Microeconomics and Macroeconomics Concepts

Microeconomics Economic Concepts

• Scarcity:

  • Limited resources but unlimited wants.

  • Example: limited money, endless desires.

  • Forces choices.

• Factors of Production:

  • Resources for goods/services.

  • Land

  • Labor

  • Capital

  • Human Capital

  • Entrepreneurship

• Choice:

  • Scarcity requires decisions on production and distribution.

• Opportunity Cost:

  • Cost of the next best alternative.

• Rational Choices:

  • People maximize their well-being.

• Role of Economics in Business:

  • Micro-economic:

    • Affects individual firms/markets.

    • Examples: competition, demand.

  • Macro-economic:

    • Affects overall economy.

    • Examples: inflation, unemployment.

  • PEST Analysis:

    • Political, Economic, Social, Technological factors.

  • STEEPLE Analysis:

    • Extension of PEST.

    • Considers Environmental, Legal, Ethical factors.

• Why Firms Exist:

  • Reduce transaction costs.

  • Efficient coordination within a firm.

  • Enable specialization and division of labor.

  • Increase efficiency and economies of scale.

Principal-Agent Problem

• One person (principal) hires another (agent).

• Agent has more information.

• Example: shareholders (principals) hire a CEO (agent).

• CEO's interests may differ from shareholders.

Demand and Supply

• Demand Curve:

  • Consumer's willingness and ability to pay.

• Law of Demand:

  • Price up, quantity demanded down; vice versa.

• Demand Curve Influenced by:

  • Good's market price

  • Consumer income

  • Consumer preferences

  • Number of potential customers

  • Price of other goods

  • Expectations of future outcomes

• Supply Curve:

  • Factors of production transformed into goods.

• Law of Supply:

  • Price up, quantity supplied up; vice versa.

• Supply Curve Depends On:

  • Market price of the good

  • Price of inputs

  • Technology

  • Number of producers

  • Expectations

• Changes in Supply Curve:

  • Factors other than the good's own price.

  • Examples: input costs, number of producers.

• Market Equilibrium:

  • Demand and supply curves intersect.

  • Quantity demanded equals quantity supplied.

• Shortage:

  • Price below equilibrium.

  • Demand exceeds supply.

  • Price tends to rise.

• Surplus (Excess Supply):

  • Price above equilibrium.

  • Supply exceeds demand.

  • Price tends to fall.

• Price Mechanism:

  • Prices adjust to balance supply and demand.

• Changes in Demand/Supply:

  • Increase in demand (right shift):

    • Increases equilibrium price and quantity.

  • Increase in supply (right shift):

    • Decreases equilibrium price.

    • Increases equilibrium quantity.

Elasticities

• Type of goods

  • Normal Good: demand increases, income increases.

  • Inferior or giffen good: demand decreases, income increases.

  • Luxury or Veblen good: demand increases more than proportionally as income increases.

• Elasticity:

  • Measures quantity demanded change due to income or price change.

  • Measure of responsiveness.

  • Calculated as percentage change in one variable divided by the percentage change in another.

• Types of Elasticities:

  • Own Price Elasticity of Demand:

    • Quantity demanded changes when its price changes.

  • Cross Price Elasticity of demand:

    • Quantity demanded of one good changes when the price of another changes.

  • Income Elasticity of demand:

    • Quantity demanded changes when income changes.

• Price Elasticity of demand: (PED):

  • Measures quantity demanded changes in response to change in price.

  • Elastic demand (|PED| > 1):

    • Quantity demanded changes more than proportionally to price.

  • Inelastic demand (|PED| < 1):

    • Quantity demanded changes less than proportionally to price.

• Cross Price Elasticity of Demand:

  • Measures quantity demanded of one good changes in response to a change in the price of another good.

• Income Elasticity of Demand:

  • Measures quantity demanded changes in response to a change in income; helps classify goods as normal, inferior, or luxury.

Use of Elasticities

• Elasticity and Decision-Making:

  • Crucial for businesses to understand consumer behavior and make informed decisions.

• PED and Total Revenue:

  • Total revenue calculated as Price x Quantity.

  • Elastic Demand:

    • Lowering prices increases total revenue.

    • Quantity demanded increases more than proportionally.

  • Inelastic Demand:

    • Lowering prices decreases total revenue.

    • Quantity demanded increases less than proportionally.

  • Maximum Revenue:

    • Total revenue maximized when price elasticity is unitary (equal to 1).

• Applications of Elasticity:

  • Measure of responsiveness.

  • To change demand.

  • To change supply.

Consumer Demand I: Theory

• Utility:

  • Measures consumer satisfaction from buying things.

  • Satisfaction from consuming goods and services.

• Marginal Utility:

  • Satisfaction from consuming one more unit.

  • Decreases as more of the same good is consumed.

• Law of Diminishing Marginal Utility:

  • Consumers get ‘bored’ of always consuming the same good.

• Total Utility:

  • Overall satisfaction from consuming a certain amount of a good.

• Law of Diminishing Marginal Utility:

  • Additional satisfaction from each extra unit decreases as you consume more.

• Indifference Curve:

  • Shows combinations of goods with same satisfaction level.

• Marginal Rate of Substitution:

  • Slope of an indifference curve

  • Represents willingness to give up one good for another.

• Key Characteristics:

  • IC have a negative slope

  • IC are said convex to the origin

  • IC never intersect each other

  • Higher IC provide more satisfaction than lower IC

• Budget Constraints:

  • Shows limit of what a consumer can afford.

Consumer Demand II: Theory

• Indifference Curve:

  • Represents consumer preferences

  • Shows combinations of goods that provide equal satisfaction.

• Consumer’s Optimal Consumption:

  • Consumers aim to choose the combination of goods that gives them the most satisfaction, given their budget.

• Marginal Rate of Submission:

  • MRS is the rate at which a consumer is willing to trade one good for another while maintaining the same level of satisfaction; it's the slope of the indifference curve.

• Budget Constraint:

  • Shows the set of affordable consumption bundles, limited by the consumer's income and prices.

• Optimal Bundle:

  • Consumer's optimal choice occurs where the indifference curve is tangent to the budget constraint.

  • At this point, the MRS (Marginal Rate of Substitution) equals the ratio of prices (marginal rate of transformation, MRT).

• Income Effect:

  • Change in consumption due to a change in purchasing power caused by a price change.

• Substitutions Effect:

  • The change in consumption due to a change in the relative prices of goods.

Theory Of the Firm: Production and Costs 1

• Firms:

  • Organizations that combine resources to produce goods and services.

  • The main reason for firms to exist is to reduce costs.

• Transaction costs:

  • Costs involved in buying or selling in the market.

• Costs in the Short Run:

  • A period when at least one input (like machinery) is fixed.

• Costs in the Long Run:

  • A period when all inputs can be changed.

• Fixed Costs (FC):

  • Costs that don't change with how much you produce.

  • Example: Rent

• Variable Cost (VC):

  • Costs that do change with how much you produce.

  • Example: Labor, Materials

• Total Cost (TC):

  • Fixed Cost + Variable Cost

• Marginal Cost (MC):

  • The extra cost of producing one more unit. ((MC=TC/Q)

• Average Cost (AC):

  • Total Cost divided by the quantity produced.

• Average variable cost (AVC) is total variable cost per unit of output.

• Economies of Scale:

  • When producing more lowers the average cost.

• Diseconomies of Scale:

  • When producing more increases the average cost.

Theory of the firm: Production and Costs 2

• Total Revenue (TR):

  • The total money earned from sales ((TR=P*Q)

• Marginal Revenue (MR):

  • The extra revenue from selling one more unit.

• Average Revenue (AR):

  • (AR= TR/Q)

• Profit:

  • The difference between total revenue and total costs.

• Normal Profit:

  • Revenue equals total costs.

• Abnormal Profit:

  • Revenue is greater than total costs.

• Profit Maximization:

  • Firms aim to earn the highest possible profit. ((MR=MC)

• Short-run Decisions:

  • Firms decide whether to produce or shut down.

  • Decision depends on whether revenue covers variable costs.

• Long-run Decisions:

  • Firms operate if they cover all costs and earn normal profit.

Market Structures 1: Perfect and Imperfect Competition

• Perfect Competition:

  • Many firms sell the same product, no single firm controls the price.

  • Large number of buyers and sellers.

  • Homogeneous products (exactly the same products)

  • Free entry and exit from the market (enter or leave the market)

  • Perfect Information (Agents are constantly informed of the changing market conditions)

  • Perfect mobility of factors of production.

• Price Takers:

  • Firms that accept the market price.

• Imperfect competition

  • If one of these conditions fail to hold then we have imperfect competition

• Short-Run equilibrium:

  • The market situation where supply and demand are balanced in the immediate term.

  • Firms can make abnormal profits or losses.

• Long-Run Equilibrium:

  • Firms making only normal profits.

  • No incentive for entry or exit.

  • Free entry/exit drives profits to normal levels.

• Profit Motive

  • it is assumed that firms try to maximise profit. ((TR TC)

• Efficiency:

  • Perfect competition seen as desirable.

  • Firms are allocatively and productively efficient in the long run.

• Economic Surplus:

  • the net benefit to the consumers of purchasing the good on the market. the net benefit to the producer of selling the good on the market.

• Consumer Surplus:

  • the difference between the maximum amount a consumer would have been prepared to pay for a product and what the consumer actually paid.

• Producer Surplus:

  • The difference between the minimum price required for a firm to supply a good and the price that is actually paid.

• Long run equilibrium, we have P = MR = MC = AC

• Supply curve in perfect competition:

  • A firm can sell as much as it wants at the given price.

  • Example: Price = Marginal revenue

  • A firm is a profit maximiser Example: Marginal Revenue = Marginal Cost Price = Marginal Revenue = Marginal Cost This marginal cost curve is the Supply Curve.

Market Structures 2: Perfect and Imperfect Competition

• Imperfect Competition:

  • Firms have some control over prices.

• Types:

  • Monopoly: single seller.

• Comparison of Perfect Competition and Monopoly:

• Market Power:

  • Ability to influence prices.

  • Key difference from perfect competition

• Price-setter:

  • A firm with market power.

• Price discrimination:

  • A firm with the market power can also use

  • ((This is when the same good is sold to different customers at different prices))

  • Types of Price Discrimination:

    • First Degree:

      • –Each customer is charged exactly his willingness to pay –Example: Stall holders in a bazaar, car dealers, lawyers, architects, accountants

    • Second Degree:

      • –Prices depend directly on the quantity purchased by customers (very common in real life) –Examples: Three for two offers

    • Third Degree:

      • –Customers are grouped into separate markets with different prices according to the elasticity of demand–Examples: traditional airlines, cinemas, banks

  • Oligopoly: A few sellers.

  • Monopolistic Competition: Many sellers, slightly different products.

Government Intervention 1: Market Failure and Regulation

• Market Failure:

  • Market doesn't efficiently provide desired goods.

• Private Cost:

  • Cost to consumer or producer.

• External Cost:

  • Cost to bystanders.

  • Someone other than the consumer or producer.

• Social Cost:

  • Cost to everyone. (Private Cost + External Cost).

  • Example: factory pollution.

• Externalities:

  • External cost or external benefits that fall on by standers. These are like side effects.

  • Positive externality: beautiful garden.

  • Negative externality: factory pollution.

• Government Intervention:

  • Fix problems in the economy.

    • Direct provision of goods and services

    • Legislation and regulation

    • Subsidies and taxes

    • Providing information to promote particular forms of behaviour.

    • Regulating monopoly and competitive behaviour.

    • Taxing negative externalities

    • Minimum and maximum prices

    • Price stabilization schemes

    • Nationalization vs privatization

• Maximum Price:

  • Price cannot exceed this ceiling.

• Minimum Price:

  • Price cannot fall below this floor.

• Price Estabilization:

  • a government buys and sells products to stabilise the supply available and maintain the price in the market. A buffer stock scheme can be used to stabilize food prices.

• Nationalization:

  • Government takes over a company.

  • Public Hospital

  • Example: UK banks in 2008/09.

• Privatization:

  • Government sells a company.

  • Example: Royal Mail in 2013.

Government Intervention 2: Market Failure and Regulation

• Compensate for Market failure:

  • Taxes

  • Subsidies Positive and Negative

  • Regulation

  • Public goods

  • Merit goods

  • Missing Markets

• Advantages of Tax and Subsidies:

  • The rate can vary according to the size of the market distortion.

• Disadvantages of Taxes and Subsidies:

  • Subsidies have to be paid

  • Subsidies and taxes can mess up the market too. For example, a subsidy might encourage the production of something that isn't really needed, or a tax might make something too expensive.

  • Lack of precise knowledge. If the tax or subsidy is too high or too low, it won't fix the problem effectively.

• Regulation:

  • Rules set by the Government.

  • Examples:

    • –Pollution permits (carbon trading schemes) –The Office for Gas and Electricity markets (Ofgem) –The Water Services Regulation Authority (Ofwat)

• Public Goods:

  • Everyone can use.

  • One person's use doesn't stop others.

• Merit Goods:

  • Government thinks are good for people

  • Examples: Education, medication, vaccinations

• Missing Markets:

  • Markets don't exist, so goods/services aren't provided.

  • Examples:

    • Defence, Street Lighting where demand exits but supply is absent, Insurance for crop failure in poor countries.

Government Intervention: Drawbacks

• Poor information about rates

• Bureaucracy and inefficiency

• Shifts in government policy

• Lack of market incentives

• Lack of freedom of choice for the individual

• Coase Theorem:

  • Private deals can solve externality problems without government intervention.

Macroeconomics Introduction

• Macroeconomics:

  • Study of the economy as a whole.

  • Total output growth

  • Unemployment

  • Inflation

  • Balance of Payments

• Goals of Macroeconomics policy:

  • Economic growth

  • Low unemployment

  • Stable prices or low inflation

  • BoP Equilibrium

  • These goals are important for the overall well-being of the country

• Balance of Payments equilibrium:

  • A statistical statement that summarizes transaction between residents and non-residents. It consists of:

    • Current account

    • Capital account

    • Financial account

• Trade-offs in Macroeconomics:

  • Achieving one goal makes another harder.

  • Stable Economic Growth vs Inflation

  • Unemployment vs Inflation

  • Stable Economic Growth vs BoP

  • Full Employment vs BoP

• Monetary Policies:

  • Government actions related to interest rates and money supply.

• Fiscal Policies:

  • Government actions related to spending and taxes.

• Supply-side Policy:

  • Government actions to influence resources.

• Exchange Rate Policy:

  • Government actions to influence currency value.

• Other policies include structural policies to provide the rule of law, property rights, etc.

National Income Accounting and the Standards of Living

• Circular Flow of Income:

  • Movement of money between households and businesses.

  • Output, income, and expenditure are equal.

• Aggregate Demand (AD):

  • Total spending in an economy.

  • Equilibrium when AD equals total supply.

• Measuring national Income: There are 3 different ways:

  • Output: measures the final output of different sectors of the economy, such as agriculture, manufacturing and services

  • Expenditure: measures the spending by all the sectors of the economy, such as households, the governments, and foreign buyers, on a countries final goods and services.

  • Income: measures all the earnings of the economy.

• Gross Domestic Product (GDP):

  • Measures the value of final goods and services produced in an economy.

  • Key indicator of economic activity and growth.

  • Shows how much has been earned within a country’s national boundaries.

• Gross National Product (GNP):

  • Measures the value of final goods and services earned by UK nationals

  • GNP = GDP + net property income from abroad

• Standard of living Usually measured by:

  • Real GDP per capita = Real GDP/population

• Gini Coefficient:

  • Measures income equality.

• Factors other than income that affects the standard of living:

  • The quality of goods and services

  • The quality of life

  • Non-Marketed items

  • The black economy: all the work that is done in to economy but not declared.

  • Environmental issues

  • Wealth

• Human Development Index (HDI):

  • Measure of a country's overall development.

  • Includes health, education, and living standards.

Determinants of Aggregate Demand 1: Consumption and Investment

• Consumption:

  • Total spending by a household on goods and services.

  • A big part of countries overall demand (Aggregate demand).

  • People’s spending depends upon their income

    • Formula: C = a + b Yd

    • C = Total Consumption A = How much people will spend even if they have no income.

    • B = Marginal prosperity to consume (MPC) – The fraction of extra income people spends.

    • Yd = Income after taxes.

• Marginal Prosperity to Consume (MPC) influenced by

  • Interest rates

  • Expectation about the future price

  • Expectation of future state of economy.

  • Income levels

  • The availability and quality of domestic goods compared to foreign goods.

• The Multiplier Effect:

  • Initial increase in spending boosts the overall economy even more.

• Other things that affect how much people consume include:

  • How income is distributed in a country.

  • How easy it is to borrow money.

  • People’s overall wealth

  • The age of the population.

  • Expectation

  • Permanent Income.

• Investment:

  • Businesses spend money on things that will help them make more money in the future. Examples: Buying Machines, Building Factories.

  • Also a part of Aggregate demand.

    • Injects money into the economy.

  • Business decisions depend on future expectations.

  • Makes investment less predictable than consumption.

• Types of Investment:

  • Fixed capital: Long-term stuff like factories, land.

  • Working capital: Short-term stuff like stocks and materials.

  • Gross investment: Total investment in an economy. ((Net Investment + Depreciation Investment))

  • Depreciation investment: Replacing worn-out equipment.

  • Net investment: Net investment that increases the total amount of capital.

• Factors Affecting the Level of Investment:

  • How much it costs to start a project.

  • What the company expects to earn from the investment.

  • Other investment options.

  • Risk.

  • How easy it is to get financing.

  • Government policies.

• Businesses compare the potential return on an investment with the cost of borrowing money (interest rate) to decide if it's worth doing. This is called the Marginal Efficiency of Capital (MEC).

  • If the return on the project (the MEC) is > than the r (cost of borrowing) → project should go ahead.

  • If the return is < than the r, → the project should NOT go ahead.

  • At higher interest rates less, projects earn enough to cover the costs and so investment is likely to fall.

  • For each level of investment, the expected returns have changed.

• Governments use