ECON1101: Microeconomics 1

Chapter 1: Thinking as an economist

Economics
Economics is the study of how people make choices under conditions of scarcity
and of the results of those choices for society.

Microeconomics is the study of individual choice and of the combined

result of these choices for the group as a whole.

Macroeconomics is the study of national economies and the government

policies that try to improve them.

Scarcity principle
The scarcity principle (or no-free-lunch principle) states that, although
needs and wants are unlimited, resources are limited. Consequently, having
more of one thing usually means having less of another.

Cost-benefit principle
A consequence of the scarcity principle is the cost-benefit principle, which
states that an economic agent should only undertake an action if its marginal
(extra) benefits outweigh its marginal costs (ceteris paribus).

The benefit of an action is the largest price a person would pay in order
to undertake it.

The cost of an action is the largest price a person would pay in order to
avoid it.

Economic surplus is the amount by which an actions benefits outweigh

its costs.

Ceteris paribus (or all else equal) is the assumption that everything,
besides the variable being studied, stays the same.

Incentive principle
The incentive principle states that an economic agent is more likely to
undertake an action if its benefits rise or its costs fall, and is less likely to
undertake an action if its benefits fall or its costs rise.

Positive vs. normative economics

Positive economics explains what happens and why, but not what should
happen (e.g. the incentive principle).
Normative economics explains what should happen (e.g. the cost-benefit
principle).

Decision-making pitfalls
1. Failing to account for all opportunity costs 1
2. Failing to ignore sunk costs2 (e.g. all-you-can-eat buffet)
3. Failing to account for all relevant benefits (e.g. gambling restrictions not
only reduce gambling addiction, they also reduce the emotional strain on
friends and families)
4. Failing to measure costs and benefits as absolute dollar amounts rather
than as proportions (e.g. a $10 discount on a $25 DVD is the same as a
$10 discount on a $2000 computer)
5. Failing to know when to use average costs and benefits 3, and when to use
marginal costs and benefits4
a. Use average costs and benefits to determine whether an activity
should be undertake at all
b. Use marginal costs and benefits to determine the extent to which
an activity should be undertaken
6. Failing to incorporate time into cost-benefit thinking (i.e. $100 now is
better than $100 later because the $100 now can be invested)

Chapter 2: Comparative advantage

Absolute advantage
A person has an absolute advantage if he or she is able to undertake an action
with fewer resources than another person.

Comparative advantage
A person has a comparative advantage if his or her opportunity cost of
undertaking an action is lower than that of another person.

The principle of comparative advantage states that everyone can do

better if they specialise in their comparative advantage.

1 An opportunity cost is the value of the next-best alternative to undertaking

an action.
2 Sunk costs are costs that cannot be recovered when a decision is made.
3 Average costs and benefits are the total costs or benefits of undertaking

units of an activity, divided by

n .

4 Marginal costs and benefits are the increases in costs or benefits

associated with a small increase in the level of an activity.

Sources of comparative advantage

Individual:
Talent
Education or training
Experience

National:
Natural resources (e.g. Australian
minerals)
Infrastructure (e.g. Singaporean
technology)
Entrepreneurial spirit (e.g. US Silicon
Valley)
English as the de facto world
language

The production possibilities curve (PPC)

The production possibilities curve (PPC) graphs the maximum simultaneous
production of two goods.

An attainable point lies on or below the PPC.

An unattainable point lies above the PPC.
An efficient point lies on the PPC.

An inefficient point lies below the PPC.

The PPCs slope is equal to the opportunity cost of the good on the x-axis
in terms of the good on the y-axis.

If there are two PPCs, the flatter PPC has a comparative advantage in the
good on the x-axis and the steeper PPC has a comparative advantage in
the good on the y-axis.

When two PPCs specialise in their comparative advantage, they can trade
and consume beyond their PPCs (unless the PPCs are the same).

The greater the difference between the opportunity costs, the greater the
gains from specialisation.

The opportunity costs determine the bounds on the terms of trade.

The PPC for a many-person economy

The PPC for a many-person economy has an outward-bowed shape because
of the principle of increasing opportunity cost (or the low-hanging-fruit
principle): when the economy increases production of the good on the x-axis, it
first uses workers with the lowest opportunity costs (which have flatter slopes)
before using workers with higher opportunity costs (which have steeper slopes).

The principle of increasing opportunity costs (or the low-hangingfruit principle) states that, when expanding production, first use the
resources with the lowest opportunity cost before using those with higher
opportunity costs.

Factors that shift an economys PPC

The following factors shift an economys PPC outwards:

Increased labour (e.g. population growth, participation rate, immigration)

Increased capital equipment
Improved knowledge or technology

Costs of specialisation

Psychological costs of repetitive work

Dependence on other countries for certain goods
Specialise maximises total gains, but may cause inequality

Barriers to specialisation

Low population density

Laws and customs (e.g. trade sanctions)
A lack of well-developed markets

Chapter 3: Supply and demand

Types of economies
1. In centrally-planned economies, economic decisions are made by an
individual or a small number of individuals on behalf of a larger group.
2. In free-market economies, people make economic decisions for
themselves.
3. Mixed economies combine free markets and regulations.

Market
A market for any product consists of all the buyers and sellers of that product.

Demand curve
The demand curve shows the relationship between the amount of a particular
product demanded by buyers in a given time period, and the price of that
product. It slopes downwards because of the following:
1. The substitution effect is the change in the quantity demanded of a
product caused by a change in price, because the good becomes more or
less expensive relative to other goods and services.
2. The income effect is the change in the quantity demanded of a product
caused by a change in price, because of the change in the purchasing
power of a buyers income.
3. A buyers reservation is the highest price that buyer would pay for a
particular product. Buyers usually have different reservation prices. A
lower price will satisfy the cost-benefit principle for more buyers.

Supply curve
The supply curve shows the relationship between the amount of a particular
product supplied by sellers in a given time period, and the price of that product.
It slopes upwards because sellers usually have different reservation prices.

A sellers reservation price is the lowest price for which a seller would
sell an additional unit of a product. Sellers usually have different
opportunity costs and hence reservation prices. A higher price will satisfy
the cost-benefit principle for more sellers.

Horizontal vs. vertical interpretation of the demand and supply

curves
The horizontal interpretation of the demand or supply curve starts with price
on the vertical axis in order to read the corresponding quantity demanded or
supplied on the horizontal axis.
The vertical interpretation of the demand or supply curve starts with the
quantity demanded or supplied on the horizontal axis in order to read the
marginal buyers or sellers reservation price on the vertical axis.

Market equilibrium
Market equilibrium occurs when all buyers and sellers are satisfied with their
respective quantities at the market price. It occurs at the intersection of the
demand and supply curves.

Excess supply and demand

Excess supply (or surplus) is the amount by which the quantity supplied
exceeds the quantity demanded when the price of a product exceeds the
equilibrium price. It motivates sellers to lower their prices until the equilibrium
price is reached.
Excess demand (or shortage) is the amount by which the quantity demanded
exceeds the quantity supplied when the price of a product lies below the
equilibrium price. It motivates buyers to offer higher prices until the equilibrium
price is reached.

Price ceiling and floor

A price ceiling is a maximum allowable price, specified by law. If it is set below
the equilibrium price, it creates excess demand.
A price floor is a minimum allowable price, specified by law. If it is set above the
equilibrium price, it creates excess supply.

Change in the quantity demanded or supplied

A change in the quantity demanded is a movement along the demand curve
that occurs in response to a change in price.
A change in the quantity supplied is a movement along the supply curve that
occurs in response to a change in price.

Change in demand
A change in demand is a shift of the entire demand curve. A rightward shift is
caused by the following:
1. A decrease in the price of complements 5
2. An increase in the price of substitutes6
3. An increase in incomes if the product is a normal good 7
4. A decrease in incomes if the product is an inferior good 8
5. Increased preference for the product (e.g. increased preference for
healthy foods)
6. Increased number of buyers (e.g. an ageing baby boomer generation
increased the potential buyers of healthcare services)
7. Expected future price increase (e.g. an expected future petrol price hike
increases current demand)

Change in supply
A change in supply is a shift of the entire supply curve. It is caused by the
following:
1. Changes in the cost of inputs (e.g. materials and labour)
2. Technological improvements that reduce production costs
3. Changes in the weather (especially for agricultural products)
4. Changes in the number of suppliers (e.g. a shortage of dentists decreases
supply)
5. Expected future price changes (e.g. an expected increase in the price of
gold encourages prospectors to look for gold instead of silver)
5 Two goods are complements in consumption if the price of one and the
demand for the other are negatively correlated (e.g. tennis courts and tennis
balls).
6 Two goods are substitutes in consumption if the price of one and the demand
for the other are positively correlated (e.g. Coke and Pepsi).
7 A normal good is one whose demand is positively correlated with the income
of buyers (e.g. fancy restaurant meals).
8 An inferior good is one whose demand is negatively correlated with the
income of buyers (e.g. junk food).

Changes in demand or supply & the market equilibrium

1. An increase in demand increases the equilibrium price and quantity.
2. A decrease in demand decreases the equilibrium price and quantity
3. An increase in supply decreases the equilibrium price but increases the
equilibrium quantity.
4. A decrease in demand increases the equilibrium price but decreases
equilibrium quantity.

Simultaneous changes in demand and supply

1. An increase in demand and a decrease in supply increases the equilibrium
price.
2. A decrease in demand and an increase in supply decreases the equilibrium
price.
What happens to the equilibrium quantity depends on the relative changes in
demand and supply.

Surplus
A buyers surplus is the difference between the buyers reservation price and
the price they pay.
A sellers surplus is the difference between the price they receive and their
reservation price.
The total economic surplus is the sum of the buyers and sellers surpluses or,
equivalently, the difference between the buyers and sellers reservation prices.

Social optimality and efficiency

The socially optimal quantity of a product maximises the total economic
surplus from producing and consuming that good.

Economic efficiency occurs when all products are produced at their

respective socially optimal levels.

The efficiency principle states that efficiency is an important social goal

because when the economic pie grow larger, it is possible for everyone to
have a larger slice.

The equilibrium principle (or no cash on the table principle) states

that the market equilibrium maximises the markets economic surplus, but
not necessarily societys economic surplus.

Chapter 4: Elasticity
Elasticity
Elasticity is a measure of how responsive a variable is to changes in its
determinants.

Perfectly inelastic : =0

Inelastic :0< <1

Unit elastic : =1

Elastic :1< <

Perfectly elastic : =

Price elasticity of demand

Price elasticity of demand is the percentage change in quantity demanded
that results from a 1% change in price.

Price elasticity of demand()

Percentage changequantity demanded

Percentage change price

Q
P Q
P
1
=
=
( Q
P P ) ( Q P ) ( Q slope )
where 0(because of the law of demand)

Determinants of price elasticity of demand

Price elasticity of demand is increased by following:
1. More substitutes (e.g. the demand for different brands of salt is price
elastic because there are many substitute brands)
2. Larger budget share attributed to the product (e.g. the demand for a
house is more price elastic than for key rings)
3. More time to respond to price changes (e.g. the demand for air conditions
is price inelastic in summer and price elastic in winter)

Straight-line demand curves

Below the midpoint: <1
=1

At the midpoint:

Above the midpoint:

Vertical demand curve:

Horizontal demand curve:

>1
=0

Total expenditure
Total revenue=Total expenditure=P Q

Total expenditure is maximised at the midpoint.

Above the midpoint, total expenditure and price are negatively correlated.
Below the midpoint, total expenditure and price are positively correlated.

Cross-price elasticity of demand

Cross-price elasticity of demand is the percentage change in quantity
demanded that results from a 1% change in price.

Cross price elasticity of demand=

Percentage changequantity demanded

(all real values)
Percentage change price

Complements have a negative cross-price elasticity of demand.

Substitutes have a positive cross-price elasticity of demand.

Income elasticity of demand

Income elasticity of demand is the percentage change in quantity demanded
that results from a 1% change in income.

Income elasticity of demand =

Percentage changequantity demanded

(all real values)
Percentage change income

Normal goods have a positive income elasticity of demand.

Inferior goods have a negative income elasticity of demand.

Price elasticity of supply

Price elasticity of supply is the percentage change in quantity supplied that
results from a 1% change in price.

Determinants of price elasticity of supply

Price elasticity of supply is increased by the following:
1. Flexible inputs (e.g. a factory which can easily switch from making Coke to
making lemonade has price elastic supply)
2. Mobile inputs (e.g. entertainers have price elastic supply because they are
willing to travel to where work is available)
3. Substitute inputs (e.g. the recent ability to artificially create land has
mean the supply of land more price elastic)
4. More time to respond to price changes (e.g. movie stars have price
inelastic supply because they can only produce so many movies a year)

Midpoint elasticity
If the coordinates of two points are provided

(Q A , P A ) and

(Q B , PB )

midpoint formula can calculate price elasticity:

Q A +Q B
Small increase Q Average of Q A Q B
2
Price elasticity=
=
Small increase P Average of P A PB
P A + PB
P
2
Q

the

Chapter 5: Demand