FRANK & BERNANKE CHAPTERS 1-4:

THE HIGHLIGHTS

MBA 525 Microeconomics

Lecture 1 2

Basic concepts in economicsMicro Economics vs. macro economicsOpportunity cost, scarcity, “no free lunch”Opportunity cost examples“Reservation prices” (WTPThe Cost-Benefit Principle and “rational behavior”Marginal analysis and quantity decisionsEconomic surplus (consumer surplus and

producer surplus)Decision Pitfalls  

Lecture 2 3

The principle of comparative advantageGeneralizing vs. specializing at the individual

level“Low hanging fruit”The principle of comparative advantageExamples illustrating gains from tradeIf trade is good, why do we see opposition to

trade? 

Lecture 3 4

Supply and Demand (price determination)Definition of a “market”“Demand” (MB, WTP), Demand schedule, Demand

curve“Supply” (MC, WTA), Supply schedule, supply curveMarket equilibrium (equilibrium principle and

efficiency principle)Shortages and surplusesChanges (shifts) in supply and demandPrice controls 

Lecture 4 5

Elasticity measuresThe price elasticity of demandElastic vs. Inelastic demandDeterminants of demand elasticityChanges in price elasticity of demand along the

length of a demand curveChanges in revenue from price changes depend

on the price elasticity of demandThe income elasticity of demandThe cross-price elasticity of demandThe price elasticity of supply

Overall themes6

“Economic Naturalism”Using insights from economics to make

sense of observations from everyday life E.G. Look for differences in costs and benefits

Recognizing and appreciating resource scarcity and opportunity costs

Understanding the way markets work

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Lecture 1 key concepts

Opportunity Cost8

Opportunity Cost: The value of the next-best alternative that must be forgone in order to undertake an activity

Decisions depend upon opportunity costs It is not the combined value of all other forgone

activities, just the next best one

Cost-Benefit Principle9

Take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs

Measuring the costs and benefits is often difficult One may have to use assumptions and/or approximations Helps us answer “yes/no” questions

Economists assume that people make decisions this way. i.e. we assume that people are “rational”.

“Rational” here means only pursuing actions where the benefits are at least as great as the costs.

Reservation Prices10

For a consumer, reservation price is the highest price one would be willing (and able) to pay for a good.

This “maximum willingness-to-pay (WTP)” should be the same as the benefit (value) received from the good.

For a producer, reservation price is the lowest price one would be willing (and able) to accept for a good or service.

This “minimum willingness-to-accept (WTA)” should be the same as the cost (expense) incurred in producing the good.

Economic Surplus11

The benefit of taking an action minus its cost Rational decision makers take all actions that yield a

positive economic surplus Should you buy or sell an item if surplus = 0?

Consumer surplus = reservation price – actual price

Producer surplus = actual price – reservation price

Marginal Analysis12

Comparing incremental or additional costs and benefits to help make quantity decisions.

Marginal Benefit The increase in total benefit that results from carrying out

one additional unit of the activityMarginal Cost

The increase in total cost that results from carrying out one additional unit of the activity

Can be considered more powerful than traditional CBA, because marginal analysis leads us to the “best” answer (maximum surplus), while CBA only allows for “good” answers (non-negative surplus).

Marginal Analysis

Example: How many slices of pizza to eat?

Assume: P = $1.50 per slice

Note: P = cost of an additional unit = marginal cost

Q MC MB

1 $1.50 $4.00

2 $1.50 $3.00

3 $1.50 $2.00

4 $1.50 $1.00

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Finding the optimal quantity 14

If the marginal benefit is greater than marginal cost Increase output (consume or produce more)

If the marginal benefit is less than the marginal cost Decrease output (consumer or produce less)

Optimal output is where marginal benefit equals marginal cost MB = MC

The principle of diminishing marginal benefit

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The additional satisfaction received from units of a good tends to diminish as more units are consumed.

Marginal benefit curves will be downward-sloping Assumes all units are of the same quality Addictive goods may be an exception

Decision Pitfalls16

It is a mistake to use proportions to make decisions (use dollars instead).

It is a mistake to ignore opportunity costs (opp costs are real economic costs that should influence our decisions).

It is a mistake to use average costs and benefits to make quantity decisions (use marginal costs and benefits).

It is a mistake to consider sunk costs (sunk costs are unrecoverable and they do not affect opportunity costs or marginal costs).

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Lecture 2 key concepts

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The Principle of Comparative Advantage

If nations (or individuals) specialize in producing goods for which they have low opportunity cost and trade for goods for which they have high opportunity cost, then they can consume more via trade. Trade leads to higher standards of living.

“Comparative advantage” means being able to do something at lower opportunity cost than someone else. Sources of Comparative Advantage?

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Principle of Increasing Opportunity Cost

AKA “The Low Hanging-Fruit Principle” In expanding the production of any good, first employ

those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs

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Why trade barriers & opposition to trade?

International trade does increase the total value of all goods and services, but certain industries may be harmed.

Putting all your eggs in one basket may be unwise if trading partners have unstable economies or politics

Putting all your eggs in one basket may be unwise if the future market for that commodity or product is uncertain

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Example of Comparative Advantage and Mutual Gains from Trade

Assume that Lara and Leah can spend the day either washing cars or mowing lawns. The table below shows how much of each task they could accomplish in one day if they spent the whole day doing just that task. For example, Lara could wash 20 cars or mow 5 lawns in one day.

______________________________________________ Lara Leah______________________________________________Cars washed 20 15 Lawns mowed 5 3______________________________________________

Question: Use the principle of comparative advantage to illustrate how specialization can make them more productive than they can be alone.

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Lecture 3 key concepts

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An Introduction to Supply and Demand

What is a market? Where do prices come from? What happens if prices are set “too high”? What happens if prices are set “too low”? Do markets really achieve equilibrium?

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Demand

Shows the total quantity of a good or service that buyers wish to buy at each price On a graph = demand curve In a schedule = demand schedule

Inverse relationship between P and QD

As price rises, consumers want fewer items People switch to substitutes People cannot afford as much

At higher quantities, consumers are willing to pay less (application of the principle of diminishing marginal utility/benefit)

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Daily Demand Curve for Hamburgers

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Supply

Shows the quantity of a good or service that sellers wish to sell at each price On a graph = supply curve In a schedule = supply schedule

Positive relationship between P and QS As price rises, a higher quantity can be sold

because more opportunity costs can be covered Application of the “low-hanging fruit principle” Reflects the rising marginal costs of producing

additional units

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Daily Supply Curve of Hamburgers

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Market Equilibrium

When all buyers and sellers are satisfied with their respective quantities at the market price There is a stable, balanced, unchanging situation The supply and demand curves intersect This results in the equilibrium price

The price the good sells for This results in the equilibrium quantity

The quantity that will be sold Do markets really exist in equilibrium?

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The Equilibrium Price and Quantity of Hamburgers

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Disequilibrium

Excess supply “Market Surplus” Price is higher than equilibrium price Sellers are dissatisfied

Excess demand “Market Shortage” Price is lower than equilibrium price Buyers are dissatisfied

Free markets have an automatic tendency to eliminate excess supply and excess demand A market surplus serves as a signal to sellers that price is

too high and therefore leads producers to decrease the price

A market shortage serves as a signal to sellers that price is too low and therefore leads producers to increase the price

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Markets and Efficiency

Efficiency Principle Efficiency is an important social goal Everyone can have a larger slice of a larger pie

Equilibrium Principle A market in equilibrium leaves no unexploited

opportunities for individuals No “cash on the table” remains All opportunities for profit have been exploited

Efficiency occurs when the market-demand curve captures all the

marginal benefits of the good the market-supply curve captures all the

marginal costs of the good

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Shifting supply and demand

Several factors cause changes in demand or supply If there is a “change in demand”, we shift of the

entire demand curve If there is a change in supply”, we shift of the

entire supply curve Change in supply or demand cause equilibrium

price to change. Price changes are the RESULT of shifts, not the

CAUSE of shifts

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Shifts in Demand

1. Change in price of complement goods2. Change in price of substitute goods3. Change in consumer Income

normal v. inferior goods4. Change in consumer preferences5. Change in consumer expectations about price6. Change in consumer expectations about

income normal v. inferior goods

Demand curve shifts rightward higher equilibrium price and higher equilibrium

quantity Demand curve shifts leftward

lower equilibrium price and lower equilibrium quantity

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Shifts in Supply

1. Change in input or factor prices 2. Change in current production technology 3. Change in prices of other goods that can be

produced with the same inputs 4. Change in the number of sellers in the market

Favorable changes to the producer shift supply curve rightward

lower equilibrium price and higher equilibrium quantity Unfavorable changes to the producer shift

supply leftward higher equilibrium price and lower equilibrium quantity

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Example: An Increase in Demand

Sequence of events:1. Conditions change such that consumers

want more units at any price. Egs: lower price of complement good, higher price of a substitute, higher income, …

2. Higher Qd at all prices means rightward shift in the demand curve

3. Demand shifts right (along supply) resulting in higher P* and Q*

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The Effect on the Market for Tennis Balls of a Decline in Court Rental Fees

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Example: An Increase in Supply

Sequence of events:1. Conditions become more favorable to

firms. Eg: lower cost of inputs2. Firms now can earn higher per-unit

profits at any price, so they wish to sell more units at all prices.

3. Firms increase Qs for all Prices = shift right in the supply curve (along demand).

4. Shift results in lower P* and higher Q*

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The Effect on the Market for New Houses of a Decline in Carpenters’ Wage Rates

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Simultaneous Shifts

In reality, several factors may be changing at the same time.

Example: suppose that consumer income is falling while technology used in production is advancing. Demand decreases (shifts left) and supply increases

(shifts right)Demand shift implies a lower price & lower quantitySupply shift implies a lower price, higher quantityWe can predict that price will fallBut, what happens to quantity?

We must know the magnitude of the shifts

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Legislation and Markets

Legislators protect producers and consumers by using price controls Price ceilings Price floors

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Price controls

price ceilings – intended to help consumers A maximum allowable price specified by law because

the true equilibrium price was deemed “too high” Price ceiling price < P* so now consumers want too

much e.g. rent controls, limits on the price of gasoline Result in permanent shortages

price floors – intended to help producers A minimum allowable price specified by law For example, agricultural price supports, minimum wages Price floor price is > P* so now sellers want to sell more Result in surpluses

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Lecture 4 key concepts

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Price Elasticity of Demand

In order to predict what will happen to sales and expenditures (revenue) firms must know how much quantity will change when the price changes.

The price elasticity of demand is the percentage change in the quantity demanded

that results from a one-percent change in its price

P

QDD

P

%

%

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Price Elasticity

Demand is said to be “elastic” if quantity demanded changes by a lot when price changes even a little price elasticity is greater than one

Demand is said to be “inelastic” if quantity changes by a little even if price changes a lot price elasticity is less than one

Demand is said to be “unit elastic” if quantity changes by the same amount as the price change price elasticity equals one

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Price Elasticity and Expenditures

If demand is elastic: Quantity demanded is highly responsive to price

changes Percentage change in quantity dominates An increase in price will reduce total expenditure A decrease in price will increase total expenditure

If demand is inelastic: Quantity demanded is not very responsive to price

changes Percentage change in price dominates An increase in price will increase total expenditure A decrease in price will decrease total expenditure

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Determinants of Elasticity

Substitution possibilities Price elasticity of demand will be relatively high

if it is easy to substitute between products – Why?

Budget share The larger the share of the budget the good

uses tends to have higher price elasticities of demand – Why?

Time Because substitution takes time, price elasticity

will be higher in the long run than in the short run

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Examples?

What are some goods that will have very elastic demand? Can demand be perfectly elastic? What does an elastic demand curve look like?

What are some goods that will have very inelastic demand? Can demand be perfectly inelastic? What does an inelastic demand curve look like?

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Other Elasticities of Demand

Income Elasticity of Demand The amount by which the quantity demanded changes

in response to a one-percent change in income Positive for normal goods Negative for inferior goods

Cross Price Elasticity of Demand The amount by which the quantity demanded of one

good changes in response to a one-percent change in the price of another good

Positive for substitutes Negative for complements

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Price Elasticity of Supply

The percentage change in the quantity supplied that will occur in response to a one-percent change in its price

slope

QP

PP

QQS

S

P P

Q1%

%

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Elasticity of Supply

What determines whether the supply of a particular good will be elastic or inelastic? Availability of resources used to produce the

good – how quickly and easily can producers respond to a price change?

Eg of good with inelastic supply? Eg of good with elastic supply?

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Perfect Elasticity

Perfectly Inelastic Elasticity of supply is zero Whether the price is high or low, the same

amount is availablePerfectly Elastic

Elasticity of supply is infinite When additional units can be produced using

the same combination of inputs purchased at the same prices

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Naturalist Questions

Why do you pay $6 for a beer in the airport when you can buy the same beer for less than $1 outside the airport?

Why do you get a discounted airfare when you stay over a Saturday night?

Why are there so many personalized license plates in Virginia vs. NC?