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Microeconomics precourseAcademic Year 2013-2014

Course PresentationThis course aims to prepare students for the Microeconomics course of the MSc in BA. It provides the essential background in microeconomics

PAOLO PAESANI Office: Room B6, 3RD floor, Building B Telephone: 06-72595701 E-mail: paolo.paesani@uniroma2.itOffice hours: to be agreed

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WHY ARE WE HERE ?

• Get to know each other

• Economics in a nutshell

• Cracking the nutshell open …

• It can’t be easier than this.

• Friendly advice: make sure you know this by heart !

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PRESENTATION OUTLINE

• What is economics about?

• What is microeconomics about?

• The market

• Consumer theory

• Theory of the firm

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Micro

ECONOMICS

“Political economy or economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing” (Marshall 1890).

“Economics is the science that studies human behavior as a relationship between ends and scarce means which have alternative uses.” (Robbins 1935).

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ECONOMICS

“It seems to me that economics is a branch of logic, a way of thinking; […] Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time. […] The object of a model is to segregate the semi-permanent or relatively constant factors from those which are transitory or fluctuating so as to develop a logical way of thinking about the latter, and of understanding the time sequences to which they give rise in particular cases. […] In the second place, as against Robbins, economics is essentially a moral science and not a natural science. That is to say, it employs introspection and judgments of value”. (Keynes 1938)

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MICROECONOMICS

Microeconomics studies: • How individuals take rational economic decisions• How individuals interact in a defined social context.

Individuals = Economic agents = Decision-takers / Choice-makers Human beings, firms, policy-makers

Decisions about what? What kind of decision?

Rational economic decisions = decisions about how to best use limited resources to achieve possibly conflicting goals

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ECONOMIC RATIONALITY

Rational agents facing economic decisions are confronted with constrainst and alternative courses of action (COAs). Constraints (individual, socio-cultual, economic, legal, time-related) shape COA .

Each COA entails costs and benefits which materialise over different time periods … short-term vs. long-term (MOTLO)

Costs and benefits associated to different COAs may be uncertain (risk) or unknown (uncertainty)… expectations

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ECONOMIC RATIONALITY

Economic rationality is about choosing the best course of action for a give constraint-set where best is defined with respect to the individual’s objective function (which we assume to be well-defined) and on the information at his disposal (full vs. limited information).

Rationality assumption and its two motivations

More on rationality and homo economicus (Sen 1987, Smith 2008, Rodriguez-Sickert 2009)

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SOCIO-ECONOMIC CONTEXT

Free market economy:• Well-defined property rights over available resources.• Freedom to put available resources to the best (most profitable) use as

judged by the owner (resource allocation).• Property rights protection.• Freedom to transfer property rights in a regulated and organised way

(Voluntary exchange)• Price-based resource allocation.

Modelling social interaction:• The Robinson Crusoe economy (no interaction)• Strategic interaction (Game theory)• Market interaction

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ECONOMIC THEORY AND ECONOMIC MODELS (NOT THE SAME THING)

Theory: A set of statements or principles devised to explain a group of facts or phenomena in their relation to one another. Theories can be deduced from given axioms or be the result of observation and conjecture, they can be empirically tested and used to make predictions about phenomena.

Economic model: simplified representation of reality based on a set of pre-specified simplifying assumptions and on the use of one or more languages (the three languages of economics).

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MARSHALL ON THE USE OF MATHEMATICS IN ECONOMICS

“[I had] a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules - (1) Use mathematics as a shorthand language, rather than an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can't succeed in (4), burn (3). This last I did often”. [Marshall 1906]

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ECONOMIC THEORY AND ECONOMIC MODELS (NOT THE SAME THING)

“Models are objects to enquire into and to enquire with: economists enquire into the world of the economic model, and use them to enquire with into the economic world that the model represents” (Morgan 2012, p. 217).

“Reasoning in terms of models involves four steps “Step 1 is to construct a model relevant for some problem of interest. Step 2 is to ask questions about ‘something in the model or in the world’. Step 3 is to ‘demonstrate the answer to the questions using the model’s resources’. This is where manipulation comes in: the answer is arrived at by manipulating the model. Step 4 is to add a ‘narrative’ that ‘accompanies the demonstration to link the answers back to the questions and to their domains”. (Morgan 2012 p. 225).

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Micro

Varian (2010)

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THE MARKET

“A mechanism for effecting purchases and sales in a relatively public manner. Thus a market entails a way of carrying out transactions and some means of collecting and disseminating information on the terms of the transactions, particularly price. These two aspects are inherently interrelated. ” (Burns 1979, p. 5)

Market identification: Where ? When ? Who ? What ? How ?

Market classification: • Markets for goods and service, factor markets, asset markets• Spot, futures and options markets• Perfect competition, monopolistic competition, oligopoly, duopoly,

monopoly/monopsony• Auction markets, dealer markets, broker markets, private negotiations• Regulated vs non-regulated (OTC) markets

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Micro

THE COMPETITIVE MARKET

•Many potential buyers and sellers, motivated by self-interest, competing against each other and acting as price-takers.• Traded goods are excludable (the owener can exercise

property rights on it) rivalrous (use by one necessarily prevents that of another) and homogenous (only price matters). • No barriers to entry and exit• Perfect information• No transaction costs (costs related to market participation):

search and information costs, bargaining and decision costs, policing and enforcement costs.

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Probability

• y = Market price• x = Quantity traded over a

given period of time• DD = Demand function• SS = Supply function• A = Market equilibrium• ds = Excess demand)• sd = Excess supply)

Marshall (1890)

THE MARSHALLIAN CROSS

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THE COMPETITIVE MARKET - PARTIAL EQUILIBRIUM MODEL

P = market price , nominal price (money?), relative price (MOTLO)Q = quantity traded over a given period of time (flow variable … MOTLO)DD = Market Demand function (Horizontal aggregation, MOTLO)

• Inverse demand function Pd = f(Q) ; f’(Q) < 0 • Demand price the MAXIMUM price that consumers are willing to pay for the

goods and services the are planning to buy when a particular amount or quantity is available.

• Demand function proper Qd = g(P) ; g’(P) < 0SS = Market Supply function

• Inverse supply function Ps = h(Q) ; h’(Q) > 0 • Supply price the MINIMUM price that firms are willing to accept in return for a

particular amount or quantity of goods and services.• Supply function proper Qs = k(P) ; k’(P) > 0

EQUILIBRIUM ; Pd = Ps or alternatively Qd = Qs

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THE COMPETITIVE MARKET – DEMAND ANALYSIS

Slope: The law of demand states that when the price of a good rises CP, the amount demanded falls, and when the price falls, the amount demanded rises.(MOTLO)

Position of the demand curve depends: Preferences, Disposable incomes, Income distribution, Price of complements and subsitutes, Expected own-price, Expected price of complements and substitutes … when one of these EXOGENOUS VARIABLES changes the demand curve shifts up or down.

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Micro

ELASTICITY

Price elasticity of demand: the degree to which the number of products sold changes when the product's price changes

Marshall (1890)

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ELASTICITY

Income elasticity of demand: the degree to which the number of products demanded changes with an individual’s income.

Brown e Deaton (1972)

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THE COMPETITIVE MARKET – SUPPLY ANALYSIS

Slope: No equivalent of the law od demand, slope of supply function in a competitive market depends on marginal costs (MOTLO)

Position of the supply curve depends: Technology, Fixed inputs, Input prices, Degree of sectoral integration … when one of these EXOGENOUS VARIABLES changes the demand curve shifts up or down.

Marshall (1890)

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EQUILIBRIUM AND WELFARE ANALYSIS

• Efficient allocation of scarce resources

• Welfare maximization– Consumers surplus– Producers surplus

• Market “freedom”• Market “democracy”• How long does it take?• Existance? Unicity, stability?

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CONSUMER SURPLUS

Varian (2010)

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MARKET ANOMALIES

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Narrow definition (Fama 1970) “A market is efficient when prices fully reflect available information” : Weak, Semi-strong and Strong efficiency.

Broad definition (Burns 1979): “An efficient market is liquid, orderly and well-organised. Liquidity fosters orderly market conditions and influences a market’s organisation. In turn, orderly market conditions and good market organization promote market liquidity”.

Liquidity

Good market organisationOrderly market conditions

MARKET EFFICIENCY

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MARKET LIQUIDITY

Market liquidity, or liquidity of an asset traded on a market, has two interreated aspects: certainty of price (with respect to underlying value) and expected marketability (inversely related to transaction costs). Liquidity depends on:

• Breadth and urgency of demand, • Cost of ascertating an asset quality (quality standardisation in case of commodities,

publicly available info in case of financial assets), • Expected cost of default underlying financial assets (default risk together with

enforcement cost), • Transport cost and cost of holding inventories (storage, deterioration, theft,

financing costs, risks of price change).

Risk of price uncertainty associated with inventory holdings one of the main factors behind the establishement of futures and option markets and of the activities of Hedgers, Speculators and Arbitrageurs.

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ORDERLY MARKET CONDITIONS

Disorderly market conditions are associated with:

• Unexpectedly high price volatility (symptom, rather than cause), • Artificial barriers to entry or exit (e.g. monopoly / monopsony)• Information manipulation • Traders overreaction• Destabilising trading activity as a result of trading restrictions

Liquidity helps to prevent structural monopolies and price manipulation and together with an appropriate organisation contributes to generating orderly market condition

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MARKET ORGANISATION

The organisation of a market embraces the institutions that service it: dealers, brokers, clearing houses, inspection services, regulatory authorities.

Development of a market’s organisation involves applying economies of scale to effecting transactions as well as to provide information about the terms of the transaction.

The history of a market organisation is one of increasing specialization of function induced by, and in turn inducing, an increase in market liquidity.

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Random variable

IMPERFECT MARKET - DEALER

Dealers are specialised market operators standing ready to transact Ai = Ask price , Bi = Bid price, AiBi = Bid-Ask spread (transaction cost indicator,

inversely related to market liquidity) [Demsetz 1967]

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IMPERFECT MARKET – PRICE CEILING AND RATIONING

Varian (2010)

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MARKET FAILURES

A market failure is a situation where free markets fail to allocate resources efficiently. Economists identify the following cases of market failure:Productive and allocative inefficiency: Markets may fail to produce and allocate scarce resources in the most efficient way.Monopoly power: Markets may fail to control the abuses of monopoly power.Missing markets: Markets may fail to form, resulting in a failure to meet a need or want, such as the need for public goods, such as defence, street lighting, and highways.Incomplete markets: Markets may fail to produce enough merit goods, such as education and healthcare.De-merit goods: Markets may also fail to control the manufacture and sale of goods like cigarettes and alcohol, which have lessmerit than consumers perceive.Negative externalities: Consumers and producers may fail to take into account the effects of their actions on third-parties, such as car drivers, who may fail to take into account the traffic congestion they create for others. Third-parties are individuals, organisations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self interest.

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MARKET FAILURES

Property rights: Markets work most effectively when consumers and producers are granted the right to own property, but in many cases property rights cannot easily be allocated to certain resources. Failure to assign property rights may limit the ability of markets to form.Information failure: Markets may not provide enough information because, during a market transaction, it may not be in the interests of one party to provide full information to the other party. Information asymmetry (adverse selection, moral hazard, costly state verification) belong to this category.Unstable markets: Sometimes markets become highly unstable, and a stable equilibrium may not be established, such as with certain agricultural markets, foreign exchange, and credit markets. Such volatility may require intervention.Inequality: Markets may also fail to limit the size of the gap between income earners, the so-called income gap. Market transactions reward consumers and producers with incomes and profits, but these rewards may be concentrated in the hands of a few.

Source http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html

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MARKET REGULATION

Increase market efficiency by promoting liquidity, orderly market conditions and an appropriate organization.

Correct market failures by resorting to:

• Price mechanism: change the behaviour of consumers and producers by using the price mechanism. For example, this could mean increasing the price of ‘harmful’ products, through taxation, and providing subsidies for the ‘beneficial’ products. In this way, behaviour is changed through financial incentives, much the same way that markets work to allocate resources.

• Legislation and force: For example, by banning cars from city centres, or having a licensing system for the sale of alcohol, or by penalising polluters, the unwanted behaviour may be controlled.

Source http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html

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REFERENCE

Burns J.M. (1979) A Treatise on Markets, American Enterprise Institute, Studies in Economic Policy, Washington DC.

Rodriguez-Sickert C. (2009) “Homo economicus”, Handbook of Economics & Ethics, Peil, J., and Van Staveren, I. (eds.) Edward Elgar Publishing.

Sen, A. (1987) “Rational Behaviour”, The New Palgrave Dictionary of Economics, vol 3, pp. 68-76,

Smith V. L. (2008) Rationality in Economics, Cambridge University Press, Cambridge.

Varian H. (2010) Intermediate Microeconomics, 8° edition, W. W. Norton & Company