27250177 Micro Economic Principles and Policy Course Introduction

8/3/2019 27250177 Micro Economic Principles and Policy Course Introduction

1/32

Microeconomic Principles and Policy

Course Introduction and Overview

Contents

1 Course Objectives 32 The Course Author 33 Course Content 44 The Course Structure 55 Learning Outcomes 66 Study Materials 77 Studying the Course 7


2/32


2 University of London


3/32


4/32



3 Course Content

This course covers four main topics that you will need to understand in order to have a

good grasp of microeconomic theory:

basic concepts of the market demand, supply and equilibrium principles underlying consumer demand principles underpinning the theory of the firm concept of market structures, especially competitive and monopolistic markets.

The course starts by introducing the idea of the market, which is comprised of three

concepts: demand, supply and equilibrium. In terms of the economic principles you will

study here, markets are at the centre of economic activity. But in order to be able to

analyse why consumer demand changes when, for example, the price of a good

changes or why a firm decides to produce a certain level of output, you need to inves-

tigate the theoretical underpinnings of both demand and supply.

Unit 2 considers the economic behaviour of consumers and develops an economic

model designed to explain how consumers choose the most preferred bundles of goodsand services they can afford. There you will study how consumer preferences are

explained using indifference curves; how the budget constraint represents the resources

available to the consumers; how and why consumer choice is expressed by the interac-

tion of indifference curves and the budget constraint; and lastly, how these choices are

used to derive the demand curve for goods and services.

Units 3 and 4 turn to the supply side of the market and examine the theory of the firm

and how output and pricing decisions are made on the basis of the notion that firms

aim to maximise profits. In those units we investigate both the technical and economic

relationships of the firm and how it makes its decisions about pricing and output, and

how the firm and market supply curves are derived. In developing this model of firmsbehaviour, it is initially assumed that all markets are perfectly competitive.

But in Unit 5, you will study what happens when the assumption of perfect competi-

tion is relaxed and what the implications are for the firms pricing and output

decisions when the market structure is non-competitive. In Unit 6, we develop a model

of the demand and supply for factor input markets, firstly in a competitive market

and then in non-competitive markets.

Up to this point, your study will focus on the market behaviour of consumers and

firms as if they were each a separate market with no interaction between them. Obvi-

ously, that is not true in the real world, and you will be introduced to general

equilibrium analysis in Unit 7. This is a model of how equilibrium conditions areachieved when consumers, firms and factor markets all interact, and whether the

equilibrium achieved is in any way efficient in terms of resource allocation. Finally, in

Unit 8, you will study what happens when the market fails to result in pricing and

output decisions that are efficient in terms of resource allocation.


5/32


Centre for Financial and Management Studies 5

4 The Course Structure

Unit 1 Concepts of Demand, Supply and Markets

1.1 Introduction to Unit 1

1.2 The Market1.3 The Basics of Demand and Supply1.4 Elasticities of Demand and Supply1.5 Applications of Supply and Demand Analysis1.6 Conclusion

Unit 2 Consumer Theory

2.1 Introduction to Consumer Theory2.2 Consumer Preferences2.3 Budget Constraint2.4 Consumer Choice2.5 Consumer Demand2.6 Case StudyAnnex 2.1Utility TheoryAnnex 2.2 Revealed Preference Analysis

Unit 3 Theory of Production and Costs

3.1 Introduction to the Theory of Production and Costs3.2 Production, Technology and the Firm3.3 Theory of Production3.4 Economic Costs3.5 Cost Functions3.6 Case Study

Unit 4 Profit Maximmisation and Competitive Supply

4.1 Introduction4.2 Profit Maximisation4.3 Perfect Competition4.4 Short-run Supply Curves4.5 Long-run Supply Curves4.6 Applications in Competitive Markets4.7 Conclusion

Unit 5 Non-Competitive Market Structures

5.1 Introduction5.2 Monopoly and Monopoly Power5.3 Monopolistic Competition5.4 Contestable Markets5.5 Policy Analysis5.6 Conclusion


6/32



Unit 6 Factor Input Markets

6.1 Introduction6.2 Competitive Input Markets6.3 Non-Competitive Factor Markets6.4 Summary of Input Markets6.5 Applications6.6 Case Study6.7 Conclusion

Unit 7 General Equilibrium, Efficiency and Pareto Optimality

7.1 Introduction7.2 General Equilibrium Analysis7.3 Efficiency and the Pareto Optimality Criterion7.4 Reviewing Theory7.5 Conclusion

Unit 8 Externalities, Public Goods and Asymmetric Information

8.1 Introduction8.2 Externalities8.3 Public Goods8.4 Asymmetric Information8.5 Case Study8.6 Conclusion

5 Learning Outcomes

When you have completed your study of this course you will be able to

explain the basic concepts of the market demand, supply and equilibrium discuss the principles underlying consumer demand identify and discuss the principles underpinning the theory of the firm outline the concept of market structures, especially competitive and monopolistic

markets

analyse the effect of taxing monopoly profits explain the implications of introducing a minimum wage or a production quota

on the pricing and output decisions of the firm

argue whether taxing a firm that is dumping pollutants into a river can result inless pollution

discuss the implications of introducing a minimum wage or a production quotaon the pricing and output decisions of a firm.


7/32



6 Study Materials

This Study Guide is your central learning resource as it structures your learning unit by

unit. Each unit should be studied within a week. It is designed in the expectation that

studying the unit and the associated core readings will require 15 to 20 hours during

the week, but this will vary according to your background knowledge and experience of

studying.

Text Books

Two textbooks are provided for this course:

Robert Pindyck and Daniel Rubinfeld (2009) Microeconomics, Seventh edition,

Upper Saddle River New Jersey USA: Pearson Education International

Saul Estrin, David Laidler and Michael Dietrich (2008) Micro-economics, Fifth

edition, Harlow Essex UK: Pearson Education Ltd.

The reason for having two textbooks is that the two together will provide you with the

best grounding in microeconomic theory and its applications. The Pindyck and Rubin-

feld textbook covers all the basic theory and provides you with plenty of examples of

its applications. At the end of each chapter of this book, the authors set Questions for

Review and Exercises, and I recommend that you jot down at least brief answers to

these.

Estrin, Laidler and Dietrich also cover the theory, but their textbook

does so in more depth and this is especially true of the topics youll be studying in the

second half of the course. It also provides an algebraic treatment of the main theory

and this should be helpful if you are comfortable using calculus.

For each course unit you will see instructions for which chapters of the textbooks tostudy, and when you should stop and read them.

Course Reader

The Course Reader provides a selection of academic articles and extracts from books

and journals, which you are expected to read as part of your study of this course. You

will note from reading them that the topics covered in these articles often vary widely

from the Study Guide. The Course Reader articles are often more technical or adopt a

more in-depth approach. This should not put you off, as many were written with an

academic audience in mind. These articles were selected so that the central arguments

and concepts could be understood and appreciated at a level appropriate to this

course.

7 Studying the Course

In the units, you will be asked to answer questions and solve exercises related to the

course materials. The exercises are an essential part of the course, and it is important


8/32



that you take your time to answer them. Solution to the exercises are provided either

within the text of the Study Guide or at the end of the unit.

There are two assignments, after Unit 4 and Unit 8. These count together for 30% of the

course grade. A three-hour unseen written examination counts for the other 70%. To

gain good marks it is essential that you make use of the materials in the textbooks and

reader and apply ideas and techniques to real world circumstances. You will be asked

to show your analytical skills and, of course, you will be judged only on the quality of

your knowledge and argument and not on your opinions.


9/32


Unit 1 Concepts of Demand, Supply

and Markets

Contents

1.1 Introduction to Unit 1 31.2 The Market 31.3 The Basics of Demand and Supply 61.4 Elasticities of Demand and Supply 121.5

Applications of Supply and Demand Analysis 15

1.6 Conclusion 18References 18Answers to Review Questions 19


10/32



Unit Content

Unit 1 examines the theories and applications of microeconomics. It intro-

duces the basic concepts, such as the market, equilibrium and supply and

demand. The unit explains how the demand-supply framework is used for

analysing economic problems and its application for policy purposes.

Learning Outcomes

When you have completed s tudy of this unit and its readings, you will be

able to

outline the characteristics of the market in economic analysis discuss the concept of equilibrium analyse the nature of a market clearing equilibrium explain what factors influence demand and supply

draw demand and supply curves and explain their significance discuss the difference between a movement along the demand/supply

curve and a shiftof the demand/supply curve explain the economics meaning and significance of elasticity use the demandsupply framework for analysis.

Reading for Unit 1

Textbook

Robert Pindyck and Daniel Rubinfeld (2009)Microeconomics, Seventh

edition, New Jersey USA: Pearson PrenticeHall. Part I Introduction:

Markets and Prices, Chapters 1 Preliminaries and 2 The Basics of Supply

and Demand.

Course Reader

DN Hyman (1993) Import Quotas, Tariffs and Consequences of Protecting

Domestic Industries from Foreign Competition,Modern Microeconomics

Analysis and Applications, Third edition, Homewood Illinois, USA: Richard

D Irwin Inc; pp. 41-45.


11/32



1.1 Introduction to Unit 1

The first unit of this course focuses on the basics of demand and

supply. These concepts are used throughout this course and most of

the other courses you will be studying for your degree. So they are impor-

tant concepts.

In this unit are questions and exercises to enable you to apply the theoreti-

cal material you are studying to specific economics problems. We expect

you to read the course material criticallyand to question the ideas you

meet in your answers. Therefore, to begin this unit, we set the principal

question that the unit tries to answer. You should keep this question in

mind as you study this unit and, at the end, consider what answer you

would give. The overall question for this unit is

Can the concepts of demand and supply be used to explain marketbehaviour, and what are the assumptions required for this to happen?

1.2 The Market

The conventional view of a market is a place, where people buy and sell

fruit, vegetables, clothes, household goods and so on. A shop and a large

department store are, of course, other examples of markets, as is the stock

exchange or the trade in raw materials such as copper bars or gold bullion,

or a container loaded with scrap metal. However, the economic definition of

a market, the one that you will use in your study of microeconomics, is the means through which buyers and sellers interact and transactions

take place.Clearly, for any market to function there must be both buyers and sellers.

But usually it is much more than that. There must also be dealers who are

ready to make a market. There must be rules and regulations setting out

how the market operates, and there must also be a means of transmitting

information so that all the market participants know what is going on.

We will turn first to the economic agents who are required to make a

market function. Buyers or consumers consist of individuals who purchase

goods and services, as well as firms that purchase labour, capital and the

raw materials needed for the production of goods and services. Sellers are

also individuals and firms that sell the goods and services they produce individuals who sell their labour, and resource owners who sell other

natural resources such as oil or timber. In a simple market, there are usu-

ally just buyers and sellers who interact directly with each other. But in

more complex markets, there are a whole host of roles available for inter-

mediaries, such as brokers, dealers, market-makers, information agents and

so on, whose role it is to ensure that the market functions by setting prices,

providing information and introducing buyers and sellers.

1.2.1 Markets and prices

In economics a market is a concept that should not be thought of as neces-

sarily having a physical location. Although particular markets are located

in a specific building or on a particular street, such as the New York Stock


12/32



Exchange on Wall Street, the concept of a market is not confined to a

physical location. Some markets such as foreign exchange markets are

international in scope, and access to such markets is usually through a

computer terminal. Other markets are much smaller and more localised,

like the market for rented housing that may be found in the back pages of

your local newspaper.The other key element of the market is the role ofprices, which provide the

signals by which buyers and sellers react to each other. To the buyer, prices

provide information about the availability of goods and services in the

market, and decisions about the quantities to purchase are based on this

information. On the other side, sellers use the information conveyed by

prices to decide what quantities to sell. So prices play a key role in co-

ordinating market decisions.

Although prices provide the signals that co-ordinate market decisions, there

is no overall co-ordination of how these signals are acted upon by the

various market players. In other words, there is no conscious direction tothe functioning of the market. So in an atomistic market of the type de-

scribed above, each buyer and seller acts alone and not as part of some

centralised plan. This characteristic of the market, whereby economic

decisions are co-ordinated on a decentralised basis, led eighteenth century

economists to talk of a policy of laissez-faire (to leave alone). These econo-

mists used this French expression to condemn any deliberate or

governmental interference in business or industry as being inappropriate

and potentially harmful. Today it is usually interpreted to mean that the

economy functions best when it is largely free from government intervention

and economic decisions are determined mainly by the market.

1.2.2 Markets and competition

We study the market because it is a process or mechanism by which eco-

nomic decisions are made. While it is not the only mechanism for making

economic decisions, it is the one that is often used to characterise those of

most industrialised countries. The fact that such economies may be better

described as mixed economies is sometimes overlooked, and it is the

market element that is focused on instead. One of the key features of a

market is the decentralised nature of the decision making where each

player, whether buyer or seller, makes a decision based on the signals

transmitted by the prices. This contrasts with the centralised nature ofeconomic decision making in command economies.

It is because of this decentralisation of the markets decision-making

process that we study and develop models of the economic behaviour

of the buyers and sellers. In other words, you need to study the

economic behaviourof buyers and sellers in order to explain how the

market functions.

There are, however, other specific market features that are important in

economics. For example, a market in which there are both many buyers and

many sellers, such that no single buyer or seller can influence prices alone, is

a perfectly competitivemarket. Some stock markets, like those in New Yorkand London, are usually considered to be competitive because there are


13/32



both many buyers and many sellers and no one party is able to dictate or

exert a significant impact on the market price at which company shares or

stocks are exchanged. You will study the characteristics of perfect competi-

tion in Unit 4 of this course.

But perfect competition is not always the case. In some markets, there may

be just one producer or a number of producers who between them doinfluence the price at which goods are traded. Here the actions of the

Organisation of Petroleum Exporting Countries (OPEC) in raising the

world price of oil in 1973 and again in 1979 provide good examples of

noncompetitivemarket behaviour. A single buyer or a small number ofbuyers may also be able to influence market prices, and this too would lead

to noncompetitive market behaviour. As an analogy, it might be useful to

think of a spectrum, where at one end there is perfect competition with its

many buyers and sellers, and at the other is a market with just one buyer or

just one seller. In between there are many other combinations of buyers and

sellers and the markets resulting from their interaction have varying degreesof competitiveness.

ReadingPlease read Section 1.2 of Pindyck and Rubinfeld, pages 712. As you read this section,you should focus on the following questions.

What are the assumptions underlying the concepts of competitive andnoncompetitive markets?

What do we mean by the term market price? What is meant by the extent of a market?

Why do we need to be able to define a market?

When you have finished this reading, write down some examples of competitive andnoncompetitive markets in your local economy. Then, review your list of markets andconsider their extent both in terms of physical boundaries and product ranges. Are any ofthe markets you have listed international in scope?

Now that you have studied markets and market behaviour in general,

consider the following question:

Are there economic activities that take place outside the market?The answer is yes. Think about the meals you eat at home. If you went to arestaurant to eat all your meals, then this would be classified as a market

activity as you are buying both goods the food, and a service someone

prepares and serves the food to you. Yet, if your meals are prepared by a

family member at home, it is a nonmarket activity as (apart from the raw

ingredients) its preparation does not involve any buying or selling.

ReadingThe main thrust of Chapter 1 of Pindyk and Rubinfeld is to introduce you to the study ofmicroeconomics. In Section 1.1, the themes of microeconomics are laid out, and in 1.3,

the authors discuss the difference between realand nominal prices. Section 1.4 asks

Robert S Pindyck and

Daniel L Rubinfeld

(2009)

Microeconomics,

Chapter 1 Preliminaries,

section 1.2 What is a

Market?

Robert Pindyck and

Daniel Rubinfeld (2009)

Microeconomics,

Chapter 1 Preliminaries.


14/32



the question, why study economics?, using the Ford Motor Company to exemplifydecision making. You should read the whole of the chapter now.

As you read this chapter, please focus on the following questions:

How do planned and market economies differ in the allocation of scarceresources?

What different sorts of constraints are faced by consumers, workers and firms? How are theories used and evaluated in economics?

What is the difference between positive and normative economics? How do real and nominal prices differ?

1.3 The Basics of Demand and Supply

In this course, we shall develop different types of economic models to

explain different types of economic behaviour in particular, the equilib-

rium value of economic decisions.

1.3.1 The concept of equilibrium

Equilibrium can be thought of as analogous to the balance of opposing

forces. It is a state in which there is no tendency to change a point of rest.

In a set of scales, an equilibrium condition is achieved when the weights on

opposite sides of the scale are in balance or at a point of rest. In a mathe-

matical model, the equilibrium condition is the solution derived from a set

of equations, given the values of the other parameters.

First consider a simple economic model of demand and supply for a good.

In this case, we are seeking to explain how demand and supply interact so

that the price at which a good is traded means that consumers may pur-chase all they want of the good and producers can sell all they want to

produce of the good. In other words, we are considering the equilibrium

price and quantity of a particular good. Underlying this equilibrium solu-

tion are assumptions about how consumers and producers behave their

demand and supply, respectively. To return to the analogy of the mathe-

matical model, think of the consumer demand and producer supply as a

set of two equations and the equilibrium values of price and quantity as

the solutions to these equations given the values of other variables.

More formally, we say in the case of an economic model that an equilibrium

is a set of the values derived on the basis of behavioural assumptions andthe values of the other variables.

This is not to say equilibrium is always static. Equilibrium can change if

one or more of the other variables influencing it changes, or the assump-

tions underlying the model are altered. For example, if the price of potatoes

rises, then consumers may alter their expenditure so that they buy fewer

potatoes and more of other goods. This would result in a new equilibrium

based on new circumstances.

It is important to note that the concept of economic equilibrium does not

incorporate any notion of desirability or fairness or correctness. It is simply

the outcome of a model based on a set of assumptions and given values forthe other factors. Therefore, it is a positive, rather than a normative, concept.


15/32



In developing economic models, equilibrium is an important concept, and

you need to know how to achieve an equilibrium point and how to move

from one equilibrium position to another. To understand consumer behav-

iour, we need a model that will enable us to explain what quantities are

consumed given a set of assumptions about how consumers behave and

the values of other factors, as well as what happens when there is a changein price or income. Although we have used the example of quantities in the

discussion of equilibrium, it is a general concept and applies to prices,

incomes, interest rates, hours worked, acres of land, computers, office

buildings or any set of interacting objects or forces.

The departure from an equilibrium position or a state in which equilibrium

has not been achieved is called disequilibrium. That is, there is no balance of

forces and so there is a tendency for things to change over time. It is not a

point of rest a state of disequilibrium is considered to be unstable as it

involves a tendency for change of one or more of the variables we are trying

to explain.

1.3.2 The demand curve and the supply curve

Because these concepts are practical ones, we begin this discussion with

and exercise for you to complete.

Exercise

As an introduction to the concepts of demand and supply, consider the followingquestions and note down your answers:

What determines how much of a particular good or service a consumer is

willing to buy at a particular time? What determines the level of output a producer decides to sell? What determines the equilibrium price and quantity?

Consider the factors that determine consumer demand for a particular

good. The price of the good is obviously one important consideration. But

so is the consumers level of income. It is one thing for a consumer to want

to buy a bicycle, but the consumer will not plan to buy one unless the price

is acceptable and he or she has sufficient income to afford the purchase.

The price of other goods, such as bus fares, shoes or cars, is also a consid-

eration affecting the demand for bicycles. If bus fares are very cheaprelative to the price of a bicycle, then this may affect the consumers deci-

sion about whether or not to buy a bicycle. The consumers demand is also

influenced by his or her preference. Perhaps, regardless of relative prices,

the consumer has a preference for travelling by bicycle rather than by bus,

or vice versa. Other factors that influence a consumers demand for a bicycle

may be the weather, advertising, the population of the surrounding area or

the state of the roads. So we can say that the quantity demanded of a good

or service is determined by, or is a function of, its price, the consumersincome, the price of other goods and services and other factors, such as

preferences, weather, advertising and population.

One of the usual assumptions of market economics is that the higher the

price for a product, the lower the quantity demanded. This is sometimes


16/32



referred to as the law of demand, whereby consumers are assumed to buy

more if the price of a product falls and less if the price rises. The reasoning

underlying this assumption is that as the price of a particular good rises,

consumers switch their demand to another good that might serve them

almost as well. This would be consistent with the assumption that indi-

viduals pursue their self-interest. If the price of bicycles rises, for example,demand falls as people switch to cheaper options such as using the bus

or walking. If the price of bicycles falls, then the quantity demanded in-

creases as walkers and bus users now plan to buy bicycles.

To represent theoretical concepts, economists often use graphs. In drawing

graphs of the relationship between price and quantity, it is customary to

put prices on the vertical or Y-axis and quantity on the horizontal or X-

axis. An example of a graph of a demand curve is shown by line DD in

Figure 1.1. It slopes down to the right, as consumers are willing to buy

more as the price decreases.

Exercise

Using the lefthand panel in Figure 1.1, consider the following questions:

What is happening in moving from point A to point B on the demandcurve DD?

What happens in shifting from demand curve DD to demand curve D1D1?

Figure 1.1 Demand and Supply Curves

B

A

C

DP1

P2

Q1 Q2 Q3 Q4

P1

P2

Q1 Q2

S

S1

S

S1

D

D1

D

D1

Demand Supply

Moving from A to B on demand DD is a movement along the demandcurve, and it represents an increase in the quantity demanded from Q1 to

Q2 as the price falls from P1 to P2. A movement along the demand curve

from B to A would represent a price rise and a decrease in the quantitydemanded. A shift of the demand curve from DD to D1D1 is different from

the movement along the demand curve. In this case, the whole curve has

shifted to the right and at each and every price the quantity demanded hasincreased. So at price P1, the new quantity demanded is Q3, while at price

P2, the new quantity demanded is Q4. A shift of the demand curve to theleft would signify the reverse.


17/32



Now consider the supply of a good. This is the amount that producers plan

to sell in a particular period, and it too is dependent on price. Like demand,

the supply of an item is affected by a number of different factors, such as

the prices of other goods and services in the market, the prices of the inputs

required to produce the item and the technology used to produce it. In the

case of the supply of bicycles, it is influenced by the price of bus travel, carsor other forms of transport; and it is affected by the cost of the inputs such

as the metals, the tyres and the labour required to make a bicycle.

The usual assumption with respect to the supply of goods is that the

higher the price, the larger the quantity producers are willing to supply;

while the lower the price, the less they will supply referred to as the law of

supply. In the case of firms producing or supplying goods, it is generally

assumed that producers require higher prices in order to gain from selling

increased quantities because production costs rise as the quantity pro-

duced increases. In graphical terms, this means that the supply curve

slopes upwards, as shown by line SS in Figure 1.1. As with demand curves,it is necessary to distinguish between movement along the supply curve fromCto D and a shift of the supply curve from SS to S1S1. The former, a move-ment along the supply curve, represents an increase in the quantitysupplied from Q1 to Q2 as the price increases; whereas a shift of the supply

curve to the right represents a higher level of the amount supplied at each

and every price.

ReadingTo examine the interaction of demand and supply, you should now read Sections 2.1 and

2.2 of Pindyck and Rubinfeld, pages 2226.

When reading these pages, you should note down the assumptions madeconcerning the operation of the market. You should also note why the assumptions areimportant for achieving an equilibrium

1.3.3 Market-clearing equilibrium

The market-clearing equilibrium is where consumer demand is fully satis-

fied and the producers have sold all they supply, as illustrated by point E

in Figure 1.2. The market mechanism works to ensure that there are no

surpluses or shortages of goods to be bought or sold. It is in equilibrium

because there is no reason why the market should move to any other point,

and it is market clearing because the quantity demanded and the quantity

supplied are equal. In Figure 1.2, the market would not clear at any pointother than the equilibrium point E. If the price is P1, then it is said to be in

disequilibrium as the quantity supplied at point B is greater than the

quantity demanded at point A and there is pressure for the price to fall

until demand equals supply.

Consider the following questions:

Does an equilibrium always exist? Is it possible for there to be more than one equilibrium point? Is an equilibrium point stable?

Robert Pindyck and


Microeconomics,

Chapter 2 The Basics of

Supply and Demand,sections 2.1 Supply and

Demand and 2.2 The

Market Mechanism.


18/32



Figure 1.2 Demand and Supply Equilibrium

P

S

E

D

Q

A B

P0

P1

To achieve equilibrium, we need to have the demand and supply curves

crossing. It is possible to think of situations where this does not happen

and so there is no equilibrium, as illustrated in Figure 1.3.

Figure 1.3 Examples Where There are No Equilibria

Panel A Panel BP

S

S

D

D

P

QQ

In the first case, Panel A, supply is always greater than demand. This can

happen if the price of the good is zero or free, either entirely as is the case

with the air we breathe or up to a certain quantity. In the second case,Panel B, the price suppliers want to charge is everywhere greater than the

price consumers are willing to pay. An example of this might be solid gold

briefcases. It is possible to draw other sets of supply and demand curves

that do not intersect. However, not all such examples necessarily make

sense in economic terms.

Figure 1.4 illustrates some examples of multiple equilibria where there is no

unique intersection of demand and supply. However, in each of these cases,

either the supply curve is not always upward sloping, as in Panels A, B

and C, or the demand curve is not always downward sloping, as in Panel

C. In general, we can say that there is a unique equilibrium as long as the

demand curve is always downward sloping and the supply curve is always

upward sloping.


19/32



Figure 1.4 Examples of Multiple Equilibria

Panel A Panel B Panel CP

S

S

D

P

QQ

SP

Q

D

Source: Henderson and Quandt (1980: 131)

An equilibrium is said to be stable if adisturbance

results in a return toequilibrium, and it is unstable if it does not. A disturbance denotes a

situation where the actual price is not the equilibrium price and so there is

excess demand or excess supply. The equilibrium is said to be stable if in

this situation consumers and producers adjust the quantities they demand

and supply so as to eliminate the excess demand or excess supply. This

will always be the case if the demand curve slopes downward and the

supply curve slopes upward throughout.

This depends on the assumptions made about how consumers and pro-

ducers behave that is, that consumers demand more at lower prices andproducers supply more at higher prices. If the consumers were to demand

more at higher prices and therefore the demand curve was upward sloping,

then any disturbance is unlikely to lead to a new equilibrium, and so it is

referred to as unstable.

1.3.4 Shifts in demand and supply

So far, the graphical analysis has considered demand and supply as a

function of price. But, as noted above, demand can be influenced by other

factors such as the price of other goods, the level of income, preferences

and population whereas supply can be influenced by the prices of other

goods, the prices of factors of production and the technology of produc-

tion. Changes in any of these factors can affect the equilibrium price and sowe need to examine, in graphical terms, how the market mechanism han-

dles such changes.

ReadingPlease read Section 2.3 of Pindyck and Rubinfeld, including their examples, pages 2633.

When you have finished reading, make a list of the factors that cause the demandcurve (1) to shift to the right and (2) to the left, and similarly for the supply curve.

In discussing the shifts of the supply curve, we have been making an

assumption about production that producers can continue to increase

Robert Pindyck and

Daniel Rubinfeld (2009)Microeconomics


Supply and Demand,

section 2.3 Changes in

Market Equilibrium.


20/32



the quantity supplied and do not face any constraints such as factory size

or limits on the availability of raw materials. In the real world, producers

may be able to increase supply only to a certain extent before they face such

limits as factory size or lack of skilled labour or other inputs. So markets

may not achieve an equilibrium position as seamlessly as we have been

indicating.We have also been ignoring time in the discussion of the market mechanism.

Time affects the way in which the producer can alter the use of inputs in

production. Not all inputs can be increased or decreased quickly. For

example, it takes different amounts of time to build a new factory, to

install new machinery and to hire new workers. To differentiate these time

periods, we talk about the short run, which is the production period where

some inputs cannot be varied. The short run usually refers to the time

period in which labour can be hired and fired and raw material inputs

altered but in which it is not possible to build new factories, for example.

The latter occurs only in the long run, when all production inputs can bevaried.

The analysis so far has been comparing one equilibrium position with

another. This type of exercise is known as comparative statics because it

involves comparing two equilibria positions without concern as to the time

it takes to move from one equilibrium position to another, or to how the

market achieves it. Economic analysis concerned with studying the move-

ment of economic systems through time is referred to as dynamics. The

movement from one equilibrium to another in time raises interesting ques-

tions, and it is generally referred to as disequilibrium dynamics. Most of the

analysis you will be doing in this course is comparative statics, which

ignores how the market moves from one equilibrium to another.

Exercise

To make sure you understand the difference between movements alongdemand andsupply curves and shifts in demand and supply, explain what happens to the equilibriumprice and quantity, using demand and supply curves, in each of the following situations:

hot weather causes the demand for ice cream to rise

the demand for gasoline if the price rises the supply of shoes if shoemakers wages increase tea prices rise on the news that pests have destroyed the Sri Lankan tea crop oil producers are refining and selling larger quantities of oil new technology reduces the price of computers.

Sample answers are provided at the end of this unit.

1.4 Elasticities of Demand and Supply

The concepts you have been studying enable you to analyse what is hap-

pening if there is a change in one of the factors influencing demand or

supply. But is it possible to give any quantitative answers to such questions

as by how much can we expect the demand and supply for a good to

change if the price of that good is halved? In asking this type of question,we are concerned with a measure of sensitivity of the quantity demanded


21/32



or supplied to a change in another variable. This measure of sensitivity is

called the elasticity.

We can define the elasticity of the quantity demanded or supplied as the

percentage change that occurs in the quantity demanded or supplied in

response to an incremental change (or a very tiny change such as 1%) in

another variable. For instance, theprice elasticity ofdemand(ED) measuresthe change in quantity demanded of an incremental change in the price, and

it can be expressed as

ED =QD/QD

P/P =

PQD

QDP or

PdQD

QDdP

where P is the incremental price change and Qdis the change in the

quantity demanded.2 From the last expression you can see that the priceelasticity can be expressed as the ratio of price to quantity (P/QD) times the

inverse of the slope of the demand curve,

1

dP /dQD

= dQ

D

dP .

The price elasticity of demand is usually a negative number because the

quantity demanded falls as the price increases. That is, the expressionQD/P is negative, so the whole expression is negative. Price elasticity can

range from zero to minus infinity (). To express price elasticity as a

positive number, multiply by (1). If the percentage change in quantity

equals the percentage change in price that is, the elasticity = 1, then we

talk of unit elasticity. If the change in quantity is proportionately greater

than the change in price that is, the elasticity is greater than 1 (>1), we

talk about an elastic demand. In the case where the change in quantity isproportionately less than the change in price (elasticity % change in P Elastic

Source: Hyman (1986: 35)

ReadingNow read Pindyck and Rubinfeld, Chapter 2, Sections 2.4 and 2.5 on pages 3448.

As you do this reading, write down your answers to the following questions: What is meant by the terns completely inelastic and infinitely elastic?

What happens to the price elasticity of demand as you move along thedemand curve?

2 If the changes are very small, this can be expressed in terms of calculus, dQD/dP.

Robert Pindyck and


Microeconomics

Chapter 2 The Basics ofSupply and Demand,

sections 2.4 Elasticities

of Supply and Demand,

and 2.5 Short-Run

versus Long-Run

Elasticitiies.


22/32



What measures of elasticity are there besides the price elasticity of demand? How do the presence of substitute goods and complementary goods affect

the cross-price elasticity of demand? Why is it important to distinguish between short-run and long-run elasticities?

Infinitely elastic or completely inelastic demand can be thought of asspecial cases of the price elasticity of demand. If demand is perfectly

elastic, then any change in price results in an infinite change in the quantity

demanded. If it is completely price inelastic, then a change in price has no

effect whatsoever on the quantity demanded. These two cases are illus-

trated on page 36 of Pindyck and Rubinfeld.

On page 35 of this textbook in Figure 2.11, the price elasticity of demand

varies as you move along the linear demand curve. When the price is zero,

the price elasticity of demand is also zero; whereas when the price is very

high the price elasticity of demand approaches minus-infinity. This is

because elasticity is being measured at different points along the demandcurve with the assumption that the percentage change in prices is incremen-

tally small.3 From this, it is seen that consumers are more responsive to

price changes when prices are already high than when prices are low.

As well as measuring consumers sensitivity to changes in the price of a

good, economists are also interested in assessing the responsiveness of

consumer demand to percentage changes in income or in the price of other

goods. That is, we want to measure the income elasticity of d emand and the

cross-price elasticityof demand. The expressions for calculating these elas-ticities are set out on page 36 of Pindyck and Rubinfeld.

When goods are substitutes, then the cross-price elasticity of demand ispositive because one good can be used in place of the other. This can be

illustrated by considering blue ink and black ink pens as substitute goods. If

the price of blue ink pens increases and they are more expensive relative to

black ink ones, then the likely result is an increase in the demand for black

ink pens. However, if goods are complementary, such as lamps and light

bulbs, an increase in the price of lamps reduces the demand for lamps and

this tends to reduce the demand for light bulbs.

Optional RereadingPindyck and Rubinfeld explain the significance of short-run and long-run elasticities onpages 4048; you should reread those pages if you are unsure about it.

As an exercise please do the following: Prepare a similar to Table 1.1 above for the price elasticity of supply. Answer Review Questions 3 and 6 on page 61 of Pindyck and Rubinfeld.

My answers are given at the end of the unit, but be sure to complete the exerciseyourself before looking at them.

3 This is referred to as the point of elasticity of demand and it is calculated as(P/QD)(dQD/dP), where the last expression is the inverse of the slope of the demand curve for

a given P and QD.


23/32



1.5 Applications of Supply and Demand Analysis

In the previous reading, Pindyck and Rubinfeld give some examples of how

to use the concept of elasticity for analytical purposes. The next section

introduces another application of the concept with respect to the effect of

a change in price on the total revenue earned from selling a good.

1.5.1 Price elasticity and revenue

Revenue can be thought of as the receipts from sales the price of the good

times the quantity sold.

Although we know that if the price of a good falls, the quantity demanded

increases, this does not tell us anything about the effect such a change

could have on revenue. If the price falls by only a small percentage and yet

there is a large percentage change in the quantity demanded, then total

revenue could rise. Or, if a fall in prices only results in a small percentage

increase in quantity demanded, total revenue could decline. So the effect ontotal revenue of a change in price depends on the elasticity of demand. The

derivation of the relationship between price elasticity and total revenue is

set out in the box below.

Price Elasticity and Revenue

Total revenue (R) is the price of a good times the quantity and is written as P * Q.Assume the price changes to (P +P) and the quantity demanded changes to(Q +Q), then the revenue this generates is (P +P) * (Q +Q), which can be

rewritten

R1= PQ + PQ + QP + PQ

Taking the difference in revenue as

R = R R1 = PQ + QP + PQ.

Assume that the last expression (PQ) is so small that it can be ignored. Therefore, thechange in revenue is approximately equal to the original price times the change inquantity plus the original quantity times the change in price.

To measure the effect of a change in price on a change in revenue, we can divide bothsides of the above expression by Pand rearrange it as follows:

R/P = Q + P(Q/P) = Q[1+ (P/Q) * (Q/P)]

The last expression is equal to the price elasticity so that the change in revenue with

respect to a change in price is equal to the quantity times one plus the price elasticity:

R/P = Q[1 + price elasticity]

Recall that the price elasticity of demand is usually a negative number, so if the absolutevalue of the price elasticity (the actual number ignoring any negative signs) is greaterthan one, the change in revenue resulting from a change in price is negative and viceversa.

You can also think of it in the following way: if the demand is very responsive to changesin pricethat is, elasticthen a fall in price will increase demand so much that revenuewill rise. However, if demand is not very responsivethat is, inelasticthen a fall in pricewill not change demand by much and total revenue will fall.

Source: Varian (2007: 26567)


24/32



1.5.2 Calculating supply and demand curves

You can complete this section with a reading from your textbook.

Reading

In Section 2.6, pages 4958, Pindyck and Rubinfeld use numerical examples to constructsupply and demand curves using price elasticities. I would like you to read these pagesand follow through their examples.

When you have completed this reading, I would like you to do Exercises 2 and 8 onpages 62 and 63.

Answers are given at the end of the unit.

1.5.3 Analysing government policies

The concepts of demand and supply can also be used to examine theimpact of a governments decision to regulate prices by introducingprice

controls enabling it to set maximum prices price ceilings , or minimum

prices price floors.

ReadingFor a further discussion of how the concepts of demand and supply can be used toexamine the implications of government price controls, please read Pindyck andRubinfeld, Chapter 2, Section 2.7 on pages 5861.

In this exercise, you should show what would happen to the demand and supply for

labour if a minimum wages law were passed. Suppose the government legislates toensure that all workers are paid a minimum wage for their work. In doing this exercise,you should consider two possibilities:

1 the minimum wage is set at a level below the existing equilibrium wage level,

and

2 the minimum wage rate is higher than the present equilibrium wage rate.

Illustrate your answer by using supply and demand curves.

My answer is provided at the end of the unit.

While on the subject of government policy, what do you think wouldhappen to demand and supply if the government imposed a tax on a

specific good?

ExerciseExamine that question by considering a new tax on petrol sales of 10 cents per litre. Inthis analysis, you can assume that the market is in equilibrium before the tax is imposedand that the petrol supplier collects the tax on behalf of the government. Please draw therelevant demand and supply curves.

Robert Pindyck and


MicroeconomicsChapter 2 The Basics of

Supply and Demand,

section 2.6

Understanding and

Predicting the Effects of

Changing MarketConditions.

Robert Pindyck and

Daniel Rubinfeld (2009)Microeconomics


Supply and Demand,

section 2.7 Effects of

Government

InterventionPriceControls.


25/32



For the petrol supplier, the tax will be the same as an increase in the cost of

production because each month the supplier will have to remit to the

government an amount equal to the new tax rate times the number of litres

of petrol sold. What will this do to the supply curve, and why?

The supply curve shifts to the left and there is a new equilibrium price of P1

rather than P0, as shownin Figure 1.5. The new equilibrium quantity ofpetrol bought and sold will be lower at Q1 rather than Q0.

This analysis can actually tell us quite a lot. The new market price P1 is the

gross price paid by the consumer, while the price P2 is the net price received

by the supplier. The difference, P1 P2, is equivalent to the new 10 cents per

litre tax and the shaded area represents the total tax revenue the govern-

ment will receive.

Figure 1.5 Impact of new tax on petrol

Price

S

D

Quantity

P0

P1

P2

Q0Q1

S1

Figure 1.5 also enables us to determine how the payment of the tax is being

shared between the supplier and the consumer this usually referred to as

sharing the tax burden. The share of the tax being paid by the petrol supplieris P0 P2, and by the consumerP1 P0.

Exercise

Now that you have drawn your own demand and supply curves and studied the analysis,answer the following questions:

Which party would be bearing the tax burden if the demand for petrol isinelastic? Is that a realistic assumption?

What is the impact of the tax if the supply curve is very elastic?

Sample answers are given at the end of the unit.

The policy applications of demand and supply that we have been examin-

ing so far all relate to price. It is also important to consider what happens if

the government were to introduce restrictions on the quantity of goods sold

in the form of quotas. Import quotas are a good example, where the gov-

ernment restricts the quantity of a foreign good that can be sold in thecountry.


26/32



ReadingTo see how such quotas work, I would like you to read the extract by David Hyman,which illustrates an application of the basic concepts you have learned by examining theeffects of tariffs and import quotas on the US textile and clothing industries.

While reading the article, you should focus on the following questions: What are import quotas and tariffs?

Why is the supply curve kinked following the imposition of quotas on theimport of Japanese cars?

Why is the price of a car higher with import quotas than without?

What factors affect whether sales revenue increases or decreases when quotasare applied to car imports?

What effect did quotas on Japanese cars have on the sales of American madecars?

Why can the imposition of a tariff have the same effect as introducing quotasfrom the point of view of consumers?

Which would the Japanese producers prefer quotas or tariffs, and why?

The answers to all these questions are found in the reading. So refer back to it if youhave any difficulties in replying to them.

1.6 Conclusion

It is important that at the end of this units study, you feel comfortable

using the concepts of markets, demand and supply. While the demand

supply framework may appear simple, it is extremely useful as the basis of

quite sophisticated analyses of economic problems. To check your under-

standing of the concepts, look again at the learning outcomes listed on the

introductory page at the start of the unit. If you are unsure of any of the

topics, review the unit section that covers it.

References

Henderson, JM and RE Quandt (1980) Microeconomic Theory: A Mathemati-

cal Approach, Third edition, London: McGraw Hill.

Hyman, DN (1993)Modern Microeconomics Analysis and Applications, Third

edition, Homewood Illinois, USA: Richard D Irwin Inc.Parkin, M (2008) Economics, Eighth edition, London: Pearson Addison-

Wesley.

Pindyck, RS and DL Rubinfeld (2009)Microeconomics, Seventh edition, New

Jersey USA: Pearson PrenticeHall.

Varian, HR (2007) Intermediate Microeconomics, A Modern Approach, Sixth

edition, London: Academic Internet Publishers Incorporated.

David Hyman (1993)

Import Quotas, Tariffs

and Consequences of

Protecting Domestic

Industries from Foreign

Competition, reprinted

in the Course Reader

from ModernMicroeconomics

Analysis and

Applications.


27/32



Answers to Review Questions

Section 1.3.4

What happens to the equilibrium price and quantity, using demand and supply

curves, when hot weather causes the demand for ice cream to rise?

Hot weather increases the demand for ice cream at all prices so the demandcurve shifts to the right from D to D1. At price P0, there is excess demand

for ice cream (Q2 Q0). This excess demand is then mitigated in some way

i.e. through queuing and suppliers also increase the amount of ice

cream they can sell. A new equilibrium is reached when prices have risen toP1 and the quantity demanded and supplied is Q1.

Figure 1.6 Demand and supply of ice cream

Price

S

D

Quantity

P0

P1

Q0 Q1

D1

Q2


curves, when the demand for gasoline if the price rises?

Figure 1.7 Gasoline demand and supply

Price

S

D

Quantity

P0

P1

Q0Q1 Q2

The price of gasoline is increased by producers from P0 to P1. This leads to

excess supply of gasoline of Q2 Q1 because at the higher price the quan-

tity demanded is Q1 and the quantity supplied is Q2. Because there is

excess supply, there is a tendency for suppliers to lower the price and this


28/32



will push up the amount demanded and so there is a tendency for the

market to return to its original equilibrium position.


curves, when the supply of shoes if shoemakers wages increase?

Figure 1.8 Demand and supply for shoes

Price

S

Quantity

P0

P1

Q0Q1

S1

The increase in shoemakers wages increases the price of shoes for allquantities supplied so the supply curve shifts to the left from S to S1. The

result is that the new equilibrium quantity demanded and supplied de-clines from Q0 to Q1, where the equilibrium price is P1.


curves, when tea prices rise on the news that pests have destroyed the Sri

Lankan tea crop?

The destruction of much of the tea crop means there is a shift of the supply

curve to the left and that prices rise for all quantities supplied. As a result

of the price rise, the demand for tea declines and a new equilibrium isachieved at a price of P1 and with the quantity traded of Q1.

Figure 1.9 Demand and supply for tea

Price

S

Quantity

P2

P1

Q0Q1

S1

D

What happens to the equilibrium price and quantity, using demand and supplycurves, when oil producers are refining and selling larger quantities of oil?


29/32



If oil producers increase the amount of oil they are selling from Q0 to Q1,

this gives rise to excess supply at the price P0. Excess supply will put

pressure on producers to lower prices or cut back on the amounts refined.

The tendency is for the market to return to its original equilibrium position.

Figure 1.10 Demand and supply for oil

Price

S

Quantity

P0

Q0 Q1

D

P1

S1


curves, when new technology reduces the price of computers?

Figure 1.11 Demand and supply of computers

Price

S

Quantity

P0

Q0 Q1

D

New technology means that computer manufacturers can produce and sell

computers more cheaply and so the supply curve shifts right from S to S1.This results in a new equilibrium at a lower price P1 and at a higher quan-

tity of Q1.

Section 1.4

Price Elasticity of Supply

Value ofelasticity

Relative Responsiveness ofquantity supplied to price change

Supply (ES)

response

0 ES < 1 % change in QS < % change in price inelastic

ES = 1 % change in QS = % change in price unit elastic

1 < ES % change in QS > % change in price elasticSource: Hyman (1986: 36)


30/32



Pindyck & Rubinfelds Review Question 3

The elasticity of demand is the percentage change in quantity demandeddivided by the percentage change in price. So a 6% fall in quantity ( 6)divided by a 3% increase in price (3) yields an elasticity of 2.

Pindyck & Rubinfelds Review Question 6In the short run, consumers and producers cannot always react quickly toprice changes and so their demand and supply curves may be relatively

inelastic compared to the long run when all changes can be taken intoaccount. For example, it takes time to build a new factory and increase theamount of goods supplied.

In the case of consumers, the demand for non-durable goods, such aspaper towels, probably changes very little in the short run and so its de-mand would be expected to be relatively inelastic in the short run. In the

long run, consumers tastes can be expected to change and so one would

expect its price elasticity of demand to be greater in the long run.Television sets are considered to be durable goods and it is expected that

the quantity demanded is responsive to price changes in the short run.

Section 1.5.2

Exercise 2

a The price elasticity = (P/Q).(Q/P) at p = 80, the price elasticity ofdemand = 0.4; at price = 100 , the price elasticity of demand = 0.56

b At p = 80, the price elasticity of supply = 0.50; at price = 100, theprice elasticity of supply = 0.56

c The equilibrium price = $100 and the equilibrium quantity = 18million

d With a price ceiling of $80, consumers plan to buy 20 million whereasproducers plan to supply 16 million, so there is a shortage of 4million.

Exercise 8a Using the same method as outlined in the text, we want to solve for a

and b in the equation QD = a b.P. We are given the following data :

ED = b.P*/Q*= 0.4, P* = 0.75 and Q* = 7.5. Therefore, 0.4 = b(0.75/7.5), so b = 4. To solve for a = Q* + b.P*; a = 7.5 + 4 (0.75) =

10.5. The demand curve is QD = 10.5 4.P.b If there is a 20% decline in copper demand, this implies the demand

curve (QD = 10.5 4.P) is shifted to the left by 20%; that is,equivalent to its being 80% of its original form QD1 = 80% (10.5 4.P) = 8.4 3.2.P. Equating this with the supply curve QS = 4.5 +16.P and solving for P, the new equilibrium price is $0.672 or 67.2cents/lb.

Section 1.5.3

In the minimum wage imposed by the new law is less than the presentequilibrium wage W

E, then the quantity of labour supplied by workers

willing to work at that wage declines from QE to Q1, while the amountdemanded by firms rises to Q2. At a minimum wage of W1, there is excess


31/32



demand for labour. On the other hand, if the minimum wage of W2 is

higher than the present equilibrium wage, there will be an increase in the

quantity of labour supplied at that wage while demand will fall, and hence

there is excess supply. It is assumed that the labour market is competitive.

Figure 1.12 Minimum wage

Price(wage rate)

S

D

excess supply

excess demand

We

W2

W1

Q2QeQ1

When the demand for petrol is perfectly inelastic, the demand curve is a

vertical straight line. The imposition of a tax on petrol shifts the supplycurve to the left (SS to S1S1) and the price increases from P0 to P1 but the

equilibrium quantity does not change. The petrol consumers have to bear

the full burden of the tax.

D

P1

P0

Q1

S1

Q0

S

P1

P0

Quantity

S

S1

S

S1

D

D

Quantity

Price Price

Inelastic petrol demand Elastic petrol supply

If the supply curve for petrol is perfectly elastic, then we show it as a

horizontal straight line. In this case, the imposition of new tax shifts thesupply curve to the left and the price increases from P0 to P1 while the

equilibrium quantity decreases to Q1. It is the consumers, again, who bear

the full burden of the tax.


32/32


Documents

27250177 Micro Economic Principles and Policy Course Introduction