Intecon micro review 1

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Micro review 1 for International Economics' students: the simple market model.

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  • This video clip reviews the microeconomic concepts that we’ll be using in our course.----- Meeting Notes (1/22/12 08:53) -----In our international economics course.
  • The review includes two items: (1) the mechanics of the simple model of a competitive market that economists use and (2) the underpinnings of the conventional choice theory – both collective and individual.
  • First off, what is a market? For our purposes here, we’ll view a market as a bunch of people trading a good on a voluntary basis. The good defines the market. If the good is oranges, then it is a market for oranges. Markets are social structures – people relating to one another in certain ways (in this case, acknowledging and respecting their mutual property and cooperating with one another via trade). For more on this, see my slides on Cooperation & Social Structures.At this point, we make the assumption that this market is competitive. By this we mean, first, that the good is homogeneous. There are no differences in the quality or characteristics of the good. Say it is oranges. They are generic oranges. For a buyer, it doesn’t matter who supplies the oranges, because they all look and taste and smell the same. And second, to say that the market is competitive is to say that there are many buyers and many sellers, so no particular buyer or seller has “market power” – i.e. the ability to manipulate the price individually. And since there are many and the good is the same, the sellers cannot differentiate the good or form coalitions. Neither can the buyers. Basically, it’s just a bunch of individual buyers and sellers trying to do the best they can for each of them individually without regard for the wellbeing of others. No individual buyer or seller can set the price. They all determine the price through their haggling and negotiation, but they do this collectively. Individually, each of them takes the price as given.How do we model this competitive market?
  • We split the people into two groups – one group, we call the buyers. These people have money and want the good. The second group is the sellers. These people have the good, but they want the money. The two groups meet and make the market by negotiating prices at which they are willing to trade. There will be a single price in this market, at which all buyers will buy the good and all sellers will sell the good. Once the two groups agree on a price such that the buyers want to buy the same amount of the good that the sellers wish to sell – and we call that the “market equilibrium” – the deal is made, they shake hands, sellers hand the good to the buyers, buyers pay the sellers the money, and each group goes home happier or at least not less happy than they were before. Remember: it is a voluntary transaction. If people felt that trading made them less happy, then why would they do it voluntarily?We construct the model in the following way: First, we study the behavior of buyers. We call that the demand side. Second, we study the behavior of the sellers. We call that the supply side. Third, we put the two together. We call that equilibrium. Fourth, we study how equilibrium is attained. Fifth, we shock the model by making some or other factor (other than price) affect the behavior of buyers or sellers or both, and see what the model predicts. This is the way in which we test the model. If the predictions of the model match what we observe in reality, then – and to that extent – we deem the model as reliable and use it in our practical applications. Because, ultimately, that is the purpose of the model – to help us predict the effects on the market (on price and quantity traded) of changes in the economic environment.Then let’s begin with the behavior of buyers. We call this demand analysis.
  • Demand.The question we pose here is: What makes buyers buy more (or less) of a good? There are many factors. Let me limit my list to a few of these factors: Price is the first one. And in the graphic model that we use, this is the variable that is explicitly included in the analysis. Economists say that this variable, price, and the quantity traded (demanded and supplied) are the *endogenous* variables. Other variables, which are not explicitly visible in the analysis, are called *exogenous*. It doesn’t mean that we don’t care about them. We have ways to reflect the impact of changes on those variables on our market model – on price and quantity. But our little model cannot explain *why* they change. We are just going to assume, whenever we may deem that convenient, that these variables change and then register the effect of those changes on price and quantity.Price matters here, because – and this seems like a reasonable assumption to make, since it appears to match what we observe in the world – if the price is higher, buyers will tend to buy less of the good. If, on the other hand, the price is lower, buyers will tend to buy more. So, there’s a negative or inverse relationship between price and quantity demanded – the quantity that buyers wish to buy given all other things.The second variable in the list is income or wealth. Income and wealth are related: One is a flow and the other a stock measure. But they ultimately and essentially refer to the same thing. Economists tend to believe that most goods are “normal” (or “superior”) meaning that, when income increases (other things equal), then the quantity that buyers want to buy increases as well. A good is “normal” when there is a positive or direct relationship between income/wealth and the quantity demanded.The third factor is the tastes or preferences of the buyers. Economists are not judgmental about the source or cause of changes in the preferences of buyers. For example, say that buyers change their preferences about oranges, because they assimilate scientific research showing that oranges have anti-oxidant properties that lead to better health, etc., that is not essentially different from buyers changing their preferences about oranges, because they think that oranges have magic properties or are just “cute.”Now, markets are all interrelated. What happens in one market affects other markets. And this variable (or set of variables), the prices of other goods, is indicative of this interrelationship among all markets. Let’s use an example to illustrate this. Suppose we are referring to the market for bikes. People use bikes for transportation, entertainment, exercising, etc. There are alternatives. People could use other means of transportation, entertainment, exercise, etc. Think of skateboards. Say that skateboards become cheaper. Since people face limited budgets, then the lower price of skateboards may persuade some buyers to leave the bike market and try and buy a skateboard instead. Or vice versa – if the price of skateboards increases, then potential skateboard buyers may switch to the bike market. When the higher price of another good makes the demand for this good (e.g. bikes) increase, the goods are said to be substitutes. Now, think of the relationship between the market for bikes and the market for bike locks. Clearly, in Brooklyn (and even more so in Manhattan), owning a bike without a lock may not be a very lasting experience. So we usually think of biking and having a lock to park it as a single experience. That means that, as far as we are concerned, we view the lock almost as if it were a part of the bike. Consider what would happen if the price of bike locks increased. Clearly, if the price of bike locks goes up, the quantity of bikes that buyers wish to buy will decline. When that happens – when the increase in the price of another good leads to a decrease in the quantity demand of this good, the goods are said to be complementary.The final variable (or set of variables, rather) that I will list here is expectations. What is expectations? It’s the anticipation that people make about the future price of the good, their future income or wealth, their future tastes regarding a good, future changes in the prices of other goods, etc. That is, expectations that affect the decision of buyers to buy more or less of the good now. For example, suppose people expect the economy to stay in a tough spot, unemployment to be high, etc. Then people’s expectations about their own future income or wealth may be a bit dim, so they may reduce the quantity demand for the good in question.
  • Here’s the graph of the demand relationship. This graph (the curve or line) shows directly the relationship between the quantity demanded for the good and the price of the good. It is a negative relationship. That is why the slope of the line is negative. The line is downward sloping. Now, for simplicity, I’m drawing it as a straight line. Real demand lines, if we are able to estimate them (and there are difficulties to estimate them empirically), don’t need to be straight lines. This is a simplification, but it is a simplification that helps us clarify things nicely.Note that in this graph, we can only show two variables explicitly or directly. As I said, the two variables we care most about are the price and the quantity traded. So the graph only shows the link between price and quantity explicitly. When we consider the change in the price of the good and then the reaction of buyers, then we say that we are “moving along” the demand line or demand curve. Let me note that we are drawing the demand curve as a straight line for convenience only. There is no reason why an actual demand curve would be linear.
  • When other factors (not explicitly indicated -- the factors that we listed before: income, tastes, other prices, expectations)… when those factors change, that has an effect on the whole demand line. The demand line shifts. For example, suppose that this is the market for oranges and the price of apples increases. Then, as a result, the entire demand line for oranges may shift to the right – indicating that for each given price, buyers are willing to buy more oranges due to the higher price of apples. This is called a rightward *shift* of the demand line. It is easy to see that the effect of changes in the other variables listed (variables other than price and the quantity demanded) can be shown in this graph as a shift of the demand line.Now, just by looking at the shift in the diagram, we may not be able to know what cause that shift. So, we’ll need to add separate information to our diagram so that we know why the graph, the demand line shifted.
  • Let us now consider … supply. This is the description of how the sellers (the other side of the market) behave.The question here is: What makes sellers sell more (or less) of a good? There are also many factors. These are a few important ones: Price is, again, the first one. The higher the price, the more of the good the sellers would want to sell, other things equal.Suppose that the producers and, more generally, the sellers of the good are business people. They are offering the good for sale, because they want to make a profit. The profit they obtain per unit of the good is the difference between the price of the good and the cost of the good for them. Let us define here the cost of the good as the minimum price at which the sellers are willing to sell the good. Clearly, if the cost of the good is given, the higher the price, the higher their profit. On the other hand, if the price of the good is given, then the lower the cost of the good, the higher the profit.Given the price of the good, its cost is going to be their main consideration when deciding how much of the good to sell. What is the cost: Well, if they are the producers, they need to assemble the inputs required to produce the good and pay the going prices or rental rates for those inputs. They need to hire workers, rent a facility or store, buy supplies and materials, rent equipment, etc. They must pay each worker the wage rate, the price of the supplies, the rents. If they use money in their business, and most business must use money, given that they operate in a monetary economy, then they are either using their own money or someone else’s money. In either case, there is a cost involved in using money. If you spend one dollar in your business, producing something for sale and for profit, then you sacrifice what you could, otherwise, earn with that dollar – say the interest rate in a savings or investment account. In other words, the interest rate is the cost of using one dollar in your business. If you use your own money in your business, then the sacrifice is implicit, because you cannot use your money otherwise. If you use someone else’s money, and she charges you the interest rate, then the sacrifice is explicit, because you have to pay that interest. One way or another, it is a cost.All those things affect your decision to sell more or less of the good. Now, to summarize the idea about cost. The cost of producing a batch of pizzas is equal to the sum of your expenditures in the inputs of production. And how much you spend in inputs depends on two things – the technology, which tells you how much of each input you should use and the price of the input in the market, where you buy the input. Therefore, we list two separate variables affecting the quantity supplied: the input prices and technology. They are the variables that determine your cost.Finally, we mention expectations. In this case, it will be expectations about the price of the good, future shifts in technology that you may anticipate, and future changes in input prices that you may also anticipate.
  • Here’s the graph of the supply relationship. This graph (the curve or line) shows directly the relationship between the quantity supplied of the good and the price of the good. It is a positive relationship. The supply curve or line is upward sloping. For simplicity, I draw it as a straight line. Real supply lines, also hard to estimate empirically, don’t need to be straight lines. But we are simplifying matters.You will note that the supply curve here is also a straight line, just like the demand curve was a straight line. Again, this is for convenience only. There is no reason why an actual demand or supply curves would be linear. Now, again, if we are studying the change in the price of the good and how sellers react to it, we are “moving along” the supply curve.
  • When the other factors change, the supply curve shifts entirely. Suppose that this is the market for oranges and the price of labor decreases (say, there is high unemployment in the area and workers have to accept lower wages). Then, as a result, the entire supply curve to the right – indicating that for each given price, sellers are willing to sell more oranges due to the lower cost of labor. This is called a rightward *shift* of the supply curve. And when any of the other factors may change, we can do something similar to register that change and its effect on the market in our diagram.
  • We are now ready to put the demand and the supply sides together. In the diagram, we show now the demand and the supply curves. Demand is downward sloping. Supply is upward sloping. As a result, they cross at a point. Let us examine the point where they cross.The demand curve shows the different quantities of the good that buyers wish to buy at different prices (given the economic environment). The supply curve shows the different quantities of the good that sellers wish to sell at different prices (again, given the economic environment). The point where the two curves cross is a price and a quantity – the price at which the quantity demand and the quantity supplied are equal.At this price, buyers and sellers agree on the quantity they wish to trade. We call it equilibrium, because if nothing changes in the economic environment, then there is no reason why buyers or sellers may want to be somewhere else rather than at that point.Consider the case where the price is higher than the equilibrium price – say about here. Note then that the quantity that buyers want to buy falls short of the quantity that sellers want to sell. As a consequence, there is no deal. There is a gap between the quantity demanded and the quantity supplied. Economists call that gap a glut. It is called a glut, because the sellers want to sell more of the good that buyers want to buy. So there’s an oversupply of the good – a glut.If this is the case, and people in this market are free to take action, then this is not a situation we expect to last long. Why? Because sellers will compete for the few buyers in the market by lowering the price. The buyers of course will sit tight and wait for the price to drop. Since at any price above equilibrium, there will be a glut, the price is then push down by the competition among the sellers to its equilibrium level.Alternatively, suppose the price is below the equilibrium price – say about here. Then the quantity supplied is less than the quantity demanded. The price is now too low for some sellers who leave the market, which is great for some buyers who join the market. As a result, the quantity supplied falls short of the quantity that buyers wish to buy at that price. There is a shortage – the opposite of a glut. A shortage is an excess of the quantity demanded compared to the quantity supplied.Again, this situation is going to be fleeting in a competitive market. Buyers are going to compete among one another the get the few goods available and by so doing, they are going to drive the price up. The sellers will hold on their sales until the price (which must be the same for everybody) goes up to a level where the shortage disappears. At any price below equilibrium, there will be a shortage and, because the market is competitive, the price will then be driven up by the competition among the buyers until it reaches its equilibrium level. This all presupposes that all other variables (the economic environment) do not change.It is important to note that the demand and supply relationships do not exist as something that we can observe directly. They are what-if constructs. They are answers to questions such as: What is the quantity of the good demanded (or supplied) if the price is 2 or 3 or $4/unit), other things (the other variables we listed) constant. What we can observe (after the fact) is the actual quantity of the good traded and the price at which it was traded. We can also observe the amount of money that the buyers spent on the good (the buyers’ expenditure) which is also the amount of money that the sellers received from selling the good (the sellers’ revenues).
  • Let us now do the algebra.The demand equation is this one: P = 12 - .8 Qdwhere 12 is the vertical intercept and -0.8 is the slope.The intercept or any price above it would discourage buyers from buying the good. No buyer would pay that much for the good. The slope (.8) indicates the drop in the price that would make buyers buy one extra unit of the good.Note that the vertical axis shows you how much the buyers value one unit of the good. It indicates how much they benefit from it, since they would only pay the price for it if they felt that the benefit received compensates them properly.
  • And here is the supply equation: P = 2 + .2 Qs, where 2 is the vertical intercept and 0.25 is the slope.At the intercept or any price below it, no seller would sell any of the good. The slope indicates the increase in the price that would lead sellers to sell one extra unit of the good.It is important to note here that the vertical axis also shows how much the sellers value the good. It indicates how much the good costs the sellers, since they would only sell it if they feel compensated for such cost.
  • We have a system of two linear equations. The demand has to satisfy the rule P = 12 - .8 Qd and the supply the rule that P = 2 + .2 Qs. In equilibrium, the price that buyers pay is the same price that the sellers receive. And the quantity that the buyers want to buy is the quantity that the sellers want to sell. In other words, the equilibrium price and quantity are the values of P and Q that solve the two equations simultaneously.Let us solve the system algebraically now. Since the price has to be the same for both buyers and sellers, then we can make the RHS of these equations equal and then solve for Q, which is also only one Q, both quantity demanded and quantity supplied. After doing the algebra, we find that the quantity that both buyers and sellers want to trade is 10 units of the good. By plugging this value of Q in any of the original equations, we find the equilibrium price, which is $4/unit. I do the substitution with both equations, demand and supply, to show that the result must be the same.…The equilibrium is a pair of numbers, a price and a quantity: 10 units of the good and $4/unit.
  • Let us use now the model for its practical purpose. We need it to predict the response of the market to changes in the economic environment. Say, for example, that we want to know the effect on the market (on its Q* and P*) of a new sales tax by of $2/unit of the good. Note that the same effect would result from any other change in the economic environment leading to a leftward shift of the supply curve of the same size.The result is a new equilibrium. A higher price and a smaller quantity. I’ll leave up to you to consider what happens to the equilibrium price and quantity if the supply curve shifts to the right instead. Also, what happens to the market (to Q* and P*) if the supply curve does not move, but the demand curve shifts to the right and left? Play with the model until you feel comfortable enough understanding its mechanics and implications.
  • Let us now do the algebra for the new conditions in the market. The demand equation stays the same. But the supply curve has a new – higher – intercept: The supply equation is now P = 4 + .2 Qs.Let us solve the new system for P* and Q*. Again, since the price has to be the same for both buyers and sellers, then we can make the RHS of these equations equal and then solve for Q, which is also only one Q, both quantity demanded and quantity supplied. We find that the quantity that both buyers and sellers want to trade is 8 units of the good. Again, we plug this value of Q in any of the original equations to find the equilibrium price, which is now $5.6/unit. I do this substitution in both equations, demand and supply, to show again that the result is the same. The new equilibrium is 8 units of the good and $5.6/unit.
  • Suppose the price in the market is $4/unit. The amount that buyers will buy at that price is 10 units. The buyers’ total benefit (so-called “consumer” benefit) is the area under the demand curve and bound by the quantity: 10 units. Now, the buyers spend in the good: P Q = ($4/unit) (10 units) = $40. They receive the 10 units of the good that yields for them the total benefit. However, a portion of the total benefit – the rectangle representing their expenditure – is not free. They pay for that. Still, there is the triangle above the expenditure rectangle for which buyers pay nothing. It is their net benefit or “consumer surplus.” It is the welfare that buyers receive for free from the amount of the good they buy from the sellers. They receive this net benefit or “consumer surplus” because the market exists – because there is another side to the market, because there are sellers willing to cooperate or trade with them. This is the source of the consumer surplus.The consumer surplus is represented by the area of that triangle. To calculate the area, we use the formula (b h)/2. In this case, the base is 10 units and the height is the intercept of the demand curve minus the price in the market, which is $4/unit. Therefore, it is 12-4 = 8, multiplied by 10, that is 80, and 80 divided by 2 is 40. Note that the units are just dollars: $40. The values on the vertical axis are prices: $/unit. So $12/unit minus $4/unit = $8/unit. Now when you multiply $/unit times units, the units cancel out, and you obtain $, just plain dollars.So, the net benefit of the buyers, the consumer surplus (a measure of the welfare of buyers in the market that they receive gratis from the existence of the market) is calculated in dollars. It’s $40.
  • Let us now calculate the producer surplus.Again, if the price in the market is $4/unit. The amount that sellers will sell at that price is 10 units. Remember that the height of the supply curve indicates the lowest price that sellers ask for one unit of the good, and that is precisely the cost of the good for them. The sellers’ total receipts or revenues are P Q = (4) (10) = $40. That is represented by this rectangle. The area below the supply curve and bound by the quantity: 10 units is the cost for the producers. Note that the sellers’ revenues P Q, $40, are more than the sellers’ cost. The difference of R – C = profit. The profit is also called the “producer surplus.”The consumer surplus is represented by the area of this triangle. Again, the area is (b h)/2. In this case, the base is 10 units and the height is the market price, $4/unit, minus the intercept of the supply curve, $2/unit. The height is then 4-2 = $2/unit. Therefore, the producer surplus is (10) (2) = 20, divided by 2: $10. So, the net welfare benefit of the sellers, their profit or producer surplus, is a measure of the welfare of sellers in the market – something they receive for free, because the market exists. It is calculated in dollars. It’s $10.
  • The total surplus or the net welfare benefit that the buyers and sellers receive altogether is the sum of the consumer and the producer surpluses.
  • In other words, the total surplus is equal to $40 + $10 = $50.To repeat: This is a measure of the net welfare benefits that both buyers and sellers together receive as a result of the existence of the market, which is to say, as a result of their cooperating with each other. It’s the fruits of their cooperation, which – in this particular case – takes the form of trade.And to keep the time of this videos short, there’s no summary. You can go back and replay the parts that you may need to study more carefully.I hope this was helpful to you. I’ll see you in class.
  • Intecon micro review 1

    1. 1. InternationalEconomics –Micro Review 1Jhuato.sfc@gmail.com
    2. 2. Micro review 1A simple (competitive) market  Demand, supply, and equilibrium  Shifts in demand or supply  Algebra and graphs  Consumer & producer surpluses
    3. 3. Markets Markets are defined by the good traded Markets are social structures – people relating to one another in certain ways (in this case, respecting their property and cooperating with one another via trade) In our simple model, we assume the market to be competitive:  Homogeneous good  Many buyers & sellers (no market power)
    4. 4. Market model1. We split the market into two groups: (1) buyers and (2) sellers2. Study the behavior of buyers (demand)3. Study the behavior of sellers (supply)4. Study demand and supply together (equilibrium)5. Study the model’s reactions to changes in the economic environment (comparative statics)6. Insofar as the model’s implications match our observations of the real world, we view the model as reliable – helpful in practical applications
    5. 5. DemandWhat makes buyers buy (consumers consume)more of a good? A lower price of the good Higher income or wealth Enhanced taste for the good Suitable changes in prices of related goods Expectations Etc.
    6. 6. Demand graph
    7. 7. Demand graph
    8. 8. SupplyWhat makes sellers sell (producers produce)more of a good?A higher price of the good Lower input prices (e.g. wages) Improved technology Expectations Etc.
    9. 9. Supply graph
    10. 10. Supply graph
    11. 11. Equilibrium graph
    12. 12. Demand equation P =12 -.8Qdwhere 12 is the vertical intercept and -0.8 is theslope.
    13. 13. Supply equation P = 2 +.2Qswhere 2 is the vertical intercept and 0.25 is theslope.
    14. 14. Solving the systemDemand: P =12 -.8QdSupply: P = 2 +.2Qs 12 -.8Q = 2 +.2Q 12 - 2 = .8Q +.2Q Q* = 10 P * = 12 - (.8 ´10) = 12 - 8 = 4 P * = 2 + (.2 ´10) = 2 + 2 = 4Equilibrium: (Q =10, P = 4) * *10 units of the good, $4/unit.
    15. 15. Leftward shift in supply
    16. 16. New equilibriumDemand: P =12 -.8QdNew supply: P = 4 +.2Qs 12 -.8Q = 4 +.2Q 12 - 4 = .8Q +.2Q Q* = 8 P * = 12 - (.8 ´ 8) = 12 - 6.4 = 5.6 P * = 4 + (.2 ´ 8) = 4 +1.6 = 5.6 New equilibrium: (Q* = 8, P* = 5.6) 8 units of the good, $5.6/unit.
    17. 17. Welfare analysis The market model allows us to study the implications of trade in a market to the welfare (well-being) of buyers and sellers. We will be using this analysis once we study international trade. First, we study the welfare of buyers. This measure is called “consumer surplus.” Second, we study the welfare of sellers. This measure is called “producer surplus.” Finally, we study the welfare of the market as a whole. This measure is the “total surplus.”
    18. 18. Consumer surplus The demand curve shows the different prices at which buyers are willing to buy a good The price that a buyer is willing to pay for a good is a measure of how much the buyer values the benefits from having the good The area under the demand curve shows the gross benefits that buyers in the market receive from having a given amount of the good The area under the demand curve but above the expenditure rectangle is the consumer surplus.
    19. 19. Consumer surplus
    20. 20. Producer surplus The supply curve shows the different prices at which sellers are willing to sell a good The price that a seller is willing to charge for a good is a measure of the cost of the good to the seller The area below the supply curve shows the total cost that sellers in the market incur from producing a given amount of the good The area of the “triangle” inside the revenue quadrangle but above the cost
    21. 21. Producer surplus
    22. 22. Total surplus Thesum of the consumer surplus and the producer surplus is a measure of the total welfare that results from the existence of the market
    23. 23. Total surplus

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