Microeconomics Unit 1 notes PDF

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Instructor: Dr. Seiler - Chapters 1-5...

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Chapter 1: 10 Principles of Economics Scarcity - Limited nature of society’s resources Economics - the study of how society manages scarce resources

How People Make Decisions: Principle 1) People Face Trade-offs - Allocation of resources - time and money here or there - Efficiency vs Equality: welfare increases “equality” but by de-centivizing work, decreases efficiency. Efficiency - the property of society getting the most it can from its scarce resources Equality - the property of distributing economic prosperity uniformly among the members of society Principle 2) The cost of something is what you give up to get it Opportunity cost - whatever must be given up to obtain something

Principle 3) Rational people think at the margin Rational people - people who systematically and purposefully so the best they can to achieve their objectives Marginal change - the small incremental change to a plan of action A phone call to a friend might be valued at 7 dollars, for example. If the 10 min phone call costs 9 dollars, is it worth it? Wrong thinking. The Marginal Cost - the amount your bill increases if you make the call - is only 5 dollars. -

“Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is a classic question: Why is water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are unnecessary. Yet people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for a good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has. Water is essential, but the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large”

Principle 4) People Respond to incentives Incentive - something that induces a person to react

Principle 5) Trade can make everyone better off -

Trade makes both parties better off Trade allows countries to specialize in what they do best ad enjoy a greater variety of goods and services

Principle 6) Markets Are usually a good way to organize economic activity Market economy - An economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services -

Free market economy: everyone looks out for their best interests Proven successful in organizing economic activity to promote overall economic well being

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1776 An Inquiry into the Mature and Causes of the Wealth of Nations: Adam smith observes that people interact in markets as if guided by an “invisible hand” that leads them to desirable market outcomes. Individuals are best left on their own

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Principle 7) Government can sometimes improve market outcomes -

We need governments to protect property rights

Property rights - the ability of an individual to own and exercise control over scarce resources -

Government provides police and laws to protect movie theatres, restaurants, or anything like that.

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We also need government to promote efficiency or equality

Efficiency: the government has to deal with Market failure - a situation in which the market on its own fails to produce an efficient allocation of resources - This can be caused by externality Externality - The impact of one person’s actions on the well being of a bystander (ex. pollution) - Another cause of market failure is market power Market Power - The ability of a single economic actor (or small group of people) to have a substantial influence on market prices (ex. Martin Shkrelli) Equality: the government has to deal with -

Efficiency often leads to inequality in outcome and the government - depending on political philosophy - may want to correct that.

Principle 8) A country’s standard of living depends on its ability to produce goods and services -

Almost all variation in living standards in different countries can be attributed to a country’s productivity Productivity: the quantity of goods and services produced from each unit of labor input -

Labor unions or minimum wage laws may seem to be improving the living standards a lot but in reality the American productivity has increased greatly. Any policy decisions MUST consider: what will this do to American productivity

Principle 9) Prices Rise When the Government Prints Too Much Money Inflation - an increase in the overall level of prices in the economy What causes it: - Growth in the quantity of money Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment Short-run effects of monetary injections: - Increasing the amount of money in the economy stimulates GDP and AD - Higher demand makes firms raise prices but also hire workers and produce more - More hiring = lower unemployment This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off between inflation and unemployment Business cycle - the irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed

Chapter 2: Thinking like an economist -

They use scientific methods Make assumptions to understand the concepts simply that can then apply at least to an extent, to the real world.

Economic Models: -

Simplified models make it easier to understand complex problems One example is a circular flow model

Circular Flow Diagram - a visual model of the economy that shows how dollars flow through markets among households and firms -

In this model, the economy has only two types of decision makers: firms and households Firms produce goods and services using factors of production Households own the factors of production and consume the goods and services the firms produce

- Households and firms interact in two types of markets: 1) Market for goods and services: households are buyers and firms are sellers 2) Market for factors of production: households are seller and firms are buyers The production Possibilities Frontier - a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology -

Most likely, economy divides its resources between the industries With the resources it has, the economy can produce at any point on or inside the production possibilities frontier, but it cannot produce at points outside the frontier.

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An economy is efficient when its getting all it can from the scarce resources available Once reached an efficient frontier, the economy cannot produce more of one good without decreasing the other

A shift in the production possibilities frontier: - An advancement in an industry allows the economy to produce more computers (for example) for any given number of cars (for example) Microeconomics - the study of how households and firms make decisions and how they interact in specific markets. Macroeconomics - the study of economy-wide phenomena.

Economists in Washington + their advice positive statements - claims that attempt to describe the world as it is normative statements - claims that attempt to prescribe how the world should be - Economists give conflicting opinions because of 1) Alternate theories 2) Different values/normative views

Chapter 4: The Market Forces of Supply and Demand Market - a group of buyers and sellers of a particular good or service Competitive Market - a market in which there are many buyers and many sellers so that each has a negligible impact on the market price A perfectly competitive market: (1) The goods offered for sale are all exactly the same, and (2) the buyers and sellers are so numerous that no single buyer or seller has any influence over the market price.

Demand: The Demand Curve: The Relationship between Price and Quantity Demanded Quantity demanded - the amount of a good that buyers are willing and able to purchase Law of demand - other things being equal, the quantity demanded of a good falls when the price of the good rises Demand schedule - a table that shows the relationship between the price of a good and the quantity demanded Demand curve - a graph of the relationship between the price of a good and the quantity demanded Market demand - the sum of all the individual demands for a particular good or service The market demand at each price is the sum of the individual demands.

Shifts in the demand curve: -

The price of the good itself represents a movement along the demand curve (does not shift)

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Most important shift of demand curve is income

1) 2) 3) 4) 5)

Income Related goods Tastes Expectations Number of buyers

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Normal good - a good for which, other things being equal, an increase in income leads to an increase in demand Inferior good - a good for which, other things being equal, an increase in income leads to a decrease in demand Substitutes - two goods for which an increase in the price of one leads to an increase in the demand for the other Complements - two goods for which an increase in the price of one leads to a decrease in the demand for the other

Supply The Supply Curve: The Relationship between Price and Quantity Supplied Quantity supplied - the amount of a good that sellers are willing and able to sell Law of supply - Other things being equal, the quantity supplied of a good rises when the price of the good rises Supply schedule - a table that shows the relationship between the price of a good and the quantity supplied

Market Supply versus Individual Supply: -

Just as market demand is the sum of the demands of all buyers, market supply is the sum of the supplies of all sellers.

Shifts in the Supply Curve 1) Input Prices 2) Technology 3) Expectations - If a firm expects the price of ice cream to rise, it will put some current production into sotade and supply less today 4) Number of sellers -

A change in the price of the good itself represents a movement along the supply curve (not a shift)

Supply and Demand Together: Equilibrium: Equilibrium - a situation in which the market price has reached the level at which quantity supplied equals quantity demanded Equilibrium price - the price that balances quantity supplied and quantity demanded Equilibrium quantity- the quantity supplied and the quantity demanded at the equilibrium price -

The actions of buyers and sellers naturally move markets toward the equilibrium of supply and demand

Surplus (excess supply) - a situation in which quantity supplied is greater than quantity demanded Shortage (excess demand) - a situation in which quantity demanded is greater than quantity supplied Law of supply and demand - The price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance.

Three Steps to Analyzing Changes in Equilibrium: 1) Decide whether the event shifts the supply curve, the demand curve, or, in some cases, both. 2) Decide whether the curve shifts to the right or to the left. 3) Use the supply-and-demand diagram to compare the initial equilibrium with the new one, which shows how the shift affects the equilibrium price and quantity. -

Supply refers to the position of the supply curve, whereas the quantity supplied refers to the amount suppliers wish to sell

Chapter 5: Elasticity and its application Elasticity - a measure of how much buyers and sellers respond to changes in market conditions Price elasticity of demand - measures how much the quantity demanded responds to a

change in price. -

Demand for a good is elastic if the quantity demanded changes a lot with a change in price and vise versa The price elasticity of demand for any good measures how willing consumers are to buy less of the good as its price rises

What influences the price elasticity of demand: Availability of close substitutes: - Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others - Ex. Butter and margarine are easily substitutes - a change in the price of one may significantly affect the quantity demanded - Ex. Eggs are not easily substituted, thus they are less elastic, quantity demanded is likely to stay relatively the same with a change in price Necessities vs luxuries: - Necessities have inelastic demand, luxuries have elastic demand

Definition of the market: - The elasticity of demand in any market depends on the boundaries of the market - Narrow categories often have elastic demand whereas broad categories would not - Ex. When looking only at Ice cream, it is elastic. When looking at food, it is inelastic Time horizon: - Goods have more elastic demand over longer periods of time - When gas rises, quantity demanded for gas barely falls in the first few months - over time people buy more gas efficient cars or find other ways to avoid gas prices - thus quantity demanded falls significantly

Calculating the Price Elasticity of Demand Price elasticity of demand = % change in quantity demanded/% change in price Ex. 10 percent increase in the price of an ice-cream cone causes the amount of ice cream you buy to fall by 20 percent = 20/10 = Elasticity of 2 -

In this example, the elasticity is 2, reflecting that the change in the quantity demanded is

proportionately twice as large as the change in the price. -

Since the quantity demanded of a good is negatively related to its price, percentage change in quantity will always have the opposite sign as the percent change in price

The Midpoint Method: A Better Way To Calculate Percentage Changes and Elasticities -

The midpoint method divides the change by the average of the initial and final levels Ex. A change from $4 to $6 is considered a 40% rise because (6-4)/5 = .40

price elasticity of demand = (Q2 - Q1)/ [(Q2 + Q1) / 2] / (P2 - P1)/ [(P2 + P1) / 2] -

The numerator is the percentage change in quantity computed using the midpoint method, and the denominator is the percentage change in price computed using the midpoint method

The Variety of Demand Curves -

Demand is considered elastic when elasticity is greater than 1: meaning the quantity moves proportionately more than the price

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Demand in considered inelastic when the elasticity is less than 1: meaning the quantity moves proportionately less than the price

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If the elasticity is exactly 2 the percentage change in quantity equals the percentage change in price and is called unit elasticity.

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The flatter the demand curve that passes through a given point, the greater the price elasticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand.

Total Revenue and the Price Elasticity of Demand Total Revenue - the amount paid by buyers and received by sellers of goods. Total Revenue = P x Q - Price times Quantity -

If demand is inelastic then an increase in price will increase total revenue because demand won't change much and vice versa

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When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction: If the price increases, total revenue also increases.

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If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes.

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Even though the slope of a linear demand curve is constant, the elasticity is not because the slope is the ratio of changes in the two variables, whereas the elasticity is the ratio of percentage changes in the two variables

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The linear demand curve illustrates that the price elasticity of demand need not be the same at all points on a demand curve. A constant elasticity is possible, but it is not always the case.

Other Demand Elasticities Income elasticity of demand - measures how the quantity demanded changes as consumer income changes. -

It is calculated as the percentage change in quantity demanded divided by the percentage change in income.

Income elasticity of demand = percentage change in quantity demanded/percentage change in income -

Normal goods: Higher income raises quantity demanded Inferior goods: Higher income lowers quantity demanded

Cross Price Elasticity of Demand - measures how the quantity demanded of one good responds to a change in the price of another good. - Calculated as the percentage change in quantity demanded of good 1 divided by the percentage change in the price of good 2

Elasticity of Supply The Price Elasticity of Supply and Its Determinants Price elasticity of supply - measures how much the quantity supplied responds to changes in the price -

Supply is elastic if the quantity supplied responds significantly to changes in price and is

inelastic if it does not change -

This depends on the flexibility of sellers to change the amount of the good they produce Ex. Manufactured goods are elastic, beachfront land is not

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In most markets a key determinant of elasticity of supply is the time period: Long run: Supply is more elastic Short run: Supply is inelastic - firms cannot easily change the size of a factory to produce to more or less of a good - those changes are made in the long run

Calculating the Price Elasticity of Supply Price elasticity of supply = percentage change in quantity supplied/percentage change in price Ex. increase in price of milk from $2.5 to $3.15 per gallon raises the amount that dairy farmers produce from 9,000 to 11,000 gallons per month Percentage change in price = (3.15 - 2.85) / 3 = .10 = 10% Percentage change in quantity supplied = (11,000 / 9,000) / 10,000 x 100 20 = 20% Price elasticity of supply = 20/10 = 2

Variety of Supply Curves Zero elasticity - (vertical line) supply is perfectly inelastic (quantity supplied is the same regardless of price) Perfectly elastic - (elasticity approaching infinity) (horizontal line) Very small changes in price result in huge changes in quantity supplied...