MICROECONOMICS

Economics:
The study of how groups allocate scare resources to satisfy unlimited
wants and needs

Opportunity Cost:
The value of the next-best alternative forgone

Factors of Production:
All inputs used to produce goods and services
C- Capital (equipment)
E- Entrepreneurship (management)
L- Land (natural resources)
L- Labor (workforce)

Normative Statement:
A statement that is a matter of opinion

Positive Statement:
A statement that can be proven or disproven

PPF (Production Possibilities Frontier):

Represents all combinations of the maximum amounts that two goods can
be produced in an economy when there is a full employment of resources
and efficiency. The PPF model demonstrates concepts such as scarcity
and opportunity cost.

Point A = the economy is operating

less than full efficiency

Point B = the economy is operating

at full efficiency however the
opportunity cost to produce more
guns is a lot of bread

Point C = the economy is operating

at full efficiency however the
opportunity cost to product more
bread is a lot of guns

Point X = the economy can not

operate at this efficiency as they do
not have the factors of production to do so
Economic Growth:
The measure of a change in countries GDP, or real national income such
that an increase in national income is classified as economic growth

Economic Development:
The measure of welfare and well-being, instead of being measured in
monetary indicators, it is measured in terms of indicators such as
education, health and social indicators
Demand

Demand and the Law of Demand

Demand is the quantity of a good that consumers are willing and able to
purchase at a given price in a given time period.
The law of demand states that as the price of a product falls, the quantity
demanded increases. Ceteris paribus.

Shifts in the Demand Curve

Income
Normal Goods: as a consumer’s income rises, the demand for the product
will also rise, shifting the demand curve to the right
Inferior Goods: as a consumer’s income rises, the demand for the product
will fall, shifting the demand curve to the left

Substitutes
If products are substitutes, then a change in the price of one of the
products will lead to a change in the demand for the other product. For
example, if there is a fall in the price for Good A (movement along the
demand curve), then the demand for Good B will decrease (demand shifts
left).

Complements
If products are complements to each other, then a change in the price of
one good will lead to a change in the demand for the other product. For
example, if there is a fall in the price for Good A (movement along the
demand curve), then the demand for Good B will increase (demand shifts
right).

Calculating the Demand Curve (HL)

Qd=a−bP

A = where the graph meets the x-axis and where demand would be if the
price was zero. If A changes, there will be a parallel shift in the demand
curve.
B = sets the slope for the demand curve (rise/run). If B changes, there will
be a change in the steepness of the curve therefore a change in the
elasticity.

Supply

Supply and the Law of Supply

Supply is the willingness and ability of products to produce a quantity of a
good or serve at a given price in a given time period.
The law of supply states that as the price of a product rises, the quantity
supplied of the product will increase. Ceteris Paribus.

Shifts in the Supply Curve

Cost of Factors of Production

If there is an increase in the costs of the factors of production, such as a
wage increase, ths will increase the firm’s costs meaning that they can
supply less (shift to the left)

Price of Other Products

Producer’s often have a choice of what they would like to produce such
that if there is a raise in the price of Good A, they may produce less of
Good B (shift to the left) to maximize revenue

Technology
Improves in the state of teachnology in a firm should lead to an increase
in supply thus a shift of the supply curve to the right

Calculating the Supply Curve (HL)

Qs=c+ dP

C = the quanitity that would be supplied if the price was zero. If C

changes, there will be a parallel shift in the supply curve
D = sets the slope of the curve. If D changes, there will be a change in the
slope therefore the elasticity.

Market Equilibrium

Equilibrium
The point in which the demand and supply curve intersect and the
economy is in a state of rest such that there is no “outside disturbance”

Changes in Equilibrium
If there is a change in one of the determinants of demand or supply there
will be a shift in one of the curves resulting in a new equilibrium.

Surpluses and Shortages

If the price is raised above the equilibrium, suppliers will have more
incentive to produce however demand will decrease resulting in a surplus
(excess supply)
If the price is lowered, demand will increase while supply will decrease
resulting in a shortage (excess demand)

Consumer and Producer Surplus

Consumer surplus: the highest price consumers are willing to pay minus
the price they actually pay. Consumers who are willing to pay for a
product at a higher price, but only have to pay at equilibrium price are
experiencing a gain.
Producer surplus: the price received by firms for selling their goods minus
the lowest price they are willing to accept. Producers who are willing to
supply a product at a lower price, but instead can supply at equilibrium
are experiencing a gain.
Economic Efficiency
When allocative and productive efficiency are achieved and marginal cost
= marginal benefit (MC=MB) in every market

Allocative Efficiency
When an economy produces the combination of goods most desired by
society where the consumer surplus is equal to producer surplus thus
community surplus is achieved and where marginal cost is equal to
marginal benefit

Calculating Market Equilibrium

1. Set Qs and Qd equal to one another and solve for P to get the
equilibrium price
2. Substitute P into either of the equations to get the equilibrium quantity

Elasticity’s

Elastic vs. Inelastic

Elastic: responds substantially to price (e.g. luxuries, goods with close
substitutes), such that if the price goes down the change in Qd/Qs is
greater
Inelastic: does not respond to price (e.g. necessities, addictiveness), such
that if the price goes down the change in Qd/Qs is smaller

Price Elasticity of Demand (PED)

Price Elasticity of Demand

The measure of how much the demand for a good change when there is a
change in the price of the product

% change∈quanitity demanded
PED=
% change∈ price

*Percentage change is calculated by taking (New – Old)/Old

Values of PED
PED<1 inelastic
PED>1 elastic
PED=1  unit elastic
PED=0  perfectly inelastic
PED=∞  perfectly elastic

Inelastic Demand
If a product has inelastic demand, then a change in the price of a product
leads to a proportionally smaller change in the quantity demanded of it.
Therfore raising the price of an inelastic product leads to a larger total
revenue.
P ↑ TR ↑
P ↓TR ↓

Elastic Demand
If a product has elastic demand, then a change in the price leads to a
greater than proportionate change in the quantity demanded of it.
P ↑ TR ↓
P ↓TR ↑

Determinants of PED
The number of substitutes: If a product has more substitute then likely
the demand will be elastic
The necessity of the product: If a product is a necessity, then likely it will
have inelastic demand

Cross Elasticity of Demand (XED)

Cross Elasticity of Demand

The measure of how much the demand for a product change when there
is a change in the price of another product

% change ∈demand of product X

XED=
% change ∈ price of product Y

Values of XED
XED>0  substitutes
XED<0  complements
Large number  close substitutes/complements
Small number  remote substitutes/complements
Income Elasticity of Demand (YED)

Income Elasticity of Demand

The measure of how much the demand for a product change when there
is a change in the consumer’s income

% change∈ demand for the product

YED=
% change∈income

Values of YED
YED>0  normal good
YED<0  inferior good
0<YED<1  income inelastic (necessity)
YED>1  income elastic (superior good)

Price Elasticity of Supply (PES)

Price Elasticity of Supply

The measure of how much the supply of a product changes when there is
a change in the price

% change ∈supply of product

PES=
% change ∈ price of the product

Values of PES
PES=0  perfectly inelastic
PES=P  perfectly elastic
0<PES<1  inelastic supply
PES >1  elastic supply
PES=1  unit elastic supply

Determinants of PES
Mobility of factors of production: the ability for the factors of production to
be switched, if it is easily switched then PES is elastic but if they cannot
be easily switched then PES is inelastic
Time Period: the time in which elapses for suppliers to change their
supply, in the short run PES is inelastic while in the long run PES is elastic
Spare Capacity Available: the higher the spare capacity the more elastic
PES is
Taxation

Indirect Tax
A tax imposed upon expenditure. It is placed upon the selling price of a
product so it raises the firm’s costs and shifts the supply curve for the
product vertically upwards by the amount of the tax.

Specific Tax
This is a fixed amount of tax that is imposed upon a product like $1, thus
shifting the supply curve vertically upwards by the amount of the tax.

Ad Valorem Tax
This is a percentage tax on the selling price so the supply curve will shift
such that as prices increase, the tax curve will become increasingly
larger.
Effect of Taxation

Revenue Before Tax:

Q x $5.00

Revenue After Tax:

Q1 x $4.50

Government
Revenue:
Consumer burden +
producer burden

Deadweight Loss:
The triangle formed
by the loss in
producer and
consumer surplus

Incidence of Taxation
Refers to the group that shares the greatest burden of the tax, since the
elastic group is more affected by the tax, the more inelastic party has the
greatest burden
When the government taxes an inelastic product, they generate large
revenue whereas when they tax elastic products, they generate much
smaller revenue

Subsidization

Subsidies
An amount of money paid by the government to a firm per unit of output
thus shifting the supply curve vertically downwards. The government may
do this for two reasons:
1. The lower the price of essential goods to consumers
2. To guarantee the supply of products that the government thinks are
necessary for the economy

Effect of a Subsidy

Consumers:
P decreases (P1)
Quantity increases (Q1)

Producers:
Price increases (P0)
Quantity increases (Q1)
TR increases

Tax Payers:
Pay more taxes to cover subsidies

Price Control and Government Intervention

Price Controls
Price controls are imposed when policymakers believe the market price is
unfair to either producers or consumers

Price Ceiling
A price ceiling is the legal maximum at which a good can be sold. If it is
above the equilibrium, it is not binding because the equilibrium can be
obtained. However, if it is below the equilibrium, then it is binding
because the equilibrium cannot be obtained

Consequences of a price ceiling

1. Smaller quantity supplies and sold
2. Quality decreases
3. Failure to meet allocative efficiency (shortage)
Price Floor
A price floor is the legal minimum at which a good can be sold. If it is
below the equilibrium it not binding because equilibrium can be reached
however if is it above equilibrium, then it is binding because equilibrium
cannot be obtained.

Consequences of a price floor

1. Failure to reach allocative efficiency (surplus)
2. Smaller quantity demanded and purchased
3. Illegal sales below the price floor

Market Failure

Market Failure
A situation in which the free market leads to a misallocation of societies
resources leading to either an overproduction or underproduction of a
good

Private (MPC) vs. Social (MSC) Cost

Private Cost: internal monetary costs such as wages, raw materials and
heating/lighting
Social Cost: real cost to society such that it reflects the private costs plus
the negative externality

Private (MPB) vs. Social (MSB) Benefit

Private Benefit: the monetary value of the benefit such as sales revenue
Social Benefit: the benefit to society such that is reflects the private
benefit plus the positive externality

Positive Externality
A benefit not reflected in the free market price that the generator of the
externality imposes benefits on others who are not responsible for
initiating it.

Positive Externality of Consumption

Occurs when marginal social benefit exceeds marginal private benefit in
relation to marginal social cost.

Positive Externality of Production

Occurs when marginal private cost is greater than marginal social cost in
relation to marginal social benefit. There is potential welfare gain because
quantity could be increased to Qs.
Negative Externality
A cost not reflected in the free market price such that the generator of
the externality imposes the cost not those who are not responsible for it.

Negative Externality of Production

Occurs when marginal social cost is larger than marginal private cost in
relation to marginal private benefit. There is welfare loss because there is
an overproduction.

Negative Externality of Consumption

Occurs when marginal private benefit is larger than marginal social
benefit in relation to marginal social cost.

Merit vs. Demerit Goods

Merit Goods: goods that are deemed socially desirable but are likely to be
under produced and under consumed (e.g. education, health care and
public parks). Merit goods are often associated with positive externalities.
Demerit Goods: goods that are deemed socially undesirable and are likely
to be over produced and over consumers (e.g. alcohol, cigarettes and
illegal drugs). Demerit goods are often associated with negative
externalities.

Remedies for Externalities

Taxation: the government could tax a negative externality of production,
which would result in MPC shifting upwards towards MSC. If they tax a
negative externality of consumption, the MSC will shift upwards therefore
decreasing quantity because of an increase in price.

Cap and Trade: the government could issue tradable emission permits to
give firms the license to create pollution up to a set level, this would solve
negative externalities of production.

Subsidization: the government could subsidize firms who generate

positive externalities, which would decrease the marginal social cost
curve
Advertising: the government could advertise the consequences of
negative externalities of consumption to reduce consumption, or could
increase the advertising of the benefits of positive externalities of
consumption

Tragedy of the Commons

Tragedy of the Commons

The overconsumption of resources in the interest of self-worth and are
able to do so because the goods are common or unknown

Public Goods
Public goods have two qualities that make them a part of the tragedy of
the commons.
1. Non rivalry: one person consumption of the public good does not
deprive another’s ability to consumer that goods
2. Non-excludability: once the good is provided for one person it is not
possible to prevent others from consuming it

Public Goods and Market Failure

Public goods are likely to be under produced or not produced at all
because their properties make them incapable of providing private
profitability.
The free rider problem arises because those who enjoy the benefits of a
public good do not have to pay.

Costs, Revenues and Profits

Short Run vs. Long Run

Short run: the period of time in which at least one factor of production is
fixed.
Long run: the period of time in which all factors of production are variable

Fixed vs. Variable Costs

Fixed Costs: costs that do not change as production is increased or
decreased
Variable Costs: costs that vary in direct proportion to output

Total Product (TP)

The total output that a firm produces using its fixed and variable factors
in a given time period

Average Product (AP)

Average product is the output that is produced, on average, by each unit
of the variable factor.

total product
AP=
number of units of variable factor employed

Marginal Product (MP)

The change in output resulting from one additional unit of the variable
input

∆ total product
AP=
∆ units of variable factor

Law of Diminishing Returns

As more units of variable input are added to fixed inputs, the marginal
product at first increases but then decreases

Economics Costs
A combination of explicit and implicit costs
Explicit costs: firms use resources they do not own and makes payments
of money to the resource suppliers
Implicit Costs: the cost is the opportunity cost of the sacrifice of income
that would have been earned if the resource had been employed in its
best alternative use

Economics of Scale
Advantages that a firm gains due to an increase in size.
1. Constant Returns to Scale: change in input is equal to change in
output
2. Increasing Returns to Scale: as input changes, output increasingly
changes
3. Decreasing Returns to Scale: as input changes, output decreasingly
changes

Cost Curves
Average Fixed Cost (AFC): The fixed cost per unit of output. Calculated by
dividing total fixed cost by quantity. Since total fixed cost is constant, AFC
falls as output increases.

Average Variable Costs (AVC): The variable cost pet unit of output.
Calculated by dividing total variable cost by quantity. AVC tends to fall as
output increases but then increases again.

Average Total Cost (ATC): The total cost per unit of output. Calculated by
dividing total cost by quantity. ATC tends to fall as output increases and
then rise again as the output continues to increase.
Marginal Cost (MC): The increase in total cost of producing and extra unit
of output. Calculated by dividing the change in total cost by the change in
quantity. MC tends to fall as output increases and then start to rise
because as more variable factors are added to fixed factors, the cost per
unit of output eventually begins to rise

Graphical Representation of Cost Curves

Perfect Competition

Perfect Competition
Type of Product: identical
Market Power: price takers
Number of sellers: many
Role of advertising: negligible
Barriers to entry: low
The price of the industry determines the price that firms must sell at. The
shaded region represents normal profit such that it shows both the cost
and the revenue of the firm.

Short Run vs. Long Run

Supernormal profits can be earned in the short run if the demand in the
industry shifts right, therefore increasing price. However in the long run,
the entry of new firms will result in supply in the industry shifting right
and therefore price decreasing back to its original.

Allocative and Productive Efficiency

Allocative: when P = MC, in this market P = MR
Productive: when P = min AC, in this market P = min AC

Monopoly

Monopoly
Type of Product: the same
Market Power: price market
Number of sellers: one or two firms
Role of Advertising: possibly high
Barriers to entry: very high

Cost Curves
The light grey box represents the firm’s costs, while the dark grey box
represents supernormal profits.

Short Run vs. Long Run

In the short run and the long run, the monopolist experiences
supernormal profits as there are high barriers to entry and exit.

Allocative and Productive Efficiency

Allocative: when P= MC, in this market P>MC because there is an under
allocation of resources
Productive: when P= min ac, in this market P> min AC because the
monopolist is producing at higher than minimum average cost

Monopolistic Competition

Monopolistic Competition
Type of Product: different but serve the same purpose
Market Power: non-price determinants
Number of sellers: many
Role of Advertising: high
Barriers to entry: moderate

Monopolistic Competitive firms aim to achieve the benefits that

monopolies enjoy, therefore by using product differentiation and
advertising, they can experience similar characteristics

Cost Curves
The light grey box represents the firm’s costs, while the dark grey box
represents supernormal profits.

Short Run vs. Long Run

In the short run, monopolistic competitive firms can experience
supernormal profits however in the long run, more firms are attracted by
the supernormal profits and therefore average revenue shifts downwards,
erasing supernormal profits.

Allocative and Productive Efficiency

Allocative: when P=MC, in this market P>MC indicating there is an under
allocation of resources
Productive: when P= min AC, in this market P>min AC therefore average
cost is higher than what is optimal, if excess capacity is lowered than it
can become productively efficient

Oligopolies

Oligopoly
Type of Product: similar
Market Power: compete on strategy not price
Number of Sellers: few
Role of Advertising: high
Barriers to Entry: very high

Collusion
Oligopolistic firms are very competitive and because of that, they try to
limit competition on price as much as possible. A cartel is an agreement
between firms to limit competition, or what is referred to as “collusion.”

Cost Curves when firms Collude

The light grey box represents the firm’s costs, while the dark grey box
represents supernormal profits.

Cost Curves when firms do not collude

The Kinked Demand Curve explains price inflexibility of oligopolistic firms

that do not collude. Firms also maximize profits where MC=MR, therefore
firms will always produce at Q, which is the point that reflects the dashed
part of the MR curve.