connecting Information

In your speech, you should make connections between pieces of information for your audience.

A switchboard staff making connections in 1979.

Connect ideas and content when preparing the speech. After researching and collecting information for your speech, you will need to connect the ideas and different pieces of information into an organized message. You will group similar ideas together and connect them to form the main points of your speech. In addition to making connections between ideas and pieces of information, one of the most important connections is that between the speech and the audience.

Connect the topic to audience interests. There are many ways to establish this fundamental connection. One of the ways is to explain why the topic of the speech is important. This might occur in the introduction of the speech where you lay out what your speech will say. In addition to laying out the trajectory of the speech, you would include an additional explanation of why the topic is relevant to the audience. Another way to make the connection between the speech and the audience is to express your own interest in the topic. Demonstrating your own excitement could help the audience connect with you and your ideas.

Connect the ideas in the speech with transitions. Transitions are certain words, expressions, or other devices that give text or speech greater cohesion by making it more explicit, or signaling how ideas are meant by the writer or speaker to relate to one another. Transitions can signal addition, example, contrast, comparison, concession, result, summary, time (often chronologically), and place. The following are examples of transitional words and phrases: last, first, second, next, but, on the other hand, moreover, in addition, furthermore, however, to begin with, otherwise, conclusively, lastly, secondly, thirdly, most importantly, in conclusion, to end with, first of all, last of all, to sum it up, last but not least, lastly, finally, for example, on top of all, ultimately, or nevertheless.

Connect the important ideas with signposts. Signposts are a particular type of transition in the form of a brief statement that indicates where the speaker is in the speech, such as first and finally. You use signpost transitions to help the audience organize ideas when you number the main points, such as first, second, etc. You will also use signposts transitions to help the audience remember ideas by telling them what is important by directing their attention to an idea or concept. For example, you might saynow get this, this is really important, or now remember this when you want to signpost the attention of the audience.

Connect ideas with internal previews and summaries. Often you will devote more time to connecting ideas than a simple word or phrase. You may provide a short introductory preview of what you are going to be talking about in order to prepare the audience for what will come next. Additionally, you may want to summarize what you have just said to connect one main point to the next before you start talking about your next point.

13.2.6: Tailor Abstraction to Your Audience

Learning Objective

Use concrete terminology and abstract terminology when it is appropriate for your audience

Key Points

• The ability to simplify experiences with a word makes it easier to communicate, but it also makes us lose the connection to the specific meaning that we want to convey through the abstract wording.
• When you want the audience to make a concrete connection to their direct experience, remember to come down to earth on the the abstraction ladder. You can move up the ladder again to talk about boarder concepts.
• Your objective when choosing words is not to avoid abstract general words altogether, but rather to avoid using them when your audience needs more specific,concrete connections to what you are saying.

Key Term

abstraction

The act of comparing commonality between distinct objects and organizing using those similarities.

Abstraction and the Abstraction Ladder

Abstraction is the process of perceiving similarities from our direct, specific observations in the universe, organizing the similarities, and then assigning a word label for the more general concept. The ability to simplify experiences with a word makes it easier to communicate, but it also makes us lose the connection to the specific meaning that we want to convey through the abstract wording.

Abstraction, the Process

I see a number of different objects and I see something similar about all of them, let’s say the color. I take this one characteristic, the color, and give it a label, for example, red. Here I have a direct observable experience with the objects and I see the color in them. I abstract the color and give it the label red. For you my label red is not connected with the objects I saw, but you may see similar objects and learn to assign the same label, red, to the color. We group together all the similar experiences to form a higher-level concept, which includes all the specific, individual observations we are engaging in abstraction.

Abstraction Ladder, the Concept

S. I. Hayakawa explained the concept using a ladder . Hayakawa used his cow Bessie to illustrate the four levels of abstraction from highest level four at the top to lowest at the bottom.

Ladder

Think of abstraction as a ladder. The most specific and direct experiences are at the bottom, while each step above is more abstract.

• 4 – Wealth
• 3 – Farm Asset
• 2 – Cattle
• 1 – Bessie, my cow

Lets look at another example with clothing. Level one is very specific, such as Levi 501. Moving up to level two, you have noun categories, such as clothing. Moving up a level, you have a broad noun class or group names such as manufactured goods or industry. Finally, at the top level, you have even more abstract concepts such as power, beauty, and casualness.

Almost anything can be described either in relatively abstract, general words or in relatively concrete, specific ones. You may say that you are writing on a piece of electronic equipment, or that you are writing on a laptop computer. You may say that your company produces consumer goods, or that it makes cell phones. When groups of words are ranked according to degree of abstraction, they form hierarchies.

Tailor the level of abstraction to the specific content and the audience level of

understanding

.

Using Concrete, Specific Words for Clarity

In general, as you move from one level to another while speaking, you will tailor the level of abstraction to the specific speech content and the audience level of understanding. You can increase the clarity, and therefore the usability, of your speaking by using concrete, specific words rather than abstract, general ones. Concrete words help your audience understand precisely what you mean. If you say that you want to produce television shows for a younger demographic segment, they won’t know whether you mean teenagers or toddlers. If you say that you study natural phenomena, your audience won’t know whether you mean volcanic eruptions or the migrations of monarch butterflies. Such vagueness can hinder audience from getting the information they need in order to make decisions and take action. When you want the audience to make a concrete connection to their direct experience, remember to come down to earth on the the abstraction ladder. You can move up the ladder again to talk about boarder concepts.

For example, you will draw heavily on level one to create images of specific people, places, or things in the minds of your audience. You may move up and down the level of abstraction as needed. For example, if you are talking about a top-level abstraction such as transportation, you may need to make it real for the audience by describing actual means of transportation such as your green mountain bike for city use or your blue and silver BMW for longer trips.

Abstract and general terms do have important uses for different audiences and occasions. For example, in scientific, technical, and other specialized fields, speakers often need to make general points, describe the general features of a situation, or provide general guidance for action.

Use abstract and specialized terminology to communicate

messages

economically.

Specialized, abstract terminology only works when your audience will understand them. You can use the specialized terminology of a particular profession or group if you know that they already have specific connections to the more abstract terminology. With audiences who understand the abstractions, the technical meanings can communicate messages economically with fewer words than if you started with specific instances at the bottom of the abstraction ladder.

Your objective when choosing words is not to avoid abstract general words altogether, but rather to avoid using them when your audience needs more specific, concrete connections to what you are saying.

13.2.7: Make It Memorable

Learning Objective

List ways to make your speech memorable for your audience

Key Points

• Use visual aids to help make your speech memorable.
• Repeat key points of your speech to make it more memorable.
• Making your speech memorable is important because it increases the likelihood that the audience will walk away informed.

Key Term

memorable

Worthy to be remembered; very important or remarkable.

Remember that the goal of an informative speech is to inform the audience . Ideally, not only are they informed while you are speaking, but they actually retain that information after you have left the podium. In order for this to happen, you have to make your speech memorable.

Memorable Speech

Making your informative speech memorable increases the likelihood that your audience will retain the information.

An audience clapping at a conference.

There are multiple ways to make your speech memorable. One way to do this is to repeat the key information that you want the audience to remember. This means repeating important information, within reason, throughout the speech. Lay out the important keys in the introduction of the speech, reiterate them in the body of the speech, and then repeat them again in the conclusion.

Another way to make your speech memorable is to use visual aids. Visual aids have the advantage of providing the information of your speech in an easily digestible form. In addition, visualizations have the ability to be uniquely captivating. Having an attractive visual can get the attention of the audience and improve the chances that they will remember the information contained in the visualization.

Though there are many ways to make an informative speech memorable, another way is to let yourself be engaged in the presentation of the speech. Demonstrating your own excitement by the speech’s topic has the possibility of drawing in the audience. If the speaker seems uninterested in the speech, then why should the audience be engaged? Therefore, let yourself be absorbed and excited by the speech, which might lure in the audience and make the speech more memorable.

These are just a few ways to make your speech memorable. Remember, the goal of making an informative speech memorable is to increase the likelihood that your audience will walk away informed. Using visual aids and repetition of key points are two strategies to use in order to deliver an effective informative speech.

13.2.8: Utilizing Devices to Enhance Audience Understanding

Learning Objective

Describe the use of devices in public speaking

Key Points

• Visual aids such as graphs, handouts, slide show presentations, and objects can help audiences understand complicated subjects. Many people learn visually and need information provided in this context, as well as orally, to enhance learning.
• A podium can help the presenter provide the audience with necessary information on a topic by offering a place for the speaker to have cue cards or scripts.
• A microphone is a good way to make sure that everyone in the audience hears the presentation properly. Wireless headsets allow the speaker to amplify the presentation while moving about the audience or reviewing visual aids.
• A video screen is a good way to make sure the audience can see the entire presentation in a large venue.

Key Term

podium

A platform on which to stand, as when conducting an orchestra, preaching at a pulpit, or delivering a speech.

Utilize Devices to Enhance Audience Understanding

Visual Aid

Using a visual aid, like a large-screen digital projector, helps inform the audience.

Speakers at the re:publica XI visual language conference are showcasing their designs by using a large-screen digital projector.

Visual Aids

Many people need the assistance of visual material to understand complicated topics. Visual aids help the speaker reinforce the information provided in the speech to increase absorption and retention of the material. Visual aids can include objects, models, handouts, graphs, charts, photos, and slide show presentations. With visual aids, a speaker needs to make sure they adequately enhance the presentation without causing a distraction for the audience.

Podium/Rostrum

A podium can help an audience understand a speech. It allows the speaker to have notes or scripts to make sure the important information is covered regarding the subject matter. Additional information can be included in the notes so that if the audience has any questions the speaker can make sure they provide a complete answer.

Amplification

Amplification is important to make sure that the entire audience can hear the speech properly. Some large auditoriums and amphitheaters are designed to assist acoustics. Still, a microphone is a beneficial addition to a speaker’s toolkit. With the advancements in wireless technology, a headset can also be used, enabling the speaker to move about during the presentation, go over visual aids, or enter the audience during the question and answer session.

Video Screens

Video screens are beneficial for an audience, especially those who are seated in a large venue. The screens can help the audience see the speaker and the visual aids better, especially if they are in the back of the room or off to the far right or far left of the stage. Video screens are often available at modern conference centers and auditoriums that can be synced with presentation devices.

With the addition of visual aids, podiums, microphones, and video screens, a presenter can ensure that the audience is able to see, hear, and understand the material properly. When determining the type of visual aids needed for a speech, the speaker needs to consider the subject matter, audience, and venue so that the right materials are used to enhance audience understanding.

18.2: Presenting Group Thinking

18.2.1: Group Presentation Formats

Learning Objective

Define four formats of group presentations

Key Points

• A panel format is a discussion between group members led by a moderator.
• A divided presentation is a sequence of individual presentations by group members.
• A debate format presents two sides of an issue and reasons for and against each side.

Key Terms

forum

A form of discussion involving a panel of presenters and often participation by members of the audience.

symposium

A conference or other meeting for discussion of a topic, especially one in which the participants make presentations.

format

The form of presentation of something.

Group presentations can take place in different formats. These formats give a group an idea of how to structure their presentation, though different components can be taken from several formats and combined according to a group’s particular needs and goals.

Panel Presentation

A panel is a format in which the presenters talk to each other in addition to the audience. Typically the panel will consist of several group members to whom a moderator poses questions. The panel members then present their views on the question and discuss their different answers. The audience has the benefit of viewing this dynamic discussion play out before them. Often questions will also be taken from the audience, so audience members can become involved in the discussion as well. However, with such loose organization, the moderator must maintain control over the presentation and keep the group on topic .

Panel Discussion

In an panel discussion, the panel members talk to one another as well as the audience.

Symposium

A symposium presentation is a group presentation that is essentially a collection of individual presentations covering a broad topic. The topic is broken up into subtopics, and each group member, one after another, makes a presentation on his or her subtopic. All together, the group covers the topic in its entirety. This format is very easy to organize and coordinate as long as each group member remains cognizant of not addressing a different member’s subtopic. Since this method can make for a long presentation, the group members must concentrate on engaging the audience and keeping their attention.

Public Forum

Public forum debate can be compared to a nationally-televised debate, such as ‘Crossfire’ in which the debaters argue a topic. The debate in a public forum is conducted by teams of two people alternating speeches for their side, either affirming or negating their topic. Successful public forum debaters must make persuasive and logical arguments in a manner that is accessible to a wide variety of audiences. Public forum debate also focuses on not only logical, but research based arguments.

Oral Report by Group Leader

In this format, the designated leader of a group makes an individual presentation of the group’s thoughts and findings on a topic. The leader may summarize views from several different group members and present points of agreement and disagreement.

18.2.2: Thoughts for Group and Individual Presenters

Learning Objective

Demonstrate how to each individual in a group should participate in a group presentation

Key Points

• The first speaker should introduce the entire presentation. After that, each speaker should introduce the next and transition with a preview of their topic.
• Each presenter should make eye contact with the audience and move to the front of the group when it is his or her turn to speak. The last speaker should then conclude the entire presentation.
• When preparing the presentation, the group should check each individual’s work for consistency of information and formatting. Group members should answer audience questions as a team with no one member dominating.

Key Terms

transition

The process of change from one form, state, style, or place to another.

consistency

correspondence or compatibility

There are several important considerations for an individual to keep in mind to help a group presentation succeed.

Choosing Roles

The instructor may require every person to speak during the presentation. However, if you are given a choice of how many speakers to include, decide which group members will speak and which ones will not. Because it is important for every student to develop strong knowledge of presenting, every member could benefit from speaking. Any members who do not present should be given other significant responsibilities .

Group Presentation

In a group presentation, all of the members will have a specific role.

Members of a group speak during a Tuskegee Airmen presentation.

Group Introduction

The first speaker should open with an introduction to the whole presentation rather than an introduction to only his or her part. This group introduction makes the presentation as a whole accessible to the audience. It introduces the group members, establishes goodwill between speakers and the audience, motivates them to listen, and previews all the talks.

Transitions between Speakers

Each speaker should identify the next speaker by name and signal that person’s topic. Changing speakers without such a spoken transition can break the flow of the presentation, and it may leave the impression that you are unprepared or that your presentation is unorganized. A transition should remind the audience of the sequence the group introduction promised. It should help listeners know where they are in the presentation as a whole. Transitions may also emphasize any special qualifications of the next speaker.

Internal Previews

Each individual speaker except the first should connect his or her part to the overall argument and tell the audience what topics he or she will discuss. Such statements identify the structure of the talk and help the audience follow along.

Group Conclusion

The last speaker should present a conclusion for the whole presentation rather than just a conclusion for his or her part. The last speaker is responsible for ensuring that the series of talks is comprehensible as a whole. He or she should summarize briefly the key points, motivate the audience to act, or reinforce the group’s interpretation of the issue with a memorable closing statement.

Move to the Front to Speak

If all the group members remain standing during the presentation, each one should move to the front of the room when it is his or her time to speak. Moving to the front will non-verbally draw the audience’s attention to the speaker.

Connect with the Audience through Eye Contact

In a team presentation, every individual speaker needs to develop rapport with the audience. Since each person has only a short time to connect with the audience, eye contact and introductions are especially important. Speakers should stand where they can see the computer screen, the audience, and, if possible, other team members.

Check for Overlaps, Accuracy, and Consistency

Since group members often prepare their parts of the presentation individually, it is necessary to check for overlapping or contradictory information once the individual parts are assembled. Although the first and last speakers cover the presentation as a whole, the speakers in the middle should not re-present evidence unless new analysis is involved. A speaker should build on what the previous speaker said—not merely repeat it.

Check for Consistent Formatting

All handouts or visuals should use the same formatting. A patchwork of different fonts, font sizes, and other formatting conventions may negatively impress the audience, distract or mislead them, and undermine the group’s credibility.

Answering Questions as a Team

The person who speaks first should act as the leader during Q&A. He or she should direct questions to the team member who knows most about the topic of the question and should therefore answer first. The leader should not dominate Q&A. Other team members may unobtrusively signal that they would like to contribute to the answer when the first person finishes.

18.2.3: Preparing for Team Presentations

Learning Objective

Define the processes that describe the dynamics of group thinking and team presentations

Key Points

• The model for understanding team processes can be grouped into three categories: transition, action, and interpersonal.
• Teamwork processes examine interpersonal interactions between group members, which can be used as strategies for successful presentations.
• Another approach to the dynamics of a team presentation involves looking specifically at the strategies that guide interactions between group members throughout the team effort.
• Establishing ground rules, coordinating meeting times, and effectively resolving disputes are some methods used to build effective teams and group presentations.

Key Terms

process

A series of events to produce a result, especially as contrasted to product.

strategy

A plan of action intended to accomplish a specific goal.

Preparing for Team Presentations

The way a team prepares for a presentation can be broken down into formal processes and interactions. This is not a strict distinction, but two different ways of analyzing how a team achieves its goals while building, practicing, and delivering a presentation.

Processes

Researchers have identified ten teamwork processes divided into three categories, which can be used to describe the dynamics of group thinking and team presentations.

Transition processes are reflective in nature, and take place between periods of action. They serve to assess previous actions and outline future actions. In team and group presentations, these processes can serve to:

• Determine what the team is trying to achieve, and what steps will lead there.
• Specify the incremental goals and accomplishments that will lead to overall mission success.
• Formulate an approach to achieving the goals and mission.

Action processes embody the steps that the group takes to move forward. Whether during preparation or delivery of a presentation, these actions are crucial to working effectively in a team. Team members within groups must:

• Monitor progress toward goals and make sure the team is on track, rather than veering off course.
• Assure that roles and responsibilities are being fulfilled.
• Monitor and backup behavior to ensure that all members remain engaged.
• Coordinate roles to keep things organized and working smoothly.

Interpersonal processes apply during the delivery of group presentations, while team member both present and transition between roles (e.g., speaker and observer). They include:

• Identifying and resolving disputes.
• Motivating and building confidence, while maintaining high member performance.
• Making sure group member participation steers rather than stalls the development and delivery of the presentation.

Interactions

Another approach to the dynamics of a team presentation involves looking specifically at the strategies that guide interactions between group members throughout the team effort. Examples of strategies for interaction include:

Group Interactions

Timing transitions between slides and other breaks is crucial to a well-prepared group presentation.

Three members of a group stand together and give a presentation.

• Establishing ground rules: Establishing ground rules sets expectations for each group member on how the group plans to achieve its end goal (e.g, educate students, sell a product to prospects, etc). Making these rules explicit helps avoid miscommunication at the beginning of the project.
• Mission analysis:This strategy ensures every team member has contact information for the others, and that everyone’s schedule is coordinated for meeting times. At a higher level, it means achieving consensus on how group decisions will be made and how group information will be shared with all team members.
• Managing team cooperation: This strategy applies to group meetings. It focuses on outlining an intention for each meeting, and reviewing meeting activities and actions to ensure the intention has been met.
• Resolving conflict: Resolving conflict requires the group to acknowledge that there is a legitimate conflict. The group must then agree on an approach to address it, and determine how to proceed. Possible solutions include discussing a compromise, referring to previously established group decisions, or deciding to address the issue later.
• Preparing Back-ups: Practicing transitions between group members’ sections, preparing extra copies of handouts and other visual aids, and reviewing group members’ roles are all part of this strategy. This helps improve preparation and the delegation of tasks within the group.

16.2: Types of Sensory Enhancements

16.2.1: Physical Objects and Animations

Learning Objective

Indicate when using physical and animate objects is appropriate in presentations

Key Points

• Choosing the appropriate object for a presentation depends on the speaker’s preference, as well as the content and setting of the presentation.
• Ultimately, objects should enhance rather than detract from a presentation.
• Using physical objects is often necessary when demonstrating how to do something so that the audience can fully understand the procedure or process.

Key Terms

LCD

A flat panel display, electronic visual display, or video display that uses the light modulating properties of liquid crystals. Liquid crystals do not emit light directly.

prop

An item placed on a stage or set to create a scene or scenario in which actors perform. Contraction of “property”.

Physical and Animate Objects

In today’s media-driven world, public speakers have a plethora of visual aids to choose from when augmenting their presentations. From LCD projections to flip charts, visual aids help presenters inform and persuade audiences, as well as help them understand the presentation topic. Physical and animate objects can also help integrate the verbal and visual elements of the speaker’s presentation into one unified and memorable message.

Using Objects

Physical and animate objects can help audiences better understand the topics being presented.

Ron Davis holds a lightbulb box at the EcoCampus Dedication.

Objects as Visual Aids

Ultimately, objects should enhance rather than detract from a presentation. The use of objects as visual aids involves using actual objects as live demonstrations or props for the audience. For example, a speech about tying knots would be more effective by bringing a rope. Using physical objects is often necessary when demonstrating how to do something so that the audience can fully understand the procedure or process.

The use of physical and animate objects in formal presentations is the same as in stage acting where actors use still and animated props. For the objects to be as effective as possible, they must be positioned in a way where they are quickly detected and easily understood by the audience. A common mistake involves placing an object where it is obstructed or hidden from view, or in front of a more interesting object that divides the audience’s attention. Speakers must also be cognizant of objects that are too large or inconvenient for stage use.

Choosing Objects for Presentations

There are many physical and animate objects available for presentations. Choosing the appropriate visual aids depends on the speaker’s preference, as well as the content and setting of the presentation. Objects can be both beneficial or distracting during speeches. Therefore, presenters should prepare and plan ahead accordingly to ensure that objects are appropriate for the audience and material being presented.

16.2.2: Chalkboards, Flip Charts, and Transparencies

Learning Objective

Distinguish between the use of chalkboards, dry boards, whiteboards and flipcharts during presentations

Key Points

• While chalkboards are typically used in academic settings, universities and organizations employ dry boards for presentations and record-keeping.
• Chalkboards, dry boards, and flipcharts allow for fast, simple and easy use by presenters who may not be familiar or comfortable with presentation software tools.
• Transparencies are used across a wide variety of organizations, allowing for easy note-taking and steady eye contact during presentations.
• Despite its heavy use in academia, transparencies are quickly becoming outdated and being replaced by computer-based presentation tools.

Key Term

transparency

specifically, a transparent material with an image on it, that is viewable by shining light through it.

Chalkboards, Flipcharts, and Transparencies

Visual aids such as chalkboards, flipcharts, and transparencies are used by presenters to help weave their words and images together into a cohesive message. Using visual tools effectively during a presentation helps speakers appear prepared, professional, interesting, and credible. Writing tools and imagery also help audience members focus on and remember the presenter’s major points, as well as better understand the presenter’s argument.

Choosing Visual Aids

Modern chalkboards are often made with green slate stone so that the writing is easier to read.

Chalkboards: From School to the Workplace

Although we often think of chalkboards in academic or teaching settings, chalkboards (or dry boards) are also commonly used in business environments. Chalkboards are reusable writing surfaces where text and drawings are made using sticks of calcium sulfate or calcium carbonate known as chalk. Chalkboards were originally made of smooth, thin sheets of black or dark grey slate stone. Modern versions are often green because the color is considered easier for reading.

Organizations typically use dry boards, which use dry erase markers for easy application and removal. These boards can be used for presentations, as well as advertisements or record-keeping.

In presentations, chalkboards and dry boards provide significant flexibility for recording audience responses and jumpstarting discussions. This spontaneity allows for fast, simple and easy use by presenters who may not be familiar or comfortable with presentation software tools.

On the other hand, writing on a chalkboard or dry board can delay presentations. Presenters may be tempted to speak to the board instead of the audience. Also, the chalkboard’s size limits visibility for large groups. Presenters with poor spelling or illegible handwriting can also pose problems for audience members.

Flipcharts in Presentations

Like chalkboards and dry boards, flipcharts have a low learning curve, allowing anyone with the ability to write to quickly convey information to audience members. Flipcharts are typically stationary items consisting of pads of large paper sheets fixed to the upper edge of a whiteboard. These are typically supported on a tripod or four-legged easel. Invented by Peter Kent, who built one to help him in a presentation, flipcharts are commonly used for presentations.

Flipcharts come in various forms, including:

• Stand-alone flipcharts
• Metallic tripod (or easel) stands
• Metallic mounts on wheels

Recently, scientists have developed a digital self-writing flipchart which writes word-for-word everything it is instructed to record. Self-heightening flipcharts such as the POGO system are also being introduced into public use. However, traditional flipcharts where text is usually hand-written with marker pens are still widely used in organizations.

Transparencies in Business, Academia, and the Church

In today’s information age, digital presentations and slideshows are by far some of the most widely used visual aids in public speaking. However, transparencies are still used by a variety of organizations. A transparency, also known in industrial settings as a “viewfoil” or “foil”, is a thin sheet of transparent flexible material, typically cellulose acetate, onto which figures can be drawn. These are then placed on an overhead projector to display to an audience.

Many companies and small organizations use a system of projectors and transparencies in meetings and other groupings of people; though this system is being largely replaced by LCD projectors and interactive whiteboards. In academia, mathematics and history classes traditionally used transparencies to illustrate a point or problem. Math classes in particular used a roll of acetate to illustrate sufficiently long problems and create illustrations that were difficult to do on computers due to a lack of math symbols on standard computer keyboards.

Nevertheless, more colleges are switching to digital projectors and PowerPoint presentations. In churches and other religious organizations, religious leaders used transparencies to show sermon outlines and illustrate certain topics such as Old Testament battles and Jewish artifacts during worship services.

While transparencies allow presenters to maintain eye contact with the audience, and multitask (e.g. take notes), they often appear plain looking with no motion or sound. Moreover, transparencies must be shown in dim lighting, which may potentially cause visibility problems for viewers. As a result, overhead projectors are quickly becoming outdated and being replaced by computer-based presentation tools.

16.2.3: Static Representations: Images, Drawings, and Graphs

Learning Objective

Discuss the appropriate placement of images, graphs, and drawings in presentations

Key Points

• Static imagery can either serve as a useful visual tool to further emphasize or support a speaker’s point, or confuse audiences and detract from the speaker’s message.
• Photographs, maps, and handouts are all examples of visual aids that employ static imagery.
• Bar graphs, line graphs, and other types of graphs are used in both static and electronic presentations to visualize relationships between different quantities.
• Drawings or diagrams can be used when photographs do not show exactly what the speaker wants to show or explain.

Key Term

typography

The appearance and style of typeset matter.

Static Presentations: Images, Drawings, and Graphs

Visual communication, as the name suggests, conveys ideas and information in forms that can be read or looked upon. Audiences partially rely on vision to receive a speaker’s message, using physical cues, signs, typography, drawing, graphic design, illustration, color, and electronic resources. Public speakers often employ a variety of presentation tools—including drawings, paintings, and graphs—to inform, educate or persuade a person or audience. Although static in nature, non-electronic imagery has both advantages and disadvantages when used as visual aids in presentations.

Drawings

Drawings can be used in place of complex or detailed photographs.

A drawing that’s labeled with hand-written notes to add clarity.

The Many Uses of Images in Presentations

Images can be any two-dimensional figure such as a map, a graph, a pie chart, or an abstract painting. In this wider sense, images can also be rendered manually (e.g., by drawing, painting, carving) or automatically (e.g., by printing, computer graphics technology). Static images such as photographs, paintings, and illustrations can serve as useful visual tools to further emphasize or support a speaker’s point. However, if the images appear unrealistic, too small, or confusing, they can hinder the presentation and dilute the speaker’s message.

Examples of static images used in presentations include:

Photographs – Photographs are helpful tools to make or emphasize a point, or to explain a topic when the actual object cannot be viewed. For example, photographs are particularly useful for displaying historical places and sites that no longer exist.

Maps – Maps show geographical areas of interest. They are often used as aids when speaking of differences between geographical areas or showing the location of something.

Handouts – Charts, graphs, pictures, illustrations, and other images can be printed on handouts for distribution before, during, or after a presentation. An important aspect of the use of a handout is that a person can keep the handout long after the presentation is over. This helps the person better remember what was discussed.

Graphs and Data

Graphs are used in both static and electronic presentations to visualize relationships between different quantities. Various types of graphs are used as visual aids, including bar graphs, line graphs, pie graphs, and scatter plots. Graphs are particularly helpful for visualizing statistics that might be overlooked if just presented verbally. However, it is graphs’ complexity—detailed calculations, complex data and large figures—that cause them to become cluttered during use in a speech. Graphs often include too much detail, overwhelming the audience and making the graph ineffective.

Drawings in Presentations

Drawings or diagrams can be used when photographs do not show exactly what the speaker wants to show or explain. It could also be used when a photograph is too detailed. For example, a drawing or diagram of the circulatory system throughout the body is a lot more effective than a picture of a cadaver showing the circulatory system.

Nevertheless, talent and skills are usually needed for professional drawings that require significant detail or realism. If not done correctly, drawings can look sloppy, be ineffective, and appear unprofessional.

16.2.4: Dynamic Representations: Video and Multimedia

Learning Objective

Illustrate how multimedia tools can enhance audiences’ experience

Key Points

• Presenters may use navigation devices such as text links, picture thumbnails, or miniature screenshots to move around spontaneously within and between large collections of interconnected content.
• Although studies have revealed that audiences are more engaged during presentations that employ dynamic elements, there have been no assessments as to whether using multimedia improves learning and retention of presentation material.
• Multimedia such as video enhances the experience of the audience member, and can help presenters convey information more easily and quickly than static presentations.
• Integrating multimedia with online applications and hardware elements can ease the job of presenters by adding emphasis and bringing attention to specific points in the presentation.

Key Term

multimedia

The use of different media to convey information; text together with audio, graphics and animation, often packaged on CD-ROM with links to the Internet.

Dynamic Representations: Video and Multimedia

Presenters may use navigation devices such as text links, picture thumbnails, or miniature screenshots to move around spontaneously within and between large collections of interconnected content. Using these relational presentation techniques allows presenters to interact with rather than “talk at” audiences .

Multimedia in Presentations

Presenters often use multimedia in presentations to make the content more engaging for audiences.

Audience Reception of Dynamic Content

Although studies have revealed that audiences are more engaged during presentations that employ dynamic elements, there have been no assessments as to whether using multimedia improves learning and retention of presentation material. Regardless of whether speakers use static or dynamic content, all presentations must present consistent and compelling information within a limited time frame. The various formats of technological or digital multimedia available to presenters may be intended to enhance the users’ experience, quickly and easily convey information, or transcend everyday experiences.

Software Presentation Programs

Presentation software programs provide public speakers with the ability to display video, photography, and other dynamic content in slideshow formats suitable for small and large audiences. For example, Apple’s iPhoto allows groups of digital photos to be displayed in a slideshow with options including transitions, looping functions, and the integration of music and digital photos. Zooming presentation programs such as Prezi present content on one infinite canvas. This allows for non-linear presentations where presenters can present richer detail of content, as well as provide a better overview and understanding of complex visual messages and relations.

Multimedia Tools in Presentation Software

Many presentation programs come with pre-designed images (clip art) and/or have the ability to import graphic images. Some tools also have the ability to search and import images from Flickr or Google directly from the tool. Custom graphics can also be created in other programs such as Adobe Photoshop or Adobe Illustrator and then exported.

Similar to programming extensions for an operating system or web browser, plugins for presentation programs can be used to enhance their capabilities. For example, it would be useful to export a PowerPoint presentation as a PDF document. This would make delivery through removable media or sharing over the Internet easier. Since PDF files are designed to be shared regardless of the platform, this format would allow presentations to be more widely accessible.

Certain presentation programs also offer an interactive, integrated hardware element designed to engage an audience (e.g., audience response systems) or facilitate presentations across different geographical locations (e.g., web conferencing). Integrated hardware devices such as laser pointers and interactive whiteboards can ease the job of the presenter by adding emphasis and bringing attention to specific points in the presentation.

16.2.5: Slideshows

Learning Objective

Explain how slideshows are used for personal and business purposes

Key Points

• Presentation software is most commonly used for instructional purposes, usually with the intention of creating a dynamic, audiovisual presentation.
• Before the introduction of motion pictures and computer software, slides originally were projected onto a theater screen via magic lanterns.
• In addition to business presentations, slideshows are used to provide dynamic imagery for museum presentations and installation art, and for saving personal memories as digital photo albums.

Key Terms

annotation

The process of writing comments or commentary.

phenomenological

Using the method of phenomenology, by which the observer examines the data without trying to provide an explanation of them.

magic lantern

An early form of slide projector that could achieve simple animation by moving and merging images.

Slideshows

A slideshow is an on-screen presentation of information and/or ideas presented on slides. Since the late 1960s, visual artists in museums and galleries have used slideshows as a device for presenting specific information about an action or research, or as a phenomenological form in itself. Before the advent of motion pictures, slides originally were projected onto a theater screen by magic lanterns. This practice later evolved into moving picture shows .

Building a Slideshow

Consumers can use online programs such as Flickr to assemble photo slideshows.

A screenshot of Flickr’s login page.

Even after the introduction of motion pictures, slides continued to be used between film showings to advertise for local businesses or advise on theater decorum—for example, by requesting that gentlemen remove their hats and refrain from smoking, and urging mothers to remove crying infants from the auditorium.

Slideshows were later conducted using apparatuses such as a carousel slide or overhead projector. Most recently, modern slideshows are commonly assembled using presentation software such as Microsoft PowerPoint or Prezi.

Personal and Business Uses

Presentation software is most commonly used for instructional purposes, usually with the intention of creating a dynamic, audiovisual presentation. The relevant points and imagery of the entire presentation are placed on slides and accompanied by a spoken monologue. The old adage “a picture is worth a thousand words” holds true, in that a single image can save a presenter from speaking a paragraph of descriptive details. As with any public speaking or lecturing, a certain amount of talent, experience, and rehearsal is required to make a successful slideshow presentation.

Slideshows have artistic uses as well. They are often used to provide dynamic imagery for museum presentations and installation art. Consumer uses of slideshows include personal screensavers, and digital photo slides for display. Vendors or consumers can custom make slideshows using their using photos, music, wedding invitations, birth announcements, or other digital files. The slideshows are typically placed onto DVDs, converted into HD video format, or saved in an executable file for computer use. Ultimately, photo slideshow software—coupled with digital cameras and computer technology—has made it easier to create photo slideshows, eliminating the need for expensive color reversal film.

Common Slideshow Features

Photo slideshow software often provides a wide range of editing features. For example, users can add transitions, pan and zoom effects, video clips, background music, narrations, and captions.

Slideshows created using presentation software result in a file sometimes referred to as a “slide deck” or simply a “deck” in business settings. Some key features useful in desktop or cloud-based presentation software include screen capturing, image editing and annotation tools, and slide transition and text effects.

Web-based slideshows are slideshows that can be viewed or presented using a web browser. Some web-based slideshows are generated from presentation software, but may be difficult to modify. Others offer templates where slideshows can be easily edited and changed. Web-based slideshows are typically generated or authored in HTML, JavaScript, and CSS code (files). However, compared with desktop presentation programs, web-based slideshows are usually limited in features.

16.3: Preparing Sensory Enhancements

16.3.1: The Do’s of Using Sensory Enhancements

Using sensory enhancements correctly will make your presentation come to life.

Learning Objective

Discuss the best practices of using text, video, sound, graphics and animation in presentations

Key Points

• During your presentation, your audience will see you and your visual aids.
• It is important to pay attention to the quality of the text as well as what is actually said.
• Learners are attracted to colors and may find programs without color to be boring.
• Video is a great attention grabber but may distract the audience from more important information.

Key Terms

color-blind

Of a person or animal, unable to distinguish between two or more primary colors (usually red and green).

animation

The technique of making inanimate objects or drawings appear to move in motion pictures or computer graphics.

Introduction

When you give a presentation, you are truly alive, as being on stage activates all of your senses. You see your audience waiting to receive your wisdom. You hear the noise they make as they shift in their places. You smell the scent of success that accompanies a job well done. You taste the nervousness bubbling in your gut. You feel your heart beating faster, your legs shaking.

Shouldn’t your presentation make your audience come alive, too?

Sight

During your presentation, your audience will see you and any visual aids you may include.

You

The audience is going to have to look at you throughout the the entire presentation. You want to keep them engaged by:

• Dressing in a way that suits your personality (Could you imagine Steve Jobs giving a presentation wearing a suit and tie? )
• Wearing colors that suit the setting and appeal to the audience
• Showing confidence through your body movements (Even when Steve Jobs was speaking about iPhone 4 “defects,” you knew that he was in control)
• Using gestures that go with your message

Text

Some useful suggestions for using text as a video presentation are:

• Text should be read from left to right, top to bottom
• Use consistent indentation and spacing
• End sentences or paragraphs on the same display screen

Text Quality

According to Alessi and Trollip (2001), the five important factors that should be used in determining the quality of text are:

• Leanness: Say the bare minimum
• Transitions: Should be used when moving from one topic to another to facilitate the flow of ideas
• Clarity: Use language that is comprehensible by your target audience as well as consistent words for defining terms
• Reading level: Ensure that the reading level is suitable to the learners intended to use it
• Mechanics: Always remember to correct grammar, spelling and punctuation

Color

Color should draw attention to the important terms or concepts in your presentation. Color should be consistently used throughout the design of the presentation. Learners are more attracted to colors and may find programs without color to be boring.

Power of Color

Using color in a presentation catches the audience’s attention and highlights important facts.

Colored pencils arranged in a circle.

One of the disadvantages of using color is that color-blind individuals may miss out on some information in certain colors.

Useful suggestions for using color:

• Be consistent with use of colors
• Use color to indicate a difference or change
• Try to keep color use to a minimum
• Make sure that there is a good contrast between the background and the color of the text to allow the audience to read it easily

Video

Video is a great attention grabber, but may distract the audience from more important information.

Here are some useful suggestions for using video:

• Use video to emphasize important information
• Pay careful attention to where video is placed in the presentation
• Make sure the length of the video is appropriate
• Ensure that you have control over the video as far as pausing, ending and repeating

Sound

Your voice can serve as a sensory enhancement. To make it effective:

• Add variety to your tone
• Speak loudly and clearly
• Use proper enunciation and pronunciation

If you use sound other than your own voice:

• Use sound as an attention grabber if it makes sense to do so
• Use high quality sound

Graphics and Animation

Graphics and animation should enhance the presentation.

Useful suggestions for using graphics and animation:

• Use graphics that are consistent throughout presentation
• Sometimes less is better
• Decide if a realistic picture is necessary or not
• Some graphics may need to be broken into smaller pictures
• When using text and graphics, present both simultaneously

An effective presentation or speech will touch your audience; an alive audience is likely to take action.

16.3.2: The Don’ts of Using Sensory Enhancements

Using visuals in presentations is a good way to make sure people remember them, but it is important to do so in the proper manner.

Learning Objective

Identify the common missteps presenters make when using sensory enhancements in presentations

Key Points

• According to research carried out at UCLA, a visual presentation is five times more likely to be remembered after three days than a presentation using bullet points.
• When using objects in a presentation, set aside time for the audience to examine the object so it doesn’t detract from the speech.
• If using audio to enhance a speech, make sure it is loud enough to be heard without distracting the audience.
• Be careful with scents in a presentation, so as not to offend or distract the audience.
• A presentation with sensory enhancements should be practiced, so you can make sure that any problems are rectified ahead of time.

Key Terms

acoustics

The physical quality of a space for performing music.

clip art

A set of images, distributed as files with other software, that may be copied and pasted into documents or other files.

Don’ts of Using Sensory Enhancements

If sensory enhancements aren’t used properly, they can detract or distract from a presentation.

Awakening the Senses

Sensory enhancements are good in presentations, but they can be a distraction if they aren’t used correctly.

A drawing of a man’s head that shows all of the senses – sight, hearing, smell, and taste.

Visual Missteps

The famous psychologist Albert Mehrabian showed that the way people take in information during a presentation is 55% visual, compared to 38% vocal and only 7% through text. Yet simply adding a few visuals into a presentation may not be the solution. There are a number of traps that people fall into.

1. Using Bullet Points: According to research carried out at UCLA, a visual presentation is five times more likely to be remembered after three days than a presentation using bullet points.
2. Corny Images: These often have actors showing emotions such as surprise or happiness. The difficulty is that they can look very corny. Additionally, if the photos are a few years old, the fashions can look very dated.
3. Using Clip Art: An idea behind its time. Clip Art used to be a great way of making a presentation visual—particularly when computers were less powerful and every presentation had be small enough to fit onto a floppy disk. The problem now is that clip art looks very dated compared to a color photograph.
4. Grainy Pictures: Generally these images are taken from a web page and increased in size. The problem is that, since they were saved as small files to make them load quickly, they do not enlarge well .
5. Copyright Theft: It’s easy and tempting to just lift an image off the web, but you must obtain the permission of the copyright owner before you can use any image.
6. Images Purely for Decoration: A picture is worth a thousand words. So why would you slap down any old image just to fill up a bit of space? Instead of an image showing how their products could suit a wide range of businesses, their graphic design agency had added a picture of a horse! Relevance is everything.
7. Long Video Clips: It can be helpful to add a video clip into a visual presentation, but be aware that an audience’s attention will dwindle if the clip is too long.

Audio Missteps

If you are going to use sound in a presentation, make sure that it is appropriate to the setting and subject matter. Don’t have the audio so loud that people can’t hear the speech properly or that it distracts the audience from your speech. You should also make sure that it isn’t so soft that it can’t be heard properly by everyone in the room.

Touch Missteps

If you bring objects for the audience to touch and examine during the presentation, you will want to bring more than one item so that you can have the objects pass around the venue quickly. You’ll also want to schedule a period of time during your speech for the examination, otherwise people will be paying more attention to the object and miss important elements of the speech.

Sense Missteps

Some people are sensitive to smells, so if you are including this aspect into your presentation, make sure the scent isn’t too strong or cloying. You want to be able to enhance your speech without distracting or offending your audience.

The Important of Preparation

Preparation is the most important part of sensory enhancements. Make sure that you practice your presentation in the same room in which it will be delivered. Check acoustics, visibility, and the ability to deliver objects and scents in the room without distraction. Have people listen and experience your presentation beforehand, so you can adjust any mistakes before the final presentation and ensure that your speech goes as smoothly as possible.

16.3.3: Design Tips

Designing an effective and engaging presentation in PowerPoint or other presentation program requires simple graphics, fonts, and structure.

Learning Objective

State the design best practices that should be incorporated into PowerPoint presentations

Key Points

• Do not write your entire presentation on your PowerPoint. Rather, use bullets and sub-bullets to break up the text into manageable, easy-to-read chunks.
• Be consistent with your color themes.
• Use at least 18-point font for main points and smaller font sizes for sub-points.
• Use a font color that is readable and stands out against the background.
• Use graphics.

Key Terms

PowerPoint

(noun) an electronic slide presentation created and presented using the program (verb) to communicate to (an audience) by electronic slides

design

To plan and carry out (a picture, work of art, construction etc. ).

Introduction

Let’s face it. Love it or hate it, PowerPoint, or PowerPoint type slides, are the most common form of visual aid seen during a presentation. We all know that we have encountered boring power points presentations with an overload of information and lack of creativity. Developed by Microsoft, PowerPoint is a presentation software that enables users to communicate text, graphics, video, and other content via electronic slides.

The following design tips can help users develop effective PowerPoint presentations, while keeping in mind PowerPoint etiquette.

PowerPoint Presentation

Using software, like PowerPoint, allows the speaker to create an engaging presentation.

PowerPoint Tips

• Do not write the entire presentation on your PowerPoint. Instead, create bullet points and headings no longer than three to five words that give the main points.
• Present no more than five to seven lines per slide.
• Use two slides rather than cramming too much information into one.
• Be consistent with your “theme” throughout the presentation (i.e., do not use a different theme for each slide).
• Do not overuse transitions. They are meant to enhance, not overwhelm your presentation.
• Be careful with your color scheme. Again, this is meant to enhance your presentation. Make sure the audience can read the text.
• Make an outline of what you will be talking about so listeners can know what to expect from the presentation.
• Use at least an 18-point font for main points and a smaller sized font for sub-points. Avoid using complicated and unreadable font.
• Use a font color that stands out against the background.

Easy-to-Read Text and Graphics

Use graphics! People identify items more quickly with images rather than just text alone. When creating your visual aids, however, make sure your text and graphics are readable.

Labeling

• Use headlines and sub-headlines in a larger font.
• Bold, italicize, or CAPITALIZE important information.
• Use bullet points or create lists to organize material. Make sure this is “nice” to look at (i.e., easy-to-read).

Charts and graphs

• Make sure the information is clear and supports your presentation. Color coordinate charts/graphs if necessary.
• Use text to support/explain your charts and graphs (be brief but cover the high points).
• Avoid charts and graphs that can be misleading to your readers.

Wording and Lettering

• Use large, easy-to-read fonts.
• Be concise, using as little text as possible. Also use simple language to avoid confusion.
• Limit your text to one or two fonts.
• Think of the demographic (e.g., age) of your audience when setting font size and type.
• Minimize the number of lines to no more than six lines per slide with six words per line.

→Overcrowding slides is common and can be easily avoided by limiting the amount of text.

Color

• Use color for clarity and emphasis, not for decoration.
• Use color schemes.
• Keep a similar color scheme throughout the entire presentation.
• Use contracting colors to highlight main points.

16.3.4: The Role of Color

When properly used color should draw attention to the important terms or concepts in your presentation.

Learning Objective

Describe how color can be used to enhance presentations

Key Points

• One of the disadvantages of using color is that individuals who are colorblind may miss out on some information in certain colors.
• Do not “waste” information by using unnecessary colors.
• It may also be useful to apply some color psychology when choosing which colors to use.

Key Term

color-blind

Of a person or animal, unable to distinguish between two or more primary colors (usually red and green).

Introduction

When properly used color should draw attention to the important terms or concepts in your presentation. They can also create emotion. Color should be consistently used throughout the design of the visuals to achieve these goals.

Learners and audiences are more attracted to colors and may find presentations without color to be boring. Some presenters change up their color schemes regularly to prevent their presentations from becoming too monotonous. You can also change the shades of your colors.

Using Color Effectively

Color can be used in a presentation to get the audience’s attention.

The sun shines through stained glass windows at the Nasir ol Molk Mosque located in Shiraz, Iran.

One disadvantage of using color is that individuals who are color-blind may miss out on some information in certain colors. Using certain shades, and using them consistently, can eliminate this problem.

Useful Suggestions for Using Color

• Be consistent with the use of colors.
• Use color to highlight a difference or change.
• Try to keep color use to a minimum; each color should communicate necessary information.
• Make sure that there is a good contrast between the background and the color of the text to allow the learner to read the text easily.
• Use color for clarity and emphasis, not for decoration.

The Psychology of Colors

It may also be useful to apply some color psychology when choosing which colors to use. Basic internet research uncovers a whole host of analysis on the meanings of different colors.

Something else to consider is that on flip charts, blue, black, and green inks have the best visibility. People say that blue is the most pleasing color to view. Red comes in second, even though it is not the most visible. But too much red can be too strong. Avoid using purple, yellow, pink, and brown, which can be more difficult to see.

When creating graphs, bright colors will bring focus to a small graph while subtle colors will keep a large graph from overwhelming the audience.

16.4: Presenting with Sensory Enhancements

16.4.1: The Do’s of Using Visual Aids

Visual aids should be easily understood, aesthetically pleasing, easy to move, easily seen and heard, and act as a supplement to the speech.

Learning Objective

List best practices for presenting visual aids in a speech

Key Points

• Presentation aids must be easily understood by the audience. Graphic elements should be large enough to be easily seen and/or read.
• Presentation aids must be easy to transport. In addition, you should make sure you know to use presentation equipment ahead of time.
• The design of your presentation should not detract from the content of your speech.
• Consider whether you can understand if each visual aid is addressing and furthering the key point of your presentation.
• Visual aids are useful to help the audience better understand your topic if they are used as a supplement to your presentation.

Key Terms

extraneous

Not essential or intrinsic.

verbatim

A word-for-word report of a speech.

Visual aids are essential to helping your audience better understand the key points of your presentation. Visual aids will also help to improve the attention span of audience members during the presentation. However, it is important that presenters use visual aids in a manner that does not distract from the overall presentation. An effective visual aid will include the following attributes:

• Easily seen or heard by the audience
• Easily handled
• Aesthetically pleasing
• Easy to understand the key point
• Act as a supplement to the speaker’s message and not a replacement

Easily Seen or Heard by the Audience

Presentation aids must be easily understood by the audience, even those sitting at the very back of the room. Graphic elements in presentation aids must be large enough to be easily seen and/or read. Similarly, audio elements must be loud enough to hear.

Easily Handled

Your presentation aids should be easy to transport. In addition, you should make sure you know how to use presentation equipment ahead of time. You should seamlessly incorporate presentation aids into your speech. You don’t want your audience to be distracted by these elements.

Aesthetically Pleasing

Your visual aids should not detract from the content of your speech. Keep your presentation simple so people can focus on the content rather than the aesthetics. The decisions you make when you design your visual aids should be very deliberate. If you add color to a visual aid, for example, use it for a clear purpose. 

PowerPoint Presentation

The
audience should be able to quickly understand the key point of each slide in a PowerPoint presentation.

An audience views a PowerPoint presentation.

Easy to Understand the Key Point

If your PowerPoint slides or handouts have too much extraneous information, then the audience may not be able to understand the takeaway message of the presentation. A way to test if your visual aids are addressing the key point is to ask someone who is unfamiliar with your presentation if they can understand what the key point is. If they cannot determine the key point, it may be a good idea to revise your visual aids to include less non-essential information.

Supplement not Replace, the Presentation

Visual aids are useful to help the audience better understand your topic if they are used as a supplement to, and not a replacement for, your presentation. For example, a visual aid that replaces a presentation could be a PowerPoint that includes big blocks of text that the presenter reads verbatim. While this will be an accurate presentation, it will likely bore the audience members who will not gain much from the presentation. However, if the visual aid acts as a supplement, it will enhance the audience member’s understanding through diagrams, graphs, charts, and summaries.

16.4.2: The Don’ts of Using Visual Aids

Some “don’ts” of visual aids include inconsistent themes, small fonts, too much information, and distracting noises and animation.

Learning Objective

Discuss the missteps presenters should avoid when using visual aids

Key Points

• If your visual aid has inconsistencies in color scheme or theme, the audience may become confused since color change may indicate a change in topic.
• Avoiding small font is essential to making sure that the audience can read your visual aids. A general standard is to make sure that all PowerPoint slides are at least 18-point font to ensure that audience members in the back row will be able to read your presentation.
• Try to keep the amount of information on each slide to a minimum and use only what is necessary to convey the key point of the visual aid or slide.
• Avoid distracting animation and noises. These will take the focus of the audience away from your presentation and shift it toward the noise or animation instead.

Key Term

Detract

Take away the value of.

Visual aids can be effective at enhancing your presentation and helping the audience better understand the key points of your presentation. However, if visual aids do not help your message or are too confusing, they may actually detract from the presentation and hinder understanding. Some key “don’ts” of using visual aids include:

• Inconsistency in color scheme or theme
• Small or complicated font or overwhelming text or graphics
• Too much information or too many slides
• Distracting animation or noises

Inconsistency in Color Scheme or Theme

If your visual aid has inconsistencies in color scheme or theme, the audience may become confused since color change may indicate a change in topic. Consistency in theme and color will help coordinate all of the information in your presentation and will help the audience understand the topics in relation to one another. There are a number of default themes that Microsoft PowerPoint offers that can help unify your color scheme and theme. 

Small or Complicated Font or Overwhelming Text and Graphics

Avoiding small font is essential to making sure that the audience can read your visual aids. A general standard is to make sure that all PowerPoint slides are at least 18-point font to ensure that audience members in the back row will be able to read your presentation. Additionally, you should avoid overwhelming text and graphics as they will distract from the main topics and points of your presentation.

Complicated Graphics

The speaker should avoid using complicated graphics in a presentation.

The “aggregate supply” and “aggregate demand” curves for the AS-AD model.

Too Much Information or Too Many Slides

Try to keep the amount of information on each slide to a minimum and use only what is necessary to convey the key point of the visual aid or slide. Additionally, try to keep the number of slides or visual aids in your presentation to a minimum. A rule of thumb is to use each slide in a PowerPoint for 30 seconds to a minute of your presentation. Remember that the majority of your presentation should come across in what you are speaking about rather than through the text on your visual aids. 

Distracting Animation or Noises

Avoid distracting animation and noises. These will take the focus of the audience away from your presentation and shift it toward the noise or animation instead.

16.5: Using PowerPoint and Alternatives Successfully

16.5.1: The Advantages and Disadvantages of PowerPoint

PowerPoint is a quick and easy way to organize ideas and information, but can encourage the creation of presentations that lack substance.

Learning Objective

Name the advantages and disadvantages of using PowerPoint

Key Points

• PowerPoint is regarded as the most useful, accessible way to create and present visual aids; others believe it has its own mind-set which forces presenters to spend countless hours thinking in PowerPoint and developing slides.
• Advantage—easy to create colorful, attractive designs using the standard templates and themes; easy to modify compared to other visual aids, such as charts, and easy to drag and drop slides to re-order presentation.
• Advantage—easy to present and maintain eye contact with a large audience by simply advancing the slides with a keystroke, eliminating the need for handouts to follow the message.
• Disadvantage—speakers create slides so they have something to present rather than outlining, organizing, and focusing on their message.
• Disadvantage—the linear nature of PowerPoint slides forces the presenter to reduce complex subjects to a set of bullet items which are too weak to support decision-making or show the complexity of an issue.
• Disadvantage—basic equipment required to present. You will need to have a computer and projection equipment in place to display the slides to the audience.

Key Terms

PowerPoint

(noun) an electronic slide presentation created and presented using the program (verb) to communicate to (an audience) by electronic slides

bullet points

Bulleted items – known as bullet points – may be short phrases, single sentences, or of paragraph length; used to introduce items in a list.

Advantages and Disadvantages of PowerPoint

PowerPoint—Advantage or Disadvantage for the Presenter?

PowerPoint is the most popular presentation software. It is regarded by many as the most useful and accessible way to create and present visual aids to the audience.

On the other hand, others believe it has created its own mind-set which forces presenters to spend countless hours thinking in PowerPoint and developing slides. A political party has even formed to ban PowerPoint in Switzerland. Depending on one’s perspective, it seems that many advantages could easily be viewed as disadvantages.

Using PowerPoint

When used correctly, PowerPoint is a helpful program for creating an engaging presentation.

A screenshot of a slide in Microsoft PowerPoint.

Look over the list below to see where you stand—with or against PowerPoint.

Advantages

Design

• Quick and easy: the basic features are easy to master and can make you appear to be organized, even if you are not.
• Simple bullet points: it can reduce complicated messages to simple bullet points. Bullet points are a good basis for a presentation and remind the speaker of main points and the organization of the message.
• Easy to create a colorful, attractive design: using the standard templates and themes, you can create something visually appealing,even if you do not have much knowledge of basic graphic design principles .
• Easy to modify: when compared to other visual aids such as charts, posters, or objects, it is easy to modify.
• Easily re-order presentation: with a simple drag and drop or using key strokes, you can move slides to re-order the presentation.

Finally, PowerPoint is integrated with other products that allow you to include parts of documents, spread sheets, and graphics.

Delivery

• Audience Size: PowerPoint slides are generally easier to see by a large audience when projected than other visual aids.
• Easy to present: you can easily advance the slides in the presentation one after another with a simple key stroke while still maintaining eye contact with the audience.
• No need for Handouts: they look good visually and can be easily read if you have a projector and screen that is large enough for the entire room.

Disadvantages

Design

• Design power pointless: gives the illusion of content and coherence, when in fact there is really not much substance or connection between the different points on the slides.
• PowerPoint excess: some speakers create presentations so they have slides to present rather than outlining, organizing, and focusing on the message.
• Replaces planning and preparation: PowerPoint is a convenient prop for poor speakers, as it can reduce complicated messages to simple bullet points and elevates style over substance.
• Oversimplification of topic: the linear nature of PowerPoint forces the presenter to reduce complex subjects to a set of bullet items that are too weak to support decision-making or show the complexity of an issue.
• Feature abundance: while the basic features are easy to use and apply, a speaker can get carried away and try to use all the features at once rather than simply supporting a message. Too many flying letters, animations, and sound effects without seeing much original thought or analysis can be a real issue. In many cases, the medium shoves the message aside.

Delivery

• Basic equipment required: you will need to have a computer and projection equipment in place to display the slides to the audience.
• Focus on medium, not message: Too many people forget that they are making a presentation first and that PowerPoint is just a tool.

16.5.2: An Overview of PowerPoint

Microsoft PowerPoint is a computer software package that displays information in the form of a slide show.

Learning Objective

State the arguments for and against using PowerPoint as a visual aid

Key Points

• PowerPoint presentations consist of a number of individual pages or “slides,” with individual slides containing text, graphics, sound, video, or other objects that can be arranged by the presenter.
• A PowerPoint presentation can be automatically controlled by pre-programming transitions from one slide to another, or manually controlled by a user.
• Supporters of PowerPoint say the presentation software is easy to use and can save a lot of time for by replacing the need for a variety of different visual aids.
• Some opponents of PowerPoint argue that the program encourages the reduction of complex ideas into simplified points, while others contend that the program encourages overstuffing presentations with too much information, both of which negatively effect the audience’s experience.

Key Term

PowerPoint

(noun) an electronic slide presentation created and presented using the program (verb) to communicate to (an audience) by electronic slides

An Overview of PowerPoint

PowerPoint is a presentation software program . A presentation program (also called a presentation graphics program) is a computer software package used to display information, normally in the form of a slide show. It typically includes three major functions: an editor that allows text to be inserted and formatted, a method for inserting and manipulating graphic images, and a slide-show system to display the content.

PowerPoint

PowerPoint software runs on Microsoft and Mac operating systems. It allows users to
create visual presentations comprised of individual slides.

Commander Naval Reserve Force, Vice Adm. John G. Cotton, stands in front of a PowerPoint presentation at the Naval Station North Island’s theater.

Microsoft PowerPoint 9 is easy-to-use presentation software that runs on Microsoft Windows and Mac OS operating systems. PowerPoint is commonly used by business people and students to create slide show presentations. The ease of use is demonstrated by the fact that the program can be used by junior high and high school students. PowerPoint can accommodate a range of uses, with intermediate to more technical options. Microsoft estimates that thirty million presentations are made each day using the PowerPoint program. As of 2012, various versions of PowerPoint claim approximately 95% of the presentation software market share, having been installed on at least 1 billion computers.

PowerPoint Logo

With 95% market share, PowerPoint presentation software is one of the most widely used programs for developing visual presentations.

PowerPoint has almost become a generic term similar to Xerox or Coke or Google and is often used when one is referring to any computer supported presentation, thus demonstrating how ubiquitous the program has become.

The Use of Slides in PowerPoint Presentations

PowerPoint presentations are comprised of a number of individual pages, or “slides. ” The “slide” analogy is a reference to slide projectors. Unlike slide projectors however, which only projected static images, slides in PowerPoint are more dynamic. They can include text, graphics, sound, movies, and other objects, which can be arranged by the presenter. The PowerPoint presentation can be printed, displayed live on a computer, or navigated through at the command of the presenter. For larger audiences the computer display is often projected using projection equipment. The slides can also be used as the basis for a webcast.

After designing the individual slides for your presentation, you can control the presentation by pre-programming the transitions from one slide to another with the exact timing you want. Or, you can advance the slides manually as you speak about each.

Supporters and Critics

Supporters of the software say the PowerPoint can save people time by circumventing the need for other types of visual aids, such as hand-drawn or mechanically typeset slides, blackboards, whiteboards, or overhead projections. Because the software is easy to use, it encourages people to give presentations that contain visual aids who otherwise may not have even given a presentation.

PowerPoint does have its critics, and the benefits of the software are continually debated. Some critics of PowerPoint argue that condensing complex issues into simplified bullet points is detrimental, and compromises the quality of information provided to the audience. This view finds that audience do not receive enough detailed information to make informed decisions about presentation topics. Additionally, there are also some critics who say that rather than providing too little information, PowerPoint allows users to put too much information into presentations. This can lead to “death by PowerPoint,” which is a state of bordem or fatigue as a result of sitting through a presentation that contains too much information.

As is clear from the debate about its merits, PowerPoint can present many benefits and challenges to a user who develops a slideshow to accompany a speech or presentation.

16.5.3: The Elements of a Slide

PowerPoint is a multi-media platform that incorporates elements of written, audio, video, and graphical communication.

Learning Objective

Break down the elements that comprise a PowerPoint slide

Key Points

• The most basic element of a PowerPoint presentation is the slide.
• Slides are comprised of a combination of textual and visual elements.
• Text may be organized as captions, paragraphs, or bulleted points.
• Add graphics such as shapes, pictures stored on your computer, pictures retrieved online, and charts or tables from other programs such as Excel.
• To add video clips, search for them from within the PowerPoint platform using Bing, Flickr, and Youtube, and import them directly into a slide.

Key Term

slide

A single page of a presentation, developed using a presentation program such as Microsoft PowerPoint. Collectively, a group of slides may be known as a slide deck or slide show.

Elements of a Slide

The basic element of the presentation is the slide. The new default aspect ratio of the slide is 16:9 for wide screens, but the previous aspect of 4:3 is still available. Some basic example elements used to compose a slide are as follows:

Titles and sub-titles: After first opening PowerPoint to start a new presentation using the Blank Presentation Template, the user can select a title and sub-title for the presentation, using one of a variety of fonts and colors.

Text: Users can enter the content as bullets on the slide along with a title for the slide. They can also select the font style, size, and content to support their message.

Shapes: PowerPoint can merge two shapes together to create a custom shape.

Pictures: Users can search for and insert their own photographs. Remember to re-size the photo to fit the slide.

Charts/Graphs: Create custom charts or move relevant charts from Excel spreadsheets.

Audio/Video Clips: Download videos, images, and audio files directly into a slide for a presentation without first downloading to the computer. Search for audio and video from within PowerPoint to find images using Bing or Flickr and videos on You Tube. After locating the desired supporting media, incorporate it into the slide. By default, the results show images that are licensed under Creative Common, so the images can be used in presentations without violating an owner’s copyright, but users can also view all results.

Transitions: Transitions move the presentation gracefully from one slide to the next or build the side dynamically. There are many standard transitions available, or users can program their own special effects to animate the movement of the sides.

PowerPoint Slide

PowerPoint allows users to create slides and add animation, transitions, and video and audio clips.

A screenshot of an empty slide in PowerPoint 2013.

16.5.4: Formatting Tips

Formatting choices, including layout, font selection, transitions and use of space and color, are important components of a presentation.

Learning Objective

Give examples of how to best format a PowerPoint presentation

Key Points

• The blank template provides an initial format that allows a user to clearly distinguish main points from subpoints and supporting material.
• In the body of a slide, use keywords and phrases instead of sentences as listed bullet items to help the audience skim the slide and see relationships between main and sub-points.
• Insert and re-size visuals such as WordArt, shapes, charts, graphs, images, or pictures from your own computer or from the internet, into a slide to provide support for claims.
• Audio and video clips of a high quality not only clarify or provide support an idea, but also improve the quality of a presentation. Avoid videos with low resolution or poor quality audio clips, as they may affect audience perception.
• When using effects to transition from one slide to another, avoid slow moving or fancy effects such as crawl in, swivel and spiral. Don’t overuse special effects and keep transition choices consistent.
• After the Presentation – you can format and export your slides to a Word Document for handouts or share by email, pdf, or internet.

Key Term

Placeholder

dotted or hatch-marked borders for entering text, charts, tables, or images on a slide.

PowerPoint Features

PowerPoint incorporates elements of written, oral, and visual communication. By focusing on decisions regarding blank space or color, contrast, and font, you can design a presentation that is not only aesthetically appealing, but also enhances and underscores key content and objectives. The following tips will help you and your audience get the most from your presentation.

Formatting the Slide

Templates: You may either select an existing template or design your own. The blank template allows you to modify colors, themes, and the style of different elements to best suit your needs.

Normal view – Blank Presentation template: The blank presentation template provides placeholders for title and sub-title on the first slide, and additional placeholders for the title on each blank slide. This allows you to distinguish your main points from sub-points. Follow basic design rules:

• Use blank space to group or separate items.
• Use visual balance to please the eye.
• Create contrast to make objects stand out. Contrast occurs when any two elements are different.

Colors: Choose colors so that text is clearly legible. In addition, consider how the colors will look in the space where the slideshow will be presented. For example:

Picking Colors

In a presentation, there can be different colors and fonts, but all of the text must be easy to read for the audience. 

A graphic that uses colors to show the interrelationships between main areas of sustainable development.

• Strong light reduces contrast on dark background.
• In a well-lit room, use light background with dark text and visuals.
• In a dimly-lit room, use dark background with light text and visuals.
• Avoid vibrating colors. Bright complementary colors that are close to each other in intensity “vibrate” or reduce legibility.

Adding Content

Text: Use text properly.

• Use keywords and phrases instead of sentences.
• Be consistent in your use of capitalization.
• Put similar ideas in the same formatting by using the same parts of speech, same clauses, phrases, or all complete sentences.

Organization

On a slide, information can be organized using bullet points or lists.

A screenshot from the Rice University website that illustrates how to use bullet points.

• Use bullet points. Bullets help the audience skim the slide and see relationships between main and sub-points. Here is how to use bullets:

1. Select the “bulleted list” or “two-column list” slide (from the pre-designed slide formats).
2. Type a phrase then hit “return.”
3. Type a second phrase, hit “return” then hit “tab” to indent.
4. OR use “promote” or “demote” arrows at top to create a bulleted hierarchy, in order to distinguish main claims from subclaims.

Creating a Contrast

A speaker can create contrast in a presentation changing the font, color, or size.

A heading that uses contrasts and says “Principles of Design.”

Fonts: Choose easy-to-read fonts.

• Select fonts that are good for projecting, not ones that are just good for printing.
• Pay attention to the legibility of the font you choose, such as the contrast between background and text, size of the font, and any type treatment such as shadowing that may reduce legibility.

Graphics: Insert needed visuals such as WordArt, shapes, or images. Make sure to re-size the images to best fit the slide. Here is how to re-size images:

1. Click on the visual you wish to resize.
2. Go to “format” and then “object” or “autoshape.”
3. Select “size.”
4. Change size and scale.
5. OR, simply click and drag the corners of the image.
6. You can also combine two different shapes by selecting one and then selecting and dragging another into it for a custom image.

Video and Audio: You can search and select video in different media formats. Just click to select the video/audio and insert where you want them to play on the slide. You can also record your own audio to add to a slide. When choosing video or audio to add to your presentation, make sure that it is of a high quality. This enhances the authority of the presenter as well as improves audience receptivity.

Moving Between Slides

Effects and transitions: PowerPoint comes with a preset collection of transitions. You can choose different types of transitions to move between slides. Newer versions of PowerPoint even have some 3D transitions. In addition, there are many free transition templates available from Microsoft and open sources.

Effects between slides: Effects should have a point and support the overall concept of the presentation. Avoid slow moving or fancy effects such as crawl in, swivel, and spiral. Don’t overuse special effects as they can distract your audience from your main points. To avoid this from happening, keep effects and transitions consistent.

After the Presentation

Handouts: You can export your PowerPoint presentation to a Word Document. When you do this, there are different choices available for how slides and notes are positioned. In the latest version of PowerPoint you can go to File—-> Export and then click on the {Create Handouts} button. Your presentation will then be exported to a Word document for formatting.

Share: You can also share your PowerPoint presentation by email, through web access. or publish your slides so that others can access them electronically rather than having to distribute handouts.

16.5.5: Delivery Tips

PowerPoint presentation software is your assistant and should help you by supporting your presentation, not taking over the show.

Learning Objective

Illustrate how PowerPoint features can be used to communicate to audiences

Key Points

• Rehearse the show to see what it will really look like when it is presented to an audience; try controlling the movement from one slide to next or preprogramming the amount of time for each slide to appear on the screen.
• The content of the slides serves as a guide or outline for you and the audience, so you want to make sure you talk about each slide, not read the content to the audience who can read what is projected.
• Presenter View allows you to see your notes on your monitor while the audience only sees the slide. While you move from one slide to the next you can also zoom in on a particular part of the slide or use a pen or laser pointer to call attention to specific details.
• Relational presentation practitioners structure small message units that are rather self-contained and can be pulled together as the speaker interacts with the audience.

Key Terms

Relational

A type of interactive presentation using presentation software that is structured to allow dynamic customization of the message while presenting.

linear

Pertaining to or resembling a line; step-by-step in order.

PowerPoint Software Is Your Assistant

PowerPoint presentation software is your assistant and should help you, not take over the show. Nothing can substitute for a carefully prepared message, whether that message is a standard linear message or a relational interactive message. The delivery of the message is guided by the best practices that you have been using throughout your speeches; however, there are some special considerations when working with PowerPoint.

Practice and Rehearsal

After putting together a PowerPoint slide show, you will want to get a “reality check” by actually running the show to see what it will look like when you present it. You may control the movement from one slide to the next as you speak, or you may preprogram the amount of time that each slide appears on the screen and speak only for that amount of time.

If at all possible, rehearse with the same display equipment in a similar space. If you are speaking to a colocated audience, make sure that your projected slides are large enough for all members of the audience to see (usually about 1 inch high for each 10 feet that separates the audience from the projected slide). Additionally, if you are speaking to a remote audience, check your display so that you can see the presentation in the same way that the audience will see it on their screens.

Basic Delivery

One critical aspect of delivery is avoiding the temptation to read the content to the audience; the audience can read what is projected themselves. The content of the slides serves as a guide or outline for you and the audience. Stand to the left of the screen . For the English speaker who reads from left to right, the audience will see you as their eyes move across the screen in one continuous left to right eye movement. And remember to speak WITH the audience, not AT them .

Delivering a Speech

The speaker delivers the speech with assistance from PowerPoint slides in the background.

Vice Adm. John G. Cotton, is silhouetted during PowerPoint Presentation.

Using Views

Using PowerPoint Views allows you to follow a linear path or relational interactive paths for delivery.

Slide Show View

You can use the Slide Show view to deliver your presentation. The slide occupies the full screen and displays the way your presentation will look when you project it. You can use the Slide Show view to see the slide show on your computer screen one slide at a time. You can move to the next slide by clicking the mouse or using the up and down arrow keys.

Presenter View

You can see your notes on your monitor while the audience only sees the slide. You can also zoom in on a particular part of the slide or use a pen or laser pointer to call attention to details. In Presenter view, you can display the current slide on the left side, the next slide on the right, and the notes at the bottom right of the screen.

Interactive Relational Delivery

Relational presentation (also known as visually interactive presentation) uses standard presentation software such as PowerPoint in a way that allows for dynamic customization of messages while presenting.

Relational presentation practitioners structure their material using a combination of strategies to develop and access small message units. Each small message unit is rather self-contained and can be pulled together as the speaker interacts with the audience. While presenting, you interact with the audience rather than “talk at” them. You can use the Presenter view to quickly select and navigate to each message unit spontaneously within and between collections of interconnected shows. Some of these navigation devices use text links and others incorporate picture thumbnails or miniature screenshots as link sources.

Navigation in a Presentation

Whether you are delivering a traditional, linear message or an interactive, relational presentation, it is helpful to gain control of the basic movements for the slide show.

Interact with the Audience

It’s important that the speaker maintains eye contact with the audience while projecting the slides.

A man sitting at a desk with a laptop. He is speaking to the audience.

Move to the last slide: Drag the scroll box to the bottom of the scroll bar or press [Ctrl] and [End]

Move to the first slide: Drag the scroll box to the top of the scroll bar or press [Ctrl] and [Home]

Move to the next slide: Click in the scroll bar below the scroll box or press [Page Down]

Move to the previous slide: Click in the scroll bar above the scroll box or press [Page Up]

Move to a specific slide: Drag the scroll box up or down until you displays the slide you want

Delivery Wrap-Up

So to wrap it up, you should prepare your lecture before firing up your software. Remember that the technology is your assistant and should help you, not take over the show. You may creatively deliver a linear presentation, but you can also use PowerPoint to craft a highly interactive relationship experience with the audience.

16.5.6: Other Presentation Software Options

Microsoft PowerPoint dominates the presentation software market, but other options include Mind Maps, SlideRocket, and Prezi.

Learning Objective

Describe the different software programs available as an alternative to PowerPoint

Key Points

• Presentation software’s three major functions: an editor allowing text to be inserted and formatted; a method for inserting and manipulating graphic images; and a slide-show system to display the content.
• Mind Maps break away from the linear format by using graphic symbols to show connections between different ideas.
• SlideRocket is an online presentation platform that lets users create, manage, share and measure presentations.
• Prezi is a free, web- based application allowing users to create visual presentations by zooming in, out and around a visual work space.
• Google Docs is a free SaaS part of Google Drive, and includes its own presentation software.
• There is a move at present away from traditional presentation software towards mobile-friendly solutions developed for tablets and smartphones such as Haiku Deck or Explain Everywhere.

Key Term

Presentation Software

A computer software package used to display information; typically includes text editor, method for inserting and manipulating graphic images and a slide show system to display content

Alternatives to PowerPoint Presentation Software

Presentation software is a computer software package used to display information, normally in the form of a slide show. The software typically includes three major functions:

• an editor that allows text to be inserted and formatted;
• a method for inserting and manipulating graphic images, and;
• a slide-show system to display the content.

Microsoft PowerPoint dominates the market with 95% of the presentation software market share. However, there are other presentation graphic programs with different features and approaches. Some of the alternatives to PowerPoint include:

Mind Maps You can use mind maps to plan and modify your presentation. Mind Maps break away from the linear format of PowerPoint by using graphic symbols to show connections between different ideas, allowing the presenter to show a top level map and then drill down to show details for different connecting ideas. For presentation slides, you can start with a general, top level map and then create additional slides to drill down to the subtopics. You can summarize the sub points and then go back to the main, top-level mind map to show the connection to the whole.

Mind Map Software

A graphic and conceptual layout that can be used for non-linear presentation.

A sample layout using Mind Map software.

SlideRocket is an online presentation platform that lets users create, manage, share and measure presentations. SlideRocket is provided via a monthly SaaS model or an annual subscription plan. You can also import your PowerPoint presentations or Google Presenter presentations into SlideRocket.

Users initially sign up for a free 14-day trial then decide which plan to subscribe to. Users can also use a free, basic version of the software. In addition, SlideRocket premiered the presentation resume with a variety of templates for users to promote themselves to different companies.

Prezi is a free application which allows you to create visual presentations by zooming in, out and around your visual workspace.Instead of individual slides, these ZUI’s (zoom user interface) are based on one infinite canvas on which all content is presented. This allows for non-linear presentations, richer detail of content, and a better overview of complex visual messages. Prezi also has a mobile app for tablet users.

Prezi

Prezi is web-based presentation software that uses zoom interface rather than individual slides.

Google Docs is now a part of Google Drive’s “software as a service” office suite. The free service includes it own presentation software that can be exported in open office format as well as Microsoft Office. Google Docs are automatically saved to a Google server, which prevents loss while also offering”anytime, anywhere” access.

Internet based collaboration

Another option with all these different packages is internet based collaboration. Using this method, several people revise content or review the changes as they are made by others.