Unit 2: Microeconomics Flashcards
Demand
The quantity of a good or service that consumers are willing and able to purchase at a given price
Theory of demand
States that price of good increase = quantity demand decrease, and vice-versa
Ceteris paribus
All other things being equal (assumption in theory of demand/supply)
Economic theory assumptions
Consumers want to maximize utility (satisfaction gained from consumption) and are rational
Marginal utility
The additional satisfaction a consumer gains from consuming one additional unit of a good
Law of diminishing marginal utility
Marginal utility declines as more of good is consumed, hence price consumer is willing to pay for additional unit decreases, and hence there is an inverse relationship between quantity demanded and price
Why price increase = quantity demanded decrease
Income effect and substitution effect
Income effect
Price increase means consumers can afford less
Substitution effect
Price increase causes some consumers to switch to alternative good/service
Leftward movement along supply/demand curve
Contraction
Rightward movement along supply/demand curve
Expansion
Non-price determinants of demand
- substitute goods (actions of competitors)
- publicity
- demographic changes
- global events
- speculation
- marketing
- seasonality
- government policy
- trends/tastes
Price elasticity of demand (PED)
Measures responsiveness of quantity demanded to a price change
Price elastic demand
Price change leads to a proportionally greater change in quantity demanded (flatter demand curve, PED > 1)
Price inelastic demand
Price change leads to a proportionally smaller change in quantity demanded (steeper demand curve, PED < 1)
Unit elastic demand
Quantity demanded changes in proportion to price (PED = 1)
Determinants of PED
- number and closeness of substitutes
- necessity of good
- proportion of income spent on good
- brand loyalty
- time period under consideration (demand more elastic in long run)
Calculating PED
%∆Qd / %∆P
Percentage change
difference / original value (x 100)
Interpreting PED
Always negative and written as such, but negative ignored to interpret value
Revenue
Money earned by a business from selling good/service (price x quantity)
Revenue for price elastic good/service
Price decrease = higher revenue
Revenue for price inelastic good/service
Price increase = higher revenue
Primary commodities PED
More inelastic (due to higher necessity, less substitutes)
Manufactured goods PED
More elastic (due to lower necessity, more substitutes)
Supply
The quantity of a good or service that producers are willing and able to produce/sell at a given price
Theory of supply
States that price of good increase = quantity supplied increase, and vice-versa
Why price increase = quantity supplied increase
Incentive of higher revenue/profits (incentivizes producers to enter market)
Non-price determinants of supply
- changes in costs of factors of production
- random shocks (e.g. natural disasters, weather, conflict)
- government intervention (e.g. taxes, subsidies)
- profitability of producing alternative products
- technological changes (can reduce costs of production)
- joint supply (production process yields multiple outputs)
- number of firms in market
Price elasticity of supply (PES)
Measures responsiveness of quantity supplied to a price change
Price elastic supply
Price change leads to a proportionally greater change in quantity supplied (flatter supply curve, PES > 1)
Price inelastic supply
Price change leads to a proportionally smaller change in quantity supplied (steeper supply curve, PES < 1)
Unit elastic supply
Quantity supplied changes in proportion to price (PES = 1)
Fully inelastic supply
Quantity supplied not at all responsive to price change (vertical supply curve, PES = 0)
Determinants of PES
- mobility of factors of production (how quickly can production change in response to price)
- storage of product (how long can it be stored)
- time period under consideration (longer time under consideration = supply more price elastic, as factors of production are fixed in short term but can be changed in long run)
Calculating PES
%∆Qs / %∆P
Market
Interaction of consumers (demand) and sellers/producers (supply)
Point where supply = demand
Equilibrium (or market clearing price)
Functions of prices in a market
- Signalling function (determine how resources should be allocated)
- Rationing function (reduce demand for scarce resource)
- Incentive function (change behaviour of consumers/producers)
Price mechanism
- Demand/supply curve shifts due to non-price determinant
- Disequilibrium at original price due to excess demand/supply signals to producers to increase/decrease prices
- Expansion/contraction along demand curve due to price change rationing demand/incentivizing buying—more/less people willing and able to buy due to income effect
- Expansion/contraction along supply curve due to price change incentivizing/disincentivizing production—more/less suppliers willing and able to supply due to increased/decreased profits
- New equilibrium price/quantity forms and market clears at P1 Q1
Consumer surplus
Difference between what a consumer is willing to pay for a good and the price they actually pay (top half of left sector)
Producer surplus
Difference between the price a firm would be willing to receive for a good and the actual price they receive (bottom half of left sector)
Consumer + producer surplus
Community (social) surplus
Community surplus maximized at market equilibrium
Allocative efficiency / optimal allocation of resources
Stakeholder
Individual/group/organization that can affect or be affected by economic activity
Stakeholder diagram (impact of price mechanism on buyers/sellers)
[see image]
Primary commodity
Unprocessed raw material of agricultural or mineral origin
Price gouging
Practice of increasing the prices of goods, service, or commodities to a level much higher than is considered reasonable after a demand or supply shock
Reasons not to price gouge
- bad publicity
- might cause government to intervene and cap prices
- legal issues
- higher prices incentivize more producers to enter market
Price ceilings (maximum prices)
When the government/market regulator sets a maximum price which prevents producers/suppliers raising the price above it
Price ceilings diagram
[see image]
Impacts of price ceiling
- market disequilibrium due to excess demand
- can lead to black market activity where shortage causes more consumers to be willing and able to purchase at a higher price
How to resolve disequilibrium due to price ceiling
- government/regulator can resolve disequilibrium by subsidising production of good by amount needed to cover shortage
- introducing a rationing system (as in WWII)
Government expenditure on subsidising production of good to resolve excess demand after maximum price
Pmax X (Qd – Qs)
Impact on stakeholders and welfare (price ceiling)
- producer revenue decreases (increases, if PED is elastic and government subsidises shortage)
- producer surplus decreases
- consumer surplus increases (if PED is elastic OR government subsidises shortage) / decreases if PED is inelastic
- deadweight welfare loss
Arguments for price ceilings
- protect consumers from rising prices of essential goods/services
Arguments against price ceilings
- create disequilibrium in market
- costs of subsidies require government spending which either requires increased taxes, government borrowing, or incurs an opportunity cost in reducing spending elsewhere
- black market activity – promotes illicit activity, violence, and heavier tax burden on law-abiding citizen (as black market is not taxed)
- inefficiency – create deadweight welfare loss due to reduced community surplus
Price floors (minimum prices)
When the government sets a minimum price to prevent producers/suppliers from reducing the price below it
Price floors in agriculture
- common for governments of developed economies to set floor price for agricultural commodities
- want to protect food supply (in order to be self-sufficient in case of war/sanctions/natural disasters)
- agricultural commodities’s prices are unstable (thus revenues are inconsistent, yet costs tend to be stable)
Price floors diagram
[see image]
Government expenditure on buying excess supply in order to maintain a guaranteed minimum price
Pmin X (Qs – Qd)
Government maintaining guaranteed minimum price
- buying excess supply is effective for non-perishable goods
- they can be stored (additional costs) and released during shortage
- profitable if prices are higher when goods are released
Impact on stakeholders and welfare (price floor)
if government does not buy up excess supply
- producer revenue decreases
- producer surplus increases (decreases if PED elastic)
- consumer surplus decreases
- deadweight welfare loss
Arguments for price floors
- incentivize suppliers of essential goods to stay in market by guaranteeing producer revenues
- discourage overconsumption of demerit goods
Arguments against price floors
- create disequilibrium in market
- costs for government of buying up excess supply to maintain guaranteed minimum price either require increased taxes, government borrowing, or incur an opportunity cost in reducing spending elsewhere
- unintended consequences (consumers buying from abroad, reducing money entering local economy)
- inefficiency – create deadweight welfare loss due to reduced community surplus
Demerit good
Good/service that consumption of which is unhealthy, degrading, or socially undesirable
Indirect tax
A tax on expenditure, paid by seller who may pass the tax on to consumers in form of higher prices
Two types of indirect taxes
- Specific tax – where tax is levied as a fixed amount (e.g. excise duties put on demerit goods)
- Ad-valorem tax – where tax is levied as percentage of selling price (e.g. value-added tax (VAT) on most goods/services in UK)
Specific tax diagram
[see image]
Ad-valorem tax diagram
[see image]
Impact on stakeholders and welfare (indirect tax)
- government tax revenue
- producer revenue decreases
- producer surplus decreases
- consumer surplus decreases
- deadweight welfare loss
Evaluation of indirect taxes
- elasticity of good (less effective when PED inelastic)
- unintended consequences (e.g. black market—neither decreases consumption nor raises tax revenue)
- setting right tax level difficult
- inefficient allocation of resources (deadweight welfare loss)
Production subsidy
An amount of money paid by the government to a producer per unit of output
Production subsidy impact
Lowers cost of production for producers allowing for increased output of good
Reasons for production subsidy
- lower price of essential goods
- guarantee food supply within country
- make domestic producers more competitive in international markets
Production subsidy diagram
[see image]
Impact on stakeholders and welfare (production subsidy)
- government expenditure
- producer revenue increases
- producer surplus increases
- consumer surplus increases
- deadweight welfare loss
Evaluation of subsidies
- government incurs opportunity cost
- inefficient allocation of resources (expenditure > community surplus increase)
- dumping
Dumping
Selling below costs of production of over-subsidized/over-produced agricultural products (HICs to LEDCs)—predatory pricing hurts farming industry of LEDC
Consumption subsidy
An amount of money paid by the government to a consumer to encourage them to purchase a good/service
Consumption subsidy
[see image]
Consumer incidence (indirect tax)
Seller raises price to cover part of tax
Producer incidence (indirect tax)
Seller pays part of tax by accepting less revenue
Consumer/producer incidence diagram (indirect tax)
[see image]
Consumer incidence (subsidy)
Producer incidence (subsidy)
Consumer/producer incidence diagram (subsidy)
[see image]
