Microeconomics Study Notes: Foundations, Demand & Supply, Equilibrium, and Elasticity

Economic Issues and Concepts

What is Economics?

Economics is the study of how scarce resources are used to satisfy unlimited human wants. It addresses fundamental questions about production, allocation, and consumption in society.

• Scarcity: Limited resources versus unlimited wants.

• Factors of Production: Land (natural resources), Labour (human effort), Capital (machinery, buildings), Entrepreneurship (organization and risk-taking).

• Goods: Tangible products (e.g., food, clothing).

• Services: Intangible activities (e.g., teaching, cleaning).

• Production Possibilities Frontier (PPF): Shows the maximum combinations of goods/services that can be produced with available resources.

• Opportunity Cost: The value of the next best alternative forgone when making a choice.

Example: Choosing to produce more cars means fewer resources for producing food.

Types of Economic Systems

• Traditional Economy: Based on customs and traditions.

• Command Economy: Centralized decision-making (e.g., government plans).

• Market Economy: Decentralized, decisions made by individuals and firms.

Example: Most modern economies are mixed, combining elements of market and command systems.

Positive vs. Normative Statements

• Positive Statement: Describes what is, can be tested (e.g., "Higher income taxes reduce spending").

• Normative Statement: Prescribes what ought to be, value judgment (e.g., "Government should lower taxes").

Economic Theories, Data, and Graphs

Building and Testing Economic Theories

Economic theories are constructed to explain phenomena, distinguished by variables and assumptions.

• Variables: Quantities that can take different values (e.g., price, income).

• Endogenous Variables: Determined within the theory.

• Exogenous Variables: Determined outside the theory.

• Correlation vs. Causation: Correlation is a mutual relationship; causation implies one variable directly affects another.

Scientific Approach: Empirical observation and hypothesis testing are central to economics.

Economic Data and Graphs

• Index Numbers: Used to compare data across time periods.

• Formula for % Change:

$\text{\% change} = \frac{\text{New Price Index} - \text{Old}}{\text{Old}} \times 100$

Demand, Supply, and Price

Demand

Demand refers to the total amount of a good or service that consumers are willing and able to purchase at various prices over a given time period.

• Quantity Demanded: Amount consumers want to buy at a specific price.

• Law of Demand: As price increases, quantity demanded decreases (inverse relationship).

• Demand Curve: Downward sloping, showing the relationship between price and quantity demanded.

• Shifts in Demand: Caused by changes in income, tastes, prices of related goods, expectations, and population.

Example: An increase in consumer income shifts the demand curve for normal goods to the right.

Supply

Supply is the total amount of a good or service that producers are willing and able to sell at various prices over a given time period.

• Quantity Supplied: Amount producers are willing to sell at a specific price.

• Law of Supply: As price increases, quantity supplied increases (direct relationship).

• Supply Curve: Upward sloping, showing the relationship between price and quantity supplied.

• Shifts in Supply: Caused by changes in input prices, technology, taxes/subsidies, expectations, and number of sellers.

Example: A technological improvement shifts the supply curve to the right.

Market Equilibrium

Market equilibrium occurs where quantity demanded equals quantity supplied, determining the equilibrium price and quantity.

• Equilibrium Price: The price at which the market clears (no surplus or shortage).

• Disequilibrium: Occurs when market price is above or below equilibrium, resulting in surplus or shortage.

Example: If the price is set above equilibrium, there will be excess supply (surplus).

Calculating Equilibrium

• Set demand and supply equations equal to each other: $Q_D = Q_S$

• Solve for price ($P$) to find equilibrium price.

• Substitute $P$ back into either equation to find equilibrium quantity.

Example: If $Q_D = 100 - 3P$ and $Q_S = 20 + 2P$, set $100 - 3P = 20 + 2P$ and solve for $P$.

Market Interactions

Markets can be affected by regional linkages, input-output relationships, and joint production.

• Mobile Supply/Demand: Changes in one region can affect prices and quantities in another.

• Input-Output Linkages: Changes in supply of one input affect related products.

• Joint Production: Production of one good affects supply of by-products.

Example: A decrease in anchovy supply affects cattle feed prices.

Elasticity

Price Elasticity of Demand

Elasticity measures the responsiveness of quantity demanded or supplied to changes in price or other factors.

• Elastic Demand: Quantity demanded changes significantly with price changes.

• Inelastic Demand: Quantity demanded changes little with price changes.

• Formula for Price Elasticity of Demand:

$E_d = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}$

• Midpoint Formula:

$E_d = \frac{Q_2 - Q_1}{(Q_2 + Q_1)/2} \div \frac{P_2 - P_1}{(P_2 + P_1)/2}$

• Determinants of Elasticity: Availability of substitutes, necessity vs. luxury, proportion of income spent, time horizon.

Example: Demand for gasoline is typically inelastic; demand for restaurant meals is more elastic.

Other Elasticities

• Income Elasticity of Demand: Measures response of quantity demanded to changes in income.

• Cross Elasticity of Demand: Measures response of quantity demanded of one good to changes in price of another good.

Formula for Income Elasticity:

$E_I = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in income}}$

Formula for Cross Elasticity:

$E_{xy} = \frac{\% \text{ change in quantity demanded of good X}}{\% \text{ change in price of good Y}}$

Tax Incidence and Surplus

• Tax Incidence: Refers to how the burden of a tax is shared between buyers and sellers, depending on elasticity.

• Consumer and Producer Surplus: Measures the benefit to consumers and producers from market transactions.

Formula for Utility Maximization:

$\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$

Where $MU$ is marginal utility and $P$ is price of goods $x$ and $y$.

Table: Example of Price Reductions and Elasticity (Cheese)

Price	Quantity Demanded	% Change in Price	% Change in Quantity	Elasticity
$5.00	100	-20%	+40%	2.0
$4.00	140	-25%	+30%	1.2
$3.00	182	-33%	+20%	0.6
$2.00	218	-50%	+10%	0.2

Additional info: Table values inferred for illustration; actual values may differ.

Summary

• Microeconomics analyzes how individuals and firms make choices under scarcity.

• Key concepts include opportunity cost, market equilibrium, and elasticity.

• Understanding demand and supply is essential for predicting market outcomes.

• Elasticity helps explain consumer and producer responses to price and income changes.