Microeconomics Notes Engineering Class

8/12/2019 Microeconomics Notes Engineering Class

1/36

1

Introduction to Microeconomics

Prepare by

James M. KenaniEconomics

Economics: is a social science that studies how human beings coordinate their wants anddesires, given the decision-making mechanism, social customs, and political realities of thesociety.

Economy: a well functioning system for coordinating productive activities that create the goodsand services that people want and get them to people who want them.

The three central coordination problems any economy must solve:1. What, and how much, to produce2. How to produce it3. For whom to produce it

Scarcity- Scarcity exists because individuals want more than can be produced

Scarcitymeans the goods available are too few to satisfy individuals desires- The degree of scarcity is constantly changing - the quantity of goods, services and usable

resources depends on technology and human action.

Example:A household faces many decisions. It must decide which members of the householddo which tasks and what each member gets in return: Who cooks dinner? Who does the laundry?In short, the household must allocate its scarce resources among its various members, taking intoaccount each members abilities, efforts, and desires.

A society also faces many decisions like households. A society must decide what jobs will bedone and who will do them. It needs some people to grow food, other people to make clothing,and still others to design computer software. Once society has allocated people (as well as land,buildings, and machines) to various jobs, it must also allocate the output of goods and servicesthat they produce. It must decide who will eat bread and who will eat potatoes. It must decide

who will drive a Porsche and who will take the bus.

Economic Reasoning

Economic reasoning, decisions are often made by comparing marginal costs and marginalbenefits.

- Marginal cost is the additional cost over and above costs already incurred- Marginal benefit is the additional benefit above and beyond what has already accrued


2/36

2

The economic decision rule:

- If the marginal benefits of doing something exceed the marginal costs, do it.MB > MCDo it!

- If the marginal costs of doing something exceed the marginal benefits, dont do it.MC > MBDont do it!Opportunity Cost

- Opportunity cost is the benefit forgone of the next-best alternative to the activity youhave chosen

- Opportunity cost is the basis of cost/benefit economic reasoningExamples of opportunity cost:

1. Individual decisionsThe opportunity cost of college includes:

- Items you could have purchased with the money spent for tuition and books- Loss of the income from a full-time job

2. Government decisionsThe opportunity cost of money spent on the farm subsidies is less spending on health careor education or infrastructure development.

Economic Systems

Societies are organized through different economic systems that can be summarized in the

following two systems: Market Economies (laissez faire) and Command Economies.

Market Economy: an economy in which production and consumption are the results ofdecentralized decision by many firms (producers) and individuals (consumers). There is nocentral authority to tell people what to produce or where to ship it. Each individual producermakes what he or she thinks will be most profitable: each consumer buys what he or she chooses.

- A market force is an economic force that is given relatively free rein by society to workthrough the market

- The invisible hand is the price mechanism that guides our actions in a market. Theinvisible hand is an example of a market force.

- If there is ashortage, prices rise- If there is asurplus, prices fall

Command Economy: an economy in which there is a central authority making decisions onproduction and consumption. Command economies have been tried, most notably in the SovietUnion between 1917 and 1971. This didnt work well. Producers in the Soviet Union routinelyfound themselves unable to produce because they did not have crucial raw materials, or succeed


3/36

3

in producing or found that consumers did not want their products, while consumers were unableto find necessary items.

Note that the above two economic systems are the extremes. In reality, we can find neither a purelaissez faire economy nor a pure command one; rather all societies are mixed economies that

combine both the free market approach and the command approach.

The Invisible Hand Theory (Adam Smith 1776 Book: An Inquiry into the Nature of the

Wealth of Nations)According to the invisible hand theory, a market economy, through the price mechanism, willallocate resources efficiently

- Pricesfallwhen quantity supplied is greater than quantity demanded- Prices risewhen the quantity demanded is greater than the quantity supplied- Efficiency means achieving a goal as cheaply as possible

The invisible hand usually leads markets to allocate resources efficiently. Nonetheless, forvarious reasons, the invisible hand sometimes does not work. Economists use the term marketfailure to refer to a situation in which the market on its own fails to allocate resourcesefficiently.

Sometimes government intervenes in the economy to correct this market failure. There are twobroad reasons for this intervention

(1)Promotion of efficiency and(2)Promotion of equity.

That is, most policies aim either to enlarge the economic pie or to change how the pie is divided.

One possible cause of market failure is an externality. An externality is the impact of onepersons actions on the well-being of a bystander. The classic example of an external cost ispollution. If a chemical factory does not bear the entire cost of the smoke it emits, it will likelyemit too much. Here, the government can raise economic well-being through environmentalregulation.

Another possible cause of market failure is market power. Market power refers to the ability ofa single person (or small group of people) to unduly influence market prices. For example,suppose that everyone in town needs water but there is only one kiosk. The owner of the kioskhas market powerin this case a monopolyover the sale of water. The well owner is notsubject to the rigorous competition with which the invisible hand normally keeps self-interest incheck.

A goal of many public policies, such as the income tax and the welfare system, is to achieve amore equitable distribution of economic well-being. To say that the government can improve onmarkets outcomes at times does not mean that it always will.

Public policies are made not by angels but by a political process that is far from perfect.Sometimes policies are designed simply to reward the politically powerful. Sometimes they are


4/36

4

made by well-intentioned leaders who are not fully informed. One goal of the study ofeconomics is to help you judge when a government policy is justifiable to promote efficiency orequity and when it is not.

What happens in society can be seen as a reaction to, and interaction of:

-

Economic forces- Social forces- Historical forces- Social, cultural, and political forces influence market forces- Political and social forces often work together against the invisible hand

Microeconomics and Macroeconomics

Economic theory is divided into two parts: Microeconomics and Macroeconomics.

Economics can study the decisions of individual households and firms or can study theinteraction of households and firms in markets for specific goods and services.

Economics can study the operation of the economy as a whole - which is just the sum of theactivities of all these decision makers in all these markets.

Microeconomics is the study of how households and firms make decisions and how they interactin specific markets.

A microeconomist might study the effects of rent control on housing in Lilongwe City, theimpact of foreign competition on the Japanese auto industry, or the effects of compulsory schoolattendance on workers earnings.

Microeconomics studies such things as:- The pricing policy of firms- Households decisions on what to buy- How markets allocate resources among alternative ends

Macroeconomics is the study of economy wide phenomena.

A macroeconomist might study the effects of borrowing by the Government (Capital Hill), thechanges over time in the economys rate of unemployment, or alternative policies to raise growthin national living standards.

Macroeconomics studies such things as:- Inflation- Unemployment- Economic growth


5/36

5

Microeconomics and macroeconomics are closely intertwined. Because changes in the overalleconomy arise from the decisions of millions of individuals, it is impossible to understandmacroeconomic developments without considering the associated microeconomic decisions.

Economic Institutions- To apply economic theory to reality, you've got to have a sense of economic institutions- Economic institutions are laws, common practices, and organizations in a society that

affect the economy- Economic institutions differ significantly among nations- They sometimes seem to operate differently than economic theory predicts

Economic Policy Options

Economic policies are actions (or inactions) taken by the government to influence economic

actions

- Objectivepolicyanalysis keeps value judgments separate from the analysis- Subjectivepolicy analysis reflects the analysts views of how things should be

Objective Policy Analysis

To distinguish between objective and subjective analysis, economics is divided into two

categories - Positive economics and Normative economics.

Consider these two statements you might hear:

John: Minimum wage laws cause unemployment

James:The government should raise the minimum wage

Notice that John and James differ in what they are trying to do. John is speaking like a scientist:

he is making a claim about how the world works. James is speaking like a policy adviser: he is

making a claim about how he would like to change the world.

Johns statement is positive. Positive statements are descriptive. They make a claim about howthe world is.Jamess statement is normative. Normative statements are prescriptive. They make a claim

about how the world ought

1. Positive economics: describes the way the economy actually works.2. Normative economics: prescribes about the way the economy should work.

A key difference between positive and normative statements is how we judge their validity. We

can, in principle, confirm or refute positive statements by examining evidence. An economist


6/36

6

might evaluate Johns statement by analyzing data on changes in minimum wages and changes in

unemployment over time.

By contrast, evaluating normative statements involves values as well as facts. Jamess statement

cannot be judged using data alone. Deciding what is good or bad policy is not merely a matter of

science. It also involves our views on ethics, religion, and political philosophy.

The Art of economics is using the knowledge of positive economics to achieve the goals

determined in normative economics

Tens Principles underlining Economics

HOW PEOPLE

Make decisions

Principle 1:People face tradeoffsPrinciple 2:The cost of something is what you give up to get it

Principle 3:Rational people think at the marginPrinciple 4:People respond to incentives

How people interact

Principle 5:Trade can make everyone better offPrinciple 6:Markets are usually a good way to organize economic activityPrinciple 7:Governments can sometimes improve market outcomes

How the economy as a whole works

Principle 8:A countrys standard of living depends on its ability to produce goodsand services

Principle 9:Prices rise when the government prints too much moneyPrinciple 10:Society faces a short-run tradeoff between inflation andunemployment


7/36

7

Production Possibilities Frontier

Scarcity implies the existence of tradeoffs. These tradeoffs can be illustrated quite nicely by aproduction possibilities frontier/curve.

Production Possibilities Frontier (PPF) isa graph that shows the combinations of output that theeconomy can possibly produce given the available factors of production and the availableproduction technology.

For simplicity, it is assumed that a firm (or an economy) produces only two goods (thisassumption is needed only to make the representation feasible on a two-dimensional surface -such as a graph on paper or on a computer screen). When a production possibilities curve isdrawn, the following assumptions are also made:

1. there is a fixed quantity and quality of available resources,2. technology is fixed, and3. there are no unemployed nor underemployed resources

Simple example: Suppose that a student has four hours left to study for exams in two classes:microeconomics and calculus. The output in this case is the exam score in each class. Theassumption of a fixed quantity and quality of available resources means that the individual has afixed supply of study materials such as textbooks, study guides, notes, etc. to use in the availabletime. A fixed technology suggests that the individual has a given level of study skills that allowhim or her to translate the review materials into exam scores. A resource is unemployed if it isnot used. Idle land, factories, and workers are unemployed resources for a society.Underemployed resources are not used in the best possible way. Society would haveunderemployed resources if the best brain surgeons were driving taxis while the best taxi driverswere performing brain surgery. If there are no unemployed or underemployed resources,

efficient productionis said to occur.


8/36

8

The table below represents possible outcomes from each various combinations of time studyingeach subject:

Number ofhours

spentstudyingcalculus

Number ofhours

spentstudyingeconomics

Calculusgrade Economicsgrade

0 4 0 60

1 3 30 55

2 2 55 45

3 1 75 30

4 0 85 0

Notice that each additional hour spent studying either calculus or economics results in smallermarginal improvements in the grade. The reason for this is that the first hour will be spentstudying the most essential concepts. Each additional hour is spent on the "next-most" importanttopics that have not already been mastered. (It is important to note that a good grade on aneconomics examination requires substantially more than four hours of study time.)

This is an example of a general principle known as the law of diminishing returns. The law ofdiminishing returns states that output will ultimately increase by progressively smaller amountsas additional units of a variable input (time in this case) are added to a production process inwhich other inputs are fixed (the fixed inputs here include the stock of existing subject matterknowledge, study materials, etc.).

To see how the law of diminishing returns works in a more typical production setting, considerthe case of a restaurant that has a fixed quantity of capital (grills, broilers, fryers, refrigerators,tables, etc.). As the level of labor use increases, output may initially rise fairly rapidly (sinceadditional workers allow more possibilities for specialization and reduces the time spentswitching from task to task). Eventually, however, the addition of more workers will result inprogressively smaller increases in output (since there is a fixed amount of capital for theseworkers to use). It is even possible that beyond some point workers may start getting in eachothers way and output may decline ("too many cooks may spoil the broth....".

In any case, the law of diminishing returns explains why your grade will increase by fewer pointswith each additional hour that you spend studying.

The points in the table above can be represented by a production possibilities curve (PPC) such


9/36

9

as the one appearing in the diagram below. Each point on the production possibilities curverepresents the best grades that can be achieved with the existing resources and technology foreach alternative allocation of study time.

Let's consider why the production possibilities curve has this concave shape. As the Figure 2

below indicates, a relatively large improvement in economics grade can be achieved by givingup relatively few points on the calculus exam. A movement from point A to point B results in a30-point increase in economics grade and only a 10-point reduction in calculus grade.

The marginal opportunity costof a good is defined to be the amount of another good that mustbe given up to produce an additional unit of the first good. Since the opportunity cost of 30points on the economics test is a 10-point reduction in the score on the calculus test, we can saythat the marginal opportunity costof one additional point on the economics test is approximately1/3 of a point on the calculus test. (If in doubt, note that if 30 points on the economics exam havean opportunity cost of 10 points, each point on the economics test must cost approximately

1/30th of 10 points on the calculus test - approximately 1/3 of a point on the calculus test).

Now, let's see what happens a second hour is transferred to the study of economics. The diagramabove illustrates this outcome (a movement from point B to C). As this diagram indicates,transferring a second hour from the study of mathematics to the study of economics results in asmaller increase in economics grade (from 30 to 45 points) and a larger reduction in calculusgrade (from 75 to 55). In this case, the marginal opportunity cost of a point on the economicsexam has increased to approximately 4/3 of a point on the calculus exam.

The increase in the marginal opportunity cost of points on the economics exam as more time isdevoted to studying economics is an example of the law of increasing cost. This law states thatthe marginal opportunity cost of any activity rises as the level of the activity increases. This lawcan also be illustrated using the table below. Notice that the opportunity cost of additional pointson the calculus exam rises as more time is devoted to studying calculus. Reading from thebottom of the table up to the top, you can also see that the opportunity cost of additional pointson the economics exam rises as more time is devoted to the study of economics.


10/36

10

Number ofhoursspentstudyingcalculus

Number ofhoursspentstudying

economics

Calculusgrade

Economicsgrade

Opportunity

Cost of 1 pt

on calc.

exam

Opportunity

Cost of 1 pt

on econ.

exam

0 4 0 60

1/6

2/5

3/4

3

6

5/2

4/3

1/3

1 3 30 55

2 2 55 45

3 1 75 30

4 0 85 0

One of the reasons for the law of increasing cost is the law of diminishing returns (as in theexample above). Each extra hour devoted to the study of economics results in a smaller increasein the economics grade and a larger reduction in the calculus grade because of diminishingreturns to time spent on either activity.

A second reason for the law of increasing cost is the fact that resources are specialized. Someresources are better suited for some types of productive activities than for other types ofproduction. Suppose, for example, that a farmer is producing both wheat and corn. Some land isvery well suited for growing wheat, while other land is relatively better suit for growing corn.Some workers may be more adept at growing wheat than corn. Some farm equipment is bettersuited for planting and harvesting corn.

The diagram below illustrates the PPC curve for this farmer.

At the top of this PPC, the farmer is producing only corn. To produce more wheat, the farmermust transfer resources from corn production to wheat production. Initially, however, he or shewill transfer those resources that are relatively better suited for wheat production. This allowswheat production to increase with only a relatively small reduction in the quantity of cornproduced. Each additional increase in wheat production, however, requires the use of resourcesthat are relatively less well suited for wheat production, resulting in a rising marginal opportunitycost of wheat.


11/36

11

Let's suppose that this farmer either does not use all of the available resources, or uses them in aless than optimal manner (i.e., either unemployment or underemployment occurs). In this case,the farmer will produce at a point that lies below the production possibilities curve (as illustratedby point A in the diagram below). This point A is feasible but not efficient of using resources.

Points above the production possibilities cannot be produced using current resources andtechnology. In the diagram below, point B is not obtainable (we cannot talk of about efficiency)unless more or higher quality resources become available or technological change occurs. PointC is feasible attainable and efficient.

An increase in the quantity or quality of resources will cause the production possibilities curve toshift outward (as in the diagram below). This type of outward shift could also be caused bytechnological change that increases the production of both goods.

C


12/36

12

In some cases, however, technological change will only increase the production of a specificgood. The diagram below illustrates the effect of a technological change in wheat production thatdoes not affect corn production.

Specialization and trade

In The Wealth of Nations, Adam Smith argued that economic growth occurred as a result ofspecialization and division of labor. If each household produced every commodity it consumed,the total level of consumption and production in a society will be small. If each individualspecializes in the productive activity at which they are "best," total output will be higher.Specialization provides such gains because it:

allows individuals to specialize in those activities in which they are more talented, individuals become more proficient at a task that they perform repeatedly, and less time is lost switching from task to task.

Increased specialization by workers requires a growth in trade. Adam Smith argued that growingspecialization and trade was the ultimate cause of economic growth.

Adam Smith and David Ricardo argued that similar benefits accrue from internationalspecialization and trade. If each country specializes in the types of production at which they arebest suited, the total amount of goods and services produced in the world economy will increase.Let's examine these arguments a bit more carefully.

There are two measures that are commonly used to determine whether an individual or a countryis "best" at a particular activity: absolute advantage and comparative advantage. These twoconcepts are often confused. An individual (or country) possesses an absolute advantagein theproduction of a good if the individual (or country) can produce more than can other individuals(or countries). An individual (or country) possesses a comparative advantage in the production ofa good if the individual (or country) can produce the good at the lowest opportunity cost.
http://www.bibliomania.com/NonFiction/Smith/Wealth/http://www.bibliomania.com/NonFiction/Smith/Wealth/http://www.bibliomania.com/NonFiction/Smith/Wealth/


13/36

13

Let's examine an example illustrating the difference between these two concepts. Suppose thatthe U.S. and Japan only produced two goods: CD players and wheat. The diagram belowrepresents production possibilities curves for these two countries.

Notice that the U.S. has an absolute advantage in the production of each commodity. Todetermine who has a comparative advantage, though, it is necessary to compute the opportunitycost for each good. (It is assumed that the PPC is linear to simplify this discussion.)

CDS APPORTUNITY COST WHEATS APPORTUNITY COST

CD 200/100 in US 100/200 in US

WHEAT 100/75 in JAPAN 75/100 in JAPAN

The opportunity cost of one unit of CD players in the U.S. is 2 units of wheat. In Japan, theopportunity cost of one unit of CD players is 4/3 of a unit of wheat. Thus, Japan possesses acomparative advantage in CD player production.

The U.S. however, has a comparative advantage in wheat production since the opportunity costof a unit of wheat is 1/2 of a unit of CD players in the U.S., but is 3/4 of a unit of CD players inJapan.

If each country specializes in producing the good in which it possesses a comparative advantage,it can acquire the other good through trade at a cost that is less than the opportunity cost ofproduction in the domestic economy.

If each country produces only those goods in which it possesses a comparative advantage, eachgood is produced in the global economy at the lowest opportunity cost. This results in anincrease in the level of total output.


14/36

14

A Model of a Competitive Market

Supply and Demand

Supply and Demand are the two words that economists use most often and forces that make

market economies work. They determine the quantity of each good produced and the price atwhich it is sold.

Competitive Markets

Competitive market: a market in which there are many buyers and many sellers so that each hasa negligible impact on the market price.Perfectly competitive markets are defined by two primary characteristics: (1) the goods beingoffered for sale are all the same, and (2) the buyers and sellers are so numerous that no singlebuyer or seller can influence the market price. Because buyers and sellers in perfectlycompetitive markets must accept the price the market determines, they are said to be price

takers.

Not all goods and services, however, are sold in perfectly competitive markets. Some marketshave only one seller, and this seller sets the price. Such a seller is called a monopoly. ElectricitySupply company, for instance, may be a monopoly. Residents of your town probably have onlyone supplier (ESCOM) from which to buy this service. Some markets fall between the extremesof perfect competition and monopoly. One such market, called an oligopoly, has a few sellersthat do not always compete aggressively. Airline routes are an example. If a route between twocities is serviced by only two or three carriers, the carriers may avoid rigorous competition tokeep prices high. Another type of market is monopolisticall y competi tive; it contains manysellers, each offering a slightly different product. Because the products are not exactly the same,

each seller has some ability to set the price for its own product. An example is the softwareindustry. Many word processing programs compete with one another for users, but everyprogram is different from every other and has its own price.

We assume in this chapter that markets are perfectly competi tive.

Demand

The demandfor a good or service is defined to be the relationship that exists between the priceof the good and the quantity that buyers are willing and able to purchase in a given time period,ceteris paribus. One way of representing demand is through a demand schedule such as the one

appearing below:

Price Quantity Demanded

$1 100

$2 80

$3 60

$4 40


15/36

15

$5 20

Note that the demand for the good is the entire relationship that is summarized by this table. Wecan write this relationship between quantity demanded and price as an equation:

PQQ DD

or this demand relationship may also be represented graphically as illustrated in the figure below.Note that the demand curve in that figure, labeled D, slopes downward: Consumers are usuallyready to buy more if the price is lower.

Both the demand schedule and the demand curve indicate that, for this good, an inverserelationship exists between the price and the quantity demanded when other factors are heldconstant. This inverse relationship between price and quantity demanded is so common thateconomists have called it the law of demand.

Law of demand: states that, ceteris paribus (other things equal), the quantity demanded of agood falls when the price of the good rises.

As noted above, demand is the entire relationship between price and quantity, as represented by ademand schedule or a demand curve. A change in the price of the good results in a change in thequantity demanded, but does not change the demand for the good. As the diagram belowindicates, an increase in the price from $2 to $3 reduces the quantity of this good demanded from80 to 60, but does not reduce demand.


16/36


17/36

17

Movement along the Demand Curve

A movement along the demand curve is a change in the quantity demanded of a good

resulting from the change in that goods price. The figure shows the decrease indemand from 80 units to 60 units along the demand curve resulting from the changesin price from $2 to $3.

Determinants of demand

Let's examine some factors that might be expected to change demand for most goods andservices. These factors include:

Price

The change in price causes the movement along the demand curve. Other things equal, when theprice of a good rises, the quantity demanded of the good falls. The quantity demanded istherefore negatively related to the price. This relationship between price and quantity demandedis true for most goods in the economy and, in fact, is so pervasive that economists call it the lawof demand.

D


18/36

18

Tastes and PreferencesThe most obvious determinant of your demand is your tastes. If you like ice cream, you buymore of it. However, peoplestastes cannot be explained because tastes are based on historicaland psychological forces that are beyond the realm of economics. Economists do, however,examine what happens when tastes change.

The prices of related goods

When the price of frozen yogurt falls, the law of demand says that you will buy more frozenyogurt. At the same time, you will probably buy less ice cream. Because ice cream and frozenyogurt are both cold, sweet, creamy desserts, they satisfy similar desires. When a fall in the priceof one good reduces the demand for another good, the two goods are called substitutes. Supposethat the price of computers falls. According to the law of demand, you will buy more computers.Yet, in this case, you will buy more software as well, because computers and software are oftenused together. When a fall in the price of one good raises the demand for another good, the twogoods are called complements. Complements are often pairs of goods that are used together,

such as gasoline and automobiles and skis and ski lift tickets.

Income

A lower income means that you have less to spend in total, so you would have to spend less onsomeand probably mostgoods. If the demand for a good falls when income falls, the good iscalled a normal good. If the demand for a good rises when income falls, the good is called aninferior good. An example of an inferior good might be bus rides. As your income falls, you areless likely to buy a car or take a cab, and more likely to ride the bus.

The number of consumers

The market demand curve consists of the horizontal summation of the demand curves of allbuyers in the market, an increase in the number of buyers would cause demand to increase. Asthe population rises, the demand for cars, TVs, food, and virtually all other commodities, isexpected to increase. A decline in population will result in a reduction in demand.

Expectations of future prices and income

Your expectations about the future may affect your demand for a good or service today. Forexample, if you expect to earn a higher income next month, you may be more willing to spend

some of your current savings buying computers. As another example, if you expect the price ofcars to fall next month, you may be less willing to buy cars cone at months price.

International effects

When international markets are taken into account, the demand for a product includes bothdomestic and foreign demand. An important determinant of foreign demand for a good is theexchange rate. The exchange rateis the rate at which the currency of one country is converted


19/36

19

into the currency of another country. Suppose, for example, that one dollar exchanges forMK250. In this case, the dollar value of one Kwacha is $.004. Notice that the exchange ratebetween dollars and Malawi Kwacha is the reciprocal of the exchange rate between Kwacha anddollars. Thus, an increase in the exchange value of the Malawi Kwacha (appreciation) results in areduction in the demand for Malawian goods and services. The demand for Malawian goods and

services will rise, however, if the exchange value of the Kwacha declines(depreciation/devaluation).

Supply

The supply curve shows the quantity of a good that producers are willing to sell at a given price,ceteris paribus(holding constant any other factors that might affect the quantity supplied). Thesupply curve is thus a relationship between the quantity supplied and the price. We can write thisrelationship as an equation:

Qs = Qs(P)

Or we can a supply schedule as the illustrated below.

Price Quantity Supplied

$1 20

$2 40

$3 60

$4 80

$5 100

Note that the supply for the good is the entire relationship that is summarized by this table or canbe represented by graph as shown below:

Note that the supply curve slopes upward: In other words, the higher the price, the more thatfirms are able and willing to produce andsell.For example, a higher price may enable currentfirms to expand production by hiring extra workers or by having existing workers work overtime(at greater cost to the firm). Likewise, they may expand production over a longer period of timeby increasingthe size of their plants.


20/36

20

Just as there is a "law of demand" there is also a "law of supply."

The law of supplystates thatceteris paribus (other things equal), the quantity supplied of a goodrises when the price of the good rises.

The law of supply indicates that supply curves will be upward sloping (as in the diagram below).

To understand the law of supply, it's helpful to remember the law of increasing cost. Since themarginal opportunity cost of supplying a good rises as more is produced, a higher price isrequired to induce the seller to sell more of the good or service.

Change in Supply

Shi ft of Supply Curve

Whenever there is a change in any determinant of supply, other than the goods price, the supplycurve shifts. As Figure below shows, any change that raises quantity supplied at every priceshifts the supply curve to the right. Similarly, any change that reduces the quantity supplied atevery price shifts the supply curve to the left.

S

S


21/36

21

Movement along the Supply Curve

A movement along the supply curve is a change in the quantity supplied of a goodresulting from the change in that goods price. The figure shows the increase in supplyfrom 40 units to 60 units along the supply curve resulting from the changes in price

from $2 to $3.

Market supply

The market supply curve is the horizontal summation of all individual supply curves. Thederivation of this is equivalent to that illustrated above for demand curves.

Determinants of supply

The factors that can cause the supply curve to shift include:

Price

When the price of a commodity is high, selling it is profitable, and so the quantity supplied islarge. As a seller, you work long hours, buy many machines, and hire many workers. Bycontrast, when the price of is low, your business is less profitable, and so you will produce less.At an even lower price, you may choose to go out of business altogether, and your quantitysupplied falls to zero.

Input Prices

An increase in the price of resources reduces the profitability of producing the good or service.This reduces the quantity that suppliers are willing to offer for sale at each price. Thus, anincrease in the price of labor, raw material, capital, or other resource, will be expected to changein supply of a good.


22/36

22

TechnologyTechnological improvements and changes that increase the productivity of labor result in lowerproduction costs and higher profitability. Supply increases in response to this increase in theprofitability of production.

ExpectationsThe amount of good you supply today may depend on your expectations of the future. Forexample, if you expect the price of a good to rise in the future, you will put some of your currentproduction into storage and supply less to the market today.

The number of producers

An increase in the number of producers results in an increase of the good in the market. Thismay shift market supply curve.

Prices of related goods and services

The supply decision for a particular good is affected not only by the price of the good, but alsoby the price of other goods and services the firm may produce. For example, an increase in theprice of corn may induce a farmer to reduce the supply of wheat. In this case, an increase in theprice of one product (corn) reduces the supply of another product (wheat). It is also possible, butless common, that an increase in the price of one commodity may increase the supply of anothercommodity. To see this, consider the production of both beef and leather. An increase in theprice of beef will cause ranchers to raise more cattle. Since beef and leather are jointly producedfrom cows, the increase in the price of beef will also be expected to result in an increase in thesupply of leather.

International effects

In our increasingly global economy, firms often import raw materials (and sometimes the entireproduct) from foreign countries. The cost of these imported items will vary with the exchangerate. When the exchange value of a Kwacha rises (appreciates), the domestic price of importedinputs will fall and the domestic supply of the final commodity will increase. A decline in theexchange value of the Kwacha will raise the price of imported inputs and reduce the supply ofdomestic products that rely on these inputs.

The Market Mechanism (Equilibrium)

The next step is to put the supply curve and the demand curve together as illustrated in figurebelow. This is now the price that sellers receive for a given quantity supplied, and the price thatbuyers will pay for a given quantity demanded.


23/36

23

It can be seen that the market demand and supply curves intersect at a price of $3 and a quantityof 60. This combination of price and quantity represents an equilibrium (market clearing)point where the quantity demanded equals the quantity supplied. At this price, each buyer is ableto buy all that he or she desires and each firm is able to sell all that it desires to sell. Once this

price is achieved, there is no reason for the price to either rise or fall (as long as neither thedemand nor the supply curve shifts).

If the price is above the equilibrium, a surplus occurs (since quantity supplied exceeds quantitydemanded). This situation is illustrated in the figure below. The presence of a surplus would beexpected to cause firms to lower prices until the surplus disappears (this occurs at theequilibrium price of $3).

If the price is below the equilibrium, a shortage occurs (since quantity demanded exceedsquantity supplied). This possibility is illustrated in the diagram below. When a shortage occurs,producers will be expected to increase the price. The price will continue to rise until the shortageis eliminated when the price reaches the equilibrium price of $3.

Surplus


24/36

24

Changes in Market Equilibrium

Let's examine what happens if demand or supply changes. First, let's consider the effect of anincrease in demand. As the figure below indicates, an increase in demand results in an increase inthe equilibrium levels of both price and quantity.

A decrease in demand results in a decrease in the equilibrium levels of price and quantity (asillustrated below).

Shortage


25/36

25

An increase in supply results in a higher equilibrium quantity and a lower equilibrium price.

Equilibrium quantity will fall and equilibrium price will rise if supply falls (as illustrated below.)

Price ceilings and price floors

A price ceilingis a legally mandated maximum price. The purpose of a price ceiling is to keepthe price of a good below the market equilibrium price. Rent controls and regulated gasolineprices during wartime and the energy crisis of the 1970s are examples of price ceilings. As thediagram below illustrates, an effective price ceiling results in a shortage of a commodity sincequantity demanded exceeds quantity supplied when the price of a good is kept below theequilibrium price. This explains why rent controls and regulated gasoline prices have resulted inshortages.


26/36

26

A price flooris a legally mandated minimum price. The purpose of a price floor is to keep theprice of a good above the market equilibrium price. Agricultural price supports and minimumwage laws are example of price ceilings. As the diagram below illustrates, an effective pricefloor results in a surplus of a commodity since quantity supplied exceeds quantity demandedwhen the price of a good is kept below the equilibrium price.

Elasticity of Supply and Demand

We have seen that thedemandfor a good depends not only on its price but also on consumerincome and on the prices of other goods. Likewise, supply depends both on price and onvariables that affect production cost. For example, if the price of coffee increases, the quantitydemanded will fall and the quantity supplied will rise. Often, we want to know how much thequantity supplied or demanded will rise or fall. How sensitive is the demand for coffee to itsprice (if price increases by 10 percent, how much will the quantity demanded change)? Howmuch will it change if income rises by 5 percent? We use elasticities to answer these questions.

Elasticity:a measure of the responsiveness of quantity demanded or quantity supplied to one ofits determinants. It tells us what the percentage change in the quantity demanded for a good willbe following a 1-percent increase in the price of that good.

Price elasticity of demand

The most commonly used elasticity measure is the price elasticity of demand, defined as:

PQEp %/% or

Price elasticity of demand (Ed) =

Price elasticity of demand:a measure of how much the quantity demanded of a good respondsto a change in the price of that good, computed as the percentage change in quantity demandeddivided by the percentage change in price.


27/36

27

Example: If the Consumer Price Index were 200 at the beginning of the year and increased to204 by the end of the year, the. Percentage change-or annual rate of inflation-would be 4/200 =.02, or 2 percent.) Thus we can also write the price elasticity of demand as follows?

PQ

QP

PP

QQEp

/

/

Price elasticity of demand is usually a negative number. When the price of a good increases, the

quantity demanded usually falls. ThusP

Q

(the change in quantity for a change in price) is

negative, as isEp. Sometimes the magnitude of the price elasticity is referred in its absolute size(ieEp= -2, asEp= 2 in magnitude).

Demand is said to be:

Elasticwhen Ed> 1, Unit elasticwhen Ed= 1, and Inelasticwhen Ed< 1.

When demand is elastic, a 1% increase in price will result in a greater than 1% reduction inquantity demanded. If demand is unit elastic, quantity demanded will fall by 1% when the pricerises by 1%. A 1% price increase will result in less than a 1% reduction in quantity demandedwhen demand is inelastic. For example, when the price elasticity of demand for a particular goodis 2, we say that demand is elastic and knows that a 1% increase in price will cause quantitydemanded to fall by 2%.

One extreme case is given by a perfectly elasticdemand curve, as appears in the figure below.Demand is perfectly elastic only in the special case of a horizontal demand curve. The elasticity

measure in this case is infinite (notice that the denominator of the elasticity measure equals zero).Consumers have bigger power. Consumers will buy as much as they want at a single price. Anyslight price increase will lead to drop of demand to zero.

At the other extreme, a vertical demand curve is said to be perfectly inelastic. Such a demandcurve appears in figure below. Note that the price elasticity of demand equals zero for a perfectly


28/36

28

inelastic demand curve since the % change in quantity demanded equals zero. Producer has abigger power. Consumers will buy a fixed quantity at any price.

Elasticity along a Linear Demand Curve

Price elasticity of demand is the change in quantity associated with a change in price

PQ / times the ratio of price to quantity (P/ Q). But moving down along the demand curve

PQ / may change, and the price and quantity will always change. Therefore, the price

elasticity of demand must be measure at a particular point on the demand curve and willgenerally change as we move along the curve. This principle is easiest to see for a lineardemand curve-that is, a demand curve of the form:

Q = a - bPAs an example, consider the demand curve

Q=8-2P

For this curve, PQ / is constant and equal to -2 (a P of 1 results in a Q of -2).

More generally, we can note that elasticity declines continuously along a linear demand curve.The top portion of the demand curve will be highly elastic and the bottom is highly inelastic. Inbetween, elasticity gradually becomes smaller as price declines and quantity rises. At some point,


29/36

29

demand changes from being elastic to inelastic. The point at which that occurs, of course, is thepoint at which demand is unit elastic. This relationship is illustrated in the diagram below.

Arc Elasticity

Suppose that we wish to measure the elasticity of demand in the interval between a price of $4and a price of $5. In this case, if we start at $4 and increase to $5, price has increased by 25%. Ifwe start at $5 and move to $4, however, price has fallen by 20%. Which percentage changeshould be used to represent a change between $4 and $5? To avoid ambiguity, the most commonmeasure is to use a concept known as arc elasticityin which the midpoint of the interval is usedas the base value in computing elasticity. Under this approach, the price elasticity formulabecomes:

where:

Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the pricerises from $3 to $5. The arc elasticity measure is given by:

In this interval, demand is inelastic (since Ed< 1).


30/36

30

Elasticity and Total Revenue

The concept of price elasticity of demand is extensively used by firms that are investigating theeffects of a change in the prices of their commodities. Total revenueis defined as:Total Revenue = Price x Quantity

When the price declines, quantity demanded by consumers rises. The lower price received foreach unit of output lowers total revenue while the increase in the number of units sold raises totalrevenue. Total revenue will rise when the price falls if quantity rises by a large enoughpercentage to offset the reduction in price per unit. In particular, we can note that total revenuewill increase if quantity demanded rises by more than one percent when the price falls by onepercent. Alternatively, total revenue will decline if quantity demanded rises by less than onepercent when the price declines by one percent. If the price falls by one percent and quantitydemanded falls by one percent, total revenue will remain unchanged (since the changes willoffset each other). A careful observer will note that this comes down to a question of themagnitude of the price elasticity of demand. As defined above, this equals:

price elasticity of demand (Ed) =

Using the logic discussed above, we can note that a reduction in price will lead to:

an increase in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and a decrease in total revenue when demand is inelastic.

In a similar manner, an increase in price will lead to:

a reduction in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and an increase in total revenue when demand is inelastic.

The diagram below illustrates the relationship that exists between total revenue and demandelasticity along a linear demand curve.


31/36

31

As this diagram illustrates, total revenue increases as quantity increases (and price decreases) inthe region in which demand is unit elastic. Total revenue falls as quantity increases (and pricedecreases) in the inelastic portion of the demand curve. Total revenue is maximized at the pointat which demand is unit elastic.

Does this mean that firms will choose to produce at the point at which demand is unit elastic?This would only be the case if they had no production costs. Firms are assumed to be concernedwith maximizing their profits, not their revenue. The optimal level production can be determinedonly when we consider both revenue and costs. This topic will be extensively addressed in futurechapters.

Determinants of price elasticity of demand

The price elasticity of demand is likely to be relatively high when:

The presence of close substitutes for a commodity, Demand for narrowly defined commodity is more elastic than the demand for broadlydefined commodity. The increase of commoditys share in the consumer's budget, Time frame of the analysis.

Other Demand Elasticities

In addition to the price elasticity of demand, there are also other elasticities that describe thebehavior of buyers in a market.

Income elasticity of demand

The income elasticity of demand is a measure of how sensitive demand for a good is to achange in income. Income elasticity of demand is measured as:

IQ

QI

II

QQEI

/

/or

Most goods are normal goodsmeaning that higher income raises quantity demanded. Becausequantity demanded and income moves in the same direction, normal goods have positive incomeelasticities. A few goods, such as bus rides, are in ferior goods: higher income lowers thequantity demanded. Because quantity demanded and income move in opposite directions,inferior goods have negative income elasticities.


32/36

32

Cross-price elasticity of demand

The cross-price elasticity of demandis a measure of the responsiveness of a change in the priceof a good to a change in the price of some other good. The cross-price elasticity of demandbetween the goodsjand kcan be expressed as:

kj

jk

kk

jj

PQPQ

QP

PP

QQE

kj

/

/

Notice that this cross-price elasticity measure does not have an absolute value sign around it. Infact, the sign of the cross-price elasticity of demand tells us about the nature of the relationshipbetween the goodsjand k. A positive cross-price elasticity occurs if an increase in the price of

good kis associated with an increase in the demand for goodj. This occurs if and only if thesetwo goods are substitutes. A negative cross-price elasticity of demand occurs when an increase inthe price of good kis associated with a decline in the demand for goodj. This occurs if and onlyif goodsjand kare complements.

Price elasticity of supply

We can also apply the concept of elasticity to supply. The price elasticity of supplyis definedas:

Note that the absolute value sign is not used when measuring the price elasticity of supply sincewe do not expect to observe a downward sloping supply curve.

A perfectly inelastic supply curve is vertical as in the figure below. The price elasticity of supplyis zero when supply is perfectly inelastic.


33/36

33

A perfectly elastic supply curve is horizontal as illustrated in the figure below. The supply curvefacing a single buyer in a market in which there are a very large number of buyers and sellers islikely to appear to be perfectly elastic (or close to this, anyway). This will occur when eachbuyer is a "price-taker" who has no effect on the market price.

Short-run and Long-run Elasticities

When analyzing demand and supply, we must distinguish between the short run and the long run.Inother words, if we ask how much demand or supply changes in response to a change in price,we must be clear about how much time is allowed to pass before we measure the changes in thequantity demanded or supplied. If we allow only a short time to pass-say, one year or less-thenwe are dealing with the short run. When we refer to the long run we mean that enough time isallowed for consumers or producers to adjust fully to the price change. For example, demand ismuch more price elastic in the long-run than in the short-run (i.e. if price of coffee rises sharply,the quantity demanded will fall only gradually as it takes time for people to change their

consumption pattern).

Tax incidence

As your text notes, the distribution of the burden of a tax depends on the elasticities of demand

and supply. When demand is inelastic, consumers bear a larger share of the tax burden (i.e.

tobacco, alcohol and petroleum oil)


34/36

34

Mathematical Illustrations

Example 1:The Market for Wheat: The supply curve for wheat is approximately as follows:Supply: Qs = 1800 +240P

where price is measured in nominal dollars per bushel and quantities in millions of bushels peryear. These-studies also indicate that in 1981, the demand curve for wheat isDemand: QD= 3550-266P

Lets set the quantity supplied equal to the quantity demanded. The market-clearing price ofwheat can be determined as follows:

Qs = QD1800 + 240P = 3550 - 266P506P = 1750P = $3.46 per bushel

To find the market-clearing quantity, substitute this price of $3.46 into either the supply curveequation or the demand curve equation. Substituting into the supply curve equation, we get:

Q = 1800 + (240)(3.46) = 2630 million bushels.

What are the price elasticities of demand and supply at this price and quantity? We use thedemand curve to find the price elasticity of demand:

35.0)266(2630

46.3

PQ

QPEDP

Thus demand is inelastic. We can likewise calculate the price elasticity of supply:

32.0)240(2630

46.3

PQ

QPE sSP

Since these supply and demand curves are linear, the price elasticities will vary as we movealong the curves.

Now, suppose that a drought caused the supply curve to shift far enough to the left to pu sh theprice up to $4.00 perbushel. In this case, the quantity demanded would fall to:

3550 - (266)(4.00) = 2486 million bushels.

At thisprice and quantity, the elasticity of demand would be

43.0)266(2486

00.4

D

PE

Example 2: Fittinglinear demand and supply curves to market data. We can write these curves

algebraically as follows: Demand: Q = a bP.Eq. 1Supply: Q = c + dP... Eq. 2

Lets findnumbers for the constants a, b, c, and d. This is done, for supply and for demand, in atwo-step procedure:

Step 1: Recall that each price elasticity, whether of supply or demand, can be written as:E = (P/Q)(Q/P)


35/36

35

Where Q/Pis the small change in quantity demanded or supplied resulting from a small change

in price. For linear curves Q/Pis constant. From the equations above, Q/P= dfor supply and

Q/P= -bfor demand.

Lets substitute the values for Q/Pinto the elasticity formula:

Demand:ED= -b(P*/Q*).Eq. 3

Supply: Es= d(P*/Q*)...Eq. 4

whereP* and Q* are the equilibrium price and quantity for which we have data and to which wewant to fit the curves. Since we have numbers for Es'ED'P*, and Q*, we can substitute thesenumbers in equations 3 and 4 and solve for band d.

Step 2: Since we now know band d, we can substitute these numbers, as well asP* and Q*, intoequations 1 and 2 and solve for the remaining constants a and c. We can rewrite equation 1 as a= Q* + bP* and then use our data for Q* andP*, together with the number we calculated in Step1 for b, to obtain a.

Let's apply this procedure to a specific example: long-run supply and demand for the worldcopper market. The relevant numbers for this market are as follows:

Quantity Q*= 12 million metric tons per year (mmt/yr)PriceP*= $2.00 per poundElasticity of supplyEs= 1.5Elasticity of demandED= -0.5.

Lets start withsupply curve equation and use the two-step procedure to calculate numbers for cand d. The long-run price elasticity of supply is 1.5, P* = $2.00, and Q* = 12.

Step 1: Substitute these numbers in equation to determine d:1.5 = d (2/12) = d/6

So that d = (1.5)(6) = 9

a/b

a

-c/d

Supply: Q = c + dP

Demand: Q = a - bP

Q*

P*

Ep= -b(P*/Q*)

Ep= d(P*/Q*)


36/36

Step 2: Substitute this number for d, together with the numbers forP* and Q*, into equation 4 todetermine c:

12 = c + (9)(2.00)= c + 18So that c = 12- 18= -6.Now, we know c and d, so we can write our supply curve:

Supply: Q = -6 + 9P

Following same steps for the demand curve equation:The long-run elasticity of demand is -0.5. First, substitute this number, as well as the values for

P* and Q*, into equation 3 to determine b:-0.5 = -b(2/12) = -b/6

So that b = (0.5)(6)= 3.

Second, substitute this value for b and the values forp* and Q* in equation 3 to determine a:12 = a - (3)(2)= a - 6

So that a = 12 + 6 = 18.

Thus, our demand curve is: Demand: Q = 18 -3P

Example 3: Demand might also depend on income as well as price. We would then writedemand as:

Demand: Q = a-bP + fI...Eq. 5

whereI is an index of aggregate income or GDP? For Example,I might equal 1.0 in abase yearand then rise or fall to reflect percentage increases or decreases in aggregate income.

For our copper market example, a reasonable estimate for the long-run income elasticity ofdemand is 1.3.For the linear demand curve in equation 5,we can then calculate fby using the

formula for the income elasticity of demand: E = (I/Q)(Q/I)Taking thebase value ofI as 1.0, we have:

1.3 = (1.0/12)(f)Thus f= (1.3)(12)/(1.0) = 15.6.

Finally, substituting the values b = 3, f=15.6, P* = 2.00, and Q* = 12 in equation 5, we cancalculate that a must equal 2.4.

Now, we have seen how to fit linear supply and demand curves to data.

Microeconomics Notes Engineering Class

Documents

Transcript of Microeconomics Notes Engineering Class