Introduction to Microeconomics Msc Induction

MSc Induction

Simon Hayley

Simon. Hayley. 1@city. ac. uk Overview of Economics

1. Microeconomics – The behaviour of individuals and firms in market interactions – Policy options when markets don’t work 2. Macroeconomics – The economy as a whole: GDP, inflation, unemployygment and growth. – Fiscal and monetary policy Reading

Lipsey + Chrystal “Economics” Eleventh Edition, Oxford University Press, 2007. Plan of session

• Key concepts: scarcity and choice • Analysis of markets • A common approach: – consumers maximize utility subject to a budget constraint – firms maximize profits subject to cost and demand constraints The Market Economy

• A market economy is self-organising in the sense that when individuals act independently to pursue their own self- interest, responding to prices set on open markets, they produce co-ordinated and relativ ely efficient economic activ ity. Resources and Scarcity • Scarcity is a fundamental problem faced by all economies because not enough resources (land, labour, capital, and entrepreneurship) are availa ble to pro duce a ll the goo ds an d services that people would like to consume. • Scarcity makes it necessary to choose among alternative pppossibilities: what products will be produced and in what quantities. • Microeconomics analyses the allocation of scarce resources. How We Work in Economics

• The real world is complex so we have to pick out key features of an issue and consttbtt“dl”truct abstract “models”. • We illustrate the relationships in these models with graphs, equations or numerical examples. • Models are not the truth but they are a way of thinking about what might be going on. Making Economic Choices • Opportunity cost: the cost of obtaining a unit of one product in terms of the number of units of other products that could have been obtained instead. This emphasises scarcity and choice. • A prodtiduction-possibility bdboundary shows all of the combinations of goods that can be proddduced by an economy whose resources are fully employed. Movement from one point to another on the boundary shows a shift in the amounts of goods being produced, which requires a reallocation of resources. A Production-Possibility Boundary

Unattainable combinations

Production possibility boundary Attainable combinations

Quantity of public sector goods A Production-Possibility Boundary

Unattainable combinations a c0 •d

Production possibility C boundary Attainable combinations c1 b c G

0 g0 g1 Quantity of public sector goods The Effect of Economic Growth on the Production-Possibility Boundary

a d

Production possibility boundary before growth Production possibility boundary after growth

0 Quantity of public sector goods Analysis of Markets

• All markets can be approached in same way, even though there are many different features. • IktthihdtIn any market there is one group who do not have the product but want to get it: demanders • And another group who have the product and want to sell it: suppliers • For consumer gg(oods (and services ) demanders are individuals and suppliers are firms. Main Factors That Affect an Individual's Demand for a Specific Product

• Price of the product • Price of other products: substitutes or complements • Income and wealth • PlhtitiliiddtPersonal characteristics: age, religion, dependants etc • TtTastes • External factors: weather, festivals, special events. • Economic analysis focuses on prices and incomes BUT other things do matter in real markets. Price Elasticity and Income Elasticity

• Quantity demanded is (generally) negatively related to the price of the product itself. [price elasticity] • Demand increases with rise in price of a substitute and fall in price of a complement (and vice versa). [cross elasticity] • Demand increases with income for a normal gooddfllhid and falls when income increases for an inferior good. [income elasticity] Price Elasticity Low High ity ww cc Lo lasti e E hh mm Hig Inco • Necessities have low income elasticity. Luxuries have higher income elasticity. • Price elasticity partly depends on how tightly we define each market: – BdlBroadly-dfiddefined goo ds (eg. foo d)hd) have few substitutes, and so have low price elasticity (inelastic demand) – Specific items such as a particular brand of baked beans have many substitutes , and so a high price elasticity (elastic demand) – But if advertisements succeed in convincing consumers that a particular brand is not like others, then this price elasticity may be reduced. Alice’s Demand Schedule

Quantity demanded Reference Letter Price [£ per dozen] [dozen per month]

a 0.50 7.0 b 1.00 5.0 c 1.50 3.5 d 2.00 2.5 e 2.50 1.5 f 3.00 1.0 Alice’ s Demand Curve

3.00 f e 2.50 d 2002.00 c 1.50 b 1001.00 a 0.50

123475 6 Quantity of Eggs [dozen per month] The Relation Between Individual and Market Demand Curves

3.00

2.00

1.00 3.00

24 68 [i]. William Quantity of Eggs 2.00 [dozen per month]

1.00

3.00

2.00 2468101214 Quantity of Eggs [dozen per month] 1001.00 [iii]. Total Demand William & Sarah

2468 [ii]. Sarah Quantity of Eggs [dozen per month] A Market Demand Schedule for Eggs

RfReference L Lttetter PiPrice [£ per dozen ] Quantity demanded [000 dozen per month]

u 0.50 110.0

v 1.00 90.0

w 1.50 77.5

x 2.00 67.5

y 2.50 62.5

z 3003.00 60. 0 A Market Demand Curve for Eggs

3503.50 D Z 3.00

Y 2.50

X 2.00

W 1.50

V 1001.00

U 0500.50

20 40 60 80 100 120 140 Quantity of Eggs [thousand dozen per month] Shifts in the Demand Curve

D0 rice PP

0 Quantity Shifts in the Demand Curve

D0 D2 rice PP

0 Quantity Determinants of Supply

• The price of the product itself • The prices of inputs (factors of production) • The production technology Influences on supply

• Quantity supplied is positively related to the price of the product itself • Supply increases (shifts right) as input prices fall and vice versa • Supply shifts with changes in technology. Improvements in technology increase supply (shift right) A Market Supply Schedule for for Eggs

RfReference L Lttetter PiPrice [£ per dozen ] Quantity supplied [000 dozen per month]

5.0 u 0.50 46.0 v 1.00

77.5 w 1501.50

x2.00100.0

y 2.50 115.0

z 3003.00 122.5 A Supply Curve For Eggs

3.50 S

Z 3.00

Y 2.50

X 2.00

W 1.50

V 1001.00

U 0.50

20 40 60 80 100 120 140 Quantity of Eggs[thousand dozen per month] Shifts in the Supply Curve

S0 S1

Quantity Shifts in the Supply Curve

S2 S0

Quantity Demand and Supply Schedules for Eggs and Equilibrium Price

Price Quantity Quantity supplied Excess Demand [quantity [£ per dozen] demanded [‘000 dozen demanded minus [‘000 dozen pp]er month] qqypp]uantity supplied] per month] [‘000 dozen per month]

0.50 110.0 5.0 105.0

1.00 90.0 46.0 44.0

1.50 77.5 77.5 0.0

2.00 67.5 100.0 -32.5

2.50 62.5 115.0 -52.5

3003.00 60. 0 122. 5 -62. 5 Determination of the Equilibrium Price of Eggs

3.50 D S Z Z 3003.00

Y Y 2.50

X X 2.00

1.50 W W

V V 1001.00 U U

0.50

20 40 60 80 100 120 140

Quantity of Eggs [thousand dozen per month] Museum Charges

• In November 2001 the UK Government abolished admission charges on many museums. • The Victoria and Albert Museum (V&A) experienced the biggest increase, with visitor numbers rising from 42, 600 in December 2000 to 174,000 in December 2001, an increase of 309%. • Similarly, though not so dramatically, the Museum of London had an 88% increase, the Natural History Museum had an 82% increase and the Museums of Science and Industry in Manchester had a 75% increase. Price of museum entry

£5

42K 174K Number of admissions The price of Brazilian arabica coffee, 1976-2005

250

200 r lb ee 150

100 cents p

US 50

0 1976 1983 1990 1997 2004 Date

Brazilian arabica Coffee market

Price of demand coffee

P1 supply

Q1 Q2 Quantity of coffee

NMktNewspaper Market

• In September 1993 the Times lowered its price from 45p to 30p while the Independent stayed at 50p. • Average daily sales of the Times went from 370K to 450K. • Average d a ily sa les o f the In depen den t wen t from 362K to 311K. • Independent and Times were substitutes. Demand for The Times price

45p

30p

370K 450K Market for The Independent price

50p

311K 362K quantity Channel Tunnel What happened when the opening of the tunnel introduced massive new supply of cross-channel travel? – Increase in supply leads to fall in price. – Demand for substitutes falls: ships, planes, hovercraft. – Competition between suppliers leads to price cutting and special deals – Total quantity of travel rises • “Drought report sends wheat prices surging” (FT 6/6/2007) • “Commodities prices slumped on Friday fllfollow ing s harp fllifalls in g lbllobal equ ity mar ktkets amid mounting fears that the global economy was hea ding in to recess ion ” (FT 10/8/2008) • “Members of the OPEC oil cartel are considering an emergency meeting in Vienna next month as oil pppprices dropped to their lowest level in nearly a year.” (FT 10/8/2008) Different Features of Markets

• Coffee and wool prices in wholesale markets change day by day to equate demand and supply. • Many prices, especially retail prices are set by the seller and only changed periodically: quantity then adjusts. These are administered prices ((geg. newspppaper prices and museum entry charges). • But, as we have seen, supply and demand analysis is relevant for both types. Consumer Choice

• Consumers maximize utility subject to a budget constraint. Value to consumers (and therefore price) depends on marginal and not total utility. • Similarly, firms maximize profit subject to a cost and demand constraint. UTILITY is the personal satisfaction derived fidtifrom consuming a product or service

• Total utility = utility a consumer gets from total consumption of all units of a particular product. • MilMarginal utility=theaddition to ttltotal utility diderive d from consuming one more unit of the product. • The marginal utility usually declines as the consumer consumes more of the product (Diminishing Marginal Utility). • We assume each consumer maximises his/her own utility. Each consumer reaches a utility-maximising equilibrium when the utility he or she derives from the last £1 spent on each product is equal. Diminishing Marginal Utility y l Utiit aa Margin

Units Consumed Why are diamonds more expensive than water?

• Water is vital – without it we will die. • Diamonds are a luxury. • So wh y is wa ter c heap, w hils t diamon ds are expensive? The Paradox of Value

• This paradox of value involves confusion between total and marginal utility. The market clearing price is determined by marginal utility not total utility. • Clearly the total utility derived from water exceeds the total utility derived from diamonds. • Diamonds have a high price because they are scarce and the marginal utility is high, but water is cheap because it is abundant, so its marginal utility has been driven down. Total and Marginal Utility Schedules

Number of films Total utility Marginal utility attended per month 0 0000.00

1 15.00 15.00

2 25.00 10.00

3 31.00 6.00

4 35.00 4.00

5 37.50 2.50

6 39.00 1.5

7 40.25 1.25

8 41.30 1.05

90.9042.20

10 43.00 0.80 Total and Marginal Utility Curves

50 20

40 15

30 10 20

5 10

0 2 46 810 0 2 46 810

Quantity of films [attendance per month]

[i]. Increasing total utility [ii]. Diminishing marginal utility A Consumer’s Equilibrium

• To maximize utilityyj, each consumer should adjust spending so that marginal utility per pound is the

same for each good consumed (MUx/Px = MUy/Py). • If this we r e n ot tr ue, coul d in cr ease t ot al utilit y by shifting towards consuming good with higher utilityyg at the margin. • So a scarce good has a high price and a high marginal utility…but this says nothing about total utility. Diminishing Marginal Utility and Demand

• Demand curves have negative slopes because when the price of a product falls, the marginal utility per pound spent on this produce increases. The consumer responds by purchasing more of this good, thus reducing the marginal utility. • The consumer will keep increasing consumption of this gggyppood until the marginal utility per pound falls to the level which could be achieved on other goods. • A good which has steeply falling marginal utility will have relatively low price elasticity (a large shift in ppqrice will be required to cause a si gnificant increase in consumption). CSlConsumer Surplus Consumer surplus is the difference between: 1) The value consumers place on their total consumption of some product (the maximum theyypy would pay for the amount consumed rather than go without it comppy)letely). 2) The actual amount paid for it. Consumer Surplus for an Individual

3.00

2.00

1.00 Market price

0.30

123468957 10

Glasses of milk consumed per week Consumer Surplus for the Market

Market price

0 Quantity q0 Competition vs. Monopoly

• A competitive industry has many producers. Each mustlltthitit sell at the existing mar kti(ifthffket price (if they offer their product at a higher price no-one will buy it). They are price takers. • A monopolist has no competitors, and can chiiifhildihoose to raise prices if this would increase profits. Monopolists are price makers. • An intermediate case: oligopoly, where a few producers each have substantial market share. They may be able to increase prices above the competitive level (especially if they agree not to undercut each other). Consumer surplus under monopoly

Consumer surplus

p1 Price

Deadweight loss

0 q1 Quantity q0 Impppylications of Monopoly Power

– Reduced output – Increased prices – Substantial loss of consumer surplus – A monopolist may also tend to be less dynamic, leadinggg to slower growth and less innovation For these reasons governments try to prevent companies from forming monopolies (and forbid collusion in oligopolies). Where this is not possible (for “natural monopolies” such as utilities) regulation is imposed to try to replicate the effect of competition. Price Discrimination

Consumer surplus (1)

p1 Price (1)

Consumer surplus (2)

Price (2) p0

0 q1 Quantity q0 Examples of Price Discrimination

• Haggling • Discount vouchers and early-booking discounts • First class facilities (arguably) • “Three-for-two” deals Recap: Consumer Demand

• We have modelled how consumer demand varies as a function of: –Prices – Incomes (budget constraint) – Preferences (“taste”)....etc. • Spec ifica lly, we foun d it use fu l to ana lyse demand on the assumption that consumers aim to max im ise t he ir own tota l ut ility. Firm behaviour can be modelled using a similar approach

• Firms seek to maximize profits • They are constrained by the production technology and by the market demand. • They have (at a point in time) a given capital stock and face market prices of inputs. • They maximize profit where marginal cost equals marginal revenue. • See: Lipsey and Chrystal, Chapter 6-9. A Production-Possibility Boundary

RltiRelative pr ice line

0 Quantity of good B An Ideal Market Equilibrium

Indifference curve

RltiRelative pr ice line

0 Quantity of good B An Ideal Market Equilibrium

• Firms shift their production to a point on the production possibility boundary where the degree to which the they could produce slightly more of one gg(ppy)ood and less of the other (the opportunity cost) reflects market prices. • Consumers adjust their consumption so that their indifference curve also reflects market prices. • This allows consumers to reach the highest level of utility (highest indifference curve) that is compatible with the Production Possibility Boundary. • This is a slightly idealised result (market imperfections may prevent it from happening), but it is a very powerful illustration of the ‘invisible hand’ at work! Market Failures

We can identify some situations in which the market will not work well, suggesting that society is likely to be better off if the government intervenes: • Monopoly power • Information failures • Ex ternaliti es • Public goods Monopoly

• Governments generally aim to prevent firms from expl oiti ng monopo ly power. • In the UK proposed mergers between firms may be referred to the Monopolies and Mergers Commission (MMC). This body then decides whether the merger would give the resulting firm an unacceptably high market share. If so, the MMC will forbid the merger. Natural Monopolies

• However, for some industries there may be massive economiflies of scale. AltitlAs a result it only makes sense for there to be only one provider. • For example it would be prohibitively expensive to have two competing companies running water and sewage pipes to each house. • Such industries are natural monopolies. They are typically utility networks such as gas, electricity and water supplies. Regulating Natural Monopolies • Natural monopolies must be prevented from exploiting their monopolyyy power. They were often nationalised. But this left them with little incentive to be efficient. • In the 1980s the UK government privatised many of these companies. Other countries followed suit. These pppgygygrivate monopolies are tightly regulated to try to get them to behave as if they had competitors. • The UK has regulatory bodies which set price caps for these firms: • OFWAT (water companies) • OFGEN (electricity generation) • OFGAS ( gas suppl y) Information Failures

• The proper functioning of a market requires consumers to be able to judge the quality of the goods and services which they purchase. • Where this is not possible, the government may step in to regulate quality. For example: • Food hygiene in restaurants • Safety standards (eg. in cars) • Otherwise low quality products would tend to force more ex pensiv e higher qu ality produ cts ou t of the market, and quality would collapse to a minimum. Externalities

• Markets only work properly where individuals’ welfare is affected only by the goods and services they consume. But there may be eeeaxternaliti es. • For example firms may cause pollution which affects everyone ’ s welfare. But as long as the goods they produce sell well, these firms have no incentive to stop! • The existence of externalities could justify the governmentbt bann ing cer ta in po lltilluting processes, or setting minimum standards. • A more creative solution is to make firms pay for the damage they create (the “polluter pays ” principle). For example: – Charging firms for their carbon emissions allows them to keep po llu ting, bu t on ly if the benefits outweigh the costs to everyone else of the pollution involved. – Similarly, every extra driver on the roads increases congestion for other drivers. Congestion charging should mean that people on ly dr ive if the bene fits to them exceed the adverse effects on others. • More generally, where there is a common resource which nobody owns, a free market will tend to lead to it being over-exploited. • For example, fish stocks are a common resource. But individuals maximise profits by catching as many fish as possible. Attempts to prevent this byyg establishing quotas etc. have not yet been very successful. Public Goods

• Some goods and services tend to benefit everyone (eg. the provision of defence, law and order). • Individuals have no incentive to contribute to the costs of these services. As everyone benefits, each individual has an incentive to “free ride”,,p and hope that someone else p pyays! • Hence these goods tend to be provided by the government(t (out of general lt taxati on) or b y compulsory subscriptions (eg. the UK TV licens ing fee ). Market Failure vs. Government Failure

• We have identified several market failures: • Monopoly power • Information failures • Ext ernaliti es • Public goods • These could justify government intervention. But such intervention is likely to be imperfect: it may be costly, or further distort incentives, or lead to political interference. • The costs of market failure must be weighed up against the possible costs of “government failure” ittttin attempts to correct tit it. Microeconomic Theory (1)

• “Self-organising” market economies have tended to outperform centrally-planned economies. • Scarcity and opportunity cost • Demand: • Price elasticity • Income elasticity • Cross elasticity • SlSupply: pr i/itt/thlice/input costs/technology • Supply and demand curves • Prices shift so that supply=demand • The invisible hand Microeconomic Theoryy( (2 )

• Diminishinggg marginal utilit y • Underpins consumer demand curves • The paradox of value • Consumer surplus • Monopoly pricing • Price discrimination • Market failure • Natural monopoly • Information failures • Externalities • Public goods Summary: Microeconomics

• Analysis of supply and demand is key to understanding movements in market prices. • The price mechanism can achieve some very desirable results. • But the price mechanism isn’t necessarily perfect, and we have seen how microeconomic analysis can inform some key policy issues APPENDIX Indifference Curve Analysis

• The use of indifference curves allows the analysis of demand without having to assume that utility is measurable.

• It allows us to distinguish between (a) income and (b) substitution effects. How the Consumer Reaches Equilibrium

• Indifference theory assumes only that individuals can order alternative consumption bundles, sayyging which bundles are preferred to which but not by how much. • A single indifference curve shows combinations of products that give the consumer equal satisfaction, and among which he or she is therefore indifferent. An indifference map is a set of indifference curves. • The basic assumption about tastes in indifference curve theory is that of a diminishing marginal rate of substitution: the less of one good and the more of another good the consumer has, the less willing he or she will be to give up some of the first good to get more of the second. This implies that indifference crescurves are negativ ely sloped and conv ex to the origin. Indifference Theory

• While indifference curves describe the consumer’s tastes and, therefore, refer to what he or she would like to pp,urchase, the budget line describes what the consumer can purchase. • Each consumer achieves an equilibrium that maximises his or her satisfaction at the point at which an indifference curve is tangent to the budget line. Bundles Conferring Equal Satisfaction

Bundle Clothing Food a 30 5

b 18 10

c 13 15

d 10 20

e 8 25

f 7 30

An Indifference Curve 35 a 30

25 g 20 b

15 c d 10 e f h 5 T I

5101520253035 Quantity of food An Indifference Map

I5 I4 I3 I2 I1

0 Quantity of food per week Shapes of Indifference Curves

Perfect Substitutes Perfect Complements A gggood that gives zero utility

I1 I1

I1 0 0 0 [i]. Packs of green pins [ii]. Right hand gloves [iii]. Meat

A good that confers a negative utility after some level of consumption

I1 All other goods

f0 The Equilibrium of a Consumer

35 k ee 30

25 ng per we ii

20 ity of cloth tt

Quan 15

5101520253035

Quantity of food per week The Equilibrium of a Consumer

35 k ee 30

a 25 ng per we ii

20 ity of cloth tt

Quan 15

f I1 5101520253035

Quantity of food per week The Equilibrium of a Consumer

35 k ee 30

ab 25 ng per we ii c

20 ity of cloth tt E

Quan 15

10 d

I4 5 e I3 f I2 I1 5101520253035

Quantity of food per week • Consumers maximise their utility by adjusting their consumption to the point on the budget line which gets them to the highest possible indifference curve. • At this point the indifference curve will be at a tangent to the budget line.