Microeconomics Level 1

Microeconomics Level 1

0915 Registration0930 Course objectives and outline0940 Introduction to economics1040 COFFEE

1100 What markets do: supply, demand, and equilibrium1145 Group work1215 Review of group work

1300 LUNCH

1400 Market failure, and government intervention1445 Group work

1505 Review of group work & TEA1530 Cost benefit analysis1600 Lessons from Level 11610 Test1645 End

COURSE OBJECTIVES

This course has three objectives

• to provide an overview of the scope and methods of economics

• to offer a self-contained introduction to key themes in microeconomics

• to equip participants to proceed to Level 2

COURSE OBJECTIVES

• Economic analysis aims to be rigorous, but it need not be technical.

• No prior knowledge of economics or mathematics is assumed.

CONCEPTS & TOOLS

Basic Concepts

• Stocks and Flows• Goods and services

% of National Output

Agriculture Industry Services

UK

1965 3 46 51

1997 2 30 68

France

1965 8 39 53

1997 2 27 71

Basic Concepts

• What, how and for whom• Markets versus Command Economy

Basic Concepts

• MICROECONOMICS: detailed study of decisions made by consumers, producers and their interaction in specific markets

• MACROECONOMICS: big picture – emphasizes interactions in the economy as a whole.

Basic Concepts

• POSITIVE ECONOMICStries to explain behaviour

• NORMATIVE ECONOMICS prescriptions based on value judgments

Basic Concepts: The Production Possibility Frontier

Maximum quantity one good that can be produced, given quantities of other goods being produced

A

B

C

D

E

F

G

.

GOOD 1

GOOD 2

A, B, C efficient

(on the frontier)

D, E inefficient

(inside the frontier)

F, G unattainable

(outside the frontier)

Basic Concepts

OPPORTUNITY COST OF A GOOD

What we could have had instead

Basic Concepts

COMMAND ECONOMY central planner issues orders

FREE MARKET ECONOMYwhat, how & for whom decided by prices, incomes, wealth

DEGREES OF GOVERNMENT INTERVENTION

Hong Kong- China - Denmark - UK - USA -Cuba

(but how long?)

Scale of government(spending as % of national income)

1880 1930 1960 1990

Japan 11 19 18 32

USA 8 10 28 36

UK 10 24 32 41

Germany 10 31 32 45

France 15 19 35 52

Sweden 6 8 31 50

TOOLS

MODEL Deliberate simplification of realitylike a map

DATA TIME SERIESCROSS SECTION

TOOLS

NOMINAL & REAL VARIABLES

1970 1982 1991Unit labour

costs100 406 589

Real unit labour costs = (Unit labour costs / Retail prices) x 100

Real unit labour costs

100 93 82

Retail prices 100 438 720

Tools: Visualizing data

A scatter diagram

variable x

variable y

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++

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+

+

+

+

+

+

+

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+

Tools: Interpreting the data

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+

+

+

+

Bus fare

Bus Revenue

It appears that higher bus fares cause higher revenue…

Tools: Interpreting the data

+++

++

+

+

+

+

Bus fare

Bus Revenue

… but it might not be true

Low tube fare

High tube fare

Suppose the two clusters are from two different time periods – what might that imply?

Tools: Interpreting the data

Bus revenue depends on bus fare

But it also depends on other things• incomes• price of other modes of travel• relative reliability (relative to other modes of

travel)• relative comfort

• relative perception of safety

DEMAND, SUPPLY & PRICE ADJUSTMENT

Market

• DEMANDquantity buyers wish to buy at each price

• SUPPLY quantity producers wish to sell at each price

• MARKET arrangement to exchange goods & services

• EQUILIBRIUM PRICEthe price at which market clears(i.e. quantity demanded = quantity supplied)

Market

Demand curve

quantity

price

EquilibriumQuantity

EquilibriumPrice

PRICE ADJUSTMENT

Equilibrium price clears market

Supply curve

Market

The demand curve shows the relation between price of a good and quantity demanded of that good.

But how does demand change when ‘other things’ change?

DEMAND IN MORE DETAIL elaborating on the ‘other things’

How does DEMAND for a good vary when

1 price of a related good changes?– substitutes – complements

2 consumer’s income changes?– normal goods– inferior goods

3 tastes change? – role of fashions and fads, culture

COMPARATIVE STATICS(effect of changing the ‘other things’)

Suppose income rises, increasing demand

Quantity

Price

Demand: low income

Equilibrium price rises

Equilibrium quantity rises

Demand : high income

Supply

SUPPLY IN MORE DETAIL elaborating the ‘other things’

How does SUPPLY of a good vary when

1 technology improves?

2 input prices change?energy, labour, capital

3 regulation imposes extra costs?

COMPARATIVE STATICS

Suppose technical breakthrough raises supply

Quantity

Price

Demand

2 but equilibrium price falls

1 Equilibrium quantity rises...

Supply rises

COMPARATIVE STATICS

An important differenceAn important difference

• If demand shifts, equilibrium price and quantity move in the SAME DIRECTION

• If supply shifts, equilibrium price and quantity move in OPPOSITE DIRECTIONS

SOME EXAMPLES

Third world farmingThird world farming• What is the effect of better irrigation & fertilizer?• What happens to price? To quantity? • To revenue?

ComputersComputers Over the last 5 years the price of a PC has been falling.• Which is shifting, demand or supply?

Introduction to EconomicsGROUPWORK

1 Are the following statements positive or normative?

(a) Higher tax rates cut revenue from tobacco taxes(b) Poor countries got an unfair share of world income(c) Smoking is antisocial & should be discouraged(d) Airbus needs public support(e) Airbus deserves public support(f ) Airbus is a good investment for Britain

GROUPWORK

2 The price of crude oil increased from $2.90 to $9 per barrel in 1973, in a coordinated move by OPEC members.

(a) How did the OPEC members manage to raise the price? Show using a supply-demand diagram for the oil market.

(b) What happened to the demand for coal and the price of coal? Show using a supply-demand diagram for the coal market.

(c) What happened to the demand for fuel-guzzling cars?

(d) What happened to supply and demand for oil eventually?

Real Oil Price (1997 = 100)

0

100

200

300

400

70 74 78 82 86 90 94 98

GROUPWORK

3 The following data describe price and output of a product:

(a) Plot a scatter diagram(b) “Higher prices make firms raise

output.”“People buy less when prices are higher”Does the diagram shed any light on these statements?Could both be correct? Explain.

Year Price Output

1985 100 101

1986 104 107

1987 108 112

1988 112 122

1989 118 128

1990 117 128

1991 108 118

1992 98 103

GROUPWORK

4 For each government intervention listed below, identify the possible rationale.

(a) Income tax(b) Taxation of petrol(c) Regulating gas prices(d) Banning the use of cannabis(e) Running the NHS(f ) Maintaining an army

Why Intervene?

The Role of Government

IF MARKETS ARE EFFICIENT (i.e. ‘invisible hand’ works), the government could confine attention to– Legislation and general regulation– Redistribution (taxation and transfer

payments)– Macroeconomic management (stabilization,

etc)

The Role of Government

However, sometimes free markets are not efficient

These instances are called MARKET FAILURESMARKET FAILURES

When markets fail, the government could intervene for efficiency reasons

SOURCES OF MARKET FAILURE

1. EXTERNALITIES1. EXTERNALITIES

One person's decisions/choices affect others DIRECTLY

If markets were free and unregulated

• cannot be made to PAY for the HARM you inflict on others

e.g. pollution

• cannot RECOVER all the value of BENEFITS you confer upon others

e.g. use of green technology

SOURCES OF MARKET FAILURE

1. EXTERNALITIES1. EXTERNALITIES

Individual’s optimal decision is not optimal for society

Result: OVERPRODUCE the bad things, UNDERPRODUCE the good things.

Market outcome is INEFFICIENT,

Government intervenes to CORRECT INEFFICIENCY

Policy Tools: Tax, subsidy, quota, creating artificial markets

SOURCES OF MARKET FAILURE

2.2. PUBLIC GOODSPUBLIC GOODS

Goods that we consume together, so that • no individual can be excluded from consuming • consumption by one does not leave less for others

National defence Street lighting

No one has any incentive to pay for such goods. In the absence of government intervention, too little of

these will be provided.

Government steps in to ensure right level is produced.

SOURCES OF MARKET FAILURE

33. . IMPERFECT COMPETITIONIMPERFECT COMPETITION

If firms have market power (power to set prices above cost), markets are usually INEFFICIENT

Once again, government can intervene to lower prices

Example: Regulation of National Grid

4. INFORMATIONAL PROBLEMS4. INFORMATIONAL PROBLEMS

Example: Health Insurance

GOVERNMENT FAILURE

In PRINCIPLE, the government can correct market failures

In PRACTICE, the government • does not always improve matters• sometimes makes things worse

Why?

GOVERNMENT FAILURE

• INCENTIVE PROBLEMS INCENTIVE PROBLEMS • INFORMATIONAL PROBLEMSINFORMATIONAL PROBLEMS• RENT SEEKING & CAPTURERENT SEEKING & CAPTURE• SPILLOVERS ACROSS GOVERNMENTSSPILLOVERS ACROSS GOVERNMENTS

Hence, must check for the possibility of GOVERNMENT FAILURE before jumping to conclusions.

MARKET FAILURE & GOVERNMENT FAILURE GROUPWORK

1 There is a tax on cars in Central London

(a) Why not leave things to the market? List the different motives for intervention.

(b) Which of these are to do with efficiency?

(c) Are there any other motives than efficiency?

(d) Is there a possibility of government failure?

MARKET FAILURE & GOVERNMENT FAILURE GROUPWORK

2 If people want to watch advert-free terrestrial TV, there should be a market for this. So what is the case for the compulsory TV License?

COST-BENEFIT ANALYSIS

Usually applied to government investment decisions

– roads – channel tunnel– subsidies to start-ups, R&D

The main question:

How do we value SOCIAL costs and benefits of a project?

COST-BENEFIT ANALYSIS

STEPS IN THE PROCEDURE• check how the private sector would do it• adjust for discrepancies between

private profits private profits PLUS spillover benefits to others

private costs private costs PLUS spillovercosts borne by others

Private valuations Social Valuations

COST-BENEFIT ANALYSIS

EXAMPLE: THE JUBILEE LINE EXTENSION

PRIVATE VALUATIONS

• CostsCostspresent value of construction cost(say, takes 4 years to build)

+ present value of future operating costs(maintenance, wages, electricity)

• BenefitsBenefits present value of passenger fares

Build if Net Present Value of project is positive (i.e. project is profitable).

COST-BENEFIT ANALYSIS EXAMPLE: THE JUBILEE LINE EXTENSION

SOCIAL COST BENEFIT ANALYSIS

Were any social benefits or costs missed in the above valuation?

Beneficial externalities

less congestion on roadsless pollutionhelps integrate London

Harmful externalities

vibration to houses above linecongestion near terminuses

Social cost benefit analysis should attempt to measure as many of these implications as possible.

Externalities

• economic models are deliberate simplifications of reality• ‘other things equal’ streamlines thought but its validity

needs checking• supply and demand explain equilibrium price and

quantity• markets sometimes fail to be efficient• governments could intervene to correct failure• but government action is itself vulnerable to failures• of course, governments also care about equity • social cost benefit analysis tries to measure as many

inputs and outputs of a project as possible