IB Economics/Microeconomics

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Microeconomics

Markets

  • Definition of markets with relevant, local, national, and international examples
  • A place or situation where buyers and sellers communicate with exchange in mind.

Brief description of perfect competition, monopoly, and oligopoly as different types of market structures and monopolistic competition using the characteristic

  • Perfect Competition: an industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products. These firms are price takers. There are no barriers to entry or barriers to exit.
  • Monopolistic Competition: an industry structure in which there are many firms, producing slightly differentiated products. There are close substitutes for the product of any given firm. Competitors have slight control over price. There are no barriers to entry or exit and success invites new competitors.
  • Monopoly: an industry structure where a single firm produces a product for which there are no close substitutes. Monopolists can set price, but are constrained by market discipline. Barriers to entry and exit exist and in order to ensure profits, a monopoly will attempt to maintain them.
  • Oligopoly: an industry structure in which there are a few firms producing products that range from slightly differentiated to highly differentiated. Each firm is large enough to influence this industry. Barriers to entry and exit are difficult, but exist.
  • Importance of price as a signal and as an incentive in terms of resource allocation

Demand

  • Demand is quantity of a commodity that will be bought at a given period of time at a given price. What consumers are willing and able to buy at a price affects the demand for that good.
  • The law of demand states that as a price of good or service rises, the quantity demanded will fall. Concurrently, if the price of a good or service falls, the quantity demanded will increase.
  • Determinants of Demand
  • Function of demand: Qn= f[Pn, Y, (P1....Pn-1), T]
  • Price of a good: A change in the price of a good causes a movement along the demand curve.
  • Price of related goods
  • If the price of a substitute rises, demand will increase.
  • If the price of a compliment falls, demand will increase.
  • Income: An increase in income will cause an increase in demand for normal goods and a decrease in demand for inferior goods.
  • Tastes/Preferences
  • Other macro factors: Change in the size and composition of a population, advertising, legislation.
  • Fundamental distinction between a movement along the demand curve and a shift of the demand curve
  • A movement along the demand curve is caused by a change in price. However, a shift of the demand curve means that more is demanded at each price- this is caused by a change in any of the determinants of demand (with the exception of price).
  • The demand curve is downsloping for several reasons, including the law of diminishing marginal utility. The extra utility gained from the consumption of a good falls. Therefore, the price must be lower for a person to purchase extra units of a given good. The income effect states that as prices fall, real income increases. Consumers can therefore afford to consume a greater quantity, providing a second reasons for the downsloping curve. A third reason is the "substitution effect," whereby the falling price of a good makes that good cheaper in relation to other goods (substitutes).
  • (HL) Exceptions to the law of Demand
  • Veblen goods: Veblen goods are named after the economist Thornstein Veblen and tie in with his theory of conspicuous consumption. If price for a status good rises, then demand for that good also rises.
  • Giffen goods: Giffen goods are goods which are absolutely vital for a person. This is usually refers to staple crops such as rice in some parts of China and potatoes during the Irish potato famine. As price for the good increases, individuals will be able to buy little of anything else and instead spend their income purchasing staple crops.
  • Speculative goods: As share prices increases, so does the quantity demanded of shares, as individuals predict further price increases.

Supply

  • Supply is the willingness and ability for producers to produce a good at a given price over a given period of time.
  • Law of supply with diagrammatic analysis: A higher quantity of a good will be supplied at a higher price. This is because producers can afford to supply extra units at a higher price because it allows them to produce more before AC is greater than MC.
  • Determinants of Supply:
  • Function of supply: Qn= f(Pn,Pn1....P(n-1),F1...Fm,G,Tech) + Macro Factors
  • Price of substitute goods
  • Costs of the factors of production
  • Technology
  • Government Intervention: Taxes/Subsidies
  • New firms entering a market
  • Effect of taxes and subsidies: An indirect tax is a tax placed on each unit of a good. Therefore the good become more expensive at every price by a certain value, and the supply curve shifts upwards. A subsidy, or tax credit, has the opposite effect, namely it shifts the supply curve downwards because the good is cheaper at every price.
  • Fundamental distinction between a movement along the supply curve and a shift of the supply curve: As with a movement along the demand curve, a movement along the supply curve is a change in quantity supplied resulting from a change in the good price. All other determinants of supply will change the supply and so will shift the entire supply curve.

Supply and Demand

  • Interaction of Supply and Demand: When a good is placed on a market, it suddenly doesn't begin to sell at its equilibrium price. What follows is a game of trial and error. Say a new pair of jeans comes out on the market at $20.00 and it instantly becomes a success selling out everywhere. Producers decide to produce more and charge it at $30.00. Now they're not selling enough and have a surplus of stock. They reduce the price to $25 and they sell as much as they make.
  • Diagrammatic analysis of changes in demand and supply to show adjustment of a new equilibrium

Price Control

  • Maximum Price: a maximum price that sellers may charge for a good or service. This is usually set by the government. For example, concert tickets may have maximum prices. To be effective, the maximum price (or price ceiling) must be set below the market clearing price.
  • Minimum Price a minimum price (or price floor) that sellers may charge for a good or service. This again is usually set by the government. To be effective, it must be set above the market clearing price.
  • Buffer stock scheme: A scheme in which the government tries to relegate the price level of a good or service by buying the good up when demand is too low or selling off any surplus when supply is too low. In the free market, commodities tend to fluctuate in price.
  • Buffer stock schemes tend to be very expensive. There are storage costs, the goods in question might be perishable, and there is an opportunity cost made by the government in implementing them.
  • Commodity agreements: Agreements between countries to attempt to stabilise commodity prices. This may be done by a buffer stock scheme or placing a tariff on foreign goods. OPEC is a good example of such an agreement.

Why do governments intervene in Agricultural markets

  • There has been a downward trend in agricultural markets: Thanks to more efficient technology, there has been an increase in supply. The result has been lower prices as demand has increased a bit. Moreover, the income elasticity of demand for food is inelastic. Someone does not buy more apples because he has more money.
  • Agricultural prices are subject to fluctuations because of harvests, time lags in supply, and the price elasticity of demand is very low. There are thousands of substitutes which are available. If the price of beef goes up, individuals will switch to chicken instead.
  • Governments may wish to subsidize to prevent cheap imports from abroad in an effort to protect domestic jobs.

Governments may wish to intervene by using buffer stocks, subsidies, or high fixed prices.

Price Elasticity of Demand

  • Formula
  • %Change in Quanity Demanded of Good A/ %change in Price of Good A
  • Definition
  • The responsiveness of the quantity demanded of a good to a change in its price.
  • Possible range of values
  • PED > 1: Demand is elastic
  • PED < 1: Demand in inelastic
  • PED = 1: Demand is unit elastic
  • PED = 0: Demand is perfectly inelastic
  • PED = ∞: Demand is perfectly elastic
  • Diagrams illustrating the range of values of elasticity
  • Varying elasticity along a straight-line Demand curve
  • Determinants of Price Elasticity
  • Closeness of substitutes
  • Luxury or necessity
  • Percentage of income spent on the good
  • Time Period
  • Branding

Cross Elasticity of Demand

  • Definition
  • The responsiveness of the quantity demanded of one good to a change in price of another.
  • Formula'
  • %Change in QD of Good A / %Change in the Price of Good B
  • Significance of signs with respect to compliments and substitutes
  • A positive value signifies that the two goods are substitutes.
  • If the goods are complements, the value will be negative.

Income Elasticity of Demand

  • Definition
  • The responsiveness of the quantity demanded of a good to a change in income.
  • Formula
  • %Change in QD / %Change Y
  • Normal goods: When income increases, demand for normal goods increases as well. Positive YED.
  • Inferior goods: When income increases, demand for this good falls. Negative YED.

Price Elasticity of Supply

  • Definition
  • The sensitivity of supply to a change in price.
  • Formula:
%Change QS / %Change in Price.
  • Possible range of values:
PES > 1: Supply is elastic
PES < 1: Supply is inelastic.
  • Diagrams illustrating the range of values of elasticity:
  • Determinants of price elasticity of supply
  • Number of producers.
  • Spare capacity
  • Ease of storage
  • length of production period
  • time period of training
  • Factor mobility
  • How costs react

Applications of concepts of elasticity

  • PED and business decisions: the effect of price changes on total revenue.
  • PED may be important for businesses attempting to distinguish how to maximize revenue. For example, if a business finds out its PED is very inelastic, it may want to raise its prices. If a business finds that its PED is very elastic, it may wish to lower its prices.
  • PED may be important for a government to find the impact of a tax or subsidy.
  • PED and taxation
  • Governments may wish to know how a tax or subsidy will affect a good.
  • Cross-elasticity of demand:
  • Competitors may wish to know what will happen if there is a change in compliments, or substitutes.
  • Significance of income elasticity for sectoral change (primary> secondary > tertiary) as economic growth occurs.
  • Primary sector is generally income elasticity of demand inelastic. Just because a person's income changes does not mean he will buy more tomatoes. However, secondary and tertiary sectors tend to be income elasticity of demand elastic. A change in income will have a big impact on quantity demanded of cars, or the demand for personal massages.

Taxes

  • Flat rate and ad valorem taxes
  • A flat rate tax is a tax which is the same rate regardless of price or income.
  • An ad valorem tax is a tax which is a percentage of the price of a good. The United States has an ad valorem tax of ten percent.
  • Incidence of indirect taxes and subsidies on the producer and consumer
  • An indirect tax raises the price of a good. Its elasticity determines if the burden of the tax is on the producer or on the consumer. In the case of a good with inelastic demand the tax burden can be easily passed on to the consumer.
  • Implication of elasticity of supply and demand for the incidence (burden) of taxation.
  • If the product is demand inelastic or supply elastic, the consumer would need to bear the majority of the burden of tax.
  • If the product is demand elastic or supply inelastic, the producer would need to bear the majority of the burden of tax.

Theory of the Firm (HL)

Types of costs: distinction between short run and long run

  • Fixed costs: Costs a firm bears in the short run regardless of output. A firm could produce absolutely nothing and still face fixed costs. These are things such as rent, etc.
  • Total costs: Total cost is variable costs plus fixed costs.
  • The Law of diminishing returns states that as additional variable units are added to fixed units, after a certain point- the marginal product of the variable unit declines.
  • Total product: total output produced by factors of production.
  • Average product: The output per unit of variable factor.
  • Marginal product : The extra output from employing an additional variable factor.
  • Short-run cost curves: The short run is the period in time in which at least one factor of production is fixed.
  • Long-Run cost curves: The long run is the period of time in which all factors of production are variable.
  • Economies of Scale : An increase in a firm's scale of production leads to lower average costs per unit produced.
  • Diseconomies of scale: An increase in a firm's scale of production leads to a higher average cost per units produced.

Revenues

  • Total revenue: The total amount that a firm takes in from the sale of its product.
  • Marginal revenue: the additional revenue that a firm takes when it increases output by one additional unit.

Profit

  • Distinction between normal (zero) and supernormal (abnormal) profit.
  • Normal profit is where all costs are covered including the expected return of the entrepreneur, anything gained beyond that is considered supernormal profit.
  • Profit maximization in terms of total revenue and total costs and in terms of marginal revenue and marginal costs.
  • Profit maximization occurs when the marginal revenue, that is the revenue gained from producing one extra unit of output, equates the marginal cost of producing that extra unit.
  • Profit maximization assumed to be the main goal of firms but other goals exist (sales volume maximization, revenue maximization, environmental concerns)
  • Though a firm may have its primary goal of profit maximization- in the case of most corporations, other goals may exist. For example, sales volume maximization, the maximization of revenue, and environmental concerns. For example, the Body Shop before being incorporated, proceeded to include many animal friendly measures, which prevented the firm from maximizing profit.
  • However, the main goal is indeed profit maximization, rare cases exist where it is otherwise, and indeed these are valid examples, but they are a small minority in today's business world.

Perfect Competition

  • Assumptions of the model: Perfect competition is an industry structure which holds numerous assumptions. It is also theoretical.
  • There are numerous buyers and sellers of which none are able to influence the market.
  • There is perfect information.
  • Products are homogeneous
  • There are no barriers to entry and no barriers to exit.
  • Demand curve facing the industry and the firm in perfect competition
  • Profit-maximizing level of output and price in the short run and long run
  • The profit maximizing level of output is where MC = MR.
  • The possibility of abnormal profits/losses in the short-run and normal profits in the long-run.
  • Short run- yes
  • Long run- never.
  • Shut down price, break-even price.
  • Company has to shut down (in the short-run) if variable costs are not being covered. In the long-run it's all about covering the average costs.
  • Definitions of allocative and productive (technical) efficiency
  • Allocative efficiency occurs when output is at society's optimum level. P=MC
  • Productive efficiency is when a firm produces at the lowest possible cost per unit. AC=MC
  • Efficiency in perfect competition
  • Perfect competition is both allocatively and productively efficient. However, it is dynamic efficient, in the sense that products can't be differentiated and no new technology can be produced. In the long run, no firm will have any profit to spend on research and development.

Monopoly

  • Assumptions of the model
  • One single firm dominates a market for which there are no close substitutes.
  • Barriers to entry and exit.
  • Sources of monopoly power/barriers to entry
  • Government legislation.
  • Patents and copyrights.
  • Control over supplies
  • Cost advantage, such as massive economies of scale.
  • Product differentiation.
  • Use of force.
  • Natural monopoly
  • A monopoly which has gained its status because of massive economies of scale.
  • Demand curve facing the monopolist
  • Profit-maximizing level of output
  • A monopoly maximizes profits when MC=MR.
  • Advantages and disadvantages of monopoly in comparison with perfect competition.

Monopoly: price - higher,Output- lower, Profit-Abnormal, Produces where Average costs are higher(inefficient)

  • However, a monopoly may use economies of scale therefore reducing costs and increasing output


Perfect Competition: Price- Lower, output- higher,Profit- normal, Produces Where average costs are lowest(efficient)


  • Efficiency in monopoly
  • A monopolist is neither allocatively or productively efficient. It may be dynamically efficient if it wishes to maintain its monopolistic position.
  • How to control a monopoly
  • Dogmatic Approach: This is the approach in the USA. Monopoly is illegal.
    • Anti-trust legislation bans monopoly
    • If a firm is accused of being a monopoly, they are taken to court and if found guilty, they are broken up.
  • Pragmatic Approach: Looking at monopoly with an open mind
    • looking at advantages and disadvantages and coming to a conclusion
    • the conclusion may be, for example, lowering prices
  • State control: the government takes over the monopoly because it is assumed that the government will run the firm for the 'benefit' of the country
  • A licence: you are given a licence to run a monopoly. If you run it well, it will be renewed, if not it will be cancelled.

Monopolistic Competition

  • Assumptions in the model
  • Large number of small firms.
  • (Almost) perfect knowledge.
  • Differentiated products.
  • No barriers to entry or exit.
  • Short-run and long-run equilibrium:
  • In the short-run abnormal profits can be earned (at MC=MR)
  • In the long-run only normal profits can be earned.
  • Product differentiation:
  • Efficiency in monopolistic competition:
  • Monopolistic competition is an inefficient market structure.
  • In the short-run/long-run neither allocative nor productive efficiency is achieved!

Oligopoly

  • Assumptions of the model:
  • Competition between a few firms
  • many buyers, few sellers
  • differentiated products
  • oligopolists will try to block entry
  • the oligopolist believes that if he puts his price down his competitors will follow his example
  • therefore in oligopolistic competition there is non-price competition, for example supermarkets compete in terms of:
      • car parks
      • loyalty cards
      • trollies
  • Collusive and non-collusive oligopoly:
  • Non-collusive Oligopoly: where firms compete against each other in a normal way
  • Collusive Oligopoly: where firms try to come to an agreement to reduce the amount of competition.
      • It is usually illegal
      • they will fix the output of the industry and then share the output between them - this is often called a cartel
  • Cartels:
    • One example: OPEC
  • Kinked demand curve as a model to describe interdependent behaviour:
    • The kinked demand curve basically illustrates the downward-stickiness of prices. The kinked demand curve shows how a change in e.g. raw material costs does not bring about a change in the price of the final good, due to the concept of downward-stickiness. The fear of changing prices and then loosing numerous customers is too big to actually change prices.


  • Importance of non-price competition:
  • Theory of contestable markets:

Price Discrimination

  • Definition:

price discrimination occurs when different people are charged different prices for exactly the same good

  • Reasons for price discrimination
  • Necessary conditions for the practice of price discrimination:
  • Time
  • Age
  • Income
  • You must be a monopolist- however in the real world every firm has a monopoly in their own name e.g. Ford
  • There must be 2 separate markets which must be kept separate
    • Geographically
    • Lack of knowledge
  • there must be no leakage between markets e.g. cigarettes in UK are 5 pounds and in Poland are 1 pound, but markets are kept apart
  • Price elasticity of demand in each market must be different i.e. demand is more elastic in one market than in another
  • The aim of the firm is to maximise profits
  • Possible advantages to either the producer or consumer

Market Failure

Definition of Market Failure

the inability of an unregulated market( no government intervention) to use its resources efficiently

Reasons for Market Failure

Perfect markets are socially efficient, they are operating at pareto optimality in which no one can be made better off with someone being made worse off. Consumer surplus is maximized. P=MC where MSC=MSB.

In the real world, markets are not perfect. MSC does not equal MSB and market failure occurs. This is because of externalities, underprovision of merit goods, the overprovision of demerit goods, a lack of public goods, and imperfect markets. If the free market is left to its own devices, market failure will occur.

  • Inefficient Producers: the producers don't produce where the average costs are at minimum. Therefore they are using more resources than they need to.
  • Positive and Negative externalities: An externality is defined as an effect on a third party which is caused by the consumption and/or production of a good or service. There are four types of externalities.
  • Positive externality of production: This occurs when the MSC is greater than MPC. (bee-keeping)
  • Negative externality of production: This occurs when MSC is less than MPC. (Pollution)
  • Positive externality of consumption: This occurs when MPB is greater than MSB. (listening to good music)
  • Negative externality of consumption: This occurs when MPB is less than MSB (smoking)
  • Short-term and long-term environmental concerns, with reference to sustainable development
  • Lack of public goods : Public goods are defined as a good which total cost of production does not increase with the number of consumers. The classic example is national defence. Other example: street lights. Public goods will not be provided by the market.
  • Underprovision of merit goods: If left to its own devices, merit goods( a private good with positive externailites) will be underprovided. These are goods and services which have a positive effect on society like education, healthcare and sports centers.
  • Overprovision of demerit goods: If left to its own devices, demerit goods ( a private good with negative externalities)will be overprovided. These are such things as prostitution, alcohol, and cigarettes.
  • To discourage these demerit goods the government creates: negative advertising, tax on the good, or ban it.
  • Abuse of monopoly power: Imperfect markets such as oligopolies and monopolies restrict output in an attempt to maximize profit. Thus, MSB is not equal to MSC. MSC is equal to MR.

Possible government responses

  • Legislation: Antitrust legislation can be brought in an attempt to break monopoly power and collusive oligopolies. Legislation to make high school attendance mandatory. Ban smoking in restaurants.
  • Direct provision of merit and public goods: Governments can 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. This will internalize some of the external costs (ie smokers will pay for their second hand smoke through the tax).
  • Subsidies: Reduce the cost of university education because it has beneficial externalities. The price will be reduced to reflect the benefit society attains through the education of individuals.
  • Tradable permits: Tradable permits are permits allowing a firm to produce a given amount of pollution. There is limited supply for how much pollution a firm can produce so if a firm would want to pollute more it has to purchase tradable permits from other firms. A Carbon Tax (taxing consumption which causes pollution, such as fossil fuels) achieves the same result. In both cases, firms and individuals are motivated to reduce costs by reducing environmental damage.
  • Extension of property rights:
  • Advertising to encourage and discourage competition:
  • International cooperation among governments: In the case of acid rain for example international cooperation among governments is necessary in order to reduce its occurrence.

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