Introduction to Microeconomics: Course Notes P1

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University of Toronto Scarborough
Economics for Management Studies
Michael Krashinsky

10 September 2012 What is economics? Study of the allocation of scarce resources among competing uses – there is not enough to go around so we have to figure out how best to place our resources, doing this well result a successful economy.  Scarcity means if resource is not scarce, nothing to study  Competing uses means we have to make choices PPF (Production Possibilities Frontier) Represents the limit society can produce in any period of time using its resources. PPF divides the diagram into 3 parts: unattainable, attainable and efficient (line itself), attainable and inefficient (area inside the line). Point B allows you to have more of X and more of Y. Efficiency is getting the most that we can. Shape of PPF is convex (blows out). Any line joining any two points inside the set is also within the set. Choice is represented by which point along the PPF we choose. Notice the inevitability of having to give up one thing to get something else. Process of society’s drive to produce more is the process of pushing PPF outwards. To get more public goods, one must give up some private goods and vice versa. Imagine construction VS teaching, to get more construction, we must give up some teachers who barely know anything about construction to be constructers. Then, if we want more constructors, we give up more teachers, who are bad at construction to get more constructors. Then, one must give up teachers who know nothing about construction to get constructors – hence the shape of the PPF as a concave and not a straight line. When someone offers you a way to get more public/private goods (point g) they are within the PPF and have a way to point B or point C. The changing slope of the PPF illustrates the concept of increasing costs; the slope of the PPF illustrates the concept of opportunity costs OPPORTUNITY COST = GIVE UP/ GET OPPORTUNITY COST OF X = -DELTA Y/ DELTA X OPPORTUNITY COST OF Y = -DELTA X/DELTA Y ** The derivative in negative Y = 33 – X – X Opportunity Cost of X: -dY/dX = -(-1 – 2x) = 1 + 2x X = 2, Y= 27, Cost of X = 1+2(2) = 5 X and Y are coordinates while 5 is the slope The cost of Y is the inverse of the cost of X. To get value, sub in Y to the value equation and simplify. To maximize, derive the value equation and set it to 0, solve for X. Sub in X to original equation. 12 September 2012 2 3 Value: U = XY = 60X – 1.5X – X dY/dX = 60 – 3x-3X = 0 20 – X – X = 0 (5 + X)(4 – X) = 0 X = +4/-5 Not possible to have -5 units of X in terms of economics, so we cross it out. We never have negative values; the PPF is always in a positive quadrant. Assessment of Value It must somehow relate to what makes consumers happy, we judge this by looking at what they choose to buy, we call this notion revealed preference. There is no discussion, debate or large player to set the price; people reveal what they want by in the market by the choices they make with shifts in values or tastes. Note that this assumes fundamental value of individualism. Consumer Demand In order to figure out how we choose the best point on the PPF, we have to know what consumers want to consume. In a decentralized economy, consumers have a lot to say in determining what is produced. Demand is what consumers want to buy (not what they can buy) given certain economic conditions. Quantity of X demanded = D (econox.c variables). Given the values of the economic variables, the demand function “spits out” a number that tells us how much of the good (in this case X) is demanded. We call that number “quantity demanded”. Demand depends on: 1. Own Price: P (wxen price goes up, people want to buy less – LAW OF DEMAND). ∂DX/∂PX < 0. Technically, should not use derivative since function D is x function of several variables. What we are doing is holding all of the other variables constant and looking at what happens to quantity demanded when we change one variable (in this case P ). The xechnical way of writing this is called “partial derivative.” 2. Other Prices: P (yffect of change can go either way). ∂DX/∂PY > 0 substitute – price of one good has positive effect on another good (IE: Price of strawberry jams decreases, more likely to use more strawberry; therefore, less grape jam) ∂DX/∂PY < 0 complement – price of one good has negative effect on the another good (IE: Grape jelly goes along with peanut butter. So when there is a rise in price for peanut butter, grape jelly would also decrease) Demand curve is the relationship between the quantity demanded and the price of the quantity itself – everything else is held constant. 17 September 2012 3. Income: ∂DX/∂I > 0 normal good – positive effect: when income is high, one has more money to spend thus buying more of products, those goods affected are normal goods. ∂DX/∂I < 0 inferior good – negative effect: when income is high, one buys less of some products, those goods affected are inferior goods. (IE: Instead of a vacation to buffalo, one goes to a more exotic place such as Paris) 4. Population: More people, demand increases as the quantity demanded tends to be larger Taste: Changes either way. Quality: Not part of function as there is an issue on how one person defines the term “good” X = DX(PX, PY, PZ, Petc, I, pop) 0 2. Input Prices: Typically goes into the opposite direction – inputs are things you use to produce the products. When the price of your input becomes higher, it becomes more expensive to produce and profitability goes down. This tends to result in less quantity being in supply – negative. (IE: Wages). ∂SX/∂ (any input price) < 0 3. Number of Firms: Represented by the letter n. If number of firms goes up it means there is an increased quantity supply. ∂SX/∂N > 0 4. Technology: Reduces the cost of production, therefore this increases quantity supply. ∂SX/∂T > 0 Combine the both: Equilibrium price is the only price that equalizes the quantity that sellers wish to sell and the quantity that buyers wish to buy – clears the market. If one calls out the wrong price, market is not clear, either buyer or seller will be unsatisfied. 19 September 2012 The supply curve shifts to the right when there is a reduction in the price of any input, if technology improves, or if there are more firms. The supply curve shifts to the left when there are fewer firms or more expensive inputs. Adjustment Mechanism EXCESS SUPPLY leads to price falling. Why? Because there are a bunch of unsatisfied sellers as the price is set too high and no consumers want to purchase, the sellers can either: have a sale, or lower the price. If the price is too high, there are natural forces that cause the price to drop (such as competition for lowest price). EXCESS DEMAND leads to price increasing. Why? Because there are a bunch of customers that want the limited goods, as a smart businessman, one will raise the price. There are natural forces that cause the price to rise (such as bidding wars). This moves towards the equilibrium. All consumers will get to consume the amount of the good they are willing to consume at that price and all suppliers will get to supply the amount of the good they are willing to supply at that equilibrium price. There will be no consumers who want to change their consumption behaviour and no suppliers who wish to change their supply decisions. The quantity of the good supplied by suppliers is just equal to the quantity of the good that consumers wish to purchase. Stable Equilibrium is the forces that bring you towards equilibrium if you are out of it. Demand P = 10 – Q Supply P = 1 + 0.5Q 10-Q = 1+ 0.5Q (SET IT EQUAL TO EACHOTHER) 9= 1.5Q Q = 9/1.5 Q = 6 Something happens that increases demand (what that means is that at each price, there is more quantity demanded) [DIAGRAM TO LEFT SHOWS] At the old price P0 there is excess demand. ED causes price to rise moving us to the new equilibrium point P1. The exact opposite happens when something happens that reduces demand (what that means is that at each price, there is less quantity demanded). At the old price P0 there is excess supply. ES causes price to fall moving us to the new equilibrium point P1. Special Case: Q: Normal good, income rises; at same time price of substitute falls. Normal good, income rises = Demand shifts right Price of substitute falls = Demand shifts left A: Result is either the entire curve will shift to the right in which case both price and quantity will rise or the entire curve will shift to the left in which case both price and quantity will fall or both will cancel out and the entire curve will not move and both price and quantity will not change. In particular, the notion of atomistic actors on both sides of the market − that is, individual buyers and sellers react to the price, and although their action together affect price, no individual can influence the price. Prices play a critical role in allocating resources. The rise in price (is an efficient signal to both buyers and sellers) that results to two things: 1. It calls forth additional units of supply - it does this by causing producers to want to produce more output in order to make profit. This moves resources into this industry. Economist Adam Smith’s theory of the “Invisible Hand” said that it was as if people were guiding the marketplace to equilibrium, eliminating either excess demand or excess supply. 2. It causes buyers to ration the amount that they buy - economists like this mechanism basically says “try to use a little less” or that if it is not essential, do not use it unless it is really important because it is scarce. Those who “really” want the good get it, while those who don’t really want it look elsewhere. The supply side response is just what we would want. Imagine that news of a hurricane in the Gulf of Mexico causes consumers to panic and want to “gas up” before prices rise. The resulting rise in price may not seem “fair” or “just”. After all, sellers (owners of gas stations) are making windfall profits, and the rise in prices has nothing to do with the cost of the gasoline to those sellers. Outrage by consumers often leads politicians to try to alter this outcome. This is not new (religions have often dealt with issue of “just price”). But there is an inherent problem in trying to alter market outcomes, as we will see. Suppose for example that a world increase in the demand for energy causes oil prices to rise. Can we artificially push the price down by passing a law? This will not work, and in fact will make things worse by destroying the signal that higher prices would send to both consumers and producers. Prices play a critical role in allocating resources. A lower legislated price would encourage consumers to continue to overuse energy, and would not encourage producers to look for new sources of energy. ED at the lower price will continue over time. 24 September 2012 If people want the government to do something about high prices, someone in parliament may speak up and propose a lower price by law called price ceiling – a limit above a price can’t go. Effective only if PC < P* the ceiling price must be below the equilibrium price (IE: Establishing the ceiling price that a banana cannot exceed $1000 per kilo – which is meaningless). Since there is excess demand, who gets the excess demand? Ration (IE: During wartime, there is certain number of coupons that goes out for the products to obtain them. Now there is a market set up where people trade the coupons. Where people sell the coupons is illegal, this market is called a black market. People have been allocated politically the units but they want more than they have) Seller Preference is where the seller decides who they want to sell to without raising the price (IE: Rent control, there is a law against raising the price on rent and the demand is high. Seller could charge the buyers for the key – under the table money). Queuing is based on the first come first serve principle. When Rent Controls are instituted, many problems arise in the long run, they include:  no new construction if prices set too low for profits  landlords don’t maintain units – as the units are scarce and nobody wants to leave the buildings landlords do not bother putting effort into cleaning them  “best way to destroy housing stock of city short of bombing”  no one can move, so end up with wrong housing Both supply and demand curve get a little flatter in the long run (S1 and D2). Why this is true is because the longer you have the more you have to adjust to low prices. Buyers have more time to adjust and decide they want a lot more of the product. Sellers have more time to adjust and decide this is not a good market – effective reduction in quality. When there is a demand for government to raise prices it is called the price floor (IE: minimum wage for workers). Effective only if PF > P* the floor price has to be above the equilibrium price. Since there is excess supply, who gets the quantity demanded? Quota is being only allowed to sell so much (IE: limit on amount of cheese sold in Canada) Random – Unemployment where the people who do not get jobs are those who are young – as then you would have to train them, or old – who will retire soon. BUT the floor does raise the price for those who are able to sell – if one gets a job then it is better off to get minimum wage than a lower wage; however, if you lose your job because of minimum wage (firing an old person for a younger, more energetic person), they are better off without minimum wage. Economists View is that messing with prices is usually a poor way to accomplish stated goal; you end up messing up production with minor effects on problem (IE: poverty and rent controls, poverty and low wages, problems of farmers). Utility Assume that consumers maximize well-being called UTILITY: U = U(X) Assume dU/dX > 0 (first derivative – positive value of additional units), call dU/dX “marginal utility” (MUX – the extra utility for one more unit of consumption), also assume d2U/dX2 < 0 “diminishing marginal utility” (each additional add value but each additional unit is worth less than previous one). U = 100 + 10X0.5 = 100 + 10X1/2 -1/2 dU/dX = 5X -3/2 d2U/dX2 = -2.5X Check for diminishing marginal utility: X 0 1 2 3 4 5 6 U 100 110 114.14 117.32 120 122.36 124.49 ΔU 10 4.14 3.18 2.68 2.36 2.23 ΔU is the difference between each utility (IE: 110 – 100 = 10) Consumers will maximize net gain from consumption NET GAIN = {U(X) − U(0)} − amount paid We call this consumer surplus – extra you get beyond what you pay from consumption. Typically, if the price is PX, the amount paid isXP X (price per unit, X = number of units), so: CS = U(X) − U(0) – X X dCS/dX = dU/dX − P X 0 dU/dX = P XOPTIMAL PURCHASE RULE) The marginal utility of X is equal to the price of X. This is the demand curve: MU X dU/dX = P (Xo demand curve and MU curve are the same). 26 September 2012 U = 100 + 10X 1/2 Demand is 5X = P X What is the value of the last unit purchased? The value of the last unit purchased is given by the price (IE: x = 1, then it is $1). If X = 1 and X = 25, what is the consumer surplus? (Typically, U functions that have U(0) = 0) CS = U(X) 1/2(0) - PXX CS = 100 + 10X – 100 – (1)(25) CS = $25 Diagram of Consumer surplus as area under demand curve, between demand curve and price line: Demand is P = 10 – Q. Total utility from consuming 8 units. The consumer surplus is a triangle if the demand curve is linear. The answer is related to the fundamental theorem of calculus. This theorem tells us that if we graph the derivative of a function df/dx, then the area under that graph between X and X is equal to 0 1 f(X1) –f(X0). The area under the curve is an integral, so this means that: ∫(df/dx)dx = f WHY IT IS A TRIANGLE WILL NOT BE ON THE EX
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