PRINCIPLES OF MICROECONOMICS NOTES [For Class Test 1]

Michael Cornish
THE CAVEAT: These notes are not necessarily exhaustive – you must therefore use or rely
upon them to your own peril!
LECTURE I: INTRODUCTION
What is economics? The study of the allocation of resources
The economic problem: Limited resources v. unlimited wants (i.e. ‘scarcity’!)
Analysis of economic problems:
• Decisions are made at the margin => hence, ‘marginal analysis’
• Positive v. normative analysis:
o Positive: descriptive/explanatory analysis (can be checked with facts)
o Normative: prescriptive analysis (is based on values/opinions)
Economics as the ‘dismal science’
• The discipline of economics attempts to create standardised theories and models for human
interactions regarding the exchange of products and money -> human interactions are to some extent
unpredictable!
A spectrum of economic systems:
Central planning <--> mixed economy <--> laissez-faire capitalism
Productive efficiency
• A product is made using the least amount of resources
Allocative efficiency
• Resources are allocated according to their most productive social use
Economic rationalism
• Assumption is that people make rational decisions in pursuit of their self-interest
Opportunity cost
• The value of the next best alternative [i.e. we can value resources by the value of their next best
alternative use]
• Distinguishes economics from accounting!
LECTURE II: FOUNDATIONAL MICROECONOMIC CONCEPTS
Production possibility curves/frontiers (‘PPCs’ / ‘PPFs’)
• Illustrate opportunity cost
o Outwards bending - increasing opportunity cost
o Straight line - constant opportunity cost
o Inwards bending - decreasing opportunity cost (not possible!!)
• Assumptions:
o Fixed resources
o Fixed technology
o Productive efficiency
o Full employment
• Efficiency? Anywhere on the curve
• How to expand the curve?
o Additional resources
o Improved technology
Absolute advantage
• The ability to produce more of a product than other producers using the same amount of resources
Comparative advantage
• The ability to produce a product at a lower opportunity cost than other producers
• Comparative advantage determines where the greatest gains from specialisation and trade are
Factors of production
• Labour (‘L’): Income paid on labour is a wage
• Capital (‘K’): Income paid on capital is rent (or interest)
• Land (‘T’) (but the category is broader than ‘land’!): Income paid on land is rent
• Entrepreneurship: Income paid on entrepreneurship is profit
 PRINCIPLES OF MICROECONOMICS, UPNG, SEMESTER 1, 2016

Property rights
• The exclusive (‘inalienable’) use of property, including the right to buy or sell it
• Increase certainty in economic transaction and thus mitigate risk
• Are a precondition for efficient markets
The Circular Flow Model

LECTURE III: INTRODUCING SUPPLY AND DEMAND

Basics of Demand
• Law of Demand: Inverse relationship between P and QD
• Three reasons the Law of Demand holds true:
o Income effect
When the price of a product is lower, a consumer can afford more of the product
without giving up other products
The decline in prices therefore increases the purchasing power of consumers, and
increases their real income
o Substitution effect
When the price of a product is lower, consumers have a greater incentive to
substitute other products for it
o Diminishing marginal utility
The utility gained from each additional unit of product decreases (as more of it is
purchased)
• Utility: The satisfaction derived from a product
Prices must therefore be lower for greater quantities to be purchased
• Movements along the curve are due to price
• Shifts of the curve are due to:
o A change in price of a related good
o Substitutes
o Complements
o Changes in tastes and preferences
o Income
o The number of consumers
o Expected future prices
Utility
• Utility = satisfaction
o I.e., the level of utility derived from the purchase of a good is the level of satisfaction that
good gives the consumer
• Utility is ordinal, not cardinal (i.e. rankable; no such thing as one product giving ‘twice the utility’ of
another product!)
• Utility curves are parallel, and cannot intersect; inwards-bending shape indicates diminishing marginal
utility
• Utility curves are also called ‘indifference curves’
• Demand curves are derived by consumers seeking to maximise utility
Basics of Supply
• Law of Supply: Positive relationship between P and QS
• Movements along the curve are due to price
• Shifts of the curve are due to:
o Prices of inputs (i.e. changes in production costs)
 PRINCIPLES OF MICROECONOMICS, UPNG, SEMESTER 1, 2016

o Technological change / productivity

o Number of firms in the market
o Expected future prices
o Prices of substitutes
• Supply curves are derived by producers seeking to maximise profit
Supply and Demand in Equilibrium
• While we may perceive it as static when we simply look at a graph, market supply and demand are
constantly adjusting over time => this is what is called a dynamic equilibrium
LECTURE IV: ELASTICITY
Elasticity is a concept that measure the responsiveness of one variable to another
Price elasticity of demand (PεD)
• Measures the responsiveness of quantity demanded to changes in price: PεD = %ΔQD / %ΔP
PεD > 1 Elastic [QD is highly responsive to Δs in P]

PεD = 1 Unit elastic [QD is equally proportionally responsive to Δs in P]

PεD < 1 Inelastic [QD is not very responsive to Δs in P]

Price elasticity of demand and total revenue

Nb. The numbers are not important in the example, the concepts are!

Cross-price elasticity of demand (Cross-PεD)

• Measures the responsiveness of the quantity demanded to changes in the price of another product:
Cross-PεD = %ΔQD / %ΔP of another product
If the products are… Cross-PεD will be… Example:

Substitutes Positive Lamb and chicken

Complements Negative Fish and chips

Unrelated Zero Economics textbooks and movie tickets

 PRINCIPLES OF MICROECONOMICS, UPNG, SEMESTER 1, 2016

Income elasticity of demand (Income

Income εD)
• Measures
easures the responsiveness of the quantity demanded to changes in income::
Income εD = %ΔQD / %ΔY
If income εD is... Then the good is… Example:

0>1 Normal Milk

>1 Superior Ferrari

<0 Inferior Meat flaps

Price elasticity of supply (PεS)
• Measures
easures the responsiveness of quantity demanded to changes in price:
price PεD = %ΔQS / %ΔP
Elasticity over time
• Both supply and demand curves become more elastic over time: in n the very long-run,
long quantity is
perfectly responsive to changes in price (i.e. perfectly elastic!)
LECTURE V: MARKETS IN ACTION
Note: You need d to know how to do welfare analysis (i.e. how has CS, PS, DWL, government revenue changed)
on all of the supply and demand diagrams; and be able to comment on how effective the policies are!
Consumer surplus (CS)
• Measures
easures the additional benefit that accrues to consumers, beyond the cost of the products they
purchase (the net benefit)
Producer surplus (PS)
• Measures
easures the benefit that accrues to the suppliers beyond the cost of the products they produce (the
net benefit)

Price controls
• Price ceiling: the government makes it illegal to sell at a price higher than the price they fix
o Aim is to protect the consumer => leads to a shortage

• Price floor: the government makes it illegal to sell at a price lower than the price they fix
o Aim is to protect the producer => leads to a surplus
 PRINCIPLES OF MICROECONOMICS, UPNG, SEMESTER 1, 2016

Taxes
• The government can apply a tax to the supplier or the consumer
o However, it makes no difference to who bears the burden of the tax! It just changes who
actually writes
es the cheque to the government!
• When a product is taxed, it leads to a loss of efficiency in that market (DWL)
• Why levy a tax?
o To discourage consumption or production of a particular product
o To spend the revenues in a way that creates a larger social benefit than the loss in efficiency
in that market
o For political purposes
• The more inelastic party bears the greater burden of the tax
o The actual division of this burden is called the tax incidence
Example: A tax on suppliers (same result as a tax on consumers!)

Subsidies
• Payments
ayments made by the government to consumers or producers in a market to encourage
consumption or production
• When a product is subsidised,
subsidised it leads to a loss of efficiency (DWL) [the gain in surplus in the market is
less than the cost of the subsidy]
• The more elastic party gets the greater benefit of the subsidy
o The actual division of the benefit is called the subsidy incidence
Note: I do not expect you to learn the diagram, other than that subsidies are usually paid to the supplier and
leads to an expansion in supply
LECTURE VI: LABOUR MARKETS
Derived demand
• Demand
emand for a factor of production that is used in (and derived from the demand of) another product
Marginal revenue product of labour (MRPL)
• The revenue generated by hiring an additional (‘the next’) worker
Note: w = wage
 PRINCIPLES OF MICROECONOMICS, UPNG, SEMESTER 1, 2016

MRPL > w The firm should hire more workers to increase profits

MRPL < w The firm should hire fewer workers to increase profits

MRPL = w The is hiring the optimal number of workers and is maximising profits
Shifts in demand for labour are caused by:
• Changes in human capital
• Changes in technology
• Changes in the price of the product the labour is being used to produce
• Change in quantity of other inputs to production (usually K)
• Changes in the number of firms in the market
Backwards-bending labour supply curve
• Income effect: As income , workers can now afford more leisure (which is at least a normal good
for most people!)
• Substitution effect: As the wage , the opportunity cost of leisure increases, thus increasing the
amount of labour supplied

Shifts in supply for labour are caused by:

• Changing size of population (n)
• Changing demographics
• Changes in alternative labour markets
Why do wages differ?
• Differences in MRPL: e.g. A movie star v. cleaner
• ‘Compensating differentials’: e.g. wages of Australian expats in Papua New Guinea v. Australian
wages
• Discrimination: employers who discriminate bear an economic penalty
• Relative market power
Economic rent
• The payment to a factor of production (L, K, T) beyond what is required to bring that factor into the
market
• The additional income received (the ‘rent’) is unearned, in the sense that it not earning a return due
to any kind of entrepreneurship
LECTURE VII: INTERNATIONAL TRADE
Terms of trade
• The relative price of exports to imports; i.e. how many imports can be purchased per unit of exports?
Autarky
• Economic self-sufficiency (an economy is in autarky when it does not trade, i.e., when it is a ‘closed
economy’)
Protectionism
• Policies which seek to limit international trade with the aim of ‘protecting’ domestic producers and
their employees [most economists are against most forms of protectionism]
 PRINCIPLES OF MICROECONOMICS, UPNG, SEMESTER 1, 2016

Protectionism: Tariffs
• Tariffs = import taxes

Protectionism: Quotas
• Quotas = quantitative restrictions on imports
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Protectionism: Other measures

• Domestic price controls (price floors, price ceilings)
• Domestic subsidies / export subsidies
• Tied procurement laws (i.e., government departments must buy domestically)
• Exchange rate manipulation
• Intellectual property laws
• Quarantines
• Embargos
• Product standards
(Bad) arguments for protectionism
• Infant industry argument
o Argument is that industries need time to establish, so that they can compete with overseas
firm
o But can governments pick winners?
How do we know if the industry is an area of comparative advantage?
o And does the ‘infant’ ever grow up?
Elite capture of protectionist policies
• The dumping argument
o Foreign firms may dump cheap products on a country that undercut local businesses and
drive them out of business, allowing the foreign firms to capture the industry
o But in practice, few foreign firms have enough power to dominate a market where there
more foreign competition is allowed!
• Saves jobs
o International trade does destroy jobs, but it creates jobs too – price signals reallocate labour
to where they are more efficient!
• Allows rich countries to compete with cheap foreign labour
o Wages are related to productivity when there is free competition
o Rich countries have higher average productivity… so they don’t need protection to compete!
• Prevent rich countries exploiting developing countries
o Trading with developing countries increases the demand for their products, thus leading to
increases in wages…
• Penalises lax environmental standards
o Often, poor countries need to increase their income in order to improve their capacity to
undertake environmental protection
o Not trading with developing countries denies them this chance to increase protection!
Free trade v. protectionism
• Overall, the empirical evidence points toward free trade being the much better choice
• But whilst free trade creates more winners, it does also create losers
• Losses to the losers are highly concentrated, whilst the benefits to the winners (usually consumers)
are thinly spread => consumers are usually not even aware how they are benefitting!!
• Compelling argument that economic losers should be compensated so that they can adjust to the new
economic reality => e.g. provision of training
LECTURE VIII: EFFICIENCY AND EQUITY
Skipped! Will not be tested!

~O~

Finé!