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Micro economics slides

  1. 1. Notes on Microeconomics Prof. Theodore Tolias (Draft – Not for Quotation)
  2. 2. Agenda <ul><li>Theory of Demand and Supply </li></ul><ul><li>Elasticity </li></ul><ul><li>Applications </li></ul><ul><ul><li>Minimum Wage and Unemployment </li></ul></ul><ul><ul><li>Sales Taxes </li></ul></ul><ul><li>Possibilities, Preferences and Consumer Choices </li></ul><ul><li>The Theory of the Firm </li></ul>
  3. 3. The Theory of Demand <ul><li>The quantity demanded (Qd) of a good or service is the amount that consumers plan to buy during a given time period at a particular price (p). </li></ul><ul><li>A linear relationship between P and Qd, other things remaining equal. </li></ul>
  4. 4. Mathematically <ul><li>P = a – bQd, </li></ul><ul><li>Where: </li></ul><ul><li>P = Price of good or service </li></ul><ul><li>a = y-intercept or the price where Qd = 0 </li></ul><ul><li>b = slope of demand curve </li></ul><ul><li>Qd = Quantity demanded </li></ul>
  5. 5. Factors That Affect Demand <ul><li>The price of the good </li></ul><ul><li>The prices of related goods </li></ul><ul><li>Income </li></ul><ul><li>Expected future prices </li></ul><ul><li>Population </li></ul><ul><li>Preferences </li></ul>
  6. 6. Movements Along Demand curve <ul><li>“ Law of Demand” </li></ul><ul><li>Change in “quantity demanded” </li></ul><ul><li>Changes in the price of the good, cause “movements along” the curve, everything else remaining the same. </li></ul>
  7. 7. Shifts of the Demand Curve <ul><li>“ Change in Demand” </li></ul><ul><li>Decrease in demand - leftward shift </li></ul><ul><li>Increase in demand – rightward shift </li></ul>
  8. 8. Decrease in Demand <ul><li>Fall in the price of a substitute </li></ul><ul><li>Rise in the price of a complement </li></ul><ul><li>Income falls (normal good) </li></ul><ul><li>Expected fall in price </li></ul><ul><li>Population decrease </li></ul>p Q D2 D1
  9. 9. Increase in Demand <ul><li>Rise in the price of a substitute </li></ul><ul><li>Fall in the price of a complement </li></ul><ul><li>Income rises (normal good) </li></ul><ul><li>Expected rise in price </li></ul><ul><li>Population Increase </li></ul>p Q D1 D2
  10. 10. Theory of Supply <ul><li>The quantity supplied (Qs) is the amount of a good that producers plan to sell in a given period at a particular price (p). </li></ul><ul><li>A linear relationship Qs and P, other things remaining the same. </li></ul>
  11. 11. Mathematically <ul><li>P = c + dQs, </li></ul><ul><li>Where: </li></ul><ul><li>P = Price of good or service </li></ul><ul><li>c = y-intercept or the price where Qs = 0 </li></ul><ul><li>d = slope of supply curve </li></ul><ul><li>Qs = Quantity supplied </li></ul>
  12. 12. Factors That Affect Supply <ul><li>The price of the good </li></ul><ul><li>The prices of factors of production </li></ul><ul><li>The prices of other goods produced </li></ul><ul><li>Expected future prices </li></ul><ul><li>The number of suppliers </li></ul><ul><li>Technology </li></ul>
  13. 13. Movements Along Supply Curve <ul><li>“ Law of Supply” </li></ul><ul><li>Change in “Quantity Supplied” </li></ul><ul><li>Changes in the price of the good, causes “movements along” the curve, everything else remaining the same. </li></ul>
  14. 14. Shifts of the Supply Curve <ul><li>“ Change in Supply” </li></ul><ul><li>Decrease in Supply – Leftward shift </li></ul><ul><li>Increase in Supply – Rightward shift </li></ul>
  15. 15. Decrease in Supply <ul><li>Rise in the price of a </li></ul><ul><li>factor of production </li></ul><ul><li>Rise in the price of a </li></ul><ul><li>substitute in production </li></ul><ul><li>Fall in the price of a </li></ul><ul><li>complement in production </li></ul><ul><li>An expected rise in price </li></ul><ul><li>of the good </li></ul><ul><li>Fall in the number of firms </li></ul>p Q S2 S1
  16. 16. Increase in Supply <ul><li>Fall in the price of a </li></ul><ul><li>factor of production </li></ul><ul><li>Fall in the price of a </li></ul><ul><li>substitute in production </li></ul><ul><li>Rise in the price of a </li></ul><ul><li>complement in production </li></ul><ul><li>An expected fall in price </li></ul><ul><li>of the good </li></ul><ul><li>Rise in the number of firms </li></ul><ul><li>Technology </li></ul>p Q S1 S2
  17. 17. Price Determination - Equilibrium <ul><li>The price at which the quantity demanded equals the quantity supplied </li></ul><ul><li>Qd = Qs </li></ul>
  18. 18. Diagrammatically <ul><li>Prices below the equilibrium, there is a shortage (excess demand) and the price rises. </li></ul><ul><li>Prices above the equilibrium there is a surplus (excess supply) and the price falls. </li></ul>p Q S D p* Q*
  19. 19. The Effects in the Change of Demand <ul><li>When demand increases, both the price and the quantity increase </li></ul>p Q S p1 Q1 D2 p 2 Q 2 D1
  20. 20. The Effect of a Change in Supply <ul><li>When supply increases, the quantity increases and the price falls. </li></ul>p Q S1 D p1 Q1 S2 p2 Q2
  21. 21. Elasticity <ul><li>Elasticity of Demand </li></ul><ul><ul><li>measures the responsiveness of the quantity demanded of a good or service to a change in its price </li></ul></ul><ul><ul><li>the percentage change in the quantity demanded of a good divided by the percentage change in its price </li></ul></ul>
  22. 22. Derivation <ul><li>Elasticity of demand: </li></ul>
  23. 23. Perfect Inelastic demand Unit Elastic Demand Perfectly Elastic 0 1 p Q D p Q D Q p D
  24. 24. Elasticity Along a Straight Line Demand Curve p Q   
  25. 25. Elasticity, Total Revenue and Expenditure <ul><li>When demand is elastic, a decrease in price brings an increase in the total revenue. </li></ul><ul><li>When demand is inelastic, a decrease in price brings a decrease in the total revenue. </li></ul>Maximum total revenue TR A price cut increases total revenues A price cut decreases total revenues Q
  26. 26. The Factors That Influence The Elasticity of Demand <ul><li>The closeness of substitutes </li></ul><ul><li>The proportion of income spent on the good </li></ul><ul><li>Time elapsed since a price change </li></ul>
  27. 27. Other Elasticities of Demand <ul><li>Cross price elasticity of demand </li></ul><ul><li>Income elasticity of demand </li></ul>
  28. 28. Cross Price Elasticity of Demand <ul><li>Assume Two Goods (X, Y) </li></ul><ul><li>if = then goods are perfect substitutes </li></ul><ul><li>if > >0 then goods are substitutes </li></ul><ul><li>if =0 then goods are independent </li></ul><ul><li>if <0 then goods are complements </li></ul>
  29. 29. Income Elasticity of Demand <ul><li>if >1 the good is normal. </li></ul><ul><li> Demand is income elastic. > </li></ul><ul><li>if 1> >0 the good is normal. </li></ul><ul><li>Demand is income inelastic. < </li></ul><ul><li>if <0 the good is inferior. </li></ul><ul><li>If income increases demand decreases. </li></ul>
  30. 30. Elasticities of Supply <ul><li>When the value of the elasticity of supply,  , is: </li></ul><ul><li> = the supply is perfectly elastic </li></ul><ul><li>>  >1 the supply is elastic </li></ul><ul><li>1>  >0 the supply is inelastic </li></ul><ul><li> = 0 the supply is perfectly inelastic </li></ul>
  31. 31. Applications <ul><li>Minimum wage and Unemployment </li></ul><ul><li>Sales taxes- Who pays the tax? </li></ul>
  32. 32. Minimum wage and Unemployment <ul><li>A price floor - the wage should not fall below the minimum wage. </li></ul><ul><li>To be effective the price must be set above the market equilibrium price. </li></ul><ul><li>Creates an excess supply and a rise in unemployment. </li></ul>
  33. 33. W Quantity (millions of hours) W* Q* Wmin Qd Qs D S
  34. 34. Sales taxes- Who pays the tax? <ul><li>Shifts the supply to the left. Producers and suppliers share the tax burden. </li></ul>Tax revenues p Q1 Q2 S1 S2 tax p1 p2 Q
  35. 35. Sales tax and Perfectly Inelastic Demand <ul><li>If demand is inelastic the consumer pays the entire tax </li></ul>p Q1 S1 S2 tax p1 p2 Q Tax revenues
  36. 36. Sales tax and Perfectly Elastic Demand <ul><li>If demand curve is perfectly elastic the entire tax is paid by the seller </li></ul>p Q1 S1 S2 tax p2 Q Tax revenues Q2
  37. 37. Additional Applications <ul><li>The case of a perfectly inelastic supply curve </li></ul><ul><li>The case of perfectly elastic supply curve </li></ul><ul><li>Given that the demand for farm products is highly inelastic examine how farmers’ income is affected if the crop is poor </li></ul>
  38. 38. Possibilities, Preferences, and Consumer Choices <ul><li>Possibilities: </li></ul><ul><ul><li>Consumption choices are limited by income and prices. The limits to household’s consumption choices are described by its budget line. </li></ul></ul>
  39. 39. Possibilities <ul><li>The budget equation: </li></ul><ul><li>where I= income, Px, Py are the prices of goods X and Y respectively. </li></ul><ul><li>A relative price is the price of one good divided by the price of another good. It measures the slope of budget line: </li></ul>
  40. 40. Solve for Y Y Y X X X a)budget line for Px, Py, I b) budget line shifts right c) budget line pivots when income increases to the right when Px decreases
  41. 41. Preferences <ul><li>A person’s preferences can be represented by a preference map that consists of a series of indifference curves. </li></ul><ul><li>An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. </li></ul>
  42. 42. Y X Uo U1 U2
  43. 43. Properties of indifference curves <ul><li>For most goods, indifference curves slope downward and bow towards the origin (convexity). </li></ul><ul><li>They never intersect. </li></ul><ul><li>The magnitude of the slope of an indifference curve is called the marginal rate of substitution. </li></ul><ul><li>The marginal rate of substitution diminishes as a person consumes less of the good measured on the y-axis and more of the good measured on the x-axis. </li></ul>
  44. 44. Slope and the Marginal Rate of Substitution (MRS) Y X Uo Y1 Y2 X1 X2 A B
  45. 45. Indifference Between Combination A and B <ul><li> Y.MUy =  X.MUx, </li></ul><ul><li>where MUy is the marginal utility derived from the consumption of Y </li></ul><ul><li>where MUx is the marginal utility of the extra units of X </li></ul><ul><li>To remain indifferent between combination A and B the losses in terms of satisfaction must equal the gains </li></ul>
  46. 46. Rearranging is the slope of the indifference curve and it is equal to the MRS =
  47. 47. Best Affordable Point <ul><li>The consumer’s objective is to maximize utility subject to the budget constraint. </li></ul><ul><li>The best affordable point must be on the budget line and also on the highest possible indifference curve. </li></ul>
  48. 48. Point is the best affordable point. Given the budget line, the consumer chooses to Y1 and X1 quantities. At point A the slope of the budget line equals the slope of the indifference curve, i.e. Y X Y1 X1 A
  49. 49. Derivation of the Individual Demand for good X <ul><li>Assume a point on the individual’s demand curve for good X, i.e. point X1 for price Px. </li></ul><ul><li>Assume that Px decreases (Px1) </li></ul><ul><li>The budget line pivots to the right and the individual can now move to a higher indifference curve </li></ul>
  50. 50. The new affordable point for most goods, (normal goods), will indicate that the consumer will be willing to buy more of X. New affordable point is B and the utility maximizing quantity of X is X2. Y X Y1 X1 A B X2
  51. 51. Demand curve for Good X From the above we notice that every point on the demand curve represents a maximum utility point for given prices. A change in income will shift the individual demand to the right assuming the good is normal. X P Px Px1 X1 X2 D P
  52. 52. Implications of Marginal Utility Theory <ul><li>Consumer Surplus </li></ul><ul><li>value a consumer places on a good is the maximum amount that the person would be willing to pay for it. </li></ul><ul><li>For X1 units the consumer would be willing to pay Px and that for X2 units the price that would maximize utility is Px1. </li></ul>
  53. 53. Consumer Surplus Cont.. <ul><li>The price that a consumer actually pays to buy any unit of X is determined in the market. </li></ul><ul><li>If the market price is below what the consumer would be willing to pay then we can say that he/she enjoys a surplus. </li></ul><ul><li>Consumer surplus = the value of a good minus the market price. </li></ul>
  54. 54. The consumer surplus when the market price is Px2 is the area of the triangle APx2B. The consumer would be willing to pay higher prices for any units of X less than X2. The lower the market price the higher the consumer surplus. P X X2 Px2 B
  55. 55. THE THEORY OF THE FIRM <ul><li>The firm’s objective is to maximize profits given the market and technology constraints. </li></ul><ul><li>Definition of economic profit: </li></ul><ul><ul><li>equal to the firm’s total revenue minus its opportunity cost of production. </li></ul></ul><ul><ul><li>Opportunity cost measures cost as the value of the best alternative forgone. </li></ul></ul>
  56. 56. THE THEORY OF THE FIRM <ul><li>The market constraints are the conditions under which the firm can buy its inputs or sell its output </li></ul><ul><ul><li>i.e. whether it faces competitive or non-competitive input and output markets. </li></ul></ul><ul><li>The firm’s technology constraints are the limits to the quantity of output that can be produced by using given factors of production. </li></ul><ul><ul><li>The firm chooses a technologically and economically efficient method of production. </li></ul></ul>
  57. 57. Short-run technology constraint <ul><li>Definitions </li></ul><ul><li>Short run : The period for which the capital stock of the firm remains fixed. In the short run the total product can increase only if variable inputs increase. </li></ul><ul><li>Marginal product : The additional product produced by an additional unit of the variable input. </li></ul>
  58. 58. Definitions Cont… <ul><li>Average product : the average productivity of the variable input. Calculated by dividing total output by the units of the variable input. </li></ul><ul><li>The law of diminishing marginal productivity : As more units of the variable input (labour) are employed total product increases but at a decreasing rate. This implies that marginal product of labour first increases and then decreases. </li></ul>
  59. 59. Relate marginal product (MP L ) to the average product (AP) L <ul><li>When MP L exceeds the AP L , the AP L increases </li></ul><ul><li>when MP L is less than AP L , AP L decreases </li></ul><ul><li>when MP L and AP L are equal, AP L is at its maximum </li></ul>
  60. 60. AP MP Labour units MP AP
  61. 61. Short-run Cost <ul><li>A firm’s total cost is the sum of the costs of all the inputs it uses in production. </li></ul><ul><li>Total cost (TC) = Fixed cost (FC) + Variable cost (VC). </li></ul><ul><li>Recall that all costs ,opportunity and money costs, are included in the total cost measure. </li></ul>
  62. 62. Short-run Cost Cont… <ul><li>Marginal cost (MC) is the extra cost of producing an additional unit of output </li></ul><ul><li>Since in the short-run additional output can only be produced by using an additional unit of the variable input, the MC is related to the MP L . </li></ul>
  63. 63. Example <ul><li>If the marginal product (MP L ) is increasing, the production of an additional unit of output costs less because of increasing productivity. However, as the (MP L ) declines MC increases. </li></ul><ul><li>The lowest MC corresponds to the highest (MP L ). </li></ul>
  64. 64. Average Cost <ul><li>ATC=AFC + AVC </li></ul><ul><li>Average fixed cost (AFC) declines as more output is produced. </li></ul><ul><li>Average variable cost (AVC): Initially decreases because average product increases, and starts increasing when the average product decreases. The lowest average cost corresponds to the highest average product. </li></ul>
  65. 65. Relate MC and AVC to MP L and AP L AP MP AVC MC Labour units Output units MC AVC MP AP
  66. 66. The shape of Short-run Average Cost Curves It is U-shaped because as output increases, it combines the influences of falling fixed cost and eventually diminishing returns. AVC MC AC Output units MC AVC AC
  67. 67. Output and costs in the Long run <ul><li>Long-run cost is the cost of production when all inputs have been adjusted to their economically efficient level </li></ul><ul><li>When a firm increases all inputs proportionally, it experiences returns to scale </li></ul>
  68. 68. Definitions <ul><li>Constant returns to scale : % increase in firm’s output = % increase in firm’s inputs </li></ul><ul><li>Increasing returns to scale (economies of scale): % increase in firm’s output > % increase in firm’s inputs </li></ul><ul><li>Decreasing returns to scale (diseconomies of scale): % increase in firm’s output < % increase in firm’s inputs </li></ul>
  69. 69. Output and Costs in the Long run Cont… <ul><li>There is a set of short-run cost curves for each different plant size and one least-cost plant size. </li></ul><ul><li>The larger the output, the larger the plant size and the lower the average cost. </li></ul><ul><li>The long-run average cost traces the relationship between the lowest attainable average cost and output when both capital and labour inputs are varied. </li></ul>
  70. 70. Shape of LRAC: With economies of scale it declines, while with diseconomies of scale it increases. AVC MC AC Output units LRAC AC 1 Economies of scale Diseconomies of scale AC 2
  71. 71. Perfect Competition <ul><li>In perfect competition, a firm is a price taker and its marginal revenue (MR) equals the market price (P). </li></ul><ul><li>If price exceeds AVC, a firm maximizes profit by producing the output at which marginal cost (MC) = MR. </li></ul><ul><li>Since in perfect competition MR=P the profit maximizing output level is found by MC=P. </li></ul>
  72. 72. Short Run <ul><li>The firm makes economic profits when P>AC, </li></ul><ul><li>Breaks even when P=AC </li></ul><ul><li>Loses part of its return on capital if P<AC. </li></ul><ul><li>The lowest price at which the firm produces is equal to the AVC. </li></ul>
  73. 73. The supply curve of the firm: Corresponds to the portion of the MC curve above the AVC. <ul><li>P 1 ABC represents short-run economic profits when market price is P 1. </li></ul><ul><li>The existence of economic profits attracts new entrants into the industry. </li></ul><ul><li>The increase in supply, everything else being the same, drives the price down to P 2 </li></ul><ul><li>At point D the firm breaks even. Thus, in the long run economic profits are zero. </li></ul>AVC MC AC Output units AC MC P 1 A C B D P=AR=MR P 2 AVC
  74. 74. Allocative Efficiency <ul><li>Consumer’s efficiency is achieved at all points on the demand curve. </li></ul><ul><li>Producer’s efficiency is achieved at all points on the supply. </li></ul><ul><li>Exchange efficiency is achieved at the quantity Q* and P* where the sum of consumer surplus (area A) and producer’s surplus (area B), is maximized. </li></ul>P Q D S P* Q* A B
  75. 75. MONOPOLY <ul><li>The demand curve facing the monopoly is the industry demand curve. </li></ul><ul><li>The marginal revenue for the monopolist is less than the price and it declines as output increases. </li></ul>
  76. 76. <ul><li>The monopolist maximizes profits where MC=MR. </li></ul><ul><li>Sets price Pm according to the demand curve. Pm is greater than MC. </li></ul><ul><li>Since there is no possibility of entry the monopolist can enjoy economic profit even in the long run. </li></ul>P MR Pm Qm Q AC MC profits
  77. 77. Compare Monopoly to Perfect Competition <ul><li>Perfect Competition </li></ul><ul><li>Qc is produced at price Pc </li></ul><ul><li>consumer surplus = a+b+c </li></ul><ul><li>Monopoly </li></ul><ul><li>Qm is produced at price Pm </li></ul><ul><li>consumer surplus = a </li></ul><ul><li>Area b  producer surplus </li></ul><ul><li>Areas c+d  deadweight loss or loss in social welfare </li></ul>P Pm Pc Qm Qc D MC=S Q MR