Economics I: Foundations and Microeconomics
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The NIE Economics syllabus (implemented from 2017) covers microeconomics, macroeconomics, international economics, and development economics, with a focus on the performance of the Sri Lankan economy (NIE, n.d.-f; NIE, n.d.-g).
The Economic Problem
- Scarcity: unlimited wants and limited resources force choices; every choice has an opportunity cost.
- Basic questions: what, how, and for whom to produce.
- Production possibility frontier (PPF): shows the maximum combinations of two goods; points inside show inefficiency; outward shifts show growth; the bowed shape reflects increasing opportunity cost.
- Economic systems: market, command (planned), and mixed economies. Sri Lanka has a mixed economy.
- Positive statements (facts) versus normative statements (values); microeconomics studies individual units, macroeconomics the whole economy (Mankiw, 2021).
Demand and Supply
- Law of demand: ceteris paribus, a higher price reduces quantity demanded. Determinants of demand: income, prices of related goods (substitutes and complements), tastes, population, and expectations. A change in price causes a movement along the curve; a change in a determinant shifts the curve.
- Law of supply: a higher price increases quantity supplied. Determinants: input costs, technology, taxes and subsidies, the number of sellers, and expectations.
- Equilibrium: where demand equals supply; shortage (price below equilibrium) and surplus (price above). Analyze how shifts change equilibrium price and quantity.
- Price controls: a price ceiling below equilibrium (shortage, black markets; for example controlled prices of essentials) and a price floor above equilibrium (surplus; for example guaranteed prices for farm produce). Taxes and subsidies change supply and the incidence on buyers and sellers.
Elasticity
| Concept | Formula | Interpretation |
|---|---|---|
| Price elasticity of demand (PED) | % change in quantity demanded ÷ % change in price | Elastic if ∣PED∣ > 1; inelastic if < 1; unit elastic if = 1 |
| Income elasticity (YED) | % change in quantity ÷ % change in income | Positive for normal goods; > 1 for luxuries; negative for inferior goods |
| Cross elasticity (XED) | % change in quantity of A ÷ % change in price of B | Positive for substitutes; negative for complements |
| Price elasticity of supply (PES) | % change in quantity supplied ÷ % change in price | Elastic if > 1 |
Example: a price rise from 100 to 110 (10 percent) reduces quantity from 500 to 450 (−10 percent): PED = −10 ÷ 10 = −1 (unit elastic). Total revenue: if demand is elastic, raising the price reduces revenue; if inelastic, it increases revenue. Determinants of PED: availability of substitutes, necessity versus luxury, share of income, and time.
Consumer Theory
- Utility (satisfaction); marginal utility diminishes as consumption increases; consumers maximize utility where MU/P is equal across goods.
- Indifference curves and budget lines: the consumer's optimum lies where the budget line is tangent to the highest indifference curve; derive demand from changes in price; income and substitution effects.
- Consumer surplus: the difference between what consumers are willing to pay and what they pay.
Production and Costs
- Production function; short run (at least one fixed factor) and long run (all factors variable). Law of diminishing marginal returns: adding more of a variable factor to a fixed factor eventually yields smaller additions to output.
- Costs: fixed, variable, total; average cost (AC) and marginal cost (MC); the MC curve cuts the AC curve at its minimum. Long-run costs: economies of scale (technical, managerial, financial, marketing) and diseconomies of scale.
- Revenue and profit: profit is maximized where marginal revenue equals marginal cost (MR = MC), with MC rising.
Market Structures
| Feature | Perfect competition | Monopoly | Monopolistic competition | Oligopoly |
|---|---|---|---|---|
| Number of firms | Many | One | Many | Few |
| Product | Homogeneous | Unique | Differentiated | Homogeneous or differentiated |
| Entry barriers | None | High | Low | High |
| Price control | Price taker | Price maker | Some | Interdependent; may collude |
| Example | Some agricultural markets | A utility with a legal monopoly | Restaurants, clothing | Banks, telecommunications |
Know the diagrams: profit in the short run and long run; the monopolist's deadweight loss and the case for regulation; price discrimination; and the kinked-demand and game-theory models of oligopoly.
Factor Markets and Distribution
Demand for labour is a derived demand based on marginal revenue product; wages are set by demand and supply, with influences from trade unions and minimum wages; rent, interest, and profit as returns to land, capital, and entrepreneurship; income inequality.
Market Failure and Government Intervention
Market failure occurs when markets do not allocate resources efficiently: externalities (positive and negative: pollution, education), public goods (non-excludable and non-rivalrous), common resources, monopoly power, information asymmetry, and inequity. Policies: taxes and subsidies, regulation, public provision, property rights, and information. Evaluate government failure as well.
Common Mistakes
- Confusing a shift with a movement along a curve.
- Drawing curves without labeled axes and equilibrium points.
- Equating a high price with a high profit.
CHAPTER 14