UNIT 2: Microeconomics
Definitions:
Demand: indicates the quantities of a good/service the customer is willing and able to buy at
different possible prices during a particular time period, ceteris paribus.
Ostentatious good: where main attraction of good is price/expensive, so as price increases demand
increases ?
Some non-price determinants of demand (causes a shift in demand):
1. Income in the case of normal and inferior goods (with normal goods, as income increases
demand increases and with inferior goods as income increases demand falls)
2. Preferences and tastes: if preferences and tastes of consumers change/trends
3. Price/availability of CLOSE substitute goods, if substitute goods become cheaper then
demand for OG good may fall.
4. Prices of complementary good: goods which are complementary are often bought and used
together, so the fall in prices of one will lead to an increase in the demand for other good.
Law of diminishing marginal utility (HL): as consumption of a good increases, the marginal utility
decreases with each additional unit consumed. This underlies law of demand which shows a
customer is only willing to buy an additional unit of a good if its price falls.
***marginal benefit and marginal utility are very similar except for the fact marginal benefit
indicates the consumer’s willingness to pay for the last unit bought, which is simply price and
therefore measurable UNLIKE UTILITY.
Income and substitution effect (alternative explanation for law of demand):
INCOME: A fall in price means consumers real income/purchasing power has increased. Therefore, as
price falls and income increases the quantity demanded of the good increases.
SUBSTITUTION EFFECT: if price of good falls, the consumers buys more of the cheaper substitute
good. Therefore quantity demanded increases.
,Non-Price Determinants of Supply
1. Cost of factors of production (labour, land, capital, entrepreneurship)
2. Indirect taxes: firms treat taxes as costs of production, so curve shifts left
3. No.Firms: the more firms, the greater the supply
4. Technology (lowers cost of production)
5. Subsidies (reduces cost of production)
6. Supply side shocks e.g. weather conditions e.g. in 2010 there was an oil spill in Louisiana
which decreased supply of locally produced seafood.
7. Prices of related goods (competitive supply of 2+ goods refers to competition for use of
same resources to produce different goods, so producing more of good 1 results in sacrifice
of good 2)
Assumptions underlying the law of supply (HL)
Short-run: at least one input is fixed and cannot be changed by the firm (e.g. heavy machinery is
fixed)
Long-run: time period where all inputs can be changed
Law of diminishing marginal returns: as more and more units of variable unit increases (such as
labour) the marginal product will initially increase and then begin to decrease.
• When marginal product increases, marginal cost decreases
• When marginal product is at maximum, marginal cost in minimum
Price mechanism: in a free market, disequilibrium will never last because of price mechanisms: ARSI
1. Allocates scarce resources efficiently
2. Rations any excess demand/supply (adjusting price so scarce resources are distributed
optimally)
3. Signals (price signal to consumers…)
4. Incentives (to change prices, drop out of market..)
, Consumer surplus: Utility consumers gains due to
difference between the highest price they are willing
to pay and the actual price they paid.
Producer surplus: price received by firms subtract the
lowest price they are willing to accept to produce the
good.
Critique of Rational Economic Decision Making and Behavioural Economics (HL)
Consumer rationality, a rational consumer will make purchasing decisions based on their
tastes/preferences which satisfy three assumptions:
1. Completeness assumption: consumer is ably to rank goods according their preference, e.g.
they can say with certainty that they prefer A to B
2. Transitivity assumption: Preferences among alternative choices are consistent (e.g. if
consumer prefers A to B and B to C then she must prefer A to C)
3. Non-satiation assumption: consumer always prefers more of a good to less of a good.
More assumptions of rational economic behaviour:
1. Perfect information: it is assumed that consumer has knowledge of all possible products,
product qualities and prices
2. Utility maximisation: according to theory of consumer behaviour, consumers maximise
their utility
**Homo economicus an assumed being who is forever rationally maximising utility as a consumer
Behavioural Economics: limitations of the assumptions of rational behaviour
1. Heuristics: simplifying complex decisions based on “common sense”, easily recalled
information and rules of thumb. So prioritising optimal behaviour as opposed to maximising
behaviour
2. Anchoring: use of irrelevant information to make decisions, often because it’s the first piece
of information that consumers happen to come across.
3. Framing: deals with how choices are presented to decision makers (e.g. 80% lean meat
sounds better than 20% fat meat)
4. Availability: refers to information that is most recently available, which people tend to reply
on more heavily.
5. Bounded rationality: suggests consumers rather satisfice (satisfy minimum requirement to
achieve goal) rather than maximise, due to limitations such as time, cognitive ability…
6. Bounded self-control: People have little self-control, and therefore do not have self-control
that would be required to make rational decision (e.g. people eat too much, spend too
much..)- tendency to chose short term benefits
7. Bounded selfishness: were slightly altruistic, chose less optimal outcomes for ourselves to
support others (e.g. charity)
, 8. Imperfection information: very often we do not have access to all information and therefore
make choices based on incomplete information leading to not maximising of utility.
NUDGE THEORY: behavioural economic in action:
Nudge: a method designed to influence consumers’ choices in a predictable way, without offering
financial incentives, imposing sanctions or limiting choice.
Choice architecture: based on idea that consumers make decisions in a particular context and that
their choices are influenced by how options are presented to them.
REAL WORLD APPLICATION:
- default choice (e.g. organ donation opt out scheme in UK)
- In a Danish municipality, streetlights turned red when solar panels are no longer sufficient to
power lights, thus making residents more aware of their electricity consumption
Evaluation of use of Behavioural Economics:
Advantages Disadvantages
- Relatively simple and low-cost way to - Unsystematic approach means policy
influence peoples decisions to act in may not be as valid among certain
socially desirable ways social groups, income groups etc..
- Offers consumers freedom of choice (reduces applicability)
- Policies are based on principles of - Manipulative?, encourage paternalistic
psychology (such as framing) which has behaviour of the state
been tested?
- Development of policies is based on
trials, indicating the use of a flexible
trial and error method to discover
which policies achieve desired results?
Elasticities
PED measures the responsiveness of quantity demanded to changes in price
%∆𝑄
𝑃𝐸𝐷 =
%∆𝑃
Interpreting PED:
if 0< PED <1 then demand is inelastic
if 1< PED <∞ then demand is price elastic
when PED=1, demand is unit elastic (change in QD of -5% correlates with price change of 5%)
when PED=0, then demand is perfectly inelastic (e.g. heroin addict)
when PED= ∞, then demand is perfectly elastic (if there is an increase in price, QD drops to zero!)
