Microeconomics (full summary) PDF

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Warning: TT: undefined function: 32 Warning: TT: undefined function: 32C1 Introduction1 Microeconomics: the allocation of scarce resources The three trade-offs of a society - Which goods and services to produce: limited amount of resources. - How to produce: use more of one input if it uses less of ...

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C1 Introduction 1.1 Microeconomics: the allocation of scarce resources The three trade-offs of a society • Which goods and services to produce: limited amount of resources. • How to produce: use more of one input if it uses less of another input. • Who gets the goods and services: an unlimited amount of goods and services. The government may make these three allocation decisions for society. Besides, the interaction of independent choices by many individual consumers and firms may determine society’s allocation decisions. The prices link the decisions about which goods and services to produce, how to produce them, and who gets them. The prices influence the decisions by consumers and firms, and the interactions of those decisions by consumers, firms, and the government determine price. Market: an exchange mechanism that allows buyers to trade with sellers. 1.2 Models Model: a description of the relationship between two or more economic variables – used to predict how a change in one variable will affect another. Economic model: a simplification of reality that contains only it most important features – many assumptions to simplify the models. Economy theory: the development and use of a model to test hypotheses, which are predictions about cause and effect – economists test theories by checking whether predictions are correct. A good model makes sharp, clear predictions that are consistent with reality. In most economic models, a decision maker maximizes an objective subject to a constraint – the limit on resources plays a crucial role in models. Positive statement: a testable hypothesis about cause and effect – “positive” means that we can test the truth of the statement. Normative statement: a conclusion as to whether something is good or bad – untestable because a value judgement cannot be refuted by evidence (a prescription rather than a prediction). A normative statement concerns what somebody believes should happen, a positive statement concerns what will happen. 1.3 Uses of microeconomics models Microeconomic models explain why economic decisions are made and allow us to make predictions – useful for individuals, governments, and firms in making decisions. One major use of microeconomic models by governments is to predict the probable impact of a policy before it is adopted.

C2 Supply and Demand 2.1 Demand Information about the characteristics of a good affects consumer’s decisions – the price of other goods also affect the purchase decisions of a consumer. Substitute good: a good or service that may be consumed instead of another good or service. Complement good: a good or service that is jointly consumed with another good or service. Income, government rules and regulations are factors that have an effect on demand. The relationship between price and quantity demanded plays a critical role in determining the market price and quantity in a supply-and-demand analysis. Quantity demanded: the amount of a good that consumers are willing to buy at a given price, holding constant the other factors that influence purchases. Demand curve: the quantity demanded at each possible price, holding constant the other factors that influence purchases. Demand function: shows the relationship between the quantity demanded, price, and other factors that influence purchases. Law of demand: the slope of the demand curve is negative – slope is equal to

∆𝑝 ∆𝑄

Total quantity demanded: sum of the quantity each consumer demands at that price. 2.2 Supply Costs of production affects how much firms want to sell of a good. Factors that affects costs, also affects the supply – taxes and many government regulations alter the cost of production. Quantity supplied: the amount of a good that firms want to sell at a given price, holding constant other factors that influence firm’s supply decisions, such as costs and government actions. Supply curve: the quantity supplied at each possible price, holding constant the other factors that influence firm’s supply decisions. No law of supply – the market supply curve can have every kind of slope. A change in price – movement along the supply curve. A change in other factors – shift of supply curve. Supply function: shows the correspondence between the quantity supplied, price, and other factors that influence the number of units offered for sale. Total supply curve: total quantity produced by all suppliers at each possible price – the horizontal sum of the domestic and foreign supply curves, the total supply curve is flatter than the other two supply curves.

Quota: the limit that a government sets on the quantity of a foreign-produced good that may be imported. 2.3 Market Equilibrium Equilibrium: a situation in which no one wants to change his or her behaviour. If the price are not at the equilibrium level, consumers or firms will have an incentive to change their behaviour in a way that will drive the price to the equilibrium level. Disequilibrium: the quantity demanded would not equal to the quantity supplied. • Excess demand: the amount by which quantity demanded exceeds the quantity supplied at a specified time. • Excess supply: the amount by which the quantity supplied is greater than the quantity demanded at a specified price. The market has no excess demand or excess supply at the equilibrium price. 2.4 Shocking the Equilibrium The equilibrium changes only if a shock occurs that shifts the demand curve or the supply curve – the curve changes if one of the variables we are holding constant changes. - Shift of the demand curve and shift of the supply curve. - Shift of the demand curve and movement along the supply curve. - Shift of the supply curve and movement along the demand curve. 2.5 Effects of Government Interventions Government supply policies • Licensing law: limits the number of firms that may sell goods in a market. • Quotas: limit the amount of a good that firms may sell – commonly used to limit import (affects the supply curve). Price ceiling: maximum price – no effect if they are set above the equilibrium price. Price floor: minimum price – prevents that market forces would drive up the market price and eliminate excess demand. Shortage: a persistent excess demand. Equilibrium with shortage: no consumers or firms wants to act differently, given the law. With enforces price controls, sellers use criteria other than price to allocate the scarce commodity. When the government sets a price ceiling or price floor, the quantity supplied does not equal the quantity demanded • Quantity supplied: the amount firms want to sell a given price, holding other factors constant. • Quantity demanded: the quantity that consumers want to buy at a given price, holding the other factors constant.

When the government regulates the price, the quantity that consumers want to buy and the firms wants to sell is not equal to quantity that they actually sell and buy. 2.6 When to Use the Supply-and-Demand Model The supply-and-demand model is applicable to market in which 1 Everyone is a price takers. 2 Firms sell identical products. 3 Everyone has full information about the price and quality of goods. 4 Costs of trading are low. Price taker: cannot affect the market price. Price setter: can affect the market price – monopoly. Firms are also price setters in an oligopoly or in the market where they sell differentiated products. Oligopoly: a market with only a small number of firms. The supply-and-demand model does not apply to markets with a small number of sellers or buyers. Transaction cost: the expenses of finding a trading partner and making a trade for a good or service beyond the price paid for that good or service.

C3 Applying the Supply-and-Demand Model 3.1 How Shapes of Supply and Demand Curves Matter A shift of the supply curve causes a movement along the demand curve – the demand curve is downward sloping. A vertical demand curve is not sensitive for a price change – a shift of the supply curve will only affect the price, equilibrium quantity stays the same. A horizontal demand curve is sensitive for a price change – a shift of the supply curve will only effect the quantity, equilibrium price stays the same. 3.2 Sensitivity of the Quantity Demanded to Price Elasticity: the percentage change in a variable in response to a given percentage change in another variable. Price elasticity of demand: the percentage change in the quantity demanded in response to a given percentage change in the price – the percentage change in quantity demanded divided by the percentage change in price (𝜀 =

∆𝑄/𝑄 ∆𝑝/𝑝

)

The elasticity is a pure number and has no units of measure. The negative sign before ɛ illustrates the law of demand – consumers demand less quantity as the price rises. The other formula for the elasticity is 𝜀 =

∆𝑄 𝑝 ∙ ∆𝑝 𝑄

The ratio of change in quantity to the change in price is the change in quantity divided by the change in price. The elasticity of demand is different at every point along a downward-sloping linear demand curve – the higher the price, the more negative the demand elasticity. The elasticities are constant along horizontal and vertical linear demand curves. Perfectly inelastic: at a point where the elasticity of the demand is zero – the quantity does not change. Inelastic: a point along the demand curve, where the elasticity lies between zero and minus one – 0 < ɛ < -1 Unitary elasticity: an elasticity which is equal to minus one – ɛ = -1 Elastic: the elasticity is less than minus one – ɛ < -1 Perfectly elastic: a point where the elasticity is approaching minus infinity. Constant elasticity demand curve: the elasticity is the same at every point along the curve. Horizontal demand curve: the demand curve is perfectly elastic at every quantity – a small increase in price causes an infinite drop in the quantity (demand curves are horizontal because consumers view a good as identical to another good).

Vertical demand curve: the demand curve is perfectly inelastic at every quantity – if the price changed, the quantity will be unchanged (vertical demand curve for essential goods). Revenue: the price times the market quantity sold – whether the revenue rises or falls when the price increases, depends on the elasticity of demand. The duration of the short run depends on how long it takes consumers or firms to adjust for a particular good. Two factors that determine whether short-run demand elasticities are larger and smaller than longrun elasticities are the ease of substitution and the storage opportunities. Goods that can be stored easily or long-lived have short-run demand curves that may be more elastic than long-run curves. Income elasticity of demand: the percentage change in the quantity demanded in response to a given percentage change in income. The income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. - The elasticity is positive when the income and demand increases. - The elasticity is zero when the quantity does not change when the income increases. - The elasticity is negative when the quantity decreases when the income increases. Necessities have income elasticity between zero and one. Luxury goods have income elasticity greater than one. Cross-price elasticity: the percentage change in the quantity demanded in response to a given percentage change in the price of another good. The cross-price elasticity is the percentage change in quantity demanded divided by the percentage change in price of another good. • Complements: negative cross-price elasticity – the demand curve shifts to the left when people buy less of a good. • Substitutes: positive cross-price elasticity. 3.3 Sensitivity of the Quantity Supplied to Price Price elasticity of supply: the percentage change in the quantity supplied in response to a given percentage change in the price – the percentage change in quantity supplied divided by the percentage change in price.

The elasticity of supply describes the movement along the supply curve as price changes. The elasticity of demand describes the movement along the demand curve as price changes. • Perfectly inelastic: ƞ = 0 • Inelastic: 0 < ƞ < 1 • Unitary elasticity: ƞ = 1 • Elastic: ƞ > 1 • Perfectly elastic: ƞ = ∞ The constant elasticity of the supply curves have the same elasticity at every point along the curve. A supply curve that is vertical is perfectly inelastic – perishable items. A supply curve that is horizontal is perfectly elastic. 3.4 Effects of a Sales Tax When a tax is applied, the supplier gets the price minus the tax. A specific tax causes the equilibrium price consumers pay to rise, the quantity to fall, and tax revenue to rise – the total amount that consumers pay is the price plus the tax. The equilibrium after the tax is the same regardless of whether the taxes are imposed on consumers or sellers. Incidence of a tax on consumers: the share of the tax that consumers pay – the entire tax effect is one. The incidence of the tax that falls on the consumers is equal to

∆𝑝 ∆𝑡

=

𝜀 ƞ−𝜀

The tax incidence on consumers depends on the elasticities of the supply and demand. - The more elastic demand is, the less the equilibrium price rise when a tax is imposed. - The greater the supply elasticity, the larger the increase in the equilibrium price consumers pay when a tax is imposed. The buyers and sellers share the incidence of an ad valorem tax – the incidence of a specific tax is the same as the incidence of an ad valorem tax. The subsidy is a negative tax – the opposite effect of what a tax does (lower the equilibrium price and increase the quantity).

C4 Consumer Choice 4.1 Preferences Economists assume that consumers have a set of tastes and preferences that they use to guide them in choosing between goods – tastes may differ substantially among individuals. Three assumptions about the property of the consumer’s preferences • Completeness: when facing a choice between any two bundles of goods, a consumer can rank them so that one and only one of the following relationships is true ▪ A consumer weakly prefers a to b. ▪ A consumer weakly prefers b to a. ▪ A consumer is indifferent between a and b. • Transitivity: if a consumer weakly prefer a to b, and b to c, then the customer also weakly prefers a to c. ▪ Rational: consumer has well-defined preferences between any pair of alternatives. • More is better: more of a commodity is better than less of it. ▪ Good: a commodity for which more is preferers to less, at least at some levels of consumption. ▪ Less: something for which less is preferred to more, such as pollution. The completeness property rules out the possibility that the consumer cannot rank the bundles. The transitivity property eliminates the possibility of certain types of illogical behaviour. The more is better property is included to simplify the analysis. Indifference curve: the set of all bundles of goods that a consumer views as being equally desirable – indifference curves are continuous (no gaps). Indifference map: a complete set of indifference curves that summarize a consumer’s taste or preferences. Indifference curve map have four properties 1 The bundles on the indifference curves farther from the origin are preferred to the indifference curves closer to the beginning. 2 An indifference curve goes through every possible bundle. 3 Indifference curves cannot cross. 4 The slope of an indifference curve is downward. Connecting bundles that give the same pleasure as the given bundle produces an indifference curve that includes the given bundles. Indifference curves cannot cross because preferences are transitivity and more is better than less. Marginal rate of substitution: the maximum amount of one good a consumer will sacrifice to obtain one more unit of another good – MRS = ∆Q1 / ∆Q2. The marginal rate of substitution is the slope of the indifference curve – a negative MRS shows that someone is willing to give up something of one good to get more of the other good (indifference curve slope downward).

An indifference curve does not have to be convex, but observation suggests that most indifference curves are convex – consumers views two goods as imperfect substitutes. Diminishing marginal rate of substitution: the marginal rate of substitution approaches zero as we moved down and to the right along an indifference curve, becomes flatter. Perfect substitutes: goods that a consumer is completely indifferent as to which to consume – parallel lines with a slope of a constant. Perfect complements: goods that a consumer is invested in consuming only in fixed proportions. 4.2 Utility Utility: a set of numerical values that reflect the relative rankings of various bundles of goods. Utility function: the relationship between utility values and every possible bundle of goods. The utility function is equal to 𝑈 = √𝑄1 ∙ √𝑄2 -the more one consumes of either good, the greater the utility – used by economists to help them think about consumer behaviour. It is unlikely to know by how much more a consumer prefers one bundle to another. Ordinal: a consumer’s relative ranking of two goods – does not measure the degree to which the consumers value one good over another. Cardinal: one by which absolute comparisons between ranks may be made. As indifference curve consist of all those bundles that corresponds to a particular level of utility – each indifference curve reflects a different level of utility on a map of indifference curves. Marginal utility: the extra utility that a consumer gets from consuming the last unit of a good – the slope of the utility function as we hold the quantity of the other good constant. The marginal utility of a good falls, when the quantity of that good increases. The marginal rate of substitution depends on the marginal utilities – negative ratio of the marginal utility of another good 1 to the marginal utility of another good 2. 4.3 Budget Constraint The consumer maximizes their well-being subject to constraint, the personal budget constraint is the most important constraint – the budget constraint is equal to 𝑝1 ∙ 𝑄1 + 𝑝2 ∙ 𝑄2 = 𝑌 Budget line: the bundles of goods that can be bought if the entire budget is spent on those goods at given prices – the slope of the budget line depends on the relative prices of two goods. Opportunity set: all the bundles a consumer can buy including all the bundles inside the budget constraint and on the budget constraint. Marginal rate of transformation: the trade-off the market imposes on the consumers in terms of one good the consumer must give up to obtain more of the other good – the slope of the budget line (equal to – p2 / p1)

The budget line would rotate outward when the price decreases. The budget line would rotate inward when the price increases. If income increases, the budget constraint shifts outward – parallel to the original one. If the intercepts shift outward in proportion to the change in income – change in income affects the position, but not the slope. 4.4 Constrained Consumer Choice The optimal bundle is the bundle out of all the bundles that can be afforded and gives the most pleasure – must lies on the budget constraint and be on an indifference curve that does not cross it . The two types of optimal bundles • •

Interior solution: the optimal bundle has positive quantities of both goods and lies between the ends of the budget constraint. Corner solution: occurs when the optimal bundle is at one end of the budget line, where the budget line forms a corner with one of the axis.

The budget constraint and the indifference curve have the same slope at the point where they touched. The utility is maximal when four equivalent conditions hold – maximized when MRS is equal to MRT 1 The indifference curve between the two goods is tangent to the budget constraint. 2 The consumer buys the bundles of goods that is one the highest obtainable indifference curve. 3 The consumer’s marginal rate of substitution equals the marginal rate of transformation. 4 The last dollar spent on good 1 gives the consumers as much extra utility as the last dollar spent on good 2. If indifference curves have both concave and convex se...