Principles of Microeconomics

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1 Principles of Microeconomics By A. V. Vedpuriswar October 15, 2016

2 Economics: The Basics When wants exceed the resources available to satisfy them, there is scarcity. Faced with scarcity, people must make choices. Economics is the study of the choices people make to cope with scarcity. More of one thing means less of something else. The opportunity cost of any action is the best alternative forgone.

3 Discussion question What are the opportunity costs you have incurred in your personal life?

4 Useful Definitions (1) Term Microeconomics Definition The study of the decisions of people and businesses and the interaction of those decisions in individual markets. The goal of microeconomics is to explain the prices and quantities of goods and services in specific markets. Macroeconomics Positive statements Normative statements The study of the national economy and the global economy and the way that economic aggregates grow and fluctuate. The goal of macroeconomics is to explain average prices and the total employment, income, and production. Statements about what is. Statements about what ought to be. 3

5 Useful definitions (2) Term Ceteris Paribus Definition Other things being equal or if all other relevant things remain the same. The fallacy of composition The post hoc fallacy What is true of the parts may not be true of the whole. What is true of the whole may not be true of the parts. The error of reasoning from timing to cause and effect. 4

6 Economic Goals Goal Economic efficiency Economic growth Description Production costs are as low as possible. Consumers are as satisfied as possible with the combination of goods and services that is being produced. Economic growth leads to an increase in incomes and production per person. It results from the ongoing advance of technology, the accumulation of ever larger quantities of productive equipment, ever rising standards of education and higher productivity. Economic stability There are no wide fluctuations in the economic growth rate, the level of employment, and average prices. 5

7 The Modern economy Term Description Economy A mechanism that allocates scarce resources among alternative uses deciding what to make, how to make and for whom to make. Decision Makers Household Households, Firms, Governments Any group of people living together as a decision-making unit. Every individual in the economy belongs to a household. Firm Government Market An organization that uses resources to produce goods and services. All producers are called firms, no matter how big they are or what they produce. Car makers, farmers, banks, and insurance companies are all firms. An organization that sets laws and rules, maintains law and order, taxes households and firms, and provides public goods and services such as defense, public health, transportation, education. Any arrangement that enables buyers and sellers to get information and to do business with each other

8 Types of Economies Type Coordination mechanism Market economy Command economy Mixed economy Description A method of determining what, how, when, and where goods and services are produced and who consumes them. An economy that uses a market coordinating mechanism. Decisions are taken based on supply and demand. An economy that relies on a command mechanism, ie using a hierarchical organization structure in which people carry out the instructions given to them. An economy that relies on both markets and command mechanism. 7

9 Current thinking on economic policy making (1) Till the early 1980s, economic planning and public ownership of the means of production were the wave of the future. But it is now clear that planners cannot find out what needs to be done to co-ordinate the production of a modern economy. Even if a technically feasible plan can be drawn up, there is no reason to believe it will be implemented. How can a central planner know better than the consumers what they want? Planners can only provide users with what they believe they should want. Because prices bear no relation to costs, there is no way to calculate what needs to be produced more and what less.

10 Current thinking on economic policy making (2) But the government has not become irrelevant. Besides reinforcing property rights and maintaining law and order, the government has three functions: To provide public goods that the market underprovides. To provide merit goods which are consumed individually but society insists on a certain level or type of provision. To internalize externalities or remedy market failures. To provide a safety net to people who are struggling.

11 Current thinking on economic policy making (3) Today economic policies are expected to have credibility, predictability, transparency and consistency. The more the government focuses on its essential tasks and the less it is engaged in economic activity and regulation, the better it is likely to work and the better the economy itself is likely to run. If a large number of bureaucratic permissions is needed to do business, the officials have an opportunity to demand bribes. If the government is heavily involved in regulating the economy, there will be lobbying by interest groups. Resources will be wasted in such rent-seeking unproductive activities.

12 Factors of Production Factors of production - The economy s productive resources; Labor, Land, Capital, Entrepreneurial ability. Factor Land Labour Capital Entrepreneurship Description Natural resources used to produce goods and services. The return to land is rent. Time and effort that people devote to producing goods and services. The return to labour is wages. Equipment, buildings, tools and other manufactured goods used to produce other goods and services. The return to capital is interest. The resource that organizes the other three factors of production, makes business decisions, innovates, and bears business risk. The return to entrepreneurship is profit.

13 Discussion question What are the most critical factors of production today?

14 Production Possibility Frontier The quantities of goods and services that can be produced are limited by the available resources and by technology. That limit is described by the production possibility frontier. Production Possibility Frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot. Production efficiency is achieved when it is not possible to produce more of one good without producing less of another. Production efficiency occurs only at points on the PPF.

15 The Production Possibility Frontier (Contd) Consider an economy which can produce two goods. The PPF shows how much of each can be produced. Fa A Fb B C B C A

16 Discussion question Explain the shape of the PPF.

17 Substitutability of resources Absolute Advantage - If by using the same quantities of inputs, one person can produce more of both goods than some one else can, that person is said to have an absolute advantage in the production of both goods. Comparative Advantage - A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. Because of comparative advantage, different resources are better suited for making different kinds of goods. So resources are substitutable only up to a point. Silicon Valley techies cannot become steel mill workers and vice versa.

18 How growth takes place Economic growth essentially means pushing out the PPF. The two key factors that influence economic growth are technological progress and capital accumulation. Technological progress refers to the development of new and better ways of producing existing goods and services and the development of new goods. Capital accumulation leads to the growth of capital resources, ie plant, equipment and knowledge.

19 Law of Demand Demand curve - Shows the relationship between the quantity demanded of a good and its price, all other influences on consumers planned purchases remaining the same. Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded. This is due to two factors : Substitution effect Income effect. As the opportunity cost of a good increases, people buy less of that good and more of its substitutes. Faced with higher price and unchanged income, people feel poorer and quantities demanded must in general come down.

20 Types of goods Type of good Substitute Complement Normal Inferior Description A good that can be used in place of another good. A good that is used in conjunction with another good. A good for which demand increases as income increases. A good for which demand decreases as income increases. 19

21 Movements and shifts If the price of a good changes but everything else remains the same, there is a movement along the demand curve. If the price of a good remains constant but some other factor influencing demand changes, there is a change in demand for the good leading to a shift of the demand curve.

22 Price per unit Consumer surplus Consumer surplus Total consumer expenditure Demand Quantity

23 Law of Supply Supply curve - Shows the relationship between the quantity supplied and the price of a good, everything else remaining the same. Supply of a good depends on: The price of the good; The prices of factors of production; The price of other goods produced; Expected future prices; The number of suppliers; Technology. Law of supply Other things remaining the same, the higher the price of a good, the greater is the quantity supplied.

24 Movements and shifts If the price of a good changes but other factors affecting supply remain constant, there is a movement along the supply curve. If the price of a good remains the same but some other underlying factor influencing the supply changes, the quantity supplied changes and there is a shift of the supply curve.

25 Price per unit Producer surplus Supply Producer s surplus Total cost to sellers Total revenue to sellers Quantity per period

26 Equilibrium Equilibrium: A situation in which supply equals demand. The equilibrium price is the price at with the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. When both demand and supply increase, the quantity increases. The price may increase, decrease, or remain constant. When both demand and supply decrease, the quantity decreases. The price may increase, decrease, or remain constant. When demand decreases and supply increases, the price falls. The quantity may increase, decrease, or remain constant. When demand increases and supply decreases, the price rises and the quantity increases, decreases, or remains constant.

27 Changes in Demand and Supply An increase in supply S1 P R I C E S2 D1 Q1 Quantity Q2

28 Changes in Demand and Supply Decrease in supply S1 P S2 R I C E D1 Q2 Q1 Quantity

29 Changes in Demand and Supply Decrease in Demand P R I C E S1 D2 D1 Q1 Q2 Quantity

30 Changes in Demand and Supply Increase in Demand P R I C E S1 D2 D1 Q2 Q1 Quantity

31 Elasticity The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold. An increase in price increases the revenue on each unit sold. But an increase in price also leads to a decrease in the quantity sold. The total expenditure may increase or decrease depending on the responsiveness of demand to the price. Price elasticity of demand A measure of the responsiveness of the quantity demanded of a good to a change in its price, other things remaining the same. It is the percentage change in demand divided by percentage change in price.

32 Elastic and inelastic demand Inelastic demand - If the % change in the quantity demanded is less than the % change in price, then the magnitude of the elasticity of demand is between zero and 1, and demand is said to be inelastic. If quantity demanded remains constant when the price changes, then the elasticity of demand is zero and demand is said to be perfectly inelastic. Elastic demand - If elasticity is greater than 1, it is elastic. If quantity demanded is indefinitely responsive to a price change, then elasticity of demand is infinity, and demand is said to be perfectly elastic. The income elasticity of demand is the percentage change in demand divided by percentage change in income. The cross elasticity of demand is the percentage change in demand divided by percentage change in price of another related good.

33 Elasticity : A graphical depiction Elastic Region P r i c e A B Unit Elastic Inelastic Region C D Quantity

34 When markets do not work Markets try to bring about a match between supply and demand. But in some cases this does not happen. These include: Price ceiling - A regulation that makes it illegal to charge a price higher than a specified level. When a price ceiling is applied to rents in housing markets, it is called a rent ceiling. Black market - An illegal trading arrangement in which buyers and sellers do business at a price higher than the legally imposed price ceiling. Minimum wage law - A regulation that makes hiring labor below a specified wage illegal. Externalities Social costs, but no private costs.

35 Rent (dollars per unit per month) Rent ceiling S Rent ceiling S Housing shortage D Quantity( thousand of units per month)

36 Wage rate (dollars per hour) Minimum wages and unemployment SS Unemployment a b Minimum wage DA Quantity( millions of hours per week)

37 Discussion topic You are a fisherman operating off the coast of Kerala. When your catch is good, that of the others is good too. There is an excess supply in the local market. The prices will be low and you may not be able to sell the full catch. You can go down the coast to another market. But if the situation is no different there, you will be in big trouble. The market is open only for a couple of hours before dawn. It will be too late for you to sell and make money. Meanwhile, a press report indicates that 5-8% of the total catch is wasted because of demand supply mismatch. What is the problem here? What could be a good solution?

38 Discussion topic : The market for second hand cars As soon as you drive your new car from the dealer s parking lot, the value tumbles. When it was in the showroom even for weeks together, its value was in tact. But after it hits the road, the car loses value. Why is this so?

39 Consumption & Utility A household s consumption choices are determined by Budget constraint Preferences. Utility - The benefit or satisfaction that a person gets from the consumption of a good or service. Total utility - The total benefit or satisfaction that a person gets from the consumption of goods and services. Marginal utility - The change in total utility resulting from a oneunit increase in the quantity of a good consumed. Consumer equilibrium - A situation in which consumers have allocated their income such that, given the prices of goods and services, their total utility is maximised.

40 Soda (six-packs per month) Indifference curves C g Indifference curve Movies (per month)

41 Are the poor rational? A commonly used definition of poverty is an income of $ 1 per day. One dollar a day would suggest that there is little room for choice or discretion. Surely, the poor should spend it on food. But the poor do not seem to do so. The poor also do not seem to grab all the opportunities available to make money. Poor farmers for example do not grow more profitable crops. As two eminent economists recently pointed out, One senses a reluctance of poor people to commit themselves psychologically to a project of making more money. Discuss why this is so.

42 Understanding Costs Term Short run Long run Variable inputs Fixed inputs Total cost Definition Period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. Period of time in which the quantities of all inputs can be varied. Inputs whose quantity can be varied in the short run. Inputs whose quantity cannot be varied in the short run. The sum of the costs of all the inputs used in production. This includes the fixed and variable costs.

43 Basic cost terms Term Marginal cost Average fixed cost Average variable cost Average total cost Long run average cost curve Economies of scale Diseconomies of scale Definition The increase in total cost for increasing output by one unit. Total fixed cost per unit of output. Total variable cost per unit of output. Total cost per unit of output. Traces the relationship between the lowest attainable average total cost and output when both capital and labor inputs can be varied. As output increases, up to a point, long-run average cost decreases. As output increases, beyond a point, long run average cost increases. 42

44 Behaviour of Average fixed, variable and total costs AFC reduces with increasing output as fixed costs do not change with increased level of output. AVC first reduces with increasing output due to increasing returns and then increases because of diminishing returns. Initially when we add resources, they are very productive. But productivity growth tapers off and falls as more resources are added. Upto a point, Average Total Cost (ATC) falls as the fall in AFC more than compensates for the rise in AVC. This explains economies of scale. Then ATC starts rising as the rise in AVC takes over. This explains diseconomies of scale.

45 Short Run Cost Curve Firms produce output corresponding to the lowest point on the ATC curve. ATC1 ATC2 ATC3 ATC4

46 Long Run Average Cost Curve In the short run, only labour can be varied. Capital cannot. In the long run, both capital and labour can be varied. The Long Run Average Cost (LRAC) curve traces the relationship between the lowest attainable ATC and output when both capital and labour inputs can be varied. Due to economies of scale, LRAC slopes downward to start with. Later due to diseconomies of scale, the curve slopes upward.

47 Price and cost (dollars per sweater) Plant size and long run equilibrium MCo MC1 Short run profit maximizing point SRACo SRAC1 LRAC MR0 MR1 Long run competitive equilibrium Quantity (sweaters per day)

48 Discussion topic What is the marginal cost for a software company like Microsoft? What is the marginal cost of providing a service for a portal like Yahoo? What is the marginal cost for a telecom provider like Bharti?

49 Perfect Competition There are many firms, each selling an identical product. There are many buyers. There are no restrictions on entry into the industry. Incumbents have no advantage over potential new entrants. Firms and buyers are completely informed about the prices of the product of each firm in the industry. Firms are price takers ie they cannot influence the price of a good or service.

50 The entry and exit of firms If the firms in a perfectly competitive industry make an economic profit, new firms enter the industry and the industry supply curve shifts rightward. As a result, the market price falls and so does the firm s economic profit. Only when the economic profit has been eliminated and normal profit is being made do firms stop entering.

51 Economic profit P=MC=AR=MR>ATC MC ATC P=AR=MR

52 Normal profit P=MC=AR=MR=ATC MC ATC Break even point P=AR=MR

53 Economic loss P=MC= AR=MR<ATC ATC MC Economic loss P=AR=MR

54 In the short run Each firm has a given plant. The number of firms in the industry is fixed. But prices can change. And the firm must know how to react to price changes. In the short run, the important decisions are : whether to produce or shut down how much to produce. Breakeven occurs when P=ATC At shutdown point, P=AVC

55 In the long run In the long run, the important decisions are : Whether to increase or decrease plant size. Whether to stay in the industry or leave it.

56 Imperfect Competition Monopoly - An industry that produces a good or service for which no close substitute exists. There is one supplier who is protected from competition by an entry barrier. Monopolistic competition - A market structure in which a large number of firms compete with each other by making similar but slightly different products. Entry and exit of firms is possible. Oligopoly - A market structure in which a small number of producers compete with each other. Each has to take decisions taking into account how others will react.

57 Characteristics of monopoly Single seller : A monopoly is a one firm industry. No close substitutes. A pure monopolist is a price maker. There are formidable barriers to entry. These include economies of scale, patents, licenses, ownership of essential resources, etc. A monopolist may decide to advertise depending on the need to stimulate demand.

58 Monopoly and perfect competition The main difference between monopoly and perfect competition lies on the demand side of the market. The demand curve is downward sloping unlike the perfectly elastic demand curve of perfect competition. The marginal revenue in perfect competition is price. But a monopolist can sell more only by lowering the price. So marginal revenue < price for every unit except the first. Total revenue increases at a decreasing rate. The monopolist will continue to produce till the point at which marginal revenue equals marginal cost. The monopolist does not charge the highest price possible as is commonly believed but that price at which MR=MC. This is the profit maximising price.

59 Price discrimination The monopolist often practises price discrimination. This means charging different prices to different customers not because of differences in cost of production but because different customers have different elasticities of demand. Price discrimination cannot take place under following conditions: Resale is possible. There are difficulties in segmenting the market.

60 Inefficiency of a monopoly A monopoly is inefficient because it restricts output below the level at which price equals marginal cost. See figure on next slide.

61 Price, marginal revenue, marginal cost The monopoly solution Marginal cost E G Marginal revenue Demand Quantity per period

62 Price, marginal revenue, marginal cost, average total cost The monopoly solution (Contd) Marginal cost E Average total cost G Marginal revenue Demand Quantity per period

63 Natural monopoly Desirable from society s point of view. Single producer has the necessary economies of scale.

64 Monopolistic competition A large number of firms compete with each other. They make similar but slightly different products. Due to product differentiation, there is an element of monopoly power. Each firm is small. So it cannot effectively influence what other firms do. The demand curve is downward sloping. There is free entry and exit. Firms cannot make economic profit in the long run.

65 Monopolistic competition (Contd) The monopolistic firm behaves just like a monopoly. It produces the quantity at which MR = MC and charges the price that buyers are willing to pay for that quantity, as determined by the demand curve. In the long run, economic profits are eliminated. But the output is below the level at which price = marginal cost. However, the loss in efficiency must be weighed against the gain in variety. Some of this variety is real while part is perceived. Advertising and promotion are used for differentiation. This drives up costs to a level above those of a competitive firm or a monopoly.

66 Monopolistic competition (short run) MC ATC P C Economic profit Q MR D

67 Discussion topic Is advertising good or bad for customers?

68 Oligopoly In oligopoly, a small number of players compete with each other. The quantity sold by one player depends on the producer s own price and that of the others. Each firm must take into account how its own actions will affect the actions of other firms. One way of analysing an oligopoly is to assume that if a player raises its price, others will not follow suit. But if it cuts prices, others will. This leads to the kinked demand curve.

69 The Kinked demand curve model MC1 MC2 p a b D MR Q

70 Game theory Often used to explain how an oligopoly works. In each game there are rules, strategies and payoffs. A commonly played game is the Prisoner s dilemma. Consider two petty thieves who have been caught red handed. But the Police Commissioner suspects that they were accomplices in a larger crime. He locks them up in two separate rooms so that they cannot communicate with each other. Then the interrogation begins. What is likely to happen? Both will admit to the crime though they would be better off by both denying.

71 Prisoners dilemma payoff matrix 3 years 10 years Both admit 3 years 1 year One denies, other admits One denies, other admits 10 year 1 year 2 years 2 years Both deny

72 Cartels A dominant firm oligopoly arises when one firm has a substantial cost advantage over other firms and produces a large part of the industry output. The dominant firm sets the market price and others are price takers. A duopoly is a special case of oligopoly where there are two players. A collusive agreement involves producers agreeing to restrict output in order to raise price and profits. Such a group is called cartel.

73 Discussion question Take any industry and explain what kind of a structure it has.

74 Thank You