Introduction to Microeconomics
Microeconomics is a branch of economics that focuses on the behavior and decisions of individual actors, such as households, firms, and governments, within specific markets. Unlike macroeconomics, which deals with the economy as a whole, microeconomics zooms in on the smaller units and examines how their choices affect the supply and demand for goods and services.
Key Areas of Study in Microeconomics
- Individual Choices: How individuals and households make decisions about what to consume.
- Firm Behavior: How firms decide on production levels, pricing, and resource allocation.
- Market Dynamics: How these individual decisions influence market prices, demand, and supply.
- Government Influence: How government interventions like taxes, subsidies, and regulations affect markets.
Demand
Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various price levels during a given period.
Demand, Price & Quantity
- Law of Demand: There is an inverse relationship between the price of a good and the quantity demanded, ceteris paribus (all else being equal). As the price decreases, the quantity demanded increases, and vice versa.
- Demand Curve: A graphical representation of the relationship between the price of a good and the quantity demanded. It typically slopes downward from left to right.
$$ Q_d = f(P) $$
where $ Q_d $ is the quantity demanded and $ P $ is the price.
Non-Price Determinants of Demand
Several factors other than price can shift the demand curve:
- Income: An increase in consumer income generally increases demand for normal goods and decreases demand for inferior goods.
- Preferences: Changes in tastes or preferences can increase or decrease demand.
- Substitutes and Complements: The demand for a good can be affected by the price of related goods. For example, an increase in the price of a substitute good can increase demand, while an increase in the price of a complementary good can decrease demand.
- Expectations: Expectations about future prices and incomes can affect current demand.
- Population: Changes in the size and composition of the population can affect demand.
Example:
For instance, if the price of coffee increases, the demand for tea (a substitute) might increase as consumers switch to a cheaper alternative.
Supply
Supply refers to the quantity of a good or service that producers are willing and able to sell at various price levels during a given period.
Supply, Price & Quantity
- Law of Supply: There is a direct relationship between the price of a good and the quantity supplied, ceteris paribus. As the price increases, the quantity supplied also increases, and vice versa.
- Supply Curve: A graphical representation of the relationship between the price of a good and the quantity supplied. It typically slopes upward from left to right.
$$ Q_s = f(P) $$
where $ Q_s $ is the quantity supplied and $ P $ is the price.
Non-Price Determinants of Supply
Several factors other than price can shift the supply curve:
- Input Prices: An increase in the price of inputs (e.g., raw materials, labor) can decrease supply.
- Technology: Technological advancements can increase supply by making production more efficient.
- Taxes and Subsidies: Taxes can decrease supply, while subsidies can increase it.
- Expectations: Expectations about future prices can affect current supply.
- Number of Sellers: An increase in the number of sellers in the market typically increases supply.
Example:
For example, if the cost of labor decreases due to new labor-saving technology, the supply of goods produced using that technology will likely increase.
Competitive Market Equilibrium
Market equilibrium occurs at the price where the quantity demanded equals the quantity supplied.
Market Equilibrium & Disequilibrium
- Equilibrium Price: The price at which the quantity demanded equals the quantity supplied.
- Equilibrium Quantity: The quantity bought and sold at the equilibrium price.
- Disequilibrium: Occurs when the market price is not at equilibrium, leading to either a surplus (excess supply) or a shortage (excess demand).
Functions of the Price Mechanism
The price mechanism performs several key functions in a market:
- Rationing Function: Prices help to ration scarce resources.
- Incentive Function: Prices provide incentives for producers and consumers to alter their behavior.
- Signaling Function: Prices signal where resources are needed and where they are not.
Price Elasticity of Demand (PED)
Price Elasticity of Demand measures the responsiveness of the quantity demanded to a change in price.
$$ PED = \frac{% \Delta Q_d}{% \Delta P} $$
where $ % \Delta Q_d $ is the percentage change in quantity demanded and $ % \Delta P $ is the percentage change in price.
Determinants of PED
- Availability of Substitutes: More substitutes make demand more elastic.
- Necessity vs. Luxury: Necessities tend to have inelastic demand, while luxuries have more elastic demand.
- Time Period: Demand is usually more elastic in the long run.
- Proportion of Income: Goods that take up a larger proportion of income tend to have more elastic demand.
Tip:
A good way to remember the determinants of PED is the acronym SPLAT: Substitutes, Proportion of income, Luxury vs. necessity, Addictiveness, Time period.
Common Mistake:
A common mistake is to confuse the direction of the relationship between price and quantity demanded with the elasticity itself. Elasticity measures the degree of responsiveness, not the direction.
Income Elasticity of Demand (YED)
Income Elasticity of Demand measures the responsiveness of the quantity demanded to a change in consumer income.
$$ YED = \frac{% \Delta Q_d}{% \Delta Y} $$
where $ % \Delta Q_d $ is the percentage change in quantity demanded and $ % \Delta Y $ is the percentage change in income.
Types of Goods Based on YED
- Normal Goods: Positive YED; demand increases as income increases.
- Inferior Goods: Negative YED; demand decreases as income increases.
- Luxury Goods: YED greater than 1; demand increases more than proportionately as income increases.
Example:
If the income of consumers increases by 10% and the demand for organic food increases by 15%, the YED for organic food is 1.5.
Price Elasticity of Supply (PES)
Price Elasticity of Supply measures the responsiveness of the quantity supplied to a change in price.
$$ PES = \frac{% \Delta Q_s}{% \Delta P} $$
where $ % \Delta Q_s $ is the percentage change in quantity supplied and $ % \Delta P $ is the percentage change in price.
Determinants of PES
- Time Period: Supply is usually more elastic in the long run.
- Flexibility of Production: If producers can easily switch between different goods, supply is more elastic.
- Availability of Spare Capacity: More spare capacity makes supply more elastic.
- Stock Levels: Higher stock levels make supply more elastic.
Note:
PES is often more inelastic in the short term because it takes time for producers to respond to price changes.
Role of Government in Microeconomics
Governments intervene in markets to correct market failures, redistribute income, and achieve economic objectives.
Reasons for Government Intervention in Markets
- Market Failure: To correct inefficiencies such as externalities and public goods.
- Redistribution of Income: To reduce income inequality.
- Economic Stability: To stabilize the economy and promote growth.
Government Intervention: Indirect Taxes & Subsidies
- Indirect Taxes: Taxes on goods and services to reduce consumption of harmful goods (e.g., cigarettes).
- Subsidies: Financial support to encourage production and consumption of beneficial goods (e.g., renewable energy).
Government Intervention: Price Controls, Direct Provision & Regulation
- Price Controls: Setting maximum or minimum prices to control market prices (e.g., rent control).
- Direct Provision: Government directly provides goods and services (e.g., public healthcare).
- Regulation: Rules and regulations to control market activities (e.g., environmental regulations).
Market Failure: Externalities & Common Pool (Access) Resources
Market failure occurs when the market fails to allocate resources efficiently.
Externalities
- Negative Externalities: Costs imposed on third parties (e.g., pollution).
- Positive Externalities: Benefits received by third parties (e.g., education).
Common Pool Resources
- Tragedy of the Commons: Overuse of common resources due to lack of ownership (e.g., overfishing).
Government Intervention to Address Market Failure
- Taxes and Subsidies: To internalize externalities.
- Regulation: To control the use of common resources.
- Public Goods Provision: To provide goods that the market fails to supply efficiently.
Market Failure: Public Goods
Public goods are non-excludable and non-rivalrous, meaning they are available to all and one person's use does not reduce availability to others.
Characteristics of Public Goods
- Non-Excludability: Cannot exclude people from using the good.
- Non-Rivalry: One person's use does not diminish another's.
Examples of Public Goods
- National Defense: Protects all citizens regardless of individual contribution.
- Public Parks: Available for everyone to use without reducing the enjoyment of others.
Note:
Public goods often lead to the free-rider problem, where individuals consume the good without contributing to its cost.
Common Mistake:
A common misconception is that all goods provided by the government are public goods. However, some government-provided goods can be excludable and rivalrous (e.g., public transportation).
This document provides a comprehensive overview of key concepts in microeconomics as outlined in the International Baccalaureate (IB) syllabus. Understanding these concepts is crucial for analyzing how individual decisions impact markets and how government interventions can correct market failures.