Microeconomics 200

1. Microeconomics 200 Welcome!

2. ME • Paul Miller • Email:paul.miller@.curtin.edu.au • Ph: 9266 7758 • Rm: 402:416 • Consult Hours:

3. This Course Aims: 1. To provide students with an understanding of the standard theoretical analysis of consumer and producer behaviour. 2. To provide students with an appreciation of the economic efficiency and equity effects of economic actions and policies. 3. To stress the relevance and application of microeconomics for decision-making.

4. A short word about microeconomics • This course will provide you with an understanding of neo-classical/traditional microeconomic theory. The course has this focus because the traditional theory is: • Currently very influential • Currently the ‘dominant’ view on economic theory • However, traditional microeconomics is also very contentious • You need to know this theory even if you don’t agree with it!

5. Traditional Microeconomics • Focuses on individuals; that is, on consumers, producers and workers, and their involvement in markets • Consumers – buy/demand goods and services • Producers/firms • Buy/demand labour and other inputs to produce goods and services • Sell/supply goods and services • Workers – sell their labour • Markets – are ‘places’ where individuals interact to achieve their needs and wants and negotiate prices • Largely ignores social, inter-personal and cultural factors and assigns government and multi-national institutions a marginal role 5

6. Traditional Microeconomics • Is optimistic about the ability of individuals to achieve their needs and wants through their involvement in market exchange • Is optimistic about the ability of markets to ensure an efficient allocation of resources • Focuses on efficiency rather than equity 6

7. Traditional Microeconomics • Consumer Theory focuses on the decisions made by individuals about their purchases of goods and services • It relies on assumptions of rationality & maximisation • It studies how a rational consumer will make decisions about using her income • How she will respond to changing prices (e.g. higher food prices) • How her consumption patterns reflect her preferences • How her consumption pattern and level will change when her income changes 7

8. Traditional Microeconomics • It relies on assumptions of rationality & maximisation • It studies how a rational producer will make key decisions, such as • How much to produce • How much labour and other inputs to hire • How to respond to changes in wages or new technologies Producer Theory focuses on the decisions made by firms about their levels of production and production methods 8

9. Traditional Microeconomics • And before they make any decision they will weigh up the opportunity costs and benefits of alternative actions • For example, before a consumer decides to spend all her week’s pay on a new pair of shoes she will consider the trade-offs (such as the consequences of not paying the rent) Rationality & Maximisation imply individuals will attempt to make the best use of their resources 9

10. Traditional Microeconomics Rationality & Maximisation alsoimply that individuals will make the decisions that they think are best for them Thus, the theory generally predicts negative consequences if, for example, government policy restricts or alters the choices available to individuals 10

11. Traditional Microeconomics • Is challenged by many economists and non-economists • Many question: • i) The realism of the theory’s assumptions (e.g. about rationality) • ii) The accuracy of the theory’s predictions • iii) The theory’s focus (e.g. on efficiency over equity) 11

12. Traditional Microeconomics • For example, we can use the theory to study some of the effects of biofuelson: • - Consumers’ budgets • - Consumers’ choices • - Firms’ cost of production • - Firms’ input choices However, although it is far from perfect, the theoryis useful for examining some important issues. 12

13. This unit provides you with several key resources to help you further your knowledge of microeconomic theory and its applications: Text Lectures and Tutorials Challenges and Feedback This Course 13

14. The Text • Pindyck, R.S and D. L. Rubinfeld (2013), Microeconomics, 8th edition, Pearson Prentice Hall, New Jersey.

15. Other resources • Blackboard • Lecture slides posted before the lecture • Unit outlines • Tutorial questions • Messages and announcements

16. ASSESSMENT…see unit outline • Class Assignments (weekly) 20% • Mid-Semester Test (May 2) 15%..covers weeks 1-4; all MC • Essay (April 18) 20% • Final Examination 50%; involves both MC and essay-style questions.

17. Some final tips • Keep reading • Attempt the tutorial exercises each week • Practice and re-practice the diagrams • Listen carefully! • Take many notes!!!

18. Best wishes for a successful semester!

19. CONSUMER BEHAVIOUR PART 1 Read Textbook Chapter 3.1 & 3.2

20. Introduction to Consumer Theory This part of traditional microeconomic theory is used to analyse and predict how individuals make decisions about the consumption of goods and services. An important focus of the theory is on the effects of changes in prices and incomes on consumers’ demand for goods and services. 20

21. The theory has 2 key components An individual’s demand for different goods & services is seen to depend on 1) her preferences (how she values different commodities) 2) her budget (what she can afford given her income and the prices of different goods and services)

22. Key Learning Outcomes • Part 1: Consumer preferences • Assumptions of consumer choice theory • Indifference curves • Indifference maps • Utility • Marginal Rate of Substitution (MRS) • Formula • Graphical representation • Special cases 22

23. Assumptions about Preferences The assumptions about preferences need to be known. The theory assumes consumers are rational. This implies: • 1. Completeness • 2. Transitivity • 3. Greed Note that in this work we only require our consumer to make binary comparisons!!!!!

24. 1. Preferences are complete Consumers can rank all available consumption choices. That is, they can say they Consumer Preferences: Assumptions Prefer to Or to Or, they’re indifferent between & 24

25. Consumer Preferences: Assumptions 2. Preferences are transitive If I prefer choc milk to tea, AND I prefer tea to lemonade, THEN I must prefer choc milk to lemonade. This is a contentious assumption. Chocolate milk Tea Lemonade

26. Consumer Preferences: Assumptions 3. Preferences are for more goods than less • = Assumption of GREED, • (Except in the case of ‘bads’ where less is preferred to more e.g. pollution)

27. Consumer Preferences: Showing Preferences on a Graph The graphical presentation of these ideas about consumer preferences focuses on how a rational consumer would rank different baskets of goods and services HOW WOULD YOU RANK THESE BASKETS??? Are there any baskets you definitely prefer?

28. B E A D G Step 1: Graph the market baskets from the example Clothing (units) 50 40 30 20 10 Food (units) 10 20 30 40

29. B has less food but more clothing than A. Clothing (units) 50 E has more food & more clothing than A. 40 30 D has more food but less clothing than A. 20 G has less food & less clothing than A. 10 Food (units) 10 20 30 40 Step 2: Identify all baskets that will be preferred to A (green); and all the baskets that are inferior to A (red). B E A D G

30. This is REALLY IMPORTANT E G U1 Indifference Curves Clothing (units) SUPPOSE the consumer is indifferent between points B, A, & D. They will all be on the SAME INDIFFERENCE CURVE. B 50 40 A 30 D 20 10 Food (units) 10 20 30 40

31. Indifference Curves, Satisfaction & Utility • An indifference curve represents all combinations of market baskets that the person is _______________. • Any basket located on the one indifference curve will give a consumer the same level of satisfaction or ________. Utility is a numerical score representing satisfaction levels. indifferent between utility

32. Important: Indifference Curves ARE NOT Demand Curves Clothing (units) Price of food ($) INDIFFERENCE _______________ curve DEMAND __________ curve Food (units) Food (units)

33. U1 Indifference Curves: Are used to describe how consumers “feel” about different commodities Clothing (units) If we take some clothing away from this consumer 50 We need to compensate him with more food W 40 to maintain the same satisfaction level 30 If the consumer needs a lot of compensation clothing must be important to him and vice versa X 20 10 Food (units) 10 20 30 40

34. Special Case: Indifference Curves for “Bads” Pollution (units) If we take some pollution away from this consumer R We can reduce her level of food and she would maintain the same satisfaction level T NB Indifference curves slope upwards if one of commodities is a “bad”. If both commodities are goods the IC slopes downward Food (units)

35. Special Case: Indifference Curve for a“Bad” Risk Return

36. Special Case: Indifference Curves: Neutrals Clothing (units) No matter how much or how little of a neutral commodity– same satisfaction level Neutral (units)

37. Indifference Curves: Neutrals Neutral (units) Clothing (units)

38. Indifference Map This is REALLY IMPORTANT E G U1 U2 Clothing (units) SUPPOSE the consumer PREFERS point E to points B, A, & D. It will all be on a HIGHER INDIFFERENCE CURVE. B 50 40 A 30 D 20 10 Food (units) 10 20 30 40 38

39. A E U2 U1 G U0 Indifference Map: Goods Clothing (units) Direction of ___________ satisfaction/utility increasing • Indifference maps: • Comprise a set of indifference curves E is preferred to A. A is preferred to G. Food (units)

40. Special Case: Indifference Map for “Bads” U T S Pollution (units) S is preferred to T, which is preferred to U Direction of increasing satisfaction/utility Food (units) 40

41. Indifference Curves: Neutrals Clothing (units) Neutral commodity does not change utility level. Utility can only be increased by increasing clothing (a ‘good’). Neutral (units)

42. Indifference Curves Maps • Every commodity bundle must be on an IC • ICs cannot intersect • Shape must reflect preferences

43. Question on the Indifference Maps Good B • Refer to the indifference curve in the figure opposite. Which of the following statements is correct? • This individual will only consume A and B in fixed proportions. • This individual receives no satisfaction from Good A. • This individual receives no satisfaction from Good B. • None of the above. Increasing utility Good A This question is from a past year test and more than half of the students got it right. How about U? Feedback

44. Marginal Rate of Substitution: Measuring the Strength of Consumer’s Preferences U1 We’ve already learnt that if the consumer needs a lot of compensation if we reduce his clothing allowance, the good must be important to him and vice versa Clothing (units) 50 W 40 30 The technical term used to measure this trade-off and, thus, to describe the strength of consumer preferences for different commodities is MRS X 20 10 Food (units) 10 20 30 40 44

45. To get 1 unit of F Give up 3 units of C Marginal Rate of Substitution MRSF = Food, C = Clothing • Suppose Jo is willing to give up 3 units of C to get 1 additional unit of F. • Jo’s MRS of F for C is the maximum amount of Cshe’s willing to give up to obtain 1 additional unit of F. • MRS (F for C) = –C/F = –(–3)/1 = 3 MRS (F for C) = -C/F

46. MRS General definition of MRS: The maximum amount of a good that a consumer is willing to give up to get one additional unit of another good. Need to know: • Formula • Use/Meaning • Graphical representation

47. Suppose BOB is willing to give up 2 units of C to get 1 additional unit of F. Meaning/Use of MRSMRS describes the intensity of prefs To get 1 unit of F Give up 2 units of C Notice Bob will give up fewer C to get 1 extra F. This implies C is more valuable and F is less valuable to him, as compared to Jo MRS (F for C) = –C/F = –(–2)/1 = 2 47

48. MRS: What is being Substituted for What? We say “MRS of F for C”, what is the consumer giving up? Answer: ____ “MRS of F for C” – consumer is giving up C. “MRS of C for F” – consumer is giving up F. C 48

49. MRS MRS X for Y Y X 49

50. Marginal Rate of Substitution: Graphs U1 Clothing (units) The absolute value of the SLOPE of the Indifference Curve measures MRS 5 W 4 BOB is willing to give up 2C for 1F. His MRS (F for C)=2 3 X 2 1 Food (units) 1 2 3 4 50