Econ Study Guide Micro PDF

Econ Study Guide 2.1 Demand What is a market? -​ Where buyers and sellers meet to exchange goods and services. What is demand? -​ The quantity of goods and services that will be bought at any given price during a period of time. Effective demand -​ Must be willing AND able to pay...

Econ Study Guide 2.1 Demand What is a market? -​ Where buyers and sellers meet to exchange goods and services. What is demand? -​ The quantity of goods and services that will be bought at any given price during a period of time. Effective demand -​ Must be willing AND able to pay for a good/service. Law of demand -​ There is an inverse relationship between price and quantity demanded -​ The greater the price, the lower the quantity demanded. -​ Ceteris paribus - all other things being equal Market demand -​ The sum of all quantities demanded by each person in the market at a given price. Shifts in the demand curve -​ There is only a movement from one point to the other along the demand curve if the price changes -​ If there are nonprice determinants, the curve will shift as a whole NPDS 1)​ Income: A change in consumers income -​ Normal goods: As income rises, the demand for the product will rise accordingly. -​ Inferior goods: As income rises, the demand for the product will decrease. 2)​ Price of related goods: A change in the price of substitutes and complementary goods -​ Substitute goods: a good that can be used in place of another. A change in the price of one will lead to a change in the demand for the other. -​ Complementary goods: A good that is used in conjunction with another. A change in the price of one will lead to a change in the demand for the other 3)​ Tastes and preferences: If tastes change favoring a particular product, then more will be demanded at every price. Similarly, if tastes change so that a product becomes unpopular, less will be demanded at every price. 4)​ Future price expectations: If consumers think the price of a product will increase in the future, they may demand more of that product in the present in order to purchase it before a price increase 5)​ Number of consumers: If there is an increase in the number of consumers of a product, then there will be a shift of the demand curve to the right. This can come about due to an increase in population or an increase in the population of a certain demographic 6)​ Special circumstances: Events such as natural disasters may lead to an increase in demand for certain products or services. 2.2 - Supply What is supply? -​ The quantity of goods and services that producers and willing and able to produce and sell at different prices. Effective supply -​ Must be willing AND able to supply the good/service. Law of supply -​ The greater the price, the higher the quantity supplied. Shifts of the supply curve Non price determinants of supply will lead to a shift in the supply curve at every given price level. 1)​ Cost of factors of production. -​ If there is an increase in the cost of a factor of production, such as wages for a firm that  relies heavily on workers, then this will increase the firm’s costs and they will therefore be able to supply less of their consumer good (finished product) at all prices. -​ -​ A fall in the costs of production will enable firms to increase their supply, shifting the supply curve to the right. 2)​ The price of related goods -​ Competitive supply- Often, producers have a choice as to what they are going to produce because the factors of production that they control are capable of producing more than one product -​ Joint supply - When a good is produced at the same time as another, often as a “by product” 3)​ Government intervention -​ Indirect taxes: taxes on good or services that are added to the price of the product. (leftward shift because price will go up) -​ Subsidies : Payments by the government to firms that reduces the cost of production. (rightward shift) 4)​ Future price expectations -​ If producers think the demand for a product and subsequent price of a product might increase in the future then they may hold back supplies until the price increases (shift leftwards of the supply curve), then increase supply once the price is higher (shift rightwards of the supply curve). However if they think prices may fall then they may reduce supply and consider switching to the production of an alternative product. 5)​ Changes in technology -​ Improvements in technology in a firm or industry should lead to more being supplied at all prices (shift to the right of the supply curve). 6)​ Number of producers -​ in a situation where a new producer identifies a market in which they believe the could earn economic profit, they may choose to enter this market. This results in an increase in Supply at any price level. 7)​ Special circumstances 2.3 market equilibrium A market equilibrium is when the price and quantity are at a level where supply equals demand. When a market is in equilibrium, resources are allocated efficiently Consumer surplus -​ The extra benefit enjoyed by consumers who were willing to pay at a higher price than they had to. Producer surplus -​ The extra benefit enjoyed by producers who were willing to sell at a lower price than they had to Total welfare -​ Sum of consumer and producer surplus. Price mechanism -​ The price mechanism is simply the price determined by Supply and demand in a competitive market Functions of the price mechanism Signaling function -​ Prices communicate important information to consumers and producers. Incentive function -​ Prices motivate decision-makers to respond to this information. Income effect -​ When the price of a product falls, then people will have an increase in their “real income” , which reflects the amount that their income will buy. -​ With this increase in real income, the people will be likely to buy more of the product, thus partly explaining the reason for an increase in quantity demanded when there is a fall in the price of a product. Substitution effect -​ When the price of a product falls, people will switch from purchasing a substitute good, and so the demand for the product will increase. The law of diminishing marginal utility -​ Marginal utility is The extra utility or satisfaction that you gain from consuming one extra unit of a good. -​ Diminishing marginal utility is when the extra satisfaction, or marginal utility, that is gained with each additional unit decreases during a period of time. Law of diminishing marginal returns -​ As we increase the amount of one factor of production, the marginal return or output achieved will begin to decrease. 2.5 elasticities of demand What is it? -​ The elasticity of demand is a measure of how much the quantity demanded of a product changes when there is a change in one of the factors that determines demand. PED (Price Elasticity of demand) -​ Measures the responsiveness of the quantity demanded to a change in price. The negative value indicates that there is an inverse relationship between price and quantity demanded. However, in order to simplify matters, economists ignore the negative value and give the answer as a positive value. Interpreting PED values -​ PED < 1 = inelastic -​ PED>1 = elastic -​ PED = 1 = Unit elasticity -​ PED = 0 = perfectly inelastic -​ PED = infinity = perfectly elastic Inelastic demand -​ % change in price > % change in demand Elastic demand -​ % change in price < % change in demand Elasticity and total revenueÑ -​ TR=p x q -​ -​ -​ DETERMINANTS OF PED -​ S: SUBSTITUTES - when there are more substitutes, ped is higher because there is no dependence on that product, and when less substitutes it is more inelastic due to a lack of options. -​ P: PROPORTION OF INCOME - when only a small proportion of income is spent on a good, a change in price will not deeply affect quantity demanded (inelastic), but when a large portion of a consumer’s income is spent on a good, the price change will impact quantity demanded deeply. -​ L = LUXURY OR NECESSITY - When something is needed consumers will be less responsive to price changes. -​ A = ADDICTIVE OR NOT -​ T = TIME - In immediate terms, consumers dont have time to react and look for substitutes (inelastic), when they have more time they can find alternates (elastic). HL - ped for commodities and manufactured goods Primary commodities - agricultural, fishery, etc. and oil, coal, minerals. -​ Lower ped -​ They are necessities with no or limited substitute. Manufactured goods - produced by labor working with capital to transform to commodities -​ Many are luxuries -​ Reasonable substitute Price volatility  -​ With PED being inelastic, a small change in quantity supplied leads to a big price change (remember the natural gas podcast) YED ( Income Elasticity of demand) -​ Responsiveness of quantity demanded to a change in income. PES (Price Elasticity of Supply) -​ The responsiveness of quantity supplied to a change in price Determinants of pes -​ M - mobility of factors of production -​ U - unused capacity -​ T - time -​ S - ability to store stock ​ Supply becomes more elastic over time ​ Producers want their supply to be as elastic as possible in order to respond to price changes and make more profit ​ Making it easier to hire and fire people can make supply more elastic PES for commodities vs manufactured goods -​ Primary commodities have a lower PES -​ The reason is the time needed to respond to price changes -​ For manufactured goods, generally more elastic. However, often firms do not respond quickly to price increases, and wait to ensure the price increase is sustainable before committing resources. This is especially so when the capital needs for a new plant are very high. 2.4 HL - Critique of the maximizing behaviour of consumers and producers Assumptions: consumer rationality, utility maximization, perfect knowledge 1)​ Rational consumer and producer behavior -​ Rational behavior: acting in pursuit of self interest -​ Consumer rational behavior: maximizing welfare or utility gained from the goods and services consumed. -​ Producer rational behavior: maximizing profits. -​ Making rational choices, involves weighing the extra benefit of doing a bit more (marginal) of an activity against the extra costs of doing a bit more. If the extra benefits exceed the extra costs, it is rational to choose to do more of the activity 2)​ Consumer utility maximization -​ Utility: the satisfaction a consumer gains from consuming a good or service. -​ Marginal utility: the ADDITIONAL satisfaction a consumer gains from consuming one more unit of a good or service. -​ Total utility: the total satisfaction a consumer gains from consuming a total number of units of a good or service. -​ As more units of a good are consumed, each marginal unit yields a lower value of marginal utility, therefore individuals are only willing to consume more of a good or service if the price of it falls to the point that P=MU 3)​ Perfect knowledge for consumers -​ The consumers are fully aware of prices in the market, the quality of the goods or services and the availability of the products. -​ Only when consumers have perfect knowledge, will they be able to make informed decisions and make the best decisions. In other words, for efficient use of resources it is necessary to have perfect knowledge. Behavioral economics System 1: Operates automatically and quickly, with little or no effort and no sense of voluntary control. - emotional, fast, reflexive, effortless, impulsive, short sighted System 2: allocates attention to the effortful activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of … choice. - analytic, slow, reflective, effortful, deliberative, patient. Limitations of consumer rationality and utility maximization Cognitive biases: systematic errors in thinking or evaluating  1)​ Rules of thumb: simple guidelines based on experience and common sense, easier than making complicated decisions. EX - a portion of salads is two handsful 2)​ Anchoring: The use of irrelevant information to make decisions, often used because is is the first piece of information available. EX - We see a shirt we want first for $50, then for $40, so we think $40 must be a good price and we buy it. Perhaps another store had it for $35. 3)​ Framing: how choices are presented, often by language or environment. EX - 80% lean meat vs 20% fat. 4)​ Availability: we tend to rely on information seen most recently. Also known as recency bias. Limitations of pure rationality and maximization -​ Bounded rationality: people have a limited capacity to process information and searching for all information is a costly process. So, consumers are rational within these limits. -​ Bounded self control: people exercise self control within limits. They dont always have the self control required to make the rational decision. -​ Bounded selfishness: People are selfish within limits. At some point, a level of selfishness and interest in the public good comes forward Nudge theory -​ A method designed to influence consumer decisions in a predictable way. Without imposing sanctions or limiting choice. Ex: -​ Positioning ( healthy foods in cafeterias and public service notices) -​ Signage (footsteps on floor, pictures on cigarette packs, lots of covid examples) -​ Personal messages (tax reminders) -​ Posting of visible progress in charity fundraising Choice architecture - the design of how choices are presented to a customer -​ Default choice: a choice is a default, and an action must be taken to change it. (opt in vs opt out, organ donation) -​ Restricted choice: limiting the choices of consumers in order to make decision making easier. (Speed limits take away the need for a consumer to have to figure out an appropriate speed taking into account safety, cost of fuel, vehicle emissions, etc.) -​ Mandated choice. Evaluating behavioral economics +​ Low cost method to achieve societal gains +​ Significant potential based on results so far. +​ Generally does not limit or remove choice. +​ It can address flaws in the theory of consumer behavior. +​ Based on previously studied psychological concepts. -​ Unscientific approach does not lead to a systematic model of behaviour across various groups (income, social, cultural, etc.) -​ Can be used to manipulate behaviour in undesirable ways -​ The choice architect has power to influence action, so their biases matter -​ Leaders might hope for nudges to work when something stronger is required -​ It’s a new form of regulation - “a wolf in sheep’s clothing” Assumption 2 - producer product maximization Profit: Profit is what is left for the owner after all of the bills have been paid. Goals other than profit -​ Market share increase: The percentage of total shares in a market for a specific firm. Can help achieve economies of scale, market power, and assess performance. -​ Growth maximization: making the firm bigger. Similar to gaining market share. -​ Corporate social responsibility: Helps the image of the firm. -​ Satisficing: Large modern enterprises can’t be thought of as a single entity with a single goal. Different groups within the firm may have different, and sometimes conflicting goals. Ultimately these firms are simultaneously trying to achieve Assumption 3 - perfect knowledge for producers Perfect knowledge in the market means that the producers are fully aware of market prices, costs in the industry and the workings of the market, including competitor activity. Only when producers have perfect knowledge, will they be able to make informed decisions and make the best decisions. In other words, for efficient use of resources it is necessary to have perfect knowledge. 2.10 - asymmetric information -​ In perfect markets, all relevant information is known to both buyer and seller (symmetric information) -​ Quite commonly, this is not the case -​ One party in a transaction usually has access to more or better information (asymmetric information) -​ This situation is not necessarily bad - it is often necessary and beneficial Adverse selection ​ Either the buyer or the seller has better information than the other and uses that difference to their advantage. One party makes a selection that does not maximize community surplus due to this information difference. ​ Occurs before the economic transaction is completed Ex: -​ Buyer has better information: buyer of health insurance knows their own health. -​ Seller has better information: used car seller knows of problems with car. Solutions -​ Signalling: the party with more information takes steps to share it with the other party -​ Screening: the party with less information takes steps to acquire more. -​ Governmental regulations Moral hazard -​ One party has an incentive to take more risk knowing the negative consequences will be borne by others -​ Occurs after the economic transaction is completed ex: -​ Buyer takes risk: Buyer of health insurance chooses riskier behaviors knowing that costs will be covered if they have an accident, 2.7 government intervention Price ceiling -​ The maximum price, set below the market price, that a seller is allowed to charge for a particular good or service by law. A form of market regulation used to ensure that firms do not abuse their market power by charging consumers excessively high prices, particularly for goods which are considered a necessity such as water, electricity, or food. Impacts -​ Consumer: low price but less availability. -​ Producer: sells lower quantity at lower price, may need to reduce employment. -​ Government: may be a popular move. -​ Workers: may lead to losing job. -​ Society: shortages, underallocation of resources. Price floor -​ Minimum price, set above market price, that a seller must charge for a particular good or service by law. A form of market regulation used to provide income support to producers. What could happen with the excess supply? -​ Government could purchase it and store it for future shortages or given to those of low income. -​ Government could purchase it and destroy it. Costly and inefficient -​ Government could purchase it and dump it to other countries -​ Government could increase demand for domestic products. Impacts of a price floor -​ Consumer: paying higher price for a lower quantity. -​ Producer: sells at a higher price, quantity dependent upon government action on surplus. -​ Government: likely to become buyer of surplus. -​ Workers: can benefit due to job creation. -​ Society: overallocation/inefficiency. Indirect taxes and subsidies Direct tax: a tax on income or profit Indirect tax: a tax imposed on consumption. Purpose of tax -​ Increase government revenue -​ Income redistribution -​ Reduce consumption of harmful goods. -​ Improve allocation of resources. Indirect taxes -​ Specific tax: fixed amount of tax that is imposed on a product (ex: 1$ per unit. ). Shifts supply curve to the left by amount of tax. -​ Percentage / ad valorem tax: a percentage of the selling price. supply curve will shift up/to the left and tilted away from the original supply curve. Impacts -​ Consumer - paying higher price, and able to buy less -​ Producer - sells lower quantity and at a lower price -​ Government - receives revenue -​ Workers - potentially lose if reduced producer revenue leads to job losses Subsidies -​ An amount of money paid by the government to a firm, per unit of output. Functions -​ Lowers price of an essential good. -​ Guarantee supply of products. -​ Support selected producers. Impact -​ Consumer win - pay lower price, and able to buy more -​ Producer - sells higher quantity and at a higher revenue (consumer + subsidy), may increase employment -​ Government - significant spending for the government to fund the subsidy Direct provision of services -​ Public transport -​ Rail networks -​ Tele communications -​ Airlines -​ Education -​ Energy Legislation and regulation -​ Advertising bans -​ Packaging rules -​ Age limits -​ Smoking bans (locations) Consumer nudges E - EASY - simple to implement and grasp A - ATTRACTIVE - get attention S - SOCIAL - we are influenced by others around us. T - TIME - when are people responsive. Market failure/ externalities -​ An externality occurs when actions of private parties (consumers/producers) result in negative or positive side effects on others not part of the actions and whose interests were not considered before the transaction. Why do markets fail? -​ Any situation where the allocation of resources by a free unregulated market is not efficient. MPC - marginal private costs - cost to producers MSC - marginal social costs - cost to society MPB - marginal private benefit - benefits to consumers MSB - marginal social benefits - benefits to society Negative externality of production -​ The production of a product creates a negative spillover/external cost to others. Correcting them -​ Generally shifting MPC upwards towards MSC. Market based solutions -​ Indirect taxes: -​ Carbon tax -​ Tradable permits Evaluating taxes +​ Internalizing the externality by aligning costs and incentives. +​ Directly at source rather than on product output -​ Hard to define exact emissions -​ All regressive Other correction forms Government legislation -​ Restrictions or limitations on pollutants -​ Bans on the use of harmful substances -​ Requirements for licenses to limit access International agreements -​ Broader scale version of government legislation. Education and awareness Common pool resources -​ Resources not owned by any individual or company -​ Do not have a price -​ Available for anyone to use without restriction -​ Clean air, lakes, rivers, fishery stocks, wildlife, hunting ground, forests, soil fertility, grazing land, stable global climate, …  -​ Rivalrous - use by one person reduces amount available for others -​ Non-Excludable - people can’t be prevented from accessing it Negative externality of consumption -​ The consumption of a product creates an external cost to others. Correcting them Positive externality of production -​ The production of a product creates a spillover/external benefit to others. Correcting them Positive externalities of consumption -​ Consumption of a product creates a positive spillover/external benefit to others. ON ALL GRAPHS, WELLFARE LOSS STARTS AT QM AND POINTS TOWARDS Q OPT Market failure and public goods Public goods are: -​ Non rivalrous: the consumption of the product by one person does not reduce the ability of someone else to consume it. -​ Non excludable: not possible to exclude someone who hasn’t paid for that good from using it. A free market will supply private goods. A free market will NOT supply public goods. This is because “free rider” issue means that the producer will not receive enough compensation. Therefore the government must generally intervene to find a way to provide them.