1. Microeconomics
Factors of production:
Land and raw materials are inputs into production provided by nature, for example, agricultural and nonagricultural land, forests, pastures, mineral deposits, oil, natural gas, lakes and rivers. The world’s land area and raw materials are limited. Some resources, such as oil and coal deposits, are non-renewable: if they are used now, they will not be available. Other resources, for example, forests (timber) and fish stock, are renewable.
Labour is the human input, both physical and mental, into production. The labour force is, at any point in time, limited both in number and in skills. The labour force or working population is the total number of people available for work.
Capital includes manufactured resources; in other words, produced means of production. The world has a limited stock of capital (a limited supply of factories, machines, tools and other equipment). Note that capital's meaning in economics differs from that in ordinary speech, where people refer to capital as money.
Entrepreneurship is the willingness and ability that some individuals have to take risks and manage the other three factors of production. Entrepreneurship is related to but not identical to management. When a new venture is being considered, risks exist. They involve the unknown future. Someone must assess these risks and make judgments about whether or not to undertake them. The people who do so are called entrepreneurs.
Production possibility curve/frontier
The axis must be labelled with any non-substitutable goods. A great example would be civilian/military goods. Another great example is consumption/capital goods.
Opportunity cost
The PPC (PPF) can also illustrate choice and opportunity cost. Since we have limited FoPs, we must choose how to use them best. This involves giving up (sacrificing) some of one good to produce more of another one. (Think of a factory with a limited number of machines and labour - to make more of one good means you cannot do as much of the other good as before, in case you already used all FoPs fully earlier.)
On the PPC, opportunity cost can be represented by moving from one axis closer to another: from producing more capital goods to producing more consumptions goods.
Opportunity cost is usually expressed per one unit of a good.
The gradient of PPC. Bowed vs linear.
A linear PPF illustrates constant opportunity cost (the ratio of how much of one good has to be given up to produce more of the other good stays the same no matter where on the PPF we produce).
A bowed-out PPF (more realistic!) shows that opportunity cost changes as we move along the PPF. This is because different FOPs are not equally valuable for producing both goods (try welding a teddy bear or sewing a tank…).
Potential growth
Potential growth is the shift of PPF to one or both sides. It can be caused by increased quality or quantity of FOPs. Graphically, potential growth leads to another PPC that covers more area.
Examples of reasons for potential growth:
More capital investment
Immigration
Education
Actual growth
Actual growth is the movement of the inefficient point towards the curve (becoming more efficient). Actual growth is caused by more efficient use of current FOPs. For instance, reduced unemployment (does not change the volume of labour in general but increases the volume utilised for production). Graphically, actual growth is represented by moving from inefficient to efficient or more efficient production points.
Demand
Law of demand
The law of demand states that if the price of a good rises, then the quantity demanded per period will fall, ceteris paribus.
Non-price determinants of demand (shift factors)
Income
An increase in consumers’ income will lead to increased demand for a normal good and a rightward shift of the demand curve. However, an increase in consumers’ income will lead to a decrease in demand for an inferior good and a leftward shift in the demand curve.
Price of related goods
If goods X and Y are substitutes, an increase in the price of good Y will increase demand for X, and the demand curve will shift to the right.
If goods X and Y are complements, an increase in the price of Y will lead to a decrease in demand for X, and the demand curve will shift to the left.
Tastes and preferences
If a good appears more attractive to consumers due to advertising, fashion, trends or health considerations, demand for that will increase, and the demand curve will shift to the right.
Expectations of future price changes
If the price of a product is expected to rise in the future, then its demand will now increase, and the demand curve will shift to the right. Or, if the price is expected to fall in the future, then its demand will decrease, and the demand curve will shift to the left.
Number of consumers
If the number of consumers in a market increases, demand will increase, and the demand curve will shift to the right, and vice versa.
Price elasticity of demand
Price elasticity of demand measures the responsiveness of quantity demanded when there is a change in the price of the good itself, i.e. to what extent quantity demanded reacts or responds when the price of the good in question changes.
Sign: always negative or zero, so we are taking the absolute value for calculations
Range of values
PED determinants
Number of close substitutes
If there are many close substitutes, the demand is relatively price elastic.
Degree of necessity or luxury
Necessities and luxuries have relatively price-inelastic demand.
Time
Demand is relatively price inelastic in the short run. Demand is relatively price elastic in the long run.
The proportion of income spent on the good.
Demand is relatively price inelastic if the proportion is relatively small.
Demand is relatively price elastic if the proportion is relatively big.
PED significance
The effect of a change in price on quantity demanded
The effect of a change in price on total revenue
The likely price volatility in the market following unexpected changes in supply
The effect of change in indirect tax on price and quantity demanded and also whether the business can pass on some or all of the tax to consumers
PED and total revenue
Each linear demand curve that cuts through both axes has an elastic and inelastic part. Consumer spending reaches its maximum at the mid-point, where the absolute value of PED is 1 or unit elastic.
The demand section above the unit elastic point is price elastic — the part below is price inelastic.
Hence, if we graph the output (quantity) versus total revenue, we will get a concave down parabola, where the maximum total revenue is gained at the unit elastic point.
Supply
Law of supply
The law of supply states that if the price rises, then the quantity of a good supplied per period will increase, ceteris paribus.
Non-price determinants of supply (shift factors)
Changes in costs of factors of production
An increase in the costs of factors of production (such as wages and raw material prices) will lead to a decrease in supply and a leftward shift of the supply curve.
Prices of related goods
If goods X and Y are in joint supply, an increase in the price of good Y will lead to an increase in the supply of good X and to a rightward shift of the supply curve.
If goods X and Y are in competitive supply, an increase in the price of good Y will lead to a decrease in the supply of good X and a leftward shift of the supply curve.
Indirect taxes and subsidies
An indirect tax will increase production costs, leading to a decrease in supply and a leftward supply curve shift.
A subsidy will decrease production costs, increasing supply and a rightward supply curve shift.
Expectations of future price changes
If the product price is expected to rise, producers may reduce supply now, and the supply curve will shift to the left.
Changes in technology
Improved technology will lead to an increase in supply, shifting the supply curve to the right.
Number of firms
If more firms enter a market, supply will increase, shifting the supply curve to the right.
Price elasticity of supply
Price elasticity of supply measures the responsiveness of quantity supplied when there is a change in the price of the good itself, i.e. to what extent quantity supplied reacts or responds when the price of the good in question changes.
Sign: always positive or zero
Range of values
PES determinants
Time
Elastic in the long-run
Inelastic in the short-run
Mobility of FOPs
Elastic with high mobility
Inelastic with low mobility
Unused capacity
Price elastic, if not all the resources are used
Ability to store stocks
Price elastic, if it can be stored for a long time
Price inelastic, if it can not be stored for a long time
PES significance
The effect of change in price on quantity was demanded
The effect of change in price on total revenue
The likely price volatility in a market following unexpected changes in supply
The effect of a change in indirect tax on price and quantity demanded and also whether the business can pass on some or all of the tax to the consumer
Income elasticity of demand
Income elasticity of demand measures the responsiveness of quantity demanded when there is a change in income.
If the good is:
Inferior
Demand for inferior goods is income inelastic.
Demand increases when income decreases
YED is less than zero
Necessity
YED is less than 1
Demand increases when income increases
Demand for normal goods is income inelastic
Luxury
YED is greater than 1
Demand increases when income increases
Demand for normal goods is income elastic
Engel curve
The role of the price mechanism
The operation of the price mechanism, also known as the invisible hand (a phrase introduced by Adam Smith), allows markets to reach equilibrium automatically. More specifically, in a competitive market where many firms produce the same product, a change in the demand or the supply of a product leads to a change in its price. This change in price acts as a signal and also creates incentives, leading to either more or less of the sound produced and, thus, a change in the allocation of scarce resources.
Consider the case where demand for a product has increased. For example, spreading kale's (a green leafy vegetable) health benefits and nutritional value has increased the demand for kale in the market. This is shown in Figure 2.3.4
Initially, the market is in equilibrium at h whereby the price of kale is at P1 per unit, and quantity is at Q1 per time with some scarce resources of land, labour and capital allocated to produce the good. The increase in demand for kale is illustrated by a rightward shift of the demand curve from D1 to D2. At P1, excess demand for kale is now equal to the line distance (hf) that puts upward pressure on the price of kale. The increase in the price of kale emits information and thus signals to kale producers that the demand for kale has increased. It also incentivises producers to offer more kale to the market, as it is now more profitable for them. So, as the price increases, there is an “extension” along the supply curve—from h to f. At the same time, some consumers will be cutting back on their purchases of kale or even dropping out of the market. The price increase also leads to a decrease in the quantity demanded. The new demand curve has a “contraction”—from f to j. As long as excess demand exists in the market for kale, its price will continue to rise. A new equilibrium is reached at j when the price of kale reaches P2, and the equilibrium quantity is Q2. What is happening is that the higher price of the good is signalling that consumers are willing to see resources diverted from other uses. This is just what producers do: they divert resources (such as land, labour and capital) from uses and allocate them to kale production. A resource reallocation occurs only due to the change in the price of kale.
More generally, a rise in the demand for a good raises its price and profitability. Firms respond by increasing the number of goods offered. To do so, they divert resources from goods with lower prices to goods that have become a more profitable. Therefore, society’s scarce resources are reallocated. Symmetrically, a fall in demand is signalled by a fall in price. This then acts as an incentive for producers to decrease the amount of the goods they offer to the market. The goods are now less profitable to produce. Resources will again be reallocated.
As such, producers and consumers acting in their self-interest and responding only to changes in relative prices adjust their behaviour and are responsible for the new outcome. It is as if an invisible hand guides their behaviour.
We have seen prices have a signalling and incentive role in a market. They also have a rationing function. If a market is free, meaning there is no government intervention, then whoever is willing and able to pay the market-determined price will end up with the good.
Price mechanism functions
1. Signalling function
Prices perform a signalling function – i.e. they adjust to demonstrate where resources are required.
Prices rise and fall to reflect scarcities and surpluses.
Suppliers will expand production to meet the higher demand if prices rise because of high consumer demand.
If there is excess supply in a market, the price mechanism will help to eliminate a surplus of goods by allowing the market price to fall.
2. Incentive function
Through choices, consumers send producers information about their changing needs and want.
A critical feature of a free-market system is that decision-making is decentralised, i.e., no single body is responsible for deciding what to produce and in what quantities.
This contrasts with a planned (state-controlled) economic system with significant intervention in market prices and state ownership of key industries.
3. Rationing function
Prices ration scarce resources when demand outstrips supply.
When there is a shortage, the price is bid up, leaving only those willing and able to pay to buy.
Consumer and producer surplus
Consumer surplus is extra satisfaction consumers gain from paying a lower price than they were prepared to pay.
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.
Social or community surplus is maximised at the equilibrium (D = S).
Government intervention
Reasons for government intervention
Earn government revenue
Support firms
Support households on low incomes
Influence the level of production
Correct the market failure
Promote equity
Indirect taxes
The supply curve shifts to the left
Customers pay the above part from the original price. The producers pay the lower part.
If the demand is price elastic, an indirect tax will reduce the quantity demanded, eroding the tax base. Tax revenue is relatively small. The tax revenue paid by the producers is greater than that paid by consumers.
If the demand is price inelastic, an indirect tax will be ineffective in reducing the quantity demanded but will significantly increase the tax revenue. The tax revenue paid by consumers is greater than that paid by producers.
Impact of the indirect taxes
Consumers pay a higher price and enjoy less of the good.
Consumer surplus decreases.
Firms earn less per unit and sell fewer units, so revenues collected decrease.
Producer surplus decreases.
The government collects tax revenues that may be spent on infrastructure, education, health care, etc.
A welfare loss results unless the good taxed is a demerit good or its production generates pollution
Pros of indirect taxes
Increase in tax revenue.
It is an effective way to change consumer behaviour if demand is price elastic.
Cons of indirect taxes
Because indirect tax is usually applied on goods with price inelastic demand, it increases consumer prices and does not significantly impact consumer behaviour. It will also hurt other industries because people will have less money to spend on normal or luxury goods.
The producer’s total revenue would decrease (unless demand perfectly prices inelastic).
It might decrease the sales of the company.
Subsidies
Subsidies are money from the government to producers to increase the output and/or lower the prices.
If the demand is price elastic, producers benefit more than consumers. The total revenue gained from the increased quantity demanded exceeds the total revenue lost from the price decrease.
Producers benefit greatly if the demand is price elastic, gaining additional government revenue and increased quantity demanded. Unless perfectly price inelastic demand, consumers will also benefit from the subsidies, as they will have more disposable income as they spend less of their goods on this product.
If the demand is price inelastic, producers will have
Impact of subsidies
Consumers pay a lower price and enjoy more of the good.
Consumer surplus increases.
Firms earn more per unit and sell more units, increasing revenues collected.
Producer surplus increases.
The government must finance the cost of the subsidy, so it may have to increase taxation now, borrow and tax later or cut back on another government programme.
A welfare loss results unless the subsidized good is a merit good or its production generates significant benefits for society.
Pros of subsidy
It makes the product more affordable, potentially promoting equality and equity.
It might hurt competing industries (need to decrease pollution → decrease the usage of conventional cars by subsidizing electric cars)
Producers will increase the total revenue, which can be used to develop the product.
Subsidising might be publicly successful, generating better awareness of the problem and shifting the demand curve to the left. It also might increase the market share of the company.
Cons of subsidy
Subsidising requires government spending, which might be an issue during the recession or if the economy is not doing well.
Resource misallocation
Subsidies can also have unintended consequences, such as creating dependence on government support, distorting international trade, or contributing to environmental degradation.
Crowding out private investment: Subsidies can crowd out private investment by making it more difficult for non-subsidized firms to compete in the same markets. This can lead to reduced innovation and entrepreneurship as private firms find it more challenging to enter the market and attract investment.
Minimum price (price floor)
The minimum price is the lowest price that is allowed to be charged
Their purpose is to protect the producers, most likely, farmers
Impact of minimum price
Producers and, more specifically, farmers are better off as their incomes are stabilized and increased. Producers’ revenue increases from the area (PeQe0) to the area (P'bQs0). The producer surplus increases from areas (4 + 5) to areas (2 + 3 + 4 + 5 + 6).
Buyers pay more than they would otherwise and enjoy less of the good. Consumers are, therefore, worse off. The consumer surplus decreases from areas (1 + 2 + 3) to areas (1). If the price-controlled product is used as an input in manufacturing, then production costs for these manufacturing firms will be higher. This may lead to higher prices for their goods. For example, a minimum price on corn in Mexico may lead to a higher price for tortillas.
The government is forced to spend heavily to purchase the surplus. Specifically, the government must spend (P' × ab); that is, the product of the promised price Floor times the amount of the surplus equal to area (QdabQs). This implies an opportunity cost involved as financing this government expenditure will require imposing new taxes now, or borrowing more now and imposing higher taxes later or cutting back expenditures on some other government project (for example, not building some schools).
The shaded area represents the welfare loss to society caused by the overproduction of the good and, in turn, the misallocation of resources; too much land is allocated to produce one particular farm product. There is allocative ineficiency.
Pros of minimum price
Raise the income of the farmers and protect them from market vulnerability
Ensure that sustainable life is available for workers
Cons of minimum price
Excess supply
Misallocation of resources
Potential for corruption
The minimum price might not be attainable for low-income earners. For instance, price floot on eggs and potatoes will damage the factory workers making shoes.
Maximum price (price ceiling)
Max price is the highest price that is allowed to be charged
Their purpose is to protect low-income earners
They are imposed on market necessities
Reasons for the maximum price
Prevent monopoly
Make a necessary good accessible
Impact of the maximum price
Social surplus decreases due to both decreases in consumer and producer surplus. Some people might benefit from a price decrease. However, it might not be the poorest people or those in need. Therefore, there is an allocative inefficiency.
Rationing can be based on “first come, first served”, which may lead to queues developing outside grocery stores, bakeries and gas stations as people rush to buy the good before there is none left.
Firms may decide which customers should be allowed to buy goods; they may prefer to sell to regular customers or attract customers or important customers.
There may be random allocation of supplies by ballot.
The government may adopt a rationing system: people could be issued a set number of coupons for each item. For example, this may take place in wartime.
Illegal markets will likely develop where some sellers will sell at prices above the legal maximum, depending on the willingness to pay and buyers' income.
Quality may worsen as producers use lower quality inputs to increase their prot margin. For instance, bakers may use lower-quality flour.
If other non-price-controlled goods may be produced with the same inputs, then the quantity offered may further shrink, making shortages more severe. For example, bakers may choose to sell cookies instead of bread.
Pros of the maximum price
Promotes equity.
It makes the goods accessible for low-income families, especially during inflation.
This prevents the chance of monopoly occurring.
Lower prices that low-income earners can attain
Cons of the maximum price
Decreases producer’s total revenue. Hence, producers are not willing to produce at the same rate and amount of goods as before the price control — the consequent reduction of availability. The price might be insufficient to run the company or the business.
It might cause shortages.
Possible reduced quality of goods.
The government must intervene (rationing) in the market to cover shortages.
Opportunity for corruption and parallel markets where the goods are rationed inefficiently
Market failure
Externalities
Market failure - failure to allocate resources optimally from the society’s point of view
Marginal private cost - producer supply
Marginal private benefit - producer demand
Marginal social cost - society supply
Marginal social benefit - society supply
Private goods are rivalrous (can only be used by one person at a time without reduced quality) and excludable (their use can be restricted) — examples: roller skates, pen.
Merit goods are private goods with positive externalities of consumption — for example: vaccines or education. Very often, the costs have to be paid “now”, whereas the (uncertain) benefits will only accrue later.
Demerit goods are private goods with negative consumption externalities — for example, alcohol and tobacco.
Pure or public goods are non-rivalrous and non-excludable goods.
Common pool or common access resources
When resources are rivalrous, but there is no price mechanism to exclude potential users (for instance, it’s free to use the resource), there is a tendency for the resource to be overconsumed and for it to degrade as everyone has the incentive to overuse it in the short-run even though this may well damage everyone in the long run.
Poverty exacerbates such problems as people may be aware of the long-run consequences but may not have options to overuse the common access resource in the short run.
The problem with rivalrous but not excludable resources is sometimes known as the Tragedy of the Commons.
Unsustainable production creating negative externalities can also harm global common-pool resources such as clean air. International agreements are thus needed to protect such resources. Free rider problems often abound, as monitoring compliance and enforcing rules internationally is difficult. Tradable permits sometimes provide an alternative solution, though real-life evidence ranges from success to less.
A tradable permit is an economic policy instrument under which rights to discourage pollution or exploit resources can be exchanged through a free or controlled permit market.
Responses to the threat to sustainability common pool resources face
Regulation by the government
International agreements
Education
Collective self-governance
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