Three fundamental questions of economics
“What goods and services are produced?”, “How (i.e. with what input factors) are goods and services produced?”, and “Who (i.e. which consumers) gets goods and services?”
Price signalling helps answer the three fundamental questions of microeconomics. An increase in the price of a good decreases the production of that good, changes the input prices of the factors to produce good, and makes it harder for poor people to purchase it.
Theoretical Economics vs. Empirical Economics
Theoretical economics builds models; the “theory” is that a particular model is accurate. Empirical economics tests those models – those theories – by seeing if they accurately describe reality.
Positive vs. Normative Economics
Positive – study of the way things are
Normative – study of the way things should be
Positive statements describe what is (or isn’t), rather than what should be (or shouldn’t be). Describing how a price is set or who would receive a good is a simple factual statement.
Words like “bad”, “unfair”, and “ought” all indicate human judgments about what should be. These are normative statements.
How you slice up that pie of goods & services
maximize size of economic pie (producing as many goods and services as possible)
market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where individuals’ pursuit of pure self-interest leads to results that are not efficient– that can be improved upon from the societal point of view.
What determines the quantity & price of a good?
Supply and demand jointly determine the quantity of each good produced, and the price at which it is sold.
everyone who wants to buy a certain good and everyone who wants to sell that same good
The buyers alone determine the market demand for that good.
The sellers alone determine the market supply for that good.
Perfectly competitive market
there are so many buyers and sellers that no single buyer or seller can influence the price of the good unilaterally. If there are many sellers of a good, then any seller who charges a higher price will not attract any buyers, and the price of actual goods sold will remain unchanged.
In a perfectly competitive market, are the sellers price takers or price makers?
We call these sellers price takers because they take the market price as given.
the amount of a good or service that buyers are willing and able to buy at a specific price. It is usually negatively related to price.
Law of demand
The negative relationship between quantity demanded and price. As price rises, quantity demanded falls.
Demand is the set of all quantities demanded over the range of all possible prices. It describes the entire relationship between price and quantity demanded, and is graphically represented as the demand curve.
the amount of a good or service that sellers are willing and able to sell at a specific price. It is usually positively related to price.
Law of supply
The positive relationship between quantity supplied and price; think of sellers entering the market only when they can profitably sell their good.
the set of all quantities supplied over the range of all possible prices. It describes the entire relationship between price and quantity supplied, and is graphically represented as the supply curve
At this price, buyers demand exactly as much as sellers supply. The price is the equilibrium price, often designated P∗, and the quantity is the equilibrium quantity, often designated Q∗; intersection of supply and demand curves
Market clearing price
If all the buyers and sellers gathered together in a single marketplace, and buyers purchased as much as they were willing and able to at the equilibrium price, then each buyer and seller would finish their business and go home for the day. There would be nobody left in the market trying fruitlessly to buy or sell additional goods at that price. Thus, this market is said to have cleared.
Excess demand (supply shortage)
Below the market equilibrium. At this price, quantity demanded exceeds quantity supplied. Buyers would be delighted to buy cheap gasoline, but many sellers are going to close up shop. This is a shortage.
Excess supply (surplus)
Above the market equilibrium. At this price, quantity supplied exceeds quantity demanded. Sellers would be delighted to provide expensive gasoline, but many buyers are going to cut back on purchases. This is a surplus.
Law of supply and demand
When the market price is below the equilibrium price, the market price will rise. When the market price is above the equilibrium price, the market price will fall.
Putting two and two together, we see that market forces will always push the market price toward the market-clearing price, and once it arrives there, there is no further pressure to move. This is the law of supply and demand, and it is one of the most powerful concepts in economics. Adam Smith called this equilibrium-seeking behavior the Invisible Hand of the market.
Which axis does price go on?
Y-axis/vertical axis, always.
Inward vs. outward shift
Inward = left, outward = right
Explain what happens when there’s a shift in the demand curve (say, the price of beef goes up, what happens to the pork market?)
What is the relationship between beef and pork? They’re substitutes
As the price of beef goes up, people will want to shift towards pork
So that’s an outward demand shift for pork
We start initially in equilibrium (e1), then suddenly people want more pork so the entire demand curve shifts out & we move along the supply curve
For every price of pork, people want more
But there is a constraint to how high producers can raise the price before demand falls away (at point e2 = new equilibrium, producers have higher price, consumers are okay with it & they are at equilibrium again)
Explain what happens when there’s a shift in the supply curve
Let’s say there’s a drought & the price of hogs rises – so the cost to producers has gone up
Therefore, producers will raise prices – causing an inward shift to the supply curve (looks like it shifts up, when its really shifting left)
At every quantity, the producers needs a higher price to justify higher input costs
Causes excess demand, prices rise until a new equilibrium has been met
This time, we move along the demand curve
What happens when you introduce a price floor that’s above the market equilibrium? (i.e. minimum wage)
A new equilibrium is found where the minimum wage intersects with the demand curve; the price rises (because the minimum wage is higher than the market equilibrium price) & then labor demanded falls (because firms can’t afford to have as many workers). More workers want to work at this higher wage, so we’re left with a market with excess supply = unemployment.
What happens when you introduce a price ceiling above the market equilibrium?
Nothing, because both consumers and producers are already happy where they are. There’s no constraint/bind on either party.
Summarize why the government introduced a gasoline price ceiling in the 1970’s.
In the 1970’s – gas was really cheap, then OPEC formed (cartel) - and they got together and raised the price of gasoline in the 70’s
Before 1973, we’re at equilibrium point e1 (low price, high quantity)
Then, OPEC formed and decided to lower supply – so it raised the price (enough to overcome the quantity they lose by lowering supply); now we’re at e2
So, the government implemented a gas ceiling to interfere with OPEC’s impact.
How did consumers & producers react to the 1970’s price ceiling?
Consumers are now ready to get gas (high demand)
Gas stations can only sell a little bit of gas because they are still facing taxes from OPEC – so they lowered their supply. Suddenly, you have a massive excess demand.
Negative implications of the 1970’s gas ceiling?
Low efficiency – I would be willing to pay more to get more gas, the gas station would be willing to sell more gas at a higher price but because of the price ceiling, that can’t happen - the ‘size of the pie’ is not getting maximized
Allocation problems – when there’s excess demand, who gets the gas?
In the perfectly competitive equilibrium of e2, it’s not an issue. People who are WTP at that market price get it & others don’t. Since the market can’t adjust to that equilibrium, so now… it’s who has the time to sit there and wait in line to get gas. People are sitting there in line could be engaged in more productive activities.
The pie is being shrunk – wasting time & gas
Equity is also an issue - Poor people liked the lower prices, but again created massive inefficiencies. An example of an efficiency-equity tradeoff. Typically, if we want to distribute the pie differently then the pie will shrink (generally)
An efficient outcome is a outcome in which all trades that both parties want to make are made.
Perfectly inelastic demand
What is the slope?
Inelastic demand – demand is not at all sensitive to price
Demand curve is perfectly vertical; slope is 0.
The quantity demand will be the same at any price
Perfectly inelastic demand - what happens when supply shifts?
When the price rises, they’ll sell the same quantity at a higher price. There’s no wiggle/waggle - because consumers will just accept the higher price.
Perfectly inelastic demand - examples
Consumers will buy the same of something no matter what because there’s no substitute. Example: Insulin
Perfectly elastic demand
Demand where people are willing to pay the given price; Very price sensitive
If the price is raised by 1 cent more, they won’t buy any of it. If the price is lowered by 1 cent less, they’ll buy an infinite amount.
Perfectly horizontal demand curve; slope is negative infinity.
Perfectly elastic demand - examples
Fast food restaurants - many substitutes; people are very price sensitive.
The equation for the elasticity of demand
Percent change in quantity demanded over percent change in price, or change in Qd/Qd divided by change in P/P
Elasticity of demand
When the price gets higher, consumers want less – how rapidly they want less is the shape of the demand curve
Elasticity of supply
When the price goes up, how rapidly they want to supply more as price changes is the shape of the supply curve; it’s positive (positive slope)
Who bears the burden of taxation?
Statutory tax incidence - whoever pays the check bears the burden. If I pay my income tax, the tax is on me. If the gas station pays the gas tax, then the burden is on them
Whoever sends the check in is not necessarily the person who bears the burden of the tax because the market will adjust. The difference in somebody’s resources before & after a tax is imposed
Why is economic incidence not equal to statutory incidence?
Because of the market reaction to a tax
When a tax is imposed on producers in a competitive market, they’ll raise their price to some extent - so their incidence will be lower than the check that they sent to the government.
If a tax is levied on consumers, they’ll buy less & the price will be lowered – so their incidence will be lower than the check that they sent to the government
Consumer tax burden =
Price post tax – price pre tax + tax payment (per unit)
Producer tax burden =
Price pre tax – price post tax + tax payment (per unit)
Total economic burden =
a.k.a the “tax wedge”; includes consumer and producer tax burden.
Generally, the tax burden is shared on both sides of the market regardless of who pays them.
Why is the side of the market on which the tax is imposed is irrelevant?
Imagine the $0.50 is all on the consumers – you are bearing the tax totally. Well, the market will react.
As a consumer, only WTP to $1.00 and my demand curve will shift inwards by $0.50. Producers will have to move up the supply curve – they’ll have to cut the price to $1.30 and 90 billion gallons being sold
Either way, if tax is levied on producers or consumers they still reach a quantity of 90 billion gallons. The burden on consumers vs. producers is the same burden as last time.
CTB = $1.50 - $1.00 = -$0.30 burden
PTB = $1.50 - $1.30 = -$0.20 burden
Why economic incidence is determined by elasticities? (stuck vs. slippery)
Stuck parties bear taxes; more slippery parties avoid taxes. If you’re stuck, if you have to buy that insulin, you have to bear that tax. If you’re slippery, if you can just go next door to someone else, then you likely won’t bear the tax.
As curves get more elastic, the incidence is going to be borne by the other party. As the demand curve gets more elastic, suppliers bear more incidence. As the supply curve gets more elastic, consumers bear more incidence.
Who bears the tax burden if there is perfectly inelastic demand?
The full burden is on the consumer. They can do this because demand isn’t affected by changes in price
Who bears the tax burden if there is perfectly elastic demand?
Producers have to bear the entire tax, but if they raise the price nobody will buy anything (very price sensitive)
Correlation vs causality
Correlation – two variables move together vs. Causality - a change in one variable causes the other one to move
How do you estimate the slope of the demand curve from changes in supply?
A shift of the supply curve causes movement of the equilibrium along the demand curve, which enables us to estimate the slope of the demand curve, and consequently the price elasticity of demand.
How do you estimate the slope of the supply curve from changes in demand?
A shift of the demand curve causes movement of the equilibrium along the supply curve, which enables us to estimate the slope of the supply curve, and consequently the price elasticity of supply.
How do you estimate the slope of the supply or demand curve from changes in both the supply and demand?
You can’t. You have to isolate a shift in either the supply or the demand curve. A shift of both the demand and supply curves causes movement of the equilibrium of both original curves, which enables us to estimate neither the slope of the original demand curve nor the slope of the original supply curve, and consequently neither the price elasticity of demand nor the price elasticity of supply.
Name 3 elements of microeconomics
Microeconomics is about trade-offs, the study of scarcity, and constrained optimization. Economics is a quasi-science, not a real science because economic models do not perfectly explain real-world phenomena, they only approximate them.
What do consumers maximize?
Consumers maximize utility subject to budget constraints.
What do producers seek to maximize?
Producers maximize profits subject to marketplace constraints.
Another term for “excess supply of labor”?
Efficiency is a concept analogous to making the economic “pie”…
…as big as possible. Efficiency is about not preventing economic transactions from happening, thereby growing the size of the economy. This is like growing the pie. Dividing the pie equally is a concept analogous to equity.
Do price ceilings always result in excess demand?
No. If a price ceiling is nonbinding – that is, if a price ceiling is established above the equilibrium price – then the equilibrium will not change in response to the price ceiling.
What makes a price ceiling binding?
In order for a price ceiling to be binding, it must be below the free-market equilibrium price. If the price ceiling were imposed above the free-market equilibrium price, the market would continue on as though nothing had happened.
What are revealed preferences? How did economists try to use revealed preferences to gauge how much people value their own life?
Revealed preferences uses observations about the choices people make to estimate their underlying preferences. In this case, the amount people choose to pay for safety features reveals how much they value lowering their risk of death, and therefore how much they value death itself.
What goods have perfectly inelastic demand?
If a good has no substitutes, then consumers in the market for that good have no option but to buy it at whatever price it is offered.
measures the willingness of consumers to buy the good
measures the willingness of producers to sell the good
Supply and demand curves can shift when there are
– shocks to the ability of producers to supply
– shocks in consumer tastes
– shocks to the price of complement/substitute goods. A rise in the price of a substitute good for good X raises the demand for the X.
What kinds of interventions in market can lead to disequilibrium?
– for example, imposing a minimum wage means that more people will want to work than employers want to hire at the minimum wage. This creates unemployment.
Cost of government interventions? In terms off efficiency/equity?
The cost of these interventions is found in reduced efficiency (trades that are not made); there may be benefits in greater equity.
Explain the difference between a movement along the demand (supply) curve and a shift of the demand (supply) curve
If you’re moving along the curve, it’s due to a change in price. If you shift the demand curve, it means at any price, the demand is different - i.e. different input prices, changes in consumer preferences, changes in substitutable markets, etc.
Describe factors that shift supply and demand curves
Price of a Commodity - As already discussed, the movement in a demand curve occurs due to a simple change in the price of goods. This may usually occur because of the changes in supply conditions. The factors that affect the demand are assumed to be held constant. Therefore, a change in the price of a commodity leads to a movement along the demand curve and is referred to as a change in quantity demanded.
Income of Consumers -If something happens to alter the quantity demanded at a given price, a shift in a demand curve occurs. Lower income means that a person has less to spend, so he is likely to spend less on most of the goods. Change in the level of income of the consumers causes a shift in the demand curve because their purchasing power overall changes.
Expectation of Consumers - For example, if consumers will expect to earn higher income next month, they may be willing to spend more of their current savings purchasing the ice cream. Also, if they believe that the price of an ice cream would drop tomorrow; they will be reluctant to purchase it at today’s price. This ultimately causes a shift in the demand curve.
Price of Related Goods - A change in the price of related goods affects the demand for a certain product and causes a demand curve to shift. There are two kinds of related goods, complementary and substitute goods. When the demand of one good reduces due to the fall in a price of another good, the two goods are known as substitutes. Whereas, when the demand for one good increases due to fall in a price of another good, the two goods are known as complements.
If the price of Popsicle falls, the law of demand says that people will purchase more popsicles as compared to ice creams because they have the same characteristics and satisfy similar desires of consumers. Therefore, a change in the price of related goods causes a shift in the demand curve rather than a movement along the demand curve because this factor externally affects the demand curve.
Consumer Preferences - The most obvious determinant of demand is the consumer preference and a change in a consumer preference causes a shift in the demand curve. If people like ice cream, they purchase more of it. With the passage of time, economists have become more interested in explaining consumer preferences and taste. The development in neuroscience has made it more evident as to why people make decisions and this has come into the realm of economics, which helps economists examine what happens when the preferences of consumers change.
The Size of the Population and its Structure - A large population size, keeping other things equal, shows a higher demand for all goods and services. Therefore, more consumer base means there will be more consumption and more demand, which will externally affect the demand curve and hence, will cause it to shift. Moreover, changes in the way a consumer population is structured also leave an impact on the demand. For example, goods and services required by elderly in European countries, where there is more ageing population, will increase the demand of those goods and services as a result.
“what’s wrong” with excess supply or excess demand
Leads to inefficient outcomes, market failure, etc.
How does elasticity affect consumers’ response to a shift in the price?
The elasticity affects consumers’ response to a shift in price: if the elasticity is between 0 and -1, then firms can raise revenues by raising the price (since consumers will still buy the good in significant quantities); if elasticity < -1, then raising the price results in a decline in from revenue.
What could you observe in order to estimate an elasticity of demand?
Accurately estimating an elasticity requires a shift along the supply curve (e.g., a tax on suppliers).
Perfectly inelastic demand is correlated to a good with substitutes or no substitutes? What about perfectly elastic demand?
Perfectly inelastic demand is characteristic of a good with no substitutes; perfectly elastic demand is a good with perfect substitutes
Which equation should you use when you have a table of quantities and prices and want to figure out the demand and supply equations?
Elasticity of demand equation
% change in quantity/% change in price
R = p * q(p)
What is the elasticity of demand if our revenues remain unchanged given an infinitesimal change in our prices?
For revenues to remain unchanged when we change prices by x% , quantities must change by −x% (locally).
ϵD=% change in quantity% change in price=−x%x%=−1
What is the elasticity of demand if by raising our prices by 8% we will lose half of our customers?
What are all possible values for elasticity of demand if raising the price of our product led to a decrease in revenues?
Revenues are R=p⋅q(p) . When we raise prices, there are two forces opposing each other for revenues: higher prices will increase revenue but also detract the quantity demanded. Algebraically, dRdp=q+p⋅dqdp=q(1+ϵD) .
What are all possible values for elasticity of demand if a positive shock to the supply resulted in higher quantity sold but market price remained the same?
What are all possible values for elasticity of demand if cutting prices will have no effect on the number of units we sell?
True or False In the short run, a profit-maximizing firm chooses its input mix by setting MRTS=−w/r .
In the short run, firms cannot adjust K , so they cannot choose the input mix this way.
True or false - In the long run, a profit-maximizing firm chooses its input mix by setting MRTS=−w/r .
This may or may not be true. Depending on the production function, production may be at a corner solution, and the firm may choose production to remain at the corner solution.
The short run marginal cost curve is __________ due to the law of diminishing marginal returns.
The law of diminishing marginal returns means that the marginal cost curve will eventually be increasing. However, at low levels of the input, there can be increasing marginal returns to an input, and MC may decrease at first.
If a firm has U-shaped marginal cost, then AVC=MC at the point where AVC is minimized.
Never? Sometimes? Or Always?