DEVELOPMENT ECONOMICS
MICRO & MACRO ECONOMIC PRINCIPLES
The foundation of economics is an understanding of how individuals and firms make decisions with limited resources in a constantly changing environment. These micro-level decisions are key to understanding economic development.
Scroll down or use the menu to the right to learn more about microeconomics and macroeconomic principles.
Supply, Demand & Market Equilibrium
How do markets influence individual and firm decisions?
Economics is the study of how people and organizations allocate scarce resources among competing and unlimited demands.
Given that scarcity exists, people must make tradeoffs. Microeconomics studies how people choose to allocate their scarce resources (labor, land, capital, time, etc.), how these choices are driven by incentives, and how policies affect incentives and outcomes.
What is microeconomics?
Microeconomics is the branch of economics that focuses on actions of particular agents within the economy, like households, workers, and businesses.
Microeconomics can help answer some of these typical questions.
Individuals
- What determines how households and individuals spend their budgets?
- How do consumers determine the best combination of goods and services to meet their needs and wants, given the budget they have to spend?
Firms & Businesses
- What determines the products, and how many of each, a firm will produce and sell?
- What determines what prices a firm will charge?
- How does a firm decide to expand, downsize, or even close?
To understand how policies impact markets, we need to understand the market itself.
There are two sides to each market:
Demand Side – Buyers
Buyers will buy fewer units of a good as prices rise.
Price
Quantity Purchased
Supply Side – Sellers
Sellers will bring more product to the market when prices rise.
Price
Quantity Sold
Interactions between buyers and sellers establish a market equilibrium
Market Equilibrium
When prices go up, the quantity supplied goes up (upward-sloping supply curve) while the quantity demanded goes down (downward-sloping demand curve).
The market price settles at P where the quantity demanded balances the quantity supplied at Q. This is known as the market equilibrium.
Markets can undergo upsetting shocks that affect prices and availability of goods
Deep Dive: Supply & Demand
Cory Krupp is an economist and a Professor of the Practice of Public Policy in the Sanford School. She has taught courses on International Trade and Policy, Economic Foundations of Development, Microeconomic Policy Tools, European Union Trade and Finance Issues, and Macroeconomic Policy and International Finance. Prof. Krupp also serves as the Associate Dean of Academic Programs at the Sanford School, with responsibility for curriculum development for the school’s main programs.
Consumer & Producer Surplus
Who benefits from a market equilibrium?
Understanding who benefits from a market equilibrium is key to understanding policy impact
Consumer Surplus (CS)
Definition: How much more consumers would be willing to pay for a good than its market price P. Since the demand curve represents consumer’s willingness to pay, the yellow area under the demand curve between its top and the market price represents aggregate CS.
Producer Surplus (PS)
Definition: How much more producers earn above the cost of bringing the good to the market. Since the supply curve represents producers’ minimum cost, the red area between the supply curve and the equilibrium price represents aggregate PS.
The combined benefit to both consumers and producers is known as Social Welfare
Social Welfare
Social welfare is maximized in a well-functioning competitive market, and it shrinks in the presence of market or government failures.
Monitoring the social welfare of the market can inform a government if intervention is needed to improve social welfare and benefit the market participants.
Our understanding of market prices and quantities assume functioning markets.
Functioning markets require active competition:
Competitive Market
Competitive markets are dynamic, since firms must keep innovating and creating new varieties to compete with each other. Competitive markets often exhibit the following:
- Producers produce very similar products
- No individual firm can impact the market price or quantity – Price-Takers
- Producers are small relative to the market size
- New producers can easily enter the market
Non-Competitive Market
Non-competitive markets are dominated by one or only a few firms. These markets often exhibit the following:
- Firms have the power to set price in the market – Price Makers
- Entry conditions are expensive or complex, so new entrants are very rare
- Existing firms can maintain high prices without fear of competition
- The number of transactions tends to be smaller, prices are higher, and choices more limited for consumers
Without competition, markets will not maximize social welfare and consumers can be harmed.
In non-competitive markets, governments often use regulation to ensure that consumers are not unduly harmed.
Example Pro-Competition Policies:
- If a country does not have
- Antitrust policies that forbid mergers that significantly reduce competition
- Punish price-fixing and anti-competitive agreements among firms that block entry
- Require monopolies (e.g. energy utilities) to serve the entire market at prices set by the government.
Deep Dive: Market Competition
Market competition varies widely depending on the overall economic environment, the regulatory environment, and a country’s institutional capacity. In many developing countries, state-owned enterprises often complicate market reforms.
Data Source
Read more about the World Bank’s work on market competition and development here.
Government Policies & Social Welfare
How can public policy affect individuals and firms?
In an ideal market-based economy, allocations are based on prices and the profit motive with private ownership of resources. However, the market-based economy is not always efficient. In the next section, we will look at several government tools and policies that address inefficiency in market economies.
Besides lack of competition, markets sometimes fail due to several factors:
Externalities
Costs that are not priced into a market that harm consumers or other third party
Asymmetric Information
One party has more information than the other, giving them an advantage
Factor immobility
Labor or capital are unable to reallocate to new activities.
Two of the largest government responses are the following:
Price Regulations
- Price Floors
- Price Ceilings
Financial Interventions
- Consumption Taxes
- Subsidies
Governments often establish price floors to protect individual workers and suppliers
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Problem
The government is concerned about producers (e.g., workers/factories) being harmed by low prices.
Solution
Government sets a minimum price (Pmin) at which a good can be sold in the market
Example
National and local minimum wage laws
However, price floors can significantly disrupt market prices and harm consumers
Social Welfare Effects
- Consumers are worse off. They are paying more for a product than the value they assign to it (Pmin).
- Suppliers have ambiguous welfare outcome: gain from the higher price (P to Pmin) but lose from the lower number of sales (Q to Qd).
- Government gains no revenue and faces no cost.
- Overall, price floors lead to a smaller market and a loss of social welfare.
Governments sometimes set price ceilings to protect vulnerable consumers
Social Welfare Effects
- Consumers have ambiguous welfare outcome: gain from the lower price, but lose from the lower number of products available.
- Suppliers are worse off – they are producing less and selling at a lower price.
- Government gains no revenue and faces no cost.
- Similar to price floor interventions, price ceilings lead to a smaller market and an overall loss of social welfare.
Alternative Policy:
Offer vouchers to the targeted group. This would make the good or service more affordable while not distorting the whole market and causing it to shrink.
Problem
The government is concerned about consumers being harmed by high prices.
Solution
Government sets a maximum price that can be charged for a good in the market.
Example
Housing Rent-Control Policies
If governments want to actively intervene in markets, they sometimes impose taxes
Problem
The government wants to generate revenue and possibly to dissuade over consumption
Solution
Government imposes a tax:
-Lump sum tax (charge per unit)
-Ad valorem tax (% of the value of)
Example
Tax on sugary drinks to reduce obesity
However, consumption taxes can harm both consumers and producers depending on the good
Social Welfare Effects
- Consumers are worse off due to a higher price paid. The loss is larger if consumers have few substitutes for the good.
- Producers are worse off due to a lower net price received. The loss is larger if it is difficult to change supply.
- Government gains tax revenue.
- Overall, taxes distort the price signal to both buyers and sellers, and shrink the size of the market.
In contrast, governments sometimes subsidize essential goods or promote new markets
Social Welfare Effects
- Consumers are better off due to a lower price paid.
- Producers are better off due to a higher net price received.
- Government incurs high costs by providing the subsidies.
- Overall, subsidies expand the market – An increase in the quantity of the good sold in the market – but the cost of the subsidy exceeds the benefits gained by consumers and producers.
Policy Insight:
In many developing countries, excessive use of subsidies can cause huge pressure on government budgets and result in chronic budget deficits. Such issues can lead to macroeconomic instability.
Problem
The government wants to increase consumption and production of specific goods.
Solution
Government creates a lump sum payment (usually to the supplier) per unit of a good consumed or produced.
Example
Government subsidies on necessities such as bread, cooking oil, childcare
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