ECN-261 Principles of Microeconomics Lecture Notes PDF

ECN-261 Principles of Microeconomics Lecturer: Dr Afroditi Kero What is this course about? ❑This course is a first glance in the economic way of thinking and working. ❑It is relevant to you because through this course you are going to: ▪ understand the basics notions and theories that explain ho...

ECN-261 Principles of Microeconomics Lecturer: Dr Afroditi Kero What is this course about? ❑This course is a first glance in the economic way of thinking and working. ❑It is relevant to you because through this course you are going to: ▪ understand the basics notions and theories that explain how the economics system, we live in, is organized and how it operates. ▪ acquire important qualitative and quantitative skills Objectives of the Course The main objectives of the course are to: ❑Develop an economic way of thinking ❑Introduce graphical analysis ❑Introduce the concepts of demand and supply ❑Introduce the decision-making process regarding the optimal level of output ❑Identify and distinguish among different market structures Learning Outcomes After completion of the course students are expected to be able to ❑Apply graphical analysis on economic issues ❑Identify how equilibrium price is determined in a free market through the interaction of supply and demand ❑Demonstrate the concepts of demand and supply analysis relevant to the business environment ❑Analyze market examples and applications to simulate realistic business experience ❑Discuss the dynamics of income distribution and resource allocation Course Contents 1. Introduction to Economics 2. Scarcity, Choice and Opportunity Cost 3. Demand and Supply 4. Elasticity 5. Demand and Supply Applications 6. Consumer choice 7. Output and Costs 8. Perfect competition 9. Monopoly 10.Monopolistic competition and oligopoly Contact Details ❑Lecturer: Dr Afroditi Kero ❑E-mail: [email protected] ❑Office Hours: At the end of the lecture and by appointment Bibliography Required Textbook ❑Economics, 11th European edition, Pearson (2021), Parkin M, Powell M and Matthews K., ❑Book link through the University’s library: https://ebookcentral.proquest.com/lib/nicosia/detail.action?docID=5 186435 ❑You can find older versions of the book easily online ❑Lecture Notes Assessment Methods ❑Final Examination (40 multiple choices) – 50% ❑Midterm Examination (30 multiple choices) – 40% ❑Participation – 10% ❑Attendance Regulations: Students are required to attend all classes  Chapter 1 What is Economics? 1 Week Topics: st ❑A Definition of Economics ❑Big Questions in Economics ❑The Economic Way of Thinking ❑ Quiz Review ❑Graphing Data A definition of Economics ❑All economic questions arise because we want more than we can get. ❑Our inability to satisfy all our wants is called scarcity. ❑Because we face scarcity, we must make choices. ❑Scarcity is universal. It affects both the rich and the poor. A definition of Economics ❑ Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity. ❑Economics divides into two parts: ▪ Microeconomics ▪ Macroeconomics A definition of Economics ❑Microeconomics is the study of choices that individuals and businesses make, the way these choices interact in markets and the influence of government on those choices. ❑Macroeconomics is the study of the effects on the national economy and the global economy of the choices that individuals, businesses and governments make. Big Economic Questions Two big questions summarize the scope of economics: ❑ How do choices end up determining what, how, when, where and for whom goods and services get produced? ❑ When do choices made in the pursuit of self-interest also promote the social interest? Economic Questions What, How, When, Where and For Whom? ▪ People value goods and services because they satisfy theirs needs and wants. ❑What should we produce? ▪ Do we produce more cars or more wheat? ▪ What we produce changes over time as changes in technology allow us to produce more. ▪ The facts about what we produce raise the deeper question: What determines the quantities of education and health services, new homes, cars, machines, bread, etc that we produce? Economics provides some answers to these questions about what to produce. Economic Questions What we produce? Source of data: CIA World Factbook 2020 Economic Questions What, How, When, Where and For Whom? ❑ How should we produce the goods and services that we need? ❑ Goods and services are produced by using productive resources that economists call factors of production, which are grouped in four big categories: ▪ Land ▪ Labour ▪ Capital ▪ Entrepreneurship Economic Questions What, How, When, Where and For Whom? ❑ Land: The “gifts of nature” (natural resources) that we use to produce goods and services are land. ❑ Labour: The work time and effort that people devote to producing goods and services is labour. ❑ Capital ▪ Physical Capital: The tools, instruments, machines, buildings, and other constructions that are used to produce goods and services are physical capital. ▪ Human Capital: The quality of labour depends on human capital, which is the knowledge and skills that people obtain from education, on-the-job training, and work experience. ❑ Entrepreneurship: The human resource that organizes land, labour, and capital is entrepreneurship. Economic Questions A measure of human capital Source of data: OECD, Education at a Glance 2020 Table A1.2 Economic Questions What, How, When, Where and For Whom? ❑ When should we produce ? ❑ The economic production is not constant. Sometimes production slows down (recession) and other times it expands rapidly. ❑ A recession is a significant decline in economic activity spread across the economy ❑ A business cycle describes the fluctuations in an economy over a period, generally the period from the start of one recession to the start of the next. ❑ What makes production rise and fall? Can government action prevent recession? ❑ Economics helps us to answer questions about when things are produced. Economic Questions What, How, When, Where and For Whom? Economic Questions What, How, When, Where and For Whom? ❑Where should we produce? ▪ Ford Motor company produces cars in several countries and sells them in many more countries. ▪ Financial services are concentrated in Frankfurt and London, while IT industries concentrate in Silicon Valley (US). ▪ Economics helps us to answer questions about where things are produced. Economic Questions What, How, When, Where and For Whom? ❑For Whom should the goods and services be produced? ▪ Who gets the goods and services depends on the incomes that people earn. Land earns rent. Labour earns salaries (wages). Capital earns interest. Entrepreneurship earns profit. The Economic Way of Thinking ❑Choices and Trade-offs ▪ The economic way of thinking places scarcity and its implication, choice, at centre stage. ▪ You can think about every choice as a trade-off—giving up one thing to get something else. ▪ For example, we face a trade-off between longer hours of work and less free time: we cannot have both. The Economic Way of Thinking What, How, and For Whom Trade-offs ❑The questions what, how, and for whom become sharper when we think in terms of trade-offs. ❑“What?” Trade-offs arise when people choose how to spend their incomes, when governments choose how to spend their tax revenues, and when businesses choose what to produce. ❑“How?” Trade-offs arise when businesses choose among alternative production technologies. ❑“For Whom?” Trade-offs arise when choices change the distribution of buying power across individuals. Government redistribution of income from the rich to the poor creates the big trade-off—the trade-off between equality and efficiency. The Economic Way of Thinking What, How, and For Whom Trade-offs We face three trade-offs between enjoying current consumption and leisure time and increasing future production, consumption, and leisure time. I. If we consume less today, we can have more capital and increase production in the future. II. If we take less leisure today, we can increase our human capital and increase production in the future. III. If we devote more resources to creating new technologies, we produce less today but more in the future. The Economic Way of Thinking Opportunity Cost ❑ Thinking about a choice as a trade-off emphasizes cost as an opportunity forgone. ❑ The highest-valued alternative that we give up to get something is the opportunity cost of the activity chosen. ❑ In other words, there is no such a thing as “free lunch”. If we want to have more of one thing, we must forego the opportunity of getting the next best thing. The opportunity cost is the sacrifice of this choice. ❑ Examples? The Economic Way of Thinking Choosing at the Margin ❑People make choices at the margin, which means that they evaluate the consequences of making incremental changes (a little more or a little less) in the use of their resources. ❑The benefit from pursuing an incremental increase in an activity is its marginal benefit. ❑The opportunity cost of pursuing an incremental increase in an activity is its marginal cost. The Economic Way of Thinking Choosing at the Margin ❑Example: An airline will have to decide how much to charge its passengers for the Paphos-Paris flight. Let's say the average cost is 250 euros per seat. ▪ Question: The company should never sell a ticket cheaper than 250 euros? ▪ But if twenty-four hours before the flight, there are ten empty seats left, and there are passengers willing to pay 200 euros for the ticket, the company should think in marginal terms and ask the following question: What will it cost to add an extra passenger? ▪ If the cost of the additional passenger is e.g., just his meal, then the company could make a profit by selling the extra seats at 200 euros instead of 250. If the company thinks in marginal terms, it can increase its profits. The Economic Way of Thinking Rational Behaviour ❑For any activity, if marginal benefit exceeds marginal cost, people have an incentive to do more of that activity. ❑If marginal cost exceeds marginal benefit, people have an incentive to do less of that activity. ❑Doing more of an activity if the marginal benefit is greater that marginal cost, describes rational behaviour. The Economic Way of Thinking Human Nature, Incentives and Institutions ❑Economists take human nature as given and view people as acting in their self-interest. ❑Self-interested actions are not necessarily selfish actions. ❑But if human nature is given and people pursue self-interest, how can the social interest be served? ❑Economist answer this question by emphasizing the role of institutions that create incentives to behave in the social interest. ❑The paramount “institution” is the rule of law that protects private property and facilitates voluntary exchange in markets. Economics: A Social Science ❑ Economic science attempts to understand the economic world. The distinction between "what is" and "what ought to be" is important. ❑ Positive statements describe how the world is; they can be tested and possibly rejected if there is insufficient evidence. Positive statements tell “what is”. ▪ For example, the statement “Smoking causes lung cancer" is a positive statement because it can be tested with the help of sufficient scientific (medical or statistical) data. ❑ Normative statements tell how the world should be; they depend on value judgments and cannot be tested. Normative statements tell "what ought to be". ▪ For example, the statement “You should not smoke" is a normative statement because it involves ethical judgment. You may agree with or disagree with the statement, but you cannot test it. Economics: A Social Science ❑The task of economic science is to discover positive statements that are consistent with what we observe in the world and that enable us to understand how the economic world works. ❑This task is large and breaks into three steps: I. Observation and measurement II. Model building III. Testing models Economics: A Social Science Observation and Measurement Economists observe and measure economic activity, keeping track of such things as: ❑Quantities of resources ❑Wages and work hours ❑Prices and quantities of goods and services produced ❑Taxes and government spending ❑Quantities of goods and services bought from and sold to other countries. Economics: A Social Science ❑Model Building: An economic model is a description of some aspect of the economic world that includes only those features of the world that are needed for the purpose at hand. ❑Testing Models: We test models to reject those that don’t fit the facts and identify the ones that do fit the facts. ❑Model and Theory: An economic theory is a generalization that summarizes what we think we understand about the economic choices that people make and the performance of industries and entire economies. Economics: A Social Science Obstacles and Pitfalls in Economics ❑Economists cannot easily do experiments, and economic behaviour has simultaneous causes. ❑To isolate the effect of interest, economists use the logical device called ceteris paribus or “other things being equal. ❑Economists try to isolate cause-and-effect relationship by changing only one variable at a time, holding all other relevant factors unchanged. ❑ Two common fallacies that economists try to avoid are: ▪ The fallacy of composition ▪ The post hoc fallacy Economics: A Social Science Obstacles and Pitfalls in Economics ❑The fallacy of composition, which is the false statement that what is true for the parts is true for the whole or what is true for the whole is true for the parts. ▪ Example: “Saving money improves an individual's financial security, so if everyone in the nation saves money instead of spending, the economy will improve.” ❑The post hoc fallacy from the Latin term “Post hoc, ergo propter hoc”—means “after this, therefore because of this,” which is the error of reasoning that a first event causes a second event because the first occurs before the second. ▪ Example: You have an ice cream shop and last week you changed one of the machines with a new one. In the end of the week profit was lower than expected. You attribute the lower profits in the new machine. Even though this is possible, other factors may have contributed to lower profits too like bad weather, the salesman got sick, etc. Review Quiz 1. Scarcity is a situation in which _______. a) we are unable to satisfy all our wants b) something is being wasted c) long queues for petrol form at service stations d) some people are poor, and some people are rich Review Quiz 1. Scarcity is a situation in which _______. a) we are unable to satisfy all our wants b) something is being wasted c) long queues for petrol form at service stations d) some people are poor, and some people are rich Review Quiz 2. People who sell the services of the factor of production _____ earn an income called ______. a) land; interest b) capital; profit c) entrepreneurship; rent d) labour; wages Review Quiz 2. People who sell the services of the factor of production _____ earn an income called ______. a) land; interest b) capital; profit c) entrepreneurship; rent d) labour; wages Review Quiz 3. The choices that you make are _______. a) choices made in the social interest b) the best choices for society c) choices made in self-interest d) choices that make the best use of society’s resources Review Quiz 3. The choices that you make are _______. a) choices made in the social interest b) the best choices for society c) choices made in self-interest d) choices that make the best use of society’s resources Review Quiz 4. When the government increases taxes and spends the extra revenue on airport security, its choice involves______. a) no trade-off b) a better use of resources c) a trade-off between other goods and services and airport security d) a trade-off between taxes and airport security Review Quiz 4. When the government increases taxes and spends the extra revenue on airport security, its choice involves______. a) no trade-off b) a better use of resources c) a trade-off between other goods and services and airport security d) a trade-off between taxes and airport security Review Quiz 5. Last month, you played tennis once. This month, you play twice. So, this month, your ____. a) opportunity cost of a game has risen b) marginal cost of a game must have fallen c) marginal cost of a game exceeds its marginal benefit d) marginal benefit from the first game exceeds its marginal cost Review Quiz 5. Last month, you played tennis once. This month, you play twice. So, this month, your ____. a) opportunity cost of a game has risen b) marginal cost of a game must have fallen c) marginal cost of a game exceeds its marginal benefit d) marginal benefit from the first game exceeds its marginal cost Review Quiz 6. The statement that ________________ is a positive statement. a) consumers deserve lower interest rates on credit cards b) the fine for drunk driving is too low c) police roadside checks for drunk drivers during December decreases the number of accidents d) police should increase the number of roadside checks for drunk drivers throughout the year Review Quiz 6. The statement that ________________ is a positive statement. a) consumers deserve lower interest rates on credit cards b) the fine for drunk driving is too low c) police roadside checks for drunk drivers during December decreases the number of accidents d) police should increase the number of roadside checks for drunk drivers throughout the year Review Quiz 7. The task of economic science is to _________________________. a) tell us what is good for us b) help us understand how the economic world works c) make moral choices about things like drugs d) save the earth from the overuse of natural resources Review Quiz 7. The task of economic science is to _________________________. a) tell us what is good for us b) help us understand how the economic world works c) make moral choices about things like drugs d) save the earth from the overuse of natural resources Chapter 1 Appendix Understanding Graphs in Economics Graphing Data ❑ In economics, we often use graphs to give us a picture of the relationships between variables. Let's first look at the basic construction of graphs. ❑ A graph is a visual representation of a relationship between any two variables such as, x and y. ❑ A graph consists of two axes called the x (horizontal) and y (vertical) axes. These axes correspond to the variables we are relating. In economics we will usually give the axes different names, such as Price and Quantity. ❑ The point where the two axes intersect is called the origin. The origin is also identified as the point (0,0). Graphs Graphs Two graphs of economic data Graphs ❑ A coordinate is one of a set of numbers used to identify the location of a point on a graph. Each point is identified by both an x and a y coordinate. ❑ The x-coordinate of a point is the value that tells us how far from the origin the point is on the horizontal, or x-axis. To find the x- coordinate of a point on a graph, draw a straight line from the point directly to the x-axis; the number where the line hits the x- axis is the value of the x-coordinate. ❑ The y-coordinate of a point is the value that tells you how far from the origin the point is on the vertical, or y-axis. To find the y- coordinate of a point on a graph, draw a straight line from the point directly to the y-axis; the number where the line hits the x- axis is the value of the y-coordinate. Graphs Graphs ❑ Once you have the coordinates of a point you can use the ordered pair notation for labeling points. The notation is simple. Points are identified by stating their coordinates in the form of (x, y). Note that the x-coordinate always comes first. For example, in the next graph, we have identified both the x and y coordinate for each of the points M and N. ▪ The x-coordinate of point M is 20; the y-coordinate of point B is 1; coordinates of point B are (20, 1). ▪ The x-coordinate of point N is 40; the y-coordinate of point N is 4; coordinates of point D are (40, 1). ▪ If a point is lying on an axis, we do not need to draw lines to determine the coordinates of the point. In the graph, point B lies on the y-axis and point A lies on the x-axis. When a point lies on an axis, one of its coordinates must be zero. The coordinates of point B are (0, 2). The coordinates of point A are (30, 0). Graphs Graphing Data ❑Economists use three types of graph to reveal relationships between variables. They are: ▪ Time-series graphs ▪ Cross-section graphs ▪ Scatter diagrams Graphing Data Time-Series Graphs ❑ A time-series graph measures time along the x-axis and the variable or variables in which we are interested along the y-axis. ▪ Time series graphs make trends easy to spot. These trends are important as they can be used to project into the future as variables exhibit cyclical patterns: the variable being studied does not exhibit a continual increase or decrease, but instead goes up and down depending upon the time of year. These cyclical patterns are also easy to see with a time series graph. ▪ The time series graph in the next slide shows the 5-year gold price history in US dollar per ounce. Time Series Graph Graphing Data Cross Section ❑ Cross section graphs show different observations made at a specific point in time. ▪ For example, we could show market shares of firms in the same industry, quantities of several goods (food, clothing, electrical appliances) bought at different levels of income, opinion polls during a pre-election campaign, production cost for different quantities, etc. ▪ Cross section graphs can take the form of bar charts or pie charts. ▪ The cross-section graph in the next slide shows the budget breakdown of EU’s Horizon 2020 Framework Program Cross section graph Graphing Data Scatter Diagrams ❑ One variable is plotted on the horizontal axis and the other is plotted on the vertical axis. The pattern of their intersecting points can graphically show relationship patterns. ❑ Scatter diagrams will generally show one of four possible correlations between the variables: ▪ Variables move in the same direction ▪ Variables move in opposite directions ▪ Variables have a maximum or a minimum ▪ Variables are unrelated Graphing Data Scatter Diagrams Graphing Data Scatter Diagrams  Graphing Data Scatter Diagrams Variables That Move in the Same and Opposite Directions ❑ A relationship between two variables that move in the same direction is called a positive relationship or a direct relationship. A line that slopes upwards shows a positive relationship. The value of Y increases as the value of X increases. ❑ A relationship between two variables that move in opposite directions is called a negative relationship or an inverse relationship. The value of Y decreases as the value of X increases. A line that slopes downwards shows a negative relationship. ❑ A relationship (positive or negative) shown by a straight line is called a linear relationship. A relationship shown by a curve is a called a non-linear relationship. ❑ The next slides show the positive and negative relationships. Graphing Data Positive (direct) relationships Graphing Data Negative (inverse) relationships Graphing Data ❑ Variables That Have a Maximum or a Minimum ▪ These relationships are positive over part of their range and negative over the other part. ❑ Unrelated Variables ▪ Many variables have no relationship or are independent of one another. For example, the quantity of milk is not related to the price of smart TVs. ▪ On the one hand, the x-variable does not change no matter what the value of the y-axis is. On the other hand, the y-variable remains constant irrespective of the value of the x-axis. The graphs on the next two slides show examples of variables with a maximum or minimum and variables with no relationships. Scatter diagrams Variables with a maximum or a minimum Scatter diagrams Unrelated variables Graphing Data Variables that are unrelated Graphing Data ❑One of the most important characteristics of graphs in economics is the rate at which the line or curve slopes upward or downward as we move to the right. The slope tells us how much one variable (y) changes in relation to the change of another variable (x). ❑The slope of a relationship is measured as the change in the value of the variable measured on the y-axis divided by the change in the value of the variable measured on the x-axis. Graphing Data The Slope of a Relationship ❑We use the Greek letter Δ (capital delta) to represent “change in”. ❑So ΔY means the change in the value of the variable measured on the y-axis and ΔY means the change in the value of the variable measured on the x-axis. ❑The slope of the relationship is (Y2 – Y1 )/ (X2 – X1 )= ΔY/ΔX. Graphing Data The Slope of a Relationship ❑ The slope of a straight line is constant. The slope is positive if the line is upward sloping. ❑ The slope of 0.25 (1/4) below tells us that there will be 1 unit increase in Y for every 4 units increase in X. Notice that the line with the greater slope is the steeper of the two. ❑ The greater the slope, the steeper the line. Graphing Data The Slope of a Relationship ❑ The slope is negative if the line is downward sloping. ❑ The slope of -1.5 (-3/2) below tells us that there will be 3 unit decrease in Y for every 2 units increase in X. Graphing Data The Slope of a Relationship ❑A horizontal line has a zero slope because the y-variable does not change. ❑A vertical line has an infinite slope because the x-variable does not change. Graphing Data The Slope of a Relationship ❑The Slope of a Curved Line ▪ The slope of a curved line at a point varies depending on where along the curve it is calculated. ▪ We can calculate the slope of a curved line either at a point or between two points (across an arc) Graphing Data The Slope of a Relationship ❑ The slope of a curved line at a point is equal to the slope of a straight line that is the tangent to that point. ▪ In graph (a) in the next slide, we calculate the slope of the curve at point A. The slope of the curve at that point is the slope of the tangent line. ❑ The slope of a curved line between two points (or across an arc) is equal to the slope of a straight line that joins the two points of the arc. It is, by definition, an average slope. ▪ In graph (b) in the next slide, we calculate the average slope of the curve along the arc BC or between points B and C. Graphing Data The Slope of a Relationship Graphing Data Linear relationship Graphing Data Calculating slope Graphing Data The y-axis intercept Graphing Data Negative relationship