Applications of Microeconomics Theory PDF

**APPLICATIONS OF MICROECONOMICS THEORY AS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS** Learning Objectives: - Understand the significance of microeconomics theory as applied to business. - Know the nature of and the factors affecting the demand for produc...

**APPLICATIONS OF MICROECONOMICS THEORY AS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS** Learning Objectives: - Understand the significance of microeconomics theory as applied to business. - Know the nature of and the factors affecting the demand for product other than its price. - Distinguish between elastic and inelastic demand how they affect the price of goods and services. - Distinguish the factors affecting the supply of a product other than its price. - Understand the significance of market equilibrium and pricing. - Know the nature of short-run and long-run total cost. - Explain the role of money in the economy and the relationship between its supply and demand. - Understand the nature of interest and how the interest rates are determined. **Introduction** Economics focuses on the understanding of how society allocates its resources under the condition of scarcity. ***Microeconomics*** focuses on the behavior and purchasing decisions of individual and firms. Goods and services are sold to those [willing and able to pay] the market price. The market price is determined based on demand and supply. - *Rationing* is the allocation of a limited supply of a good to users who would like to have more of it. When price performs this function, the good is allocated to those willing to give up the most other things in order to obtain ownership rights. **Demand** *Demand* is the [quantity] of a good or service that consumers are [willing and able] to purchase at a range of prices at a particular time. Graphically, a *demand curve* shows an [inverse relationship between the price and quantity demanded]. A demand curve *shifts* when demand variables other than price change. - **Factors Affecting the Demand for a Product other than Its Price** **Factors** **Effects** ------------------------------------------------------ ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Consumer income and wealth *Direct relationship* for normal goods, and opposite for inferior goods. The demand for inferior goods goes up as income goes down. Example is when your income falls, you are less likely to ride taxis, and more likely to ride a jeepney. Price of other goods and services (substitute goods) *Direct relationship.* If the price of pork increase, the demand for beef may increase. Price of complement products *Inverse relationship*. If the price of hamburger increases, the demand for hamburger buns decreases. Consumer tastes *Intermediate relationship*. It depends whether the shift is towards or away from the product. Group boycott *Inverse relationship.* If a group of consumers boycott a product, demand will decrease. Size of the market *Direct relationship.* A larger customer base may increase demand. Expectations of price increase *Direct relationship.* - **Price Elasticity of Demand** is the relationship between % Change in Quantity Demanded and % Change in Price, which indicates the [degree of consumer response] to variation in price. Perfectly inelastic Despite an increase in price, consumers still purchase the same amount. ---------------------- --------------------------------------------------------------------------------------------------------------------- Relatively inelastic A % increase in price results in a smaller % reduction in sales. Unitary elasticity The % change in QD is equal to the % change in price. Relatively elastic A % change in price leads to larger % reduction in purchases. Perfectly elastic Consumers will buy the product at the market price, but none will be sold above market price. **Supply** *Law of Supply* is a principle stating that there will be a [direct relationship] between the price of a good and the amount of it offered for sale. Graphically, a *supply curve* shows the amount of a product that would be supplied at various prices. A [supply curve shift] occurs when supply variables other than price change. - **Factors Affecting the Supply of a Product other than Its Price** **Factors** **Effects** ------------------------------------------------------ ---------------------------------------------------------------------------------------------------------------------- Prices of other goods *Inverse relationship.* If other products can be produced with greater returns, producers will produce those goods. Number of producers *Direct relationship.* An increase in number of producers will cause an increase in amount of goods supplied. Government price controls This limits the amount of goods supplied by holding the price low. Price expectations *Direct relationship*. Production of a good increases if it is expected that the price will be higher in the future. Government subsidies *Direct relationship.* Subsidies reduce the production cost of goods, and therefore increase the goods supplied. Change in production costs or technological advances *Inverse relationship.* If cost goes up, fewer products will be produced. - **Elasticity of Supply** measures the [% change in the QS of a product resulting from a change in the price]. In the extreme case of a zero elasticity, supply is *perfectly inelastic*, and the supply curve is vertical. In this case, the quantity supplied is the same regardless of the price. As the elasticity rises, the supply curve gets flatter, which shows that the quantity supplied responds more to changes in the price. At the opposite extreme, supply is *perfectly elastic*. This occurs as the price elasticity of supply approaches infinity and the supply curve becomes horizontal, meaning that very small changes in the price lead to very large changes in the quantity supplied. **Market Equilibrium and Pricing** *Market* encompasses the forces generated by the [buying and selling] decisions of economic participants. - **Equilibrium** is a state of balance between conflicting forces, such as supply and demand. The demand curve is downward sloping due to the [law of diminishing marginal utility]. The supply curve slopes upward; the more suppliers expect to be able to charge, the more they will be willing to produce and bring to market. In the *equilibrium point*, the two slopes will intersect. The market price is sufficient to induce suppliers to bring to market that same quantity of goods that consumers will be willing to pay for at that price. - **Impact of Shifts in the Supply and Demand Schedule on Equilibrium** - Market prices will bring supply and demand into balance. If QS exceeds QD, price will decline until surplus is eliminated. - Changes in income, prices of related goods, taste, and expectations of future prices will cause demand curve shift. An increase in demand will cause price to rise and QS to increase. - Changes in factors that influence the cost of production will cause supply curve shift. An increase in supply will cause price to fall and QD to expand. **Total Cost and Profits** - **Short-run Total Cost** Fixed Cost Costs that don't vary without output. They will be incurred as long as firm continues in business ad assets have alternative uses. ----------------------- ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Variable Cost Costs of variable inputs, and are directly related to the level of production for the period. Average Fixed Cost Fixed cost per unit of production. It goes down as more units are produced. Average Variable Cost Total variable costs divided by number of units produced. It initially stays constant until inefficiencies of producing in a fixed-size facility cause variable cost to begin to rise. Marginal Cost Added cost or producing one extra unit. It initially decreases but begins to increase due to inefficiencies. Average Total Cost Total cost divided by the number of units produced. Its behavior depends on the makeup of fixed and variable costs. - *[Law of Diminishing Returns]* states that as we try to produce more and more output with fixed productive capacity, marginal productivity will decline. - **Long-run Total Cost:** If a firm increases all production factors by a given proportion in the long-run, it may result to: - *Constant returns to scale.* - *Increasing returns to scale.* - *Decreasing returns to scale.* - **Profits** - *Normal Profit* is the amount of profit necessary to compensate the owners for their capital and managerial skills. It is just enough to keep the firm in business in the long-run. - *Economic Profit* is the amount of profit in excess of normal profit. **Money and Interest Rates** ***Money*** is any item or commodity that is generally accepted as a means of payment for goods and services. It is composed of currency (bills and coins) which have been minted or printed by the National Government. - **Role of Money in the Economy** - *Medium of exchange* - *Store of value:* It requires a stable value so that purchasing power is retained over time. - *Standard value or Unit of account:* It is usable for quoting prices. - **Supply of Money** - *Measures for money supply:* +-----------------------------------+-----------------------------------+ | M1 | - money used as a medium of | | | exchange | | | | | | - narrowest measure | | | | | | - includes currency in | | | circulation held by nonblank | | | public, demand deposits, | | | other checkable deposits, and | | | traveler's checks | +===================================+===================================+ | M2 | - money used as a store of | | | value | | | | | | - includes money held in | | | savings deposits, money | | | market deposit accounts, | | | noninstitutional money market | | | mutual funds and other | | | short-term money market | | | assets | +-----------------------------------+-----------------------------------+ | M3 | - money used as a unit of | | | account | | | | | | - includes the financial | | | institutions | +-----------------------------------+-----------------------------------+ | L | - Includes liquid and | | | near-liquid assets | +-----------------------------------+-----------------------------------+ - *[Bangko Sentral ng Pilipinas]* is responsible for determining the supply of money. It uses daily [open market operations], [reserve requirements], and [discount rate] to influence the creation of money by banks and to guide the availability of money in the economy. - [Open Market Operation] is the central bank's activity of buying or selling of government securities in the open market, and is used to effect changes in interest rates. When there's a purchase, the monetary base is expanded, thereby raising the money supply and lowering short-term interest rates. Conversely, when there's a sale, the monetary base shrinks, lowering money supply and raising short-term interest rates. - [Discount Policy.] The central bank lends money to depository institutions. The interest rate charged to the borrower is called discount rate. Discount policy involves changes in discount rate. Any increase in discount loans adds to monetary base and results to expanded money supply. Any decrease reduces the monetary base resulting to reduced money supply. - [Reserve Requirements] refers to the regulation making it obligatory for depository institutions to keep a certain fraction of their deposits in accounts with the central bank. This helps the central bank exercise more precise control over the money supply. - **Demand for Money** - *Sources of the demand for money:* +-----------------------------------+-----------------------------------+ | Transaction demand | - Money demanded for | | | [day-to-day] | | | payments through balances | | | held by households and firms | +===================================+===================================+ | Precautionary demand | - Money demanded as a result of | | | [unanticipated] | | | payments | +-----------------------------------+-----------------------------------+ | Speculative demand | - Money demanded due to | | | [expectations] | | | about interest rates in the | | | future | | | | | | - Has negative relationship | | | with interest rate | +-----------------------------------+-----------------------------------+ - The opportunity cost of holding money goes up if the interest rate increases, which may lead to decreased consumption and increased saving. - When banks develop new money products that allow for easier, low-cost withdrawal, the demand for money will decrease. - **Impact of Money** - BSP's *monetary policy* can impact economy. Higher interest rates will decrease investment because of the expensive cost to borrow money, and decrease consumption because consumers tend to save more due to high return. - In the short-run, when experiencing inflationary gap (real GDP exceeds potential GDP), BSP may decrease quantity of money and raise interest rate to avoid inflation. Higher rate decreases investment and consumption, and this decrease in demand will decrease real GDP and lower price level. - In the long-run, if BSP increases money supply, it will increase demand. The price level goes up, as well as real GDP, and inflationary gap exists. - **Quantity Theory of Money** holds that changes in money supply directly influences the price level. This theory follows from the *equation of exchange* ***M×V=P×Y*** where: M= quantity of money V= velocity of money (number of times a unit of money is used during a year to purchase GDP's goods and services) P= price level Y= real GDP The *equation of exchange* states that nominal GDP or expenditures (P×Y) equal the money actually used in the economy (M×V). Velocity and potential real GDP are not affected by the quantity of money. ***Interest rates*** allows individuals to evaluate the present value of future income and costs. For a borrower, this is the [premium] that must be paid to acquire goods sooner and pay for them later. For the lender, this is the [reward] for waiting. It allows lenders to calculate the future benefit of extending a loan or savings funds today. Interest rate is [market price] of earlier availability of goods and services purchased. - **Determination of Interest Rate** - *Keynesian Theory* states that interest rate is determined as a price in 2 markets: +-----------------------------------+-----------------------------------+ | Investment funds | The interest rate balances the | | | demand for funds (required for | | | investment) and the supply of | | | funds (from savings). | | | | | | - If investors can earn a 10% | | | return on capital investment | | | project, they will be willing | | | to pay a rate of up to 10%. | | | | | | - Households also delay | | | consumption by saving to earn | | | interest depending on their | | | *time preference* and rate. | +===================================+===================================+ | Liquid assets | Households and firms hold assets | | | in liquid form. This shows the | | | impact of *liquidity preferenc*e | | | on the rate. | | | | | | - Since borrowers require cash | | | in the long-term, they are | | | willing to compensate lenders | | | for giving up liquidity. | +-----------------------------------+-----------------------------------+ - **3 Components of Money Interest** 1. *Pure interest*: real price paid for earlier availability. 2. *Inflationary-premium*: expectation that loan will be repaid with pesos of less purchasing power as result of inflation. 3. *Risk-premium*: probability of default. - **Effect of Change in Interest Rates:** BSP controls short-term interest rates to achieve its main goals of controlling inflation, smoothing out business cycle, and ensuring financial stability. Short-term interest rates are relevant for loans with relatively short length for repayment. - If BSP pushes short-term interest rates up or down, the effects are felt most directly by interest-sensitive sectors. When it is more expensive to borrow, people make fewer purchases that require borrowing.