economics 349 intermediate micro theory fall 2007 dr. delemeester

Economics 349Intermediate Micro Theory

Fall 2007

Dr. Delemeester

Course Essentials

Course Web Page www.marietta.edu/~delemeeg/econ349

Grade Exams (60%) Problem Sets (25%) Spreadsheet Projects (15%)

http://www.marietta.edu/~delemeeg/econ349

Economic Roundtable …to promote an interest in and to enlighten its

members and others in the community on important governmental, economic, and social issues…

Business networking opportunity Student memberships: $5

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The most important determinant of my success in Economics 349 will be:

0% 0% 0%0%0%

a) My interest in the material

b) The amount of time I put into the class

c) The instructor’s ability to inspire me

d) My mathematical skills

e) None of the above.

a) My interest in the material

b) The amount of time I put into the class

c) The instructor’s ability to inspire me

d) My mathematical skills

e) None of the above.

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21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

41 42 43 44 45 46 47 48 49 50

What Do Schoolteachers and Sumo Wrestlers Have in Common?

How Is the Ku Klux Klan Like a Group of Real-Estate Agents?

Why Do Drug Dealers Still Live with Their Moms?

Where Have All the Criminals Gone? What Makes a Perfect Parent? Would a Roshanda by Any Other Name

Smell as Sweet?

Increasing Residual Wage Inequality: Composition Effects, Noisy Data, or Rising Demand for Skill?

Medium-Term Business Cycles Can Information Heterogeneity Explain the

Exchange Rate Determination Puzzle? Media Frenzies in Markets for Financial

Information An Efficient Dynamic Auction for

Heterogeneous Commodities Matching and Price Competition Paying Not to Go to the Gym On the Simple Economics of Advertising,

Marketing, and Product Design

Introduction

What are the key themes of microeconomics?

What is a market?What is the difference between real and

nominal prices?Why study microeconomics?

Themes of Microeconomics

Microeconomics deals with limits Limited budgets Limited time Limited ability to produce

How do we make the most of limits?How do we allocate scarce resources?


Workers, firms and consumers must make trade-offs Do I work or go on vacation? Do I purchase a new car or save my money? Do we hire more workers or buy new

machinery?

How are these trade-offs best made?


Consumers Limited incomes Consumer theory – describes how

consumers maximize their well-being, using their preferences, to make decisions about trade-offs

How do consumers make decisions about consumption and savings?


Workers Individuals decide when and if to enter the

workforceTrade-offs of working now or obtaining more

education/training What choices do individuals make in terms of

jobs or workplaces? How many hours do individuals choose to

work?Trade-off of labor and leisure


Firms What types of products do firms produce?

Constraints on production capacity and financial resources create needs for trade-offs

Theory of the Firm – describes how these trade-offs are best made


Prices Trade-offs are often based on prices faced

by consumers and producers Workers make decisions based on prices for

labor – wages Firms make decisions based on wages and

prices for inputs and on prices for the goods they produce


Prices How are prices determined?

Centrally planned economies – governments control prices

Market economies – prices determined by interaction of market participants

Markets – collection of buyers and sellers whose interaction determines the prices of goods

Theories and Models

Economics is concerned with explanation of observed phenomena Theories are used to explain observed

phenomena in terms of a set of basic rules and assumptions:

The Theory of the Firm The Theory of Consumer Behavior

Theories and Models

Theories are used to make predictions Economic models are created from theories Models are mathematical representations

used to make quantitative predictions

Black-Scholes Option Pricing Model

Theories and Models

Validating a Theory The validity of a theory is determined by the

quality of its prediction, given the assumptions

Theories must be tested and refined Theories are invariably imperfect – but gives

much insight into observed phenomena

Which of the following is a normative statement?

1 2 3 4 5

Sola

r ener

..

Mer

gers

b...

An in

crea

se ..

If th

e US g

...

25% 25%25%25%a) Solar energy will be used increasingly over

the next 100 years.

b) Mergers between two companies should always be allowed.

c) An increase in advertising by one major auto company will affect the sales of the other auto companies.

d) If the US government lifts the current sugar quotas, the price of sugar will fall and the corny syrup industry will suffer.

a) Solar energy will be used increasingly over the next 100 years.

b) Mergers between two companies should always be allowed.

c) An increase in advertising by one major auto company will affect the sales of the other auto companies.

d) If the US government lifts the current sugar quotas, the price of sugar will fall and the corny syrup industry will suffer.

Positive & Normative Analysis

Positive Analysis – statements that describe the relationship of cause and effect Questions that deal with explanation and

predictionWhat will be the impact of an import quota on

foreign cars?What will be the impact of an increase in the

gasoline excise tax?

Positive & Normative Analysis

Normative Analysis – analysis examining questions of what ought to be Often supplemented by value judgments

Should the government impose a larger gasoline tax?

Should the government decrease the tariffs on imported cars?

What is a Market?

Markets Collection of buyers and sellers, through their

actual or potential interaction, determine the prices of products

Buyers: consumers purchase goods, companies purchase labor and inputs

Sellers: consumers sell labor, resource owners sell inputs, firms sell goods

What is a Market?

Market Definition Determination of the buyers, sellers, and

range of products that should be included in a particular market

Arbitrage The practice of buying a product at a low

price in one location and selling it for more in another location

What is a Market?

Defining the Market Many of the most interesting questions in

economics concern the functioning of markets

Why are there a lot of firms in some markets and not in others?

Are consumers better off with many firms?Should the government intervene in markets?

Which of the following markets do you think is perfectly competitive?

1 2 3 4 5

a) b) c) d) e)

20% 20% 20%20%20%a) The market for local phone

calls.

b) The world soybean market.

c) The world oil market.

d) b) and c)

e) a), b), and c)

a) The market for local phone calls.

b) The world soybean market.

c) The world oil market.

d) b) and c)

e) a), b), and c)

Market Model

Consider the demand for beer during the summer months. Let

Qd = 30 – 5P + 0.01I – 2R

Where Q is measured in thousands of 6-packs, P is the price per 6-pack in dollars, I is income, and R is the number of rainy days during the summer.

Supply is given by Qs = -100 + 20P

a) Plot the supply and demand curves if I = $20,000 and

R = 15. What is the equilibrium price and quantity?

b) If I = $20,000 and R = 10, plot the new demand curve and find the new equilibrium. Compare this to the original equilibrium. Does the movement in P and Q make sense with the decline in the number of rainy days?

Real Versus Nominal Prices

Comparing prices across time requires measuring prices relative to some overall price level Nominal price is the absolute or current dollar

price of a good or service when it is sold Real price is the price relative to an

aggregate measure of prices or constant dollar price


Consumer Price Index (CPI) is often used as a measure of aggregate prices Records the prices of a large market basket

of goods purchased by a “typical” consumer over time

Percent changes in CPI measure the rate of inflation


Calculating Real Prices

yearcurrent yearcurrent

yearbase Price Nominal x CPI

CPI RealPrice

baseyear

Real Price of College

Year Nom. Price

CPI Real Price

1970 $2,530 38.8

1990 $12,018 130.7

2006 $22,218 201.6

$3,569$12,018*130.738.8

$4,276$22,218*201.638.8

$2,530$2,530*38.838.8

You have been hired to examine whether consumption of gasoline has been affected by changes in the price of gasoline over time. To complete the analysis, you need to adjust nominal gasoline prices per gallon for changes in the overall price level. Use the data below to calculate the real price of gasoline for 1977 and 1989 using 1970 dollars.

Year Gasoline Price ($/gallon)

CPI (1982-84=100)

Real Price of Gasoline

1970 0.28 38.8

1977 0.58 60.6

1989 1.10 124.0

0.37

0.34

The Price of a College Education

The real price of a college education rose 69 percent from 1970 to 2006 Increases in costs of modern classrooms and

wages increased costs of production – decrease in supply

Due to a larger percentage of high school graduates attending college, demand increased

Market for a College Education

Q (millions enrolled))

P(annual cost

in 1970dollars)

D1970

S1970

S2006

D2006

$4,276

17.3

New equilibriumwas reached at $4,276 and a quantity of 17.3 million students

$2,530

8.6

Price Elasticity of Demand

Measures the sensitivity of quantity demanded to price changes It measures the percentage change in the

quantity demanded of a good that results from a one percent change in price

P

QE DDP

%

%P

Q

Q

P

PP

QQE D

P


Usually a negative number As price increases, quantity decreases As price decreases, quantity increases

When |EP| > 1, the good is price elastic |%Q| > |%P|

When |EP| < 1, the good is price inelastic |%Q| < |% P|


The primary determinant of price elasticity of demand is the availability of substitutes Many substitutes, demand is price elastic

Can easily move to another good with price increases

Few substitutes, demand is price inelastic


Looking at a linear demand curve, as we move along the curve Q/P is constant, but P and Q will change

Price elasticity of demand must therefore be measured at a particular point on the demand curve

Elasticity will change along the demand curve in a particular way


Q

Price

4

8

2

4

Ep = -1

Ep = 0

EP = -

Elastic

Inelastic

Demand Curve

Q = 8 – 2P


The steeper the demand curve, the more inelastic the demand for the good becomes

The flatter the demand curve, the more elastic the the demand for the good becomes

Two extreme cases of demand curves Completely inelastic demand – vertical Infinitely elastic demand – horizontal

Infinitely Elastic Demand

DP*

Quantity

Price

EP =

Completely Inelastic Demand

Quantity

Price

Q*

D

EP = 0

Other Demand Elasticities

Income Elasticity of Demand Measures how much quantity demanded

changes with a change in income

I

Q

Q

I

I/I

Q/Q EI

Other Demand Elasticities

Cross-Price Elasticity of Demand Measures the percentage change in the

quantity demanded of one good that results from a one percent change in the price of another good

m

b

b

m

mm

bbPQ P

Q

Q

P

PP

QQE

mb

Price Elasticity of Supply

Measures the sensitivity of quantity supplied given a change in price Measures the percentage change in quantity

supplied resulting from a 1 percent change in price

P

QE SSP

%

%

Elasticity: An Application

During the 1980’s and 1990’s, the market for wheat went through changes that had great implications for American farmers and US agricultural policy

Using the supply and demand curves for wheat, we can analyze what occurred in this market


Supply: QS = 1800 + 240P

Demand: QD = 3550 – 266P


QD = QS

1800 + 240P = 3550 – 266P

506P = 1750

P = $3.46 per bushel

Q = 1800 + (240)(3.46) = 2630 million bushels


We can find the elasticities of demand and supply at these points

035.)266(630,2

46.3

P

Q

Q

PE DD

P

032.)240(630,2

46.3

P

Q

Q

PE SS

P


Assume the price of wheat is $4.00/bushel due to decrease in supply

486,2)00.4)(266(550,3 DQ

43.0)266(486,2

00.4D

PE

economics 349 intermediate micro theory fall 2007 dr. delemeester

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