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Econ 1101 Lecture Notes Microeconomics
Econ 1101 Lecture Notes Microeconomics
Microeconomics
Zhi Ying Feng
Contents
Thinking as an Economist .................................................................................................................... 2
Comparative Advantage: the Basis for Trade ...................................................................................... 3
Supply and Demand: an Introduction .................................................................................................. 4
Elasticity............................................................................................................................................... 7
Demand: the Benefit Side of the Market ........................................................................................... 11
Perfectly Competitive Supply: the Cost Side of the Market .............................................................. 12
Efficiency and Exchange ................................................................................................................... 15
International Trade and Policies ........................................................................................................ 17
Profit and the Invisible Hand ............................................................................................................. 20
Monopoly and Other Forms of Imperfect Competition ..................................................................... 23
Thinking Strategically ........................................................................................................................ 27
Externalities and Resource Allocation ............................................................................................... 29
Public Goods and Private Goods ....................................................................................................... 32
Information Asymmetry..................................................................................................................... 33
1.
Thinking as an Economist
The fundamental economic problem is that there is scarcity, i.e. our resources are finite and not
enough to satisfy our boundless needs and wants. Therefore, we must make choices and
compromises between competing interests. Microeconomics is the study of small economic units,
such as households, firms and industries that together makes up the entire economy.
Opportunity Cost
Opportunity cost is the cost of an action, implicit and explicit, measured as the value of the next
best alternative to that action.
Cost-Benefit Principle
An individual/firm/society etc. should only take an action if, and only if, the extra benefits from
taking the action are at least as great as the extra costs. We assume ceteris paribus, i.e. only 2
variables change and others remain constant, and everyone is rational.
Economic Surplus
Economic surplus is the difference between the benefits and the costs of an action. An economists
goal is to maximise the positive economic surplus
Pitfalls of Cost-Benefit Principle
Failing to account for all opportunity costs, including time
Measuring costs and benefits as proportions rather than absolute dollar amounts
- Saving $10 off $25 and $10 off $2000 is equivalent in rational decision making
Failing to ignore sunk costs
- Sunk cost is a cost that cannot be recovered and should not affect future decisions
Failing to know when to use averages costs and benefits and when to use marginal cost
and benefits
- Marginal benefit should be considered when expanding production or trials
Average Cost
The total cost of n units divided by n
Marginal Cost
The cost associated with a small increase in unit
or level of activity
Average Benefit
The total benefit of n units divided by n
Marginal Benefit
The benefit associated with a small increase in
unit or level of activity
2.
Comparative Advantage
When one persons opportunity cost of
producing a good or service, or performing a
certain task, is lower than anothers.
3.
A market for any good consists of all the buyers and sellers of that good. Due to scarcity,
production and resources must be allocated
o Central planning: where all economic decisions are made centrally by a small group of
individuals on behalf of a larger group.
o Free market: where production and distribution decisions are left to individuals interacting
in private markets
Market concentration refers to the number and size of firms in a market, while market power is
the ability of an individual firm to influence price by altering output. Any market can have:
- High concentration: small number of large firms, hence high market power
- Low concentration: large number of small firms, hence low market power
- Price takers: those who must accept the market price and have little control over price
- Price makers: those who can control price by restricting output due to little competition
Market Demand and Supply
We analyse market demand and supply under the assumption of ceteris paribus and that the market
is in perfect competition, i.e. no participants has enough market power to set prices:
- Low market concentration
- No government intervention and regulations
- Everyone is a price taker
- No non-price related competition, e.g. advertising, brand names
- Homogeneous products, i.e. all products are identical
- Ease of entry/exit for new sellers
Demand Curve
The demand curve is a representation of the relationship between the amount of a particular good or
service that buyers want to purchase in a given time period and the price of that good or service. If
we add up all the individual demand curves, we have the demand curve of the market.
Changes in demand caused by a change in price occur for 2 reasons:
- Substitution effect: where other goods or services become more or less expensive
relatively, i.e. people switch out to cheaper alternatives
- Income effect: where the purchasing power of a buyers income changes
Supply Curve
The supply curve is a representation of the relationship between the amount of a good or service
that sellers want to supply in a given time period and the price of that good. Supply increases with
price because suppliers can make a greater profit
Buyers reservation price: the most a buyer is willing to pay for a good or service.
Sellers reservation price: the least amount for which a seller would be willing to sell an additional
unit, usually equal to the marginal cost.
Market Equilibrium
In economics, equilibrium is where neither the price nor the quantity of a particular good or service
is changing. The price and quantity to achieve this is known as the equilibrium price and
equilibrium quantity. This point is given by the point of intersection between the demand and
supply curve.
In market equilibrium, all buyers and sellers are satisfied with their respective quantities at the
market price
Change in Equilibrium
o Excess Supply (Surplus): Prices above the equilibrium point leads to competition between
sellers for less demand from buyers, eventually lowering price to equilibrium.
o Excess Demand (Shortage): prices below equilibrium leads to greater demand thus
incentive for more suppliers, eventually raising price to equilibrium
In an unregulated market, any changes to equilibrium will eventually revert back to the
equilibrium. However, in a regulated market, governments may introduce:
- Price ceiling: the maximum allowable price, specified by law
- Price floor: the minimum allowable price, specified by law
Shift in Demand Curve
o Proportional to price of the compliments. Two products are compliments in consumption if
an increase in the price of one causes a fall in demand for the other
o Inversely proportional to price of substitutes. Two products are substitutes in consumption
if an increase in the price of one causes a rise in demand of the other
o A normal goods demand curve shifts right with increase in income, people want more of it
o An inferior goods demand curve shifts left with increase in income, people want less of it
o Increase preference by buyers
o Increase in population of potential buyers
o An expectation of higher prices in the future, people buy more to stock up now
Shift in Supply Curve
o Decrease in costs of inputs
o Improvements in technology that reduces production costs
o Improvements in weather, for agricultural products
o Increase in number of suppliers
o Expectation of lower prices in the future
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Economic Surplus
- Buyers surplus is the difference between the buyers reservation price and the price they
actually pay
- Sellers surplus is the difference between the price received by the seller and their
reservation price
- Total economic surplus is the sum of the buyers surplus and the sellers surplus
The Equilibrium Principle:
A market in equilibrium leaves no unexploited opportunities for individuals, i.e. no cash on the
table, but may not exploit all gains achievable through collective group actions. A market out of
equilibrium still offers surplus but some transaction won't take place so there is surplus, or cash on
table, not exploited.
The socially optimal quantity of any good is the quantity that results in the maximum possible
difference between the total benefits and total costs from producing the good. It takes into account
of all costs, not just monetary costs. E.g. total cost of car production also takes into account the
pollution it emits.
Therefore, socially optimal quantity is usually different to the actual equilibrium quantity, which
only takes into account private costs. When a quantity of a good is:
- Less than the socially optimal quantity, boosting production increases the surplus of benefits
over costs
- More than the socially optimal quantity, reducing its production increases total surplus
Economic efficiency occurs when all goods and service in the economy are produced and
consumed at their respective socially optimal quantities. It reflects how efficiently resources are
being used. A market is ONLY efficient if it is in equilibrium i.e. no cash on table.
The Efficiency Principle:
Efficiency is an important social goal, because when the economic pie grows larger, it is possible
for everyone to have a larger slice
4.
Elasticity
Elasticity is the measure of the responsiveness of one variable to changes in another variable that
determines it. The price elasticity of demand for a good is a measure of the responsiveness of the
quantity demanded of that good to changes in its price.
Price elasticity of demand () is equal to the percentage change in quantity demanded that results
from a 1% change in its prince:
% change in quantity demanded
% change in price
Elasticity
1 Elastic
demand
1 Unit elastic
demand
1 Inelastic
demand
Effect
The good is elastic with respect to price so a small % change
in price results in a large % change in quantity demanded
Any % of change in the price of the good will result in an
equal % change in quantity demanded
the good is inelastic with respect to price so that a large %
change in price will only result in a small change in quantity
demanded
Example
Overseas
holidays
Table salts,
anti-snake
venom
Q P
P Q
P
Q
1
m
Note:
- Price elasticity decreases along the demand curve
- Price elasticity is greater for curves with greater gradient
point along a horizontal demand curve. This means that even the slightest increase in price
results in the consumers completely abandoning the product in favour of substitutes
o Perfectly inelastic demand
along a vertical demand curve. This means that consumers will not, or cannot, switch to
substitutes even if the prices increase significantly
Elasticity determines whether increase in price will increase or decrease total expenditure:
1 , changes in price is always in OPPOSITE direction to change in total expenditure
- If
1 , changes in price is always in SAME direction to change in total expenditure
- If
1 , changes in price has NO EFFECT on total expenditure
- If
8
Q P
P Q
P
Q
1
m
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5.
The law of demand states that the quantity demanded of a good or service in a given time period
declines as its price increases, ceteris paribus. Demand is a result of peoples wants for satisfaction.
Utility is a measure of the satisfaction or happiness people get from their consumption activities,
measured by an abstract unit utils. Utility maximisation is then the assumption that rational
people try to allocate their incomes so as to maximise their utility. Marginal utility is the additional
utility gained from consuming an additional unit of a good in a given period
The law of diminishing marginal utility is the tendency for additional utility gained from
consuming an additional unit of a good in a given time period to diminish as consumption increases
beyond a certain point. By this law, marginal utility will become negative at some point.
Allocation of Fixed Income between Two Goods
Law of diminishing marginal utility imply that spending it all on a single good is not a good idea.
Instead, rational people should aim for the optimal combination of goods, i.e. the affordable
combination of goods that yields the highest total utility, in order to maximise utility.
To do so, we follow the rational spending rule, which states that spending should be allocated
across goods and services so that the marginal utility per dollar is the same for each good.
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6.
The law of supply states that an increase in price results in an increase in quantity supplied, ceteris
paribus. The supply curve has an increasing slope because suppliers exploit their most attractive
opportunities first, i.e. the principle of increasing opportunity cost.
Production Time Periods
o Short run: period of time sufficiently short that at least one factor remains fixed but long
enough to change some variable factors, although existing fixed factors can be used more
o Long run: period of time of sufficient length to vary all factors, i.e. no fixed factors
Factors of Production in Short Run
o Variable factors of production: an input that changes in the short as the output of a
particular good or service produced in a given time period changes, e.g. labour
o Fixed factors of production: an input that does not change as the output of a particular
good or service produced in a given time period changes, even if output is zero
The law of diminishing return states that in the short run when at least one factor is fixed,
successive increase in input of a variable factor eventually makes less and less of a difference to
output. This is due to the eventual overcrowding or overusing of a fixed factor. This means that
increase production of a good eventually requires larger and larger increase in input of a variable
factor.
Production Costs
Average Fixed Cost (AFC)
AFC is the total fixed cost divided by the total output quantity. The AFC decreases with quantity as
the fixed cost spread among a greater quantity of outputs.
TFC
AFC
and lim AFC 0
Q
Q
Average Variable Cost (AVC)
AVC is the total variable cost divided by the total output quantity. The AVC decreases initially due
to specialisation, but increases afterwards as the law of diminishing return takes place.
TVC
AVC
and lim AVC
Q
Q
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Profit
Profitable IF P
ATC
Q P
ATC
ATC
When the curves of MC, ATC and AVC are graphed together, the marginal cost curve must
intersect the average total cost curve (ATC) and the average variable cost curve (AVC) at their
respective minimum points
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Maximum-Profit Condition
For a firm to maximise their profit, they should supply at a quantity such that the price (P) at that
quantity is equal to the marginal cost, assuming output and employment can be varied continuously.
Graphically, it is where y P intersects the marginal cost curve.
Therefore, for a firm in a market where:
- P MC then INCREASING output INCREASES profit
-
Measuring Profit
Profit can be measured graphically, it is the region bound between the rectangle formed by the price
and the rectangle formed by the ATC
Profit ( P ATC ) Q
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7.
Pareto efficiency is a state where there is no opportunity for exchange or trade that will make at
least one person better off without harming others. Pareto efficiency occurs when market is at
equilibrium. When the market is out of equilibrium, it is always possible to make a Paretoimproving transaction, one that benefits at least one person without harming others.
Price Ceilings
A price ceiling is a government imposed limit on the price of a product/service.
Under perfect competition, the market of milk reaches equilibrium at $1.4/litre, this results in
maximum economic surplus of $1800. However, with a price ceiling of $1, producers will only
supply 1000 litres so their surplus is reduced to $100. Also with the low supply, only those with
willing to pay $1.80 or more can afford milk. The total lost in surplus is $800
Price Subsidies
Subsidy is when government pays the producers directly so that consumers can purchase the
product at a lower cost.
Normally, the consumers in this country will receive $4,000,000 surplus per month. Since the
country can import as much milk as it wants, the supply is perfectly elastic. With a $1/litre subsidy,
the price consumer pays for a litre of milk drops to $1, which leads to a total of 6 million litres
consumed per month. Seemingly, consumer surplus would have increased by $5,000,000 However,
the cost of subsidy is paid for by taxpayers and its equal to $6,000,000 per month, so economic
surplus has actually reduced by $1,000,000
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The equilibrium price increased by $0.50, since the $1 tax is essentially an increase in marginal
cost. Therefore, although only sellers were taxed, buyers now have to pay $0.50 more for a burger
and suppliers pay $0.5 more to make a burger. The tax also reduces the economic surplus, as the
size of the triangle decreased. The area would have decreased from $9000 to $6250 but they also
pay $2500 les tax elsewhere so the total loss in surplus is $250. This is known as the deadweight
loss, the reduction in total economic surplus that arise when a market does not operate where
marginal cost equal to marginal benefit. The rectangle represents tax revenue.
Taxes, Elasticity and Efficiency
In general, for goods with smaller the price elasticity of demand or supply for a good, the smaller
is the deadweight loss from a tax imposed on seller of that good. E.g. salt is inelastic so, if a 50%
tax was placed upon it people would still buy it so there is minimal loss of surplus. Therefore, it is
more efficient to tax sellers for goods with lower price elasticity of demand or supply
E.g. consider the deadweight loss in the following two markets with different elasticity of demand
In both markets, the original equilibrium is the same. However, the demand in (b) is more inelastic
than (a) since its gradient is larger. So with tax, the deadweight loss represented by the triangle is:
A a 0.5 1 5 $2.5
A b
0.5 1 3
$1.5
So the good with a less elastic demand has less deadweight loss as a result of tax
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8.
In general:
- If the price of a good in a closed economy is greater than the world price, the economy
becomes a net importer of that good
- If the price of a good in a closed economy is less than the world price, the economy
becomes a net exporter of that good
Winners and Losers from Trade
Although international free trade benefits the economy as a whole, some groups within the
economy are better off while others are worse off.
a) Consumers benefit from lower prices from imports so they can consume more. Therefore,
consumer surplus increases by the sum of the purple and green area. Domestic producers
lose because they now have to sell at lower prices, so producer surplus decreases by the
purple area.
b) Consumers lose because they now have to pay higher prices and consume less, so consumer
surplus decreases by the purple area. Domestic producers benefit from being able to sell at
higher prices as economy opens up to international trade at world prices. Thus, producer
surplus increases by the sum of the purple and green area
In general:
- When a good is imported, domestic consumers benefit and producers suffer
- When a good is exported, domestic consumers suffer and producers benefit
Protectionist Policies
Protectionism is the use of policies intended to protect domestic industries from competition, since
producers are hurt when imported goods are cheaper than domestically produced goods. Free trade
allows countries to specialise in the production of those in which they have the greatest comparative
advantage. This makes the economic pie as big as possible whereas protectionism prevents this and
thus protectionist policies are inefficient. However, producers are better organised politically so
they are often successful in lobbying for trade barriers.
Instead, the gains from free trade should be used to compensate the loss producers suffer, or at least
reduce its impact, such as retraining workers for other sectors.
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Import Tariff
Tariff is a tax imposed on an imported good which essentially raises the world price of that good,
allowing domestic producers to raise their prices of that good to match the new world price while
consumers must pay more. This decreases
demand and increases supply, so the
difference between demand and supply, i.e.
the amount imported, decreases.
The clear winners are the domestic
producers, who can now charge more for
their products. Government also win because
they collect revenue from tariffs, which is
equal to the bright blue area in middle.
However, total economic surplus decreases,
so there is deadweight loss
Deadweight Loss:
- Consumption Loss (green area): some people can't afford anymore, so less is bought
- Production Loss (purple area): loss of efficiency, as resources taken from other goods,
where they are more efficiently produced
Import Quota
Quota is a legal limit on the quantity of a good
that can be imported. At world price, the
quantity that needs to be imported is qD qS
but by limiting it with a quota, producers now
need to supply more to cover the demand. For
producers to do that, price has to rise as an
incentive. Thus it can be thought of a shift in
supply to match the new price as well.
The market effect of quota and tariff is exactly
the same, if the quota is set to permit the same
level of import as the tariff. However, with a
quota, the government collects no revenue!
With quotas, the revenue that wouldve gone to the government with a tariff instead goes to firms or
individuals that have the right to import the good. E.g. importers of computers can purchase them at
world price on international market, and then sell them at a higher price in domestic market to
pocket the difference.
With Tariff
With Quota
Decrease
Decrease
Consumer surplus
Increase
Increase
Producer surplus
Increase
No effect
Government surplus
Decrease
Decrease
Economic surplus
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9.
20
The existence of economic profit entices others to enter the apple market. This causes the supply to
increase, so equilibrium price decreases and thus each producer makes less economic profit.
As long as economic profit exists in the apple market, price will continue to fall until it is at the
minimum value of ATC. At this point, there is NO more economic profit.
However, if the initial price was below the ATC due to demand curve being lower than the previous
case, then producers make an economic loss:
If this low demand persists, apple growers will keep leaving the market. Eventually, this will push
prices back up to the minimum value of ATC for a normal profit, thus no need to quit anymore
In conclusion, for firms in a competitive market that pose no barriers to entry or exit, all firms will
tend to earn zero economic profit (normal profit) in the long run. This also reflects the no cash on
table principle, as people always exploit opportunities for gains, in this case either by entering for
the profits or leaving the market to pursue profits elsewhere
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Graphically:
- Marginal revenue curve meets the demand curve at the y-intercept
- Marginal revenue curve cuts the x-axis at half of the demand curve
Monopolists Profit Maximising Rule
By the cost-benefit principle, monopolist should continue to expand output as long as the marginal
revenue exceeds marginal cost. Profit maximisation rule is the same as perfectly competitive
markets, i.e. marginal benefit to marginal cost, just that now marginal benefit doesnt equal to price!
a) Profit is maximised at selling 20 million minutes per day, however the firm still suffers
$400,000 economic loss because the profit maximising price is less than ATC
b) The firm makes an economic profit because the profit maximising price is greater than ATC
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When both prisoners play their dominant strategy, i.e. confess, they will get 5 years each. However,
if both played their dominated strategy, i.e. deny, then they will get 1 year each only.
By colluding, both firms capture half the market (500 out of 1000) and make an economic profit of
$500, as given by the profit maximising condition where MR equals MC (marginal cost is zero).
However, if firm X decides to cut prices to $0.9 per bottle, then it will capture the entire market
demand of 1100 and make an economic profit of $990. Now firm Y must also match this new price,
otherwise it will make zero profit. By matching the price, both again split the market but now only
make $495 economic profit, less than the $500 before. This cycle will continue until there is no
more economic profit for either firm.
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Coase Theorem
The Coase theorem states that if people can negotiate, at no cost, the purchase and sale of the right
to perform activities that cause externalities, they will arrive at efficient solutions to the problems
caused by the externalities.
E.g. Consider Ruth whose factory dumps toxic waste into the river which harms fisherman Hugh.
Ruth can install a filter at a cost to remove this harm, how should Hugh negotiate?
With Filter
Without Filter
Hugh Pays $40 for Filter
$100
$130
$140
Gain to Ruth
$100
$50
$60
Gain to Hugh
Hugh should offer $40 to Ruth for the filter, this way both are $10 better off for a net gain of $20
Legal Remedies for Externalities
Legal remedies such as laws help people to reach efficient solutions where negotiation is difficult.
These laws generally require the adjustments to be made by the party that can do it with the lowest
cost. E.g. restrictions on loud music are often on late weekend nights, because the cost of loud
music to other people is less on weekend than weekdays.
Market-Based Instruments (MBIs)
MBIs are policies that positively influence the behaviour of people in markets to achieve targeted
outcomes, i.e. to lower production of goods that generate negative externalities.
Price Based MBIs
Price based MBIs include:
- Subsidies to encourage activities with positive externalities
- Taxes to discourage activities with negative externalities
Both tax and subsidy should be equal to the external cost/benefit in order to achieve socially
optimal levels. They make the economy more efficient by making produces take account of relevant
social cost that they ignore as a profit maximising firm
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