Microeconomics Principles: Market Dynamics and Resource Allocation

Posted on Jun 23, 2025 in Economy

Circular Flow Model: U.S. and Global Economy

The circular flow model illustrates the economy, showing the circular flow of expenditures and incomes resulting from decision-makers’ choices and their interactions.

Households are individuals or people living together as decision-making units. Firms are institutions that organize the production of goods and services.

A market is where goods and services are exchanged. We have:

Factor markets: Where factors of production (e.g., labor, capital, land) are bought and sold.
Goods markets: Where goods and services are exchanged.

Money flows in the opposite direction of real flows (goods, services, factors).

Government’s Role in the Circular Flow

Governments in the circular flow receive taxes, make transfers, and buy goods and services. We distinguish between federal government and state and local governments.

Federal Government:
- Major Expenditures: Providing goods and services, Social Security, and welfare benefits.
- Revenue Sources: Personal income taxes, corporate taxes, and Social Security taxes.
State and Local Governments:
- Major Expenditures: Providing goods and services and welfare benefits.
- Revenue Sources: Sales taxes, property taxes, and state income taxes.

The circular flow model of the global economy illustrates the flows of U.S. exports and imports, as well as the international financial flows resulting from lending to and borrowing from other countries.

Demand and Supply: Price and Quantity Determination

The law of supply and demand is a fundamental theory in economics, explaining how the price of goods and services is determined by their scarcity or abundance in the marketplace. This law of market forces ultimately brings about market equilibrium.

The logic of the demand and supply model is straightforward. The demand curve shows the quantities of a particular good or service that buyers are willing and able to purchase at each price during a specified period. The supply curve shows the quantities that sellers will offer for sale at each price during that same period. By combining these two curves, we find the equilibrium price – the price at which the quantity buyers are willing and able to purchase equals the quantity sellers will offer for sale.

Surpluses and shortages determine the movements of these curves, and consequently, the price and quantity of a product in the market. These are caused by various factors, such as changes in productivity or income. The price adjusts to maintain market equilibrium—to keep the quantity demanded equal to the quantity supplied.

A surplus is the amount by which the quantity supplied exceeds the quantity demanded at the current price. A surplus typically leads to a fall in price to restore market equilibrium.
A shortage is the amount by which the quantity demanded exceeds the quantity supplied at the current price. A shortage typically leads to a rise in price to restore market equilibrium.

Changes in demand and supply affect equilibrium as follows:

An increase in demand increases both the price and the quantity; a decrease in demand decreases both the price and the quantity.
An increase in supply increases the quantity but decreases the price; a decrease in supply decreases the quantity but increases the price.

Price Elasticity of Demand and Influencing Factors

The elasticity of demand refers to the responsiveness of demand to a change in an economic factor. Specifically, price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price.

The demand for a good is elastic if, when its price changes, the percentage change in the quantity demanded exceeds the percentage change in price, leading to a decrease in total revenue from a price rise.
When the percentage change in the quantity demanded equals the percentage change in price, demand is unit elastic, leaving total revenue unchanged from a price rise.
The demand for a good is inelastic if, when its price changes, the percentage change in the quantity demanded is less than the percentage change in price, leading to an increase in total revenue from a price rise.

Price elasticity of demand is mainly influenced by two factors: the availability of substitutes for the good and the proportion of income spent on it.

The demand for a good is elastic if a substitute for it is easy to find. For example, soft drink containers can be made of either aluminum or plastic, making the demand for aluminum elastic.
The demand for a good is inelastic if a substitute for it is hard to find. For instance, oil has few close substitutes (imagine a coal-fueled car), making the demand for oil inelastic.

A price rise, similar to a decrease in income, reduces people’s ability to afford the same quantities of goods and services. The greater the proportion of income spent on a good, the more significant the impact of a price increase on the quantity people can afford, and thus, the more elastic the demand for that good.

Allocating Scarce Resources and Efficiency

Economists have a clear definition of efficiency, but fairness is less precisely defined and involves ethical considerations beyond economics.

Fairness, under the fair-rules approach, typically involves two principles:

All valuable resources must be privately owned.
Goods, services, and factors of production can only be transferred through voluntary exchange, with everyone free to participate.

This fair-rules approach, while consistent with allocative efficiency, often leads to unequal outcomes. Many perceive this as unfair; for instance, a bank president earning millions while a teller earns thousands.

The fair-result approach, conversely, often conflicts with allocative efficiency, leading to the “big tradeoff”—a recognition of the costs associated with income transfers aimed at achieving more equal outcomes.

An allocation is efficient if the scarce resource is used by the people who value it most. Fairness, however, depends on the adopted view:

In the fair-rules view, an allocation is fair if the rules for rationing the scarce resource (e.g., per family, per person) are followed and exchange is voluntary.
In contrast, the fair-result view considers an allocation unfair if the resource is distributed unequally, regardless of the rules. This perspective emphasizes that fairness requires both fair rules and fair outcomes.

Example: Candle Allocation During a Storm

Consider a winter storm that cuts the power supply and isolates a small town. People rush to buy candles from the only store.

The people who buy candles from the town store are not necessarily the people who will use them. A buyer might resell a candle if they can get a price exceeding their marginal benefit. The people who value the candles most—who are willing to pay the most—will ultimately use them. Only those willing to pay the most receive consumer surplus on candles, and the store owner receives normal producer surplus. People who resell candles they bought from the store receive additional producer surplus.
The allocation is efficient because the people who value the candles most use them. Whether the allocation is fair depends on which view of fairness is adopted:
- In the fair-rules view, if a rule like”one candle per famil” is followed and exchange is voluntary, the outcome is fair.
- In the fair-result view, if the candles are allocated unequally, the allocation is considered unfair.

Taxes: Price, Quantity, Incidence, and Inefficiency

Regardless of whether a tax is imposed on buyers or sellers, its effects are the same: the price paid by the buyer rises, and the price received by the seller falls.

A tax creates inefficiency by driving a wedge between marginal benefit and marginal cost, leading to a deadweight loss.
The less elastic the demand or the more elastic the supply, the greater the price increase and the larger the share of the tax paid by the buyer.
If demand is perfectly elastic or supply is perfectly inelastic, the seller bears the entire tax burden; conversely, if demand is perfectly inelastic or supply is perfectly elastic, the buyer bears the entire tax burden.
If demand or supply is perfectly inelastic, the tax creates no deadweight loss and is considered efficient.

The Benefits Principle proposes that people should pay taxes proportional to the benefits they receive from public goods and services. Thus, those who benefit most pay the most.

Average tax rate: The percentage of income paid in tax.
Marginal tax rate: The percentage of an additional dollar of income paid in tax.
Progressive tax: A tax whose average rate increases as income increases.
Proportional tax: A tax whose average rate is constant at all income levels.
Flat tax: A tax system with a constant average and marginal tax rate, essentially a proportional tax where everyone pays the same percentage.

In a flat tax system, the poorest individuals may disproportionately suffer, as the state requires a certain sum from contributors, which they might not be able to afford. This system is more common in some Eastern European countries (formerly communist).

International Trade Barriers and Their Effects

International trade barriers are measures imposed by governments to regulate the flow of goods, services, and capital across their borders. They can significantly impact international trade by making certain goods and services more expensive, reducing competition, and limiting access to foreign markets. They can also lead to job losses and create geopolitical tensions between countries.

These barriers can take various forms, including:

Tariffs: Taxes on imported goods.
Quotas: Limits on the quantity of goods that can be imported.
Subsidies: Government payments to domestic producers.
Other measures aimed at limiting or influencing the flow of goods and services.

These policies can affect prices, product quality, and availability in both importing and exporting countries. They can also influence the competitiveness of trading firms in different markets and often lead to disputes between nations.

International trade barriers can have significant effects on the economies of both exporting and importing countries. They can lead to higher prices, reduced competition, and fewer job opportunities in the importing country. In the exporting country, they may reduce demand for goods and services produced by local manufacturers, leading to a decrease in exports. Trade barriers can also lead to retaliatory measures between trading partners, which could further reduce the flow of goods and services.

Distinguishing Private, Public, and Common Resources

Goods and resources can be distinguished based on two characteristics: rivalry and excludability.

A good is rival if one person’s consumption of it diminishes another person’s consumption.
A good is excludable if it is possible to prevent someone from enjoying its benefits.

Based on these characteristics, we define three types of goods:

A private good is a good or service that is rival and excludable. These are produced and consumed by individuals, meaning their consumption by one person reduces their availability to others. Private goods are typically advertised, traded, and consumed by private individuals and are not usually available to the general public.
A public good is a good or service that is non-rival and non-excludable. These are collective efforts, often financed by taxes or other public resources. Examples include national defense, public transport, and street lighting.
A common resource is a resource that is rival but non-excludable. These are shared resources used by many people. Examples include air, water, land, and forests. Common resources are essential for human survival but are often mismanaged or overexploited due to their non-excludable nature.

Asymmetric Information in Insurance Markets

In insurance markets, buyers typically possess more information about the risk being insured than sellers. This situation is known as asymmetric information. While asymmetric information exists across all insurance types, we will focus on auto collision insurance for illustration.

Consider auto collision insurance: some drivers are careful, while others are aggressive. A careful driver is less likely to have an accident than an aggressive driver. Each driver knows their own type, but the insurance company does not. If careful and aggressive drivers pay the same premium, insurance companies incur losses on aggressive drivers and make profits on careful drivers.

Since insurance companies don’t know the driver type they are selling to, the supply curve (S) is the same for all drivers, based on an average marginal cost of insuring both aggressive and careful drivers. This outcome is inefficient due to two problems: moral hazard and adverse selection.

Moral hazard is the tendency for an individual with private information to act in ways that impose costs on an uninformed party with whom they have an agreement. Insurance companies face moral hazard because an insured person may have less incentive to avoid the insured loss than an uninsured person. For example, a driver with full collision coverage might drive less carefully than one with little or no coverage. Once insurance is purchased, incentives change, potentially harming the insurance company’s interests.
Adverse selection arises because individuals at greater risk are more likely to purchase insurance than those with very low risk.

Insurance companies are incentivized to mitigate moral hazard and adverse selection. By doing so, they can offer lower premiums to low-risk individuals and higher premiums to high-risk individuals.

Solutions often involve screening, where an uninformed party creates incentives for an informed party to reveal relevant private information. This can be achieved in two main ways:

No-claim bonus: A discount on the insurance premium for drivers who do not make claims. Drivers accumulate this bonus by driving safely, with longer periods of no claims leading to greater discounts.
Deductible: The amount of a loss that the insured person agrees to bear personally. A larger deductible typically results in a lower premium, with the premium decrease often more than proportionate to the deductible increase.

Through screening, insurance companies can offer different insurance terms to different risk groups. For instance, with aggressive and careful drivers, they can offer a higher premium for aggressive drivers and a lower premium for careful drivers. The higher premium incentivizes aggressive drivers to behave more carefully, potentially reducing their numbers and increasing careful drivers. This outcome is known as a separating equilibrium.

Monopoly: Formation and Pricing Strategies

First, it’s crucial to understand what a monopoly is: a market where a single company has no close substitutes and significant barriers prevent new firms from entering.

Monopolies typically arise due to three types of barriers to entry:

Natural monopoly: Arises from natural barriers, such as economies of scale, where a single firm can satisfy the entire market demand at a lower cost than two or more firms. This discourages other companies from entering, as they would be unable to compete profitably.
Legal monopoly: Created by legal barriers that prevent other companies from entering. Examples include public franchises (e.g., US Postal Service’s exclusive right to deliver first-class mail), government licenses, patents for innovative products, and copyright titles.
Ownership monopoly: Occurs when a competitor’s entry is restricted by a concentration of ownership, or when one company owns all or nearly all of the essential resources in a market. For example, Luxottica holds a near-monopoly in the sunglasses market due to its extensive brand ownership.

To sell a larger quantity of products, a monopoly must typically lower its price. This leads to two primary price-setting strategies, each with different tradeoffs:

Single-price monopoly: A firm that sells all units of its product for the same price to all customers. Using the Luxottica example, if it tried to vary prices, customers offered a higher price would simply buy from those offered a lower price, making a single price necessary.
Price-discriminating monopoly: A firm that sells different units of a product for different prices. Examples include airlines offering varied prices for seats based on time or class, or a pizza producer selling a single pizza for €9 but six pizzas for a total of €42 (€7 per pizza). However, not all monopolies can price discriminate, as customer resale can be an obstacle. For instance, a customer buying six pizzas for €42 might resell individual pizzas for €8, profiting while undercutting the producer’s single-pizza price and diverting sales.

Oligopoly: Definition and Emergence

An oligopoly is a market structure characterized by a small number of interdependent firms competing behind barriers to entry. Both natural (e.g., economies of scale, market demand) and legal barriers prevent new firms from entering, thus creating an oligopoly.

Unlike monopolistic and perfect competition, an oligopoly features a small number of firms, each holding a significant market share. These firms face a strong temptation to collude, potentially forming a cartel to limit output, raise prices, and increase economic profits, much like a monopoly. While cartels are illegal in the U.S. and most other countries, firms may still attempt to coordinate their actions informally.

In an oligopoly, firms are interdependent: each firm’s actions significantly influence the profits of its competitors, and vice versa.

A natural oligopoly arises from the interaction of market demand and the extent of economies of scale in production.
A legal oligopoly occurs when legal barriers to entry protect the small number of firms already in a market.