ECO 304K - Introduction to Microeconomics

Dr. Katherine Grooms

[email protected]

Chapter 1: Five Foundations of Economics

1. Marginal Thinking
2. Opportunity Cost
3. Trade-offs
4. Incentives
5. Value created through trade
- ***Economics is everywhere
- economics – examines the choices that people/firms make with limited resources
- goal is to overcome scarcity
- microeconomics – study of the individual units that make up the economy
- macroeconomics – study of the overall aspects and workings of an economy
- scarcity – exists when the marginal cost of obtaining something is greater than zero
- e.g. water, diamonds, cars, dirt → most things are scarce except air and gravity
Incentives
- positive/negative, direct/indirect; influence our actions in particular ways
- can lead to unintended consequences
- e.g. what value of money is worth picking up, cost of parking ticket, auto-insurence scams + more
dashcams in Russia
Trade-offs
- consist of the entire set of things we might have done
- with policies you’re always giving something else up
Opportunity Cost
- highest-valued alternative that must be given up to engage in an activity
- value of the next best alternative, not all of the things you’re missing out of
- value of time determines relative prices of goods and services, investments mproductivity,
economic growth, and measures of income inequality
- society is under-valuing time improvements and subsequently under-investing public resources in
time-saving infrastructure projects and technologies
- implicit expenses – forgone income
- adds implicit and explicit costs
Marginal Thinking
- Is the additional benefit greater than the additional cost?
- most of our thinking is marginal thinking, marginal decision making, not extreme options
- e.g. when cleaning what is the optimal amount, closets and under appliances isn’t worth it
- e.g. restaurants creating specials and crossing them out, pushing them, increasing demand, and
showing that there’s scarcity
Trade
- trade creates value and depends on specialization and comparative advantage
- benefits both parties
Chapter 2: Model Building & Gains from Trade
- trade allows people to specialize in what they’re good at, more productive and efficient
How do economists study the economy? – The Scientific Method
- economics uses the scientific method to develop economic models that require them to make
many assumptions to simplify reality
- answer questions about observable phenomena and explain how the world works
- observe a phenomenon
- develop of hypothesis
- construct a model to test the hypothesis
- look for opportunities to test how well the model works, collecting data and verifying,
revising, or refuting the hypothesis
- natural experiment – real world events meet the criteria of an experiment designed to test a
hypothesis
- positive statements are testables, don’t have to be true (e.g. Mentos reacts more in Coke than
Sprite)
- normative statements are opinion (e.g. Coke tastes better with Mentos)
- e.g. auctioning a kidney on Ebay
- positive question (objective, testable) – Why did the price of the kidney get so high?
- demand is high, people are willing to pay a high price for something life saving
- not many people are selling, low supply
- normative question (subjective, opinion, arise from positive questions) – Should Ebay be
allowed to auction kidneys? Is it fair that wealthier people have more access to a kidney
when they have to bid on it?
- not one right answer, depends on your value
Economic Models
- simplified versions of reality, emphasize key concepts
- ceteris paribus – other things being equal or all else equal
- changing one variable while holding everything else constant, essential for models
- endogenous factors – factors we can control, inside the model
- exogenous factors – factors we can’t control, outside the model
- be mindful of what we include in the model, what assumptions we make when choosing what to
include in the model, and outside conditions that can affect the model’s performance – think
about real world conditions
- e.g. Great Recession in December 2007 – banks wrongly assumed that real estate prices
will always rise
- rationality is a cornerstone of most economic theory
What is the PPF? – Production Possibilities Frontier
- illustrates the cominations of outputs a society can produce if all of its resources are being used
efficiently (resources are fully utlized and potential output is maximized)
- only way to get one good is to accept less of another
- expand if the population grows
- anything that falls under the curve is feasible but not optimital, any area outside are not feasible
→ would require capital investments
- resources are not perfectly adaptable so production does not expand at a constant rate
 - law of increasing opportunity cost – opportunity cost of producing a good rises as a society
produces more of it, non-linear
- economic growth – process that enables a society to produce more output in the future
What are the benefits of specialization and trade?
- specialization – limiting of one’s work to a particular area, leads to greater output
- absolute advantage – one can produce more than another with the same quantity of resources
- comparative advantage – low opportunity cost goes with having the comparative advantage,
often means you should specialize
- e.g. paying someone to be your bodyguard because a celebrity benefits from
specialization; making a chicken sandwich completely from scratch

- pricing – exchange ratio should fall in between their opportunity cost ratio’s
What is the trade-off between having more now and having more later?
- short run – decisions that reflect our immediate wants, needs, or limitations; consumers can
partially adjust their behavior
- long run – decisions that reflect out wants, needs, or liimitations over a longeer time; consumers
have time to fully adjust to market conditions
consumer goods – any good produced for present consumption, e.g. food, entertainment, and clothing
capital goods – help in the future production of other valuable goods and services, e.g. roads, trucks
investment – process of using resources to create or buy new captial
Chapter 3: The Market at Work: Supply and Demand
- buyers and sellers determine prices
What are the Fundamentals of Markets?
- markets bring trading partners together to create order out of chaos
- market economy – resources are allocated among households and firms with little to no
government interference
- invisible hand – guides the marketplace, unobservable market forces that guide resources to their
highest-valued use, coined by Adam Smith
- e.g. resort and hotel prices during off season versus busy seasons
- competitive market – so many buyers and sellers that each has only a small impact on the
market price and output
- imperfect markets – markets in which either the buyer or seller can influence the market price
- e.g. elevator ticket price to the CN Tower – seller has more control over the price with a
unique good/service or specialized products
- market power – firm’s ability to influence the price of a good or service by exercising control
over its demand, supply, or both
- monopoly – exists when a single company supplies the entire market for a particular good or
service
What Determines Demand?
 - quantity demand – the amount of a good or service that buyers are willing and able to purchase
at the current price
- law of demand – all other things being equal, the quantity demanded falls when the price rises,
and the quantity demanded rises when the price falls, inverse relationship
- e.g. cookie auction
- demand schedule – table that shows the relationship between the price of a good and the quantity
demanded
- demand curve – graph of the relationship between the prices in the demand schedule and the
quantity demanded at those prices, often a straight line
- a price change causes movement along a given demand curve, but it cannot cause a shift
of the demand curve
- market demand – sum of all the individual quantities demanded by each buyer in a market at
each price, increases as more individuals enter the marketplace
- purchasing power – how much you can afford
- normal good – customers will buy more a normal good as income rises, holdng all other factors
constant
- inferior good – demand declines as income rises, can be seen in different brands
- complements – two goods that are used together
- substitutes – two goods that are used in place of each other
- subsidy – payment made by the government to encourage the consumption or production of a
good or service, e.g. a tax break
What Determines Supply?
- price level and quantity supplied are positively related
- quantity supplied – amount of a good or service that producers are willing and able to sell at the
current price
- law of supply – all other things being equal, the quantity supplied increases when the price rises,
and the quantity supplied falls when the price falls
- supply schedule – table that shows the relationship between the price of a good and the quantity
supplied
- supply curve – graph of the relationship between the prices in the supply schedule and the
quantity supplied at those prices, upward sloping curve, direct/positive relationship
- variables other than price shift the entire supply curve
- when supply curve switched, we assume that price is constant and something else
changed
- would a change cause a company to produce more or less of the good?
- market supply – sum of the quantities supplied by each seller in the market at each price
- inputs – resources used in the production process, e.g. workers, equipment, buildings, capital
goods, raw materials
- cost of input changes, so does the seller’s profit; cost of input declines, profits improve
How Do Supply and Demand Interact to Create Equilibrium?
- equilibrium – point at which the supply curve and demand curve intersect, supply and demand
are perfectly balanced
- equilibrium price/market-clearing price – price at which the quantity supplied equals the
quantity demanded
 - equilibrium quantity – quantity supplied equals the quantity demanded
- law of supply and demand – idea that market prices adjust to bring the quantity supplied and
thee quantity demanded into price
- shortage/excess demand – quantity supplied is less than the quantity demanded
- surplus/excess supply – quantity supplied is greater than the quantity demanded, usually leads
to sellers lowering their prices
- Hudsucker Proxy – markets coordinate prices and eliminate excess supply (suplesses) and excess
demand (shortages)
Chapter 4: Elasticity
- e.g. being more willing to pay a higher price for a highly in demand toy right before Christmas
- elasticity of demand measures the responsivness
- elasticity – measure of the responsiveness of buyers and seller to changes in price or income;
how strongly the quantity consumed or produced responds to a change in price
What is the price elasticity of demand, and what are its determinants?
- price elasticity of demand (ED) – measures the responsiveness of consumer desires for a product
when the price changes
- depends on consumer preferences, e.g. an avid
golfer versus amatuer’s willingness to pay for a
famous course

- midpoint method – standardizes the results

- demand is inelastic when the percentage change in the quantity demanded is smaller than
the percentage change in price
- responsive – small change in price will likely cause many people to switch from one good to
another
- unresponsive – consumers are unwilling to change their behavior, even when the price of the
good or service changes
- 5 determinants – necessity versus luxury goods + share of budget + how broadly definite the
market is + substitutes + time
- more substitutes = more elastic
- demand is more inelastic for expensive items on sale
- when need trumps price, demand should be inelastic
- e.g. Creast is more elastic than toothpaste
- time and adjustment process
- immediate run – no time for consumers to adjust their behavioro (e.g. gas if
you’re on empty)
- short run – period of time when consumers can partially adjust their behavior
- long run – period of time when consumers have time to fully adjust to market
conditions
- e.g. price of toilet paper during the pandemic became more elastic
- perfectly inelastic = ED = 0
- relatively inelastic = small numerator, large denominator; ED = 0 – -1
 - relatively elastic = large numerator, small denominator; ED < -1
- perfectly elastic = nearly infinite change, very small change, e.g. $10.00 → $9.99; ED approaches
-∞
- unitary elasticity – elasticity is neither elastic or inelastic, ED = -1
- total revenue – amount that a firm receives from the sale of goods and services
How do changes in income and the price of other goods affect elasticity?
- income elasticity of demand (EI) – measures how a change in income affects spending, can be

positive or negative
- necessities (0 < EI < 1) and luxuries (EI > 1)
- inferior goods have a negative EI
- cross-price elasticity of demand (EC) – positive, measures the percent change in the
quantity demanded of one good to the percentage change in the price of a related good

What is the price elasticity of supply?

- price elasticity of supply (ES) – measure of the responsiveness of
the quantity supplied to a change in price

How do the price elasticities of demand and supply relate to each other?

Chapter 5: Market Outcomes and Tax Incidence

What are consumer surplus and producer surplus?
- welfare economics – branch of economics that studies how the allocation of resources affects
economic well-being; enhanced by the balance between demand and supply
- willingness to pay/reservation price – maximum price a consumer will pay for a good or service
- consumer surplus – difference between the willingness to pay for a good or service and the price
paid to get it
- lower prices create more consumer surplus in the market
- willingness to sell – minimum price a seller will accept to sell a good or service
- determined by the direct costs (travel) of producing the good and the indirect/opportunity
costs (not cleaning a pool)
- producer surplus – difference between the willingness to sell a good or service and the price the
seller recieves
When is a market efficient?
- total surplus/social welfare – add consumer and producer surplus, measures the well-being of all
participants in a market, measures the benefits markets create
- efficient – when allocation of resources maximizes total surplus, occurs at point E/market is in
equilibrium
- equity – fairness of the distribution of benefits among the members of a society
Why do taxes create deadweight loss in otherwise efficient markets?
- excise tax – a tax levied on a specific good or service
- incidence – who actually pays the tax
- independent, determined by the market, doesn’t matter whether a tax is levied on the
buyer or seller
- when a good is perfectly inelasitc, the consumer bears the incidence
- when a good is perfectly elastic, the seller bears the incidence
- deadweight loss – the decline inconomic activity that the tax creates; combined reductions in
consumer and producer surplus
- levy – who is legally responsible for paying the tax