Micro Economics (Year 1)

What is the basic economic problem?

Individual have unlimited wants but there are scarce resources. Therefore resources have to be allocated efficiently between competing uses.

Scarcity

Resources are limited and will eventually run out

Why is choice central to the basic economic problem?

All economic decisions incur an opportunity cost. Because all wants cannot be satisfied, choices must be made about resource allocation.

What is the purpose of economic activity?

To produce goods and services to satisfy the needs and wants of society.

Factors of Prduction

Resources used by firms to make goods or services (CELL)

What are the factors of production? (CELL)

Land- natural resources and physical space available for production

Labour - the workforce; the people who produce goods and services

Capital - machinery and equipment used in production

Enterprise (Entrepreneurship) - the ability to combine factors and create a business

Positive statement

A value free statement and can be tested true or false using economic data.

Normative statement

A normative statement is a value judgement that cannot be tested true or false using economic data.

What does a PPF show?

A production possibility frontier (PPF) illustrates the maximum potential output that an economy can produce between two goods or services, when all its factors of production are efficiently employed.

What does producing on the PPF show?

Productive efficiency

What does operating inside the PPF show?

Productive inefficiency

What does operating outside the PPF show?

Currently unattainable

What does a curving PPF show?

It shows an increasing opportunity cost.

What does a straight line PPF show?

It shows a constant opportunity cost.

Opportunity cost

The value of the next best alternative forgone

Factors that shift the PPF outwards:

Improvement in technology - AI

Increase in specialisation/ productivity - Training

Discovery of new natural resources - New oil reserves

Increase in the size of the workforce - Immigration

Factors that shift the PPF outwards:

Natural Disasters - Earthquake

War

Disease/ Pandemic - Covid 19

Depletion of natural resources - oil running out

Would a fall in unemployment shift a PPF?

No, it would move closer to the line. (Unemployment shows we are not operating productively efficient and therefore not on the PPF)

Buffer stock scheme

A scheme intended to stabilise the price of a commodity by purchasing excess supply in periods when supply is high, and selling commodity reserves when supply is low.

Why is supply inelastic in the short run?

At least one factor of production is fixed (commonly land), limiting firms responsiveness.

Factors that effect demand (PACIFIED):

Population

Advertisement

Complement & Substitute Goods

Income

Fashion/ Trends / Season

Interest Rates

Expectation of Future Prices

Debt

Factors that effect Supply (PENTS WC):

Productivity

Expectation of future prices

Number of suppliers

Technology

Subsidies + Tax

Weather

Cost of Production

What does the supply curve show?

The supply curve shows the relationship between price and quantity supplied. As price increases, firms are incentivised to produce more - the law of supply.

What does the demand curve show?

The demand curve shows the relationship between price and quantity demanded. As price falls, more is demanded - the law of demand.

How could worker productivity be improved?

More training

Better technology

Specialisation

Why is supply more elastic in the long run?

All factors of production are variable, allowing firms to increase output.

Public sector

The part of the economy concerned with the provision of goods and services by the government, funded through taxation

Private sector

The part of the economy concerned with the provision of goods and services by privately owned individuals and firms, motivated by profit.

Free goods

Goods that are unlimited in supply and which therefore have no opportunity cost - air, sunlight

Economic goods

Goods that are scarce because their use has an opportunity cost. They are created from scarce resources and therefore command a price

When price increases it causes

A contraction along the demand curve

Why does a contraction occur on the demand curve?

Substitution effect: a price rise means consumer retract their demand and find other cheaper goods instead

Income effect: as price rises, consumers experiment a fall in their real income so they demand less

Demand

amount of goods and services that consumer are willing and able to buy at various prices.

When price decreases it causes

An extension along the demand curve

Why is the demand curve downward sloping?

The law of diminishing marginal utility

Income effect

Substitution effect

Abilities and willingness to pay

Diminishing marginal benefit

Eval:

PED

Veblen goods

What is the law of diminishing marginal utility?

As consumers consumer more of a good, the additional satisfaction (marginal utility) they get falls.

Consumers are only willing to pay less for each additional unit.

Therefore, price must fall to increase quantity demanded.

What is the income effect?

A fall in price increases consumers’ real purchasing power causing their real incomes to rise. As a result consumers buy more.

What is the substitution effect?

When the price falls, the good becomes relatively cheaper compared to substitutes.

Veblen goods

Higher prices increases their demand

E.G. luxury goods due to increased reputation and desirability

Why does inequality occur in the free market?

There is freedom to own resources. Those who own resources and assets are likely to earn more income than those who do not own them.

Direct tax

A tax that must be paid directly to the government by the person on whom it is imposed - income tax and corporation tax

Indirect tax

A tax levied on goods and services - sugar tax

Under what elasticity will the government receive more tax revenue?

Demand is inelastic

Specific tax

The tax is a fixed amount per unit - cigarettes, petroleum

Ad valorem tax

The tax is a fixed percentage - vat 20% in UK

Utility

The satisfaction gained from consumption

Allocative efficiency

Taking action which maximise social welfare

Demerit goods

Goods that are considered to be undesirable for consumers and are over-provided by the market, maybe due to the good having negative externalities.

Asymmetric information

Where consumers and producers have unequal access to information about a good or service in the market.
e.g the over-consumption of tobacco or under-consumption of education

Why is indirect tax seen as regressive?

because even when people have a high income they pay the same tax as those who have a low income causing a big burden on the lower income individuals.

Information failure

information failure occurs when consumers do not have sufficient information to take decisions that will maximise their welfare

How short is the short run and how long is the long run?

short run: at least one FOP is fixed, long run they are all variable

What is the social optimum?

the price and quantity combination that would exist if there were no externalities, occurs where MSB=MSC

Where is the social optimum?

MSB=MSC

Why are merit goods underprovided?

they have a higher private cost than social cost so these externalities are ignored and the good is underproduced

internalise the externality

an attempt to deal with an externality by bringing an external cost or benefit into the price system through tax or subsidy

Why does the government impose specific taxes?

Increase revenue

Internalise the externality

In order to internalise the externality, the tax imposed must be equal to ....

the external cost at the socially efficient quantity

What is market failure?

when the market fails to allocate society's resources efficiently, instead of producing and consuming goods at the socially optimal level of output.

How is the unequal distribution of wealth considered as market failure?

some economists argue that wealth should be redistributed to benefit society

advantages and disadvantages of subsidies on goods with positive externalities

- internalises the benefit of the good
- could change consumer preferences
but
- difficult to put a monetary value on the externalities
- opportunity cost

How does market failure come about?

the price mechanism has not taken into account all the costs and/or benefits in the production/consumption of the g/s

What is the social benefit?

private benefit + external benefit
(e.g a child goes through education - private benefit of a job that pays a reasonable income
- social benefit that she becomes a doctor, treating people so that they can return to work)

What is the private benefit?

the benefit received by the consumer of a good or service

consumer surplus

the amount a buyer is willing to pay for a good minus the market price

factors affecting consumer surplus

The gradient of the demand curve (more inelastic, more surplus)
Changes in the condition of demand (e.g increase demand will increase the surplus)

producer surplus

the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives

effect of a subsidy on consumer surplus

increases size if firms pass these savings on or demand is elastic

Effect of tax on surplus

both decrease

Where is consumer surplus on a graph?

below the demand curve and above the price (the top one)

Where is producer surplus on a graph?

The area below the price and above the supply curve (the bottom one)

3 parts of price mechanism

rationing - makes sure supply = demand
incentivising - suppliers can determine whether there is profit to be made
signalling - it highlights to producers whether they need to increase or decrease their levels of supply

Disadvantages of the price mechanism? (3)

Some goods objectively shouldn't be produced through the price mechanism (organs)
- There will be missing markets for some goods
- The price mechanism usually has no moral overlay or beliefs before a government intervenes.

What did Smith call the price mechanism?

the invisible hand

effect of emigration on ppf

inward shift

What is meant by Enterprise/Entrepreneurship?

An entrepreneur combines and organises land, labour and capital to produce a good

what could cause demand for houses to increase?

- Limited supply, would be difficult to increase the supply of houses due to time lags
- buying of second homes by the wealthy
- migrants buying homes

Why do goods become more elastic over time?

More time means consumers can find substitutes. This means they can adjust habits making them more responsive to price changes. As a result there is more elastic demand.

what is a public good?

a good that is both non-rivalrous and non-excludable

non-excludable

people cannot be prevented from consuming the good

non-rival

consuming does not reduce the quantity available for the next person

Quasi public goods

Public goods which may not fit both condition (non-excludable and non-rivalrous)

Why would public goods not be produced in a free market?

Suppliers cannot stop consumers from accessing these goods and therefore they will not produce them (free rider problem)

Why may the government have to pay for flood defenses?

Individuals may refuse to pay but still use services due to the free-rider problem (if the flood services were provided by private sector) leading to insufficient funds to build flood defences. Therefore the government will do this via taxation.

What is a command economy?

an economy in which production, investment, prices, and incomes are determined centrally by a government.

what is a free market?

An economic system in which prices are determined by unrestricted competition between privately owned businesses.

Subsidy

A government grant given to producers which decrease their production costs leading to lower prices and higher output.

what is unitary demand?

Total revenue will remain the same if price is increased

Specialisation

A firm, country or individual produces a limited range of goods and becomes a specialist at it.

Division of Labour

The production process is broken down into specific roles and each unit of labour specialises in one part of that process.

Benefits of Specialisation

Increase in output

Increase in quality

Cost savings on training

Benefits of Division of labour

increase in output

Lower unit costs

Cost savings on training

Drawback of division of labour/ specialisation

Interdependence amongst the stages of production

Demotivating

Absenteeism

Employee turnover (meaning staff leave frequently)

Administration costs to recruit new worker

Structural unemployment

Free Market economy

No government intervention: goods are allocated via the price mechanism or as Adam smith says the invisible hand.

Which economist supports free market economy?

Adam smith

Mixed economy

Some government intervention but goods are allocated via the the price mechanism too. -95% of the real world

Which economist support mixed economy?

Friedrich Hayek

command economy

All resources allocated by the government

Which economist supports command economy?

Karl Marx

Advantages of free market economy

Efficiency allocation of resources:

Resources are allocated through the price mechanism → prices rise when demand is high → firms increase supply → resources move to where they’re most valued → leads to allocative efficiency

Innovation and dynamic efficiency:

Firms compete to survive → must reduce costs / improve products → invest in R&D → leads to dynamic efficiency over time

high consumer choice:

Many competing firms → wide variety of good → consumer can choose based on preferences → increases consumer welfare