The Fundamentals of Economics: formula sheet

Key formulas

Smith's definition

Economics = Science of wealth

Wealth definition. Book: The Wealth of Nations. Smith is called the father of economics.

Marshall's definition

Economics = Study of mankind in the ordinary business of life, focused on material welfare

Welfare definition. Wealth is a means, welfare is the end.

Robbins' definition

Economics = Science of human behaviour between unlimited ends and scarce means having alternative uses

Scarcity definition. Three keys: unlimited wants, scarce means, alternative uses.

Samuelson's definition

Economics = Study of choice in using scarce resources over time, for present and future consumption

Growth (dynamic) definition. Key word: time.

Micro vs macro

Micro = individual units; Macro = aggregates of the whole economy

Price of one good is micro. General price level (inflation) is macro.

Positive vs normative

Positive = what is (testable); Normative = what ought to be (value judgement)

Words like should, ought, better, fair usually signal normative.

Opportunity cost

Opportunity cost = value of the next best alternative forgone

Only the single best alternative counts, not all alternatives added together.

Marginal rate of transformation (MRT)

MRT = units of good Y given up ÷ units of good X gained

This is the slope of the PPC and equals the opportunity cost of one more unit of X.

Central problems

What to produce | How to produce | For whom to produce

These arise because resources are scarce and have alternative uses.

Position relative to PPC

On the curve = full and efficient use; inside = underuse; outside = unattainable

Growth in resources or technology shifts the PPC outward.

Three central questions

What to produce? How to produce? For whom to produce?

Every economic system must answer these because resources are scarce.

Capitalism in one line

Private ownership + profit motive + price mechanism

Also called free enterprise or market economy. Consumer sovereignty applies.

Socialism in one line

State ownership + central planning + social welfare motive

Also called a planned or command economy. Prices are controlled by the state.

Mixed economy in one line

Private sector + public sector + government regulation

India is the standard example.

Law of demand

Price ↑ ⇒ Quantity demanded ↓ ; Price ↓ ⇒ Quantity demanded ↑ (other things equal)

Inverse relationship. Demand curve slopes downward.

Demand function

Dx = f(Px, Py, Y, T, E, N …)

Px is own price, Py is price of related goods, Y is income, T is tastes, E is expectations, N is number of buyers.

Market demand

Market demand at a price = Σ individual demands at that price

Add quantities horizontally, not prices.

Movement along the curve

Own price changes ⇒ extension or contraction of demand

The curve does not move.

Shift of the curve

Any other determinant changes ⇒ increase (right shift) or decrease (left shift) in demand

Price stays on the Y-axis; the whole curve moves.

Exceptions to the law

Giffen goods, Veblen (conspicuous) goods, expectation of price change, necessities in emergencies

Here a price rise may be accompanied by higher quantity demanded.

Law of supply

Price ↑ ⇒ Quantity supplied ↑; Price ↓ ⇒ Quantity supplied ↓

Holds only when other determinants stay constant. Supply curve slopes upward.

Supply function

Sx = f(Px, Pr, Pf, T, G, Tx, O)

Px = own price, Pr = price of related goods, Pf = price of inputs, T = technology, G = firm's goal, Tx = taxes/subsidies, O = other factors such as weather and number of sellers.

Movement along the curve

Change in own price ⇒ extension or contraction of supply

Same curve, different point.

Shift of the curve

Change in any other determinant ⇒ increase (right shift) or decrease (left shift) in supply

A new curve is formed.

Market supply

Market supply at a price = sum of all sellers' quantities at that price

Add horizontally across sellers.

Price elasticity of demand (percentage method)

Ed = (% change in quantity demanded) ÷ (% change in price)

Usually quoted as an absolute value. % change in quantity = (ΔQ ÷ original Q) × 100.

Price elasticity (original-value form)

Ed = (ΔQ ÷ Q) ÷ (ΔP ÷ P) = (ΔQ ÷ ΔP) × (P ÷ Q)

Use the original (old) price and quantity unless the question says to use the average.

Arc (midpoint) elasticity

Ed = (ΔQ ÷ ΔP) × [(P1 + P2) ÷ (Q1 + Q2)]

Use when the question asks for elasticity between two points or the average method. It gives the same value in either direction.

Point elasticity on a straight-line demand curve

Ed = lower segment ÷ upper segment (of the demand line, measured from the point)

At the midpoint of the demand line Ed = 1. At points above the midpoint Ed > 1, and at points below the midpoint Ed < 1.

Total expenditure method

Price up and total expenditure down: Ed > 1. Price up and expenditure unchanged: Ed = 1. Price up and expenditure up: Ed < 1. Price down and total expenditure up: Ed > 1. Price down and expenditure unchanged: Ed = 1. Price down and expenditure down: Ed < 1.

Expenditure moves opposite to price when demand is elastic, and with price when inelastic. The rule works the same for a price rise or a price fall.

Income elasticity of demand

YED = (% change in quantity demanded) ÷ (% change in income)

Positive: normal good. Negative: inferior good. Above 1: luxury.

Cross elasticity of demand

XED = (% change in quantity of X) ÷ (% change in price of Y)

Positive: substitutes. Negative: complements. Zero: unrelated.

Elasticity of supply

Es = (% change in quantity supplied) ÷ (% change in price)

Above 1 is elastic supply, below 1 is inelastic, equal to 1 is unitary.

Equilibrium condition

Qd = Qs

Set the demand function equal to the supply function and solve for price P.

Equilibrium quantity

Q* = Qd at P* (or Qs at P*)

Put P* in either function. Both must give the same value; use the second as a check.

Surplus (excess supply)

Qs − Qd at a price above P*

Occurs at any price above equilibrium.

Shortage (excess demand)

Qd − Qs at a price below P*

Occurs at any price below equilibrium.

Consumer surplus

Price consumer is willing to pay − Price actually paid

On a straight-line demand graph, it is the triangle between the demand curve and the price line.

Producer surplus

Price actually received − Minimum price seller would accept

On a straight-line supply graph, it is the triangle between the price line and the supply curve.

Triangle area for surplus

½ × base × height

Base is the quantity traded. Height is the gap on the price axis from the equilibrium price to the intercept of the demand or supply curve.

Effect of shifts

Demand ↑: P ↑, Q ↑ | Demand ↓: P ↓, Q ↓ | Supply ↑: P ↓, Q ↑ | Supply ↓: P ↑, Q ↓

Holds when only one curve shifts and the other stays the same.

Quick revision

• Economics studies how people choose to use scarce resources that have alternative uses.
• Microeconomics deals with individual units such as a consumer or firm; macroeconomics deals with the economy as a whole.
• Scarcity means wants are unlimited but resources are limited, which forces choice.
• Opportunity cost is the value of the next best alternative given up.
• The central problems are what to produce, how to produce and for whom to produce.
• Capitalism relies on markets and private ownership; socialism on state ownership and planning; a mixed economy combines both.
• Law of demand: other things equal, when price falls quantity demanded rises, and the demand curve slopes downward.
• Law of supply: other things equal, when price rises quantity supplied rises, and the supply curve slopes upward.
• A change in price causes movement along the curve; a change in other factors shifts the curve.
• Price elasticity of demand = % change in quantity demanded ÷ % change in price; above 1 is elastic, below 1 is inelastic.
• Equilibrium price is where quantity demanded equals quantity supplied.
• If demand rises with supply unchanged, equilibrium price and quantity both rise.

Common mistakes

• Attributing the scarcity definition to Marshall or the welfare definition to Robbins. Fix: Use the fixed chain: Smith wealth, Marshall welfare, Robbins scarcity, Samuelson growth.
• Calling inflation or unemployment a microeconomic topic. Fix: Ask if it is an aggregate for the whole economy. Inflation, unemployment and national income are macro.
• Adding up all alternatives to get opportunity cost. Fix: Remember opportunity cost is only the value of the next best alternative forgone.
• Treating scarcity as rarity or poverty. Fix: In economics, scarcity means resources are limited relative to wants. Even rich countries face it.
• Saying India is a socialist economy because of the planning era. Fix: Remember that India has both private and public sectors, so it is a mixed economy.
• Thinking pure capitalism has no government at all. Fix: Say the government role is minimal, mainly law, order and defence, not absent.
• Calling a fall in own price an increase in demand. Fix: Own price change means extension or contraction in quantity demanded. Increase or decrease in demand is only for a shift.
• Forgetting that the law needs other things to stay equal. Fix: Always include ceteris paribus in definitions. Without it, the law cannot be stated correctly.
• Calling a price-led change an 'increase in supply'. Fix: If the cause is the good's own price, the term is extension. Use 'increase' only for a rightward shift caused by other factors.
• Treating supply as the same as stock. Fix: Supply is the quantity offered for sale at a price. Stock is the total held. Supply cannot exceed stock but can be much less.

Exam tips

• Expect direct matching questions: author to definition or definition to key idea. Learn the four keywords cold.
• Micro versus macro classification is a favourite. Practise sorting topics like price of rice (micro) and national income (macro).
• Remember one criticism for each definition, since options often test the weakness.
• For positive versus normative, hunt for should, ought and better. Those words almost always signal normative.
• With no negative marking, never leave a question blank. Eliminate wrong authors first, then guess.
• Questions are usually one-line definitions, so learn exact keywords: limited resources, unlimited wants, alternative uses, next best alternative.
• Expect matching-style MCQs that give a situation and ask which central problem it shows. Match the wording to what, how or for whom.
• On PPC questions, remember: on the curve is efficient, inside is unemployment, outside is unattainable, and the outward bow means increasing opportunity cost.