Microeconomics Class 1 PDF

Class 1 Created @August 23, 2024 1:05 AM Type Class Status Not started Number 1 classes Micro-Economics Introduction Exam Course material consists of...

Class 1 Created @August 23, 2024 1:05 AM Type Class Status Not started Number 1 classes Micro-Economics Introduction Exam Course material consists of theory and exercises from lectures exercises from tutorials Exam is written and closed book, and can cover the entire course material Allocation theory-exercises is 50%-50%: each counts for 10 out of 20 points What is expected from me Understand microeconomic concepts and the relationships between them Build the reasoning behind course topics from scratch Derive results from microeconomic theory mathematically graphically Apply theory to solve economic and business economic problems Class 1 1  Critically reflect on the effect of changes in policy or market conditions on economic variables methods to measure microeconomic concepts in practice Book Chapter 1 Remarks A. The mixed economy (‘a market economy’ with ‘government intervention’) we focus on is only one of several options, but it has worked reasonably well so far mixture of capitalism & socialism (in this case meaning government intervention) B. Two major shortcomings interactions of the economic system and the physical environment: environmental concerns, health concerns continuing income and wealth inequality, remaining poverty Class 1 2  A. The mixed economy has worked well… 1. Has some pros: GDP per Capita & 1. Mixed Economy: a mixture of Growth but there are negatives → capitalism and socialism ⇒ free Externality (hasn’t been sorted out market + government intervention by mixed economy) 2. This is a the Hockey stick of the 2. Nigeria vs. Botswana ⇒ Quality of Economy Institutions a. Private Property in the a. Led to betterment of living Capitalist Revolution standards for its people i. started this spectacular (Botswana) growth 3. South Korea → Quality of higher b. Business as units of Production Education + Pressure on International Level to be c. People are free to buy and not internationally competitive to buy 4. USSR → steady growth under i. free markets communism but when the switch ⇒ Competition thrives to occurred they dipped and could innovation not immediately recover How did these three a. They didn’t have stable characteristics lead to such a institutions - very corrupt ones spectacular growth ? b. Private Property rights were Private Property was an not protected enough incentive as it meant that if you Class 1 3  do well (meaning you c. Lack of competition → innovated and technologically monopolies and oligopolies progressed) everything you d. Did not address their market accumulated is yours and only failures yours. you needed to invest in technology —> progress increased productivity by allowing specialisation in the labour force B. ….but the mixed economy is far from perfect Environmental concerns: global warming, increasing pollution, excessive use of natural resources Externalities do not go away ! → Real Problem too much production, too much pollution Covid-19 Global Warming → This graph shows that it is really a man made problem! Class 1 4  Potential negative effects of globalization Inequality, both between and within countries Poverty Persistent Inequality Does not go away → 1. Different in Marginal Productivity of Labour (different levels of schooling) 2. Policy → How you set up taxes & minimum wages Hyper Meritocracy 1. How do you measure productivity of one individual of very high CEO → they set up their own remuniration Return to capital and growth 1. Accumulation of wealth & savings gives you more opportunity 2. We want some inequality → no disincentive to work & if you study more you get more If return on capital is higher than growth than rich will get richer because they are the only ones that can afford to invest in those amounts. Top Income Taxes Class 1 5  If you have too much inequality than people stop believing in meritocracy. → leads to class consciousness, uproar and revolution → we need progressive income distribution Crucial for understanding business decisions: pricing, investment, advertising, etc. you need predictions for consumer behaviour so that business can make these decisions Crucial for understanding (the effects of) government policy decisions: policies related to health, social security, employment, education, environment, trade, transport, housing, etc. how efficient are these policies? what is their effect on inequality and poverty? Ultimately, microeconomics should lead to better decisions by firms and governments Our approach Partly ‘classical’ approach: consumers, producers, market structure, role of the government classic approach means a rational consumer Partly emphasizing recent ‘non-classical’ insights Paying attention to applications whenever possible Chapter 2 Demand and Supply Analysis Class 1 6  Example: Oil price variability Blue line is consumption over years Oil shock of 73-74: oil supply went down to the crisis in the middle east; demand stayed constant ⇒ spike in the price Demand cannot adjust itself → demand is inelastic (you cannot change your resource use from day to night) Price Inelastic Supply & Demand 01-08: Demand for oil went up ⇒ supply or demand cannot be adjusted → supply is also inelastic (you overnight! cannot just make more oil) ⇒ spike in price demand of china goes up etc crisis of 08: Demand for oil goes down ⇒ price goes down Example: News Corp’s share price on the Nasdaq stock exchange Class 1 7  Perfectly explainable by the law of demand & supply Example: Bitcoin 2013 - 2021 Can be influenced by ad hoc reasons Overview 1. A quick review: demand, supply, equilibrium, elasticities 2. Back-of-the-envelope calculations 3. The identification problem 4. The effect of demand and supply shocks on market equilibrium: comparative statics 5. Multiple markets: general equilibrium Class 1 8  1. A quick review: demand, supply, equilibrium and elasticities Conventional graphic Price too high ⇒ excess supply Price too low ⇒ excess demand Moves along the curve: Estimation of price changes Demand & supply shift: Changes other than prices: 1. Income changes 2. Price of production changes Class 1 9  Elasticities Measure to what extent buyers and sellers respond to changes in market conditions price elasticity of demand and supply Measures how much the quantity demanded of a good responds to a change in price It is computed as the percentage change in the quantity demanded divided by the percentage change in price: Example: Numerical example: the direction of change matters If the price increases from $2.00 to $2.20 and the quantity Class 1 10  demanded falls from 10 to 8 units, then the elasticity of demand is calculated as: If the price decreases from $2.20 to $2.00 and the quantity demanded rises from 8 to 10 units, the elasticity of demand is calculated as: cross-price elasticity of demand and supply The midpoint formula or arc elasticity gives the same answer regardless of the direction of the change Price: $2.00 à $2.20; Quantity: 10 à 8 Price elasticity of demand Class 1 11  Measures how much the quantity demanded of a good responds to a change in the price of another good —> you take the mean of the change!!! Midpoint method It is computed as the percentage change in the quantity demanded of the first good divided by the percentage change in the price of the second good Sign determines whether goods are complements or substitutes income elasticity of demand Measures how much the quantity demanded of a good responds to a change in the consumer’s income It is computed as the percentage change in the quantity demanded divided by the percentage change in income Typology: Income elasticity Classification Example Food, fuel, utilities, clothing, milk, medical >0 Normal good services, … between 0 and 1 Necessity Milk, eggs, utilities, … >1 Luxury good Sports cars, sailing boats, fresh fruit, … specificity matters Necessities versus luxuries Time horizon (short-run vs long-run) ⇒ Demand tends to be more elastic : the larger the number of close substitutes the more narrowly defined the market if the good is a luxury the longer the time horizon (exception: durable goods. Why? With durable goods —> ex. cars you can adapt in the short run because they give utility over multiple periods of time. f.ex if you were planning to buy a new car but has become more expensive, you will refrain from doing so because (in the short run) because your car is durable. But in the long run you need to make the purchase because your car will not be functional forever. Elastic and inelastic demand Class 1 13  If Elasticity is between -1 and 0 —> inelastic If Elasticity is between -1 and - ∞ —> elastic opassen dh sinn real number net absolut numbers (dh mam sign) —> ouni sign ass et einfach between 0 & 1 ass et inelastic an mei grouss wei 1 ass et elastic. Price elasticity of demand along a (linear) demand curve Class 1 14  Price elasticity of demand is not always the same on the same curve! At some points it will be highly elastic, at other highly inelastic. → Above Equilibrium it will be elastic, below equilibrium it will be inelastic! Elastic part: between - ∞ and -1 ; Inelastic part: between -1 and 0 -1 is in the middle of the demand curve → ALWAYS Formula: Q = a-bP P= a/b - Q/b -b x ((intercept a - Qd / slope b)/Qd) = - intercept a - Qd / Qd Comparing price elasticity of demand (in a given point) on different demand curves Class 1 15  Comparing D1 and D2: D2 is more horizontal → more flat = more elastic D1 is more vertical → more steep = more inelastic If we increase P with deltaP for D1 we lose Q1 only → small amount, meaning small response to price change = INELASTIC If we increase P with deltaP for D2 we lose Q2 → big amount, meaning big response to price change = ELASTIC Price Elasticity of demand and the impact of a price increase on revenues Class 1 16  → TR can be seen as a demand curve Price elasticity of demand has an impact on a firms price strategy! TR = P x Q(P) → if P is high then Q(P) will be low How total revenue changes when price increases: Inelastic demand With demand inelastic, an increase in price from 5 to 6 leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases from 200 to 225. ⇒ good idea to increase because TR has gone up How total revenue changes when price increases: Elastic demand Class 1 17  With demand elastic, an increase in the price from 5 to 6 leads to a decrease in quantity that is proportionately larger. Total revenue decreases from 200 to 120. ⇒ not a good idea to increase because it has gone down Price Elasticities of demand: Examples Cross-Price elasticity of demand Measures how much the quantity demanded of a good responds to a change in the price of another good It is computed as the percentage change in the quantity demanded of the first good divided by the percentage change in the price of the second good Sign determines whether goods are complements or substitutes Cross - Price Elasticities of demand: Examples Class 1 18  The price elasticity of supply Measures how much the quantity supplied responds to a change in price Computed as the percentage change in the quantity supplied divided by the percentage change in price Elasticity of supply: Determinants Ability of sellers to change the amount of good they produce Class 1 19  beachfront land and specialized medical surgery is inelastic books, cars, and most manufactured goods are elastic Time period supply tends to be more elastic in the long run —> if more time has passed then supply will react more, because it has time to change its inputs ex: hire more workers, buy new machines etc… exceptions: some minerals —> aluminium, if demand goes up, producers want to supply more (because they can increase price), in the short run they can directly start extracting more aluminium from a stock of scrap metal (recycle), but in the long run you will go out and so their supply will go down again.⇒ inverse reaction to normal supply elasticity Short-run and long-run supply curves Back-of-the-envelope calculations Very often people in business and government have only crude and limited information Class 1 20  access the effect of policy change on price & quantity Still, it is often possible to predict the effect of policy changes quite accurately; this works in two steps use information on one observation and an estimate of the price elasticity to recover demand and supply functions use the ‘constructed’ functions to ‘predict’ the effect of the policy change Such back-of-the-envelope calculations are often useful to get a quick first idea of the effect of policy changes or changes in market demand or supply Methodology First determine demand and supply functions use one observation (on price and quantity) → 1 equilibrium assume specific form for the demand and supply functions → ex. linear use an estimate of the price elasticities of demand and supply Why does this method work? Intuition: there is only one demand function that has the proposed functional form, that passes through a given price-quantity observation, and that is consistent with the information on price elasticities you have a point, you have the elasticity (so you also have the slope) technically then you can draw it!! same holds for the supply side Then calculate the effect of the policy change Class 1 21  Example: Demand Basic information (assume linear demand/supply) estimates of price elasticities of demand and supply one observed price-quantity combination (P^∗,Q^∗) ⇒ a-bP = linear demand curve!! 1. First formula is given 2. Elasticity is given so replace EDQ = -derivative x P/Q (-derivative = -b = slope) 3. We know 3 of these variables 4. Turn it around and find b 5. Turn it around and find a Supply Also works for other functional forms of demand and supply (for example, log linear) Class 1 22  Consider an example: OPEC-supply cuts on the oil market Oil supply comes from two major groups of countries: competitive suppliers + OPEC members competitive supply is price-responsive: it reacts to price changes supply by OPEC is determined by agreement of its member countries in special meetings, supply is fixed allocated among member countries How to predict the effects of a supply cut buy OPEC? The 2011 OPEC oil supply cut In 2011, oil price on international markets was about 80 USD per barrel world demand and supply was 32 billion barrels 19 billion barrels of supply came from competitive (non- OPEC) countries, 13 billion barrels from OPEC countries The following elasticity information has been estimated by industry analysts Short-run Long-run Class 1 23  Demand -0,05 -0,3 Supply 0,05 0,3 Unexpectedly, OPEC decided to cut its supply by 3 billion barrels what are the expected effects on the oil market? Interpretation Class 1 24  the supply cut has an enormous effect on the price the quantity is hardly affected because the -3 barrels from OPEC were compensated by the competitive suppliers. Demand for oil is inelastic so regardless of the price they will buy it ! Long - run Class 1 25  long run Identification Problem Can we learn about demand and supply functions from observations on prices and quantities only? The general answer is NO Changes in market demand due to changes in other determinants than the price are needed to identify the supply curve Changes in market supply due to changes in other determinants than the price are needed to identify the demand curve Observations on prices and quantities say nothing about demand and supply, only about equilibria Example: Shifts in supply identify demand Class 1 26  You need a shift in supply to give you a second point (28,10). You can only draw a function curve with two points so you need to derive one from the other! But just one observation is not enough! → you need a shock of supply! and vice-versa! Either you have 1 observation and Elasticity Or you have two observations on the same demand curve Nothing can be learnt from observations on prices and quantities: more information is needed on what shifted demand and/or supply If you are sure demand was stable but supply was changing over time, then the observed price-quantity combinations give you the demand function If you are sure supply was stable but demand was changing over time, then the observed price-quantity combinations give you the supply function Recall Write 3+ Qs to test Future You Write 3+ Qs to test Future You Class 1 27