Summary Principles of Microeconomics - N. Gregory Mankiw PDF

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Summary Principles of Microeconomics

N. Gregory Mankiw 7th Edition

Contents 1. The Principles of Economics ........................................................................................................... 4 2. Thinking Like an Economist ............................................................................................................. 8 2.1. The Economist as a Scientist.................................................................................................... 8 2.2. The Economist as a Policy Advisor........................................................................................ 11 2.3. Why Economists Disagree ..................................................................................................... 11 3. Interdependence and the Gains from Trade ............................................................................... 13 3.1. A Parable for the Modern Economy ..................................................................................... 13 3.2. Comparative Advantage: the Driving Force for Specialisation .......................................... 14 3.3. Applications of Comparative Advantage .............................................................................. 14 4. The Market Forces of Supply and Demand................................................................................. 16 4.1. Markets and Competition ....................................................................................................... 16 4.2. Demand .................................................................................................................................... 17 4.3. Supply ....................................................................................................................................... 19 4.4. Supply and Demand Together ............................................................................................... 20 5. Elasticity and its Application ......................................................................................................... 24 5.1. Elasticity of Demand ............................................................................................................... 24 5.2. Elasticity of Supply .................................................................................................................. 26 6. Supply, Demand and Government Policies ................................................................................. 28 6.1. Controls on Prices ................................................................................................................... 28 6.2. Taxes ......................................................................................................................................... 29 7. Consumers, Producers and the Efficiency of Markets ............................................................... 30 7.1. Consumer Surplus ................................................................................................................... 30 7.2. Producer Surplus ..................................................................................................................... 31 7.3. Market Efficiency .................................................................................................................... 32 8. Application: the Costs of Taxation ............................................................................................... 33 8.1. The Deadweight Loss of Taxation ......................................................................................... 34 8.2. The Determinants of Deadweight Loss ................................................................................ 36 9. Application: International Trade ................................................................................................... 38 9.1. The Determinants of Trade .................................................................................................... 38 9.2. The Winners and Losers from Trade .................................................................................... 38 9.3. The Arguments for the Restriction of Trade ........................................................................ 40 10. Externalities ................................................................................................................................... 42 10.1. Externalities and Market Inefficiency ................................................................................. 42 10.2. Public Policies Towards Externalities ................................................................................. 43

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10.3. Private Solutions to Externalities ........................................................................................ 44 11. Public Goods and Common Resources ...................................................................................... 45 11.1. Public Goods .......................................................................................................................... 45 11.2. Common Resources .............................................................................................................. 46 12. The Design of the Tax System .................................................................................................... 48 12.1. The Financial Overview of the US Government ............................................................... 48 12.2. Taxes and Efficiency ............................................................................................................. 49 12.3. Taxes and Equity ................................................................................................................... 49 13. The Costs of Production .............................................................................................................. 51 13.1. What Are Costs? ................................................................................................................... 51 13.2. Production and Costs ........................................................................................................... 52 13.3. The Various Measures of Costs .......................................................................................... 52 13.4. Costs in the Short Run and in the Long Run ...................................................................... 53 14. Firms in Competitive Markets .................................................................................................... 54 14.1. What is a Competitive Market?........................................................................................... 54 14.2. Profit Maximisation and the Competitive Firm's Supply Curve ...................................... 54 14.3. The Supply Curve in a Competitive Market....................................................................... 55 15. Monopoly ...................................................................................................................................... 57 15.1. Why Monopolies Arise ......................................................................................................... 57 15.2. How Monopolies Make Production and Pricing Decisions ............................................. 57 15.3. The Welfare Cost of Monopolies ........................................................................................ 58 15.4. Price Discrimination .............................................................................................................. 59 15.5. Public Policy toward Monopolies ........................................................................................ 59 16. Monopolistic Competition........................................................................................................... 60 16.1. Between Monopoly and Perfect Competition .................................................................. 60 16.2. Competition with Differentiated Products ........................................................................ 60 16.3. Advertising ............................................................................................................................. 61 17. Oligopoly ....................................................................................................................................... 62 17.1. Markets with Only a Few Sellers ........................................................................................ 62 17.2. The Economics of Cooperation ........................................................................................... 62 17.3. Public Policy toward Oligopolies ......................................................................................... 63 18. The Markets for the Factors of Production .............................................................................. 65 18.1. The Demand for Labor ......................................................................................................... 65 18.2. The Supply of Labor .............................................................................................................. 66 18.3. Equilibrium in the Labor Market.......................................................................................... 66

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18.4. The Other Factors of Production: Land and Capital ......................................................... 67 19. Earnings and Discrimination ....................................................................................................... 69 19.1. Some Determinants of Equilibrium Wages ........................................................................ 69 19.2. The Economics of Discrimination ....................................................................................... 70 20. Income Inequality and Poverty ................................................................................................... 72 20.1. The Measurement of Inequality .......................................................................................... 72 20.2. The Political philosophy of Redistributing Income ........................................................... 73 20.3. Policies to Reduce Poverty .................................................................................................. 74 21. The Theory of Consumer Choice ............................................................................................... 76 21.1. The Budget Constraint: What the Consumer Can Afford ............................................... 76 21.2. Preferences: What the Consumer Wants .......................................................................... 77 21.3. Optimization: What the Consumer Chooses ..................................................................... 78 21.4. Three Applications ................................................................................................................ 79 22. Frontiers of Microeconomics ...................................................................................................... 82 22.1. Asymmetric Information ...................................................................................................... 82 22.2. Political Economy .................................................................................................................. 83 22.3. Behavioural Economics ........................................................................................................ 84

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1. The Principles of Economics The most important principles in economics, to be put in very general terms, are that rational actors evaluate the opportunity costs of all actions, value and compare things at the margin and change their behaviour in response to changing incentives. Markets are considered to be the most efficient allocators of resources and simply by participating in trade people can get benefit out of it. Although in case of market failure a governmental intervention can be beneficial as well. The economies wellbeing is largely based on its productivity and the growth of the money supply in it causes inflation, which has an inverse relationship with unemployment.

The principles: How people make decisions. 1. Trade-offs In economics as in almost all other areas of life, people have to make compromises. In other words they face trade-offs: they have to exchange one thing for another of similar value, because having both of them is not possible. Examples of this include a high level of income and the environment: we need to impose regulations on companies to protect the environment, but those regulations will make the firms and hence the economy less profitable. This is a trade-off and it needs to be studied to decide how much income we will sacrifice for what level of environmental protection. 2. Opportunity costs In economics the costs of something are not only the accounting costs or the direct price of it. We need to calculate the opportunity costs as well in order to get all of the economic cost. An opportunity cost is something you give up in order to take up a project or purchase a thing. For example the cost of going to college will include not only tuition fees and books, but also the earnings you could have made, if the time you spent studying you would have spent working. However, these costs will not include how much you pay for food or shelter, since you would have had to make them in any case. Similarly, if a company wants to make an investment, it has to calculate not only the funds needed for it, but also the profits made by other projects it could have invested in instead. 3. Rational people compare marginal benefits and costs

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Economists assume that people act rationally: they try to fulfil their objectives systematically and purposefully, (although rational behaviour is highly disputed). Rational actors weight costs and benefits at the margin, meaning they compare the costs and benefits of an additional increment of a good, service or action. For example, when preparing for an exam, you do not choose between studying for 24 hours and not studying at all, but rather between studying for an extra hour and watching TV during that time. One paradox in economics is the diamond paradox: why are diamonds so expensive, but unnecessary and water is so cheap, but vital. The reason is that you value the additional increment and since water is plentiful and additional litre is not as valuable as an additional carat of a very rare diamond. 4. Incentives A very important principle in economics is that people respond to incentives, which by definition are something that induces a person to act. This can be a reward, like a bonus for good work performance or a punishment like a fine for bad driving. Policy makers need to carefully analyse the incentives they give to people and companies in order to avoid unintended consequences. For example a seatbelt law may protect a person in case of an accident, but it may also make that person a less careful driver, which increases the risk of accident. How people interact. 5. Gains from trade another principle of economics is that trade whether it is inside an economy or international can benefit all parties. Even though competition exists, for example, between the US and Japan in the auto industry, each country can specialize in what it does best and trade for the things the other country does most efficiently thus getting it cheaper than if it were made domestically. Inside a country this also applies: even though you will compete with others for jobs and resources, it is beneficial compared to isolation and no trade. 6. The market economy A market economy is an economic system where decisions and allocation are made by the interactions between companies, households and individuals rather than a central planner such as the government in a communist state. This interaction is of course not a direct conversation, but something, which is guided by “the invisible hand” a term coined by Adam Smyth to describe how the market works. Prices are the instrument with which resources are allocated. How that is done is a large part of what the science of economics is about.

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7. Government intervention Even though the market economy is the most efficient way to allocate resources, it can benefit from public policy. Governments try to assure two things by intervening: efficiency and equality. It needs to intervene when there is a market failure: the market fails to efficiently allocate resources or there is too much market power; when a single actor has too much influence in an economy (such as a monopoly). Also, even when the economy is efficient, the government depending on its political views may want to ensure equality. This is necessary, because even though some individuals cannot succeed in the market economy we still want them to have a decent standard of living and opportunities for progress. How the economy as a whole works 8. Productivity and standard of living Unfortunately there are huge differences in the standards of living between countries: some can afford second cars, while others have staggering hunger rates. The main determinant of this is productivity: the quality and quantity of goods produced from one labour unit. For example if a worker in country A produces 2 chairs in an hour and in country B a worker produces 4 identical chairs in that hour, country B has twice as high the productivity in making these chairs. In order to raise the living standard efforts need to be made to raise productivity by increasing education, technological progress and efficiency. 9. Inflation and growth in money supply An important tool the central bank of an economy (in most cases) has is the control of its money supply, which is basically printing money. One phenomenon it causes is inflation - the rising of prices. Since the government puts more money into the economy, money loses its value, so naturally prices rise. Inflation has its costs and should be kept at certain level. However too little inflation or even deflation (the fall of prices) can be very damaging to an economy as well, therefore inflation should be at a stable and calculated level. 10. Short-run trade-off between Inflation and unemployment. When the government prints more money, in the short-run people feel they have more money and therefore spend more. So the demand for goods and services rises and firms need to meet it. They will eventually raise prices, but will also expand their work force and therefore decrease the rate of unemployment in the overall economy. Policy makers can use this short-run trade-off to influence the demand for goods and

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services by controlling government spending, tax collection and money supply. This will influence the combination of the inversely related inflation and rate of unemployment in the economy. Example: The price of oil is very influential in global economics. From 2005 to 2008 the world saw sharp increases in oil prices, in the US it rose from 2$ to 4$ per barrel. This changed the incentives people have and spurred debate on the future of energy, investment in green technology and a reduction in oil consumption. In the economic downturn in 2008 and 2009 oil demand continued to decline.

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2. Thinking Like an Economist Economics is much like, but not exactly like other sciences. Economists create models, which simplify reality in order to make useful insights. These models are an approximation of the real world but are based on some assumptions. Two of these models are the circular flow diagram and the production possibilities frontier. The study of economics is split into two large categories of microeconomics and macroeconomics. The former deals with household and firm internal decision-making and their interactions, while the later deals with the economy as whole. Economists can be policy advisors and scientists. A scientist would use positive statements, which tell what is, while policy advisors would use normative st...