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Introduction to Microeconomics

an introduction to the main microeconomics principles prepared for undergraduate students
by

Stefano Visintin

on 25 September 2017

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Transcript of Introduction to Microeconomics

Economics
WHAT IS ECONOMICS?
A SCIENCE
ECONOMICS is the SOCIAL SCIENCE that studies how the society satisfy its NEEDS dealing with a GIVEN (FINITE) amount of RESOURCES
Biologists study nature
Chemists study molecules and atoms
Philosophers study ....
?
Economists study how society organizes the division of roles in order to produce what is needed, taking into account that resources use to be scarce
SOCIAL
HISTORY
Tradition
Central authority
Market forces
How was this organisation made over the
?
SOCIETY
Individuals
persons / firms
to work or not to work
save money or not, how much
buy or not
produce product A or product B
Aggregation
groups
how to organise the labour force
how to make the financial system work
how to govern the general level of prices
M CROECONOMICS
M CROECONOMICS
I
A
Microeconomics
the branch of the economic science studying how
individuals
deal with
SCARCITY

resources (money)
time
space in our stomach...
by the way...if there was no scarcity (in other words if there was abundance of everything) life will have scarce intensity
dealing with scarcity means taking decisions
For an economist
taking a decision =
COST - BENEFITS
PRINCIPLE
In terms of money and much more...
OPPORTUNITY COST
Doing something = not doing something else
Doing x = not doing y
COST-BENEFITS ANALYSIS
Benefits
of x
<

=

>
of
Costs
of not doing not doing y
?
Should I go to the beach or stay and work?
Should I go to university or not?
Should we charge an interest on money we lend to a friend?
...
ATTENTION
be aware of:
sunk costs
Should we go to Barcelona by train or by car?
600 km
Train Ticket 130€
Car costs:
Every year we drive 10.000km and pay
Insurance 1000
Interests 500
Gasoline 1000
Maintenance 1000
3500 € -> 0,35€ km
0,35*600 = 210€
These are fixed costs that shouldn't be taken into consideration, since we cannot recuperate
2000€ -> 0,20€ km
0,2*600=120€
MARGIN
Rational people think at the
Often the decision is not doing x or not doing
but
how much?
Should I eat another slice of pizza?
The cost-benefits analysis is performed over the cost and benefits of an
additional unit
THE ADDITIONAL UNIT IS THE MARGIN
Often benefits and cost vary depending on the
quantity
Price per unit
Units
Marginal benefits
Marginal cost
the benefit of an additional unit
the cost of an additional unit
Example where marginal benefit decreases and marginal cost is fixed (extra memory)
How Markets work
Markets and welfare
Industrial organisation
Public sector
Supply & Demand
Probably the most used words in economics!
S&D are the forces behind
MARKETS
determining
PRICES
QUANTITIES
Where buyers and seller meet to exchange goods and services
COMPETITION
perfect competition
oligopolies
monopolies
goods are homogeneous
several buyers and sellers
goods are not homogeneous
only one sellers
What distinguishes different markets is their level of organisation
which influences
reduced number of sellers
the quantity buyers are willing to purchase at any given price
the
law of demand
: the the , the the demanded
PRICE
QUANTITY
Demand for ice cream
12
$3.00
Ice-Cream Cones
Quantity of
11
10
9
8
7
6
5
4
3
2
1
0.50
1.00
1.50
2.00
2.50
0
Ice-Cream Cone
Price of
The Demand curve
The demand curve is a graph of the relationship between the price of a good and the quantity demanded.
Movements
ON
the curve
the change is in
Price
and affect the quantity demanded
4
$2.00
1.00
8
B
A
A tax that raises the price of ice-cream cones results in a movement along the demand curve.
Quantity of Ice-Cream Cones
Price of Ice-Cream Cones
0
Movements
OF
the curve
the change is in something other than price and affect the position of the curve
Changes in income levels
Trends
Prices of other goods
Expectations
Changes in the population
substitute
complements
0
2
D
curve,
Demand
1
D
curve,
Demand
3
D
Demand curve,
in demand
Decrease
in demand
Increase
Ice-Cream Cones
Quantity of
Cone
Ice-Cream
Price of
the quantity sellers are willing to sell at any given price
the
law of supply
: the the , the the supplied
PRICE
QUANTITY
Supply of ice cream
The Supply curve
The supply curve is a graph of the relationship between the price of a good and the quantity supplied.
Movements
ON
the curve
the change is in
Price
and affect the quantity supplied
Movements
OF
the curve
the change is in something other than price and affect the position of the curve
Changes in factor prices
Technology
Number of sellers
External factors
0.50
12
$3.00
Ice-Cream Cones
Quantity of
11
10
9
8
7
6
5
4
3
2
1
1.00
1.50
2.00
2.50
0
Cone
Ice-Cream
Price of
A rise in the price of ice cream cones results in a movement along the supply curve.
$3.00
B
A
1.00
S
0
Quantity of Ice-Cream Cones
Price of Ice-Cream Cone
5
1
2
S
curve,
Supply
1
S
Supply
curve,
3
S
Supply curve,
in supply
Decrease
in supply
Increase
0
Cone
Ice-Cream
Price of
Quantity of Ice-Cream Cones
Supply & Demand
TOGETHER
S&D together determine the
EQUILIBRIUM
Price reached a level where
quantity DEMANDED = quantity SUPPLIED
Supply Schedule
Demand Schedule
At $2.00, the quantity demanded is equal to the quantity supplied!
P
Q
D
S
7
2
equilibrium PRICE
market clearing price
equilibrium QUANTITY
What happens when we
do not have equilibrium
?
Market Price > Equilibrium Price
P
Q
D
S
equilibrium QUANTITY
market price
2.50
SURPLUS
Surplus or excess of supply
Market Price < Equilibrium Price
P
Q
D
S
equilibrium QUANTITY
market price
SHORTAGE
Shortage or excess of demand
In properly working markets
SURPLUS
and
SHORTAGE
are only temporary phenomena
+
=
Elasticity
S&D respond to changes in
PRICES
HOW FAR
The measure of
Demand
so far we just talked about directions, now it's time talk about quantities
The PRICE ELASTICITY OF DEMAND measures
how much
the
quantity demanded
responds to
changes in prices
ELASTIC
When prices change demand responds substantially
INELASTIC
When prices change demand responds slightly
What makes demand more or less elastic?
availability of substitutes
necessities and luxuries
time horizon and market size of our analysis
% change in quantity demanded
% change in price
= Price Elasticity of Demand
Price Elasticity of Demand
>
1
Price Elasticity of Demand
<
1
P
Q
D
Elasticity and the Demand curve
PERFECTLY INELASTIC
P
Q
D
INELASTIC
Large changes in prices
No change in quantities
Large changes in prices
Small change in quantities
P
Q
D
ELASTIC
Small changes in prices
Large change in quantities
P
Q
D
PERFECTLY ELASTIC
No changes in prices
Consumers will buy any quantity at this price
INELASTIC
ELASTIC
Total expenditure
The amount spent by buyers
TE = P x Q
P
Q
D
Total Expenditure
PxQ
P
Q
D
INELASTIC
Price
Total expenditure
P
Q
D
ELASTIC
Price
Total expenditure
Other Elasticities
The
INCOME
ELASTICITY OF DEMAND measures
how much
the
quantity demanded
responds to
changes in income
The
CROSS PRICE
ELASTICITY OF DEMAND measures
how much
the
quantity demanded
responds to
changes in PRICES
of
other
goods
% change in quantity demanded
% change in income
= Income Elasticity of Demand
% change in quantity demanded of good 1
% change in price of good 2
= Cross Price Elasticity of Demand
Supply
The PRICE ELASTICITY OF SUPPLY measures
how much
the
quantity
supplied responds to
changes in prices
ELASTIC
When prices change supply responds substantially
INELASTIC
When prices change supply responds slightly
What makes supply more or less elastic?
Basically their flexibility in producing
availability of production factors
time horizon
% change in quantity supplied
% change in price
= Price Elasticity of Supply
Price Elasticity of Supply
>
1
Price Elasticity of Supply
<
1
P
Q
S
Elasticity and the Supply curve
PERFECTLY INELASTIC
P
Q
S
INELASTIC
Large changes in prices
No change in quantities
Large changes in prices
Small change in quantities
P
Q
S
ELASTIC
Small changes in prices
Large change in quantities
P
Q
S
PERFECTLY ELASTIC
No changes in prices
Producers will supply any quantity at this price
INELASTIC
ELASTIC
Total revenue
The amount earned by sellers
TR = P x Q
P
Q
S
Total Revenue
PxQ
S,D and Government Policies
often influence the market forces (and economists can tell how)
GOVERNMENTS
Price control
the legislated
maximum
is called
price ceiling
P
Q
D
S
7
2
equilibrium PRICE
market clearing price
equilibrium QUANTITY
P
Q
D
S
7
theoretical
equilibrium PRICE
supplied QUANTITY
PRICE CEILING
PRICE CEILING
not binding
(nothing happens)
binding
influencing market outcomes:
shortage
rationing
not all buyer are then benefited
demanded QUANTITY
SHORTAGE
the legislated
minimum
is called
price floor
P
Q
D
S
7
2
equilibrium PRICE
market clearing price
equilibrium QUANTITY
P
Q
D
S
7
theoretical
equilibrium PRICE
supplied QUANTITY
PRICE FLOOR
PRICE floor
not binding
(nothing happens)
binding
influencing market outcomes:
surplus
not all sellers are then benefited
demanded QUANTITY
SURPLUS
Taxes
Let's suppose government imposes a
tax on sellers
.
Who is really paying the tax burden?
tax on each quantity sold
P
Q
D
S1
3
EQ1
100
EP1
S2
The new tax will shift the Supply curve upward by exactly the amount of the tax on each quantity
0.5
3.5
EP2
3.3
EQ2
90
2.8
applying the
An action should be taken if, and only if, its
benefit
is at least as great as its
cost
THE PRODUCTION POSSIBILITY FRONTIER
A
graph
showing different combination of
output
that an economy can produce (given a certain amount of inputs)
Quantity of good A
Quantity of good B
1
5
1
5
A very good examples of how we use graphs in economics
Inefficient outcome
Efficient outcome
Efficient outcome
4
6
Here we can see represented:
scarcity
opportunity cost
Time needed to make 1 kg of
Meat
Potatoes
Gardener
Farmer
6 h/Kg
2 h/kg
1.5 h/Kg
1 h/kg
Amount produced in 48h
Meat
Potatoes
8 Kg
24 Kg
32 Kg
48 h/kg
Quantity of Meat
Quantity of Potatoes
4
16
8
32
Gardener
Quantity of Meat
Quantity of Potatoes
12
24
24
48
Farmer
GAINS FROM TRADE
Gardener
Meat
Potatoes
Without trade:
Production and Consumption
With trade:
Production
Trade
Consumption
Gains from trade:
Increased consumption
4 16

0 32
5 -15
5 17

+1 +1
Farmer
Meat
Potatoes
12 24

18 12
-5 15
13 27

+1 +3
Why we live in an organised society and not like Rambo
EXAMPLE
in isolation
both
specialise
in the production of only 1 good
exchange
products
15 kg of potatoes
5 kg of meat
Quantity of Meat
Quantity of good Potatoes
4
16
8
32
Gardener
Quantity of Meat
Quantity of good Potatoes
12
24
24
48
Farmer
Production & Consumption before trade
Production
after trade
Consumption
after trade
Production & Consumption before trade
Production
after trade
Consumption
after trade
COMPARATIVE ADVANTAGE
The producer who gives up less of other goods when producing one good has
the lowest opportunity cost
and is said to have a
comparative advantage
As long as 2 people have different opportunity costs, each will benefit from trade
Opportunity cost of of
Meat (1kg)
Potatoes (1kg)
Gardener
Farmer
4 Kg of pot.
2 kg of pot.
0.25 Kg of meat
0.5 Kg of meat
INCIDENCE ON CONSUMERS
INCIDENCE ON SELLERS
S&D characteristics (
elasticity
) influence how
the burden
of a tax is
assigned
S&D is basically a model of the forces the determine
which products get produced
in which quantities and
at what prices
a measure of how much people are willing to pay for something
a measure of the benefits of consuming it
people keep on buying as long as the benefit of the last unit is greater than its cost (price)
a measure of the terms on which producers are willing to a product for sale
producers keep on offering as long as the benefit (the price) is greater than the cost of producing the last unit
4
10
4
10
maximum or minimum prices are decided by law
binding
influencing market outcomes:
surplus
not all sellers are then benefited
Welfare Economics
or how the allocation of resources affects peoples'
well being

Consumers, producers and efficiency
Consumers surplus
is the
benefit
that
buyers
receive from taking part in the
market
The
willingness to pay
for a good or service measure
s

how much
a consumer values the good or service
Consumer surplus =
the amount a buyer is willing to pay - the price actually paid
Total Consumer surplus =
the sum of each consumer surplus
P
Q
DEMAND CURVE IN AN AUCTION
100
80
70
50
1
2
4
3
P
Q
100
80
70
50
1
2
4
3
market price
consumer surplus
market price
consumers surplus
DEMAND CURVE
P
Q
market price
consumer surplus
it's a measure of the perceived well-being
Producers surplus
is the
benefit
that
sellers
receive from taking part in the
market
The
cost
of producing a good or service measure
s

how much
a producer values the good or service
Producer surplus =
the amount a seller is paid - the cost of production
P
Q
SUPPLY CURVE IN AN AUCTION
300
250
200
180
1
2
4
3
market price
SUPPLY CURVE
P
Q
market price
producer surplus
producer surplus
P
300
250
200
180
1
2
4
3
market price
Q
producer surplus
A lower price rises consumers surplus
A higher price rises producers surplus
The
price
of a good or service measure
s

how much
a consumer pays for it
OBVIOUSLY!
Think about an auction
The
price
of a good or service measure
s

how much
a producer receives for it
it's a measure of the perceived well-being
Total Producer surplus =
the sum of each producer surplus
Total surplus
is the
sum
of consumers and producers surplus
Total surplus =
the value to buyers - the price
+the price - the cost of production
the value to buyers
Total surplus =
the value to buyers - the cost of production
The
allocation of resources
that
maximise
the Total Surplus is defined as
EFFICIENT
Quantity produced
Price
Who consumes
Who produces
Examples of
the good is not produced by the seller with the lowest costs
the good is not consumed by the the buyers who values it the most
INEFFICIENCY
MARKET EQUILIBRIUM
P
Q
market price
eq. price
producer surplus
consumer surplus
equilibrium quantity
the buyers who value the good the most buy it
the sellers whose costs are the less produce the good
Market equilibrium
allocate the supply of goods and services to the buyers who value it the most
allocate the demand of good and services to the producer with the lowest costs
the equilibrium quantity maximise the sum of consumers and producer surplus
Taxation and International Trade
A Tax
rises
the price
buyers
pay and
lowers
the price
sellers
receive
Externalities
Often (economic) actions affect third parties (who do not pay or are paid for this). These involuntary effects are called
Example
When you decide whether or not to use a car you take into consideration
costs (gasoline, opportunity costs, etc.)
benefits (comfort, timing, etc.)
but you do not think about the smog someone else will have to breath
Positive
externalities
Negative

externalities
the presence of a museum is a positive externality for local restaurants
a good highway network is a positive externality for companies established in the region
A vaccination programme is a positive externality even for those who do not take part
the pollution emitted by an industrial plant is a negative externality for society
the noises nearby a disco is a negative externality because neighbours are disturbed
P
Q
market price
eq. price
equilibrium quantity
D
S
private cost
S'
social cost
private cost + external cost
social cost
optimum
optimum quantity
P
Q
market price
eq. price
equilibrium quantity
D
S
private value
optimum
optimum quantity
social value
D'
social value
private value + external benefit
Externalities
lead Markets to allocate resources
inefficiently
SOLUTIONS
Private
solutions
Public
(solutions)

policies
Social codes
Charities / NGO
The Coase Theorem
if privates can
bargain
, then the private market will solve the problem of externalities
and allocate resources
efficiently
They can
Internalise
the externality
unfortunately...
Private solution often fail
transaction costs
asymmetric information
free riders
not rational behaviour
Regulation

Taxes and subsidies
a cost to (the right to) produce negative externalities
a benefit to produce positive externalities
Incentive to innovate
Regula
tion vs Taxes
a limited amount of pollution is permitted for the whole country's industries
EXAMPLE
Industries can buy the "right to pollute" paying a tax
EXAMPLE
P
Q
Quantity of pollution emitted
D
S
THE POLLUTION MARKET
demand for pollution (rights)
quantity of pollution established
=supply of pollution permits
price to pollute
P
Q
Quantity of pollution emitted
D
S
demand for pollution (rights)
Tax to be paid to pollute
price to pollute
quantity is set
price is determined by the market
price is set
quantity is determined by the market
Negative

externalities
Positive
externalities
The costs of production
How
firms' decisions
depend on the
market conditions
they face

Total revenues - Total costs = Profits
We assume that entrepreneurs aim is to have as large profits as possible - they
maximise
profits
This is not always true, of course, but it works most of the time and is, therefore, a good starting point for economic analysis
Quantity * Price
= Explicit costs + Implicit costs
money to pay to run the business
salaries
suppliers
financing costs
...
the opportunity costs of some productive factors
how much would the owner have earned somewhere else
how much would the capital have earned if invested somewhere else
...
Pigovian
Arthur Pigou
1877 - 1959
Number of workers Output (quantity) Cost of workers Cost of plant Total costs Marginal product of labour

0 0 0 30 30 0

1 50 10 30 40 50

2 90 20 30 50 40

3 120 30 30 60 30

4 140 40 30 70 20

5 150 50 30 80 10
EXAMPLE
150
Number of workers
1
25
50
75
100
0
Quantity of Output
2
3
4
5
125
The production function
Output
25
10
0
Total cost
50
75
100
125
150
20
30
40
50
60
70
80
The cost function
Quantity of output Total cost Fixed cost Variable cost Average fixed cost Average variable cost Average total cost Marginal cost

0 3 3 0 - - - 0.3

1 3.3 3 0.3 3 0.3 3.3 0.3

2 3.8 3 0.8 1.5 0.4 1.9 0.5

3 4.5 3 1.5 1 0.5 1.5 0.7

4 5.4 3 2.4 0.75 0.6 1.35 0.9

5 6.5 3 3.5 0.6 0.7 1.3 1.1
not determined by the amount produced
rent
personnel
...
change as the quantity produced
raw materials
extra hours
...
the cost of the
typical
product
Total costs
quantity
the cost of the
last
product, the amount of total cost rise when the firm increase the production by one


Total cost (last unit) - Total cost (previous unit)
Δ TC
ΔQ
AFC
AVC
ATC
MC
10
8
9
5
6
7
2
3
4
1
0
of Output
Quantity
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
Costs
Economies of scale
ATC
0
of Output
Quantity
Costs
Average total cost decrease as the production increase
They arise when
larger production allows for specialisation, that make each worker to become more productive
larger production allows for a better use of the capital invested and each "machine become more productive"
Diseconomies of scale
ATC
0
of Output
Quantity
Costs
Average total cost increase as the production increase
They arise when
coordination problems. the firm is not able to manage the production process and it becomes harder and harder to produce
EXAMPLE
Competition
a
market
is
competitive
if each buyer and seller is
small
compared to the size of the market

and cannot influence market prices
In a
Competitive
market
many buyers and many sellers
goods offered are more or less the same
the same or close substitutes
single buyers and seller cannot influence the market price. They're
price takers
Output (quantity) Total revenue Total cost Profit Marginal revenue Marginal cost Change in profit

0 0 3 -3 0 0 0

1 6 5 1 6 2 4

2 12 8 4 6 3 3

3 18 12 6 6 4 2

4 24 17 7 6 5 1

5 30 23 7 6 6 0

6 36 30 6 6 7 -1
Prices * Quantities
Total revenues - Total cost
Δ TR ΔQ
Δ TR
ΔC
MR - MC
AVC
ATC
MC
0
of Output
Quantity
Costs and Revenues
P = AR = MR
Q MAX
P'
P
P''
Q MAX''
Q MAX'
AVC
ATC
MC
0
of Output
Quantity
Costs and Revenues
SHOUT DOWN OR NOT?
Shut down if TR < VC
in the
short
run
TR/Q < VC/Q
AVR < AVC
P < AVC
AVC
ATC
MC
0
of Output
Quantity
Costs and Revenues
EXIT OR NOT?
Exit if TR < TC
in the
long
run
TR/Q < TC/Q
AVR < ATC
P < ATC
Supply decisions
for the competitive firm
In or out of the market?
ATC
MC
0
of Output
Quantity
Costs and Revenues
Q
Profits = TR - TC
Measuring profits in graphs
Profits / Q = TR/Q - TC/Q
Profits = (TR/Q - TC/Q) * Q
Profits = (AVR - ATC) *Q
Measuring profits
AVR = MR = P
Profits = (P - ATC) *Q
Profits
ATC
MC
0
of Output
Quantity
Costs and Revenues
Q
Losses
Average fixed cost constantly decrease

Average variable cost constantly increase

Average total cost curve is U shaped

Marginal cost constantly increase
(since a fixed amount is divided by a higher output quantity)
(given a diminishing marginal product)
(since is the sum of AFC and AVC)
(given a diminishing marginal product)
THEREFORE
Supply in the short and long run?
MC = S
0
of Output
Quantity
Costs and Revenues
One Firm
10
20
S
0
of Output
Quantity
Costs and Revenues
Market
10 000
20 000
EXAMPLE
1 000 FIRMS
all firms
ATC
MC
0
of Output
Quantity
Costs and Revenues
One Firm
P = min ATC
0
of Output
Quantity
Costs and Revenues
Market
S
ATC
MC
0
of Output
Quantity
Costs and Revenues
One Firm
P = min ATC
0
of Output
Quantity
Costs and Revenues
Market
S
long run
short run
S
D
ATC
MC
0
of Output
Quantity
Costs and Revenues
One Firm
0
of Output
Quantity
Costs and Revenues
Market
S
long run
short run
S
D
D'
Eq
Eq1
Eq2
P
2
P
2
P
1
Profit
ATC
MC
0
of Output
Quantity
Costs and Revenues
One Firm
P = min ATC
0
of Output
Quantity
Costs and Revenues
Market
S
long run
short run
S
D
D'
Eq1
Eq2
P
2
P
1
short run
S'
Eq3
THEREFORE
Firms
Exit
the market when P < ATC
Firms
Enter
the market when P > ATC
THEREFORE
Firms
Exit
the market when there're Losses
Firms
Enter
the market when there're Profits
Ok, now we know how firms behave .
Let's see what happens when we have a
shift in the Demand
Science: applying the scientific method
observation
hypothesis
prediction
test
analysis
assumptions
models
MARGINAL BENEFIT
: the benefit of an additional unit
MARGINAL COST
: the cost of an additional unit
Absolute advantage
Who can produce potatoes at the lowest cost? The Farmer
Who can produce meat at the lowest cost? The Farmer
Comparative advantage
Who can produce potatoes at the lowest OPPORTUNITY cost? The Gardener

Who can produce meat at the lowest OPPORTUNITY cost? The Farmer
(when two or more firms are rivals for customers)
Individual demand
The demand of a single person
Individual demand
Individual demand
Individual demand
Market demand
normal goods
inferior goods
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