Flashcards · IB Diploma Programme Economics · Topic 2

Microeconomics flashcards

71 cards on Topic 2, subtopics 2.1 to 2.12. Pick a subtopic or study them all.

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2.1 Demand (includes HL-only sub-topics)

Law of demand: Other things unchanged, a higher price means a lower quantity demanded: the demand curve slopes downward (price on the vertical axis, quantity on the horizontal).
Movement along versus shift of the demand curve: A change in the good's own price causes a movement along the curve (extension or contraction). A change in any non-price determinant shifts the whole curve (increase or decrease in demand).
Non-price determinants of demand: Income (normal and inferior goods), tastes and preferences, expectations of future prices, prices of related goods (substitutes and complements), and the number of consumers.
What happens to demand for a good when the price of a substitute rises? When the price of a complement rises?: Substitute price rises: demand for the good shifts right (buyers switch to it). Complement price rises: demand for the good shifts left (fewer buy the pair).
Market demand from individual demand: Add the quantities each consumer demands at each price (horizontal summation). Add quantities, not prices.
Assumptions underlying the law of demand: Substitution effect: a lower price makes the good cheaper relative to alternatives. Income effect: a lower price raises purchasing power. Diminishing marginal utility: each extra unit gives less satisfaction, so buyers take more only at a lower price. (HL only)

2.2 Supply (includes HL-only sub-topics)

Law of supply: With nothing else changing, a rise in price raises the quantity supplied: the supply curve slopes upward.
Non-price determinants of supply: Costs of factors of production, prices of related goods (competitive and joint supply), indirect taxes, subsidies, future price expectations, technology and the number of firms.
Competitive supply versus joint supply: Competitive supply: same inputs, either good. A higher price of oats reduces the supply of wheat. Joint supply: produced together. A higher price of lamb increases the supply of wool.
Effect of a per-unit indirect tax and a per-unit subsidy on the supply curve: Tax: supply shifts up (left) by a vertical distance equal to the tax. Subsidy: supply shifts down (right) by the subsidy. A producer that supplied 50 at 9 needs 12 after a tax of 3, or 6 with a subsidy of 3.
Why does the supply curve slope upward? Explain using marginal returns.: With a fixed input, diminishing marginal returns mean each extra worker adds less output. At the same wage, marginal cost per unit rises, so producers need a higher price to supply more. Example: a wage of 90 and an extra 15 units gives MC = 6; if the next worker adds 9, MC = 10. (HL only)

2.3 Competitive market equilibrium

Market equilibrium, excess demand and excess supply: Equilibrium: the price at which quantity demanded equals quantity supplied. Excess demand (shortage): price below equilibrium, Qd > Qs. Excess supply (surplus): price above equilibrium, Qs > Qd.
Effect on equilibrium price and quantity of: a rise in demand; a fall in supply: Rise in demand: D shifts right; price and quantity both rise. Fall in supply: S shifts left; price rises and quantity falls. If both curves shift, one of price or quantity is certain; the other depends on the relative size of the shifts.
The functions of the price mechanism: Signalling: price changes tell buyers and sellers about changing relative scarcity. Incentive: a higher price encourages producers to supply more and consumers to buy less. Rationing: price shares out scarce goods to those willing and able to pay.
Consumer surplus and producer surplus: Consumer surplus: the most buyers would pay minus what they pay (area under demand, above price). Producer surplus: what sellers receive minus the least they would accept (area above supply, below price). Social (community) surplus = consumer + producer surplus.
Allocative efficiency in a competitive market: Output where marginal benefit (demand) equals marginal cost (supply), so social surplus is at its maximum. Producing more or less than this creates a welfare loss.
Calculate surplus: demand intercept 20, supply intercept 2, equilibrium price 8 and quantity 50: Consumer surplus = ½ × 50 × (20 − 8) = 300. Producer surplus = ½ × 50 × (8 − 2) = 150. Social surplus = 450. (HL only)

2.4 Critique of the maximizing behaviour of consumers and producers (HL only)

Assumptions of rational consumer choice: Consumers are rational (compare costs and benefits and choose consistently), maximise utility, and have perfect information. (HL only)
Biases: rule of thumb, anchoring and framing, availability: Rule of thumb: a simple shortcut for deciding quickly. Anchoring: a first number sways later judgements. Framing: the wording of the same facts changes the choice. Availability: judging likelihood by how easily examples come to mind. (HL only)
Bounded rationality, bounded self-control and bounded selfishness: Bounded rationality: limited information, time and thinking power restrict decisions. Bounded self-control: knowing the better long-run choice but not acting on it. Bounded selfishness: caring about fairness and others, not only own gain. (HL only)
Choice architecture: default, restricted and mandated choice; nudge: Default: an option is pre-selected (opt-out). Restricted: fewer options offered. Mandated: an active choice must be made before going on. Nudge: a change in presentation that steers choice without banning options or changing prices. (HL only)
Business objectives other than profit maximisation: Corporate social responsibility (accepting costs for social or environmental aims), market share, satisficing (a satisfactory rather than maximum profit) and growth. Profit maximisation is output where MR = MC. (HL only)
Evaluate: how far does behavioural economics weaken the rational model?: For the critique: biases are systematic and explain choices the model misses, such as under-saving. Against: the model still predicts average behaviour where choices are repeated and feedback corrects errors; behavioural results may not carry across settings. (HL only)

2.5 Elasticity of demand (includes HL-only sub-topics)

PED: formula and example. Price rises from 60 to 66; quantity falls from 700 to 595.: PED = % change in quantity demanded ÷ % change in price. Price +10%, quantity −15%: PED = −15 ÷ 10 = −1.5, so demand is price elastic.
Perfectly inelastic, unitary and perfectly elastic demand: values and curves: PED 0: perfectly inelastic, a vertical line. PED 1: unitary, a rectangular hyperbola (total revenue constant). PED infinite: perfectly elastic, a horizontal line.
Determinants of PED: More elastic with many close substitutes, a luxury, a large share of income and a long time period. More inelastic with few substitutes, a necessity, a small share of income and a short period.
PED and total revenue: a cinema cuts its price from 12 to 10 and attendance rises from 600 to 780: PED = 30% ÷ −16.67% = −1.8: elastic. Revenue rises from 7,200 to 7,800. With elastic demand, price and revenue move in opposite directions; with inelastic demand they move together.
YED: formula and example. Income rises 10%; restaurant meals rise 30% and instant noodles fall 10%.: YED = % change in quantity demanded ÷ % change in income. Meals: +3.0, normal and income elastic (luxury). Noodles: −1.0, inferior. Between 0 and 1: income inelastic (necessity).
Why does PED vary along a straight-line demand curve?: The slope is constant but the percentage changes differ. The upper section is elastic, the midpoint is unitary (where total revenue is at its maximum) and the lower section is inelastic. (HL only)
Why is PED generally lower for primary commodities than for manufactured goods?: Commodities have few close substitutes and are often necessities or essential inputs, are a small share of the cost of the final good, and have demand derived from the final product. Manufactures can be branded and differentiated. (HL only)
Why does YED matter for an economy's sectoral structure?: Agriculture has low YED and grows more slowly than income; services have high YED and grow faster. So as incomes rise, the share of services in output tends to rise. (HL only)

2.6 Elasticity of supply (includes HL-only sub-topics)

PES: formula and example. Price rises from 20 to 25 and quantity supplied from 160 to 200.: PES = % change in quantity supplied ÷ % change in price. Price +25%, quantity +25%: PES = 1.0, unitary. PES is positive on an upward-sloping supply curve.
Reading a straight-line supply curve: which PES does it show?: Meets the price axis: elastic (above 1). Meets the quantity axis: inelastic (below 1). Passes through the origin: unitary (1), however steep. Vertical: 0. Horizontal: infinite.
Determinants of PES: Time (longer period, more elastic), mobility of factors of production, unused capacity, ability to store stocks, and the rate at which costs increase as output rises.
Why might supply be inelastic in the short run but elastic in the long run?: In the short run at least one input (such as capital) is fixed and output cannot rise quickly. In the long run all inputs can change, new capacity can be built and firms can enter, so the long-run supply curve is flatter.
Why is PES generally lower for primary commodities than for manufactured goods?: Production takes a long time (growing seasons, mine development), land and deposits are fixed, many are perishable or hard to store, and extra output brings steeply rising costs. Manufacturers can add shifts and hold stocks. (HL only)

2.7 Role of government in microeconomics (includes HL-only calculation)

Reasons for government intervention in markets: To earn government revenue, support firms, support low-income households, influence the level of production or consumption, correct market failure, and promote equity.
Price ceiling (maximum price): where is it set and what are the effects?: Set below equilibrium to bind. Quantity demanded rises and quantity supplied falls, so there is a shortage; quantity traded is Qs. Possible black markets, queues and lower quality.
Price floor (minimum price): where is it set and what are the effects?: Set above equilibrium to bind. Quantity supplied exceeds quantity demanded, so there is a surplus. The government may have to buy the surplus, at a cost to taxpayers.
Indirect tax versus subsidy: price paid and price received: Tax: supply shifts up by the tax; consumers pay a higher price and producers keep that price minus the tax. Subsidy: supply shifts down; consumers pay less and producers receive the new price plus the subsidy.
Direct provision versus command and control regulation: Direct provision: the government supplies a service itself, funded by taxes; widens access but has an opportunity cost. Command and control: rules, limits or bans set by law; clear and quick but needs inspection and enforcement.
Tax incidence calculation: demand P = 200 − 4Q, supply P = 20 + 2Q, tax of 18 per unit: Before: Q = 30, P = 80. After: 200 − 4Q = 38 + 2Q, so Q = 27 and consumers pay 92; producers keep 74. Consumers bear 12, producers 6. Revenue = 18 × 27 = 486. Welfare loss = ½ × 18 × 3 = 27. (HL only)
Consumer nudges as a form of intervention: A change in how a choice is framed or set by default. Strength: cheap and keeps freedom of choice. Limits: effects can be small or uncertain, and people disagree about who decides what is best for the chooser. (HL only)

2.8 Market failure – externalities and common pool or common access resources (includes HL-only calculation)

Externality, MSC and MSB: Externality: a side effect of a transaction on a third party who neither pays nor is paid. MSC = MPC + external cost. MSB = MPB + external benefit. The social optimum is where MSB = MSC.
Diagram in words: negative externality of production: Axes: price or cost and quantity. MSC lies above MPC. The market produces where MPB = MPC, more than the optimum where MSB = MSC: overproduction. The welfare loss triangle lies between MSC and MSB from the optimum to the market output. Example: factory pollution.
Which curve shifts for each type of externality, and what is the market outcome?: Negative production: MSC above MPC, overproduction. Negative consumption: MSB below MPB, overconsumption. Positive production: MSC below MPC, underproduction. Positive consumption: MSB above MPB, underconsumption (education).
Common pool resources and the tragedy of the commons: Common pool resources are rivalrous but non-excludable. Each user gets the whole gain from extra use but the damage to the stock is shared, so the resource is overused: unsustainable production and a negative externality.
Pigouvian tax versus tradable permits: A Pigouvian tax equal to the marginal external cost shifts MPC up to MSC; it fixes the price of pollution, but the external cost is hard to measure. Tradable permits fix the quantity of pollution, and cuts are made by the firms that can cut most cheaply.
Merit good versus positive externality: A merit good is under-consumed because people undervalue its benefit. A positive externality is a benefit to others. A good can be both (education).
Welfare loss: MPB P = 40 − Q, MPC P = 4 + Q, marginal external cost 6: Market: Q = 18, P = 22. MSC = 10 + Q, so the optimum is Q = 15, P = 25. At Q = 18, MSC = 28 and MSB = 22. Welfare loss = ½ × 3 × 6 = 9. (HL only)

2.9 Market failure – public goods

Public good: A good that is both non-rivalrous (one person's use leaves the amount for others unchanged) and non-excludable (non-payers cannot be stopped from using it). Example: a sea wall defending a whole bay.
Why does the market fail to provide public goods?: Non-payers cannot be excluded, so people free ride: they use the good but pay nothing. Firms cannot earn enough revenue, so a good whose total benefit exceeds its cost may not be provided at all.
Public good versus a good provided by the government, and versus a free good: A state school place is government-provided but rival and excludable, so not a public good. A free good has no opportunity cost; a public good uses scarce resources.
Direct provision versus contracting out of public goods: Both are funded by compulsory taxation, removing free riding. Direct provision: a government agency produces the good. Contracting out: a private firm chosen by tender produces it; competition can cut cost, but contracts are costly to write and monitor.

2.10 Market failure – asymmetric information (HL only)

Asymmetric information: One side of a deal holds more relevant knowledge than the other, so the market may misallocate resources or shrink. (HL only)
Adverse selection versus moral hazard: Adverse selection: hidden quality or risk before the deal drives out the better cases (used goods). Moral hazard: behaviour changes after the deal because another party carries the risk (an insured owner stops maintaining equipment). (HL only)
Adverse selection in numbers: half of pianos are good. Buyers value good at 900 and poor at 400; good sellers want at least 800.: Uninformed buyers offer the average: 0.5 × 900 + 0.5 × 400 = 650. Good sellers need 800, so they withdraw, and the market shrinks towards poor pianos. (HL only)
Signalling versus screening: Signalling: the informed party reveals its quality by a costly action (a warranty, a qualification). Screening: the uninformed party designs a test that makes the informed party reveal its type (a menu of insurance contracts). (HL only)
Government responses to asymmetric information: Legislation and regulation (compulsory disclosure of defects, licensing) and the provision of information (published inspection results). Limits: enforcement cost, rules lag behind practice, information may be misread. (HL only)

2.11 Market failure – market power (HL only)

Market power, and price taker versus price maker: Market power: a firm's ability to influence the price it charges. Price taker: no market power; faces a horizontal demand curve (P = AR = MR). Price maker: chooses a price along a downward-sloping demand curve. (HL only)
Abnormal profit, normal profit and loss: Abnormal profit: AR > AC. Normal profit: AR = AC. Loss: AR < AC. A firm selling 6 units at 9 with TC 54 earns normal profit, not a loss. (HL only)
Monopoly compared with perfect competition: Monopoly produces where MC = MR and sets price from AR, so output is lower and price higher than the competitive P = MC outcome. P > MC means allocative inefficiency and a welfare loss triangle between demand and MC. Possible benefits: economies of scale, profit for R&D. (HL only)
Natural monopoly: why one firm, and how might it be regulated?: Economies of scale are so large that AC falls across all of market demand, so one firm supplies at lowest cost. P = MC gives a loss because MC is below AC; a regulated price of P = AC gives normal profit and more output than the unregulated firm. (HL only)
Collusive versus non-collusive oligopoly: Collusive: firms agree price or output and act like a monopoly, producing where industry MC = MR. Non-collusive: firms compete, with a risk of a price war. Either way P > MC, so oligopoly is allocatively inefficient. (HL only)
Oligopoly: the incentive to collude and the incentive to cheat: Incentive to collude: higher joint profit. Incentive to cheat: a firm that secretly undercuts gains at its rivals' expense, so agreements tend to break down. (HL only)
Concentration ratio: shares are 26, 21, 17, 13, 9, 8 and 6. Find CR3 and CR4.: Add the largest n shares. CR3 = 26 + 21 + 17 = 64%. CR4 = 64 + 13 = 77%. (HL only)
Monopolistic competition: short run and long run: Many firms, free entry, differentiated products. Short run: abnormal profit is possible (MC = MR). Long run: entry shifts each firm's demand left until AR is tangent to AC, giving normal profit. P > MC, but there is product variety. (HL only)

2.12 The market's inability to achieve equity (HL only)

Income versus wealth: Income: a flow, what a household earns in a period from selling factors of production. Wealth: a stock, the value of what a household owns at a point in time. (HL only)
The four factor incomes: Wages (labour), rent (land), interest (capital), profit (enterprise). Rent, interest and profit are property income, going to owners of non-labour factors. (HL only)
Using the circular flow, why does a free market produce unequal incomes?: Households sell factor services in the factor market. Income depends on how many units of each factor a household owns and on the price each factor earns. Those with only labour to sell earn wages alone; owners of land, capital and businesses also earn property income. (HL only)
Why does inequality in wealth tend to widen inequality in income over time?: Wealth earns a return (interest, rent, profit). Richer households earn more from their wealth, save more, and so build more wealth, which earns still more income. The gap keeps moving in one direction. (HL only)