Micro Economics - ECO402 Handouts PDF

Lesson No. TOPICS Page No. 1 Markets and prices 1 2 Markets and prices (continued) 3 3 The basics of supply and demand...

Lesson No. TOPICS Page No. 1 Markets and prices 1 2 Markets and prices (continued) 3 3 The basics of supply and demand 5 4 The basics of supply and demand (continued) 9 5 Elasticities of supply and demand 16 6 Consumer behavior 22 7 Consumer behavior (continued) 27 8 Consumer behavior (continued) 34 9 Marginal utility and consumer choice 36 10 Individual and market demand 41 11 Individual and market demand (continued) 46 12 Individual and market demand (continued) 51 13 Choice under uncertainty 56 14 Choice under uncertainty (continued) 60 15 Choice under uncertainty (continued) 64 16 Production 68 17 Production (continued) 73 18 Theory of costs 78 19 Theory of costs (continued) 82 20 Theory of costs (continued) 85 21 Theory of costs (continued) 89 22 Perfectly competitive markets 93 23 Perfectly competitive markets (continued) 97 24 Equilibrium in perfectly competitive markets 101 25 Equilibrium in perfectly competitive markets (continued) 104 26 Profit maximization and competitive supply 108 27 The analysis of competitive markets 112 28 The analysis of competitive markets (continued) 115 29 The analysis of competitive markets (continued) 119 30 Market structure and competitive strategy 122 31 Market structure and competitive strategy (continued) 126 32 Market structure and competitive strategy (continued) 129 33 Market structure and competitive strategy (continued) 133 34 Pricing with market power 137 35 Pricing with market power (continued) 141 36 Pricing with market power (continued) 144 37 Pricing with market power (continued) 148 38 Pricing with market power (continued) 151 39 Monopolistic competition 156 40 Oligopoly 158 41 Competition versus collusion 163 42 Markets for factor inputs 168 43 Markets for factor inputs (continued) 171 44 Markets for factor inputs (continued) 174 45 Markets for factor inputs (continued) 177 Micro Economics –ECO402 VU LESSON 1 MARKETS AND PRICES Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people. MICROECONOMICS VS. MACROECONOMICS Microeconomics deals with behavior of individual units. When Consuming; How we choose what to buy When Producing; How we choose what to produce Markets: The interaction of consumers and producers. Macroeconomics deals with analysis of aggregate issues: y Economic growth y Inflation y Unemployment Microeconomics is the foundation of macroeconomic analysis. THEMES OF MICROECONOMICS According to Mick Jagger & the Rolling Stones, “You can’t always get what you want”. Why Not? Š Limited Resources Š Unlimited Wants Allocation of Scarce Resources and Trade-offs Š In a planned economy Š In a market economy Microeconomics and Optimal Trade-offs 1. Consumer Theory 2. Workers 3. Theory of the Firm Microeconomics and Prices – The role of prices in a market economy – How prices are determined THEORIES AND MODELS Microeconomic Analysis Theories are used to explain observed phenomena in terms of a set of basic rules and assumptions. For example, the theory of the firm or the theory of consumer behavior. Models: A mathematical representation of a theory used to make a prediction. Validating a Theory The validity of a theory is determined by the quality of its prediction, given the assumptions. Evolving the Theory Testing and refining theories is central to the development of the science of economics. POSITIVE VERSUS NORMATIVE ECONOMICS Positive economics deals with the observations or predictions of the facts of economic life. For example: What will be the impact of an increase in wages on the price of a product? © Copyright Virtual University of Pakistan 1 Micro Economics –ECO402 VU Normative Economics is the value judgments about how economics should operate, based on certain moral principles or preferences?” For example: What wage rate should be paid to the auto workers to make them an active member of the society? WHAT IS A MARKET? Š Markets vs. Industries Market is a geographically defined area where buyers and sellers interact to determine the price of a product or a set of products. Industries are the supply side of the market. Š Defining the Market The market parameters must be set before an analysis of the market can take place. Š Arbitrage Buying a product at a low price in one location and selling at a high price in another. Š Competitive vs. Noncompetitive Markets – In competitive Markets,because of the large number of buyers and sellers, no individual buyer or seller can influence the price. Š Example: Most agricultural markets – Noncompetitive Markets are the markets where individual producers can influence the price. Š Example: OPEC Š Market Price – Competitive markets establish one price. – Noncompetitive markets may set many prices for the same product. Š Market Definition - The Extent of a Market – Market Definition Which buyers and sellers should be included in a given market? – Market Extent Defines the boundaries of the market Š Geographic Š Range of products – Examples – Geographic boundaries Š Gold: Lahore vs. Karachi Š Housing: Islamabad vs. Rawalpindi – Range of Products Š Gasoline: regular, super, & diesel Š Cameras: Polaroid, point & shoot, digital – Markets for Prescription Drugs Š Well-defined markets - therapeutic drugs Š Ambiguous markets – painkillers © Copyright Virtual University of Pakistan 2 Micro Economics –ECO402 VU LESSON 2 MARKETS AND PRICES (Continued) ECONOMICS; ANOTHER PERSPECTIVE Economics is the study of the choices made by people who are faced with scarcity. Scarcity is a situation in which resources are limited but can be used in different ways; so one good or service must be sacrificed for another. SOCIETY’S CHOICES The decisions of producers, consumers and government determine how an economic system answers three fundamental questions: 1. What products do we produce? 2. How do we produce these products? 3. Who consumes the products? FACTORS OF PRODUCTION Factors of production are the resources that are used to produce goods and services: 1. Natural resources: The things created by acts of nature such as land, water, mineral, oil and gas deposits, renewable and nonrenewable resources. 2. Labor: The human effort, physical and mental, used by workers in the production of goods and services. 3. Physical capital. All the machines, buildings, equipment, roads and other objects made by human beings to produce goods and services. 4. Human capital: The knowledge and skills acquired by a worker through education and experience. 5. Entrepreneurship: The effort to coordinate the production and sale of goods and services. Entrepreneurs take risk and commit time and money to a business without any guarantee of profit. THE PRODUCTION POSSIBILITIES FRONTIER (PPF) The PPF curve shows the possible combinations of goods and services available to an economy, g given that all productive resources are fully and 600 efficiently employed. Tons of factory goods per When the economy is at point i, resources are not 400 d fully employed and/or they are not used efficiently. Point g is desirable because it yields more of both goods, but not attainable given the amount of resources available. Point d is one of i the possible combinations of goods produced 300 when resources are fully and efficiently employed. 20 50 Tons of farm goods per day © Copyright Virtual University of Pakistan 3 Micro Economics –ECO402 VU SCARCITY AND THE PPF To increase the amount of farm goods by b 10 tons, we must sacrifice 100 tons of 700 c factory goods. 650 The PPF curve is bowed out because Tons of factory goods per year resources are not perfectly adaptable to the production of the two goods. As we d increase the production of one good, we 400 sacrifice progressively more of the other. e 300 120 f 10 20 50 60 70 SHIFTING THE PPF CURVE To increase the production of one good without decreasing the production of the other, the PPF curve must shift outward. The PPF curve shifts outward as a result of an increase in the economy’s resources OR a technological innovation that increases the output obtained from a given amount of resources. From point d, an additional 200 tons of factory goods or 20 tons of farm goods are now possible (or any combination in between). © Copyright Virtual University of Pakistan 4 Micro Economics –ECO402 VU LESSON 3 THE BASICS OF SUPPLY AND DEMAND REAL VERSUS NOMINAL PRICES Nominal price is the absolute or current dollar price of a good or service when it is sold. Real price is the price relative to an aggregate measure of prices or constant dollar price. The Consumer Price Index (CPI) is an aggregate measure. Real prices are emphasized to permit the analysis of relative prices. CALCULATING REAL PRICES CPI base year Real Price = x Nominal Price current year CPI current year CALCULATING THE REAL PRICE OF MILK Nominal Price Real Price of Milk Year of Milk CPI in 1970 dollars 1970.40 38.8.40=38.8/38.8x.40 1980.65 82.4.31=38.8/82.4x.65 1999 1.05 167.0.24=38.8/167.0x 1.05 CALCULATING REAL PRICES: AN EXAMPLE - EGGS & COLLEGE 38.8 1970 Real Price of Eggs = 163 x 1.04 1998 (1970 = 100) Real Price of 38.8 College Education = x $19,213 = $4,573 1998 (1970 = 100) 163.0 1970 1975 1980 1985 1990 1998 Consumer Price Index 38.3 53.8 82.4 107.6 130.7 163.0 (1983 = 100) Nominal Prices ($) Grade A 0.61 0.77 0.84 0.80 0.98 1.04 Large Eggs College 2530 3403 4912 8156 12800 19213 Education Real Prices ($1970) Grade A 0.61 0.56 0.40 0.29 0.30 0.25 Large Eggs College 2530 2454 2313 2941 3800 4573 Education © Copyright Virtual University of Pakistan 5 Micro Economics –ECO402 VU SUPPLY AND DEMAND THE SUPPLY CURVE Price ($ The Supply S The supply curve shows how much of a good per unit) Curve Graphically producers are willing to sell at a given price, holding constant other factors that might affect quantity supplied. This price-quantity relationship can be shown by the equation: P2 The supply curve slopes upward Q s = Q S(P ) P1 demonstrating that at higher prices firms will increase output Q1 Q2 Quantity P S’ S Change in Supply NON-PRICE DETERMINING VARIABLES OF SUPPLY Costs of Production Labor Capital P1 Raw Materials P2 The cost of raw materials falls – At P1, produce Q2 – At P2, produce Q1 – Supply curve shifts right to S’ – More produced at any price Q0 Q1 Q Q2 on S’ than on S Supply - A Review – Supply is determined by non-price supply-determining variables as such as the cost of labor, capital, and raw materials. – Changes in supply are shown by shifting the entire supply curve. – Changes in quantity supplied are shown by movements along the supply curve and are caused by a change in the price of the product. THE DEMAND CURVE Price ($ per The demand curve slopes The demand curve shows how much of a unit) downward demonstrating that consumers are willing to buy good consumers are willing to buy as the more at a lower price as product becomes relatively cheaper and price per unit changes holding non-price the consumer’s real income factors constant. This price-quantity increases relationship can be shown by the equation: Q D = Q D (P) D Quantity © Copyright Virtual University of Pakistan 6 Micro Economics –ECO402 VU NON-PRICE DETERMINING VARIABLES OF DEMAND P Change in Demand D D’ – Income – Consumer Tastes P2 – Price of Related Goods Substitutes Complements Income Increases P1 – At P1, produce Q2 – At P2, produce Q1 – Demand Curve shifts right – More purchased at any price on D’ than on D Q0 Q1 Q2 Q Demand - A Review – Demand is determined by non-price demand-determining variables, such as, income, price of related goods, and tastes. – Changes in demand are shown by shifting the entire demand curve. – Changes in quantity demanded are shown by movements along the demand curve. THE MARKET MECHANISM Price ($ per S Characteristics of the equilibrium or market unit) clearing price: – QD = QS The curves intersect at equilibrium, or – No shortage market clearing, – No excess supply price. At P0 the P0 quantity supplied is – No pressure on the price to change equal to the quantity demanded at Q0. D Q0 Quantity Price The market price is above equilibrium ($ per S A Surplus – There is excess supply unit) Surplus – Producers lower prices P1 – Quantity demanded increases and Assume the price is P1,then: quantity supplied decreases P2 1) Qs : Q1 > Qd : Q2 2) Excess supply is Q1:Q2. – The market continues to adjust until 3) Producers lower price. the equilibrium price is reached. 4) Quantity supplied decreases and quantity demanded increases. 5) Equilibrium at P2Q3 D Q3 Q2 Quantity Q1 © Copyright Virtual University of Pakistan 7 Micro Economics –ECO402 VU The market price is below equilibrium: Price – There is a shortage ($ per S Shortage – Producers raise prices unit) – Quantity demanded decreases and quantity supplied increases Assume the price is P2,: – The market continues to adjust until 1) Qd : Q2 > Qs : Q1 P3 the new equilibrium price is 2) Shortage is Q1:Q2. 3) Producers raise reached. price. 4) Quantity supplied P2 increases and quantity demanded decreases. 5) Equilibrium at P3, Q3 Shortage D Q1 Q3 Q2 Quantity Market Mechanism Summary 1) Supply and demand interacts to determine the market-clearing price. 2) When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium. 3) Markets must be competitive for the mechanism to be efficient. © Copyright Virtual University of Pakistan 8 Micro Economics –ECO402 VU LESSON 4 THE BASICS OF SUPPLY AND DEMAND (Continued) CHANGES IN MARKET EQUILIBRIUM Equilibrium prices are determined by the relative level of supply and demand. Supply and demand are determined by particular values of supply and demand determining variables. Changes in any one or combination of these variables can cause a change in the equilibrium price and/or quantity. For example: P D S Raw material prices fall S’ – S shifts to S’ – Surplus @ P1 of Q1, Q2 – Equilibrium @ P3, Q3 P1 P3 Q1 Q3 Q2 Q Raw material prices rise P D S’ S – S shifts to S’ – Shortage @ P1 of Q1, Q2 – Equilibrium @ P3, Q3 P3 P1 Q2 Q3 Q1 Q Income Increases P D D’ S – Demand shifts to D’ Shortage @ P1 of Q1, Q2 – Equilibrium @ P3, Q3 P3 P1 Q1 Q3 Q2 Q © Copyright Virtual University of Pakistan 9 Micro Economics –ECO402 VU P D’ D S Income Decreases – Demand shifts to D’ – Surplus @ P1 of Q1, Q2 – Equilibrium @ P3, Q3 P1 P3 Q2 Q3 Q1 Q P Income Increases & raw material prices fall D D’ S S’ – The increase in D is greater than the increase in S – Equilibrium price and quantity increase to P2, Q2 P2 P1 Q1 Q2 Q Income Increases & raw material prices fall P D S – The increase in D is less than the D’ S’ increase in S – Equilibrium price decrease to P2 and quantity increase to Q2 P1 P2 Q1 Q2 Q Income Decreases & raw material prices Fall P – The decrease in D is greater than the D’ D S S’ increase in S – Equilibrium price and quantity decrease to P1 P2 Q2 P2 Q2 Q1 Q © Copyright Virtual University of Pakistan 10 Micro Economics –ECO402 VU Š Income decreases & raw material prices fall P D’ S D – The decrease in D is less than the S’ increase in S – Equilibrium price decrease to P2 and quantity increase to Q2 P1 P2 Q1 Q2 Q SHIFTS IN SUPPLY AND DEMAND When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by: 1) The relative size and direction of the change 2) The shape of the supply and demand curves THE PRICES OF EGGS & EDUCATION REVISITED The real price of eggs fell 59% from 1970 to 1998. Supply increased due to the increased mechanization of poultry farming and the reduced cost of production. Demand decreased due to the increasing consumer concern over the health and cholesterol consequences of eating eggs. MARKET FOR EGGS Prices fell until P S1970 a new equilibrium (1970 was reached at $0.26 dollars per and a quantity dozen) of 5,300 million dozen S1998 $0.61 $0.26 D1970 5,300 5,500 Q (million dozens) PRICE OF COLLEGE EDUCATION Š The real price of a college education rose 68 percent from 1970 to 1995. Š Supply decreased due to higher costs of equipping and maintaining modern classrooms, laboratories and libraries, and higher faculty salaries. Š Demand increased due a larger percentage of a larger number of high school graduates attending college. © Copyright Virtual University of Pakistan 11 Micro Economics –ECO402 VU MARKET FOR COLLEGE EDUCATION P S1995 Prices rose until (annual a new equilibrium cost was reached at in 1970 $4,573 dollars) and a quantity $4,573 of 12 3 million S1970 $2,530 D1995 D1970 8.6 12.3 Q (millions of students enrolled) THE LONG-RUN BEHAVIOR OF NATURAL RESOURCE PRICES OBSERVATIONS – Consumption of copper has increased about a hundred fold from 1880 through 1998 indicating a large increase in demand. – The real price for copper has remained relatively constant. CHANGES IN MARKET EQUILIBRIUM Price S19 S19 S19 Long-Run Path of price D1900 D1950 D1998 Quantity CONCLUSION Decreases in the costs of production have increased the supply by more than enough to offset the increase in demand. © Copyright Virtual University of Pakistan 12 Micro Economics –ECO402 VU FACTORS SHIFTING DEMAND CURVE Factors Changing Effect on Direction of Effect on Effect on Demand Demand Shift in Equilibrium Equilibrium Demand Curve Price Quantity Increase in income Increase Rightward Increase Increase (normal good) Decrease in Decrease Leftward Decrease Decrease income(normal good) Increase in income Decrease Lefward Decrease Decrease (inferior good) Decrease in Increase Rightward Increase Increase income(inferior good) Increase in price of Increase Rightward Increase Increase Substitute Decrease in price of Decrease Leftward Decrease Decrease substitute Increase in price of Decrease Leftward Decrease Decrease complement Decrease in price of Increase Rightward Increase Increase complement Increase in taste and Increase Rightward Increase Increase preference for good Decrease in taste and Decrease Leftward Decrease Decrease preference for good Increase in number of Increase Rightward Increase Increase consumers Decrease in number of Decrease Leftward Decrease Decrease consumers FACTORS SHIFTING SUPPLY CURVE Factors Changing Effect on Direction of Effect on Effect on Supply Supply Shift in Supply Equilibrium Equilibrium Curve Price Quantity Increase in resource Decrease Leftward Increase Decrease price Decrease in resource Increase Rightward Decrease Increase price Improved technology Increase Rightward Decrease Increase Decline in technology Decrease Leftward Increase Decrease Expect a price increase Decrease Leftward Increase Decrease Expect a price decrease Increase Rightward Decrease Increase Increase in number of Increase Rightward Decrease Increase suppliers Decrease in number of Decrease Leftward Increase Decrease suppliers © Copyright Virtual University of Pakistan 13 Micro Economics –ECO402 VU ELASTICITIES OF SUPPLY AND DEMAND Generally, elasticity is a measure of the sensitivity of one variable to another. It tells us the percentage change in one variable in response to a one percent change in another variable. PRICE ELASTICITY OF DEMAND Price Elasticity of Demand measures the sensitivity of quantity demanded to price changes. It measures the percentage change in the quantity demanded for a good or services that results from a one percent change in the price of that good or service. The price elasticity of demand is: Percentage change in Quantity Demanded Percentage change in Price E P = (% ∆ Q)/(% ∆ P) The percentage change in a variable is the absolute change in the variable divided by the original level of the variable. So the price elasticity of demand is also: ∆ Q /Q P ∆Q EP = = ∆ P /P Q ∆P INTERPRETING PRICE ELASTICITY OF DEMAND VALUES 1) Because of the inverse relationship between P and Q; EP is negative. 2) If IEPI > 1, the percent change in quantity is greater than the percent change in price. We say the demand is price elastic. 3) If IEPI < 1, the percent change in quantity is less than the percent change in price. We say the demand is price inelastic. The primary determinant of price elasticity of demand is the availability of substitutes. – Many substitutes demand is price elastic – Few substitutes demand is price inelastic – PRICE ELASTICITIES OF DEMAND Price Ep = ∞ The lower portion of a 4 downward sloping demand curve is less Q = 8 - 2P elastic than the upper portion. Ep = -1 Linear Demand 2 Curve Q = a - bP Q = 8 - 2P Ep = 0 4 8 Q © Copyright Virtual University of Pakistan 14 Micro Economics –ECO402 VU Price 12 A Ep = -3 9 B Ep = 1 6 C Ep = -0.4 3 D D 0 2 3 6 10 Q Infinitely Elastic Demand Price P D Ep = - ∞ Quantity Completely Inelastic Demand Price EP = 0 Q Quantity © Copyright Virtual University of Pakistan 15 Micro Economics –ECO402 VU LESSON 5 ELASTICITIES OF SUPPLY AND DEMAND INCOME ELASTICITY OF DEMAND Income elasticity of demand measures the percentage change in quantity demanded resulting from a one percent change in income. The income elasticity of demand is: ∆Q/Q I ∆Q EI = = ∆I/I Q ∆I Income Elasticity of Demand for: – Normal goods – Superior goods – Inferior goods Quantity Demanded Income Elasticity less than 1 (but greater than 0) Normal goods Negative Income Income Elasticity Elasticity Inferior greater than 1 goods superior goods Money Income CROSS ELASTICITY OF DEMAND Cross elasticity of demand measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good. For example consider the substitute goods, butter and margarine. The cross elasticity of demand is: ∆Qb/Qb Pm ∆Qb EQbPm = = ∆Pm/Pm Qb ∆Pm Cross elasticity for substitutes is positive and Cross elasticity for complements is negative. PRICE ELASTICITY OF SUPPLY Price Elasticity of supply measures the percentage change in quantity supplied resulting from a 1 percent change in price. This elasticity is usually positive because price and quantity supplied are directly related. We can refer to elasticity of supply with respect to interest rates, wage rates, and the cost of raw materials. © Copyright Virtual University of Pakistan 16 Micro Economics –ECO402 VU Price ($) Quantity Demanded Quantity Supplied 60 22 14 80 20 16 100 18 18 120 16 20 Recall ∆Q/Q P ∆Q EP = = ∆P/P Q ∆P Š Elasticity of demand when price is $80 is Ep = 80/20 x -2/20 = -0.40 Š Elasticity of demand when price is $100 is Ep = 100/18 x -2/20 = -0.56 Š Elasticity of supply when price is $80 is Ep = 80/16 x 2/20 = 0.50 Š Elasticity of supply when price is $100 is Ep = 100/18 x 2/20 = 0.56 THE MARKET FOR WHEAT – 1981 Supply Curve for Wheat – QS = 1,800 + 240P – 1981 Demand Curve for Wheat – QD = 3,550 - 266P – Equilibrium: Q S = Q D 1,800 + 240 P = 3, 550 − 266 P 506 P = 1, 750 P = 3.46 / bushel Q = 1,800 + (240)(3.46) = 2, 630 million bushels P ∆QD 3.46 EPD = = ( −266) = −.035 Inelastic Q ∆P 2, 630 P ∆QS 3.46 EPS = = (240) =.032 Inelastic Q ∆P 2, 630 – Assume the price of wheat is $4.00/bushel QD = 3, 550 − (266)(4.00) = 2, 486 4.00 QPD = ( −266) = −0.43 2, 486 Supply (Qs) Demand (Qd) Equilibrium Price Qs = Qd 1981 1800 + 240P 3550 – 266P 1800 + 240P = 3550 – 266P 506P = 1750 P1981 = $3.46 / bushel 1998 1944 + 207P 3244 – 283P 1944 +207P = 3244 – 283P P1998 = $2.65 / bushel © Copyright Virtual University of Pakistan 17 Micro Economics –ECO402 VU SHORT-RUN VERSUS LONG-RUN ELASTICITIES Price elasticity of demand varies with the amount of time consumers have to respond to a price. For most goods and services, short-run elasticity is less than long-run elasticity. (e.g. gasoline, Drs.). For other Goods (durables), short-run elasticity is greater than long-run elasticity (e.g. automobiles) GASOLINE: SHORT-RUN AND LONG-RUN DEMAND CURVES Price DSR People tend to drive smaller and more fuel efficient cars in the long-run Gasoline DLR Quantity AUTOMOBILES: SHORT-RUN AND LONG-RUN DEMAND CURVES DLR Price People may put off immediate consumption, but eventually older cars must be replaced. Automobiles DSR Quantity Income elasticity also varies with the amount of time consumers have to respond to an income change. For most goods and services, income elasticity is greater in the long-run than in the short run. For example, higher incomes may be converted into bigger cars so the income elasticity of demand for gasoline increases with time. For other Goods (durables), Income elasticity is less in the long-run than in the short-run. For example, originally, consumers will want to hold more cars. Later, purchases will only to be to replace old cars. Gasoline and Automobiles are complementary goods. For gasoline, the long-run price and income elasticities are larger than the short-run elasticities. For automobiles, the long-run price and income elasticities are smaller than the short-run elasticities. © Copyright Virtual University of Pakistan 18 Micro Economics –ECO402 VU THE DEMAND FOR GASOLINE Years Following price or income change Elasticity 1 2 3 4 5 6 Price -0.11 -0.22 -0.32 -0.49 -0.82 -1.17 Income 0.07 0.13 0.20 0.32 0.54 0.78 THE DEMAND FOR AUTOMOBILES Years Following price or income change Elasticity 1 2 3 4 5 6 Price -1.20 -0.93 -0.75 -0.55 -0.42 -0.40 Income 3.00 2.33 1.88 1.38 1.02 1.00 SUPPLY For Most goods and services, long-run price elasticity of supply is greater than short-run price elasticity of supply. For other Goods (durables, recyclables), long-run price elasticity of supply is less than short-run price elasticity of supply Price SSR Primary Copper: Short-Run and Long-Run Supply Curves SLR Due to limited capacity, firms are limited by output constraints in the short-run. In the long-run, they can expand. Quantity Secondary Copper: SLR Price SSR Short-Run and Long-Run Supply Curves Price increases provide an incentive to convert scrap copper into new supply. In the long-run, this stock of scrap copper begins to fall. Quantity © Copyright Virtual University of Pakistan 19 Micro Economics –ECO402 VU SUPPLY OF COPPER Price Elasticity of: Short Run Long run Primary Supply 0.20 1.60 Secondary Supply 0.43 0.31 Total Supply 0.25 1.50 WEATHER IN BRAZIL AND THE PRICE OF COFFEE IN NEW YORK Elasticity explains why coffee prices are very volatile. – Due to the differences in supply elasticity in the long-run and short run. S’ S Price A freeze or drought decreases the Coffee supply P1 Short-Run 1) Supply is completely inelastic P0 2) Demand is relatively inelastic 3) Very large change in price D Q1 Q0 Quantity © Copyright Virtual University of Pakistan 20 Micro Economics –ECO402 VU Price S’ S P2 P0 P0 Intermediate-Run 1) Supply and demand are more elastic 2) Price falls back to P2. 3) Quantity falls to Q2 Q0 D Q2 Q0 Quantity Price Long-Run 1 Supply is extremely elastic. 2) Price falls back to P0. 3) Quantity increase to Q0. P0 S D Q0 Quantity © Copyright Virtual University of Pakistan 21 Micro Economics –ECO402 VU LESSON 6 CONSUMER BEHAVIOR The explanation of how consumers allocate their resources (income) to the purchase of different goods and services to maximize their well being. There are three steps involved in the study of consumer behavior. 1) We will study consumer preferences to describe how and why people prefer one good to another. 2) Then we will turn to budget constraints because people have limited incomes. 3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices. WHAT COMBINATION OF GOODS WILL CONSUMERS BUY TO MAXIMIZE THEIR SATISFACTION? CONSUMER PREFERENCES A market basket is a collection of one or more commodities. One market basket may be preferred over another market basket containing a different combination of goods. Three Basic Assumptions 1) Preferences are complete. 2) Preferences are transitive. 3) Consumers always prefer more of any good to less. Market Basket Units of Food Units of Clothing A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 INDIFFERENCE CURVES Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Clothing (units The consumer prefers per week) A to all combinations 50 B in the blue box, while all those in the yellow box are preferred to A. 40 H E A 30 D 20 G 10 Food (units per week) 1 2 3 4 © Copyright Virtual University of Pakistan 22 Micro Economics –ECO402 VU Clothing Combination B,A, & D (units per yield the same satisfaction week) 50 B E is preferred to U 1 40 H E U is preferred to H & G 1 A 30 D 20 U1 G 10 Food 10 20 30 40 (units per week) Indifference curves slope downward to the right. If it sloped upward it would violate the assumption that more of any commodity is preferred to less. Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve. An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities. Each indifference curve in the map shows the market baskets among which the person is indifferent. Clothing (units per Market basket A week) is preferred to B. Market basket B is preferred to D. D B A U3 U2 U1 Food (units per week) Finally, indifference curves cannot cross. This would violate the assumption that more is preferred to less. Clothing Indifference Curves (units per week) U Cannot Cross U The consumer should be indifferent between A, B and D. However, A B contains more of both goods than D. B D Food (units per week) © Copyright Virtual University of Pakistan 23 Micro Economics –ECO402 VU Clothing 16 A Observation: The amount (units of clothing given up for per week) 14 a unit of food decreases from 6 to 1 12 -6 10 B 1 8 -4 D 6 1 -2 E 4 1 -1 G 2 1 Food (units per 1 2 3 4 5 week) MARGINAL RATE OF SUBSTITUTION The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good. It is measured by the slope of the indifference curve. Clothing 16 A (units per 14 MRS = 6 MRS = − ∆ C ∆F week) 12 -6 10 B 1 8 -4 6 D MRS = 2 1 4 -2 E 1 -1 G 2 1 Food (units per 1 2 3 4 5 week) We will now add a fourth assumption regarding consumer preference: Along an indifference curve there is a diminishing marginal rate of substitution. Note the MRS for AB was 6, while that for DE was 2. Indifference curves are convex because as more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one.Consumers prefer a balanced market basket. PERFECT SUBSTITUTES AND PERFECT COMPLEMENTS Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. Apple Juice 4 Perfect (glasses) Substitutes 3 2 1 Orange Juice (glasses) 0 1 2 3 4 © Copyright Virtual University of Pakistan 24 Micro Economics –ECO402 VU Two goods are complements when the indifference curves for the goods are shaped as right angles. Left Shoes4 Perfect 3 Complements 2 1 Right 0 1 2 3 4 Shoes BADS are the things for which less is preferred to more. For example, air pollution DESIGNING NEW AUTOMOBILES Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling. An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars. Consumer Styling Preference A: High MRS These consumers are willing to give up considerable styling for additional performance Performance Consumer Styling Preference B: Low MRS These consumers are willing to give up considerable performance for additional styling Performance © Copyright Virtual University of Pakistan 25 Micro Economics –ECO402 VU DESIGNING NEW AUTOMOBILES – What Do You Think? How can we determine the consumer’s preference? A recent study of automobile demand in the USA shows that over the past two decades most consumers have preferred styling over performance. Growth of Japanese Imports in 1970’s and 1980’s 15% of domestic cars underwent a style change each year This compares to 23% for imports © Copyright Virtual University of Pakistan 26 Micro Economics –ECO402 VU LESSON 7 CONSUMER BEHAVIOR (Continued) UTILITY Utility is the numerical score representing the satisfaction that a consumer gets from a given market basket. If buying 3 copies of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt. UTILITY FUNCTIONS Assume: The utility function for food (F) and clothing (C) U(F,C) = F + 2C Market Baskets: F units C units U (F, C) = F + 2C A 8 3 8 + 2(3) = 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C Clothing Utility Functions & Indifference Curves (units per week) Assume: U = FC 15 Market Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) C 10 A U3 = 100 (Preferred to U2) 5 B U2 = 50 (Preferred to U1) U1 = 25 Food (units per week) 0 5 10 15 ORDINAL VERSUS CARDINAL UTILITY Ordinal Utility Function places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another. Cardinal Utility Functionis a utility function describing the extent to which one market basket is preferred to another. ORDINAL VERSUS CARDINAL RANKINGS The actual unit of measurement for utility is not important. Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made. BUDGET CONSTRAINTS Preferences do not explain all of consumer behavior. Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services. THE BUDGET LINE The budget line indicates all combinations of two commodities for which total money spent equals total income. Let F equal the amount of food purchased, and C is the amount of clothing. © Copyright Virtual University of Pakistan 27 Micro Economics –ECO402 VU Š Price of food = Pf and price of clothing = Pc Then Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing. The budget line then can be written: PFF + PCC = I Market Basket Food (F) Clothing (C) Total Spending Pf = ($1) Pc = ($2) PfF + PcC = I A 0 40 $80 B 20 30 $80 D 40 20 $80 E 60 10 $80 G 80 0 $80 Clothing (units Pc = $2 Pf = $1 I = $80 per week) A Budget Line F + 2C = $80 (I/PC) = 40 B 30 1 10 Slope = ∆C/∆F = - = - PF/PC D 2 20 20 E 10 G Food 0 20 40 60 80 = (I/PF) (units per week) As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other. The slope of the line measures the relative cost of food and clothing. The slope is the negative of the ratio of the prices of the two goods. The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent. The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I. The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I. THE EFFECTS OF CHANGES IN INCOME AND PRICES An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant). A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant). Clothing A increase in (units income shifts per week) 80 the budget line 60 A decrease in income shifts 40 the budget line L3 L2 20 (I = L1 Food $40) (I = $80) (I = $160) (units per week) 0 40 80 120 160 © Copyright Virtual University of Pakistan 28 Micro Economics –ECO402 VU If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept. If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept. Clothing (units An increase in the per price of food to week) $2.00 changes the slope of the budget line and A decrease in the rotates it inward. price of food to 40 $.50 changes the slope of the budget line and rotates it outward. L3 L1 L2 (PF = 1) (PF = 1/2) (PF = 2) Food 40 80 120 160 (units per week) If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change. However, the budget line will shift inward to a point parallel to the original budget line. If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change. However, the budget line will shift outward to a point parallel to the original budget line. CONSUMER CHOICE Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them. The maximizing market basket must satisfy two conditions: 1) It must be located on the budget line. 2) Must give the consumer the most preferred combination of goods and services. Recall, the slope of an indifference curve is: ∆C MRS = − ∆F Further, the slope of the budget line is: PF Slope = − PC Therefore, it can be said that satisfaction is maximized where: PF M RS = PC It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C). © Copyright Virtual University of Pakistan 29 Micro Economics –ECO402 VU Clothing (units per Pc = $2 Pf = $1 I = $80 Point B does not week) maximize satisfaction 40 because the MRS (-(-10/10) = 1 is greater than the B price ratio (1/2). 30 -10C Budget 20 U1 +10 0 20 40 80 Food (units per week) Clothing (units per Pc = $2 Pf = $1 I = $80 week) 40 D Market basket D 30 cannot be attained given the current budget constraint. 20 U3 Budget 0 20 40 80 Food (units per week) Clothing (units per Pc = $2 Pf = $1 I = $80 week) At market basket A the budget line and the 40 indifference curve are tangent and no higher level of satisfaction 30 can be attained. A 20 At A: MRS =Pf/Pc =.5 U2 Budget 0 20 40 80 Food (units per week) © Copyright Virtual University of Pakistan 30 Micro Economics –ECO402 VU DESIGNING NEW AUTOMOBILES (II) Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of cars. Each group has different preferences. By finding the point of tangency between a group’s indifference curve and the budget constraint auto companies can design a production and marketing plan. Styling $10,000 These consumers are willing to trade off a considerable amount of styling for some additional performance $3,000 Performance $7,000 $10 000 Styling $10,000 These consumers are willing to trade off a considerable amount of $7,000 performance for some additional styling $3,000 $10,000 Performance DECISION MAKING & PUBLIC POLICY Choosing between a non-matching and matching grant to fund police expenditures Private Non-matching Expenditures Grant ($) Before Grant P Budget line: PQ A: Preference maximizing market basket A R Expenditure U1 OR: Private OS: Police Police O S Q Expenditures © Copyright Virtual University of Pakistan 31 Micro Economics –ECO402 VU Private Expenditures Non-matching ($) Grant T After Grant P Budget line: TV B: Preference maximizing market basket B U A Expenditure R U3 OU: Private U1 OZ: Police Police O S Z Q V Expenditures ($) Private Expenditures Before Grant Matching ($) Grant Budget line: PQ T A: Preference maximizing P Market basket After Grant C: Preference maximizing W A Market basket R C U2 Expenditures U1 OW: Private OX: Police O S X Q R Police ($) Private Expenditures ($) Matching Grant T Non-matching Grant P Point B OU: Private expenditure B OZ: Police expenditure U Matching Grant W A C U3 Point C U2 OW: Private expenditure U1 OX: Police expenditure O Z X Q R Police ($) S © Copyright Virtual University of Pakistan 32 Micro Economics –ECO402 VU CORNER SOLUTION A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves are tangent to the horizontal and vertical axis. MRS is not equal to PA/PB. Frozen Yogurt (cups monthly) A A corner solution U1 U2 U3 exists at point B. B Ice Cream A CORNER SOLUTION At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line. This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so. However, there is no more frozen yogurt to give up! When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio. In this instance it can be said that: MRS ≥ PIceCream / PFrozen Yogurt If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket. A COLLEGE TRUST FUND Suppose Jane Doe’s parents set up a trust fund for her college education. Originally, the money must be used for education. If part of the money could be used for the purchase of other goods, her consumption preferences change. Other A College Trust Fund Consumption ($) A: Consumption before the trust fund The trust fund shifts the budget line B: Requirement that the trust fund C must be spent on education P U3 C: If the trust could be spent on B other goods A U2 U1 Q Education ($) © Copyright Virtual University of Pakistan 33 Micro Economics –ECO402 VU LESSON 8 CONSUMER BEHAVIOR (Continued) REVEALED PREFERENCES If we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary. REVEALED PREFERENCES--TWO BUDGET LINES Clothing l1 I1: Chose A over B (units A is revealed preferred to B per l2: Choose B over D month) B is revealed preferred to D I2 A B D Food (units per month) Clothing l1 (units per All market baskets month) in the blue shaded area are l2 preferred to A. A B D B is preferred to all market baskets in the pink area Food (units per month) © Copyright Virtual University of Pakistan 34 Micro Economics –ECO402 VU REVEALED PREFERENCES--FOUR BUDGET LINES I3: E revealed preferred to A Clothing (units l3 per All market baskets in the blue area preferred to A E l1 l4 A l2 B G A: preferred to all market baskets in I4: G revealed preferred to A the pink area Food (units per month) Scenario Other Roberta’s recreation budget = $100/wk Recreational Activities Price of exercise = $4/hr/week ($) Exercises 10 hrs/wk at A given U & I1 1 100 C The rate changes to $1/hr + 80 $30/wk New budget line I & combination B 2 60 A B Reveal preference of B to A 40 U1 U2 Would the Club’s 20 profits increase? l1 l2 Amount of Exercise 0 25 50 75 (ho