Dr E’s Study Guide for ECO 012
i. Introduction to Microeconomics
The Economic Way of Thinking
“It [economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.”
– John Maynard Keynes
Guideposts to Economic Thinking
The use of scarce resources to produce a good is always costly.
– There are no free lunches.
» Goods produced by the public sector have an opportunity cost.
Decision-makers choose purposefully; therefore, they will economize.
– Economizing behavior accomplishes an objective at the least possible cost
– Utility is the subjective satisfaction derived from the choice of a specific alternative.
Incentives matter
– Human choice is influenced in a predictable way by changes in economic incentives.
Economic thinking is marginal thinking.
– Marginal choices involve the effects of net additions or subtractions from the current conditions.
Although information can help us make better choices, its acquisition is costly.
– Purposeful decision-makers do not have perfect knowledge when making choices.
» Expected benefits versus cost of gathering information
Economic actions often generate secondary effects.
– Secondary effects are the consequences that are indirectly related to the initial policy and felt only with the passage of time
The value of a good or a service is subjective.
– Preferences differ among individuals.
» How individuals value items is seldom known perfectly.
» The value of a good or service depends on many factors.
The test of a theory is its ability to predict.
– Economic theory is developed from the analysis of how incentives will affect decision-makers.
» Economists seek to predict the general behavior of a large number of individuals.
Opportunity Cost
– The opportunity cost of a choice is the highest valued alternative that must be sacrificed because one chooses an option.
– Opportunity cost is subjective.
» It exists in the mind of the decision-maker.
» The opportunity cost of the same event may differ among individuals.
– Cost may have both a subjective and objective (monetary) component.
– Opportunity Cost and the Real World
» Changes in opportunity cost will influence decisions.
Transaction Costs
– Transaction costs are the costs of time, effort, and other resources necessary to search out, negotiate, and conclude an exchange.
– Transaction costs reduce our ability to gain from mutually advantageous potential trades.
Property Rights
Property Rights
– The right to use, control, and obtain the benefits from a good or service
» Exchange takes place when property rights change hands.
– Exist when property rights are exclusively controlled by one owner and are transferable to others.
– Private property rights link responsibility to authority, thereby making owners accountable for their actions.
– Owners gain by employing resources in beneficial ways, lose by bearing the opportunity cost of ignoring the wishes of others.
– Private owners have strong incentives to properly care for their items.
– They have incentive to conserve for the future.
– Those who are negligent can be held accountable for changes due to misuse of their property.
Specialization and Division of Labor
Division of Labor
– A method that breaks down the production of a commodity into a series of specific tasks, each performed by a different worker.
– Often leads to enormous gains in overall output per worker.
» Allows individuals to take advantage of their existing skills and abilities.
» Allows the development of more skills through specialized experience.
» Allows complex, large scale production techniques.
Gains From Specialization and Comparative Advantage
– The law of comparative advantage states that output of a group is always greatest when the output of each good is produced by the one with the lowest opportunity cost.
– When opportunity cost differs, potential gains from trade are present.
» Applies to individuals, firms, and regions
– Gains from trade are a key to economic progress.
Personal Motivation and Specialization and Exchange
– People are motivated by the pursuit of personal gain.
– In a market economy, individuals have an incentive to specialize voluntarily in areas of production where they are a low opportunity producer.
Marginal Benefit vs. Marginal Costs
All of this implies that individuals make their decisions by weighing the costs and benefits of the action. Specifically they weigh the marginal benefits and the marginal costs of the action. Marginal benefit is the additional amount of benefit the individual receives from one more unit of the thing that is generating the benefit. Marginal costs the additional cost that one more unit will produce. As long as the marginal benefit of an additional unit of the object of their desire is greater than or equal to the marginal cost, it is worth consuming one more unit. For example, if a family has two children and the extra benefit of a third child is greater than the cost, they will have one more child. At that point the marginal costs of a fourth child may outweigh the benefit, so they will stop. Marginal benefit and marginal cost analysis thus determined for this family that they will end up with three kids.
ii. Supply and Demand: Revisited
Consumer Choice and the Law of Demand
Law of Demand
– As the price of a product decreases, other things constant, buyers will increase the quantity of the product demanded.
» The price of a good is negatively related to the quantity demanded.
The Market Demand Schedule
– Height of demand curve indicates the maximum price that consumers are willing to pay for an additional unit of a product.
Producer Choice and the Law of Supply
What Producers Do
– They convert resources into commodities and services.
– They pay the opportunity cost for resources used.
– They desire profits motivating them to supply goods.
– Profit is residual "income reward" granted to decision-makers who increase the value of the resources.
– Loss results when consumers value a product less highly than the opportunity cost of the resources used to produce the product.
Supply and the Entrepreneur
– To prosper, entrepreneurs must use resources in a way that increases their value.
Market Supply Schedule
– Law of supply
» As the price of a product increases, other things constant, producers will increase the amount of the product supplied to the market.
» The amount of a good supplied is positively related to the price of that good.
– Height of supply curve indicates the minimum price necessary to induce producers to supply an additional unit of a product.
Supply and Demand Interact
The Market
– An abstract concept that encompasses the forces generated by the buying and selling decisions of economic participants.
Equilibrium
– State of balance between conflicting forces such as supply and demand.
Short-Run Market Equilibrium
– In the short run, firms do not have time to adjust fully to changes in market conditions.
– Short-run equilibrium is attained when supply and demand are in balance.
Long-Run Market Equilibrium
– The long run is a period of time sufficient to fully adjust to a market change.
– In long run equilibrium, supply and demand must be in balance.
– In long run equilibrium, supply and demand must be in balance.
– The selling price must equal the producer's opportunity cost of production.
– In long run equilibrium, supply and demand must be in balance.
– The selling price must equal the producer's opportunity cost of production.
– Firms are neither earning economic profit nor suffering economic loss.
Shifts in Demand
Shifts in Demand Versus Changes in Quantity Demanded
– A change in demand shifts the demand curve.
– A change in quantity demanded is a movement along the same curve.
Factors that Cause Shifts in Demand
– Changes in income
– Changes in the price of a related good
» Substitutes perform similar functions or fulfill similar needs.
» Complements are consumed jointly.
– Changes in consumer preferences
– Changes in the expected future price of a good
Shifts in Supply
Shifts in Supply Versus Changes in Quantity Supplied
– A change in supply shifts the supply curve.
– A change in quantity supplied is a movement along the same curve.
Factors That Cause Shifts in Supply
– Changes in resource prices
– Changes in technology
– Changes in taxes or regulations on sellers
– Changes in expected future prices
Time and the Adjustment Process
Time and the Adjustment Process
– Market adjustments of producers and consumers will be more complete with the passage of time.
– Both demand and supply are more elastic in the long run than in the short run.
Repealing the Laws of Supply and Demand
Price Ceilings
– A price ceiling is a legally established maximum price that sellers may charge.
– Price ceilings cause shortages.
» Shortages can be eliminated by allowing price to rise, which will encourage production and discourage consumption.
– Secondary effects of price ceilings:
» Reduction in the quality of the good.
» Inefficient use.
» Lower future supply.
» Nonprice rationing will be of more importance.
Price Floors
– Result in surpluses
» The surplus can be eliminated by allowing price to fall, which will encourage consumption and discourage production.
The Invisible Hand Principle
How the Invisible Hand Works
– Market prices tend to direct individuals pursuing their own interests into productive activities that also promote the economic well-being of society.
Communicating Information to Decision-Makers
– Prices communicate up-to-date information about consumer valuation of additional units of numerous commodities.
Coordinating Actions of Market Participants
– Prices coordinate the decisions of buyers and sellers.
– Price changes signal shortages or surpluses, and create profit (and loss) opportunities for entrepreneurs.
Motivating the Economic Players
– Individuals have a strong incentive to provide productive resources in exchange for income.
Prices and Market Order
– Market order is the result of market prices, not central planning.
Qualifications
– The efficiency of market organization is dependent upon the presence of competitive markets and well-defined and enforced private property rights.
iii. The Market and Government Intervention
PROBLEM AREAS FOR THE MARKET
Market Failure and Property Rights
· Market Failure
Market failure is often caused by a lack of securely defined private property rights.
· External Costs and Property Rights
Property rights give owners the exclusive right to control and benefit from their resources as long as their actions do not harm others.
Property rights provide legal protection against the actions of parties who might damage, abuse, or steal property.
- External costs are the harmful effects of an individual’s ora group’s action on the welfare of a nonconsenting secondary party, not accounted for in market prices.
· Enforceable Property Rights and Information
Owners must be able to show the rights have been violated to legally enforce property rights.
- High cost of information can make property rights unenforceable.
· Common Property Resources
Resource for which rights are held in common by a group of individuals, none of whom has a transferable ownership interest.
If access is unrestricted, a common property resource is called an open-access resource.
- The use of an open-access resource generates external costs and the resource will be over-utilized.
· External Costs and Benefits
Group or individual action that spills over and has a detrimental or beneficial effect on the well-being of third parties.
- Result in a divergence between price and social cost.
- Social cost is the sum of private and external costs.
- Private and social costs will be equal if there are no external costs.
- When external costs are present, market prices understate the social cost of resource use.
When external costs are present, there is a net loss to the community.
- When external benefits are present, the market demand curve understates the social gains of conducting the activity.
- Potential social gains go unrealized because no single decision-maker can capture the gains fully.
Public Sector Responses to Externalities
· Pollution Tax Approach
User’s charge is applied to the polluting activity.
A pollution tax promotes efficient resource allocation by reducing the supply of the pollution-intensive good by increasing its cost of production.
- Higher production costs encourage firms to use less polluting production methods. Problems with the approach:
- Problems with the approach:
Some pollution continues
Difficult to estimate true damage costs
Emission controls must be monitored
Very high taxes may put firms out of business and increase unemployment
· Maximum Emission Standard Approach
Regulators choose a tolerable level of total pollution and require all producers to reduce pollution to that level.
Fines are imposed on those that do not comply.
- Although more costly, it is more often imposed than the more efficient pollution
tax.
· Transferable Emission Rights
Program under which each firm in an industry is assigned a maximum level of acceptable pollution and is allowed to sell any “right to pollute” it does not use to other firms.
· Specific Prescription Approach
Regulators specify the methods polluting firms must use to reduce or eliminate pollution
This approach is the least efficient response to externalities.
· Should Government Always Try to Control Externalities?
Little net gain is likely if the economic inefficiency resulting from externalities is small compared to the cost of government action.
- Markets often find reasonably efficient means of dealing with externalities. Government action may impose an external cost on secondary parties.
Market Failure: Public Goods
· Public Goods
- Public goods are non-excludable and non-rival in consumption.
A good is non-excludable if producers cannot exclude those who do not pay.
A good is non-rival in consumption if consumption by one person does not
reduce the good’s availability to others.
· The Free Rider Problem
- A free rider is one who receives the benefits of a good without paying toward its costs.
Sufficient amounts of public goods may not be provided by the market because non-paying consumers cannot be excluded.
Market Failure: Poor Information
· Getting Your Moneys Worth
- There is a harmony of interest between producers and consumers on repeat purchase items.
- Producers will be better off if consumers receive accurate information and are satisfied with the products purchased.
- The probability of customer dissatisfaction is increased by the presence of inadequate information.
- Goods are difficult to evaluate on inspection and are seldom purchased from the same producer.
Goods are capable of serious and lasting harmful side effects.
· Entrepreneurs and Information
- Entrepreneurial sellers have an incentive to bridge the information gap with consumers.
- To bridge the information gap, firms establish franchises or build national reputations through advertising.
· One-Sided Information
The asymmetric information problem occurs when one party knows more than the other.