# Review of Basic Concepts (Microeconomics

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Review of Basic Concepts (Microeconomics) Ch.1 Scope of Economic Analysis 1. There is no such a thing as a free lunch, i.e. most of the goods we study are scarce goods. 2. A free good is good that has a zero MUV, though it has a positive TUV. 3. Scarcity and shortage are two different things; only shortage can be eliminated by price and/or non-price competition. 4. Cost is the highest valued option forgone. 5. Cost exists only when there are choices. Without choices, there will not be any valued option to forgo, and hence there is no cost. 6. Scarcity (in a society) implies competition and discrimination. Scarcity also implies some discriminatory criteria to determine winners and losers in competition are necessary. The existence of price and/or non-price competition imply (implies) scarcity. Price mechanism helps to transmit information, determine income distribution and provide incentives. It serves as an invisible hand to direct the use of resources and determine income distribution. Competition exists in any economy, no matter it is a capitalist or socialist economy. The usefulness of a theory lies on (a) its predictive/explanatory power and (b) whether testable implications can be yielded. All useful theory must be testable (i.e. the theory must contain at least 2 observable/measurable variables and it must not contain indefinite predictions/outcomes). It does not matter whether the assumptions of the theory are realistic or not. A tautological statement consistent with all phenomena is not a theory since it is not testable. An ad hoc theory is not useful as well because of its low generalization power. Equilibrium is achieved if we can obtain testable implication(s), though equilibrium itself is a concept and is not observable. Equilibrium cannot be used to explain human behaviour.. However, we can use it to derive implications refutable by fact. The 4 basic constraints in economic analysis, according to Steven Cheung, are: (a) scarcity of resources /goods, (b) diminishing productivity, (c) property rights, and (d) transaction costs.

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Ch. 2 Consumer Demand: The MUV Approach 1. Price is the maximum amount a consumer is willing to pay at the margin (i.e. price is
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MUV). It is also the AUV when a consumer is confronting an all-or-nothing choice. A change in demand/supply of a good may affect TUV, TEV, MUV and P, as well as the total revenue of the supplier who supplies the good's substitutes (or complements) A lump-sum payment will not affect the marginal choice of a consumer/producer, however, a per-unit payment will do. Consumer equilibrium means: To an individual, his MUV = P Market equilibrium means: MUVa = MUVb = … = MUVn = P The market demand curve of a private good which is exclusive in consumption, is obtained by horizontal summation of individuals' MUV curves. Base on Alchian's generalizations, a per unit tax (or a per-unit transportation cost)

added to a higher-quality (a higher-priced) good will reduce its relative price, and lead to a greater amount to be purchased. However, the imposition of a percentage tax (cost) does not affect the relative price of the higher-quality good (or lowerquality good). 8. Consumer's surplus, which is consumer's gain in purchase is the difference between TUV and TEV. 9. The concept of consumer's surplus throws light on why different pricing arrangements (e.g. membership fee, all-or-nothing pricing, tie-in contracts, etc.) are adopted. Since sellers want to capture consumer's surplus. 10. The law of demand (the negative relation between price and quantity demanded) is an assertion because we cannot derive it from any economic theories (e.g. the indifference curve approach). Besides, as quantity demanded is never observable, the law cannot be tested directly. It can be tested only in conjunction with other propositions. 11. If a Giffen good (a good of which people would buy more when its price rise) exists, the law of demand is rejected. 12. The price (average exchange value) of a good is determined by the good's relative supply and MUV, rather than the TUV. However, Adam Smith had confused the concepts of 'total' and 'marginal' in the water-diamond paradox. Ch.3 Exchange and Supply 1. The theorem of exchange states that if the marginal use values of a good are not the same among individuals, then exchange will occur, provided property rights are welldefined and transaction costs negligible. 2. Without the law of demand, there will be no theorem of exchange. It is because the
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equilibrium condition, MVa = MVb = …= P, as is predicted by the theorem of exchange, would not be achieved. The conditions for trade (exchange) include: (a) well-defined property rights, (b) traders have different MUVs on the same good before exchange, and (c) transaction costs involved must be less than the potential gains from exchange. With zero transaction costs, the theorem of exchange predicts that the market equilibrium occurs when all persons' MUVs are equalized and is equal to the market price. The Pareto condition is satisfied. With positive transaction costs, people's MUVs may not be equalized, but the Pareto condition is still achieved The presence of a per-unit transaction cost will reduce the volume of trade. However, a lump-sum transaction cost does not have such an effect. Economic inefficiency exists when some constraints are missed, however, if all the constraints are fully specified, economic efficiency can always be achieved.

Ch. 4 Consumer Demand: The Indifference Curve Approach 1. Utility does not mean satisfaction. 2. Utility is an arbitrary assignment of number for the purpose of ranking options so as to explain human behaviour. 3. Utility cannot be used to measure welfare of an individual or of the society. 4. Increasing marginal rate of substitution implies corner solution (i.e. specialization in consumption). Diminishing MRS can be consistent with both interior and corner solutions. 5. The difference between MUV and MRS lies in the utility content of the latter. 6. If good X is measured on the horizontal axis and good Y on the vertical axis, a vertical price consumption curve (PCC) for X means X is an inferior good. However, a horizontal PCC for X implies X is a normal good. Ch. 5 Elasticities of Demand and supply 1. Two straight-line demand curves having same y-intercepts will have same elasticity at every positive price. 2. A rectangular-hyperbola-shaped demand curve has unit elasticity at every price. 3. A unit(ary) elastic demand implies no change in seller's revenue (or consumer's expenditure) no matter how the price of a good changes. 4. A rise in the price of a good will lead to a greater demand for its substitutes, but a lower demand for its complements. As a result, those sellers selling substitutes of the
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good will record a rise in sale revenue whereas those selling complementary goods will record a drop in sale revenue. It is not possible to have all luxuries or all inferior goods in the economy. The tax incidences (burden) shared by buyers and sellers depend on their respective elasticity of demand and elasticity of supply. The lower the demand elasticity and the greater the supply elasticity, the greater will be the consumer's burden. Under uniform pricing with zero marginal cost, a wealth-maximizing seller will charge a price at the level where the demand is unit elastic. The higher the information cost to find substitutes, the lower the elasticity of a price change.

Ch.6 Cost 1. Cost is the highest valued option forgone when making a choice. 2. Cost changes if and when the highest-valued alternative changes. 3. No choice, no cost. 4. Cost can be a flow or a stock concept. 5. A change in cost affects resource allocation. 6. Sunk (historical) cost is not a cost of current decision. 7. Money price is only a part of cost. 8. Full price (money price + non-pecuniary price) can represent cost. 9. The law of diminishing marginal returns states that in the short run, when more of any variable factor is added to given amounts of fixed factors, the marginal product resulting from each additional unit of the variable factor will diminishing eventually, other things being constant. 10. Diminishing returns occurs when the marginal product begins to fall. 11. If diminishing marginal returns holds (a) both 'superior' (most fertile) and 'inferior' (less fertile) land will be cultivated; (b) the fixed factor can receive a rent (c) MC curve will be upward sloping. 12. If diminishing returns does not hold (a) only the 'most superior' land will be cultivated; (b) the return to land(owners) is zero; (c) MC will not be rising. 13. The relationship between MC and MP, AVC and AP, and AC and AP are as follows: (a) MC = W / MP (b) AVC = W / AP
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(c) AC = AFC + W / AP If the average variable costs are constant, a firm's short run supply curve is a horizontal line. Haste (a higher production rate) makes a higher cost. The average cost of production will decrease when (a) the volume of output increases and/or (b) the production rate of output decreases. Rent is cost, but cost is not necessarily rent. Cost is not necessarily rent in that a change in rent will not change supply or alter behaviour in a certain dimension. Profit is an unexpected (unanticipated) increase in wealth or income. Profit arises only if it is unanticipated, thus the concept is useless in explaining human behaviour.

Ch.7 Price Taking 1. The existence of numerous sellers is not a necessary condition for price-taking. 2. A price-taking seller faces a horizontal demand curve; the revenue from selling an extra unit of output is constant (i.e. P = MR). 3. If diminishing marginal returns holds, the portion of MC above AVC is the supply curve of a price taker. 4. For a constant-cost price taking industry, the long run supply curve is horizontal. 5. The long run equilibrium is characterized by P = MC = AC and there is no entry/exit of firms. 6. Since all the firms are producing at the same MC (and AC in the long run) that equals P (also the MUV), the Pareto condition (economic efficiency) must be achieved in a price taking market. 7. P = AC implies the return in the industry is equal to the return from the best alternative, i.e. no better alternative elsewhere. Ch.8 Price Searching 1. A monopolist is a price searcher who faces a downward sloping demand curve. The price searcher searches for a price that maximizes wealth (where MR = MC). 2. It is wrong to say that a monopolist faces no competition. A monopolist still compete with others for resources, for customers, etc.) 3. Simple monopoly pricing means a price searcher sells the product at one uniform price. 4. With zero marginal cost of production, a monopolist will set a price at the output where MR=0 that corresponds to the mid-point of a demand curve. (The price
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elasticity of demand at that point is one.) With positive marginal cost of production, a monopolist will always set a price at the elastic range of the demand curve. With zero transaction cost and the availability of alternative pricing arrangements, a price searcher adopting uniform pricing is inefficient because at the wealth maximizing output, MUV > MC. Due to positive transaction costs involved in using alternative pricing arrangements, a price searcher adopting uniform pricing is said to be efficient if alternative pricing arrangements cannot bring a higher net gain. The expected (monopoly) rent from an entry barrier (a franchise) due to government regulations determines the price of the franchise paid by a price searcher in obtaining

the monopoly status. 9. Once the monopolist paid the price for the monopoly right, the price paid is a sunk cost that would not affect the future decision of on the product price to be charged. 10. The monopoly rent (due to a franchise) is a cost to the price searcher if he has the option to transfer the franchise (monopoly right) or the business outright. 11. A price searcher has no supply curve. Ch.9 Price Discrimination and Pricing Tactics 1. Only a price searcher can use different kinds of pricing strategies. 2. The third-degree price discrimination (also called market segmentation) is the practice of charging different prices to buyers of different markets for the same good (produced at the same cost). 3. If the cost of handling/serving different customers differs, different prices charged on the same product may not constitute price discrimination (e.g. Young drivers are charged more for motor insurance than are old drivers). 4. Perfect price discrimination (also called the first degree price discrimination) is the practice of charging different prices to the same buyer on the different units of a good (produced at the same cost). Under this pricing arrangement, the seller will set different prices for each unit of the product that equals the consumer’s MUV. As a result of this, the MUV of the consumer and the seller’s MR coincide. 5. The conditions for practising price discrimination include: (a) Monopoly power (b) Separable markets (c) Different elasticities of demand (d) Imperfect information
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Pricing tactics other than the price discrimination include the all-or-nothing pricing, two-part tariff, tie-in contract, …etc. Due to the presence of transaction costs, different pricing arrangements are employed by price searchers to extract consumer’s surplus such that the gains from production and exchange are maximized.

Ch. 10 Derived Demand 1. The demand curve for a factor is downward sloping because of the law of diminishing marginal productivity. 2. The law of diminishing marginal productivity states that in the short-run when more units of a variable factor is added to a given amount of fixed factors, the product resulting from each additional unit of the variable factor will diminish eventually, 3. 4. 5. 6. other things being constant. The demand (curve) for a factor input of a price-taker is the portion of its MRP (VMP) below its ARP. In equilibrium, the MP of a factor would be equalized across firms. When additional units of labour are employed, the MP of labour falls whereas the MP of land rises. In some property right arrangements, the marginal productivity theory does not apply (e.g. A professor in HKU earns twice the salary of a lecturer does not imply the professor is twice as productive).

Ch.11 Determination of Wage 1. With private property rights, the more productive your labour (and the greater the demand for your service relative to its supply), the higher will be your wage rate. 2. An individual labour supply curve can be backward bending because the substitution effect between work and leisure is smaller than the income effect when the wage increases. 3. If leisure is an inferior good, the labour supply curve will not be backward bending. 4. The market supply curve of labour is not likely to be backward-bending. 5. With an unchanged labour demand but a greater labour supply, (a) both MP and AP will fall, (b) the total product of labour will rise (c) the total wage receipts may rise or fall (depends on elasticity of demand) Ch.12 Determination of Rent 1. Economic rent is a payment that does not affect the availability of a good nor
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resource allocation. Economic rent can be earned by any economic resource. Economic rent is a cost of running a business if there is the option to sell the business outright. If the law of diminishing marginal returns does not hold, the price of land will be zero and only 'superior' land will be cultivated. A change in cost affects resource allocation but a change in rent does not. Economic rent exists only in some particular dimensions. Given there are numerous alternatives available, rent is cost.

Ch. 13 Capital, Wealth and Interest 1. Interest (a) is the price for the earlier availability of goods (b) is the whole of income (c) is the potential flow of consumption which can made without trenching on wealth (d) is a premium of future over present consumption (e) exists even without money (f) exists in a one-man economy (g) is a series of events Capital refers to any asset that is capable of generating income/service. When interest rate rises, (a) the price of a durable asset (relative to a non-durable asset) falls. (b) trees will be cut earlier (c) the present value of a bond falls Wealth is the discounted present values of all incomes generated by a stock of economic good. Wealth is ambiguous if there is no market or market interest rate. Investment is the balance of consumption over time. We sacrifice present consumption for future consumption. Therefore, investment is said to take place when: (a) people produce more durable goods and fewer perishable goods (b) students play less and study more (c) people covert fresh milk (fish, food, …) to cheese (salted fish, canned food, …) (d) people go to bed early (e) people take vitamin pills (f) buy shares
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7. Profit is an unexpected (a windfall) gain in wealth / income 8. Profit arises when the actual rate of return is higher than the expected rate of return 9. Wealth cannot be determined (a) if the market interest rate does not exist (b) if there is no loanable fund market (c) in a one man economy 10. Wrong concept: Wealth maximization is preferred to income maximization. Income maximization is preferred to wealth maximization. 11. Amongst the maximization of wealth, income, rent, utility and profit, profit maximization is the worst choice in terms of economic explanation. 12. The pre-requisite of consumption maximization is wealth maximization. 13. In a given period of time, consumption may exceed income given there are opportunities to borrow or lend. 14. Even if both income and interest rate fluctuates over time, consumption may still be constant over time. Ch. 14 Property Rights and Transaction Costs 1. Property rights (rules of the game) are social expectations restraining human behaviour. 2. There are (transaction) costs to define and enforce any property rights systems 3. Private Property Rights are the pre-requisite of market transactions (Coase Theorem) 4. The attenuation of private property rights leads to non-price competition and hence rent dissipation. 5. The main criterion used to allocate resources under private property rights is price 6. The owner of a private property has the exclusive right to use the property, to derive income from the property, to transfer the property, to choose the kinds of contract. 7. A higher value is attached to a good that is transferable. 8. A common property is a scarce good of which no delimitation on who can use it 9. A common property is a scarce good subjected to common exploitation. Under nonprice competition it will lead to rent dissipation. 10. Under the postulate of constrained maximization, the rent dissipated under a common property situation must be a constrained minimum. 11. A common property is a scarce good that has no capital value. 12. A common property is usually subject to a higher utilization rate than a private property. 13. A common property does not have a market price.
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Transaction costs are all non-production costs that exist only in a society Transaction costs may or may not be information cost. Transaction costs can exist even if there is no market transaction. Transaction costs determine the choice of contracts and the choice of economic systems (institutions). 18. When transaction costs are positive, the Pareto condition can still be achieved. 19. Transaction costs help us to explain why (a) advertisements on goods are placed by sellers but advertisements on jobs are placed by employers (b) the airline companies accept more reservations for a flight than there are available seats on the airplane (c) reputable stores with big names often pay considerable lower rentals per square foot Ch. 15 Government Regulations and Dissipation of Rent 1. Government control attenuates private property rights and hence leads to a change in human behaviour 2. Government control usually takes in the forms like price, quantity, and rate-of-return controls or through taxation 3. Rent (price) control gives rise to non-exclusive income that attracts competition in non-price manner, dissipation of rent will result. 4. Under a rent control, the turnover rate of the controlled flat tends to fall. 5. In traditional economics, price control will lead to a disequilibrium state. However, according to Steven Cheung, equilibrium is always attained if the specified constraints (e.g. monetary and non-monetary costs) are rigid enough to yield implications refutable by facts. 6. The creation of monopoly right (due to government control) attracts competition for monopoly rent. 7. A per unit tax imposed on a good will lead to a rise in relative market share of highquality good. However, the tax burden shared by consumers / producers is determined by the respective elasticities of demand and supply. 8. An ad valorem tax imposed on a good will lead to a quality change of the good. 9. A lump-sum tax will reduce the amount of rent earned but will not affect the wealthmaximizing output level of a firm. Nevertheless, the number of firms in the market will fall in the long run. 10. A lump-sum tax will not affect a consumer's consumption level.
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11. A rate-of-return control leads to a higher capital/labour ratio and thus a higher MP of labour. 12. An effective wage control leads to a rise in marginal productivity of labour.. Ch. 16 Nature of the Firm 1. A firm exists because there are (transaction) costs of using the price mechanism. 2. A communist state is a super-firm because the use of resources is direct by central planning (authority), instead of directed by market signals (prices). 3. A firm will cease to exist when the cost of managerial coordination outweighs the cost of market coordination. 4. With zero costs of transaction, the choice of institutions (e.g. firm, market, 5. middleman) is indeterminate. When a firm exists, (a) input owners are not paid by directly measuring their contributions, but by a proxy.) (b) input owners do not trade directly with consumers In some situations the product market and the factor market are inseparable: (e.g. A shoe-shine boy working for himself receives a payment of \$X for shining a pair of shoe.) With positive transaction costs, there will be contractual supersession. Some contracts will be adopted to reduce transaction costs so as to maximize the gains from exchange. For example, (a) a time-rate contract is adopted to employ a teacher (b) a basic salary plus commission to employ a salesman (c) a taxi-driver pays a fixed rent to taxi companies and take the residual income Firm / market are alternative contractual/institutional arrangements amongst consumers, input owners and entrepreneurs

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Ch.17 Problem of Social Cost 1. According to Steven Cheung, the Coase Theorem has three versions: (a) The delineation of rights is the essential prelude to market transactions. (b) If private property rights are clearly delineated and all costs of transactions zero, then resource use will be the same (identical) regardless of who owns the property rights. (c) If private property rights are clearly delineated and if all costs of transactions are zero, then the allocation of resources will be efficient, so there is no problem
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of externality. Implications of the Coase theorem: a. With the absence of private property rights, market transactions are impossible. b. The divergence between private and social costs will disappear if there are welldefined property rights and negligible transaction costs. c. Government intervention is a solution to the social cost problem only when the cost of government intervention is lower than the costs of market transaction d. Under a private property rights system, resources allocation will always be the same. e. If property rights are enforceable at negligible transaction costs, the optimal level of pollution may not be zero but is subject to private contracting. The divergence between private and social costs does not imply inefficiency or market failure. It is not market failure because the market is not allowed to function well since property rights are absent. If the marginal value of an unpaid effect is zero, there is no divergence between private and social costs.

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Ch.18 Public Goods and Economic Efficiency 1. A good is a public good if a. it can be consumed concurrently by many individuals. b. the marginal cost of serving an additional user is zero. 2. A public good can be produced by the government as well as by private firms 3. Economic inefficiency is inconsistent with the postulate of maximization. Even if certain marginal values are not equal, the situation is still efficient if we consider that the cost of moving to their equality is higher than the extra benefit entailed.

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