Econ unit 2 - microeconomics

demand

quantity of a good/ service that consumers are willing and able to purchase at various prices during a specific period.

demand curve

A graphical representation of the relationship between the price of a good or service and the quantity demanded by consumers.

law of demand

price ↑= quality demanded ↓

non-price determinants of demand

• income ↑ = quality demanded ↑ (D → D1)

• good preference↑ = quantity demanded ↑ (D → D1)

• price of substitute↑ = quantity demanded↑ (D → D1)

• number of consumers ↑ = quantity demanded ↑ (D→ D1)

• price of complementary goods ↑ = quantity demanded ↓ (D → D2)

supply

amount of a good or service that producers are willing and able to sell at various prices over a specific time period.

supply curve

a graphical representation of the relationship between quantity supplied and price

law of supply

price ↑ = quantity demanded ↑

non price determinants of supply

• subsidies ↑ = supply ↑ (S→ S2)

• new technology ↑ = supply ↑ (S→ S2)

• competitors ↑ = supply ↑ (S→ S2)

• cost of production ↑ = supply ↓ (S→ S1)

• taxes ↑ = supply ↓ (S→ S1)

• weather disaster = supply ↓ (S→ S1)

• opportunity cost of related products ↑ = supply ↓ (S→ S1)

consumer surplus

• difference between the amount the consumer is willing to pay for a product and the price they have actually paid

• benefit gained by the consumer for purchasing the product at a lower price.

producer surplus

• difference between the price producer is willing to sell a product for and the price they actually do

• benefit to producers from selling at a higher price than their minimum acceptable price.

producer and consumer surplus graph

supply ↑ = producer/consumer surplus ↑

demand ↑ = producer/consumer surplus ↑

allocative efficiency/ equilibrium

• resources are distributed in a way that maximizes total societal welfare

• quantity of a good produced is equal to the quantity demanded.

productive efficiency

• at minimum average total cost

• all resources are utilized effectively.

traditional economic theory

Focuses on supply and demand to determine prices and allocation of resources in a market.

• consumer rationality

• utility maximization

• perfect information

limitations of the assumptions of rational consumer choice

• biases

• bounded rationality

• bounded self-control

• bounded selfishness

• imperfect information

forms of biases

• based on experience

• framing ‘20% fat vs 80% fat free’

• anchoring (seller suggest a higher price than the real value)

• availability bias

bounded rationality theory

individuals make decisions based on the limited information available to them, leading to less-than-optimal choices.

bounded self control

the tendency to struggle with making choices that align with long-term goals due to immediate temptations and distractions.

bounded selfishness

the tendency of individuals to prioritize their own interests over the collective good, often leading to suboptimal outcomes for the group.

imperfect information

the situation where all relevant information is not available to consumers or producers, leading to suboptimal decision-making in markets.

types of choice

• default

• restricted

• mandated

nudge theory EAST

using reinforcement and indirect suggestions can influence the motivation and decision-making of individuals.

• E - easy → simplify

• A - attractive → gain people’s attention

• S - social → individuals may be influenced by others doing said thing

• T - timely → identify when people are most responsive

advantages of nudge theory

• cost effective

• preserves freedom of choice

• improves public health

• improves decision making

• improves sustainability

• encourages positive behavior change.

profit maximization

the process of increasing profit by determining the most effective level of production and pricing strategy.

marginal costs = marginal revenue

→ beyond this point with each unit produced marginal loss occurs

p1 = selling price

c1 = average cost

super-normal profit = total revenue> total costs

advantages of profit maximization

• enables financial stability and growth

• enhances shareholder values

• efficient allocation of resources

• drives innovation and competitiveness

disadvantages of profit maximization

• ethical and social concerns

  • may neglect long-term sustainability and employee welfare.

• lack of knowledge about the point of profit maximization

• often results in higher prices for consumers

growth

an increase in the capacity of an economy to produce goods and services over time, often measured by GDP.

price elasticity of demand

• measure of how responsible the quality demanded is to a change in its price

• indicates consumers’ sensitivity to price changes

• price↑ = demand ↓

price elasticity of demand formula

PED = % change in quantity demanded / % change in price

interpreting PED values

determinants of PED

• availability of substitutes ↑ = PED ↑

• addictiveness of the product ↑ = PED↓

• price of products as proportion of income ↓ = PED ↓

  • consumers are less responsive to price changes of cheap products

• time period

  • short term = low PED

  • long term = high PED

total revenue rule

to maximize revenue businesses should

• increase the price of products that are inelastic in demand

  • big increase in price results in small decrease in demand

• decrease the price of products that are elastic in demand

  • small decrease in price results in big increase in demand

income elasticity of demand YED

• measures the responsiveness of demand for a product to changes in consumer income

• positive YED indicates that a good is a normal good,

• negative YED signifies an inferior good.

• influenced by factors that affect the wages

  • minimum wage

  • taxes

YED formula

YED = % change in quantity demanded / % change in income

YED values

inferior goods

• YED<0

• income ↑ = demand ↓

normal goods

• YED>0

  • income↑ = demand↑

luxury goods

• YED> 1

  • income↑ = demand↑↑

price elasticity of supply PES

• measures the responsiveness of the quantity supplied of a good to changes in its price.

• higher PES value indicates that supply is more responsive to price changes.

PES formula

PES = % change in quantity supplied / % change in price

PES values

0 → perfectly inelastic/ unresponsive

0-1 → relatively inelastic

1→ relatively elastic

1-∞→ perfectly elastic/fully responsive

determinants of PES

production time ↑= PES↑

availability of resources↑ = PES ↑

flexibility of the production process = PES ↑

reasons for government interventions into the market

• to support firms

  • intervene to support key industries

• to promote equity

  • intervene to reduce opportunity gap between rich and poor

• to collect government revenue

  • provision of essential services, public and merit goods

• to support poorer households

• to correct market failures

  • intervene to influence level of consumption/ production

methods of government interventions

• indirect taxes

• subsidies

• price controls

  • price ceilling

  • price floor

taxes types

• direct

  • income tax

• indirect

  • goods and services tax

direct taxes types

• progressive (more you earn more you pay, tax brackets)

• flat/ fixed

• regressive (more you earn less you pay)

indirect taxes types

• general taxes (on all goods and services)

• excise taxes

  • on alcohol

  • tobacco

  • sugar

indirect taxes

• imposed on government causing supply curve to shift left

ad valorem VAT indirect tax

amount of good/service↑ = tax↑

specific indirect tax

fixed tax per unit of output

welfare loss

cost to society caused by the lack of efficiency in the allocation of resources

advantages of indirect taxes

• raises price and lowers demand for demerit goods

• raises revenue for government

disadvantages of indirect taxes

• tax may be ineffective on demerit goods

• helps develop illegal/ grey markets

• may lead to staff layover due to lower demand

subsidies

financial assistance given by the government

• to increase production

• to increase provision of merit goods

• to reduce costs

• to support employment

advantages of subsidies

• financial benefits for producers

• lowers prices for consumers

• increases supply of merit goods

• wealth redistribution

  • may benefit lower-income individuals

• encourages economic growth.

disadvantages of subsidies

• opportunity cost

• over-dependency

  • may stifle innovation and efficiency improvements

• fairness concerns

• mis-allocation of resources

  • fossil fuel subsidy may discourage investment in green energy

• environmental and social impacts

price controls

government regulations that set maximum or minimum prices for goods and services to stabilize the economy.

price ceiling

government-set maximum price that can be charged for a good or service

• to protect consumers from excessively high prices.

government use of price ceiling

• long period of time

  • rent control

  • medicine for chronic conditions

• short period of time

  • to stabilize markets that have increased prices due to unusual context

advantages of price ceiling

• increased consumer surplus

  • benefit from lower prices

• can protect vulnerable consumers during disasters

• can prevent monopolies from setting excessively high prices

disadvantages of price ceiling

• shortages

• decreased producer surplus

• reduces quality

• wastage/ over-consumption/ inefficient allocation of scarce resources

• creation of illegal/ grey markets

• government may have to supply the product to meet the excess demand of necessities

fixed supply and price ceiling (concert tickets)

price floor

• a minimum price set by the government to prevent prices from being too low

• to ensure producers have a fair price

• often applied in agricultural markets

government use of price floor

• help producers earn more in times of crisis

• decrease consumption of a demerit good

• to protect workers from wage exploitation

  • minimal wage

advantages of price floor

• increased producer surplus

• minimal compensation secured for suppliers

• prevention of price fluctuations and market stability

disadvantages of price floor

• supply surplus

• decreased consumer surplus

• potential unemployment

• increased prices for consumers

• black markets may emerge.

minimum wage

advantages of minimum wage

• increased income for workers

• reduction of poverty

• improved worker productivity and morale.

disadvantages of minimum wage

• potential job loss

• higher costs od production

• reduced demand for low-skilled labor

market failure

occurs when the allocation of resources, goods and services is less than optimal

causes of market failures

• public goods

• common pool resources

• negative externalities of consumption

• negative externalities of production

• positive externalities of consumption

• positive externalities of production

marginal private benefit MPB

the additional benefit received by consumers from consuming one more unit of a good or service.

marginal private cost MPC

the additional cost incurred by producers for producing one more unit of a good or service.

marginal social benefit MSB

the total benefit to society from the consumption of one more unit of a good or service.

marginal social cost MSC

the total cost to society of producing one more unit of a good or service.

socially optimum output

MSB = MSC

• level of output desired without market failure

negative externalities of production

• created during production

• failing due to over-provision

• producers only consider private and not external costs

  • air pollution, water contamination, health problem

ways of correcting negative externality of production

• taxation

• regulation and legislation

• subsidies

• tradable permits

negative externalities of consumption

• caused during consumption of demerit goods

• failing due to over-consumption

• consumers consider only private costs and not external

  • waste

ways of correcting negative externalities of consumption

• education

• taxation

• regulation

• campaigns and advertisements to improve consumer behavior

demerit goods

Goods that are considered harmful to individuals and society

merit goods

Goods that are deemed beneficial for individuals and society, often under-consumed if left to the market.

positive externalities of production

• created during production

• market is failing due to under-provision

• only private benefits are considered by producers and not external

ways of correcting positive externalities of production

• subsidies

• regulations

• direct government provision of goods that enhance social benefits.

• price floor

positive externalities of consumption

• created during consumption of merit goods

• failing due to under-consumption

• customers only consider private benefit and not external

ways of correcting positive externalities of consumption

• subsidies to consumers

• public awareness campaigns

• government provision of merit goods

• consumer nudges

perfect/ symmetric information

A situation where all consumers and producers have equal access to all relevant information, leading to optimal decision-making in the market.

imperfect/ asymmetric information

A situation where one party in a transaction has more or better information than the other, leading to suboptimal decision-making in the market.

government responses to assymetric information

• government responses

  • regulation

  • provision of information

  • licensure (obtaining a license by service/ good provider)

• private responses

  • screening/ research by buyers

  • signalling by sellers

    • eg. warranties, brand name, service records

moral hazard

when one party takes risks, but doesn’t face full costs of the risks because the full costs are borne by the other party

• buyers of insurance change their behavior after obtaining insurance, so that the outcome works against the interests of the seller of insurance

market structures

• perfect competition

• imperfect competition

  • monopolistic competition

  • oligopoly

  • monopoly

perfect competition

A market structure characterized by

• many small firms

• homogeneous products

• no barriers to entry or exit

• no market power

• perfect knowledge

• perfect competition

  leading to optimal outcomes for consumers and producers.

eg. agriculture

imperfect competition

A market structure where individual firms have some control over price due to product differentiation, which results in a range of firm market power and potentially inefficient outcomes.

monopolistic competition

• many relatively small companies

• differentiated products

• low barriers to entry

• some market power

• imperfect knowledge among consumers

• good amount of competition

eg. restaurants, computer games, books, furniture

oligopoly

• few large companies

  • mutual interdependence

• differentiated or homogeneous products

• high barriers of entry

• significant market power

• imperfect knowledge

• some competition

eg. cars,household appliances, detergents, cereal

monopoly

• one large company

• unique product

• no close substitutes

• high to impossible barriers of entry

• complete market power

• imperfect knowledge

• no competition

eg. public utilities

profit maximisation

profit = total revenue - total costs

break even/ normal profit

total revenue = total costs

abnormal profit

total revenue > total costs

profit loss

total revenue < total costs

profit maximisation rule

a firm should continue producing additional units until

• marginal costs MC = marginal revenue MR

marginal costs MC

change in total costs resulting from additional unit produced

marginal revenue MR

the increase in revenue resulting from an additional unit produced