Microeconomics Essentials

CHAPTER 1

FUNDAMENTALS OF SUPPLY AND DEMAND

1.1 ECONOMICS AND SCARCITY

Economics is a social science that studies society’s problem of choice among a limited amount of resources in its quest to attain the highest practical satisfaction of its unlimited wants. It is the allocation of scarce resources among competing ends.

Microeconomics focuses on problems specific to a household, firm, or industry, rather than those of a national or world-wide scale.

Scarcity is considered to be the basic problem of economics. Since all resources are limited in their availability, and society’s desires for them are unlimited, there must exist some process of determining what, how, how much, and for whom to produce. Scarcity is the reason for the existence of price systems: as quantities of goods are limited, consumers must bid for desired goods.

Economic Goods are scarce and limited in their quantity; therefore, their prices are positive.

Free Goods are those goods which are not scarce. Their prices are zero because of their unlimited quantity. An example of a free good is air.

1.2 FACTORS OF PRODUCTION

1.2.1 DEFINITIONS

Economic Resources and factors of production are the natural and unnatural inputs that are used in the production of goods and services. They fall into four general categories: Land, Labor, Capital and Entrepreneurial talents.

Land is distinguishable as being fixed in its supply. It includes surface land, minerals, and other natural resources found in the air, soil and sea.

Labor is composed of all human physical and mental abilities and qualities used in production of goods and services.

Capital includes produced goods such as machines, buildings, computers, etc. ..., that are used as factor inputs for further production.

Entrepreneurial Talent involves human decision making, risk taking, invention, and ingenuity.

1.2.2 CONSUMER GOODS VS. CAPITAL GOODS

Consumer Goods directly satisfy the demands of the ultimate purchaser or consumer.

Capital Goods (real capital) indirectly satisfy consumer demands through their use in production of another good. Capital goods do not include money (financial capital). Money is not considered to be an economic resource.

Note: some goods can be both consumer and capital goods.

1.3 OPPORTUNITY COST

The true cost of anything is the value of the next best thing which is given up because of that decision. Opportunity Cost stems from the foregone opportunities that are sacrificed in performing this certain thing. For example, a tailor may be able to sew either a pair of pants or two shirts in an hour. If the tailor opts to make the pants, his opportunity cost will be the two shirts that could have been made in the same time.

1.4 PRODUCTION POSSIBILITIES FRONTIER

The Production Possibilities Frontier Curve (PPF or PPC) or Transformation are names given to a way of illustrating the concepts of scarcity and opportunity cost. The curve defines the current limits on production capabilities in a given economic situation due to the physical restraints on resource supply and technology. It represents the maximum output combinations that are achievable under given market circumstances.

Figure 1.4.1– The Production Possibilities Curve

On PPC–the curve ADB represents the different production combinations of Good A and Good B that are possible in the economy under given market conditions if all the technology and other resources are being fully utilized. Furthermore, the economy displays full employment and maximum resource utilization along this curve.

Point A represents the maximum of Good A that could be produced if all resources were directed for production of Good A. Point B represents the maximum of Good B that could be produced if all resources were directed for production of Good B.

Inside PPC—(i.e., point C) although it is technologically feasible to produce at point C, it involves underutilization of resources. More of Good B can be produced while still producing the same quantity of Good A.

Outside PPC—(i.e., point E) is an unattainable region of production given the current state of technology and resource supply.

Where MC is Marginal Cost, and P is price

1.4.1 PPC PROPERTIES

Shifts of PPC

Courses of Growth=

1. Improvement in technology

2. Increase in resource supply

3. Education

Figure 1.4.2

Causes of growth =

1) Improvement in taechnology

2) Increase in resource supply

3) Education

Let us assume that Good A is a capital intensive good (i.e., uses proportionately more capital than labor) and Good B is a labor intensive good (i.e., uses relatively more labor than capital). If the supply of capital increased and the supply of labor stayed the same, then the shift in the PPC curve will look like the shift in the graph depicted below.

Figure 1.4.3 –Shift in PPC Due to Increase in Capital

Note: Shifts along the PPC line do not represent a change in technology. Rather, they represent equally technological efficient combinations of output from which to choose.

1.4.2 CONCAVITY OF PPC

The PPC is usually drawn concave to the origin because inputs are, in general, not equally adaptable to alternative uses. The concavity of the PPC illustrates the Laws of Increasing Relative Costs and Diminishing Returns.

1.5 INCREASING RELATIVE COSTS AND DIMINISHING RETURNS

1.5.1 LAW OF INCREASING RELATIVE COSTS

In order to get equal extra amounts of one good, you must give up an ever increasing amount of another good.

1.5.2 LAW OF DIMINISHING RETURNS

If the input of some resource is increased while others