ECONONE Reviewer Economics in Perspective Economics as a social science It is a systematic study that focuses in the activities of man in relation to his environment. It studies the society’s allocation of scarce resources to meet unlimited needs and wants. Scarcity is a general characteristic of resources, basically due to a resource’s alternative uses. Economics as the science of choice From the households’ choice to purchase goods to the firms’ choice of production, everything in our world now is a result of the many decisions individuals made in the past. Economics studies these choices and how and why these choices are made. The concept of Opportunity Cost In economics, the full cost of making a certain choice includes the value of what we give up by not choosing the alternative choice. For example, the opportunity cost of studying in college is the time you could have used to do other things or the money you could have earned if you decided to work as a high school graduate. Ceteris Paribus Translated to English, this means all else equal. This concept allows one variable to change as other variables are held constant. Three basic questions in economics: What to produce? How is it produced? For whom is it produced? Microeconomics The branch of economics that examines the behaviour of individual decision-making units, e.g. the household and the firms. Macroeconomics
Transcript
ECONONE Reviewer
Economics in Perspective
Economics as a social science It is a systematic study that focuses in the activities of man in relation to his environment. It
studies the society’s allocation of scarce resources to meet unlimited needs and wants. Scarcity is a general characteristic of resources, basically due to a resource’s alternative uses.
Economics as the science of choiceFrom the households’ choice to purchase goods to the firms’ choice of production, everything in
our world now is a result of the many decisions individuals made in the past. Economics studies these choices and how and why these choices are made.
The concept of Opportunity Cost
In economics, the full cost of making a certain choice includes the value of what we give up by not choosing the alternative choice. For example, the opportunity cost of studying in college is the time you could have used to do other things or the money you could have earned if you decided to work as a high school graduate.
Ceteris ParibusTranslated to English, this means all else equal. This concept allows one variable to change as
other variables are held constant.
Three basic questions in economics: What to produce? How is it produced? For whom is it produced?
Microeconomics The branch of economics that examines the behaviour of individual decision-making units, e.g. the household and the firms.
MacroeconomicsThe branch of economics that deals with the behaviour of aggregates (income, employment,
output etc.) on a national level.
*ECONONE is a course that serves as an introduction to Microeconomics.
In a market economy, individual consumers make plans of consumption and individual firms make plans of production based on the changes in market prices.
Analysis of Demand and Supply
The Law of Demand
It shows the negative relationship between price and quantity demanded. As price of a commodity increases, demand for it decreases and vice-versa.
For a better understanding of the concept, refer to Table 1.1 and Figure 1.1
A demand schedule is a table showing the quantities of a good that a consumer would buy at all different prices. Below is an example of a demand schedule.
Table 1.1 Demand Schedule for Candy
Price Quantity Demanded0 201 152 103 54 0
In mathematics, price & quantity demanded have a functional relationship. (In a demand function, price is called the independent variable and quantity demanded the dependent variable). A demand curve shows the above relationship in a graph.
Figure 1.1 Demand Curve for Candy
P
4.00
3.00
2.00
1.00
0 5 10 15 20 Qd
Demand curves are downward-sloping due to the negative relationship of price and demand, thus the Law of Demand applies.
Factors affecting a change in demand: A Shift of Demand Curve
Prices of Related GoodsWhen the price of a good (X) rises, it does not only affect its Qd, but also the Qd of another related good (Y).If a rise in price of good X leads to a in demand of good Y, these 2 goods are called
substitutes in economics. (There involves a movement along the demand curve of X and a shift of the demand curve of Y.)If a rise in price of good X leads to a fall in demand of good Y, these 2 goods are called complements or complementary goods. They are in joint demand.
IncomeA rise in income leads to a higher purchasing power or ability to buy of the consumers.( If nominal income and prices increase by the same percentage, the real income is unchanged.)If a rise in income leads to a rise in demand of a good by a consumer, the good is called a normal good or superior good.If a rise in income leads to a fall in demand of a good, the good is called an inferior good. “Inferior” does not refer to the quality of the good.
Summary:
Table 1.2
Table 1.3
Movement along a demand curve:Changes in price of a commodity Change in quantity demanded.
Shift of a demand curveChanges in income, tastes & preferences, prices of other goods Change in demand.
Type of Good Income DemandNormal Increases Increases
Decreases DecreasesInferior Increases Decreases
Decreases Increases
Type of Good Price of good 1 Demand for good 2Substitute Increases Increases
Decreases DecreasesComplement Increases Decreases
Decreases Increases
The Law of SupplyIt shows the positive relationship between price and quantity supplied. An increase in market price would increase quantity supplied, and vice-versa.
A supply schedule is a table showing the quantities of a good that a firm or producer would produce (sell) at all different prices within a time period, ceteris paribus.
Table 2.1 Supply Schedule for candy
Price Quantity Supplied2 04 16 28 3
10 4
A supply curve shows the relationship of price and quantity supplied in graph, in a similar manner with the demand curve.
Figure 2.1 Supply Curve for Candy
P
10
8
6
4
2
0 1 2 3 4
Movement along a supply curveWhenever the market price changes, a firm or supplier will change its quantity supplied accordingly.
Change in price of a good Change in quantity supplied
Shift of a supply curveChange in costs, input prices, technology,
weather, or prices if related goods Change in supply
Market Equilibrium
Equilibrium is achieved when Quantity Demanded = Quantity Supplied. (Qd = Qs)
Shortage or Excess demand is a condition wherein Qd > Qs at the current price. Surplus or Excess supply a condition wherein Qs > Qd at the current price.
Figure 3.1 Shortage Figure 3.2 Surplus
P P
3.5 3 e
2.5 e 2
20 25 40 Q 10 30 35 Q
(Fig. 3.1) The equilibrium point e is when P = 3. When P= 2, a shortage or excess demand of 20 units is present. (Fig. 3.2) The equilibrium point e is when P = 2.5. When P=3.5, a surplus or excess supply of 25 units is present.
Solving for Equilibrium Price & Equilibrium Quantity
Since Qd = Qs when e100 – 2P = 20 + 2P Qs = 20 + 2(20) = 60 P = 20 Qd = 100 – 2(20) = 60
Consumption is based on utility
Utility is the satisfaction a product yields.Marginal Utility is the additional utility gained from additional consumption.
Law of Diminishing Marginal UtilityAs the consumer increases consumption, overall utility increases while marginal or
additional utility obtained from every consumption decreases.
Indifference CurvesA set of points that shows different combinations of consumption of commodities that
gives the consumer the same level of satisfaction.
Fig. 4.1 Indifference Curves for Chips and Juice Fig. 4.2 Intersecting Indifference Curves
Chips Good 1
CA A
A D
CB B B
C
E U1
CC C U2
JA JB JC Juice Good 2
(Fig. 4.1) In this indifference curves, the combinations A (CA amount and JA), B and C will give the same level of total utility. The curve has a negative slope implying that in order for the individual to have the same total utility, he has to reduce consumption of chips to increase consumption of juice. The curve is convex because of the diminishing marginal rate of substitution. This means that the rate at which Chips is being replaced by Juice is decreasing.
(Fig. 4.2) U1 and U2 intersect at point B. Points A, B and C are indifferent along U1 while points D, B and C are indifferent along U2. If B is indifferent to both U1 and U2, then applying the assumption of transitivity in consumption, then A is indifferent to D and so on. This does not hold however because U2 has a higher level of Total Utility. Therefore, indifference curves should not intersect.
The Budget LineThe various combinations of the amount of goods an individual can consume given his
budget and the price of commodities.
Consumer Equilibrium – When the slope of the indifference curve and the budget line are equal, then the marginal utility per amount of money derived from good1 is equal to the marginal utility per amount of money derived from good2.
Substitution Effect & Income Effect
Table 3 Income & Substitution Effect*This summarizes the effect of price increases and decreases for each type of good.
Type of Good Price Substitution Effect Income EffectNormal Increases - (buy less) - (buy less)
Consumer SurplusThe excess utility derived by an individual when consuming a good or service. It is the
difference between the amounts he/she is willing to pay from the actual amount he/she paid for the good or service.
Fig. 4.3 Consumer Surplus
Price A
(Fig. 4.3) If market price is set at P1
and quantity demanded is at Q1, there are still consumers willing to but at less than Q1 and pay a higher price than P1. These consumers therefore gain a consumer surplus equal to triangle AP1B when they buy at price P1 and get quantity Q1 .
P1 B
D Q1 Quantity
Price elasticity of demand- Responsiveness of demand for a good due to a change in its price.
Inelastic Demand: - Demand that responds slightly to a change in price.- Absolute value < 1- Producers will benefit from an increase in price because it
will increase revenue, as the % decline in demand is less than the increase in price.
Perfectly Inelastic Demand: - Qd does not respond at all to a change in price.
Elastic Demand: - % change in Qd > % change in price- Absolute value is > 1- Producers will benefit from a decrease in price because it
will increase demand and revenue.
Perfectly Elastic Demand: - Qd drops to zero at an increase in the change in price.
Cross elasticity of demand- Responsiveness of demand for a good due to changes in the price of other goods.
When cross elasticity is:
Positive - substitute goods (e.g. an increase in the price of beef will increase the demand for pork.)
Negative - complementary goods (e.g. price increase in sugar would decrease the demand for coffee.)
Income elasticity of demand- The change in quantity demanded brought due to a percentage change in the income of the
consumer.
When income elasticity is:
Positive - normal goodsuperior good
Negative - inferior good
The Production Function
This shows the relationship the quantities of inputs and the maximum quantities of outputs produced. Below illustrates the concept in a table.
1st Stage of Production: K is underutilized so MP is increasing up to the 3rd labourer being added. 2nd Stage of Production:K is fully utilized so MP is decreasing (diminishing marginal productivity)
until it reaches 0.3rd Stage of Production: K is over-utilized so MP is negative meaning additional labourers
IsoquantsA curve showing different combinations of variable inputs that will give the same level of production.
Marginal Rate of Technical Substitution : Rate at which capital is being substituted for labor.
IsocostsA locus of points showing combinations of variable inputs that will result in the same total cost for the firm.
Condition for efficient production:
Fig. 5 Efficient Production
Capital K
A
K* E
Q1
B Q2
L* Labor L
(Fig. 5) At point E, the isoquant line Q1 is tangent to the isocost line. This is the condition for efficient production. It means that the marginal productivity of capital per amount spent and marginal productivity of labor per amount spent will give the same marginal productivity. The firm should therefore produce at K* and L*. Production at isoquant Q2 will not be efficient because at point A nor at point B where it meets the isocost line.
Market Structures
Perfectly competitive market- No single firm has market power. Firms are price takers.- Many buyers and sellers.- Homogenous products are being sold in the market.- There is a free entry/exit in the market.
Profit Maximization is attained when Marginal Revenue = Marginal CostIn a perfectly competitive market, it is attained when MR=Price=MC
The demand curve of a perfectly competitive firm is perfectly elastic.
The supply curve in a perfectly competitive market is its MC curve from the point where it is equal to the AVC curve. The firm should not produce below this point.
Monopoly- Single producer of a product or service in the market.- Product sold is differentiated/unique.- Barriers to entry in the market are present.
The market demand curve is the AR curve, and since there is only one producer, it is also the firm’s demand curve.
Profit Maximization in a monopoly is when MR=MC.The monopolist will produce where MR=MC. There is an incentive to gain profit if it produces at MC<MR while losses will be incurred if it produces at MC>MR.
Discriminating Monopolist is a firm that gives the same output or service at different price levels, by dividing its market to maximize profit. Consumers with an inelastic demand curve will be charged a higher price while those with an elastic demand curve will be charged a lower price.
Oligopoly- Price and output of one firm is based on the actions of competitors in the market.- Few sellers present in the market.
Reaction of Competitors and Kinked Demand Curve
Fig. 6.1 Market Reaction Function Fig. 6.2 Kinked Demand Curve
Qty. Price B
XA1 D P1 C
XA2 E J E
XAC
RFA
RFB DXB1 XB2 XBC Qty. Q1 Quantity
MR (Fig. 6.1) If firm A produces at quantity XA1 firm B reacts to this and produces at XB1 to maximize its profit based on its
reaction function. In turn, firm A adjusts to production level XA2, and firm B produces at XB2. The intersection of RFA and RFB is the equilibrium amount to be supplied by each firm in the market, XAE and XBE.
(Fig. 6.2) The kinked demand curve BCD is broken at point N. At this point, market price is at P1. If prices are set above P1, the portion of the demand curve is more elastic, thus if one firm increases price others will not follow, and that firm will lose consumers. If one firm decreases price it is on the portion wherein the demand curve is more inelastic, meaning that % increase in demand < % decrease in price.
Monopolistic Competition- Numerous sellers present in the market.- Products are differentiated through advertising, packaging, etc.The most efficient production level cannot be achieved because of the firm’s ability to influence price through product differentiation. Price is set where it is higher than the MC of the firm. It cannot operate on the lowest AC because its demand curve has an negative inclination.
