Induction Course Microeconomics

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1 Induction Course Microeconomics The lectures will provide a fairly rapid revision of basic concepts from microeconomics. If you do not fully understand any of the concepts covered in the lectures then you are advised to read up on them. It would also be a good idea to do so if you have not studied economics in English before. The library has a good selection of suitable texts. Topics 1. Consumer Choice 2. Supply and Demand 3. The Firm and its Goals 4. Technology and Production; Costs 5. The Price-Taking Firm; Perfect Competition 6. Monopoly 7. Externalities/ Public Goods 8. Choice Under Uncertainty/ Welfare (brief topic) 9. Monopolistic Competition 10. Oligopoly Some of the Books in the Library Mankiw and Taylor. Economics (as well as copies in the Library, there is online access to the book through the Library catalogue system) Mankiw. Principles of Economics Lipsey and Chrystal. Economics Parkin, Powell, and Matthews. Economics Sloman. Economics Sloman. Essentials of Economics Anderton. Economics Kay. The Business of Economics Begg, Fischer and Dornbusch. Economics

2 1: Consumer Choice Microeconomics Lecturer: Dr Nigel Wadeson Model of Rational Choice Preferences what the consumer wants to do Budget Constraint what the consumer can afford to do The Rational Decision the optimum decision given preferences and budget constraint consumer equilibrium 2 An Indifference Curve Shows the bundles of two goods which have the same level of utility An individual s preferences can be illustrated by a set of indifference curves - an indifference map 3

3 An Indifference Map U 1 (10) U 2 (35) U 3 (62) 4 Indifference Curve Properties Negatively sloped slope is the Marginal Rate of Substitution (MRS) Convex shaped diminishing MRS Cannot intersect The further from the origin, the higher the utility 5 Budget Constraint The budget line shows the maximum amounts of each good that can be purchased by spending all income. The budget line depends on three parameters price of good X price of good Y income of consumer 6

4 Example: Budget Line Pi Price of fx = 2 Price of Y = 6 Income = 30 Units of X Units of Y A Budget Line Y Good Y Good X 8 Slope of the Budget Line Equals the relative price of good X to good Y Slope = P X P Y It s the amount of good Y that has to be given up to purchase one more unit of good X 9

5 Shifts in the Budget Line Changes in the prices of the goods or income shift the budget line A change in income causes a parallel shift the budget line A change in the price of one good swivels the budget line (i.e. the slope changes) 10 A Fall in the Price of Good Y Pi Price of fx = 2 Price of Y = 4 Income = 30 Good Y Good X 11 Consumer Equilibrium The consumer is in equilibrium when he/she is maximising utility given the budget constraint To maximise utility choose the point on the budget line which is on the indifference curve furthest away from the origin. 12

6 Utility Maximisation Y Good Y G 3 2 E 1 U 4 (50) 0 U 2 (35) Good X 13 Equilibrium Conditions All income is spent (point E is on the budget line) The slope of the indifference curve equals the slope of the budget line Marginal rate of substitution = the relative price ratio 14

7 2: Supply & Demand Microeconomics Lecturer: Dr Nigel Wadeson Derivation of Demand Curve Good Y Effect of a fall in the price of good X, ceteris paribus E 1 E2 U 2 U 1 X 1 X 2 Good X Demand for a Good depends upon Price of the good Prices of related goods substitutes & complements Income of consumers Tastes/preferences of consumers 1

8 A Demand Schedule shows how demand varies with price, ceteris paribus Price per unit Quantity per week A Demand Curve it Price per un D Quantity per w eek Supply of a Good depends upon Price of the good Prices of inputs Technology employed 2

9 A Supply Schedule shows how supply varies with price, ceteris paribus Price per unit Quantity per week A Supply Curve nit Price per un S Quantity per w eek Market Equilibrium Equilibrium is a position of balance No incentive for anyone to change their behaviour Market equilibrium exists when demand equals supply The equilibrium price clears the market 3

10 Market Equilibrium Price per unit Quantity demanded per week Quantity supplied per week Equilibrium Market Equilibrium nit Price per un S D Quantity per week Elasticity of Demand Measures the responsiveness of the quantity demanded to a change in one of its determinants, ceteris paribus Uses percentage changes - unit free Three demand elasticities price, income, cross 4

11 Price Elasticity of Demand measures the percentage change in quantity demanded for a one percent change in price, ceteris paribus %ΔX ε = % ΔP Arc Elasticity ε = ΔX ΔP X P Example: Arc Elasticity Price of a good rises from 10 to 20 Quantity demanded falls from 200 to 120 ΔX = = 80 X = ( ) / 2 = 160 ΔP = = 10 P = ( ) / 2 = 15 ΔX X ε = ΔP P = = 0.67 =

12 Range and Meaning Type Value of ε Meaning Perfectly Inelastic 0 No change in quantity when price changes Inelastic < 1 Quantity changes by less than price Unit Elasticity 1 Quantity & price change by same % Elastic > 1 Quantity changes by more than price Perfectly Elastic Demand only exists at one price Determinants of Price Elasticity Availability of Substitutes the more substitutes the more elastic Commodity share i.e. the % of total expenditure on the good the smaller the % the more inelastic Time demand is more elastic in the long run Price Elasticity & Expenditure Total expenditure = price per unit x no. of units purchased If demand d is and price then total expenditure Elastic rises falls falls rises Inelastic rises rises falls falls 6

13 Elasticity along a Demand Curve Price per unit ε = inf ε > 1 ε = 1 ε < 1 ε = 0 Quantity per period Income Elasticity of Demand measures the percentage change in quantity demanded for a one percent change in income, ceteris paribus ε = % ΔX % ΔI Positive (< 1): Normal necessity Positive (> 1): Normal luxury Negative: Inferior Good Empirical Estimates Category of Good Income elasticity Fuel & Light Alcohol 1.14 Bread & Cereals

14 Cross Elasticity of Demand measures the % change in quantity demanded of good X for a 1% change in the price of good Y, ceteris paribus ε = % ΔX % Δ P Y Positive: Substitutes Negative: Complements Elastic & Inelastic Supply Price per unit S 1 (inelastic) S 2 (elastic) Quantity per period Determinants of Supply Elasticity Amount that costs rise as output does the lower the extra cost the more elastic is supply Time supply is generally more elastic in the long run 8

15 9/26/2008 3: Price Changes & Consumer Surplus Microeconomics Lecturer: Dr Nigel Wadeson Income & Substitution Effects Substitution Effect the effect on consumption of a good resulting only from the change in its relative price (i.e. the slope of the budget line) Income Effect the effect on consumption of a good resulting only from the change in real income (i.e. the position of the budget line) A Fall in Price of Good X All other goods (Y) Substitution effect: E 1 to E 2 Income effect: E 2 to E 3 E 1 E 3 E 2 U 2 U 1 X 1 X 2 X 3 Good X 1

16 9/26/2008 Consumer Surplus (CS) the difference between what a consumer is willing to pay for a good and what he/she has to pay. It is measured as the area under the demand curve and above the going price Demand & Marginal Value Price per unit MV 1 = 40 MV 2 = Qty per period Consumer Surplus Price per unit CS 1 = 25 CS 2 = 9 Market price = Qty per period 2

17 9/26/2008 Smooth Demand Curve Price per unit 1 Consumer surplus of consuming X 1 units P1 D X1 Qty per period 3

18 9/26/2008 4: The Firm & Its Goals Microeconomics Lecturer: Dr Nigel Wadeson Firm s Goal: Maximise Profit A firm tries to maximise economic profit Economic Profit = Total revenue minus Total Economic Cost Total revenue is the total payment received from sales of output Economic Costs are opportunity costs of inputs Economic Costs Opportunity costs - the value of inputs in their best alternative use Generally not equal to accounting cost may be greater or less than accounting cost Sunk expenditures are not economic costs 1

19 9/26/2008 A Firm s Two Decisions Should it produce? Yes, if an economic profit can be made Shut-Down Rule How much to produce? The profit-maximising output Marginal Output Rule Shut-Down Rule If for every choice of output level average revenue is less than average cost, the firm should shut down (produce nothing) as an economic profit cannot be made Average revenue (AR) = revenue per unit (i.e. price) Average cost (AC) = cost per unit Shut-Down Rule Economic Loss AC 1 P 1 AC AR(D) Q 1 Output per period 2

20 9/26/2008 Marginal Output Rule If a firm does not shut down, then to maximise profit it should produce at a level where marginal revenue (MR) is equal to marginal cost (MC) Marginal Revenue MR is the change in revenue due to the sale of one more unit of output R MR Q Example: Marginal Revenue Output Price Total Revenue Marginal Revenue

21 9/26/2008 Marginal Revenue Curve MR -10 Output Marginal Cost MC is the change in total cost due to the production of one more unit of output C MC Q Example: Marginal Cost Output Total Marginal Cost Cost

22 9/26/2008 Marginal Cost Curve MC Output Profit Maximisation Total Marginal Total Marginal Output Revenue Revenue Cost Cost Profit Profit Maximisation 30 MC MR Output 5

23 9/26/2008 5: Technology & Production Microeconomics Lecturer: Dr Nigel Wadeson Production Inputs (Factors): Labour, Capital Production: The Firm Outputs: Goods A Production Function Shows the maximum output that can be produced from any combination of inputs ( L K ) Q = F, 1

24 9/26/2008 Long Run & Short Run A firm s production possibilities depend on the time period The Long Run is the period long enough for the firm to vary all its inputs The Short Run is the period when only one of the firm s inputs can be varied Long Run Production Function Units of Labour Units of Capital Output Isoquants An isoquant shows the combinations of capital and labour that produce the same level of output Labour Capital 2

25 9/26/2008 Isoquant Properties Negatively sloped Convex to the origin The further from the origin the higher h the level l of output t Returns to Scale What happens to output when all inputs are increased by a given percentage? Increasing Returns output increases by a larger percentage Constant Returns output increases by the same percentage Decreasing Returns output increases by a smaller percentage Short Run Production Function & the Law of Diminishing Returns Units of Capital Units of Labour Total Output

26 t 9/26/2008 Short Run Production Function Output Slope = MPP Labour Marginal Physical Product MPP is the extra output that can be produced by using one more unit of an input, holding all other inputs constant. MPP L ΔQ = ΔL Example: MPP of Labour Units of Capital Units of Labour Output Marginal Physical Product Diminishing returns to labour 4

27 9/26/2008 6: Cost Microeconomoics Lecturer: Dr Nigel Wadeson Calculating Total Cost What is the minimum total cost of producing a given output? Short run & Long run production periods - hence short and long run costs Short Run Total Cost Short run TC = short run VC + short run fixed cost Short run Fixed cost = expenditure on fixed factors Short run FC is NOT an economic cost 1

28 9/26/2008 Short Run Economic (Variable) Cost Only economic cost is labour - capital has no alternative use in the short run To calculate short run variable cost of any output level: use short run production function to determine minimum labour input required multiply labour input by the wage rate to get the total labour cost Example: Short Run VC Units of Total Wage Variable Labour product Rate per Cost per per week per week week week Short run (Variable) Cost Curve per wee ek Slope = MC SR Output per week 2

29 9/26/2008 Marginal Cost & MPP L Short run MC is the change in short run VC due to the production of one more unit of output 1 MCSR = W MPP L W = MPP L Example: Marginal Cost Units of Total Marginal Wage Variable Labour product Physical Rate per Cost per Marginal per week per week product week week Cost Short Run MC & MPP L Marginal Physical Product Units Labour Marginal Cost Output 3

30 9/26/2008 SR Average Variable Cost Short run AVC is short run variable cost divided by the units of output (i.e. unit cost) Remember that AVC is relevant to the shut down decision - if average revenue (price) is less than AVC at all levels of output the firm should shut down in the SR Example: Short Run AVC Total product Variable Cost per Average Marginal Variable per week week Cost Cost Short Run AVC & MC Marginal Cost Average Cost Output 4

31 9/26/2008 Isocost Line An isocost line shows all the combinations of capital and labour that have the same total cost To draw an isocost line we need to know: the wage rate of labour (w) the user cost (price) per unit of capital (r) the total cost Example: Isocost Line Wage rate = 100 User cost = 40 Total cost = 1600 Units of Units of Labour Capital per week per week Example: An Isocost Line week Capital per Labour per week 5

32 9/26/2008 Slope of an Isocost Line The slope of an isocost line is the relative price of labour and capital - i.e. the wage rate (w) divided by the user cost of capital (r) It tells us how many units of capital have to be given up to purchase one more unit of labour An Isocost Map Capital per week Labour per week Finding the Minimum Total Cost To produce a given output at least cost, choose the mix of inputs which is on the isocost line nearest the origin At the least cost point, the isoquant is tangential to (just touches) the isocost line - i.e. they have the same slope w MRTS K, L = r 6

33 9/26/2008 Cost Minimisation week Capital per Cost minimising point Labour per week 7

34 7: The Price-Taking Firm Microeconomics Lecturer: Dr Nigel Wadeson What is a Price-Taking Firm? A firm that cannot influence the prices of its output or inputs WHY? It is too small in relation to the total market A change in its own supply or demand has a negligible effect on total market supply or demand - hence no change in market price Demand & Marginal Revenue A price-taking firm s demand curve is horizontal (perfectly elastic) at the given market price Hence MR is constant and equal to the given price 1

35 Example: Demand & MR Quantity Price per Total revenue per week Marginal revenue per week per week unit ( ) ( ) ( ) Shut Down Rule P AC MR, D If the given price is less than average cost for every output level,the firm should shut down Quantity Marginal Output Rule P MC MR, D Unless the firm shuts down, it should produce the output level where price is equal to marginal cost Quantity 2

36 Firm s Short Run Supply Curve When the price is above minimum AVC, the firm will produce and sell the output where price equals short run MC When the price is below minimum AVC, the firm will produce zero output Firm s Short Run Supply Curve P 1 P* Q 1 Q 2 MC SR AVC Quantity The short run supply curve coincides with the vertical axis at prices less than minimum AVC. It coincides with the short run MC curve at prices above minimum AVC Firm s Long Run Supply Curve When the price is above minimum long run AC, the firm will produce and sell the output where price equals long run MC When the price is below minimum long run AC, the firm will shut down and produce zero output 3

37 Firm s Long Run Supply Curve P 1 P* Q 1 Q 2 MC LR ACLR Quantity The long run supply curve coincides with the vertical axis at prices less than minimum AC. It coincides with the long run MC curve at prices above minimum AC 4

38 8: Competitive Markets Microeconomics Lecturer: Dr Nigel Wadeson The Perfect Competition Model Sellers are price-takers Entry into the market is free Buyers are price-takers Market Structure Large number of buyers Large number of sellers, each with negligible market share Homogeneous H products Well informed buyers No barriers to entry 1

39 Short Run Equilibrium A fixed number of firms in the market Firms operating on their short run supply curves Market k t supply is sum of each firm s supply Market & Firm Equilibrium (SR) Firm MC SR AVC Market S SR P 1 P 1 C 1 D SR x 1 Qty X 1 Qty Long Run Equilibrium Number of firms in the market is not fixed new firms can enter (attracted by economic profits) loss-making firms can leave Firms operating on their long run supply curves 2

40 Long Run Equilibrium Assume that: All existing and potential new firms have access to same technology and hence face the same costs Input prices remain constant regardless of number of firms in the market: i.e. constant cost industry Market & Firm Equilibrium (LR) Firm MC LR Market AC LR P* P* S LR D LR x 1 Qty X 1 Qty 3

41 9: Monopoly Microeconomics Lecturer: Dr Nigel Wadeson The Monopoly Model Sellers are price makers Entry into the industry is completely blocked Buyers are price takers Market Structure Many buyers ONE seller No close substitutes for the firm s product Blocked entry to the market 1

42 Marginal Revenue Output per month Total Revenue per month ( ) Marginal Revenue ( ) Price per unit ( ) Two Points to Note About MR Marginal revenue falls as output sold increases Marginal revenue is less than price (AR) (assuming no price discrimination) Demand & MR Curves D MR -20 Output per month 2

43 Monopoly Equilibrium P MC AC Economic (Monopoly) Profit Q MR Qty D Short Run & Long Run? No entry of new firms takes place, so economic profit can exist in the long run Monopoly v Competition Comparing a competitive industry with a multi-plant monopolist (hence same costs): The monopoly charges a higher price and produces less output Hence, the monopoly creates a deadweight loss 3

44 Monopoly v Competition P M P C MC Deadweight loss of monopoly Q M Q C MR Qty D Public Policy Toward Monopoly Patent Policy Allow temporary monopoly power to encourage innovation Anti-Monopoly (Antitrust) Policy Conduct Remedies regulate firm behaviour Structural Remedies introduce/maintain competition (where possible) Natural Monopoly Economies of scale are extensive in relation to the size of the market Hence, a single firm can produce the total industry output at less cost than any greater number of firms Structural remedy not possible or desirable 4

45 Regulation of Natural Monopoly P M P B P E Q M MR Q B Q E AC MC D Qty Implications/Problems Firm must be allowed to make nonnegative profits A regulated firm will use its private information to its own advantage Regulatory controls may have unintended consequences 5

10: Externalities/Public Goods Microeconomics Lecturer: Dr Nigel Wadeson Externalities Externality a direct effect of the actions of one person or firm on the welfare of another person or firm, in a

46 10: Externalities/Public Goods Microeconomics Lecturer: Dr Nigel Wadeson Externalities Externality a direct effect of the actions of one person or firm on the welfare of another person or firm, in a way that is not transmitted by market prices Externalities can be positive or negative Externalities result from missing markets Absence of property/ownership rights Private v Social Cost Private marginal cost = incremental opportunity costs actually paid by producers Social marginal cost = incremental cost of production which includes the opportunity cost of all scarce resources, whether priced or not SMC = PMC + MD 1

47 Example: Negative Externality per period P* Net efficiency gain SMC (= PMC + MD) S (= PMC) P 1 D MD X* X 1 Output per period Private Responses Mergers internalise the externality by combining the parties involved Social conventions Bargaining i between the parties Coase Theorem Coase theorem Assuming there are no bargaining costs, once ownership rights to a resource are established, individuals will bargain their way to an efficient use of the resource 2

48 Why Bargaining May Fail Costs of Bargaining Too many parties involved Free-rider rider problem Difficulty identifying i source of damages Asymmetric information Government Responses Regulation Corrective Taxes Creating a Market e.g. for pollution rights Public Goods A public good is a commodity that is nonrival in consumption Nonrival one person s consumption of the good does not reduce the consumption of another person Non-excludable public good Free-rider rider problem makes market provision unlikely or impossible 3

49 9/26/ : Choice Under Uncertainty/ Welfare Microeconomics Lecturer: Dr Nigel Wadeson Expected Value The value of a variable, which depends on the state of the world, that occurs on average Is equal to the sum of each outcome multiplied by its respective probability E ( X ) = px1 + ( 1 p) X 2 Attitudes to Risk Risk averse an individual who will not accept an actuarially fair gamble Risk loving an individual who prefers an uncertain prospect with a particular expected value to a certainty with the same expected value Risk neutral an individual who is indifferent among alternatives with the same expected value 1

50 9/26/2008 Welfare Economics Concerned with how well an economy operates in terms of efficiency and equity/social justice Efficiency - allocation of resources Equity - distribution of income Pareto Efficiency An allocation of commodities and inputs is Pareto Efficienti if the only way to make one individual better off is to make another worse off 2

51 12. Monopolistic Competition Lecturer: Nigel Wadeson Monopolistic Competition Features: Product differentiation Many firms Free entry and exit E.g. restaurants Each firm faces downward sloping demand curve P D Q 1

52 Short-run The short-run diagram is like the monopoly diagram. But in the long run firms enter and exit As new firms enter/exit the firm s demand curve shifts down/up Firms enter/exit until there is no further motive to do so. This is the point where zero profits are made Long-run P MC AC D Q 2

Model Question Paper Economics - I (MSF1A3)

Model Question Paper Economics - I (MSF1A3) Answer all 7 questions. Marks are indicated against each question. 1. Which of the following statements is/are not correct? I. The rationality on the part of