Introduction - Themes of microeconomics Pindyck and Rubinfeld Tradeoffs Resources are finite and must be allocated somehow among different economic agents. Economic agents (workers, consumers and firms) have to choose among different possibilities. For instance, with a finite budget, a consumer may have to choose whether to buy 6 units of books and 4 units of food or 7 units of food and 2 units of books, or some other combination. Microeconomics studies how the consumer optimally makes a choice among various combinations of goods. It also studies how a worker, with a limited amount of time, allocates time between working and leisure. Firms are constrained by factories’ production capacity and financial resources. Microeconomics studies how the firm chooses how much to produce, what to produce, and which input combination to use, given its constraints. Prices and Markets Economic agents make tradeoffs in part based on the prices they face. For instance a consumer chooses how to allocate her budget between books and food partly based on her preferences over these two goods and partly based on their prices. A worker decides whether to spend an additional hour per day working or not partly based on the wage he can get. A firm decides whether to hire more workers partly based on the wages and the prices of other inputs. Prices are determined by the interactions of consumers, workers and firms. Section 1.2 What is a market? A collection of buyers and sellers that through their actual or potential interactions determine the price of a product. A market includes, but is not limited to an industry. An industry is a collection of firms that sell the same or closely related products. Market definition - which buyers and sellers should be included in a particular market. Chapter 2 - the basics of supply and demand NOTE: The following analysis applies to the special case of a competitive market. A firm with market power has no supply curve, because it can partially determine the price; it does not take price as given. For example, a monopolist’s choice of price and quantity depends on the entire demand curve. Supply and demand curves can be used to describe the market mechanism how a price is determined that causes amount supplied and amount demanded of a good to be equal (without government intervention). 1
The market supply curve shows the total quantity of a good that producers are willing to sell at each price. Price is normally represented on the vertical axis and quantity on the horizontal axis of the graph. The relationship can also be written as an equation, with quantity as a function of price: QS = QS (P ). The supply curves of competitive firms do not slope downwards. When the price rises, the firm never supplies less (it could supply more or the same amount). Why are producers generally willing to sell more of the good at a higher price? Let P1 and P2 be two prices such that P1 > P2 . Let Q1 be the quantity supplied by a firm when price is P1 and Q2 the quantity supplied when price is P2 . This implies that Q1 and Q2 are the profit-maximizing quantities at prices P1 and P2 , respectively. So we have: P1 Q1 − C(Q1 ) ≥ P1 Q2 − C(Q2 ), P2 Q2 − C(Q2 ) ≥ P2 Q1 − C(Q1 ), where C(Q) is the firm’s cost function, and P Q − C(Q) is the firm’s profit at price P and quantity Q. Then, rearranging the expressions, P1 (Q1 − Q2 ) ≥ C(Q1 ) − C(Q2 ), and C(Q1 ) − C(Q2 ) ≥ P2 (Q1 − Q2 ). Therefore, subtracting the second line from the first, (P1 − P2 )(Q1 − Q2 ) ≥ 0. Since P1 > P2 , this implies Q1 − Q2 ≥ 0, so Q1 ≥ Q2 . This shows that a profit-maximizing competitive firm has a supply curve that is not downward-sloping. Other variables that affect supply There are other variables besides price that can affect quantity supplied. These include production costs - wages, interest charges and costs of raw materials. When you draw a supply curve, you assume particular values of these variables. If one of them changes, the supply curve will shift. Suppose the cost of raw materials falls. Lower costs make production more profitable. This causes the supply curve to shift downwards, so that more is supplied at any price. The same would be true if wages or interest charges fell. A list of variables that affect the supply curve a. The technology for production of the good. We will study in detail how this affects quantity supplied later in the course. One would think that an improvement in the technology for producing a good would cause the amount supplied to increase, but this is not always the case. 2
b. Prices of inputs. In general when the price of inputs increases, the amount supplied will decrease, but there are exceptions to this too. c. prices of other goods sellers could sell: If the price of another good a seller could sell increases, the amount offered of the initial good will probably decrease. d. Past and expected future prices. Similar to the analysis for the demand curve. If past prices have been high and recently fell, the supplier may not have had time to shift resources to decrease production. For instance, it may be impossible to fire workers in the short run. If prices stay low for a long time, it may be possible to lay off workers, sell machinery and do other things to decrease production. If future prices are expected to be higher than they are now, a firm will offer less for sale now (if the good is nonperishable), hoarding it for later sale. If future prices are expected to be lower, a firm will probably offer to sell more now. e. The sellers’ composition also affects amount supplied. The number, size and internal structure of firms. f. the legal system (taxes, regulation, enforcement) g. time period The response of quantity supplied to changes in price (with other variables held constant) can be shown by movements along the supply curve. The response of quantity supplied to changes in variables other than price can be shown by shifts in the supply curve. Change in supply refers to shifts in the supply curve. Change in the quantity supplied refers to movements along the supply curve. The demand curve The market demand curve shows the total quantity of a good that consumers are willing to buy at different prices. The relationship between quantity demanded and price can be written as an equation: QD = QD (P ). In general demand curves slope downward, but there are exceptions. Usually, though, consumers are willing to buy more of a good when its price is lower. There are other variables besides the price that affect the amount of a good that consumers are willing to buy. The main one is income. For a normal good, consumers will demand more of it when income is higher and less when income is lower. For an inferior good, consumers will demand less of it when income is higher and more when income is lower. Consider a normal good. Suppose (real) income levels increase. Then the quantity demanded will increase at every price. This leads to a rightward shift in the demand curve. Change in demand refers to shifts in the demand curve and change in the quantity demanded refers to movements along the demand curve.
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Another variable that affects demand for a good is the price of a complementary or substitute good. Goods are substitute when an increase in the price of one leads to an increase in the quantity demanded of the other. Copper and aluminum are substitute goods, because they can be often substituted for each other in industrial processes. Goods are complements if an increase in the price of one leads to a decrease in the quantity demanded of the other. For example, computers and software. As the price of computers has dropped over the last decade, more software packages have been purchased. A list of variables that affect the demand curve a. Income of the population. For many goods, demand for a good will increase when income increases. Such goods are called normal goods. For other goods, demand will decrease when income increases. Such goods are called inferior goods. i. Examples of normal goods? ii. Examples of inferior goods? b. Prices and availability of other goods, especially of substitutes and of complements. i. Good B is a substitute for good A if the consumption of good B can replace the consumption of good A. Examples of pairs of substitutes (each good is a substitute for the other): videos and movies in a theater, Honda Civics and Toyota Corollas, ii. Good B is a complement for good A if the consumption of good B is associated with the consumption of good A, or if consumption of good B is necessary for consumption of good A. Examples: A right shoe and a left shoe, shoes and shoelaces, a computer and software. When the price of a complement for a good increases, we expect that demand for the good will fall if all else is equal. When the price of a substitute for a good increases, we expect that demand for the good will rise if all else is equal. Also, past prices of the good in question and expected future prices of the good affect demand for the good. If people expect the price of a (nonperishable) good to rise in the future, they may buy more of it now to allow for future consumption. If people expect the price of a good to fall, they may wait to buy it later. Past prices affect the demand for a good in the following way. Suppose gas prices were low until recently, then became high. Buyers will not have had time to adjust their lifestyle to account for the newly high gas prices, so they will still demand close to the initial amount of gas demanded when prices were low (price elasticity of demand is low in the short run). However if gas prices have been high for a long time, people will have had time to buy more fuel-efficient cars, move closer to their job, etc. and they will be able to demand less gas.
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c. Tastes and perceived quality of the good relative to substitutes, demographics (the population composition by age, sex, education and ethnicity). So for instance if the population is aging, there may be more demand for drugs for age-related diseases, hearing aids, magnifying glasses, etc. If the population is getting more educated there may be less demand for junk food. If the population is getting more literate there may be more demand for newspapers. d.legal system (taxes, regulation, enforcement). A tax on a good causes the effective price of the good to increase for buyers, and thus demand for the good to fall. e. The time period in question also affects demand for a good. Example: The demand for ice cream is bigger in the summer than in the winter. Demand for a good in the short run may be different than demand in the long run. Over a long period of time, the demand for any given good is generally bigger and more elastic than over a short period of time. But there are exceptions - in some cases the demand is more elastic in the short run. (price elasticity of demand: the percentage change in demand for a percentage change in price) Changes in these variables other than price cause the demand curve to shift. The shift will generally not be parallel. This means that for an upward shift in the demand curve, increases in demand will be different over different price ranges. Give an example of a shift in demand for good A due to the creation of a new substitute product. The initial demand curve is a typical downwardsloping demand curve. Now suppose a competitor offers a new product, good B, which is a perfect substitute for good A, at a certain price P ∗ . Then the new demand curve for product A will be flat at P ∗ and only slope downwards below P ∗ . Consumers will not buy product A at a price above P ∗ ; they will buy product B. But at prices below P ∗ the demand curve for product A is the same as before. This shows that in general the shift will not be parallel. Also, demand curves are not in general linear. Given that a demand curve has shifted to the left, what could be some reasons for this shift? The market mechanism A market equilibrium is found at an intersection of the supply and demand curves (there may be more than one). The market mechanism is the tendency in a free market for the price to adjust until the quantity demanded equals the quantity supplied. Supply and demand need not always be in equilibrium it may take time for the market to adjust to the shock. But there is pressure towards equality of amount demanded and amount supplied that leads the price to adjust towards an equilibrium price. When price is above the market-clearing level, there is a surplus - the amount sellers are willing to supply exceeds the amount buyers are willing to buy. Then sellers will notice this to prevent their stock from accumulating will lower prices.
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When price is below the market-clearing level, there is a shortage. The amount buyers are willing to buy at that price exceeds the amount sellers are willing to sell. Buyers may bid up the price, and sellers will raise prices. In this course we will study both partial equilibrium and general equilibrium models. Partial equilibrium models, such as the supply and demand model, focus on a market for a single good. Such models assume negligible income effects. When the price of a good changes, it causes consumers’ incomes to change. The change in incomes could shift the demand curve. But this effect is not taken into account in partial equilibrium analysis. We do not shift the demand curve in response to a move along the demand curve. In general equilibrium analysis, the interaction among markets for different goods is considered. Changes in prices of each good are allowed to affect the incomes of the consumers. A change in price of one good will thus have an effect on the demand for all other goods. Elasticity Elasticity measures the response of one variable to changes in another variable. In particular, elasticity is often used to measure the response of quantity demanded to a change in price. Economists use elasticity as a measure for this because unlike the slope of the function relating one variable to another, elasticity does not depend on the units of measurement used. Suppose we are measuring the response of demand for steel to price changes using slope of the demand function. First we measure in kilos of steel, in which the demand function is P = −2Q + 10 (What is the slope of this demand function, why is there a negative sign in front of the Q, and why is it negative?) (Because usually quantity demanded falls when price rises). The slope of the graph relating P to Q is −2. Then we measure in metric tons of steel. When the unit of steel used is multiplied by 1000, the quantity demanded (in the new units) is divided by 1000 at each price. So the new relation between P and Q 10 2 2 Q + 1000 . The slope of the graph relating P to Q is − 1000 . So the is P = − 1000 slope is not invariant to the units of measurement used. The elasticity of variable y with respect to variable x (also called the x-elasticity of y) is the percentage change in y divided by the percentage change in x. The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. This is unit free, because percent is a pure number not depending on units. Two different concepts of elasticity exist - the arc elasticity and the point elasticity. The arc elasticity between two points (Q1 , P1 ) and (Q2 , P2 ) on the graph 2 −Q1 )/((Q1 +Q2 )/2) of the function Q = f (P ) equals (Q . The arc elasticity must (P2 −P1 )/((P1 +P2 )/2) be defined between two different points. Choosing two points on the graph of P = −2Q + 10 (using kilos as units of measurement), (0, 10) and (4, 2), calcu(4−0)/2 late the arc elasticity between these two points. (2−10)/6 = −3/2. Now change 6
the units of measurement to metric tons. The function relating P and Q be2 10 comes P = − 1000 Q + 1000 . Now the arc elasticity between the points (0, 10) and (4/1000−0)/(2/1000) (4/1000, 2) is = −3/2. (2−10)/6 Arc elasticity can be used when you want to calculate a price elasticity over a portion of the demand curve or supply curve. For instance if you want to know the effect on quantity demanded of a tax that increases the price from $8.00 to $10.00, you should use arc elasticity. If you are interested in effects of small changes in price on other variables (not just the quantity demanded) such as revenue of sellers, the point elasticity is useful. Point elasticity is the limit of the arc elasticity when we make the length of the = arc small. Formally, the point price elasticity of demand at (Q, P ) is dQ/Q dP/P 1 (dQ/dP )(P/Q). So, if the demand function is defined by Q(P ) = P 2 , then the (point) price elasticity of demand at the point (1/4, 2) is (−2/P 3 )(P/Q) = P−2 2Q , which is −2 at that point. A linear demand function has varying elasticity; high magnitude of elasticity at low prices and low magnitude elasticity at high prices. Examples: Calculate the point elasticity of the demand function Q = −4P + 20 when the price is 4 and when the price is 1. Calculate the point elasticity of Q = 1/P at any point. The following example illustrates the relationship between price elasticity of demand and sellers’ revenue: In 1988 there was a drought which caused the US quantity of wheat to decrease by 14%. This caused the price of wheat to increase by 46%. This means that the price elasticity of demand was −14/46 ≈ −0.3 because in order for the quantity demanded to decrease by 14%, the price had to increase by 46%. While many sellers went bankrupt and lost their farms because their wheat crop did not grow that year, the sellers who were not affected by the drought saw their incomes rise. This is because the percentage increase in price was more than the percentage decrease in quantity. (Note that we are using arc elasticity in this example). This example illustrates a general relationship between sellers’ revenue and price elasticity of demand. When price elasticity of demand Ep is less than 1 in magnitude and there is a quantity drop, price rises more in % than quantity falls, so sellers’ revenue increases. When Ep > 1 in magnitude and there is a quantity drop, price rises less in % than quantity falls, so sellers’ revenue decreases. When the magnitude of Ep equals 1 and there is a quantity drop, price rises the same in % as quantity falls so there is no change in revenue. We can also do the same example using point elasticity. Suppose the supply falls but the demand curve stays the same (Wheat in drought). The price rises. What is the effect on sellers’ revenue? Revenue is R(P ) = P × D(P ) = price times quantity sold. It rises if R0 (P ) > 0, the derivative is positive. Use the product rule to find R0 (P ). Let f (P ) = P . Then R0 (P ) = f 0 (P )D(P ) + f (P )D0 (P ) =
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0
D (P ) D(P ) + P D0 (P ) > 0 if 1 > −PD(P . So again, revenue rises if elasticity is less ) than one. Similar calculations can be used to show that revenue decreases if elasticity is greater than one.
So when they know that demand is inelastic, why don’t sellers cut output in order to raise price? The reason is that no individual seller can influence the market price by cutting their output; such an action would have to be done jointly by many of the sellers and in a competitive market there are too many sellers to be able to collude in this way. However, we will talk about such strategies in the two-seller game theory model. What is wrong with this argument: When there is a drought, suppose there are some farmers affected by it and others who are not affected by it. The demand stays the same, so the demand that was going to the farmers who were affected by the drought now goes to those who weren’t affected. We can also talk about the price elasticity of supply. The arc price elasticity of supply between two points on the graph of the supply curve is the percentage change in quantity supplied divided by the percentage change in price. The point elasticity is defined as above. How does a shift in the demand curve affect sellers’ revenue? It depends on the elasticity of the supply curve and on the elasticity of the demand curve. In any case, an outward shift of the demand curve will raise revenue and an inward shift of the demand curve will decrease revenue. But by how much will revenue rise due to a rightward shift in the demand function? This depends on the elasticity of the supply curve and of the demand curve. There is also income elasticity of demand. When income elasticity is less than 0, the good is inferior. In that case the quantity demanded increases when income decreases and decreases when income increases. When income elasticity is greater than 0, the good is a normal good. When income elasticity is less than 1, the good is a necessity. When income elasticity is greater than one the good is a luxury. Example: P Q = 1/4 so that the spending on the good is a constant fraction of income. Show that income elasticity of demand equals 1. Elasticity and time period. Over a longer period, elasticity usually has higher magnitude. There is more time for adjustment. Example: Gasoline. As price rises over time, people junk old gas guzzlers and buy more fuel-efficient cars. But if prices rise a lot in a short period of time, people may not have time to respond by adjusting their lifestyle to make it possible to buy less.
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