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Ec100 Economics a Microeconomics Michaelmas Term 2017/18 Alan Manning

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Ec100 Economics a Microeconomics Michaelmas Term 2017/18 Alan Manning Ec100 Economics A Microeconomics Michaelmas Term 2017/18 Alan Manning Contact details: Lecturer, Alan Manning, [email protected] Course Manager, Roberto Sormani, [email protected] Although I have tried to make sure these notes are clear and without error, there is always room for improvement. Please email corrections or suggested improvements to me or Roberto. Contents Page 1. Introduction 5 1.1 use of these notes 5 1.2 what is economics? 5 1.3 Markets 7 1.4 The Hockey Stick of History 9 1.5 Specialization and Exchange 10 1.6 Innovation and Exchange 10 1.7 Distribution and inequality 12 1.8 Economics as a science 13 1.9 Controversy in economics: positive and normative questions 14 2. A Simple Model of a Market 15 2.1 Economists and Models 15 2.2 A stylized Model of a market 15 2.2.1 Demand, supply and price 15 2.2.2 The market‐clearing price 16 2.2.3 Do prices always clear markets? 19 2.3 Comparative statics 19 2.3.1 A shift in the demand curve 20 2.3.2 A shift in the supply curve 20 2.3.3 The price elasticity of demand and supply 22 2.4 Bubbles 23 3. Are Market Outcomes Good or Bad 27 3.1 The Gains from Trade, absolute and comparative advantage 27 3.2 Free trade agreements 30 3.3 Uber 31 3.4 The Case for Markets, Consumer and Producer Surplus 31 3.5 Central Planning 34 3.6 The Sources of Market Failure 39 3.6.1 Equity Considerations 39 3.6.2 Market Pathologies 40 3.7 Wider Impacts of Markets on Attitudes 42 3.8 Conclusion 43 4. Household Behaviour 44 4.1 Consumer demand 44 4.1.1 The budget constraint 44 4.1.2 Indifference curves 45 4.1.3 Combining indifference curves and the budget constraint 48 4.2 Comparative statics 49 4.2.1 A change in income: the income effect 49 4.2.2 A change in prices: the substitution effect 50 4.3 Incentives 53 4.4 Labour Supply 53 4.4.1 Preferences and budget constraint 53 4.4.2 A change in non‐labour income 55 4.4.3 A change in wages 56 4.4.4 Application: the top rate of income tax 57 4.4.5 Application: helping the poor 57 5. Firms: Production and Prices 60 5.1 What do firms do? 60 5.2 Pricing 60 5.2.1 The revenue function, average revenue and marginal revenue 60 2 5.2.2 The cost function, average cost and marginal cost 63 5.2.3 Returns to scale 64 5.2.4 Profit maximization 66 5.2.5 Comparative statics: a change in costs 68 5.2.6 Entry and exit 68 5.2.7 Comparative statics: a change in demand 69 5.2.8 The mark‐up 71 5.3 Market Structure 72 5.3.1 Factors affecting the demand curve for a firm’s products 72 5.3.2 Forms of market structure 72 5.3.3 The sources of monopoly 72 5.3.4 Oligopoly 73 5.3.5 Monopolistic competition 74 5.3.6 Perfect competition 76 5.3.7 A normative comparison of market structures 79 5.4 Price Discrimination 81 6. Firms: Costs, Factor Demands and Innovation 83 6.1 The production function 83 6.1.1 average product and marginal product 83 6.1.2 Isoquants 84 6.1.3 Substitutes and complements in production 85 6.2 Cost minimization 86 6.2.1 Iso‐cost Curves 87 6.2.2 Changing the relative price of inputs: the substitution effect 88 6.3 The scale effect 89 6.4 Combining substitution and scale effects: factor demand curves 90 6.5 Application: The Labour Market Impact of Immigration 91 6.6 Application: the Employment Effect of a Minimum Wage 92 6.7 The sources of pay differentials 92 6.8 Monopsony 94 6.9 The Gender pay gap and the Equal Pay Act 95 6.10 The impact of a minimum wage in a Monopsonistic Labour Market 96 6.11 The impact of new technology on the demand for labour 98 6.12 Innovation 101 7. Inequality and Redistribution 104 7.1 Pen’s People’s Parade 104 7.2 Measuring Inequality: Lorentz Curves and Gini Coefficients 106 7.3 Variation in Income Inequality Across Countries and Over Time 107 7.4 The sources of income inequality 111 7.5 Redistribution 112 7.5.1 Why does redistribution exist? 114 7.5.2 Designing redistribution 115 7.5.3 Average and marginal tax rates 116 7.5.4 Universal Basic Income 118 7.6 The rise in the income shares of the top 1% 120 3 8. Externalities, public goods and common resources 127 8.1 What is an externality? 127 8.2 Why externalities are a source of market failure? 127 8.3 Policies for externalities 128 8.3.1 Markets and property rights 128 8.3.2 Taxes and subsidies 129 8.3.3 Regulation 130 8.3.4 Cap‐and trade: carbon markets 131 8.4 A typology of goods 132 8.5 Public goods 133 8.6 Common pool resources 134 9. Information and Markets 137 9.1 Asymmetric Information 137 9.2 The market for Lemons 137 9.3 Adverse selection 138 9.3.1 Health insurance 139 9.3.2 Interbank markets in the financial crisis 139 9.3.3 Bank runs 140 9.4 Moral Hazard 141 9.5 Application: Illegal online drugs markets 141 10. Conclusion 144 4 1. INTRODUCTION (Acemoglu, Laibson, List, Chapters 1 and 2) 1.1 Use of These Notes These notes are intended as ‘skeleton notes’ to explain what I say in the lectures and to follow, more or less, the structure of the lectures. They are intended to help students with understanding the overall structure of the course and as a bridge between the lectures and the textbook and other books. They are not intended as a substitute for the use of the textbook, Acemoglu, Laibson and List which provides explanations of the concepts in greater depth than these notes. 1.2 What is Economics? Perhaps the most famous definition of economics is due to Lionel Robbins, who was an LSE professor and has the library building named after him. He defined economics as “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”. There are several elements of this and we will discuss them in turn but let’s start with the last part. Saying we have scarce means is saying that we don’t have unlimited resources available to us so that we have to make choices about the way in which we use those resources. We cannot get everything that we would like so we have to prioritise. In the words of another LSE alumnus, Mick Jagger, “you can’t always get what you want”. This part of Robbins’ definition can be used to justify a very wide definition of economics. You have one vote, and several political parties competing for that vote, so you have to choose which party to vote for. In most societies you can marry just one person so you have to make a choice about who your spouse is going to be. These topics are not the traditional subject matter of economics. Something closer to traditional economics is the choice you make about what to spend your limited income on. But, there are people calling themselves economists writing about topics which seem closer to political science or sociology or some other social science. However we will not be discussing these applications of “economics” in this course. Choices are necessary because people have limited resources relative to their desires. The general approach that economics takes to understanding people’s choices is that individuals weigh up the costs and benefits of different courses of action and the choose the one that they think offers the greatest benefits relative to costs. We will see lots of examples of this later on in the course. One implication of this is that people are likely to respond to incentives, by which I mean that if you alter the costs and benefits of different actions you are likely to alter people’s behaviour. If the benefit from one course of action rises, people are more likely to take that course of action. A focus on incentives is a key part of the way in which economists think about many issues as we will see later on in the course. I have emphasised how Robbins’ definition of economics can be interpreted in a very broad way to encompass most if not all of the decisions that people have to make. But there is another sense in which Robbins’ definition is very narrow. If you are alone on a desert island with limited resources, you will have to make choices about what to do with those resources. Should you use the wood to build a fire to try and attract passing ships, or should you build a shelter against the storms? But you are just an isolated individual on your desert island and the decisions that you make affect no‐one but yourself. But most of the decisions that we make affect others, not just ourselves. We are much more interested in the interactions between people, something not mentioned at all in Robbins’ definition. 5 Humans are social animals and have always lived in groups, interacting with each other.
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