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Microeconomics
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Focuses on individual action
▪
2 main schools or streams of thoughts
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General equilibrium theory
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Partial equilibrium theory
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Ceteris Paribus
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All other things being the same
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Mutatis Mutandis
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Taking into account certain variables
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Law of Demand
◆
The price and quantity in the minds of buyers is inversely related
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Price goes up, demand goes down
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Equilibrium if supply and demand are equal
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Elasticity
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Measure of the extent of which a change in one variable, may have on another
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Price to Quantity
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Price elasticity of demand
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Ratio of Relative changes in price and quantity
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Elastic Demand
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Implies that a small change in price is likely to result in a large change in the quantity
▪
Likely to occur toward the upper portion of the demand curve
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EX: sports cars, organic fruits and veggies, gasoline
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Inelastic Demand
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Even a significant change in price would practically not result in any chance in the quantity
demanded
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Irrespective of price, quantity would remain unchanged
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Curve is vertical
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Ex: Medicine and baby food, water, salt, precious stones, cigarettes
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Supply elasticity
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Extent to which the quantity supplied responds to a change in price
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Likely to go up? Increasing Cost industry - Scare resources (salt & sand)
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Constant cost industries
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Mobile?
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Decreasing cost industries
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Independent = Coefficient of 0
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Close substitutes = positive coefficient
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Complement = negative coefficient
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Normal goods, necessity goods – water, electricity
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Inferior goods – negative income elasticity of demand
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Rich = no bus, poor = bus
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Instant coffee, milk powder, unbranded
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Giffen Good
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Price up = demand up
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In elastic producer will produce the same quantity irrespective of price
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Inelastic consumer will demand the same quantity irrespective of price
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Elastic producer and an elastic consumer are both sensitive to price
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Degree of sensitivity determines how the tax will be shared between the producer and consumer
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Tax burden is shared between the producer and the consumer
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Group having the greater relative inelasticity will bear a higher burden of the tax
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UTILITY
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Total satisfaction or benefit or experience that results from the consumption of a good or a
service
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Self-interest, consumers will always attempt to maximize their utility
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Can be expressed as a number
▪
Represents the innate or psychological satisfaction a particular good or service provides
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Unit of utility is UTIL
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Marginal Utility or MU
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Additional utility gained or experienced from the consumption of an additional unit of a
good or service
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Total utility or TU
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Total level or amount of satisfaction or benefit of experience that a person can derive by
consuming all the units of the particular good or service possible
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Law of diminishing marginal utility
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Useful in understanding the phenomenon of diminishing prices
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Consumers expect to pay less for more
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As consumption of a product or service increases, keeping the consumption of other goods
and services constant, a decline in the marginal utility is to be expected
▪
The price must always match the consumers marginal utility and willingness to consume the
good or service
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Curve tends to rise with additional units consumed till it reaches a level that corresponds to
complete satisfaction from consuming the good or service
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Beyond the point of satiety, total utility declines since additional units have negative marginal
utility
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Diamond-Water paradox
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Water = essential
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Diamond – non essential
▪
Diamonds valued more
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Subjective valuation and marginal utility
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Economic decisions are primarily driven by marginal benefit rather than total benefit
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Maximizing Utility
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Consumers equilibrium bundle – choosing a combo of goods and services that on consumption
would provide the consumer with the maximum total utility, subject to the income constraint or
the budget constraint
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Utility maximization is assumed to be the goal of everyone
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Preferences
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Prices
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Threshold (budget constraint)
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(MUX/PX) = (MUY/PY)
▪
X and y are two goods/services, MUX is the marginal utility of X and MUY is the Marginal
Utility of Y, PX is the price per unit of X and PY is the price per unit of Y
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Optimal decisions are made at the margin
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Movement
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Change along a curve
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Assumes consistency in the relationship between quantity and price
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Said to occur only when a change in the quantity demanded is caused by a change in price or a
change in price is caused by a change in the demand, consistent with the relationship between
the two variables
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Shift in Demand Curve
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Shift implies that demand has changed due to a factor or factors other than price
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Shift in Supply curve
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Indicates a change in supply even without a change in the price
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Shift in Demand
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Income could bring changes in demand
▪
Mass Manufacturing and economies of scale can help bring down costs and maintain
demand at viable levels
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Substituting high-value inputs (gold) to low-value inputs (silver) can also help maintain a
certain level of demand
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Price can create shifts
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Expectations and preferences of consumers keep changing
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John Naisbitt
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Trends & Mega-trends
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Mega Trends
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Global, have significant and sustained impact across a host of industries, societies, cultures,
families and individuals
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Trends
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Regional or local impact
▪
Urbanization
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Demographics
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Can shift demand away from certain products and services towards new categories of products
and services
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Factors that can cause a shift in supply
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New ways of Producing Goods
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New entrants
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Increased supply of related goods
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Weather
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Regulation
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Growth
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Problem with Divisibility
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For utility maximization principle to operate, goods and services must be divisible
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Can’t get half an orange at the store
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Most goods and services cannot be divided
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Nobel Laureate Herbert Simon
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Satisficing
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Denote an alternative to the theoretical concept of optimization
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Preferences and implications
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Several needs and wants
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Some may be plenty, some scarce, some may be more important than others, some may be
preferred
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Completeness
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More is better
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Transitivity
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Bundle of goods, XYZ
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Consumer prefers X to Y and prefers Y to Z
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Than we assume consumer will always prefer X to Z
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Convexity
▪
Assume that consumers prefer a variety of a mix of available goods and services to
extremes-of just having one
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Indifference Curves
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Indifference curves are ubiquitous – any bundle of preferences has an indifference curve passing
through it
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Cannot cross
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Downward slopping (more-is-better)
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Become less steep as we move to the right and downward – convexity assumption
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Marginal Rate of substitution
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Represents the rate at which a consumer is willing to exchange the good or service measured
along one axis for the good or service measured along the other axis
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Absolute value of the slope of the indifference curve
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Declines or diminishes as we move downward and to the right
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Best Bundle
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Convex indifference curves
▪
Best bundle is at the point of tangency between the budget constraint and the indifference
curve
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Law of Large numbers
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The mean of a large sample randomly drawn from a population is likely to be close to the mean
of the entire population
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Law of small numbers
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States that an individual’s choices are determined by an undue influence of outcomes in a small
sample
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Sunk Costs
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Key concept in production is the role of the firm
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Firm = Economic entity that facilitates that transformation of factors of production (inputs) into
goods and services (outputs)
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Typically…
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Integrates
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Manages
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Sells
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Some firms subcontract or outsource
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Firm & Market have two-way relationship
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Types of firms
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Sole proprietorships - one person owns the firm
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Partnerships – two or more persons come together to form a partnership
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Corporations – legal entity in its own right and can be closely held or widely held
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Not-for-profit – philanthropic or altruistic motive
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Cooperatives – number of indivd. Come together in a cooperative venture (farming, milk
production, small banks)
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Firm wants to maximize profit
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Profit = difference between total revenue cost & total costs
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Revenue can also include an increase in the value of the assets that the firm owns
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Profit = total revenue – total Cost
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Accountants
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Profit is explicit revenue minus explicit costs
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Economists
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Include any increase in the value of the assets also as revenue (positive or negative)
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Opportunity costs of the factors of production that owners provide along with the costs that
can be attributed to the transformation process
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Economic Profit = (explicit and implicit revenue) – (explicit and implicit costs)
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Short run or short term
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Provides limited or constraining choices as regards the transformation process
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Adaptability is absent
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Fixed costs
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Long run or Long term
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Provides several choices as regards the transformation process for the firm to choose from
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A firm can make changes in the inputs, in the processes and in the outputs
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Both do not constitute any fixed time horizons
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Only refer to the degree to which the firm can alter the transformation process to its advantage
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Production Table
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Illustrated the combinations of the factors of production that can result in different outputs
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Marginal product
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Additional output that may result from an additional unit of labor
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Average product
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Total output divided by the quantity of the output
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Production function
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The relationship between inputs and outputs
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Maximum output can be obtained through the transformation of a certain number of inputs
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After a certain point, the additional unit of output that can be obtained with an additional unit
of labor started to decline – Law of Diminishing marginal returns
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After a while, the total output itself beings to decline
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Diminishing absolute returns
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Diminishing marginal productivity
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In all real world production systems
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Marginal productivity and average productivity tend to rise initially, and after a certain stage,
both start declining
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Initial stages > increasing marginal productivity
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Second stage > diminishing marginal productivity
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Each additional unit of input produces a lower increase in output than the previous unit
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Range that denotes diminishing marginal productivity is the most critical
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While maintaining other inputs constant, when we add more of one input alone, at
some stage the additional output that we can derive from the additional unit of input
starts declining
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Decision makers should be able to determine when to stop adding units of any input
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Final stage > negative Marginal utility
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Each additional unit of input now decrease the output
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Remember production costs
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Fixed Costs
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Do not change with units of input or output
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Land, building a factory
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Useful in short run
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In the long run, all costs tend to be variable or semi-variable
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Variable Costs
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Costs that change when inputs and/or outputs change
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Labor costs
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Total Cost = fixed costs + Variable costs
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Firms are more concerned with average costs than total costs
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Average Total Cost = total cost/Quantity
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Average Fixed Cost = Fixed Cost/Quantity
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Average Variable cost = Variable cost/Quantity
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Average Total Cost = Average fixed cost + Average variable cost
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Marginal cost
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Most important cost
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Defined as the increase in the total cost as a consequence or increasing the level of output
by one unit
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Production Cost graphs
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Fixed cost line is shown as a parallel to the horizontal axis
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Variable cost line starts at the origin and gradually increases as output increases and after a
certain stage, increases rapidly
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Total cost line mimics the variable cost line but starts from the point where the fixed cost
line meets the vertical axis
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If we calculate average fixed cost and plot it on a graph, it shows a declining trend as
quantity increases
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After a certain stage, the decrease per unit is so small that the average fixed cost tends to be
parallel to the horizontal axis
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The average variable cost and average total cost are both U or V shaped
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Initially they decline as quantity increases but after a certain point, start increasing
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Marginal cost also is U or V Shaped with an initial decline and a steep increase after a certain
point
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Understanding Cost Curves
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Law of Diminishing marginal productivity
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As we increase one input while keeping everything else constant, both marginal and
average productivities tend to decline and marginal costs starts to rise
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After a certain stage, average productivity declines, therefore the average variable cost
tends to rise
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If the firm increases its output to very high levels, the average variable cost curve and
the average total cost curve start converging
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A firms focus is on keeping total costs at the lowest point on the total cost curve
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Productivity and cost curves are almost mirror images of each other
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Productivity increase = per unit cost tend to decrease
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Productivity decrease = unit cost tend to increase
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When Marginal cost is greater than average total cost, upward sloping portion of the average
total cost curve, increases
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When marginal cost is less than average total cost, we can see the downward slopping
portion, decreases
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When marginal cost equals average total cost, the average total cost is at its minimum
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Applies to average variable cost as well
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When marginal cost equals average variable cost, average variable cost is at its minimum
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Production function in the long run
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Long run = shortest period of time necessary to make changes to all the inputs utilized in a
production system
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Reasonable to assume that different combinations of inputs would yield different levels of
output
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Isoquant to denote the various combinations of inputs that would result in a given level of
output
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Important concept
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Marginal rate of technical substitution
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Rate at which we can exchange one input for another without affecting the total
level of output
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Assumption = increasing both capital and labor, we can continuously increase the output
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Isoquants for Cobb-douglas production function
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Q = Ka Lb
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K & L = capital and labor
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A & b = constant that can take values between 0 and 1
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Inputs are considered to be not perfectly substitutable, but output requires both inputs
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The slope changes along the isoquant
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Due to diminishing MRTS, the slope becomes flatter (Marginal Rate of Technical substitution)
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Isoquants for Leontief production function
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Q=Min(aK,bL)
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Function treats capital K and Labor L, as perfect complements and assumes that they cannot
be substituted
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MRTS is absent and there is no slope
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For increased levels of output, capital and labor have to be increased in fixed proportions
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Both inputs are considered necessary to produce the output
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L-Shaped or right angles isoquants
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Marginal Rate of Technical Substitution
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Represents the rate at which one factors needs to be substituted for another to produce a
given of output
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Represents the amount of capital that we need to sacrifice so as to use more labor in the
production process
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The level of output remains the same, all points on the isoquant represent an output of 100
units, the output can be obtained by utilizing different combinations of capital and labor
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Sloped of the isoquant is negative
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To represent MRTS as a positive number, the ratio is multiplied by -1
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Isoquants for perfect substitutes
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When considering perfect substitute, the isoquant becomes a straight line
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MRTS is constant and equals the slope of the line
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MRTS is independent of Z1 and Z2
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Gasoline, perfect substitutes
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Perfect complements
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Leontief Production function holds
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Intel vs. Microsoft
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Capital and labor to be perfect complements
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Typists and typewriters
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Concept of returns to scale
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Increasing returns to scale – a production process in which a proportional increase in every
input results in a more than proportional increase in the output
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Isoquants get closer together
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Constant returns to scale – a production process in which a proportional increase in every
input results in an equal proportional increase in the output
•
Isoquants are spaced equally apart
▪
Decreasing returns to scale – a production process in which a proportional increase in every
input results in a less than proportional increase in the output
•
Isoquants move away from each other
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Economies of scale
▪
Quantity (output) increases, the marginal cost or unit cost decreases up to a point
▪
Beyond this, the marginal cost increases
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Should operate where the marginal cost is the lowest
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First zone – Economies of scale
•
Shows the range in which the firm can benefit from decreasing marginal costs thus
generating higher profit
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Second zone – Diseconomies of scale
•
Shows the ranger where producing more output in fact increases costs and therefor may
erode profits
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Widely used in the real world
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Shifts in cost curves
▪
Shift in technology that causes an increase in productivity shifts the total product curve
upward
•
The marginal product curve and the average product curve shift upward as well
◆
Automation & robots cause this
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Technological advances can also reduce waste and defective products thus effectively
increasing output per unit of input
•
Tends to lower both average and marginal costs
◆
Result = short-run cost curves shift downward
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Change in the prices of the factors of production can also shift the cost curves
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Wages go up, variable cost curve goes up
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Or rent goes up, variable cost curve goes up
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A firm may decide to invest in a new plant to exploit economies of scale
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This can shift the marginal cost, variable cost & average cost curves downward
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Changes in interest rates can increase costs for a firm with high levels of debt
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Agricultural produce can have a devastating effect on unit costs and push the cost
significantly upward
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If no substitutes, demand forces the price to shift upward
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If all the farmers are growing the same crop based on the previous year, this can lead to a
sudden glut of surplus in the market propelling prices to crash downwards
▪
TOSS THE CROPS OUT THE VAN
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Implications of shifts
▪
Decision makers need to be constantly looking out for signals that might indicated shifts in
short-run costs
▪
Natural disasters can push up the average, marginal & total variable costs
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Depending on just one supplier for an input can cause sudden jolts in the form of increased
prices
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Real challenge is to leverage on opportunities for economies of scale and to avoid the pitfalls
of diseconomies of scale
