MICROECONOMICS Price Theory

How much does Windows 7 sell for? How much does Linux sell for? If a negligent driver kills an 85 year old woman,

how much money will the jury award the estate of the family?

In a similar accident, but involving a 20 year old man, how much will the award be?

How much more money does a white male make compared with a white female make doing similar work?

How much more money can you expect to earn over your lifetime with a Master’s Degree from Chulalongkorn University compared with if you did not go to school?

SUPPLY & DEMAND

One of the most persuasive models in the business, social, and behavioral sciences.

Wide applications in fields such asEconomicsFinanceLaborStatisticsHealth

Major Goal: Price Determination.

THE LAW OF DEMAND

An inverse relationship between a measure of price and a measure of the quantity demanded.

As the price of something goes up less of that something is demanded.

What is price? What is demand?

PRICES In microeconomics a price is a ratio

that represents terms of trade. Prices, in micro, are real. Opportunity costs represent real

prices. In order to get something you have to give

something up. We will use monetary units for

convenience. Thus Baht or Dollars represent a medium of exchange…dollars per shirt or dollars per baht represent the price of shirts (in $’s) or the price of baht (in $’s).

A MODEL

Maybe your first economic model was the PPF model…it represents prices in real terms:

PPF

In this model we see the terms of trade, i.e., how much Y we get (or give up) when we give up (or get) some amount of X.

Did you notice the curvature of the PPF? It doesn’t need to be this way, but the curve represents increasing marginal cost. That is a standard (and useful assumption):As we get more X we have to give up

increasing amounts of Y.

GOODS & SERVICES

Production is transformation. It might be a physical transformation of

resources. It might be a spatial transformation of

resources. It might be a temporal transformation of

resources.

THE LAW OF DEMAND

Intuitive. Applicable to individual decision making. Applicable to market activity. Applicable to non-market activity:

Demand for drunk driving. Demand for quality of life.

DEMAND

Demand exists in the output market. For example: demand for automobiles.

Demand exists in the input market. For example: demand for labor.

Some goods & services are both inputs and outputs. For example: tomatoes.

MARKET DEMAND

Generated from individual demand. For example, at a price of 10 baht

Miss Kawita wants 5 units Mr Chayanin wants 4 units Mr Satta does not want any units Miss Utumporn wants 1 unit

At this price 10 units are demanded.

DEMAND MAY BE BINARY At a price of Bt 3.95 million (Mercedes E220

CDI) Richard has zero effective demand – is not in the

market Miss Ungkana has non-zero effective demand – is

in the market (do not let BMW know this!) Aggregation of many zeroes and ones leads

to market demand

THE LAW OF DEMAND

Sometimes we can quantify Qd and P We might model Qd

QdRichard = f(…,P,YRichard, …)

QdRichard = a + bP + cY

b might be -5 c might be .025 a represents other determinants

LAW OF DEMAND

QdRichard = a + bP +

cY This is a linear

model and looks like this:

LINEAR DEMAND

If we examine our demand function holding Y constant (=1000) then we have

Qd = 35 – 5P This is the same as P = 7 – Qd/5 Graphing P against Q – Alfred Marshall

P = 7 – QD/5

Which Graphs as:

DEMAND AS WILLINGNESS TO PAY The demand function for an individual

represents the maximum amount of money that a person would be willing to pay to purchase a given quantity of a good or service.

The law of demand in this case is a reflection of diminishing marginal utility.

Marginal: incremental.

THE SUPPLY FUNCTION If I offered to buy all the chocolate chip

cookies you brought to class on Saturday for Bt 1000 each, how many cookies would you bring?

If I offered to buy all of the cookies you brought for Bt 2 each, how many would you bring?

In this sense, the Supply Function represents the minimum amount of money a person would be willing to accept to provide a given quantity of a good or service.

SUPPLY PREVIEW

Because of the profit motive there is a direct or positive relationship between the quantity supplied of a good or service and its price.

We might model this like: Qs = f(…, P, …) Qs = 10P, for example.

EQUILIBRIUM

When we have a demand function (Qd) and a supply function (Qs) we can think about the price (P) which equilibrates Qd and Qs. This is Pe.

Typically when an observed price Po is greater than Pe we see excess supply and when Po < Pe we have excess demand. Does this make sense to you?

QD = 10 – P; QS = P; PE = 5

IN LABOR ECONOMICS There is a demand for labor by firms and

there is a supply of labor by households. The price of labor is the wage. The demand for labor depends on what sorts

of things? The supply of labor depends on what sorts of

things?

WAGE DETERMINATION

As we will see, the demand for labor is called a derived demand. As more consumers want a particular good or service that creates demand for labor in the industry that produces that particular good or service.

What is We in a particular industry?

COMMODIFICATION OF LABOR

Note that it is theoretically easy to treat labor as we would any other classical input into production such as tomatoes, steel, seeds, or capital.

In the course of your studies you might want to think about this from time to time.

LABOR How mobile is labor? Do prevailing wages adjust to excess supply

or demand for labor? Can certain kinds of labor easily be

discriminated against? What important institutions influence labor

supply and/or labor demand decisions?

FROM HERE WHERE? Now that we have previewed some aspects

of micro theory we will explore methods used to model demand and supply functions.

What goes on behind the demand function? What goes on behind the supply function?

FROM HERE…

Price determination might be a reflection of optimal decision making by consumers and producers.

Micro theory can be used as a guide: Descriptive models of behavior Prescriptive models of behavior

Ethical Models Optimal Models

STEP ONE

We build are skills by first looking at the demand function.

We will need a few mathematical tools to help us understand how the demand function expresses optimal consumer choice.

Consumers choose among baskets of commodities in order to maximize utility subject to budgetary constraints.

STEP TWO

After we derive the demand function we will do similar exercises for the firm – to discover how the supply function represents maximal profit decision making.

The model is a bit asymmetrical, as we will see.

STEPS THREE, FOUR, …

Once we are familiar with the basics of supply & demand What are industries? What is meant by economic welfare? When do markets work and when do markets

fail? How would we measure failure? When is their a role for government?

CALCULUS

Derivatives measure the slopes of lines. For example, curves do not have slopes, but

lines tangent to curves do. Notice something about curves that have

peaks and troughs: At the peaks and the troughs, the lines tangent

at these points have zero slope.

FIRST ORDER CONDITIONS

Finding where the derivatives are equal to zero constitute the first order conditions for maxima and/or minima of functions.

SECOND ORDER CONDITIONS If we find a candidate for a maximum or a

minimum, how do we tell? SOC’s help us determine if we have found a

max, a min, or something else. Why are we doing this when we could just

graph it? Multiple dimensions Econometric specification

CALCULUS

Now watch this example…after the presentation we will slow down and learn how to use the rules of calculus. We will have many simple examples and lots of practice problems.

F(X) = X3 - .25X2 – 3X + 3

F’(X) = 3X2 – .5X - 3

F’(X) = 3X2 – .5X - 3 At x = 1.0868 f’(x) = 0 At x = -0.9201 f’(x) = 0 These are called the critical values of f(x). Note that at 1.0868 , f(x) reaches what we

call a local minimum. At -0.9201, f(x) reaches a local maximum.

F’’(X) = 6X - .5

At x=1.08, f’’(x) = 6.0279 which is a positive number.

At x=-0.92, f’’(x) = - 6.0279, which is a negative number.

These are examples of FOC and SOC, finding a local min and a local max.

Note f(x) has no global max or min.

EXAMPLES

f(x) = k f(x) = ax f(x) = ax2 + bx + c f(x) = g(x)*h(x) f(x) = g(h(x)) f(x) = g(x)/h(x) f(x) = ln(x) f(x) = ex

EXAMPLES f(x,y)

Now we have two derivativesfx and fy which are called partial derivatives

f(x,y) = axy + by2 + c fx = ay fy = ax + 2by FOC’s involve a simultaneous system

of equations to solve:fx = 0fy = 0

F(X,Y) = 3X2 + 2Y2

F(X,Y) = 3X2 + 2Y2

Here, fx = 6x and fy = 4y At the point (0,0) both of these equations are

equal to zero. Thus (0,0) is a critical value and we see that

(0,0) is associated with a minimum value of our objective function

F(X,Y) = 3X2 – 2Y2

F(X,Y) = 3X2 – 2Y2

For this function there is one critical value, again at (x,y) = (0,0).

But note that this is not associated with a max or a min.

It is called a saddle point.

GREAT NEWS In this class (and in other econ classes you

will take) the functions you deal with will be nicely behaved.

By nicely behaved we mean that we can easily find critical values.

And these critical values will be associated with maximum or minimum values.

FOREST FOR TREES

Let’s also remember something important. We do not want to get bogged down in the details of mathematics and forget why we are doing calculus in the first place!

At our level we want to come up with models of prescriptive (optimal) behavior and calculus is tool we use along the way.

Always remember … narrative reasoning is more convincing that equations.