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Unit 2: Microeconomics
Microeconomics: Is the area of economics that deals with behavior and decision making by small
units, such as individuals and firms.
Circular Flow Model—illustrates the flow of economic activity between households and firms. See
figure 1.3, pg. 15.
Market: is a location or mechanism that allows buyers and sellers to exchange goods and services.
Markets can be local, regional, national, or global in scope. There are 2 types.
Product Market: A market where firms sell their goods and services to consumers. Firms supply
goods and services while households demand goods and services.
Factor Market: A market where resources are bought and sold. Households supply their resources
and firms demand resources.
When households sell/supply their resources to firms they receive income in return.
Land-- rental income
Labor—Wages or salary income
Capital—interest income
Entrepreneur—Profit income
Barter: A moneyless economy that relies on trading goods for goods or goods for services.
3 Functions of money
 Medium of Exchange: Something accepted by all parties as payment for goods/services.
 Measure of Value: A common denominator that can be used to express worth in terms that most
people can understand.
 Store of Value: Allows purchasing power to be saved until needed.
Commodity Money: Money that has an alternative use as an economic good, or commodity.
Fiat Money: Money by government decree.
Specie: Money in the form of coins made from silver or gold.
Characteristics of Money
1. Portable
2. Durable
3. Divisible
4. Limited in supply
Consumers represent the demand side of the market. They purchase goods and services to satisfy
their economic wants.
Demand: Is the desire and ability of consumers to buy a good or service. Desire without ability does
not constitute demand.
Porshe—I lack the ability, not the desire
McDonald’s value meal—I lack the desire, not the ability
Demand Schedule: Is a table or schedule that shows the various quantities demanded by
consumers of a particular product at all prices that might prevail in the market at a given time. Figure
4.1, pg. 90.
Demand Curve: Is the graphical representation of the demand schedule.
As you look at the demand schedule, notice how price and quantity demanded are related to each
other.
Law of Demand: States that the quantity demanded of a good/service varies inversely with its
price. Inversely means opposite. When price goes up, Quantity goes down. When price goes down,
quantity goes up. This should be common sense to all consumers.
Market Demand Curve: Represents all consumers in the market. Figure 4.2, pg. 92.
Change in Quantity Demanded: This is a movement along the demand curve and shows a change
in the quantity purchased in response to a change in price. Figure 4.3, pg. 96. This is simply a
restatement of the law of demand.
Change in Demand: Occurs when people are now willing to buy different amounts of the product
at the same prices as before. Figure 4.4, pg. 98. This is shown as a shift in the curve, not a
movement along the curve.
Increase in demand—rightward shift
Decrease in demand—leftward shift
There are 6 factors that can cause the demand curve to shift. They include:
Consumer Income: An increase in income allows consumers to buy more of most goods/services
so the curve shifts right. A decrease in income would cause a decrease in demand and therefore a
leftward shift of the curve.
Tastes & Preferences: This reflects our likes and dislikes. Advertising, news reports, fashion
trends, seasonal changes, and others can affect our tastes.
Substitutes: Are products that can be used in place of other products. When the price of one good
goes up, the demand for the substitute will also go up.
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Butter and Margarine
Oil and Natural Gas
Coffee and Tea
Coke and Pepsi
Complements: Are products that are used together. When the price of one good goes up, the
demand for the complement will go down.
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Cameras and film
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Milk and cereal
Pc’s and software
P&J
Change in expectations: Demand may change because of the expectation of some future event. If
I expect prices to rise in a few weeks, I might buy more now. If I think I might lose my job soon, I’ll
begin to spend less now.
Number of Consumers: More buyers in the market will lead to an increase in demand. Fewer
buyers will lead to a decrease in demand.
Demand Elasticity: The extent to which a change in price causes a change in the quantity
demanded. Elasticity = Responsiveness. In essence, we want to know how much the quantity
changes in response to a change in price.
3 Ranges of Elasticity
1. Elastic Demand: When a given change in price causes a relatively larger change in the quantity
demanded. Figure 4.5, pg. 103.
2. Inelastic Demand: When a given change in price causes a relatively smaller change in the quantity
demanded.
3. Unit Elastic: When a given change in price causes a proportional change in the quantity
demanded.
Determinants of Demand Elasticity—Figure 4.6, pg. 106
1. Can the purchase be delayed?
Yes-- elastic
No-- inelastic
2. Are adequate substitutes available?
Yes-- elastic
No-- inelastic
3. Does the purchase use a large portion of income?
Yes-- elastic
No-- inelastic
The other side of demand is supply. This represents producers or firms that use resources to make
goods and services. Producers attempt to maximize profits by selling what consumers want and by
producing as efficiently as possible.
Supply: Is the amount of a product that firms are willing to offer for sale at all possible prices that
might prevail in the market.
Supply Schedule: A table or schedule that shows the various quantities supplied of a product at all
prices that might prevail in the market at a given time. Figure 5.1, pg. 114.
Supply Curve: The graphical representation of the supply schedule.
As you look at the supply schedule notice how price and quantity supplied are related to each other.
Law of Supply: States that the price and the quantity supplied are directly related to each other.
Direct means both variables move together. As price increases, so does quantity supplied. As price
decreases, so does quantity supplied.
The resulting supply curve is upsloping. The reason is that it is assumed that costs increase as output
increases.
Market Supply Curve: Represents all producers in the market. Figure 5.2, pg. 115.
Change in Quantity Supplied: Is a movement along the supply curve showing a change in the
quantity of product supplied in response to a change in price. This is simply a restatement of the law
of supply.
Change in Supply: When firms are now willing to offer different amounts of the product for sale at
the same prices as before. Figure 5.3, pg. 117. This is shown as a shift in the curve, not a movement
along the curve.
Increase in Supply-- rightward shift
Decrease in Supply-- leftward shift
There are 7 factors that can cause the supply curve to shift. They include:
Cost of inputs/resources: When the firm pays less for its land, labor, or raw materials, it is willing
to supply more now. The reason is that the firm is making more profits as their costs fall. If the cost
of resources increases, the firm will supply less.
Productivity: When workers are more efficient they can produce more. The result is that costs fall,
so firms are willing to supply more than before. When workers are not as productive, costs rise and
the firm is not as willing to supply.
Technology: The introduction of a new machine or process will lower the firm’s costs and will result
in an increase in supply. Think about flat screen tv’s and computers. What has happened to their
costs over the last several years?
Taxes: Firms view taxes as an increase in their costs and therefore supply will fall. Taxes will always
shift the supply curve to the left.
Subsidies: Are the opposite of a tax. In this case the government gives money to firms to
encourage or protect a certain type of economic activity. Subsidies lower costs and increase supply.
Government Regulations: When the government regulates a firm’s product, costs rise and supply
falls. Ask yourself how much more expensive it is to comply with federal standards on exhaust
emissions on cars. More regulation means less supply. Less regulation means more supply.
Number of Sellers: More firm’s leads to more supply, fewer firm’s leads to less supply.
Supply Elasticity: The extent to which a change in price causes a change in the quantity supplied.
Elasticity = Responsiveness. In essence, we want to know how much the quantity changes in
response to a change in price. Figure 5.4, pg. 119.
3 ranges of elasticity
1. Elastic Supply: When a given change in price causes a relatively larger change in quantity supplied.
2. Inelastic Supply: When a given change in price causes a relatively smaller change in quantity
supplied.
3. Unit Elastic Supply: When a given change in price causes a proportional change in quantity
supplied.
Price is the monetary value of a product/service and is established by supply and demand.
Prices act as signals that help us make our economic decisions. Prices communicate information and
provide incentives to buyers and sellers.
Ex.
High price: Firm produces more
Buyer buys less
Low price: Firm produces less
Buyer buys more
How would society allocate goods/services and resources without a system of prices? One possible
method could be rationing.
Rationing: Is a system under which an agency such as government decides everyone’s fair share.
Problems with rationing include:
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Fairness
Administration costs
Diminished incentives
Rebate: A partial refund of the original price of the product.
We now want to bring supply and demand together to determine how prices are established in a
market economy. It is a process of trial and error.
Market Equilibrium: Is a situation in which prices are relatively stable and the quantity supplied is
equal to the quantity demanded. Figure 6.1, pg. 143, and Figure 6.2, pg. 145.
Surplus: When the quantity supplied is greater than the quantity demanded at a given price. The
result of the surplus is that price will fall. (Qs > Qd )
Shortage: When the quantity demanded is greater than the quantity supplied at a given price. The
result of the shortage is that price will rise. ( Qd > Qs )
Equilibrium Price: The price that clears the market by leaving neither a surplus nor a shortage. (Qs
= Qd)
Sometimes society may have to sacrifice some efficiency and freedom in order to achieve greater
equity and security. Think back to the economic and social goals in unit 1. Sometimes 2 goals may
conflict with each other. One common way to achieve more equity or security for a certain group of
people is for the government to set prices at the socially desirable level. When this happens, prices
are not allowed to adjust to reach equilibrium.
Price Ceiling: The maximum legal price that can be charged for a product. Figure 6.5, pg. 151.
Ex. Rent control on apartments creates a permanent shortage of 800,000 apartments.
Price Floor: The lowest legal price that can be charged for a product. Figure 6.5, pg. 151.
Ex. Minimum wage for labor creates a permanent surplus of workers of 14 million workers.
Another example is farm products like wheat or corn.
Legal Forms of Business—figure 3.1, pg. 58
1. Sole Proprietorship: A business owned and run by one person. This is the most common form
of business numerically.
2. Partnership: A business jointly owned by 2 or more people. The 2 types are.
a. General—all partners are responsible for the management and financial obligations of the
business.
b. Limited—At least 1 partner is not active in the daily operation of the business although they
may have contributed funds to finance the operation.
3. Corporation: Is recognized by law as a separate legal entity having all the rights of an individual.
Charter: Government document giving permission to create a corporation.
Stock: Ownership certificates in a corporation.
Stockholders: Investors who buy shares of stock in a corporation.
Dividend: A check representing a portion of the corporations profits payed back to the stockholders.
To compare the advantages and disadvantages of each form of business, look at pgs. 58 to 65.
Profit Motive: This is the driving force that encourages people and organizations to improve their
material well-being. Entrepreneurs start businesses to make the greatest amount of profit possible.
Total revenue > Total cost = Profits
Total revenue < Total cost = Losses
Total revenue = Total cost = Breakeven
Market Structure: Represents the nature and degree of competition among firms operating in the
same industry.
An industry represents all firms in the same market like airlines, or cars.
We will examine 4 types of market structures by looking at various characteristics. See figure 7.2, pg.
169 for a summary.
1. Perfect Competition—Most competitive, 100’s to 1000’s of firms
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Large numbers of buyers and sellers who have no control over price.
Buyers and sellers deal in an identical product, standardized.
Buyers and sellers act independently.
Buyers and sellers are reasonably well informed about products and prices.
Buyers and sellers are free to enter or leave the market when they choose.
Figure 7.1, pg. 165 shows what output firms will produce.
2. Monopolistic Competition—Next most competitive, 20 to 70 firms
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Has all the conditions of perfect competition except for identical products. These firms have a
little bit of control over price.
Product Differentiation: The real or imagined differences between competing products in the same
industry.
Ex.
Store location
store design
Manner of payment
delivery
Packaging
service
Non-price competition: The use of advertising, giveaways, or other promotional campaigns to
convince buyers that the product is somehow better than another brand.
3. Oligopoly—3rd most competitive, 3 to 12 firms.
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Few firms.
Product can be identical or different.
Firms tend to act together.
Entry is difficult.
Interdependent behavior: Whenever one firm acts it must consider how the other firms will respond.
Ex.
Raise price—ignore
Lower price—lower
Collusion: A formal agreement to set prices or behave in a cooperative manner to increase profits.
This is illegal in the United States.
Price-fixing: Agreeing to charge the same or similar price for a product.
4. Monopoly—Least competitive, 1 firm.
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Single seller of a good or service. Monopoly tends to be rare in the U.S.
4 Types of Monopoly
1. Natural Monopoly: When the costs of production are minimized by having a single firm produce the
good. This is called economies of scale.
2. Geographic Monopoly: A single firm by virtue of its location such as a country store.
3. Technological Monopoly: A monopoly based on the ownership or control of a manufacturing
method, process, or other scientific advance such as a patent or copyright.
4. Government Monopoly: A monopoly that the government owns and runs like the postal service,
the city water company, or the TVA.
Sometimes markets fail because of inadequate competition, inadequate information, resource
immobility, externalities, and public goods. We will focus on 2 types of market failures.
Externalities: A cost or benefit that accrues to a 3rd party not involved in the transaction. Look at
the photo on page 175.
Negative—Noise, air, or water pollution.
Positive—Education, or immunizations.
Public Goods: Goods or services that are collectively consumed by everyone, and whose use by 1
person does not diminish the satisfaction or value available to others. Public goods are non-rival and
non-excludable. Examples include;
Ex. National defense
Police
Lighthouses
Flood control programs
Firemen
Parks