Microeconomics Cheatsheet

Cheatsheet Content

### Microeconomics: Consumer Behavior - **Utility:** Satisfaction derived from consuming a good or service. - **Total Utility (TU):** Total satisfaction from consuming a given quantity. - **Marginal Utility (MU):** Additional satisfaction from consuming one more unit. - **Law of Diminishing Marginal Utility:** As consumption increases, MU eventually decreases. - **Utility Maximization:** Consumers allocate their budget to maximize total utility. - $\frac{MU_A}{P_A} = \frac{MU_B}{P_B} = ...$ (Marginal Utility per dollar spent is equal for all goods). - **Budget Constraint:** Shows all combinations of goods a consumer can afford given income and prices. - **Indifference Curves:** - Show combinations of goods that yield the same level of utility. - Downward-sloping, convex to the origin, do not intersect. - **Marginal Rate of Substitution (MRS):** Slope of the indifference curve; rate at which a consumer is willing to trade one good for another while maintaining the same utility. - **Consumer Equilibrium:** Point where the budget constraint is tangent to the highest attainable indifference curve. ### Microeconomics: Market Demand & Supply - **Demand:** - **Law of Demand:** As price increases, quantity demanded decreases. - **Demand Curve:** Downward-sloping. - **Determinants of Demand (Shifters):** Income, Tastes, Price of Related Goods (Complements/Substitutes), Expectations, Number of Buyers. - **Supply:** - **Law of Supply:** As price increases, quantity supplied increases. - **Supply Curve:** Upward-sloping. - **Determinants of Supply (Shifters):** Input Prices, Technology, Expectations, Number of Sellers, Government Policies. - **Market Equilibrium:** Intersection of demand and supply curves, determining Equilibrium Price ($P_e$) and Quantity ($Q_e$). - **Surplus:** Quantity supplied > Quantity demanded (price falls). - **Shortage:** Quantity demanded ### Microeconomics: Theory of the Firm - **Production Function:** Relationship between inputs and output ($Q = f(L, K)$). - **Short Run vs. Long Run:** - **Short Run:** At least one input is fixed. - **Long Run:** All inputs are variable. - **Marginal Product (MP):** Additional output from one more unit of input. - **Law of Diminishing Marginal Returns:** MP eventually decreases. - **Costs in the Short Run:** - **Fixed Costs (FC):** Do not vary with output. - **Variable Costs (VC):** Vary with output. - **Total Cost (TC):** $TC = FC + VC$ - **Average Costs:** AFC, AVC, ATC. - **Marginal Cost (MC):** Additional cost of producing one more unit. MC intersects AVC and ATC at their minimums. - **Costs in the Long Run:** - **Long-Run Average Total Cost (LRATC):** lowest average cost for each output level. - **Economies of Scale:** LRATC decreases as output increases. - **Diseconomies of Scale:** LRATC increases as output increases. - **Constant Returns to Scale:** LRATC remains constant. ### Microeconomics: Producer's Equilibrium - **Profit Maximization:** Firms aim to maximize profit ($\pi = TR - TC$). - **Rule for all Market Structures:** Produce where Marginal Revenue (MR) = Marginal Cost (MC). - **Perfect Competition:** - Many firms, homogeneous product, free entry/exit. - Firms are **Price Takers** ($P = MR = AR$). - Equilibrium: $P = MR = MC$. In long run, $P = MC = ATC_{min}$ (zero economic profit). - **Monopoly:** - Single seller, unique product, high barriers to entry. - Firms are **Price Makers**. - Demand curve is downward-sloping, $MR MC$ and $P > ATC_{min}$ (excess capacity). - **Oligopoly:** - Few large firms, interdependent. - Strategic behavior (Game Theory, Prisoner's Dilemma). - Collusion (cartels) vs. competition. ### Microeconomics: Pricing of Factors of Production - **Factor Markets:** Markets for inputs (labor, capital, land, entrepreneurship). - **Derived Demand:** Demand for an input is derived from the demand for the output it produces. - **Marginal Revenue Product (MRP):** Additional revenue from employing one more unit of an input. - $MRP_L = MP_L \times MR$ (for labor). - In perfect competition, $MRP_L = MP_L \times P$. - **Marginal Factor Cost (MFC):** Additional cost of employing one more unit of an input. - In competitive factor markets, $MFC_L = Wage$. - **Optimal Input Employment:** Firms hire inputs until $MRP = MFC$. - **Labor Market:** - **Demand for Labor:** Downward-sloping (MRP curve). - **Supply of Labor:** Upward-sloping (wage increases, more willing to work). - **Equilibrium Wage:** Where labor supply = labor demand. - **Monopsony:** Single buyer of labor. - $MFC_L > Wage$. Hires less labor & pays lower wages. - **Rent:** Payment for the use of land or other fixed factors. - **Interest:** Payment for the use of capital. - **Profit:** Reward for entrepreneurship. ### Macroeconomics: Basic Economic Concepts - **Macroeconomics:** Study of the economy as a whole. - **Key Goals:** Economic growth, full employment, price stability. - **Gross Domestic Product (GDP):** Total market value of all final goods and services produced within a country's borders in a specific time period. - **Nominal GDP:** Measured at current prices. - **Real GDP:** Measured at constant prices (adjusted for inflation). - **Inflation:** General increase in the price level over time. - **Deflation:** General decrease in the price level. - **Unemployment:** - **Labor Force:** Employed + Unemployed. - **Unemployment Rate:** (Unemployed / Labor Force) * 100. - **Types:** Frictional, Structural, Cyclical. - **Natural Rate of Unemployment (NRU):** Frictional + Structural. ### Macroeconomics: National Income Accounting - **Methods of Calculating GDP:** - **Expenditure Approach:** $GDP = C + I + G + (X - M)$ - C = Consumption, I = Investment, G = Government Spending, X = Exports, M = Imports. - **Income Approach:** Sum of all incomes earned (wages, rent, interest, profits). - **Output/Value Added Approach:** Sum of market values of all goods and services, or sum of value added at each stage of production. - **Other National Income Measures:** - **Gross National Product (GNP):** GDP + Net Factor Income from Abroad. - **Net National Product (NNP):** GNP - Depreciation. - **National Income (NI):** NNP - Indirect Business Taxes + Subsidies. - **Personal Income (PI):** NI - Corporate Profits - Social Security Contributions + Transfer Payments + Net Interest. - **Disposable Personal Income (DPI):** PI - Personal Taxes. ### Macroeconomics: Consumption Function & Multiplier - **Consumption Function:** Relationship between consumption ($C$) and disposable income ($Y_d$). - $C = a + bY_d$ - $a$ = Autonomous Consumption (consumption when $Y_d=0$). - $b$ = Marginal Propensity to Consume (MPC) = $\Delta C / \Delta Y_d$. - **Saving Function:** Relationship between saving ($S$) and disposable income ($Y_d$). - $S = -a + (1-b)Y_d$ - $1-b$ = Marginal Propensity to Save (MPS) = $\Delta S / \Delta Y_d$. - **Note:** $MPC + MPS = 1$. - **Investment (I):** Autonomous spending, not dependent on income. - **Aggregate Expenditure (AE):** Total spending in the economy ($AE = C + I + G + (X-M)$). - **Multiplier Effect:** An initial change in autonomous spending leads to a larger change in equilibrium income. - **Spending Multiplier:** $k = \frac{1}{1 - MPC} = \frac{1}{MPS}$. - $\Delta Y = k \times \Delta AE$. ### Macroeconomics: Determination of Equilibrium Level of Income and Output - **Keynesian Cross Model (AE-AD Model):** - **Equilibrium:** Occurs where Aggregate Expenditure (AE) equals National Income (Y). - $Y = AE \implies Y = C + I + G + (X - M)$ - Graphically: Intersection of the AE curve and the 45-degree line. - **Leakages-Injections Approach:** - **Equilibrium:** Occurs where total leakages equal total injections. - **Leakages:** Saving (S), Taxes (T), Imports (M). - **Injections:** Investment (I), Government Spending (G), Exports (X). - $S + T + M = I + G + X$ - **Shifts in Equilibrium:** - Changes in autonomous consumption, investment, government spending, or net exports shift the AE curve, leading to a new equilibrium income level via the multiplier effect. - **Recessionary Gap:** Equilibrium output is below full employment output. - **Inflationary Gap:** Equilibrium output is above full employment output. ### Macroeconomics: Inflation - **Definition:** Sustained increase in the general price level. - **Measurement:** Consumer Price Index (CPI), Producer Price Index (PPI), GDP Deflator. - **Types of Inflation:** - **Demand-Pull Inflation:** Caused by excessive aggregate demand (too much money chasing too few goods). - **Cost-Push Inflation:** Caused by increases in the costs of production (e.g., rising wages, oil prices). - **Effects of Inflation:** - **Redistribution of Income:** Harms fixed-income earners, savers; benefits borrowers. - **Reduced Purchasing Power:** Money buys less. - **Uncertainty:** Discourages investment. - **Shoe-leather Costs:** Costs of frequent trips to the bank. - **Menu Costs:** Costs of changing prices. - **Phillips Curve:** - **Short-run:** Inverse relationship between inflation and unemployment. - **Long-run:** No trade-off, vertical at the Natural Rate of Unemployment (NRU). - **Disinflation:** A decrease in the rate of inflation. - **Deflation:** A decrease in the general price level. ### Money and Banking: Functions of Money - **Money:** Anything generally accepted in exchange for goods and services or for the repayment of debt. - **Functions of Money:** - **Medium of Exchange:** Facilitates transactions, avoids the double coincidence of wants required for barter. - **Store of Value:** Can be held and exchanged for goods and services later. (Subject to inflation). - **Unit of Account:** Provides a common measure of value for goods and services. ### Money and Banking: Quantity Theory of Money - **Equation of Exchange:** $MV = PY$ - $M$ = Money Supply - $V$ = Velocity of Money (average number of times a unit of money is spent) - $P$ = Price Level - $Y$ = Real Output (or Real GDP) - **Fisher Formulation:** Assumes $V$ and $Y$ are constant in the short run. Therefore, changes in $M$ lead to proportional changes in $P$. - Implies that inflation is purely a monetary phenomenon. - **Cambridge Formulation (Cash-Balance Approach):** - Focuses on the demand for money, specifically the proportion of income people wish to hold as cash balances (k). - $M^d = kPY$ - If $k$ and $Y$ are stable, then $M$ and $P$ are directly related. - Less rigid assumption about velocity than Fisher's. ### Money and Banking: Systems of Note Issue - **Fixed Fiduciary System:** Central bank can issue notes up to a fixed amount without gold backing, beyond which full gold backing is required. - **Proportional Reserve System:** Central bank must maintain a certain percentage of gold or approved securities against the notes issued. - **Minimum Reserve System:** Central bank is required to keep a minimum amount of gold and foreign exchange as reserves, regardless of the amount of notes issued (most common modern system). - **Currency Board System:** Monetary authority maintains a fixed exchange rate with a foreign currency and issues domestic currency only when fully backed by foreign reserves. ### Money and Banking: Credit Creation - **Commercial Banks:** Financial institutions that accept deposits and make loans. - **Fractional Reserve Banking:** Banks hold only a fraction of deposits as reserves and lend out the rest. - **Money Multiplier (or Deposit Multiplier):** The amount by which an initial deposit can be expanded in the banking system. - $Money Multiplier = \frac{1}{\text{Required Reserve Ratio}}$ - **Process of Credit Creation:** 1. A new deposit enters the banking system. 2. The bank keeps a portion as required reserves and lends out the excess reserves. 3. The loan is deposited into another bank, creating a new deposit. 4. The process continues, leading to a multiple expansion of the money supply. - **Limitations to Credit Creation:** - **Required Reserve Ratio:** Set by the central bank. - **Cash Drain:** People holding cash instead of depositing it. - **Excess Reserves:** Banks choosing to hold more reserves than required. - **Lack of Demand for Loans:** Banks may not find willing borrowers. ### Money and Banking: Functions of Central Banks - **Central Bank:** The monetary authority of a country. - **Key Functions:** - **Banker to the Government:** Manages government accounts, debt, and issuing new currency. - **Banker to Banks:** Holds commercial banks' reserves, acts as a "lender of last resort." - **Controller of Money Supply and Credit:** Implements monetary policy. - **Custodian of Foreign Exchange Reserves:** Manages foreign currency holdings. - **Supervising Banking System:** Regulates and oversees commercial banks. - **Publisher of Economic Data:** Collects and disseminates financial statistics. ### Money and Banking: Instruments of Credit Control - **Monetary Policy:** Actions taken by the central bank to manage the money supply and credit conditions. - **Quantitative (General) Instruments:** Affect the overall quantity of credit. - **Bank Rate (or Discount Rate):** The interest rate at which commercial banks can borrow from the central bank. - Higher rate discourages borrowing, reducing money supply. - **Open Market Operations (OMOs):** Buying and selling of government securities in the open market. - Buying securities injects money (increases supply), selling withdraws money (decreases supply). - **Required Reserve Ratio (CRR):** The fraction of deposits banks must hold in reserve. - Higher ratio reduces excess reserves, limiting credit creation. - **Qualitative (Selective) Instruments:** Influence the direction or purpose of credit. - **Margin Requirements:** Percentage of the loan value that borrowers must provide themselves for certain assets (e.g., stocks). - **Moral Suasion:** Persuading banks to follow certain policies through advice or pressure. - **Direct Action:** Imposing penalties on banks that do not follow central bank directives. - **Consumer Credit Regulation:** Setting terms for installment purchases. ### Money and Banking: Theory of Liquidity Preference - **Developed by John Maynard Keynes.** - **Demand for Money:** People hold money for three motives: - **Transactions Motive:** For day-to-day spending (depends on income). - **Precautionary Motive:** For unexpected expenses (depends on income). - **Speculative Motive:** To take advantage of future changes in interest rates or asset prices. - **Inverse relationship between bond prices and interest rates.** When interest rates are low (bond prices high), people expect rates to rise (bond prices to fall), so they prefer to hold cash (speculative demand for money is high). - **Supply of Money:** Determined by the central bank. - **Equilibrium Interest Rate:** Determined by the interaction of the demand for money (liquidity preference) and the supply of money. ### Public Financing: Government Expenditure - **Government Expenditure:** Spending by the government on goods and services, and transfer payments. - **Types of Expenditure:** - **Revenue Expenditure:** Day-to-day running of government, interest payments, subsidies (non-asset creating). - **Capital Expenditure:** Spending on creating productive assets like infrastructure, buildings (asset-creating). - **Reasons for Increase in Government Expenditure:** - Welfare state activities, defense, infrastructure development, population growth, urbanization. - **Impact of Government Expenditure:** - **On Production:** Can stimulate demand, provide public goods, develop infrastructure. - **On Distribution:** Transfer payments can reduce inequality. - **On Economic Stability:** Fiscal policy tool to manage business cycles. ### Public Financing: Sources of Government Revenue - **Government Revenue:** Funds collected by the government. - **Tax Revenue:** - **Direct Taxes:** Levied directly on income and wealth (e.g., income tax, corporate tax). - **Indirect Taxes:** Levied on goods and services (e.g., sales tax, VAT, customs duties). - **Non-Tax Revenue:** - Fees (for services), fines, penalties, profits from public enterprises, grants, donations. - **Borrowing:** - **Internal Debt:** From domestic sources (e.g., selling government bonds to citizens/banks). - **External Debt:** From foreign sources (e.g., international organizations, foreign governments). - **Deficit Financing:** Printing new money or borrowing from the central bank to cover budget deficit. ### Public Financing: Types of Taxes - **By Nature of Payment:** - **Direct Taxes:** Paid directly by the person or entity on whom it is levied. Burden cannot be shifted. - Examples: Income tax, corporate tax, property tax. - **Indirect Taxes:** Levied on goods and services; the burden can be shifted from the producer/seller to the consumer. - Examples: Sales tax, Value Added Tax (VAT), excise duties, customs duties. - **By Impact on Income:** - **Progressive Tax:** Tax rate increases as income increases (e.g., income tax with slabs). - **Proportional Tax:** Tax rate remains constant regardless of income (e.g., flat tax). - **Regressive Tax:** Tax rate decreases as income increases (e.g., sales tax, as lower-income individuals spend a larger proportion of their income). - **Canons of Taxation (Adam Smith):** - **Canon of Equality/Justice:** Should be fair. - **Canon of Certainty:** Taxpayer should know how much, when, and where to pay. - **Canon of Convenience:** Should be easy to pay. - **Canon of Economy:** Cost of collection should be minimal. ### Public Financing: Incidence of Different Taxes - **Impact of Tax:** Who legally pays the tax to the government. - **Incidence of Tax:** Who ultimately bears the economic burden of the tax. - **Factors Determining Incidence:** Elasticities of demand and supply. - **Inelastic Demand:** Consumers bear a larger share of the tax burden. - **Elastic Demand:** Producers bear a larger share of the tax burden. - **Inelastic Supply:** Producers bear a larger share of the tax burden. - **Elastic Supply:** Consumers bear a larger share of the tax burden. - **Specific Taxes:** - **Income Tax:** Incidence typically on the earner. - **Corporate Tax:** Can be shifted to consumers (higher prices), workers (lower wages), or shareholders (lower dividends). - **Sales Tax/VAT:** Primarily on consumers, but depends on market elasticities. - **Excise Duty:** On producers, but shifted to consumers depending on demand elasticity. - **Property Tax:** On property owners, but can be shifted to tenants in rental markets. ### Public Financing: Public Debt - **Public Debt (Government Debt):** Total amount of money owed by the government to its creditors (internal and external). - **Objectives of Public Debt:** - Finance budget deficits. - Fund development projects (infrastructure). - Finance wars or emergencies. - Influence money supply and interest rates (monetary policy tool). - Stabilize the economy (counter-cyclical policy). - **Methods of Repayment:** - **Sinking Fund:** Setting aside funds periodically to repay debt. - **Budget Surplus:** Using excess government revenue to repay debt. - **Refunding:** Issuing new debt to pay off maturing debt. - **Conversion:** Converting old debt into new debt with different terms. - **Capital Levy:** A one-time tax on capital assets to pay off debt. - **Annulment/Repudiation:** Government refuses to pay the debt (rare, damages credibility). - **Burden of Public Debt:** - **Internal Debt:** Redistribution of wealth within the country. - **External Debt:** Transfer of real resources to foreign countries. - **Crowding Out:** Government borrowing can raise interest rates, reducing private investment. ### Public Financing: Deficit Financing - **Deficit Financing:** Covering the gap between government expenditure and revenue through borrowing from the central bank or printing new currency. - **Methods:** - **Borrowing from the Central Bank:** The central bank purchases government securities, effectively creating new money. - **Printing New Currency:** Direct issuance of new currency notes. - **Objectives:** - Finance planned development expenditure. - Meet emergency needs (war, natural disasters). - Counter recessionary pressures. - **Consequences:** - **Inflationary Pressure:** Increased money supply without a corresponding increase in goods and services can lead to demand-pull inflation. - **Impact on Income Distribution:** Can exacerbate inequality if inflation hurts fixed-income earners more. - **Impact on Savings and Investment:** High inflation can deter savings and discourage investment. - **Impact on Balance of Payments:** Inflation can make exports less competitive and imports more attractive. ### International Trade: Theory of Comparative Cost - **Developed by David Ricardo.** - **Absolute Advantage:** A country can produce a good using fewer resources than another country. - **Comparative Advantage:** A country can produce a good at a lower opportunity cost (i.e., by giving up less of another good) than another country. - **Basis for Trade:** Countries should specialize in producing goods where they have a comparative advantage and trade with each other. - **Gains from Trade:** Specialization and trade lead to: - Increased total world output. - Greater consumption possibilities for all trading partners. - More efficient allocation of global resources. - **Terms of Trade:** The rate at which one country's good exchanges for another country's good. Must lie between the opportunity costs of the two trading partners. ### International Trade: Arguments for Protection - **Protectionism:** Government policies to restrict international trade. - **Arguments for Protection:** - **Infant Industry Argument:** New domestic industries need temporary protection to grow and become competitive. - **National Security:** Protect industries deemed vital for national defense (e.g., arms, agriculture). - **Job Protection:** Shield domestic jobs from foreign competition. - **Anti-Dumping:** Protect domestic industries from foreign firms selling goods below cost or below their domestic price. - **Fair Trade/Level Playing Field:** Counter unfair foreign trade practices (e.g., subsidies, lower labor standards). - **Balance of Payments Correction:** Reduce imports to improve a trade deficit. - **Revenue Generation:** Tariffs can generate government revenue (especially for developing countries). - **Environmental/Labor Standards:** Pressure foreign countries to adopt higher standards. ### International Trade: Balance of Payments (BOP) - **Balance of Payments:** A statistical record of all economic transactions between residents of a country and residents of the rest of the world during a specific period. - **Always Balances:** Total credits must equal total debits. - **Components:** - **Current Account:** Records transactions related to current income and expenditure. - **Trade Balance:** Exports of goods - Imports of goods. - **Services Balance:** Exports of services - Imports of services. - **Primary Income (Factor Income):** Income from investments abroad - Income paid to foreign investors. - **Secondary Income (Transfers):** Remittances, foreign aid. - **Capital Account:** Records capital transfers (e.g., debt forgiveness, sale/purchase of non-produced, non-financial assets). - **Financial Account:** Records international transactions in financial assets. - **Direct Investment:** Long-term investment (e.g., building a factory abroad). - **Portfolio Investment:** Purchase of stocks and bonds. - **Reserve Assets:** Changes in central bank's foreign currency reserves. - **BOP Deficit/Surplus:** Refers to specific components, typically the current account or overall balance excluding reserve assets. ### International Trade: International Liquidity - **International Liquidity:** The availability of financial assets that are universally accepted for settling international transactions. - **Components:** - **Gold:** Traditionally a key component, now less so. - **Convertible Currencies:** Currencies widely accepted in international payments (e.g., USD, Euro, Yen, Pound, Yuan). Held as foreign exchange reserves. - **Special Drawing Rights (SDRs):** An international reserve asset created by the International Monetary Fund (IMF), based on a basket of major currencies. Not a currency itself, but a claim on currencies. - **Reserve Positions in the IMF:** A country's quota subscription to the IMF can be drawn upon. - **Importance:** - Facilitates international trade and investment. - Helps countries manage balance of payments imbalances. - Insufficient liquidity can lead to global financial instability or restrict trade. ### International Trade: International Money and Banking Institutions - **International Monetary Fund (IMF):** - **Purpose:** Promote international monetary cooperation, ensure exchange rate stability, facilitate international trade, and provide temporary financial assistance to countries facing BOP problems. - **Functions:** Surveillance (monitoring global economy), financial assistance (loans), technical assistance. - **World Bank Group:** - **Purpose:** Provide financial and technical assistance to developing countries to reduce poverty and support economic development. - **Key Institutions:** International Bank for Reconstruction and Development (IBRD), International Development Association (IDA). - **World Trade Organization (WTO):** - **Purpose:** Oversee and liberalize international trade, provide a forum for trade negotiations, and handle trade disputes. - **Principles:** Non-discrimination (MFN, national treatment), reciprocity, transparency. - **Other Institutions:** - **Regional Development Banks:** Asian Development Bank (ADB), African Development Bank (AfDB). - **Bank for International Settlements (BIS):** Fosters cooperation among central banks. - **Commercial Banks:** Facilitate international payments, trade finance, foreign exchange transactions.