2.1 Microeconomics 1

Question 1

Economics Defined

Answer 1

The study of the allocation of scarce economic resources among alternative uses.

From a business perspective, economics is concerned with studying the production, distribution and consumption of goods and services, generally so as to maximize desired outcomes. The field can be divided into three general areas for study purposes: microeconomics, macroeconomics and international economics.

Question 2

Microeconomics, macroeconomics and international economics

Answer 2

1. Microeconomics – Studies the economic activities of distinct decision-making entities, including individuals, households and business firms. Major areas of interest include demand and supply, prices and outputs, and the effects of external forces on the economic activities of these individual decision makers.
2. Macroeconomics – Studies the economic activities and outcomes of a group of entities taken together, typically of an entire nation or major sectors of a national economy. Major areas of interest include aggregate output, aggregate demand and supply, price and employment levels, national income, governmental policies and regulation, and international implications.
3. International economics – Studies economic activities that occur between nations and outcomes that result from these activities. Major areas of concern include socio-economic issues, balance of payments, exchange rates and transfer pricing.

Question 3

Use of Graphs

Answer 3

Many economic concepts and relationships are depicted using graphs. These graphs often show the relationship between two variables, an independent variable (usually shown on the horizontal “X” axis) and a dependent variable (usually shown on the vertical “Y” axis).
Thus, the variable plotted using values on the “Y” (vertical) axis (the dependent variable) depends on the value shown on the “X” (horizontal) axis (the independent variable). The point at which the plotted relationship (i.e., the “graphed line”) intersects the “Y” axis (at the left end of the “X” axis) is called the “intercept.”

By historic convention, in economics price is plotted (measured) on the vertical axis and quantity on the horizontal axis.

Question 4

The relationship between variables may be positive, negative or neutral

Answer 4

1. Positive – The dependent variable moves in the same direction as the independent variable.
2. Negative – The dependent variable moves in the opposite direction as the independent variable.
3. Neutral – One variable does not change as the other variable changes. (This indicates that the variables are not interdependent.)

Question 5

The basic equation for a straight-line plot on a graph

Example:
A common accounting example would include the determination of total cost for various levels of production using fixed cost and variable cost; it could be expressed as:

TC = FC + VC(Units)

Where:

TC     = 	Total cost.
FC     = 	Fixed cost (incurred independent of the level of production; the Y-intercept).
VC     = 	Variable cost per unit of variable X produced; the change in total cost as the number of units of variable X are produced (also, the slope of the total cost line).
Units = 	Number of units of the variable X produced.

a. If the value of FC and VC are known, TC can be computed and plotted for any number of levels of production (Units).

Answer 5

U = y + q(x)

Where:
U = unknown value of the variable Y being determined and/or plotted.
y = the value of the plotted line where it crosses the Y axis; called the “intercept” (or “Y-intercept”). In economic graphs this is commonly the value of Y where X = 0.
q = the value by which the value of Y changes as each unit of the X variable changes; this expresses the slope of the line being plotted.
x = the value (number of units) of the variable X.

Any letters can be used to represent the two variables being plotted and the expression can be rearranged. For example, the same formula could be, and sometimes is, written as:

Y = mx + b;
Where: 	
Y = 	unknown value of Y.
m = 	slope of the plotted line.
x = 	the value of the variable X.
b = 	the Y-intercept.

Question 6

Economic Systems

Answer 6

The nature of economic activity, at the microeconomic, macroeconomic and international levels, depends on the political environment (or economic system) within which the economic activity takes place.
A.
Command Economic System – A system in which the government largely determines the production, distribution and consumption of goods and services. Communism and socialism are prime examples of command economic systems.
B.
Market (Free-Enterprise) Economic System – A system in which individuals, businesses and other distinct entities determine production, distribution and consumption in an open (free) market. Capitalism is the prime example of a market economic system.

Question 7

Business firms acquire economic resources from individuals, including:

Answer 7

a.
Labor – human work, skills, and similar human effort;
b.
Capital – financial resources (e.g. savings) and man-made resources (e.g. equipment, buildings, etc.);
c.
Natural resources – land, minerals, timber, water, etc.;
d. These resources are essential to the production of (other) goods and services, and they are scarce.

Question 8

Individuals receive compensation from business firms for the use of those individuals’ resources, including:

Answer 8

a. Wages, salaries and profit sharing for labor;
b. Interest, dividends, rental and lease payments for capital;
c. Rental, lease and royalty payments for natural resources.

Question 9

Because of the reciprocal relationship (in the top half of the model) between the economic resources provided by individuals and the compensation received for those resources, the cost of production (price of economic resources) to business firms is equal to the money compensation (income) of individuals.

Answer 9

As a consequence of the reciprocal relationship (in the bottom half of the model) between goods and services produced by business firms and the payment for those goods and services by individuals, the cost of purchasing (price of goods and services) to individuals is equal to the money income of business firms.

Question 10

Characteristics of Free-Market Economy

Central to the relationships in the free-market model is the role of price. The prices of economic resources and of goods and services produced are determined by demand and supply in the market.

Answer 10

The relationships in the model show, among other things, that in a true free-market economy:

1. There exists an interdependent relationship between individuals and business firms. Individuals depend on business firms for money (income) to use in the purchase of goods and services provided by the business firms. Business firms depend on individuals for economic resources to carry out production, and for the money (purchase price) individuals pay for goods and services provided by the firms;
2. What gets produced by business firms, and how those goods and services are distributed, depends on the preferences (needs and wants) of individuals who have the ability (money resources) to pay for those goods and services;
3. How goods and services get produced by business firms depends on the availability of economic resources (labor, capital and natural resources), the level of technology available, and how business firms choose to use available resources and technology.
4. Business firms will produce goods and services only if the price at which those goods and services sold to individuals is equal to, or greater than, the cost (price) of the economic resources acquired from individuals;
5. The dollar value of flows provides a means of measuring the level of activity in the economy. For example, the flows in the model, when supplemented by the effects of government (taxes, spending, etc.), financial institutions (savings, investments, etc.) and foreign exchange (imports, exports, etc.), provide a basis for measuring the gross domestic product (GDP) of the economy. These aggregate measures are covered in detail in the section on macroeconomics.

Question 11

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Answer 11

Demand is the desire, willingness and ability to acquire a commodity. Thus, the existence of demand depends on not only having needs and wants, but also on having the financial ability to act on those needs and wants in the market. Because demand depends on having the financial ability to acquire a commodity (good or service), the quantity of a commodity for which there will be demand (quantity demanded) will be negatively associated with the price of the commodity. If other influences are held constant, the higher the price, the lower the quantity demanded, and the lower the price, the higher the quantity demanded.

Question 12

Individual Demand

Answer 12

A demand schedule for an individual shows the quantity of a commodity that will be demanded at various prices during a specified time, ceteris paribus (holding variables other than price constant). The graphic representation of a demand schedule presents a demand curve with a negative slope.

At P1, the lower price, quantity demanded (Q1) is greater than the quantity demanded (Q2) at P2, the higher price. Two factors account for an increase in individual demand at lower prices:
1.
Income effect – A given amount of income can buy more units at a lower price;
2.
Substitution effect – Lower priced items purchased as substitutions for higher priced items.

Question 13

Market Demand

Answer 13

A market demand schedule shows the quantity of a commodity that will be demanded by all individuals (and other entities) in the market at various prices during a specified time, ceteris paribus. A market demand curve, like an individual demand curve, is negatively sloped.

A. As the market demand curve D1 shows, holding other variables constant, as price falls aggregate demand for a commodity increases. However, if certain other variables in the market change, aggregate demand will change and a new market demand curve will result. Changes in other market variables that may change aggregate market demand include:
1.
Size of market – As the size of the market for a commodity changes, the demand for a commodity may change. For example, if the population of individuals in a market increases, the market demand for a commodity (e.g., bread) may increase, or vice versa. This increase in market demand will result in a new demand curve, shown as D2 in the graph;
2.
Income or wealth of market participants – As the spendable income or level of wealth of market participants change, the demand for a commodity may change:
a. An increase in the income of individuals in the market may increase demand for normal (or preferred) goods (e.g., fresh meat), and decrease the demand for inferior (or less than preferred) goods (e.g., canned meat);
b. A decrease in the income of individuals in the market may increase demand for inferior goods, and decrease the demand for normal goods.
3.
Preferences of market participants – As the tastes of individuals in the market change, the demand for a commodity may change. The change in preference from standard 2 and 4-door automobiles to the SUV-type vehicle decreased market demand for automobiles, but increased demand for SUVs. A market “fad” represents an extreme shift in market preference for a commodity;
4.
Change in prices of other goods and services – A change in the price of other goods and services may change the demand for a particular commodity. The effect of a change in other prices depends on whether the other goods/services are substitutable for/or complementary to, a particular commodity.
a. Substitute commodities satisfy the same basic purpose for the consumer as another commodity. The demand for a commodity may increase when the prices of substitute commodities increase, and vice versa. For example, the demand for rice may increase as the price of potatoes (a substitute for rice) increases.
b. Complementary commodities are those which are used together; therefore, the demand for a commodity may increase when the price of a complementary commodity decreases, or vice versa. For example, the demand for shoe laces may increase when the price of shoes decreases because consumers buy more shoes, and thus more shoe laces.

Question 14

Demand - Important Distinction

Answer 14

t is important to distinguish a change in quantity of a commodity demanded from a change in the demand for a commodity:
A. Change in quantity demanded is movement along a given demand curve (for an individual or for the market) as a result of a change in price of the commodity. Variables other than price are assumed to remain unchanged;
B. Change in demand results in a shift of the entire demand curve that is caused by changes in variables other than price. The demand curve will shift to the left and down when aggregate demand decreased (D1 to D0), and to the right and up when aggregate demand increases (D1 to D2).

Question 15

Supply

Answer 15

The quantity of a commodity provided either by an individual producer or by all producers of a good or service (market supply) at alternative prices during a specified time.

Question 16

Individual Supply

Answer 16

A supply schedule for an individual producer shows the quantity of goods or services that the producer is willing to provide (supply) at alternate prices during a specified time, ceteris paribus. The graphic representation of a supply schedule presents a supply curve, which normally has a positive slope;

B. At P2, the higher price, the quantity supplied (Q2) is greater than the quantity supplied (Q1) at P1, the lower price. Producers normally are willing to provide higher quantities of goods and services only at higher prices because higher production costs are normally incurred in increasing production in the short run. The higher production costs (known as the principle of increasing cost) occur because the additional resources used to increase production typically are not as efficient in producing the commodity as the resources previously used.
C. The principle of increasing costs recognizes that once the fixed factors of production are being used efficiently, increasing production (i.e., supply) will cost more than the prior average cost per unit. Therefore, increasing production (and thus increasing average cost) will occur only if that increase in average cost can be recovered through a higher sales price for the good/service. (The principle of increasing costs reflects the effects on cost as a result of the law of diminishing returns, covered in a later lesson.)

Question 17

Market Supply

Answer 17

A. A market supply schedule shows the quantity of a commodity that will be supplied by all providers in the market at various prices during a specified time, ceteris paribus. A market supply curve, like an individual supply curve, is positively sloped.

B. As the market supply curve S1 shows, holding other variables constant, as price increases aggregate supply for a commodity (quantity) increases; however, if certain other variables in the market change, aggregate supply will change and a new market supply curve will result (S2 or S0). Changes in other market variables that may change aggregate supply include:
1.
Number of providers – As the number of providers of a commodity increase, the market supply of the commodity increases, or vice versa. An increase in market supply will result in a new supply curve, shown as S2 in the graph. The new supply curve shows more of the commodity being provided at a given price. If the number of suppliers of the product decreases, the supply curve would move (up and left) to S0, showing less of the commodity provided at a given price;
2.
Cost of inputs (economic resources) change – As the cost of inputs to the production process change (e.g. labor, rent, raw materials, etc.), so will the supply curve. An increase in input prices would cause per unit cost to increase, and the supply curve would shift up and to the left (S1 to S0), indicating less output at a given price. A decrease in input prices would reduce per unit cost and would shift the curve from S1 to S2, with more output at a given price;
a.
Related commodities – Changes in the price of other commodities that use the same inputs as a given commodity will result in more or less demand for the inputs, change the cost of inputs for the given commodity, and, thus, change the supply of that commodity.
b.
Government influences – If government taxes or subsidizes the production of a commodity, it effectively increases cost (taxes) or decreases cost (subsidizes) of the product. Thus, government can influence aggregate supply through its taxation and subsidization programs;
3.
Technological advances – Improvements in technology for the production of a commodity reduces the per-unit cost and subsequently shift the supply curve down and to the right (S1 to S2), showing more of a commodity provided at a given price.

Question 18

Supply - Important Distinction

Answer 18

It is important to distinguish a change in the quantity of a commodity supplied from a change in supply of a commodity.
A. Change in the quantity supplied is movement along a given supply curve (for an individual provider or for the market) as a result of a change in price of the commodity. Variables other than price are assumed to remain unchanged;
B. Change in supply results in a shift of the entire supply curve that is caused by changes in variables other than price. The supply curve will shift right and down when aggregate supply increases (S1 to S2), and to the left and up when aggregate supply decreases (S1 to S0).

Question 19

Market Equilibrium

Answer 19

he equilibrium price for a commodity is the price at which the quantity of the commodity supplied in the market is equal to the quantity of the commodity demanded in the market. Graphically, the market equilibrium price for a commodity occurs where the market demand curve and the market supply curve intersect.
Equilibrium for the commodity occurs at the intersection (E) of the demand and supply curves. The equilibrium price is EP, and the equilibrium quantity is EQ. For the given supply and demand curves, at the equilibrium price (EP), the quantity of the commodity demanded (i.e., that can be sold) is exactly equal to the quantity of the commodity that will be supplied at that price. There will be no shortage or surplus of the commodity in the market.

Question 20

Shortages and surpluses in quantity occur when the actual price (AP) of the commodity is less (shortage) or more (surplus) than the equilibrium price (EP).

Answer 20

1. Market shortage – The actual price is less than the equilibrium price (AP less than EP); therefore, the actual quantity supplied is less than the quantity demanded at AP (AQ less than DQ). A shortage equal to DQ - AQ exists.
2. Market surplus – The actual price is higher than the equilibrium price (AP greater than EP); therefore, the actual quantity supplied is greater than the quantity demanded at AP (AQ greater than DQ). A surplus equal to AQ - DQ exists.

When attained, market equilibrium will continue until there is a change in demand and/or supply of the commodity. The shifts in the demand and/or supply curves that result will change market equilibrium.

Question 21

Change in Equilibrium

Answer 21

The effect of change(s) in demand and/or supply on market equilibrium depends on whether demand changes, supply changes or both change.
A.
Change in market demand (only) – An increase in market demand (D1 to D2) due to an increase in the size of the market (or increased income, changes in consumer preferences, etc.) causes the demand curve to shift up and to the right. If there is no change in market supply, the results will be an increase in both the equilibrium price (EP1 to EP2) and equilibrium quantity (EQ1 to EQ2). A decrease in market demand would cause both equilibrium price and equilibrium quantity to decrease.

B.
Change in market supply (only) – An increase in market supply (S1 to S2) due to an increase in the number of providers in the market (or lower cost of inputs, technological advances, etc.) causes the supply curve to shift down and to the right. If there is no change in market demand, the results will be a decrease in equilibrium price (EP1 to EP0) and an increase in equilibrium quantity (EQ1 to EQ2). A decrease in market supply causes a higher equilibrium price and a lower equilibrium quantity.

C.
Changes in both market demand and market supply – The effect of simultaneous changes in both market demand and market supply depends on the direction of the changes (increase or decrease) and the relative magnitude of each change.
1. Increases in both market demand and market supply will shift both curves to the right resulting in a higher equilibrium quantity, but the resulting equilibrium price will depend on the magnitude of each change. The equilibrium price could remain unchanged, increase or decrease.
2. Decreases in both market demand and market supply will shift both curves to the left resulting in a lower equilibrium quantity, but the resulting equilibrium price will depend on the magnitude of each change.
3. The effects of a simultaneous increase in one market curve (demand or supply) and a decrease in the other market curve (supply or demand) on market price and market equilibrium can be determined only when the specific magnitude of each change is known.

Question 22

Governmental Influences on Equilibrium

Answer 22

A. As noted earlier, government taxation and subsidization have the effect of both increasing and decreasing the effective cost of production (supply). For example, a tax on a commodity at the production level increases the cost and shifts the market supply curve up and to the left. If demand remains constant, equilibrium price increases and equilibrium quantity decreases. Government subsidies have the opposite effect.
B. By imposing a rationing system, government can change market demand and, thereby the equilibrium. Rationing would be intended to shift the demand curve down and to the left, thus lowering equilibrium price and equilibrium quantity.
C. Government also can affect the price of a commodity through price fiat by establishing an (artificial) price ceiling or price floor. These artificial prices result in disequilibrium in the market. An imposed market ceiling (less than free-market equilibrium price) results in market supply being less than market demand at the imposed price. Market demand and market supply are not in equilibrium. An imposed market floor (greater than free-market equilibrium price) results in market supply being more than market demand at the imposed price.

Question 23

Elasticity

Answer 23

Measures the percentage change in a market factor (e.g., demand) seen as a result of a given percentage change in another market factor (e.g., price).

Question 24

Elasticity of Demand

Answer 24

Elasticity of demand (ED) measures the percentage change in quantity of a commodity demanded as a result of a given percentage change in the price of the commodity; therefore, it is computed as:
ED = % change in quantity demanded / % change in price

This formula expresses the slope of the demand curve when showing demand graphically.

1. Technically, the results of the formula will almost always result in a negative value (coefficient) because the change in quantity demanded will be the opposite of the change in price.
2. In those cases, the elasticity coefficient (value) is conventionally referred to as an absolute value (i.e., the negative sign is ignored).

Question 25

Major factors that affect elasticity

Answer 25

1. Nature of the good/service – The more essential a good or service is, the less elastic the demand will be because consumers would be compelled to continue to buy even in the face of price increases.
2. Availability of substitutes – The more substitutes available, the more elastic the demand will be because, as price increases, consumers have alternative goods or services to which they can switch.
3. Income available – The more limited the income available to spend on a good or service, the more elastic the demand will be because demand will be more sensitive to price increases.

Question 26

Elasticity of Supply

Answer 26

Elasticity of supply (ES) measures the percentage change in the quantity of a commodity supplied as a result of a given percentage change in the price of the commodity; therefore, it is computed as:
ES = % change in quantity supplied / % change in price

This formula expresses the slope of the supply curve when showing the supply graphically.

Question 27

Elasticity of Other Market Factors

Answer 27

A. Cross Elasticity of demand—Measures the percentage change in quantity of a commodity demanded as a result of a given percentage change in the price of another commodity.
1. The formula for cross elasticity of demand (XED) is:
XED = % change in quantity demanded of Y / % change in price of X
B. Income elasticity of demand—measures the percentage change in quantity of a commodity demanded as a result of a given percentage change in income.
1. The formula for the income elasticity of demand (IED) is:
IED = % change in quantity demanded / % change in consumer income

Question 28

Utility

Answer 28

Consumers (individually and in the aggregate) demand a commodity because it satisfies a need or a want. In economics, the satisfaction derived from the acquisition or use of a commodity is referred to as “utility.” Thus, demand for a good or service occurs because of the utility derived from that good or service. A hypothetical unit of measure called “utils” is often used to assign value (or measure) to an individual’s utility (or satisfaction) derived from each commodity.

Question 29

Marginal Utility

Answer 29

The more of each commodity an individual acquires during a given time, the greater total utility (or utils) the individual derives. However, while total utility increases as acquisition increases, the utility (or utils) derived from each additional unit of a commodity decreases. The last unit acquired is referred to as the “marginal unit,” and the decreasing utility derived from each (additional) marginal unit is referred to as the law of diminishing marginal utility.
An individual will maximize total utility (satisfaction) for a given amount of income when the marginal utility of the last dollar spent on each and every commodity acquired is the same. Thus, total utility is maximized when:
(MU of A) / (A Price) = (MU of B) / (B Price) = (…MU of Z) / (Z Price)

Question 30

Indifference Curves

Answer 30

When the various quantities of two commodities that give an individual the same total utility are plotted on a graph, the result is an indifference curve. Assume, for example, that with a fixed income and given prices, an individual would be equally satisfied (have the same total utility) with the following combination of soft drinks and beer:
Soft Drinks 	Beers
10 	1
7 	2
5 	3
2 	4

According to this schedule, an individual would be equally happy with 10 soft drinks and 1 beer as with 2 soft drinks and 4 beers; there is no preference for any of the shown combinations of soft drinks and beers.

Question 31

Inputs

Answer 31

In the free-market model it was shown that business firms acquire economic resources in order to produce (other) goods and services. These inputs to the production process are the major determinants of a firm’s supply curve. As noted in the discussion of supply, changes in the cost of inputs to the production process cause a shift in an entity’s supply curve (i.e., change the quantity of goods supplied at a given price).

Question 32

The analysis of cost of production (and other areas of economics) distinguishes between analysis in the

Answer 32

1. Short-run – The time period during which the quantity of at least one input to the production process cannot be varied; the quantity of at least one input is fixed.
2. Long-run – The time period during which the quantity of all inputs to the production process can be varied.
   Since business firms can vary all inputs in the long-run and since they must nevertheless operate in the short-run, analysis of production costs tends to focus on the short-run.

Question 33

Average Cost (unit cost)

Answer 33

The cost per-unit of commodity produced. Average fixed cost (AFC), average variable cost (AVC) and average total cost (ATC) are computed by dividing the cost (FC, VC or TC) by the quantity of units produced.

Question 34

Marginal Cost

Answer 34

The cost of the last acquired unit of an input. It is computed as the difference between successive total costs, or because only variable costs change, successive total variable costs.

Note: The lowest MC occurs at a lower output than the lowest point on the AVC or ATC. The MC curve crosses the AVC and ATC at their respective lowest point.

Question 35

Law of Diminishing Returns

Answer 35

A. In the foregoing graphs the ATC, AVC and MC curves all have a general “U” shape. That shape is basic to each curve and occurs because of eventual diminishing returns from adding more variable inputs. In the short-run, as the quantity of variable inputs increases, output initially increases, causing AC, AVC and MC to decrease.
B. However, at some quantity of variable inputs, the addition of more units, in combination with the fixed inputs, results in decreasing output per unit of variable input. Simply put, at some point the quantity of variable inputs begins to overwhelm the fixed factors, resulting in inefficiencies and diminishing return on marginal units of variable inputs. As a consequence of diminishing returns as inputs increase, ATC, AVC and MC all begin to increase. Thus, their curves are “U” shaped. (Note, however, that AFC continues to decline.)

Question 36

Long-Run Cost Analysis

Answer 36

In the long-run all costs are considered variable, including plant size. Thus, plants of various sizes can be assumed in the long-run, but in the short-run a plant of a particular size will operate. By plotting the short-run average cost (SAC) curve of plants of various sizes (1—4), the long-run average cost (LAC) curve can be constructed.

Question 37

The long-run average cost curve (LAC) is also “U” shaped, reflecting that as plant size (scale) increases there are various returns to (or economics of) scale. Three possible cost outcomes exist:

Answer 37

1. Economies of (or increasing return to) scale - as shown where the LAC curve is decreasing, quantity of output increases in greater proportion than the increase in all inputs, primarily due to specialization of labor and equipment;
2. Neither economy nor diseconomy of (constant return to) scale - as shown at the bottom of the LAC curve, output increases in the same proportion as inputs;
3. Diseconomies of (or decreasing return to) scale - as shown where the LAC curve is increasing, quantity of output increases in lesser proportion than the increase in all inputs, primarily due to problems or managing very large scale operations.