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Semester 1: Principle of Micro Economics
Problem of scarcity and choice: scarcity, choice and opportunity cost; production possibility frontier
Problem of scarcity and choice
Understanding Scarcity
Scarcity refers to the situation where human wants exceed the resources available to satisfy those wants. It is a fundamental economic problem faced by all societies. Scarcity forces individuals and societies to make choices about how to allocate limited resources.
Choice and Decision Making
Due to scarcity, choices must be made regarding the allocation of resources. Individuals, businesses, and governments must evaluate their options and make decisions that reflect their priorities and goals. Choice involves trade-offs, where selecting one option means forgoing another.
Opportunity Cost
Opportunity cost is the value of the next best alternative that is foregone when a choice is made. It highlights the cost of scarcity and the necessity of making choices. Understanding opportunity cost is essential for effective decision-making in both personal and economic contexts.
Production Possibility Frontier (PPF)
The Production Possibility Frontier illustrates the maximum output combinations of two goods that can be produced given fixed resources. The PPF demonstrates scarcity, efficiency, and choice by showing trade-offs. Points inside the frontier indicate inefficiency, while points outside are unattainable with current resources.
Application in Economics
Scarcity and choice are central to economic theory. They influence how markets function, how prices are determined, and how resources are allocated. Understanding these concepts helps in analyzing economic behavior and policy decisions.
The economics of Information: search costs, searching for lowest price, search and advertising; Asymmetric information: market for lemons and adverse selection; moral hazard
The economics of Information
Search Costs
Search costs refer to the time, effort, and resources expended by consumers to find information about products and prices. High search costs can limit consumers' ability to make informed choices, leading to market inefficiencies.
Searching for Lowest Price
Consumers often engage in price search to find the best deals. This process can be affected by search costs and information asymmetry. Technology has reduced search costs, allowing more consumers to efficiently compare prices.
Search and Advertising
Advertising serves as a tool to reduce search costs by providing information about products and prices. However, it can also lead to information overload or mislead consumers.
Asymmetric Information
Asymmetric information occurs when one party has more or better information than another. This can lead to market failures, as seen in the market for lemons.
Market for Lemons
The concept of the market for lemons explains how asymmetric information can lead to a lack of quality in the market. Sellers have more information about product quality than buyers, leading to adverse selection.
Adverse Selection
Adverse selection refers to situations where sellers have information that buyers do not, leading to higher-risk or lower-quality products dominating the market.
Moral Hazard
Moral hazard occurs when one party is incentivized to take risks because they do not bear the consequences of those risks. In the context of information, this can lead to poor decision-making and exploitation of asymmetric information.
Demand and supply: law of demand, determinants of demand, shifts of demand versus movements along a demand curve, market demand, law of supply, determinants of supply, shifts of supply versus movements along a supply curve, market supply, market equilibrium
Demand and Supply in Microeconomics
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The law of demand states that, all else being equal, as the price of a good decreases, the quantity demanded increases, and vice versa.
Downward sloping demand curve.
Giffen goods and Veblen goods.
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Factors that cause changes in demand for a good or service, independent of its price. These include:
Consumer preferences
Income levels
Prices of related goods (substitutes and complements)
Consumer expectations
Number of buyers
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A shift in the demand curve occurs due to changes in determinants other than price, resulting in a new demand curve.
Movements along the demand curve occur due to changes in the price of the good itself.
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The total quantity of a good or service demanded across all consumers in a market at various price levels.
Sum of individual demand curves.
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The law of supply states that, all else being equal, an increase in price results in an increase in quantity supplied, and vice versa.
Upward sloping supply curve.
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Factors that lead to changes in supply irrespective of the price. These include:
Production costs
Technology advancements
Prices of related goods
Supplier expectations
Number of sellers
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Shifts in the supply curve occur due to changes in determinants other than price, leading to a new supply curve.
Movements along the supply curve occur due to changes in the price of the good itself.
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The total quantity of a good or service that all producers are willing to sell at various prices.
Sum of individual supply curves.
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The point at which the quantity demanded equals the quantity supplied, resulting in a stable market price.
Changes in demand and supply can shift the equilibrium point, affecting price and quantity.
Applications of demand and supply: price rationing, price floors, consumer surplus, producer surplus
Applications of demand and supply
Price Rationing
Price rationing occurs when the price of a good or service adjusts to balance supply and demand. In a competitive market, if demand exceeds supply, prices will rise, which reduces demand and increases supply until equilibrium is reached. Price rationing helps to allocate scarce resources efficiently.
Price Floors
A price floor is a minimum price set by the government, below which a good or service cannot be sold. It is typically used to protect producers' incomes, ensuring they receive a certain level of compensation. Common examples include minimum wage laws and agricultural price supports. Price floors can lead to surpluses if the minimum price is above the equilibrium price, as supply exceeds demand.
Consumer Surplus
Consumer surplus is the difference between what consumers are willing to pay for a good or service and what they actually pay. It represents the benefit consumers receive when they purchase a product for less than the maximum price they are willing to pay. Changes in demand and supply can affect consumer surplus, which is an indicator of consumer welfare.
Producer Surplus
Producer surplus is the difference between the market price producers receive for a good or service and the minimum price they are willing to accept. It reflects the benefit producers receive from selling at a higher price than their minimum acceptable price. Like consumer surplus, producer surplus can change due to shifts in supply or demand, indicating the overall welfare of producers in the market.
Elasticity: price elasticity of demand, income elasticity of demand, cross elasticity of demand, arc and point elasticity, point elasticity and total expenditure, price elasticity of supply
Price Elasticity of Demand
Price elasticity of demand measures how quantity demanded responds to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. If the absolute value is greater than 1, demand is elastic; if less than 1, it is inelastic; if equal to 1, it is unit elastic.
Income Elasticity of Demand
Income elasticity of demand indicates how quantity demanded changes in response to a change in consumer income. It is calculated as the percentage change in quantity demanded divided by the percentage change in income. If greater than 1, the good is a luxury; if between 0 and 1, it is a necessity; if negative, it is an inferior good.
Cross Elasticity of Demand
Cross elasticity of demand measures the responsiveness of the quantity demanded for one good when the price of another good changes. It is calculated as the percentage change in quantity demanded of Good A divided by the percentage change in price of Good B. Positive values indicate substitutes, while negative values indicate complements.
Arc and Point Elasticity
Arc elasticity calculates elasticity between two points on a curve, using the average of the two quantities and prices. Point elasticity measures elasticity at a specific point, using derivatives to find the slope of the demand curve at that point.
Point Elasticity and Total Expenditure
Point elasticity can be linked to total expenditure (total revenue). If demand is elastic, a price decrease will increase total expenditure. If demand is inelastic, a price decrease will reduce total expenditure.
Price Elasticity of Supply
Price elasticity of supply measures how much the quantity supplied changes in response to a change in price. It is calculated as the percentage change in quantity supplied divided by the percentage change in price. Supply is elastic if the value is greater than 1 and inelastic if less than 1.
Consumer Theory: Budget constraint, concept of utility, diminishing marginal utility, Diamond-water paradox, income and substitution effects; consumer choice: indifference curves, Some applications of indifference curves
Consumer Theory
Budget Constraint
A budget constraint represents the combinations of goods and services a consumer can purchase given their income and the prices of those goods. It is a linear representation in a two-dimensional space, with one good on each axis. The slope of the budget line is determined by the relative prices of the goods.
Concept of Utility
Utility is a measure of satisfaction or pleasure derived from consuming goods and services. It is subjective and varies from person to person. The total utility is the overall satisfaction from consumption, while marginal utility refers to the additional satisfaction from consuming one more unit of a good.
Diminishing Marginal Utility
The principle of diminishing marginal utility states that as a consumer consumes more units of a good, the additional satisfaction from each subsequent unit decreases. This concept is crucial in understanding consumer choice and demand.
Diamond-Water Paradox
The diamond-water paradox illustrates the difference between total utility and market price. While water provides essential utility for survival, diamonds, which are non-essential, command higher prices due to their scarcity. This highlights the concepts of value, price, and subjective utility.
Income and Substitution Effects
The income effect occurs when a change in the price of a good alters a consumer's purchasing power, affecting the quantity bought. The substitution effect occurs when a change in price makes one good more attractive relative to another, leading consumers to substitute one for the other in their consumption choices.
Consumer Choice and Indifference Curves
Indifference curves represent combinations of two goods that provide the same level of satisfaction to the consumer. Higher curves represent higher levels of utility. Consumers choose combinations of goods based on their preferences and budget constraints.
Applications of Indifference Curves
Indifference curves can be used to analyze consumer behavior in various scenarios, such as determining the optimal consumption bundle, understanding the impact of price changes, and assessing the effects of changes in income on consumption choices.
Production and Costs: behaviour of profit maximizing firms, production process, production functions, law of variable proportions, choice of technology, isoquant and isocost lines, cost minimizing equilibrium condition
Production and Costs
Behavior of Profit Maximizing Firms
Profit maximizing firms aim to produce at a level where marginal cost equals marginal revenue. This ensures that firms maximize their profits by choosing the optimal output level. Firms analyze their cost structures and pricing strategies to achieve this goal.
Production Process
The production process involves transforming inputs into outputs. It encompasses the techniques, labor, machinery, and materials used to produce goods and services. Efficiency in the production process is crucial for minimizing costs and maximizing productivity.
Production Functions
A production function describes the relationship between input quantities and output quantities. It can be represented mathematically and shows how many units of output can be generated from a given set of inputs, highlighting concepts like returns to scale.
Law of Variable Proportions
The law of variable proportions states that as we increase one input while holding others constant, the marginal product of that input will eventually decline after a certain point. This principle is fundamental in understanding how firms optimize input usage.
Choice of Technology
The choice of technology impacts production efficiency and costs. Firms select technologies based on their productivity, cost-effectiveness, and suitability to the production process. Technological advancements can lead to improved production functions.
Isoquant and Isocost Lines
Isoquants represent combinations of inputs that produce the same level of output, while isocost lines show combinations of inputs that cost the same amount. Analyzing these lines helps firms identify optimal input combinations for cost minimization.
Cost Minimizing Equilibrium Condition
The cost minimizing equilibrium occurs when a firm achieves the lowest possible cost for a given level of output. This condition is met when the ratio of the marginal products of inputs is equal to the ratio of their prices, ensuring optimal resource allocation.
Costs: costs in the short run, costs in the long run, revenue and profit maximizations, minimizing losses, short run industry supply curve, economies and diseconomies of scale, long run adjustments
Costs in Economics
Costs in the Short Run
In the short run, at least one factor of production is fixed. Costs can be categorized as fixed costs, which do not change with the level of output, and variable costs, which do change. Short-run average cost curves typically show U-shaped behavior due to increasing and then diminishing returns. Businesses must manage these costs carefully to ensure profitability.
Costs in the Long Run
In the long run, all factors of production are variable. Firms can adjust their scale of production and adopt new technologies. The long-run average cost curve represents the lowest possible cost of producing each level of output when adjustments have been made. This curve is influenced by economies of scale.
Revenue and Profit Maximization
Profit maximization occurs when marginal cost equals marginal revenue. Firms analyze their output levels to determine the quantity of goods to produce that maximizes profits. This involves assessing market demand and adjusting production to avoid overproduction or underproduction which can either lead to losses or missed opportunities.
Minimizing Losses
In the short run, firms may continue to operate at a loss if they can cover their variable costs. By minimizing losses, firms can maintain operations until market conditions improve. Identifying the shutdown point is crucial as it indicates the level of output where total revenue equals total variable costs.
Short Run Industry Supply Curve
The short run industry supply curve is derived from the individual supply curves of all firms in the market. It reflects the total quantity supplied by all producers at different prices. Factors influencing this curve include the number of firms, input prices, and technology.
Economies and Diseconomies of Scale
Economies of scale occur when increasing the scale of production leads to a decrease in average costs, often due to operational efficiencies. Diseconomies of scale occur when firms grow too large, resulting in increased per-unit costs due to factors such as management inefficiency or difficulties in coordination. Analysing these can help firms determine optimal production levels.
Long Run Adjustments
In the long run, firms can adjust all inputs to achieve a more efficient scale of production. This can involve scaling up or down depending on market conditions, technology changes, and competition. Long run adjustments are critical for sustaining competitiveness and adapting to market dynamics.
Market Structures: Perfect Competition - assumptions, firm equilibrium in SR and LR, long run industry supply curve, welfare; Imperfect Competition - Monopolistic competition, oligopoly models including game theory
Market Structures
Perfect Competition
Imperfect Competition
Theory of a Monopoly Firm: short run and long run price and output decisions, social cost of monopoly, price discrimination, remedies for monopoly
Theory of a Monopoly Firm
Short Run Price and Output Decisions
In the short run, a monopoly firm maximizes profit by setting output where marginal cost equals marginal revenue. The firm faces a downward sloping demand curve, leading to a price that is higher than marginal cost. The firm can earn supernormal profits due to its market power.
Long Run Price and Output Decisions
In the long run, a monopoly may adjust its output and pricing strategies. Barriers to entry prevent other firms from entering the market, allowing the monopoly to maintain higher prices and profits. Long run adjustments may involve investments in technology and efficiencies to reduce costs.
Social Cost of Monopoly
The social cost of monopoly includes allocative inefficiency and productive inefficiency. Consumers pay higher prices and consume less than in competitive markets, leading to misallocation of resources. Deadweight loss represents the lost welfare that occurs due to the reduced quantity of goods produced.
Price Discrimination
Price discrimination occurs when a monopoly charges different prices to different consumers for the same product. This practice can increase profits by capturing consumer surplus. Conditions for effective price discrimination include market power, identifiable consumer segments, and the ability to prevent resale.
Remedies for Monopoly
Various remedies exist to address monopoly power, including antitrust laws, regulation, and promoting competition. Policies may involve breaking up monopolies, regulating prices, or fostering market entry for new firms. The aim is to enhance consumer welfare and restore efficient market conditions.
Consumer and Producer Theory in Action: externalities, marginal cost pricing, internalising externalities, public goods, imperfect information (adverse selection, moral hazard), social choice, government inefficiency
Consumer and Producer Theory in Action
Externalities
Externalities occur when a third party is affected by the economic activities of others. They can be positive or negative. For instance, pollution from a factory is a negative externality affecting community health and environment, whereas a well-maintained garden can enhance neighborhood property values, a positive externality.
Marginal Cost Pricing
Marginal cost pricing involves setting the price of a good or service equal to the additional cost of producing one more unit. This pricing approach ensures that resources are allocated efficiently, promoting optimal production levels in markets.
Internalising Externalities
Internalising externalities is a way to incorporate external costs or benefits into the market price. This can be done through taxes, subsidies, or regulations that encourage producers and consumers to account for societal impacts. An example is a carbon tax applied to polluters.
Public Goods
Public goods are non-excludable and non-rivalrous, meaning that one person's use does not diminish another's ability to use it. Examples include national defense and public parks. The market often underprovides public goods, necessitating government intervention.
Imperfect Information
Imperfect information refers to situations where all parties in a transaction do not have equal access to information. This can lead to adverse selection, where buyers or sellers use hidden information to their advantage, and moral hazard, where one party takes risks because they do not bear the full consequences of their actions.
Social Choice
Social choice theory examines how individual preferences can be aggregated into a collective decision. Issues like voting systems and collective decision-making highlight the challenges in achieving fair and efficient outcomes.
Government Inefficiency
Government inefficiency can arise from bureaucratic processes, lack of competition, and misaligned incentives. This can lead to misallocation of resources and failure to achieve the desired social outcomes, as seen in poorly designed public policies.
Markets and Market Failure: market adjustment, sources of market failure, evaluating the market mechanism
Markets and Market Failure
Market Adjustment
Market adjustment refers to the process through which supply and demand in a market reach equilibrium. This involves changes in price and quantity as market participants react to shifts in consumer preferences and production costs.
Sources of Market Failure
Market failure occurs when the allocation of goods and services is not efficient. Common sources include externalities (positive and negative), public goods, information asymmetries, and monopolies or oligopolies that distort competition.
Evaluating the Market Mechanism
The market mechanism involves buyers and sellers interacting to determine prices. Its effectiveness is evaluated based on how well it allocates resources, promotes competition, and responds to consumer needs, taking into account potential market failures that necessitate intervention.
Income Distribution and Factor pricing: input markets, labor and land markets, profit maximisation condition, income distribution
Income Distribution and Factor Pricing
Introduction to Income Distribution
Income distribution refers to the way in which total income is distributed among various individuals or groups in society. It is crucial for understanding economic disparities and the general well-being of a population.
Overview of Factor Pricing
Factor pricing is the determination of prices for the factors of production: labor, land, and capital. It helps in understanding how incomes are allocated to different resources and inputs in the production process.
Input Markets
Input markets are where factors of production like labor and raw materials are bought and sold. The equilibrium in these markets affects the pricing of inputs and, subsequently, the distribution of income.
Labor Markets
Labor markets determine the wages paid to workers. Wage levels are influenced by demand and supply, productivity, and negotiation power between employers and employees. Effective functioning of these markets is essential for equitable income distribution.
Land Markets
Land markets establish the rental prices for land used in production. The productivity of land and the demand for space significantly influence income derived from land, impacting overall income distribution.
Profit Maximization Conditions
Firms aim to maximize profit by equating marginal cost and marginal revenue. This behavior influences factor pricing as firms adjust their demand for labor, land, and capital based on their productivity, thus affecting income distribution.
Relationship Between Income Distribution and Factor Pricing
The way income is distributed is closely tied to the pricing of factors. Higher wages for labor or rents for land can lead to a more equitable income distribution, while disparities in pricing can exacerbate income inequality.
Conclusion
Understanding the interplay between income distribution and factor pricing is essential for developing policies aimed at promoting economic equity and enhancing the welfare of all societal members.
International Trade: absolute advantage, comparative advantage, terms of trade, trade barriers, free trade/protectionism
International Trade
Ability of a country to produce a good more efficiently than another country.
If Country A can produce 10 cars with the same resources that Country B uses to produce 5 cars, Country A has an absolute advantage in car production.
Ability of a country to produce a good at a lower opportunity cost than another country.
Even if Country A has an absolute advantage in both cars and computers, it should specialize in the good where it has the least absolute advantage relative to the other good.
Ratio at which goods and services of one country can be exchanged for those of another.
Determines the gains from trade and affects the trade balance of countries.
Regulations or policies that restrict international trade.
Tariffs
Quotas
Subsidies
Import licenses
Can protect domestic industries but may lead to trade wars and higher prices for consumers.
Policy to eliminate tariffs and other barriers to free trade.
Encourages competition, lowers prices, and increases consumer choices.
Economic policy of restraining trade between countries through tariffs and other regulations.
Protects domestic industries and jobs but can lead to higher prices and retaliation from other countries.
