Microeconomics

Economics

The study of how we make choices about allocating scarce resources under constraints to maximize welfare.

Scarcity

The starting point of economics; resources are insufficient to satisfy every possible want.

Choice

Because not everything is feasible at once due to scarcity, agents must rank alternatives. Every choice has a cost.

Market-Based Economy

An economic system where all decisions are made by markets via privately owned producers and consumers, with prices acting as the only allocative mechanism.

Centrally Planned Economy

An economic system where all resource allocation decisions (what to produce, who provides, who consumes) are made by the state.

Mixed Model Economy

Most modern economies harness the welfare-producing powers of markets, but the government regulates industries, provides public goods, and redistributes resources.

GDP

Measures the market value of final goods and services produced in a country over a period. Standard because it's comparable, but misses inequality, unpaid work, environmental damage, and leisure.

Economic Freedom Index

An imperfect proxy (by Fraser Institute) for institutions and policies that shape economic choices. Should be used cautiously as it is a model, not a complete ranking of "good" societies.

Opportunity Cost

The cost of a choice; what you give up when making a decision (e.g., the cost of 10 hours of extra leisure is the $200 of lost wages at $20/hr).

Marginal Utility

The extra value gained from consuming one more unit of a good or activity (e.g., another hour of leisure is worth more when leisure is scarce).

Present Bias

A behavioral concept where immediate costs and rewards receive extra weight, leading to procrastination.

Commitment Device

A rule, deadline, or constraint that helps future behavior follow current intentions (e.g., a quit date for smoking or a homework deadline).

Positive Economics

Objective economics: What is happening? What caused it? What will happen if policy changes? (e.g., "What happens if rents are capped?")

Normative Economics

Subjective economics: What should we do? Which outcomes matter most? How should costs/benefits be shared? (e.g., "Should affordability justify rent controls?")

Wealth Creation vs Redistribution

Economics does not endorse greed; it studies how growing the "pie" can make people better off without making others worse off, while acknowledging trade-offs and fairness.

Keynes’ Productivity Prediction

Economist Keynes predicted working hours would fall to 15 hours per week by 2030 due to productivity increase. He was wrong because people now desire more goods and services over additional leisure.

Economic Models

Simplifications of reality that leave out detail on purpose. A good model isolates a useful mechanism, clarifies trade-offs, and makes predictions.

Constraint

A limit on feasible choices, income, time, technology, law or physical resources

Choice

Because not everything is feasible at once, alternatives must be ranked.

Demand

The quantities of a good/service that buyers are willing and able to buy at a given price at a particular time. It reflects the Marginal Benefit (MB) of consumption.

Law of Demand

The principle that Price (P) and Quantity Demanded (Qty) are inversely (negatively) related: when price ↑, Qty ↓, and vice versa.

Income Effect

One reason the demand curve slopes downward. As a good becomes cheaper, consumers’ purchasing power improves, allowing them to buy more goods with their unchanged actual income, so Qty demanded goes up.

Substitution Effect

One reason the demand curve slopes downward. As a good becomes cheaper relative to other goods, consumers substitute away from the more expensive goods and toward the cheaper good, so Qty demanded ↑.

Normal Goods

Goods for which Quantity Demanded (QD) increases when consumer Income (Y) increases, and vice versa. E.g., restaurant meals, new cars.

Inferior Goods

Goods for which Quantity Demanded (QD) decreases when consumer Income (Y) increases, and vice versa. E.g., instant noodles, used clothing.

Substitute Goods

Goods that are used as an alternative to another. An increase in price of Good X leads to a decrease in QD for X and an increase in demand for Good Y, because Y becomes relatively cheaper.

The demand for Y is positively related to the price of X.

Compliment Goods

Goods that are used together (car and petrol). An increase in the price of Good X leads to a decrease in QD for X and a decrease in demand for Good T.

The demand for Y is negatively related to the price of X.

Network Effect

A non-price determinant of demand where a good becomes more useful (and thus more valuable) as more people use it. E.g., social media platforms, telephones. This increases demand.

Congestion Effect

A non-price determinant of demand where a good becomes less valuable as more people use it. E.g., traffic on a highway, crowded beach. This decreases demand.

Expectations of Future Price

A non-price determinant of demand. If buyers expect prices to rise in the future, they buy more now (↑ Demand). If they expect prices to fall, they delay purchases (↓ Demand).

Non-Price Determinants of Demand

• Network Effect

• Congestion Effect

• Expectation of Future Price

• Number of Consumers

• Price of Related Goods
  - Complement Goods
  - Substitute Goods

Number of Consumers

A non-price determinant of demand. An increase in the number of buyers in the market increases demand (shifts curve right). A decrease shifts it left.

Supply

The quantities of a good/service that producers are willing and able to provide for sale at a given price at a particular time. It reflects the Marginal Cost (MC) of production.

Law of Supply

The principle that Price (P) and Quantity Supplied (QS) are positively related: when price ↑, QS ↑, and vice versa. This is because higher prices provide a profit incentive to increase production, and increased production typically involves higher marginal costs.

Natural Conditions for Production

A non-price determinant of supply. Favorable weather (e.g., for agriculture) can increase supply (shift right). Adverse conditions (e.g., drought, frost) can decrease supply (shift left).

Input Prices

A non-price determinant of supply. An ↑ in the price of an input (e.g., wages, raw materials) increases production costs and decreases supply (shifts left). A ↓ in input prices decreases costs and increases supply (shifts right).

Technological Change

A non-price determinant of supply. An improvement in technology or productivity lowers production costs, allowing firms to supply more at each price (shifts supply curve right).

Prices of Substitutes in Production

A non-price determinant of supply. These are alternative goods a firm could produce using similar resources. If the price of an alternative good (e.g., wheat) rises while the price of the current good (e.g., corn) falls, a farmer may switch production, decreasing supply of the current good (shifts left).

Expected Future Prices

A non-price determinant of supply. If firms expect prices to be higher in the future, they may decrease supply now to sell later (shifts left). If they expect prices to fall, they may increase supply now to "flog off" goods before the price drops (shifts right).

Number of Firms in the Market

A non-price determinant of supply. An ↑ in the number of sellers increases market supply (shifts right). A ↓ in the number of sellers decreases market supply (shifts left). More firms also typically mean more competition and lower prices.

Market Equilibrium

A situation where the plans of buyers match the plans of sellers. The quantity demanded (QD) equals the quantity supplied (QS) at the prevailing price. The market "clears" with no shortage or surplus. There is no incentive for price to change.

Surplus (Excess Supply)

A situation where Quantity Supplied (QS) > Quantity Demanded (QD) at the current price. This puts downward pressure on prices. As price falls, QD rises and QS falls until equilibrium is reached.

Shortage (Excess Demand)

A situation where Quantity Demanded (QD) > Quantity Supplied (QS) at the current price. This puts upward pressure on prices. As price rises, QD falls and QS rises until equilibrium is reached.

Dynamic Market Analysis

The use of the demand and supply model to analyze how markets adjust to changes (shocks) and explain past events, current situations, or hypothetical "what-if" scenarios. It involves a four-step process.

1. Which curve is affected? (S or D)

2. How is it affected? (Increase or decrease, determinant)

3. How does the market adjust? (Shift curve, new equilibrium)

4. What are the consequences? (New Price, Quantity, effects on goods)

Movement vs Shift

A movement along a curve is caused by a change in the price of the good itself. A shift of the curve is caused by a change in a non-price determinant. This is the most crucial distinction in dynamic market analysis.

Example of Demand

The COVID-19 pandemic caused a massive increase in Demand for face masks (due to heightened tastes/preferences for safety and government mandates). The demand curve shifted right. This led to a higher equilibrium price and quantity.

Non-price Determinants of Supply

• Natural Conditions for Production

• Prices of inputs

• Productivity and technology

• Prices of substitutes in production

• Expected future prices

• Change in the type and number of firms

Consumer Surplus

the difference between the maximum price a consumer is willing to pay for a good (buyer reservation price) and the price they actually pay for that good

The reservation price is the marginal benefit to consumer and the price they pay

Producer Surplus

the difference between the lowest price the seller is willing to sell for (seller reservation price) and the price actually received for that good

the lowest price is the marginal cost of producing (otherwise they will incur a loss).

Market Consumer Surplus

The area between the demand curve and the market price up to the equilibrium quantity.

Market Producer Surplus

The area between the supply curve and the market price up to the equilibrium quantity.

Consumers who don’t buy

They don’t get benefit of owning the good, but don’t incur any cost either because they choose not to participate in the market.

Producers who don’t sell

They don’t get the benefit of selling the good, but they don’t incur cost of selling it either. They choose not to participate because the price for selling is too low.

Total Economic Surplus (TS)

Consumer surplus plus producer surplus. Measures total welfare generated by a market

Allocative Efficiency

Occurs when marginal benefit equals marginal cost (MB = MC). Total surplus is maximised

Deadweight Loss (DWL)

The loss of potential surplus that is not transferred to anyone, so not enjoyed by anyone. Represents welfare lost because too little or too much is produced.

3 Types of Efficiency

1. Allocative Efficiency - MB = MC

2. Productive Efficiency - Firms operate at lowest point on the average costs curve.

3. Dynamic Efficiency - Occurs when firms are willing and able to continually improve production processes and products through research and development.

Market Intervention

Best way to achieve maximum efficiency is to let markets operate freely and be guided by the ‘invisible hand.’

However, governments can still interfere by:

• Placing restrictions on prices

• Placing restrictions on quantities

• Implementing taxes and subsidies

Price Ceiling (Pc)

A type of price intervention where the government mandates a maximum price.

Only comes into effect when P* > Pc

Price Floor (Pf)

A type of price intervention where the government mandates a minimum price.

Only comes into effect when P* < Pf

Prohibition

Government prevents producing, selling, buying or consuming

Mandates

The government makes an activity compulsory

Quotas

The government sets a maximum allowable quantity for production or sale (or purchase or consumption).

Permits

The government grants or sells a license which allows the holder to produce/sell or buy/consumer

Types of Quantity Restrictions

• Prohibition

• Mandates

• Quotas

• Permits

Tax

An artificial added cost, which drives a wedge between the price paid by buyers (P_B) and the price received by sellers (P_S).

It means that sellers receive less and buyers pay more. BOTH LOSE

Subsidy

An artificial added benefit, which drives a wedge between the price received by sellers (P_S) and the price paid by buyers (P_B).

It means sellers get more and buyers pay less, BOTH BENEFIT

Tax Analysis

• A flat tax of $t can be implemented

• Tax can be charged directly from the producer when a good is produced. It doesn’t matter whether taxes are levied on consumers or producers, it has the same economic implications for both sellers and buyers and we get the same market outcome.

• This is often modeled by treating tax as an added cost of production. The cost of producing at each quantity therefore rises by $t.

Elasticity

A way of measuring how sensitive one variable is to changes to another variable.

Price Elasticity of Demand (PED or Ed)

How sensitive demand is to changes in price

Measures the percentage change in QD for each percentage change in Price.

Income Elasticity of Demand (YED, IED or Ey, Ei)

• Inferior Good, Normal Good, Luxury Good

How sensitive demand is to changes in income

Cross-Price Elasticity of Demand (XED or Ex)

How sensitive the demand for one good is to changes in the price of another related good

Price Elasticity of Supply (PES or Es)

How sensitive supply is to changes in price

Determinants of Price Elasticity of Demand

1. Availability of Close Substitutes - people can switch easily if price rises

2. Time - greater opportunity to find suitable alternatives

3. Necessities vs Luxuries - Can do without luxuries, so more responsive to change in price

4. Definition of the Market - The broader the market is defined, the less elastic

5. Share of budget spent on good - Smaller fraction of budget spent on a good, less elastic demand

Determinants of Price Elasticity of Supply

1. Time - firms need time to adjust production, longer time means more price elasticity of supply

2. Cost of Inputs - extra production means input becomes scarce and so more costly, more price inelasticity

Absolute Advantage

Being able to produce a good using fewer resources than another country.

Comparative Advantage

Being able to produce a good at a lower opportunity cost than another country.

Production Possibility Frontiers

The Maximum combinations of two goods that a country can produce. Slope of PPF represents the opportunity cost.

Specialisation

Countries focus production on the goods in which they have a comparative advantage.

Exports

When World Price is higher than Domestic Price, countries will export their goods to others.

Formula: QS - QD

Imports

When World Price is lower than Domestic Price, countries will import goods from others

Formula: QD - QS

Effect of Exports

• Producers are better off because they receive a higher price

• Consumers are worse off because they are paying a higher price

• QD falls because price rises. QS increases because price rises.

Effect of Imports

• Producers are worse off as they receive a lower price

• Consumers are better off because they pay a lower price

• QD increases as price falls. QS decreases.

Tariff

A tax on imported goods, usually for the purposes of protecting domestic industries.

Imports decrease. Consumers worse off because they pay higher price. Domestic producers receive higher price.

Overall welfare falls and tariff creates a deadweight loss

Midpoint Formula

PED = (Q1 - Q0)/Q / (P1 - P0)/P

Finding Equilibrium

Use simultaneous equation with QD = QS formula to find equilibrium Price, then substitute into one of the equations to find the equilibrium Quantity.

Government Failure

Losses in efficiency and welfare caused by government intervention.

Market Failure

When the market fails to produce the social optimum outcome.

Sources of Market Failure

1. Externalities - benefits/costs of consumption/production fall on other members of society

2. Public goods - when consumption of good/service cannot be restricted to only those who pay for it.

3. Common resources - commonly accessed resource is depleted due to tragedy of commons.

4. Asymmetric information - one party in transaction has more information than other.

5. Concentrated market power - one or few firms dominate the market

Rivalry

Situation that occurs when one person’s consuming a unit of a good means no one else can consume it.

Excludable

Situation in which anyone that does not pay for a good cannot consume it.

Public Goods

Goods that are non-excludable and non-rival. Leads to a market failure in provision of these goods due to free-rider problem. A good will never be produced if no one pays for it.

So, this most often has to be provided by government.

Common Resources

They are rival but non-excludable. Leads to market failure in allocation of these goods due to Tragedy of the Commons. It is in individual’s interest to take more.

So, these tend to be over-exploited and governments need to intervene to manage them.

Private Property Rights

A way out of the Tragedy of the Commons. If someone owned the common, then it would be in their interest to ensure sustainability of common resource.

Adverse Selection

Asymmetric information that occurs before the transaction has occurred. Such as a used car dealer selling to a buyer when both parties know that information could potentially be withheld.

Moral Hazard

Asymmetric information that occurs after the transaction has taken place. Such as drivers taking more risk after buying car insurance or health insurance members not taking good steps to ensure good health.

4 Types of Markets

1. Perfect Competition

2. Monopolistic Competition

3. Oligopoly

4. Monopoly

Market Power

Individual firm’s ability to set a price that is

• different from its competitors

• above marginal cost

Sources of Market Power

• Production Differentiation - degree to which a firm’s products are perceived as different from competitors

• High barriers to market entry (and exit) - if hard for new firms to enter market, incumbent firms are insulated from having to contend with new competitors

Barriers to Entry and Exit

1. Government imposed restrictions

2. Access and control over a key resource

3. Important network externalities

4. Economies of Scale

5. Brand Loyalty