ECB1MI

Microeconomics, Institutions and Welfare

Lecture 1

Prof. Dr. Stephanie Rosenkranz

Dr. Annette van den Berg

Drs Linda Keijzer

Drs Joyce Delnoij

Drs Sergei Hoxha

Drs Oke Onemu

11:11 1

Important information about the course

Schedule:

– one lecture per week (Monday)

– one test (45 Minutes) on MyLabsPlus per week

(Wednesday 6 PM until Sunday 11PM)

– two tutorials a week (Wednesday, Friday)

• but only one tutorial in week 47 (check schedule on WebCT!!)

11:11 2

Important information about the course

Material:

– Pindyck and Rubinfeld, 8th ed.

– Chapters 1- 4, 6 -14, 16 -18

– Book Chapter Institutional Economics

– Lecture notes (see course details)

– same book is used in course Intermediate Microeconomics

(remaining chapters + Game Theory)

– Problem sets

– MyLabsPlus (MLP)

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Problem sets:

=> Treated in tutorials (see folders Course Content on

Blackboard)

• multiple choice questions

• open questions

=> Active participation counts

11:11 4

Look at sample exam

2 mid-term examinations (100% multiple choice,

see MLP) course week 4 and course week 7

end-term examination (100% open questions,

see tutorial questions) course week 9

Final grade: 30% Midterms (15% each), 70% final exam

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1. MyLabsPlus

=> Log in (see folders Course Information on Blackboard)

• Username (login name): student number

• Password: student number

=> Code (comes with the book, can be bought via MLP)

=> Multiple choice questions • Have to be done in once

• Limited time

2. Active participation in class

Effort requirements

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Blackboard

11:11 7

What is microeconomics about?

Scarcity → making choices = trade-offs

Strict assumptions

- rational, consistent choices (w.r.t information and preferences)

- optimizing behaviour → maximizing utility or maximizing profit/revenue

How do economic agents allocate scarce resources

• Consumers

• Workers

• Households

• Firms

• Politicians

• etc.

• time

• money

• production factors,

etc.

Markets

Interaction of economic agents on markets determine prices (demand and

supply) → Trade-offs are based on prices

11:11 8

Theories and Models

In economics, explanation and prediction are based on theories.

Theories are developed to explain observed phenomena in terms

of a set of basic rules and assumptions.

A model is a mathematical representation, based on economic

theory, of a firm, a market, or some other entity.

Theories and Models

11:11 10

Assume you are an alien on your first

visit to Earth

You see this animal and you are told it is called a ‘dog’.

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Assume you are an alien on your first

visit to Earth Then you see these very different animals. Are these dogs?

Panda dogs are the new rage in China. Most are

chows that have undergone cosmetic primping to

have them appear as pandas.

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Assume you are an alien on your first

visit to Earth Slowly but surely a dog-model emerges in your mind:

Does any individual case of a dog look like this? NO

Does it help you to define and identify dogs? YES

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Theories and Models

11:11 14

Theories and Models

11:11 15

Positive versus Normative Analysis

positive analysis

Analysis describing relationships of cause and effect.

normative analysis

Analysis examining questions of what ought to be.

Agenda for today:

1. Introduction to demand and supply

→ what is a demand curve, what is a supply curve

→ the notion of equilibrium

2. Shifts in demand and supply

→ the effect on equilibrium

3. Elasticities, short term and long term

4. Government intervention

→ the effect on equilibrium

11:11 17

The Demand Curve

We can write this relationship between

quantity demanded and price as an equation:

QD = QD(P)

or

P = P(QD) (inverse demand function)

demand curve Relationship between the quantity of a

good that consumers are willing to buy and the price of the

good.

1. Introduction to demand and supply

(individual) Demand Curve

Q2

(Shift along the demand curve)

Note: downward sloping curve 11:11 19

Aggregate demand

4 7 11

4 8 12 24

0

Note: Aggregate demand is always less steep than individual demand 11:11 20

The Supply Curve

We can write this relationship between

quantity supplied and price as an equation:

QS = QS(P)

or

P = P(QS) (inverse supply function)

supply curve Relationship between the quantity of

a good that producers are willing to sell and the price

of the good.

Q2

(individual or market) Supply Curve

(Shift along the

supply curve)

Note 1: upward sloping curve

Note 2: derivation of aggregate supply is similar to derivation of aggregate demand

11:11 22

(Competitive) Market Equilibrium: Q`D(P) = QS(P)

Conditions:

1) Free entry/exit

2) Homogeneity

3) No market power

4) Transparency

One market price

results 11:11 23

Market mechanism leading to equilibrium

Now, suppose that originally

the price is above P0: surplus

→ P(QS) > P(QD)

→ underbidding

→ P(QS)

→ QS and QD

(shifts along the curves)

until QS = QD 11:11 24

2. Shifts in demand and supply

When a non-price determinant of demand (or supply) changes

the curve shifts.

These "other variables" are part of the demand (or supply)

function. They are "merely lumped into the intercept term of a

demand (or supply) function."

Thus a change in a non-price determinant of demand (or supply) is

reflected in a change in the x-intercept causing the curve to shift

along the x axis.

11:11 25

A shift of the (whole) demand curve

Due to one of the following changes ():

1) number of consumers

2) disposable income

3) taste and preferences

4) prices of related goods (substitutes and complements)

5) expectations

D’’

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Effect of demand change on equilibrium

So, shift of demand curve

leads to shift along supply curve !

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The Economist explains

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Why it is cheaper to buy property in Berlin

than in other European capitals

Nov 6th 2014, 23:50

Property prices continue to climb in London

and in other major European cities, but Berlin

has defied the trend

Due to one of the following changes ():

1) number of suppliers (or magnitude of supply)

2) technology

3) production costs (and management skills)

4) government policies

A shift of the (whole) supply curve

S”

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Effect of supply change on equilibrium

So, shift of supply curve

leads to shift along demand curve !

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3. Elasticities

Measuring effects of changes in prices or other

factors on demand or supply.

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Elasticity Percentage change in one variable resulting from

a 1-percent increase in another.

Price elasticity of demand Percentage change in quantity

demanded of a good resulting from a 1- percent increase in

its price.

(2.1)

The importance of elasticities

The importance of elasticities

In other words:

the elasticity measures the sensitivity to a price change

Hereafter:

1) Price elasticity of demand (most slides)

2) Price elasticity of supply (one slide)

3) Income elasticity (one slide)

4) Cross-price elasticity (one slide)

11:11 33

The importance of elasticities (II)

the degree in which a % price change

leads to a % change in the quantity demanded

Q

P P

Q

D

D

P0

P1

Q0 Q1 Q0 Q1

Q is very small

= relatively inelastic demand Q is very big

= relatively elastic demand

In other words: the relationship between %P and %Q

P

34

The importance of elasticities (III)

the degree in which a % price change leads

to a % change in the quantity demanded (or supplied)

Q

P P

Q

D

D

P0

P1

Q0 Q1 Q0 Q1

10

8

20 22 20 30

(Q1-Q0)/Q0

(P1-P0)/P0

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Task 2: calculate

the elasticities

at (P0, Q0) for both

functions.

The importance of elasticities (IV)

Q

P P

Q

D

D

P0

P1

Q0 Q1 Q0 Q1

10

8

20 22 20 30

(Q1-Q0)/Q0

(P1-P0)/P0

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the degree in which a % price change leads

to a % change in the quantity demanded (or supplied)

The importance of elasticities (V)

Relatively elastic: if E < –1 or: if E > 1

Relatively inelastic: if –1 < E < 0 or: if 0 < E < 1

→ turning point is at E = –1 (unit elasticity)

What does it mean if E = –1?

→ When a price rises with, say, 10%, demand decreases with 10%

What does it mean if E = –0.5?

→ When a price rises with, say, 10%, demand decreases with only 5%

What does it mean if E = –2.5?

→ When a price rises with, say, 10%, demand decreases with 25% 11:11

37

The importance of elasticities (VI)

Q

P = first derivative

(slope) of (demand)

function

E = -2 * 2/4 = -1

1

6

-2 * 1/6 = -1/3 E =

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The importance of elasticities (VII)

Elastic part of the (linear) demand curve: E < –1

Inelastic part of the demand curve: –1 < E < 0

Note: Each point on a linear,

downward sloping curve gives

a different value for E

and each linear curve,

irrespective of its steepness, has

elastic and inelastic points 11:11 39

The importance of elasticities (VIII)

4 8

With linear demand curves, we see a

steady relationship between

E(lasticity) and TR (total revenue):

TR

Q 0

8

2 6

4

6

3.5

(TR = P*Q)

2

3

6

1

●

● ●

● ●

1. If E is elastic, a decrease in the

price leads to rising revenue

2. If E is inelastic, a decrease in the

price leads to declining revenue

→ policy implications! 11:11 40

Two extremes:

The importance of elasticities (IX)

Infinitely Elastic Completely Inelastic (the slope is infinite) (the slope is 0)

(i.e. demand is very sensitive to P) (i.e. demand does not react to P at all)

Examples?? Perfectly elastic demand: good has a large number of very close (that is, perfect) substitutes-

in-consumption readily available.

Perfectly inelastic demand: good has absolutely no substitutes-in-consumption.

41

Market for gasoline Market for automobiles

The importance of elasticities (X)

Short-term (SR) versus Long-term (LR) elasticities

P P

Q (SR) < Q (LR) Q (SR) > Q (LR)

11:11 42

the degree in which a price change

leads to a change in the quantity supplied

Price elasticity of supply

(Q1-Q0)/Q0

(P1-P0)/P0 EP =

Suppose P1 = 10

P3 = 12

Q1 = 10

Q3 = 14

→ Calculate EP

→ EP = +40%/+20% = 2

→ if EP > 1 → elastic supply; if 0 < EP < 1 inelastic supply 43

Income elasticity and cross-price elasticity

(formulas are in the book, p. 35) Recall: Demand curve may shift due to:

1) number of consumers

2) income

3) preferences

4) price substitution goods

price complementary goods

Income elasticity:

the degree in which

a % income change leads

to a % change in the

quantity demanded

Cross-price elasticity: the degree in which a % price

change in a substitution good or

complementary good leads to a

change in the quantity demanded

of another good

Substitution goods show

a positive sign for E;

Complementary goods show

a negative sign for E.

11:11 44

4. Effects of government interventions

Price controls are governmental impositions on the prices

charged for goods and services in a market.

A “price ceiling” is a government-imposed limit on the price

charged for a product. Governments often impose price ceilings

to protect consumers from conditions that could make

necessary commodities unattainable.

A “price floor” is a government-imposed limit on how low a

price can be charged for a product.

Price ceiling

Government intervention → the effect on equilibrium I

Introduction of maximum price

Interference with free market leads to a trade-off decision:

Some people gain and some lose from price controls. 11:11 46

Government intervention → the effect on equilibrium II

Introduction of minimum price

Pmin

Price floor

Excess supply ?

Only in combination

with price support! 11:11 48

Thank you for

your attention

and see you next

week!

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