Topic 2 - Microeconomics

Market

a place where people come together to buy and sell goods

Types of markets and what they are

• product = goods and services

• factor = labour market

• financial = foreign + stock exchange

Law of Demand

• price goes down = demand goes up

• price goes up = demand goes down

what is demand?

quantity of a good or service that consumers are willing and able to buy (at a given time and price, ceteris paribus)

Individual Demand

the demand for a good or a service by a single consumer at a particular cost and at a specific point in time

Market demand

sum of all individual demands for a good or service

Demand curve relationship

negative

Determinants of demand (and what they cause)

• price determinants = cause a movement along the curve

• non - price determinants = cause a shift of the curve

Non-price determinants of demand

• income (normal goods, inferior goods)

• preferences and tastes

• price of other products (substitute goods, complementary goods)

• number of consumers

demand for normal goods when income changes (what type of shift they cause)

• income goes up = demand goes up

• shift to the right

demand for inferior goods when income changes (what type of shift they cause)

• income goes up = demand goes down

• shift to the left

demand for substitute goods

• P1 goes up = D2 goes up

demand for complementary goods

• P1 goes down = D2 goes up

Assumption for law of demand

• Law of diminishing marginal utility

• The substitution effect

• The income effect

Law of diminishing marginal utility

consumption of additional units of a product, the satisfaction (utility) for each additional unit (marginal unit) grows smaller (diminishes) 

The substitution effect

price of a good increases, consumers switch from other similar products to this good, for lower price

The income effect

price of a good decreases, the quantity demanded increases (consumers have more real income to spend) With more purchasing power, consumers are more likely to buy more of the same product

Supply

quantity of a good or service that producers are willing to offer for sale (at a given price during specific time period, ceteris paribus)

Law of supply

• price increases = supply increases

• price decreases = supply decreases

Determinants of supply (and what they cause)

• price determinants = cause a movement along the curve

• non - price determinants = cause a shift of the curve

Non-price determinants of supply

• Costs of factors of production

• Price of related goods (joint supply, competitive supply)

• State of technology

• Expectations

• Government intervention

• Number of firms

• Unpredictable events

Assumption of law of supply

• Law of diminishing marginal returns

• Increasing marginal costs of production

Law of diminishing marginal returns

adding more of one factor of production, while holding at least one other factor of production constant, will at some point yield lower marginal returns

Increasing marginal costs and the firms supply curve

• the cost of producing one additional unit of a good or service for a firm is higher at each level of production than it was previously

• the law of supply is based on the assumption that marginal costs increase, making firms willing to supply more only if the price rises

joint supply

• occurs when two or more goods are derived from the same product

• it is not possible to produce more of one without producing more of the other

competitive supply

• when the production of two goods use similar resources and processes

• producing more of one good means producing less of the other

Market equilibrium

state in which the quantity supplied is equal to the quantity demanded

equilibrium price

price at which quantity supplied and demanded are equal

equilibrium price term

P(e)

equilibrium quantity term

Q(e)

market equilibrium term

M(e)

Market disequilibrium

any price at which demand and supply quantities are not equal

Surplus (Market disequilibrium)

when the quantity of a good supplied is larger than quantity demanded (excess supply)

Shortage (Market disequilibrium)

when the quantity of a good demanded is larger than the quantity supplied (shortage of supply)

Price mechanism

how changes in price affect the quantity demanded and the quantity supplied, determining how scarce resources are allocated in an economy

forces of price mechanism

• signaling

• inscentive

• rationing

• allocative efficiency

price mechanism surplus explain

• increase in supply or decrease in demand

• prices fall

• signal surplus, producers should allocate less resources

• incentive to decrease output to increase profit

• rationing by increasing consumption

• allocative efficiency

price mechanism shortage explain

• increase in demand or decrease in supply

• prices rise

• signal shortage, producers should allocate more resources

• incentive for producers to increase output to increase profit

• rationing by decreasing consumption

• allocative efficiency

Allocative efficiency

when economy allocates its resources according to consumer preferences

Productive efficiency

producing goods by using the fewest possible resources, hence producing at the lowest possible cost

MC (demand or supply?)

supply

MB (demand or supply?)

demand

MB > MC

shortage

MC > MB

excess

MB = MC

allocative efficiency

consumer surplus

difference between the highest price consumers are willing and able to pay for a good and the actual price they pay

Producer surplus

the difference between the lowest price producers are willing and able to offer the good and the actual price that they receive for it

Consumer surplus formula (+graph)

willing to pay - market price (A = bxhx0.5)

Producer surplus formula (+graph)

market price - supply price (A = bxhx0.5)

Community surplus

consumer surplus + producer surplus

Rational consumer choice

• Consumer rationality

• Perfect information

• Utility maximization

Limitation of rational consumer choice

• rule of thumps

• anchoring

• framing

• availiability

Bounded rationality

the idea that customers are rational only within limits

Elasticity

Measures responsiveness of a variable to changes in price of the variables determinants (ceteris paribus)

Types of elasticities

• Elasticities of demand

• Elasticities of supply

What is PED?

A measure of how much the quantity demanded of a product changes when there is a change in price

PED

Price elasticity of demand

formula PED

(percentage change in quantity demanded) / (percentage change in price)

percentage change formula

(new - old) / (old)

Why is PED important? (To a business)

• how consumers respond to changes in the price of a product

• aware of effect that changes in price will have on market demand

Why is PED important? (To a governments)

deciding which goods to place taxes on

PED < 1

• inelastic demand

• A change in price leads to a proportionately smaller change in the quantity demanded

PED > 1

• elastic demand

• A change in price leads to a proportionately greater change in the quantity demanded

PED = 1

• unit elastic demand

• A change in price leads to a proportionately equal change in the quantity demanded

PED = 0

• perfectly inelastic demand

• A change in price leads to no change in the quantity demanded

PED = infinity

• perfectly elastic demand

• Any change in price would lead to an infinite change in the quantity demanded

Determinants of PED

• number of close substitutes

• degree of necessity

• proportion of income spent on the good

• time

• habits, addictions

PED along demand curve

PED decreases along demand curve

why does PED decrease along demand curve

• same price change causes a smaller percentage change in quantity demanded

• at higher prices consumers are more worried about the financial impact of their purchase, hence demand is sensitive to price changes

• at lower prices consumers are not bothered by financial impact of their purchase, less percent of their income is spent, hence demand is less sensitive to price changes

Relationship between PED and total revenue

PED>1 elastic = TR increases
PED=1 unitary elastic = TR max
PED<1 inelastic = TR decreases

why does total revenue increase when PED is elastic?

• price decreases and PED is elastic the quantity demanded increases proportionally greater

• quantity demanded for a good increases, hence total revenue increases

Total revenue (TR) formula

P x Q

PED elastic + indirect taxes

• taxes = price goes up

• price goes up = big change in demand

• low tax revenue for government

PED inelastic + indirect taxes

• taxes = price goes up

• price goes up = small change in demand

• high tax revenue for government

What is YED?

measure of how much the quantity demanded of a good will change in response to a change in consumers incomes

YED

Income Elasticity of Demand

Formula YED

(change in quantity demanded) / (percentage change in income)

YED > 0 (positive YED)

• income increases, demand increases

• upward sloping Engel Curve

• normal good

YED < 0 (negative YED)

• income increases demand decreases

• downward sloping Engel Curve

• inferior good

income inelastic demand

• -1<YED<1

• percentage change in quantity demanded is less than the percentage change in income

YED=0

• good is a necessity

• very inelatic

income elastic demand

• YED>1

• YED< -1

• percentage change in quantity demanded is greater than the percentage change in income

YED > 1

• income elastic demand

• percentage increase in income = bigger percentage increase in demand

• luxury goods

inferior goods YED

negative YED

normal goods YED

positive YED

necessity goods YED

low positive YED

luxury goods

YED>1 elastic + positive

economic recession impact on inferior goods

• incomes decrease

• demand for inferior goods increases

• increase in revenue

economic growth impact on normal and luxury goods

• incomes increase

• demand for normal and luxury goods increases

• revenues increase

what are the 3 sectors of economy?

• primary = primary commodities

• secondary = industries producing goods from primary commodities

• tertiary = economic goods which are not tangible, improve quality of life

Sectorial change

when an economy grows over time and the size of the sectors changes

why does sectorial change happen in relation to YED?

• as economy grows incomes increase

• higher incomes means demand for manufactured goods (higher YED) will increase

• demand for primary commodities (lower YED) will decrease

• When an economy achieves a high level of national income, consumers will spend disproportionately more in the tertiary sector (even higher YED)

Engel curve

accurate way to illustrate YED

What is PES?

a measure of how much the quantity supplied of a good changes when there is a change in its own price

PES

price elasticity of supply

Formula PES

(percentage change in quantity supplied) / (percentage change in price)

why is PES always positive?

price and the quantity supplied have a positive relationship (law of supply)

if supply curve intersects the y-axis it is

PES elastic

if supply curve intersects the x-axis it is

PES inelastic

0<PES<1

• supply price is inelastic

• A change in price leads to a proportionately smaller change in the quantity supplied