Microeconomics Made Simple: Basic Microeconomic Principles
Explained in 100 Pages or Less by Austin Frakt, Mike Piper
Last annotated on October 22, 2014
my notes are typed in italics
Each of us has limited resources. We have neither the time nor the money to
do everything we might want to do. So we must choose: Out of all the possible
options, on what will we spend our money and time?
Economics is the study of how people make these decisions. It asks how
individuals, families, businesses, and governments decide how to allocate their
limited (i.e., scarce) resources. In other words, economics is the study of how
people deal with scarcity.
Economics is also concerned with incentives and their impact on behavior.
Because we each have scarce resources (e.g., money), we’re naturally motivated
by the prospect of acquiring more resources. Economics looks at how this
motivation to acquire more resources affects the decisions we make.
This is well
matching with Theory of constraints. There is a constraint. We want more out of
it. There are motivating factors (local vs global performance) for us.
Macroeconomics focuses primarily on decisions made by governments and
trends in economic sectors in aggregate (e.g., housing, manufacturing, etc.),
and the impacts of those decisions and trends on the overall national or global
economy.
microeconomics—the topic of this book—focuses on the decisions made by
individual people, families, and businesses. Microeconomics includes
examination of “markets”—places (whether physical or online) where goods1 are
exchanged between buyers and sellers (a.k.a. consumers and producers).
we focus on basic models that assume economic entities are rational, have
all relevant information for decision-making, and are able to fully understand
and process that information. Assumptions like these obviously do not always
hold in the real world.
Again
matching with TOC, available information is not relevant for fully make proper
decisions (local vs global)
economics provides valuable tools to help individuals, businesses,
governments, and other entities extract the greatest value their resources will
allow.
But economics does not generally deal directly with other important
concepts like justice and equity, and it is sometimes at pains to explain
cultural conventions (like the giving of birthday gifts instead of cash).
In economics, the word “utility” refers to a person’s overall happiness or
satisfaction. Economics assumes that each person’s goal when allocating his or
her resources is to make decisions to maximize his or her utility (i.e.,
achieve maximum happiness).
Perfect
match with Goldratt's definition of Goal and main idea of The Choice book.
Some people think that trying to maximize utility is the same thing as
acting selfishly. In reality, however, utility includes the happiness, sense of
fulfillment,
here comes
to "resistance to change". We are selfishly doing our best for our
local environment but the sense of fulfillment coming from utility is lying
somewhere in global context.
“Marginal utility” refers to how much additional utility is derived
from consumption of one additional unit of a particular good. In theory, with
each dollar in her budget, a rational person would buy the good that provides
the highest marginal utility for that dollar (i.e., the most additional
happiness per dollar).
This is
throughput per constraint unit.
The “opportunity cost” of a choice is the value of the best alternative
that you must forgo in order to make that choice.
This is very
similar to Throughput Accounting supported decision making process. Change in
T, I, OE is a version of opportunity cost.
In economics, it is assumed that each person’s goal is to maximize his/her
total “utility” (i.e., happiness).
Most goods have decreasing marginal utility. That is, each additional unit
consumed brings less additional happiness than the prior unit.
decreasing
marginal utility = rate of diminishing returns and corresponds to green curve
in TOC Viable Vision concept. To go for a leverage we need to switch to next
best option.
To maximize utility, you must spend each dollar of your budget on the good
that offers you the highest marginal utility for that dollar.
Optimal decision making requires consideration of opportunity costs (i.e.
the value of the forgone, best alternative option).
these are the scarce resources that we, as a society, must choose how to
allocate. Ideally, we would do so in a way that maximizes our wellbeing.
Traditionally, the factors of production are:
Land (which includes land itself as well as other natural resources and
phenomena— water, forests, fossil fuels, weather, etc.),
Labor (the human work necessary to produce and deliver goods), and
Capital (manmade goods used to produce other goods—factories, machinery,
highways, electrical grid, etc.).
More recently, human capital—the knowledge and skills that make workers
productive—has been considered a fourth factor of production.
How should a society allocate its factors of production?
One desirable criterion is to use all resources to their fullest capacity
or, to put it another way, to use the fewest possible resources for any given
level of output. “Productive efficiency” is the term used to describe a
situation in which this is achieved.
This is a
reductionist view, local optima. Producer driven. Push mentality.
Another desirable criterion is that the factors of production are all used
to make the quantities and types of goods that society most highly values. “Allocative
efficiency” is the term used to describe a situation in which productive
resources are being used in their most valuable way.
This is a
global view, TOC way. Go for highest Throughput per constraint unit. Demand
driven. Pull mentality.
A “production possibilities frontier” conveys the various choices that an
economic entity could make when choosing what to produce, given the constraint
imposed by its limited factors of production.
Frontier is
implying with constraint. Below frontier it is not "productive
enough", ie. the constraint is the market. On the frontier we are talking
about exploitation of the constraint, throughput per constraint unit matters.
Beyond frontier means we need to elevate the constraint.
Specialization and trade makes everybody better off. an entity can
specialize and gain from trade even if it does not have an absolute advantage
in anything. To be more specific, it makes sense to specialize in something if
you have a “comparative advantage” in it—that is, your opportunity cost for
producing that thing is lower than that of other potential producers.
Due to comparative advantage, gains from trade are possible even for an
entity that does not have an absolute advantage in anything
Factors of production (land, labor, capital, and human capital) are limited
resources that a society must choose how to allocate. A production possibilities
frontier shows all combinations of two goods that an entity can produce with
its factors of production. Through specialization and trade, an entity can
consume more than its production possibilities frontier implies in isolation.
This is a
variety of global view, subordination.
A producer has an absolute advantage in producing a good if it can produce
it with fewer inputs than other producers require. A producer has a comparative
advantage in producing a good if it can produce it at a lower opportunity cost
than other producers. Gains from trade are possible due to comparative, not
absolute, advantages.
This is
verifying throughput per constraint unit approach.
The “demand” for a good is simply how much of that good consumers would buy
at various prices. Demand is often illustrated using a graph known as a “demand
curve.” If a good has a horizontal demand curve, its demand is said to be
“perfectly elastic.” If a good’s demand curve is vertical, its demand is said
to be “perfectly inelastic.” There are multiple factors that affect the
elasticity of demand for a good, such as:
- Availability of substitutes,
- Whether the good is a necessity or a luxury,
- Whether the good is a small or large part of buyers’ overall budgets, and
- Time.
“substitute goods.” They are similar enough to one another that one can
readily serve as a substitute for the other.
The demand curve for a product shows the quantity of that product that
consumers would buy at various prices.
This could
be a way to market segmentation.
When demand for a good is elastic, the quantity that consumers want to buy
is more sensitive to price changes. When demand for a good is inelastic, the
quantity purchased is less sensitive to price changes.
A change in the quantity demanded is a movement along the demand curve due
to a price change. A change in demand is a shift of the demand curve due to
changes in factors other than the price of the good.
Demand can change in response to changes in factors such as consumer
preferences, income levels, expectations, number of buyers in the market, and
prices of other goods. When the price of a good goes up, demand for its
substitutes goes up and demand for its complements goes down.
The “supply” for a good is how much of that good producers would produce at
various prices. Like demand, supply is often illustrated via a graph—known as a
“supply curve” in this case. A good’s supply curve shows the quantity producers
would produce at various prices. A good’s marginal cost of production is the
additional cost that must be incurred to produce one additional unit of the
good.
Same as
Totaly Variable Cost in Throughput calculation.
Most supply curves are upward sloping because most goods have increasing
marginal costs of production.
When supply for a good is elastic, the amount producers will produce is
more sensitive to price changes. When supply for a good is inelastic, the
amount producers will make is less sensitive to prices changes. A movement
along the supply curve due to a change in price is a change in the quantity
supplied. A shift of the supply curve is a change in supply due to changes in
factors other than the good’s price. Supply can change in response to changes
in any of several factors: costs of production, opportunity costs, supplier
expectations, or the number of suppliers.
In a market in which buyers and sellers are permitted to act without
constraints (often called a “free market”) their actions drive the price and
quantity of a good toward market equilibrium. When we graph a good’s supply and
demand together, not only can we determine the market equilibrium price and
quantity, we can also determine how the equilibrium changes when supply or
demand for the good changes. At the market equilibrium point for a good,
quantity supplied and quantity demanded are equal. Unconstrained buyers and
sellers acting in their best interests drive a market to equilibrium.
This is the
basis of Mafia Offer. If our offer is realy creating a value for a client,
client will give more orders to us.
A shift in demand or supply affects both the equilibrium price and quantity
of a good. The easiest way to determine the effect is to sketch a graph with
the original and shifted curves.
In some cases, the government imposes a minimum price on a good—a “price
floor.” In such a case, if the price floor is above the equilibrium price,
there would be a surplus of the good. A surplus is not desirable because it
wastes resources, as more is produced than gets purchased—though, as discussed
below, society sometimes decides that a price floor is worthwhile anyway due to
other factors.
In other cases, the government imposes a maximum price on a good—a “price
ceiling.” If the price ceiling is below the equilibrium price, there would be a
shortage of the good. A shortage is not desirable because people cannot obtain
the goods they want to purchase—though again, society sometimes decides that a
price ceiling is worthwhile due to other factors.
In TOC view,
if you have excess capacity and there is shortage in the market and there is a
price ceiling for all then anything above TVC is a good enough price for more
sales.
Many goods are taxed or subsidized by the government. A shortage occurs
when a price ceiling is imposed below the equilibrium price for a good. A
surplus occurs when a price floor is imposed above the equilibrium price for a
good. A tax increases the price paid by consumers, reduces revenue received by
suppliers, and reduces the quantity transacted. A subsidy reduces the price
paid by consumers, increases the revenue received by suppliers, and increases
the quantity transacted. The party (buyer or seller) with the lower elasticity
pays more of a tax and receives more of a subsidy. Though government
interventions distort the market, they are sometimes justified and supported by
society.
firm can face decreasing, constant, or increasing marginal costs of
production, depending on its level of output, the expense of acquiring
additional inputs, and the extent to which they can be used productively.
variable costs would include ingredients, employee labor, electricity to
run ovens, etc.
In TOC,
labor is not part of a variable cost since it is not changing with the
reasonable increase in production. We pay the same salaries anyway. In the short
run it is "fixed".
Given enough time, fixed costs can become variable costs. In economics, the
“short run” is the length of time over which a firm’s fixed costs are just
that—fixed. The “long run” is any length of time longer than the short run.
Said differently, in the short run, some costs are variable, while others are
fixed. In the long run, all costs are variable.
In TOC, OE
covers all fixed costs in the short run. There is exploitation in short run and
elevation in the long run by viable vision.
A firm’s “average total cost” is simply its total costs, divided by the
number of units produced. Average total cost is an important concept because a
firm cannot earn an economic profit selling a good unless its unit price is
above average total cost.
In TOC there
are two different points: First, constraint matters not all machinery. Second
throughput (excluding labor and overhead) matters not product cost.
Marginal cost of production is the cost of producing one additional unit of
output. Most firms face diminishing marginal returns (and, therefore,
increasing marginal costs) after some level of output. Fixed costs do not vary
with production levels. Variable costs do. The short run is the time over which
fixed costs are fixed. The long run is any length of time greater than the
short run. Because sunk costs have already been incurred and cannot be
recovered, they should be ignored when making decisions.
Accounting costs include all financial costs. Accounting profit/loss is
equal to revenue minus accounting costs.
Economic costs include accounting plus opportunity costs. Economic
profit/loss is equal to revenue minus economic costs. Businesses are concerned
with maximizing economic, not accounting, profit.
Business are
lost in cost accounting and GAAP but desperately seeking for maximization of
economic profit which can be achieved by Throughput Accounting.
Buyers and sellers each have “perfect information,” meaning, for example,
that each buyer knows exactly how much utility he/she would derive from
purchasing the good and each seller knows the most efficient way to produce the
good.
In TOC,
·
clients do common practise which is against common sense. They are not
fully aware of their true needs. There is an opportunity for a good mafia
offer.
·
suppliers do common practise (paradigm) which is against common sense like
clients. They are concerning artificial product costs, going for scale
economies, MTS with a local mentality. There is an opportunity for a paradigm
shift and having a decisive competitive edge - hence providing a mafia offer
for the market.
In a perfectly competitive market, firms are “price takers.” That is, they
have no ability to influence the market price for the good they produce.
The term “marginal revenue” refers to how much additional revenue a firm
would earn from one additional unit of output. As a rule, any time the marginal
revenue for the next unit of output exceeds the marginal cost of production, a
profit-maximizing firm will make that unit of output.
This is the
point that companies are struggling to grow. They are too busy with phantom
product cost and hence marginal cost is usually greater than marginal revenue
and they are stopping.
As discussed previously, in a perfectly competitive market, there are no
barriers to entry or exit; firms are able to enter or leave the market as they
please. As a result, if profit-maximizing firms in a perfectly competitive
market were earning profits, other firms would enter the market to grab a share
of the profits. When new firms enter the market, supply increases, causing the
price of the good to fall, thereby resulting in smaller profits for firms
already in the market. In fact, this phenomenon (firms entering the market,
causing a decline in price) will continue until the price has fallen to a level
at which firms are earning exactly zero profit, thereby leaving no incentive
for additional firms to enter the market. (A similar argument can be made about
firms exiting the market if they are incurring a loss.)
We know from earlier in this chapter that a firm in perfect competition
earns exactly zero profit when the market price for the good it sells is equal
to the firm’s average total cost for producing that good (i.e., P = ATC). We
also know that profit-maximizing firms choose to produce at the point at which
marginal revenue—defined as the market price—is equal to marginal cost of
production (i.e., P = MC). In other words, in the long run, in a perfectly
competitive market, each firm produces at the point at which marginal cost,
average total cost, and price are all equal. This applies to every firm in the
market because one of the assumptions of perfect competition is that all firms
have the knowledge and ability to produce most efficiently. That is, they all
have the same marginal and average cost curves.
The fact that firms earn zero profits in the long run in a perfectly
competitive market is generally considered to be good for society. It means,
among other things, that consumers are paying the lowest prices necessary to
get firms to produce what they’re producing. (Remember, while these firms have
no economic profits, they still have accounting profits.) An additional
societal benefit of perfect competition is that, in the long run, firms are
forced to produce at the lowest cost possible.
“Consumer surplus” refers to the value that consumers derive from
purchasing a good. For example, if you would be willing to spend $10 on a good,
but you are able to purchase it for just $7, your consumer surplus from the
transaction is $3. You’re getting $3 more value from the good than it cost you.
“Producer surplus” refers to the value that producers derive from
transactions. For example, if a producer would be willing to sell a good for
$4, but he is able to sell it for $10, he achieves producer surplus of $6.
“Total surplus” refers to the sum of consumer surplus and producer surplus.
Total surplus is maximized in perfect competition because free-market
equilibrium is reached.
That is, if a quantity less than the free-market equilibrium quantity were
transacted, total surplus would be less, because there would be beneficial
transactions that are failing to occur (i.e., transactions where consumers’
willingness to pay is greater than the lowest price suppliers are willing to
accept).
And if a quantity greater than the free-market equilibrium quantity were
transacted, total surplus would be less, because transactions that cost more to
producers than consumers would be willing to pay would occur.
In a perfectly competitive market, there are many firms making identical
products. In a perfectly competitive market, firms cannot influence the market
price. As a result, each firm’s marginal revenue curve is equal to the market
price (P = MR). In a perfectly competitive market, each firm has the same
marginal cost curve, because each firm knows how to produce with maximum
efficiency. To maximize profit (or minimize loss), firms will produce at the
point at which their marginal revenue equals their marginal cost of production
(where MR = MC). In perfect competition, firms will enter or leave the market
until the market price is such that each firm earns exactly zero economic
profit and produces at its lowest possible cost. (Remember, zero economic
profit does not mean zero accounting profit.) Total surplus is maximized in a
perfectly competitive market.
Because it has no competition, a monopoly is not a price taker.
When a firm has the ability to profitably raise the price of its product
above the price that would occur in a perfectly competitive market, the firm is
said to have “market power.”
the monopoly faces a downward sloping marginal revenue curve—meaning that
each additional unit the firm sells brings in less revenue than the unit
before. The reason for this declining marginal revenue is that the firm must
reduce the price it charges for its product if it wants to sell more units. And
that new lower price would apply to all units sold—including all the units sold
to buyers who would have been willing to pay a higher price.
Whether a monopoly earns profit or loss depends on how the firm’s average
total cost of production at its profit-maximizing output compares to the price
at that level of output.
What is different about a monopoly (relative to a firm in perfect
competition) is that it can earn a profit in the long run as well as the short
run.
Industries like this—in which one producer can supply the good in question
at a lower average cost than multiple producers—are known as “natural
monopolies.”
In some cases, governments will require the monopoly to allow potential
competitors to use its infrastructure for a reasonable fee.
In other cases, governments even choose to create a monopoly. For example,
when a patent is granted to an inventor, that inventor is given a monopoly over
the market for the invention (until the patent expires).
A monopoly is a firm with no competition. A monopoly has market power. That
is, it can profitably increase the price of the good it sells by reducing the
output it produces. Monopolies face downward sloping marginal revenue curves. Like
other firms, monopolies maximize profit (or minimize loss) by producing at the
point where marginal revenue equals marginal cost of production. To maximize
profit, monopolies restrict their production below what would be produced in a
competitive market. The resulting lower output and higher price cause a
deadweight loss to society. To address the deadweight loss, in some cases,
governments will enforce antitrust laws to break up or otherwise regulate a
monopoly.
An “oligopoly” is an industry dominated by a few firms (as few as two),
with barriers to entry that make it difficult for new firms to enter the
industry. In an oligopoly, because there are only a few sellers, each seller’s
actions do have an impact on market price. Because firms in an oligopoly can
influence the price of their product by changing output levels, they face
downward sloping marginal revenue curves—much like a monopoly faces.
Essentially, cartel behavior takes a competitive market and turns it into a
monopoly, with each firm getting a share of the monopoly’s profits.
An oligopoly is an industry dominated by just a few firms. Because each
firm in an oligopoly makes up a significant part of the market, firms’ behavior
has an effect on the market price of the good in question. An oligopoly market
can be highly competitive, or it can have the properties of a monopoly,
depending on how firms behave. In an oligopoly, firms sometimes collude (act as
a cartel) in order to secure profits by reducing output and driving up the
market price of the good in question. Cartels often fail due to the incentive
that each firm has to cheat. In many countries, cartel behavior is prohibited
via antitrust laws.
A “monopolistically competitive” market is one in which there are many
sellers competing not only on price but also on the basis of small differences
in their products, known as “product differentiation.” In other words, their
products are similar enough to be in competition with one another, but they are
not perfect substitutes.
As with firms in other market circumstances, firms in monopolistic
competition choose to produce at the point where marginal revenue equals
marginal cost because that is the point at which they maximize their profit (or
minimize their loss). And, like monopolies and firms in an oligopoly, firms in
monopolistic competition face downward sloping marginal revenue curves because
their decisions to increase or decrease output will have an impact on the
market price of their product.
Monopolistically competitive markets have no (or low) barriers to entry. As
a result, as with a perfectly competitive market, firms should have no profits
or losses in the long run. Remember, this is the result of new firms entering
the market in the presence of short run profits, thereby driving prices
downward (until profits are zero), and the result of firms leaving the market
in the presence of short run losses, thereby driving prices upward (until
losses are zero).
like a monopoly, firms in monopolistic competition do not produce at the
lowest-cost level of output. That is, as a result of their downward sloping
marginal revenue curves (and their resulting incentive to restrict production
to maximize profits), they produce at a lower level of output than the level at
which average total cost is minimized.
A monopolistically competitive market is one in which there are many
sellers competing on price as well as on the basis of product differentiation. Firms
in monopolistic competition have some degree of market power because their
products are differentiated from the products of their competitors. Because
firms in monopolistic competition have market power (i.e., the market price of
their product is impacted by their decisions of how much to produce), they face
downward sloping marginal revenue curves. Due to no (or low) barriers to entry,
firms in a monopolistically competitive market earn no economic profit in the
long run. (Remember, a firm with exactly zero economic profit is earning an
accounting profit.)
Like monopolies and oligopolies, monopolistically competitive markets are
productively inefficient because firms in such markets do not produce at the
lowest-cost level of output. Maximizing utility, surplus, and economic profit
are the domains of economics, but they are clearly not the only things of value
to society. In addition to being concerned with economic efficiency (utility
maximization), we are also concerned with fairness or equity.
Economics is useful, but incomplete. Economic models are powerful, but
approximate.
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