MICROECONOMICS

IE University
Professor LUIS ALBERTO RIVAS HERRERO
E-Mail: [email protected]

Key words:
Part 1:
Trade off: comparison of the cost and benefit of doing something
Market: an economy that allocates through the decentralized decisions of many firms and
households as they interreact in markets for goods and services
Human capital: the educational achievement and skills of the labour force
Positive economics: Is the branch of economic analysis that describes the way the economy
actually works (description)
Normative economics: makes prescriptions about the way the economy should work
(prescription)
Part 2:

INTRODUCTION TO MICRO:

The principles –
 Choices are necessary because resources are scarce
 The true cost of something is the opportunity cost
 ‘How much’ is a decision at the margin
 People respond to incentives, exploiting opportunities to make themselves
better off
Economic systems –
 Traditional economy
 Market economy
 Planed economy
 Mixed economy

Factors of production –
 Land
 Labour
 Physical capital

Circular flow of income:

Production bilbility frontier:
Shows the combination of two goods that are possible for society to produce at full
employment.
Concept illustrated are:
 Efficiency
 Opportunity cost
 Technology
 Trade offs
 Economic growth

When and why economists disagree:

 Media coverage tends to exaggerate the real differences in views among
economist
 Economics is often tied up with politics
 Diverse people have diverse values
 Economic modelling requires simplifying assumptions

Supply, demand & Equilibrium:

A shift in the demand curve:

 Consumer income
o Normal good – demand increases as income increases (vice versa)
o Inferior good – demand decreases as income increases (vice versa)
 Prices of related goods
o Substitutes – decrease in price of one leads to a decrease in demand
for the other
o Complimentary – decrease in price of one leads to an increase in
demand do the other
 Tastes
 o Vary among consumers
 Expectations
o Buyers adjust current spending in anticipation of the direction of
future prices in order to obtain the lowest possible price
 Number of buyers
o Population changes the number of buyers thus changing the demand
 Climate
 Law

The market demand curve is the horizontal sum of all individual demand curves of all
consumers:

Supply:
Supply curve shows the quantity supplied at different points

Quantity supplied is the quantity that producers are willing and able to sell at a particular
price

A shift in the supply curve:

 Input prices
o A decrease in the price of an input increase profits and encourages
more supply
o Inputs used in production have opportunity costs. Sellers will choose
to use inputs whose profit is the highest.
 Technology
o New, better technology makes sellers willing to offer more at a given
price or sell their quantity at a lower price
 Expectations
o The expectation of a higher price for a good in the future decreases
current supply of the good – if they can store the good (vice versa)
 Number of sellers
o As producers enter and exit the market, the overall supply changes
 Law

Equilibrium:
 The amount consumers would purchase at this price is matched exactly by the
amount producers wish to sell.

Surplus – will ush the price down until it reaches the equilibrium Qs > Qd

Shortage – will push the price of until it reaches the equilibrium Qs < Qd

Elasticity and welfare analysis:

A demand curve is elastic when an increase in price reduces the quantity demanded a lot
(vice versa).

A demand curve is inelastic when an increase in price reduces the quantity by just a little

The more responsive quality demanded is to a change in price, the more elastic the demand
curve is .
If two linear demand curves run through a common point, then at any given quantity, the
curve that is flatter is more elastic.

Problem being that it depends on our choice of starting point. Hence, to solve this

we use the midpoint formula for percentage changes.

IF the E < 1, demand is inelastic (TR increase as price increase)

If the E > 1, demand is elastic (TR decreases when price increase)
If the E = 1 the demand is unit elastic (TR doenst change)

Factors determining the price elasticity of demand:

 The availability of close substitutes
o Fewer substitutes makes it harder for consumers to adjust Q when P changes,
sop demand is inelastic
o Many substitutes, causes switching to be easier hence demand is elastic.
 Whether the good is a necessity or luxury
o Necessity = inelastic
o Luxury = elastic
 The share of income spent on the good
o We are less sensitive to price changes when the good feels cheap, inelastic
o We are more sensitive to price changes when the good feels expense, elastic
 Time elapsed since the price change
o Less time to adjust means lower elasticity, inelastic
o Over time consumers can adjust their behaviour by finding substitutes, elastic

Cross-price elasticity of demand measures how sensitive the quantity demanded of a good A
is to the price of good B:

For substitutes, cross price elasticity of demand is positive. (an increase in P of one
increase D for the other)

For complements, the corss elasticity of demand is negative ( an increase in P of one

decrease D for the other)

((Use to the formula verify))

The income elasticity of demand measure show sensitive the quantity demanded of a good
is to changes in income.

Normal goods have a positive elasticity

Inferior goods have a negative elasticity

Price elasticity of supply:

supply curve is elastic of a rise in price increases the quantity supplied a lot.

Its inelastic if seller change quantity just a little

Factors determining elasticity of supply:

 Availability of inputs:
o If increased production is very expensive, then the supply curve will
be inelastic If production can be increases cheaply, supply is elastic
 Time
o Price elasticity of supply increases as producers have more time to
respond to price changes, becomes more elastic at time goes

Welfare analysis:
Consumer surplus: the difference between market price and what consumers (as an
individuals or the market) would be willing to pay)

Consumer surplus rises with a fall in price !

Producer surplus: the difference between the market price and the price at which firms are
willing to supply the product.

Individual producer surplus: is h tenet gain to an individual seller from selling a good. It is
equal to the difference between the price received and the sellers cost.

Total producer surplus: is the sum of the individual producer surpluses of all the sellers of a
good in a market

Producer surplus rises when prices increase !

Efficiency of markets:
Ways to UNSUCCESFULLY increase total surplus:
 Reallocate consumption among consumers
 Reallocate sales among sellers
 Change the quantity traded

Competitive markets are usually efficient:

  They allocate consumption of the good to the potential buyers who most
value it.
 They allocate sales to the potential sellers who most value the right to sell
the good
 They ensure that all transactions are mutually beneficial (every consumer
who makes a purchase values the good more than every seller who makes a
sale.

Equity and efficiency

 Efficiency is important, but society also cares about equity.
 Sometimes societies choose to have government intervene in markets to
increase efficiency (even though it reduces it)

Market work well because

o Property rights
o Create incentive to trade with others and to innovate
o They are rights of owners of valuable items, whether resources or
goods, to dispose of those items as they choose.
o Economic signals
o Equilibrium prices signal to resources exactly where they are most
valued
o Is any piece of information that helps people make better economic
decisions
 Prices translate complex information into an easy signal for
producers
 Profits rise in industries when consumers want more of
that industry’s product
 Profits decline in industries when consumers want less
of that industry’s products.

Inefficient: opportunities are missed. Some people could be better off without making other
people worse off.

Government Policies:
Price controls: legal restrictions on how high or low market price may go:

Price ceiling: maximum price sellers are allowed to charge for a good or service
o Inefficiency
o Low quantity
 Deadweight loss
o Inefficient allocation to customers
 Consumers who value a good most don’t necessary get
it
o Wasted resources, time and effort
 Lead to bribery
 Normally buyers would compete with each other by
offering higher prices, if prices cant rise, buyers must
compete in other ways (waiting in line, illegal bribes
and favors)
o Inefficiently low quality
 Sellers have more customers than goods, due to price
constrains they are unable to make pore profit, hence
they reduce the quality and reduce the service
o Black market
 Exchange of goods and services are illegal prices
o Why ?
o Benefit some people
o If price ceiling is longstanding, buyers may noy have a realistic
idea of what would happen without it.
o Gov don’t understand supply and demand analysis

Price floor: a minimum price buyer are required to pay for a good or service
o Inefficiency
o Inefficient allocation of sales
 Due to allowing high-cost firms to operate
 Preventing low-cost firms from entering the industry
o Wasted resources
 Price floors encourage waste
 To deal with the surplus generated by dairy
price floors, the government sometimes buys
back the excess and donates or destroys it
o Inefficiently high quality
 Higher quality raises cost and reduces sellers profit
 Buyers get higher quality but would prefer a lower
price
 Price floors encourage sellers to waste resoruces
o Temptation to break the law by selling below the legal price.
o Why ?
 o They do benefit some people
o If the price floor is longstanding, buyers may noy have realistic
idea of what would happen without it
o Government official do not often understand supply and
demand analysis

Government mostly control these because market prices do not necessarily please buyer or
sellers: they may lobby the government to help them by altering the price.

o Price ceiling pushes the price of a good down, and causes fewer sellers will want to
sell
o Price floor pushes the price of a good up, fewer buyers will want to buy

o A quota, by definition reduces sales

Governments sometimes control quantity instead of price.

Quota: an upper limit, set by the government, on the quantity of some good that can
be bought or sold; also referred to as a quantity control.

Quota limit: the total amount of a good under a quota or quantity control that can
be legally transacted

License: the right, conferred by the government, to supply a good.

Taxes:

Drive a wedge between the price buyers pay and the price sellers receive.
((Incidence of tax refers to who really pays for the tax))
The greater the elasticity the greater the deadweight loss.
The lower the elasticity the lower the deadweight loss.
This is why when the main goal is efficiency when imposing taxes, gov should do it on
low elastic demand goods.
Benefits principle: those who benefit from public spending should bear the burden of the
tax that pays for that spending.
The ability-to-pay principle: those with greater ability to pay a tax should pay more tax.
Trade-off between equity and efficiency: the systems can be made more efficient
only by making it less fair, and vice versa.
The tax base is the measure, such as income or property value, that determines how much
tax an individual or firm pays.

o Lump-sum tax: is the same for everyone, regardless of any actions people take
o Income tax: depends on income from wages and investments
o Payroll tax: depends on the earnings an employer pays and employee
o Sales tax: depends on the value of goods sold
o Profits tax: depends on a firms profits
o Property tax: depends on the value of property, such as a home
o Wealth tax: is a tax that depends on an individual wealth
The tax structure specifies how the tax depends on the tax base
Progressive tax takes a larger share of the income of high-income taxpayers than of low-
income taxpayers.
Regressive tax takes a smaller share of the income of high-income taxpayers than of low-
income taxpayer
Marginal tax rate is the percentage of an increase in income that is taxed away

Price elasticities and tax incidence

When the price elasticity of demand is low and the elasticity of supply is high, most of the

tax will be for the consumer.

When the price elasticity of demand is high and the elasticity of supply is low, most of the

tax will be for the supplier

The administrative cost of a tax are the resources used for its collection, for the method of
payment, and for any attempts to evade the tax. Taxes cost society time and effort that
could have been used elsewhere.

Externalities

Market failure: free-market equilibrium that is not providing the socially optimum amount
of a good

Environmental standards: rules that protect the environment by specifying actions by

producers and consumers

Fossil fuel: is fuel derived from fossil fuels sources such as coal and oil

Renewable energy sources: are energy sources that are inexhaustible, unlike fossil fuel
sources, which are exhaustible.

Clean energy source: are energy sources that do not emit greenhouse gases. Renewable
energy sources are also clean energy sources

Great energy transition: is the transition from heavy reliance on fossil fuels to a heavy
reliance on clean energy sources in order to avert catastrophic climate change.

External benefit: a benefit received by people other than the consumers or producers
trading in the market

Pigouvian subsidy: a payment designed to encourage activates that yield external benefits.
The socially optimal quantity can be achieved by a Pigouvian subsidy equal to the
marginal social benefit at the optimum quantity.

A technology spill over: is an external benefit that results when knowledge spreads among
individuals and firms.

Marginal social cost (MSC): the sum of the willingness to pay among all members of society
to avoid that unit of pollution.

Marginal social benefit (MSB): it’s the highest willingness to pay for the right to emit that
unit measured across all polluters.
Solutions:
o Private
o Coase theorem
 Argues that individuals have incentive to find a way to make
mutually beneficial deals that lead them to ‘internalize the
externality’
o Public
o Transaction costs: all the costs to individuals of making a deal
o Emissions tax: cost depends on the amount of pollution a firm
produces
 Pigouvian taxes: taxes designed to reduce external costs
o Tradable emissions permits: licences to emit limited quantities of
pollutants

Public Goods
- Non-excludable: people who don’t pay cannot be easily prevented from using a
good
- Non-rival: more than one person can consume the same unit of the good at the
same time
- Excludable: people who don’t pay can be easily prevented from using a good
- Rival: the same unit of the good cannot be consumed by more than one person
at a time
Public goods: non-excludable and non-rival
Scarce goods: excludable and non-rival
Common resources: non-excludable and rival

Free-riders: many individuals are unwilling to pay for their own consumption and instead
will take a free ride on anyone who does pay
Public goods – there is no way for private firm to earn enough revenue to create as much as
society wants.
Governments do cost-benefit analysis to estimate the social costs and social benefits of
providing a public good by good data are hard to come by.

Common resources

Common resources tend to be overused if left to the market: individuals ignore the fact that
their use depletes the amount of the resource remaining for others.
e.g when one person catches, there are fewer fish available for everyone else. Each
person has the incentive to fish before others

Solutions ?
- A tax or a regulation on the use of the common resource
- Making it excludable and assigning property right to it
- Creating a system of tradeable licence for the right to use the common resource

Scarce goods

the marginal cost of allowing one more person to consume the good is zero

however, because it is excludable, sellers charge a positive price, which leads to innefienctly
low consumption

the problems of artificially scarce goods are similar to those posed by a natural monopoly
The rational consumer

Capital: is the total value of assets owned by an individual or firm

The implicit cost of capital is the opportunity cost of the use of one’s own capital; that is, the
income earned if the capital had been employed in its next best alternative use.

“Either-or” decisions:
- When faces with an “either-or” choice between two activities, choose the one
with the positive economic profit.
Marginal cost: the additional cost incurred by producing one more unit of that good or
service

The marginal cost curve shows how the cost of producing one more unit depends on the
quantity that has already been produced.

- Increasing marginal cost: each additional unit costs more to produce than the
previous one
- Constant marginal cost: each additional unit costs the same to produce as the
previous one
- Decreasing marginal cost: each additional unit costs less to produce than the
previous one
Marginal benefit: the additional benefit derived from producing one more unit of a good or
service
There is a decreasing marginal benefit from an activity when each additional unit of
the activity yields less benefit than the previous unit.

The marginal benefit curve shows how the benefit from producing one more unit
depends on the quantity that has already been produced.

Optimum quantity: the quantity that generated the highest possible total profit.
Profit maximization principle of marginal analysis: the largest quantity at which the marginal
benefit is greater or equal to marginal cost

Sunk costs:
 A cost that has already been incurred and is not recoverable
 a sunk cost should be ignored in decisions about future actions

Accounting profit: represents the total earnings from a company, which includes explicit
costs
Economic profit: total revenue less explicit less Implicit costs

Behavioral economics

A rational decisions maker always chooses the available option that lead to the outcome he
or she most prefers

3 reasons why people might choose a worse payoff:

- Concerns about fairness: providing for others sometimes trumps self-interest
- Bounded rationality: making a choice that is close to the highest possible profit
may make sense because the effort of finding the best pay off is too costly
- Risk aversion: willingness to sacrifice some economic payoff in order to avoid a
potential loss is fairly common
A irrational decisions maker chooses an option that leaves him or her worse off than
choosing another available option would have left him or her.

6 common mistakes in decision making.

- Misperceptions of opportunity costs
- Overconfidence
o Nonprofessional investors who engage in speculative investing have
significantly worse result than professional brokers because of their
misguided faith in their ability to spot a winner
- Unrealistic expectations about future behaviour
- Counting dollars equally
 o Mental accounting: the habit of mentally assigning dollar to different
accounts so that some dollars are worth more than others
- Loss aversion
o An oversensitivity to loss that leads to unwillingness to recognize a loss
and move on
- Status quo bias
o The tendency to avoid making a decision altogether

Util is a unit of utility

Budget constraints:
Because the amount of money a consumer can spend is limited, a decision to consume more
of one good is also a decision to consume less of some other good.
- A budget constraint requires that the cost of a consumers consumption bundle
be no more than the consumers income
- A consumers consumption possibilities is the set of all consumptions bundles
that can be consumer given the consumers income and prevailing prices
- A consumers budget line shows the consumption bundles available to a
consumer who spends all of his or her income

The optimal consumption bundle is the one that maximizes a consumers total utility given
his or her budget constraint.
Use the marginal utility per dollar when makes choices !

Pitfalls – the right marginal comparison

In consumption decisions, unlike production decisions, a budget constraint must be
accounted for, by factoring in prices, we take into account the fact that a consumer has
limited amount of money to spend. The right answer for marginal decisions involving
consumption is that the marginal utility per dollar spend on each good must be the same at
as the optimal consumption bundle.

The substitutional effect is the change in the quantity consumed of that good as the
consumer substitutes the good that has become relatively cheaper for the good that has
become relatively more expensive.

The income effect:

- Is change in the quantity consumed of a good that results from a change in the
consumers purchasing power due to the change in the price of the good
o Normal goods: increase In price causes consumers purchasing power to
drop and reduce consumption (vice versa)
o Inferior goods: increase in price causes consumers purchasing power to
drop and increase consumption (vice versa)