📄 IB Economics HL Unit 2 Microeconomics — complete revision guide

Law of Demand

There is an inverse relationship between price and quantity demanded, ceteris paribus. As price rises, Qd falls; as price falls, Qd rises. Shown as a downward-sloping demand curve (D).

HL reasons: Income effect (higher price = lower real income = less purchased) + Substitution effect (higher price makes substitutes relatively cheaper)

HL: Law of diminishing marginal utility — each additional unit consumed gives less extra satisfaction, so consumers only buy more at lower prices.

Non-price determinants of demand (shift factors)

Causes the entire demand curve to shift. Mnemonic: PIRATE

• Price of related goods — substitutes (XED positive) & complements (XED negative)
• Income — normal goods (demand rises with income); inferior goods (demand falls with income)
• Related goods (see above)
• Advertising & tastes/preferences
• Taxes / subsidies affecting consumers
• Expectations of future prices
• Population size and composition

Movement along the demand curve = change in price. Shift of the curve = change in any non-price determinant.

Law of Supply

There is a positive (direct) relationship between price and quantity supplied, ceteris paribus. As price rises, Qs rises; as price falls, Qs falls. Shown as an upward-sloping supply curve (S).

HL reason: Law of diminishing returns — as more variable factors are added to a fixed factor, marginal output eventually falls, raising marginal cost. Firms require higher prices to supply more.

Non-price determinants of supply (shift factors)

Mnemonic: PINTSWC

• Price of factors of production (costs) — higher wages/raw materials → supply decreases
• Indirect taxes — increase in tax → supply decreases (shifts left)
• Number of firms in the market
• Technology — improvements reduce costs → supply increases
• Subsidies — government subsidy → supply increases (shifts right)
• Weather / natural factors (especially agriculture)
• Changes in prices of goods in joint/competitive supply

Joint supply: producing more of X automatically produces more of Y (beef & leather). Competitive supply: resources used for X cannot be used for Y.

Allocative efficiency

Achieved when P = MC (= MB). Resources are allocated to their highest-valued use from society's perspective. Community surplus is maximised. Any other output level creates a deadweight loss (reduction in community surplus).

HL: Using linear equations

You may be given Qd = a − bP and Qs = c + dP. To find equilibrium: set Qd = Qs, solve for P, substitute back for Q. For TR: TR = P × Q. For CS/PS: triangles on the diagram (½ × base × height).

Rational consumer choice — assumptions

• Consumers are rational — they always seek to maximise utility
• They have access to perfect information about all alternatives
• They are self-interested (homo economicus)
• They are consistent and stable in preferences

Limitations — behavioural biases

Bounded concepts

• Bounded rationality — limited information, time, and cognitive ability mean decisions are "good enough" (satisficing), not optimal
• Bounded self-control — people lack willpower to act in their own long-term interest (e.g. overspending, unhealthy eating despite knowing better)
• Bounded selfishness — people are sometimes altruistic and care about fairness, not purely self-interested (e.g. tipping, charitable giving)

Behavioural economics in action — choice architecture & nudges

• Choice architecture — the intentional design of how choices are presented to steer behaviour. Three types:
• — Default choices: opt-out organ donation; auto-enrolment pensions
• — Restricted choices: removing unhealthy options from menus
• — Mandated choices: forcing a decision (e.g. must select organ donation preference)
• Nudge theory (Thaler & Sunstein) — small changes in choice environment that predictably alter behaviour without restricting freedom or changing financial incentives. Preserves freedom of choice (libertarian paternalism).

Business objectives (HL) — beyond profit maximisation

• Profit maximisation — standard assumption; produce where MC = MR
• Revenue maximisation — produce where MR = 0 (Baumol); managers may prefer larger firm size
• Market share growth — grow market share even at cost of short-run profit (e.g. Amazon in early years)
• Satisficing (Simon) — firms aim for "good enough" outcomes; complex organisations cannot truly maximise
• Corporate social responsibility (CSR) — firms consider environmental/social impact alongside profit

Price Elasticity of Demand (PED) formula

• PED is always negative (inverse relationship) — IB often uses the absolute value
• |PED| > 1 → price elastic (luxury goods, many substitutes, non-necessity, long time period)
• |PED| < 1 → price inelastic (necessities, few substitutes, addictive goods, short time period)
• |PED| = 1 → unit elastic; |PED| = 0 → perfectly inelastic; |PED| = ∞ → perfectly elastic
• TR rule: elastic demand → cut price to raise TR (% rise in Q > % fall in P). Inelastic → raise price to raise TR.

Determinants: number of substitutes, necessity vs luxury, proportion of income, time period, definition of market (narrow = more elastic)

Income Elasticity of Demand (YED) formula

• YED > 0 → normal good; YED < 0 → inferior good
• 0 < YED < 1 → income inelastic normal good (necessities)
• YED > 1 → income elastic / luxury good
• Application: firms producing luxury goods benefit most from economic growth. Inferior good producers may lose out.

Cross Elasticity of Demand (XED) formula

• XED > 0 → substitutes (tea & coffee; rise in price of B increases demand for A)
• XED < 0 → complements (cars & petrol; rise in price of B reduces demand for A)
• XED = 0 → unrelated goods
• Higher positive XED = closer substitutes; higher negative XED = stronger complements

Price Elasticity of Supply (PES) formula

• PES always positive; PES > 1 = elastic; PES < 1 = inelastic
• Perfectly inelastic supply (PES = 0) — vertical supply curve (e.g. land, original artwork)
• Perfectly elastic supply (PES = ∞) — horizontal supply curve

Determinants: time period (short-run more inelastic), availability of spare capacity, ease of storing stocks, mobility of factors of production, length of production period (agricultural goods = inelastic), nature of the good

Elasticity and tax incidence

• When demand is inelastic relative to supply → consumers bear a larger share of the tax burden (tax passed on as higher prices)
• When demand is elastic relative to supply → producers bear a larger share (can't raise price much without losing sales)
• Government prefers to tax inelastic goods to raise revenue with minimal fall in output (e.g. cigarettes, alcohol, fuel)

Government failure

Government intervention can itself cause inefficiency: unintended consequences, policy being captured by special interests, imperfect information, administrative costs, or creating greater distortions than the original market failure it was designed to fix.

Key terminology — externality diagrams

Common pool (common access) resources

• Definition: resources that are non-excludable (cannot prevent access) but rivalrous (use by one reduces availability to others)
• Examples: ocean fisheries, clean air, groundwater, forests
• "Tragedy of the commons" — individual incentive to overuse leads to collective depletion
• Policies: quotas, licences, property rights, tradable permits, international agreements (e.g. fishing quotas), taxation, education
• Link to sustainability — key concept

Characteristics of public goods

Free rider problem

Because public goods are non-excludable, individuals can benefit without paying. No private firm can charge for them profitably, so they will be underprovided or not provided at all by the free market. This is a market failure — the government must provide them (e.g. national defence, street lighting, flood defences).

Merit and demerit goods (related concepts)

• Merit good — positive externality of consumption; underprovided / underconsumed in a free market because individuals undervalue social benefits. E.g. education, healthcare, museums.
• Demerit good — negative externality of consumption; overconsumed because individuals ignore social costs. E.g. cigarettes, alcohol, gambling.

Adverse selection

Occurs before a transaction. The party with less information selects unfavourably.

• Classic example: used car market (Akerlof's "market for lemons") — buyers can't distinguish good from bad cars; they only pay average price; sellers of good cars withdraw; market left with only lemons
• Insurance market: sicker people more likely to buy health insurance; insurer raises premiums; healthy people drop out; adverse selection spiral
• Solution: mandatory insurance, government provision, disclosure requirements, screening, signalling (warranties, qualifications)

Moral hazard

Occurs after a transaction. One party takes more risk because the other bears the consequences.

• Example: someone with car insurance drives more recklessly because the insurer bears the cost
• Financial crisis example: banks took excessive risks knowing governments would bail them out ("too big to fail")
• Solutions: deductibles/co-payments in insurance, monitoring, performance-based contracts, regulation, financial regulation (capital requirements for banks)

Government responses to asymmetric information

• Mandatory information disclosure (e.g. nutritional labelling, financial product prospectus)
• Quality standards and licensing (e.g. medical licensing, food safety inspections)
• Compulsory insurance (e.g. third-party car insurance)
• Public provision (healthcare, education)
• Market solutions: reputation, warranties, signalling (education as signal of productivity)

Market structures — comparison

Profit maximisation rule (all market structures) diagram required

Firms maximise profit by producing where MC = MR. Price is then read off the demand (AR) curve above this output.

• Normal profit = TR = TC (zero economic profit). Minimum required to keep firm in the market.
• Abnormal (supernormal) profit = TR > TC. AR > ATC at the profit-maximising output.
• Loss-making = TR < TC. AR < ATC.
• Shutdown condition (SR): if P < AVC, firm shuts down rather than produce.

Government responses to market power

• Competition (antitrust) policy — preventing mergers that reduce competition; breaking up monopolies
• Regulation — price controls on natural monopolies (e.g. utilities); quality standards
• Nationalisation — state ownership of natural monopolies
• Trade liberalisation — opening markets to foreign competition reduces domestic market power

2.12 The market's inability to achieve equity HL

• Even a fully efficient free market may produce highly unequal outcomes — distribution of income and wealth is determined by ownership of factors, not need
• Lorenz curve — graphical representation of income distribution; the further from the line of perfect equality, the more unequal the distribution
• Gini coefficient — numerical measure of inequality (0 = perfect equality; 1 = perfect inequality)
• Government can use progressive taxation and transfer payments to address inequity — but there is a trade-off with efficiency (incentive effects)
• Link to key concepts of equity and economic well-being