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Introduction to Microeconomics

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

Stefano Visintin

on 3 April 2013

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