Principles of Microeconomics

Definition

• Economics is the study of how people and societies use their scares resources to produce valuable goods and services and distribute them among different section of society.

Economics

Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices.

Scarcity • means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as a household cannot give every member everything he or she wants, a society cannot give every individual the highest standard of living to which he or she might aspire. •

Scarcity

• Scarcity is situation in which goods are limited relative to desire. • Goods are offered is less than its required • Shortage – Demand greater than supply

Microeconomics Microeconomics is the study of choices that individuals and businesses make, the way those choices interact in markets, and the influence of governments. Macroeconomics Macroeconomics is the study of the performance of the national and global economies.

Production Possibility Frontier-PPF

• Production Possibility Frontier shows the maximum amounts of production that can be obtain by an economy, given its technological knowledge and quantity of inputs available.

Production Possibilities and Opportunity Cost  The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.  To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant.  That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods we’re considering.5

Production Possibilities and Opportunity Cost • Production Possibilities Frontier  Figure 2.1 shows the PPF for two goods: CDs and pizza.

 Any point on the frontier such as E and any point inside the PPF such as Z are attainable.  Points outside the PPF are unattainable.

Economic system • Market Economy • In market economy individuals and firms make major decisions about production and consumption. In market economy a system of price mechanism prevails. Firm adopt low cost of production techniques and fix prices in order to maximize their profit. In market economy price Mechanism plays an important role. In market economy what, how and for whom are three important elements.

Command Economy • In Command economy Govt. makes decisions about what to produce and how to distribute goods and services. All economic resources, such as land; capital and are owned by Govt. All workers are Govt. employees and are paid by Govt. for their services. All lands and factories controlled and managed by the Govt.

Mixed Economy • In mixed economy some sectors of economy are operated by Govt. while others are being managed by private sector. Govt. has an important role in proper functioning of market economy; Govt. enforces certain rules and regulations. Govt. focuses more attention on peace and order through police, better education and health services for the masses.

Two Big Economic Questions Two big questions summarize the scope of economics:

 How do choices end up determining what, how, and for whom goods and services get produced?  When do choices made in the pursuit of self-interest also promote the social interest?

Two Big Economic Questions What, How, and For Whom? Goods and services are the objects that people value and produce to satisfy human wants. What? What we produce changes over time. Seventy years ago, almost 25 percent of Americans worked on farms. Today that number is 3 percent. Seventy years ago, 45 percent of Americans produced services. Today, almost 80 percent of Americans have service jobs.

Two Big Economic Questions Figure 1.1 shows the trends in what the U.S. economy has produced over the past 70 years. It shows the decline of employment in agriculture and in mining, construction, and manufacturing, and the expansion in services. Economics explains these trends.

Two Big Economic Questions How?

Goods and services are produced by using productive resources that economists call factors of production. Factors of production are grouped into four categories:

 Land  Labor  Capital

 Entrepreneurship

Two Big Economic Questions The “gifts of nature” that we use to produce goods and services are land.

The work time and work effort that people devote to producing goods and services is labor. The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, on-the-job training, and work experience. The tools, instruments, machines, buildings, and other constructions that are used to produce goods and services are capital. The human resource that organizes land, labor, and capital is entrepreneurship.

Two Big Economic Questions For Whom?

Who gets the goods and services depends on the incomes that people earn.  Land earns rent.

 Labor earns wages.  Capital earns interest.  Entrepreneurship earns profit.

Economic Coordination  To make coordination work, four complimentary social institutions have evolved over the centuries:  Firms  Markets

 Property rights  Money

Economic Coordination  A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.  A market is any arrangement that enables buyers and sellers to get information and do business with each other.

 Property rights are the social arrangements that govern ownership, use, and disposal of resources, goods or services.  Money is any commodity or token that is generally acceptable as a means of payment.

Economic Coordination • Circular Flows Through Markets  A circular flow diagram, like Figure 2.8 on the next slide, illustrates how households and firms interact in the market economy.

Economic Coordination • Coordinating Decisions  Markets coordinate individual decisions through price adjustments.

Demand If you demand something, then you 1. Want it, 2. Can afford it, and 3. Have made a definite plan to buy it.

Wants are the unlimited desires or wishes people have for goods and services. Demand reflects a decision about which wants to satisfy. The quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at a particular price.

Demand The Law of Demand The law of demand states: Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the larger is the quantity demanded. The law of demand results from  Substitution effect  Income effect

Demand Substitution effect When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded of the good or service decreases. Income effect When the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded of the good or service decreases.

Demand Demand Curve and Demand Schedule

The term demand refers to the entire relationship between the price of the good and quantity demanded of the good. A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.

Demand Figure 3.1 shows a demand curve for energy bars. A rise in the price, other things remaining the same, brings a decrease in the quantity demanded and a movement along the demand curve.

Demand Willingness and Ability to Pay A demand curve is also a willingness-and-ability-topay curve.

The smaller the quantity available, the higher is the price that someone is willing to pay for another unit. Willingness to pay measures marginal benefit.

Demand A Change in Demand

When any factor that influences buying plans other than the price of the good changes, there is a change in demand for that good. The quantity of the good that people plan to buy changes at each and every price, so there is a new demand curve. When demand increases, the demand curve shifts rightward.

When demand decreases, the demand curve shifts leftward.

Demand Six main factors that change demand are

 The prices of related goods  Expected future prices  Income  Expected future income  Population  Preferences

Demand Prices of Related Goods

A substitute is a good that can be used in place of another good. A complement is a good that is used in conjunction with another good. When the price of substitute for an energy bar rises or when the price of a complement of an energy bar falls, the demand for energy bars increases.

Demand Expected Future Prices

If the price of a good is expected to rise in the future, current demand fore the good increases and the demand curve shifts rightward. Income When income increases, consumers buy more of most goods and the demand curve shifts rightward. A normal good is one for which demand increases as income increases. An inferior good is a good for which demand decreases as income increases.

Demand Expected Future Income

When income is expected to increase in the future, the demand might increase now. Population

The larger the population, the greater is the demand for all goods. Preferences

People with the same income have different demands if they have different preferences.

Demand Figure 3.2 shows an increase in demand. Because an energy bar is a normal good, an increase in income increases the demand for energy bars.

Demand A Change in the Quantity Demanded Versus a Change in Demand Figure 3.3 illustrates the distinction between a change in demand and a change in the quantity demanded.

Demand A Movement along the Demand Curve When the price of the good changes and everything else remains the same, the quantity demanded changes and there is a movement along the demand curve.

Demand A Shift of the Demand Curve If the price remains the same but one of the other influences on buyers’ plans changes, demand changes and the demand curve shifts.

Supply If a firm supplies a good or service, then the firm 1. Has the resources and the technology to produce it, 2. Can profit from producing it, and 3. Has made a definite plan to produce and sell it.

Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce. The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price.

Supply The Law of Supply The law of supply states: Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied. The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases (Chapter 2, page 37). Producers are willing to supply a good only if they can at least cover their marginal cost of production.

Supply Supply Curve and Supply Schedule

The term supply refers to the entire relationship between the quantity supplied and the price of a good. The supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same.

Supply Figure 3.4 shows a supply curve of energy bars. A rise in the price of an energy bar, other things remaining the same, brings an increase in the quantity supplied.

Supply Minimum Supply Price A supply curve is also a minimum-supply-price curve. As the quantity produced increases, marginal cost increases. The lowest price at which someone is willing to sell an additional unit rises. This lowest price is marginal cost.

Supply A Change in Supply

When any factor that influences selling plans other than the price of the good changes, there is a change in supply of that good. The quantity of the good that producers plan to sell changes at each and every price, so there is a new supply curve. When supply increases, the supply curve shifts rightward.

When supply decreases, the supply curve shifts leftward.

Supply The five main factors that change supply of a good are

 The prices of productive resources  The prices of related goods produced  Expected future prices  The number of suppliers  Technology

Supply Prices of Productive Resources

If the price of resource used to produce a good rises, the minimum price that a supplier is willing to accept for producing each quantity of that good rises. So a rise in the price of productive resources decreases supply and shifts the supply curve leftward.

Supply Prices of Related Goods Produced

A substitute in production for a good is another good that can be produced using the same resources. The supply of a good increases if the price of a substitute in production falls. Goods are complements in production if they must be produced together. The supply of a good increases if the price of a complement in production rises.

Supply Expected Future Prices

If the price of a good is expected to rise in the future, supply of the good today decreases and the supply curve shifts leftward. The Number of Suppliers The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward.

Supply Technology

Advances in technology create new products and lower the cost of producing existing products, so advances in technology increase supply and shift the supply curve rightward. A natural disaster is a negative technology change, which decreases supply and shifts the supply curve leftward.

Supply

Figure 3.5 shows an increase in supply. An advance in the technology for producing energy bars increases the supply of energy bars and shifts the supply curve rightward.

Supply A Change in the Quantity Supplied Versus a Change in Supply Figure 3.6 illustrates the distinction between a change in supply and a change in the quantity supplied.

Supply A Movement Along the Supply Curve When the price of the good changes and other influences on sellers’ plans remain the same, the quantity supplied changes and there is a movement along the supply curve.

Supply A Shift of the Supply Curve If the price remains the same but some other influence sellers’ plans changes, supply changes and the supply curve shifts.

Market Equilibrium Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price.  Price regulates buying and selling plans.  Price adjusts when plans don’t match.

Market Equilibrium Price as a Regulator

Figure 3.7 illustrates the equilibrium price and equilibrium quantity. If the price is $2.00 a bar, the quantity supplied exceeds the quantity demanded.

There is a surplus of 6 million energy bars.

Market Equilibrium If the price is $1.00 a bar, the quantity demanded exceeds the quantity supplied. There is a shortage of 9 million energy bars. If the price is $1.50 a bar, the quantity demanded equals the quantity supplied.

There is neither a shortage nor a surplus of energy bars.

Market Equilibrium Price Adjustments At prices above the equilibrium price, a surplus forces the price down. At prices below the equilibrium price, a shortage forces the price up. At the equilibrium price, buyers’ plans and sellers’ plans agree and the price doesn’t change until some event changes either demand or supply.

Predicting Changes in Price and Quantity An Increase in Demand

Figure 3.8 shows that when demand increases the demand curve shifts rightward. At the original price, there is now a shortage. The price rises, and the quantity supplied increases along the supply curve.

Predicting Changes in Price and Quantity An Increase in Supply

Figure 3.9 shows that when supply increases the supply curve shifts rightward. At the original price, there is now a surplus. The price falls, and the quantity demanded increases along the demand curve.

Predicting Changes in Price and Quantity All Possible Changes in Demand and Supply A change demand or supply or both demand and supply changes the equilibrium price and the equilibrium quantity.

Predicting Changes in Price and Quantity Change in Demand with No Change in Supply When demand increases, equilibrium price rises and the equilibrium quantity increases.

Predicting Changes in Price and Quantity Change in Demand with No Change in Supply When demand decreases, the equilibrium price falls and the equilibrium quantity decreases.

Predicting Changes in Price and Quantity Change in Supply with No Change in Demand When supply increases, the equilibrium price falls and the equilibrium quantity increases.

Predicting Changes in Price and Quantity Change in Supply with No Change in Demand When supply decreases, the equilibrium price rises and the equilibrium quantity decreases.

Predicting Changes in Price and Quantity Increase in Both Demand and Supply An increase in demand and an increase in supply increase the equilibrium quantity. the increase in demand raises the equilibrium price and the increase in supply lowers it.

Predicting Changes in Price and Quantity Decrease in Both Demand and Supply A decrease in both demand and supply decreases the equilibrium quantity. the decrease in demand lowers the equilibrium price and the decrease in supply raises it.

Predicting Changes in Price and Quantity Decrease in Demand and Increase in Supply A decrease in demand and an increase in supply lowers the equilibrium price. the decrease in demand decreases the equilibrium quantity and the increase in supply increases it.

Predicting Changes in Price and Quantity Increase in Demand and Decrease in Supply An increase in demand and a decrease in supply raises the equilibrium price. the increase in demand increases the equilibrium quantity and the decrease in supply decreases it.

Producer surplus is the difference between what the producer receives for the good and the amount he/she must receive to be willing to provide the good.

It is the area above the supply curve & below the price.

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Consumer surplus is the difference between what the consumer has to pay for a good and the amount he/she is willing to pay.

It is the area under the demand curve & above the price.

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Change in Consumer Surplus: Price Increase

Price New Consumer Surplus Original Consumer Surplus

Loss in Surplus: Consumers paying more P1 Po

Loss in Surplus: Consumers buying less

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Minimum Amount Needed to Supply Qo Qo

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Loss in Efficiency Too High of Price (Price Floor)

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Loss in Efficiency Too Low of Price (Price Ceiling) Price

Deadweight Loss Lost Consumer Surplus

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Loss in Efficiency Taxation STax Price Tax New Consumer Surplus

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Size of Deadweight Loss • The deadweight loss of the tax will depend upon two factors:  The size of the tax  The reduction in the quantity sold

• The reduction in the quantity sold will depend upon the elasticity of demand and supply  The more elastic demand or supply is the larger the deadweight loss will be  If either demand or supply is price inelastic then the deadweight loss will small and could be zero if perfectly inelastic (no change in the quantity sold and consumed)

Loss in Efficiency Subsidy Price

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