Lecture 1 PME 2021.12sept(1).pdf

Principles of Microeconomics Week 1 Linda Keijzer [email protected] 1  What is economics? Banking? Unemployment? Consumption? Profit? MONEY?  What is economics? Crossing borders, Nobel P...

Principles of Microeconomics Week 1 Linda Keijzer [email protected] 1  What is economics? Banking? Unemployment? Consumption? Profit? MONEY?  What is economics? Crossing borders, Nobel Prize winners - export: Buchanan (1986, political science), Coase (1991, property rights), Becker (1992, human behaviour), Fogel (1993, history), North (1993, history) - import: Akerlof (2001, information and identity), Kahneman (2002, psychology), Smith (2002, use of experiments), Ostrom (2009, economic governance), Thaler (2017, behavioural economics) Thaler and Sunstein, “Nudge” Kahneman, “Thinking, fast and slow” “Economics is life” 4  What is economics? Economics and business economics - General economics: micro and macroeconomics - Macroeconomics: aggregates - Microeconomics: individuals and markets  Why is (micro)economics important? Economics is supposed to engage with the many challenges facing society, including global warming, unemployment, the post-2008 global financial order, the Covid-19 pandemic and the proper balance between the free market and regulation; to serve society, and to offer rigour where gut instincts go wrong; to suggest policies that help our institutions align social and private interests;  What is microeconomics about? How do economic agents allocate scarce resources Consumers Workers Households time Firms money Politicians production factors etc. clean water,air, etc Scarcity → making choices = trade-offs Markets Interaction of economic agents on markets determine prices (demand and supply) → Trade-offs are based on prices Assumptions - rationality, choices (w.r.t information and preferences) 7 - optimizing behaviour → maximizing utility or maximizing profit/revenue  Theories and Models In economics, explanation and prediction are based on theories. Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity. Assume you are an alien on your first visit to Earth You see this animal and you are told it is called a ‘dog’. 11:36 9 Assume you are an alien on your first visit to Earth Then you see these very different animals. Are these dogs? Panda dogs are the new rage in China. Most are 11:36 chows that have undergone cosmetic primping to 10 have them appear as pandas. Assume you are an alien on your first visit to Earth Slowly but surely a dog-model emerges in your mind: Does any individual case of a dog look like this? NO Does it help you to define and identify dogs? YES 11:36 11  Positive versus Normative Analysis positive analysis Analysis describing relationships of cause and effect. normative analysis Analysis examining questions of what ought to be.  1. Introduction to demand and supply The Demand Curve demand curve Relationship between the quantity of a good that consumers are willing to buy and the price of the good. We can write this relationship between quantity demanded and price as an equation: QD = QD(P) or P = P(QD) (inverse demand function)  (individual) Demand Curve (Shift along the demand curve) Q2 Note: downward sloping curve 11:36 15  Aggregate demand 0 4 7 11 4 8 12 24 16 The Supply Curve supply curve Relationship between the quantity of a good that producers are willing to sell and the price of the good. We can write this relationship between quantity supplied and price as an equation: QS = QS(P) or P = P(QS) (inverse supply function)  (individual) Supply Curve (Shift along the supply curve) Q2 Note 1: upward sloping curve Note 2: derivation of aggregate supply is similar to derivation of aggregate demand 11:36 18  (Competitive) Market Equilibrium: QD(P) = QS(P) Conditions: 1) Free entry/exit 2) Homogeneity 3) No market power 4) Transparency One market price 11:36 results 19  Market mechanism leading to equilibrium Now, suppose that originally the price is above P0: surplus → P(QS) > P(QD) → underbidding → P(QS)  → QS  and QD  (shifts along the curves) until QS = QD 11:36 20  2. Shifts in demand and supply When a non-price determinant of demand (or supply) changes the curve shifts These "other variables" are part of the demand (or supply) function. They are "merely lumped into the intercept term of a demand (or supply) function." Thus a change in a non-price determinant of demand (or supply) is reflected in a change in the intercept causing the curve to shift along the axis. 11:36 21  A shift of the (whole) demand curve D’’ Due to one of the following changes (): 1)  number of consumers 2)  disposable income 3)  taste and preferences 11:36 4)  prices of related goods (substitutes and complements) 22 5)  expectations  Effect of demand change on equilibrium So, shift of demand curve leads to shift along supply curve ! 11:36 23  The Economist explains Global Why London’s housing house prices are markets falling Nov 10th 2017 Upwardly mobile Plutocrats are leaving the city, but that is not House prices are on the rise the main reason again around the world Oct 3rd 2015 11:36 24  A shift of the (whole) supply curve S” Due to one of the following changes (): 1)  number of suppliers (or  magnitude of supply) 2)  technology 3)  production costs (and  management skills) 11:36 25 4)  government policies  Effect of supply change on equilibrium So, shift of supply curve leads to shift along demand curve ! 11:36 26  3. Price Elasticity of Demand If a firm wants to increase profits, should it raise the price or offer a discount?  Price Elasticity of Demand A negatively sloped demand curve implies that when prices increase, consumers buy less But HOW MUCH less? We answer this question using the “Price Elasticity of Demand” Elasticities: Measure effects of changes in prices or other factors on demand or supply.  The definition of elasticities Elasticity Percentage change in one variable resulting from a percentage increase in another. Price elasticity of demand Percentage change in quantity demanded of a good resulting from a percentage increase in its price. → Measure of responsiveness (2.1) E < 0 (use negative sign!)  The importance of elasticities In other words: the elasticity measures the sensitivity to a price or income change Hereafter: 1) Price elasticity of demand 2) Price elasticity of supply 3) Income elasticity 4) Cross-price elasticity 11:36 30  Elastic and inelastic demand : entire demand curves The degree in which a % price change leads to a % change in the quantity demanded. In other words: the relationship between %P and %Q P P P0 P P1 D D Q0 Q1 Q Q0 Q1 Q Q is very small Q is very big 31 = relatively inelastic demand = relatively elastic demand  The importance of elasticities The degree in which a % price change leads to a % change in the quantity demanded. Calculate the (Q1-Q0)/Q0 elasticities P at (P0, Q0) for both P (P1-P0)/P0 functions. 10 P0 8 P1 D D Q0 Q1 Q Q0 Q1 Q 20 22 20 30 11:36 32  The importance of elasticities The degree in which a % price change leads to a % change in the quantity demanded. (Q1-Q0)/Q0 P P (P1-P0)/P0 10 P0 8 P1 D D Q0 Q1 Q Q0 Q1 Q 20 22 20 30 11:36 33  What does it mean? Relatively elastic: if EP < –1 or: if  EP  > 1 Relatively inelastic: if –1 < EP < 0 or: if 0 <  EP  < 1 → turning point is at EP = –1 (unit elasticity) What does it mean if EP = –1? → When a price rises with e.g. 10%, demand decreases with 10% What does it mean if EP = –0.5? → When a price rises with e.g. 10%, demand decreases with only 5% What does it mean if EP = –2.5? → When a price rises with e.g. 10%, demand decreases with 25% 34 11:36  The elasticity along a (linear) function (P&R page 56) 1 6 P = 4 – 0.5 Q = inverse demand 11:36 35  Note: - Make sure to know how to take a derivative (see e.g. Blackboard) - Make sure how to write down the equation for a lineair curve ( Y = intercept + slope * X), where slope = rise/run (∆Y/∆X) Tutorial problems to be found on Blackboard (course content/material and instructions week 1/tutorial instructions week 1/problems/ Elasticities: problem 4-6, 10-16 11:36 36 Note: - Make sure to know how to take a derivative (see e.g. Blackboard) - Make sure how to write down the equation for a lineair curve ( Y = intercept + slope * X), slope = rise/run If the demand equation is Q = 8 – 2 P, the slope of the demand curve = dQ/dP = -2 However, in the graph on page 56 of the book, the inverse demand curve is shown: P = 4 – 0.5 Q (make sure to check you can derive this from the graph yourself). The slope of this graph is dP/dQ = -0.5 ( is equal to rise/run = -4/8) To calculate 11:36 the price elasticity of demand, we need dQ/dP ! 37  The elasticity along a (linear) function (P&R page 56) Q = first derivative P (slope) of (demand) function 1 6 E = -2 * 2/4 = -1 E= -2 * 1/6 = -1/3 11:36 38  The elasticity along a (linear) function Even though a curve as a whole can be described as relatively elastic or inelastic, every downward sloping lineair demand curve has an elastic and an inelastic part Elastic part of the (linear) demand curve: EP < –1 Inelastic part of the demand curve: –1 < EP < 0 Note: Each point on a linear, downward sloping curve gives a different value for EP and each linear curve, irrespective of its steepness, has elastic and inelastic points 11:36 39  Elasticity and a firm’s revenue With linear demand curves, we see a steady relationship between 3 EP(Elasticity) and TR (total revenue): (TR = P*Q) 1 2 6 TR 1. If EP is elastic, a decrease in the 8 6 price leads to rising revenue 2. If EP is inelastic, a decrease in the price leads to declining revenue Q → policy implications! 11:36 0 2 4 6 8 40  Two extremes Infinitely Elastic Completely Inelastic (i.e. demand is very sensitive to P) (i.e. demand does not react to P at all) slope of inverse demand, dp/dq = 0 slope of inverse demand, dp/dq is infinite slope of demand, dq/dp is infinite slope of demand, dq/dp is o Perfectly elastic demand: good has a large number of very close (that is, perfect) substitutes- in-consumption readily available. Examples?? 41 Perfectly inelastic demand: good has absolutely no substitutes-in-consumption.  Short-term (SR) versus Long-term (LR) elasticities Market for gasoline Market for automobiles P P Q (SR) < Q (LR) Q (SR) > Q (LR) 11:36 42 => true for most durable goods  Price elasticity of supply The degree in which a price change leads to a change in the quantity supplied (Q1-Q0)/Q0 EP = (P1-P0)/P0 Suppose P0 = 10 P1 = 12 Q0 = 10 Q1 = 14 → Calculate EP → EP = +40%/+20% = 2 → if EP > 1 → elastic supply; if 0 < EP < 1 inelastic supply 43  Income elasticity and cross-price elasticity (formulas are in the book) Recall: Demand curve may shift due to: 1)  number of consumers Income elasticity: 2)  income the degree in which 3)  preferences a % income change leads 4)  price of other goods to a % change in the quantity demanded Cross-price elasticity: the degree in which a % price Substitution goods show change in a substitution good or a positive sign for E; complementary good leads to a change in the quantity demanded Complementary goods show of another good a negative sign for E. 11:36 45 4. Effects of government interventions Usually markets tend to move toward their equilibrium prices and quantities. Surpluses and shortages of goods are short-lived as prices adjust to equate quantity demanded with quantity supplied. In some markets, however, governments have been called on by groups of citizens to intervene to keep prices of certain items higher or lower than what would result from the market finding its own equilibrium price. Price controls - Government interventions Price controls are governmental impositions on the prices charged for goods and services in a market. A “price ceiling” is a government-imposed limit on the price charged for a product. Governments often impose price ceilings to protect consumers from conditions that could make necessary commodities unattainable. A “price floor” is a government-imposed limit on how low a price can be charged for a product.  Government intervention → Introduction of maximum price Price ceiling 11:36 Interference with free market leads to a trade-off decision: 48 Some people gain and some lose from price controls.  Government intervention → the effect on equilibrium To supply demand at the ceiling price, the most obvious approach is to lower costs. However, in most cases, lower costs mean lower quality. During World War II, for example, food sellers operating under ceilings reduced portion size and used less expensive ingredients (more fat, and flour, among others) to survive the ceiling. Also, price ceiling might invite a black market for goods. Those who, by luck or good management, obtain goods in short supply, can profit by illegally selling at a higher price than the ceiling price allows Also, if there is a shortage of a good due to price ceiling, sellers may start to discriminate among customers. In the case of rent control in New York city, for example, landlords have given rent-controlled apartments to celebrities over less-wealthy and non-famous people.  Government intervention → Introduction of minimum price Price floor Pmin Often in combination 11:36 51 Excess supply ? with price support! Two examples of price floors 1. Minimum wages 2. EU Production quotas for agricultural products (butter mountains)  The Economist explains Rice in Asia Paddy-whacked By meddling in the market for rice, Asian governments make their own citizens poorer Nov 14th 2015 | SINGAPORE | 11:36 53  Next week: chapters 3 and 4 11:36 54