Microeconomics Study Notes: The Circular Flow, Markets, and Equilibrium

The Circular Flow in Microeconomics

Overview of the Circular Flow Model

The circular flow model is a foundational concept in microeconomics, illustrating how resources, goods, services, and money move between households and firms through various markets. It helps explain the interactions that determine prices, wages, and interest rates in an economy.

• Households supply labor and capital, and demand goods and services.

• Firms demand labor and capital, and supply goods and services.

• Commodity Markets determine market-based prices for goods and services.

• Labour Markets determine market-based wages.

• Capital Markets determine market-based interest rates.

Payments flow between households and firms, ensuring that desired resources are exchanged for goods, services, and financial assets. Receipts are earned by firms from the sale of goods and services, while households receive income from supplying labor and capital.

Commodity Markets

Demand in Commodity Markets

Demand represents the desired purchases of buyers in the market. The demand curve shows the relationship between the price of a good and the quantity demanded, holding other factors constant.

• Law of Demand: As price increases, quantity demanded decreases, and vice versa.

• Demand Function: $D = D(p, I, p_1, ..., p_n)$, where p is the price of the good, I is income, and p_1, ..., p_n are prices of related goods.

• Reservation Price: The highest price a consumer is willing to pay for a given quantity.

• Shifts in Demand: Changes in income, prices of substitutes or complements, and consumer preferences shift the demand curve.

Example: If the demand for Product X is given by $D = 10 - 2p$, and the price increases from 3 to 4, the quantity demanded falls from 4 to 2.

Supply in Commodity Markets

Supply represents the desired sales of sellers in the market. The supply curve shows the relationship between the price of a good and the quantity supplied, holding other factors constant.

• Law of Supply: As price increases, quantity supplied increases, and vice versa.

• Supply Function: $S = S(p, p_1, ..., p_n, w)$, where p is the price of the good, p_1, ..., p_n are prices of related goods, and w is the wage rate or input cost.

• Reservation Price: The lowest price a seller is willing to accept for a given quantity.

• Shifts in Supply: Changes in input prices, technology, and prices of related goods shift the supply curve.

Example: If the supply for Product Y is given by $S = 2p$, and the price increases from 2 to 4, the quantity supplied rises from 4 to 8.

Market Equilibrium

Equilibrium Price and Quantity

Market equilibrium occurs where the quantity demanded equals the quantity supplied. The equilibrium price balances the desired purchases of buyers with the desired sales of sellers.

• Equilibrium Condition: $D(p^*) = S(p^*)$

• Shortages: Occur when quantity demanded exceeds quantity supplied at a given price.

• Surpluses: Occur when quantity supplied exceeds quantity demanded at a given price.

• The market adjusts to eliminate shortages and surpluses, moving toward equilibrium.

Example: Given $D = 12 - 2p$ and $S = 2p - 4$, set $D = S$ to solve for equilibrium price and quantity:

• $12 - 2p = 2p - 4$

• $12 + 4 = 2p + 2p$

• $16 = 4p$

• $p^* = 4$

• Equilibrium quantity: $Q^* = 12 - 2(4) = 4$

The Statics of Equilibrium

Response to Changes in Exogenous Determinants

The statics of equilibrium examine how buyers and sellers respond to changes in factors outside the market, such as income, input prices, and prices of related goods.

• Shifts in Demand: Caused by changes in income, prices of substitutes or complements, and consumer preferences.

• Shifts in Supply: Caused by changes in input prices, technology, and prices of related goods.

• These shifts result in new equilibrium prices and quantities.

Example: If the wage paid to employees increases, the supply curve for a good may shift left, resulting in a higher equilibrium price and lower equilibrium quantity.

Factor Markets

Labour Markets

Labour markets determine market-based wages. Households supply labor, and firms demand labor. Equilibrium wages balance the desired hours worked by households with the desired hours employed by firms.

• Labour Supply Function: $S = 2w - 8$

• Labour Demand Function: $D = 24 - 2w$

• Equilibrium Wage: Set $S = D$ to solve for equilibrium wage and quantity.

Example: $2w - 8 = 24 - 2w$ leads to $4w = 32$, so $w^* = 8$ and $Q^* = 8$.

Capital Markets

Capital markets determine market-based interest rates. Households save funds, and firms borrow funds for investment. Equilibrium interest rates balance the desired amounts saved by households with the desired amounts borrowed by firms.

• Supply of Funds: $S = 4r - 20$

• Demand for Funds: $D = 60 - 4r$

• Equilibrium Interest Rate: Set $S = D$ to solve for equilibrium interest rate and quantity.

Example: $4r - 20 = 60 - 4r$ leads to $8r = 80$, so $r^* = 10$ and $Q^* = 20$.

Comparative Statics: Effects of Changes in Related Goods

Substitutes and Complements

Goods can be classified as substitutes or complements, affecting how changes in the price of one good influence the demand for another.

• Substitutes: An increase in the price of one good increases the demand for its substitute.

• Complements: An increase in the price of one good decreases the demand for its complement.

Example: If apples and bananas are substitutes, an increase in the price of apples will increase the demand for bananas.

Summary Table: Types of Markets and Their Functions

Market Type	Main Function	Key Variables
Commodity Market	Determines prices of goods/services	Price, Quantity
Labour Market	Determines wages	Wage, Hours
Capital Market	Determines interest rates	Interest Rate, Funds

Key Terms and Definitions

• Equilibrium: The point at which quantity demanded equals quantity supplied.

• Reservation Price: The maximum price a buyer is willing to pay or the minimum price a seller is willing to accept.

• Substitute: A good that can replace another in consumption.

• Complement: A good that is consumed together with another good.

• Exogenous Determinant: A factor outside the market that affects demand or supply (e.g., income, input prices).

Applications and Problem Solving

Solving for Equilibrium

• Set the demand and supply equations equal to each other to solve for equilibrium price and quantity.

• Analyze how changes in exogenous determinants shift the curves and affect equilibrium.

Example: If demand is $D = 100 - 0.5p$ and supply is $S = 0.5p - 20$, set $D = S$ to solve for $p$ and $Q$.

Comparative Statics

• Examine how changes in income, input prices, or prices of related goods affect market outcomes.

• Use diagrams to illustrate shifts in demand and supply curves.

Example: An increase in the wage paid to workers shifts the supply curve left, raising equilibrium price and lowering equilibrium quantity.

Conclusion

Understanding the circular flow, market equilibrium, and the effects of changes in exogenous determinants is essential for analyzing microeconomic outcomes. Mastery of these concepts enables students to interpret market behavior, predict responses to policy changes, and solve real-world economic problems.

Additional info: Some diagrams and tables referenced in the original material were not fully visible; standard microeconomic context and examples have been added to ensure completeness and clarity.