Unit 2 Microeconomics

2.1.1Law of demand

• Demand shows the relationship between price and quantity demanded • Quantity demanded usually falls as price rises, ceteris paribus

2.1.2(HL)—Assumptions behind demand

• Income and substitution effects help explain the law of demand • The law of diminishing marginal utility helps explain why consumers demand less at higher prices

2.1.3Demand curve

• Demand can be represented by a downward-sloping demand curve • Diagram: downward-sloping demand curve

2.1.4Individual and market demand

• Market demand is derived from individual consumers' demand • Demand analysis distinguishes individual behaviour from total market behaviour

2.1.5Non-price determinants of demand

• Demand shifts with income, tastes and preferences, future price expectations, and number of consumers • Demand also shifts with prices of related goods, including substitutes and complements

2.1.6Movements and shifts in demand

• A price change causes movement along a demand curve • Non-price determinants shift the demand curve • Diagram: movements along and shifts of the demand curve

• Supply shows the relationship between price and quantity supplied • Quantity supplied usually rises as price rises, ceteris paribus

• The law of diminishing marginal returns helps explain rising production costs • Increasing marginal costs help explain the upward-sloping supply curve

• Supply can be represented by an upward-sloping supply curve • Diagram: upward-sloping supply curve

• Market supply is derived from individual producers' supply • Supply analysis distinguishes firm behaviour from total market behaviour

• Supply shifts with factor costs, related goods prices, indirect taxes, subsidies, future price expectations, technology, and number of firms • Related goods include joint and competitive supply cases

• A price change causes movement along a supply curve • Non-price determinants shift the supply curve • Diagram: movements along and shifts of the supply curve

• Demand and supply curves form market equilibrium • Equilibrium price and quantity coordinate buyers and sellers • Diagram: market equilibrium

• Shifts in demand or supply create new market equilibrium • Excess demand causes shortages; excess supply causes surpluses • Diagram: changes in equilibrium and the role of the price mechanism

• The price mechanism allocates resources through signalling and incentives • Rationing is another function of the price mechanism for scarce goods and services

• Consumer surplus and producer surplus measure welfare gains in a market • Social or community surplus combines consumer and producer surplus • Diagram: consumer surplus and producer surplus as social or community surplus

• Allocative efficiency occurs at competitive market equilibrium when social surplus is maximized • Marginal benefit equals marginal cost at the allocatively efficient output • Diagram: social or community surplus maximized at competitive market equilibrium

• Calculate consumer surplus and producer surplus from a diagram

• Rational consumer choice assumes consumer rationality, utility maximization, and perfect information • Behavioural economics critiques these assumptions • Limitations include rule of thumb, anchoring, framing, availability bias, bounded rationality, bounded self-control, bounded selfishness, and imperfect information

• Choice architecture includes default, restricted, and mandated choices • Nudge theory uses behavioural insights to influence decisions

• Firms may pursue profit maximization • Alternative objectives include corporate social responsibility, market share, satisficing, and growth

• Elasticity measures responsiveness between economic variables • Diagram: relatively elastic and relatively inelastic demand

• PED equals percentage change in quantity demanded divided by percentage change in price • PED has a theoretical range of values and indicates responsiveness of demand to price • Calculation: PED, change in price, quantity demanded, or total revenue from data

• PED can be perfectly elastic, perfectly inelastic, unitary, elastic, or inelastic • PED affects total revenue when price changes • Diagram: constant PED cases and unitary PED along a demand curve • Diagram: revenue changes when demand is price elastic or price inelastic

• PED changes along a straight-line downward-sloping demand curve • Diagram [HL]: PED along a straight-line demand curve

• PED depends on number and closeness of substitutes, necessity, income proportion, and time • PED matters for firm pricing and government decision-making

• Primary commodities generally have lower PED than manufactured products • Lower substitutability and necessity can reduce responsiveness

• YED equals percentage change in quantity demanded divided by percentage change in income • Positive YED identifies normal goods; negative YED identifies inferior goods • YED below one is typical of necessities; YED above one is typical of services and luxury goods • Diagram: income elastic, income inelastic, and inferior goods on an Engel curve • Calculation: YED, change in income, or quantity demanded from data

• YED helps firms predict demand changes after income changes • YED helps explain changes in the sectoral structure of an economy

• PES equals percentage change in quantity supplied divided by percentage change in price • PES has a theoretical range of values and indicates responsiveness of supply to price • Calculation: PES, change in price, or quantity supplied from data

• PES depends on time, factor mobility, unused capacity, ability to store, and rate of cost increases • Diagram: relatively elastic and relatively inelastic supply • Diagram: perfectly elastic, perfectly inelastic, and unitary PES along a supply curve

• Primary commodities generally have lower PES than manufactured products • Biological, seasonal, capacity, and storage constraints can limit responsiveness

• Governments intervene to raise revenue, support firms, support low-income households, and influence production or consumption • Intervention can aim to correct market failure and promote equity

• Main tools include price ceilings, price floors, indirect taxes, subsidies, direct provision, command and control regulation, and legislation • Diagram: price ceiling, price floor, indirect tax, and subsidy with effects on markets and stakeholders

• Government intervention affects market outcomes and stakeholders • Consequences should be analysed and evaluated using efficiency, equity, and welfare criteria

• Consumer nudges are a form of government intervention in markets • Nudges influence behaviour without banning choices or changing prices directly

• Calculate effects of price ceilings and price floors on markets and stakeholders • Calculate effects of indirect taxes and subsidies on markets and stakeholders

• Social optimum occurs where marginal social benefit equals marginal social cost • Allocative efficiency maximizes social or community surplus • Diagram: allocative efficiency

• Positive externalities of production or consumption create under-allocation without intervention • Negative externalities of production or consumption create over-allocation without intervention • Merit goods and demerit goods are linked to positive and negative externality cases • Diagram: market failure from negative production, negative consumption, positive production, and positive consumption externalities

• Calculate welfare loss from an externality diagram

• Common pool resources are rivalrous but non-excludable • The tragedy of the commons can cause unsustainable production and negative externalities

• Responses include Pigouvian taxes, carbon taxes, regulation, education, tradable permits, international agreements, collective self-governance, subsidies, and government provision • Diagram: government responses to externalities using Pigouvian taxes, carbon taxes, subsidies, legislation, regulation, and education • Diagram: carbon tax effects on a particular polluting industry

• Evaluation considers measurement challenges, policy effectiveness, and stakeholder consequences • International cooperation matters because sustainability issues are global • Monitoring and enforcement are major challenges in international cooperation

• Public goods are non-rivalrous and non-excludable • Free rider problems can prevent efficient market provision

• Governments may directly provide public goods • Governments may contract provision out to the private sector

• Asymmetric information occurs when one side of a transaction has more or better information • Adverse selection and moral hazard are key cases

• Government responses include legislation, regulation, and provision of information • Private responses include signalling and screening

• Perfect competition has many firms, free entry, and homogeneous products • Monopoly has a single or dominant firm, high barriers to entry, and no close substitutes • Oligopoly has a few large firms, high barriers to entry, and interdependence • Monopolistic competition has many firms, free entry, and product differentiation

• Profit maximization occurs where marginal cost equals marginal revenue • Profit equals total revenue minus total costs • Abnormal profit occurs when average revenue exceeds average cost; normal profit when they are equal; losses when average revenue is below average cost • Calculation [HL]: profit, MC, MR, AC, and AR from data

• Market power is the ability of a firm to influence price • Perfectly competitive firms have no market power and are price takers • Imperfectly competitive firms have varying degrees of market power and are price makers • Diagram: perfectly competitive firm as price taker where P = D = AR = MR • Diagram: perfectly competitive firm showing abnormal profit, normal profit, and losses • Diagram: perfectly competitive market equilibrium and allocative efficiency where P = MC or MB = MC

• Monopoly profit maximization can create allocative inefficiency and welfare loss • Monopoly may restrict output and raise price compared with perfect competition • Natural monopoly is a special monopoly case linked to economies of scale • Diagram: market power where AR exceeds MC • Diagram: monopolist showing abnormal profit, normal profit, and losses • Diagram: monopoly versus perfect competition with welfare loss • Diagram: natural monopoly

• Oligopoly can be collusive or non-collusive • Interdependence creates risk of price war, incentive to collude, and incentive to cheat • Oligopoly may create allocative inefficiency • Firms may use price and non-price competition • Market concentration can be measured using concentration ratios • Diagram: collusive oligopoly acting as a monopoly • Diagram: simple game theory payoff matrix

• Monopolistically competitive firms maximize profit in the short run and long run • Many substitutes make demand more elastic than monopoly demand • Monopolistic competition is allocatively inefficient but offers more product variety and less inefficiency than monopoly • Diagram: monopolistically competitive firm showing abnormal profit, normal profit, and losses • Diagram: monopolistic competition with more elastic demand than monopoly

• Large firms may gain economies of scale, including natural monopoly efficiencies • Abnormal profit may fund research, development, and innovation • Market power risks include lower output, higher prices, and reduced consumer choice

• Governments may use legislation, regulation, government ownership, and fines • Responses target abuse of significant market power

• Free market outcomes may create unequal distribution of income and wealth • Diagram: circular flow model illustrating why free markets may create inequalities