IB Economics: Microeconomics
Terms in this set (78)
Quantity of a good or service that consumers are willing and able to purchase at a given price in a given time period.
Explain the law of demand.
As the price of a product falls, the quantity demanded of the product will usually increase, ceteris paribus.
Determinants of demand.
more normal goods bought when income higher, less inferior goods bought when income high
•PRICE OF OTHER PRODUCTS
substitutes and complements
•TASTE AND PREFERENCES
Distinguish between a shift of the demand curve and a movement along the demand curve.
Change in price of good leads to movement along existing demand curve, change in any other determinant lead to a shift in demand curve.
The quantity producers are willing and able to sell (or produce or provide or offer for sale) at a series of prices.
Explain the law of supply.
A the price of a product rises, the quantity supplied of the product will usually increase, ceteris paribus.
Determinants of supply.
•COST FACTORS OF PRODUCTION
land, labour capital and entrepreneurship)
•PRICE OF RELATED PRODUCTS
•STATE OF TECHNOLOGY
(indirect taxes, subsidies)
•NUMBER OF MARKETS
Distinguish between shift of supply curve and a movement along a supply curve
Change in price of good leads to movement along existing supply curve, change in any other determinant lead to a shift in shift curve.
Explain market equilibrium.
A state of rest, self-perpetuating in the absence of any outside disturbance when demand and supply curves cross.
Effects of producers rising or lowering equilibrium price.
•Raising price lead to fall in demand but rise in supply → excess supply
•Lower price lead to rise in demand but fall in supply → excess demand
Effects of changes in demand and supply upon equilibrium.
•Change in determinants of demand or supply will lead to a shift in curves.
•Shift in demand curve outwards → excess demand
•Shift in supply curve outwards → excess supply
•Whenever there is a shift of the demand or supply curve, the market will adjust to a new equilibrium.
Explain resource allocation.
•Scarce resources (almost all resources are limited) are allocated and re allocated in response to changes in price.
•Producers will allocate more resources towards those goods where the demand is highest, as they will be able to make more profit.
•Opportunity cost is the value of the benefits lost of the next best choice of use of a certain resource.
Define consumer surplus.
Extra satisfaction (or utility) gained by consumers from paying a price that is lower than that which they are prepared to pay.
Define producer surplus.
Excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would prepare to accept for that output.
Describe Allocative Efficiency.
Best allocation of resources from societies point of view is at competitive market equilibrium where social (community) surplus (consumer surplus and producer surplus) is maximized (marginal benefit=marginal cost)
Role of price in resource allocation.
•determined by demand and supply
•acts as a signal to producers and consumers
•incentive to producers to reallocate resources (allocate where thy gain most profit)
Measure of responsiveness, measures how much something changes when there is a change in one of the factors that determines it.
Define elasticity of demand.
Measure of responsiveness of quantity demanded to a change in one of its factors.
Define and calculate price elasticity of demand.
Measure of responsiveness of quantity demanded to a change in price along a given demand curve.
PED=(%change in quantity demanded)/(%change in price).
(If calculate a negative value, ignore negative sign and treat it as if positive)
Illustrate the different values of price elasticity of demand using demand curves.
1. Price Inelastic demand, 0<PED<1, change in price leads to proportionally smaller change in demand.
2. Price Elastic demand: 1<PED, change in price leads to greater proportionate change in quantity demanded.
3. Unit elastic demand: PED=1, change in product leads to a proportionate, opposite, change in quantity demanded.
4. Perfectly inelastic demand: PED=0, completely unresponsive to price changes.
5. Perfectly elastic demand: PED= infinity.
Determinants of price elasticity of demand.
1. Number and closeness of substitutes.
2. Necessity of the product and how widely the product is defined.
3. Time period considered.
4. Proportion of income spent on the good.
Role of PED for firms in making decisions regarding price changes and their effect on total revenue.
•Price inelastic demand: if price increases, total revenue increases
•Price elastic demand: if prices decrease, total revenue increases
•Unit price elastic demand: price change does not affect total revenue.
Compare PED for primary commodities and for manufactured products.
PED for primary commodities is relatively low due to the fact that they have very few substitutes whereas manufactured products have a relatively high PED because of the existence of many substitutes.
Significance of PED for government in relation to indirect taxes.
•If tax put on very elastic product, price increases as result, leading to large fall in demand for product. This means demand for production workers is likely to fall, increasing unemployment.•Governments normally place taxes on products where demand is relatively inelastic, so that demand for the product will not fall by a significant amount, and thus will not lead to high unemployment.
Define and calculate cross elasticity of demand.
Measure of responsiveness of demand for one good (and hence shifting demand curve) to a change in the price of another good.
XED=(%change in demanded of X)/(%change in price of Y)
Possible range of values for cross elasticity of demand.
XED explains relationship between products.
1. XED positive, two goods are substitutes .
2. XED negative, two goods complements.
3. XED=0, two goods unrelated.
XED values and the strength of relationship between products.
More negative→closer complements
More positive→Closer substitutes
Define and calculate income elasticity of demand.
Measure of responsiveness of demand (and hence a shifting demand curve) to a change in income
YED=(%change in demand)/(%change in income)
Possible range of values for income elasticity of demand.
YED tells us if it is a normal or inferior good:
1. 1<YED income-elastic, normal good
2. 0<YED<1 income-inelastic, necessity good
3. YED negative, inferior good.
YED for different types of goods.
Necessity goods: products that have a low-income elasticity, the demand for them will change very little if income rises.
Superior goods: products that have a high-income elasticity, demand for them will change significantly if income rises.
Examine the implications for producers and for the economy of a relatively low YED for primary products, a relatively higher YED for manufactured products and an even higher YED for services.
Define and calculate price elasticity of supply.
Measure of responsiveness of quantity supplied to a change in price along a given supply curve
PES=(%change supply)/(%change price)
Possible values for price elasticity of supply.
1. PES=0, perfectly inelastic, vertical line, completely unresponsive to price changes.
2. PES=infinity, perfectly elastic, horizontal line.
3. 0<PES<1 inelastic supply (touches x axis), change in price leads to less than proportionate change in supply.
4. 1<PES, elastic supply (touches y axis), change in price leads to greater than proportionate change in supply.
5. PES=1, unit elastic supply (goes through origin), change in price leads to proportionate change in supply.
Determinants of price elasticity of supply.
1. How much cost rise as output is increased.
2. Time period considered (longer time period considered, more elastic).
3. Unused capacity (firm with lots of unused capacity able to increase output without great cost increasing elasticity).
4. Ability to store stocks (firm with high storage able to react to price increases with increase in supply, to stay elastic).
5. Mobility of factors of production (factors of production easily move from one productive use than another).
PES for different products (primary and manufactured).
Primary commodities- tend to have inelastic supply (PES relatively low) as a change in price cannot lead to a proportionately large increase in quantity supplied.
Manufactured goods- tend to be more elastic (PES relatively high) as it is easier to increase or decrease quantity supplied in response to a change in price.
Different types of government intervention in allocation of resources.
•Minimum and maximum prices
What are indirect taxes.
Imposed on expenditure, raising firms costs and shifting supply curve vertically upwards.
Reason for imposing indirect taxes.
To generate government revenues, discourage consumption, alter the pattern of consumption.
Distinction between specific and ad valorem taxes.
Specific tax: is a flat rate of tax, specific amount is imposed upon a good.
Ad valorem: percentage tax, imposed on the basis of the monetary value of the taxed item (expressed as a percentage of selling price).
Impact of indirect taxes on market outcomes.
Amount of specific tax changes in same proportion as quantity sold increases.
In Ad Valorem, tax collected is more at higher prices than at lower prices.
Consequences of imposing indirect tax.
•When tax imposed, price increases by amount of tax, burden of tax falls on consumer.•If tax lowers wages or lowers prices for some of the other factors of production, burden of tax falls on owners of these factors.•If prices adjust by a fraction of tax, burden is shared.•Government generates revenue however this could cause the market size to fall implicating level of employment.
What are subsidies.
Form of financial assistance paid by the government to a business of economic sector.
Why governments provide subsidies?
Lower costs of necessary goods, guarantee the supply of merit goods, help domestic firms become more competitive in the international market.
Impacts of subsidies.
Reduces the cost of production, supply curve shifts vertically downwards by amount of subsidy.
Consequences of providing a subsidy.
PRODUCERS: lead to increase in producer revenue, producers able to lower their prices and increase their output till a new equilibrium is reached.
CONSUMERS: Consume more of the product due to lower prices. Pay lower prices.
GOVERNMENT: need to pay the subsidy, involve an opportunity cost, they will need to sacrifice investments in other sectors of economy to provide subsidy.
What is a price control?
Two types, maximum price and minimum price.
What are price ceilings?
Maximum price, set below natural market equilibrium.
Why do governments impose price ceilings?
•protect consumers (usually for products that are a necessity or a merit good. Examples include food price controls, rent controls)
Impacts of price ceiling.
For price ceiling is set at, there is more demand than there is at equilibrium but also less supply, creating a shortage as there is excess demand.
Possible consequences of a price ceiling.
•inefficient resource allocation (marginal benefit exceeds marginal cost)
•underground parallel markets (due to demand exceeding supply, there are some buyers willing to purchase good at higher price creating black markets)
•reduce quantity of scarce resources
Government intervention to correct problems of price ceiling.
Subsidies may be offered to firms to encourage production of goods however involves opportunity cost, government could produce products themselves, government could release previously stored inventory of such goods to ensure no shortage → these options will lead to shift of the supply curve to the right forming a new equilibrium.
What are price floors?
Minimum prices set above equilibrium.
Why are price floors imposed?
•provide stability to producers
•Attempt to raise incomes for producers of goods and services that the government things are important
•protect workers by setting a minimum wage
•Examples include price support for agricultural products and minimum wages.
Impact of price floor.
Price will rise causing demand to fall, leading to excess supply.
Possible consequences of a price floor.
•cost to government to dispose of the surpluses (government can eliminate excess surplus by buying the excess supply resulting in shift of the demand curve to the right)
•inefficient resource allocation
•discourage firms from producing alternative goods
•firms with surplus evade price control
Consequences of a price floor to different stakeholders.
GOVERNMENTS: may store or sell new supply. Buying surplus and storing it cost an opportunity cost for government as they have diverted funds from other important areas and exporting it to other countries may be considered as dumping.
PRODUCERS: can ignore price controls and cut their prices, firms can become productively inefficient.
Describe a Buffer stock scheme.
Government tries to regulate the price level of a good or service by buying the good up when demand is too low or selling off any surplus when demand is too high (in a free market, commodities tend to fluctuate in price)
•Buffer stock schemes tend to be very expensive, as there are storage costs, the goods in question might be perishable, and there is an opportunity cost made by the government in implementing them
Why do governments intervene in agricultural markets?
•Downward trend in agricultural markets: thanks to more efficient technology, there has been an increase in supply, resulting in lower prices (as demand has increased only slightly).
•income elasticity of demand for food is INELASTIC.
•Agricultural prices are subject to fluctuations because of:
→time lags in supply
→the price elasticity of demand is very low (many substitutes available).
•Governments may wish to subsidize to:
→prevent cheap imports from abroad in an effort to protect domestic jobs
→National security concerns and ability of a country to feed itself
→Governments may wish to intervene by using buffer stocks, subsidies, high fixed prices, or some combination of all of these.
Define community surplus, social efficiency and pareto optimality.
COMMUNITY SURPLUS: The welfare of society and it is made up of a consumer surplus plus a producer surplus
SOCIAL EFFICIENCY: Exists when community surplus is maximized
PARETO OPTIMALITY: Market is in equilibrium; no external influences and with no external affects
Define market failure.
•When community surplus is not maximized
•failure of market to achieve allocative efficiency
•results in an over-allocation or resources (over-provision of a good) or an under allocation of resources (under-provision of a good)
Types of market failure.
1. Imperfect competition.
2. Lack of public goods(goods that would not be provide in a free market, national defence).
3. Under supply of merit goods(goods that merit people, education, health).
4. Over supply of demerit goods (bad for consumer, cigarettes, alcohol).
Failure of the market to achieve social optimum where MSB=MSC.
Define, distinguish, illustrate and give examples of positive and negative externalities of production and consumption.
1. Negative externalities of production: Creation of goods or services that are unintentionally damaging to third parties. Marginal social cost of production greater than marginal private cost.
2. Positive externalities of production: production of a good or service creates unintentional external benefits. Marginal Private cost of production is greater than marginal social cost.
3. Negative externalities of consumption: When consumed by individuals have unintentional effect on third parties. Marginal social benefits less than marginal private benefits.
4. Positive Externalities of consumption: when consumption leads to unintentional external benefits to third parties, healthcare, MSB greater than MPB.
Methods for correcting Negative Production externalities.
•Legislation and regulations (prevent or reduce effects of production externalities by lowering quantity of goods produced e.g.limit emission of pollutants, limit production, force polluting units to install technologies which reduce emissions).
•Tradable permits (cost efficient, market driven approach, reducing amount of goods produced).
Methods for correcting negative consumption externalities.
•ADVERTISING AND EDUCATION (use persuasive awareness campaigns to alert consumer and influence them to reduce their consumption in long run).
•LEGISLATION AND REGULATIONS (pass legislations or impose fines on certain activities).
•Imposing INDIRECT TAXES (reduce the supply).
Methods for correction of positive production externalities.
Subsidies can be provided to firms who produce these goods.
Methods for correction of positive consumption externalities.
•Subsidies(giving subsidies to producers, result in increase of supply shifting curve downwards).
•Advertising (persuade consumers to increase their consumption, shifting MPB to right, increasing demand).
Evaluate different government methods of intervention to deal with existence of externalities.
▪DIRECT PROVISION of merit and public goods: control the supply of goods that have positive externalities by supplying a high amount of education, public roads, parks, libraries, etc.
▪TAXATION: place a 'sin tax' on the sale of tobacco products to discourage consumption, internalizing some of the external costs
▪SUBSIDIES: reduce the cost of university education because it has beneficial externalities
▪TRADABLE PERMITS: tradable permits are permits allowing a firm to produce a given amount of pollution
▪Extension of property rights:
▪ADVERTISING AND EDUCATING to encourage and discourage consumption.
Distinguish between public goods and private goods.
→goods that would not be provided in a free market.
→Goods that benefit society.
→It is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others.
→an item that yields positive benefits to people
→excludable (owners can exercise private property rights, preventing others from using the good or consuming its benefits)
→rivalrous (consumption by one necessarily prevents that of another)
How does a lack of public goods indicate market failure?
•The "free rider" principle says that you cannot charge an individual a price for the provision of a non-excludable good because somebody else would gain the benefit from consumption without paying anything.
•if left to its own devices, merit goods (a private good that society considers underconsumed, often with positive externalities) will be under provided
•These are goods and services which have a positive effect on society like education, healthcare and sports centers
•under provided especially to less well off people in society
Discuss the implications of
the direct provision of public
goods by government.
•existence of strong positive externalities in merit goods
•private benefits may be underestimated leading to under-consumption
•benefits of merit goods, e.g. impact on economic growth
•costs of merit goods are borne by taxpayers
•opportunity costs of providing merit goods
•relative costs and benefits of direct provision or subsidy to supply merit goods
•physical/psychological crowding out of the private sector by labour intensive merit good provision
• promotion of greater equality as the less affluent have access to merit
•pure public goods are non-excludable. This is the essence of the "free rider problem": the incentive which consumers have to avoid contributing to financing public goods in proportion to their valuation of such good.
•inefficiency of state provision
•the problem of government of judging and meeting the socially efficient level of output
•interference with market forces
Describe, using examples,
common access resources.
Typically natural resources such as fishing grounds, forests and pastures or human-made systems for managing natural resources such as irrigation systems. Problems is that it is very difficult or very expensive to exclude people from using them.
Exists when consumption needs of present generation are met without reducing ability to meet needs of future generations.
What happens where there is a lack of a pricing mechanism for
common access resources.
These goods may be overused/depleted/degraded as a result of activities of producers and consumers who do not pay for the resources that they use, and that this poses a threat to sustainability.
Explain, using negative
externalities diagrams, that
economic activity requiring
the use of fossil fuels to satisfy
demand poses a threat to
Extraction and use of fossil fuels generates external costs which may pose immense threats to future generations.
Externalities created through existence of poverty in economically less developed countries that threaten sustainability?
Pursuit of economic growth results in environmental problems such as over-exploitation of land, soil erosion, land degradation, and deforestation. For developing countries these problems compound poverty and low standards of living.
Evaluate, using diagrams,
responses to threats to
Legislation, carbon taxes, cap and trade schemes, and funding for clean technologies.
Why are there limitations to government responses to threats to sustainability?
Limited by the global nature of the problems and the lack of ownership of common access resources, and that effective responses require international cooperation.