FIRST MEETING PJJ ECN3101: MICROECONOMICS 11 FEBRUARY 2012 (8.30 -10.20AM) SEMESTER 2, 2011/2012

1. FIRST MEETING PJJ ECN3101: MICROECONOMICS11 FEBRUARY 2012 (8.30 -10.20AM)SEMESTER 2, 2011/2012

2. Chapter 2 The Basics of Supply and Demand

3. Lecture Outline • Supply and demand • Market mechanism • Effects of changes in market equilibrium • Elasticities of supply and demand • Effects of government intervention- price controls

4. Supplyand Demand • Supply and demand analysis can: • Help to understand and predict how world economic conditions affect market price and production. • Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy. • Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers

5. The supply curve • Law of supply • Shows the relationship between the quantity of a good that producers are willing to sell and the price of the good. • Supply curve slopes upward demonstrating a positive relationship between price and output • at higher prices firms will increase output and vice versa Price S P2 P1 Q1 Q2 Quantity

6. Movement and shifting of supply curve • Changes in the quantity supplied - movement along the curve caused by a change in price • Change in supply - shift of the curve caused by a change in something other than price • such as change in costs of production due to changes in input prices, technology improvement and increase in number of producers

7. Other variables affecting supply • Example: Costs of Production • When cost of inputs (such as labor, capital and raw materials) used in production changes. • Lower costs of production allow a firm to produce more at each price. • Suppose the cost of raw materials falls. Supply curve shifts right to S’. • Higher costs of production reduces production. Suppose the cost of raw materials increase • Supply curve shifts left to S” Price S” S S’ P1   P2   Qo Q1 Q2 Quantity

8. The Demand Curve Price • Law of Demand • Shows the relationship between the quantity of a good that consumers are willing to buy and the price of the good • Demand curve slopes downward demonstrating a negative relationship between quantity demanded and price. • consumers are willing to buy more at a lower price as the product becomes relatively cheaper P2 P1 D Q1 Q2 Quantity

9. Movement and shifting of demand curve • Changes in the quantity demand - movements along the demand curve caused by a change in price • Change in demand - a shift of the entire demand curve caused by a change in something other than price (such as income, taste and preferences, number of consumer, etc)

10. Other variables affecting demand • Income • increases in income allow consumers to purchase more at all prices • For normal goods – the relationship between income and demand is positive (income  - demand for normal . • For inferior good - the relationship between income and demand is negative. • Price of related goods • For substitutes goods (coffee and tea) the relationship – positive • Price of coffee  – quantity coffee demanded  – demand for tea  • For complements goods (car and petrol) – negative relationship • Price of petrol  – quantity petrol demanded  – demand for car  • Consumer tastes • Number of consumer

11. Change in Demand • Income increases • Initially purchased Qo at P2 and Q1 at P1 • Now purchased Q1 at P2 and Q2 at P1 • Increase in income  ↑DD  demand curve shifts right. • Income decreases • Decrease in income  DD  demand curve shifts left. Price P2   P1   D’ D D” Qo Q1 Q2 Quantity

12. The market mechanism • Is the tendency in a free market for price to change until the market clears. • Markets clear when quantity demanded equals quantity supplied at the prevailing price. • Market clearing price – price at which markets clear or at equilibrium.

13. The market mechanism Price At market equilibrium • There is no shortage or excess demand • There is no surplus or excess supply • Quantity supplied equals quantity demanded (Qd = Qs) S Market equilibrium Po  D Qo Quantity

14. Market surplus Price • If the market price is above equilibrium there is excess supply/ surplus (Qs > Qd) • There will be a downward pressure on price. • Qd ↑ and Qs ↓ • Market adjust until new equilibrium is reached (E). S surplus P1 E  Po D Quantity Qd Qo Qs

15. Market shortage Price • The market price is below equilibrium there is excess demand or shortage (Qd > Qs) • Upward pressure on prices • Qd ↓ and Qs ↑ • Market adjust until new equilibrium is reached (E). S E  Po P1 shortage D Qs Qo Qd Quantity

16. The Market Mechanism • Supply and demand interact to determine the market clearing price • When not in equilibrium, the market will adjust to eliminate shortage or surplus and return to equilibrium. • Market must be competitive for the mechanism to be efficient.

17. Changes in market equilibrium (Supply change) Price • Initial equilibrium at A. • Suppose raw material prices fall – cost of production decrease. • Supply curve shifts to right from S to S’ • There is surplus at Po between Q1 and Q2 • Price will adjust downward to reach equilibrium at P3 & Q3 S surplus S’ A Po   B  P3 D Q3 Q1 Q2 Quantity

18. Changes in market equilibrium (Demand change) Price • Suppose income increases • Demand curve shifts to right from D to D’ • There will be shortage at Po between Q1 and Q2 • Price adjust upward to reach equilibrium at P3 and Q3 D’ D S B P3  shortage A Po   Q1 Q3 Q2 Quantity

19. Changes in market equilibrium (DD and SS change) Price • Initially market in equilibrium at A (P1, Q1) • Suppose income ↑ & raw material prices ↓. • Both DD and SS curve shifts rightward to D’ and S’. • New equilibrium at B (P2, Q2) • Price and quantity increases D’ D S S’ P2  B  A P1 Q1 Q2 Quantity

20. Shifts in supply and demand • When supply and demand change simultaneously, the impact on the equilibrium price & quantity is determined by: • The relative size and direction of the change. • The shape of the supply and demand curve.

21. An Application: Market for a College Education Price (annual cost) • The supply curve for a college education shifted up as the costs of equipment, maintenance and wages rose - increased costs of production (S1970 shifts to S2002). • DD curve shifted to the right as a growing number of high school graduates desired a college education (D1970 shifts to D2002). • Both price and enrollments rose sharply. s2002 S1970 $3,917 B  A $2,530  D2002 D1970 8.6 13.2 Quantity (millions enrolled)

22. Elasticities of Supply and Demand • Measures the sensitivity of quantity demanded to price or income changes. • It measures the percentage change in the quantity demanded of a good that results from a one percent change in price or incomes

23. Price elasticity of demand • Can be written as: Ed = % Δ Qd % Δ P Ed = Δ Q/ Q X 100 Δ P/ P Ed = PΔ Q Q Δ P

24. Price elasticity of demand • Usually a negative number because the relationship between price and quantity demanded is inverse according to law of demand: • As price , quantity  • As price  , quantity  • When Ed > 1, the good is price elastic (%ΔQ > %ΔP) • When Ed < 1, the good is price inelastic (%ΔQ < %ΔP)

25. Linear demand curve and elasticity P • Given a linear DD curve: • Top portion of DD curve is elastic – P is high and Q small. • The bottom portion of demand curve is inelastic – P is low & Q high. • The steeper the DD curve , the more inelastic the good. • The flatter the demand curve , the more elastic the good. • Two extreme cases of demand curve: • Completely inelastic demand – vertical curve • Infinitely elastic demand – horizontal curve Ed = -  Elastic (Ed >1) Unit elastic 2 Inelastic (Ed < 1) Ed = 0 8 4 Q

26. Extreme cases of demand curves Price Price Ed = 0 Ed = -  Quantity Quantity Completely elastic demand Completely inelastic demand

27. Other demand elasticities • Income elasticity of demand • Measures how much quantity demanded changes with a change in come. EI = Δ Q/ Q X 100 Δ I/ I EI = IΔ Q Q Δ I Normal good (positive) Inferior good (negative)

28. Other demand elasticities • Cross-price elasticity of demand • Measures the percentage change in the quantity demanded of one good that results from a one percentage change in the price of another good. • EQbPm = Δ Qb / Qb X 100 Δ Pm / Pm EQbPm= PmΔQb Qb ΔPm Complements : Gasoline and Cars : (negative) (Pgasoline ↑, Qcar ↓) Substitutes: Butter and margarine (positive) (Pbutter ↑, Qmargarine ↑)

29. Price elasticity of supply • Measures the sensitivity of quantity supplied given a change in price. • measures the percentage change in the quantity supplied resulting from a one percent change in price • Can be written as: Es = % Δ Qs % Δ P Es = Δ Q/ Q X 100 Δ P/ P Es = P Δ Qs Qs Δ P

30. Short-run vs long-run elasticity • To examine how much demand or supply changes in response to a change in price – must consider how much time is allowed for the quantity demanded or supplied to respond to the price change. • Short-run demand and supply curves look very different from the long-run. • Influenced by • Demand & durability • Income elasticities • Supply & durability

31. Short-run vs long-run elasticity i. Demand and durability • For many goods – DD is more price elastic in long-run than short-run because it takes time for consumer to change their consumption habits. • E.g. if P of coffee rises , the Qd will fall only gradually • If P of gasoline rises, Qd decrease in the short-run but it has greatest impact on demand by inducing consumers to buy smaller & more fuel-efficient cars.

32. Gasoline: Short-run and Long-run Demand Curves • In the short-run, an increase in price has only a small effect on the quantity of gasoline demanded. • Motorists may drive less, but they will not change the kinds of cars they are driving overnight. • In the long-run – there is tendency for drivers to shift to smaller and more fuel-efficient cars, so the effect of the price increase will be larger • Thus demand is more elastic in the long run than in the short run. P DSR DLR Q

33. ii. Income elasticities • Also varies with the amount time consumers have to an income change. • For most goods & services – food, beverages, fuel, etc. – income elasticity of demand is larger in the long run than in the short run • This is because the change in consumption takes time, and demand initially increases only by a small amount. • The long-run elasticity will be larger than the short-run elasticity.

34. Elasticity of supply iii. Supply and durability • Elasticity of supply also differ from the long run to the short run. • For most products (agricultural products), long run supply is much more price elastic than short run supply. • Firms face capacity constraints in the short run and need time to expand capacity by building new production and hiring workers. • The output can be expanded more in the long run than in the short run. • For some goods & services, short-run supply is completely inelastic. E.g. rental housing. • In short run, there is only fixed number of rental units. An increase in demand will only pushes rents up. Only in the long run the quantity supplied increases.

35. Effects of Price controls • Markets are rarely free of government intervention • Imposed taxes, grant subsidies and implement price controls • Price controls [price ceilings (max) and price floors (min)] usually hold the price above or below the equilibrium price. • When price is below equilibrium price – there is excess demand (shortage) • When price is above equilibrium price – there is excess supply (surplus)

36. Effects of Price controls Price • Price is regulated to be no higher than Pmax • Qs falls and Qd increases • A shortage created in the market S Po E P max shortage D Quantity Qo Qs Qd

37. Chapter 3 Consumer Behavior

38. Consumer Behavior • Consumer preferences - Assumptions - Indifference curves and Indifference maps - The shape of Indifference curves - Marginal rate of substitution (MRS) - Perfect substitutes and perfect complements • Budget Constraints - Budget line - The effects of changes in income and prices • Corner Solutions • Marginal utility and consumer choice

39. Introduction • How are consumer preferences used to determine demand? • How do consumers allocate income to the purchase of different goods? • How do consumers with limited income decide what to buy? • How can we determine the nature of consumer preferences for observations of consumer behavior?

40. Theory of consumer behavior • The explanation of how consumers allocate income to the purchase of different goods and services • There are 3 steps involved in the study of consumer behavior • Consumer Preferences • To describe how and why people prefer one good to another • Budget Constraints • Consumer have limited incomes which restrict the quantities of goods they can buy • Consumer choice • What combination of goods will consumers buy to maximize their satisfaction – given their preferences and limited incomes?

41. Consumer Preferences – Basic Assumptions • Preferences are complete. • Consumers can compare and rank market baskets (for any market basket A and B – consumer will prefer A to B, will prefer B to A or indifferent (or equally satisfied) • Preferences are transitive. • If prefer A to B, and B to C, then the consumer must prefer A to C. Transitivity is normally regarded as necessary for consumer consistency. • Consumers always prefer more of any good to less. • More is better – however some goods may be undesirable such air-pollution.

42. Consumer Preferences • Consumer preferences can be represented graphically using indifference curves • An Indifference curve represent all combinations of market baskets that provide a consumer with the same level of satisfaction. • A person will be equally satisfied with either choice

43. Indifference Curves: An Example

44. B 50 Clothing H E 40 A 30 D 20 G U1 10 Food 10 20 30 40 Indifference Curves: An Example • Because more of each good is preferred to less: • Basket A preferred to G • E is preferred to A • Indifferent between B, A, & D • A preferred to H – lies below U1

45. Indifference Curves • Any market basket lying northeast of an indifference curve is preferred to any market basket that lies on the indifference curve. • Points on the curve are preferred to points southwest of the curve • Indifference curves slope downward to the right. • If it sloped upward it would violate the assumption that more is preferred to less (compare point A and E).

46. Indifference Maps • To describe preferences for all combinations of goods/services, we have a set of indifference curves – an indifference map • Each indifference curve in the map shows the market baskets among which the person is indifferent.

47. Clothing D B A U3 U2 U1 Food Indifference Map Market basket A (U3) is preferred to B (U2). Market basket B (U2) is preferred to D (U1). * U3 generates the highest level of satisfaction followed by U2 and U1

48. U2 U1 Clothing A B U1 D U2 Food Indifference curvescannot intersect because it violates the assumption that more is better • A and B at U1 so consumer are indifferent between A and B • A and D at U2, so consumer are indifferent between A and D • So this means that consumer are indifferent between B and D – this can’t be true • Because B must be preferred to D because it contains more of both Food and Clothing

49. A 16 Clothing 14 12 -6 B 10 1 8 -4 D 6 E 1 G -2 4 1 -1 1 2 Food 1 2 3 4 5 The Shape of Indifference Curves • The shapes of indifference curves describes how a consumer is willing to substitute one good for another (consumer face trade-offs) • A to B, give up 6 clothing to get 1 food • D to E, give up 2 clothing to get 1 food • The more clothing and less food a person consumes – the more clothing he will give up in order to obtain more food.

50. Marginal Rate of Substitution • The slope of the indifference curve is called marginal rate of substitution (MRS) • It quantifies the maximum amount of a good a consumer is willing to give up in order to obtain one additional unit of another good.