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CPL — Sun, 06 May 2007 08:02:55 CDT

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Microeconomics

CPL — Sun, 06 May 2007 07:50:16 CDT

Part 1: Analysis, Factors of Production, Economies of Scale, Consumer, Law Diminishing Marginal Utility
Page 2: Function of demand, function of supply, equilibrium.

II

CPL — Sun, 06 May 2007 07:49:15 CDT

REASONS WHY CONSUMERS BUY GOODS & SERVICES

Functional Demand: This is the most basic source of demand. People buy products so that they can perform certain tasks. E.g.: a camera in order to take photographs
Bandwagon effect People sometimes buy goods because others have bought similar items.
Exclusive Demand Sometimes expensive goods are bought because of the status attached to them e.g. designer clothes, expensive jewelry.
Speculative demand: Sometimes people purchase items because they believe that these items will go up over a period of time. This is the case of forex trading, currencies, property, land and antiques.
Impulse buying Sometimes people purchase goods on the spur of the moment possibly as a result of a very persuasive advertising campaigns.

MARKET

A market includes all the individuals and institutions involved in buying or selling a good or service.

A market is a mechanism which allows people to trade, normally governed by the theory of supply and demand, so allocating resources through a price mechanism and bid and ask matching so that those willing to pay a price for something meet those willing to sell for it

Markets provide the answers to four fundamental economic questions:

What goods should be produced and in what quantities
For whom are the goods produced
How are the goods to be produced (what combinations of factors of production should be used?)
What rewards should be given to those who supply the factors of production?

The supply of a good is the quantity that producers would be willing to make available at a specific price

The demand of a good quantity that consumers would be willing to buy at different prices

Two statements are true in the vast majority of cases:

If prices rise then the demand falls
If prices fall then the demand rises

Excess supply exists when the quantity supplied is greater than the quantity demanded. A glut of supply develops and prices fall.

Excess demand exists when quantity demanded is greater than the quantity supplied. There is excess demand and prices rise.

If no interference in the market occurs, the price settles at that level where demand and supply are equal. This price is known as the market equilibrium price.

TYPES OF MARKET

FACTOR MARKET A factor market is a market where a factor of production is bought and sold. The buyer is the entrepreneur who wishes to use that factor of production in the production of goods and services. The seller is the person who owns that factor of production. A simple example is the buying and selling of labor. The reward for labor is wages.

INTERMEDIATE MARKETS An intermediate market is one where the output is sold to be used as an “input” in the production of another good or service. For example the output of the steel industry is bought by the car manufacturing industry to be used to make cars. Intermediate goods are also known as producer goods.

FINAL MARKETS Final markets are markets which deal with goods and services that give consumers utility and for which they are therefore prepared to pay a price. These are known as consumer goods.

DEMAND

If price rises, then quantity demanded falls
If price falls then quantity demanded rises
This is known as the Law of Demand

Goods which obey the Law of Demand are known as normal goods. They have therefore an inverse relationship between price and quantity. There are, however a number of important exceptions

Giffen Goods: Named after a Scottish economist who noted that in the case of some certain goods necessary for subsistence, such as rice, a rise in price actually led to a rise in the quantity demanded. Poor people eat mostly bread and a few other luxury goods such as meat. If the price of bread rises, they are forced to do without the luxury goods and spend all of their income on the meat, therefore causing increasing their demand for bread

Snob Goods: These are goods which are attractive to some consumers because they are expensive. The price is considered to be an indication of their prestige. A rise in prices leads to a rise in their perceived “exclusivity” and this leads to increased demand. An example is Rolls Royce luxury cars, or Silver jet in the case of an airline.

Goods affected by consumers expectations of a further price rise may cause people to increase their demand for a good following an initial price rise. This can be seen in shares on a stock exchange. When stocks break a critical price level such as a breakout, support or resistance level, rise on good news, or are backed by good fundamentals and bullish market sentiment investors buy more shares during the rise. This is an example of speculative demand.

DEMAND FOR A GOOD DEPENDS ON THE PRICE OF OTHER GOODS

Complementary goods are goods which are used jointly. The use of one involves the use of another.
(E.g. cars and petrol, bread and butter)
Substitute goods are goods which satisfy the same need and thus can be considered as alternative to one another
(E.g. coffee and tea, butter and low-fat spreads)

Change in the price of a complimentary good

An increase in the price of a complementary good causes the demand for good X to fall. (Graph 1)
(E.g. an increase in the price of petrol causes the demand for cars to fall)
A decrease in the price of a substitute good causes the demand for good X to fall (Graph 1)

Graph 1

An increase in the price of a substitute good causes the demand for good X to rise (Graph2)
A fall in the price of a complementary good causes the demand for good X to rise. (Graph2)

Graph 2

DEMAND FOR GOODS DEPENDS ON THE LEVEL OF INCOME

Money Income: The amount of money a person earns expressed in monetary terms
Real Income: Purchasing power of this money. Amount of goods and services it will buy

The cost of living creates a difference between the two incomes

For most goods, a rise in income will lead to an increase in demand. Most goods have, therefore, a positive, directly proportional relationship between demand and income, such goods are known as “normal goods” .

A normal good is a good with a positive income effect. A rise in income causes an increase in demand for the good, whilst a fall in income will lead to a fall in demand for that good.

INFERIOR GOODS

An inferior good is a good with a negative income effect. A rise in income causes less of it to be demanded while a fall in income causes more of it to be demanded

As income rises, less of an inferior good is demanded.

OVERALL SUMMARY OF FACTORS AFFECTING DEMAND

The demand function is the name given to the list of factors which affect the demand for a good. The full demand function for good X can be expressed as follows:

Dx = f(Px, Pc, Ps, Y, t, E)

Where Px is the price of good X
Pc is the price of complementary goods
Ps is the price of substitute goods
Y is income
T is tastes
E is expectations

SUBSTITUTION EFFECT AND INCOME EFFECT

If the price of a good falls, two things happen.

The price becomes cheaper relative to other goods, this is called the substitution effect
The real income of the consumer is increased. This is called the income effect.

Good Sub. Effect Price effect Income Effect Type of good
A More More More Normal Good
B More More Less An inferior good which is not a Giffen Good
C More Less Less An inferior good which is also a Gifen Good

The law of supply states that if the price of a good increases, more of it will be supplied. Conversely, if the price of a good falls, less of it will be supplied.

Most supply curves are upward sloping from left to right. These are the exceptions:

PERFECTLY INELASTIC SUPPLY

This is whereby the quantity supplied of a product is fixed so that an increase in price will not bring forth further supplies, while a fall in price will not result in less being supplied. An example of this would be the daily supply of fresh fruit and newspapers.

MINIMUM PRICE ESTABLISHED BELOW WHICH SUPPLY WILL BE ZERO

The below figure depicts a situation where the suppliers are able to impose a minimum price. At prices below this minimum price (P1) the quantity supplied is zero. An example occurs in the factor market where the minimum wage marks the price below which no labor will be supplied.

Minimum supply.

THE FIRM REACHES ITS MAX CAPACITY

A capacity constraint exists when the firm has a defined maximum level of output beyond which it is unable to supply the product. In the below example, the firm is unable to increase its supply beyond Q1 because this represents the capacity output

FACTORS AFFECTING THE SUPPLY OF A GOOD

Supply of a good depends on its own price
As we have already seen most goods obey the Law of Supply. If prices rise more will be supplied and vice-versa.

Supply of a good depends on the prices of related goods
If the price of a related good rises, while the price of the good the firm is making remains the same, it becomes more attractive for the firm to supply the good that has increased in price. Consequently it will switch its resources to the production of the relatively more highly priced good.
By related goods, we mean the goods that a firm could supply instead of its own

An increase in the price of a related goods will cause a fall in the supply of good X
A decrease in the price of a related good will cause a rise in the supply of good Y.

Supply of a good depends on the costs of production

If there is an increase in the cost of production there will be a fall in the supply of good X
If there is a rise in the cost of production there will be a rise in the supply of good X.

Supply of a good depends on the state of technology at the firm.
As technology advances it improves the productivity of the firm and supply advances.

Supply of a good depends on factors which are outside the control of the firm
These are put into the equation as U which stands for unplanned factors. Examples of such unplanned factors include strikes, shortages of raw materials.

Overall summary of factors affecting supply
Sy= f(Py, Pr, C, T, U)

DEMAND AND SUPPLY COMBINED: THE MARKET EQUILIBIUM

Effects of outward and inward shift of the original supply and demand curves on the equilibrium price:

An increase in demand causes an increase in the equilibrium price and the equilibrium quantity
An increase in demand could be caused by:

An increase in the price of a substitute
A fall in the demand for a complement
An increase in income (if the good is a normal good)
A change in taste in favor of the good
Expectations of higher prices in the future or scarcity

A fall in demand causes a reduction in the equilibrium price and the equilibrium quantity.

A fall in demand could be caused by:

A fall in the price of a substitute
A rise in the price of a complement
A fall in income (if the good is a normal good)
A change in taste away from the good
Expectations of lower prices in the future or greater supplies

An increase in supply leads to a fall in the equilibrium price and the equilibrium quantity

An increase in supply may be caused by:

A fall in the price of a related good
A fall in the cost of production
An improvement in technology
Favorable unplanned factors

A decrease in supply leads to an increase in the equilibrium price and the equilibrium quantity

A decrease in supply may be caused by:

A rise in the price of a related good
A rise in the cost of production
Unfavorable unplanned factors

I

CPL — Sun, 06 May 2007 07:30:00 CDT

DEDUCTIVE AND INDUCTIVE ANALYSIS

DEDUCTIVE This involves reasoning from the general to the particular. A law is derived from a set of assumption which are believed to be generally true. This is then tested to see if it is true for a particular case. A hypothesis is put forward and then tested.
INDUCTIVE Reasoning from the particular to the general. A mass of data is drawn up and then a hypothesis is drawn up from the data.

Normative statements are what “ought to be” true in a perfect world, whilst positive statements reflect reality.

THE FACTORS OF PRODUCTION

Land: The term ‘land’ in economics refers to everything supplied by nature (i.e. not manmade) and used in the production of goods and services.
Agricultural land: Used for the production of cereal crops, fruit and vegetables
Rivers lake and sea: Used for fishing, fish farming, and Mari culture.
Mineral wealth & Natural Resources: Oil iron ore coal turn lead zinc gold. The earth’s mineral wealth and natural resources are raw materials which are used in the production of finished goods.
Forests supply us with timber which is an essential resource for the building industry.
Atmosphere weather and climate are natural resources which are vital for life and the production of goods and services. Adequate rainfall and sunshine are essential for the growing of agricultural produce while certain climatic conditions are required for the operation of a successful tourist industry.

Labor: The term labor in economics means all human effort which goes into the production of goods and services.

Capital: Anything made by man which is used to produce goods and services.
Fixed cap: The name given to stocks of fixed assets: plant, machinery, buildings and tools
Working cap: Stocks of man made raw materials stocks of partly finished goods
Social cap: Cap which is owned by the community in general.

Enterprise is the factor of production which takes the initiative in organizing land labor and capital and which bears the risks involved in production.

A firm can be defined as an individual unit of business which produces output and sells its product in the market.
An industry is the group of firms which produce the entire output of a particular good.

PRIVATE SECTOR FIRMS: Those firms which are privately owned businesses engaged in the production of goods and services:
Sole Traders: The business is owned by a single individual for example a shop or farm
Partnerships: At least two and up to 20 people join together to run the business and share the profits in an agreed manner.
Private Limited Companies: Business units which are owned by shareholders who have limited liability but whose shares are not traded on the stock exchange. There must be a min of one and a max of 50 shareholders.
PLCs Large businesses with many shareholders who each have limited liability and whose shares can be traded on the stock exchange.
Co-operatives Business unit where each member's profits depends on how much business he/she carries on with the co-op

THE INTERNAL ECONOMIES OF SCALE

The internal economies of scale are those forces at work within a firm which lower the average cost of production as the firm expands in size. In other words the internal economies of scale represent the advantages to the firm of large scale production.

Technical Economies of Scale: A large firm can justify the purchase of the most technically advanced machines because it can spread the cost of such equipment over a large quantity of output. The output of a small firms would not make the purchase of such machines worthwhile

Construction Economies: Building costs do not increase in proportion to the size of the firm.

Economies in the use of labor A large firm is more likely to be able to engage in the specialist division of labor. Each worker can concentrate on a specific task at which he/she becomes very skilled. This increases the output per worker by making them more efficient.

Production Economies A large firm can operate three 8 hour shifts and this is an economy of scale because it does away with the time wasted setting up for the day. There is no interruption to productions, thereby increasing the efficiency of the firm.

Economies in the uses of raw materials As a big firm is able to produce a wider range of goods than a smaller firm, any raw material not used up in the production of one good is likely to be able to be used in the production of another good.

Financial economies Large firms are seen as more “secure” by financiers and are therefore more likely to be able to raise finance, both debt and equity. Various financiers (banks, venture capitalists, business angels and shareholders) see large firms as more secure and are therefore more likely to commit to investing in them

Purchasing economies Because large firms will generally have to buy in bulk they are more likely to benefit form bulk discounts and trade discounts than their smaller counterparts.

EXTERNAL ECONOMIES OF SCALE

Economies in supply of component parts
As an industry expands other firms may be established to supply component parts to that industry. For example in Detroit there are many support firms to supply the huge automotive industry there.

Similarly as an industry expands it becomes worthwhile for firms to be established to supply specialized machinery.

As an industry expands local educational institutes may provide training courses to develop skills related to that industry.

Marketing agencies also may be established to sell the increased output of the industry as it expands. Also, through a trade association technical information may become available.

The cost of conducting research and development may be shared by various firms in the same industry as it is mutually advantageous.

If the economy expands the social capital I.e. national infrastructure may be improved .I.e. the provision of three phase electricity by the ESB for industry, good roads and a good transport infrastructure.

INTERNAL DISECONOMIES OF SCALE

Managerial Diseconomies The bigger the firm and the more powerful it is the more difficult it is going to be to run it. The channels of communication become more difficult .

Conflict As the firm expands the management and the workers may come into conflict. This can be for a variety of reasons; one such reasons is that the workers may feel that the company now only sees them as insignificant “cogs in the wheel”. Workers morals may suffer as a result and this can lead to absenteeism.

THE CONSUMER

In economics the consumer is the decision making unit that buys goods and services.

Assumptions concerning the behavior of consumers:

Consumer income: The ability of the consumer to purchase goods and services is limited and depends on his/her income. This income is limited or finite

Consumer choice: The consumer’s income is limited but the choice of goods and services which he/she has is unlimited. Once the basic needs of food and shelter are met, the consumer is faced with a huge range of goods and services which he/she can buy.

Consumer rationality the consumer is said to act rationally. This means that the consumer will spend his/her income on the goods and services that give him/her the greatest satisfaction. The satisfaction a consumer gets from using a good is called the utility of that good . the consumer spends his/her income in order to get the maximum possible utility from the good/service.

A rational consumer can be defined as one that spends his/her money on the goods and services which give him the most total utility.

ECONOMIC GOODS

The consumer will spend his/her income on what are known as economic goods. An economic good is defined as any physical object, or any service rendered which possesses the following three characteristics:
A It must give utility or satisfaction
B It must be scarce in relation to demand for it.
C it must transferable

THE LAW OF DIMINISHING MARGINAL UTILITY

The consumer is subject to the law of diminishing marginal utility. This law states that:

As extra units of a good are consumed, the satisfaction gained from each extra unit of that good falls.

The marginal utility of a good is the satisfaction a consumer gains from consuming an extra unit of that good.

The following two features of economic behavior verify for us the fact that the Law of Diminishing Utility does indeed hold true in the vast majority of cases.

Producers offer quantity discounts for consumers such as “buy three for the price of two” which shows that this exists. If the LDMU was not true, there would be not need to reduce the cost of extra units.

There is a limit to the amount of a good that people will consume, even if there is now extra charge levied.

HOW WILL A UTILITY-MAXIMISING CONSUMER SPENDS HIS/HER INCOME?

“In order to enjoy maximum utility, a rational consumer will spend his/her income in such a way that the ratio of marginal utility to price is the same for all the goods. “ (Law of Equi-Marginal Return)

MU1/ P 1 =MU2/P2 and

Economics

CPL — Sun, 06 May 2007 07:21:01 CDT

Micro notes

Macro notes (Uner construction)