Table of Contents
ECON10004 - Introductory Microeconomics
Key concepts
Fundamental problem - Scarcity
Limited resources with which to produce good and services. The number of goods and services wanted greatly outnumbers the resources available. This limitation causes the need to make decisions about how to allocate resources.
Models
An aggregation of behaviour characteristics used for predictions. These are heavily simplified representations and omit many details in order to enhance understandability and improve the usefulness of predictions. For example, demand is used in place of individual consumers.
Models also assume decision-makers are rational. This means they have a well-defined objective and make choices consistent with achieving that objective. This assumption is central to economics. This rational assumption causes a decision-maker to maximise total net gain.
Opportunity cost
Resources used in taking an action causes them not to be available for other uses. This gives rise to opportunity cost, being the value of resources used in the next best alternative use. Sunk costs are separated as they are used before the decision was made.
Marginal costs and benefits
Marginal cost (MC) is the addition to the Total cost by doing or increasing by one unit the level of an activity. Marginal benefit (MB) is the addition to the Total benefit by doing or increasing by one unit the level of an activity. Activities where \(MB\geq MC\) should be done. Conversely, activities where \(MB < MC\) should not be done. This means that activities where the benefit outweighs the costs should be done. We can state that the total net gain is \(TNG(x)=TB(x)-TC(x)\). The derivative of this set to zero gives us the optimal value. \[\frac{\partial TNG(x)}{\partial x}=\frac{\partial TB(x)}{\partial x}-\frac{\partial TC(x)}{\partial x}=MB(x)-MC(x)\]
Incentives
Changes in the situation affecting the benefits or costs alter, its expected that rational decision-makers will change their actions. This is known as responding to incentives.
Perfectly competitive markets
Markets
Markets are places where trade takes place. Every buyer wonders “what should I buy?” Every seller asks “what should I sell?” Both parties will sell if their benefits are greater than their costs.
Markets are characterised by the price for a quantity of good/service. Perfectly Competitive markets are considered to contain identical goods traded by all buyers and sellers. There are many buyers and sellers, such that any individual cannot influence the overall price - “price-takers”. This model is applicable to those with a high degree of competition. Market demand and supply is the aggregate of the buyers and sellers respectively. When trade occurs, we get an equilibrium as the outcome of the overall transactions.
Demand
The law of demand states that “when the price of a good increases (decreases), the quantity demanded of the good decreases (increases) [All other things being equal].”
Factors affecting demand
Income
An item is a normal good if demand and income move in the same direction. That is, if an increase in income increases the demand for a good or service. An example would be cruise holidays. The counterpart to this is inferior goods, where demand and income move in opposite directions. These are less common. An example is fast food.
Price of other goods
A good is a substitute if they are used for similar purposes such that a an increase (decrease) in price for one causes an increase (decrease) in demand for the other. Compliment goods are used together such that an increase (decrease) in price for one causes an decrease (increase) in demand for the other.
Consumer tastes
Trends and such can affect the demand for a good or service.
(Non-price) costs of consuming a good or service
Things such as environmental costs or time use can affect the demand.
Price expectations
Future expectations of price will influence the current demand.
Number of buyers
Having more people consume increases demand.
Supply
The law of supply states: “When price of a good increases (decreases) the quantity supplied of the good increases (decreases) [All other things being equal].”
Factors affecting supply
Costs of production
Costs of inputs and efficiency of production sit here. If a good costs more to produce, that costs will cause its supply to decrease.
Price expectations
A belief about an increased future price will cause a decrease in the current supply.
Weather
Poor weather will decrease the amount of food produced. Also has affects on industries not directly dependent on weather.
Number of suppliers
More suppliers causes the supply to increase
Equilibrium
The outcome of trade. This is the price and quantity traded in a market such that the quantity demanded of a good equals the quantity supplied. Occurs at the intersection of demand and supply. This would lead to predicting that prices will tend to the equilibrium price as equilibrium provides a stable price. If the price is greater than equilibrium, there is excess supply, causing suppliers to reduce their prices in order to induce extra demand. If the price is less than equilibrium, there is excess demand, causing consumers to offer more to producers in order to induce extra supply.
An increase (decrease) in demand causes an increase (decrease) in quantity and price. An increase (decrease) in supply causes an increase (decrease) in quantity and a decrease (increase) in price.
Elasticity
Measure of responsiveness demand or supply to their determinants.
Own-price (both)
The amount quantity moves with price. \[\epsilon=\frac{Q_2-Q_1}{\frac{Q_1+Q_2}{2}}\div\frac{P_2-P_1}{\frac{P_1+{P_2}}{2}}=\frac{\frac{\Delta Q}{Q}}{\frac{\Delta P}{P}}=\frac{\frac{\Delta Q}{\Delta P}}{\frac{Q}{P}}=\frac{\partial Q}{\partial P}*\frac{P}{Q}\] This formula gives the change for the midpoint, or the average for the curve. Elasticity gives proportionate changes rather than the absolute, making it related to gradient but not the same. An elasticity of -1 is unit elastic, a 1% increase in price causes a 1% decrease in quantity. An elasticity between -1 and 0 is inelastic, meaning quantity is relatively unresponsive to changes in price. An elasticity less than -1 is elastic, meaning quantity is relatively responsive to changes in price. Perfect elasticity is horizontal, representing all the demand/supply at a single price. The converse to this is perfect inelasticity, where the same quantity is demanded/supplied for all prices. Total revenue changed such that it increases with inelasticity, decreases with elasticity and stays the same for unit elasticity. Factors affecting elasticity are the degree of necessity, availability of substitutes, time horizon and share of household budget. In implementing policies, a greater effect can be seen from moving the inelastic quantity rather than the elastic one.
Income (demand)
\[\epsilon=\frac{\text{% change in demand}}{\text{% change in income}}\] Measures responsiveness of demand to changes in income. A positive elasticity represents a normal good, negative an inferior. The magnitude shows the degree of responsiveness.
Cross-price (demand)
\[\epsilon=\frac{\text{% change in demand for x}}{\text{% change in price for y}}\] Measures responsiveness in demand for x in changes in price for y. Positive values are substitutes, negative are compliments. The magnitude shows the substitutability/complimentarity of the goods.
Intervention
Indirect taxes
Payment to the government per unit of good sold. This causes a different price to be paid by the consumer and received by the supplier. As a result, the supply for consumers is reduced by the tax amount. The tax incidence depends on the own-price elasticity of demand and supply. The effect of the tax does not depend on which party the tax is imposed on.
Subsidy
Payment by the government per unit sold. Increases the supply to consumers by the subsidy amount. The party given the subsidy doesn't affect the modelling.
Direct controls
A price floor (ceiling) is a minimum (maximum) price for a good or service. This only has use if it is implemented above (below) the equilibrium price. Creates an incentive for buyers and sellers trying to evade regulations, often creating unintended consequences. These are represented as horizontal lines at the price.
Quotas set limits on the maximum quantity that can be traded. These are represented as vertical lines. They increase the price, as they restrict the quantity.
Welfare
Welfare is measured by surplus and efficiency. Surplus is the net gain buyers and sellers receive from their economic activity. Efficiency is a reference point for judging whether a society is as well off as possible.
The demand curve maps out the benefits to consumers, the consumer surplus is the area between the demand curve and the price. The supply curve maps out the benefits to suppliers, the producer surplus is the area between the supply curve and the price. The total surplus is the sum of the producer and consumer surpluses. This is the area between the two curves to the left of equilibrium.
The most efficient a market can be is when its total surplus is maximised. Total surplus is maximised at market equilibrium. Equity is focused on the distribution of surplus and is a subjective societal judgement call. Market interventions, such as taxes introduce inefficiencies, called dead weight losses. The dead weight loss is represented as the region between equilibrium and the quantity traded.
International trade
Countries have some comparative advantage, providing incentive to specialise.
Trade allows specialisation as goods not produced can be bought from other countries where they have an advantage in producing that good.
When representing international trade, we assume there is a world price and that any country's consumption has no overall effect on the price. When the world price is less than the world price, local suppliers produce until the world price, at which consumers buy. When the world price is greater than the world price, producers sell at the world price and to those consumers who would pay for more than the world price. The difference between the local consumption and production is imports or exports. Trade increases the surplus for the party who has increased consumption/production and increases the overall well being.
The government can affect the amount of international trade by:
- Tariff: Tax on imported goods
- Export subsidy: Subsidy paid for exported goods
- Export tax: Tax on exported goods
- Import/Export quota: Restriction on the quantity of imports/exports allowed
- Quarantine/Health and Safety regulations, Anti-dumping regulations, etc.
Market failures
Market failure is when the natural equilibrium is not the optimal. That is, the social well being is less than socially optimal. Factors which can affect the social well being can include external effects such as pollution, public goods, imperfect competition and imperfect information. Government intervention in cases of market failure can increase social well being.
Market failure occurs with externalises. Externalities are effects of a transaction on third parties, and can be positive or negative. The third party effects must not be borne by the parties involved in the transaction. Demand and supply are made up of the private marginal benefits and costs, determining market demand and supply. Society also has social marginal benefits and costs, determining a socially optimal demand and supply. If SMB=PMB and SMC=PMC, no market failure occurs. If this isn't true, a market failure occurs as the decision makers in the market do not fully account for the costs and benefits of their decisions. Market failure causes a dead-weight loss to the right of the social equilibrium, which can be reduced by shifting the private curves.
Property rights can also assign property rights. Assigning property rights ties the parties trading and those experiencing the external effects and then allowing the market to readjust. This is done by providing a legal system to enforce property rights. This can be seen as a more hands off method of reducing market failure than taxes and subsidies. The Coase theorem states that allocation of resource through which the external effect is being transmitted allows trade between the economic agents to achieve an efficient solution.
Public goods are goods which are not excludable (consumption cannot be prevented) and are not rivalrous (consumption by one consumer does not diminish another consumer's use). Private goods are those which are excludable and rivalrous. Goods can be any combination of excludable or rivalrous. Examples of public goods are national defence and knowledge. Public goods tend to be under-supplied in competitive markets. The social marginal benefit of a public good is the sum of private marginal benefits of the members of society, as the good is non-rivalrous. Because the decision to produce the good is determined by private marginal benefit, resulting in a good not being produced as no individual PMB is greater than the PMC despite the SMB being greater. The non-excludability of public goods gives rise to the free-rider problem. This is where individuals can improve their own well-being by making others pay for the good. This disincentives all parties to pay for the good. To resolve this, the government can intervene as a collective agent for society and finance through taxation. Such a tax could be a Lindahl tax, where each consumer pays a share proportional to the total value derived from the benefit gained from the good. A Lindahl tax results on all parties receiving a positive benefit if the good should be socially produced. Alternatively the government could assign property rights as an incentive to produce the good. Examples of this is patents and copyrights. The problem with this is it creates exclusive ownership, which may lead to monopolies.
The firm and managerial economics
Definitions
A firm's goal is to maximise profits. Profits are total revenue less the total opportunity cost. Total revenue is the quantity sold by the price per unit. Economic profits account for opportunity costs on top of accounting profits. A firm with zero profit is indifferent to being or not being a supplier. A firm with positive profit wants to be, or will start acting as a supplier. A firm with negative profit does not want to be a supplier and would cease being one.
The short run is the period over which the level of at least one input cannot be varied. The long run is the period over which the level of all inputs can be varied. The total product is the total quantity of a firm's output. The marginal product of an input is the addition to total product from using one more unit of that input. Generally there is diminishing marginal product of labour due to congestion effects.
Costs
In the short run, we can describe a firms costs by its fixed and variable costs. The fixed costs are those which do not vary with output. The variable costs are those which do vary with output. The total cost is the sum of the fixed and variable costs. Diminishing marginal products cause increasing marginal costs.
Short run average total cost follows the short run marginal cost. This is as the marginal cost is pulling the total cost towards itself. Increasing variable costs causes a U shaped total cost with an optimal amount of production above which profits decrease. If the variable cost is constant, the marginal costs is also constant and the average total cost is always decreasing. This suggests that the average costs are always decreasing, so total profit can be maximised at large production.
The long run average total cost is the average total cost of a production method with the minimum short run average total cost. This is because in the long run the firm will seek to maximise the total profit by minimising total costs. This means that the production method can change with quantity as each method has a different optimal range. For segments of decreasing long run average total costs, there are economies of scale. If on segments of increasing costs, there are diseconomies of scale.
Reducing costs
Maximising profits involves reducing costs and maximising revenue. In shifting fixed costs to variable costs, by renting capital for example, the cost of output in low production can be reduced. Costs can also be reduced by changing the production methods to optimise for the current level of production. There is the question of whether a firm should produce internally or obtain from outside sources. Contracting out can reduce the costs of supply, however it can have problems related to the dependence on an external entity.
Maximising profits
Competition
Competition is dependent on the numbers of suppliers and degree of differentiation. These are determined by the barriers to entry and degree of substitutability respectively. Competition exists on a spectrum from perfect competition where infinite suppliers all supply identical items with free entry to the market to a monopoly where there is a single supplier without substitutes. There can also be monopolistic competition where there are many suppliers supplying imperfect substitutes.
Market power is the ability of a firm to set a price above the level that would exist in a perfectly competitive market. This occurs when there are low numbers of competitors, either due to legal restrictions, natural monopolies or other barriers to entry. It can also occur when there is a high degree of product differentiation. This can include things like product quality, location, brand characteristics and others. In perfect competition there is a flat firm-level demand, where a individual firm must supply at the equilibrium price. As the firm gains market power, the firm-level demand begins to approach the market-level demand, doing so at a monopoly.
Pricing
To maximise profits, a firm should supply output for which marginal revenue is greater than or equal to marginal costs. This is because it increases total revenue more than total costs, so profits increase. Firms with market power have a demand curve with a negative relationship between price and quantity sold. The marginal revenue is the extra revenue from the additional unit less the loss in revenue from the lower prices on the existing units. As a result price is greater than marginal revenue. The maximal profit occurs at the intersection of marginal costs and marginal revenue. A firm with more market power is capable of setting a more optimal price, and so is capable of generating greater profits.
Whether to operate
In the short run, the opportunity costs are the variable costs as the fixed costs are sunk. In the long run, the opportunity costs are the total costs as any fixed costs can be changed. This results in the following table:
| Shut down | Operate | |
|---|---|---|
| Short run | TR < VC | TR > VC |
| Long run | TR < TC | TR > TC |
This results in the long run with price being greater than average total costs.
Market outcomes
Market supply
The market supply is the sum of the individual firm's supplies, or marginal costs. The profit is equal to the area between the costs and revenue being raised by the firm at the equilibrium quantity. In the short run, the number of firms is fixed. In the long run the number of firms can vary, so the outcomes can vary as well.
The introduction of new firms happens when there are positive economic profits, which increases supply, reducing profits. This happens until there are no economic profits, eliminating the incentive for new firms to enter the market. As a result, in the long run there are no economic profits. A shift in demand causes an increase in marginal revenue on the firm level, causing an increase in price immediately. In the long run, new firms will enter until supply has returned to its former level where there were no economic profits. This results in an increase in supply on the market level, where price is the same as before the increase in demand. We can use this to draw in a horizontal long run market supply curve, which exits for constant cost industries. Increasing cost industries have positively slanted long run supply curves, like traditional supply curves. The increased price is needed to compensate for the increasing costs of supply.
Monopolistic competition
In the short run, the number of firms is fixed. The profit maximising quantity is chosen to maximise each firm's profit. If in the long run, there is a firm making positive profits, new imitative firms will enter the market,leading to lower profits. Due to product differentiation, a desire to maintain economic profits will drive innovation to further differentiate the product for higher profits. In the long run, the balance between imitation and innovation determines the outcome.
Monopoly
No other firms can enter the market, so firm will act to maximise its own profits without downside. Because the firm is the only player in the market, it can freely determine the market. The monopoly maximises the producer surplus, which is 0 in the competitive case. In the competitive case, the community surplus is greater than in the monopolistic case due to the decrease in consumer surplus. This results in a dead-weight loss, showing a market failure in the monopolistic case.
Overall results of competition
A high degree of competition results in a lower price and a greater quantity traded. In the long run, perfectly competitive markets have 0 economic profits for producers. Monopolistic competition can sustain positive economic profits in the long run due to differentiation. A monopoly can sustain positive economic profits with barriers to entry. The total welfare is reduced when suppliers have market power so governments seek to regulate the markets. This regulation can seek to promote competition or directly regulate the prices and quantities traded.
Pricing strategies
Firms with market power are able to set their own prices. Price discrimination is the sale of an identical product to different customers at different prices, where the price differences are not fully accounted for by differences in the cost of supply. First degree discrimination is the charging of ever consumer what they would be willing to pay. Third degree discrimination is the charging based on observable characteristics. Second degree discrimination is all other types. In order to discriminate, a firm must have market power, information to distinguish between willingness to pay of different consumers and must be able to prevent resale between customers. First degree price discrimination maximises a firm's profits, although this can increase administrative overheads and be infeasible for a large customer base. Third degree price discrimination allows some better targeting of sub-markets in order to increase overall profits. Second degree price discrimination can occur with “versioning” of a product with similar products of differing quality to capture differing profits from the market. Another form of second degree discrimination is that of a membership fee, which is initally higher than an initial marginal benefit but decreases with continued use.
Informational advantage
A lack of information presents uncertainty in decision making. When decision makers in the economy have different information, a distinction can be drawn between:
- Moral hazard or post contractual information asymmetry: Exists between a buyer and seller after the agreement to trade
- Adverse selection or pre contractual information asymmetry: Exists between a buyer and seller before an agreement to trade
The latter case is of interest. Such asymmetry can cause only the trade of lowest common denominator goods, where a good of high quality would be sold as per the lemon argument. This reduces the amount of goods being sold, reducing the profits of firms. This is as per Gresham's law: “The bad drives out the good”. By providing information to the buyers provides information, rectifying the asymmetry. Informational asymmetry can harm both the buyers and sellers. The use of a warranty as a signal as to the quality of a product can help provide information to the buyer. A good reputation can also provide a signal as to quality, given that lying will destroy the reputation, resulting in short term gains but long term losses. An external, trusted information service can be used to provide information about the product.
Game theory
Introduction
Game theory is the study of strategic situations. A strategic situation is one where we need to know how best to behave and a decision maker needs to anticipate other parties' decisions or reactions. There is an inter-dependency of decisions. Strategic situations are ubiquitous and decision making in these situations is important.
Game theory can be applied to oligopolies, politics, sports, auctions, bargaining and other strategic situations. An oligopoly is a market consisting of a few sellers interacting strategically.
In order to analyse a situation, we must first develop a model of the strategic situation. Who are the player? What are the available strategies? What are the payoffs? We assume the players are rational and have common knowledge about the situation. In order to predict an outcome, we use an equilibrium concept. We assume each player chooses a strategy that is best for them
We can distinguish between simultaneous and sequential games. Simultaneous games are ones where the players are unaware of the other player's choices for a given round. A sequential game is one where at least one player observes a decision made by another player prior to choosing their own strategy.
Strategies
The prisoners dilemma & Strictly dominant strategies
We can represent the game with a game table
| Prisoner B | Column player | ||
|---|---|---|---|
| Confess | Don't Confess | ||
| Prisoner A | Confess | -10,-10 | -1,-25 |
| Row player | Don't confess | -25,-1 | -3,-3 |
A strictly dominant strategy is one where a strictly higher payoff is achievable regardless of the other player's payoff. Rational player will always choose the strictly dominant strategy. A strict dominant strategy equilibrium is the predicted outcome where all players have strictly dominant strategies.
Weak dominant strategy
A strategy that always gives at least as high a payoff as other available strategies, and for some strategy combination of other players gives a strictly higher payoff.
Nash equilibrium
A strategy for each player where each player cannot obtain a strictly higher payoff by changing strategy. Formally when each player's strategy achieves the highest possible payoff for them given other players are choosing equilibrium strategies.
Multi-dominant strategies
When only one player has a dominant strategy, the other players can choose their strategy based off the best outcome from that player's strategy. This can allow for them to find their optimal strategy. If there isn't a dominant strategy but there is a dominated strategy, the game table can be reduced to reduce the complexity of the game.
Sequential games
A game where at least one player observes a decision made by another player prior to choosing their own strategy. The games can be modelled by starting from the end and thinking backwards. The game can be modelled as a game tree where each player makes their move to create a branch in the tree. We can find rollback equilibrium using backwards induction, starting at the final nodes in the tree and work to find the best choices. We then find the chose the best option from the nodes which we calculated a cost for. Order matters when playing sequential games, there can be a first or second mover advantage where the first or second player can always get a higher payoff. A rational play will try to look ahead and reason what the other player would do.
Oligopoly
When a few sellers interact strategically. This can maintain/increase market power and decrease market competition. Can be modelled by a two stage game where a potential entrant chooses to enter or not, and the incumbent chooses to fight or share. The oligopoly operates at a position not at a Nash equilibrium, as any party could do better by competing with the other firms while they don't compete. The use of threats to take action to harm other players can affect their choice of strategy, but threats need to be followed through. The market quantity traded corresponds to the degree of competition within the market, somewhere between monopoly and perfectly competitive. The potential value of being able to commit to a quantity to be supplied prior to other firms offers a first mover advantage. With price competition, price is equal to marginal cost, same as in a perfectly competitive outcome.