Introduction to Microeconomics MSc Induction Simon Hayley Simon.Hayley.1@city.ac.uk

1. Introduction to Microeconomics MSc InductionSimon HayleySimon.Hayley.1@city.ac.uk

2. Overview of Economics 1. Microeconomics • The behaviour of individuals and firms in market interactions • Policy options when markets don’t work 2. Macroeconomics • The economy as a whole: GDP, inflation, unemployment and growth. • Fiscal and monetary policy

3. Reading Lipsey + Chrystal “Economics” Eleventh Edition, Oxford University Press, 2007.

4. Plan of session • Key concepts: scarcity and choice • Analysis of markets • A common approach: • consumers maximize utility subject to a budget constraint • firms maximize profits subject to cost and demand constraints

5. The Market Economy • A market economy is self-organising in the sense that when individuals act independently to pursue their own self-interest, responding to prices set on open markets, they produce co-ordinated and relatively efficient economic activity.

6. Resources and Scarcity • Scarcity is a fundamental problem faced by all economies because not enough resources (land, labour, capital, and entrepreneurship) are available to produce all the goods and services that people would like to consume. • Scarcity makes it necessary to choose among alternative possibilities: what products will be produced and in what quantities. • Microeconomics analyses the allocation of scarce resources.

7. How We Work in Economics • The real world is complex so we have to pick out key features of an issue and construct abstract “models”. • We illustrate the relationships in these models with graphs, equations or numerical examples. • Models are not the truth but they are a way of thinking about what might be going on.

8. Making Economic Choices • Opportunity cost:the cost of obtaining a unit of one product in terms of the number of units of other products that could have been obtained instead. This emphasises scarcity and choice. • A production-possibility boundary shows all of the combinations of goods that can be produced by an economy whose resources are fully employed. Movement from one point to another on the boundary shows a shift in the amounts of goods being produced, which requires a reallocation of resources.

9. A Production-Possibility Boundary Unattainable combinations Production possibility boundary Attainable combinations Quantity of private sector goods 0 Quantity of public sector goods

10. A Production-Possibility Boundary Unattainable combinations a c0 • d Production possibility boundary C Attainable combinations c1 b Quantity of private sector goods c G 0 g0 g1 Quantity of public sector goods

11. The Effect of Economic Growth on the Production-Possibility Boundary a d Production possibility boundary before growth Production possibility boundary after growth Quantity of private sector goods b 0 Quantity of public sector goods

12. Analysis of Markets • All markets can be approached in same way, even though there are many different features. • In any market there is one group who do not have the product but want to get it: demanders • And another group who have the product and want to sell it: suppliers • For consumer goods (and services) demanders are individuals and suppliers are firms.

13. Main Factors That Affect an Individual's Demand for a Specific Product • Price of the product • Price of other products: substitutes or complements • Income and wealth • Personal characteristics: age, religion, dependants etc • Tastes • External factors: weather, festivals, special events. • Economic analysis focuses on prices and incomes BUT other things do matter in real markets.

14. Price Elasticity and Income Elasticity • Quantity demanded is (generally) negatively related to the price of the product itself. [price elasticity] • Demand increases with rise in price of a substitute and fall in price of a complement (and vice versa). [cross elasticity] • Demand increases with income for a normal good and falls when income increases for an inferior good. [income elasticity]

15. Price ElasticityLow High Income ElasticityHigh Low

16. Necessities have low income elasticity. Luxuries have higher income elasticity. • Price elasticity partly depends on how tightly we define each market: • Broadly-defined goods (eg. food) have few substitutes, and so have low price elasticity (inelastic demand) • Specific items such as a particular brand of baked beans have many substitutes, and so a high price elasticity (elastic demand) • But if advertisements succeed in convincing consumers that a particular brand is not like others, then this price elasticity may be reduced.

17. Alice’s Demand Schedule Quantity demanded [dozen per month] Reference Letter Price [£ per dozen] 0.50 7.0 a b c d e f 1.00 5.0 1.50 3.5 2.00 2.5 2.50 1.5 3.00 1.0 Alice’s Demand Curve f 3.00 e 2.50 d Price of eggs [£ per dozen] 2.00 c 1.50 b 1.00 a 0.50 1 2 3 4 5 6 7 Quantity of Eggs [dozen per month]

18. The Relation Between Individual and Market Demand Curves 3.00 2.00 Price of eggs [£ per dozen] 1.00 3.00 2 4 6 8 Quantity of Eggs [dozen per month] 2.00 [i]. William 1.00 Price of eggs [£ per dozen] 3.00 2 4 6 8 10 12 14 2.00 Quantity of Eggs [dozen per month] Price of eggs [£ per dozen] 1.00 [iii]. Total Demand William & Sarah 2 4 6 8 [ii]. Sarah Quantity of Eggs [dozen per month]

19. A Market Demand Schedule for Eggs Quantity demanded [000 dozen per month] Reference Letter Price [£ per dozen] u v w x y z 0.50 110.0 1.00 90.0 1.50 77.5 2.00 67.5 2.50 62.5 3.00 60.0

20. A Market Demand Curve for Eggs 3.50 D Z 3.00 Y 2.50 X 2.00 Price of eggs [£ per dozen] W 1.50 V 1.00 U 0.50 20 40 60 80 100 120 140 Quantity of Eggs [thousand dozen per month]

21. Shifts in the Demand Curve D1 D0 Price 0 Quantity

22. Shifts in the Demand Curve D0 D2 Price 0 Quantity

23. Determinants of Supply • The price of the product itself • The prices of inputs (factors of production) • The production technology

24. Influences on supply • Quantity supplied is positively related to the price of the product itself • Supply increases (shifts right) as input prices fall and vice versa • Supply shifts with changes in technology. Improvements in technology increase supply (shift right)

25. A Market Supply Schedule for for Eggs Quantity supplied [000 dozen per month] Reference Letter Price [£ per dozen] 5.0 0.50 u 46.0 1.00 v 77.5 1.50 w 100.0 x 2.00 115.0 y 2.50 122.5 z 3.00

26. A Supply Curve For Eggs 3.50 S Z 3.00 Y 2.50 X 2.00 Price of eggs [£ per dozen] W 1.50 V 1.00 U 0.50 20 40 60 80 100 120 140 Quantity of Eggs[thousand dozen per month]

27. Shifts in the Supply Curve S0 S1 Price Quantity

28. Shifts in the Supply Curve S2 S0 Price Quantity

29. Demand and Supply Schedules for Eggs and Equilibrium Price Price [£ per dozen] Quantity demanded [‘000 dozen per month] Quantity supplied [‘000 dozen per month] Excess Demand [quantity demanded minus quantity supplied] [‘000 dozen per month] 0.50 110.0 5.0 105.0 1.00 90.0 46.0 44.0 1.50 77.5 77.5 0.0 2.00 67.5 100.0 -32.5 2.50 62.5 115.0 -52.5 3.00 60.0 122.5 -62.5

30. Determination of the Equilibrium Price of Eggs 3.50 S D Z Z 3.00 Y Y 2.50 X X 2.00 Price of eggs [£ per dozen] 1.50 W W V V 1.00 U U 0.50 20 100 120 140 40 60 80 Quantity of Eggs [thousand dozen per month]

31. Museum Charges • In November 2001 the UK Government abolished admission charges on many museums. • The Victoria and Albert Museum (V&A) experienced the biggest increase, with visitor numbers rising from 42,600 in December 2000 to 174,000 in December 2001, an increase of 309%. • Similarly, though not so dramatically, the Museum of London had an 88% increase, the Natural History Museum had an 82% increase and the Museums of Science and Industry in Manchester had a 75% increase.

32. Price of museum entry £5 174K 42K Number of admissions

34. Coffee market Price of coffee demand P1 supply P2 Q1 Q2 Quantity of coffee

36. Newspaper Market • In September 1993 the Times lowered its price from 45p to 30p while the Independent stayed at 50p. • Average daily sales of the Times went from 370K to 450K. • Average daily sales of the Independent went from 362K to 311K. • Independent and Times were substitutes.

37. Demand for The Times price 45p 30p 370K 450K

38. Market for The Independent price 50p 311K 362K quantity

39. Channel Tunnel What happened when the opening of the tunnel introduced massive new supply of cross-channel travel? • Increase in supply leads to fall in price. • Demand for substitutes falls: ships, planes, hovercraft. • Competition between suppliers leads to price cutting and special deals • Total quantity of travel rises

40. “Drought report sends wheat prices surging” (FT 6/6/2007) • “Commodities prices slumped on Friday following sharp falls in global equity markets amid mounting fears that the global economy was heading into recession” (FT 10/8/2008) • “Members of the OPEC oil cartel are considering an emergency meeting in Vienna next month as oil prices dropped to their lowest level in nearly a year.” (FT 10/8/2008)

41. Different Features of Markets • Coffee and wool prices in wholesale markets change day by day to equate demand and supply. • Many prices, especially retail prices are set by the seller and only changed periodically: quantity then adjusts. These are administered prices (eg. newspaper prices and museum entry charges). • But, as we have seen, supply and demand analysis is relevant for both types.

42. Consumer Choice • Consumers maximize utility subject to a budget constraint. Value to consumers (and therefore price) depends on marginal and not total utility. • Similarly, firms maximize profit subject to a cost and demand constraint.

43. UTILITY is the personal satisfaction derived from consuming a product or service • Total utility = utility a consumer gets from total consumption of all units of a particular product. • Marginal utility = the addition to total utility derived from consuming one more unit of the product. • The marginal utility usually declines as the consumer consumes more of the product (Diminishing Marginal Utility). • We assume each consumer maximises his/her own utility. Each consumer reaches a utility-maximising equilibrium when the utility he or she derives from the last £1 spent on each product is equal.

44. Diminishing Marginal Utility

45. Why are diamonds more expensive than water? • Water is vital – without it we will die. • Diamonds are a luxury. • So why is water cheap, whilst diamonds are expensive?

46. The Paradox of Value • This paradox of value involves confusion between total and marginal utility. The market clearing price is determined by marginal utility not total utility. • Clearly the total utility derived from water exceeds the total utility derived from diamonds. • Diamonds have a high price because they are scarce and the marginal utility is high, but water is cheap because it is abundant, so its marginal utility has been driven down.

47. Total and Marginal Utility Schedules Number of films attended per month Total utility Marginal utility 0 0.00 1 15.00 15.00 2 25.00 10.00 3 31.00 6.00 4 35.00 4.00 5 37.50 2.50 6 39.00 1.5 7 40.25 1.25 8 41.30 1.05 9 42.20 0.90 10 43.00 0.80

48. Total and Marginal Utility Curves 50 20 40 15 30 Utility [£] Utility [£] 10 20 5 10 0 4 6 8 10 0 4 6 8 10 2 2 Quantity of films [attendance per month] [i]. Increasing total utility [ii]. Diminishing marginal utility

49. A Consumer’s Equilibrium • To maximize utility, each consumer should adjust spending so that marginal utility per pound is the same for each good consumed (MUx/Px = MUy/Py). • If this were not true, could increase total utility by shifting towards consuming good with higher utility at the margin. • So a scarce good has a high price and a high marginal utility…but this says nothing about total utility.

50. Diminishing Marginal Utility and Demand • Demand curves have negative slopes because when the price of a product falls, the marginal utility per pound spent on this produce increases. The consumer responds by purchasing more of this good, thus reducing the marginal utility. • The consumer will keep increasing consumption of this good until the marginal utility per pound falls to the level which could be achieved on other goods. • A good which has steeply falling marginal utility will have relatively low price elasticity (a large shift in price will be required to cause a significant increase in consumption).