Micro Flashcards
What is scarcity?
- We have infinte wants but only finite resources, meeting one want means not meeting other wants so trade offs must be made.
what are the three trade offs made?
What to produce?
How to produce them?
For whom to produce them?
the key economic problem for a society
how to resolve the conflict between peoples desires for goods and service and the scarcity of resources with which these goods and services require to be produced
Law of diminishing return
One input is varied but other inputs remain fixed. The first worker has sole use of these facilities. With more workers, these facilities can be shared. Adding extra workers dilutes equipment per worker. Output per film worker falls as employment rises
choices when making a decison
What goods and services should be produced given the available resources?
What is the best process to produce these goods and services?
How do we want these goods and services to be distributed?
what decisions do individuals make
How much to work, what to buy and how much to buy of various goods and services
what decisions do firms make
What to produce, how much to produce of various goods and services and which resources to use in production.
when are the government likely to intervene
Not all resources are allocated through markets, such as we all want a clean environment however there is no such good to ensure this.
what is a fundamental assumption in economic analysis
that individuals behave rationally when making choices
what is a rational individual
someone who uses all of their available information to compare the costs and benefits associated with these decisions.
what are incentives
rewards or penalties that affect individuals’ choices. They can be monetary or not and can affect the benefits or the cost of our decisions, for example, smokers have the incentive to stop smoking because of high taxes imposed by the government.
Four basic principles of economics
Cost benefit principle
Opportunity cost principle
Marginal decision principle
Sunk cost principles
Cost benefit principle
An action should be taken if, and only if, the benefit from taking the action is greater than the cost.
Opportunity cost principle
Any action that is chosen that restricts options to take other actions, whenever there is scarcity choices must be made
Marginal decision principle
When waking up in the morning, you don’t decide a set amount of coffee to drink all day, you decide one cup at a time. This is because most decisions we make aren’t all or nothing.
In these cases we apply the marginal principle to decision making. And even if we do not explicitly make decisions this way, we behave as if we do.
Sunk cost principle
A consequence of making choices at the margin that we ignore costs incurred which cannot be recovered. This will show up when we look at decisions made by firms, firms often incur a sunk start-up cost before that start producing output.
Positive economics
The study of the way things is, it the pursuit of objective truths.
The aim of positive economics is to analyse how society makes decisions about consumption, production and exchange of good. And it aims both to explain why the economy works as it does, and to allow predictions about how the economy will respond to changes.
Normative economics
The study of the way things should be. Based on subjective beliefs and value judgements
exogenous variables
variables that aren’t explained by the model
endogenous variables
variables are explained within the model
Ceteris Paribus
other things being equal
what is an economic model
A model or a theory makes assumptions from which if deduces how people will behave. It is a deliberate simplification of reality.
Rational agent
makes choices that make there self at least as well-off as the next best alternative, conditional on
- preferences (or objectives),
- constraints (e.g. income and prices),
- information.
how do data and facts interact
1) the data helps us quantify the relationships to which our theoretical models draw attention
2) the data helps us to test models.
nominal vs real
Nominal values are measured in the prices ruling at the time of measurement.
Real values adjust nominal values for changes in the price level.
Purchasing power of money
When the prices of goods rise, the purchasing power of money (an index of the quantity of goods that can be bought for £1) falls because £1 buys fewer goods. To distinguish between real and nominal variables in current pounds and real variables in constant pounds.
Consumer product index
measure changes in the cost of living by looking at the cost of a standard ‘shopping basket of goods.
It is used to measure the cost of living - the government then use this data to influence their policy in line with the Bank of England’s target.
What are gains from trade?
Gains from trade refer to the net benefits to all economic agents from entering in voluntary trade with each other.
When are gains of trade possible?
Diversity in the population is necessary.
Differences in tastes for goods in question.
Differences in skills or production technology.
Differences in opportunity cost.
how should an economy allocare productive resources
Production of a good X should be allocated to agents with the lowest opportunity cost first and the highest opportunity last.
What happens to the PPF when a new worker is added
It shifts out the PPF
Change production cost
PPF
shows the maximum combination of output that the economy can produce using all the resources available.
what does the frontier display
more of one commodity implies less of the other. Points above the frontier need more inputs than the economy has to offer and points inside are inside. By fully using available inputs the economy could expand output to the frontier
absolute advantage
the person can produce a good or service at a lower cost
comparative advantage
compared to another in production of a good they have a lower opportunity cost of production.
calculating oppourtunity cost
why is the PPF curved?
The curve reflects the law of diminishing marginal returns to production. Diminishing marginal returns means that each input adds less to output than the previous input adds.
impact of technological changes on the PPF
The slope has become steeper this means that the OC of one more unit of clothing has increased and as such the cost of clothing production has increased
impact of educating the population
it will move out the PPF
what is a market
a market is a means of transferring goods and services from one person to another. In markets:
1. Exchanges is reciprocated
2. Exchange is voluntary
3. There is competition
demand schedule
the quantity of a good that buyers wish to purchase at every conceivable price.
supply schedule
the quantity of a good that sellers wish to sell at every conceiveable price
law of demand
the price of a good increased, ceteris paribus, the quantity demanded decreases.
substitution effect
Buyers tend to substitute the more expensive goods for cheaper alternative. this results in a decrease in the quantity demanded of the good for which the price is increasing
income effect
Buyers are poorer since their real income decreases. Because of that they may not be able to afford the same amount of the good they used to before the increase in the price.
determiants of demand
Tastes/preferences
Number and price of substitute goods
Number and price of complementary goods
Income
Distribution of income
Expectations and beliefs.
substitutes
alternative goods sought by consumers because of a price increase in their original choice of good; a price rise in the chosen good will raise demand for substitutes
complements
goods which accompany a chosen good; a price increase for one good reduces the demand for these complements
normal good
a good for which demand increases when income rises; it has a positive income elasticity of demand.
inferior goods
a good for which demand falls when income rises; it has a negative elasticity of demand
determinant of the supply curve
Costs of production.
Profitability of alternative products.
Profitability of goods in joint supply.
Nature (i.e. weather patterns)
Objectives of the producers.
Expectations of the producers.
exogenous demand shift
Increase in demand:
- There is a shortage in supply at price P1 – Buyers express a higher willingness to pay, sellers start to raise their prices.
- price and market quantity has increased.
exogenous supply shift
decrease in supply:
- There is a supply shortage at the price P1 – sellers will charge more so that demand does not exceed the level of supply.
- price increased and market quantity decreased
producer surplus
difference between what cost producers want to sell an amount of goods at compared to what they do.
consumer surplus
the difference between what consumers are willing to pay and what they actually pay
what happens in a competitive market
producers start to under – cut one another to get a larger market share. This will happen until the cost of producing the last pizza sold is equal to the cost of its production.
As such producers realise that they can profitably raise their prices and increase their quantity. This will happen until the last consumer who purchased a pizza was just willing to pay the market price
the marginal cost of production
the cost of producing the last unit of output
- if price exceeds MC then the firm wont be making a profit
- if price is below MC then the firm wont produce
what does total surplus represent
The represents the total welfare realised through trade (i.e. gains from trade)
dead weight loss
represented the lost total surplus that results from a market distortion.
what is a price floor
Prices must not go below the floor
what happen if equilibrium price is lower than the price set by the price floor
price controls do not influence market outcomes.
what happen if equilibrium price is higher than the price set by the price floor
price controls lead to a market surplus.
What happens to welfare when a price floor is imposed in a competitive market
- Producer who supply 𝑄𝐷 units realise an increase in surplus.
- Consumers who purchase a good realise a surplus decrease.
- There are 𝑄∗ − 𝑄𝐷 units of output for which the cost of production is less than the willingness to pay.
- The area between supply and demand for these units is the dead weight loss.
what is a price ceiling
Prices must not go above the ceiling
what happen if equilibrium price is higher than the price set by the price ceiling
price controls do not influence market outcomes.
what happen if equilibrium price is lower than the price set by the price ceiling
price controls lead to market shortages.
What happens to welfare when a price ceiling is imposed in a competitive market?
- Producer who supply 𝑄𝐷 units realise a decrease in surplus.
- Consumers who purchase a good realise a surplus increase.
- There are 𝑄∗ − 𝑄𝑆 units of output for which the cost of production is less than the willingness to pay.
- The area between supply and demand for these units is the dead weight loss.
what is elasticity?
A measure of the responsiveness of demand (or supply) to a change in other variables.
two part of expenditure change
- Expenditures decrease as the quantity purchased decreases.
- Expenditures increase as the price per unit increases.
what does the size of each expenditure change depend on
- The slope of the demand curve.
- Position on the demand curve.
PED definition
The % change in the quantity demanded of a good given a 1% change in the good’s price.
PED calculation
% change in Qd
PED = ————————
% change in price
PED arc calculation
PED pont elasticity
perfectly elastic demand curve
there is no end to the amount people will demand at a given price. The change in quantity is equal to the shift in demand and the price will not change.
Change in expenditure is
entirely due to a decrease in quantity.
Perfectly inelastic demand curve
the quantity demand will not change depending on the price as such the change in price will be 0 and the change in price will reflect the entire shift in supply. PED = 0. Change in expenditure is entirely due to the increase in price.
values of PED
- Is less than -1 then it will be elastic
- Is equal to -1 then it is unit elastic
- Is greater than -1 but less than 0 it will be inelastic
PED on a linear demand curve
- Every point has a different elasticity.
- There are as many elastic as inelastic points.
impact of a price increase on an elastic demand curve
total expenditure decreases
impact of a price decrease on an elastic demand curve
total expenditure increases
impact of a price increase on an unit demand curve
no change
impact of a price decrease on an unit demand curve
no change
impact of a price increase on an inelastic demand curve
total expenditure increases
impact of a price decrease on an inelastic demand curve
total expenditure decreases
what is cross elasticity
The change in the demand for good Y, with respect to a change in price of good x
XED calculation
XED point method
what does it mean if XED is negative
the goods are complements
what does it mean if XED is positive
substitutes
what does it mean if XED is 0
they are independent
what is income elasticity of demand
Asks how much consumer spending changes as consumers income increases
YED calculation
budget share calculation
what is an inferior good and what is its value
a good for which demand falls when income rises, negative value
what is an normal good and what is its value
a good for which demand increases as income rises, positive value
what is an luxury good and what is its value
a good with income elasticity above unity, value of above 1
what is an necessity good and what is its value
a good with income elasticity below unity, value between 1 and 0
what is PES
The % change in the quantity supplied of a good given a 1% change in the good’s price.
PES calculation
what is a specific tax
- A tax which specifies the amount per unit of purchase
what is ad valorem tax
- A tax that is proportional to expenditure on a good.
Tax incidence
the share of the tax paid by consumers and producers.
what is the tax incidence measure by
the portion of the total tax revenue paid by consumers and producers.
what is the tax incidence determined by
elasticities of supply and demand.
if demand is more elastic then who has the higher incidence of tax
producers
if demand is more inelastic then who has the higher incidence of tax
consumers
if supply is more elastic then who has the higher incidence of tax
consumers
if supply is more inelastic then who has the higher incidence of tax
producers
If demand is more inelastic than supply who pays more of the tax
consumers
If supply is more inelastic than demand who pays more of the tax
producers
DWL from a specific tax
the tax also
creates a DWL where the
cost of production (without
the tax) is less than the
willingness to pay.
The tax creates a market
distortion, leading to a social
loss.
what is utiltity
a numerical indicator of the value that on individual places on an outcome.
what is rationality
assumes that individuals always choose outcomes that provide higher utility to outcomes that provide lower utility when both are feasible.
what is cardinal utility
Cardinal utility means that an individual can attach a specific number of utils to every outcome. The difference in the number of utils between two outcomes has meaning (bigger difference = more preferred).
what is ordinal utility
Ordinal utility only ranks different outcomes. When presented with a choice between two outcomes, ordinal utility requires only that an individual can indicate which outcome is preferred (or indifference).
how does the concave shape of the utility curve reflects the law of diminishing marginal utility
For a single good, marginal utility is non-increasing in the amount of the good consumed.
what does completeness mean
- For any two bundles of goods and services, call the A and B, a consumer can always rank them such that either:
- A is preferred to B,
- B is preferred to A,
- Indifferent between A and B
what does transitivity mean
- A consumer’s rankings are consistent with one another:
- If A is preferred to B and B is preferred to C, then A is preferred to C.
- If consumer is indifferent between A and B, and indifferent between B and C, then she is also indifferent between A and C.
what does non-satiation mean
- Consumers prefer more of all “goods” to less.
- If A and B are different bundles of goods, and B is subset of A, then A will be preferred to B.
properties of the indifference curve
- Infinitely many curves covering all possible bundles. Each curve represents a different utility level provided by all bundles on the curve - this is the completeness assumption.
- downward sloping - a consumer is willing to give up one good if they get more of the other good to remain equally happy
- The transitivity assumption means that indifference curves never cross
what is the marginal rate of substitution
The amount of one good that a consumer requires as compensation to give up one unity of another good, holding utility constant.
The MRS of good y for good x is equal to:
Change in y MUx
- —————– = ———–
Change in x MUy
cobb-douglas and MRS
MRS is different at every point on the indifference curve.
perfect substitutes and MRS
MRS is the same at every point on the indifference curve.
perfect compliments and MRS
MRS=0
Cobb-dogulas utility mathematically
what bundels are affordable and unaffordable
All bundles above the curve are unaffordable and those under are affordable.
what does an increase in incoem do to the budget line
shift the budget line – the set of affordable bundles increases.
what does a price change do to the budget line
- A price change will cause the budget line to pivot, moving on the axis of the good that experienced the price change.
- Price increase → pivot inward (left).
- Price decrease → pivot outward (right)
what does the budget line show
shows combinations of goods which can be purchased when all income is spent.
income expansion paths if goods are normal goods
upwards sloping curve
income expansion paths if goods are inferior goods
downwards sloping
what does the income expansion path show
The income expansion path shows how consumption changes with income.
what is the engle curve
shows the relationship between quantity
consumed and a consumer’s income.
engel curve of normal goods
upwards sloping Engel curves.
engel curve of inferior goods
downwards sloping, or backwards bending Engel
curves.
what is a giffen good
A giffen good is so inferior that as price increases the positive income effect dominates the negative substitution effect.
labour-lesuire choice - a wage rise
- Increases income at each level of free time, increasing the level of utility that can be achieved.
- Increases the opportunity cost of free time.
labour-lesuire choice - a wage rise - two offsetting effects on lesuire
- Positive income effect reflecting the effect of more income with not change to opportunity cost.
- Negative substitution effect reflecting the effect of a higher opportunity cost of leisure.
when will an individual work until
An individual will want to work until the marginal utility derived from goods that an extra hour of work will provide is just equal to the marginal utility from the last hour of leisure.
A firm
A company which produces and sells goods or services for the purpose of making a profit.
Sole trader and partnerships
Firm owners receive all profits but are also responsible for losses. In the case bankruptcy owners may be required to sell personal possessions to pay creditors.
Companies
have a legal existence distinct from the owners. Can raise money through the buying and selling of shares. Owners of shares have limited liability in the company, they are not responsible to repay creditors beyond the value of company (reflected by share ownership).
the factors of production
- Land
- Capital (physical or financial)
- Labour
- Ideas/knowledge/entrepreneurship
three things that determine market behaviour
1) Market demand for goods the firm produces
2) The firms cost of production
3) The competitive environment the firm faces e.g. perfect competition, monopoly and oligopoly
5 assumptions about firms
1) The firm’s objective is to maximize profits.
2) The firm produces a single good (e.g. a car, or a spoon, or a haircut).
3) The firm has perfect information about market demand for its product.
4) The firm must sell all units of its product at the same price.
5) For the moment we ignore interactions between firms (competitive behaviour).
If PED is greater than 1:
revenue increases with q
If PED is less than 1:
revenue is decreasing with q
If PED is equal than 1:
revenue is maximised at q
Profits when MR > MC
Profits increases when q increases.
Profits when MR < MC
Profits decrease when q increases.
principle agent problem
difficulties of a principal or owner in monitoring an agent to whom decisions have been delegated. The agents here are tempted to act in their own interests.
what does the production function represent
It reflects only technically efficient ways to combine inputs to produce outputs on the firm’s PPF.
Factors of production in SR
In the short run at least one factor of production is fixed.
- It takes time to build a larger factory, or have customized machinery built, or develop a new technology.
- It takes relatively little time to increase or decrease the amount of labour used in production.
marginal product of labour
the change in output when we increase labour by one unit.
mathematical MPL
𝑀𝑃𝐿 = 𝑞 (𝐾0,𝐿) − 𝑞 (𝐾0,𝐿 – 1)
𝑀𝑃𝐿 = 𝑑𝑞/𝑑𝐿.
Average product of labour
𝐴𝑃𝐿 = 𝑞(𝐾0,𝐿)/𝐿
production function
𝐾0𝐿0.5
MPL derived
0.5 (𝐾0/𝐿0.5)
APL derived
𝐾0/𝐿0.5
total cost of production
𝐶 = 𝑟 × 𝐾0 +𝑤 × 𝐿
rearrange the prodcution function in terms of labour
𝐿 =(𝑞/𝐾0)^2.
what determines the cost of production
- The price of the capital that was used in production.
- The price of the labour that was used in production.
- The production technology (i.e. productivity of inputs).
relationship between AC and MC
If MC>AC the AC is increasing
If MC<AC the AC is decreasing
If MC=AC then AC is minimum
what happens if P > SATC
the firm is making a profit
if P < SAVC and P > SATC
the firm loses money in the short-run
If P < SAVC
then the firm shuts down
cobb dogulas prodcution function
𝑞 (𝐾, 𝐿) = 𝐾^0.5𝐿^0.5
isoquant
provides a graphical depiction of the relationship between inputs for a given output level.
scale
refers to the output of a firm when all inputs can be varied. It is a measure of
size.
returns to scale
refer to the relationship between long-run average costs and output.
There are three cases of interest to us
increasing returns to scale
𝐿𝐴𝐶 is decreasing as 𝑞 increases.
Constant returns to scale
𝐿𝐴𝐶 do not change as 𝑞 increases.
decreasing returns to scale
𝐿𝐴𝐶 is increasing as 𝑞 increases.
minimum efficient scale
the lowest point for which LAC is at its minimum
why do firms experience economies of scale
- Indivisibilities in the production process.
- Specialisation
- Network effects in production (learning or teamwork effects)
cobb dogulas economies of scale and it’s return to scale
𝑞 (𝐾, 𝐿) = 𝐾𝛼𝐿𝛽
- If 𝛼 + 𝛽 > 1 then increasing returns.
- If 𝛼 + 𝛽 = 1 then constant returns.
- If 𝛼 + 𝛽 < 1 then decreasing returns.
market structure under perfect competition
- Firms are price takers (small relative to the entire market),
- Firms are free to enter,
- Firms produce an identical product,
- Firms all have perfect information about the market.
profits in PC
𝜋 𝑞 = 𝑃 × 𝑞 − 𝐶(𝑞)
- Notice that the firm’s choice of 𝑞 no longer influences 𝑃.
- In other words, P is an exogenous variable for the individual firm in a perfectly competitive market.
LR equilbrium PC
In the long-run in a perfectly competitive industry, all firms will produce such that long-run average costs are minimized.
- Price = MC = LAC
what happens when demand increases in PC
- In the short-run the market price will increase to 𝑃′ > 𝐿𝐴𝐶, so firms in the market make positive profits.
- This induces entry into the market by other firms, shifting the SRS curve until price falls back to 𝑃∗ = 𝐿𝐴𝐶.
- The long-run market supply curve is horizontal at 𝑃∗ = 𝐿𝐴𝐶.
- If the LAC cost is increasing in Q (less efficient firm’s enter) then the LRS curve will slope up.
what is a monopolist
One firm supplies the entire market for a good.
- No direct competitors.
- This firm sets both the market price and quantity.
DWL monopoly
Price discrimination
Price discrimination is when a firm can charge a different price to different people.
First degree price discrimination
The monopolist can perfectly tell how much consumers are willing to pay and charge each a different price.
- This is the objective in purchases where price is negotiated between a buyer and a seller.
Second-degree price discrimination
Discounts are given for purchasing larger quantities.
Third-degree price discrimantion
The monopolist can identify different consumers and charge different prices.
Why do some industries have monopoly provision?
- Legal monopoly
- Anticompetitive behaviour
- Natural monopoly
monopolistic competition
- Products across firms are imperfect substitutes.
- Each firm faces a downward sloping demand curve.
- Limited opportunities for economies of scale.
SR vs LR monopolisitc competition
In the short run a firm may enter a new industry and make positive profits.
* Over time, other firms notice the profits and enter the industry.
* This shifts the incumbent firm’s market demand left.
* Other firms continue to enter
until the incumbent’s demand is just tangent to average cost.
LR equilbrium MC
Firms are not producing at minimal average cost (unlike with perfect competition).
- Firms produce where 𝑀𝐶 < 𝐴𝐶.
- Expending production would reduce costs, but the increase in revenue would be too low.
There is some monopoly power as 𝑃 > 𝑀𝐶 (unlike perfect competition).
Firms are maximising profits, but just break even as 𝑃 = 𝐴𝐶.
Oligopoly
A firm does not consider how its behaviour might influence the behaviour of rival firms.
- In an oligopoly industry there are only a few large firms which directly compete with
one another.
Strategic firm behaviour
Each firm makes decisions based on what its competitor does, considering how the
competitor will react to its actions.
Cartels
A cartel is a formal agreement between firms to restrict quantity in the market as to influence price and profits.
what happens if one firm increases production in the cartel
The cheating firm’s profits increase
Total market profits decrease.
expected value calculation
𝐸𝑉 = 𝑝 × (𝑊 + 𝐺) + (1 − 𝑝) × (𝑊 − 𝐵)
Expected utilty calculation
E𝑈(𝑊 + 𝐺, 𝑊 − 𝐵; 𝑝) = 𝑝 × 𝑈(𝑊 + 𝐺) + (1 − 𝑝) × 𝑈 𝑊 − 𝐵
when will an individual choose to play the lottery
𝐸𝑈 (𝑊 + 𝐺, 𝑊 − 𝐵; 𝑝) > 𝐸𝑈 (𝑊; 1)
when will a risk averse person gamble
This risk-averse person will only take the gamble with very favourable odds.
risk-seeking person
- A risk loving person sees risk as a good. This person take gambles even when the odds are unfavourable. A risk-seeking (risk-loving) person has increasing marginal utility over income (convex utility).
risk neutral person
- A risk neutral person is indifferent towards risk. This person takes all gambles which are fair or favourable.
Risk neutrality implies ..
implies that utility is a straight line; MU is the same at every point.
when does a risk neutral person take a gamble
takes any gamble with fair or favourable odds
assymetric information
Asymmetric information exists whenever a transaction or contract involves one agent (the informed agent) has more information that the other (uninformed agent).
adverse selection defintion
There is relevant information about unobservable characteristics that the informed agent knows but the uninformed agent does not.
Moral Hazard
The uninformed agent cannot observe the behaviour of the informed agent, where this behaviour influences an outcome of interest.
signaling
provides a partial solution to adverse selection. The signal must be credible and correlated with desired unobservable attributes.
