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Economics 2150A/B

Sep 09 Introduction- Course Syllabus What is economics? Study of how we allocate scarce resources among competing groups with unlimited wants. What is the difference between Microeconomics and Macroeconomics? Why should you study Microeconomics? -Offers insights into real world situations that affect us every day. Ex: Climate change = common resource problem. -Provides solutions. Ex: Cap and Trade = lowest cost solution. -Increases understanding Why prices fluctuate in different markets. Should we raise P or lower P to increase TR? Three types of models 1. Constrained Optimization 2. Equilibrium Analysis 3. Comparative Statics Constrained Optimization Df – Try to max or min an objective function subject to a constraint. Ex: Suppose you wish to fence your yard. Want to maximize area s.t. the constraint that you have a limited amount of fencing (100m) Objective function that you are trying to maximize = area = L x W s.t. perimeter = 2L+ 2W ≤ 100m Write: CHOOSE L and W Max L,WLW s.t. 2L +2W ≤ 100. Exogenous v. Endogenous variables Exogenous are taken as given. EX: total fencing=100m. Endogenous are determined by the model. EX: Choose L and W to max area. Ex: Consumer Theory Lives in two-good world. Can expand to many more goods. Chooses F and C to max utility (satisfaction) s.t. income constraint. Max F,C(C,F) s.t. PcC +PfF ≤ I Exogenous? Pc, Pf, I Endogenous? C, F Ex: Firm Theory Production function – turn K,L into output Qo. Given that we want to produce a certain amount of output, how do we maximize profit? -We choose an input level that minimizes out costs of production. Minimizes costs = wL +rK s.t. an output constraint. Min L,K wL + rK s.t. Qo = f(K,L) Exogenous?  w, r, Qo Endogenous?  L, K Marginal Decision Making  Constrained Optimization is a form Marginal Analysis. Asks how a marginal unit change in the exogenous (independent) variable changes  the endogenous (dependent variable). Ex: 1.16 Real world: To maximize SUV sales, where should we spend our advertizing budget, on NFL,  on PGA golf, or on both? d) How should we allocate? Common ans: Spend all on Football since 2 million sells 20 SUV’s instead of 9. NOTE: Can do better if use marginal reasoning look at incremental effects.> The manager should spend $750,000 on football (44 SUV) and $250,000 on golf (4 SUV). 2.Concept of Equilibrium a. Natural state in which a system rests. Q: What is the equilibrium price and quantity? Q: Why is this price the equilibrium price? Why will the price not stay at P=$2.50? Surplus Qs > Qd. Prod lower P. Why will the price not stay at $1.50? b. How to think about the Demand Curve. ­ willingness to pay for the last unit consumed - marginal benefit to society of the last unit consumed -Law of Demand c. How to think about the Supply Curve - Q producers willing to supply at a particular price, ceteris paribus -Marginal costs of producers summed d. Equilibrium -Qs=Qd -Market eqbm is Efficient because those who value most and those who produce at lowest costs transact. 3. Comparative Statics How a change in an exogenous variable affects the endogenous variables. -Applied to both Constrained Optimization and Partial Eqbm. Partial Eqm saw before: 1. Initial Eqbm P, Q 2. Change which affects the D or S or both curves 3. Look at final eqbm P,Q. Ch. 2 – Comparative Statics of Demand and Supply DEMAND Qd = f(Po, P, I, ….) ordinary demand curve Po = h(Qd,P, I, …) Inverse Demand curve Downward sloping because of Law of Diminishing MU. Giffen good exception. (Rice in Hunan – Rob Jensen) 1. Change in Qd v. Change in Demand Change in Quantity Demanded -Movement along -Due to change in Good’s own price. Change in demand -Shift entire curve 2. What are some other factors that shift market demand? 1. Income ↑ -Normal good - demand ↓ (most items) -Inferior good – demand ↑ (bus ticket, used item) 2. Prices of Related Goods ↑ -Substitutes – demand ↑ Examples? (Coke v. Pepsi) -Complements – demand ↓ Examples? (hotdog v.hotdog buns) 3. Tastes - advertizing 4. Expectations of future P and Income – electronics, deflation 5. Number of buyers – Baby boom(1947-1966) Echo(1980- 1995) 3. Inverse Demand Function to graph Po = f(Qd, …) Example: Graph: SLOPE: Increase P by 1 unit, decrease Qd by 2 units. Student Example: Write the inverse demand function for the ordinary demand curve Qd = 4-2P and graph. Sep 11 SUPPLY Tells us that the quantity of a good supplied by all producers in the market depends on various factors. 1. Quantity supplied v. Change in Supply 2. What are some factors that shift market supply? 1. Prices of Inputs – oil prices and supply of plastics 2. Prices of other goods produced – natural gas is byproduct of oil 3. Technology – fracking increased supply of natural gas. 4. Expectations of future prices – hoarding by oil companies 5. Number of sellers – LR entry drive Supply up, P down. Example: 2.18 a) Note the positive and negative coefficients. The sign tells you how and increase in one variable affects Qd or Qs. Note and increase in P is a movement along the demand or supply curve since P is on the y-axis. A change in anything else (G or E) represents a shift in demand and/or supply. Qd = 1000 + 50G -4E -400P Qs = 200-30G +100P G↑ → Qd ↑ (price of substitute) and Qs↓(input in production) E↑ → time cost of driving ↓ (price of sub ↓) → Qd taxi ride ↓ b) G=$4.00/gallon and E = 30 min. Qd= 1080-400P Qs = 80+100P Find Eqbm taxi fare P. Qs = Qd 1080-400P = 80+100P P = $2. QS=Qd = 1080-400(2) = 280. Graphing a line. Graph. B+) Comparative Statics: What happens to eqbm P,Q if Pgas (G) increases to $5.00? Qs = 50 + 100P Qd = 1130 -400P New Eqm: QS = Qd 1130 – 400P = 50 + 100P P=$2.16 Qs=Qd = 50+ 100(2.16) = 266 Does this match your intuition? c) skip ELASTICITY (responsiveness) Elasticity = responsiveness A. Own Price Elasticity of Demand 1) Definition - The price elasticity of demand measures how much the quantity demanded responds to changes in the good’s own price. Q: Why do governments and firms care about elasticity? 2) Calculation a. The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. a) d = %Qd / %P Ex. If the price of ice cream increases by 10% and the quantity demanded decreases by 30% then the d= -30%/10%= -3. NOTE: d is negative because an increase in P causes a decrease in Qd. This negative sign will be important for determining income elasticity and cross-price elasticity. However, by convention, we make the own-price elasticity positive because it is the magnitude of the changes that matter not the direction. So we make it positive by taking the absolute value of the own-price elasticity, and it should be written: d =  %Qd / %P Q: If the elasticity of demand is 3, what how much do we expect Qd to decrease if Pincreases by 20%? Q: Does this make intuitive sense? Surely, I would respond differently to a price increase of 20% than a price increase of just 1%. This may be true. Note that elasticity is calculated at a particular point on the demand curve. In other words, it is point dependent. A20% price increase will place you further away from the original price point, and the elasticity may differ in this region. For our purposes, we will ignore this complication and assume that the effect of a 20% price increase has the same elasticity as a 1% price increase for a particular price point on the demand curve. b) Midpoint method –observe 2 prices associated with 2 different quantities i. Use when calculating the elasticity between 2 points (P1,Q1) and (P2, Q2) on a demand curve because the percentage change will vary depending on whether you use (P1, Q1) or (P2, Q2) in the denominator. The midpoint method eliminates this problem by using the average of the two points. εd = (Q2−Q1)/ [(Q2+Q1)/2 ] (P2− P1)/ [(P2+ P1)/2 ]   ii. Example: Suppose we increase the price of a pack of cigarettes from $8 to $13.33 and the quantity demanded drops from 100 million sold to 80 million sold. What is the price elasticity of demand? Q: Is the demand elastic or inelastic? c) Finding elasticity for a LINEAR demand curve So if we return to our previous formulation of the equation of a demand curve in Problem 2.18 and assume that P = 2 and Q=280, we can calculate the own-price elasticity of demand as follows: 1. Slope =ΔQ/ΔP = -400 2. P/Q = 2/280 3. εd = (-400)(2/280) = -2.86 4. Taking the absolute value, εd = 2.86 NOTE: For any linear demand of the form Qd = a - bP , the own-price elasticity of demand is given by the formula NOTE: The inverse demand curve allows us to find the choke price where the price is so high that Qd is zero. Inverse Demand The choke price = a/b is the P at which Qd falls to 0. 3) Calculus method.
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