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Microeconomic Principles &Policy

product: 4345 | course code: c357

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Microeconomic Principles and Policy

Centre for Financial and Management Studies

SOAS, University of London

This edition: 2013

All rights reserved. No part of this course material may be reprinted or reproduced or utilised in any form or by any electronic,

mechanical, or other means, including photocopying and recording, or in information storage or retrieval systems, without written

permission from the Centre for Financial & Management Studies, SOAS, University of London.

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Course Introduction and Overview

Contents

1 Introduction 3

2 Course Content 3

3 The Structure of the Course 4

4 The Course Author 7

5 Course Materials 7

6

Studying the Course 8

7 Assessment 8

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2 University of London

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Centre for Financial and Management Studies 3

1 Introduction

Welcome to the courseMicroeconomic Principles and Policy. We hope that you

will find the course stimulating and useful.

When you have completed the course you will be able to

explain the principles underlying consumer demand from differentperspectives

discuss what economists mean by the theory of the firm

spell out the implications of competitive and noncompetitive marketstructures on the firms pricing and output decisions

evaluate how firms respond to the pricing and output decisions of otherfirms in the market

debate the importance of the markets for inputs or factors of production,

such as labour, capital and natural resources analyse how firms expand and the implications for market structure

discuss how globalisation has influenced the firms behaviour and theimplications for pricing and output decisions.

The course introduces a wider range of microeconomic theories and applica-

tions, some of which are more contentious than others as they have

implications for public policy.

2 Course Content

There are two narratives or theoretical approaches running through this

course. The first is the traditional neoclassical approach, which is based on the

assumption that all economic actors behave rationally to improve their own

self-interest in markets that are competitive. So consumers want to maximise

their satisfaction from the goods and services they consume, while firms want

to maximise their returns or profits from the goods and services they produce

and it is assumed that consumers and producers have all the information

needed to make economic decisions rationally. This neoclassical approach is

developed on the basis of this simplified analysis of economic behaviour ,

although the model can and does get more complex in order to analyse

situations where the above assumptions do not hold. Over time this approachhas been developed into an elegant model of economic behaviour, expressed

in mathematics and graphically.

The neoclassical narrative has become the basic economic model taught in

schools and universities, albeit in some highly complex mathematical forms at

post-graduate level. It is a useful model in that it enables us to analyse key

economic relationship within the context of the models assumptions. How-

ever, in the real world, economic agents do not necessarily behave rationally

so as to maximise their own self-interest. For instance, consumers decisions

may be influenced by habits or advertising, while large corporations may be

motivated by wanting to acquire market concentration as well as earningprofits.

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So the second narrative running through this course covers alternative ap-

proaches that have been developed to analyse economic behaviours. In

particular, you will be learning about the behavioural approaches to consumer

theory as well as alternative models for analysing producer behaviour and

market structures.

However, it is important to note that there are no right or wrong models ofeconomic behaviour, but rather a spectrum of approaches based on different

underlying assumptions of how economic actors behave. In some cases, these

models also reflect political ideologies. So, for example, the neoclassical

approach and its focus on the primacy of markets as the modality of economic

actors interaction is often viewed as being aligned with more conservative-

based political approaches whereas some of the alternative approaches are

often viewed as being more closely aligned with more liberal political stances.

It is not the purpose of this course to promote one or other of these narratives

rather it is to introduce you to the range of models, analytical tools and

examples to help you to form your own views

3 The Structure of the Course

The course is structured in the following way. Unit 1 is an introduction to

Microeconomics providing an overview of market economic activity and

supply and demand. Unit 2 is concerned with the theory of consumer behav-

iour which underpins the concept of consumer demand. As well as discussing

the neoclassical model, the newer behavioural approaches to consumer

demand are introduced. In addition, the second unit demonstrates how both

the neoclassical and behavioural models can be used to analyse consumersavings and borrowing decisions.

Units 3 to 5 are concerned with the neoclassical model of production and

costs. While Unit 3 is concerned with the basics of neoclassical cost and

production theory, Units 4 and 5 focus on the firms pricing and output

decisions in markets where there is perfect competition, monopoly and

monopsony power, monopolistic competition and oligopoly. Unit 5 is devoted

to the latter as the theoretical models are both more complicated and provide

a better reflection of decision making in the real world. The units discuss

examples of the different market types, such as the degree of competition in

Russian banking, and price wars and collusion in Chinas airline industry.

Unit 6 is concerned with the markets for the input or factor of productions,

including the markets for labour, manufactured capital, social capital, natural

resources and finance. It looks at the neoclassical models as well as other

theoretical approaches.

Units 7 and 8 are concerned with bigger picture issues, such as alternative

models of firms behaviour in modern industrial structures, the impact of

globalisation on firms decision making, the role of government in market

economies and economic systems. In doing so, Unit 7 looks at case studies ,

such as price bundling behaviour in the telecommunications industry and the

economic behaviour of two very different companies the American companyWal-Mart and Swedish company IKEA in their efforts to expand globally.

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Unit 8 is concerned with the role of government in a market economy and

how this reflects the prevailing economic system. The course ends with a

discussion of how the theoretical concepts and models of microeconomics can

be used in environmental economics.

Some of the units are more theoretical in nature than others, and you may find

that some require more time to complete than others. This is especially thecase if microeconomics is new to you. If you have previously studied micro-

economics then you will find that much of the traditional theory covered in

the course is familiar to you. However, many of the readings will update the

theoretical ideas and/or applications and so you are nonetheless encouraged

to do the readings.

Unit 1 provides an introduction to the basic concepts of demand and supply,

which will be familiar if you have previously studied an economics course.

But if this is your first encounter with economics and microeconomics in

particular, you may find you need to spend a bit more time studying the unit.

Unit 2 covers both the neoclassical and behavioural approaches to consumertheory and so it is going to take you longer to do all the readings, than, for

example, Unit 3, which concerns the neoclassical theory of production and

costs. However, this may be to your advantage as you will be probably be

working on your first assignment when you come to study Units 3 and 4.

Similarly, Units 5 and 6 may take you more time to complete than Unit 4

because of the greater complexity in studying theories of oligopolistic markets

and theories of factor markets, respectively. On the other hand, you will

probably find Units 7 and 8 less theoretical and more accessible, as they are

concerned with present day economic problems such as the pricing behav-

iours of multinational firms, globalisation of business and the role ofgovernment

Unit 1 Introduction to Microeconomics

1.1 Introduction

1.2 Markets

1.3 Supply and Demand

1.4 Elasticity

1.5 Conclusion

Unit 2 Theories of Consumer Behaviour

2.1 Introduction

2.2 Traditional Approach of Utility Theory

2.3 Limitations of the Consumer Theory

2.4 Behavioural Approach

2.5 Policy Issues

2.6 Conclusion

Unit 3 Theory of Production and Costs

3.1 Introduction

3.2 Types of Resources Used in Production

3.3 Production and Costs

3.4 Production Decisions

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3.5 Analysing Costs and Production

3.6 Conclusion

Unit 4 Markets and Competition

4.1 Introduction

4.2 Perfect Competition4.3 Non-Competitive Market Structures Monopoly

4.4 Monopsony

4.5 Non-Competitive Market Structures Monopolistic Competition

4.6 Conclusion

Unit 5 Oligopoly and Other Noncompetitive Markets

5.1 Introduction

5.2 Oligopoly models of output decision-making

5.3 Oligopoly models of price competition

5.4 Game theory5.5 Collusion by firms

5.6 Prohibiting collusion

5.7 Case study Chinas airline markets

5.8 Conclusion

Unit 6 Markets for Resources Labour, Capital and Other Inputs

6.1 Introduction

6.2 Labour Markets

6.3 Manufacture, Natural and Social Capital Markets

6.4 Finance Capital6.5 Conclusion

Unit 7 Industry Structures, Pricing Behaviour and Globalisation

7.1 Introduction

7.2 Alternative Theories of Firms Behaviour

7.3 Big Business

7.4 Pricing Behaviour

7.5 Globalisation

7.6 Conclusion

Unit 8 Economic Systems and Microeconomics Applied to Environmental Econom-

ics

8.1 Introduction

8.2 Externalities and Public Goods

8.3 Economic Systems

8.4 Environmental Economics

8.5 Conclusion

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4 The Course Author

Alison Johnson is an Associate of Development Finance International, which

works with developing country governments to develop the full independent

capacity to design and execute their own national resource mobilisation and

debt strategies and policies. She also has experience in preparing analyticalstudies and training materials on aid and debt issues for the United Nations,

African Development Bank, Commonwealth Secretariat, Oxfam and other

organisations.

Prior to this, she was Acting Director of the Centre for International Education

in Economics (precursor of CEFIMS), with responsibility for policy and

operations of the postgraduate programmes in economics, finance and

development by distance learning, and Lecturer in Economics at SOAS with

responsibility for designing and writing distance learning economics courses.

She was the convenor and principal author of the courses on economic princi-

ples, and she also has extensive experience of writing practically-focusedtraining materials and running workshops.

5 Course Materials

The textbook for this course is

Neva Goodwin, Julia Nelson, Frank Ackerman and Thomas Weisskopf

(2009)Microeconomics in Context, Second edition, New York & London:

ME Sharpe.

The textbook is designed to provide an introduction to most of the topics youwill be studying in this course. However, it is different from the standard

microeconomics textbook in that its focus is wider than just the traditional

neoclassical approach. Not only does it take account of alternative theories but

also its presentation is broader based, focusing on consumption and produc-

tion decision-making within the context of an economic system. So it is

aligned more with the traditional notion of political economy, than the nar-

rower more mathematical discipline that economics became in the twentieth

century.

The textbook is non-mathematical, as is this course. While it does use a few

equations in some of its technical annexes, much of the exposition is done in

terms of diagrams. At the end of the book there is useful glossary of terms.

The one drawback to this and many other textbooks is its American orienta-

tion. So you will find that most of the applications and real world examples

quoted in the textbook are American, with a smattering of a few from else-

where. To counterbalance this, the course introduces non-American

applications and examples, while noting that many of these are European

focused, with the use of African, Asian and Latin American circumstances

where possible.

In addition to the textbook, the course materials include other readings, made

up of chapters and extracts of other books, and articles from respected aca-demic economic journals, international organisations and newspapers. The

articles and extracts are found in the Course Reader. Some of the extracts and

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articles are concerned with economic models and concepts whereas others

discussion applications and policy aspects of the theory.

At the end of each unit you will find a list of Additional Readings, which are

there for you to follow up if you are interested in pursuing some of the unit

topics in more detail. In addition, you are encouraged to look at the reference

section of the articles included as course readings, as these too will provideyou with further articles or readings to explore if you are interested. The

additional readings are not compulsory, but rather they are there for you to

refer to if you have time and are particularly interested.

In several of the exercises in the units you will be invited to submit summaries

of your answers to the Online Study Centre, and you are urged to do this, to

start a dialogue with fellow students and to share your ideas and experiences

of the topics studied in the course.

6 Studying the CourseAs you work through the course materials, there are various exercises that are

designed to consolidate your knowledge and skills. We recommend that you

do the exercises, most of which take half an hour or less, before you look at

any model answers that are given in the unit.

At certain points we will ask you to reflect on various aspects of the policy

and processes relevant to your own place of work. It will be valuable for you

and your fellow students to share these reflections on the OSC (the online

study centre). Short notes setting out the issue and the approach will enrich

your, and your fellow students, experience of the course.Please feel free to raise queries with your tutor and with your fellow students

if there are things that are not clear to you. Do this as soon as you find a

problem, because waiting will hold you up as you work through the course.

We hope that you will find the course instructive, useful and occasionally

challenging.

7 Assessment

There are two assignments for this course, one after four weeks and oneafter eight weeks. Together they account for 30% of the grade for the course.

In addition there is a three-hour written examination, which counts for the

other 70%. The specimen examination, which shows the format of the final

exam but not the questions you will get, is printed at the end of this Course

Introduction.

Your performance on each course is assessed through two written assignments

and one examination. The assignments are written after weeks four and eight of

the course session and the examination is written at a local examination centre

in October.

The assignment questions contain fairly detailed guidance about what isrequired. All assignment answers are limited to 2,500 words and are marked

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using tutor-marking guidelines. When you receive your grade it is accompa-

nied by comments on your paper, including advice about how you might

improve, and any clarifications about matters you may not have understood.

These comments are designed to help you master the subject and to improve

your skills as you progress through your programme.

The written examinations are unseen (you will only see the paper in theexam centre) and written by hand, over a three hour period. We advise that

you practice writing exams in these conditions as part of you examination

preparation, as it is not something you would normally do.

You are not allowed to take in books or notes to the exam room. This means

that you need to revise thoroughly in preparation for each exam. This is

especially important if you have completed the course in the early part of the

year, or in a previous year.

Preparing for assignments and examinations

There is good advice on preparing for assignments and exams and writingthem in Sections 8.2 and 8.3 of Studying at a Distanceby Talbot. We recom-

mend that you follow this advice.

The examinations you will sit are designed to evaluate your knowledge and

skills in the subjects you have studied: they are not designed to trick you. If

you have studied the course thoroughly, you will pass the exam.

Understanding assessment questions

Examination and assignment questions are set to test different knowledge and

skills. Sometimes a question will contain more than one part, each part testing

a different aspect of your skills and knowledge. You need to spot the keywords to know what is being asked of you. Here we categorise the types of

things that are asked for in assignments and exams, and the words used. All

the examples are from CeFiMS examination papers and assignment questions.

Definitions

Some questions mainly require you to show that you have learned some concepts, by

setting out their precise meaning. Such questions are likely to be preliminary and be

supplemented by more analytical questions. Generally Pass marks are awarded if the

answer only contains definitions. They will contain words such as:

Describe Define

Examine

Distinguish between

Compare

Contrast

Write notes on

Outline

What is meant by

List

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Reasoning

Other questions are designed to test your reasoning, by explaining cause and effect.

Convincing explanations generally carry additional marks to basic definitions. They will

include words such as:

Interpret

Explain

What conditions influence

What are the consequences of

What are the implications of

Judgment

Others ask you to make a judgment, perhaps of a policy or of a course of action. They will

include words like:

Evaluate

Critically examine

Assess Do you agree that

To what extent does

Calculation

Sometimes, you are asked to make a calculation, using a specified technique, where the

question begins:

Use indifference curve analysis to

Using any economic model you know

Calculate the standard deviation

Test whetherIt is most likely that questions that ask you to make a calculation will also ask for an

application of the result, or an interpretation.

Advice

Other questions ask you to provide advice in a particular situation. This applies to law

questions and to policy papers where advice is asked in relation to a policy problem. Your

advice should be based on relevant law, principles, evidence of what actions are likely to be

effective.

Advise

Provide advice on Explain how you would advise

Critique

In many cases the question will include the word critically. This means that you are

expected to look at the question from at least two points of view, offering a critique of each

view and your judgment. You are expected to be critical of what you have read.

The questions may begin

Critically analyse

Critically consider

Critically assess Critically discuss the argument that

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Examine by argument

Questions that begin with discuss are similar they ask you to examine by argument, to

debate and give reasons for and against a variety of options, for example

Discuss the advantages and disadvantages of

Discuss this statement

Discuss the view that

Discuss the arguments and debates concerning

The grading scheme

Details of the general definitions of what is expected in order to obtain a

particular grade are shown below. Remember: examiners will take account of

the fact that examination conditions are less conducive to polished work than

the conditions in which you write your assignments. These criteria

are used in grading all assignments and examinations. Note that as the criteria

of each grade rises, it accumulates the elements of the grade below. As-

signments awarded better marks will therefore have become comprehensive

in both their depth of core skills and advanced skills.

70% and above: Distinction, as for the (6069%) below plus:

shows clear evidence of wide and relevant reading and an engagementwith the conceptual issues

develops a sophisticated and intelligent argument

shows a rigorous use and a sophisticated understanding of relevantsource materials, balancing appropriately between factual detail and keytheoretical issues. Materials are evaluated directly and their assumptions

and arguments challenged and/or appraised

shows original thinking and a willingness to take risks

6069%: Merit, as for the (5059%) below plus:

shows strong evidence of critical insight and critical thinking

shows a detailed understanding of the major factual and/or theoreticalissues and directly engages with the relevant literature on the topic

develops a focussed and clear argument and articulates clearly andconvincingly a sustained train of logical thought

shows clear evidence of planning and appropriate choice of sources andmethodology

5059%: Pass below Merit (50% = pass mark)

shows a reasonable understanding of the major factual and/ortheoretical issues involved

shows evidence of planning and selection from appropriate sources,

demonstrates some knowledge of the literature

the text shows, in places, examples of a clear train of thought orargument

the text is introduced and concludes appropriately

4549%: Marginal Failure shows some awareness and understanding of the factual or theoretical

issues, but with little development

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misunderstandings are evident

shows some evidence of planning, although irrelevant/unrelatedmaterial or arguments are included

044%: Clear Failure

fails to answer the question or to develop an argument that relates to thequestion set

does not engage with the relevant literature or demonstrate aknowledge of the key issues

contains clear conceptual or factual errors or misunderstandings

[approved by Faculty Learning and Teaching Committee November 2006]

Specimen exam papers

Your final examination will be very similar to the Specimen Exam Paper that

is printed at the end of this Introduction. It will have the same structure and

style and the range of question will be comparable.

CeFiMS does not provide past papers or model answers to papers. Our

courses are continuously updated and past papers will not be a reliable guide

to current and future examinations. The specimen exam paper is designed to

be relevant to reflect the exam that will be set on the current edition of the

course

Further information

The OSC will have documentation and information on each years

examination registration and administration process. If you still have ques-

tions, both academics and administrators are available to answer queries.

The Regulations are also available at www.cefims.ac.uk/regulations.shtml,

setting out the rules by which exams are governed.

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UNIVERSITY OF LONDON

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

MSc Examination

Postgraduate Diploma Examination

for External Students 91DFMC357

MICROECONOMIC PRINCIPLES AND POLICY

SPECIM EN EXAM IN ATIO N

This is a specimen examination paper designed to show you the type of

examination you will have at the end of the year for the courseMicroeconomicPrinciples and Policy. The number of questions and the structure of the exami-nation will be the same but the wording and the requirements of each

question will be different. Best wishes for success in your final examination.

The examination must be completed in THREEhours.

Answer THREE questions, selecting at leastONE question from EACH

section. The examiners give equal weight to each question; therefore, you are

advised to distribute your time approximately equally between three ques-

tions.

DO NOT REMOVE THIS PAPER FROM THE EXAMINATION ROOM. IT MUST

BE ATTACHED TO YOUR ANSWER BOOK AT THE END OF THE

EXAMINATION

University of London, 2013 PLEASE TURN OVER

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Answer THREE questions, at least ONE from EACH section. Answer all

parts of the questions.

Section A

(Answer at l east ONE quest i on from t his sect i on)

1 The neoclassical approach provides a relatively simple and

elegant model of how consumers make choices, but it does so

under some fairly restrictive assumptions.Critically assess this statement .

2 Explain how the behavioural approach to consumer theory canbe used to design public policy.

3 Discuss the main measures used to evaluate the competitive of

markets.

4 Explain how game theory is used as an analytical tool byeconomists.

Section B

(Answer at l east ONE quest i on from t his sect i on)

5 Discuss alternative theories of firms motivations and their im-

plications for corporate behaviour.

6 Explain how globalisation has influenced how businesses have

grown.

7 Discuss why governments might intervene in the economy.

8 Discuss the theoretical approaches for analysing the markets fortwo of the factors of production.

[END OF EXAMINATION]

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Unit 1 Introduction to

Microeconomics

Contents

1.1 Introduction 3

1.2 Markets 4

1.3 Supply and Demand 5

1.4 Elasticity 8

1.5

Conclusion 9

References and Websites 11

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Unit Content

This first unit of the course contains a discussion of what economics is about

and introduces the basics of market analysis such as the supply-demand

framework, equilibrium and price elasticities. Although these are familiartopics in economics courses and textbooks, it is important to have a sound

understanding of the basic concepts and tools of economic analysis before

going on to learn about the more complex theories and models for analysing

economic activity. The unit will therefore give you the opportunity to

review and consolidate your knowledge of these basics if you have studied

microeconomics before or to master them now, if you have not.

Learning Outcomes

When you have completed your study of this unit and it readings, you willbe able to

discuss what the study of economics can encompass, and why theremight be alternative approaches to economic analysis

explain how the supply-demand framework can be used as ananalytical tool

discuss what is meant by market equilibrium, and how it is achieved

explain and apply the concept of elasticity.

Reading for Unit 1

Textbook

Neva Goodwin, Julie Nelson, Frank Ackerman and Thomas Weisskopf

(2009)Microeconomics in Context, set sections of Chapters 1 Economic

Activity in Context, 3 Market Institutions, 4, Supply and Demand,

5 Working with Supply and Demand and 6 Capital Stocks and Resource

Maintenance.

You are also invited to read Chapter 2 Economic Actors and

Organizations, and further sections of the chapters above, but those

readings, though useful, are optional.

Course Reader

Bassam Fattouh (2010) Oil Market Dynamics through the Lens of the 2002-

2009 Price Cycle

Competition Commission (2011) Local Bus Services Market Investigation.

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1.1 Introduction

Before getting involved in the detailed study of economic theory and mod-

els, it is useful to take a few minutes to ask what you are trying to achieve in

studying economics. Looking back over the history of economic thought, itis notable how the answer to this question has changed. In the eighteenth

century, Adam Smith was writing about the nature and causes of the wealth

of nations, and in doing so was seeking to explain how wealth is created

principally through the value of labour invested in goods and services. Up

until the late nineteenth century economists continued Smiths focus in

economic analysis.

Then a new school of economic thought, now referred to as the neoclassical

or marginalistapproach, sprang up. This approach is based on the notion

that all economic actors behave rationally to maximise their self-interest,

be it satisfaction of the goods and services consumed or profits generatedfrom the production and sale of goods and services. One of the key

aspects of this approach is its focus on the efficiency of markets and how

this is achieved through incremental changes in the use of resources. This

approach has also led to the development of a more mathematical ap-

proach to economics.

While the neoclassical approach remains important in understanding the

modern-day study and application of economics, some economists are

saying that there are other factors which can be important in explaining

economic behaviour, such as fairness or equity of distribution of resources

and wealth, environmental sustainability of natural resources, social orcommunity relations and cooperation and peoples well-being. As a result

of these different emphases on economic behaviour and activity, new

approaches to the discipline are being developed and talked about. For

instance there are moves in the United Kingdom, following the Bhutanese

example, to design measures of national well-being which will cover the

quality of life of people in the UK, environmental and sustainability issues,

as well as the economic performance of the country1as an alternative to the

orthodox use of Gross Domestic Product (GDP) as a measure of national

wealth.

As well as considering why we are interested in studying in economics, wealso need to look at what it is about. While there is general agreement that

economic activity is about consumption, production, distribution and

resource maintenance, how these aspects are covered will vary. Traditional

neoclassical microeconomic theory focuses mainly on consumption and

production activities, whereas distribution is mainly the focus of trade

theory, while resource maintenance has tended to be ignored although this

is changing with renewed interest in environmental economics.

1 For more information about the UK well-being measures, seehttp://www.ons.gov.uk/ons/guide-method/user-guidance/well-being/index.html

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In contrast, the demand curve is downward sloping because buyers pur-

chase less the higher the price. This theory assumes that sellers and buyers

behave in this manner in respond to prices.

However, the quantity of goods and services supplied and demanded is

more complex than being simply a function of price. In the case of supply,

the quantity supplied is also a function of other factors, such as the cost ofinputs, the technology of production and prices of related goods and ser-

vices. The quantity demanded is also a function of other factors including

peoples tastes and preferences, income and the prices of related goods and

services.

Reading

To learn more about the theory of supply and demand, please read , Sections 2 and 3 of

Goodwin et al. Chapter 4.

As you do this reading, please ensure you can answer the following questions: How are changes in the quantity supplied and the quantity demanded represented?

What do economists mean when they refer to a change in supply and a change indemand, and how are these represented diagrammatically?

What are the non-price determinants of supply and demand, respectively?

What is meant by complementary and substitute goods or services?

Having seen how the quantity supplied and demanded respond to changes

in price and changes in non-price factors, we can move on to look at how

markets work to equilibrate the price and quantities supplied and de-manded. That is to reach a point which economists refer to as market-

clearing equilibrium, when the quantity supplied equals the quantity

demanded. When the market is not at equilibrium, then there is a shortage

when demand exceeds supply, or a surplus when supply exceeds demand.

In principle, the interaction of supply and demand to achieve an equilibrium

appears simple and straightforward but in practice this is not necessarily the

case. For instance, it may take time for firms to increase production and the

quantity supplied to the market. Or demand for an item could fall away

just think of rapid falls in demand for clothing items as fashion changes,

leaving producers with excess supply.

Alternatively, the market price might not be providing the appropriate

signals to buyers and sellers. For example, a higher price is often seen as

signalling a better quality product, so a buyer may decide to pay a higher

price to obtain a good quality product for example, a car which works

well. This may be the case when buying a new car, but what about in the

market for second-hand cars, where the seller has the advantage of knowing

whether the car performs well or badly? In that case, the price may not be a

reliable signal of the cars quality. This example is sometimes known as the

market for lemons where a lemon is an American term for a car that is

found to be defective after purchase.

Neva Goodwin, Julie

Nelson, Frank

Ackerman and Thomas

Weisskopf (2009)

Microeconomics in

Context, Sections 2 and

3 of Chapter 4 Supply

and Demand.

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Reading

To learn how markets adjust and to consider an application of supply-demand analysis to

the case of the crude oil market in the United States, please read Goodwin et al. Chapter

4 Sections 4 to 6.

As you do this reading, you will find it useful to make notes on the following: how markets adjust when there are surpluses or shortages

what economists mean by equilibrium and disequilibrium

the signalling and rationing function of markets

what is meant by price floors and price ceilings, and their implications for market-clearing equilibrium.

In Section 6 Goodwin and her colleagues use the supply-demand framework

to analyse the US crude oil market, and in doing so they talk about theimplications of the pricing policies of the Organisation of Oil Exporting

Countries (OPEC), which is an organisation of producers who can collude to

affect prices. We will return to the subject of cartels and collusion by pro-

ducers in Unit 5.

In their discussion of the oil market, Goodwin et al.note that using a simple

supply-demand framework to analyse a complicated market, like that for

crude oil, has its limitations. In particular, the authors make a number of

important points about the functioning of supply and demand in the real

world, namely:

demand and supply can sometimes shift in the same direction markets may start from a disequilibrium position due to an external

factor or event

there may be a number of prices and quantities prevailing in a market

prices and quantities may not move as would be expected.

These authors analysis of US crude oil markets cover the years up to 2004.

Since then, crude oil prices have continued to be volatile. Some of this

continuing volatility may be a response to changing supply and demand

factors, which are sometimes referred to by economists as the market

fundamentals. However, some of the price volatility may be because non-oil

market players, such as speculators and investors, have become moreinvolved in oil market trading. Such players are only interested in oil price

movements that is, oil as a financial asset and have no interest in actual

oil supply and demand. There is considerable debate about whether oil price

volatility in recent years has more to do with speculation or with changing

fundamentals of supply and demand.

Reading

For an update on oil price markets, please read the Summary Report of Bassam

Fattouhs study of oil market dynamics.

Neva Goodwin, Julie

Nelson, Frank

Ackerman and Thomas

Weisskopf (2009)

Microeconomics in

Context, Sections 4 to 6

of Chapter 4 Supply

and Demand.

Bassam Fattouh (2010)Oil Market Dynamics

through the Lens of the

20022009 Price

Cycle, a paper from the

Oxford Institute of

Energy Studiesreprinted in the Course

Reader.

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As you read this Summary, please note the following points and their implicationsfor the function of supply, demand and the oil market:

the changing oil supply-demand feedbacks during the 2000s

the structural changes of oil markets and the different pricing regimes

the role of signalling and expectations in the oil market.If you are interested, please do read the remaining sections of this study, which are an

optional reading.

Now that you have read Section 6, Explaining Real-World Prices and Quantities, ofChapter 4 of Goodwin et al. and Fattouhs Summary Report, what do you think about

using the supply-demand framework to analyse the crude oil market? Write a few

paragraphs of notes on this.

You might like to start a conversation about this with fellow students on the OnlineStudy Centre; if so, send in your paragraphs and see what others think.

1.4 Elasticity

As you have seen, the supply-demand framework enables us to analyse

what is happening if there is a change in one of the factors influencing

demand or supply. But is it possible to give any quantitative answers to such

questions as by how much can we expect the demand and supply for a

good to change if the price of that good is halved?

In asking this type of question, we are concerned with a measure of the

sensitivity of the quantity demanded or supplied to a change in anothervariable. This measure of sensitivity is what economists refer to as

elasticity, which is the measure of the responsiveness to changes in

conditions.

So economists talk about price elasticity of demand or supply, which

is a measure of the effect a change in the price has on the quantity

demanded or supplied. This concept is important when it comes to

assessing how a change in price will affect the revenue generated from

the sale of a good or service. Revenue is defined as the price times the

quantity of a good. If, for example, the price of a good goes up, will

people buy significantly less so that revenue declines? Or will the declinein quantity demanded be relatively small such that revenues do not

decline? The answer to these questions depends on the price elasticity of

demand. For instance, the price elasticity of an essential good, such as

diesel oil, is relatively low as consumers and businesses will continue to

need to purchase it even if there is a large price increase. On the other

hand, the goods for which there are readily available substitutes are

usually more price-elastic.

Economists also talk about income elasticity of demand, which measures

the effects of changing income on the quantity demanded. So do consumers

purchase more or less as their income rises and falls?

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Reading

Chapter 5 of Goodwin et al. discusses the different ways in which economists use the

concept of elasticity. Most of the discussion is illustrated using diagrams, although

Section 2.4 presents a more mathematical approach, which you encouraged to read. It is

also recommended that you spend a few minutes working through the numerical

examples in the Math Review box. When discussing income elasticity, Goodwin et al. talkabout the income and substitution effects of a price change, which you should make

sure you understand. You should read all of Chapter 5.

As you do this reading, write notes on the following questions: If a good is price-inelastic, why will revenues change in the same direction as any

price change?

Why might demand for a good or service be price-elastic?

Do perfectly elastic and inelastic demand and supply exist?

What do economists mean by the terms normal and inferior goods?

What do economists mean by the income and substitution effects of a pricechange, and why are these effects useful?

Can the price elasticity of a good or service change over time?

This Chapter 5 reading from Goodwin and her colleagues provides a good

introduction to the concept of elasticity and its implications for assessing

how demand responds to changes in prices and income. So the next step is

to see how economists use the concepts of price and income elasticity to

analyse consumer demand. A good example of this is found in the next

reading, which is an analysis of the demand for local bus services in the

United Kingdom. This analysis illustrates some of the complexities of

investigating the demand for a particular good or service, such as how price

elasticity for a service can be different for different consumer groups, and

the importance of other factors such as the availability of alternative

services, location and income.

Reading

Please read the article on investigating local bus services, which summarises how the

demand for bus services is affected by the level of bus fares and other factors.

When you have finished this reading, spend a few minutes noting down how youwould answer the following question:

What are the implications of this demand analysis for a bus operating company?

If you have time, post a message for discussion with your group on the Online StudyCentre, commenting on whether the analysis offered in the Reading has given you any

insights into how the bus services in your local area are run.

1.5 Conclusion

In this first unit, you have been looking at the questions of what economics

is about and how the simple supply-demand model can be used to analyse

Neva Goodwin, Julie

Nelson, Frank

Ackerman and Thomas

Weisskopf (2009)

Microeconomics in

Context, set sections of

Chapter 5, Working

with Supply andDemand.

Competition

Commission (2011)

Local Bus Services

Market Investigation, a

UK CompetitionCommission study

reprinted in the Course

Reader.

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References and Websites

Competition Commission (2011) Local Bus Services Market Investigation,

UK Competition Commission, London; accessed athttp://www.competition-

commission.org.uk/assets/competitioncommission/docs/pdf/inquiry/r

ef2010/localbus/pdf/summary_of_demand_estimation_analysis.pdf

Fattouh B (2010) Oil Market Dynamics through the Lens of the 2002-2009

Price Cycle, WPM 39, Oxford Institute of Energy Studies, January;

accessed at http://www.oxfordenergy.org/wpcms/wp-

content/uploads/2010/11/WPM39-

OilMarketDynamicsThroughTheLensofthe2002-2009PriceCycle-

BassamFattouh-2010.pdf

Goodwin N, JA Nelson, F Ackerman and T Weisskopf (2009)Microeconomics in Context, Second edition, New York: ME Sharpe.

Additional Readings

Adams C and O Ajakaiye (2011) Causes, Consequences and Policy

Implications of Global Food Price Shocks: Introduction and Overview,

Journal of African Economics,Vol 20, Oxford University Press; accessed at

http://ideas.repec.org/cgibin/htsearch?q=Adams+C+and+O+Ajakaiye+

&ul=%2Foup%2Fjafrec This article provides an example of how elasticity

is analytically in Section 3.

Porteous D (2006) Competition and Microcredit Interest Rates, Focus Note

33, Consultative Group to Assist the Poor (CGAP), February; accessed at

http://www.cgap.org/gm/document-1.9.2575/FN33.pdf This article

shows how the demand supply model and elasticity can be used in

assessing financial products.

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Documents

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