Microeconomics Level 1

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HM TREASURY

• Microeconomics Level 1

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COURSE OBJECTIVES

• This course has three objectives
• to provide an overview of the scope and methods
  of economics
• to offer a self-contained introduction to key
  themes in microeconomics
• to equip participants to proceed to Level 2

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COURSE OBJECTIVES

• Economic analysis aims to be rigorous, but it
  need not be technical.
• No prior knowledge of economics or mathematics is
  assumed.

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• Microeconomics Level 1
• 0915 Registration
• 0930 Course objectives and outline
• 0940 Introduction to economics
• COFFEE
• 1100 What markets do supply, demand, and
  equilibrium
• Group work
• Review of group work
• 1300 LUNCH
• 1400 Market failure, and government intervention
• 1445 Group work
• Review of group work TEA
• 1530 Cost benefit analysis
• 1600 Lessons from Level 1
• 1610 Test
• 1645 End

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INTRODUCTION TO ECONOMICS

• CONCEPTS TOOLS

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Basic Concepts

• Stocks and Flows
• Goods and services

of National Output of National Output of National Output of National Output of National Output
Agriculture Industry Services
UK 1965 3 46 51
UK 1997 2 30 68
France 1965 8 39 53
France 1997 2 27 71
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Basic Concepts

• What, how and for whom
• Markets versus Command Economy

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Basic Concepts

• MICROECONOMICS detailed study of decisions made
  by consumers, producers and their interaction in
  specific markets
• MACROECONOMICS big picture emphasizes
  interactions in the economy as a whole.

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Basic Concepts

• POSITIVE ECONOMICStries to explain behaviour
• NORMATIVE ECONOMICS prescriptions based on value
  judgments

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Basic Concepts The Production Possibility
Frontier

• Maximum quantity one good that can be
  produced, given quantities of other goods being
  produced

A, B, C efficient (on the frontier) D, E
inefficient (inside the frontier) F, G
unattainable (outside the frontier)
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Basic Concepts

• OPPORTUNITY COST OF A GOOD
• What we could have had instead

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Basic Concepts

• COMMAND ECONOMY
• central planner issues orders
• FREE MARKET ECONOMY
• what, how for whom decided by prices, incomes,
  wealth
• DEGREES OF GOVERNMENT INTERVENTION

Hong Kong
- China - Denmark - UK - USA -
Cuba
? (but how long?)
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Scale of government(spending as of national
income)
1880 1930 1960 1990
Japan 11 19 18 32
USA 8 10 28 36
UK 10 24 32 41
Germany 10 31 32 45
France 15 19 35 52
Sweden 6 8 31 50
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TOOLS

• MODEL
• Deliberate simplification of reality
• like a map
• DATA
• TIME SERIES
• CROSS SECTION

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TOOLS

• NOMINAL REAL VARIABLES

1970 1982 1991
Unit labour costs 100 406 589
Retail prices 100 438 720
Real unit labour costs 100 93 82
Real unit labour costs (Unit labour costs /
Retail prices) x 100
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Tools Visualizing data

• A scatter diagram

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Tools Interpreting the data
It appears that higher bus fares cause higher
revenue
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Tools Interpreting the data
but it might not be true
Suppose the two clusters are from two different
time periods what might that imply?
High tube fare
Low tube fare
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Tools Interpreting the data

• Bus revenue depends on bus fare
• But it also depends on other things
• incomes
• price of other modes of travel
• relative reliability (relative to other modes of
  travel)
• relative comfort
• relative perception of safety

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WHAT MARKETS DO

• DEMAND, SUPPLY PRICE ADJUSTMENT

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Market

• DEMAND quantity buyers wish to buy at each
  price
• SUPPLY quantity producers wish to sell
  at each price
• MARKET arrangement to exchange goods
  services
• EQUILIBRIUM PRICE the price at which market
  clears (i.e. quantity demanded quantity
  supplied)

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Market
Supply curve
price
Equilibrium Price
Demand curve
Equilibrium Quantity
quantity
PRICE ADJUSTMENT
Equilibrium price clears market
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Market

• The demand curve shows the relation between price
  of a good and quantity demanded of that good.
• But how does demand change when other things
  change?

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DEMAND IN MORE DETAIL elaborating on the
other things

• How does DEMAND for a good vary when
• 1 price of a related good changes?
• substitutes
• complements
• 2 consumers income changes?
• normal goods
• inferior goods
• 3 tastes change?
• role of fashions and fads, culture

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COMPARATIVE STATICS (effect of changing the
other things)

• Suppose income rises, increasing demand

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SUPPLY IN MORE DETAIL elaborating the other
things

• How does SUPPLY of a good vary when
• technology improves?
• input prices change? energy, labour, capital
• 3 regulation imposes extra costs?

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COMPARATIVE STATICS

• Suppose technical breakthrough raises supply

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COMPARATIVE STATICS

• An important difference
• If demand shifts, equilibrium price and quantity
  move in the SAME DIRECTION
• If supply shifts, equilibrium price and quantity
  move in OPPOSITE DIRECTIONS

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SOME EXAMPLES

• Third world farming
• What is the effect of better irrigation
  fertilizer?
• What happens to price? To quantity?
• To revenue?
• Computers
• Over the last 5 years the price of a PC has
  been falling.
• Which is shifting, demand or supply?

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GROUPWORK
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Introduction to EconomicsGROUPWORK

• 1 Are the following statements positive or
  normative?
• (a) Higher tax rates cut revenue from tobacco
  taxes
• (b) Poor countries got an unfair share of
  world income
• (c) Smoking is antisocial should be
  discouraged
• (d) Airbus needs public support
• (e) Airbus deserves public support
• (f ) Airbus is a good investment for Britain

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GROUPWORK

• The price of crude oil increased from 2.90 to 9
  per barrel in 1973, in a coordinated move by OPEC
  members.
• (a) How did the OPEC members manage to raise the
  price? Show using a supply-demand diagram for the
  oil market.
• (b) What happened to the demand for coal and the
  price of coal? Show using a supply-demand
  diagram for the coal market.
• (c) What happened to the demand for fuel-guzzling
  cars?
• (d) What happened to supply and demand for oil
  eventually?

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GROUPWORK

• 3 The following data describe price and output of
  a product
• (a) Plot a scatter diagram
• (b) Higher prices make firms raise output.
• People buy less when prices are higher
• Does the diagram shed any light on these
  statements?
• Could both be correct? Explain.

Year Price Output
1985 100 101
1986 104 107
1987 108 112
1988 112 122
1989 118 128
1990 117 128
1991 108 118
1992 98 103
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Year Price Output
1985 100 101
1986 104 107
1987 108 112
1988 112 122
1989 118 128
1990 117 128
1991 108 118
1992 98 103
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Year Price Output
1985 100 101
1986 104 107
1987 108 112
1988 112 122
1989 118 128
1990 117 128
1991 108 118
1992 98 103
Construction Industry
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GROUPWORK

• 4 For each government intervention listed below,
  identify the possible rationale.
• (a) Income tax
• (b) Taxation of petrol
• (c) Regulating gas prices
• (d) Banning the use of cannabis
• (e) Running the NHS
• (f ) Maintaining an army

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WHAT GOVERNMENT DOES

• Why Intervene?

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The Role of Government

• IF MARKETS ARE EFFICIENT (i.e. invisible hand
  works), the government could confine attention
  to
• Legislation and general regulation
• Redistribution (taxation and transfer payments)
• Macroeconomic management (stabilization, etc)

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The Role of Government

• However, sometimes free markets are not
  efficient
• These instances are called MARKET FAILURES
• When markets fail, the government could
  intervene for efficiency reasons

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SOURCES OF MARKET FAILURE

• 1. EXTERNALITIES
• One person's decisions/choices affect others
  DIRECTLY
• If markets were free and unregulated
• cannot be made to PAY for the HARM you
  inflict on others
• e.g. pollution
• cannot RECOVER all the value of BENEFITS
  you confer upon others
• e.g. use of green technology

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SOURCES OF MARKET FAILURE

• 1. EXTERNALITIES
• Individuals optimal decision is not optimal for
  society
• Result OVERPRODUCE the bad things,
  UNDERPRODUCE the good things.
• Market outcome is INEFFICIENT,
• Government intervenes to CORRECT INEFFICIENCY
• Policy Tools Tax, subsidy, quota, creating
  artificial markets

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SOURCES OF MARKET FAILURE

• PUBLIC GOODS
• Goods that we consume together, so that
• no individual can be excluded from consuming
• consumption by one does not leave less for others
• National defence
• Street lighting
• No one has any incentive to pay for such goods.
• In the absence of government intervention, too
  little of these will be provided.
• Government steps in to ensure right level is
  produced.

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SOURCES OF MARKET FAILURE

• 3. IMPERFECT COMPETITION
• If firms have market power (power to set prices
  above cost), markets are usually INEFFICIENT
• Once again, government can intervene to lower
  prices
• Example Regulation of National Grid
• 4. INFORMATIONAL PROBLEMS
• Example Health Insurance

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GOVERNMENT FAILURE

• In PRINCIPLE, the government can correct market
  failures
• In PRACTICE, the government
• does not always improve matters
• sometimes makes things worse
• Why?

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GOVERNMENT FAILURE

• INCENTIVE PROBLEMS
• INFORMATIONAL PROBLEMS
• RENT SEEKING CAPTURE
• SPILLOVERS ACROSS GOVERNMENTS
• Hence, must check for the possibility of
  GOVERNMENT FAILURE before jumping to conclusions.

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GROUPWORK
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MARKET FAILURE GOVERNMENT FAILURE GROUPWORK

• 1 There is a tax on cars in Central London
• (a) Why not leave things to the market? List the
  different motives for intervention.
• (b) Which of these are to do with efficiency?
• (c) Are there any other motives than efficiency?
• (d) Is there a possibility of government failure?

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MARKET FAILURE GOVERNMENT FAILURE GROUPWORK

• 2 If people want to watch advert-free terrestrial
  TV, there should be a market for this. So what is
  the case for the compulsory TV License?

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COST BENEFIT ANALYSIS
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COST-BENEFIT ANALYSIS

• Usually applied to government investment
  decisions
• roads
• channel tunnel
• subsidies to start-ups, RD
• The main question
• How do we value SOCIAL costs and benefits of a
  project?

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COST-BENEFIT ANALYSIS

• STEPS IN THE PROCEDURE
• check how the private sector would do it
• adjust for discrepancies between

Private valuations
Social Valuations
private profits private profits PLUS spillover benefits to others
private costs private costs PLUS
spillover costs borne by others
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COST-BENEFIT ANALYSIS

• EXAMPLE THE JUBILEE LINE EXTENSION
• PRIVATE VALUATIONS
• Costs present value of construction cost
• (say, takes 4 years to build)
• present value of future operating costs
• (maintenance, wages, electricity)
• Benefits present value of passenger fares
• Build if Net Present Value of project is positive
  
• (i.e. project is profitable).

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COST-BENEFIT ANALYSIS EXAMPLE THE JUBILEE LINE
EXTENSION

• SOCIAL COST BENEFIT ANALYSIS
• Were any social benefits or costs missed in the
  above valuation?

Externalities
Beneficial externalities less congestion on
roads less pollution helps integrate London
Harmful externalities vibration to houses above
line congestion near terminuses
Social cost benefit analysis should attempt to
measure as many of these implications as possible.
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LESSONS FROM MICROECONOMICS
Level 1
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• economic models are deliberate simplifications of
  reality
• other things equal streamlines thought but its
  validity needs checking
• supply and demand explain equilibrium price and
  quantity
• markets sometimes fail to be efficient
• governments could intervene to correct failure
• but government action is itself vulnerable to
  failures
• of course, governments also care about equity
• social cost benefit analysis tries to measure as
  many inputs and outputs of a project as possible

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MICROECONOMICS LEVEL 1
TEST