Economics - micro and macro so far

Opportunity cost

The next best alternative forgone when an economic decision is made

Scarcity

The situation in which available resources (factors of production) are finite, whereas needs and wants are infinite

Central economic problem

What to produce and in what quantities (resource allocation)

How to produce (resource allocation)

For whom to produce (distribution of income and output)

Factors of production

Land (natural capital)

Labor (human capital)

Capital (physical capital)

Entrepreneurship (management)

Ceteris paribus

All other things being equal

Positive economics

Describing and analyzing economic relationships and making factual and objective claims

Can be scientifically tested and proved

Normative economics

Concerned with how things should be and involves subject value judgements

Cannot be tested or proved

Productions possibilities curve (PPC)

A curve showing the maximum combinations of two types of output that can be produced in an economy in a given time period, if all resources in the economy are being used efficiently and the state of the technology is fixed

Inward shifts in the PPC

Shifts inward happen when there is a fall in the factors of production

Outward shifts in the PPC

The PPC can shift outward if there is an increase in the quantity or quality of factors of production

Allocative efficiency

Producing the optimal combination of goods from a society's point of view; achieved when the economy is allocating resources so that no one can be better off without making somebody else worse off

Actual growth

Shift from a point to another inside the PPC - When an economy produces a greater amount of goods and services in one period of time than in a previous one

Potential growth

Outward shift of the PPC - When the production capacity of an economy increases from one period to another. It means that the maximum amount of output that an economy can produce when all of its resources are being used efficiently increases

Leakages from the circular flow of income

Taxes

Saving

Imports

Injections into the circular flow of income

Government spending

Investment

Exports

Planned economies

The government makes decisions about what to produce, how to produce and for whom to produce

Resources are collectively owned

Free market economies

Prices are used to ration goods and services

Production is in private hands

Demand and supply set wages and prices

Demand

Quantity of a good or service that consumers are willing and able to purchase at a certain price and at a certain moment in time, ceteris paribus

Demand curve

A graph showing how the quantity demanded of a commodity or service varies with changes in its price.

Market demand

The sum of all individual demands for a good

Law of demand

There is a negative relationship between the price of a good and its quantity demanded over a particular time period, ceteris paribus

Utility

The satisfaction that consumers gain from consuming something

Total utility

The total satisfaction that consumers get from consuming something

Marginal utility

The extra satisfaction that consumers receive from consuming one more unit of a good

Market

Any kind of arrangement where buyers and sellers of goods, services or resources are linked together to carry out an exchange

Change in quantity demanded

A movement along the demand curve caused by a change in price

Change in demand

A shift (inwards/outwards) of the demand curve caused by a change in a determinant of demand

Non price determinants of demand

Income in the case of normal goods

Income in the case of inferior goods

Preferences and tastes

Future price expectations

Prices of substitute goods

Prices of complementary goods

The number of consumers

Supply

The various quantities of a good or service that a firm is willing and able to produce and supply to the market for sale at different possible prices, during a particular time period, ceteris paribus

Law of supply

There is a positive relationship between the quantity of a good supplied over a particular time period and its price, ceteris paribus

Market supply

The sum of all individual firms’ supplies for a good

Change in quantity supplied

A movement along the supply curve, caused by a change in price

Change in supply

A shift of the supply curve, caused by a change in a determinant of supply

Non price determinants of supply

Changes in the costs of factors of production

Prices of related goods - competitive supply

Prices of related goods - joint supply

Indirect taxes and subsidies

Future price expectations

Changes in technology

Number of firms

Law of diminishing marginal utility

As consumption of a good increases, marginal utility, or the extra utility the consumer receives, decreases with each additional unit consumed

Income effect (law of demand)

When the price of a product falls, then people experience an increase in their “real income”, so they are likely to buy more of the product.

Substitution effect

People receive a certain amount of satisfaction (utility) when they consume a product. People are likely to choose products that have a better ratio of satisfaction to price.

Why the law of supply works

People receive a certain amount of satisfaction (utility) when they consume a product. People are likely to choose products that have a better ratio of satisfaction to price.

Law of diminishing marginal returns

If a firm increases output by adding more and more units of a variable factor to its fixed factors, each new unit of a variable input (like labor) will add less to total output than the previous unit after a certain point

Law of diminishing marginal costs

If the output produced by each additional worker begins to fall, yet each worker costs the same, then the cost of producing each unit begins to increase

Market equilibrium

The situation when quantity demanded is equal to quantity supplied

There is no tendency for price to change

Forces of supply and demand are in balance

Shortage (excess demand)

Quantity demanded is greater than quantity supplied

The difference between the two is the shortage

Surplus (excess supply)

Quantity supplied is greater than quantity demanded

The difference between the two is the surplus

Price mechanism

Ability of the market to allocate resources

Moves markets to equilibrium

Known as the “invisible hand”

Answers the questions “what to produce” and “how to produce”

Primary purposes - resource allocation (signals and incentives) and rationing

Price mechanism - rationing

Determines who gets what resources

Based on who is prepared to pay the price

Price mechanism - resource allocation

Prices as signals - communicate information to decision-makers

Prices as incentives - motivate decision-makers to respond to the information

Productive efficiency

When output is produced using the fewest possible amount of resources; when output is produced at the lowest possible cost

Consumer surplus

The highest price consumers are willing to pay for a good minus the actual price paid

Producer surplus

Price received by firms for selling their good minus the lowest price that they are willing to accept to produce the good

Social surplus

The sum of consumer and producer surplus

Maximized at the point of competitive equilibrium

MB = MC

Social welfare

Refers to well-being of society

Maximized when the market reaches allocative efficiency

Price elasticity of demand

A measure of the responsiveness of the quantity of a good demanded to changes in its price

Price inelastic demand

0<PED<1

Price elastic demand

1<PED<infinity

Unit elastic demand

PED = 1

Perfectly inelastic demand

PED = 0

Perfectly inelastic demand

PED = infinity

Elastic demand

PED > 1

Inelastic demand

PED < 1

Determinants of PED

S - Number and closeness of Substitutes

P - Proportion of income that is required to purchase the good

L - Luxury or necessity good? Demand is more elastic for luxuries

A - Addictive? Demand is highly elastic for goods with addictive properties

T - The amount of Time a consumer has to respond to the price change

Income elasticity of demand (YED)

A measure of the responsiveness of demand to changes in income and involves curve shifts

Normal good YED

YED > 0

Inferior good

YED < 0

Income elastic demand

YED > 1
services and luxury goods

Income inelastic demand

0<YED<1
necessities

The engel curve

Shows a continuum

At low incomes, a good can be a luxury

As income increases, it becomes a necessity

At high income levels, it becomes an inferior good

Price elasticity of supply

A measure of the responsiveness of the quantity of a good supplied to changes in its price

PES is always positive

Price inelastic supply

PES < 1

Price elastic supply

PES > 1

Unit elastic supply

PES = 1

Perfectly inelastic supply

PES = 0

Perfectly elastic supply

PES = infinity

Determinants of PES

Length of time
Mobility of FOPs
Space (unused) capacity of firms
Ability to store stocks
Rate at which costs increase

Reasons for government intervention in markets

Earn revenue

Support firms

Support households on low incomes

Influence level of production

Influence level of consumption

Correct market failure

Promote equity

Main forms of government intervention

Price controls: price ceilings (maximum prices) and price floors (minimum prices)

Indirect taxes and subsidies

Direct provision of services

Command and control regulation and legislation

Consumer nudges (HL only)

Price ceiling (maximum price)

A situation where the government sets a maximum price, below the equilibrium price

Usually set to protect consumers

Usually imposed in markets where the product is a necessity good and/or a merit good

Results in excess demand (shortage)

Price ceiling consequences

Shortage

Non-price rationing

• Price mechanism no longer able to achieve its rationing function

• Waiting in line

• Distribution of coupons to all interested buyers

• Favoritism

Underground (parallel) markets

Underallocation of resources to the good and allocative inefficiency

Negative welfare impacts (diagram)

Price floor (minimum price)

A situation where the government sets a minimum price, above the equilibrium price

Usually set to protect farmers or to increase the wages of low-skilled workers

Results in excess supply (surplus)

Price floor consequences

Surplus

Firm inefficiency - too many resources allocated to the production of the good

Negative welfare impacts (diagram)

Indirect taxes

An indirect tax is one imposed upon expenditure

Examples: value added tax (VAT), sales tax, excise tax,...

Specific tax vs ad valorem tax

Reasons for governments imposing indirect taxes

To raise revenue

To discourage consumption of goods that are harmful (demerit goods)

To redistribute income

To improve the allocation of resources (to correct market failure)

Market outcomes due to tax

Equilibrium quantity falls

Equilibrium price increases

Consumer expenditure changes

Price received by producers falls

Producer revenue falls

Government receives tax revenue

There is an underallocation of resources

Subsidies

A subsidy is a payment made to the firm by the government

Usually fixed amount per unit of output (called specific subsidies)

Results in the reallocation of resources and greater production and consumption than in the free market

Reasons for government’s implemmentation of subsidies

To increase revenues of producers

To make certain goods (necessities) affordable to low-income consumers

To encourage production and consumption of particular goods/services deemed to be desirable for consumers

To support growth of particular industries

To encourage exports of particular goods

To improve the allocation of resources (reduce allocative inefficiencies)

Market outcomes due to subsidy

Equilibrium quantity increases

Equilibrium price falls

Price received by producers increases

Producer revenue increases

Government spends money

There is an overallocation of resources

Market failure

Failure of the market to allocate resources efficiently

Results in allocative inefficiency where too much or too little of goods are produced and consumed from the point of view of what is socially most desirable

Externalities

An externality occurs when the actions of consumers or producers give rise to negative or positive side-effects on other people who are not part of these actions and whose interests are not taken into consideration

They can be positive or negative

MPB - Marginal private benefit

• marginal private benefit

• benefit to consumers from consuming one more unit of a good

MSB - marginal social benefit

• marginal social benefit

• benefit to society from consuming one more unit of a good

MPC - marginal private cost

• marginal private cost

• costs to producers of producing one more unit of a good

MSC - marginal social benefit

• Marginal social cost

• Cost to society of producing one more unit of a good

No externalities

MPC=MSC=MPB=MSB

Externality situation

Divergence between MPC and MSC or MPB and MSB

MPB = MPC, but MSB ≠ MSC

Allocative inefficiency

Either too much or too little is produced relative to the social optimum

Negative externalities of consumption

When the consumption of a good or service generates a negative effect on a third party or society, which has not been factored into the calculation when deciding to consume that good.

Policies to correct negative externalities of consumption

Indirect (Pigouvian) taxes

Government legislation and regulation

Education, awareness creation (negative advertising)

Nudges (HL only)

How do taxes work to correct negative externalities of consumption?

Raise MSC so that it intersects with MPC at the optimum quantity

Advantages of taxes to reduce negative externalities of consumption

Higher prices due to taxes create incentives for consumers to decrease their consumption

Revenue for the government, which can be used to mitigate negative effects

Disdvantages of taxes to reduce negative externalities of consumption

Difficulty in measuring external costs (who is affected and how exactly)

Inelastic demand for demerit goods, so increase in price will not reduce the quantity demanded as much

If taxes are raised too much, possibility of illegal markets increases

Taxes make people pay for the external cost, but some of them will continue to consuming the good

How does regulation approach fix negative externalities of consumption?

Lowers MPB so that it re aligns with the market equilibrium

Advantages of a regulation approach to correct negative externalities of consumption

Works well for some goods, but not others

For example, easy to ban heroin, but not cars that run on petrol