Ib MicroEconomics Notes

Economics Notes Definition of Economics – Economics studies the human behavior involved in satisfying many wants with scarce resources that have alternate uses. The economic problem = SCARCITY Economic resources (or factors of production) = Anything that can be used to make goods and services available. 1) Land free gifts of nature – all natural resources 2) Labor All human input (physical or mental) 3) Capital Man-made aids to production (e.g. tools and machines) and finance 4) Enterprise An entrepreneur combines the other economic resources and takes risks (have to decide what to make/do with the resources – businessman). They organize the other factors of production. Economic goods and free goods Economic goods – goods that require scarce economic resources to be used up Free goods – goods that do not require scarce economic resources to be used up (e.g. sea water, sand) Opportunity Cost The value of the next best alternative given up by a course of action. Example 1 – bought a coke  opportunity cost = fanta What else could you have done/bought as a result instead Example 2 - Could have been at home instead of economics class Due to scarcity we have to make these decisions all the time. If a good or service has an opportunity cost then it must be relatively scarce, so it will have a price and be classified as an ‘economic good.’ A production possibility Frontier (PPF) -A PPF shows all the combinations of two sets of goods which could be produced if all economic resources are fully used (must be on the line if using all economic resources) -The slope/gradient of the PPF represents opportunity cost (all different point on the graph) -In our case, the opportunity cost of agricultural goods increases as we increase Agricultural production -The principal of increasing costs states that as the production of a good expands, the opportunity cost of producing another unit generally increases. This is due to the fact that most economic resources are specialized

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Value Judgments (or a ‘normative statement’) Economics is better than business = Value judgment -Based on opinion/belief -Cannot be proved or disproved as a result of empirical investigation (of the facts)  Economists try to stay away from value judgments ‘Positive Statement’ -Can be proven to be correct or not by empirical investigation Example: Melissa is 1m72 - can measure her height to prove/disprove this. Rationality Economists assume producers, consumers and workers (economic actors) are all rational – expected to work in a way that maximizes our satisfaction. Consumers – max value and lowest prices Producers – get high prices and workers to work as long as possible for lowest possible wages. Acting irrationally = opposite Utility The satisfaction or benefit gained from the consumption of a good or service. Consumers expected to spend their money in a way that maximizes their utility (choose something that gives them the greatest satisfaction. The Margin Consumers often take spending decisions one by one (if they have extra money they may consider the extra utility – producers are alike. They may thing what will happen to their profits if they produce one or more good  operating on the margin.) Economic Growth Economic Growth is an increase in the capacity of an economy to produce goods and services, compared from one period of time to another. It refers to an economy that is getting bigger, not necessarily ‘better.’ Measure of the increase in economic activity or national income per capita. Economic Development Economic development is a measure of welfare or well-being. Measured by Gross Domestic Product (GDP) as well as education, health, and social indicators. Demand and Supply Market In economic theory a market is where buyers and sellers come together to carry out an economic transaction. Markets can be physical places where goods and services are exchanged for money, but there are also other ways that economic transactions can be made such as online where products are sold with the use of credit cards or money transfers. Product markets – where goods and services are bought and sold Factor markets – labor markets, financial markets, stock markets etc…

Demand Demand is the quantity of a good or service that consumers are willing and able to purchase at a given price in a given time period. Willingness and ability – although consumers may be willing, they must be able (have the financial means to buy the product) This is known as effective demand (demand backed up by money - economists not focused on needs or wants) and is shown on the demand curve. A demand curve shows how the quantity demanded of a good or service per unit of time will change as the price of that good changes, holding all other things constant. ‘Cetaris Paribus’ –holding all other things equal/constant. According to the law of demand, more is demanded at a lower price rather than a higher price - why the demand curve (normally) slopes downwards. Demand is influenced by 2 sets of factors 1.The price of the good in question When the price changes, the curve doesn’t change, instead there is movement along the demand curve. Extension in demand – caused by a FALL in price of the good Contraction in demand – caused by a RISE in price of the good Graph

2. Non-price determinants of demand (‘conditions of demand’) a) Prices of related goods Substitutes – if the price of butter rises, the QD for margarine increases. The demand for a good varies directly with the price of its substitute. Complements (products that are often purchased together) – If the price of petrol rises, the price for petrol-thirsty cars will decrease The demand for a good varies indirectly (inversely) with the price of any complement. Unrelated Goods – If products unrelated, the change in price will have no effect on the other. b) Consumer Incomes Normal Goods – defined as goods for which demand rises as income rises (demand curve will increase/shift to the right) Inferior Goods – if a good is considered inferior, the demand for a product will fall as income rises and the consumer starts to buy higher priced substitutes in place of the inferior good. (e.g. Zeeman is an inferior good. If income rises consumers will shop at H&M instead)

c) Fashion, Advertising, etc. d) Demographic Factors Demography – study of population (e.g. as the life expectancy in Holland rises, the demand for certain goods will increase. Diminishing Marginal Utility How much satisfaction/benefit will you get from one more? Why does the demand curve slope downward – marginal utility decreases (if you have one sofa, you would not need another as much.) It is the amount by which the consumption of one more good or service increases total utility. - For most goods MU gets smaller as we consume more but there are exceptions such as heroin and stamps. According to the principle of DMU, additional units of a good make successively smaller contributions to the total satisfaction of the consumer. Since the general MU declines, people will only buy more of a good if the price falls. People will buy more of a good as long as its MU is greater than its price. Optimal Purchase Condition (P=MU) We would imagine someone would continue to buy gold as long as MU is greater than P – the optimal purchase condition. DMU helps explain 1. Why the demand curve slopes downward and 2. Diamonds-water paradox - Not everything that is scarce has lots of value. Measured by marginal utility (different things have different marginal utility.) When we buy goods we are comparing price with marginal utility, NOT total utility. In Holland the MU of water is relatively low which helps explain the low price for water relative to diamonds (Diamonds-water paradox) Consumer Surplus The consumer surplus is the difference between how much buyers are prepared to pay for a good and what they actually pay. Producers will think of ways to reduce consumer surplus if possible. Everyone has different marginal utility; therefore in practice everybody is willing to pay a different amount. Graph

Market demand curve Add up all the individual demands (sum of all individual demand curves) Supply Supply is the willingness and ability of producers to produce a quantity of a good or service at a given price in a given time period. Willingness and ability – although producers may be willing, they must be able (have the financial means to produce the product) This is known as effective supply (supply backed up by money) and is shown on the supply curve. According to the Law of supply, ‘as the price of a product rises, the quantity supplied of the product will usually increase, ceteris paribus.’ – Why the supply curve slopes upwards. Supply is influenced by 2 sets of factors 1.The price of the good in question When the price changes, the curve will remain the same Extension – Caused by a RISE in price of the good Contraction – Caused by a FALL in price of the good (Opposite to demand) Graph

2. Non-price determinants of Supply (‘conditions of supply’) a) Changes in the price of necessary economic resources e.g. a rise in price of labor will mean at any given price less will be supplied (resources needed to make that good) – decrease or increase in supply b) State of technology Improvements in the state of technology will generally cause for an increase in supply. In the event of severe natural disasters there may be a backwards step in state of technology causing a decrease in supply (although unlikely) c) Weather (for some goods) e.g. good harvest conditions will cause the supply of wheat to increase. d) Government Intervention -Government production taxes (VAT/BTW) e.g. an increase in VAT will raise the production cost in effect and supply for any given price. Supply decreases

-Government subsidies (payments made by the government to firms that will, in effect, reduce their costs). Supply increases - shifts to the right e) Price of related goods - Joint supply – when two or more goods are produced together so that a change in the supply affects the supply of another (e.g. beef and leather) -Competitive Supply – goods in competitive supply are alternate products that a business could make with its economic resources (e.g. land used for wheat or corn) f) Expectations e.g. producers may be optimistic (or not) about future sales Graphs

Producer Surplus The difference between the price producers are willing to receive (market price) and the price at which (some) producers are willing to supply. Graph

Producer Surplus + Consumer surplus = Community Surplus Market Equilibrium Equilibrium is where the supply and demand curves intersect (where QD=QS) Shortage and Surplus Surplus – when supply is greater than demand  decrease in price of good Shortage – when demand is greater than supply  increase in price

If there is a surplus, we would expect (in a free market) that the price would fall until it reaches equilibrium. If there is a shortage, the price would rise. In the market economy, the price will adjust in order to equalize QD and QS. * Also known as excess Supply and Demand Graphs

Resource Allocation How we use our resources (they are SCARCE) In a market economy, price has a signaling and incentive function. If the demand for I-pads increases, the price will rise and that will be a sign to Apple to use more resources to make I-pads. If the demand for BlackBerry’s decreases, that will be a signal for fewer resources to be used in their production. If the cost of producing oil increases, the rise in price will be a signal for consumers to economize on their use of petrol. Linear Demand and Supply Functions In economics QD/QS is dependent on P (ceteris paribus). This means that P is the independent Variable and QD/QS is the dependent variable. But in economics it is the convention to put P on the Y-axis and Q on the X-axis. In math slope= Rise/Run In economics slope = Run/Rise (QD/P) Linear demand Function Demand Function = an equation showing the relationship between the market demand for a product and the price of the product.

QD = a – bP QD= Quantity demanded P= Price a= The quantity that would be demanded if price were zero b= sets the slope of the curve A change in the ‘a’ term causes a shift (increase or decrease) in the demand curve. A change in the ‘b’ term causes a change in the steepness/tilt of the line. As the absolute value of the slope rises, the demand curve gets flatter and as the absolute value of the slope

falls, the demand curve will be steeper (demand curve with slope -20 will be flatter than demand curve with slope -10). Linear Supply Function Supply Function = an equation showing the relationship between the market supply for a product and the price of the product.

QS = c – dP QS= Quantity Supplied P= Price c= Quantity that would be supplied if the price were zero d= sets the slope of the curve A change in the ‘c’ term causes a shift (increase or decrease) in the supply curve. A change in the ‘b’ term causes a change in the steepness/tilt of the line. As the value of the slope rises, the supply curve gets flatter and as the absolute value of the slope falls, the supply curve will be steeper (supply curve with slope 500 will be flatter than demand curve with slope 400). Remembering SLOPE - Demand curve= flatter line when smaller slope - Supply curve = flatter line when bigger slope Calculating Equilibrium Price and Quantity Example

Calculating Surplus at a given Price Example

Consumer and Producer Surplus Consumer Surplus – The difference between how much buyers are prepared to pay for a good and what they actually pay Producer Surplus – The difference between the market price producers receive and the price at which they are prepared to supply Producer Surplus + Consumer surplus = Community Surplus Equation  A= ½ bh (area of a triangle) Graph

Allocative Efficiency The sum of consumer and producer surplus equals community surplus -In theory, a free market should lead to the community surplus being maximized so it is the optimum allocation of resources from society’s point of view. Community Surplus If consumers decide they want more of a good, demand increases which raises price – signal for producers to use more resources. If resources become in short supply, the price will rise – sign for consumers to reduce demand for the good. Community Surplus1 – Community Surplus2 = Net Welfare Loss Market Failure (Welfare Loss) If market does not function properly, the price mechanism gives out the wrong signs and resources are not allocated properly in society’s point of view. Monopoly = one company that dominates the market Community Surplus1 – Community Surplus2 = Net Welfare Loss Graph

Government Intervention in the Price Mechanism 1) Minimum Wage The least amount you are legally allowed to be paid. The lower the wage, the more people/workers (more workers as wages fall). As the minimum wage goes up, more people want to work. Graph

For min. wage to have an impact, it must be above the EQ For social reasons, many governments have min. wages to prevent worker exploitation but this simply creates a surplus of unemployed workers and the number of workers in employment falls from EQ to Q1 as a result of the min. wage. 2)Price Ceiling This is a situation where the government sets a maximum price, below the equilibrium price, which prevents producers from raising the price above it. Price ceilings usually set to protect consumers and they are usually imposed in markets where the product in question is a necessity and/or merit good (a good that would be underprovided if the market were allowed to operate freely. e.g. During WW2 there were food shortages which lead the government to implement a price ceiling. This, however, lead to excess demand. The excess demand caused for there to be ‘informal markets’ (black markets) where the products would then be sold for even more than the EP and long queues in shops. Graph

Ways government may try to reduce the shortage: -Shift supply curve to the left (until equilibrium is reached at price ceiling): but this would limit the consumption of the product, which goes against the point of imposing the max price.

-Shift the supply curve to the right (until equilibrium is reached at price ceiling with more being supplied and demanded): 1) government could offer subsidies to the firms to encourage them to produce more, 2) the government could start to produce the product themselves thus increasing supply or 3) if the government had previously stored some of the product, then they could release some of the stock (although not possible with all goods e.g. bread –perishable good). 3)Price Floor This is a situation where the government sets a minimum price, above the equilibrium price, which then prevents the producers from reducing the price below it. Mostly set for one of two reasons: 1) To attempt to raise incomes for producers of goods and services that the government thinks are important, such as agricultural products or 2) to protect workers by setting a minimum wage, to ensure that workers earn enough to lead a reasonable existence. Graph

Elasticity A measure of responsiveness. It measures how much something changes when there is a change in one of the factors that determines it. Price Elasticity of Supply (PES) Definition – The responsiveness of quantity supplied to a change in price. Formula – % change in QS % change in P If PES>1 supply is elastic If PES 1, demand is elastic (very responsive) When PED = 1, there is unit elasticity (% change QD = % change P) Diagrams

Determinants of PED -Availability of substitutes (the more substitutes, the more elastic demand) -Time (the longer the time period considered, the more elastic demanded) -% of income (If a good represents a small % of income, e.g. matches, demand is inelastic) -Degree of necessity (the more it is necessary, the less elastic) PED ≠ slope Even when the demand curve is a straight line, with a constant slope, PED differs at all points along the demand curve. This is because if we consider the top half of the demand curve, where we have high prices and low quantities a change of say 10 units will represents a small proportion of price and a large proportion of QD – therefore demand is elastic. PED and Revenue Boxes 1) rise in price where demand is inelastic

3) rise in price where demand is elastic

2) fall in price where demand is inelastic

4) fall in price where demand is elastic

Cross Elasticity of Demand (XED) Definition – Responiveness of the demand for good X to a change in price of good Y Formula – % change QD good X % change P good Y ± signs are important here! Examples -If the price of mars bars rises 10% and the QD for twix rises 9% XED = 9/10 = 0.9 These two products are substitutes. They always get a positive number. -If the price of petrol falls 10% and the QD for Porsche cars rises 8% XED = 8/-10 = -0.8 These two products are complements. They will get a negative number. -For unrelated goods XED = 0 Unrelated goods will not affect each other.

Most businesses, especially in competitive markets, will have a good idea about relative XED’s. Income Elasticity of Demand (YED) Definition – The responsiveness of QD to a change in income. Formula – % change QD % change Y For normal goods demand rises as income rises – So YED is Positive (+) For inferior goods, as income rises, demand falls – So YED is negative (-) For necessities such as salt, sugar, etc. income demand is relatively inelastic – So we will typically get a number less than 1 but greater than 0 (0