Microeconomics

1.0 Introduction

1.1 Overview

General

The standard model of market economics, specifically 'X' marks the spot where supply meets demand, was formalized by Alfred Marshall in the last part of the 19th and early part of the 20th centuries. Its roots, however, lay in what is known as the 'Marginalist Revolution' of the 1870s.  This shifted the focus of economics from the production and distribution of wealth among social classes - owners of capital, labour and natural resources - towards the atomized individual consumer (2.0 Demand) and producers (3.0 Supply).  Microeconomics was born.  Before examining that model, and how it came to be, certain key economic concepts will first be introduced.

1. Opportunity Cost, Scarcity & Relative Prices

It is assumed in micro that human wants, needs and desires always exceed the available means to satisfy them, i.e., scarcity is a permanent condition. Such wants, needs and desires (as well as the means to satisfy them), are not just physical and/or financial, but also psychic.  Put another way, scarcity is a permanent human condition and choice between both means and ends must be made.

An excellent expression of the infinity of wants, needs and desires can be found in Maslow's "Need Hierarchy".  Maslow (1908-1970) proposed  that human beings reach fulfillment through satisfying a series of needs beginning with basic physiological ones like food, water and shelter and rises to increasingly abstract ones like love, self-esteem and personal expression.  Only when primitive needs are satisfied can the individual progress up to higher levels in the hierarchy. Thus only the person reaching self-actualization will fully utilize one's potential. Put another way, once lower needs are satisfied, higher needs rise to consciousness and demand attention. They can be just as pressing as physical ones.  Furthermore, ongoing satisfaction of lower needs is required to maintain the process, i.e., basic needs must be continuously satisfied. 

How to satisfy infinite wants, needs and desires subject to scarce resources requires a choice between alternatives, e.g., a pensioner choosing between food or medicine.  The choice of the best alternative, however, implies that the next best alternative is not chosen. Put another way, the cost of choosing one alternative possibility is the next best alternative foregone. This is called 'opportunity cost'.  All economic costs are opportunity costs serving to distinguish economics from accounting or business costs.

i - Monetary vs. Real Cost

Monetary units (dollars, cents, francs, marks, pounds, yen, etc) are useful in determining economic or opportunity cost but they do not necessarily reflect 'real cost'. Monetary cost refers to the price paid on a market. Real cost, on the other hand, includes costs that are not necessarily reflected in market price, i.e., they are externalities or rather external to market price.  A number of factors can lead to a difference between monetary and real cost.  Thus real or opportunity cost includes the value of time involved in purchasing a good or service.  If one works at an hourly job, one is paid a wage per hour that when multiplied by the number of hours worked equals one's income. This income does not, however, allow for the cost of getting ready for and re-creating after work and commuting both to and from work.  Accordingly, the 'real' wage per hour would account for such external costs.  Similarly, the market price of gasoline may not reflect costs associated with polluting the environment and contributing to so-called 'global warming'.  Such additional costs are paid by society as a whole and are called 'external costs', i.e., external to market price.  They must be included to calculate the real, economic or opportunity cost of a good or service.  This is another example of the difference between economics and accounting cost.  Carbon credits and other tradeable pollution permits are innovative ways to reconcile the two.

ii - Relative Prices

Assuming market price does reflect real cost we can determine the opportunity cost of different goods and services by calculating 'relative price'.  Relative price is the ratio of one price to another. For example if the price of a Coke is $1.00 and chewing gum $0.50 the relative price of Coke is $1.00/$0.50 or 2, i.e. you could buy 2 packs of chewing gum for the price of one Coke.

There are, of course, thousands if not millions of different goods and services all with different and changing market prices. Accordingly, relative price is usually expressed in terms of the price of a standard 'basket' of goods and services measured by a 'price index' over time. Thus we divide the monetary price of a good or service by the price index. The resulting 'relative price' tells us how much of the standard basket we must exchange to buy the given good or service.

In the micro theory of supply and demand, price means 'relative price'. Thus when the price of a good or service falls, we do not mean its monetary but rather its relative price to other goods and services, i.e. it's opportunity cost declines.  In macro theory concern focuses on the aggregate price level rather than the prices of specific goods or services.

The question of relative 'international' prices is even more complicated.   One widely used way of measuring  'purchasing power parity' in different countries is the 'Mac Index' which measures the number of hours of work required to buy a 'Big Mac' in different countries.

2. Futurity, Expectations & The Price Bargain

Time plays a critical role in economic analysis. In fact there are two distinct forms of analysis based on time: static and dynamic. Static analysis involves an economic variable or phenomena in a specific fixed moment in time. Dynamic analysis involves analysis through time, that is from the past to the present, or from the present into the future.

Two great economists enhanced economic understanding of Time. John Maynard Keynes introduced the concept of 'expectations'.  Over time people's changing expectations of what tomorrow will bring causes their actions to change today.  Similarly, John R. Commons introduced the concept of 'futurity' meaning people live in the future but act in the present. The difference between what we plan to do tomorrow and what we actually do today in expectation of tomorrow introduces a constantly changing dynamic to economic analysis, especially macroeconomic analysis. For example, if we expect interest rates will fall tomorrow, we hold off borrowing money today. But when tomorrow does comes and interest rates do not fall our plans must be changed.

Another important concept introduced by Commons is the 'price bargain'. Essentially Commons noted that the evolution of the concept of property has led away from the idea of tangible physical property towards increasingly intangible property specifically the buying and selling of the 'expectation of profits'.  Thus business assets such as 'good will' and intellectual property are playing an ever increasing role in the so-called 'knowledge economy'. For further information please see Chapter VII: The Price Bargain from Common's seminal 1924 work "The Legal Foundations of Capitalism". 

3. Demand

All things being equal, the higher the price of a good or services, the smaller the quantity demanded. This is the Law of Demand. Among other things the law reflects the substitution and income effect of a price increase on the quantity of a good demanded by consumers.

i - Substitution Effect: when the price of a good increases it does so relative to all other goods. Although each good is unique it has substitutes - other goods that will serve almost as well. As the opportunity cost of a good rises, people will tend to buy less of it and more of its substitutes.

ii - Income Effect: when the price of a good rises, all things being equal, it rises relative to income. Faced with a higher price and an unchanged income, the quantity of at least some goods and services must decrease.

The demand curve (and schedule) shows the relationship between the price of a good or service and the quantity demanded. In effect the curve shows consumers' 'willingness to pay' and 'ability to pay' to obtain a given quantity of a good or service. All things being equal, the demand curve will be downward sloping reflecting the law of demand: the higher the price, the lower the demand; the lower the price, the greater the demand. Assuming other prices remain constant and other factors do not change, there will be movement along the demand curve as the price of the good or service changes.

The demand curve can, however, shift, if other prices or other factors change (MBB Micro 10th & 11th Ed. Fig. 3.3; PB Fig. 4.9).  A shift in the demand curve can result due to changes in:

i - Price of Related Goods or Services; 

ii - Income; 

iii - Expected Future Prices;

iv - Population; and,

v - Preferences.

4. Supply

All things being equal, the higher the price of a good or services, the greater the quantity supplied. This is the Law of Supply.  The supply curve (and schedule) shows the relationship between the price of a good or service and the quantity supplied by producers. In effect, the curve shows the minimum price producers' will accept to provide a given quantity of a good or service. All things being equal, the supply curve will be upward sloping reflecting the law of supply: the higher the price, the greater the supply; the lower the price, the less the supply. Assuming other factors do not change, there will be movement along the supply curve as the price of the good or service changes.

The supply curve can, however, shift, if other factors change (MBB Micro 10th & 11th Ed. Fig. 3.7; PB Fig. 4.10).  A shift in the supply curve can result due to changes in:

i - Price of Factors of Production;

ii - Price of Other Goods;

iii - Expected Future Prices;

iv - Number of Suppliers; and,

v - Technology.

5. Markets

Markets are any arrangement that enables buyers and sellers to get information and to do business with each other. Put another way, markets are where demand meets supply. Markets can be described by reference to, in addition to other things:

- whether they are geographic or commodity-based;

- whether or not they are in equilibrium and, if so, what type of equilibrium;

- their sensitivity to change (elasticity) in prices and incomes; and,

- whether or not anyone - consumer, producer or government - can influence price or, more generally, the terms of trade or exchange. 

In a market, price acts as a regulator of the quantity of goods and services demanded and supplied. If the price is too high, consumers will demand less than producers are willing to supply. If the price is too low, consumers demand more than producers are willing to supply (MBB 10th & 11th Ed. Micro 3.6; PB Fig. 4.8).

6. Efficiency

In production, efficiency refers to the ratio of outputs to inputs. To measure efficiency one must therefore be able to calculate both inputs and outputs. This is most easily done in the production of goods rather than services, especially in manufacturing, e.g. cars produced per worker.
 

7. Effectiveness

In the case of many goods and most services produced by government, however, neither inputs nor outputs can be readily calculated. Accordingly, a less stringent test--cost effectiveness--is usually more appropriate. Surrogates or proxy indicators of inputs and outputs are used.  For example, the "recidivism rate" per parole officer (percentage of repeat offenders) can be used as an imperfect proxy for output rather than the more difficult to measure concept of "rehabilitation" measured in human, social, and/or economic terms. Similarly, average salary per parole officer can be used as a crude surrogate for inputs rather than the more difficult to measure "opportunity cost" of relevant financial, human, information, and physical resources in alternative applications, e.g. early education rather than later incarceration. 
 

8. Equilibrium

Equilibrium is a condition which once achieved will continue indefinitely unless one of the variables (economic or non-economic) is altered (MBB 10th & 11th Ed Micro 3.6; PB Fig 4.8). In the case of markets, the equilibrium price 'clears' the market, that is the quantity demanded by consumers equals the quantity supplied by producers.

More generally, economic theory recognizes three types of equilibrium:

i - general equilibrium: can exist under perfect competition and monopoly or monopolistic competition. Under perfect competition, it is a static state where all prices are at their long run equilibrium, individuals are spending income to yield maximum satisfaction, and the demand and supply factors of production are equated. Under monopoly or monopolistic competition, it is the situation where there is no reason for firms to enter or leave an industry, or to expand or contract;

ii - stable equilibrium: a condition which once achieved continues indefinitely unless there is a change in some non-economic conditions. Changes in economic conditions will be followed by reestablishment of the original equilibrium. Example: ball resting at the bottom of a cup; shake it and the ball returns to the bottom; and,
iii - unstable equilibrium: a condition which once achieved will continue indefinitely unless one of the variables (economic or non-economic) is altered, and then the system will not return to the original equilibrium and will not come to rest unless there is further alteration of a variable. Example: ball resting on the top of an overturned cup - shake it and the ball falls off never to return to the same place.

9. Elasticity

Elasticity refers to the sensitivity of a variable to change in another variable. Economic theory recognizes three principal types of elasticity:

i - income elasticity of demand - with all prices constant refers to the percentage change in the quantity of a commodity demanded compared to a one percent change in income (MBB not displayed; PB 4th Ed. Fig 5.8; 5th Ed. Fig. not included);

ii - price elasticity of demand or supply - refers to the percentage change in the quantity of a commodity demanded or supplied compared to a one percentage change in its price (MBB Micro 10th Ed Fig. 5.1 & Fig. 5.3; PB 4th Ed. Fig. 5.3 & Fig. 5.11; 5th Ed. Fig. 4.3 & not displayed). The amount demanded or supplied can increase:

a) more than proportionately, i.e. elasticity is greater than one - at the extreme a horizontal demand or supply curve is perfectly elastic - a small increase in price results in a large change in the quantity demanded or supplied;

b) proportionately, i.e. elasticity is equal to one (unitary elasticity); or,

lc) ess than proportionately. i.e. elasticity is less than one (inelastic) - at the extreme, a vertical demand or supply curve is perfectly inelastic - any change in price results in no change in the amount of the commodity demanded or supplied; and,

ii - elasticity of substitution or cross-elasticity refers to the percentage change in the amount of an input substituted for another in response to a change in their relative prices (MBB not displayed; PB 4th Ed. Fig. 5.7; 5th Ed. Fig. 4.7).   Similarly, the percentage change in the amount of a commodity substituted for another by a consumer in response to a change in their relative prices.

10. Equity

The economic concept of equity evolved out of English legal history.  At the same time that the Common Law began  another unique Anglosphere legal institution emerged – Equity.  With the Norman Conquest of 1066 all rights and privileges of the previous regime were abrogated by right of conquest. In effect William the Conqueror had carte blanche to shape a kingdom without accounting for pre-existing feudal rights and obligations. Unlike other European kingdoms, it was his exclusive unqualified and personal domain. He was absolute Sovereign. Nonetheless, what he conquered was a patchwork of Angle, Saxon, Jute, Danish, Viking and Celtic settlements, regions, laws and languages. The new King divided up his new Property, after accepting fealty, to a new Anglo-Norman aristocracy. The new local rulers, while subject to the King, also, in effect, inherited rights and privileges acceded to traditional rulers under local legal systems. Some were honoured and survived to become incorporated into Common Law.

William’s new subjects, however, soon brought to his attention (and that of his successors) inequities in a supposedly unified kingdom. At the extreme, in one jurisdiction theft of a loaf of bread cost a hand; in another, two days in the stocks hit by rotten vegetable and insults thrown by one’s neighbours. It was not guilt or innocence they cried but fairness of punishment before the King. This is arguably the root of Equity – a separate and distinct strand of jurisprudence parallel to the Common Law of precedent.

Over time responsibility for hearing calls for mercy was transferred to the King’s Lord Chancellor and a court of his own – the Court of Equity also known as the Court of Conscience or of Morality. In fact until Sir Thomas More (a lawyer) became Chancellor in 1529, all had been men of the cloth. Two aspects of Equity played a critical role in the Sovereign’s ability to control his vassals. These were trusts and tenant-landlord disputes. Trusts (from which modern charities and financial trusts evolved) generally concerned widows and orphans left to the mercy of a local lord. The most famous is Lady Marion of the Robin Hood legend who was an orphan and ward of the King. With respect to tenant-landlord disputes, Equity balanced the feudal local lords by judiciously connecting the King to his subjects. This was called the ‘rent bargain’ by J. R. Commons (1924).  It stabilized the social system of post-Conquest England.

While Magna Carta (1215) and subsequent developments increasingly limited the King, Equity and Common Law continued to develop as parallel systems of courts with precedence given to Equity. It was not until 1873 in the United Kingdom that the two systems of courts merged. Nonetheless the two strands of Anglosphere jurisprudence continue to this day in all Common Law countries with Equity retaining precedence.

The economic concept of Equity arguably derives from legal Equity. In fact the Chancellor of the Exchequer (who in Canada call 'the Minister of Finance') exercised a concurrent jurisdiction in Equity with the Lord Chancellor’s Court. There are two economic definitions of Equity, each reflecting its historical roots.

First, there is Equity as the capital of a firm which, after deducting liabilities to outsiders, belongs to the shareholders.  Hence shares in a limited liability corporation are also known as equities. This links back to the historical treatment of trusts under Equity. 

Second, there is Equity as ‘fairness’.  While often used with reference to taxation it is a general economic concept. With respect to taxation Equity has three dimensions: horizontal, vertical and overall burden. Horizontal Equity refers to ‘like treatment of like’.  Vertical Equity refers to ‘unlike treatment of unlike’.  Overall Equity refers to the accumulated impact of all forms of taxation.  Crudely, it is the difference between earned and disposable income after all taxes – income, excise, sales, et al.

11. "Let Us Assume" & ceteris paribus

Another expression often used by economists is 'let us assume'. Consider the joke about the economist, mathematician and physicist marooned on a desert island with crates of canned food and no can opener. The physicist says: I can start a fire an blow the top off". The mathematician says: "And, I can calculate the trajectory of the food so we can catch it." The economist says: "Let us assume we have a can opener". Laugh, laugh, laugh, stupid economist.

But consider. The physicist has no equipment to measure the energy content of the fuel for the fire and cannot determine the temperature at which the can will blow. The mathematician cannot, therefore, determine when the can will blow and what will be the trajectory of the food. The economist, on the other hand, looks for a sharp rock to act like a can opener.

One of the most important and regularly used assumptions of economics is ceteris paribus or 'all other things being constant'.  Thus in analyzing a given economic phenomenon economist usually begin by assuming all other factors or forces are held constant and thus remain the same as the phenomenon under investigation emerges.

Ceteris paribus is a Latin expression meaning 'all other things being equal'.  This is a critical assumption used in economic analysis.  For example, if the price of a good or service changes, analysis of its effect would be difficult, if not impossible, if, for example, the price of substitutes changed at the same time.  To determine the effects of a price change, economists assume all other prices remain constant (in the first round).  

Macroeconomic

a) Unemployment

- while focus on Labour, in fact, all factors of production subject to unemployment

definition (MBB Micro 10th Ed Fig. 2.3; MBB 11th Ed. Fig. 1.4; PB Fig. 21.6, 21.7)

- rate, seasonal, cyclical, structural

- discouragement and underemployment

-  lost income and production as well as serious personal and social problem

b) Growth

Economic growth refers to growth in income and production per person.  It is important to note that economic growth is a means, not an end.  Growth allows human beings to live more satisfying lives, to reach higher and higher up the 'needs hierarchy'.  Unfortunately, we live in a time in which a 'value inversion' seems to exist.  We often hear it said that "the end does not justify the means".  In fact, with respect to economic growth "the means justifies the end".  For example, if we look at various higher values in human society like education (as opposed to skills training) or the arts, today government and private support is justified not because these are considered as ends-in-and-of-themselves but rather because they contribute to economic growth.  There are a number of reasons for this value inversion especially in the political process.