Microeconomics Notes
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1. Consumer Behavior and Utility
Indifference Curve and Budget Line
Robert Giffen and Giffen Goods: Exceptional case where the law of demand does not hold,
leading to increased consumption with increased price.
Advertising Effect on Indifference Curves: Leads to a steeper curve, showing increased
Marginal Rate of Substitution (MRS) for the advertised good.
Substitution Effect: Illustrated by creating a parallel budget line that shifts to account for price
changes, assuming no income effect.
Price Consumption Curve: Joins initial and final equilibrium, illustrating consumption changes
due to price variations.
Consumer Rationality: Assumes consumers can compare combinations of different goods,
considering the relative desirability and utility.
Utility Theory (Alfred Marshall)
Cardinal Approach: Utility can be measured numerically in "utils," a unit of satisfaction.
Marginal Utility: Diminishes as consumption increases; when marginal utility is zero, total utility
is maximized.
Equi-Marginal Principle: Utility maximization involves distributing expenditure so that Marginal
Utility per dollar is equal across all goods.
Price and Demand: A decrease in price increases the Marginal Utility per dollar, leading to an
increase in quantity demanded.
Assumptions: Consumer income is fixed, and marginal utility of money remains constant.
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2. Market Structures and Efficiency
Market Failure and Efficiency
Pareto Efficiency: Achieved when resources are allocated where no one can be made better off
without making someone else worse off.
Dynamic Efficiency: Long-run average cost falls due to innovation and scale economies.
Market Failures: Occur due to productive, allocative, or X-inefficiencies, often associated with
monopolies and public goods.
Government Intervention: To address market failures—such as providing public goods,
removing monopolistic power, and enhancing competition.
Market Structures
Perfect Competition: Firms are price takers with homogeneous products, achieving both
productive and allocative efficiency in the long run.
Monopoly: Supernormal profits are made due to high barriers to entry. Monopolies are criticized
for inefficiency but can be dynamically efficient.
Monopolistic Competition: Firms differentiate products and charge different prices, earning
normal profit in the long run.
Oligopoly: Characterized by interdependence, a kinked demand curve, and possible collusion
(cartels). Game theory explains their behavior regarding advertising or pricing strategies.
Contestable Market Theory
Contestable Markets: Feature low barriers to entry and exit, promoting competitive behavior
among firms even without perfect competition.
Firms’ Objectives: In a contestable market, firms may not focus solely on profit maximization
due to the threat of competition—opting for social or revenue-maximizing goals instead.
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3. Labour Market and Wage Determination
Wage Determination
Supply of Labour (Average Cost of Labour): The cost incurred by firms to hire workers.
Demand for Labour (Marginal Revenue Product, MRP): Product of the Marginal Physical
Product (MPP) and Marginal Revenue. MRP determines the firm’s willingness to hire additional
workers.
Perfect Labour Market Assumptions: Perfect knowledge, mobility, and wage-taking behavior by
firms.
Monopsony in Labour Market
Single Buyer of Labour: Monopsony leads to lower employment and wages compared to perfect
competition.
Marginal Cost of Labour (MCL): Higher than the average cost of labour due to wage increases
being applied to all workers.
Trade Unions and Wage Bargaining
Closed Shop: Exclusive trade union representing workers, leading to higher wages at the cost of
potential unemployment.
National Minimum Wage: Set above equilibrium, raising income for the lowest-paid workers but
potentially causing unemployment.
Wage Differentials
Causes: Due to skill differences, monopsony power, discrimination, or job conditions.
Economic Rent and Transfer Earnings: Skilled workers earn higher economic rent (reward
above transfer earnings), while unskilled workers have higher proportions of transfer earnings.
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4. Redistribution of Income and Wealth
Equity vs. Equality
Equity: Fairness in resource distribution, often justifying government intervention.
Equality: Aiming for identical outcomes for everyone.
Difference: Equity emphasizes fair processes, while equality aims at equal results.
Economic Reasons for Inequality
Labour Market Factors: Skill disparities and demand changes lead to income inequality.
Wealth Accumulation: Inheritance and asset concentration contribute to wealth disparities.
Demographic Changes: An aging population affects wealth distribution and pension
sustainability.
Policies for Redistribution
Negative Income Tax: Benefits for those earning below a threshold, taxes for others.
Universal vs. Means-Tested Benefits: Universal benefits go to everyone; means-tested benefits
target the needy.
Universal Basic Income: A proposed policy to provide a basic income to all citizens.
Poverty and Redistribution Tools
Absolute vs. Relative Poverty: Absolute poverty is defined globally (e.g., less than $1.90/day),
while relative poverty compares individuals to the median income in a country.
Poverty Trap: Occurs when increased income leads to reduced benefits, discouraging additional
work.
Measuring Inequality
Lorenz Curve: Graphically represents income inequality; closer to the diagonal line indicates
more equal distribution.
Gini Index: Measures income inequality, with 0 indicating perfect equality and 100 maximum
inequality.
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Macroeconomics:
Foreign Direct Investment (FDI) and Standard of Living (SOL)
FDI: Establishment or purchase of production units abroad, such as factories and machinery.
Typically carried out by multinational corporations (MNCs) to access economies of scale, cheap
labor, and local consumer preferences.
Impact on Low-Income Countries:
Technology & Infrastructure: Transfer of technology, factory construction, and workforce training.
Economic Growth: Increased employment, income, and output trigger the multiplier effect,
raising GDP.
Access to Goods & Services: Increased wealth opportunities and improved government revenue
for spending on public services.
Challenges: Profit repatriation (leakages) and increased imports can create imbalances.
Government may need to manage external debts.
Local Industry Impact: MNCs can displace local firms unless government intervention, like
pollution permits or minimum wage laws, is in place.
Measuring Economic Performance and Standard of Living
Economic Growth: Measured by annual percentage change in Real GDP—represents an
increase in economic output in both short and long terms.
Economic Development: Reflects improved quality of life, such as better health, education, and
law enforcement.
Main Measures:
1. GDP per Capita: Measures economic growth but ignores income inequality and externalities.
2. Human Development Index (HDI): Combines GNI per head, literacy rates, and life
expectancy.
3. Measure of Economic Welfare (MEW): More comprehensive, accounting for leisure, health,
inequality, and externalities.
Comparative Analysis:
GDP Pros: Simple, available data, linked to macroeconomic goals.
GDP Cons: Ignores wealth disparity, externalities, informal economy, and qualitative factors.
HDI and MEW: Provide broader context on welfare, with limitations like ignoring sanitation or
relying on shadow prices.
Distinguishing Low-Income Countries (LICs) and High-Income Countries (HICs)
Inflation:
LICs: Cost-push inflation—arising from high production costs.
HICs: Demand-pull inflation—results from increased demand.
Unemployment:
LICs: Due to low productivity, skills, and mobility.
HICs: More cyclical (recessions) or structural (technology changes).
Balance of Payments (BoP):
LICs: Importing capital goods, exporting primary products.
HICs: Driven by currency appreciation, high incomes, and capital outflows.
Economic Growth: Short vs. Long Run
Short-Run Growth: Increase in output due to increased aggregate demand (AD). Real GDP
growth occurs when AD or SRAS shifts.
Long-Run Growth: Increase in productive capacity, shifting LRAS or PPC.
Measures: Typically measured by changes in Real GDP or Real GNI per head.
Positive Impacts: Greater access to goods and services, lower inequality, improved fiscal
position, and increased optimism.
Negative Impacts: Resource depletion, environmental damage, income inequality, increased
stress on workers.
Sustainability in Economic Growth
Inclusive Growth (OECD definition): Distributed fairly, benefiting all members of society through
increased incomes and quality services like health and education.
Policies for Inclusivity: Progressive taxation, high-quality education, anti-discrimination laws, and
improved infrastructure to tackle geographical immobility.
Sustainable Growth: Balancing economic, social, and environmental objectives to ensure
long-term prosperity.
Resource Usage: Countries face trade-offs between resource exploitation (for immediate
growth) and conservation (for future use).
Inflation, Recession, and Exchange Rates
Inflation Types:
Demand-pull and cost-push due to economic expansion.
Recession: Real GDP decline over two consecutive quarters.
Causes: Demand-side (consumer confidence drop, falling exports) or supply-side shocks (raw
material cost increase).
Recovery Policies: Similar to those for promoting economic growth but adjusted based on
specific circumstances.
Exchange Rates:
Freely Floating: Determined by demand-supply; no government intervention.
Fixed: Stable but requires substantial foreign reserves.
Managed Floating: Allows for limited government intervention to stabilize the currency.
The Role of Economists
Keynesian Perspective (John Maynard Keynes):
Advocates for government intervention to influence aggregate demand through fiscal and
monetary policies. Particularly influential in managing unemployment during recessions by
increasing public spending.
Marshallian Perspective (Alfred Marshall):
Price Elasticity of Demand: Explains how responsiveness to price changes affects consumption
and market equilibrium.
Multinational Corporations (MNCs) and Environmental Impact
MNCs: Establish administrative centers in developed nations and seek developing markets for
resource availability and lower production costs.
Economic Impact: They contribute to employment, training, increased output, and tax revenue.
Environmental Concerns: Can cause significant environmental degradation unless regulated
(e.g., through pollution permits or incentives for green technology).
Sustainable Development Policies
Lowering Environmental Impact:
Subsidizing clean energy, provision of public information (nudging), imposing taxes on polluters,
and issuing pollution permits.
Balancing Growth and Environmental Goals: Sustainable economic growth involves fostering
economic activity while protecting resources for future use.
Types of Unemployment and Policy Solutions
Natural Rate of Unemployment: Includes frictional (transitional between jobs) and structural
(skills mismatch) but excludes cyclical (demand deficiency).
Policies: Supply-side measures—such as deregulation, mobility programs, and vocational
training—help address the natural rate, although unemployment will always exist to some
extent.
Globalization:
Definition: The world becoming increasingly interconnected, forming one global market. This is
due to reduced costs and fewer barriers for the movement of goods, capital (both direct and
portfolio investments), labor, and technology transfer. It also strengthens political ties and
promotes free trade.
Key Drivers of Globalization:
1. Communication & Technology: Advances facilitate faster information flow and reduce
transaction costs, encouraging international trade and investments.
2. Transportation Improvements: Lower costs and increased speed of shipping boost trade,
making markets more accessible.
3. Lower Trade Restrictions: Governments reduce tariffs and quotas, which increases the
volume of international trade and opens new markets.
4. Labor and Capital Mobility: Workforce migration and capital flow across borders enhance
productivity and economic output.
Impact on GDP and Productivity:
Aggregate Demand (AD): Increased due to rising exports, FDI, and consumer spending.
Employment and Output: MNCs bring in FDI, leading to job creation, infrastructure
development, and increased output.
Government Revenue: Higher economic activity increases tax revenues, which can be invested
in education, healthcare, and infrastructure.
Productivity: Enhanced due to technological transfers and adoption of efficient production
practices.
Balance of Payments (BOP) and Currency Flows
BOP Persistent Deficit: To address a deficit, a country may need positive capital flows (FDI or
portfolio investments). If not financed externally, it reduces foreign currency reserves (applies in
a freely floating exchange rate system).
Keynes's Liquidity Preference Theory
Definition: Explains why individuals hold cash. There are three motives for holding money:
1. Transaction Motive: Need for cash for day-to-day expenses. This depends on the frequency
of income payments (e.g., weekly vs. monthly).
2. Precautionary Motive: Holding money for unforeseen events. High during economic
uncertainty or pessimism.
3. Speculative Motive: Holding cash to buy assets when their price is expected to fall, influenced
by interest rate expectations. Highly interest elastic, unlike transactionary and precautionary
motives, which are interest inelastic.
Interest Rates and Bonds: There is a negative relationship between interest rates and bond
prices.
Quantitative Easing (QE) and Monetary Policy
Definition: Central banks buy securities in the open market to increase the money supply,
reducing interest rates to stimulate economic activity.
Effectiveness: Changes in interest rates may take up to 18 months to have an impact. Other
financing options like share issues may reduce the effectiveness of interest rate changes.
Policy Nature: QE is seen as contractionary monetary policy.
Keynesian and Monetarist Views on Economics
Keynesian Theory:
Focuses on total spending in the economy affecting output, employment, and inflation.
Believes inflation arises from demand-pull and cost-push factors.
Supports using government intervention to influence aggregate demand.
Monetarist Theory:
States that economic stability can be achieved by controlling the growth of the money supply.
Views inflation primarily as a result of excessive money supply.
Quantity Theory of Money: (Money Supply Velocity = Price Level Nominal Income).
Monetarists assume velocity and total transactions are constant, implying a direct relationship
between money supply and price level.
Controlling Inflation:
Keynesians advocate for controlling expenditure.
Monetarists suggest controlling money supply through monetary policy.
Fiscal and Monetary Policy Limitations
Fiscal Limitations:
Tax rates that are already high may discourage work or investment.
Government spending cuts may reduce economic development and increase inequality.
Policies may face long time lags and political resistance.
Monetary Policy Limitations:
Impact depends on commercial banks' willingness to lend.
May face a liquidity trap (low interest rates but limited borrowing).
Interest rate changes may not effectively influence consumption and investment (interest
inelasticity).
Phillips Curve (Short and Long Run)
Short-Run Phillips Curve (SRPC): Shows a trade-off between inflation and unemployment
(downward sloping).
Long-Run Phillips Curve (LRPC): Vertical line, indicating no long-term trade-off between inflation
and unemployment. Workers adjust expectations, and unemployment returns to its natural rate.
Types of Unemployment
Structural Unemployment: Includes regional (decline in specific industries) and technological
unemployment.
Frictional Unemployment: Includes people temporarily between jobs, such as seasonal
unemployment.
Circular Flow of Income
Definition: Illustrates the movement of money across the economy.
Leakages: Savings, taxes, and imports (reduce money available).
Injections: Investments, government spending, and exports (increase money available).
Deflationary and Inflationary Gaps
Deflationary Gap (Negative Output Gap): Actual output is less than potential output.
Governments may use budget deficits to stimulate the economy, but this can lead to crowding
out private investment due to higher interest rates.
Inflationary Gap (Positive Output Gap): When demand exceeds potential output, leading to
rising price levels (demand-pull inflation).
International Aid and Development
Types of Aid:
Humanitarian Aid: Provided in response to crises, aimed at immediate relief.
Development Aid: Includes tied, untied, bilateral, and multilateral aid.
Tied Aid: Given with conditions, often benefiting the donor country.
Effects of Aid:
Provides resources for investment, healthcare, and education.
May create dependency and lead to poor economic management.
Recipients often prefer trade to aid for sustainable development.
Trade vs. Aid
Advantages of Trade:
Promotes economic growth by increasing market size, encouraging innovation, and transferring
technology.
Helps reduce poverty and enhances income through specialization and competition.
Challenges for LICs/MICs:
Dependence on primary products with low-income elasticity of demand (YED).
Unfair competition due to subsidies in HICs.
Investments and Emerging Economies
Direct and Portfolio Investments: Investments flow to emerging economies with high growth
rates and potential for returns.
FDI: Multinational corporations bring FDI, boosting productive capacity and employment.
External Debts and Economic Development
Causes of Debt:
Structural current account deficits.
Overconfidence in repayment ability.
Negative shocks such as depreciation or natural disasters.
Consequences: High debt limits growth potential and creditworthiness, with many countries
defaulting or cutting essential spending.
IMF and World Bank
IMF: Focuses on international monetary cooperation, stability, and facilitating global trade.
Functions include surveillance, technical assistance, and lending.
World Bank: Aims to reduce extreme poverty and promote income growth by investing in
infrastructure and social programs.
Indicators of Globalization
World Trade to World Output Ratio.
Exports to GDP Ratio: Indicates the extent of integration into global trade.
Investment Flows: Portfolio and FDI inflows.
Migration: Worker and international migration figures.
Trade Blocs and Economic Integration
Types of Trade Blocs:
Free Trade Union: No internal barriers, but independent external policies.
Customs Union: Common external tariffs.
Monetary Union: Common currency and coordinated policies.
Full Economic Union: Complete economic integration.
Impact on Efficiency:
Trade Diversion: Switching to higher-priced imports due to bloc membership, reducing
efficiency.
Trade Creation: Switching to cheaper imports from bloc members, enhancing efficiency and
growth.
