Microeconomics precourse Academic Year 2013-2014

1. Microeconomicsprecourse AcademicYear 2013-2014 CoursePresentation This course aims to prepare students for the Microeconomics course of the MSc in BA. It provides the essential background in microeconomics PAOLO PAESANI Office: Room B6, 3RD floor, Building B Telephone: 06-72595701 E-mail: paolo.paesani@uniroma2.it Office hours: to be agreed

2. WHY ARE WE HERE ? • Gettoknoweachother • Economics in a nutshell • Cracking the nutshell open … • It can’t beeasierthanthis. • Friendlyadvice: makesureyouknowthisbyheart !

3. PRESENTATION OUTLINE • Whatiseconomicsabout? • Whatismicroeconomicsabout? • The market • Consumer theory • Theoryof the firm

4. Micro • ECONOMICS • “Political economy or economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing” (Marshall 1890). • “Economics is the science that studies human behavior as a relationship between ends and scarce means which have alternative uses.” (Robbins 1935).

5. Micro ECONOMICS “It seems to me that economics is a branch of logic, a way of thinking; […] Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time. […] The object of a model is to segregate the semi-permanent or relatively constant factors from those which are transitory or fluctuating so as to develop a logical way of thinking about the latter, and of understanding the time sequences to which they give rise in particular cases. […] In the second place, as against Robbins, economics is essentially a moral science and not a natural science. That is to say, it employs introspection and judgments of value”. (Keynes 1938)

6. Micro • MICROECONOMICS • Microeconomicsstudies: • Howindividuals take rationaleconomicdecisions • Howindividualsinteract in a defined social context. • Individuals= Economicagents = Decision-takers / Choice-makers • Humanbeings, firms, policy-makers • Decisionsaboutwhat? Whatkindofdecision? • Rationaleconomicdecisions = decisionsabouthowtobestuselimitedresourcestoachievepossiblyconflictinggoals

7. Micro ECONOMIC RATIONALITY Rationalagentsfacingeconomicdecisions are confrontedwithconstrainst and alternative coursesofaction (COAs). Constraints(individual, socio-cultual, economic, legal, time-related) shape COA . EachCOA entailscosts and benefitswhichmaterialiseoverdifferenttimeperiods … short-term vs. long-term (MOTLO) Costsand benefitsassociatedtodifferentCOAsmaybeuncertain (risk) or unknown (uncertainty)… expectations

8. Micro ECONOMIC RATIONALITY Economicrationalityisaboutchoosing the best courseofactionfor a giveconstraint-setwhere best isdefinedwithrespectto the individual’s objectivefunction (whichwe assume tobewell-defined) and on the information at hisdisposal (full vs. limited information). Rationalityassumption and itstwomotivations More on rationality and homo economicus (Sen 1987, Smith 2008, Rodriguez-Sickert 2009)

9. Micro • SOCIO-ECONOMIC CONTEXT • Free market economy: • Well-definedpropertyrightsoveravailableresources. • Freedomto put availableresourcesto the best (mostprofitable) useasjudgedby the owner (resourceallocation). • Propertyrightsprotection. • Freedomto transfer propertyrights in a regulated and organised way (Voluntaryexchange) • Price-basedresourceallocation. • Modelling social interaction: • The Robinson Crusoe economy (no interaction) • Strategicinteraction (Game theory) • Market interaction

10. Micro ECONOMIC THEORY AND ECONOMIC MODELS (NOT THE SAME THING) Theory: A set of statements or principles devised to explain a group of facts or phenomena in their relation to one another. Theories can be deduced from given axioms or be the result of observation and conjecture, they can be empirically tested and used to make predictions about phenomena. Economicmodel: simplifiedrepresentationof reality based on a set ofpre-specifiedsimplifyingassumptionsand on the useofone or more languages (the threelanguagesofeconomics).

11. Micro MARSHALL ON THE USE OF MATHEMATICS IN ECONOMICS “[I had] a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules - (1) Use mathematics as a shorthand language, rather than an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can't succeed in (4), burn (3). This last I did often”. [Marshall 1906]

12. Micro ECONOMIC THEORY AND ECONOMIC MODELS (NOT THE SAME THING) “Models are objects to enquire into and to enquire with: economists enquire into the world of the economic model, and use them to enquire with into the economic world that the model represents” (Morgan 2012, p. 217). “Reasoning in termsofmodelsinvolvesfoursteps “Step 1 is to construct a model relevant for some problem of interest. Step 2 is to ask questions about ‘something in the model or in the world’. Step 3 is to ‘demonstrate the answer to the questions using the model’s resources’. This is where manipulation comes in: the answer is arrived at by manipulating the model. Step 4 is to add a ‘narrative’ that ‘accompanies the demonstration to link the answers back to the questions and to their domains”. (Morgan 2012 p. 225).

13. Micro Varian (2010)

14. Micro • THE MARKET • “A mechanismforeffectingpurchases and sales in a relatively public manner. Thus a market entails a way ofcarrying out transactions and some meansofcollecting and disseminating information on the termsof the transactions, particularly price. Thesetwoaspects are inherentlyinterrelated. ” (Burns 1979, p. 5) • Market identification: Where ? When ? Who ? What ? How ? • Market classification: • Marketsforgoods and service, factormarkets, assetmarkets • Spot, futures and optionsmarkets • Perfectcompetition, monopolistic competition, oligopoly, duopoly, monopoly/monopsony • Auction markets, dealer markets, broker markets, private negotiations • Regulated vs non-regulated (OTC) markets

15. Micro • THE COMPETITIVE MARKET • Manypotentialbuyers and sellers, motivatedbyself-interest, competingagainsteachother and actingasprice-takers. • Tradedgoods are excludable (the owener can exercisepropertyrights on it) rivalrous(use by one necessarily prevents that of another) and homogenous (only price matters).  • No barriersto entry and exit • Perfect information • No transactioncosts (costsrelatedto market participation): search and information costs, bargaining and decision costs, policing and enforcement costs.

16. Probability • y = Market price • x = Quantitytradedover a givenperiodoftime • DD = Demandfunction • SS = Supplyfunction • A = Market equilibrium • ds = Excessdemand) • sd = Excesssupply) THE MARSHALLIAN CROSS Marshall (1890)

17. Micro • THE COMPETITIVE MARKET - PARTIAL EQUILIBRIUM MODEL • P = market price , nominal price (money?), relative price (MOTLO) • Q = quantitytradedover a givenperiodoftime (flow variable … MOTLO) • DD = Market Demandfunction (Horizontalaggregation, MOTLO) • Inverse demandfunction Pd = f(Q) ; f’(Q) < 0 • Demand price the MAXIMUM price that consumers are willing to pay for the goods and services the are planning to buy when a particular amount or quantity is available. • DemandfunctionproperQd = g(P) ; g’(P) < 0 • SS = Market Supplyfunction • Inverse supplyfunctionPs = h(Q) ; h’(Q) > 0 • Supply price the MINIMUM price that firms are willing to accept in return for a particular amount or quantity of goods and services. • SupplyfunctionproperQs = k(P) ; k’(P) > 0 • EQUILIBRIUM ; Pd = Ps or alternativelyQd = Qs

18. Micro THE COMPETITIVE MARKET – DEMAND ANALYSIS Slope: The law of demand states that when the price of a good rises CP, the amount demanded falls, and when the price falls, the amount demanded rises.(MOTLO) Position of the demand curve depends: Preferences, Disposableincomes, Incomedistribution, Price ofcomplements and subsitutes, Expectedown-price, Expected price ofcomplements and substitutes … whenoneofthese EXOGENOUS VARIABLES changes the demand curve shifts up or down.

19. Micro ELASTICITY Price elasticityofdemand: the degree to which the number of products sold changes when the product's price changes Marshall (1890)

20. Micro ELASTICITY Incomeelasticityofdemand: the degree to which the number of products demanded changes with an individual’s income. Brown e Deaton (1972)

21. Micro THE COMPETITIVE MARKET – SUPPLY ANALYSIS Slope: No equivalentof the law od demand, slopeofsupplyfunction in a competitive market depends on marginalcosts(MOTLO) Position of the supply curve depends: Technology, Fixedinputs, Input prices, Degreeofsectoralintegration … whenoneofthese EXOGENOUS VARIABLES changes the demand curve shifts up or down. Marshall (1890)

22. Micro EQUILIBRIUM AND WELFARE ANALYSIS • Efficientallocationofscarceresources • Welfare maximization • Consumers surplus • Producers surplus • Market “freedom” • Market “democracy” • How long doesit take? • Existance? Unicity, stability?

23. Micro CONSUMER SURPLUS Varian (2010)

24. Micro MARKET ANOMALIES

25. Micro Narrowdefinition (Fama 1970) “A market isefficientwhenpricesfullyreflectavailable information” : Weak, Semi-strong and Strong efficiency. Broad definition (Burns 1979): “An efficient market isliquid, orderly and well-organised. Liquidityfostersorderly market conditions and influencesa market’s organisation. In turn, orderly market conditions and good market organizationpromote market liquidity”. Liquidity MARKET EFFICIENCY Orderly market conditions Good market organisation

26. Micro • MARKET LIQUIDITY • Market liquidity, or liquidityofanassettraded on a market, hastwointerreatedaspects: certaintyof price (withrespecttounderlyingvalue) and expectedmarketability (inverselyrelatedtotransactioncosts). Liquiditydepends on: • Breadth and urgencyofdemand, • Costofascertatinganassetquality (qualitystandardisation in case ofcommodities, publiclyavailable info in case offinancialassets), • Expectedcostof default underlyingfinancialassets (default risktogetherwithenforcementcost), • Transportcost and costof holding inventories (storage, deterioration, theft, financingcosts, risksof price change). • Riskof price uncertaintyassociatedwithinventoryholdingsoneof the mainfactorsbehind the establishementoffutures and optionmarkets and of the activitiesofHedgers, Speculators and Arbitrageurs.

27. Micro • ORDERLY MARKET CONDITIONS • Disorderly market conditions are associatedwith: • Unexpectedly high price volatility (symptom, ratherthan cause), • Artificialbarriersto entry or exit (e.g. monopoly / monopsony) • Information manipulation • Tradersoverreaction • Destabilising trading activityas a resultof trading restrictions • Liquidityhelpstopreventstructuralmonopolies and price manipulation and togetherwithan appropriate organisationcontributestogeneratingorderly market condition

28. Micro MARKET ORGANISATION The organisationof a market embraces the institutionsthat service it: dealers, brokers, clearing houses, inspectionservices, regulatoryauthorities. Developmentof a market’s organisationinvolvesapplyingeconomiesof scale toeffectingtransactionsaswellastoprovide information about the termsof the transaction. The historyof a market organisationisoneofincreasingspecializationoffunctioninducedby, and in turn inducing, anincrease in market liquidity.

29. Random variable IMPERFECT MARKET - DEALER Dealers are specialised market operators standing readytotransact Ai = Ask price , Bi = Bid price, AiBi = Bid-Ask spread (transactioncostindicator, inverselyrelatedto market liquidity) [Demsetz 1967]

30. Micro IMPERFECT MARKET – PRICE CEILING AND RATIONING Varian (2010)

31. Micro • MARKET FAILURES • A market failure is a situation where free markets fail to allocate resources efficiently. Economists identify the following cases of market failure: • Productive and allocative inefficiency: Markets may fail to  produce and allocate scarce resources in the most efficient way. • Monopoly power: Markets may fail to control the abuses of monopoly power. • Missing markets: Markets may fail to form, resulting in a failure to meet a need or want, such as the need for public goods, such as defence, street lighting, and highways. • Incomplete markets: Markets may fail to produce enough merit goods, such as education and healthcare. • De-merit goods: Markets may also fail to control the manufacture and sale of goods like cigarettes and alcohol, which have lessmerit than consumers perceive. • Negative externalities: Consumers and producers may fail to take into account the effects of their actions on third-parties, such as car drivers, who may fail to take into account the traffic congestion they create for others. Third-parties are individuals, organisations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self interest.

32. Micro • MARKET FAILURES • Property rights: Markets work most effectively when consumers and producers are granted the right to own property, but in many cases property rights cannot easily be allocated to certain resources. Failure to assign property rights may limit the ability of markets to form. • Information failure: Markets may not provide enough information because, during a market transaction, it may not be in the interests of one party to provide full information to the other party. Information asymmetry (adverse selection, moral hazard, costly state verification) belong to this category. • Unstable markets: Sometimes markets become highly unstable, and a stable equilibrium may not be established, such as with certain agricultural markets, foreign exchange, and credit markets. Such volatility may require intervention. • Inequality: Markets may also fail to limit the size of the gap between income earners, the so-called income gap. Market transactions reward consumers and producers with incomes and profits, but these rewards may be concentrated in the hands of a few. • Source http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html

33. Micro • MARKET REGULATION • Increase market efficiencybypromotingliquidity, orderly market conditions and an appropriate organization. • Correct market failuresbyresortingto: • Price mechanism: change the behaviour of consumers and producers by using the price mechanism. For example, this could mean increasing the price of ‘harmful’ products, through taxation, and providing subsidies for the ‘beneficial’ products. In this way, behaviour is changed through financial incentives, much the same way that markets work to allocate resources. • Legislation and force: For example, by banning cars from city centres, or having a licensing system for the sale of alcohol, or by penalising polluters, the unwanted behaviour may be controlled. Source http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html

34. Micro • REFERENCE • BurnsJ.M. (1979) A Treatise on Markets, American EnterpriseInstitute, Studies in Economic Policy, Washington DC. • Rodriguez-Sickert C. (2009) “Homo economicus”, Handbook of Economics & Ethics, Peil, J., and Van Staveren, I. (eds.) Edward Elgar Publishing. • Sen, A. (1987) “RationalBehaviour”, The New PalgraveDictionaryofEconomics, vol 3, pp. 68-76, • Smith V. L. (2008) Rationality in Economics, Cambridge University Press, Cambridge. • VarianH. (2010) Intermediate Microeconomics, 8° edition, W. W. Norton & Company