Introduction to Microeconomics.pdf

Introduction to Microeconomics Dr Shahid Bashir Senior Lecturer, Mahindra University NET, Ph.D.(Economics), Gold Medalist Agenda A brief overview of Microeconomics The geometry The mathematics The methodology Applications Definition of Economics Adam Smith: “Economic...

Introduction to Microeconomics Dr Shahid Bashir Senior Lecturer, Mahindra University NET, Ph.D.(Economics), Gold Medalist Agenda A brief overview of Microeconomics The geometry The mathematics The methodology Applications Definition of Economics Adam Smith: “Economics is the science of wealth”. Alfred Marshall: “Economics is a study of mankind in the ordinary business of life”. Lionel Robbins: “Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”. John Maynard Keynes: “Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor draw correct conclusions”. Paul A. Samuelson: “Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people”. More penetrating definition is: Economics* is the study of how individuals and societies choose to allocate scarce resources. Deciding whether to spend a bonus on a vacation or invest in education. Microeconomics vs. Macroeconomics Since 1930s, the field of economics has been divided into two broad subfields*: Microeconomics focuses on individual and business decisions. Micro deals with small-scale economic activities. A family's decision on how much of their budget to spend on groceries. Also called price theory. Macroeconomics looks at the economy as a whole. Macro deals with large-scale economic phenomena. A country's analysis of its unemployment rate. Microeconomics- Broad areas Consumer Behaviour Production and Costs Market Structures Market Failures and Public Policy Labour Economics* Game Theory and Strategic Behaviour+ Welfare Economics- Behavioural Economics$ Macroeconomics- Broad areas National Income Accounting Business Cycles Monetary Policy Fiscal Policy Inflation and Deflation Unemployment The Geometry of Microeconomics How to read and understand graphs Economics is the most quantitative of the social sciences (use of tables and graphs). These serve a number of purposes: Illustrate important economic relationships. Make difficult problems easier to understand and analyse. Show patterns and regularities that may not be discernible in simple lists of numbers. What is a graph? A graph is a two-dimensional representation of a set of numbers or data. A time series graph – one variable Graphing two variables Graphing a relationship – Slope A positive slope indicates that increases in X are A negative slope indicates the opposite—when associated with increases in Y and that decreases X increases, Y decreases; and when X in X are associated with decreases in Y. decreases, Y increases Graphing a relationship – Slope Slope – The mathematical intuition Graphing a relationship – Negative and Constant slope Linear straight line Graphing a relationship – Negative and decreasing slope Convex to the origin Graphing a relationship – Negative and increasing slope Concave to the origin Graphing a relationship – Positive, Zero and Negative Slope Inverted U shape Graphing a relationship – Negative, Zero and Positive Slope U shape Graphing a relationship – Zero slope Horizontal straight line Graphing a relationship – No slope Vertical straight line Graphing a relationship – Changing Slopes The Mathematics of Microeconomics Equations Linear equations*: 𝑄𝑑 = 𝑎 − 𝑏𝑃 𝑄s = 𝑎 + 𝑏𝑃 Non linear equations**: 𝑄 = 𝐴𝐾𝛼𝐿𝛽 𝑻𝑪 = 𝑭 + 𝒃𝑸 + 𝒄𝑸𝟐 A quick question A straight line has x-axis intercept 50 and slope 2. What is the equation of this line? Differentiation Marginal analysis/rate of change Computation of marginal cost (MC), marginal revenue (MR), and marginal utility (MU). Maximising or minimising an objective function*. Consumer behaviour (utility maximisation). Producer behaviour (profit maximisation). Integration Areas under curves. Representing total values such as total cost or total revenue. Integration of a marginal cost function will give total cost function. Also used in calculating consumer surplus and producer surplus. Elasticity Percentage change in one variable in response to a 1% change in another variable. Price elasticity of demand: 𝜟𝑸𝒅 /𝑸𝒅 𝒅𝑸𝒅 𝑷 𝑬𝒅 = =. 𝜟𝑷/𝑷 𝒅𝑷 𝑸𝒅 Price elasticity of supply: 𝜟𝑸𝒔 /𝑸𝒔 𝒅𝑸𝒔 𝑷 𝑬𝒔 = =. 𝜟𝑷/𝑷 𝒅𝑷 𝑸𝒔 Income elasticity of demand: 𝜟𝑸𝒅 /𝑸𝒅 𝒅𝑸𝒅 𝑰 𝑬𝑰 = =. 𝜟𝑰/𝑰 𝒅𝑰 𝑸𝒅 Cross-price elasticity of demand: 𝜟𝑸𝒙 /𝑸𝒙 𝒅𝑸𝒙 𝑷𝒚 𝑬𝒙𝒚 = =. 𝜟𝑷𝒚 /𝑷𝒚 𝒅𝑷𝒚 𝑸𝒙 Is slope the same as elasticity? The answer is No. Key differences: Direct measure of change in absolute terms vs relative measure of change. Slope has units, whereas elasticity is unitless. Elasticity varies along a linear demand or supply curve but the slope remains constant. Relationship between slope and elasticity for a linear demand curve: ∆𝑸 𝑷 𝑷 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 =. = 𝑺𝒍𝒐𝒑𝒆. ∆𝑷 𝑸 𝑸 An example Δ𝑄 Consider a linear demand curve 𝑄 = 100 − 2𝑃, where the slope is -2. Δ𝑃 At 𝑃 = 10, 𝑄 = 80 : Elasticity = - 0.25 At 𝑃 = 40, 𝑄 = 20 : Elasticity = - 4 In this case, the demand is inelastic at 𝑷 = 𝟏𝟎 and elastic at 𝑷 = 𝟒𝟎. A quick question Consider a linear demand curve 𝑸 = 𝟔𝟓 − 𝟑𝑷, ΔQ What is the slope ? ΔP What is elasticity at P=10 and Q=40 ? Matrix Algebra Used in game theory to analyse strategies and payoffs in games. Methodology of Microeconomics Positive vs. Normative Economics Suppose two people are discussing minimum wage laws: Person A: Minium wage laws cause unemployment. Person B: The government should raise the minimum wage. Positive Economics (What is): Describes how the economy actually works. Increasing the minimum wage will reduce employment for low-skilled workers. Normative Economics (What should be) : Prescribes how the economy should work. The government should increase the minimum wage to ensure a living wage for all workers. A quick question 1. A 10% increase in the price of gasoline will lead to a 5% decrease in its consumption. 2. The government should impose higher taxes on gasoline to reduce environmental pollution. 3. The government ought to increase taxes on sugary drinks to promote public health. 4. Increasing taxes on sugary drinks will reduce the incidence of diabetes. Models and Theories A model is a formal statement of a theory. It is usually a mathematical statement of a presumed relationship between two or more variables. In many disciplines, including physics, chemistry, and economics, theorists build formal models of behaviour. Tools to understand and predict economic behaviour. Economists use models/theories to represent: How markets work. How consumers behave. How firms behave, etc. These models are based on assumptions. Models and Theories Economic models have two principal uses: To predict or forecast what might happen in future as a consequence of a decision/policy. To simulate an event and provide a comparison with what would have happened if the decision/policy had not happened (counterfactual). Models and Theories Models always contain a number of variables. A variable is a measure that can change from time to time or from observation to observation. Income is a variable—it has different values for different people and different values for the same person at different times. Endogenous variable: determined within the model. Exogenous variable: determined outside the model. Qd = f (P) Dependent variable (Qd) Independent variable (P) Instability of economic models Models are highly unstable because: Exogenous shocks* Time** Cause and effect Does change in price cause change in quantity demanded or does quantity demanded affect price? To answer this question, economists make use of an important assumption “Ceteris paribus” – a Latin term meaning all other things being constant. To isolate the impact of one single factor. Example of a typical demand function. Economics as a science Experimental data – in natural sciences like Physics, Chemistry, Biology etc. Non experimental data – in social sciences like economics. Key economic agents Consumers/households: Individuals or households that demand goods and services. They own factors of production. Firms/producers: Organisations that supply goods and services. Government: Regulates and influences the economy through policies. Circular flow of income – two sector economy Households are individuals living together as decision-making units. Firms are institutions that organise production of goods and services. Markets: A market is any arrangement that brings buyers and sellers together and enables them to get information and do business with each other. Goods markets are markets in which goods and services are bought and sold. Factor markets are markets in which factors of production are bought and sold. Real Flows and Money Flows Yellow lines Red and blue lines (Real flows) (Money flows) Circular flow of income – Three sector economy Households Firms Governments Applications of Microeconomics Applications of Microeconomics Pricing Strategies: How firms set prices to maximise profits. Consumer Behaviour: Understanding how consumers make purchasing decisions. Market Structures: Different types of markets: perfect competition, monopoly, oligopoly, and monopolistic competition. Public Policy: Government intervention to correct market failures. Scarcity and Choice – The economic problem Scarcity: Limited resources vs. unlimited wants. Choice: Decisions on how to allocate resources. Spending time studying for an exam or working a part-time job. Opportunity Cost The cost of the next best alternative foregone. Choosing to go to college instead of starting a job immediately means the opportunity cost is the salary foregone. Mr Rajnish is a software engineer working for Wipro in Bangalore, earning Rs 10 lakh per year. 3 alternative careers - Microsoft or IBM in Bangalore for Rs 9 lakh and Rs 9.5 lakh per year respectively. Another alternative is that he can set up his own software firm, expecting to make a profit of Rs 8.75 lakh a year for himself. What is Mr Rajnish’s opportunity cost of working in Wipro? The next best alternative is to work for IBM, the value of which option is Rs 9.5 lakh. Market Equilibrium Efficiency In economics, efficiency means allocative efficiency (Optimal use of resources). An efficient economy is one that produces what people want at the least possible cost. If the system allocates resources to the production of goods and services that nobody wants, it is inefficient. If all members of a particular society were vegetarians and somehow half of all that society’s resources were used to produce meat, the result would be inefficient. Efficiency in exchange The clearest example of efficiency is a voluntary exchange. If you and I each want something that the other has and we agree to exchange, we are both better off and no one loses (Pareto optimality). Equity While efficiency has a fairly precise definition that can be applied with some degree of rigor, equity (fairness) lies in the eyes of the beholder. To many, fairness implies a more equal distribution of income and wealth/Fair distribution of resources.