Intro to Microecon Flashcards
(143 cards)
1
Q
What is the Theory of consumer behavior?
A
An explanation of how consumers allocate incomes among different goods and services to maximize their well-being.
2
Q
3 distinct steps for understanding consumer theory’
A
Consumer preferences,
Budget constraints and Consumer choices
3
Q
Consumer preferences
A
A practical way to describe the reasons people may prefer one good to another. We focus on how to describe consumer preferences grafically and algebriacally.
4
Q
Budget constraints
A
Constraints that consumers face as a result of limited incomes.
5
Q
Consumer choices
A
Given the consumer preferences and income limitations, choices describe how consumers choose to buy combinations of goods and services for maximizing satisfaction/utility.
6
Q
Market basket (bundles)
A
A market basket is a list with specific quantities of one or more goods; (a selected mix of goods and services). The choice of a specific market basket is related to preferences, which are subject to change depending on which mix/combination of goods and services offers the highest satisfaction at that point.
7
Q
Basic assumptions about preferences
A
Completeness, Transitivity, More>Less
8
Q
Assumptions about preferences - completeness?
A
Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets. Thus, for any two
market baskets A and B, a consumer will prefer A to B, will prefer B to A,
or will be indifferent between the two. By indifferent we mean that a person will be equally satisfied with either basket.
9
Q
Assumptions about preferences - Transitivity?
A
(related to consistency!!!)
Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C. For example, if a Porsche is preferred to a
Cadillac and a Cadillac to a Chevrolet, then a Porsche is also preferred to
a Chevrolet. Transitivity is normally regarded as necessary for consumer
consistency.
10
Q
Assumptions about preferences - More>less?
A
Goods are assumed to be desirable—i.e., to
be good. Consequently, consumers always prefer more of any good to less. In
addition, consumers are never satisfied or satiated; more is always better,
even if just a little better.1
This assumption is made for pedagogic reasons;
namely, it simplifies the graphical analysis. Of course, some goods, such
as air pollution, may be undesirable, and consumers will always prefer
less. We ignore these “bads” in the context of our immediate discussion of
consumer choice because most consumers would not choose to purchase
them.
11
Q
How can consumer preferences be shown graphically?
A
Using indifference curves
12
Q
Indifference curve?
A
An indifference curve represents all combinations of market baskets that provide a consumer with the same level of satisfaction. That person is therefore indifferent among the market baskets represented by the points graphed on the curve.
(they also describe a trade off between the consumption of different goods)
13
Q
Law of diminishing marginal utility
A
The law states that the amount of satisfaction provided by the consumption of every additional unit of a good decreases as we increase the consumption of that good.
14
Q
Indifference map
A
Graph
containing a set of indifference
curves showing the market
baskets among which a consumer
is indifferent.
(indifference curves cannot intersect!)
15
Q
Why can’t indifference curves intersect?
A
The intersection of indifference curves would violate one of the assumptions of consume theory, as it would mean that the consumer should be indifferent towards any market basket along any of the intersecting curves - this would contradict the assumption that the consumer always prefers having more goods in total.
16
Q
Shape of all indifference curves?
A
Downward sloping
(The fact that indifference curves slope
downward follows directly from our assumption that more of a good is better
than less.)
17
Q
The marginal rate of substitution?
A
Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.
The magnitude of the slope of an indifference curve measures the consumer’s marginal rate of substitution (MRS) between two goods.
18
Q
What does the shape of an indifference curve describe?
A
The shape of an indifference
curve describes how a consumer is willing to substitute one good for another.
19
Q
What does MRS (Marginal Rate of Substitution) measure?
A
The MRS of food F for clothing C is the maximum amount of clothing that a person is
willing to give up to obtain one additional unit of food. Suppose, for example, the
MRS is 3. This means that the consumer will give up 3 units of clothing to obtain 1 additional unit of food. If the MRS is 1/2, the consumer is willing to give
up only 1/2 unit of clothing. Thus, the MRS measures the value that the individual
places on 1 extra unit of a good in terms of another.
The MRS measures the value that the individual
places on 1 extra unit of a good in terms of another.
20
Q
What is MRS always equal to? (marginal rate of substitution)
A
the MRS at any point is equal in magnitude to the slope of the indifference curve
MRS= - (change on Y axis)/(change on X axis)
21
Q
MRS falls as we move down the indifference curve. Why?
A
This can be explained by another important assumption regarding consumer preferences (apart from Completeness, Transitivity and More>Less) - Diminishing marginal rate of substitution (the marginal rate of substitution, i.e. the max amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good, decreases as we move down the indifference curve)
Explanation: The willingness to sacrifice N units of one thing to get a unit of another depends on how much of each thing you have to begin with. –> As more and
more of one good is consumed, we can expect that a consumer will prefer to
give up fewer and fewer units of a second good to get additional units of the
first one
22
Q
How does the diminishing marginal rate of substitution along the indifference curve affect the shape of the curve?
A
Indifference curves are usually convex, or bowed inward. The term convex means that the slope of the
indifference curve increases (i.e., becomes less negative) as we move down
along the curve. In other words, an indifference curve is convex if the MRS
diminishes along the curve
23
Q
What kind of market baskets to consumers generally prefer?
A
consumers generally
prefer balanced market baskets to market baskets that contain all of one good
and none of another
24
Q
Give an example of when an indifference curve might be non-convex and explain?
A
With nonconvex preferences, the MRS increases as the amount of the good measured on the
horizontal axis increases along any indifference curve. (i.e., the more you have of good A, the more of good B you are willing to give up in order to secure an additional unit of good A; opposite of the typical, diminishing MRS)
This unlikely possibility might arise if one
or both goods are addictive. For example, the willingness to substitute an addictive drug for other
goods might increase as the use of the addictive drug increased.
25
Perfect substitutes
Two
goods for which the marginal rate
of substitution of one for the other
is a constant.
- the indifference curve is then a straight line
- e.g. consumer always perceiving two 500g packs of pasta as equivalent to one 1kg pack of pasta, regardless of how much of each he has
26
Perfect complements
Two
goods for which the MRS is zero
or infinite; the indifference curves
are shaped as right angles.
- for example, left shoe and right shoe
- an additional left shoe will not
increase the consumer's satisfaction unless she can obtain the matching right shoe. In this
case, the MRS of left shoes for right shoes is zero whenever there are more right shoes than left shoes; the consumer will not give up any left shoes to get additional right
shoes. Correspondingly, the MRS is infinite whenever there are more left shoes
than right because the consumer will give up all but one of her excess left shoes in order
to obtain an additional right shoe
27
What are 'bads'?
Good for which less is
preferred rather than more.
28
How do we account for bads in the analysis of consumer
preferences?
We redefine the product under study so that consumer
tastes are represented as a preference for less of the bad. This reversal turns the
bad into a good. Thus, for example, instead of a preference for air pollution, we
will discuss the preference for clean air, which we can measure as the degree of
reduction in air pollution.
29
Utility?
Numerical score
representing the satisfaction that
a consumer gets from a given
market basket.
(utility simplifies the ranking of market baskets)
30
Utility function
Formula
that assigns a level of utility to
individual market baskets.
31
Ordinal utility function
Utility function that
generates a ranking of market
baskets in order of most to least
preferred.
32
Cardinal utility function
Utility function
describing by how much one
market basket is preferred to
another.
33
Budget line?
All combinations
of goods for which the total
amount of money spent is equal
to income.
A budget line describes the combinations of goods that can be purchased given the consumer’s income and the prices of the goods.
I = price A x quantity + price B x quantity
34
Slope of the budget line?
The slope of the budget line is the negative of the ratio of the prices
of the two goods.
-(price of good on x axis/price of good on y axis)
35
Intercept?
An intercept is where a line on a graph crosses (“intercepts”) the x-axis or the y-axis.
36
What do the intercepts of the budget line represent?
The vertical intercept represents the maximum amount of
good on y axis that can be purchased with income (if the whole income was spent on it). The horizontal intercept
tells us how many units of the good on x axis can be purchased if all income were spent on F.
37
Effect of income change on the budget line?
A change in income (with prices unchanged) causes the budget line to shift outwards parallel to the original line. (the intercepts of the line will move, driving this shift)
- the slope stays the same if the price of neither of the goods changed
38
Effect of price change on the budget line?
A change in the price of one good (with income unchanged) causes the budget line to rotate about one intercept. -- the slope is affected
(the slope will be affected only if the change in good price(s) affects the RATIO of the two prices)
39
It is assumed that consumers make rational choices. Which two conditions must the maximising market basket satisfy (i.e. the market basket they choose)?
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of goods and services.
These two conditions reduce the problem of maximizing consumer satisfaction
to one of picking an appropriate point on the budget line.
40
Marginal cost and benefit?
marginal benefit - Benefit
from the consumption of one
additional unit of a good.
marginal cost - Cost of one
additional unit of a good.
41
When is consumer satisfaction maximised?
Satisfaction is maximized when the marginal rate of
substitution (of good A for good B) is equal to the ratio of the prices (of good A to good B) --> i.e. marginal benefit is equal to the marginal cost
At the point of max satisfaction, the budget line and the indifference curve are tangent (have one interception)
42
Why a consumer must choose a combination of goods on a budget line, meaning the indifference curve should be a tangent to the budget line?
When making choices, consumer preferences are constrained by budget (depending on the consumer's impact). Therefore, the consumer must choose a combination of goods on the budget line (indicating the max he can afford, i.e. the amount he can buy if spending full income) that is a tangent to the indifference curve (the indifference curve containing the amount of services which corresponds to the max amount he can afford)
43
Economics?
Science about how best limited resources can be utilized
for satisfying unlimited need by individual’s or society’s
own choice.
44
Macroeconomics?
Branch of economics that deals with aggregate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation.
- The interactions/relationships between actors in microeconomics will be reflected in macroeconomics.
45
Microeconomics?
Branch of economics that deals with the behavior of individual economic units—consumers, firms, workers, and investors—as well as the markets that these units comprise.
46
Trade offs in microecon.
In modern market economies, consumers, workers, and firms have much
more flexibility and choice when it comes to allocating scarce resources.
Microeconomics describes the trade-offs that consumers, workers, and firms
face, and shows how these trade-offs are best made.
The idea of making optimal trade-offs is an important theme in microeconomics.
47
Trade-offs from Consumer perspective
Consumers have limited incomes, which can be spent on a wide
variety of goods and services, or saved for the future. Consumer theory, the subject matter of Chapters 3, 4, and 5 of this book, describes how consumers, based
on their preferences, maximize their well-being by trading off the purchase of
more of some goods for the purchase of less of others. We will also see how consumers decide how much of their incomes to save, thereby trading off current
consumption for future consumption.
48
Trade offs from worker perspective
Workers also face constraints and make trade-offs. First, people
must decide whether and when to enter the workforce. Because the kinds of
jobs—and corresponding pay scales—available to a worker depend in part on
educational attainment and accumulated skills, one must trade off working
now (and earning an immediate income) for continued education (and the hope
of earning a higher future income). Second, workers face trade-offs in their
choice of employment. For example, while some people choose to work for
large corporations that offer job security but limited potential for advancement,
others prefer to work for small companies where there is more opportunity for advancement but less security. Finally, workers must sometimes decide how
many hours per week they wish to work, thereby trading off labor for leisure.
49
Trade offs from Firms perspective
Firms also face limits in terms of the kinds of products that they can produce, and the resources available to produce them.
50
The themes of micro economics?
- Trade offs
- Prices and markets
- Theories and models
- Normative and positive analysis
51
What are theories in economics?
Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. Economic theories are the basis for making predictions.
52
What are models in economics?
With the application of statistical and econometric techniques, theories can
be used to construct models from which quantitative predictions can be made.
A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity
53
Positive analysis?
Analysis
describing relationships of cause
and effect.
- positive questions deal with explanation and prediction. e.g. What will happen with car sales and prices if the government restricts car import?
54
Normative analysis?
- normative questions deal with what ought to be, e.g. what is best? what is the most profit-maximising combination of products to produce?
55
Two broad groups of economic units
It is easiest to understand what a market is and how it works by dividing
individual economic units into two broad groups according to function—
buyers and sellers. Buyers include consumers, who purchase goods and services, and firms, which buy labor, capital, and raw materials that they use
to produce goods and services. Sellers include firms, which sell their goods
and services; workers, who sell their labor services; and resource owners,
who rent land or sell mineral resources to firms. Clearly, most people and
most firms act as both buyers and sellers, but we will find it helpful to think
of them as simply buyers when they are buying something and sellers when
they are selling something
56
A market?
Collection of buyers
and sellers that, through their
actual or potential interactions,
determine the price of a product
or set of products.
57
Market definition?
Determination of the buyers,
sellers, and range of products that
should be included in a particular
market.
(When defining a market, potential interactions of buyers and sellers can be just as important as actual ones. An example of this is the market for gold. A New Yorker who
wants to buy gold is unlikely to travel to Zurich to do so. Most buyers of gold
in New York will interact only with sellers in New York. But because the cost of
transporting gold is small relative to its value, buyers of gold in New York could
purchase their gold in Zurich if the prices there were significantly lower.)
58
Types of market?
Competitive and noncompetitive (one possible classification)
59
Perfectly competitive market?
A perfectly competitive market has many buyers and sellers, so that
no single buyer or seller has any impact on price!!
Examples/real life scenarios: Most agricultural markets are
close to being perfectly competitive. For example, thousands of farmers produce wheat, which thousands of buyers purchase to produce flour and other
products. As a result, no single farmer and no single buyer can significantly affect the price of wheat.
Many other markets are competitive enough to be treated as if they were
perfectly competitive. The world market for copper, for example, contains a few
dozen major producers. That number is enough for the impact on price to be
small if any one producer goes out of business. The same is true for many other
natural resource markets, such as those for coal, iron, tin, or lumber.
Other markets containing a small number of producers may still be treated
as competitive for purposes of analysis. For example, the U.S. airline industry
contains several dozen firms, but most routes are served by only a few firms.
Nonetheless, because competition among those firms is often fierce, for some
purposes airline markets can be treated as competitive.
60
Non-competitive market?
Market with one or limited number of buyers and sellers, so that single buyer or seller has a significant impact on price.
Some markets
contain many producers but are noncompetitive; that is, individual firms can
jointly affect the price. The world oil market is one example. Since the early
1970s, that market has been dominated by the OPEC cartel. (A cartel is a group
of producers that acts collectively.)
- key feature: individual firms can affect the price
Monopoly: Only one seller
Monopsony: Only one buyer
Oligopoly: An oligopoly is a market in which control over an industry lies in the hands of a few large sellers who own a dominant share of the market
61
Price in a perfectly competitive market?
In a perfectly competitive market, a single
price—the market price—will usually prevail.
e.g. price of wheat is easy to measure and pretty consistent
62
Price in markets that are not perfectly competitive?
In markets that are not perfectly competitive, different firms might charge
different prices for the same product. This might happen because one firm is
trying to win customers from its competitors, or because customers have brand
loyalties that allow some firms to charge higher prices than others. For example,
two brands of laundry detergent might be sold in the same supermarket at different prices. Or two supermarkets in the same town might sell the same brand of
laundry detergent at different prices. In cases such as this, when we refer to the
market price, we will mean the price averaged across brands or supermarkets.
63
Examples of practical applications of microecon
- corporate decision making (e.g. studying consumer behaviour)
- public policy design (estimating/evaluating the impact of a policy on certain groups of population)
64
What is health econ?
Science about how best limited resources can be utilized
for satisfying (unlimited) need of health by individual’s or
society’s own choice.
65
4 components that are analysed in microecon studies
- budget
- production function
- production possibility frontier
- preferences
66
Grossman model of health - key points
Grossman model of health demand: In this model, health is a durable capital good which is inherited and depreciates over time. Investment in health takes the form of medical care purchases and other inputs and depreciation is interpreted as natural deterioration of health over time!
- It is not medical care per se that consumer wants, but rather health. Medical care demand is a derived demand for an input to produce health.
- The consumer does not merely purchase health passively from the market. Instead, the consumer produces it, spending time on health-improving efforts in addition to purchasing medical inputs. (lifestyle + medical services)
- Health lasts for more than one period. It does not depreciate instantly, and thus can be treated like the capital good that it is. (health is considered a capital good because it lasts for more than one period)
- Health can be treated both as consumption and investment good. Consumption good – anything you are consuming that bring you satisfaction (health gives satisfaction)
67
Healthcare triangle?
Involves Citizen, Third party insurer or purchaser and Provider
- Citizen provides funds to the purchaser
- Purchaser allocates the funds to provider
- Provider delivers care to the citizen
68
Extent of a market?
Boundaries of a market, both
geographical and in terms of
range of products produced and
sold within it.
69
The supply curve
Relationship
between the quantity of a good
that producers are willing to sell
and the price of the good (holding constant any other factors that might affect the quantity supplied).
y axis - price that sellers receive for a given quantity supplied
x axis - total quantity supplied
Equation: Qs = Qs(P)
70
The supply curve sloped upward - explain the implications/meaning of that
The higher the price, the more that firms are able and willing to produce and sell. (For
example, a higher price may enable current firms to expand production by
hiring extra workers or by having existing workers work overtime (at greater
cost to the firm). Likewise, they may expand production over a longer period
of time by increasing the size of their plants.)
- the higher the price of a good the higher the quantity supplied
71
What changes may occur on the supply curve if production costs fall?
If production costs fall, firms can produce the same quantity at
a lower price or a larger quantity at the same price. (THE SUPPLY CURVE SHIFT TO THE RIGHT)
72
Shifts of supply curve - Other variables that affect supply?
The supply can depend on other variables besides price. For example, the quantity that producers are willing to sell depends not only on the price they receive but also on
their production costs, including wages, interest charges, and the costs of raw
materials.
73
The demand curve
Relationship
between the quantity of a good
that consumers are willing to buy
and the price of the good. (holding other factors constant)
Qd = Qd(P)
74
The demand curve slopes downwards - explain the implications/meaning of that
Consumers are usually ready to buy
more if the price is lower. For example, a lower price may encourage consumers
who have already been buying the good to consume larger quantities. Likewise,
it may allow other consumers who were previously unable to afford the good to
begin buying it.
75
Apart from price, which other factor greatly affect the quantity of a good the consumers are willing to buy? + examples of other factors
Income is especially important. With
greater incomes, consumers can spend more money on any good, and some
consumers will do so for most goods.
(+ factors such as weather or price of other goods can also affect the quantity demanded)
76
Shift of demand curve if income rises?
If the market price
were held constant, we would expect to see an increase in the quantity
demanded, as a result of consumers’ higher incomes.
Because this increase would occur no matter what the market price, the result
would be a shift to the right of the entire demand curve. Alternatively, we can ask what price consumers would
pay to purchase a given quantity. With greater income, they should be willing to pay a higher price, causing the demand curve to again shift to the right.
77
Demand for substitute goods
Two goods for
which an increase in the price of
one leads to an increase in the
quantity demanded of the other.
78
Demand for complement goods
Two goods for
which an increase in the price
of one leads to a decrease in the
quantity demanded of the other.
79
The market mechanism
Tendency in a free market for
price to change until the market
clears, i.e., until the quantity supplied and the quantity demanded are equal.
80
Where do the supply and demand curves intersect?
The two curves intersect at the equilibrium, or market-
clearing, price and quantity. At this price,. the quantity supplied and the quantity demanded are just equal.
At this
point, because there is neither excess demand nor excess supply, there is no
pressure for the price to change further. Supply and demand might not always
be in equilibrium, and some markets might not clear quickly when conditions
change suddenly. The tendency, however, is for markets to clear.
81
Equilibrium/market clearing price?
Price that
equates the quantity supplied to
the quantity demanded.
- on the graphs, the point at which the supply and demand curves intersect
82
Movement along the supply/demand curve vs shift of the curve?
Movements along the supply and demand curves are caused by price level variations, while shifts of these curves happen when another variable (other than the price level) affects the demand for goods and services (parallel movements, same slope).
We have seen that the response of quantity supplied to changes in price can
be represented by movements along the supply curve. However, the response of
supply to changes in other supply-determining variables is shown graphically
as a shift of the supply curve itself.
83
Surplus vs shortage?
surplus - Situation in which the
quantity supplied exceeds the
quantity demanded. (puts pressure on suppliers to reduce price until equilibrium is reached)
shortage - Situation in which
the quantity demanded exceeds
the quantity supplied. (puts pressure on suppliers to increase price until equilibrium is reached)
84
When can we use the supply-demand model?
When we draw and
use supply and demand curves, we are assuming that at any given price, a
given quantity will be produced and sold. This assumption makes sense only
if a market is at least roughly competitive. By this we mean that both sellers and
buyers should have little market power—i.e., little ability individually to affect the
market price.
85
Effect on equilibrium/market price following a shift of the demand curve to the right?
The market will clear at a higher price and a larger quantity
86
Elasticity
Percentage change
in one variable resulting from a
1-percent increase in another.
Elasticity is an economic measure of how sensitive one economic factor is to changes in another. For example, changes in supply or demand to the change in price, or changes in demand to changes in income.
87
Price-elasticity of demand
Percentage change
in quantity demanded of a
good resulting from a 1-percent
increase in its price.
usually a negative number (because when the price of a good increases, the quantity demanded usually falls)
88
Price elastic vs price inelastic demand
When the price elasticity is greater than 1 in magnitude, we say that demand
is price elastic because the percentage decline in quantity demanded is greater
than the percentage increase in price. If the price elasticity is less than 1 in
magnitude, demand is said to be price inelastic. In general, the price elasticity of
demand for a good depends on the availability of other goods that can be substituted for it. When there are close substitutes, a price increase will cause the
consumer to buy less of the good and more of the substitute. Demand will then
be highly price elastic. When there are no close substitutes, demand will tend to
be price inelastic.
89
Income-elasticity of demand
Percentage change in
the quantity demanded resulting
from a 1-percent increase in
income.
90
Cross-price elasticity of demand
(applied to substitute good and complimentary goods)
Percentage change
in the quantity demanded of one
good resulting from a 1-percent
increase in the price of another.
91
Effects of decrease in demand on equilibrium price
Price falls
92
Point elasticity
Price elasticity at a particular
point on the demand curve.
93
Arc elasticity
Price elasticity
calculated over a range of prices.
94
Infinitely elastic demand
Principle that
consumers will buy as much of a
good as they can get at a single
price, but for any higher price
the quantity demanded drops to
zero, while for any lower price
the quantity demanded increases
without limit.
(e.g. more preventative services)
95
Completely inelastic demand
Principle that
consumers will buy a fixed
quantity of a good regardless of
its price.
e.g. insulin, emergency surgery
96
Price elasticity of supply
Percentage change in
quantity supplied resulting from a
1-percent increase in price.
This elasticity is usually
positive because a higher price gives producers an incentive to increase output.
97
Examples of factors for which the elasticity of supply is usually negative
We can also refer to elasticities of supply with respect to such variables as
interest rates, wage rates, and the prices of raw materials and other intermediate goods used to manufacture the product in question. For example, for most
manufactured goods, the elasticities of supply with respect to the prices of raw
materials are negative. An increase in the price of a raw material input means
higher costs for the firm; other things being equal, therefore, the quantity supplied will fall.
98
Luxury good
If quantity demanded is so responsive to an income increase that the percentage increase in quantity demanded exceeds the percentage increase in income, then the elasticity value is in excess of 1, and the good or service is called a luxury.
99
Necessity good
If the percentage change in quantity demanded is less than the percentage increase in income, the value is less than unity, and we call the good or service a necessity.
100
Luxury vs necessity goods
A luxury good or service is one whose income elasticity equals or exceeds unity.
A necessity is one whose income elasticity is greater than zero and less than unity.
Luxuries and necessities can also be defined in terms of their share of a typical budget. An income elasticity greater than unity means that the share of an individual's budget being allocated to the product is increasing. In contrast, if the elasticity is less than unity, the budget share is falling. This makes intuitive sense—luxury cars are luxury goods by this definition because they take up a larger share of the incomes of the rich than the non-rich.
101
Inferior good
A good of which one buys less as their income goes up
102
Possible effect of a government imposing a maximum price which is lower than the market clearing price
Government imposing a maximum price which is lower than the market clearing price; will lead to increased demand and shortage of supply --> TRADE OFF BETWEEN EFFICIENCY AND EQUITY; accounting for people who can't afford P0
103
Influence of govs on markets?
In the United States and most other industrial countries, markets are rarely free
of government intervention. Besides imposing taxes and granting subsidies,
governments often regulate markets (even competitive markets) in a variety of
ways, e.g. price controls (e.g. ceiling price)
104
Ceiling price below equilibrium leads to?
Lower supply and higher demand (shortage)
105
Why will the equilibrium price increase if the quantity demanded rises?
consumers now place a higher value on the good,and producers must have a higher price in order to supply the good; therefore, price will increase.
The law of supply and demand states that when the demand for a good or service is higher than the supply, prices are likely to rise. In these circumstances, suppliers tend to produce more to satisfy the demand!!!! and take advantage of the margin opportunities.
Increase in quantity supplied is associated with increase of price that sellers receive.
106
Consumer surplus
- measures the aggregate net benefit that consumers obtain from a competitive market
- For consumers in the aggregate, consumer surplus is the area between the
demand curve and the market price
- (if there is a gov intervention): on the graphs, the area below the demand curve but above the set price (if the set price is lower than the market price)
107
Consumer surplus explained through example
In an unregulated, competitive market, consumers and producers buy and sell
at the prevailing market price. But remember, for some consumers the value of
the good exceeds this market price; they would pay more for the good if they
had to. Consumer surplus is the total benefit or value that consumers receive beyond what they pay for the good.
For example, suppose the market price is $5 per unit,
consumers probably value this good very highly and would pay much more
than $5 for it. Consumer A, for example, would pay up to $10 for the good.
However, because the market price is only $5, he enjoys a net benefit of $5—the
$10 value he places on the good, less the $5 he must pay to obtain it. Consumer
B values the good somewhat less highly. She would be willing to pay $7, and
thus enjoys a $2 net benefit. Finally, Consumer C values the good at exactly the market price, $5. He is indifferent between buying or not buying the good,
and if the market price were one cent higher, he would forgo the purchase.
Consumer C, therefore, obtains no net benefit.
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Producer surplus
- For the market as a whole, producer surplus is the area above the supply
curve up to the market price; this is the benefit that lower-cost producers enjoy
by selling at the market price.
- measures the aggregate net benefit that producers obtain from a competitive market
(if there is a gov intervention): on graphs, area (triangle) above the supply curve but below the set price (if the set price is lower than the market price)
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Welfare effects
Description of who gains and who loses from a policy, and by how much
(Gains and losses to consumers and producers)
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Ceiling price below the market clearing level creates a
shortage
111
Association between equilibrium price and quantity and economic welfare
the equilibrium price and
quantity in a competitive market maximizes the aggregate economic
welfare of producers and consumers
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What will happen when the set price is lower than the market clearing price and what's the justification for this?
Less quantity will be supplied than it would have been at the market clearing price, and the demand will be higher than at the market clearing price, leading to shortage. Justification: creating equity in society in exchange for efficiency losses
- the amount that will be supplied can be identified on the graph by finding an intercept between the set price and the supply curve
- some consumers enjoy the increase in consumer surplus because they are able to buy the good at a decreased price, while some lose out on the surplus because they can't access the good (not enough is supplied, shortage)
- With price controls, some producers (those
with relatively lower costs) will stay in the market but will receive a lower
price for their output, while other producers will leave the market. Both
groups will lose producer surplus.
(Producers just lose, some consumers gain and some lose surplus)
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Is the loss to producers from price controls offset
by the gain to consumers?
No. Price controls result
in a net loss of total surplus, which we call a deadweight loss. The total change in surplus is negative; We thus have a deadweight loss. This deadweight loss
is an inefficiency caused by price controls; the loss in producer surplus exceeds the gain in consumer surplus.
If politicians value consumer surplus more than producer surplus, this
deadweight loss from price controls may not carry much political weight.
However, if the demand curve is very inelastic, price controls can result in a
net loss of consumer surplus.
114
What do the areas below and above demand and supply interception (i.e. the equilibrium) represent?
Below: shortage (quantity supplied lower than quantity demanded)
Above: surplus (quantity supplied higher than quantity demanded)
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Deadweight loss
From the textbook: Net loss of
total (consumer plus producer)
surplus.
In economics, deadweight loss is defined as the inefficiency resulting from a divergence between the quantity of a product or service produced and the quantity consumed, including government taxation. This inefficiency signifies a loss that no one recovers, and thus, it's termed as a 'deadweight'.
(ALSO CALLED WELFARE LOSS; usually justified as a way to promote equity)
- Welfare losses (deadweight losses) occur when the efficient market quantity is not demanded and supplied. They result in a reduction of the economic surplus (social surplus, total surplus), which is the sum of consumer and producer surplus
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Effect of price control when demand is inelastic?
If demand is sufficiently inelastic, welfare loss will be larger than consumer surplus. Consumers, thus suffer a net loss. (producers suffer a net loss whenever there's price control)
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What is a common way of evaluating a market outcome?
Evaluating whether the market achieves economic efficiency
118
What is economic efficiency?
Maximisization of aggregate consumer and producer surplus
119
Effects of policy on the economy?
Policy imposes efficiency cost on economy = Consumer and producer surplus reduced by the amount of deadweight loss.
Efficiency cost is not necessarily bad since the policy-makers may have other objectives.
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Market failure?
Situation
in which an unregulated
competitive market is inefficient
because prices fail to provide
proper signals to consumers and
producers.
(inefficient distribution of good and services = distribution that does not maximise aggregate welfare)
(Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market. In market failure, the individual incentives for rational behavior do not lead to rational outcomes for the group.)
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Externalities?
Action taken by either a producer (e.g. a hospital not disposing of toxic waste adequately which leads to a rise in disease among local people) or a consumer (e.g. passive smoking) which affects other producers or consumers but not accounted for by the market price.
- can be positive or negative, typical example for positive is vaccinationand negative passive smoking
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Two important instances in which market failure can occur?
1. Externalities: Sometimes the actions of either consumers or producers
result in costs or benefits that do not show up as part of the market price.
Such costs or benefits are called externalities because they are “external”
to the market. One example is the cost to society of environmental pollution by a producer of industrial chemicals. Without government intervention, such a producer will have no incentive to consider the social cost of
pollution.
2. Lack of Information: Market failure can also occur when consumers
lack information about the quality or nature of a product and so cannot
make utility-maximizing purchasing decisions. Government intervention
(e.g., requiring “truth in labeling”) may then be desirable.
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Supplier induced demand
Consumers lack information about quality and nature of products and fail to make a utility-maximizing decision.
e.g. a woman going into labour can't decide whether it will be C section or vaginal delivery --> CAN LEAD TO SUPPLIER INDUCED DEMAND; HCPs can exploit the fact they have more information and subject patients to 'more healthcare' than necessary, especially in a fee for service system
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Policy setting a minimum price higher than market clearing price?
The quantity demanded identified by the intercept of the demand curve and the set price - the demand will fall below what it was at market clearing price. The size of the deadweight loss will depend on how much the suppliers produce; i.e. whether they produce the amount that corresponds to the decreased demanded quantity or whether they decide to produce more because they can get a higher price for selling (but this can ultimately result in larger losses than just decreasing production because it is likely that the goods in excess of quantity demanded won't be sold)
- producer surplus gain corresponds to the rectangle between min price, equilibrium price and quantity demanded (the same area is consumer surplus gain when market price is lower than equilibrium)
- consumers will be worse off, but this kind of price setting can also reduce profits of producers (loss of producer surplus), due to costs of excess production (gov might try to compensate by buying unsold goods)
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Summary of price ceiling and price minimum effects on consumer and producer surplus
Price ceiling (max price lower than clearing price)
- producers suffer a net loss in surplus
- some consumers enjoy a gain in surplus (because they are buying at a lower price) while some suffer a loss because there's a shortage (so the net change in surplus could be both positive and negative)
Price minimum (min price higher than clearing price)
- consumers suffer a net loss in surplus
- producers enjoy a gain in surplus for the quantity they sell because they can now sell at a higher price, however, there will be an overall drop in quantity demanded, meaning a drop in sales, which leads to some surplus loss (if producers do not choose to downscale production to correspond to the decrease in demand, that can lead to unsold output and even larger surplus losses, potentially resulting in a net loss)
126
Price support?
Price set by government above free-market level and maintained by governmental purchases of excess supply.
127
What can simple models of supply and demand be used for?
Simple models of supply and demand can be used to analyze a wide variety of government policies, including price controls, minimum prices, price support programs and taxes etc.
In each case, consumer and producer surplus are used to evaluate the gains and losses to consumers and producers.
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Effects of government tax on supply and demand?
When government imposes a tax, price usually does not rise or fall by the full amount of the tax. Also, the incidence of a tax is usually split between producers and consumers. (The burden of a tax (or the benefit of a subsidy) falls partly on the consumer
and partly on the producer). The fraction that each group ends up paying or receiving depends on the relative elasticities of supply and demand.
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How does elasticity of supply and demand influence the impact of tax?
If demand is very inelastic relative to supply, the burden of the tax falls mostly on buyers. (It takes a relatively large increase in price to reduce
the quantity demanded by even a small amount, whereas only a small price
decrease is needed to reduce the quantity supplied - cigarette tax is an example, because cigarettes are addictive and it's hard to affect the demand)
If demand is very elastic relative to supply, it falls mostly on sellers.
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Impact of gov intervention in a competitive market?
Government intervention generally leads to a deadweight loss; even if consumer surplus and producer surplus are weighted equally.
Government intervention in a competitive market is not always bad. Government—and the society it represents—might have objectives other than economic efficiency.
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Key assumptions related to the demand of health (Wagstaff 1986)
- individuals are rational; they want good health, they want more welfare, want to improve their health status
- health is a consumption good (a good that directly leads to satisfaction/feeling good, there's not an investment aspect)
- health inputs (products) increase health (healthy days)
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List microeconomic tools in analysing demand for health
- budget line
- production function
- production/welfare possibility frontier
- indifference curve/map
133
What does the budget line show?
All combinations of goods that are attainable with a certain budget.
133
Production function?
A functional relationship showing the output that can be produced by each an every input
(e.g. the number of healthy days (output) produced with every additional health product (input)
134
Explain the shape of production function (for healthy days)
the more 'health product' inputs you are adding, the smaller the output gets (in this case, healthy days). That's why the production function has this curved shape, it's not a straight line (it's not a linear function, not every health product input leads to a fixed amount of healthy days increase)
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Production possibility frontier
aka welfare possibility frontier
A curve that shows which alternative combinations of
commodities can just be attained if all resources are
used; it is thus the boundary between attainable and
unattainable commodity combinations.
(any point below the curve indicates that you are not using all your resources; any point above the curve is unattainable)
- the point on the curve one might choose depends on circumstances/preferences (i.e. which commodity is preferred at that moment)
134
Pareto efficiency/pareto optimality
Pareto efficiency is when an economy has its resources and goods allocated to the maximum level of efficiency, and no change can be made without making someone worse off. Pure Pareto efficiency exists only in theory, though the economy can move toward Pareto efficiency.
- the best possible allocation of resources (maximisation)
135
Indifference map?
A graph of indifference curves for several utility levels of an individual consumer is called an indifference map
135
Indifference curve
A curve showing all combinations of two commodities
that give the individual an equal amount of satisfaction
and between which the individual is thus indifferent.
136
Indifference curve vs budget line vs Production (welfare) possibility frontier
- budget line shows all the combinations of inputs (e.g. health product and clothes) that can be purchased with a particular budget
- the frontier shows all the combinations of outputs!! (e.g. healthy days and clothes) that can be obtained with a particular budget
(inputs and outputs will be the same for goods that can be consumed directly; the relationship between input and output is then linear, e.g. buying a cookie)
- indifference curve shows all combinations of outputs that yield the same utility/satisfaction for the consumer (circumstantial, depends on the situation and can be moved around)
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Demand for health step by step
(assuming commodities are: clothes and health products)
1. Draw the budget line in quandrant III.
2. Draw the Health production curve in quadrant II
3. Show in Health (healthy days) and Cloth axels how
much can be consumed by buying either health or cloths
in quadrant I. Draw the welfare possibility frontier.
4. Draw an indifference curve which is tangent to the
WPF. (frontier)
5. Choose the combination of health and cloths which
satisfy your utility for given income and price level.
6. Show the corresponding point on budget line.
137
Describe some factors that affect optimum health (i.e. optimum resource allocation for maximising your health)
Price change (if the price of health products increases, you will be able to obtain fewer healthy days, which will affect the frontier and the budget line and the indifference curve)
Income change (affects the budget line and frontier)
Technology change (when the technical knowledge/capabilities increase, the amount of healthy days (health) generated from each health product increases, so the production function shifts upwards (rises on the graph)
i.e. health products are factors such as nutritious food, quality housing etc. The better the scientific understanding of how these factors influence health, the greater will be their influence on health overall; they will be utilised in a way that yields more healthy days.)
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Positive vs normative economics
Positive economics is called the "what is" branch of economics. Normative economics, on the other hand, is considered the branch of economics that tries to determine the desirability of different economic programs and conditions by asking what "should" or what "ought" to be.
