Microeconomics Theme 1 <3

Ceteris paribus

all other things remaining constant

positive statement

a statement with facts and is value free scientific approach.

normative statement

statement with opinion and value judgement and is a nonscientific approach

The basic economic problem

how to allocate scarce resources given unlimited want

3 economic agents

1. Households

2. Firms

3. Government

3 key questions

1. What to produce?

2. How to produce it?

3. Who to produce for?

Difference between renewable and nonrenewable resources

nonrenewable resources are finite whereas renewable resources can replenish themselves and are infinite

Rational consumer

wish to maximise their satisfaction or utility

Rational Producers

wish to maximise profits by producing at the lowest cost

Rational Government

wish to improve the economic and social welfare

opportunity cost

the value of the next best alternative forgone when a choice is made

Production Possibility Frontier (PPF)

the maximum potential output combination of two goods an economy can achieve when all its resources are fully and efficiently employed

factors causing an outward shift in ppf

increase in quality or quantity of factors of production

factors causing an inward shift in ppf

decrease in quality or quantity of factors of production

Efficient allocation of resources

B

inefficient allocation of resources (we could produce more given FoP at no OC)

D

unattainable (given current FoP)

E

maximum productive potential of an economy

A/B/C

economic growth on ppf

outward shift

economic decline on ppf

inward shift

division of labour

splitting the production process into different parts to increase output

specialisation

the process of becoming particularly skilled in a task

Adam smith concept of division of labour

a worker will be able to make 20 pins a day if he worked alone but if 10 workers who are specialised in different parts of production then they'll produce 48000 pins a day

4 Advantages of division of labour

1. Increased productivity

2. Lower cost per unit

3. Workers can concentrate on one task

4. Increased output

3 Disadvantages of division of labour

1. Work can become tedious

2. Workers can get bored and leave

3. All stages of production will become co reliant on each other so if one stage breaks down the others are affected as well

4 Functions of money

1. Medium of exchange

2. Store of value

3. Measure of value

4. Standard of deferred payment

free market economy

an economy in which decisions on the three key economic questions and the problem of scarcity is determined by the market force (demand and supply)

command economy

a centrally planned economy in which the role of the state is to be a social planner and the decisions on the three key economic questions and the problem of scarcity is determined by the government

mixed economy

a mixture of free market economy and command economy

Adam Smith and the free market

he thought when individuals follow their own self interest they indirectly promote the good of society then the free market producers would respond to changes in consumer wants in a way that reduces waste and the governments role should be limited to proving public goods

Friedrich Hayek and the free market

he thought when the government plans economies it leads to failure, requires force and restricts freedom

Karl Marx

he thought capitalism was inherently unstable because workers were exploited and there would be a revolution and the economy would follow communism

5 characteristics of command economy

1. State ownership of resources

2. Price determined by the state

3. Resources allocated by the state

4. The role of the state is to be a social planner

5. A greater equality of income and wealth

5 characteristics of free market economy

1. Private ownership of resources

2. Producers aim to maximise profits

3. Consumers aim to maximise utility

4. Resources are allocated by the price mechanism

5. The role of the state is to reduce constraints

the role of the state in a mixed economy

fix market failure

demand

the quantity of a good or service that consumers are willing and able to buy

movement along the demand curve

change in price

shift in demand curve

Population
Advertisement
Substitutes
Income
Fashion/trends
Interest rates
Complements

diminishing marginal utility

Decreasing satisfaction or usefulness as additional units of a product are acquired

contraction and extension in demand

percentage change formula

change/original x 100

elastic demand

%change in price leads to a more than proportional %change in quantity demanded (more than 1)

inelastic demand

%change in price leads to a less than proportional %change in quantity demanded (less than 1)

price elasticity demanded (PED)

how responsive quantity demanded is to a change in price

PED formula

% change in Qd / % change in P

Determinants of PED

Substitutes
Proportion of income
Luxury/necessity
Addictive
Time period

Income elasticity demanded (YED)

how responsive quantity demanded is to a change in income

YED formula

% change in Qd / % change in Y

inferior goods

there are other alternatives so when income rises demand falls (negative YED)
more than 1 - income elastic
less than 1 - income inelastic

normal good

there are no other alternatives so when income rises demand rises (positive YED)
more than 1 - income elastic (normal luxury)
less than 1 - income inelastic (normal necessity)

Cross Elasticity of Demand (XED)

how responsive quantity demanded of good A is to a change in price of good B

XED formula

%change in Qd of Good A / %change in P of Good B

Joint demand (complements)

two goods are complements so if price increases for one demand would decrease for the other (negative XED)

competitive demand (substitutes)

a good has substitutes so if the price of the good increases the demand for the substitute increases (positive XED)

supply

the quantity of a good the producer is willing and able to sell

movement in supply

change in price

shift in supply

cost of production changes
government subsidy
entry of new things into the market

contraction and extension in supply

price elasticity supplied (PES)

how responsive quantity supplied is to a change in price

PES formula

% change in Qs / % change in P

perfectly elastic

infinity

relatively elastic

greater than 1 but less than infinity

perfectly inelastic

0

relatively inelastic

less than 1 but greater than zero

determinants of PES

Time period
Production time
Factor mobility
Spare capacity

Factors of production

Land

Labour

Capital

Entrepreneurship

Price mechanism

signals to producers that the price is too high/too low
incentive to change the price
rations excess demand/supply
successfully allocates scarce resources

consumer surplus

difference between how much a consumer is willing and able to pay and the market price

producer surplus

difference between how much a producer willing and able to sell a good for and the market price

indirect tax

a tax imposed on goods

ad valorem tax

a percentage tax imposed on good

elastic/inelastic demand in indirect tax

elastic demand more of the incidence of tax is paid by the producer
inelastic demand more of the incidence of tax is paid by the consumer

subsidy

money granted by the government

herd thinking

Making decisions based on what other people do.

habitual thinking

people prefer to carry on behaving as they always have

market failure

the market misallocates resources and isn't operating at the socially optimum level

types of market failure

Negative externality
Positive externality
Public good
Asymmetric information

negative externality

cost to the third party and social costs exceeds private costs

private cost

cost faced by producers directly involved in a transaction

external cost

cost to the third party

social cost

private cost + external cost

marginal private cost (MPC)

the cost of producing an additional unit of output

Marginal External Cost (MEC)

the cost to the third party for producing an additional unit of output

Marginal Social Cost (MSC)

The total cost to society of producing an additional unit of output MSC=MPC+MEC

negative externality causes market failure

social costs exceed private cost
overproduction of the good
misallocation of resources
not operating at the socially optimum level
market failure

positive externality

benefit to the third party and social benefits exceed private benefits

private benefit

benefits for consumers directly involved in a transaction

external benefit

benefit to the third party

social benefit

private benefits + external benefits

Marginal Private Benefits (MPB)

benefits to consumers for consuming an additional unit of output

marginal external benefit (MEB)

Benefit to third parties from the consumption of extra unit of output.

marginal social benefits (MSB)

total benefits to the consumer consuming an additional unit of output MSB=MPB+MEB

positive externality causing market failure

social benefits exceed private benefits
under consumption of the good
mis allocation of resources
not operating at the socially optimum level
market failure

public goods

good that are non excludable and non rivalrous

non excludable

can't be confined solely to those who have paid for it and non payers can enjoy the benefits at no financial cost

non rivalrous

each persons enjoyment of a good doesn't stop others enjoyment

free rider problem

difficulty of charging consumers and they will benefit from the product without paying for it

public goods cause market failure

a good is non excludable and non rivalrous
you can't charge people to use it (free rider problem)
firms have to incentive to provide it
under provision of the good
misallocation of resources
market failure

asymmetric information

one party to an economic transaction has more information than the other

asymmetric information causes market failure

information gaps
consumers don't have all the information to make a rational decision
market failure