Microeconomics Notes

Lecture 1
I) Equilibrium
A) Economists caution against normative meaning to the equilibrium price i.e. food markets may be in
equilibrium at the same time that people are starving.
B) Economic equilibrium: no player is able to change their play and do better, given what the other players
are doing
II) Opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs
to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice
is made, it is the cost incurred by not enjoying the benefit that would be had by taking the second best
choice available.
A) Explicit costs are opportunity costs that involve direct monetary payment by producers (i.e. the
opportunity cost of the factors of production not already owned by a producer is the price the producer
has to pay for them a firm spends $100 on electrical power consumed, their opportunity cost is $100).
B) Implicit costs are the opportunity costs in factors of production that a producer already owns. They are
equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm
or rented out to other firms (i.e. a firm pays $300 a month all year for rent on a warehouse that only holds
product for six months each year and the firm could rent the warehouse out for the unused six months
at any price (assuming a year-long lease requirement) and that would be the cost that could be spent on
other factors of production.
III) Positive v. Normative Economics
A) Positive economics is descriptive: it describes what is.
i) Two types: deductive (math & logic) and inductive (facts which can be established as either true or
false)
ii) Efficiency is generally positive (i.e. more innocents lived)
iii) Examples
(a) GDP will increase if liquor taxes are increased
(b) The liquor lobby says that taxes on liquor should not be increased
(c) Firms with unsafe mines make more money
(d) Executives who do not maximize their firms profits tend to be replaced
B) Normative economics (opinion) is about value judgments (i.e. state A is better than state B)
i) Use the words should, good, better
ii) Justice is generally normative (i.e. right, wrong, opinion, culture)
iii) Examples
(a) We should maximize our firms profits by making our coal mines unsafe in poor countries
IV) Economic Efficiency
A) Two assumptions:
i) Assumes rational self-interest and information (people who make money pay attention)
ii) Assumes behavior becomes predictable because markets gravitate towards equilibrium (i.e. # game
where 1
st
person guesses 1 thru 100 and 2
nd
person guesses after eventually the 1
st
person realizes
how to take advantage away from 2
nd
person by guessing 50). Observant class members saw early on
how the game worked and how to do better before others caught on. Markets are like that --- it
takes time to learn market behavior and time for markets to converge on equilibrium.
B) Markets are economically efficient when we maximize the gains from trade (at equilibrium)
C) Taxes reduce the gains from trade
D) John & Mary Example
i) Mary has an apple. John wants the apple. The apple is worth fifty cents to Mary, meaning that she is
indifferent between having the apple and not having the apple but an additional 50 instead. The
apple is worth $1 to John. John buys the apple for 75 cents. Mary has net gain of 25 and John has
net gain of 25. Both are better off and net gain is 50.
ii) Suppose 3
rd
person, Anne, is willing to pay up to $1.50 for the apple she will outbid John and the net
gain from the transaction will be $1 (better outcome than apple going to John for net gain of only
50). Efficiency rule: apple goes to whoever values it most, thus maximizing net gain.
iii) Gains from trade are independent (unrelated) to price. In real life, we dont know the gains of trading
an apple or the value to society of the entire apple market
E) Limitations: all that matters is consequences
i) Does not take knot account judging legal rules by non-consequential criteria such as justice.
ii) In 15 seconds a mob will shoot 3 people because of a heinous crime. The sheriff is there and he
knows only one did it, but he does not know which one. What should the sheriff do? Sheriff solves
problem efficiently by announcing (falsely) that he knows one of them did it and shoots that
individual he saves an innocent with certainty and a 50% chance of saving a second innocent
person
V) Game of Chicken
A) If both players decide to go straight, neither wins any gain from trade. If one player swerves and the
other goes straight, the player who goes straight wins and takes all gain from trade. If both swerve,
neither win big but instead split the gains from trade.
i) If I know other player is going to go straight it is in my best interest to swerve and vice versa
(strategic behavior: behavior in which each persons actions are conditioned on what he expects the
other persons actions to be)
B) Both players share an interest in avoiding a head on collision (death) player will only be a winner if the
other is a chicken. Gains from trade are maximized when both people swerve (given they do not know
what the other player will do)
C) In business, if both players try to take all the gains from trade (i.e. both bargain hard with no concessions)
players both get nothing (i.e. deal is not reached)
VI) Bilateral Monopoly
A) Occurs when a single seller sells to a single customer. With bilateral monopoly, since neither the buyer
nor the seller has a competitive market alternative in which to transact, there is a range over which the
price will fall (i.e. lawsuits)
B) John & Mary Example: Mary owns the only apple on the market. It is worth 50 to Mary and $1 to John.
Both Mary and John try to get the 50 difference in price (gains from trade), but it is created only if they
actually transact. John gets all the gains from trade if he pays 50 to Mary while she gets the gains from
trade if she sells the apple to John for $1. If John and Mary cant agree on a price, Mary keeps the apple
and the potential gain from trade is lost.
C) Not a zero-sum game: If we reach an agreement, gains sum to 50; and if we fail to reach an agreement,
gains sum to $0
D) Market gains from actual trade are unobservable and independent of both the price paid and the money
that changes hands. Even with trade, all that the price does is split the gains from trade between the two
parties.
E) Lost gains from the absence of trade are also unobservable (this explains why political leaders interfere in
markets frequently and prevent market efficiency, which is defined as freedom of individuals to transact
freely and to potentially maximize the gains from trade)
F) Bilateral negotiations can have the same disastrous outcome as the game of chicken. If the parties get
too aggressive in fighting over the gains from trade, the gains from trade can be lost if no agreement is
reached.



Lecture 2
I) Types of Markets
A) Factors of Production (Factor Markets)
i) Examples: crude oil and labor are factors of production
ii) Generally, firms are buyers in factor markets
B) Services & Finished Goods (Goods Markets or Product Markets)
i) Examples: cars, clothing, and liquor
ii) Generally, firms are sellers in product markets and customers are buyers
C) Intermediate Goods
i) Goods used in the production of final goods
ii) Example: Intel produces computer chips that are used in the manufacture of computers
D) Capital Markets
i) Markets where firms raise money for investment by selling debt (borrowing) or selling equities (claim
to ownership), as well as the markets where these debt and equity claims are subsequently traded.

II) Demand Function

Example: Consider an individuals demand for gasoline over a week. The price of automobiles and the price of
bus travel may be independent variables, along with income and the price of gasoline.

Note that an increase in the price of automobiles will decrease the demand for gasoline (they are
complements), and an increase in the price of bus travel will increase the demand for gasoline (they are
substitutes).

Assuming average car price is $25,000, income is $45,000, and the price of bus travel is $30, our demand
function becomes a simple linear equation. The quantity of gas demanded is a (linear) function of the price of
gas. In this form, we can see that each $1 increase in the price of gasoline reduces the quantity demanded by
1.25 gallons.

Because we graph demand curves with price (independent variable) on the vertical y-axis and quantity
demanded (dependent variable) on the horizontal x-axis, we invert the function to show price as a function of
quantity demanded:

Law of Demand: Quantity demanded typically increase at lower prices

III) Supply Function
Quantity a producer will willingly supply depends on the selling price as well as the costs of production which,
in turn, depend on technology, the cost of labor, and the cost of other inputs into the production process.

Example: Consider a manufacturer of furniture that produces tables. For a given level of technology, the
quantity supplied will depend on the selling price, the price of labor (wage rate), and the price of wood.

Assuming a wage of $12 per hour and wood priced at $150, our supply function becomes a simple linear
equation.

Law of Supply: A greater quantity is supplied at higher prices

IV) Shifts/Movements along Demand/Supply Curves
A) Movement along Demand/Supply Curve: change in the market price that simply increases or decreases
quantity supplied or demanded is represented by movement along the curve
B) Shift of Demand/Supply Curve: change in one of the independent variables other than price will result in
a shift of the curve itself
i) in Demand (curve shifts )
(a) in income
(b) in price of substitute
(c) in price of complement
ii) in Demand (curve shifts )
(a) in income
(b) in price of substitute
(c) in price of complement
Example: in gasoline demand curve, an in income or the price of bus travel (substitute) will
demand and shift the curve
iii) in Supply (curve shifts )
(a) in price of an input
Example: in furniture supply curve, an in price of wood or wage rate will quantity supplied and
shift the curve
iv) in Supply (curve shifts )
(a) in price of an input
(b) Advances in production technology
V) Aggregating Supply/Demand
A) Given a supply/demand function for an individual consumer/firm, we can add them together to get the
market supply/demand function
B) Example: if there are 50 table manufacturers, the market supply would be:

VI) Movement towards the Equilibrium
A) Under the assumptions that buyers compete for available goods on the basis of price only, and that
suppliers compete for sales only on the basis of price, market forces will drive the price to its equilibrium
level (where demand and supply curves intersect)
B) Q
S
> Q
D
(Surplus)
i) Price is above its equilibrium level. Suppliers willing to sell at lower prices will offer those prices to
consumers, driving the market price down towards the equilibrium level.
ii) Example: quantity of steel supplied is greater than quantity demanded. Steel inventories will build
up, and competition will put downward pressure on the price of steel. As the price of steel falls, steel
producers will reduce production and free up resources to be used in the production of other goods
and services until equilibrium output and price are reached.
C) Q
D
> Q
S
(Shortage)
i) Price is below its equilibrium level. Consumers will offer higher prices to compete for the available
supply, driving the market price up towards its equilibrium level.
ii) Example: quantity of steel demanded is greater than quantity supplied. Steel inventories would be
drown down, which would put upward pressure on prices as buyers competed for the available steel.
Suppliers would increase production in response to rising prices, and buyers would decrease their
purchases as prices rose.
D) Stable and Unstable Equilibrium
i) An equilibrium is stable when there are forces that move price and quantity back towards equilibrium
values when they deviate from those values. Even if supply curve slopes downward, as long as it cuts
through the demand curve from above, the equilibrium will be stable.
ii) If the supply curve is less steeply-sloped than the demand curve, this is not the case, and prices above
(below) equilibrium will tend to get further from equilibrium. We refer to such an equilibrium as
unstable.
VII) Price Elasticity of Demand: measure of the responsiveness of the quantity demanded to a change in price
A) Pepsi/Coke Example: In 1930s, Pepsi and Coke selling sodas in 6-ounce bottles. Attempting to reduce
costs, president of Pepsi (Guth) bought a large supply of recycled 12-ounce beer bottles. Initially Pepsi
priced the bottles at 10 (twice the price of 6-ounce Cokes) however, the strategy did little to boost
sales. Guth then decided to try new strategy of selling the 12-ounce Pepsi bottles for the same price as 6-
ounce Cokes. In the midst of the great depression, it was a great marketing ploy and brought Pepsi out of
bankruptcy saving the company. Whether the increase in the number of units sold translates into higher
sales revenues depends on the strength of the relationship between price and the quantity purchased
measured by price elasticity of demand. As long as Coke did not respond to Pepsis price cut with one of
its own, we would expect that the demand for Pepsi would have been relatively sensitive to price, or price
elastic. Price-elastic demand implies that a price cut not only translates into higher unit sales, but also
into higher sales revenue.
B) Price elasticity is a measure of the responsiveness of the quantity demanded to a change in price
i) Demand is elastic when quantity demanded is very responsive to a change in price. Perfectly elastic
demand - any increase in price will lead to zero units demanded (Example: demand facing individual
farmers. They have no control over price. Ever small increases in their prices can cause them to sell
nothing).
(a) When one or more goods are very good substitutes for the good in question, demands will tend
to be very elastic. Consider two gas stations along your regular commute that offer gasoline of
equal quality. A decrease in the posted price at one station may cause you to purchase all your
gasoline there, while a price increase may lead you to purchase all your gasoline at the other
station.
ii) Demand is inelastic when quantity demanded is not very responsive to a change in price. Perfectly
inelastic a change in price has no effect on quantity demanded.
(a) When there are few or no good substitutes for a good, demand tends to be relatively inelastic.
Consider a drug (two pills) you take every day that keeps you alive by regulating your heart. You
are unlikely to decrease your purchases if the price goes up and also quite unlikely to increase
your purchases if price goes down.
C) Slope is dependent on the units that price and quantity are measured in. Elasticity is not dependent on
units of measurement because it is based on percentage changes.
D) Total revenue (price x quantity) is maximized for the price and quantity combination for which price
elasticity equals -1.0 (unitary elasticity)
i) At prices less than unitary elasticity (inelastic region), the % in quantity demanded will be less than
the % in price. Total revenue will increase when price is increased.
ii) At prices greater than unitary elasticity (elastic region), the % in quantity demanded will be greater
than the % in price. Total revenue will decrease as price is increased.
E) Other Factors Affecting Demand Elasticity
i) Portion of Income Spent on a Good: the larger the proportion of income that is spent on a good, the
more elastic an individuals demand for that good will be. If the price of a preferred brand of
toothpaste increases, a consumer may not change brands or adjust the amount used, preferring to
simply pay the extra cost. When housing costs increase, however, a consumer will be much more
likely to adjust consumption, because rent is a fairly large proportion of income.
ii) Time: elasticity of demand tends to be greater the longer the time period since the price change. For
example, when energy prices initially rise, some adjustments to consumption are likely made quickly.
Consumers can lower the thermostat temperature. Over time, adjustments such as smaller living
quarters, better insulation, more efficient windows, and installation of alternative heat sources are
more easily made, and the effect of the price change on consumption of energy is greater.
iii) Available Substitutes: the more substitutes available for the good, the more elastic the demand
iv) High Price Elasticity Means Higher Price Sensitivity
F) Income Elasticity of Demand: ratio of percentage change in quantity demanded to the percentage change
in come
i) For most goods (normal goods), income elasticity is positive an increase in income leads to an
increase in quantity demanded
[income elasticity > 0]
ii) For other goods (inferior goods) it may be the case that an increase in income leads to a decrease in
quantity demanded i.e. SPAM
[income elasticity < 0]
iii) A specific good may be an inferior good for some ranges of income and a normal good for other
ranges of income.
G) Cross Price Elasticity of Demand: ratio of percentage change in the quantity demanded of a good to the
percentage change in the price of a related good
i) When an in the price of a related good increases demand for a good, we say that the two goods
are substitutes. The cross price elasticity of demand is positive (price of one , quantity demanded
for the other ). Example: if bread A and bread B are two brands of bread and considered good
substitutes by many consumers, an increase in the price of one will lead consumers to purchase more
of the other.
[cross price elasticity > 0]
ii) When an in the price of a related good decreases demand for a good, we say that the two goods
are complements. The cross price elasticity of demand is negative. Example: if an increase in the
price of automobiles (less cars purchased) leads to a decrease in the demand for gasoline.
[cross price elasticity < 0]
iii) Overall, the cross price elasticity of demand is more positive the better substitutes two goods are
and more negative the better complements the two goods are.
H) Total Revenue Test
i) If demand is elastic, an increase (decrease) in price will lead to a decrease (increase) in total revenue
|own price elasticity| > 1
ii) If demand is inelastic, an increase (decrease) in price will lead to an increase (decrease) in total
revenue
|own price elasticity| < 1
iii) Total revenue is maximized at the point where demand is unitary elastic
(a) No change in total revenue means that the % increase in quantity (numerator in elasticity
formula) = the % decrease in price (denominator in elasticity formula), thus e = -1. The
implication is that price drops lead to no change in total revenue where e = -1.
I) Example 1

From coefficient on income (+200), we know that greater income leads to greater quantity demanded, so
gasoline = normal good.
From coefficient on the price of bus travel (+1,200) we know that higher price of bus travel leads to
greater quantity of gasoline demanded, thus bus travel = substitute.
From coefficient on the price of automobiles (-100) we know that an increase in automobile prices leads
to a decrease in the quantity of gasoline demanded, thus automobiles and gasoline = complements.

Example 2
Suppose the R&D department of a computer company estimates that the own price elasticity of demand
for a particular desktop computer is -1.7. If the company cuts prices by 5 percent, will computer sales
increase enough to increase overall revenue?

Solve for %Q in:

In other words, the quantity of computers sold will rise by 8.5 percent if prices are reduced by 5 percent.
Since the percentage increase in quantity demanded is greater than the percentage decline in prices:
|E > 1|, the price cut will actually raise the firms sales revenues.


Price Elasticity of Demand Formula:

) (

)


The term (

) is simply the slope coefficient on the price of gasoline in our demand function (-12,500).
Given elasticity = 0.085, a 1% increase (decrease) in price will lead to an increase (decrease) of 0.085% in
the quantity of gasoline demanded.

Use the same formula to calculate both income elasticity of demand and cross price elasticity of demand
(substitute income or price of substitutes in equation for P).

VIII) Imposition of an effective maximum price (price ceiling) by the government results in excess demand, while
imposition of an effective minimum price (price floor) results in excess supply
IX) Imposition of an effective quota reduces supply. Payment of a subsidy to producers increases supply.
X) Imposition of a tax on suppliers reduces supply. Imposition of a tax on consumers reduces demand
XI) Imposition of a price ceiling will reduce price and decrease the traded quantity to the quantity supplied at a
reduced price. Imposition of a price floor will increase price and decrease the traded quantity to the quantity
demanded at the increased price. Imposition of taxes on either producers or consumers will increase price
(including tax) above the previous equilibrium price, decrease price (excluding tax) below the previous
equilibrium level, and decrease the traded quantity to the same amount in either case.
XII) Demand curve is flatter the closer the substitutes for the good
XIII) Shortages
A) US energy crisis of the 1970s and Californias pricing regulated electricity in 2002
B) Markets take care of perceived long-term lack of supply: prices rise quantity demanded falls
quantity supplied rises when prices get high enough the market moves to substitutes or
replacements via R&D

XIV) Pricing Game (Prisoners Dilemma)


A) Equilibrium

Firm B (right # in box)

Firm A
(left # in box)
Strategy Low Price High Price
Low Price (0,0) (50,-10)
High Price (-10,50) (10,10)
i) Determine ones best response for each response by the other player (i.e. if they decide to pick low
or high)
ii) Dominant Strategy: strategy in which ones best response is the same no matter what the other
person does
iii) The equilibrium of the game is at the intersection of the dominant strategies Low Price
equilibrium that does not maximize the interactive gains for the players (High Price)
B) Market and Social Implications
i) Lower prices are good for the market (not just the customers)
ii) Acting in own self-interest does not promote collective interest of the group (or market)
iii) Excessive advertising/lobbying dependent on how excessive other firms actions are potentially
cancel out both efforts
iv) Lawsuits are another example of prisoners dilemma (first to sue has an advantage in picking the
most favorable court for their case)