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Notes onNotes onMicroeconomicsMicroeconomics
Prof. Theodore Tolias(Draft – Not for Quotation)
AgendaAgenda
Theory of Demand and SupplyElasticityApplications
– Minimum Wage and Unemployment– Sales Taxes
Possibilities, Preferences and Consumer Choices
The Theory of the Firm
The Theory of DemandThe Theory of Demand
The quantity demanded (Qd) of a good or service is the amount that consumers plan to buy during a given time period at a particular price (p).
A linear relationship between P and Qd, other things remaining equal.
MathematicallyMathematically
P = a – bQd,
Where:
P = Price of good or service
a = y-intercept or the price where Qd = 0
b = slope of demand curve
Qd = Quantity demanded
Factors That Affect DemandFactors That Affect Demand
The price of the good The prices of related goods Income Expected future prices Population Preferences
Movements Along Demand Movements Along Demand curvecurve
“Law of Demand”
Change in “quantity demanded”
Changes in the price of the good, cause “movements along” the curve, everything else remaining the same.
Shifts of the Demand CurveShifts of the Demand Curve
“Change in Demand”
Decrease in demand - leftward shift
Increase in demand – rightward shift
Decrease in DemandDecrease in Demand
Fall in the price of a substitute
Rise in the price of a complement
Income falls (normal good)
Expected fall in price Population decrease
p
Q
D2
D1
Increase in DemandIncrease in DemandRise in the price of a substitute
Fall in the price of a complement
Income rises (normal good)
Expected rise in price
Population Increase
p
Q
D1
D2
Theory of SupplyTheory of Supply
The quantity supplied (Qs) is the amount of a good that producers plan to sell in a given period at a particular price (p).
A linear relationship Qs and P, other things remaining the same.
MathematicallyMathematically
P = c + dQs,
Where:
P = Price of good or service
c = y-intercept or the price where Qs = 0
d = slope of supply curve
Qs = Quantity supplied
Factors That Affect SupplyFactors That Affect Supply
• The price of the good• The prices of factors of production• The prices of other goods produced• Expected future prices• The number of suppliers• Technology
Movements Along Supply Movements Along Supply CurveCurve
“Law of Supply”
Change in “Quantity Supplied”
Changes in the price of the good, causes “movements along” the curve, everything else remaining the same.
Shifts of the Supply CurveShifts of the Supply Curve
“Change in Supply”
Decrease in Supply – Leftward shift
Increase in Supply – Rightward shift
Decrease in SupplyDecrease in Supply Rise in the price of a factor of production Rise in the price of a substitute in production Fall in the price of a complement in production An expected rise in price of the good Fall in the number of firms
p
Q
S2S1
Increase in SupplyIncrease in SupplyFall in the price of a
factor of production
Fall in the price of a
substitute in production
Rise in the price of a
complement in production
An expected fall in price
of the good
Rise in the number of firms
Technology
p
Q
S1S2
Price Determination - Price Determination - EquilibriumEquilibrium
The price at which the quantity demanded equals the quantity supplied
Qd = Qs
Diagrammatically Diagrammatically
Prices below the equilibrium, there is a shortage (excess demand) and the price rises.
Prices above the equilibrium there is a surplus (excess supply) and the price falls.
p
Q
S
D
p*
Q*
The Effects in the Change of DemandThe Effects in the Change of Demand
When demand increases, both the price and the quantity increase
p
Q
S
p1
Q1
D2p2
Q2
D1
The Effect of a Change in SupplyThe Effect of a Change in Supply
When supply increases, the quantity increases and the price falls.
p
Q
S1
D
p1
Q1
S2
p2
Q2
ElasticityElasticity
Elasticity of Demand – measures the responsiveness of the quantity
demanded of a good or service to a change in its price
– the percentage change in the quantity demanded of a good divided by the percentage change in its price
DerivationDerivation
Elasticity of demand:
%
%
Q
P
Q
P
P
Q
Q
QaveP
Pave
Q
P
Pave
Qave= or =
Perfect Inelastic demand Unit Elastic DemandPerfect Inelastic demand Unit Elastic Demand Perfectly Elastic Perfectly Elastic
0 1
p
Q
D p
Q
D
Q
p
D
Elasticity Along a Straight Elasticity Along a Straight Line Demand CurveLine Demand Curve
p
Q
Elasticity, Total Revenue and Elasticity, Total Revenue and
ExpenditureExpenditure When demand is
elastic, a decrease in price brings an increase in the total revenue.
When demand is inelastic, a decrease in price brings a decrease in the total revenue.
Maximumtotal revenueTR
A price cutincreases
totalrevenues
A price cut
decreasestotal
revenues
Q
The Factors That Influence The The Factors That Influence The Elasticity of DemandElasticity of Demand
The closeness of substitutes
The proportion of income spent on the good
Time elapsed since a price change
Other Elasticities of Other Elasticities of DemandDemand
Cross price elasticity of demand
Income elasticity of demand
Cross Price Elasticity of Cross Price Elasticity of DemandDemand
Assume Two Goods (X, Y)
if = then goods are perfect substitutes
if > >0 then goods are substitutes
if =0 then goods are independent
if <0 then goods are complements
xyQ
P
%
%
xy
xy
xy
xy
Income Elasticity of Income Elasticity of DemandDemand
if >1 the good is normal.
Demand is income elastic. >if 1> >0 the good is normal.
Demand is income inelastic. <if <0 the good is inferior.
If income increases demand decreases.
IQ
I
%
%
I
%Q %I
I
I
%Q %I
Elasticities of SupplyElasticities of Supply
When the value of the elasticity of supply, , is:
= the supply is perfectly elastic > >1 the supply is elastic 1> >0 the supply is inelastic = 0 the supply is perfectly inelastic
ApplicationsApplications
Minimum wage and Unemployment
Sales taxes- Who pays the tax?
Minimum wage and Minimum wage and UnemploymentUnemployment
A price floor - the wage should not fall below the minimum wage.
To be effective the price must be set above the market equilibrium price.
Creates an excess supply and a rise in unemployment.
W
Quantity(millions of hours)
W*
Q*
Wmin
Qd Qs
D
S
Sales taxes- Who pays the Sales taxes- Who pays the tax?tax?
Shifts the supply to the left. Producers and suppliers share the tax burden.
Tax revenues
p
Q1Q2
S1
S2
tax
p1
p2
Q
Sales tax and Perfectly Sales tax and Perfectly Inelastic DemandInelastic Demand
If demand is inelastic the consumer pays the entire tax
p
Q1
S1
S2
tax
p1
p2
Q
Tax revenues
Sales tax and Perfectly Sales tax and Perfectly Elastic DemandElastic Demand
If demand curve is perfectly elastic the entire tax is paid by the seller
p
Q1
S1
S2
tax
p2
Q
Tax revenues
Q2
Additional ApplicationsAdditional ApplicationsThe case of a perfectly inelastic supply
curve
The case of perfectly elastic supply curve
Given that the demand for farm products is highly inelastic examine how farmers’ income is affected if the crop is poor
Possibilities, Preferences, Possibilities, Preferences, and Consumer Choicesand Consumer Choices
Possibilities:– Consumption choices are limited by income
and prices. The limits to household’s consumption choices are described by its budget line.
PossibilitiesPossibilities
The budget equation:
where I= income, Px, Py are the prices of goods X and Y respectively.
A relative price is the price of one good divided by the price of another good. It measures the slope of budget line:
I PyY PxX
Px
Py
Solve for Solve for YI
Py
Px
PyX
Y
Y
Y
X X X
a)budget line for Px, Py, I b) budget line shifts right c) budget line pivots when income increases to the right when Px decreases
PreferencesPreferences
A person’s preferences can be represented by a preference map that consists of a series of indifference curves.
An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.
Y
X
UoU1
U2
Properties of indifference Properties of indifference curvescurves
For most goods, indifference curves slope downward and bow towards the origin (convexity).
They never intersect. The magnitude of the slope of an indifference
curve is called the marginal rate of substitution. The marginal rate of substitution diminishes as
a person consumes less of the good measured on the y-axis and more of the good measured on the x-axis.
Slope and the Marginal Rate of Slope and the Marginal Rate of Substitution (MRS)Substitution (MRS)
Y
X
Uo
Y1
Y2
X1 X2
A
B
Indifference Between Indifference Between Combination A and BCombination A and B
Y.MUy = X.MUx,
where MUy is the marginal utility derived from the consumption of Y
where MUx is the marginal utility of the extra units of X
To remain indifferent between combination A and B the losses in terms of satisfaction must equal the gains
RearrangingRearranging
Y
X
MUx
MUy
Y
Xis the slope of the indifference curve
and it is equal to the MRS = MUx
MUy
Best Affordable PointBest Affordable Point
The consumer’s objective is to maximize utility subject to the budget constraint.
The best affordable point must be on the budget line and also on the highest possible indifference curve.
Point is the best affordable point. Given the budget line, Point is the best affordable point. Given the budget line, the consumer chooses to Y1 and X1 quantities. At point A the consumer chooses to Y1 and X1 quantities. At point A the slope of the budget line equals the slope of the indifference the slope of the budget line equals the slope of the indifference
curve, i.e.curve, i.e.
Y
X
Y1
X1
A
Px
Py
MUx
MUy
Derivation of the Individual Derivation of the Individual Demand for good XDemand for good X
Assume a point on the individual’s demand curve for good X, i.e. point X1 for price Px.
Assume that Px decreases (Px1)The budget line pivots to the right and
the individual can now move to a higher indifference curve
The new affordable point for most goods, (normal goods), will The new affordable point for most goods, (normal goods), will indicate that the consumer will be willing to buy more of X.indicate that the consumer will be willing to buy more of X.
New affordable point is B and the utility maximizing quantity of X is X2.
Y
X
Y1
X1
A B
X2
Demand curve for Good XDemand curve for Good X
From the above we notice that every point on the demand curve represents a maximum utility point for given prices.
A change in income will shift the individual demand to the right assuming the good is normal.
X
Px
Px1
X1 X2
D
P
Implications of Marginal Implications of Marginal Utility TheoryUtility Theory
Consumer Surplus
value a consumer places on a good is the maximum amount that the person would be willing to pay for it.
For X1 units the consumer would be willing to pay Px and that for X2 units the price that would maximize utility is Px1.
Consumer SurplusConsumer SurplusCont..Cont..
The price that a consumer actually pays to buy any unit of X is determined in the market.
If the market price is below what the consumer would be willing to pay then we can say that he/she enjoys a surplus.
Consumer surplus = the value of a good minus the market price.
The consumer surplus when the market price is Px2 is the area The consumer surplus when the market price is Px2 is the area of the triangle APx2B. of the triangle APx2B.
The consumer would be willing to pay higher prices for any The consumer would be willing to pay higher prices for any units of X less than X2. units of X less than X2.
The lower the market price the higher the consumer surplus.The lower the market price the higher the consumer surplus.
P
XX2
Px2 B
THE THEORY OF THE FIRMTHE THEORY OF THE FIRM
The firm’s objective is to maximize profits given the market and technology constraints.
Definition of economic profit: – equal to the firm’s total revenue minus its
opportunity cost of production. – Opportunity cost measures cost as the value of the
best alternative forgone.
THE THEORY OF THE FIRMTHE THEORY OF THE FIRM
The market constraints are the conditions under which the firm can buy its inputs or sell its output– i.e. whether it faces competitive or non-competitive
input and output markets.
The firm’s technology constraints are the limits to the quantity of output that can be produced by using given factors of production. – The firm chooses a technologically and economically
efficient method of production.
Short-run technology Short-run technology constraintconstraint
DefinitionsShort run: The period for which the capital stock of the firm remains fixed. In the short run the total product can increase only if variable inputs increase.
Marginal product: The additional product produced by an additional unit of the variable input.
Definitions Cont…Definitions Cont…
Average product: the average productivity of the variable input. Calculated by dividing total output by the units of the variable input.
The law of diminishing marginal productivity: As more units of the variable input (labour) are employed total product increases but at a decreasing rate. This implies that marginal product of labour first increases and then decreases.
Relate marginal product (MPRelate marginal product (MPLL) to ) to
the average product (AP)the average product (AP)LL
When MPL exceeds the APL , the APL increases
when MPL is less than APL , APL decreases
when MPL and APL are equal, APL is at its maximum
AP MP
Labour units
MP AP
Short-run CostShort-run Cost
A firm’s total cost is the sum of the costs of all the inputs it uses in production.
Total cost (TC) = Fixed cost (FC) + Variable cost (VC).
Recall that all costs ,opportunity and money costs, are included in the total cost measure.
Short-run Cost Cont…Short-run Cost Cont…
Marginal cost (MC) is the extra cost of producing an additional unit of output
Since in the short-run additional output can only be produced by using an additional unit of the variable input, the MC is related to the MPL.
ExampleExample
If the marginal product (MPL) is increasing, the production of an additional unit of output costs less because of increasing productivity. However, as the (MPL) declines MC increases.
The lowest MC corresponds to the highest (MPL).
Average CostAverage Cost
ATC=AFC + AVC
Average fixed cost (AFC) declines as more output is produced.
Average variable cost (AVC): Initially decreases because average product increases, and starts increasing when the average product decreases. The lowest average cost corresponds to the highest average product.
Relate MC and AVC to MPRelate MC and AVC to MPLL
and APand APLL
AP MP
AVC MC
Labour units
Output units
MCAVC
MPAP
The shape of Short-run The shape of Short-run Average Cost CurvesAverage Cost Curves
It is U-shaped because as output increases, it combines the influences of falling fixed cost and eventually diminishing returns.
AVC MC AC
Output units
MCAVC
AC
Output and costs in the Output and costs in the Long runLong run
Long-run cost is the cost of production when all inputs have been adjusted to their economically efficient level
When a firm increases all inputs proportionally, it experiences returns to scale
DefinitionsDefinitions
Constant returns to scale: % increase in firm’s output = % increase in firm’s inputs
Increasing returns to scale (economies of scale): % increase in firm’s output > % increase in firm’s inputs
Decreasing returns to scale (diseconomies of scale): % increase in firm’s output < % increase in firm’s inputs
Output and Costs in Output and Costs in the Long runthe Long run Cont…Cont…
There is a set of short-run cost curves for each different plant size and one least-cost plant size.
The larger the output, the larger the plant size and the lower the average cost.
The long-run average cost traces the relationship between the lowest attainable average cost and output when both capital and labour inputs are varied.
Shape of LRAC: With economies of scale it declines, while Shape of LRAC: With economies of scale it declines, while
with diseconomies of scale it increases.with diseconomies of scale it increases.
AVC MC AC
Output units
LRAC
AC1
Economiesof scale
Diseconomies of scale
AC2
Perfect CompetitionPerfect Competition
In perfect competition, a firm is a price taker and its marginal revenue (MR) equals the market price (P).
If price exceeds AVC, a firm maximizes profit by producing the output at which marginal cost (MC) = MR.
Since in perfect competition MR=P the profit maximizing output level is found by MC=P.
Short RunShort Run
The firm makes economic profits when P>AC,
Breaks even when P=AC Loses part of its return on capital if
P<AC. The lowest price at which the firm
produces is equal to the AVC.
The supply curve of the firm:The supply curve of the firm: Corresponds to the portion of the Corresponds to the portion of the MC curve above the AVC.MC curve above the AVC.
P1ABC represents short-run economic profits when market price is P1.
The existence of economic profits attracts new entrants into the industry. The increase in supply, everything else being the same, drives the price down to P2
At point D the firm breaks even. Thus, in the long run economic profits are zero.
AVC MC AC
Output units
AC
MC
P1
A
C
B
D
P=AR=MR
P2
AVC
Allocative EfficiencyAllocative Efficiency
Consumer’s efficiency is achieved at all points on the demand curve. Producer’s efficiency is achieved at all points on the supply. Exchange efficiency is achieved at the quantity Q* and P* where the sum of consumer surplus (area A) and producer’s surplus (area B), is maximized.
P
Q
D
S
P*
Q*
A
B
MONOPOLYMONOPOLY The demand curve facing the monopoly is
the industry demand curve.
The marginal revenue for the monopolist is less than the price and it declines as output increases.
The monopolist maximizes profits where MC=MR. Sets price Pm according to the demand curve. Pm is greater than
MC. Since there is no possibility of entry the monopolist can enjoy
economic profit even in the long run.
P
MR
Pm
Qm Q
ACMC
profits
Compare Monopoly to Perfect CompetitionCompare Monopoly to Perfect Competition
Perfect Competition Qc is produced at price Pc consumer surplus = a+b+c
Monopoly Qm is produced at price Pm consumer surplus = a Area b producer surplus Areas c+d deadweight loss or loss
in social welfare
P
Pm Pc
Qm Qc
D
MC=S
Q
MR