Microeconomics

Microeconomics:

Chapter 1:

• Economics revolves around the scarcity principle; wants are unlimited but resources are not.
• Economic decisions are concerned with maximising consumer surplus. They involve opportunity costs (trade-offs)

• In determining the trade-offs, one must take into account the cost-benefit principle; only undertake an action if the marginal benefit equals or exceeds the marginal cost

• Economic surplus: difference between benefit arising from an action and the cost of its undertaking
• Opportunity cost: what was given up/what was received
• Ceteris paribus: all other things being equal (important in economic decisions)
• Incentive principle: an individual is more likely to undertake an action if its benefit rises and its cost falls
• Positive economics: analysis that explains what will happen and why, but not what should happen (i.e. what will happen because of human behaviour)
• Normative economics: analysis that states what should happen (economically optimal)
• Pitfalls:

• Failing to account for all opportunity costs
• Failing to account for all benefits
• Failing to consider time as a resource
• Failing to ignore sunk costs
• Failing to know when to use marginal benefits/costs vs average benefits/costs
• Failing to measure costs/benefits in absolute terms rather than proportions

Chapter 2:

• Absolute advantage: where one person is able to produce more than another given the same amount of resources
• Comparative advantage: where someone has a lower opportunity cost than another
• Specialisation occurs where an individual focuses on one area of production. An individual should specialise in his area of lowest comparative advantage to maximise total output of the economy

• The increase in total production is greater as the difference in opportunity cost increases

• Production possibility curve: graphical representation of the potential output of one good in relation to another

• Attainable points: points along or within the PPC
• Unattainable points: points outside the PPC
• Efficient: points along the PPC
• Inefficient: points within the PPC

• Many-person economy: PPC is represented as a curve rather than as a straight line. Reflects the principle of increasing opportunity cost
• Shift in the PPC reflects an increase in productive capacity (economic growth). Factors than drive economic growth:

• Increase in amount of resources
• Increase in quality of resources/technology/knowledge

Chapter 3:

• Market: a market is the collective of all buyers and sellers for a good or service
• Demand curve: slopes down due to law of demand – as price increases, demand for a product falls (i.e. consumer surplus falls). Relationship between price and quantity demanded
• Supply curve: slopes up due to law of supply – as price increases, suppliers are willing to provide more (i.e. producer surplus increases). Relationship between price and quantity supplied
• Substitution effect: change in demand for a good/service due to the change in price of another good/service, causing said good to become cheaper/more expensive relatively
• Income effect: change in demand for a product due to a change in price, causing the PPP of the consumer to change
• Vertical interpretations:

• demand – consumer’s reservation price (highest price willing to pay)
• supply – supplier’s reservation price (lowest price willing to sell)

• Market equilibrium: occurs at a price where quantity demanded and supplied is the same
• Excess supply (surplus): price is too high, usually occurs due to price floor
• Excess demand (shortage): price is too low, usually occurs due to price ceiling
• Difference between demand/supply and quantity demanded/supplied
• BLAH SOME STUFF GOES HERE
• Cash on the table: unexploited gains from exchange, occurs when market is in disequilibrium
• Socially optimum quantity: quantity whereby the difference in total benefit and total cost of producing+consuming a good is maximised. (the point at which marginal cost and benefit are the same).
• Efficiency: where all goods are produced at their socially optimal quantity
• Equilibrium principle (no cash on the table): market is at equilibrium; there are no unexploited opportunities

Chapter 4:

• Elasticity: responsiveness of one variable in relation to a change in another variable
• Demand elasticity: percentage change in quantity demanded over a one percent change in price. The value of demand elasticity tells us whether the good is elastic/inelastic

• <1: inelastic
• =1: unit elastic
• >1: elastic

• Determinants of elasticity:

• Substitution: goods with substitutes will be more elastic than those that don’t
• Budget share: goods comprising a lower proportion of budget share (salt) are likely to be less elastic than those of higher proportion (plane tickets)
• Time: in the short term, products are less elastic than in the long term as it takes time to seek out alternatives
• Luxury or necessity: necessities are less elastic than luxury items

• Calculating demand elasticity:

• Percentage change quantity/percentage change price
• Point elasticity: P/Q x 1/slope
• Midpoint elasticity: [pic 1]

• Special cases:

• Perfectly elastic: demand is infinite at one price, but is zero at any price above it
• Perfectly inelastic: demand is infinite regardless of price

• Elasticity and total expenditure: total expenditure/revenue varies with elasticity of a product. Total revenue = price x quantity. Price and quantity always move in opposite directions (law of demand). Increase in price does not always result in increased revenue

• For a product with a straight line demand curve, the total revenue curve is a parabola (there is a maximum revenue point)

• For a product with elasticity > 1, price and total revenue changes move in different directions
• For a product with elasticity < 1, price and total revenue changes move in the same direction
• Income elasticity of demand: percentage change of quantity demanded in relation to a 1 percent change in income

• Negative elasticity: good is inferior
• Positive elasticity: good is normal

• Cross-elasticity: percentage change of quantity demanded in relation to a 1 percent change in the price of another good

• Negative elasticity: goods are complements
• Positive elasticity: goods are substitutes

• Price elasticity of supply: percentage change in quantity supplied in relation to a 1% change in price.

• Calculated same way as elasticity of demand

• Determinants of price elasticity of supply:

• Flexibility of inputs: more flexible = more elastic
• Mobility of inputs: more mobile = more elastic
• Ability to produce substitute inputs: more easily = more elastic
• Time: less elastic in short term than in long term

Chapter 5:

• Utility: satisfaction. Economics is about maximising utility/consumer surplus

• Marginal utility: extra utility that results from taking an extra action. To maximise utility, consume until marginal utility is as close to 0 as possible.

• Law of diminishing marginal utility: tendency for marginal utility to decrease as consumption of a good or service increases
• MU1/P1 = MU2/P2. Want MU to be equal; buy more of the one that yields higher MU until optimal combination of goods (yielding highest total utility) is reached
• Rational spending rule: spending should be allocated so that MU1/P1 = MU2/P2
• Individual and market demand curves: market demand curve is the sum of all individual demand curves
• Consumer surplus: difference between reservation price and price actually paid.

• Calculated as the area under the demand curve, upwards from the price paid.

Chapter 6:

• Market supply curve curves upwards due to increasing opportunity costs; suppliers exhaust means of lowest opportunity cost first. Also because different individuals have different opportunity costs. Market supply curve is the sum of all individual supply curves
• Firms will typically aim to maximise profit (difference between total revenue and costs)
• Perfect competition:

• Homogenous product
• No barriers to entry/exit
• Buyers and sellers are well informed
• Buyers and sellers comprise an insignificant proportion of the market
• Suppliers are price takers; they have no influence on the market price. I.e. the demand for the firm’s product is perfectly elastic. Price is set by market demand and supply interaction

• Short-term production: period where at least one factor of production is fixed
• Long-term production: all factors are variable
• Law of diminishing returns: in the short-term, marginal product decreases as variable inputs increase. Usually due to congestion (1 computer, more workers will result in less increase)

• More inputs required to achieve outputs, resulting in increased variable costs

• Fixed cost: sum of payments made to fixed factors of production
• Variable cost: sum of payments made to variable factors of production
• Total cost: variable + fixed cost
• Marginal cost: change in cost/change in output

• Maximum profit where marginal revenue = marginal cost (cost-benefit)

• Short-term shutdown: firm should shutdown if PQ < VC at all values of Q. Alternately, firm should shut down if P < AVC

• Firm assumes FC, but would not lose as much as it would if it stayed open (VC)

• Firm’s profit = total revenue – total cost (PQ – ATCxQ). Profitable if P > ATC

• Maximum profit where P = MC. Profit = (P-ATC)xQ

Chapter 7:

• Pareto efficiency: situation in which trade is not possible such that one person is made better off without making another worse off.
• Pareto-improving transaction: transaction that betters one without harming another
• Whenever market is not in equilibrium, there is forgone economic surplus
• Subsidies: reduce economic surplus since subsidy is not free (represents an opportunity cost)
• Compensation policy is more efficient than the first come first served policy
• Event organisers underprice to maintain image of event or to garner goodwill from patrons

• Leaves cash on the table → ticket scalping

• Tax: for a product with perfectly elastic supply, tax is completely borne by consumer. For a product with perfectly inelastic supply, tax is borne by producer.
• Deadweight loss: reduction in total economic surplus that results market operates at a point where marginal cost does not equal marginal revenue/benefit. (surplus lost to the market)

• Deadweight loss is smaller if elasticity of demand/supply is low

Chapter 8:

• Consumption possibility frontier (CPC): graphical representation of an economy’s potential consumption of a good relative to another good.

• In a closed economy, CPC = PPC. In an open economy, CPC > PPC. (tangent to PPC)

• Economy opens up to international trade, world price becomes the domestic price

• If original domestic price > world price, product will be imported
• If original domestic price < world price, product will be exported (comparative adv.) Specialisation, will become net exporter

• While opening up to free trade does result in some loss of economic surplus, the gain is much greater.
• Protection: policies that give domestic industries an artificial advantage over foreign producers

• Tariffs and quotas are forms of protection; they cause market inefficiency