Unit 2: Microeconomics

Exam revision

Law of demand

There is an inverse relation ship between price and quantity demanded.

Law of supply

there is a direct relationship between price and quantity supplied

Relationship between an individual consumer's demand and market demand

Market demand \= sum of all individual consumers' demands

Non-price determinants of demand

Income, taste/preferences, Future price expectations, Price of substitutes or compliments, Number of consumers

Non-price determinants of supply

Cost of factors of production, competitive supply, joint supply, supply side shocks, changes in technology, inderect taxes and subsidies, future price expectations, number of firms

Competitive supply

A situation where two goods compete for the same resources.

Joint supply

A situation where two goods are produced from the same resource.

The price mechanism

shows the way in which changes in price affect the supply and the quantity demanded.

rationing

an artificial control on the supply or demand of a good/service

marginal cost

the cost of producing one more unit of a good

marginal benefit

the additional benefit to a consumer from consuming one more unit of a good or service

individual producer's supply vs. market supply

Market supply \= sum of individual producers' supply

consumer surplus and producer surplus

1. Consumer surplus measures the benefit consumers receive from buying goods and services in a particular market.
2. Producer surplus measures the benefit producers receive from selling goods and services in a particular market.

Social/Communtiy surplus

Consumer surplus + producer surplus

Functions of the price mechanism

Rationing-Scarce resources are divided among their competing uses according to what is demanded

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Signalling-The price of a product reflects the market conditions and signals if producers should increase or decrease production

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Incentive-Prices act as an incentive for both consumers and producers, low prices encourage consumers to purchase more and suppliers will leave the market due to low profit margins forcing the price back up, whilst high prices encourage producers to enter the market or produce more, increasing supply and pushing the price back down.

When does marginal benefit \= marginal cost?

at the competitive market equilibrium

When is allocative efficiency achieved?

at the competitive market equilibrium / MSB=MSC / MB=MC / welfare is maximized

When is social/community surplus maximized?

at the competitive market equilibrium

Reasons for government intervention

* earn government revenue
* support firms
* support households on low incomes
* influence level of production/consumption
* correct market failures
* promote equity

What are the main forms of government intervention?

* Price controls (ceilings and floors)
* Indirect taxes and subsidies
* Direct provision of services
* Command and control regulation and legislation

Define an indirect tax

Indirect taxes refer to taxes on expenditure. They are not charged *directly* on people's incomes or wealth. They are paid *indirectly* by consumers when they purchase a good, as indirect taxes are included in the price of the good.

Define subsidy

This an amount of money granted by the government towards producers. It is often given per unit of output and causes the producers to be able to produce more at a lower price.

Define a price ceiling and a price floor

When the government sets a minimum/maximum price on a product which all producers must legally set their price above/below.

Negative externality of production graph

* examples: air pollution
* MSC>MPC
* all units produced from Q optimal to Q actual have a higher cost to society than a benefit to society so its market failure - welfare loss
* government response to example: carbon tax (generates tax revenue, and easy to apply)
* negatives of government response: hard to measure the amount of pollution produced and put a value on it, and doesn’t actually stop firms from polluting

Negative externality of consumption graph

* MPB>MSB
* example: Cigarettes - second hand smoke is affects non-smokers
* government response to example: restricting the good by age, negative advertising, imposing an excise tax
* negatives of government response: cost of enforcing the legislations, “restriction on liberties”, prices are inelastic for addictive goods so people will pay the tax, high cost of advertisement and limited effectiveness, rise of black markets
* Q act > Q opt therefore overconsumption of goods

Positive externality of production graph

* MPC>MSC
* Example: Bee-keeping/farming honey
* benefit of example: pollination of surrounding crops by bees
* government responses: subsidising firms
* negatives for government response: opportunity cost of subsidy, money could have been used for healthcare, education, etc.
* Q actually produced is less than Q opt and therefore under allocation of resources and potential for welfare gain

Positive externality of consumption graph

* MSB>MPB
* example: Vaccine
* Benefit of example: reduces the spread of illness
* government responses: subsidising pharmacies, legislations/mandates, positive advertisement
* cost of government response: cost of enforcing laws, cost of creating advertisements, costs of subsidising pharmacies, people dont like being told what to do

When is a market optimal/allocatively efficient

MSC=MSB

Marginal social/private benefit/cost

benefit/cost to society or individuals/firms

Define social surplus

The sum of the consuer and producer surplus. The total welfare or benefit gained by society at a certain price.

What is PED and how to calculate

a measure of how responsive Quantity demanded is to Change in price

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PED = **Percentage change in quantity demanded / Percentage change in price**

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ALWAYS A POSITIVE NUMBER

Value of PED is between 0 and 1

Price inelastic demand - relatively unresponsive

Value of PED is >1

Price elastic demand - relatively responsive

Determinants of PED

* Number and closeness of substitutes
* Degree of neccessity
* Proportion of income spent on the good
* Time

What is YED and how to calculate it

A measure of how responsive quantity demanded is to change in income

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

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Positive/negative sign matters

Positive YED

normal good

Negative YED

inferior good

\-1

income inelastic demand - proportionally smaller change in Qd than income

YED

income elastic demand - proportionally greater change in Qd than income

What is PES and how to calculate it

A measure of how responsive quantity supplied is to changes in price

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

PES > 1

Supply is elastic

PES < 1

Supply is inelastic

Primary commodities

A good sold for production or consumption just as it was found in nature.

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They are neccesities and have no substitutes.

Private goods

A good that is rivalrous and excludable

Public good

* A good that is non rivalrous and non exludable


* benefits all members of society


* there is little incentive for people to pay for the good (free rider proble
* Typically a merit-good
* e.g. streetlights, national security, policing and law enforcement

Quasi public goods

Club goods and common pool resources

Club goods

Excludable but non-rivalrous

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e.g. movie theatres, gated parks

Common pool resources

non-excludable but rivalrous

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e.g. fish in the ocean

Explain with the free rider problem why public goods are a market failure

The freerider problem exists because no one is willing to pay for a good or service when they think someone else will pay for it, which means in a free market public goods would not be provided.

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Because the free market is unable to provide these goods without intervention, public goods are an example of market failure.

Government intervention in response to externalities and common pool resources

* indirect taxes
* carbon taxes
* legislation and regulation
* education
* advertising
* subsidies
* government provision
* tradable permits
* international agreements
* collective self-governance

Pros of government provision of public goods

* Improves social welfare as consumption is increased
* allows for economies of scale
* free rider problem is eliminated to a large extent

Cons of government provision of public goods

* opportunity cost - it must be financed
* May not be economically efficient as government is unable to determine the optimal output
* Some quasi-public goods, like toll-roads, could be provided more efficiently by firms

Why does the government contract out to the private sector to provide public goods

* Firms can be more efficient in provision than the government
* Profit motive gives firms incentive to raise capital and be efficient

how ever the extent of this increased efficiency is debated in real world

Price ceilings effect on stakeholders

Consumers - Pay lower price but decrease in consumer surplus due to shortage

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Producers - increased demand but selling at a lower price = less revenue, therefore producer surplus decreases