Fundamental Microeconomic Principles and Definitions
Economic Systems and Philosophies
Free Market Economy
A free market economy is a rationing system by which societies allocate resources to the production of goods and services using the price mechanism, with no government intervention. All economic decisions are based on the market forces of demand and supply. (Inspired by Adam Smith)
Command Economy
A command economy, also called a centrally planned economy, is a rationing system where the means of production are owned by the state. There is no private property, and all economic decisions are made by the government. (Inspired by Karl Marx)
Positive Economics
Positive economic statements are based on facts or evidence and are free from subjectivity. They can be tested scientifically and proven.
Normative Economics
Normative economic statements are based on norms and are therefore based on subjective evaluation. They cannot be proven or disproven scientifically.
Fundamental Economic Concepts
Scarcity
Scarcity is the condition where available resources or factors of production are finite, while human wants and needs are infinite. There are not enough resources to produce everything necessary to satisfy human beings’ needs and wants.
Opportunity Cost
Opportunity cost is the next best alternative foregone when an economic decision is made.
Production Possibility Frontier (PPF)
The production possibility frontier is a curve that shows the maximum combination of goods and services a country can produce in a specific period, using all of its resources in the most efficient way and with the current state of technology.
Economic Efficiency
Economic efficiency is a situation in which scarce resources are not wasted. It occurs when a country is producing at a point where it cannot increase the production of one good without decreasing the amount produced of another. It also means that the right amount of each good or service is produced from society’s point of view.
Productive Efficiency
Productive efficiency refers to producing goods by using the fewest possible resources, which implies producing at the lowest possible cost. If firms are producing at the productively efficient level of output, we can assume they are combining their resources as efficiently as possible and that resources are not being wasted.
Allocative Efficiency
Allocative efficiency refers to producing the optimal combination of goods from society’s point of view. It is achieved when the economy allocates resources in such a way that no one can be better off without making someone else worse off. The benefits from consuming these goods are maximized for the whole society. This situation is called “Pareto optimality”.
Demand, Supply, and Equilibrium
Demand
Demand is the quantity of a good or service that consumers are willing and able to purchase at a given price and in a specific time period, ceteris paribus.
Substitute Goods
Substitute goods are goods that are similar in characteristics and use for consumers. When the price of one increases, the demand for the other increases, as people switch their consumption to the one that has become relatively cheaper. (e.g., Apple iPhone and Samsung Galaxy)
Complementary Goods
Complementary goods are goods that are consumed together. When the price of one increases, the demand for the other decreases, as people tend to consume less of both when one has become more expensive. (e.g., DVDs and DVD players)
Supply
Supply is the quantity of a good or service that producers are willing and able to offer at a given price and in a specific time period, ceteris paribus.
Equilibrium Price
The equilibrium price is the price at which the quantity demanded of a good equals the quantity supplied, so there are no surpluses or shortages. It is the market-clearing price, as everything offered at that price is sold.
Excess Supply (Surplus)
Excess supply is a situation where, at a price above equilibrium, the quantity demanded of a good is smaller than the quantity supplied, producing a surplus in the market.
Excess Demand (Shortage)
Excess demand is a situation where, at a price below equilibrium, the quantity demanded of a good is greater than the quantity supplied, producing a shortage in the market.
Consumer and Producer Surplus
Consumer Surplus
Consumer surplus is the difference between the highest price consumers were willing and able to pay for a good and the actual price they pay.
Producer Surplus
Producer surplus is the difference between the lowest price producers were willing and able to offer the good for and the actual price they receive for it.
Elasticity Concepts
Price Elasticity of Demand (PED)
Price elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to changes in its own price.
- PED > 1: Demand is elastic (e.g., goods with many substitutes). The demand curve is relatively flat. To increase revenue, lower the price.
- PED < 1: Demand is inelastic (e.g., essential goods). The demand curve is relatively steep. To increase revenue, raise the price.
Total Revenue (TR)
Total revenue (TR) is the amount of money received by firms for selling a good or service. It is calculated as the price of the good (P) times the quantity sold (Q): TR = P × Q.
Cross-Price Elasticity of Demand (XED)
Cross-price elasticity of demand is a measure of the responsiveness of the quantity demanded of one good to changes in the price of another good.
- XED > 0 (Positive): The goods are substitutes.
- XED < 0 (Negative): The goods are complements.
Income Elasticity of Demand (YED)
Income elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to changes in people’s income.
- YED > 0 (Positive): The good is a normal good (e.g., cars, clothes, gas).
- YED < 0 (Negative): The good is an inferior good (e.g., second-hand items).
- YED > 1: Demand is income elastic.
- YED < 1: Demand is income inelastic.
Price Elasticity of Supply (PES)
Price elasticity of supply is a measure of the responsiveness of the quantity supplied of a good or service to changes in its own price.
Government Intervention in Markets
Indirect Tax
An indirect tax is imposed upon expenditure. It is placed on the selling price of a product, raising the firm’s costs of production and shifting the supply curve upwards by the amount of the tax.
Specific Tax
A specific tax is a fixed amount of tax imposed per unit of a good or service sold; for example, a tax of €2 per can of beer.
Ad Valorem (Percentage) Tax
An ad valorem tax is a fixed percentage charged on the selling price of a good; for example, a 20% tax on the price of cigarettes. The amount of tax increases as the price of the good increases.
Subsidy
A subsidy is an amount granted by the government to a firm or industry. It is usually given per unit of output, decreasing the firm’s costs of production and shifting the supply curve downwards by the amount of the subsidy.
Price Controls
A price control is a form of government intervention where the price is set above or below the equilibrium price, preventing the market from clearing and thus creating surpluses or shortages.
Price Ceiling
A price ceiling is a maximum price set below the equilibrium price. It is intended to protect consumers, especially for merit goods, to increase consumption and allow lower-income individuals to access the good or service.
Price Floor
A price floor is a minimum price set above the equilibrium price. It is intended to protect producers by increasing their income, protect workers by setting a minimum wage, or reduce the consumption of demerit goods.
Welfare Loss
Welfare loss (or deadweight loss) is the loss of economic benefits to society because resources are not allocated efficiently.
Market Failure and Externalities
Market Failure
Market failure refers to the failure of the market to allocate resources efficiently, resulting in too much or too little of a good or service being produced or consumed from society’s point of view. This happens when, due to an external effect or circumstance, the condition “Marginal Private Benefit (MPB) = Marginal Social Benefit (MSB) = Marginal Private Cost (MPC) = Marginal Social Cost (MSC)” is not met.
Externalities
An externality occurs when the production or consumption of a good or service has an effect on a third party.
Negative Externality of Production
A negative externality of production occurs when producing a good or service generates a negative effect on a third party. Here, MSC > MPC. (e.g., air pollution from factories)
Positive Externality of Production
A positive externality of production occurs when producing a good or service generates a positive effect on a third party. Here, MPC > MSC. (e.g., a firm’s research and development creates new technology that benefits the whole economy)
Negative Externality of Consumption
A negative externality of consumption occurs when consuming a good or service generates a negative effect on a third party. Here, MSB < MPB. (e.g., second-hand smoke from cigarettes)
Positive Externality of Consumption
A positive externality of consumption occurs when consuming a good or service generates a positive effect on a third party. Here, MSB > MPB. (e.g., vaccinations, planting flowers in a garden)
Types of Goods
Public Goods
Public goods are goods and services that are both non-rivalrous and non-excludable. They would not be provided by private firms in a free market because of the free-rider problem.
Merit Goods
Merit goods are goods that are beneficial for the individual and society as a whole and would therefore be under-provided and under-consumed in a free market.
Demerit Goods
Demerit goods are considered harmful to the individual and society as a whole and would therefore be over-provided and over-consumed in a free market.
Primary Commodities vs. Manufactured Goods
Primary commodities are goods that come directly from natural resources or ‘land’; they are raw materials. Manufactured goods are man-made goods produced from raw materials that have been transformed through a production process.
Sustainability and Resources
Common Access Resources
Common access resources are resources that are not owned by anyone, do not have a price, and are available for use without payment. They are rivalrous and non-excludable.
Sustainability
Sustainability refers to the ability of something to be maintained or preserved. It exists when the consumption needs of the present generation are met without compromising the ability of future generations to meet their own needs.
Sustainable Development
Sustainable development is defined as development that meets the needs of the present without compromising the ability of future generations to meet their own needs.
Cap-and-Trade Schemes
Cap-and-trade schemes impose a cap (a maximum amount) on the total amount of carbon dioxide that producers can release into the atmosphere. Permits to release carbon dioxide are distributed to producers, and these permits can be bought and sold in a market.