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Lecture 2: Basic Microeconomics I
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
March 20, 2010
Review of Last Week
10 Principles of Economics
Sunk/Fixed costs
Opportunity Cost and Comparative
Advantage
Demand and Supply
Price Controls
Article 2: Too Many Cars
 Overcapacity is the biggest problem for any automobile
company in the world




GM buys Daewoo Motor, Fiat Auto, Saab
Ford motor owns Mazda, Land Rover
Daimler Chrysler is riding to rescue Mitsubishi
Oldsmobile and Chrysler’s Plymouth, are the first major automobile
companies in 40 years
 Why do ailing automobile companies who decry overcapacity
keep ailing car companies?
•
•
•
National pride plays a big role
More brands mean more dealerships mean more sales.
But this also means more costs and complexity in business operations.
In reality, overcapacity is not really a problem.
One man’s overcapacity is other’s bargain.
Thus, lower priced leases and generous rebates abound in today’s
car market.
Who REALLY Owns that Winery (p.8)
by Terry McCarthy
Consolidation is the Norm
 60% of U.S. wine is produced by the top five companies
– Consolidation among distributors is squeezing out the
medium-sized producers, who make from 100,000 to 1 million
cases a year
 Market is not growing
– Only 10% of adults drink 86% of the wine
 Fixed Costs
– Some wineries do not have enough volume to get a priority
from distributors
Chapter 3
Comparative Advantage & Trade
Positive vs. Normative
Economics
 Positive :
– Descriptive statement ( is, was)
– Refer to data
– Examples of positive statements:
– GDP in the U.S. economy was about $7 trillion last year
– The New York City rent control laws have created a shortage
of housing in the city
 Normative:
– Value judgment (ought to be, shall, will)
– Examples of normative statements:
– Higher interest rates would be good for the U.S. economy in
the next six months
– The U.S. government should be required to balance its budget
every year
Production Possibilities Frontier
The classic tale of the farmer and the
rancher…or a better example if you have
one.
What should each produce?
Why should they trade?
Production Possibilities Frontier
(a) The Farmer ’s Production Possibilities Frontier
Meat (ounces)
FARMER:
32 oz. of Potatoes in 8 hours
8 oz. of Meat in 8 hours
If there is no trade,
the farmer chooses
this production and
consumption.
8
4
A
0
16
32
Potatoes (ounces)
Production Possibilities Frontier
(b) The Rancher ’s Production Possibilities Frontier
Meat (ounces)
RANCHER:
If there is no trade,
the rancher chooses
this production and
consumption.
24
48 oz. of Potatoes in 8 hours
24 oz. of Meat in 8 hour
12
B
0
24
48
Potatoes (ounces)
Trade Example
Without trade:
Specialization & Trade
“Farmer, my friend, have I got a deal for you! I know
how to improve life for both of us. I think you should
stop producing meat altogether and devote all your
time to growing potatoes. According to my calculations,
if you work 8 hours a day growing potatoes, you’ll
produce 32 ounces of potatoes.
If you give me 15 of those 32 ounces, I’ll give you 5
ounces of meat in return. In the end, you’ll get to eat
17 ounces of potatoes and 5 ounces of meat every
week, instead of the 16 ounces of potatoes and 4
ounces of meat you now get. If you go along with my
plan, you’ll have more of both foods.”
How Trade Increases Consumption
(a) The Farmer ’s Production and Consumption
Meat (ounces)
Farmer's
consumption
with trade
8
5
4
0
A*
Farmer's
production &
consumption
without trade
Farmer's
production
with trade
A
16
17
32
Potatoes (ounces)
How Trade Increases Consumption
(b) The Rancher ’s Production and Consumption
Meat (ounces)
Rancher's
production
with trade
24
18
13
B*
B
12
0
Rancher's
consumption
with trade
12
24 27
Rancher's
production and
consumption
without trade
48
Potatoes (ounces)
Example Continued..
With trade:
Absolute Advantage: Rancher beats the farmer in producing both
meat and potatoes
Trade According to Comparative Advantage
(CA) or Opportunity Cost (OC)
 CA is OC of two products – whatever must be given up to
obtain a product
 The producer who has the smaller OC of producing a good
has a CA in producing that good
– Rancher has CA in producing meat
– Farmer has CA in producing potatoes
Let’s Calculate OC
(Meat in terms of Potatoes)
Benefits of Trade
Whenever potential trading parties have
differences in opportunity costs, they can
each benefit from trade.
Trade can benefit everyone in a society
because it allows people to specialize in
activities in which they have a comparative
advantage.
Better Answer to Tough Questions (p.6)
by David Wessel
“What do you say to someone…who has lost his job to
someone overseas who’s being paid a fraction of what
that job paid here?”
 Those of us who benefit from low-cost imports – or who
have well-paid export jobs that wouldn’t exist if we
don’t allow imports and outsourcing – must not ask
those who lose jobs to go it alone.
 If trade and technology make us richer, then we can
afford to help pay for health insurance and protect
pensions forced to bear the cost.
Better Answer to Tough Questions (p.6)
by David Wessel
 That means pushing China and others to stop bending
trade rules or manipulating currencies and pressing
Europe and Japan to get their people spending so the
U.S. Isn’t always the consumer of last resort. It means
setting U.S. taxes so they cover government spending at
least in good times, rewriting perverse tax laws that
encourage companies to invest elsewhere and managing
the unquenchable American thirst for health care
without giving employers new excuses.
 Discuss: wage insurance and role of education
Chapter 5
Elasticity
Elasticity & Its Application
 Evaluating questions like– Banana Republic store manager/headquarters needs to
decide on sale on jeans vs. sale on shirts
– Rain destroys strawberry crop, prices go . Does it
benefit growers ?
– Why don’t you ever see sale or discounts on pure milk
but see it on orange juice ?
 These can be answered with the concept of
elasticity (or responsiveness of buyers & sellers to
changes in market conditions)
Elasticity
Price elasticity of demand: a measure of how
much the quantity demanded of a good responds
to a change in the price of that good
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
Continued..
 Two types of demand:
– Elastic – responds a lot e.g. luxury cars ( luxuries)
– Inelastic – not much change e.g. milk, certain food
items, gasoline ( necessities)
 Preferences: Luxuries vs. Necessities
 Availability of close substitutes: Elastic
– Butter & margarine; cars, booze
 Time horizon:
– Gasoline – necessity in short run
– Substitute long run (electric cars, walk, bike)
Elasticity
Inelastic Demand
– Quantity demanded does not respond strongly
to price changes.
– Price elasticity of demand is < one.
Elastic Demand
– Quantity demanded responds strongly to
changes in price.
– Price elasticity of demand is > one.
Demand Curves
Question: Can I tell from the graphical
shape of the demand curve what kind of
elasticity the curve has?
Answer: Yes, but not all the time.
Perfectly Inelastic Demand
Elasticity = 0
Price
Demand
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
3. . . . revenue goes from $4 x 100 to $5 x 100
Inelastic Demand
Elasticity < 1
Price
$5
4
1. A 22%
increase
in price . . .
Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
3. . . . revenue goes from $4 x 100 to $5 x 90
Unit Elastic Demand
Elasticity = 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
80
100
2. . . . leads to a 22% decrease in quantity demanded.
3. . . . revenue goes from $4 x 100 to $5 x 80
Quantity
Elastic Demand
Elasticity > 1
Price
$5
Demand
4
1. A 22%
increase
in price . . .
0
50
100
2. . . . leads to a 67% decrease in quantity demanded.
3. . . . revenue goes from $4 x 100 to $5 x 50
Quantity
Perfectly Elastic Demand
Elasticity = Infinity
Price
1. At any price
above $4, quantity
demanded is zero.
$4
Demand
2. At exactly $4,
consumers will
buy any quantity.
0
3. At a price below $4,
quantity demanded is infinite.
Quantity
Relationship Between Total
Revenue (Sales) & Elasticity
Total Revenue = Price x Qty Sold = P x Qty
If demand is elastic, then a price decrease
increases revenue
If demand is inelastic, then a price increase
increases revenue
Example  class to contribute
Box Shows the 50% Drop of New Paying Customers for the May &
August 2004 Conference Caused by the Latest Price Hike
Conference Date
Attendance
New Paying
% of Total
Feb’ 01
72
6
8%
May’ 01
66
10
15%
Aug’ 01
101
31
31%
Nov’ 01
163
49
30%
189
28
15%
May’ 02
160
42
26%
Aug’ 02
195
62
32%
Nov’ 02
169
44
26%
Feb’ 03
260
55
21%
May’ 03
196
37
19%
Aug’ 03
220
43
20%
Nov’ 03
222
40
18%
Feb’ 04
238
48
20%
201
25
12%
211
23
11%
Feb’ 02
May’ 04
Aug’ 04
1st Price Hike
2nd Price Hike
Applications of Supply,
Demand & Elasticity
Can good news for farmers be bad news for
farmers?
Wheat is inelastic: Bumper crop  bad
news
Increase In Supply In Market
For Wheat
Price of
Wheat
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
S1
S2
$3
2
Demand
0
100
110
Quantity of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.