1.

Microeconomics
1.1 Competitive Markets: Demand and Supply
Markets
Scarcity
- The fact that resources are limited but the wants and needs of humans are unlimited
- Due to scarcity resources must be allocated
- In economy, every good or service that is priced is scarce relative to the people’s
demand for this product (it has to be priced and sold at a cost)
- The basic economic problem
 What should be produced?
 How should things be produced?
 Who should these things be produced for?

Factors of production
- Inputs that are used in order to produce goods or services as an attempt to make profit
 Land
 Labour
 Capital
 Entrepreneurship
Risk taking and things people do when bringing other factors of production
together

Economic growth and development

- Economic growth
An increase in country’s output measured by GDP. (Only related to monetary
measures)

- Economic development
When economic development occurs, the standard of living of a country’s citizens are
improving
 When compared to economic growth it considers much more aspects such as:
 HDI
 Life Expectancy
 Literacy rates and school enrollment
 GDP Per capita

- Sustainable development
Economic development that meets the needs of the current situation and does not
compromise meeting needs for the future generation

Planned and free market economies

- Planned Economies
 The decision of what to produce, how to produce, and who to produce are made
by the government

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 Resources are collectively owned by the state and the government arranges all
production, wages, prices
 All decisions of the market are made by the government and in theory, for the best
interests of the people

- Free market economies (capitalism)

 Prices are used to ration the goods and services
 Demand and supply set the wages and prices in the economy
 Economy works relatively efficiently and with less surpluses/shortages
 Individuals make their own independent decisions
 Producers make decisions based on their personal interests of profit
 The change in demand from consumers will make the producers reallocate factors
of production in order to meet the needs of the consumer.

- Mixed economies
 All economies are mixed economies in reality
 Degrees of freedom varies from country to country
 Dangers exist within the free market if it is left completely uninterfered

Demand
The willingness and ability of a consumer to purchase a quantity of a good or service at a
certain price in a given time period.

- A change in the price of a product will change the quantity demanded of a product (a
movement)

- Factors that leads to a SHIFT in the demand curve

 Income & Income distribution
 Change of prices of competing goods
 Tastes of consumer
 Changes in season

- Excess demand
 Occurs when a firm lowers its prices
The excess demand will normally drive the lowered prices back up to the equilibrium
where the supply of the goods can meet the demand at the given price

Supply
The Law of Supply
- As price increases, quantity supplied also increases
- This is a POSITIVE (or DIRECT) CASUAL RELATIONSHIP
- It's POSITIVE because => Two variables change in the same direction
- It’s CASUAL because => Changes in price causes Changes in quantity supplied

Market Supply
- The Sum of all individual firms’ supplies for a good

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- Indicates the total quantities of good that firms are willing and able to supply in the
market at different possible prices, and is given by the sum of all individual supply of
that good

Supply Curve
- The supply of an individual firm indicates
- The various quantities of good/service a firm is willing and able to produce
- Supply to the market for a sale at different possible prices, during a particular time
period
- Ceteris Paribus: The effect of one economic variable on another, holding constant all
other variables that may affect the second variable.

Non-price Determinants
Changes in the determinants of supply cause shifts in the supply curve
- Rightward shift means that for a given price, supply increases and more is supplied
- Leftward shift means that for a given price, supply decreases and less is supplied

Non-price determinants of market supply:

- Cost of factors of production
- Technology
- Prices of related goods: competitive supply
- Prices of related goods: joint supply
- Producer (firm) expectations
- Taxes (indirect taxes or taxes on profits)
- Subsidies
- The number of firms
o “Shocks” or sudden unpredictable events

Movement along supply curve and shift of supply curve

- MOVEMENT: Change in price produces a change in quantity supplied, represented by
a movement on the supply curve
- SHIFT: Change in non-price determinants of supply produces a change in supply,
represented by a shift of the whole supply curve

Market Equilibrium
Equilibrium is defined as a state of balance between different forces, such that there is no
tendency to change

When quantity demanded is equal to quantity supplied, there is market equilibrium; the
forces of supply and demand are in balance, and there is no tendency for the price to change

Changes in market equilibrium

- Once price reaches its equilibrium level, consumers and firms are satisfied and will
not engage in any action to make it change
- However, if there is a change in non-determinants of demand or supply, shift in
the curves results, and the market will adjust to a new equilibrium

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The Role of Price Mechanism
Price mechanism: moves market into equilibrium.

- Scarce resources are allocated and reallocated in response to changes in price.

- Price signals are given to producers what consumers wish to buy
- Price changes as a result of change in equilibrium.
- A higher price would provide incentives to firms to produce more, since there is a larger
profit.

Opportunity cost: The next best alternative forgone.

When a choice is made, there is an opportunity cost.

Market Efficiency
Producer & consumer Surplus
1. Consumer surplus: is the extra satisfaction gained by consumers from paying a price
that is lower than that which they are prepared to pay.
2. Producer surplus: is the excess of actual earnings that a producer makes from a given
quantity of output, over and above the amount the producer would be prepared to
accept for that output.

Allocative efficiency happens when competitive market is in equilibrium, where resources are
allocated in the most efficient way from society’s point of view.
 Social surplus (consumer + producer surplus) is maximized.
 Marginal social benefit = Marginal social cost

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1.2 Elasticity
Price Elasticity of Demand (PED)
The responsiveness of quantity demanded to a change in price

%∆𝑄
Measured by PED = %∆𝑃

PED value is treated as if it were positive although its mathematical value is usually negative

Values are: Terms used are: Given a change in P:

PED > 1 price elastic demand %ΔQ is larger

0 < PED < 1 price inelastic demand %ΔQ is smaller

PED = 1 unitary price elastic demand %ΔQ is equal

PED → ∞ infinitely price elastic demand %ΔQ is infinite

PED = 0 perfectly price inelastic demand %ΔQ is zero

When PED is elastic, firms should lower their price to get more revenue because in that case
demand will increase more than the price will decrease. The opposite will be the case when
PED is inelastic. When PED = 1, the firm should leave the price at the current level; revenue is
maximised at this point.

Governments want to tax goods with an inelastic PED because demand changes less than the
price increase due to the tax, so they can make more tax revenue on these goods.

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The size of the price elasticity of demand is influenced by the following factors:
- The number and closeness of substitutes: The more substitutes, the higher PED. If
there are a lot of substitutes, consumers can easily switch to another product when
the price of the product increases.
- The degree of necessity: The higher the need for the product, the lower PED.
Consumers will buy goods they need anyway, regardless of the price. Examples include:
food and gasoline.
- The time period over which PED is measured: The longer this time period, the higher
PED. In the long run, consumers have more time to look for alternatives / substitutes
for a good. They will switch more often if the price of the good increases.
- The proportion of income spent on the good: The smaller this proportion, the lower
PED. When the proportion of income spent on a good is low, consumers will not notice
or care about a price change and still buy the same proportion of the good.
- The type of good: Primary commodities (i.e. materials in raw unprocessed state) have
a lower PED than manufactured commodities. Primary commodities are necessary for
producers in order to produce. They will buy them anyway, regardless of the price that
is asked for them.

Applications of PED
- Predict the direct of change of its revenues given a price range (e.g. a firm wishing to
increase its revenues will lower the price of a good if demand for it is thought to be
price elastic)
- PED for many primary commodities is relatively low because they are a “need” not a
“want”; vice versa for manufactured products.
- PED allows a government to estimate the size of the necessary tax required to
decrease consumption of demerit goods.

Cross Elasticity of Demand (XED)

The responsiveness of demand for one good (x) to a change in price of another good (y)
To measure the effect a change in price of one product has on the demand for a
certain other good.

%∆𝑄𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑓𝑜𝑟 𝑔𝑜𝑜𝑑 𝑋

Measured by XED = %∆𝑃 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑌

Interpretations of XED
- If XED > 0 then x and y are substitutes, which means they are in competitive demand
(i.e. substitute goods)
- If XED < 0 then x and y are complements, meaning that they are jointly demanded (i.e.
complementary goods)
- If XED = 0 then x and y are unrelated.
- The relationship between the goods is showed by the magnitude of the XED.

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Income Elasticity of Demand (YED)
The responsiveness of the quantity demanded for a good or service to a change in income of
the people demanding those goods, ceteris paribus

%∆𝑄
Measured by YED = %∆𝐼
- Q is the quantity demanded
- I is the Income of the people

Interpretations of YED
- A normal good has an Income Elasticity of Demand > 0 (Demand for a normal good
increases as consumer income increases).
- An inferior good has a Income Elasticity of Demand < 0 (Demand for an inferior good
decreases as consumer income decreases).
 Eg. clothes and bags from night markets, if you are wealthy it is less
likely for you to purchase those instead of more expensive wants
- YED > 1 are usually luxury goods which are income elastic, which means that consumer
demand is more responsiveness to a change in income.
- 0 < YED < 1 are goods that are relatively inelastic, which means that consumer
demand rises less proportionately in response to an increase in income.
- YED = 0 means that the demand for the good isn’t affected by a change in income.

Price Elasticity of Supply (PES)

The responsiveness of quantity demanded to a change in price

%∆𝑄
Measured by PES = %∆𝑃

The outcome of PES is typically positive (because there is a positive relationship between price
and quantity demanded)

Values are: Terms used are: Given a change in P:

PES > 1 price elastic supply %ΔQ is larger

0 < PES < 1 price inelastic supply %ΔQ is smaller

PES = 1 unitary price elastic supply %ΔQ is equal

PED → ∞ infinitely price elastic supply %ΔQ is infinite

PES = 0 perfectly price inelastic supply %ΔQ is zero

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Determinants of PES
- Mobility of factors of production: The more mobile factors of production are, the
easier it is for producers to buy and sell them. This means it is easier for producers to
increase or decrease production, therefore the PES will be more elastic.
- Unused capacity: When producers have a lot of unused capacity, it will be easier to
increase production if necessary, therefore the PED will be more elastic.
- Ability to store stocks: If a firm is able to store high levels of stock of their product,
they will be able to react to price increases with swift supply increases and therefore
the PES for the product will be relatively high.
- The time period over which PES is measured: PES will be higher when it is measured
in the long run since companies will have more time to adjust production to price
levels. In the short run producers often can’t change supply by that much.
- Type of goods: Primary commodities typically have a low PES while manufactured
commodities often have a high PES. This is due to the higher necessity of primary
goods (in manufacturing and general usage) compared to manufactured goods.

PES may be used to decide whether the government should apply taxes to a certain product.
- If the PES is very elastic, government might not choose to apply too much tax or else
the supply decreases dramatically.

1.3 Government Intervention

Indirect Taxes
Indirect taxes are the money that the government forces the producers / consumers to pay
when a product is consumed

Governments impose taxes to:

- To generate Government revenues:
Excise duties on beers, wines and spirits are price inelastic in demand, so tax price
increases by levying specific alcohol and tobacco taxes raise consumer expenditures
as a whole on these categories and therefore taxation revenues

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- To discourage consumption:
Government might use taxes to discourage consumption of certain demerit goods
such as cigarettes.

- To alter the pattern of consumption:

Government might use direct taxes a mean to alter the consumption pattern of its
population.
Certain goods can be made more price attractive through lower taxes while goods
which have high marginal social cost can be made expensive through taxation.

Excise taxes: specific taxes on goods (regressive)

- Specific Taxes: Specific tax is a flat rate of tax ad valorem tax is a percentage tax.
- The amount of specific tax changes in the same proportion as the quantity sold
increase
- Income inequality
Ad valorem tax: Percentage tax (Proportional)
- Ad valorem the tax collected is more at higher prices than at lower prices.

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Impact on market:
- Incidence: Incidence of tax means the party who actually pays the tax.
- Government revenue: the amount of tax government will receive as revenue
- Resource allocation: the amount of fall in quantity demanded and produced created
by the tax
- Consumers: Increase price level, could change consumption patterns, discourages
spending
- Producers: Increase production cost, lower efficiency

Subsidy
A subsidy is an financial assistance paid by the government to a firm per unit of output

Governments provide subsidies to:

- Lower the cost of necessary goods
- Might affect major part of population. Eg. essential food items and oil.
- Guarantee the supply of merit goods (government thinks consumers should consume)
- Protectionism internationally

Consequences of subsidies
- Reduces the cost of production
- Could cause inefficiency
- Inefficient allocation of resources
- Producers:
 Blue + Purple: Producer subsidies
(producing at a cheaper price)
 Orange: revenue for producers
- Consumer: Pink -- Consumer subsidies (paying at
a lower price for the initial Q)
- Government: opportunity cost
 Blue + Pink + Purple = Total subsidies
given

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Price Controls
A price control is a measure by the government that forces producers to sell goods for a fixed
price or for a price within a certain range. In this section we will discuss two price controls: (1)
the maximum price (price ceiling) and (2) the minimum price (price floor).

Price Ceiling (maximum price)

Government determines that there is great potential for high prices, and makes a goal of
keeping prices low.

With a price ceiling the government sets a maximum price, which lies below the equilibrium
price, beyond which producers are not allowed to raise the price. The government can do so
to protect consumers against high prices. As you can see in the diagram, in the case of a price
ceiling the demand will be greater than the supply. An excess demand will thus exist. (e.g rent)

Effects:
- Shortages: Quantity supplied is much lower than quantity demanded. This artificially
low price has caused more demand for the product. Producers cut production in
response to the lower price. Some consumers will not be able to have access to goods
that are previously available to them
- Non price Rationing: Without price to guide the rationing of the good, consumers and
producers will use other means to determine who receives the product. Such as
waiting in line for a scarce good
- Welfare loss: the market won’t be at equilibrium, consumer and producer surplus are
not maximised.
- Elimination of allocative efficiency: As market price is set by government, society is
not producing enough of the good with the price ceiling in place
- Informal (Black) markets: Due to shortages, some consumers have strong may obtain
goods informally or from the black market.

Price Floor (minimum price)

Governments may artificially increase the prices of some goods and resources.

The government may believe that a good is important or necessary, or it may be supporting
employment in a particular industry. The motivation and effects of price floor depends on the
good itself.

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With a price floor, the government sets a minimum price which lies above the equilibrium
price. Below, producers are not allowed to lower the price. The government can do so to
protect producers against large fluctuations in prices (e.g. agricultural products) or to protect
workers (e.g. setting a minimum wage). As you can see in the diagram, in the case of a price
floor supply will be greater than demand. An excess supply will thus exist.

Effects:
 Surplus: At the original equilibrium price there is no surplus as demand is equal to
supply. In price floor quantity supplied is greater than quantity demanded, creating
surplus
 Welfare loss. The market won’t be at equilibrium, consumer and producer surplus are
not maximised.
 Cost inefficiency: Higher price increases production from Qe to Qs, level above what
could satisfy the market at the original equilibrium. Higher-cost production is
inefficient, and uses resources that could be devoted to other things
 Allocative inefficiency: High price inspires producers to produce at a quantity of
output at which marginal cost is above marginal benefit, therefore market
overproduces
 Informal markets: Firms may choose to sell their surplus at price below equilibrium,
which is illegal.

1.4 Externalities
An externality occurs when production or consumption of a good has an effect on a third
party for which the latter does not pay or does not get compensated.
 This effect can be positive (benefit) in which case we speak of positive externalities.
Examples include getting educated. The third party that would benefit in this case
would be the society in general.
 This effect can be negative (cost) in which case we speak of negative externalities.
Examples include pollution from the production of a good, which hurts society (the
third party).

Definitions
- Market Failure = failure of the market to achieve allocative efficiency resulting in an
overallocation or under allocation of resources. Caused by cost/benefit of third party

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- Marginal private costs (MPC) = costs of production that are taken into account in a
firm’s decision making process. The MPC curve is equal to the supply curve.
- Marginal private benefits (MPB) = benefits the individual enjoys from the
consumption of an extra unit of a good. The MPB curve is equal to the demand curve.
- Marginal social cost (MSC) = cost of production to society.
- Marginal social benefit (MSB) = benefit of consumption of one extra unit to society.

Ideal Market
In the ideal situation, the marginal social costs are equal to the marginal private costs and the
marginal social benefits are equal to the marginal private benefits (so MPC = MSC, MPB =
MSB). The price is determined at the intersection of the demand and supply curves, which
also means that the marginal social costs are equal to the marginal social benefits (so MSC =
MSB).

When MSC=MSB, there is no market failure

Externalities of Production
Negative Externalities of Production
- Overproduction of products that
are unfriendly to environment
- Solution: Per unit tax (eg carbon
tax), tighter regulations -> Shift
MPC left

Positive Externalities of Production

- Caused by underproduction of
goods
- Solution: Subsidies/direct
provision (government
production) -> shift MPC right

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Externalities of Consumption
Negative Externalities of Consumption
(caused by demerit goods)
- Over Consumption of demerit
goods causing welfare loss
- Solution: Tax demerit goods ->
shift MPB left

Positive Externalities of Consumption

(caused by merit goods)
- Caused by under consumption
of products such as vaccination
- Solution: Subsidise merit
goods -> shift MPB right

Other source of Market Failure

Lack of Public Goods
Public goods (e.g. dams) have the following two characteristics:
- They are non-rivalrous: more people can use the good at the same time e.g. a dam
protects more people at the same time.
- They are non-excludable: people can’t be excluded from the use of the good e.g. in
the case of a dam, people living in the protected area can’t be excluded from the
protection by the dam.

In economics we also recognise private goods (e.g. tickets to a concert) which have the
following characteristics:
- They are rivalrous: the good can’t be used by more people at the same time e.g. tickets
to a concert can only be used by one person to enter.
- They are excludable: people can be excluded from the use of the good e.g. someone
checking for tickets could deny people entry.

Private firms will not supply public goods because few people will pay for it if they can use it
anyway; this is called the free rider problem. Governments can solve this by providing the
public goods themselves paying for them using taxes.

Common Access Resources, Threat to Sustainability

Common access resources are resources that everyone has access to so it is very hard to
exclude people from using them (e.g. fishing grounds, fossil fuel reserves, water, fishes).

The lack of a pricing mechanism on these resources may cause overuse or depletion. This
poses a threat to sustainability.

For example, poverty in developing nations often leads to overexploitation of agricultural land.

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What can the government do to solve this problem?
 Legislation to forbid or limit the use of some common access resources.
 Carbon taxes to make sure companies will use less common access resources that
eventually lead to the emission of carbon dioxide such as oil, coal and natural gas.
 Cap and trading schemes for companies to trade rights to emit carbon dioxide. This
has the same effect as carbon taxes, but also limits the emission to a predetermined
level because there is a certain maximum of rights to be traded.
 Funding for clean technologies so companies will use fewer resources.

But government responses are limited because:

 The problems have a global nature. They can only be solved if all countries and
governments act against them, otherwise companies will just move to countries
where the laws are less strict.
 There’s lack of ownership of the common access resources. Often no one feels
responsible for solving the problem.
 Effective responses require international cooperation, see above.

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