Introduction to Microeconomics MSc Induction Simon Hayley

Introduction to Microeconomics Introduction to Microeconomics

MSc InductionMSc Induction

Simon HayleySimon Hayley

Simon.Hayley.1@city.ac.ukSimon.Hayley.1@city.ac.uk

Overview of Economics

1. Microeconomics – The behaviour of individuals and firms in

market interactions– Policy options when markets don’t work

2. Macroeconomics– The economy as a whole: GDP, inflation,

unemployment and growth.– Fiscal and monetary policy

Reading

Lipsey + Chrystal “Economics” Eleventh Edition, Oxford University Press, 2007.

Plan of session• Key concepts: scarcity and choice

• Analysis of markets

• A common approach:– consumers maximize utility subject to a

budget constraint– firms maximize profits subject to cost and

demand constraints

The Market Economy• A market economy is self-organising in the

sense that when individuals act independently to pursue their own self-interest, responding to prices set on open markets, they produce co-ordinated and relatively efficient economic activity.

Resources and Scarcity• Scarcity is a fundamental problem faced by

all economies because not enough resources (land, labour, capital, and entrepreneurship) are available to produce all the goods and services that people would like to consume.

• Scarcity makes it necessary to choose among alternative possibilities: what products will be produced and in what quantities.

• Microeconomics analyses the allocation of scarce resources.

How We Work in Economics• The real world is complex so we have to

pick out key features of an issue and construct abstract “models”.

• We illustrate the relationships in these models with graphs, equations or numerical examples.

• Models are not the truth but they are a way of thinking about what might be going on.

Making Economic Choices• Opportunity cost: the cost of obtaining a unit of one

product in terms of the number of units of other products that could have been obtained instead. This emphasises scarcity and choice.

• A production-possibility boundary shows all of the combinations of goods that can be produced by an economy whose resources are fully employed. Movement from one point to another on the boundary shows a shift in the amounts of goods being produced, which requires a reallocation of resources.

Unattainable combinations

Production possibility boundary

Quantity of public sector goods

Qua

ntity

of p

rivat

e se

ctor

goo

ds A Production-Possibility Boundary

0

Attainablecombinations

Production possibility boundary

c0

g0

c1 b

•d

c

g1

C

G

Attainablecombinations

Qua

ntity

of p

rivat

e se

ctor

goo

dsA Production-Possibility Boundary

Quantity of public sector goods

0

aUnattainable combinations

Production possibility boundary after growth

Quantity of public sector goods0

a

b

d

Production possibility boundary before growth

Qua

ntity

of p

riva t

e se

c tor

go o

d s

The Effect of Economic Growth on the Production-Possibility Boundary

Analysis of Markets

• All markets can be approached in same way, even though there are many different features.

• In any market there is one group who do not have the product but want to get it: demanders

• And another group who have the product and want to sell it: suppliers

• For consumer goods (and services) demanders are individuals and suppliers are firms.

Main Factors That Affect an Individual's Demand for a Specific Product

• Price of the product• Price of other products: substitutes or complements

• Income and wealth

• Personal characteristics: age, religion, dependants etc

• Tastes

• External factors: weather, festivals, special events.• Economic analysis focuses on prices and incomes

BUT other things do matter in real markets.

Price Elasticity and Income Elasticity

• Quantity demanded is (generally) negatively related to the price of the product itself. [price elasticity]

• Demand increases with rise in price of a substitute and fall in price of a complement (and vice versa). [cross elasticity]

• Demand increases with income for a normal good and falls when income increases for an inferior good. [income elasticity]

Price ElasticityLow High

Inco

me

Ela

stic

ityH

igh

Low

• Necessities have low income elasticity. Luxuries have higher income elasticity.

• Price elasticity partly depends on how tightly we define each market:– Broadly-defined goods (eg. food) have few substitutes,

and so have low price elasticity (inelastic demand)

– Specific items such as a particular brand of baked beans have many substitutes, and so a high price elasticity (elastic demand)

– But if advertisements succeed in convincing consumers that a particular brand is not like others, then this price elasticity may be reduced.

Alice’s Demand Schedule

Reference Letter Price [£ per dozen]Quantity demanded [dozen per month]

abcdef

0.501.00

2.002.50

1.50

7.0

3.52.5

3.00

5.0

1.01.5

1 2 3

0.50

1.00

2.00

Quantity of Eggs [dozen per month]

Pric

e of

egg

s [£

per

doz

en]

3.00

2.50

654 7

Alice’s Demand Curve

a

b

c

e

d

f

1.50

2 4 6 8 10 12

2 4 6

1.00

2.00

3.00

1.00

2.00

3.00

8

14Quantity of Eggs[dozen per month]

Quantity of Eggs[dozen per month]

Pric

e of

egg

s [£

per

doz

en]

Pric

e of

egg

s [£

per

doz

en]

The Relation Between Individual and Market Demand Curves

[i]. William

[ii]. Sarah

[iii]. Total Demand William & Sarah

2 4 6

1.00

2.00

3.00

Quantity of Eggs[dozen per month]

Pric

e of

egg

s [£

per

doz

en]

8

A Market Demand Schedule for Eggs

Reference Letter Price [£ per dozen] Quantity demanded [000 dozen per month]

u

v

w

x

y

z

0.50

1.00

2.00

2.50

1.50

110.0

77.5

67.5

3.00

90.0

60.0

62.5

Quantity of Eggs[thousand dozen per month]

20 40 60 80 100 120

1.00

2.00

3.00

140

Pric

e of

egg

s [£

pe r

doz

en]

A Market Demand Curve for Eggs

2.50

1.50

3.50

0.50

Z

D

Y

X

W

V

U

D0

D1

Quantity0

Shifts in the Demand Curve

Pric

e

D2

D0

Quantity0

Shifts in the Demand Curve

Pric

e

Determinants of Supply

• The price of the product itself

• The prices of inputs (factors of production)

• The production technology

Influences on supply

• Quantity supplied is positively related to the price of the product itself

• Supply increases (shifts right) as input prices fall and vice versa

• Supply shifts with changes in technology. Improvements in technology increase supply (shift right)

A Market Supply Schedule for for Eggs

Reference Letter Price [£ per dozen] Quantity supplied[000 dozen per month]

w

y

u

v

z

x

0.50

1.00

2.00

2.50

1.50

5.0

77.5

100.0

3.00

46.0

122.5

115.0

20 40 60 80 100 120

1.00

2.00

3.00

140

Quantity of Eggs[thousand dozen per month]

Pric

e of

egg

s [£

pe r

doz

en]

A Supply Curve For Eggs

2.50

1.50

3.50

0.50

Z

S

Y

X

W

V

U

Quantity

Pric

e

Shifts in the Supply Curve

S0

S1

Quantity

Pric

e

Shifts in the Supply Curve

S2 S0

Demand and Supply Schedules for Eggs and Equilibrium Price

Price [£ per dozen]

Quantity supplied [‘000 dozen per month]

0.50

1.00

2.00

2.50

1.50

110.0

77.5

67.5

3.00

90.0

60.0

Quantity demanded [‘000 dozenper month]

62.5

5.0

46.0

77.5

100.0

115.0

122.5

105.0

44.0

0.0

-32.5

-52.5

-62.5

Excess Demand [quantity demanded minus quantity supplied]

[‘000 dozen per month]

20 40 60 80 100 120

1.00

2.00

3.00

140

Quantity of Eggs [thousand dozen per month]

Pric

e of

egg

s [£

pe r

doz

en]

Determination of the Equilibrium Price of Eggs

2.50

1.50

3.50

0.50

Z

S

Y

X

W

V

U

D

U

V

W

X

Y

Z

Museum Charges• In November 2001 the UK Government abolished

admission charges on many museums.

• The Victoria and Albert Museum (V&A) experienced the biggest increase, with visitor numbers rising from 42,600 in December 2000 to 174,000 in December 2001, an increase of 309%.

• Similarly, though not so dramatically, the Museum of London had an 88% increase, the Natural History Museum had an 82% increase and the Museums of Science and Industry in Manchester had a 75% increase.

Price of museum entry

Number of admissions

£5

42K 174K

The price of Brazilian arabica coffee, 1976-2005

0

50

100

150

200

250

1976

1983

1990

1997

2004

Date

US c

ents

per

lb.

Brazilian arabica

Price of coffee

Quantity of coffee

P1

P2

Q1 Q2

Coffee market

demand

supply

Newspaper Market• In September 1993 the Times lowered its

price from 45p to 30p while the Independent stayed at 50p.

• Average daily sales of the Times went from 370K to 450K.

• Average daily sales of the Independent went from 362K to 311K.

• Independent and Times were substitutes.

Demand for The Times

price

45p

30p

370K 450K

Market for The Independent

50p

price

quantity362K311K

Channel Tunnel What happened when the opening of the

tunnel introduced massive new supply of cross-channel travel?– Increase in supply leads to fall in price.

– Demand for substitutes falls: ships, planes, hovercraft.

– Competition between suppliers leads to price cutting and special deals

– Total quantity of travel rises

• “Drought report sends wheat prices surging” (FT 6/6/2007)

• “Commodities prices slumped on Friday following sharp falls in global equity markets amid mounting fears that the global economy was heading into recession” (FT 10/8/2008)

• “Members of the OPEC oil cartel are considering an emergency meeting in Vienna next month as oil prices dropped to their lowest level in nearly a year.” (FT 10/8/2008)

Different Features of Markets• Coffee and wool prices in wholesale markets

change day by day to equate demand and supply.

• Many prices, especially retail prices are set by the seller and only changed periodically: quantity then adjusts. These are administered prices (eg. newspaper prices and museum entry charges).

• But, as we have seen, supply and demand analysis is relevant for both types.

Consumer Choice

• Consumers maximize utility subject to a budget constraint. Value to consumers (and therefore price) depends on marginal and not total utility.

• Similarly, firms maximize profit subject to a cost and demand constraint.

UTILITY is the personal satisfaction derived from consuming a product or service

• Total utility = utility a consumer gets from total consumption of all units of a particular product.

• Marginal utility = the addition to total utility derived from consuming one more unit of the product.

• The marginal utility usually declines as the consumer consumes more of the product (Diminishing Marginal Utility).

• We assume each consumer maximises his/her own utility. Each consumer reaches a utility-maximising equilibrium when the utility he or she derives from the last £1 spent on each product is equal.

Diminishing Marginal Utility

Units Consumed

Mar

gina

l Utii

ty

Why are diamonds more expensive than water?

• Water is vital – without it we will die.

• Diamonds are a luxury.

• So why is water cheap, whilst diamonds are expensive?

The Paradox of Value

• This paradox of value involves confusion between total and marginal utility. The market clearing price is determined by marginal utility not total utility.

• Clearly the total utility derived from water exceeds the total utility derived from diamonds.

• Diamonds have a high price because they are scarce and the marginal utility is high, but water is cheap because it is abundant, so its marginal utility has been driven down.

Total and Marginal Utility Schedules

Number of films attended per month

Total utility

0

1

3

4

2

10

6

7

5

9

8

0.00

15.00

25.00

31.00

35.00

37.50

10.00

4.00

2.50

1.25

0.90

0.80

Marginal utility

39.00

40.25

41.30

42.20

43.00

15.00

6.00

1.05

1.5

2 4 6 8 10

10

20

30

40

50

Total and Marginal Utility Curves

[i]. Increasing total utility [ii]. Diminishing marginal utility

Quantity of films [attendance per month]

15

10

5

Util

ity [£

]

20

0

Util

ity [£

]

2 4 6 8 100

A Consumer’s Equilibrium

• To maximize utility, each consumer should adjust spending so that marginal utility per pound is the same for each good consumed (MUx/Px = MUy/Py).

• If this were not true, could increase total utility by shifting towards consuming good with higher utility at the margin.

• So a scarce good has a high price and a high marginal utility…but this says nothing about total utility.

Diminishing Marginal Utility and Demand

• Demand curves have negative slopes because when the price of a product falls, the marginal utility per pound spent on this produce increases. The consumer responds by purchasing more of this good, thus reducing the marginal utility.

• The consumer will keep increasing consumption of this good until the marginal utility per pound falls to the level which could be achieved on other goods.

• A good which has steeply falling marginal utility will have relatively low price elasticity (a large shift in price will be required to cause a significant increase in consumption).

Consumer SurplusConsumer surplus is the difference between:

1) The value consumers place on their total consumption of some product (the maximum they would pay for the amount consumed rather than go without it completely).

2) The actual amount paid for it.

1 2 3 4 6 8

1.00

2.00

3.00

9

Glasses of milk consumed per week

Pric

e of

milk

[£ p

er g

lass

]

Consumer Surplus for an Individual

0.30

75 10

Market price

Pric

e

Quantity q00

p0

Consumer Surplus for the Market

D

Market price

Competition vs. Monopoly• A competitive industry has many producers. Each must

sell at the existing market price (if they offer their product at a higher price no-one will buy it). They are price takers.

• A monopolist has no competitors, and can choose to raise prices if this would increase profits. Monopolists are price makers.

• An intermediate case: oligopoly, where a few producers each have substantial market share. They may be able to increase prices above the competitive level (especially if they agree not to undercut each other).

Pric

e

Quantityq10

p0

Consumer surplus under monopoly

D

Price

Consumer surplus

Deadweight loss

p1

q0

Implications of Monopoly Power– Reduced output– Increased prices– Substantial loss of consumer surplus– A monopolist may also tend to be less dynamic, leading to

slower growth and less innovation

For these reasons governments try to prevent companies from forming monopolies (and forbid collusion in oligopolies).

Where this is not possible (for “natural monopolies” such as utilities) regulation is imposed to try to replicate the effect of competition.

Pric

e

Quantityq10

p0

Price Discrimination

D

Price (1)

Consumer surplus (1)

p1

q0

Consumer surplus (2)

Price (2)

Examples of Price Discrimination

• Haggling

• Discount vouchers and early-booking discounts

• First class facilities (arguably)

• “Three-for-two” deals

Recap: Consumer Demand

• We have modelled how consumer demand varies as a function of:– Prices– Incomes (budget constraint)– Preferences (“taste”)....etc.

• Specifically, we found it useful to analyse demand on the assumption that consumers aim to maximise their own total utility.

Firm behaviour can be modelled using a similar approach

• Firms seek to maximize profits

• They are constrained by the production technology and by the market demand.

• They have (at a point in time) a given capital stock and face market prices of inputs.

• They maximize profit where marginal cost equals marginal revenue.

• See: Lipsey and Chrystal, Chapter 6-9.

Quantity of good B

Qua

ntity

of g

ood

A A Production-Possibility Boundary

0

Relative price line

Quantity of good B

Qua

ntity

of g

ood

AAn Ideal Market Equilibrium

0

Indifference curve

Relative price line

An Ideal Market Equilibrium• Firms shift their production to a point on the production possibility

boundary where the degree to which the they could produce slightly more of one good and less of the other (the opportunity cost) reflects market prices.

• Consumers adjust their consumption so that their indifference curve also reflects market prices.

• This allows consumers to reach the highest level of utility (highest indifference curve) that is compatible with the Production Possibility Boundary.

• This is a slightly idealised result (market imperfections may prevent it from happening), but it is a very powerful illustration of the ‘invisible hand’ at work!

Market Failures We can identify some situations in which the

market will not work well, suggesting that society is likely to be better off if the government intervenes:

• Monopoly power

• Information failures

• Externalities

• Public goods

Monopoly• Governments generally aim to prevent firms

from exploiting monopoly power.

• In the UK proposed mergers between firms may be referred to the Monopolies and Mergers Commission (MMC). This body then decides whether the merger would give the resulting firm an unacceptably high market share. If so, the MMC will forbid the merger.

Natural Monopolies• However, for some industries there may be

massive economies of scale. As a result it only makes sense for there to be only one provider.

• For example it would be prohibitively expensive to have two competing companies running water and sewage pipes to each house.

• Such industries are natural monopolies. They are typically utility networks such as gas, electricity and water supplies.

Regulating Natural Monopolies• Natural monopolies must be prevented from exploiting their

monopoly power. They were often nationalised. But this left them with little incentive to be efficient.

• In the 1980s the UK government privatised many of these companies. Other countries followed suit. These private monopolies are tightly regulated to try to get them to behave as if they had competitors.

• The UK has regulatory bodies which set price caps for these firms:• OFWAT (water companies)• OFGEN (electricity generation)• OFGAS (gas supply)

Information Failures• The proper functioning of a market requires

consumers to be able to judge the quality of the goods and services which they purchase.

• Where this is not possible, the government may step in to regulate quality. For example:

• Food hygiene in restaurants• Safety standards (eg. in cars)

• Otherwise low quality products would tend to force more expensive higher quality products out of the market, and quality would collapse to a minimum.

Externalities• Markets only work properly where individuals’

welfare is affected only by the goods and services they consume. But there may be externalities.

• For example firms may cause pollution which affects everyone’s welfare. But as long as the goods they produce sell well, these firms have no incentive to stop!

• The existence of externalities could justify the government banning certain polluting processes, or setting minimum standards.

• A more creative solution is to make firms pay for the damage they create (the “polluter pays” principle). For example:

– Charging firms for their carbon emissions allows them to keep polluting, but only if the benefits outweigh the costs to everyone else of the pollution involved.

– Similarly, every extra driver on the roads increases congestion for other drivers. Congestion charging should mean that people only drive if the benefits to them exceed the adverse effects on others.

• More generally, where there is a common resource which nobody owns, a free market will tend to lead to it being over-exploited.

• For example, fish stocks are a common resource. But individuals maximise profits by catching as many fish as possible. Attempts to prevent this by establishing quotas etc. have not yet been very successful.

Public Goods

• Some goods and services tend to benefit everyone (eg. the provision of defence, law and order).

• Individuals have no incentive to contribute to the costs of these services. As everyone benefits, each individual has an incentive to “free ride”, and hope that someone else pays!

• Hence these goods tend to be provided by the government (out of general taxation) or by compulsory subscriptions (eg. the UK TV licensing fee).

Market Failure vs. Government Failure• We have identified several market failures:

• Monopoly power• Information failures• Externalities• Public goods

• These could justify government intervention. But such intervention is likely to be imperfect: it may be costly, or further distort incentives, or lead to political interference.

• The costs of market failure must be weighed up against the possible costs of “government failure” in attempts to correct it.

Microeconomic Theory (1)• “Self-organising” market economies have tended

to outperform centrally-planned economies.

• Scarcity and opportunity cost

• Demand: • Price elasticity• Income elasticity• Cross elasticity

• Supply: price/input costs/technology

• Supply and demand curves• Prices shift so that supply=demand• The invisible hand

Microeconomic Theory (2)• Diminishing marginal utility

• Underpins consumer demand curves• The paradox of value

• Consumer surplus• Monopoly pricing• Price discrimination

• Market failure• Natural monopoly• Information failures• Externalities• Public goods

Summary: Microeconomics

• Analysis of supply and demand is key to understanding movements in market prices.

• The price mechanism can achieve some very desirable results.

• But the price mechanism isn’t necessarily perfect, and we have seen how microeconomic analysis can inform some key policy issues

APPENDIXAPPENDIX

Indifference Curve AnalysisIndifference Curve Analysis

• The use of indifference curves allows the The use of indifference curves allows the analysis of demand without having to analysis of demand without having to assume that utility is measurable.assume that utility is measurable.

• It allows us to distinguish between (a) It allows us to distinguish between (a) income and (b) substitution effects.income and (b) substitution effects.

How the Consumer Reaches Equilibrium

• Indifference theory assumes only that individuals can order alternative consumption bundles, saying which bundles are preferred to which but not by how much.

• A single indifference curve shows combinations of products that give the consumer equal satisfaction, and among which he or she is therefore indifferent. An indifference map is a set of indifference curves.

• The basic assumption about tastes in indifference curve theory is that of a diminishing marginal rate of substitution: the less of one good and the more of another good the consumer has, the less willing he or she will be to give up some of the first good to get more of the second. This implies that indifference curves are negatively sloped and convex to the origin.

Indifference Theory• While indifference curves describe the consumer’s

tastes and, therefore, refer to what he or she would like to purchase, the budget line describes what the consumer can purchase.

• Each consumer achieves an equilibrium that maximises his or her satisfaction at the point at which an indifference curve is tangent to the budget line.

Bundle Clothing Food

c

a

b

d

e

f

30

18

13

10

8

7

5

10

15

20

25

30

Bundles Conferring Equal Satisfaction

5 10 15 20 25 30

10

20

30

35Quantity of food

Qua

ntity

of c

loth

ing

per

wee

k

An Indifference Curve

25

15

35

5

a

b

cd e f

h T I

g

I1

Quantity of food per week

Qua

ntity

of c

loth

ing

per w

eek

An Indifference Map

0

I2

I3

I4

I5

I1

I1

I1

I1

Shapes of Indifference Curves

[i]. Packs of green pins [iii]. Meat[ii]. Right hand glovesLe

ft ha

nd g

love

s

Veg

etab

les

Pac

ks o

f red

pin

s

f0

0 00

Perfect Substitutes Perfect Complements A good that gives zero utility

A good that confers a negative utility after some level of consumption

All other

goods

5

10

15

25

20

30

35

The Equilibrium of a Consumer

Quantity of food per week

Qua

ntity

of c

loth

ing

per

wee

k

5 10 15 20 25 30 35

5

10

15

25

20

30

35

I1

a

The Equilibrium of a Consumer

Quantity of food per week

Qua

ntity

of c

loth

ing

per

wee

k

f

5 10 15 20 25 30 35

5

5

10

10

15

15

20 25

25

20

30

35

30 35

I4

I3

I2

I1

a b

c

E

d

e

The Equilibrium of a Consumer

Quantity of food per week

Qua

ntity

of c

loth

ing

per

wee

k

f

• Consumers maximise their utility by adjusting their consumption to the point on the budget line which gets them to the highest possible indifference curve.

• At this point the indifference curve will be at a tangent to the budget line.