Introduction: Definitions

1
Introduction Definitions

• Microeconomics
• -It is a branch of social science that studies
  the interactions among the allocation processes
  of several rational agents using scarce
  resources to satisfy competing ends.
• Science
• -Science is an organized and quantitive study
  using models. Quantitative means using
  measurement and mathematics. Mathematics is
  simply the set of tools we use to reason about
  numbers.

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• Model
• A model is simply a statement that certain facts
  and relationships are important, and others will
  be ignored. In other words, a model is abstract.
  The process of building a model is called
  abstraction, and, of course, modeling.
• Social Science
• A social science is one that deals with
  interactions within groups of people, or of
  animals, organizations, or even machines.
  Explicit description of interactions is why
  microeconomics is "micro".

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• scarce resources
• A resource is anything that might ever be useful
  to somebody. A resource is scarce when someone
  would be able to use a little bit more of it. A
  resource is free if nobody anywhere has any use
  whatsoever for it.
• competing ends
• An end is a use, goal, or purpose. Two ends
  compete when they both could use the same scarce
  resource.
• allocation
• Allocation is simply a fancy word that means to
  make a decision. In particular it refers to a
  decision about how to use a particular resource.

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Economic Models, The Market

• Building a model deliberate simplification of
  reality designed to explain and predict
• A model is simply a statement that certain facts
  and relationships are important, and others will
  be ignored.
• In other words, a model is abstract.
• The process of building a model is called
  abstraction, and, of course, modeling.
• If you bring other facts and relationships into
  the discussion, then you are violating the
  model.

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• Exogenous Variable
• A variable whose value does not change in
  response to forces described in a particular
  model.
• Endogenous Variable
• A variable whose value does change according to
  the forces described in a particular model.
• Note endogeneity or exogeneity will vary
  depending on models.
• We will see that we must often shift perspective
  according to the stage of analysis (i.e., change
  models).

6

• Rational Agent Agent simply means "decision
  maker."
• Sometimes it means a proxy decision maker (e.g.,
  a professional manager of a corporation is
  ultimately an agent of the stockholders),
• But it often simply means any decision maker.
• Rational simply means "purposeful" or
  "goal-oriented."

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• If a person is not rational, their behavior will
  be inconsistent and unpredictable in new
  circumstances.
• Often we add a number of additional conditions,
  such as selfishness and maximization.
• This more restricted form of rationality is
  usually call economic rationality.

8

• We also need some principles to simplify our
  analysis. Sometimes we need to worry about
  variables changing during the course of the
  analysis. Sometimes we can assume they won't.
• Some of the principles are
• Optimization principle people tend to choose
  that which is best for them based on their
  constraints
• Equilibrium principle prices tend to adjust
  until the amount people demand equals the amount
  others are willing to supply
• They can be referred to as Analytical Principles

9

• Market Can be defined according to three
  competing criteria
• whether there are any close substitutes
  (substitutability of products criterion)
• the degree to which firms in an industry take
  into account how others will react
  (interdependence criterion)
• the degree to which it is easy to enter and
  compete against others (condition of entry
  criterion).

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• Four basic market types from the supply side
• Perfect Competition
• homogenous product
• each firm considers only its own conditions and
  does not consider how others will react
• free and easy entry.
• Firms are price takers and can sell all they want
  at the market price
• Monopoly
• No close substitutes for product
• only one firm
• high or impossible entry barriers

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• Monopolistic Competition
• Some product differentiation but each product is
  somewhat substitutable for others
• each firm considers only its own conditions and
  does not consider how others will react
• free and easy entry.
• Firms face downward sloping demand curves.
• Excess capacity in industry.
• Oligopoly
• Product may be differentiated (cars) or
  homogenous (gasoline)
• there are only a few firms in the market
• each firm is cognizant of other firms behaviour
• high (but not impossible) entry barriers.

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• Monopsony
• One buyer of a good
• Bilateral Monopoly
• When both buyer and seller are monopolists,
  e.g., the labour market for a unionized monopoly

13
Market structure
14
Criteria for classifying firms into markets

• Market criterion
• similarity of products. For example, cars,
  software
• Technological criterion
• similarity of processes. For example,
  transportation, light manufacturing

15
Demand

• Demand Curve Represents the maximum willingness
  to pay (reservation price) for each person in a
  market .
• A consumers demand curve indicates their
  willingness to pay.

16
Willingness to Pay

• A consumers willingness to pay is the maximum
  amount that they are willing to pay for a good or
  service.
• Note that
• This value may change as the consumer has more or
  less of the good.
• Typically consumers are willing to pay less for
  each additional unit.
• This is also known as marginal benefit and
  marginal willingness to pay.

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Consumer Surplus

• The difference between what a buyer willing to
  pay and what the buyer actually pays is called
  consumer surplus.

18
Demand, Price and Income

• The relationship between demand, Price and Income
• the income effect
• the substitution effect

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Determinants of Demand

• Price of the Good
• Tastes Preferences
• Consumers Income
• Number of Consumers
• Expectations about the Future
• Prices of Related goods

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• The demand curve
• assumptions
• the axes
• illustrates how much would be demanded at each
  price

21
Market demand for potatoes (monthly)
Market demand (tonnes 000s) 700
Price (pence per kg) 20
Point
A
Price (pence per kg)
A
Demand
Quantity (tonnes 000s)
22
Market demand for potatoes (monthly)
Market demand (tonnes 000s) 700 500 350 200 100
Price (pence per kg) 20 40 60 80 100
Point
E
A B C D E
D
C
Price (pence per kg)
B
A
Demand
Quantity (tonnes 000s)
23
An increase in demand
P
Price
D0
O
Q0
Q1
Quantity
24
Supply

• Relationship between supply and price
• as price rises, firms supply more
• it is worth incurring the extra unit costs
• they switch from less profitable goods
• in the long run, new firms will be encouraged to
  enter the market
• The supply curve
• assumptions
• the axes
• illustrates how much would be supplied at each
  price

25
Market supply of potatoes (monthly)
Supply
P 20 40
Q 100 200
a b
Price (pence per kg)
b
a
Quantity (tonnes 000s)
26
Market supply of potatoes (monthly)
e
Supply
d
P 20 40 60 80 100
Q 100 200 350 530 700
a b c d e
c
Price (pence per kg)
b
a
Quantity (tonnes 000s)
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Supply

• Other determinants of supply
• costs of production
• profitability of alternative products
• profitability of goods in joint supply
• nature and other random shocks
• aims of producers
• expectations of producers
• Movements along and shifts in the supply curve

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Shifts in the supply curve
P
S0
Increase
Q
O
29
Shifts in the supply curve
P
S0
S1
Increase
Decrease
Q
O
30
The Determination of Price

• Equilibrium price and output
• response to shortages and surpluses
• significance of equilibrium
• Demand and supply curves

31
The determination of market equilibrium
(potatoes monthly)
E
e
Supply
d
D
c
C
Price (pence per kg)
b
B
a
A
a
A
Demand
Quantity (tonnes 000s)
32
The Determination of Price

• Equilibrium price and output
• response to shortages and surpluses
• significance of equilibrium
• Demand and supply curves
• effect of price being above equilibrium

33
The Determination of Price

• Equilibrium price and output
• response to shortages and surpluses
• significance of equilibrium
• Demand and supply curves
• effect of price being above equilibrium
• surplus ? price falls

34
The determination of market equilibrium
(potatoes monthly)
E
e
Supply
c
C
Price (pence per kg)
b
B
a
A
Demand
Quantity (tonnes 000s)
35
The Determination of Price

• Equilibrium price and output
• response to shortages and surpluses
• significance of equilibrium
• Demand and supply curves
• effect of price being above equilibrium
• surplus ? price falls
• effect of price being below equilibrium

36
The Determination of Price

• Equilibrium price and output
• response to shortages and surpluses
• significance of equilibrium
• Demand and supply curves
• effect of price being above equilibrium
• surplus ? price falls
• effect of price being below equilibrium
• shortage ? price rises

37
The determination of market equilibrium
(potatoes monthly)
E
e
Supply
d
D
c
C
Price (pence per kg)
a
A
Demand
Quantity (tonnes 000s)
38
The determination of market equilibrium
(potatoes monthly)
E
e
Supply
d
D
c
C
Price (pence per kg)
b
B
a
A
Demand
Quantity (tonnes 000s)
39
The Determination of Price

• Equilibrium price and output
• response to shortages and surpluses
• significance of equilibrium
• Demand and supply curves
• effect of price being above equilibrium
• surplus ? price falls
• effect of price being below equilibrium
• shortage ? price rises
• equilibrium where D S

40
The determination of market equilibrium
(potatoes monthly)
E
e
Supply
d
D
Price (pence per kg)
b
B
a
A
Demand
Qe
Quantity (tonnes 000s)
41
The Determination of Price

• Effects of shifts in the demand curve
• movement along S curve and new D curve
• rise in demand (rightward shift) ? P rises
• fall in demand (leftward shift) ? P falls

42
Effect of a shift in the demand curve
P
S
g
Pe1
D2
D1
O
Qe1
Q
43
Effect of a shift in the demand curve
P
S
Pe2
g
Pe1
D2
D1
O
Qe1
Qe2
Q
44
Effect of a shift in the supply curve
P
S2
S1
g
Pe1
D
O
Qe1
Q
45
Effect of a shift in the supply curve
P
S2
S1
Pe3
g
Pe1
D
O
Qe3
Qe1
Q
46
Elasticity

• A measure of how a change affects either quantity
  supplied or quantity demanded
• Examples
• Price and Quantity Demanded
• Income and Demand
• Price and Quantity Supplied

47
Price Elasticity of Demand

• A measure of how a change in price affects the
  quantity demanded.
• What sign (positive or negative) should price
  elasticity of demand have?

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Elastic versus Inelastic

• A good or service whose quantity demanded changes
  a great deal in response to a price change is
  said to be elastic.
• A good or service whose quantity demanded changes
  very little in response to a price change is said
  to be inelastic

49
Demand Elasticity

• ? -? perfectly elastic
• -? lt ? lt -1 elastic
• ? -1 unit elastic
• -1 lt ? lt 0 inelastic
• ? 0 perfectly inelastic

50
Cross-price Elasticity

• A measure of how a change in the price of one
  good affects the demand for another good.
• What will be the sign if goods i and j are
  substitutes?
• What will be the sign if goods i and j are
  complements?

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Income Elasticity of Demand

• A measure of how a change in income affects the
  quantity demanded.

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Income Elasticity of Demand

• Normal Good Positive income elasticity
• Gasoline
• Cable television
• Inferior Good Negative income elasticity
• Bus service
• Macaroni and Cheese
• Luxury Good Income elasticity greater than one
• Furs
• Cruises

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Ways to allocate product in a market

• Market solution
• equilibrium pricingeveryone who wants an
  apartment at the market price gets one
• Discriminating monopolist
• knows everyones reservation price so exactly the
  same people get apartments as in competitive case
  but all surplus goes to monopolist as each pays
  exactly the highest price they were willing to
  pay)

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• Ordinary Monopolist
• restricts supply to increase price and thus
  maximize profits)
• Rent Control
• Excess demand if rent control is made below
  market equilibriumallocation of apartments may
  go to different people than under competitive
  conditions
• there also will end up being fewer rented if
  supply curve is not vertical

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• Pareto Efficient solution No one can be made
  better off without making someone else worse off.
• Pareto Improvement At least one person is made
  better off without making anyone worse off.
• Pareto Inefficiency There exists a way to make
  at least one person better off without making
  anyone worse off.