Microeconomics Study Set

Demand

The amount of a good that consumers are willing and able to buy at every price level in a period of time.

Demand alone determines the buyer's intent, but not the market price.

Law of Demand

Other things being equal (ceteris paribus), there is an inverse relationship between price and the quantity demanded.

Assumptions for Demand

- Perfectly Competitive Market

- A free enterprise system exists when economic decisions are made through the market mechanism.

- No intervention to prevent the free play of supply and demand in the market.

Market

- a mechanism that brings together buyers and sellers for the purpose of making an exchange.

- Ultimately determines the market price and output.

Market Prices Bring Order by:

1. Information

2. Incentives

Supply

Shows the various quantities of a good or service that sellers will be willing and able to offer buyers at various prices during a period of time.

Law of Supply

Other things being equal (ceteris paribus), there is a direct relationship between price and the quantity supplied.

Assumptions for Supply

- Perfectly Competitive Market

- Products are of a constant quality

- Short-run analysis

Non-Price Determinants of Supply

- Cost of Resource Inputs

- Technology

- Prices of Related Goods

- Subsidies and Taxes

- Expectations

- Number of Sellers

Justification for the Law of Demand

- Common Sense: Price is an obstacle

- Diminishing Marginal Utility: Consumption is subject to the law of diminishing marginal utility; each buyer of a product derives less and less utility (benefit or satisfaction) from each successive unit consumed.

- The Substitution Effect: a change in quantity demanded resulting from substituting one good for another

- The Real Income Effect: a change in quantity demanded resulting from a change in purchasing power or Real Income (inflation should be considered).

Non-Price Determinants of Demand

- Income (Increase vs Decrease)

- Prices of Related Goods (Substitutes vs Complements)

- Expectations

- Population

- Tastes & Preferences

Elasticity

A measure of responsiveness

Price Elasticity of Demand (PEd)

A measure of how responsive the quantity demanded of a good is to a change in its price.

-Inelastic: 0-1

- Unit Elastic: 1

- Elastic: >1

Things that can impact PEd

- The number and closeness of substitutes

- Branding

- The time period involved

- The greater the % of a person's income

- Whether the good is a necessity or a luxury

Income Elasticity of Demand (YEd)

A measure of how responsive the quantity demanded of a good is to a change in average income levels.

(sign matters)

Range for YEd

- If the number is positive: 0-1, normal good.

- If the number is positive: >1, luxury good.

- If the number is negative: <1, inferior good.

Price Elasticity of Supply (PEs)

A measure of how responsive the quantity supplied is to a change in the price of the good.

Unlike PEd, the extreme ranges are possible. The ranges are always positive.

The ranges are the same as PEd

0 - Perfectly Inelastic

0 < PEs < 1 - Inelastic (less responsive)

1 - Unit Elastic

PEs > 1 - Elastic (responsive)

PEs = infinity - Perfectly Elastic

Things that impact PEs

- Substitution and Production Costs:

If capital, equipment, and/or land can easily be shifted from one product to another, then supply would be more elastic.

- Spare Capacity:

If the firm has lots of space to expand production quickly, then the supply would be more elastic.

Full capacity = inelastic

If a company has inventory, it would be more elastic.

If the firm has raw materials or components, they are more elastic.

-Time Period:

Supply becomes more elastic the longer the time period the firm has to respond to changes.

In the short run, the supply curve may be inelastic as the firm may have difficulties changing its production processes or factors of production.

Price Controls

A price imposed on the market by a central authority, so that the control price prevails and not the market price.

Forms of price controls

- Price Floors

- Price Ceilings

- Taxes and Subsidies

- Buffer Stocks

Price Floors

Minimum price set above the equilibrium.

Price floors are usually done to protect producers and ensure that an adequate supply of a good is provided.

Based on the graph: Qs > Qd, surplus

Who Benefits from Price Floors

- Workers who have jobs (Qd) at the higher wage

- The overall economy can benefit if the increase in wages leads to increased spending in the economy.

- Do you have a more motivated and therefore productive worker?

Who Loses from Price Floors

- unemployment workers (Qs - Qd)

- firms have increased costs

- The government and taxpayers have to provide for the unemployed

Agricultural Price Supports

- Used to protect producers. Keeps price above equilibrium to allow farmers can stay in business,

- The consequence is that it creates a surplus of the good, and consumers pay more for that good.

- Also creates a problem of what to do with the surplus of the good?

- Export it! However, the world price is lower

- Also, if we export it and sell it for a lower price, the goods might find their way back to our market.

- This could undermine our product.

- Exporting can also harm foreign producers, who might not be happy.

- Alternative use-Biofuel, for example

- Send it to poorer countries (LDCs)

- This could hurt farmers in those countries.

- Destroy the good

- Store it for later - if it isn't perishable.

- Costs of Storage

- Transportation Costs

- Administration Costs

Price Ceilings

A maximum price set below the equilibrium price

- Usually done to protect consumers

- Examples: Rent Controls, Tuition Freezes

- Rent controls would create a shortage of rental units where Qd > Qs

How do we solve the shortage?

- Ration the good

- Line up

- Parallel markets may for, selling the good underground for a higher price

- Discrimination might happen - i.e. only renting to a specific group.

Who wins with price ceilings?

- Those who get the good (rental unit) at the lower price,

Who loses with price ceilings?

- Those who cannot get the good.

- Landlords who can't get the amount of money they want (or should?)

- Apartments might not be kept in as good condition.

Primary Commodities

They are essentially raw materials and unprocessed goods, such as sugar, coffee, copper, etc.

Primary goods

They tend to be inelastic in demand. This is because they are necessities to those who use them.

When it comes to price elasticity of supply, primary goods (commodities) tend to be inelastic as well. This is because they are relatively fixed in supply. If the price of the commodity increases, the supply offered cannot be quickly changed.

Taxes

Taxes are amounts imposed on consumers or businesses by the government. There are different forms of taxes.

1. Direct Taxes - taxes directly on consumers, such as income, EI, and CPP. These generally come directly off a paycheque.

2. Indirect Taxes - taxes on the consumption of goods or services. Examples include GST, VAT, consumption and excise tax. In Canada, indirect taxes take up about 30% of government income. In the US, about 17%.

Reasons to impose taxes

a) Revenue generation

b) Discourage consumption

Indirect Taxes

An indirect tax is placed on the selling price of a product so that it raises the firm's costs. This will shift the supply curve to the left. Therefore, less of the product will be supplied at every price level. There are types of indirect taxes we need to consider:

i) A specific tax - a specific amount of tax that is added to a product, such as $3.00 per pack of cigarettes. This has the effect of shifting the supply curve vertically upwards by the amount of the tax. WE label the curve S + tax.

ii) A percentage tax (also known as an ad valorem tax), where the tax is a percentage of the selling price. This tax is an increasing amount as the value of the sales increases.

Factors to Consider when an indirect tax is imposed on a product

What will happen to the consumer price?

What happens to the amount received by the producer?

How much tax revenue does the government receive?

What happens to the size of the market (and employment)?

Extreme Cases (Taxes)

Perfectly Inelastic Demand

"Consumers bear 100% of the tax because they cannot reduce the quantity demanded."

Perfectly Elastic Demand

"Producers bear 100% of the tax because consumers will stop buying if the price increases."

Perfectly Inelastic Supply

"Producers bear 100% of the tax because quantity supplied cannot adjust."

Perfectly Elastic Supply

"Consumers bear 100% of the tax because producers will not accept a lower price."

Subsidies

A payment made by the government to producers of goods and services.

Purpose of Subsidies

- to help producers compete, lower their costs

- to increase the supply of a good, prevent shortages

- to lower the consumer's price of a good

Ex. subsidies are often given to farmers to increase (or maintain) production of a certain agricultural product.

Extreme Cases (Subsidies)

Perfectly Inelastic Demand

"Consumers receive 100% of the subsidy because they cannot change the quantity demanded."

Perfectly Elastic Demand

"Producers receive 100% of the subsidy because consumers refuse to pay more."

Perfectly Inelastic Supply

"Producers receive 100% of the subsidy because they cannot change the quantity supplied."

Perfectly Elastic Supply

"Consumers receive 100% of the subsidy because producers will supply any quantity at the given price."

Deadweight Loss

The loss of economic efficiency that occurs when the equilibrium outcome of a good or service is not achieved, leading to a reduction in both consumer and producer surplus.

Positive Externality

The market tends to underallocate resources for goods with positive externalities.

Negative Externality

The market tends to overallocate resources for goods with negative externalities.

Public Goods

Goods that are non-excludable and non-rivalrous, meaning that individuals cannot be effectively excluded from using them, and one person's use does not reduce availability for others.

Examples: street lighting, national defense, clean air

Private Goods

Goods that are both excludable and rivalrous, meaning that people can be prevented from using them and one person’s use of the good diminishes availability for others.

Examples: food, clothes, phones, concert tickets

Common resources

Goods that are non-excludable but rivalrous, meaning individuals cannot be excluded from using them, but one person's use reduces availability for others.

Examples: fisheries, forests, groundwater, public roads (when congested)

Club Goods

Goods that are excludable but non-rivalrous, allowing for limited access while not diminishing availability for other users.

Examples: Netflix, gyms, private parks, toll roads (when not congested)

Merit Goods

Goods that are considered beneficial for individuals and society, often underprovided in a free market. Governments may provide these or subsidize them to promote consumption.

Examples: education, healthcare, public transport

Demerit Goods

Goods that are considered harmful for individuals and society, often underprovided in a free market. Governments may discourage these or tax them to reduce consumption.

Examples: Cigarettes, Alcohol, Drugs

PPF (Production Possibilities Frontier)

• the maximum output combinations of two goods

• an economy can produce

• using all resources efficiently

• with current technology

Factors of production (LLCE)

1. Land

• Natural resources (oil, water, land, minerals)

• More land/resources → PPF shifts outward

2. Labour

• Number of workers + skills

• Better education/training → outward shift

3. Capital

• Machines, tools, factories (NOT money)

• More/better capital → outward shift

4. Entrepreneurship

• Risk-taking, innovation, organization

• New ideas/business models → outward shift

Shape of the PPF

Usually curved outward

Why?

• Law of increasing opportunity cost

• Resources aren’t equally good at making both goods

Example:

• Workers good at farming ≠ good at making computers

• Switching resources becomes more costly over time

⚠ Straight line PPF = constant opportunity cost (rare, only if resources are perfectly adaptable)

Opportunity cost

Opportunity cost = what you give up to get more of another good, usually measured by what you gave up.

Explicit costs - any costs to a firm that involve the direct payment of money. An example would be wages.

Implicit costs - the earnings that a firm could have made if it had used its factors of production in another use or hired them out, or sold them to another firm.

Points on, inside, outside the PPF

🔹 On the curve

• Productively efficient

• All resources fully used

🔹 Inside the curve

• Inefficient / unemployed resources

• Causes:

  • recession

  • unemployment

  • underused factories

🔹 Outside the curve

• Unattainable (right now)

• Needs:

  • more resources

  • better technology

Shifts of the PPF

Outward shift (economic growth)

Caused by:

• More land

• More/better labour

• More capital

• Technological progress

• Education & training

⚠ Growth biased toward one good = PPF shifts more on one axis

Movements vs shifts

• Movement along PPF → change in allocation

• Shift of PPF → change in productive capacity

Short run vs long run

• Short run: resources fixed → move along curve

• Long run: resources improve → curve shifts

PPF & economic growth trade-off

Producing capital goods now:

• Fewer consumer goods now

• More growth later
  Producing consumer goods now:

• Higher current living standards

• Slower long-term growth

PPF & efficiency types

• Productive efficiency → on the curve

• Technological efficiency → the production of the maximum amount of good and services with the available resources

• Allocative efficiency → depends on society’s preferences (not shown directly on PPF)

Different Government Lags

Recognition lag – don’t see the problem right away.

Implementation lag – Take time to decide how to respond.

Impact lag – Take time for the results of the solution to show if it worked or not.

Economic Systems

Free Market Economy:
An economic system where resources are allocated through price signals, with decisions about what, how, and for whom to produce made by consumers and firms, and minimal government intervention.

Command Economy:
An economic system where the government owns and controls resources and makes all decisions about production, distribution, and allocation.

Traditional economy:
An economic system where decisions about production and consumption are based on customs, traditions, and beliefs, often using subsistence methods.

Adam Smith

Division of Labour - specialize resources and divide into unique tasks.

Invisible Hand - Self-interest to make a profit provides an indirect benefit to society by producing goods that are needed. Competition leads to a decrease in prices and innovation.

Laissez-faire - There should be little government involvement in the economy. Government involvement reduces competition by favouring (subsidizing) some businesses.

Scarcity

Scarcity = resources are limited, but unlimited wants.

Because of scarcity:

• we can’t have everything

• choices must be made

• opportunity cost exists

3 basic economic problems

• What to produce?
  (food vs weapons, buses vs roads)

• How to produce?
  (labour-intensive vs capital-intensive, sustainable or not)

• For whom to produce?
  (income distribution, who gets the goods)

Circular Flow of Resources, Goods, Services, and Money Payments

Money Flow - Outside

Resource Flow - Inside

Resource owners (households)

They give:

• Factors of production:

  • Labour

  • Land

  • Capital

  • Entrepreneurship

They receive:

• Income from firms:

  • Wages (labour)

  • Rent (land)

  • Interest (capital)

  • Profit (entrepreneurship)

Firms (businesses)

They give:

• Goods and services to households

• Income payments to resource owners

They receive:

• Factors of production from households

• Revenue from households’ spending

Assumptions for the PPF/PPC

1. Resources are fixed

• Quantity and quality of land, labour, capital, and entrepreneurship do not change.

2. Technology is fixed

• No improvements in production methods during the period considered.

3. Only two goods are produced

• Simplifies the analysis to trade-offs between two goods.

4. Full employment of resources

• All resources are used efficiently; no unemployment or waste.

5. Efficient use of resources

• Resources are allocated optimally; producing more of one good means sacrificing some of the other (opportunity cost).

6. Resources are mobile

• Can be reallocated between the two goods, but not perfectly (this explains concavity).