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Micro and Macro Economics: chapter 1: tables of contents
- Costs and benefits analysis
- Implicit costs
- Sunk costs
- Marginal costs and benefits
- Supply and demands of goods In general, if benefits are major than costs, then you should do it! This is the cost – benefits approach, which Is strictly connected to the concept of Reservation price : the minimum price amount it would take to do something The cost-benefit principle can be explained through some example: Someone asks you to go to town for 1000£; even if it is good, In examining the factors that should be taken into account when taking important economic decisions, there are three mistakes that are commonly made: Pitfall 1: ignoring implicit costs Implicit costs: you can choose to work for 45$ or go skiing, which would normally be 60$ but today is 40. If you go skiing, you may save 20, but lose 45 you could earn by working. This is called implicit cost (- 45 $) Pitfall 2: sunk costs: unavoidable costs that should not influence future measurements Average cost : it represents the total cost divided by the number of units or actions taken to produce the unit or to carry out an action (I have three boats an it costs 300 to launch them; average cost is 100 per boat) Average benefit : exactly as the average costs, but for profit: I gain 200 for operating two boats: the average benefit is 100 per boat Marginal cost: the additional cost of producing +1 unit. Formula: total cost divided by number of unit marginal benefit: the additional benefit of producing one more unit or carrying out an additional action. economic surplus: formula: total benefit – total costs explanation:
- I’m willing to pay 1200 for a PC
- An entity is willing to sell a PC for 800
- I find a PC at 1000
- Consumer surplus: 1200-1000= 200
- Seller surplus: 1000-800=
Lesson 2: supply and demand Supply and demand is a tool for analysing market outcomes, but what is market? By definition, it is the interaction between buyers and sellers and thus between demand and supply But why is it important to understand market dynamics? It is to decide three important things:
- What goods to produce and how much
- How to produce the goods
- How to distribute the goods Demand: The demand curve tells you the quantity of a good that buyers wish to purchase at various possible prices. This can be interpreted:
- Horizontally: starting by quantity, see the buyer’s reservation price at each quantity
- Vertically: starting by price, see the corresponding quantity at each price According to the law of demand, the more the price increases the more the demand decreases; (downward slope) In the demand curve, when the prices go up two things happen:
- Substitution effect: buyers opt for other goods
- Income effect: buyers’ overall purchasing power decreases, and they will be capable of buying less goods Algebra of demand: P = independent variable Q = dependent variable A: other factors affecting quantity B: slope P determine the value of Q In other words, the equation shows the relation between the two variables of price and quantity First of all, we get the inverse function to get P: Steps:
- Excess supply: if the price goes above equilibrium (which is 12 in this case), and reach 16 this would imply that Buyers would buy 2000 lobsters Sellers would offer 4000 lobsters This would mean that more lobsters than buyers are willing to pay four are on the market, creating a surplus
- Excess demand If, on the other hand, price would drop, the buyers would be dissatisfied with the new situation as they would get less quantity than they asked for (at price 8 buyers demand 4000 but sellers only provide 2000. This Is called shortage ) In general, these shifts are always caused by shifts in prices: Incentive principle:
- Excess supply
- Excess demand at 2:
As shown here, the seller has an incentive to increase the price in order to increase the supply and to meet the market equilibrium. Indeed, if he sets prices at 2£, there is a supply of 8000 slices but a demand for 16000. If the seller sets higher prices to 3£, he can meet the demand by fixing the shortage. The same process goes for surplus, with which the seller has interest in lowering the prices to fix the surplus and sell more. Algebra of Market equilibrium: In order to be in equilibrium, the quantity demanded and the quantity supplied must be equivalent. For this reason, I have to equate the inverse function of:
- the quantity of demand
- the quantity of supply
- A positive shift in the supply curve implies a movement of the equilibrium along the demand curve
- A negative shift in the supply curve implies a movement along the demand curve Supply and demand shifts rules: Rule 1 More demand = more equilibrium price and quantity Rule 2 Less demand = less equilibrium price and quantity Rule 3 More supply = less equilibrium price and more equilibrium quantity Rule 4 Less supply = more equilibrium price and less equilibrium quantity If both supply and demand change, it’s a mess man Buyers’s surplus= buyer’s reservation price – market price Seller’s surplus = market price – seller reservation price Tax on sellers and tax on buyers Basically, a tax on payers (brasil) and a tax on producers have the same outcome: the equilibrium quantity stays the same (8.7) whereas the equilibrium price is slightly different (goes from 9 .6 with a tax on buyers to 10.6 to tax levied on producers) Self test: The cost benefit principle is a simple but useful model of how people should make choices; it basically states that one should undertake an action only if total costs are grater than total benefits The opportunity cost: If a worker who earns more than another worker decides to take a day off, the opportunity cost is higher for the higher-wage worker. What does it mean? If individuals are rational they should choose actions that yield the largest economic surplus. But what is it? The economic surplus, by definition, represents the difference between
- Total benefits
- Total costs Steps:
- Solve for P or Q
- Draw the supply and demand curves
- Find equilibrium
Consumer behaviour:
As it’s been said, the demanded quantity decreases as prices go up; but why though? In order to provide an explanation, it Is important to observe that market demand is the outcome of the decisions of the consumers and analysing consumers’ choices helps understand how market works. There are four factors:
1. Consumer income/budget constraint Each consumer has a determined budget, with which must decide what to buy; income and prices jointly determine the combination of services or products that one can consume and the line that divide affordable from unaffordable assets is called the budget line The budget line can be described as an equation; indeed if expenditures = income, then the equation would look like this: Given two services or goods, the equation is made up of: Price of good x times quantity of good x plus price of good y times quantity of good y = consumer income Example: I have the possibility to buy
- Shelter (5£ per squared meter)
- Food (10 £ per libber) I have an income of 100 I can either buy:
- 20 squared meter of shelter
- 10 libber of food (in a week) If I consider this two extremes possibilities, I can draw a line from point A to point B and this line is called the budget constraint Now, remember that the slope of a straight line is calculated by: So I divide the vertical intercept over the horizontal intercept so: 10/20: 0.5; in reality, it’s – 10.5. why? Because by moving on the budget line, one of the two goods always decreases while the other increases. Not only is the consumer able to purchase any combination on the budget line but also on the triangle delimited by the line and the x and y axis. The bundles that fall within this area are called affordable set
Given the bundles W and Z, in the straight line there must be one and only bundle which is as attractive as A. let’s call this point B. Similarly, there must be one bundle which gives the exact utility as B, which we call C etc. It shows the combinations of two goods (such as films and meals) that make consumers equally happy. In other words, every point of the curve gives the same level of satisfaction (or utility) The main property is that the slope downwards; why? Because in order to maintain the same level of satisfaction, if you increase the consumption of one good, you have to decrease the consumption of the other On the other hand, an indifference map is a collection of indifference curves yielding different utility levels
Each indifference curve has the same property but the ones to the up-right represent higher levels of utility than left ones; these properties are: According to the property of completeness of consumer preference, each consumer can determine which bundle is its favourite. If they are equally good, they will lie on the same indifference curve. In other words, there is an IC passing through each and every point of the cartesian plan According to the more is better property , having more of either good is better than having less of either good. By this property, the Indifference curve is negative. Why? If there is an increase of one good, to compensate you have to decrease the other. In other words, by this property, the slope is negative and rightward utilities hold more utility. According to the transitivity property , indifference curves never cross each other. If, for instance, these curves met at point D, it would mean that:
- E is as attractive as F
- F is more attractive than E (by the more is better principle) According to the convexity property , indifference curves become less steep moving downward and to the right. Marginal rate of substitution: Now bear with me: the slope of the indifference curve Is defined as the Marginal rate of substitution (MRS). it measures the rate at which a consumer is willing to give up a certain amount of good x to gain a corresponding amount of good y (trade off) the slope of the budget constraint, instead, measures the rate at which we can substitute food for shelter without changing total expenditure in other words:
- The MRS is the marginal benefit of shelter in terms of food
- The slope of budget constraint is the marginal cost of shelter in terms of food
- The indifference map By putting these two together, one can understand which is the best affordable bundle The utility function Consumer preferences can be represented by the utility function. How does It work? The utility function finds the level of utility (numerically quantified) for each possible bundle of goods. Esercizi: Budget line: Price x: 800 Price y: 1000 Income: 10000 Solve for y and find the intercept on y Solve for x and find the intercept on x Or:
- Divide income for x: whole quantity of x I can get when y = 0 (corner solution x)
- Divide income for y: whole quantity of y I can get when x = 0 (corner solution y) Indifference curve and utility function: Remember: each indifference curve has its own level of utility The utility function assigns a determinate utility to each bundle Divide marginal utility x per y: Divide marginal utility y per x: Given a certain utility, you can calculate what is the maximum value at which either y (with x = 0) or x (with y = 0) the consumer can keep the level of utility as the same. So basically, the utility function is necessary to draw the indifference good Diminishing marginal utility: The more you consume of a good, the more utility derived from that good diminishes Utility can increase at low levels of consumption In this case, the law of cost benefit states that we should consume an additional unit of good as long as the marginal utility is greater than the marginal cost In this case, you maximize utility when the marginal utility per dollar spent is the same for all goods Example:
Rational spending rule: Spending should be allocated across goods so that the marginal utility per dollar is the same for each good. (in other words, MU of good x must be equal to MU of good y). This is the formula: this means that on the left, we got our MRS and on the right the relation between corresponding prices (or price ratio) This means that the marginal utility per dollar of good c must be the same as the marginal utility per dollar of good v. If I set the relation as x/y I get how much of good y I gotta give up to get more x If I set the relation as y/x I get how much of good x I gotta give up to get more y So to recap: Rational spending rule:
- Tells you how to allocate your budget between goods to maximize utility
- What does it mean? At the optimal bundle, the rate at which you are willing to substitute (MRS) matches the market trade off between the two goods (the price ratio). Consumer choice and best affordable bundle (optimal consumption bundle) We got a best affordable bundle when the slope of the IC (MRS) and the slope of the budget line (price ratio) meet. However if this doesn’t happen you may be in front of a corner solution Tangency between IC and BL is not necessary Sometimes corner solutions are optimal bundle, which is the maximization of one good We got two options:
MRS greater than price ratio= consumer should be good x MRS>P
Price Ratio greater than MRS= consumer should buy good y (The market requires the consumer to give up more good y to get one unit of good x than they are willing (their MRS is lower). MRS What are the factors that can determine if the demand is elastic or not?
Other option (salt or pink salt)
Budget share: the greater the budget share, the less problem to switch to other substitutes
Time Another way to compute elasticity is given by: This is used when we know the price change and the actual price, as well as the quantity change and the actual quantity. Price elasticity pattern:s As price decreases, elasticity changes;
High P, low Q= demand is elastic
Low P, high Q = demand is inelastic
In the middle demand is unit elastic Elasticity and total expenditure: If price increases, expenditure can:
Increase (with inelastic demand)
Decrease (with elastic demand)
Remain the same (with unit elastic demand) How do I calculate expenditure? By multiplying P x Q and obtaining the rectangle formed by the two values Total expenditure behaves like a rising and falling mountain-shaped curve. Why? According to the law of demand and supply, the more the price drops, the more quantity increases. If Expenditure are given by P x Q, if prices drop quantity increases. However, if the price keep going down, the total expenditure will eventually stop increasing. The price value at which expenditure are maximized is our unit elastic; below demand becomes inelastic. Midpoint:
A property of elasticity is that it changes at any given point of the demand curve; It means that quantity demanded changes at any given point. Let’s suppose that:
- Price falls from 4 to 3
- Quantity demanded goes up from 4 to 6 Calculate the variation in both Quantity and price: Q = 6 – 4: 2 (increase) P = 3 – 4 : - 1 (decrease) Now calculate the average quantity and the average Price: Q = (6 + 4) / 2 = 5 P = (4 + 3) / 2 = 3. This is used to calculate the average of two points (given by P and Q) on the same demand curve. On a straight (linear) demand curve, elasticity changes along the curve:
- At the midpoint: demand is unit elastic (elasticity = 1).
- Above the midpoint (higher price, lower quantity): demand is elastic (elasticity > 1).
- Below the midpoint: demand is inelastic (elasticity < 1). So, in the portion above the midpoint , market demand is elastic with respect to the price. Cross price elasticity of demand: Cross-price elasticity of demand between good X and Y is:
- positive if goods are substitutes (price of X ↑ → demand for Y ↑)
- negative if goods are complements (price of X ↑ → demand for Y ↓) Since complements move in opposite directions, their cross-price elasticity is negative.
- (Positive income elasticity → normal good.
- Negative income elasticity → inferior good.) Quiz: If given a budget equation price duplicates and prices as well the budget constraint doesn’t move
FIRM BEHAVIOUR:
- Decreasing: Double inputs → less than double output.
- Increasing: Double inputs → more than double output. The different combinations between increasing capital and increasing labour are given by the isoquants , curves that hold the same level of output with different combination of the two inputs Exactly as in the indifference curve, we can calculate a marginal rate of technical substitution: the rate at which one can exchange the two inputs without modifying the level of productivity (remember: consumer preferences deals with utility; production and supply deal with productivity) The formula for the MRTS states that the ratio of marginal productivity of labour over capital and the variation of capital over the variation of labour must be same: or Remember: the left part of the equation is our Marginal rate of technical substitution. This represents the slope of the isoquant. The right part of the equation represents the slope of the budget constraint The point at which this equation is respected, we find the optimal input combination/bundle; In this two graphs, one can see the differences between:
- Perfect complementary inputs
- Perfect substitute inputs Optimal input bundle: At this point, marginal rate of technical substitution must be equal to the ratio between Labour and Capital If in market characterized by perfect competition Marginal Cost = Price, then let’s set the following equation: MC = P
Cost and supply
What is the relationship between firm output and firm costs in short run (fixed capital) and long run The production affects firm costs and, as for production n, there are differences for:
- Short run costs (not production)
- Long run costs
Short run cost:
Capital is fixed whereas labour is not In order to increase production in the short run more labour is required as capital Is fixed But how does cost responds to an increase in output? First of all we gotta distinguish among: Total costs:
- Total cost: the cost of all inputs
- total fixed cost (TFC): costs that do not vary in the short run as level of output varies
- Total variable cost (TVC): they change according to output TC = TFC + TVC As shown in the graph, total fixed costs remain the same whereas total variable costs increase as output increases Now we have to analyse two concepts:
- TVC curve
