Introduction - Themes of microeconomics

Pindyck and Rubinfeld

Tradeoffs

Resources are finite and must be allocated somehow among different economicagents. Economic agents (workers, consumers and firms) have to choose amongdifferent possibilities. For instance, with a finite budget, a consumer may haveto choose whether to buy 6 units of books and 4 units of food or 7 units of foodand 2 units of books, or some other combination. Microeconomics studies howthe consumer optimally makes a choice among various combinations of goods.It also studies how a worker, with a limited amount of time, allocates timebetween working and leisure. Firms are constrained by factories productioncapacity and financial resources. Microeconomics studies how the firm chooseshow 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. Forinstance a consumer chooses how to allocate her budget between books andfood partly based on her preferences over these two goods and partly based ontheir prices. A worker decides whether to spend an additional hour per dayworking or not partly based on the wage he can get. A firm decides whether tohire 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 interac-tions determine the price of a product.

A market includes, but is not limited to an industry. An industry is a collectionof firms that sell the same or closely related products.

Market definition - which buyers and sellers should be included in a particularmarket.

Chapter 2 - the basics of supply and demand

NOTE: The following analysis applies to the special case of a competitive mar-ket. A firm with market power has no supply curve, because it can partiallydetermine the price; it does not take price as given. For example, a monopolistschoice 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 demandedof 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 arewilling to sell at each price. Price is normally represented on the vertical axisand quantity on the horizontal axis of the graph. The relationship can also bewritten 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 pricerises, 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 suppliedby a firm when price is P1 and Q2 the quantity supplied when price is P2. Thisimplies that Q1 and Q2 are the profit-maximizing quantities at prices P1 andP2, respectively. So we have:

P1Q1 C(Q1) P1Q2 C(Q2),P2Q2 C(Q2) P2Q1 C(Q1),where C(Q) is the firms cost function, and PQ C(Q) is the firms profit atprice P and quantity Q.

Then, rearranging the expressions,

P1(Q1 Q2) C(Q1) C(Q2), andC(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 thatis not downward-sloping.

Other variables that affect supply

There are other variables besides price that can affect quantity supplied. Theseinclude 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 moreprofitable. This causes the supply curve to shift downwards, so that more issupplied 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 howthis affects quantity supplied later in the course. One would think that animprovement in the technology for producing a good would cause the amountsupplied 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 amountsupplied will decrease, but there are exceptions to this too.

c. prices of other goods sellers could sell: If the price of another good a sellercould sell increases, the amount offered of the initial good will probably decrease.

d. Past and expected future prices. Similar to the analysis for the demandcurve. If past prices have been high and recently fell, the supplier may nothave had time to shift resources to decrease production. For instance, it maybe 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 todecrease production. If future prices are expected to be higher than they arenow, a firm will offer less for sale now (if the good is nonperishable), hoardingit for later sale. If future prices are expected to be lower, a firm will probablyoffer to sell more now.

e. The sellers composition also affects amount supplied. The number, size andinternal 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 heldconstant) can be shown by movements along the supply curve. The responseof quantity supplied to changes in variables other than price can be shown byshifts 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 arewilling to buy at different prices. The relationship between quantity demandedand 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 goodthat 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 incomeis lower. For an inferior good, consumers will demand less of it when income ishigher and more when income is lower.

Consider a normal good. Suppose (real) income levels increase. Then thequantity demanded will increase at every price. This leads to a rightward shiftin the demand curve. Change in demand refers to shifts in the demand curveand change in the quantity demanded refers to movements along the demandcurve.

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Another variable that affects demand for a good is the price of a complementaryor substitute good. Goods are substitute when an increase in the price ofone leads to an increase in the quantity demanded of the other. Copper andaluminum are substitute goods, because they can be often substituted for eachother in industrial processes.

Goods are complements if an increase in the price of one leads to a decrease inthe quantity demanded of the other. For example, computers and software. Asthe price of computers has dropped over the last decade, more software packageshave been purchased.

A list of variables that affect the demand curve

a. Income of the population. For many goods, demand for a good will increasewhen income increases. Such goods are called normal goods. For other goods,demand will decrease when income increases. Such goods are called inferiorgoods.

i. Examples of normal goods?

ii. Examples of inferior goods?

b. Prices and availability of other goods, especially of substitutes and of com-plements.

i. Good B is a substitute for good A if the consumption of good B can replacethe consumption of good A. Examples of pairs of substitutes (each good is asubstitute for the other): videos and movies in a theater, Honda Civics andToyota Corollas,

ii. Good B is a complement for good A if the consumption of good B is associatedwith the consumption of good A, or if consumption of good B is necessary forconsumption of good A. Examples: A right shoe and a left shoe, shoes andshoelaces, a computer and software.

When the price of a complement for a good increases, we expect that demandfor the good will fall if all else is equal. When the price of a substitute for agood 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 goodaffect 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 futureconsumption. If people expect the price of a good to fall, they may wait to buyit later. Past prices affect the demand for a good in the following way. Supposegas prices were low until recently, then became high. Buyers will not have hadtime to adjust their lifestyle to account for the newly high gas prices, so they willstill 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 havebeen high for a long time, people will have had time to buy more fuel-efficientcars, move closer to their job, etc. and they will be able to demand less gas.

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c. Tastes and perceived quality of the good relative to substitutes, demograph-ics (the population composition by age, sex, education and ethnicity). So forinstance if the population is aging, there may be more demand for drugs forage-related diseases, hearing aids, magnifying glasses, etc. If the population isgetting more educated there may be less demand for junk food. If the populationis getting more literate there may be more demand for newspapers.

d.legal system (taxes, regulation, enforcement). A tax on a good causes theeffective price of the good to increase for buyers, and thus demand for the goodto fall.

e. The time period in question also affects demand for a good. Example: Thedemand for ice cream is bigger in the summer than in the winter. Demand fora good in the short run may be different than demand in the long run. Overa long period of time, the demand for any given good is generally bigger andmore elastic than over a short period of time. But there are exceptions - in somecases 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 shiftin the demand curve, increases in demand will be different over different priceranges. Give an example of a shift in demand for good A due to the creationof a new substitute product. The initial demand curve is a typical downward-sloping demand curve. Now suppose a competitor offers a new product, goodB, which is a perfect substitute for good A, at a certain price P . Then thenew demand curve for product A will be flat at P and only slope downwardsbelow P . Consumers will not buy product A at a price above P ; they willbuy product B. But at prices below P the demand curve for product A is thesame 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 reasonsfor this shift?

The market mechanism

A market equilibrium is found at an intersection of the supply and demandcurves (there may be more than one). The market mechanism is the tendencyin a free market for the price to adjust until the quantity demanded equals thequantity 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 pressuretowards equality of amount demanded and amount supplied that leads the priceto adjust towards an equilibrium price.

When price is above the market-clearing level, there is a surplus - the amountsellers are willing to supply exceeds the amount buyers are willing to buy. Thensellers will notice this to prevent their stock from accumulating will lower prices.

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When price is below the market-clearing level, there is a shortage. The amountbuyers are willing to buy at that price exceeds the amount sellers are willing tosell. Buyers may bid up the price, and sellers will raise prices.

In this course we will study both partial equilibrium and general equilibriummodels. Partial equilibrium models, such as the supply and demand model,focus on a market for a single good. Such models assume negligible incomeeffects. When the price of a good changes, it causes consumers incomes tochange. The change in incomes could shift the demand curve. But this effectis not taken into account in partial equilibrium analysis. We do not shift thedemand curve in response to a move along the demand curve.

In general equilibrium analysis, the interaction among markets for differentgoods is considered. Changes in prices of each good are allowed to affect theincomes of the consumers. A change in price of one good will thus have an effecton the demand for all other goods.

Elasticity

Elasticity measures the response of one variable to changes in another vari-able. In particular, elasticity is often used to measure the response of quantitydemanded to a change in price. Economists use elasticity as a measure forthis 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 changesusing slope of the demand function. First we measure in kilos of steel, in whichthe demand function is P = 2Q + 10 (What is the slope of this demandfunction, 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 thegraph relating P to Q is 2. Then we measure in metric tons of steel. Whenthe unit of steel used is multiplied by 1000, the quantity demanded (in the newunits) is divided by 1000 at each price. So the new relation between P and Qis P = 2

1000Q + 10

1000. The slope of the graph relating P to Q is 2

1000. So the

slope is not invariant to the units of measurement used.

The elasticity of variable y with respect to variable x (also called the x-elasticityof 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 demandeddivided by the percentage change in price. This is unit free, because percent isa pure number not depending on units.

Two different concepts of elasticity exist - the arc elasticity and the point elas-ticity. The arc elasticity between two points (Q1, P1) and (Q2, P2) on the graph

of the function Q = f(P ) equals (Q2Q1)/((Q1+Q2)/2)(P2P1)/((P1+P2)/2) . The arc elasticity must

be defined between two different points. Choosing two points on the graph ofP = 2Q + 10 (using kilos as units of measurement), (0, 10) and (4, 2), calcu-late the arc elasticity between these two points. (40)/2

(210)/6 = 3/2. Now change

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the units of measurement to metric tons. The function relating P and Q be-comes P = 2

1000Q+ 10

1000. Now the arc elasticity between the points (0, 10) and

(4/1000, 2) is (4/10000)/(2/1000)(210)/6 = 3/2.

Arc elasticity can be used when you want to calculate a price elasticity over aportion of the demand curve or supply curve. For instance if you want to knowthe effect on quantity demanded of a tax that increases the price from $8.00to $10.00, you should use arc elasticity. If you are interested in effects of smallchanges in price on other variables (not just the quantity demanded) such asrevenue of sellers, the point elasticity is useful.

Point elasticity is the limit of the arc elasticity when we make the length of thearc small. Formally, the point price elasticity of demand at (Q,P ) is dQ/Q

dP/P=

(dQ/dP )(P/Q). So, if the demand function is defined by Q(P ) = 1P 2, then the

(point) price elasticity of demand at the point (1/4, 2) is (2/P 3)(P/Q) = 2P 2Q

,which is 2 at that point.A linear demand function has varying elasticity; high magnitude of elasticityat low prices and low magnitude elasticity at high prices. Examples: Calculatethe point elasticity of the demand function Q = 4P + 20 when the price is 4and 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 ofdemand and sellers revenue:

In 1988 there was a drought which caused the US quantity of wheat to decreaseby 14%. This caused the price of wheat to increase by 46%. This means that theprice elasticity of demand was 14/46 0.3 because in order for the quantitydemanded to decrease by 14%, the price had to increase by 46%. While manysellers went bankrupt and lost their farms because their wheat crop did notgrow that year, the sellers who were not affected by the drought saw theirincomes rise. This is because the percentage increase in price was more thanthe percentage decrease in quantity. (Note that we are using arc elasticity inthis example).

This example illustrates a general relationship between sellers revenue and priceelasticity of demand. When price elasticity of demand Ep is less than 1 inmagnitude and there is a quantity drop, price rises more in % than quantityfalls, so sellers revenue increases. When Ep > 1 in magnitude and there isa quantity drop, price rises less in % than quantity falls, so sellers revenuedecreases. 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 fallsbut the demand curve stays the same (Wheat in drought). The price rises. Whatis the effect on sellers revenue? Revenue is R(P ) = P D(P ) = price timesquantity sold. It rises if R(P ) > 0, the derivative is positive. Use the productrule to find R(P ). Let f(P ) = P . Then R(P ) = f (P )D(P ) + f(P )D(P ) =

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D(P ) + PD(P ) > 0 if 1 > PD(P )

D(P ). So again, revenue rises if elasticity is less

than one. Similar calculations can be used to show that revenue decreases ifelasticity is greater than one.

So when they know that demand is inelastic, why dont sellers cut output inorder to raise price? The reason is that no individual seller can influence themarket price by cutting their output; such an action would have to be donejointly by many of the sellers and in a competitive market there are too manysellers to be able to collude in this way. However, we will talk about suchstrategies in the two-seller game theory model.

What is wrong with this argument: When there is a drought, suppose there aresome farmers affected by it and others who are not affected by it. The demandstays the same, so the demand that was going to the farmers who were affectedby the drought now goes to those who werent affected.

We can also talk about the price elasticity of supply. The arc price elasticity ofsupply between two points on the graph of the supply curve is the percentagechange in quantity supplied divided by the percentage change in price. Thepoint elasticity is defined as above.

How does a shift in the demand curve affect sellers revenue? It depends onthe 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 aninward shift of the demand curve will decrease revenue. But by how much willrevenue rise due to a rightward shift in the demand function? This depends onthe elasticity of the supply curve and of the demand curve.

There is also income elasticity of demand. When income elasticity is less than0, the good is inferior. In that case the quantity demanded increases whenincome decreases and decreases when income increases. When income elasticityis greater than 0, the good is a normal good. When income elasticity is lessthan 1, the good is a necessity. When income elasticity is greater than one thegood is a luxury. Example: PQ = 1/4 so that the spending on the good is aconstant fraction of income. Show that income elasticity of demand equals 1.

Elasticity and time period. Over a longer period, elasticity usually has highermagnitude. There is more time for adjustment. Example: Gasoline. As pricerises 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 torespond by adjusting their lifestyle to make it possible to buy less.

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