Microeconomics

microeconomics

the study of individual people and businesses and the interaction of those decisions in markets

scarcity

our unlimited wants exceed our limited resources

Factors of production

land, labour, capital, entrepreneurship

opportunity cost

most desirable alternative given up when you make a choice in the face of scarcity

voluntary exchange

makes both buyers and sellers better off

markets

any arrangement that enables buyers and sellers to trade a particular good/service

buyers on demand side, sellers on demand side

allows individuals to reveal their private information when making trades in self-interest → fastest, most efficient mechanism for aggregating inflow

market failure

occurs when a market doesn’t use resources efficiently

what causes market failure

a single producer controls an entire market, it can restrict production and raise the price, producers and consumers don’t account for the costs they impose on others, some goods must be consumed by everyone equally and no one wants to shoulder the cost

inflation

prices rise when the quantity of money in circulation increases faster than production

private sector

the part of the economy run by individuals and businesses

public sector

the part of the economy controlled by the government

factor payments

exchanged for FoP, rent, wages, interest, profits

transfer payments

when the government redistributes income (welfare, social securities)

subsidies

government payments to businesses for them to produce more

value of production

total amount paid to people who produced the item, equal to income and expenditure in the economy as a whole

value of production increases because

prices rise, population increases, productivity increases (which improves living standards)

PPP

absolute advantage

the producer that can produce the most output or requires the least amount of resources

comparative advantage

If a producer can produce a good at a lower opportunity cost than others

Production

The conversion of land, labour, and capital into goods and services

Labour

The time and effort devoted to producing goods and services

Land

All natural resources such as air, water, land surface, minerals

Capital

Goods that can be used in the production of other goods and services, such as buildings, power plants, factories, roadways

Human capital

The accumulated skills and knowledge of people which result from education and on-the-job training

Entrepreneurship

A resource that organises land, labour, and capital. They come up with new ideas about what, when, how, and where to produce and bear the risk of these business decisions.

Production Possibilities Frontier

Limits to production - on the line a producer cannot produce more of one good without producing less of another

Why are they inside the frontier

Unused or misallocated resources

bowed-out frontier

Resources are not equally productive in all activities. The more of anything we produce, the higher its’ opportunity cost. The additional resources allocated to producing that good are less productive.

marginal cost

the opportunity cost of producing one additional unit of a good or service. the amount of alternative goods they must forego.

plans of action adjusted incrementally

marginal benefit

the benefit a person receives from consuming one additional unit of a good or service. this decreases as something becomes more readily available/as they purchase more. the amount of alternative goods they are willing to forego.

plans of action adjusted incrementally

What social institutions organise trade in a market economy?

Property rights: social arrangements that govern the ownership, use, and disposal of resources, goals, and services.

Markets

Types of property

Real property: land, buildings, durable goods

Financial property: shares, bonds, money in banks

Intellectual property: the intangible product of creative effort

Property rights not enforced

If property rights are not enforced, the incentive to specialise and produce goods with comparative advantage is weakened, potential gains are lost as resources become devoted to protecting possessions.

When is resource use efficient

When we produce the goods and services we value most highly

Cost of economic growth

To use resources in research and development and to produce new capital, we must decrease our production of consumption goods and resources. (the opportunity cost of making more of a good in the future is less of the good today)

What drives economic growth

Technological development

Capital accumulation (including human capital)

demand

refers to the relationship between the quantity demanded and the price of a good

quantity demanded

the amount consumers plan to buy in a given period at a particular price (refers to a single point on a demand curve)

law of demand

the higher the UNIT price of a good, the lower the quantity demanded

Q_D = a - bP + cX

quantity demanded = a* - price + exogenous change (other influences)

what causes the law of demand

substitution effect

income effect

substitution effect

when the price of a good rises (and everything else stays constant) its’ opportunity cost/relative price rises, and it has substitutes that can be used in its’ place consumers buy instead

substitution

• the price of one good is positively related to the demand for the other

complements

• the price of one good is inversely related to the demand of the other good

income effect

when a price rises and all other influences on buying plans remain unchanged, the prices rise relative to people’s incomes, thus people cannot afford to buy all the things they previously bought, and the quantities demanded of at least some goods and services (usually including the item with the increased price) must be decreased. (and vice-versa)

what two things does a demand schedule/demand curve tell us

the quantity demanded when a good is a certain price

the highest price that consumers are willing to pay for the last unit bought when a certain quantity is available

other influences on consumers’ buying plans

prices of related goods

income

expected future prices

population

preferences

PIE PP

how do prices of related goods affect demand

substitutes

complements: goods used in conjunction with another good (if price of complement increases, demand for good decreases and vice-versa)

income

when income increases, consumers buy more of most goods, vice-versa

normal goods: increase in demand when income increases

inferior goods: decrease in demand when income increases

expected future prices

the higher the expected future price of a good, the larger today’s demand (and vice-versa)

population

the larger the population, the greater the demand for all goods and services (and vice-versa)

preferences

an individual’s attitudes towards goods and services

movement along the demand curve

if the price of a good changes but everything else remains the same → change in quantity demanded

shift in the demand curve

if the price remains constant but another influence on buyer’s plans changes → a change in demand

AT ANY GIVEN PRICE, THERE WILL BE A HIGHER/LOWER QUANTITY DEMANDED

supply

the relationship between the quantity supplied of a good and its’ price, all else remaining constant

quantity supplied

the amount producers plan to sell in a given period

what causes changes in supply

the prices of FoP

prices of related goods

expected future prices

no. of suppliers

technology

F RENT

law of supply

the higher the price of a good, the greater the quantity supplied

what causes the law of supply

increasing marginal cost: as the quantity produced of any good increases, the marginal cost of producing the good increases (decreasing productivity of resources)

opportunity cost of a more expensive good is higher

prices of FoP affecting supply

e.g. an increase in the prices of necessary labour and capital decreases supply

prices of related goods

substitutes in production → here are other goods that firms could produce using the same FoP. An increase in the price of a substitute in production lowers the supply of the other good because its’ opportunity cost is higher (e.g. car manufacturer deciding which to make)

complements in production → two goods are produced together, if the price of one of these increases, so does the supply of the other. (e.g. by-products)

expected future prices

if the price is expected to rise, less will be supplied today and more will be supplied in the future, and vice-versa

no. of suppliers

the larger the number of firms supplying a good, the larger the supply of the good

technology

technologies that enable producers to use fewer FoPs will lower the cost of production and increase supply (most important over long-term)

movement along supply curve

if price changes but all else influencing planned sales remains constant → change in quantity supplied

shift in the supply curve

price remains constant, another influence on suppliers’ planned sales changes, the entire supply curve shifts for all price points → change in supply

a market moves towards its’ equilibrium because

price regulates buying and selling plans

price adjusts when plans don’t match

if price is cheap and low supply?

bid upwards by consumers willing to pay more

price doesn’t rise all the way to the max they are willing to pay, because at higher prices the quantity supplied increases (and quantity demanded decreases)

if price is expensive and there is a surplus?

consumers undercut each other and price falls to lower price they are willing to charge

price doesn’t fall all the way to the minimum they are willing to charge, because at lower prices the quantity demanded increases (and quantity supplied decreases)

What happens to price and quantity when demand increases?

both the price and quantity (demanded/supplied) increase

What happens to price and quantity when demand decreases?

both the price and quantity (demanded/supplied) decrease

What happens to price and quantity when supply increases?

the quantity (supplied/demanded) increases and the price falls

What happens to price and quantity when supply decreases?

the quantity (supplied/demanded) decreases and the price rises

When both demand and supply

• increase

• decrease

• the quantity increases and the price can either increase or decrease

• the quantity decreases and the price can either increase or decrease

• When demand increases and supply decreases

• When demand decreases and supply increases

• Price rises and the quantity can either increase or decrease

• Price falls and the quantity can either increase or decrease

relative prices

the supply and demand model predicts changes in relative prices, not necessarily the dollar price, i.e. the price is rising and falling relative to related goods (which are held constant)

price elasticity of demand

the responsiveness of the quantity demanded of a good to a change in its’ price

price elasticity of demand (equation)

(percentage change in quantity demanded)

(percentage change in price)

taken from the average quantity demanded and price

elasticity of demand

absolute value of the price elasticity of demand (not negative)

means elasticity regardless of whether price increases or decreases

demand is inelastic

when elasticity is between 0 and 1

demand is elastic

when elasticity is greater than 1

perfectly elastic/inelastic

curve shape

elasticity = infinity/0(demand doesn’t change with price)

graph = horizontal/vertical

unit elastic demand

dividing line between elasticity being less than and greater than 1*

*revenue when elasticity of demand <1

percentage decrease in quantity demanded does not exceed the percentage rise in price, total revenue increases

*revenue when elasticity of demand >1

percentage decrease in quantity demanded exceeds the percentage rise in price, total revenue decreases

*revenue when elasticity of demand =1

total revenue stays constant and reaches maximum value

*relationship between elasticity and price

elasticity decreases as price falls

% change is small at a high price/quantity and a bigger proportion at a low price/quantity

the lower the initial price, the larger the % change in price, the smaller the % change in the quantity demanded → the smaller the elasticity

revenue

price x quantity sold

expenditure

price x quantity bought

what determines the size of elasticity of demand?

• the ease with which one good can be substituted for another

• the proportion of income spent on the good

• the significance of price in total cost to the consumer

• the amount of time elapsed since the price change

SIPT

the ease with which one good can be substituted for another

the closer the substitutes for a good or service, the more elastic the demand for it (e.g. oil has n close substitutes → inelastic demand)

• necessities: goods that have poor substitutes and are crucial for our wellbeing → inelastic demand

• luxuries: vice-versa → elastic demand

proportion of income

other things being equal, the higher the proportion of income spent on a good, the higher the elasticity

if a good is only worth a fraction of the buyer’s income, a change in price will have little impact on their overall budget

significance of total cost to the consumer

the total opportunity cost of a bus trip involves not just the price but also the waiting and travel time

thus a change in price may only slightly affect full cost of travel→ only a small change in demand

time frame for demand

the greater the lapse of time since a price change, the higher the elasticity of demand as people develop substitutes for the good of increased price

short- vs. long-run demand → an increase in price may increase revenue in the short run, but not the long run as elasticity changes

short-run demand

this curve describes the initial response of buyers to a change in the price of a good

depends on whether the price change is seen as permanent or temporary

• quantity bought doesn’t change much in the short run (inelastic) → people don’t readily change buying habits

• highly elastic

long-run demand

this curve describes the response of buyers to a change in price after all possible adjustments have been made

more elastic than short-run demand as people find alternatives

all kinds of elasticities of demand

• price elasticity (duh)

• income elasticity of demand

• cross-elasticity of demand

PIC

income elasticity of demand

shows how the demand for a particular good changes as income grows

income elasticity of demand (equation)

η(y) = percentage change in quantity demanded

percentage change in income

income elasticity of demand > 1

quantity demanded increases faster/at a bigger percentage than income (e.g. art, designer, cruises, watches, jewellery)

increasingly steep curve

income elasticity of demand < 1

quantity demanded increases with income, but by a lower percentage/more slowly than income (e.g. food, clothing, furniture)

increasingly flat curve

income elasticity of demand <0

as income increases, quantity demanded increases (elasticity is +ve) until it reaches a max. income at m. beyond that point, as income increases, quantities demanded decrease (elasticity is -ve) → inferior goods

cross-elasticity of demand

the responsiveness of the quantity demanded of a particular good to the prices of its’ substitutes and complements

cross-elasticity of demand (equation)

η(x) = percentage change in quantity demanded

percentage change in price of another good

can include total cost, i.e. not just price but opportunity costs, time, etc.