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ECB1MI

Microeconomics, Institutions and Welfare


Lecture 1
Prof. Dr. Stephanie Rosenkranz
Dr. Annette van den Berg
Drs Linda Keijzer
Drs Joyce Delnoij
Drs Sergei Hoxha
Drs Oke Onemu
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Important information about the course


Schedule:

one lecture per week (Monday)


one test (45 Minutes) on MyLabsPlus per week
(Wednesday 6 PM until Sunday 11PM)
two tutorials a week (Wednesday, Friday)
but only one tutorial in week 47 (check schedule on WebCT!!)

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Important information about the course


Material:

Pindyck and Rubinfeld, 8th ed.


Chapters 1- 4, 6 -14, 16 -18
Book Chapter Institutional Economics
Lecture notes (see course details)
same book is used in course Intermediate Microeconomics
(remaining chapters + Game Theory)
Problem sets
MyLabsPlus (MLP)
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Problem sets:
=> Treated in tutorials (see folders Course Content on
Blackboard)

multiple choice questions


open questions

=> Active participation counts

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Look at sample exam


2 mid-term examinations (100% multiple choice,
see MLP) course week 4 and course week 7
end-term examination (100% open questions,
see tutorial questions) course week 9

Final grade: 30% Midterms (15% each), 70% final exam

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Effort requirements
1. MyLabsPlus
=> Log in (see folders Course Information on Blackboard)

Username (login name):


Password:

student number
student number

=> Code (comes with the book, can be bought via MLP)
=> Multiple choice questions

Have to be done in once


Limited time

2. Active participation in class


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Blackboard

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What is microeconomics about?


How do economic agents allocate scarce resources

Consumers
Workers
Households
Firms
Politicians
etc.

time
money
production factors,
etc.

Scarcity making choices = trade-offs


Markets
Interaction of economic agents on markets determine prices (demand and
supply) Trade-offs are based on prices
Strict assumptions
- rational, consistent choices (w.r.t information and preferences)
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- optimizing behaviour maximizing utility or maximizing profit/revenue

Theories and Models


In economics, explanation and prediction are based on theories.
Theories are developed to explain observed phenomena in terms
of a set of basic rules and assumptions.
A model is a mathematical representation, based on economic
theory, of a firm, a market, or some other entity.

Theories and Models

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Assume you are an alien on your first


visit to Earth
You see this animal and you are told it is called a dog.

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Assume you are an alien on your first


visit to Earth
Then you see these very different animals. Are these dogs?

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Panda dogs are the new rage in China. Most are


chows that have undergone cosmetic primping to
have them appear as pandas.

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Assume you are an alien on your first


visit to Earth
Slowly but surely a dog-model emerges in your mind:

Does any individual case of a dog look like this? NO


Does it help you to define and identify dogs? YES
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Theories and Models

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Theories and Models

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Positive versus Normative Analysis

positive analysis
Analysis describing relationships of cause and effect.

normative analysis
Analysis examining questions of what ought to be.

Agenda for today:


1. Introduction to demand and supply
what is a demand curve, what is a supply curve
the notion of equilibrium
2.

3.
4.
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Shifts in demand and supply


the effect on equilibrium
Elasticities, short term and long term
Government intervention
the effect on equilibrium
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1. Introduction to demand and supply


The Demand Curve

demand curve Relationship between the quantity of a


good that consumers are willing to buy and the price of the
good.
We can write this relationship between
quantity demanded and price as an equation:

QD = QD(P)
or
P = P(QD)
(inverse demand function)

(individual) Demand Curve

(Shift along the demand curve)

Q2

Note: downward sloping curve


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Aggregate demand

4
4

11
8

12

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Note:
Aggregate demand is always less steep than individual demand
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The Supply Curve

supply curve Relationship between the quantity of


a good that producers are willing to sell and the price
of the good.
We can write this relationship between
quantity supplied and price as an equation:

QS = QS(P)
or
P = P(QS)
(inverse supply function)

(individual or market) Supply Curve

(Shift along the


supply curve)

Q2

Note 1: upward sloping curve


Note 2: derivation of aggregate supply is similar to derivation of aggregate demand
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(Competitive) Market Equilibrium: Q`D(P) = QS(P)

Conditions:
1) Free entry/exit
2) Homogeneity
3) No market power
4) Transparency

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One market price


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Market mechanism leading to equilibrium

Now, suppose that originally


the price is above P0: surplus

P(QS) > P(QD)


underbidding
P(QS)
QS and QD
(shifts along the curves)
until QS = QD
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2. Shifts in demand and supply

When a non-price determinant of demand (or supply) changes


the curve shifts.
These "other variables" are part of the demand (or supply)
function. They are "merely lumped into the intercept term of a
demand (or supply) function."
Thus a change in a non-price determinant of demand (or supply) is
reflected in a change in the x-intercept causing the curve to shift
along the x axis.

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A shift of the (whole) demand curve

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Due to one of the following changes ():


1) number of consumers
2) disposable income
3) taste and preferences
4) prices of related goods (substitutes and complements)
5) expectations

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Effect of demand change on equilibrium

So, shift of demand curve


leads to shift along supply curve !

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The Economist explains


Why it is cheaper to buy property in Berlin
than in other European capitals
Nov 6th 2014, 23:50
Property prices continue to climb in London
and in other major European cities, but Berlin
has defied the trend

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A shift of the (whole) supply curve


S

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Due to one of the following changes ():


1) number of suppliers (or magnitude of supply)
2) technology
3) production costs (and management skills)
4) government policies

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Effect of supply change on equilibrium

So, shift of supply curve


leads to shift along demand curve !

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3. Elasticities

Measuring effects of changes in prices or other


factors on demand or supply.

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The importance of elasticities

Elasticity Percentage change in one variable resulting from


a 1-percent increase in another.
Price elasticity of demand Percentage change in quantity
demanded of a good resulting from a 1- percent increase in
its price.

(2.1)

The importance of elasticities

In other words:
the elasticity measures the sensitivity to a price change
Hereafter:
1) Price elasticity of demand (most slides)
2) Price elasticity of supply (one slide)
3) Income elasticity (one slide)
4) Cross-price elasticity (one slide)

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The importance of elasticities (II)


the degree in which a % price change
leads to a % change in the quantity demanded

In other words: the relationship between %P and %Q


P

P0
P1
D
D
Q0 Q1

Q is very small
= relatively inelastic demand

Q0

Q1

Q is very big
= relatively elastic demand

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The importance of elasticities (III)


the degree in which a % price change leads
to a % change in the quantity demanded (or supplied)

10

P0

P1

Task 2: calculate
the elasticities
at (P0, Q0) for both
functions.

(Q1-Q0)/Q0
(P1-P0)/P0

D
D
Q0 Q1
20 22
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Q0

Q1

20

30

Q
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The importance of elasticities (IV)


the degree in which a % price change leads
to a % change in the quantity demanded (or supplied)

10

P0

P1

(Q1-Q0)/Q0
(P1-P0)/P0

D
D
Q0 Q1
20 22
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Q0

Q1

20

30

Q
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The importance of elasticities (V)


Relatively elastic: if E < 1 or: if E > 1

Relatively inelastic: if 1 < E < 0 or: if 0 < E < 1


turning point is at E = 1 (unit elasticity)
What does it mean if E = 1?
When a price rises with, say, 10%, demand decreases with 10%
What does it mean if E = 0.5?
When a price rises with, say, 10%, demand decreases with only 5%
What does it mean if E = 2.5?
When a price rises with, say, 10%, demand decreases with 25%
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The importance of elasticities (VI)

Q
P

= first derivative
(slope) of (demand)
function

E = -2 * 2/4 = -1
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E=

-2 * 1/6 = -1/3
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The importance of elasticities (VII)

Elastic part of the (linear) demand curve: E < 1

Inelastic part of the demand curve: 1 < E < 0


Note: Each point on a linear,
downward sloping curve gives
a different value for E
and each linear curve,
irrespective of its steepness, has
elastic and inelastic points
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The importance of elasticities (VIII)


With linear demand curves, we see a
steady relationship between
E(lasticity) and TR (total revenue):

(TR = P*Q)
1
6

TR

6
4
3.5
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1. If E is elastic, a decrease in the


price leads to rising revenue

2. If E is inelastic, a decrease in the


price leads to declining revenue

policy implications!

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The importance of elasticities (IX)

Two extremes:
Infinitely Elastic

Completely Inelastic

(the slope is infinite)


(i.e. demand is very sensitive to P)

(the slope is 0)
(i.e. demand does not react to P at all)

Perfectly elastic demand: good has a large number of very close (that is, perfect) substitutes41
in-consumption readily available. Examples??
Perfectly inelastic demand: good has absolutely no substitutes-in-consumption.

The importance of elasticities (X)


Short-term (SR) versus Long-term (LR) elasticities
Market for gasoline

Market for automobiles

Q (SR) < Q (LR)


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Q (SR) > Q (LR)


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Price elasticity of supply


the degree in which a price change
leads to a change in the quantity supplied

EP =

(Q1-Q0)/Q0
(P1-P0)/P0

Suppose P1 = 10
P3 = 12
Q1 = 10
Q3 = 14
Calculate EP
EP = +40%/+20% = 2
if EP > 1 elastic supply; if 0 < EP < 1 inelastic supply

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Income elasticity and cross-price elasticity


Recall: Demand curve may shift due to:
1)
2)
3)
4)

number of consumers
income
preferences
price substitution goods
price complementary goods

Cross-price elasticity:
the degree in which a % price
change in a substitution good or
complementary good leads to a
change in the quantity demanded
of another good
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(formulas are in the book, p. 35)

Income elasticity:
the degree in which
a % income change leads
to a % change in the
quantity demanded

Substitution goods show


a positive sign for E;
Complementary goods show
a negative sign for E.
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4. Effects of government interventions


Price controls are governmental impositions on the prices
charged for goods and services in a market.
A price ceiling is a government-imposed limit on the price
charged for a product. Governments often impose price ceilings
to protect consumers from conditions that could make
necessary commodities unattainable.
A price floor is a government-imposed limit on how low a
price can be charged for a product.

Government intervention the effect on equilibrium I


Introduction of maximum price

Price ceiling

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Interference with free market leads to a trade-off decision: 46


Some people gain and some lose from price controls.

Government intervention the effect on equilibrium II


Introduction of minimum price

Price floor
Pmin

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Excess supply ?

Only in combination
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with price support!

Thank you for


your attention
and see you next
week!

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