1B03 Intro to Microeconomics Midterm #1

Chapters 1 - 4

What does economics study?

The study of human behaviour and choice

Economics asks the questions such as:

• What choices do people make?

• What factors influence those choices

• What are the consequences of those choices for the person making them?

The 3 perspectives of Economics

1. Consumers

2. Managers

3. Government Policymakers

Assumptions about human behaviour

1. People are rational

2. People respond to incentives

3. People use cost-benefit analysis

People are rational (explanation)

People act on self-interest

Make decisions that they believe will make them happy/better off

People respond to incentives (explanation).

• When an option becomes more attractive, people are more likely to select it

  • For example: If a Uni. offers a student a scholarship, they are more likely to select that offer compared to another uni that does not offer a scholarship.

People use cost-benefit analysis (explanation)

People compare marginal benefit (MB) and marginal cost (MC)

Marginal Benefit (MB)

The benefit you receive from making a decision

• For example, eating a steak has nutritional value, making it healthy for your body 

Marginal Cost (MC)

The cost you must pay for making a decision

• For example, that same steak (that is nutritious and healthy) still costs money

Net benefit

Marginal Benefit - Marginal Cost

• Consumers will consider the option with a positive net benefit

• Positive Net Benefit: MB > MC

• Negative Net Benefit: MB < MC

The economic problem

People have unlimited wants, but societies have limited resources

Societies face trade-offs

We must decide how to spend our resources (money, time and materials) to get as much as we can from the stuff we want the most

The 3 main economic questions

1. What goods/services will be produced?

2. How will the goods and services be produced?

3. Who will receive the goods and services produced?

3 Economic models/markets

1. Market Economy

2. Centrally-Planned economy (Command)

3. Mixed Economies

Market Economy Characteristics

• Foster innovation and entrepreneurship

• People are free to choose, saving them money on taxes that the government would allocate for running the economy

• However, it generates a substantial amount of inequality 

  • Resources are not allocated fairly society is underproduced

• Country examples: United States, UK and Japan

Centrally-Planned Economy Characteristics

• Govn. appointed central planners make decisions for the economy

• Rationing reduces inequality.

  • If there’s an economic emergency, they are able to adjust and coordinate

• However, there’s a lack of innovation (no profit motive, so they aren’t striving for innovation)

• Production is usally not efficient

• Country examples: Cuba and North Korea

Mixed Economy Characteristics

• Combines both market economies and central planning

• Private sector: Businesses owned by individuals

  • Government tends to influence and regulate them

• Public sector: Government provides goods/services directly

• Attempt to obtain the advantages of both free markets and central planning, while avoiding the disadvantages of either type

• Country example: Canada and most developing countries

Positive analysis

• Facts or logic —> Focused on what “is” and “could be”

• More analytical and provides evidence (can be proven true or false)

Normative Analysis

• Value judgements that are subjective and based on personal opinions

• Cannot be proved true or false

Production Possibilities (PP)

The total quantity of goods/services our economy can produce

• Since our resources are limited, need to be strategic with how our resources can be distributed across the production of multiple goods

Economic rational

How we specialize in some sectors, and import other goods

Example of PP graph

• Any point beyond the PPF cannot be produced

  • Unemployment is an example of this as its a waste of resources

• Opportunity Set: All combinations of Good A and Good B are possible with current resources

Opportunity Cost

The benefit that could be received from the next best alternative

Example: Spending time with friends on a Friday night in comparison to studying means you'll be less prepared for the test that could've been spent studying 

Marginal Rate of Transformation (MRT)

The rate at which we can switch between good a and good b

Diminishing Returns

The more resources devoted to an activity, the less production additional resources become

• Could hit a point where adding further resources gives us no additional benefit

• The presence of diminishing returns means the ppf becomes bowed instead of linear

Absolute Advantage

When one person, firm or country can produce more in total than another using the same resources

Comparative Advantage

When one person, firm or country has a lower opportunity cost of producing a good

• Able to produce the good more efficiently than others

• This is the basis of specialization and trade 

Types of Markets

• Output market

• Factor markets

  • The labour market

  • The capital market

Output market

• Firms produce good/services, which they provide to customers

• Can be defined as 

  • Broadly (classes of goods): Such as washing machines and refridgerators

  • Narrowly (Specific goods): Such as fast food burger places and seafood houses

• Operate for profit

• Types of customers; B2C, B2B or B2G

Factor Market - The Labour market

• Households sell their time and efforts in exchange for salaries/wages

  • Firms use this time and effort as an input in the production process

• Amt. of money earned depends on education level, skill and experience

Factor Market - The Capital Market

• Households loan their savings to firms so that firms can purchase PPE

  • In return, firms pay interest and will repay the loan

• Households also loan their savings to:

  • Other households that need the money to pay for purchases

  • Governments when they spend more than they collect in tax revenue 

Supply and Demand Framework

Prices are determined by the action of action of: 

• Suppliers: Who offer goods and services

• Consumers: Who wish to buy them

Quantitty demanded (QD)

The amt. of a good/service consumers are willing to buy at a given price

Law of Demand

An increase in price —> Reduces QD
A decrease in price —> Increases QD

Indirect relationship 

-What effects cause the demand curve to be downward sloping

• The substitution effect

• The Income effect

Substitution effect:

• When the price of one good rises, consumers switch and purchase another similar good

• (Vice versa) When the price of one good falls, consumers will switch and buy this good instea

Income effect:

• When the price of a good rises, consumers cannot afford to buy as much as before

• When the price of a good falls, consumers can afford to buy more

Change in Quantity Demanded

There is movement along the curve due to a change in price

Ceteris Paribus

All else equal

Change that causes demand factors to shift right

1. Increase income

2. Increase in the price of a subsitute good

3. Deccrease in the price of a complementary good

4. An increased desire for the good

5. Increase in population

6. Reduciton in interest rates

7. Improved expectations about the future

Change that causes demand factors to shift left

1. Decreased incomes

2. A decrease in substitute goods

3. Increase in complementary goods

4. A decreased desire for the good

5. Increase in interest rates

6. Decrease in population

7. Worsening expectations about the future

Quantitty Supplied

The amount that a producer is willing and able to provide at a given price

Law of Supply

• Increase in price —> Increase Qs

• Decrease in price —> Decrease in Qs

  • Direct relationship

Why is the supply curve upward sloping?

As costs rise, firms produce more

Change in Quantity supplied

Whenever there’s a change in price, there’s movement on the curve

• Producers will take advantage of this as it means they ar able to gain more profit

Factors that cause supply to shift rightward

1. Input prices decrease (costs are more affordable)

2. Production technology improves

3. Alternative cheaper inputs become avaliable

4. Interest rates delcine

5. Number of firms increases (total market supply increases_

6. Expectations about the future improve

Factors that cause supply to shift leftward

1. Input prices increases

2. Interest rates increase

3. Number of firms decreases

4. Expecations about the future worsen

Equilibrium price

Intersection of the supply and demand curve

Shortage / Excess demand

When the current market price is too low
QS < QD

Firms will raise prices to expand production until they reach the eq point.

Surplus / Excess Supply

• When the current market price is too high

• QS > QD

• Producers are making more than consumers actually want to buy 

An increase in Demand

Any factor that causes demand to increase will cause the price to rise and will also cause the quantity sold to rise (for his graph, D is the same as D1 and D' = D2) 

Any factor that causes demand to decrease will cause the price to fall and will also cause the quantity sold to fall (for his graph, D is the same as D1 and D' = D2) 

Decrease in Demand

Increase in Supply

Any factor that causes supply to increase will cause the price to fall and will cause the quantity sold to rise (On his graph, S is the same as S1, and S' = S2) 

Decrease in Supply

Any factor that causes supply to decrease will cause the price to rise and will cause the quantity sold to fall 

Consumer surplus

The difference between what consumers are willing to pay for a good and the price they actually pay

• Perceived value - Price

  • You might be willing to pay $8 for a burger, but it actually costs $5 —→ The consumer surplus is $3

Where is the Consumer surplus located

• Total area between the demand curve and the price line

  • Beneath demand, above eq 

Total consumer expenditure

The amount that consumers pay in total for Q units

Calculated as: Price x Quantity

The green box is the Consumer expenditure

• This also becomes producer revenue 

Producer Surplus

The difference between the price producers are willing to accept (based on marginal cost) for a good/service compared to what they actually receive

• Can be calculated by: Price - Marginal Cost of Producing the unit

• Represents the extra money that producers earn above their cost to make units

Where is the producer surplus located?

• Total area between the supply curve and the price line

  • Beneath the eq

Total Surplus

Consumer surplus + Producer surplus 

Price Floor

• A minimum price set by the government

• Allowed to be higher than the price floor, but cannot be less than the price flooor

• Benefits producers

  • Producers surplus is larger and consumer surplus is smaller

Deadweight Loss

Reduction in total surplus

For example, in Ontario, the government imposes minimum prices on alcohol and tobacco products

This is due to the fact that these have serious health concerns, so the government wants you to buy less of these items

Price ceiling

Maximum price set by the government

Price is allowed to be lower than p.c but cannot be higher

Benefits consumers —> Consumer surplus is larger and producer surplus is smaller

Problems with price ceilings

• Advanatge for some consumers, and disadvantage for others

  • Some consumers take advantage of this low price

    • For example: Rent Control

• The artifically low price generates excess demand (shortage)

Quota

• Maximum quantity set by the government

• The amount producer is allowed to be lower than the quota, but cannot be higher than the quota

• Benefits produers

  • Producer surplus is larger and consumer surplus is smaller

    • Generates a deadweight loss

• For example: The government works with both egg farmers and dairy farmers to set quotas for eggs and milk 

• Even though the policy means higher prices for Canadian consumers, the government believes its worthwhile to ensure that farmers can earn enough money to continue farming 

Subsidy

• Payment made by the government to firms to cover a portion of the cost of production

  • Could be in the form of cash payments or tax rebates

• Lower costs = increased production

• Also lowers the price that consumers must pay

Sales Tax

• Added to the price consumers pay

• Firms need to cover their production costs

Unit tax

When the amt. of the tax is fixed and does not change with the underlying price

Fuel Taxes: A gasoline tax is a classic example, where a government charges a specific amount (e.g., cents or dollars) for every gallon or liter of fuel sold, regardless of the final price.  

Value added tax / Valorem tax

When the amt. of the tax is a percentage of the price, and increases as the price increases

Best example: Harmonized Sales Tax (HST) = 13%

Effect of a tax

• Since tax increases the price, consumers buy less

• Since suppliers are producing a lower quantity, they charge a lower price 

Consumer incidence of the tax

The change in the consumer price

Producer incidence of the tax

The change in the producer price

Tax amount

Consumer incidence + Producer incidence

• Firms cut their prices to try and keep some customers

  • In a way, producers are helping the consumer by covering the tax by lowering the price

Welfare effect on tax

• Tax causes the producer price to decline, and consumer price to rise, and the quantity to fall

  • Since consumers pay a higher price and buy less, consumer surplus shrinks

  • Since producers receive a lower price and sell less, producer surplus shrinks

Government tax Revenue

• Tax Revenue = Tax x Quantity sold

  • The government will use the additional income by improving the economy such as improving infrastructure and improving school education systems