Introduction - Themes of microeconomics

Pindyck and Rubinfeld

Tradeoffs
Resources are finite and must be allocated somehow among different economic
agents. Economic agents (workers, consumers and firms) have to choose among
different possibilities. For instance, with a finite budget, a consumer may have
to choose whether to buy 6 units of books and 4 units of food or 7 units of food
and 2 units of books, or some other combination. Microeconomics studies how
the consumer optimally makes a choice among various combinations of goods.
It also studies how a worker, with a limited amount of time, allocates time
between working and leisure. Firms are constrained by factories production
capacity and financial resources. Microeconomics studies how the firm chooses
how much to produce, what to produce, and which input combination to use,
given its constraints.
Prices and Markets
Economic agents make tradeoffs in part based on the prices they face. For
instance a consumer chooses how to allocate her budget between books and
food partly based on her preferences over these two goods and partly based on
their prices. A worker decides whether to spend an additional hour per day
working or not partly based on the wage he can get. A firm decides whether to
hire more workers partly based on the wages and the prices of other inputs.
Prices are determined by the interactions of consumers, workers and firms.
Section 1.2
What is a market?
A collection of buyers and sellers that through their actual or potential interactions determine the price of a product.
A market includes, but is not limited to an industry. An industry is a collection
of firms that sell the same or closely related products.
Market definition - which buyers and sellers should be included in a particular
market.
Chapter 2 - the basics of supply and demand
NOTE: The following analysis applies to the special case of a competitive market. A firm with market power has no supply curve, because it can partially
determine the price; it does not take price as given. For example, a monopolists
choice of price and quantity depends on the entire demand curve.
Supply and demand curves can be used to describe the market mechanism how a price is determined that causes amount supplied and amount demanded
of a good to be equal (without government intervention).
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The market supply curve shows the total quantity of a good that producers are
willing to sell at each price. Price is normally represented on the vertical axis
and quantity on the horizontal axis of the graph. The relationship can also be
written as an equation, with quantity as a function of price:
QS = QS (P ).
The supply curves of competitive firms do not slope downwards. When the price
rises, the firm never supplies less (it could supply more or the same amount).
Why are producers generally willing to sell more of the good at a higher price?
Let P1 and P2 be two prices such that P1 > P2 . Let Q1 be the quantity supplied
by a firm when price is P1 and Q2 the quantity supplied when price is P2 . This
implies that Q1 and Q2 are the profit-maximizing quantities at prices P1 and
P2 , respectively. So we have:
P1 Q1 C(Q1 ) P1 Q2 C(Q2 ),
P2 Q2 C(Q2 ) P2 Q1 C(Q1 ),
where C(Q) is the firms cost function, and P Q C(Q) is the firms profit at
price P and quantity Q.
Then, rearranging the expressions,
P1 (Q1 Q2 ) C(Q1 ) C(Q2 ), and
C(Q1 ) C(Q2 ) P2 (Q1 Q2 ).
Therefore, subtracting the second line from the first,
(P1 P2 )(Q1 Q2 ) 0.
Since P1 > P2 , this implies Q1 Q2 0, so Q1 Q2 .
This shows that a profit-maximizing competitive firm has a supply curve that
is not downward-sloping.
Other variables that affect supply
There are other variables besides price that can affect quantity supplied. These
include production costs - wages, interest charges and costs of raw materials.
When you draw a supply curve, you assume particular values of these variables.
If one of them changes, the supply curve will shift.
Suppose the cost of raw materials falls. Lower costs make production more
profitable. This causes the supply curve to shift downwards, so that more is
supplied at any price. The same would be true if wages or interest charges fell.
A list of variables that affect the supply curve
a. The technology for production of the good. We will study in detail how
this affects quantity supplied later in the course. One would think that an
improvement in the technology for producing a good would cause the amount
supplied to increase, but this is not always the case.
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b. Prices of inputs. In general when the price of inputs increases, the amount
supplied will decrease, but there are exceptions to this too.
c. prices of other goods sellers could sell: If the price of another good a seller
could sell increases, the amount offered of the initial good will probably decrease.
d. Past and expected future prices. Similar to the analysis for the demand
curve. If past prices have been high and recently fell, the supplier may not
have had time to shift resources to decrease production. For instance, it may
be impossible to fire workers in the short run. If prices stay low for a long time,
it may be possible to lay off workers, sell machinery and do other things to
decrease production. If future prices are expected to be higher than they are
now, a firm will offer less for sale now (if the good is nonperishable), hoarding
it for later sale. If future prices are expected to be lower, a firm will probably
offer to sell more now.
e. The sellers composition also affects amount supplied. The number, size and
internal structure of firms.
f. the legal system (taxes, regulation, enforcement)
g. time period
The response of quantity supplied to changes in price (with other variables held
constant) can be shown by movements along the supply curve. The response
of quantity supplied to changes in variables other than price can be shown by
shifts in the supply curve. Change in supply refers to shifts in the supply curve.
Change in the quantity supplied refers to movements along the supply curve.
The demand curve
The market demand curve shows the total quantity of a good that consumers are
willing to buy at different prices. The relationship between quantity demanded
and price can be written as an equation:
QD = QD (P ).
In general demand curves slope downward, but there are exceptions. Usually,
though, consumers are willing to buy more of a good when its price is lower.
There are other variables besides the price that affect the amount of a good
that consumers are willing to buy. The main one is income. For a normal good,
consumers will demand more of it when income is higher and less when income
is lower. For an inferior good, consumers will demand less of it when income is
higher and more when income is lower.
Consider a normal good. Suppose (real) income levels increase. Then the
quantity demanded will increase at every price. This leads to a rightward shift
in the demand curve. Change in demand refers to shifts in the demand curve
and change in the quantity demanded refers to movements along the demand
curve.

Another variable that affects demand for a good is the price of a complementary
or substitute good. Goods are substitute when an increase in the price of
one leads to an increase in the quantity demanded of the other. Copper and
aluminum are substitute goods, because they can be often substituted for each
other in industrial processes.
Goods are complements if an increase in the price of one leads to a decrease in
the quantity demanded of the other. For example, computers and software. As
the price of computers has dropped over the last decade, more software packages
have been purchased.
A list of variables that affect the demand curve
a. Income of the population. For many goods, demand for a good will increase
when income increases. Such goods are called normal goods. For other goods,
demand will decrease when income increases. Such goods are called inferior
goods.
i. Examples of normal goods?
ii. Examples of inferior goods?
b. Prices and availability of other goods, especially of substitutes and of complements.
i. Good B is a substitute for good A if the consumption of good B can replace
the consumption of good A. Examples of pairs of substitutes (each good is a
substitute for the other): videos and movies in a theater, Honda Civics and
Toyota Corollas,
ii. Good B is a complement for good A if the consumption of good B is associated
with the consumption of good A, or if consumption of good B is necessary for
consumption of good A. Examples: A right shoe and a left shoe, shoes and
shoelaces, a computer and software.
When the price of a complement for a good increases, we expect that demand
for the good will fall if all else is equal. When the price of a substitute for a
good increases, we expect that demand for the good will rise if all else is equal.
Also, past prices of the good in question and expected future prices of the good
affect demand for the good. If people expect the price of a (nonperishable)
good to rise in the future, they may buy more of it now to allow for future
consumption. If people expect the price of a good to fall, they may wait to buy
it later. Past prices affect the demand for a good in the following way. Suppose
gas prices were low until recently, then became high. Buyers will not have had
time to adjust their lifestyle to account for the newly high gas prices, so they will
still demand close to the initial amount of gas demanded when prices were low
(price elasticity of demand is low in the short run). However if gas prices have
been high for a long time, people will have had time to buy more fuel-efficient
cars, move closer to their job, etc. and they will be able to demand less gas.

c. Tastes and perceived quality of the good relative to substitutes, demographics (the population composition by age, sex, education and ethnicity). So for
instance if the population is aging, there may be more demand for drugs for
age-related diseases, hearing aids, magnifying glasses, etc. If the population is
getting more educated there may be less demand for junk food. If the population
is getting more literate there may be more demand for newspapers.
d.legal system (taxes, regulation, enforcement). A tax on a good causes the
effective price of the good to increase for buyers, and thus demand for the good
to fall.
e. The time period in question also affects demand for a good. Example: The
demand for ice cream is bigger in the summer than in the winter. Demand for
a good in the short run may be different than demand in the long run. Over
a long period of time, the demand for any given good is generally bigger and
more elastic than over a short period of time. But there are exceptions - in some
cases the demand is more elastic in the short run. (price elasticity of demand:
the percentage change in demand for a percentage change in price)
Changes in these variables other than price cause the demand curve to shift.
The shift will generally not be parallel. This means that for an upward shift
in the demand curve, increases in demand will be different over different price
ranges. Give an example of a shift in demand for good A due to the creation
of a new substitute product. The initial demand curve is a typical downwardsloping demand curve. Now suppose a competitor offers a new product, good
B, which is a perfect substitute for good A, at a certain price P . Then the
new demand curve for product A will be flat at P and only slope downwards
below P . Consumers will not buy product A at a price above P ; they will
buy product B. But at prices below P the demand curve for product A is the
same as before. This shows that in general the shift will not be parallel. Also,
demand curves are not in general linear.
Given that a demand curve has shifted to the left, what could be some reasons
for this shift?
The market mechanism
A market equilibrium is found at an intersection of the supply and demand
curves (there may be more than one). The market mechanism is the tendency
in a free market for the price to adjust until the quantity demanded equals the
quantity supplied. Supply and demand need not always be in equilibrium it may take time for the market to adjust to the shock. But there is pressure
towards equality of amount demanded and amount supplied that leads the price
to adjust towards an equilibrium price.
When price is above the market-clearing level, there is a surplus - the amount
sellers are willing to supply exceeds the amount buyers are willing to buy. Then
sellers will notice this to prevent their stock from accumulating will lower prices.

When price is below the market-clearing level, there is a shortage. The amount
buyers are willing to buy at that price exceeds the amount sellers are willing to
sell. Buyers may bid up the price, and sellers will raise prices.
In this course we will study both partial equilibrium and general equilibrium
models. Partial equilibrium models, such as the supply and demand model,
focus on a market for a single good. Such models assume negligible income
effects. When the price of a good changes, it causes consumers incomes to
change. The change in incomes could shift the demand curve. But this effect
is not taken into account in partial equilibrium analysis. We do not shift the
demand curve in response to a move along the demand curve.
In general equilibrium analysis, the interaction among markets for different
goods is considered. Changes in prices of each good are allowed to affect the
incomes of the consumers. A change in price of one good will thus have an effect
on the demand for all other goods.
Elasticity
Elasticity measures the response of one variable to changes in another variable. In particular, elasticity is often used to measure the response of quantity
demanded to a change in price. Economists use elasticity as a measure for
this because unlike the slope of the function relating one variable to another,
elasticity does not depend on the units of measurement used.
Suppose we are measuring the response of demand for steel to price changes
using slope of the demand function. First we measure in kilos of steel, in which
the demand function is P = 2Q + 10 (What is the slope of this demand
function, why is there a negative sign in front of the Q, and why is it negative?)
(Because usually quantity demanded falls when price rises). The slope of the
graph relating P to Q is 2. Then we measure in metric tons of steel. When
the unit of steel used is multiplied by 1000, the quantity demanded (in the new
units) is divided by 1000 at each price. So the new relation between P and Q
10
2
2
Q + 1000
. The slope of the graph relating P to Q is 1000
. So the
is P = 1000
slope is not invariant to the units of measurement used.
The elasticity of variable y with respect to variable x (also called the x-elasticity
of y) is the percentage change in y divided by the percentage change in x.
The price elasticity of demand is the percentage change in quantity demanded
divided by the percentage change in price. This is unit free, because percent is
a pure number not depending on units.
Two different concepts of elasticity exist - the arc elasticity and the point elasticity. The arc elasticity between two points (Q1 , P1 ) and (Q2 , P2 ) on the graph
2 Q1 )/((Q1 +Q2 )/2)
of the function Q = f (P ) equals (Q
. The arc elasticity must
(P2 P1 )/((P1 +P2 )/2)
be defined between two different points. Choosing two points on the graph of
P = 2Q + 10 (using kilos as units of measurement), (0, 10) and (4, 2), calcu(40)/2
late the arc elasticity between these two points. (210)/6
= 3/2. Now change
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the units of measurement to metric tons. The function relating P and Q be2
10
comes P = 1000
Q + 1000
. Now the arc elasticity between the points (0, 10) and
(4/10000)/(2/1000)
(4/1000, 2) is
= 3/2.
(210)/6
Arc elasticity can be used when you want to calculate a price elasticity over a
portion of the demand curve or supply curve. For instance if you want to know
the effect on quantity demanded of a tax that increases the price from $8.00
to $10.00, you should use arc elasticity. If you are interested in effects of small
changes in price on other variables (not just the quantity demanded) such as
revenue of sellers, the point elasticity is useful.
Point elasticity is the limit of the arc elasticity when we make the length of the
=
arc small. Formally, the point price elasticity of demand at (Q, P ) is dQ/Q
dP/P
1
(dQ/dP )(P/Q). So, if the demand function is defined by Q(P ) = P 2 , then the
(point) price elasticity of demand at the point (1/4, 2) is (2/P 3 )(P/Q) = P2
2Q ,
which is 2 at that point.
A linear demand function has varying elasticity; high magnitude of elasticity
at low prices and low magnitude elasticity at high prices. Examples: Calculate
the point elasticity of the demand function Q = 4P + 20 when the price is 4
and when the price is 1. Calculate the point elasticity of Q = 1/P at any point.
The following example illustrates the relationship between price elasticity of
demand and sellers revenue:
In 1988 there was a drought which caused the US quantity of wheat to decrease
by 14%. This caused the price of wheat to increase by 46%. This means that the
price elasticity of demand was 14/46 0.3 because in order for the quantity
demanded to decrease by 14%, the price had to increase by 46%. While many
sellers went bankrupt and lost their farms because their wheat crop did not
grow that year, the sellers who were not affected by the drought saw their
incomes rise. This is because the percentage increase in price was more than
the percentage decrease in quantity. (Note that we are using arc elasticity in
this example).
This example illustrates a general relationship between sellers revenue and price
elasticity of demand. When price elasticity of demand Ep is less than 1 in
magnitude and there is a quantity drop, price rises more in % than quantity
falls, so sellers revenue increases. When Ep > 1 in magnitude and there is
a quantity drop, price rises less in % than quantity falls, so sellers revenue
decreases. When the magnitude of Ep equals 1 and there is a quantity drop,
price rises the same in % as quantity falls so there is no change in revenue.
We can also do the same example using point elasticity. Suppose the supply falls
but the demand curve stays the same (Wheat in drought). The price rises. What
is the effect on sellers revenue? Revenue is R(P ) = P D(P ) = price times
quantity sold. It rises if R0 (P ) > 0, the derivative is positive. Use the product
rule to find R0 (P ). Let f (P ) = P . Then R0 (P ) = f 0 (P )D(P ) + f (P )D0 (P ) =

D (P )
D(P ) + P D0 (P ) > 0 if 1 > PD(P
. So again, revenue rises if elasticity is less
)
than one. Similar calculations can be used to show that revenue decreases if
elasticity is greater than one.

So when they know that demand is inelastic, why dont sellers cut output in
order to raise price? The reason is that no individual seller can influence the
market price by cutting their output; such an action would have to be done
jointly by many of the sellers and in a competitive market there are too many
sellers to be able to collude in this way. However, we will talk about such
strategies in the two-seller game theory model.
What is wrong with this argument: When there is a drought, suppose there are
some farmers affected by it and others who are not affected by it. The demand
stays the same, so the demand that was going to the farmers who were affected
by the drought now goes to those who werent affected.
We can also talk about the price elasticity of supply. The arc price elasticity of
supply between two points on the graph of the supply curve is the percentage
change in quantity supplied divided by the percentage change in price. The
point elasticity is defined as above.
How does a shift in the demand curve affect sellers revenue? It depends on
the elasticity of the supply curve and on the elasticity of the demand curve.
In any case, an outward shift of the demand curve will raise revenue and an
inward shift of the demand curve will decrease revenue. But by how much will
revenue rise due to a rightward shift in the demand function? This depends on
the elasticity of the supply curve and of the demand curve.
There is also income elasticity of demand. When income elasticity is less than
0, the good is inferior. In that case the quantity demanded increases when
income decreases and decreases when income increases. When income elasticity
is greater than 0, the good is a normal good. When income elasticity is less
than 1, the good is a necessity. When income elasticity is greater than one the
good is a luxury. Example: P Q = 1/4 so that the spending on the good is a
constant fraction of income. Show that income elasticity of demand equals 1.
Elasticity and time period. Over a longer period, elasticity usually has higher
magnitude. There is more time for adjustment. Example: Gasoline. As price
rises over time, people junk old gas guzzlers and buy more fuel-efficient cars.
But if prices rise a lot in a short period of time, people may not have time to
respond by adjusting their lifestyle to make it possible to buy less.