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Introductory Microeconomics ES10001
Topic 1: Introduction to Markets
1. What is Economics?
Economics is ... the study of choice.
More formal definition might be:
.... the study of the allocation of scarce resources amongst competing users.
1. What is Economics?
Some of the key concepts in Economics can be illustrated via. the Production Possibility Frontier (PPF).
Definition: The PPF shows for each level of the output of one good, the maximum amount of the other good that can be produced.
1. What is Economics?
Definition: The PPF shows for each level of the output of one good, the maximum amount of the other good that can be produced.
See Figure 1
Y
X 0 5 10 15 20 25 30
5
15
10
25
20
A B
C
D
E
G
F
Figure 1: Production Possibility Frontier
1. What is Economics?
Points on PPF are Pareto-Efficient - unable to make one person better off without making someone worse off
Economist's job is to move society to PPF (i.e. efficiency)
Whereabouts on PPF is job for politicians (i.e. equity)
2. Theories and Evidence
Definition: a model (or theory) makes a series of simplifying assumptions from which it is deduced how people will behave. It is a deliberate simplification of reality.
Linear example:
y
x 0
Slope =
Figure 2: Linear Model
Intercept
2. Theories and Evidence
N.B. = intercept; = slope
Consider, for example, a total cost function, where c denotes total cost and q denotes output.
i.e. Total Costs = Fixed Costs + Variable Costs
Assume = 10, = 2
Output Fixed Cost Variable Cost Total Cost
q = α + βq = c
1 10 2 12
2 10 4 14
3 10 6 16
q = 10 + 2q = c
c
q 0
c = 10 + 2q
10
1 2 3
16
14
12
Figure 3: Total Cost Function
3. Markets
Definition: A market is a set of arrangements by which buyers and sellers are in contact to exchange goods or services.
To understand how markets work we therefore need to examine the behaviour of buyers and sellers
Otherwise known as ‘Demand’ and ‘Supply’
3. Markets
Demand: Quantity of a good buyers wish to purchase at every conceivable price. Thus demand is not a particular quantity.
Supply: Quantity of a good sellers wish to sell at every conceivable price. Thus supply is not a particular quantity.
N.B. distinction between demand (supply) and quantity demanded (supplied).
3. Markets
Demand / Supply denotes schedule of demands / supplies at each and every conceivable price.
Quantity demanded / quantity supplied defines a particular demand / supply at a particular price.
Hypothesis - at ‘high’ prices we have qd < qs and at low prices the converse. Moreover, at some intermediate ‘equilibrium’ price, p*, the market clears.
3. Markets
We define the equilibrium price p* as the price which clears the market
Thus p > (<) p* implies excess supply (demand) and in a free market the actions of buyers and sellers move p towards p*.
p
q 0
Figure 4: Market Equilibrium
Demand
Supply
q*
p*
p
q 0
p1
Excess Supply
Demand
Supply
qd(p1) q* qs(p1)
p*
Figure 5: Price Floor
p
q 0
p1
Excess Demand Demand
Supply
qs(p1) q* qd(p1)
p*
Figure 6: Price Ceiling
p
q 0
Supply
Demand
p*
pf
q1 q*
pc
Figure 7: ‘Near Side’ is Satisfied
4. Demand
The demand curve shows the relationship between price and quantity demanded (qd) ceteris paribus
That is:
(i) qd at particular price per unit;
(ii) (maximum) price per unit consumers willing to pay for a particular quantity.
4. Demand
Formally
qd = qd(p)
Quantity demanded depends upon price
Normal Demand Function (Curve)
q
p 0
qd
Figure 8: Normal Demand Curve; qd = qd(p)
10
5
4. Demand
We can equivalently think of price depending upon the quantity consumed
pd = pd(q)
Inverse Demand Function
p
q 0
pd
Figure 8: Inverse Demand Curve; pd = pd(q)
p
q 0
Figure 10: (Inverse) Demand Curve; pd = pd(q)
5
10
… quantity demanded at a particular price
p
p 0
Figure 11: (Inverse) Demand Curve; pd = pd(q)
5
10
… buyer’s reservation (i.e. maximum price buyer willing to pay per unit
4. Demand
Usually, we presume that qd depends negatively on (own) price, but this is not always the case (i.e. Giffen goods)
Note: ‘Movements Along’: Arise as a result of changes in own price.
‘Shifts In’: Arise when anything else changes.
Consider the latter
4. Demand
What are these ‘other things’ that might bring about a shift in the demand curve
To answer that question, we need to look ‘behind the demand curve’ and drop our assumption of ceteris paribus – that other things remain equal.
Consider each in turn
4. Demand
Four factors that might not remain equal:
(1) Price of Related Goods
(2) Consumer Incomes
(3) Tastes
(4) Tax
4. Demand
Price of Related Goods
Example: A rise in price of butter would:
Decrease quantity of butter demanded by consumers; Increase demand for margarine at each and every price of
margarine; Decrease demand for bread at each and every price of bread.
4. Demand
That is:
Butter & margarine are substitutes for one another
Butter & bread are complements for one another
Note: Pairs of goods; most goods are substitutes.
pMargarine
qMargarine 0
p0d
p1d
Figure 12: Substitutes (Rise in pButter)
pBread
qBread 0
p0d
p1d
Figure 13: Complements (Rise in PButter)
4. Demand
Consumer Income
A normal good is a good for which demand increases when incomes rises
A inferior good is a good for which demand falls when income rises.
pPrivate Transport
qPrivate Transport 0
p0d
p1d
Figure 14: Normal Good (Increase in Income)
pPublic Transport
qPublic Transport 0
p0d
p1d
Figure 15: Inferior Good (Increase in Income)
4. Demand
Tastes
Consumer tastes or preferences regarding array of potential consumables.
Shaped by custom, attitude, advertising.
4. Demand
Tax
Consider purchase tax (e.g. VAT)
Consumer liable for £x tax per unit purchased
Thus, imposition of tax will reduce consumer’s reservation price for the good
Note: Unit / Ad Valorem
p
0 q
p
d
Figure 15: (Unit) Purchase Tax
p
0 q
tax p
d
ptd
Figure 16: (Unit) Purchase Tax
p
0 10 q
p
d
ptd
Figure 17: (Unit) Purchase Tax
5
3
t = £2
5. Supply
The Supply Curve Shows the relationship between price and quantity supplied ceteris paribus; That is:
Quantity supplied at particular price per unit;
Minimum price per unit suppliers willing to accept for particular quantity.
p
q 0
ps
Figure 18: (Inverse) Supply Curve
p
q 0
5
10
… quantity supplied at a particular price
Figure 19: (Inverse) Supply Function ; ps = ps(q)
p
q 0
5
10
… seller’s reservation price (i.e. minimum price seller wiling to accept per unit)
Figure 20: (Inverse) Supply Function ; ps = ps(q)
5. Supply
Behind the supply curve (ceteris paribus)
Four factors:
(1) Technology;
(2) Input Costs;
(3) Government Regulation;
(4) Tax.
5. Supply
Technology
Improvement in technology shifts supply curve to the right
Intuition?
Producers willing to supply higher quantity at each and every price
Figure 21: Technological Advance
q 0
p0s
p1s
p
5. Supply
Costs
If these fall then supply curve will shift to right for the same reason.
Government Regulation
Adverse technological change - i.e. safety / environmental regulations will shift supply curve to the left.
p
q 0
p0s
p1s
Figure 23: Government Regulation
5. Supply
Tax
Consider unit sales tax
Seller liable for £x tax per unit sold
Thus, imposition of tax will increase seller’s reservation price for the good
p
0 q
Figure 24: (Unit) Sales Tax
p
0 q
tax
Figure 25: (Unit) Sales Tax
p
0 q
Figure 26: (Unit) Sales Tax
t = £2 11
9
10
6. Linear Demand / Supply
Demand
Recall - the demand curve shows:
quantity demanded at particular price per unit.
(maximum) price per unit consumers willing to pay for particular quantity
6. Linear Demand / Supply
Formally
qd = qd(p)
Assume demand curves are linear - i.e. straight lines. Thus:
qd(p) = a - bp
6. Linear Demand / Supply
That is, when p = 0, individuals demand a maximum number of units of the good
qd(0) = a - b·0 = a
Simplistic, but useful, assumption
p
q 0
a
1
d
d
q a bp
bp a q
ap q
b b
a/b
Figure 27: Linear Demand Curve
p
q 0
Figure 28: Non-Linear Demand Curve
pd
6. Linear Demand / Supply
Now consider slope b
The slope of the demand curve tells us how quantity demand changes in response to a change in price
Formally
6. Linear Demand / Supply
(1) (2)
(3) = (2) - (1)
(3)
q0d a bp
0
q1d a bp
1
p
q 0
a
p0
p1
q0 q1
E0
E1
qd a bp
q
0a bp
0
q1a bp
1
Figure 29: Slope of Demand Curve
a/b
p
q 0
a
p0
p1
q0 q1
qd a bp
q bp
Figure 30: Slope of Demand Curve
E0
E1
a/b
6. Linear Demand / Supply
Now consider two demand curves
(4)
where i = x, y. Thus:
(4a) (4b)
qid a
i b
ip
dy y yq a b p
qxd a
x b
xp
6. Linear Demand / Supply
It must be the case that:
(5)
If by > bx then
Demand curve ‘y’ has a ‘bigger’ slope than demand curve ‘x’
But … it is ‘flatter’!!!
qid b
ip
p
q 0
p0
p1
,di i i
i i
q a b p i x y
q b p
qxd
qyd
0q qx1
qy1
Figure 31: Slope of Demand Curve
6. Linear Demand / Supply
Recall, we generally ‘write’ the normal demand function but ‘draw’ the inverse demand function
And if by > bx then 1/by < 1/bx
Such that the inverse demand function
(i.e. the one we draw) is flatter p
id
a
b
1
bq
6. Linear Demand / Supply
The inverse demand curve maps the consumers’ reservation price schedule
i.e. as quantity increases consumers are willing to pay less per unit - diminishing marginal utility.
Also, it tells us the maximum price consumers are willing to pay for the first unit of the good
pd(0) = a/b
6. Linear Demand / Supply
Supply
Recall, supply curve shows
Quantity producers willing/able to supply at particular price per unit.
(Minimum) price per unit sellers willing to accept for particular quantity.
6. Linear Demand / Supply
qs = qs(p)
Linear form:
(1) qs = c + dp
or
(2)
7. Equilibrium
Equilibrium
Assuming linear demands and supplies we can solve for the equilibrium prices and quantities in the market
qd = a - bp
qs = c + dp
7. Equilibrium
Recall, there is a particular price vis. the equilibrium price, p*, at which the market clears
qd(p*) = qs(p*)
or
qd (p*) = a - bp* = c + dp* = qs(p*)
7. Equilibrium
d sq p q p
a bp c dp
a c b d p
a cp
b d
7. Equilibrium
d
d
d
a cq p a bp a b
b d
a b d b a c ab ad ab bcq p
b d b d
ad bcq p
b d
7. Equilibrium
s
s
s
a cq p c dp c d
b d
c b d d a c bc cd ad cdq p
b d b d
ad bcq p
b d
7. Equilibrium
Consider the following example:
Thus
20 4
8 2
d
s
q p p
q p p
* *20 4 8 2
20 8 4 2
d sq p p p q p
p
7. Equilibrium
Such that:
Substituting equilibrium price, p*, into the demand and supply functions yields equilibrium quantity
qd(p*) =20 – 4p* = 8 + 2p* = qs(p*)
20 8 122
4 2 6
a cp
b d
7. Equilibrium
7. Equilibrium
or:
such that:
20 4
8 2
d
s
q p a bp p
q p c dp p
q*
ad bc
b d
20 * 2 4 *8
4 2
40 32
6
72
612
8. Elasticity
Measuring the price responsiveness of demand
Consider problem of seller who want to maximise sales revenue.
R = p*q
But q = q(p) and p = p(q); i.e. q depends upon p and p depends upon q
Thus trade off!
8. Elasticity
Revenue increases if price is raised ceteris paribus; but we cannot assume ceteris paribus
Strategy:
(i) sell few goods at high unit price; or
(ii) sell many goods at low unit price
Optimal choice depends upon price responsiveness of demand
8. Elasticity
We could simply look at the slope of the demand curve
Recall two individuals, x and y, where:
And by > bx such that individual y is more responsive to a change in price than individual x.
p
q 0
p0
p1
,di i i
i i
q a b p i x y
q b p
qxd
qyd
0q qx1
qy1
Figure 32: Slope of Demand Curve
8. Elasticity
Slope is OK but:
(i) It is unit dependent i.e. £, £, quantity of laptops, bottles of wine
(ii) Does not convey relative strength of changei.e. price cut from £100 to £99 increases
demand by same amount as cut from £2 to £1
8. Elasticity
Better concept
Elasticity of Demand
Definition: The (price) elasticity of demand is the percentage change in the quantity of a good demanded divided by the corresponding percentage change in its price.
%
%
dChange in qE
Change in p
8. Elasticity
Example: Price rises from £10 to £12 and demand falls from 50 units to 30 units then:
E = (-40%) / (20%) = -2
In words: “A 1% rise in price will lead to a 2% fall in demand.”
N.B. For simplicity, we usually ignore the minus sign and define E as a positive number.
8. Elasticity
Thus:
Define: E
%qd
%p 0
%x x
1 x
0
x0
100%
%x x
x0
100%
8. Elasticity
Thus:
Recall our linear model:
E
0
100%
pp
0
100%
q
q0
p
0
p
q
p
p0
q0
0
q0d a bp
0
8. Elasticity
(1) (2)
(3) = (2) - (1)
(3)
q0d a bp
0
q1d a bp
1
8. Elasticity
Thus:
Such that
qq b p b
p
8. Elasticity
Note:
E is a number and as such it is unit dependent
E conveys the relative strength of changes in price and demand
Along a linear demand curve, slope (i.e. b) is constant but elasticity [i.e. b(p/q)] varies.
8. Elasticity
E > 1: Demand is Elastic
1% rise in p leads to a more than 1% fall in qd
E < 1: Demand is Inelastic
1% rise in p leads to a less than 1% fall in qd
E = 1: Demand is Unit Elastic
1% rise in p leads to same 1% fall in qd
8. Elasticity
Recall our linear function
with p = p0 and q = q0.
where is this equal to 1?
i.e. find the (p, q) at which E = 1
8. Elasticity
Thus, solve E for
8. Elasticity
Such that:
p
q 0
E
1E
0E
1E
1E
a
Figure 33: Elasticity of Demand
8. Elasticity
Point and Arc Elasticities
So far - point elasticities
If considering responsiveness over a range of prices / quantities then arc elasticity is more appropriate
8. Elasticity
Define:
Thus:
p
q 0
p0
p1
q0 q1
a b
a
Figure 34: Arc Elasticity of Demand
8. Elasticity
Arc elasticity between, e.g., p0 and p1 (q0 and q1) is equivalent to point elasticity at:
Or:
8. Elasticity
Determinants of Elasticity
Ultimately a matter of tastes - how essential is the good; how much do individuals want it.
Also time; more elastic in long run as consumers can substitute away.
Most important consideration is the ease with which consumers can substitute another good that fulfils approximately the same function
8. Elasticity
Applications of Elasticity
Determining price and quantity the maximises revenue.
Seller can choose either how many goods to sell or the price at which to sell them, but not both. i.e:
R = p*q
8. Elasticity
Consider effect of cut in price on Revenue (R)
(i) R falls because sell fewer goods at lower p;
(ii) R rises because sell more goods at higher p.
Thus trade off!
Question: Where is trade off optimised?
8. Elasticity
Recall: If E > 1 then a 1% cut in p will lead to a more than 1% increase in qd
Thus R will rise since increase in qd dominates fall in p
Conversely if E < 1.
8. Elasticity
Strategy
If E > 1 then cut price to increase revenue.
If E < 1 then raise price to increase revenue.
Optimum point is where E = 1
From this point, an x% change in p leads to same x% change in q, such that revenue is unchanged
8. Elasticity
This point occurs half-way down the demand curve at and
Rectangle below demand curve at this point is biggest rectangle possible under the demand curve.
And since the rectangle represents sales revenue, then this is where sales revenue is maximised.
p
q 0
1E
0E
a b
a
Maximum Revenue
Figure 35: Elasticity of Demand
8. Elasticity
Example:
8. Elasticity
Strategy
If E > 1 then cut price to increase revenue.
If E < 1 then raise price to increase revenue.
Optimum point is where E = 1
From this point, an x% change in p leads to same x% change in q, such that revenue is unchanged
8. Elasticity
Thus, a producer could do no better than to put 10 units of the good onto this market.
This is interesting!
Had the producer gone to market with 12 goods, it would have been in his interest to destroy two of them!
Intuitive??????
8. Elasticity
Cross Price Elasticity
Define: Cross price elasticity of demand for good i with respect to changes in price of good j equals % change in quantity of good y demanded divided by corresponding % change in price of good j
i.e.
8. Elasticity
Eij > 0 Increase in pj leads to fall in qi
thus i and j are substitutes for one another
Eij < 0 Increase in pj leads to fall in qi
thus i and j are complements for one another
8. Elasticity
Income Elasticity
Define: Income elasticity of demand for a good is % change in quantity demanded divided by corresponding % change in income (M).
EM > 0: 1% increase in M leads to rise in demand thus the good is normal
EM < 0: 1% increase in M leads to fall in demand thus good is inferior
8. Elasticity
We can distinguish:
EM > 1 Luxuries
0 < EM < 1 Necessities
9. Final Comments
Free markets are one way for society to solve the basic economic questions of what, how, and for whom to produce.
We have begun to see how the market allocates scarce resources amongst competing users.
The market will decide:
9. Final Comments
How much of a good is producedBy finding price that equates demand and supply.
For whom a good is producedGood is purchased by all those willing to pay at least equilibrium price
By whom a good is producedGood is supplied by all those willing to supply at equilibrium price
What goods are producedThrough the supply curve
9. Final Comments
N.B. We will also see later in the course that the market can tell us how goods are produced!
In conclusion, we should note that societies may not like the answers that the market provides.
Free markets do not produce enough food for everyone to go without hunger; or enough medical care to treat all the sick.
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