Microeconomics Principles: Supply and Demand, Market Efficiency, and Government Intervention
What is Economics?
Economics is the study of how society manages its scarce resources.
Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. This leads to imports, for example, in the agriculture sector.
Efficiency vs. Equity
Efficiency means society gets the most it can from its scarce resources.
Equity means the benefits of those resources are distributed fairly among the members of society.
Ten Principles of Economics
- People face Trade-offs
- The cost of something is what you give up to get it
- Rational People think at the margin
- People Respond to Incentives
- Trade can make everyone better off
- Markets are usually a good way to organize economic activities
- Government can sometimes improve market outcomes
- A country’s standard of living depends on its ability to produce goods and services
- Prices rise when the government prints too much money
- Society faces short-run trade-offs between inflation and unemployment
Market Failure
Market failure occurs when the market fails to allocate resources efficiently.
Causes of market failure include:
- Market power, which is the ability of a single person or firm to unduly influence market prices.
- Externalities, which are the impacts of one person or firm’s actions on the well-being of a bystander.
Negative Externalities
Production or consumption costs inflicted on a third party without compensation (e.g., pollution).
Positive Externalities
Benefits accruing to third parties or the community at large (e.g., subsidizing education).
For example, the government might provide a subsidy for water if it sees it as a merit good and deems it desirable for households to consume more.
Key Economic Concepts
Productivity is the amount of goods and services produced from each hour of a worker’s time.
Inflation is an increase in the overall level of prices in the economy.
Phillips Curve: A curve that shows the short-run tradeoff between inflation and unemployment in an economy.
Market Economies
A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.
Competitive Markets
A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price.
Perfect Competition means that the goods being offered for sale are all the same. The buyers and sellers are so numerous that none can influence the market price. Buyers and sellers must accept the market price as given; they are often called”price takers”
Other Market Structures
- Monopoly: A market with only one seller, and the seller controls the price.
- Oligopoly: A market with only a few sellers. Example: Telecommunication Industry in Singapore.
- Monopolistic Competition: Many sellers with slightly differentiated products. Each seller may set the price for its own product. Examples: Cosmetics Industry.
Demand
Quantity demanded is the amount of a good that buyers are willing and able to purchase.
The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises. For example, when car prices rise too high, fewer people will buy.
The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded.
The demand curve is a graph of the relationship between the price of a good and the quantity demanded.
The market demand curve shows how the total quantity demanded of a good varies with the price of the good, holding constant all other factors that affect how much consumers want to buy.
Market demand refers to the sum of all individual demands for a particular good or service.
- An increase in demand can be represented by a shift of the demand curve to the right.
- A decrease in demand can be represented by a shift of the demand curve to the left.
Causes of shifts in the demand curve: Consumer income, prices of related goods, tastes, expectations, the number of buyers.
Change in Quantity Demanded: Movement along the demand curve, caused by a change in the price of the product.
Supply
The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises.
The market supply curve shows how the total quantity supplied varies as the price of the good varies.
Market supply refers to the sum of all individual supplies for all sellers of a particular good or service.
Shifts in the supply curve: Input prices, technology, expectations, the number of sellers.
Change in Quantity Supplied: Movement along the supply curve. Caused by a change in anything that alters the quantity supplied at each price.
Market Equilibrium
Equilibrium Price: The price that balances quantity supplied and quantity demanded. On a graph, it is the price at which the supply and demand curves intersect.
Equilibrium Quantity: The quantity supplied and the quantity demanded at the equilibrium price. On a graph, it is the quantity at which the supply and demand curves intersect.
Surplus: When the actual market price is higher than the equilibrium price, there will be a surplus of the good. Surplus is a situation in which quantity supplied > quantity demanded.
Shortage: When the actual price is lower than the equilibrium price, there will be a shortage of the good. Shortage is a situation in which quantity demanded > quantity supplied.
Law of supply and demand: The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance.
Analyzing Market Changes
To analyze how any event affects a market, we use the supply and demand diagram by following these three steps:
- Decide whether the event shifts the supply or demand curve or both.
- Decide in which direction the curve shifts.
- Use the supply and demand diagram to see how the shift changes the equilibrium price and quantity.
Price provides the mechanism to balance supply and demand.
Elasticity
The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. It is calculated as the percentage change in quantity demanded due to a percentage change in the price.
Determinants of Price Elasticity of Demand:
- Availability of Close Substitutes: The more substitutes (e.g., milk) a good has, the more elastic its demand.
- Necessities versus Luxuries: Necessities are more price inelastic (e.g., if there is an increase in the price of rice, do you think there will be a small decrease (quantity) in eating rice?).
- Time Horizon: Goods tend to have more elastic demand over longer time horizons.
- Elasticity > 1 = elastic
- Inelastic Demand: Does not respond strongly to price changes.
- Elastic Demand: Responds strongly to changes in price.
- Unit Elastic Demand: Changes by the same percentage as the price.
- Perfectly Inelastic Demand: Elasticity equals 0.
- Perfectly Elastic Demand: Elasticity equals infinity.
Total revenue:
- With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.
- With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.
Income Elasticity of Demand
Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.
Two types of goods:
- Normal goods: Taxi rides, driving a car
- Inferior goods: Bus rides
Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.
- Goods consumers regard as necessities tend to be income inelastic (e.g., rice, medical services, clothing).
- Goods consumers regard as luxuries tend to be income elastic (e.g., sports cars, fur, branded goods).
Cross-Price Elasticity of Demand
Cross-price elasticity of demand is the measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good.
Price Elasticity of Supply
Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.
Price Controls
Price Ceiling/Floor: A legal maximum/minimum on the price at which a good can be sold.
- The price ceiling is binding only if set below the equilibrium price, leading to a shortage.
- The price floor is binding if set above the equilibrium price, leading to a surplus.
When the market price hits the floor, it can fall no further, and the market price equals the floor price.
Binding Price Floor: Non-price rationing is an alternative mechanism for rationing the good, using discrimination criteria.
Taxes
Governments levy taxes (e.g., GST) to raise revenue for public projects, for example, roads, schools (affordable education), and national defense.
Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.
Tax incidence is the manner in which the burden of a tax is shared among participants in a market (buyer and seller).
Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in market equilibrium.
Buyers pay more, and sellers receive less, regardless of whom the tax is levied on.
Ed = Price Elasticity of Demand
Es = Price Elasticity of Supply
Fraction of tax borne by supplier = Ed/(Ed+Es)
In what proportions is the burden of the tax divided?
How do the effects of taxes on sellers compare to those levied on buyers?
It depends on the elasticity of demand and the elasticity of supply.
- Elastic Supply, Inelastic Demand: Burden heavier on buyers
- Inelastic Supply, Elastic Demand: Burden heavier on sellers
The burden of a tax falls more heavily on the side of the market that is less elastic.
Interdependence and Trade
Interdependence occurs because people are better off when they specialize and trade with others.
Patterns of production and trade are based upon differences in opportunity costs.
The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.
Absolute advantage refers to the person (or country) that can produce more of a product than the other. It is simply a matter of quantity. Comparative advantage refers to the person with a lower opportunity cost of producing a given item. If you have two people each producing two products, it is possible (but not necessary) that one person could have the absolute advantage in producing both goods, but each person must have the comparative advantage in one (and only one) good.
Competitive Firms
A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker.
- Buyers and sellers must accept the price determined by the market.
- No one can control the price; there is an ‘invisible hand’ that controls the price.
Average revenue is total revenue divided by the quantity sold.
Average Revenue = Price
MR = ΔTR / ΔQ. Average revenue = Price = Marginal Cost = Marginal revenue – only for competitive firms.
For competitive firms, marginal revenue equals the price of the good.
The firm will want to produce the quantity that maximizes the difference between total revenue and total cost.
- When MR > MC, increase Q
- When MR < MC, decrease Q
- When MR = MC, profit is maximized.
Average variable cost (AVC) is an economic term to describe the total cost a firm can vary (e.g., labor) divided by the total units of output.
Average total cost (ATC) is the sum of all the production costs divided by the number of units produced.
Shutdown and Exit Decisions
A shutdown refers to a short-run decision not to produce anything during a specific period because of current market conditions.
Exit refers to a long-run decision to leave the market.
- The firm shuts down if the revenue it gets from producing is less than the variable cost of production.
- Shut down if TR < VC
- Shut down if TR/Q < VC/Q
- Shut down if P < AVC
- Temporarily shut down if the price is set below AVC. This means that the revenue earned cannot even cover the variable cost.
- In the short run, the competitive firm’s supply curve is its MC curve above AVC.
- If the price falls below AVC, the firm is better off shutting down.
- The firm considers its sunk costs when deciding to exit but ignores them when deciding whether to shut down.
- Sunk costs are costs that have already been committed and cannot be recovered.
- In the long run, the firm exits if the revenue it would get from producing is less than its total cost.
- Exit if TR < TC
- Exit if TR/Q < TC/Q
- Exit if P < ATC
Entry
A firm will enter the industry if such an action would be profitable.
- Enter if TR > TC
- Enter if TR/Q > TC/Q
- Enter if P > ATC
Short-Run and Long-Run Supply Curves
- Short-Run Supply Curve: The portion of its marginal cost curve that lies above average variable cost (AVC).
- Long-Run Supply Curve: The marginal cost curve above the minimum point of its average total cost curve (ATC).
For any given price, each firm supplies a quantity of output so that its marginal cost equals price.
Industry output is the total amount produced by all identical firms.
While individual firm supply will only include its own output.
Firms will enter or exit the market until profit is driven to zero.
In the long run, price equals the minimum of average total cost.
The long-run market supply curve is horizontal at this price.
Competitive firms stay in business if they make zero economic profits.