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Introduction to Microeconomics
MSc Induction
Simon Hayley
[email protected]
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,
unemployment 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 selfinterest, responding to prices set on open
markets, they produce co-ordinated and
relatively efficient economic activity.
Resources and Scarcity
• Scarcity is a fundamental problem faced by
all economies because not enough resources
(land, labour, capital, and entrepreneurship)
are available to produce all the goods and
services that people would like to consume.
• Scarcity makes it necessary to choose among
alternative possibilities: 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
construct 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 production-possibility boundary shows all
of the combinations of goods that can be
produced 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
0
Quantity of public sector goods
A Production-Possibility Boundary
Unattainable combinations
a
c0
•d
Production possibility
boundary
C
Attainable
combinations
c1
b
c
0
G
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
b
0
Quantity of public sector goods
Analysis of Markets
• All markets can be approached in same way,
even though there are many different features.
• In 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 goods (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
• Personal characteristics: age, religion, dependants
etc
• Tastes
• 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
good and falls when income increases for an
inferior good. [income elasticity]
High
Low
Income Elasticity
Price Elasticity
Low
High
• Necessities have low income elasticity.
Luxuries have higher income elasticity.
• Price elasticity partly depends on how
tightly we define each market:
– Broadly-defined goods (eg. food) 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
Reference Letter
Price [£ per dozen]
Quantity demanded
[dozen per month]
a
b
c
d
e
f
0.50
1.00
1.50
2.00
2.50
3.00
7.0
5.0
3.5
2.5
1.5
1.0
Alice’s Demand Curve
3.00
f
e
2.50
d
2.00
c
1.50
b
1.00
a
0.50
1
2
3
4
5
6
7
Quantity of Eggs [dozen per month]
The Relation Between Individual and Market Demand Curves
3.00
2.00
1.00
3.00
2
[i]. William
4
6
8
Quantity of Eggs
[dozen per month]
2.00
1.00
3.00
2
2.00
4
6
8
10
12
Quantity of Eggs
[dozen per month]
1.00
[iii]. Total Demand William & Sarah
2
[ii]. Sarah
4
Quantity of Eggs
[dozen per month]
6
8
14
A Market Demand Schedule for Eggs
Reference Letter
Price [£ 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
3.00
60.0
A Market Demand Curve for Eggs
3.50
D
Z
3.00
Y
2.50
X
2.00
W
1.50
V
1.00
U
0.50
20
40
60
80
Quantity of Eggs
[thousand dozen per month]
100
120
140
Shifts in the Demand Curve
D1
Price
D0
0
Quantity
Shifts in the Demand Curve
D0
Price
D2
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
Reference Letter
Price [£ per dozen]
Quantity supplied
[000 dozen per month]
u
0.50
5.0
v
1.00
46.0
w
1.50
77.5
x
2.00
100.0
y
2.50
115.0
z
3.00
122.5
A Supply Curve For Eggs
3.50
S
Z
3.00
Y
2.50
X
2.00
W
1.50
V
1.00
U
0.50
20
40
60
80
100
120
Quantity of Eggs[thousand dozen per month]
140
Shifts in the Supply Curve
S0
S1
Quantity
Shifts in the Supply Curve
S2
Quantity
S0
Demand and Supply Schedules for Eggs and Equilibrium Price
Price
[£ per dozen]
Quantity
demanded
[‘000 dozen
per month]
Quantity supplied
[‘000 dozen
per month]
Excess Demand [quantity
demanded minus
quantity supplied]
[‘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
3.00
60.0
122.5
-62.5
Determination of the Equilibrium Price of Eggs
3.50
S
D
Z
3.00
Z
Y
Y
2.50
X
2.00
1.50
W
X
W
V
V
1.00
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
200
150
100
50
Date
Brazilian arabica
2004
1997
1990
1983
0
1976
US cents per lb.
250
Coffee market
Price of
coffee
demand
P1
supply
P2
Q1
Q2
Quantity of coffee
Newspaper 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 daily sales of the Independent went
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
following sharp falls in global equity markets
amid mounting fears that the global economy
was heading into recession” (FT 10/8/2008)
• “Members of the OPEC oil cartel are
considering an emergency meeting in Vienna
next month as oil prices 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 (eg. newspaper 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
from consuming a product or service
• Total utility = utility a consumer gets from total
consumption of all units of a particular product.
• Marginal utility = the addition to total utility derived
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.
Marginal Utiity
Diminishing Marginal Utility
Units Consumed
Why are diamonds more expensive
than water?
• Water is vital – without it we will die.
• Diamonds are a luxury.
• So why is water cheap, whilst diamonds
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
attended per month
Total utility
Marginal utility
0
0.00
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
9
42.20
0.90
10
43.00
0.80
Total and Marginal Utility Curves
50
20
40
15
30
10
20
5
10
0
2
4
6
8
10
0
2
4
6
8
Quantity of films [attendance per month]
[i]. Increasing total utility
[ii]. Diminishing marginal utility
10
A Consumer’s Equilibrium
• To maximize utility, each consumer should adjust
spending so that marginal utility per pound is the
same for each good consumed (MUx/Px =
MUy/Py).
• If this were not true, could increase total utility by
shifting towards consuming good with higher
utility 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 good 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
price will be required to cause a significant increase
in consumption).
Consumer Surplus
Consumer surplus is the difference between:
1) The value consumers place on their total
consumption of some product (the
maximum they would pay for the amount
consumed rather than go without it
completely).
2) The actual amount paid for it.
Consumer Surplus for an Individual
3.00
2.00
Market price
1.00
0.30
1
2
3
4
5
6
7
8
Glasses of milk consumed per week
9
10
Consumer Surplus for the Market
Market price
p0
D
0
Quantity
q0
Competition vs. Monopoly
• A competitive industry has many producers. Each
must sell at the existing market 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
choose 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
p0
D
0
q1
Quantity
q0
Implications of Monopoly Power
–
–
–
–
Reduced output
Increased prices
Substantial loss of consumer surplus
A monopolist may also tend to be less dynamic,
leading 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
D
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.
• Specifically, we found it useful to analyse
demand on the assumption that consumers
aim to maximise their own total utility.
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
Relative price line
0
Quantity of good B
An Ideal Market Equilibrium
Indifference curve
Relative price 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
good 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
• Externalities
• Public goods
Monopoly
• Governments generally aim to prevent firms
from exploiting monopoly 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 economies of scale. As 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 monopoly 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
private 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 supply)
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 expensive higher quality products out 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
externalities.
• 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
government banning certain polluting
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 polluting, but only 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 only drive if the benefits 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 by 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”, and hope that someone else pays!
• Hence these goods tend to be provided by the
government (out of general taxation) or by
compulsory subscriptions (eg. the UK TV
licensing fee).
Market Failure vs. Government Failure
• We have identified several market failures:
• Monopoly power
• Information failures
• Externalities
• 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”
in attempts to correct 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
• Supply: price/input costs/technology
• Supply and demand curves
• Prices shift so that supply=demand
• The invisible hand
Microeconomic Theory (2)
• Diminishing marginal utility
• 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, saying 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
curves are negatively sloped and convex to the origin.
Indifference Theory
• While indifference curves describe the consumer’s
tastes and, therefore, refer to what he or she would
like to purchase, 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
Clothing
Bundle
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
h
10
f
T
5
5
e
15
I
20
Quantity of food
25
30
35
An Indifference Map
I5
I4
I3
I1
0
Quantity of food per week
I2
Shapes of Indifference Curves
Perfect Substitutes
Perfect Complements
A good that gives zero
utility
I1
I1
I1
0
0
[i]. Packs of green pins
0
[ii]. Right hand gloves
A good that confers a negative utility
after some level of consumption
I1
All other
goods
f0
[iii]. Meat
The Equilibrium of a Consumer
Quantity of clothing per week
35
30
25
20
15
10
5
5
10
15
20
Quantity of food per week
25
30
35
The Equilibrium of a Consumer
Quantity of clothing per week
35
30
a
25
20
15
10
5
f
5
10
15
20
Quantity of food per week
I1
25
30
35
The Equilibrium of a Consumer
Quantity of clothing per week
35
30
a
b
25
c
20
E
15
10
d
I4
5
e
I3
I2
I1
f
5
10
15
20
Quantity of food per week
25
30
35
• 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.