ECC1000

Principles
p
of
Microeconomics
2010
Larry Cook and Cathy Fletcher
Department of Economics
Monash University

Section 1
Introduction to microeconomics
1.1 Economics: micro and macro
1.2 The economic way of thinking
1.3 Supply and demand

1.1
Economics: micro and macro
"Economics is the science of human choice
in which resources are limited in relation
to human wants, assuming that
individuals are rational maximizers of their
own self
self--interest.
interest "
(Richard Posner, Law and Economics, p.3)

Micro
deals with individual households, firms,
industries and markets
focusses on
- relative prices
- allocation of output, employment etc.
policy issues include:
pricing
g schemes
- minimum and maximum p
- taxes and subsidies
- tariffs and quotas on international trade
- licensing and other entry restrictions

Macro
deals with the economy as a whole,
including both the financial and real sides
focusses on
- the overall price level
- aggregate (i.e. total) output
- aggregate employment and
unemployment
- interest rates and exchange rates

policy issues include:

- monetary policy (changing interest
rates)
- fiscal policy (changing aggregate
government expenditure and taxation)
- supply side policy

1.2
The economic way of thinking
1.2.1 Economic approach
pp
to the study
y of
human behaviour
1.2.2 Constraints and opportunity costs
1.2.3 The laws of supply and demand: an
overview
1.2.4
1 2 4 The price system
1.2.5 Behind the economic system

1.2.1. Economic approach to the

study of human behaviour
Individuals:
(1) make CHOICES
(2) have PREFERENCES
- these tastes or values are taken as
given
- different ways to satisfy

(3) CHOOSE ON BASIS OF SELFINTEREST

- engage in purposeful behaviour
- compare net benefits
b
fi off any action
i
Net benefits = benefits - costs
- ask question is it worth it?
- maximise welfare, satisfaction or
utility
y
- select the alternative with the highest
net benefit

Implications of economic approach:

Individuals respond to incentives/
disincentives and changes in them.
"Economics
Economics is,
is at root,
root the study of
incentives: how people get what they want,
or need, especially when other people want
or need the same thing."
"We all learn to respond to incentives,
negative or positive, from the outset of
life "
life."
"There are three basic flavors of incentive:
economic, social and moral."
(S. Levitt & S. Dubner, Freakonomics: A Rogue Economist
Explores the Hidden Side of Everything, 2005, pp 20-21)

Implications of economic approach: (cont.)

Can predict what people will do in different
circumstances: e.g. if A occurs then B will
result.
(Note the difference between
positive statements, i.e. what is
and
normative statements, i.e. what ought to
be.)
Voluntary exchange is mutually beneficial.

1.2.2

Constraints and
opportunity costs

At any point in time individuals (and

economies) have constraints given by
- resources, i.e. the factors of
production labour, capital and land
- technology
So to have
S
h
more off one thing,
hi
must give
i
up something else - there is no free
lunch.

 The production possibility frontier (PPF)

shows the alternative combinations of
goods and services that can be produced
given resources and technology.
g
gy
Quantity
good y

PPF
a
b
c

Quantity good x

The opportunity cost is the value of the

sacrificed alternative, i.e. the value of
the best alternative foregone.
Increasing opportunity costs:
- in this
example, the
opportunity
cost of an extra
10y is 15x
from point a
and 5x from
point b

PPF

90
80

60

50

40

55 80 85

- an important reason why there are

increasing opportunity costs is that
some factors are better in certain
activities than others ((i.e. factors are
not homogeneous)
y

y
PPF for
person A

y
3

PPF for
person B

PPF for
A and B

1
2

Economic growth and the PPF:

- over time,
increases in
resources and
improvements
in technology
shift the PPF
outwards

PPF1
PPF0

1.2.3

The laws of supply and

demand: an overview
L
Law
off demand
d
d

There is an inverse
relationship
between the price
of a good and the
quantity demanded,
all else constant.

price

(relative
to other
goods)

D
quantity

If the price increases then

- there is a disincentive to purchase
because alternative substitute goods
are relatively cheaper
- its not worth it or its not good value
to purchase the same quantity as
before
Income effect
If the price increases then incomes will be
reduced in real terms because the same money
income buys fewer goods. For 'normal' goods
this also results in less quantity demanded.

Law of supply
There is a positive
relationship
p
between the price
of a good and the
quantity supplied,
all else constant.

price

(relative
to other
goods)

quantity

If the price increases then

- its worth it, i.e. more profitable, to
divert resources to producing more
- the relatively higher price will
compensate for the increased
opportunity costs of producing more

10

Relationship between PPF and supply

The PPF determines the shape of the supply
curve
if the PPF is linear then resources can be
pulled into production at constant opportunity
costs and the supply curve is horizontal
if the PPF is a 'rectangle' then resources can
only be used in a single activity and the
supply curve is vertical
g , then there
if the PPF is concave to the origin,
are increasing opportunity costs and the
supply curve is upward sloping

Equilibrium
If prices are free to
adjust,
j
they
y will
move to equate
quantity demanded
and quantity
supplied.

price

(relative
to other
goods) p
0

D
q0

quantity

11

If quantity supplied exceeds quantity

demanded then there is an excess supply
(oversupply) and pressure for prices to fall.
If quantity demanded exceeds quantity
supplied then there is an excess demand
(shortage) and pressure for prices to rise.

1.2.4 The price system

importance of prices in co-ordinating
decisions of millions of producers and
consumers, each
h pursuing
i
self-interest.
lf i t
t
changes in prices are important signals
- for consumers to either economise on
usage or not
- for producers to divert more or less
resources to various activities
not chaos, but invisible hand
profitable to produce what people want and
to do so efficiently

12

The general equilibrium of the price system

PL

SL

PK

DL
QL

SK
DK
QK

...

PR

SR
DR
QR

f t markets
factor
k t

consumers

producers

goods markets
P1

S1
D1
Q1

P2

S2
D2
Q2

...

Pn

Sn
Dn
Qn

Incomes determined by supply and

demand for goods and factors
Depends on:
inheritance
- human wealth
- capital
productivity and thrift
- work effort
- savings and capital accumulation
luck
- gifts and discoveries
- terms of trade
(= price of goods sold
price of goods purchased)

13

1.2.5 Behind the economic system

Importance of:
property rights: rules governing the
ownership,
p, use and disposal
p
of goods,
g
, factors
of production and assets
institutional framework: laws (formal and
informal) governing human interaction
Note that institutions
define and enforce property rights and
contracts
determine the
distribution of assets, incomes and costs
incentives of market participants
efficiency of market transactions

lead to more prosperous societies when

they are transparent (i.e. subject to
public scrutiny) and predictable (i.e.
consistent)
property rights allow economic freedom
and are clearly defined and enforced
with an impartial judiciary
competition: when individuals strive to
meet the criteria used to allocate something
which is scarce
Note that
when there is scarcity there is an
allocation problem
institutions set the rules of the game as
to how scarce things are allocated

14

 and then the individuals who best satisfy

those rules receive the scarce things
for example, if allocation of a good is by
queuing then the individuals spending
the most time in the q
queue receive the
good
discretion of the seller then those
individuals who most please the seller
receive the good
discretion of government officials then
those
h
individuals
d d l who
h most please
l
the
h
government officials receive the good
market clearing price then those who
are most willing to pay and have the
income receive the good

entrepreneurs: individuals who perceive

gaps between what is and what might be
and the opportunities from closing those
gaps
Note that opportunities arise from using
resources for
productive purposes, i.e. obtaining
income by selling something that people
want to buy;
unproductive purposes, i.e. obtaining a
transfer of income from other people:
war and crime
rent-seeking: use of resources to
obtain privilege, e.g. monopoly
licence, import quota etc.

15

1.3
Supply and demand
1.3.1
1.3.2
1.3.3
1.3.4
1.3.5
1.3.6

Demand
Supply
Equilibrium
Applications
Elasticity
Efficiency of competitive markets

1.3.1

Demand

Demand for a good (or service) depends on

price of the good itself (p)
price of other goods
- substitutes (ps)
- complements (pc)
income (y)
preferences (z)
expected future prices (pe)
population (n)

16

The demand curve

shows the relationship between the quantity
demanded of a good and its price, holding
all else constant
the demand
curve for
a given ps, pc, y,
z, etc.

price

D
quantity

A change in quantity demanded

vs
a change in demand
If the price of a good itself changes then
there is a
movement along its' demand curve
change in quantity demanded
price
a

p0

p1

D
q0

q1

quantity

cont...

17

If another determinant of demand changes

(e.g. ps) then there is a
shift of the demand curve
change in demand,
demand either
- an increase in demand, or
- a decrease in demand
price

p0
D2

D0

D1
quantity

Demand increases if
price of substitutes increases (ps )
price of complements decreases (pc )
income increases (y ) and the good is
normal
income decreases (y ) and the good is
inferior
preferences for the good increase (z )
expected future prices increase (pe )
population increases (n )
Demand decreases if
ps
etc etc

18

1.3.2

Supply

Supply of a good (or service) depends on

price of the good itself (p)
price of other goods
- substitutes in supply (pss)
- complements in supply (pcs)
- intermediate inputs (pi)
prices of factors of production
- labour (w)
( )
- capital and land (r)
technology (t)
expected future prices (pe)
number of suppliers (ns)

The supply curve

shows the relationship between the quantity
supplied of a good and its price, holding all
else constant
price

the supply
curve for
a given pss,
pcs, pi, w, t,
etc.
etc

quantity

19

A change in quantity supplied

vs
a change in supply
If the p
price of a g
good itself changes
g then
there is a
movement along its' supply curve
change in quantity supplied
price

p1

p0

a
q0

q1

quanity

cont..

If another determinant of supply changes

(e.g. pss) then there is a
shift of the supply curve
change in supply, either
an increase in supply, or
a decrease in supply
price

S2

S0

S1

p0

quantity

20

Supply increases if
price of substitutes in supply decreases
(pss )
price of complements in supply increases
( cs )
(p
price of intermediate inputs decreases (pi )
wage rates decrease (w )
rental rates decrease (r )
technology improves (t )
expected future prices decrease (pe )
number of suppliers increases (ns )
Supply decreases if
pss
etc etc

1.3.3

Equilibrium

If prices are free to adjust, they will move to

equate quantity demanded and quantity
supplied
supplied.
price
S

p0

D
q0

quantity

21

Economic analysis
comparative statics
start with market equilibrium
introduce
i t d
a shock
h k holding
h ldi
other
th things
thi
constant
compare the before and after
micro
usually use partial equilibrium analysis
focus on a single market holding things in
other markets constant

Example:
analysis of an increase in demand
price

S0

p1

p0

q0 q1 q2
price

D0

D1

quantity
quantity

p1

q1

p0

q0
0

time

time

22

1.3.4

Applications
Exercises

Analyse
A
l
the
th effects
ff t off an increase
i
in:
i
price of substitute goods in demand
price of intermediate inputs
income
technology
etc etc

Preview of supply and demand in

markets other than consumer goods
markets:
(1) asset markets
(2) factor markets
(3) foreign exchange markets

23

(1) Asset markets

Portfolio choice question is how to hold
wealth between different assets: shares,
property,
p
p y, bonds,, cash etc.
All else constant, a higher asset price will
reduce the yield or return from holding that
asset so that
the asset doesnt represent good value
relative to other assets and so
the quantity demanded would be less
At any point in time, the supply of each asset
is fixed so prices are demand determined.

Example: an increase in profitability

increasing dividend payments to share
holders.
price
of
shares

SS

pS 1
pS 0

DS 1
DS 0
qS 0

quantity of shares

24

(2) Factor markets

Producer demand for inputs depends on
profitability of purchasing inputs, i.e. value
of output
p p
produced by
y the input
p less costs of
the input.
All else constant (including the price of
output) a lower price of an input will
make it worthwhile for producers to utilise
o e of
o that
t at input
put increasing
c eas g the
t e quantity
qua t ty
more
demanded
but suppliers of the input will find it less
attractive and will provide a smaller
quantity.

Example: an increase in productivity in the

labour market (assuming wages are market
determined).
SL

pL=w
w1
w0

DL 1
DL 0
qL 0

qL1

qL

25

(3) Foreign exchange markets

Underlying the supply of FX are export
earnings, capital inflows etc while underlying
the demand for FX are demand for imports,
p
,
capital outflow etc.
All else constant (including the price of
domestic goods), a higher price of FX will
make domestic goods cheaper for
y
, increase export
p
sales
overseas buyers,
and increase the quantity supplied of FX
make imported goods more expensive for
domestic buyers, decrease imports and
decrease the quantity demanded of FX.

Example: an increase in demand for imports

(assuming floating exchange rates).
pFX = e
SFX

e1
e0

DFX 1
DFX 0
qFX 0 qFX 1

qFX

26

1.3.5

Elasticity

measure of responsiveness of one variable to

another holding all else constant
if responsive,
responsive , refer to as elastic
elastic
if unresponsive, refer to as inelastic
in general
ab = elasticity of a with respect to b
= (% a ) (% b )
where
denotes change in,
a is the dependent variable, e.g. quantity
demanded and
b is some independent variable, e.g. price
of the good

look at four important elasticities

(1)
(2)
(3)
(4)

price elasticity of demand

i
income
elasticity
l ti it off d
demand
d
cross-price elasticity of demand
price elasticity of supply

27

(1) Price elasticity of demand

= (% q) (% p )
where
%q =
=
%p =
=

100
100
100
100

( q q0 )
((q1-q0) q0 )
( p p0 )
((p1-p0) p0 )

p1

b
a

p0
q1

q0

D
q

Note that for the base of the percentage

change we are using the starting point (p0 ,
q0) but could use the average ((p0+p1)/2,
(q0+q1)/2)
Also is negative but usually ignore the sign

Linear demand curves

elasticity varies along the demand curve
elastic at the high end
unitary
y elasticity
y point
p
inelastic at the low end
except in 2 special cases
perfectly inelastic
( = 0)
p

perfectly elastic
( )

p0

D
q0

28

Elasticity and total revenue (TR)

TR = p q
if p then q so what
elastic demand
unitary elasticity
inelastic demand

happens
( > 1))
( = 1)
( < 1)

Determinates of

to TR?
TR
TR constant
TR

substitutability with other goods

(n.b. the more narrowly defined, the more
substitutes)
proportion of income spent on good
timeframe

(2) Income elasticity of demand

y = (% q) (% y)
Note that
y > 0 for normal goods
y < 0 for inferior goods

29

(3) CrossCross-price elasticity of

demand
The cross-price elasticity of demand for
good
d a with
i h respect to the
h price
i off good
db
x = (% qa) (% pb)
Note that
x < 0 for complementary goods
x = 0 for independent goods
x > 0 for substitute goods
x for perfect substitutes

(4) Price elasticity of supply

s = (% qs) (% p )
Two special cases
perfectly inelastic s = 0
perfectly elastic s
Determinants of s
technological conditions - availability and
substitutability of inputs
timeframe

30

1.3.6

Efficiency of competitive
markets

"By
By a process of voluntary exchange,
resources are shifted to those uses in
which the value to consumers, as
measured by their willingness to pay,
is highest.
g
When resources are being
g
used where their value is highest, we
may say that they are being employed
efficiently."
(Richard Posner, Law and Economics, p.10)

Competitive demand price measures

the benefit of each marginal unit (i.e.
the marginal benefit MB).

price
b

MB1
MB2
area 1 =
abc
c

area 2 =
oacd
D = MB

o 12

quantity

31

Total (gross) benefit to consumers,

TB = value in use
= sum of MB
= areas (1) + (2)
Total cost to consumers (total revenues paid
to producers),
TR = value in exchange
= area (2)
Net benefit to consumers,
NB = TB - TR
= consumer surplus = CS
= $ amount needed to compensate
consumers if didnt allow
consumption
= area (1)

Competitive supply price measures

the opportunity cost of each marginal
unit (i.e. the marginal cost MC).

price
area 2a =
eac

MC2
MC1

S = MC
area 2b =
oecd

e
o 12

quantity

32

Total (gross) revenue to producers,

TR = value in exchange
= areas (2a) + (2b) = area (2)
p
,
Total cost to producers,
TC = opportunity cost of resources
= sum of MC
= area (2b)
Net revenue to producers,
NR = TR - TC
= producer surplus = PS
= $ amount needed to compensate
producers if didnt allow production
= area (2a)

At equilibrium, the marginal net

benefit MNB of producing an
additional unit is zero.
price
S = MC

D = MB
MNB

q0

quantity

+
0
-

q0

quantity
MNB = MB - MC

33

Thus competitive markets maximise

total net benefits of both consumers and
producers
sum of CS and PS = areas (1) + (2a)

price

S = MC
1

p0

2a
2b
D = MB
q0

quantity

So there are losses (i.e. CS and PS are

less) when overproducing.
price

S = MC
deadweight
loss

P0
D = MB
MNB

q0

q1

quantity

q1

quantity

+
0
-

q0

MB - MC

34

and there are losses (i.e. CS and PS are

less) when underproducing.
price

S = MC

P0
D = MB
MNB

q1

q0

deadweight
loss

quantity

+
0
-

q1

q0

quantity
MB - MC

35