Dr.

Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS 1

ECO101— PRINCIPLES OF MICROECONOMICS—Notes

Overview

In this chapter we will briefly examine the various tools, which economists use to
analyse real life

phenomena. These are models, graphs, diagrams, and data collection, data
calculations and data

interpretation techniques.

Models and Theories

Economists observe real life economic phenomena over a period of time and
develop a theory or model to

grasp or understand the essence of the issue / problem at hand. In order to test the
predictive validity of the

theory / model, economists collect economic data and use various statistical and
other techniques to derive

conclusions. In practice or reality, researchers never confirm a theory: they simply

attempt to reject it by

subjecting it to real-world evidence. If the data do not substantiate the model /

hypothesis, then it is

rejected. If the data “fit”, and economists are very confident about the predictive
validity of the model /

hypothesis over time (after continuous testing and re-testing) then this model may
be called a ‘law’.

Using Graphs to Illustrate Relationships

Economic relationships (as any other relationship) may be expressed in a number of

ways: in words, as a

mathematical expression (i.e., an equation), in a table (or schedule), or as a graph.

In the table below, we

represent one such relationship (revenues as determined by sales, Q):

10

E x p re ssin g E co n o m ic R e la tio n sh ip s
E quation: Q d = 100 – 0.5P

T a ble:

G rap h:

Tools of Economic Analysis Dr. Savvas C Savvides--School of Business, EUROPEAN

UNIVERSITY CYPRUS 2

“A picture is worth a thousand words …” Graphs are like a picture. Certainly

economics is not all about

graphs. They are simply a very useful tool to help us illustrate the various economic
relationships. It is

generally easier to communicate an idea using a picture (or a graph) than describe
it in words.

A graph is a visual representation of the relationship between two or more variables

—these are

things/quantities that can change. There are two types of variables in a relationship:
independent

variable(s), which can change in value freely due to a number of reasons, and a
dependent variable,

which changes in value depending on the changes in the value of the independent
variable(s).

From a Schedule (or Table) to a Graph

Before we go further into the different forms of graphs, how we construct them, and
how we use them, let’s

examine how the “thousand words”—i.e., the data, the information—can be

represented and then see how

they can be converted into a graph.

Let’s return to the law of demand that we examined in Chapter 1, and use the price
of CDs as an

illustration. How many CDs would the students in this class buy if they were priced
at £15? Perhaps 10.

What would be the outcome if prices dropped to £10? Let’s say, 15 might be
bought. What if the price
dropped further – say to £5? Then perhaps 20 students in the class would decide to
buy a CD.

This information can be represented into a table (or a schedule as may also be
called), showing the

relationship between the price of CD’s and the quantity demanded at each price as
follows:

Price Quantity

£15.0 10

10.0 15

5.0 20

We can construct a graph to show the relationship between price and quantity
demanded of CDs, with a

scale of 0 – 30 on the quantity axis (in lots of 5). Likewise a price axis can be
constructed in £1 units (up to

£20). Using the combinations of price and quantities of CDs referred to above, we
can plot the demand

curve (line) for the CD’s demand schedule. We can use the graph we derived to find
out how many CDs

would be bought at a price of, say, £12. Work out the price at which no one would
buy CDs.

Price

£20

A Demand Curve

£15

£10 B

£5 C

10 15 20 Quantity Dr. Savvas C Savvides--School of

Business, EUROPEAN UNIVERSITY CYPRUS 3
Of course, not all relationships lead to graphs that are straight lines, and not all are
downward sloping. If we

were to graph the relationship between average weight and average height, the
graph will be upwardsloping indicating a positive relationship between the two
variables. In economics, such positive relationship

(upward-sloping curve) exists between price and quantity supplied.

Additionally, some relationships may not be linear, in which case the “curve” will
indeed exhibit a

“curvature”. In economics, we will see when we study the economics of the firm
that such graphic behavior

is present for Average and Marginal Costs. At other times, the curves may be
complex, exhibiting both

positive and negative relationship between the variables (such may be the behavior
of total cost curves).

Holding All Other Things Constant (Ceteris Paribus)

In the simple relationships we described above and represented in a graph, we were

forced to have one

dependent variable and one independent variable, since a graph is two-

dimensional. In reality, however, we

know, for instance, that the quantity demanded of a normal good (say CD’s) may
influenced by other

variables and factors other than price alone. These may be income, tastes, prices of
competing goods, etc.

We also know that their influence on quantity may be concurrent. However, we

cannot represent the

concurrent influences in a two-dimensional graph. This is the reason economists

represent relationships

(such as demand and supply) between two variables (such as price and quantity),
holding all other things

constant, (or ceteris paribus), in order to isolate the influence of one independent
variable (such as price) on

the dependent variable (such as quantity).

The Slope of a Linear Curve

The slope of a line (or a curve) is a very important property with many applications
in economics. Consider

the demand schedule and the graph of CD’s as discussed above. The graph is
reproduced below. They

show the quantities of CD’s that students are willing to buy at different prices.

The slope of a line is defined as the change in the value of the y variable shown on
the vertical axis (in this

case price) divided by the corresponding change in the value of the x variable
represented on the horizontal

axis (in this case quantity demanded).

Negative linear relationship Positive linear relationship Complex

non-linear relationship Dr. Savvas C Savvides--School of Business, EUROPEAN
UNIVERSITY CYPRUS 4

Slope of a Line

Slope between A & B

∆ P/ ∆ Q = -5 / + 5 = - 1

In the graph above, let’s measure the slope of the demand curve (line) as we move
from point A to point B.

The change in the y variable (the price) is - £5 (minus five pounds, from £15 to
£10), whereas the change in

the x variable (quantity in this case) is + 5 units, the number of CD’s that students
are willing to buy at that

reduced price. Applying the formula of the slope—defined above as the change in
the y variable divided by

the change in the x variable—we get:

-5/5 =-1

A useful way to apply and compute the slope of a line is to think of the change in
the y variable as the “rise”

–movement in the vertical direction—over the “run”—movement along the

horizontal axis. Conceptually, this
can be shown in the exhibit below, where the slope is measured as the value of the
“rise” divided by the

value of the “run”. When both the rise and the run are positive, the slope is positive.
When the rise and the

run have opposite signs—that is, one is positive and the other is negative—then the
slope is always

negative.

(-)

Slope = ------- = Negative

(+)

(- ) Rise

(+) Run Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY

CYPRUS 5

S lop e of N on -L in ear R elation sh ips

S lo p e o f T R a t A is p o s itiv e:

Î S lo p e o f ta n g e n c y a t p t. A

TR

T o ta l R e v e n u e

Quantity

S lo p e o f T R a t B is n e g a tiv e

Î S lo p e o f ta n g e n c y a t p t. B

Real and Nominal Variables

Many economic variables are measured in money terms: our monthly salary, the
value of savings

we have in the bank, the prices we observe on shoes and clothes and other items in
shops, as well
as many macroeconomic variables, such as the money supply, the value of goods
and services

produced in one year (GDP), the revenues from tourism in one year, the profits
reported by

companies every year, the daily value of transactions on the Cyprus Stock
Exchange, etc.

However, in many cases it is useful to know the real values of things. The real value
is the

variable’s value after we adjust for changes in prices compared to a base year
(sometimes referred

by economists as ”constant prices”). Below, we present an example using

hypothetical values for

house prices and the overall Retail Price Index (as proxy for the movement of the
general price

level.

R eal & N om inal V alues--E xam ple

H ouse P rice £2,500 £27,000 £125,000

Price Index (2000=100) 7.4 39.3 100.0

Real House Price (in £33,783 £68,702 £125,000

2000 prices)

Real House Price (in £2,500 £5,084 £9,250

1960 prices)

1960 1980 2000

(2,500*100) / 7.4 = 33,783 (125,000*7.4) / 100 = 9,250Dr. Savvas C Savvides--

School of Business, EUROPEAN UNIVERSITY CYPRUS 6

Scatter Diagrams

Up to now, we talked about the various ways of expressing relationships and

explained in some detail the

way we plot relationships between two variables, in an attempt to visualize how an

independent variable
impacts on (influences) another variable (the dependent variable). The examples
given above—as we will

do many times during the course—are hypothetical.

The real-world data that economists collect to test their theories (hypotheses)
typically produce graphs and

diagrams that are “scattered all over the place,” rather than the neat ones we
plotted above. It is from these

“scatter diagrams” that they try to derive (infer) trends. In the diagram below, we
present a set of data for

price and quantity demanded collected over a period of time (called time-series
data). When plotted on a

graph these data are represented by the X’s. Though the relationship is not perfect
since the points are

scattered, when viewed closely these points exhibit a downward trend, validating
the inverse relationship

that we expect to have between price and quantity demanded, as taught by

economic theory.

There are some statistical techniques that economists use to “fit” a curve to these
scatter points which will

come close to resembling the neat demand curve we derive from our hypothetical
values of price and

quantity.

Data & Scatter Diagrams

7 6.5 88

6 7.0 80

5 6.0 87

4 6.5 85

3 6.0 90

2 5.5 105

1 6.0 100
Year Price Quantity

Price

Quantity

X (7.0, 80)

X (6.0, 100)

7.0

6.0

80 100

Index Numbers

An Index number expresses data relative to a given base value. They are useful in
that they enable us to

compare numbers without express reference to the unit of account / measurement.

The table below shows

how index numbers are calculated for a set of values of silver prices at different
time periods. Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY
CYPRUS 7

In d e x N u m b e rs

S ilv e r I n d e x 3 7 1 0 0 1 0 4

(1990 =

100)

S ilv e r P r i ce 1 7 7 4 8 2 5 0 0

1 9 70 1 9 90 2 0 00
17 7 / 48 2 = 0.36 7 = 375 0 0 / 4 82 = 1 .03 7 = 10
4

Index Averages

We frequently come across a number of index averages: the Retail Price Index RPI),
the stock market

Index, the metals index, the purchasing managers’ index, etc are only a few
examples of many index

averages. If we think of the stock market index, we know that prices of different
stocks change differently.

For instance, the price of Bank of Cyprus may be moving upwards over a given time
period, while the price

of Cyprus Cement may be moving down. To derive a single measure of how all the
stock prices on the

stock exchange move we average different stock prices.

To see how index averages are calculated lets use the prices of different metals
over the same time period

as in the table above to construct the metals index. The calculations are shown in
the following graph:

In d e x A v e r a g es

Silver In dex 37100104

(1990 = 1 0 0)

Copper In dex 5310068

(1990 = 1 0 0)

M e t a ls I n d e x 5010075

(1990 = 1 0 0)

20%

80%

Weight =
Weight =

S i l v e r I n d ex

C o p p e r I n d ex

19 7019 9020 00

(37 *0.2 ) + ( 5 3 * 0 .8 ) = 4 9 .8 ( 1 0 7 * 0 . 2 ) + ( 6 8 * 0 . 8 ) =
7 5 .2

Total, Averages and Marginal ValuesDr. Savvas C Savvides--School of Business,

EUROPEAN UNIVERSITY CYPRUS 8

Students may associate more with their course grades in order to understand better
the meaning of

averages and marginal values. Let’s assume that during the semester, a student
attending ECO101—

Principles of Microeconomics at Cyprus College has the following grades: 80, 85, 90,
and 75 (assume all

grades have equal weighting). The total value (in this case it has no meaning!) is
330.

Average Value: The average value (average grade in this case) is the addition of all
four grades—which

happens to be the total value of 330—divided by the number of observations (the

number of tests in this

case) which happens to be 4. Thus, the average grade is:

( 75 + 86 + 93 + 84 ) / 4 = 330 / 4 = 84.5

Notice that we can find the average grade after the first two exams [(75 + 86) /2] =
80.5, or after the first

three exams [( 75 + 86 + 93) / 3] = 84.7, and so on.

Marginal Value : Let’s now calculate a slightly more difficult concept for students to
understand, that of the

marginal value and perhaps one of the most important concepts in economics. In
mathematics, a marginal

change is a very, very small (infinitesimal!) change in the total value (the total
value of your grade) as a
result of a change in the quantity of another variable (the number of exams). In the
examples we will be

using in economics, the size of the change will be one unit.

Again sticking with the example of the grades, let’s ask the question: How can you
improve (that is,

increase) your average grade? The answer is of course easy: Get a higher grade
than your average in your

next exam! After the first two exams, we found that the average was 80.5 – a total
of 161 divided by two

exams. The grade on the third exam was 93, which is substantially higher than the
average of 80.5.

Therefore, we should expect the average to improve! Let’s see this in numbers:
[( 75 + 86 + 93) / 3] = 254 /

3 = 84.7. Indeed the average has improved from 80.5 to 84.7. So what is the
marginal value of the third

grade?

We defined the marginal value as the “change in the total value as a result of a unit
change in the quantity

of another variable”. Therefore, from two exams we go to three exams. The total
value of grades goes from

161 (after two exams) to 254 (after three exams). Therefore, the total value
changes by 93. In the fourth

exam, however, the student scored 84 which a lower grade than the average, and
therefore the average fell

from 84.7 to 84.5.

In the table below we present a similar example of the relationship between total,
average and marginal

values using an economic example, that of costs.- Dr. Savvas C Savvides--School of

Business, EUROPEAN UNIVERSITY CYPRUS 9

AC = TC /Q

M C = ∆ T C /∆ Q
96

60

60

80

140

AC

240

60

20

20

120

MC

5 480

4 240

3 180

2 160

1 140

0 20

QTC

Total, Average, & Marginal Cost

General Relationship Between Average and Marginal Measures

We can now generalize the relationship between averages and marginals by stating
a mathematical and

always true relationship:

1. When MARGINAL > AVERAGE Î AVERAGE rises . If the average grade is 80 and
the next

grade is higher than the average (say 90) then the average grade will rise.

2. When MARGINAL < AVERAGE Î AVERAGE falls. If the average grade is again 80
and the next

grade is now lower than the average (say 70) then the average grade will fall.

3. When MARGINAL = AVERAGE Î AVERAGE remains the same. If now the next
grade is

exactly the same as the average (that is, it is 80) then the average grade will
remain the same.

References for further reading:

Bade, R. and Parkin, (2007). Foundations of Economics 3

rd

edition (Pearson Education).

Begg, D., Fischer, S. and Dornbusch, R. (2005). Economics 8

th

edition (McGraw-Hill).

Mankiew N. Gregory (2007). Principles of Economics 4

th

edition (Thomson, South-Western).

McConnel C. and S. Brue (2005). Economics 16

th

edition (McGraw-Hill).

Miller, R.L (2006). Economics Today 13

th

edition (Pearson Addison Wesley).

Sloman John (2006). Economics 6

th
edition (Prentice Hall).