Microeconomics
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lecture1-3.pdf
1
Prices and Markets ECON1020 Semester 2 2020
Professor Robert Hoffmann
possible new bits
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1. Business Economics 2. Market Demand 3. Price Determination
The Market Prices and Markets: Block 1
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1.1. Economics 1.2. Economic Method 1.3. The Economy 1.4. Economic Systems
The Market Prices and Markets: Block 1
Lecture 1 Business Economics
1.1.1. Economics: Definition of Economics
Lionel Robbins
Economics is the study of the economy. It
• studies how agents choose to allocate limited resources (rationality) • studies these issues using the scientific method (equilibrium and empiricism) • studies how these choices affect the welfare of society (efficiency)
Definition: Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses (Lionel Robbins).
Definitions: Microeconomics is the branch of economics that studies resource allocation by individual economic agents, markets, firms and government and the impact on efficiency. Macroeconomics is the branch of economics that studies the performance of the economy as a whole at the national, regional and global levels resulting from the interactions between markets, firms and government.
Definitions: Positive economics describes what economic agents actually do. Normative economics recommends what economic agents and society should do.
Macroeconomics 1 ECON 1016
Prices and Markets ECON 1025
em piri
cal Behavioural Business Minor
the ore
tica l
Phenomenon • identification • observation • measurement
Model • definitions • assumptions • variables
Analysis • ceteris paribus • equilibrium • efficiency
Theory • explanations • predictions • policy advice
Test • hypotheses • measurement • statistical analysis
(econometrics)
Price Qd Qs
1 97 23
2 87 33
3 81 43
4 74 54
5 66 66
DV = ⨍(IV1, IV2 …)
1.2.1. Economic Method: Theory and Empiricism Behavioural
Business Minor
1.2.2. Economic Method: Economic Thinking
Observation
Theory
Model
Evidence
Sep!mber 30, 1659.—I, poor miserable Robinson Crusoe, being shipwrecked during a dread#l s$rm, came on shore on %is dismal, unfortuna! island, a& %e rest of %e ship’s company being drowned, and myself almost dead. I had nei%er food, house, and in despair of any relief, saw no%ing but dea% before me—ei%er %at I should be devoured by wild beasts, murdered by savages, or starved $ dea% for want of food.
Definition: the factors of production (FOPs) are those resources used to produce: capital (man-made resources), land (natural resources) and labour (the human resource).
Robinson has resources: • pocket knife • papaya trees • skills • freshwater lake • time (a lot!) • wild goats • knowledge
The allocation of scare resources in the subsistence economy involves the following basic economic problems:
• Problem #1: What to produce? • Problem #2: How to produce?
Production = ⨍(capital, land, labour)
1.3.1. The Economy: The Subsistence Economy
Definition: Allocating limited resources involves trade offs. Opportunity cost is the best alternative that must be given up to obtain something.
Definition: Rationality means economic agents try to optimise and choose the best feasible option given their information and abilities.
Robinson develops labour (skills) I had never handled a $ol in my life; and yet, in (me, by labour, applica(on, and con)ivance, I found at last %at I wan!d no%ing but I could have made it, especia&y if I had had $ols.
Robinson acquires capital Oc$ber 1.—In %e morning I saw, $ my great surprise, %e ship was driven much nearer %e island; I might get on board, and get some necessaries out of her for my relief— I %en swam on board
Production Possibility Frontier
F oo
d (0
00 s
kc al
)
0
2
4
6
8
Shelter (sqm)
0 1 2 3 4 5 6 7 8
Robinson at first Robinson with tools Robinson with tools and new skills
Definition: the production possibility frontier (PPF) shows the various combinations of output that the economy can produce given the available factors of production.
Definition: opportunity cost is the best alternative that must be given up to obtain something.
Robinson must choose a point on the PPF depending on his tastes for the two products. Going from (4,2) to (2,3) involves a trade-off: to afford 1 extra unit of food there is an opportunity cost of 2 units of shelter which have to be given up in return.
Unattainable
Inefficient
1.3.2. The Economy: Economic Growth
2, 3
4, 2
Production Possibility Frontier
F oo
d (0
00 s
kc al
)
0
2
4
6
8
Shelter (sqm)
0 1 2 3 4 5 6 7 8
Robinson Crusoe "Man Friday" Both Definitions: Absolute advantage is the ability to
produce something with fewer inputs (or more with the same inputs). Comparative advantage is the ability to produce something at lower opportunity cost.
To produce 1 extra unit of shelter, Friday gives up 2 units of food but Robinson only gives up 1/2 unit. Robinson has comparative advantage in making shelter and specialises. Friday specialises in producing food. There is a division of labour.
The gains from trade means both are better off and together produce (8,8). But specialised individuals need to trade to get what each needs: • Problem #3: How to exchange?
4,44,4
6,6
8,80,8
8,0
Definition: the production possibility frontier (PPF) shows the various combinations of output that the economy can produce given the available factors of production.
1.3.2. The Economy: The Exchange Economy
Robinson must choose a point on the PPF depending on his preferences. Going from (4,2) to (2,2) involves a trade-off: 1 extra unit of food has an opportunity cost of 2 units of shelter which have to be given up.
2,4
2,3
4,2
1.4.1. Economic Systems: Markets v. Planning Definition: An economic system is the way which a society allocates its resources, i.e. organises production and exchange (i.e. solves economic problems #1-3).
The free market economy The command economyThe mixed economy
FOP ownership private public
Decision making
individually autonomous
centralised and hierarchical
Coordination market central planning
increasing government intervention
Inputs for production
Wages, rent & profit
Labour, land & capital
Income
Revenue
Firms
Goods & services
sold
Households
Markets for goods & services
Goods & services bought
Spending
Government Markets for the FOPs
Rest of the World
Imports Exports
T he
( cl
os ed
) ec
on om
y T
he (
op en
) ec
on om
y
1.4.2. Economic Systems: The Circular Flow
Singapore?Laos
Economics is about how to allocate one’s resources for the best result. One of the most important issues for a country is what it should produce: What do you use your workers, land and machines for?
Coffee is one of the most widely consumed beverages and therefore most important trade goods. It is widely produced in countries with equatorial climates, like Laos and Vietnam.
Should Singapore grow coffee?
Let’s use some economic thinking to get to the bottom of this. Economists look at real issues through models and theory.
Tutorial 1
Tutorial 1: Gaining from Trading These production possibilities frontiers (PPFs) show how many units of two products 1 worker can produce in one day in two countries:
1. What is Laos’ opportunity cost of producing (a) 1 unit of electronics and (b) 1 unit of coffee beans?
2. What is Singapore’s opportunity cost of producing (a) 1 unit of electronics, and (b) 1 unit of coffee beans?
3. Which if any product(s) does Laos have an absolute advantage in? Which if any products(s) does Singapore have an absolute advantage in?
4. Assume Laos produces 15 coffee and 5 electronics units, and Singapore produces 20 coffee units and 15 electronics units. That means together, they produce 35 units of coffee, and 20 of electronics. Advise the countries how together they can produce more of both. Hint: Economists use theory! Look back at your lecture notes and pick out the correct concept to help you answer.
5. Laos receives foreign aid. Show the new PPF: (a) Machinery from China that doubles Laos’ productivity in electronics but has no other use, (b) training from Vietnam for its coffee workers that raises their productivity by one third.
6. How can any country, like Laos or Singapore, produce more? Provide a general economic model rather than specific examples.
C of
fe e
B ea
ns
0
10
20
30
40
Electronics
0 5 10 15 20 25 30
C of
fe e
B ea
ns
0
10
20
30
40
Electronics
0 5 10 15 20 25 30
Singapore Laos
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Lecture 2 Market Demand
2.1. The Market Model 2.2. The Demand Curve 2.3. Demand Elasticity 2.4. The Supply Curve
The Market Prices and Markets: Block 1
2.1. The Market Model Definition: The market is an institution where the buyers and sellers of the same good or service come together to trade.
Variables in the allocation of resources • price (p) • quantity of output (q)
Assumptions • rational agents • perfect information • zero transaction cost • flexible prices • property rights defined and enforced • perfect competitionWhile they are “unrealistic” simplifications,
together they tell us under what conditions the market will work well. They serve as a benchmark for the design and improvement of real markets.
The market model shows the relationship between two key variables, price and quantity, for both demand and supply. We analyse the model for equilibrium and efficiency.
Demand side (buyers or consumers)
Supply side (sellers or producers)
Behavioural Business
Minor
2.2.1. Demand Curve: Law of Demand
Demand schedule P QD 14 0 12 1 10 2 8 3 6 4 4 5 2 6 0 7
Demand function: P = 14 - 2QD
QD = -(P-14)/2
Demand comprises all those consumers willing and able to buy the product. How much people buy depends on many variables, we focus on price.
P ric
e (P
)
0
2
4
6
8
10
12
14
Quantity (Q)
0 1 2 3 4 5 6 7
Definition: the law of demand states that as the price rises, the quantity demanded falls and vice versa (because consumers are relatively worse off and substitute into other products).
Definition: Demand shows how much consumers plan to buy at every conceivable price. Quantity demanded (QD) refers to purchasing plans at one particular price (P).
• slopes downward • steepness reflects consumer price sensitivity • position reflects the volume of demand
Q0
P
p
p’
q q’
D
2.2.2. Demand Curve: Own-Price Elasticity Definition: Elasticity measures the responsiveness of quantity to one of its determinants. We measure elasticity in the steepness (slope) of the curve concerned. There are many types of demand and supply elasticity to determinants such as price of this and related products, income etc.
Definition: own-price elasticity of demand (PED) measures the responsiveness of quantity demanded of a product to its price. It reflects the sensitivity or responsiveness of consumer purchasing plans to price.
The steepness or slope of the demand curve is a measure of own-price elasticity of demand. The flatter the demand curve, the greater is the change in consumers’ purchasing plans.
PED = % ∆ QD
% ∆ P
2.2.3. Demand Curve: Midpoint Formula
Q=2 P=10
Q=5 P=4
Q=0 P=14
P ric
e (P
)
0
2
4
6
8
10
12
14
Quantity (Q)
0 1 2 3 4 5 6 7
Q=7 P=0
PED = (2 – 0) ⨉ (10 + 14) = 2 ⨉ 24 = -6 (10 – 14) (2 + 0) -4 2
PED = (2-5) ⨉ (10 + 4) = -3 ⨉ 14 = -1 (10-4) (2+5) 6 7
PED = (Q2 – Q1) ⨉ (P2 + P1) (P2 – P1) (Q2 + Q1)
PED = (7 – 5) ⨉ (0 + 4) = 2 ⨉ 4 = -0.167 (0– 4) (7 + 5) -4 12
The measured elasticity between two given points of the demand curve depends on whether we calculate the change from the higher or the lower of the two values, e.g. from P=4 to P=10 or vice versa. As a result we can use the mid-point formula which gives the same result in either case:
PED = (5 – 2) ⨉ (4 + 10) = 3 ⨉ 14 = -1 (4 – 10) (5 + 2) -6 7
The elasticity measured at different points of a linear curve differs because the percentage size of same absolute change (say a price fall of 4 either from 14 to 10 or 4 to 0) differs as we go along the axis.
∆ QD
∆ P
Example calculations:
2.3.1. Demand Elasticity: Own Price
Abs. value 0 between 0 and 1 1 >1 ∞ Classification perfectly
inelastic inelastic unit elastic elastic perfectly
elastic ∆ Q P causes ∆
QD of 0 less than
proportional proportional greater than
proportional total
P
Q
PED = % ∆ QD
% ∆ P Definition: Own-price elasticity of demand (PED) measures the responsiveness of quantity demanded of a product to its price. It reflects the sensitivity or responsiveness of consumer purchasing plans to price.
Necessity Short-term No substitutes Wide market
Luxury Long-term Substitutes Narrow market
2.3.2. Demand Elasticity: Cross Price
Definition: Cross-price elasticity of demand (CPED) measures the responsiveness of quantity demanded of a product to changes the price of another good.
Complements have negative cross-price elasticities.
Substitutes have positive cross- price elasticities.
Unrelated goods have zero cross-price elasticities.
0
0 QdP ric
e of
a no
th er
g oo
d
0 Qd
P ric
e of
a no
th er
g oo
d
0 Qd
P ric
e of
a no
th er
g oo
d
CPED = % ∆ QD
% ∆ POther
Original good (coffee) Original good (coffee) Original good (coffee)
2.3.3. Demand Elasticity: Income
Normal goods have positive income elasticities.
Inferior goods have negative income elasticities.
Necessities tend to have small income elasticities.
Luxuries tend to have large income elasticities.
Income (Y)
0 Qd
YED = % ∆ QD
% ∆ Y
0 Qd
Income (Y)
0 Qd
Income (Y)
0
0 Qd
Income (Y)
Definition: income-elasticity of demand (YED) measures the responsiveness of quantity demanded of a product to changes in consumer income.
P ric
e (P
)
0
2
4
6
8
10
12
14
Quantity (Q)
0 1 2 3 4 5 6 7 8 9 10 11 12
Supply schedule
P QS
0
2 0
4 2
6 4
8 6
10 8
12 10
14 12
2.4.1. Supply Curve: Law of Supply
Supply function: P = 2 + QS
QS = P − 2
Supply comprises all those producers willing and able to produce the product. How much these firms produce depends on many variables, we focus on price.
• slopes upward • slope reflects producer price sensitivity • position reflects volume of supply
Definition: the law of supply states that as the price rises, the quantity supplied rises and vice versa (because producers substitute out of other products).
Definition: Supply shows how much producers plan to produce at every conceivable price. Quantity supplied refers to one particular price level.
2.4.2. Supply Curve: Own-Price Elasticity
Q0
P
q q’
p’ p
S
A product´s own-price elasticity depends on
• availability of close substitutes • definition of the market • availability of inputs • time horizon
Definition: Own-price elasticity of supply measures the responsiveness of quantity supplied of a product to its price. It reflects the sensitivity or responsiveness of producer purchasing plans to price.
The steepness or slope of the supply curve is a measure of own-price elasticity of supply. The flatter the supply curve, the greater is the change in firms´ producing plans.
PES = % ∆ QS
% ∆ P
Product A Product B Price of A Q
D QS QD
60 0 10.5 16.5 54 2 9 15 48 4 7.5 13.5 42 6 6 12 36 8 4.5 10.5 30 10 3 9 24 12 1.5 7.5 18 14 0 6 12 16 4.5 6 18 3 0 20 1.5
Tutorial 2 - Business Analysis of Demand You work for a market analysis firm that uses checkout data and cost information from producers to estimate the market demand and supply for different products. You have collected market data about two products one of your clients sells, product A and B. The data are shown in the table. Your manager wants you to analyse it and present findings in a report using suitable diagrams and calculations. You are meant to answer the following questions:
1. How sensitive are buyers of product A to a price change in product A from $60 to $54?
2. What is the relationship between product A and product B? 3. Interviews with customers suggest that most regard product A as a necessity. If so, how much would the quantity demanded of product A change if consumer income was to rise by 1%?
4. Your colleague claims he has good knowledge of the production process and firms selling product A and claims supply is generally own- price inelastic. Is he right?
5. Plot all the data for product A in a diagram. 6. What is the quantity of product A that you expect will be sold in this market?
50
The Market Prices and Markets: Block 1
Lecture 3 Price Determination
3.1. Market Equilibrium 3.2. Change in Demand and Supply 3.3. Comparative Statics 3.4. Market Efficiency
P QD QS Difference
14 0 12 12
12 1 10 9
10 2 8 6
8 3 6 3
6 4 4 0
4 5 2 -3
2 6 0 -6
0 7
In the competitive market, the equilibrium occurs at the price where QD = QS. This price clears the market such that no shortage nor surplus exists.
The coffee market
P ric
e (P
)
0
2
4
6
8
10
12
14
Quantity (Q)
0 1 2 3 4 5 6 7 8 9 10 11 12
Demand Supply
3.1.1. Market Equilibrium: Demand and Supply
3.1.2. Market Equilibrium: Market Clearing
Q0
P
D
S Definition: Equilibrium [from Latin aequus (equal) and lībra (level, balance) is a balance of opposing forces, i.e. a stable state of a system under prevailing conditions.
p qD qS
p qDqS
oversupply
shortage
market clearingp*
q*
At first we examine partial equilibrium in a market, i.e. ceteris paribus, prices in related markets (substitutes, complements and FOPs) are constant.
3.2.1. Change in Demand
Q0
P
Factors that change demand • price of substitutes in consumption • price of complements in consumption • consumer income • consumer tastes • changes in population
p
q’
D’
Definition: a change (rise/fall) in demand means that at every price, there is now a different (greater/smaller) quantity demanded.
q
D
q’’
D’’
risefall
3.2.2. Change in Supply
Q0
P
Factors that change supply • price of substitutes in production • price of complements in production • taxes/FOP prices • technology • firm entry/exit
p
q’
Definition: a change (rise/fall) in supply means that at every price, there is now a different (greater/smaller) quantity supplied.
risefall
S’
q
S
q’’
S’’
International Coffe prices (kg Arabica beans in 2010 real US$)
0
1
2
3
4
5
6
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
3.3.1. Comparative Statics: Co!ee Prices QUESTION Coffee is now the second most traded commodity in the world after crude oil. Not only has demand for various coffee products risen sharply in Western countries in recent years, increasingly there is also greater taste for coffee drinks in developing countries such as China and India. In addition, by-products of coffee beans have become popular such as coffee leaves which can be used to brew a tea with known health benefits. However, as a natural produce, coffee plants are subject to weather conditions. Recently major producers such as Brazil have been plagued by droughts. Using the demand-supply model, explain the likely effects of these phenomena in the coffee bean market. How can a market analyst use this information to her advantage?
3.3.2. Comparative Statics: Co!ee Demand
Coffee producing nations
Others 19%
Peru 3%
Guatemala 3%Mexico
4% India 4% Ethiopia
5% Indonesia
6% Colombia 9%
Vietnam 12%
Brazil 35%
3.3.3. Comparative Statics: Co!ee Supply
Q0
P
D
S
p1
q1
We examine the effect of a change in the prevailing conditions on the (initial) equilibrium in the market. We find the new equilibrium and compare it to the previous one.
D’
p2
q2
S’ Commodities - The Wall Street Journal India's Taste for Coffee to Affect Bean Prices Neena Rai in London and Debi Nayak in Mumbai
“The size of the Indian economy and the rate of growth of the cafe sector, combined with rising spending power and shift in consumer preferences present a tremendous opportunity for us” says Avani Saglani Davda, chief executive of Tata Starbucks Ltd.
Barron’s -Leslie Josephs - Arabica-coffee prices have surged 72% so far this year, after Brazil’s worst drought in decades crimped output, down 8% from last year. Many parts of Brazil’s main arabica-growing areas have received half the normal amount of rainfall.
p3
q3
Coffee prices expected to rise as a result of poor harvests and growing demand Coffee bean prices top $3 a pound for first time in 34 years (Julia Kollewe, The Guardian)
3.3.4. Comparative Statics: Co!ee Price Determination
=- Consumer
value Amount
paid Consumer
surplus
Consumer surplus is the area between the demand curve and the price line.
The demand curve reflects the value consumers receive from consuming.
Definition: consumer surplus is the difference between consumers’ willingness to pay and the amount they actually pay for it is consumers’ gains from trade, i.e. the benefit of buyers from participating in the market.
We measure consumer value of consumption by their willingness to pay, i.e. the price they are willing to pay at every quantity demanded.
3.4.1. Market E"ciency: Consumer Surplus
$10
$70 $4×10=$40 ($6×10)/2=$30
Demand curve: Willingness to pay
Equilibrium: The price everyone pays
Q0
$4
10
Demand
P
P
Q0
$4
Supply
10
=-Amount received Producer surplusProducer cost
The supply curve reflects the cost firms incur in producing.
We measure producer cost of production by their willingness to sell, i.e. the price they accept at every quantity supplied.
Definition: producer surplus is the difference between producers’ willingness to sell and the amount they actually receive for it is producers’ gains from trade, i.e. the benefit of producers from participating in the market.
Producer surplus is the area between the supply curve and the price line.
3.4.2. Market E"ciency: Producer Surplus
($4x10)=$40 ($3x10)/2=$15
$1
$25
Supply curve: Willingness to sell
Equilibrium: The price every firm receives
P
Q0
$4
Supply
10
=+
Demand
Producer surplus
Consumer surplus
Total surplus
Definition: Total surplus is a measure of the benefit of buyers and sellers from participating in the market, the total gains from trade. It is the sum of consumer and producer surplus.
Conversely, it is the value to buyers minus the cost to sellers.
=- Total
surplus Producer
cost Consumer
value
The total benefit to society is the value of consuming the product minus the cost of producing it.
3.4.3. Market E"ciency: Total Surplus
$15$30 $45
$70 $25 $45
P
0
Demand
Q
Supply
Society should continue to produce more as long as the marginal consumer value is greater than the marginal cost of production
This will maximise total surplus and the gains from trade in this market.
$4
10
$10
3.4.4. Market E"ciency: Marginal Surplus
Total surplus is maximal when marginal surplus is equal to the marginal cost.
1a. During the novel coronavirus (COVID-19) pandemic, people of all incomes from poor to rich are stocking up on different types of product they regard as necessary. Suppliers cannot increase their output quickly enough. Australian government is concerned about profiteering and affordability in the markets concerned and is considering intervening. Using the demand-supply model, explain these phenomena in one or two markets of your choice. Advise which market interventions, if any, government should conduct in these markets.
1b. Bangalore has become India's third biggest city following a population explosion that doubled the number of residents since 2000 to over 10 million. Public infrastructure development cannot keep up with this rapid urbanisation. A water shortage is looming. As a result the city has introduced a ban of constructing new apartments for five years. Using the demand-supply model, assess the effect on condominium unit prices. In particular comment on the likely size of this effect considering the shape of the supply curve.
1c. Workplace automation involves systems, both software and hardware, to perform repetitive tasks reducing the need for labor in the production process. For example automobile manufacturing plants are introducing industrial robots with very little need fo human intervention on the assembly line. Using the demand-supply model, explain the effect of the introduction of such industrial robots in a suitable market of your choice.
1d. During the 1993 'mad cow disease" or BSE outbreak in the UK, evidence emerges regarding the dangers of eating beef from infected animals. Which markets are affected, and what are the effects?
Tutorial 3
2. Open your notes for tutorial 2. Your legal department informs you that government has introduced a per-unit tax of $7 to be collected from the sellers in this market. Your manager is worried what that the tax will affect all firms’ willingness and ability to produce and therefore price. What do you think? Make appropriate changes in your graph and numbers to reflect this tax. What is the impact on the equilibrium price and quantity?
3. What can you say about the products in the following three markets?
3.1. 3.2. 3.3. P
0 Q
Supply
Demand
P
0
Demand
Q
Supply
P
0 Q
Supply
Demand
Behavioural Business
Minor
