REVISION
Microeconomic Principles
Economic Problem
• Scarce/limited resources
• Unlimited wants
• Choices need to be made, e.g.:
• What to produce
• How to produce
• How much to produce
• Who gets the goods and services
• Every choice involves OPPORTUNITY COST= the value
of the next best alternative foregone
Resources
• Resources are categorised into 4 groups:
• Land (Natural Resources)
• Labour
• Capital
• Entrepreneurial Ability
PRODUCTION POSSIBILITIES
FRONTIER (PPF)
50
A
 PPF shows all the maximum
PPF
C
43
combinations of rice and
computers that can be
produced if all available
resources are fully employed
and used efficiently.
U
Q of Rice
 PPF is concave to the origin.
I
20
 PPF separates attainable from
E
unattainable output
combinations.
 Attainable = combinations on
& underneath PPF
 Points ON the PPF are
efficient.
F
0
2
4
5
 Points inside the PPF are
Q of Tractors
INEFFICIENT.
2
50
48
A
PPF
B
1
5
* The negative slope shows the
opportunity cost when
production of one of the goods
in the diagram is increased.
C
43
1
9
D
34
• The opportunity cost of
producing 1 more Tractor is
amount of Rice forgone.
1
Q of Rice
14
E
20
• The concave shape of the
PPF reflects the law of
increasing opportunity cost.
1
• Law states as more of a
20
1
0
1
2
3
4
particular good is produced, a
successively larger quantity of
the other good must be
sacrificed.
F
5
• Due to resources not being
Q of Tractors
equally adaptable in
production of both goods
Shifts in the PPF (Growth)
Q of Rice
Q of Rice
A change in resources or technology may cause both a change in the
slope and location of the PPF. The change does not have to affect both
goods equally.
0
0
Q of
Tractors
Q of Tractors
PRODUCER THEORY
Accounting vs Economic Profit
• Accounting profit:
= total revenue (TR) – explicit costs
• Economic profit:
= total revenue (TR) – total costs (TC)
• Total costs = explicit costs + implicit costs
= opportunity cost of all resources
Normal Profit
• Is the minimum profit required by the entrepreneur/s
• Is equal to the opportunity cost of entrepreneurship
Production in the Short-Run
• Short-run (SR) = period too brief to permit firms to
alter all of its inputs/resources
 SR has at least 1 fixed input/resource
• Long-run (LR) = period long enough to allow firm to
vary all inputs/resources
 LR has no fixed inputs/resources
Law of Diminishing Marginal Returns
• The Law of Diminishing Marginal Returns (L of DMR)
states
“As more variable resource is added to a given
amount of another resource (i.e. fixed resource),
marginal product will eventually decline.”
• L of DMR explains the shape of the MP curve and
therefore our product and costs curves.
MPh
TPh at
increasing
rate
MPi
TPh at
decreasing
rate
Total Product
and Marginal
Product
of Labour
MP negative
TPi
Production Costs in the SR
• Marginal Cost = extra or additional cost associated with
the production of 1 extra unit of output.
TC TVC TFC
 MC 


Q
Q
Q
• However, since TFC/Q = 0, then
MC = TVC/Q
• MC = slope of both the TC and TVC curves
Production Costs in the SR
• Total Cost (TC)
$
TC
= TFC + TVC
• Total cost is parallel to
TVC
TVC, vertical distance
between TC and
TVC = TFC
TFC
0
Q
Law of DMR determines shapes of all product and cost curves
I
350
II
Costs
Output
400
III
TC
700
I
II
600
TP
300
800
TVC
500
250
400
200
TVC1
= L1 x Cost of
Labour (wage)
300
150
200
100
100
50
0
0
50
100 150 200 250 300 350 400
0
0
2
4
6
8
10
12
14
Output
16
Labour
10
Law of DMR
MC
9
I
60
III
II
50
Costs
MP
70
I
8
7
II
Q at max
MP
=
Q at min
MC
6
40
5
30
4
20
3
10
2
0
1
MP
-10
0
0
-20
0
2
4
6
8
10
12
14
16
Labour
50
100
150
200
250
300
350
400
Output
MC
Cost per ton
$150
125
100
Min
ATC
Min
AVC
AFC
ATC
75
AVC
AFC
50
25
Q
0
5
10
15 Tons per day
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Summary of Relationship between
Marginal and Average
• MC > average cost  the marginal pulls up the average
cost
• MC < average cost  the marginal pulls down the
average
• U-shape of average costs curves
• Law of DMR
• Therefore MC intersects AVC and ATC at their
minimum points
Long Run Average Cost (LRAC)
• LRAC curve shows the least costly way of producing any
given level of output.
Cost
per
unit
SRAC
curves
LRAC
Q
The LRAC is a planning curve.
A firm’s long run average cost curve
COMPARISON OF MARKET
STRUCTURES
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Number
of firms
Many
Many
A few large
One
Barriers
to entry
None
None/low
High
Very High
Type of
Product
Identical
(Homogeneous)
Differentiated,
similar but
different to
competitors
Identical or
Differentiated
Unique,
no close
substitutes
Control
over price
Price TAKER
Price MAKER
Examples
Bananas,
foreign
exchange
Shampoo,
toothpaste
PRICE MAKER PRICE MAKER
Banks,
Supermarkets,
Airlines
Sydney Water,
Australia Post
Perfect
Competition
Monopolistic
Competition
Monopoly
Pricing
decision
P = MR = MC
MR = MC
MR = MC
Allocative
Efficiency
Yes
P = MC
No
P > MC
No
P > MC
Minimum
Efficient Scale
Yes
Min LRAC
No
Q < min LRAC,
Excess capacity
No
Q < min LRAC,
Excess capacity
LR economic
profit
possible?
No
Normal profit
only
P=ATC
No
Normal profit
only
P=ATC
Yes
Economic profit
able to be
earned in the LR
PERFECT COMPETITION
Perfect Competition
MARKET
P
INDIVIDUAL FIRM
Smarket
P
P = MR = Demand
P*
P*
Dmarket
Q*
Q (‘000s)
Q
Profit Maximisation/Loss Minimisation in SR
• Set MR = MC
• Find profit maximising P* and Q*
• Compare P* and ATC
•
If P* > ATC  firm is making an ECONOMIC PROFIT
•
If P* < ATC  firm is making an ECONOMIC LOSS and
need to decide whether to shut down or stay in
production in the SR
•
If economic loss, compare P* and AVC
•
If P* > AVC  STAY In PRODUCTION as firm is able to
cover all its TVC and loss will be < TFC
•
If P* < AVC SHUT DOWN (temporarily) as unable to
cover all its TVC and loss will be smaller if shutdown
(loss = TFC if shutdown)
Perfect Competition – Profit Maximisation in SR
P > ATC
Perfect Competition – Loss Minimisation in SR
P > AVC
Summary of a perfectly competitive firm’s short-run output
decisions
Break-even
point
5
p5
Dollars per unit
Marginal cost
4
p4
d5
Average total cost
d4
Average variable cost
3
p3
2
p2
p1
Firm’s short run S curve
1
d = Dfirm
d3
d2
d1
0
q1
q2 q3 q4 q5
Quantity per period
Shutdown
point
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Aggregating individual supply curves of perfectly
competitive firms to form the market supply curve
Price per unit
(a) Firm A
(b) Firm B
sA
(c) Firm C
sB
(d) Industry, or market, supply
sC
sA + sB + sC = S
p’
p’
p’
p’
p
p
p
p
0
10 20
0
10 20
Quantity per period
0
10 20
0
Quantity per period
30
60
Quantity per period
At price p, each firm supplies 10 units of output & market supplies 30 units. In general, the market
supply curve in panel (d) is the horizontal sum of the individual firm supply curves sA, sB, and sC.
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Profit Maximisation/Loss Minimisation in
LR
• Losses are not acceptable in the LR
• Remember all resources are variable in
the LR
• So if unable to reorganise production to
make at least a normal profit then will
EXIT THE INDUSTRY
Long Run Adjustment
Loss
FIRM
MKT
S2
MC
P
P
ATC
S1
P2
P2
P1
P1
MR2
MR1
D
Q
Q1
Q2
Q
Long Run Adjustment
Supernormal profit
P
MKT
S1
P
FIRM
MC
S2
P1
P1
P2
P2
ATC
MR1
MR2
D
Q
Q2 Q1
Q
Long-run equilibrium for a firm & industry in perfect
competition
(a) Firm
(b) Industry, or market
MC
S
ATC
e
p
LRAC
D firm
Price per unit
Dollars per unit
Minimising LRAC
therefore is at MES
Allocative
Efficiency
p
P = MC,
Allocative Efficiency
0
q
Quantity
per period
D
0
Q
Quantity
per period
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
MONOPOLISTIC
COMPETITION
Monopolistic Competitor in the Short Run
(b) Minimizing short-run loss
MC
b
P*
ATC*
Profit
ATC
Dollars per unit
Dollars per unit
(a) Maximizing short-run profit
MC
ATC*
Loss
P*
AVC
b
c
D
e
Q*
Quantity per period
D
e
MR
0
ATC
c
MR
0
Q*
Quantity per period
38
Transition to the Long Run
• IF – Short Run Supernormal (Economic) Profit
• New firms enter the market
• Draw customers away from other firms
• Reduce demand facing other firms
• Demand Curves of existing firms shift to the left
• Economic Profit disappears in long run
• Zero economic profit (P = ATC in the long run)
Transition to the Long Run
P
MC
At P2, economic profit = 0
ATC
P1
P2= ATC2
ATC1
D1
D2
Q2 Q1
MR2
MR1
Q
40
Transition to the Long Run
• IF – Short Run Economic Loss
• Some firms exit the market
• Their customers switch to other firms
• Increases the demand for the remaining firms
• Demand Curves for remaining firms shift to the right
• Loss is erased in the long run
• Zero economic profit (P = ATC in the long run)
Transition
to
the
Long
Run
P
MC
At P2, economic profit = 0
ATC
ATC1
P2= ATC2
P1
D2
economic loss
D1
Q1 Q2
MR1
MR2
Q
42
Long Run Equilibrium in Monopolistic Competition
43
Comparison
• Monopolistic competition
• Downward sloping demand curve
• Not producing at minimum average cost
• Excess capacity
• Price above marginal cost
• Mark-up
• Produces less, charges more
• Than a perfect competitor…
• … in the long run
• Spend more to differentiate their products
MONOPOLISTIC COMPETITION &
EFFICIENCY
P=MC
Deadweight Loss
therefore not
Allocatively Efficient
QPC
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44 Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
MONOPOLY
Monopoly – demand curve and economic profit
P
TR = 0P*AQ*
TC = 0CBQ*
MC
ATC
A
P*
Economic profit = P*ABC
B
C
D
MR
0
Q*
Q
Comparing Monopoly and Perfect Competition
P
P*
MC
A
P = MC
B
PPC
C
D
MR
0
Q*
QPC
Q
• P > MR always, and so P > MC (allocative inefficiency)
• Consumers always pay a higher price under Monopoly and a
lower output is produced, compared to Perfect Competition
• Under Monopoly output is restricted to maximise profit.
• Because of barriers to entry a Monopoly can continue to earn
supernormal profit in the LR.
MONOPOLY – ALLOCATIVE INEFFICIENCY
49
Price Discrimination
• Price discrimination
• Increasing profit
• Charging different groups of consumers
• Different prices
• For the same product
50
Price Discrimination
• Conditions for price discrimination
• Downward sloping demand curve
• Some market power
• At last two groups of consumers
• With different price elasticity of demand
• Ability to charge different prices
• At low cost
• Prevent reselling of the product
Price Discrimination Example – Train Travel
MC drawn horizontal for simplicity
Adults
P
P1
Children
P
A
F
P2
B
C
MR
0
Q1
MC
C
D
Q of trips
MC
G
MR
0
Q2
D
Q of trips
OLIGOPOLY
Oligopoly
• A few firms.
• Barriers to entry.
• Therefore, firms are interdependent.
• Products may be identical or
differentiated..
Game Theory
• Allows us to analyse the strategic interaction
between firms who have market power
• A dominant strategy is a strategy that is best for a
player in a game regardless of the strategies
chosen by the other players.
• The Nash equilibrium is a situation in which
economic actors interacting with one another
each choose their best strategy given the
strategies that all the other actors have chosen.
Prisoners Dilemma Game
• Shows that the Nash Equilibrium leaves both parties
worse off, than the cooperative outcome
• Also illustrates why cooperation is difficult to maintain
even when it is mutually beneficial.
Prisoners Dilemma Game
Nash
Equilibrium
Virgin Australia
Low price
High price
$25,000
$8,000
Low price
$20,000
$45,000
Qantas
$40,000
$35,000
High price
$10,000
$30,000
Collusive
Equilibrium
DEMAND AND SUPPLY
• Demand
• The quantity consumers are willing and able to buy at each
possible price during a given time period, other things constant
• Law of demand
Price per unit
– Quantity demanded varies inversely with price,
other things constant
– Higher price: lower quantity demanded
D
Quantity per unit of time
Law of Demand
• When the price changes, two factors are at
work, causing quantity demanded to
change….
(1) the substitution effect of a price change
(2) the income effect of a price change
Demand
• Movement along the demand curve
• Change in quantity demanded
• Due to a change in price
• Shift in the demand curve (CHANGE IN DEMAND) due
to change in a non-price factor:






Money income of consumers
Prices of Substitutes
Prices of Complements
Consumer expectations
The number or composition of consumers in the market
Consumer tastes
Change in Quantity Demanded
Increase in
quantity
demanded
P
Decrease in
quantity
demanded
P
$10
$8
$6
$5
D
3
7
Q
D
2
4
Q
Change in Demand
• A shift of the entire D curve is called a
change in demand
= creation of a brand new D curve via the relaxation of
ceteris paribus condition
P
P
Decrease in
demand
Increase in
demand
D1
D2
Q
D2
D1
Q
• Supply
• How much producers are willing and able to offer for sale per
period at each possible price, other things constant
Price per unit
• Law of supply
• Quantity supplied is directly related to its price, other things
constant
• Higher price: higher quantity supplied
S
Quantity per unit of time
Supply
• Movement along the supply curve
• Change in quantity supplied
• Due to a change in price
• Shift in the supply curve (CHANGE IN SUPPLY) due to
change in non-price factor:






State of technology
Prices of Factors of Production
Resources with Alternative Uses
Goods in Joint Production
Producer expectations
Number of producers in the market
Change in Quantity Supplied
Increase in Q Supplied
Decrease in Q Supplied
P
P
S
P2
P1
S
P2
P1
Q1
Q2 Q
Q2
Q1 Q
Change in Supply
S1
P
S2
Shift from
S1 to S2 is an
increase in
supply
P1
Q1
Q2
Q
• It is an increase in supply because at a given price (say P1) we have a
greater willingness and ability of producers to make the product available.
• Decrease in supply shifts S curve to the left.
Equilibrium in the Pizza Market (b)
S
Price per pizza
$15
Surplus
12
c
9
6
Shortage
3
0
D
14 16
20 24 26
Millions of pizzas per week
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Price per pizza
Effects of an Increase in Demand
S
g
$12
c
9
D’
D
0
20 24
30
Millions of pizzas per week
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Effects of an Increase in Supply
Price per pizza
S
S’
c
$9
6
d
D
0
20
26
30
Millions of pizzas per week
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Effect on Equilibrium of Increases in Demand &
Supply at the same time
Sorig
S3
P
S1
S2
P3
P* = P1
P2
Dnew
Dorig
Q* Q3
Q1 Q2
Q
• We should note that if
there is a change in
demand and a change in
supply, the result may be
indeterminate.
• Consider Dh plus Sh
 Qh (for certain) but
what about price?
P may h or i or remain
unchanged.
• Depends on the relative
size of the shifts of the
curves.
ELASTICITY
Price Elasticity of Demand
The price elasticity of demand is a units-free measure of the
responsiveness of the quantity demanded of a good to a change
in its price when all other influences on buying plans remain the
same.
=
%Q
__________________
%P
The elasticity of demand for a good depends on:
 The closeness of substitutes
 The proportion of income spent on the good
 The time elapsed since a price change
Formulas for Price Elasticity of Demand
Q Pn
E

P Qn
Point
Formula
1
______________
slope
MidPoint
Formula
Position on D Curve
Q
Qaverage
%Q

P
%P
Paverage
Qn  Qo
Qn  Qo  / 2
Pn  Po  Q




x
Pn  Po
Qn  Qo  P
 Pn  Po  / 2
Summary of Impact of P on TR
E>1
Elastic
(%Q > %P)
E=1
Unit Elastic
(%Q = %P)
E<1
Inelastic
(%Q < %P)
Ph
TRi
TR no change
TRh
Pi
TRh
TR no change
TRi
Cross Elasticity of Demand
The cross elasticity of demand is a measure of the
responsiveness of demand for a good to a change in the price of a
substitute or a complement, other things remaining the same.
The formula for calculating the cross elasticity is:
Percentage change in quantity demanded
Percentage change in price of substitute or complement
The cross elasticity of demand for
 a substitute is positive.
 a complement is negative.
 Unrelated goods is zero.
Income Elasticity of Demand
The income elasticity of demand (εY)measures how the quantity
demanded of a good responds to a change in income, other things
remaining the same.
The formula for calculating the income elasticity of demand is:
Percentage change in quantity demanded
Percentage change in income

εY > 1 then demand is income elastic and the good is a normal good
(is a luxury).

0 < εY < 1 then demand is income inelastic and the good is a normal
good (is a necessity).

εY < 0, the good is an inferior good.
Calculating the Elasticity of Supply
The elasticity of supply is calculated by using the formula:
Percentage change in quantity supplied
Percentage change in price
The elasticity of supply depends on:
1. Resource Substitution Possibilities
The easier it is to substitute among the resources used to produce
a good or service, the greater is its elasticity of supply.
2. Time Frame for Supply Decision
The more time that passes after a price change, the greater is the
elasticity of supply.
EXTERNALITIES
EXTERNALITY
• Externality is the uncompensated impact of
one person’s actions on the wellbeing of a
bystander.
• A positive externality makes the bystander
better off.
• A negative externality makes the bystander
worse off.
NEGATIVE EXTERNALITIES IN PRODUCTION
(MXC)
MSC = MXC + MC
P
Sprivate cost = MC
MXC
Allocative
Efficiency
DWL
Peff
Market
equilibrium
Pmkt
D = MB = MSB
Qeff
Qmkt
Q
NEGATIVE EXTERNALITIES IN
CONSUMPTION (MXC)
P
S = MC = MSC
Market
equilibrium
Pmkt
Peff
DWL
Allocative
Efficiency
MXC
D = MB
MSB = MB - MXC
Qeff Qmkt
Q
POSITIVE EXTERNALITIES IN PRODUCTION
(MXB)
Sprivate cost = MC
P
MSC = MC - MXB
Market
equilibrium
MXB
Pmkt
Peff
Allocative
Efficiency
DWL
D = MB = MSB
Qmkt
Qeff
Q
POSITIVE EXTERNALITIES IN CONSUMPTION
(MXB)
P
S = MC = MSC
Allocative
Efficiency
Peff
DWL
Pmkt
Market
equilibrium
MXB
MSB = MB + MXB
D = MB
Qmkt Qeff
Q
SOLUTIONS TO EXTERNALITIES
4 solutions
1. Private Solutions via the Coase Theorem
2. Government Regulation
3. Market-based Solutions via Price (e.g. Pigovian tax)
4. Market-based Solutions via Quantity (e.g. permits)
GOVERNMENT ACTIONS
IN MARKETS
PRICE CONTROLS
• A price ceiling is a legal maximum on the price
at which a good can be sold.
• A price floor is a legal minimum on the price at
which a good can be sold.
TAX INCIDENCE
• Tax incidence - who bears the burden of
taxation, i.e. how the burden of the tax is
shared between consumers and producers.
A TAX ON SELLERS
A TAX ON BUYERS
ELASTICITY AND TAX INCIDENCE
ELASTICITY AND TAX INCIDENCE
ELASTICITY AND TAX INCIDENCE
• The more ELASTIC is demand – more of the tax
paid by the producer (seller)
• The more INELASTIC is demand – more of the
tax paid by the consumer (buyer)
• The more ELASTIC is supply – more of the tax
paid by the consumer (buyer)
• The more INELASTIC is supply – more of the tax
paid by the producer (seller)
THE WELFARE EFFECTS OF A TAX
Tax per unit = vertical
distance between the
supply curves = E1G
P
S + tax
Tax Revenue
= Tax per unit x Qtax
Tax creates a wedge
between price
consumers pay and
amount producers
receive.
Both the consumer
surplus (CS) and
producer surplus (PS)
are reduced.
A deadweight loss (DWL)
is created.
PB
P*
CS
Tax
Revenue
E1
DWL
S
E*
PS
PS
0
G
Qtax
D
Q*
Q
THE DETERMINANTS OF THE DEADWEIGHT
LOSS
 A tax has a deadweight loss because it induces
buyers and sellers to change their behaviour.
 The tax raises the price paid by buyers, so they
consume less. At the same time, the tax lowers
the price received by sellers, so they produce less.
Hence, the equilibrium quantity in the market
shrinks below the optimal quantity.
 The more responsive buyers and sellers are to
changes in the price, the more the equilibrium
quantity shrinks, and the greater the deadweight
loss.
THE DETERMINANTS OF THE DEADWEIGHT
LOSS
Supply + tax
Supply + tax
PB
PB
P*
P*
PS
PS
Qtax Q*
Qtax
Q*
THE DETERMINANTS OF THE DEADWEIGHT
LOSS
Supply + tax
Supply + tax
PB
PB
P*
P*
PS
PS
Qtax Q*
Qtax
Q*
Subsidy
• A subsidy is a payment from government, to
consumers or sellers, for each unit of a good
that is bought or sold.
• Subsidies can be regarded as negative taxes.
A SUBSIDY TO SELLERS
THE WELFARE EFFECTS OF A SUBSIDY
Amount of the subsidy
per unit = vertical
distance between the
supply curves = E1G
Cost of the subsidy
= Subsidy per unit x
Qsubsidy
Both the consumer
surplus (CS) and
producer surplus (PS)
are increased.
P
S
PS
G
E*
S + subsidy
P*
PB
Cost of the subsidy
E1
A deadweight loss (DWL)
is created.
D
0
Q*
Qsubsidy
Q
THE WELFARE EFFECTS OF A SUBSIDY
Amount of the subsidy
per unit = vertical
distance between the
supply curves = E1G
Cost of the subsidy
= Subsidy per unit x
Qsubsidy
Both the consumer
surplus (CS) and
producer surplus (PS)
are increased.
P
PS
S
G
CS
E*
S + subsidy
P*
E1
PB
A deadweight loss (DWL)
is created.
D
0
Q*
Qsubsidy
Q
THE WELFARE EFFECTS OF A SUBSIDY
Amount of the subsidy
per unit = vertical
distance between the
supply curves = E1G
Cost of the subsidy
= Subsidy per unit x
Qsubsidy
Both the consumer
surplus (CS) and
producer surplus (PS)
are increased.
P
S
PS
G
E*
S + subsidy
P*
PS
E1
PB
A deadweight loss (DWL)
is created.
D
0
Q*
Qsubsidy
Q
THE WELFARE EFFECTS OF A SUBSIDY
Amount of the subsidy
per unit = vertical
distance between the
supply curves = E1G
Cost of the subsidy
= Subsidy per unit x
Qsubsidy
Both the consumer
surplus (CS) and
producer surplus (PS)
are increased.
P
S
PS
G
E*
P*
S + subsidy
DWL
E1
PB
A deadweight loss (DWL)
is created.
D
0
Q*
Qsubsidy
Q
CONSUMER THEORY
Budget Line
PSQS + PMQM = Y
𝑌
∴ 𝑄𝑆 =
𝑃𝑆
Real
income
-
𝑃𝑀
× 𝑄𝑀
𝑃𝑆
Relative price
= opportunity cost
= slope of BL
Budget Line
Indifference Curve
An indifference curve (IC) is
a line that shows
combinations of goods
among which a consumer is
indifferent.
(Or equal satisfaction /utility
/happiness).
MRS =
Δ𝑦
Δ𝑥
= slope of an indifference
curve
A
B
Indifference Curves
Marginal Rate of Substitution
•
The marginal rate of substitution (MRS) measures
the rate at which a person is willing to give up good y
to get an additional unit of good x while at the same
time remaining indifferent (remaining on the same
indifference curve).
Diminishing Marginal Rate of Substitution
B
As we move along the IC, MRS falls.
D
E
Best Affordable Choice
The best affordable
choice (or point of
Utility Maximisation)
is found where the
BL just touches the
IC.
Where
slope of the IC =
slope of the BL
i.e. MRS = relative
price
Deriving the
Demand Curve
Substitution Effect
of a Price Change
The substitution effect is
the effect of a change in
price on the quantity
bought when the
consumer remains on the
same indifference curve.
Income Effect of
a Price Change
Effect of a change in
price on the quantity
bought due to
change in real
income.
TRADE
Absolute vs Comparative Advantage
•A person has an absolute advantage if that person is
more productive than others – this just means that a
person can produce more than another.
•A person has a comparative advantage in an activity if
that person can perform the activity at a lower
opportunity cost than anyone else.
•Specialise in producing the good that have a
comparative advantage in
Toshiba can make 50 computers or 10 TVs in an hour
Sony can make 20 computers or 40 TVs in an hour
1. Who has absolute advantage in which product?
2. Who has comparative advantage in which product?
3. Who will specialise in producing computers? Who will specialise
in producing TVs?
4. Find the terms of trade that the two companies would be
willing to trade at.
5. Draw the PPFs and CPFs for both companies. (Put TVs on the xaxis and computers on the y-axis.)
Toshiba can make 50 computers or 10 TVs in an
hour
Sony can make 20 computers or 40 TVs in an hour
1. Who has absolute advantage in which product?
Toshiba has absolute advantage in Computers and
Sony has absolute advantage in TVs.
Toshiba can make 50 computers or 10 TVs in an hour
Sony can make 20 computers or 40 TVs in an hour
2. Who has comparative advantage in which product?
TOSHIBA
50C : 10TV
1C : 1/5TV
or
1TV : 5C
has comparative advantage in computers
SONY
20C : 40TV
1C : 2TV
or
1TV : 1/2C
has comparative advantage in TVs
3. Who will specialise in producing computers? Who will specialise in producing TVs?
Toshiba will make Computers.
Sony will make TVs.
Toshiba can make 50 computers or 10 TVs in an hour
Sony can make 20 computers or 40 TVs in an hour
4. Find the terms of trade that the two companies would be
willing to trade at.
Price of a computer
1/5TV < ToT < 2TV
MINIMUM amount Toshiba would want to receive
as payment = cost to Toshiba of producing
Computers
MAXIMUM amount Sony would want to
pay = cost to Sony of producing
Computers itself
Price of a TV
1/2C < ToT < 5C
MINIMUM amount Sony would want to receive
as payment = cost to Sony of producing TVs
MAXIMUM amount Toshiba would want
to pay = cost to Toshiba of producing
TVs itself
• Lets say for example that the ToT is:
1C = 1/2TV
OR (alternatively, the inverse…..)
• 1TV = 2C
• (Remember that other ToT are possible)
Thus:
• If Sony sold all its TVS to Toshiba it could buy a maximum
of 80 Computers.
• If Toshiba sold all its Computers to Sony it could buy a
maximum of 25 TVs.
Toshiba can make 50 computers or 10 TVs in an hour
Sony can make 20 computers or 40 TVs in an hour
5. Draw the PPFs and CPFs for both companies. (Put TVs on
the x-axis and computers on the y-axis.)
… there is a dashed line
(limit) here since Toshiba
cannot make more than
50 Computers for Sony
to buy.
CPF
CPF
PPF
PPF