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Welcome!

Dr Siang Ng (lectures 1 & 2)Office: room 708 Email: Siang.Ng@buseco.monash.edu.au

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Objectives

• Understand the behaviour of consumers and producers, and the determination of price and output in various market environments;

• Demonstrate knowledge of the principles and tools of economic analysis used in specific business decisions;

• Understand the role of government policy in shaping the business environment.

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MICROECONOMICS

Robert Pindyck and Daniel Rubinfeld

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Lecture 1. Introduction to Economics

A. Basic Principles• What are the key themes of microeconomics?• What is a market?• Why study microeconomics?

B. The basics of supply and demand

Readings: chapters 1 & 2

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A. Basic PrinciplesThemes of Microeconomics

• Microeconomics deals with limits– Limited budgets– Limited time– Limited ability to produce

• How do we make the most of limits?

• How do we allocate scarce resources?

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Themes of Microeconomics

• Workers, firms and consumers must make trade-offs– Do I work or go on vacation?– Do I purchase a new car or save my money?– Do we hire more workers or buy new

machinery?

• How are these trade-offs best made?

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• Consumers– Limited incomes– Consumer theory – describes how consumers maximize their well-

being, using their preferences, to make decisions about trade-offs

• Workers– Individuals decide when and if to enter the workforce

• Trade-offs of working now or obtaining more education/training

– What choices do individuals make in terms of jobs or workplaces?– How many hours do individuals choose to work?

• Trade-off of labor and leisure

• Firms– What types of products do firms produce?

• Constraints on production capacity and financial resources create needs for trade-offs

– Theory of the Firm – describes how these trade-offs are best made

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– Trade-offs are often based on prices faced by consumers and producers– Workers make decisions based on prices for labor – wages– Firms make decisions based on wages and prices for inputs and on prices

for the goods they produce

How are prices determined?• Centrally planned economies – governments control prices• Market economies – prices determined by interaction of market

participants

Market: collection of buyers and sellers whose interaction determines the price of good

– Buyers: consumers purchase goods; companies purchase labor and inputs

– Sellers: consumers sell labor, resource owners sell inputs; firms sell goods

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Types of Markets• Perfectly competitive markets

– Because of the large number of buyers and sellers, no individual buyer or seller can influence the price

• Example: Most agricultural markets

– Fierce competition among firms can create a competitive market

• Noncompetitive Markets– Markets where individual producers can influence the

price• Cartels – groups of producers who act collectively• Example: OPEC dominates with world oil market

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Market Definition

• Market Definition – Which buyers and sellers should be included

in a given market?– This depends on the extent of the market –

boundaries, geographical and by range of products, to be included in it

• Market for housing in Guangzhou or Guangdong• Market for all cameras or digital cameras

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Theories and Models• Economics is concerned with explanation of observed

phenomena– Theories are used to explain observed phenomena in terms of a

set of basic rules and assumptions:• The Theory of the Firm • The Theory of Consumer Behavior

• Theories are used to make predictions– Economic models are created from theories– Models are mathematical representations used to make

quantitative predictions• Validating a Theory

– The validity of a theory is determined by the quality of its prediction, given the assumptions

– Theories must be tested and refined– Theories are invariably imperfect – but gives much insight into

observed phenomena

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• Positive Analysis – statements that describe the relationship of cause and effect– Questions that deal with explanation and prediction

• What will be the impact of an import quota on foreign cars?• What will be the impact of an increase in the gasoline excise

tax?

• Normative Analysis – analysis examining questions of what ought to be– Often supplemented by value judgments

• Should the government impose a larger gasoline tax?• Should the government decrease the tariffs on imported

cars?

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Why Study Microeconomics?

• Microeconomic concepts are used by everyone to assist them in making choices as consumers and producers

• Examples show the numerous levels of microeconomic questions necessary in many decisions

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Built Ford Explorer in 1991, Ford Expedition in 1997 and Ford Excursion in 1999. In each of these cases, Ford had to consider many aspects of the economy to ensure their introduction was a sound investment:

• How strong is demand and how quickly will it grow?• Must understand consumer preferences and trade-offs

– What are the costs of manufacturing?• Given all costs of production, how many should be produced each year?

– Ford had to develop pricing strategy and determine competitors’ reactions– Risk analysis

• Uncertainty of future prices: gas, wages– Organizational decisions– Government regulation

• Emissions standards• Clean Air Act imposed emissions standards and have become increasingly

stringent:• What are the impacts on consumers?• What are the impacts on producers?• How should the standards be enforced?• What are the benefits and costs?

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• What are supply and demand?

• What is the market mechanism?

• What are the effects of changes in market equilibrium?

B. The Basics of Supply and Demand

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Supply and Demand

• Supply and demand analysis can:1. Help us understand and predict how real

world economic conditions affect market price and production

2. Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy

3. Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers

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Supply

• In markets where sellers are price-takers, sellers’ intentions are summarised in supply.

• Quantity supplied is the amount of a good that sellers are willing and able to sell.

• A supply function (curve, table) relates quantity supplied to the price of a good at a given place and time period.

• As prices rise, a larger quantity of goods is supplied, ceteris paribus (or everything else equal).

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Example: supply table (schedule)

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• The Supply Curve– The relationship between the quantity of a

good that producers are willing to sell and the price of the good

– Measures quantity on the x-axis and price on the y-axis

(P)QQ SS

Alternative representation: supply curve

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Price($ per slice)

Quantity(1000s of slices

per day)

4

2

3

8 12 16

Supply

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Price($ per slice)

Quantity(1000s of slices

per day)

4

2

3

8 12 16

Supply

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Movement along the supply curve

P = Price of wine ($)

Q = # bottles supplied per day

When the price falls from $25to $23, the quantity supplieddecreases from 160 to 100.

It is a movement along the given supply curve.

It is a decrease in the quantity supplied.

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23

160100

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Shifts in supply

P = Price of wine

Q = # bottles supplied per day

When factors other than price change, the whole supply curve shifts.

In the example, the supply curve shifted to the left (or up, or north-west) – 23

140 250

It is a decrease in supply.

when would this happen?

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What causes shifts in supply?

• Input prices• Technology (by changing the costs of

production) • Expectations about output prices in the

future• Number of sellers

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Demand

• In markets where buyers are price-takers, buyers’ intentions are summarised in demand.

• Quantity demanded is the amount of a good that buyers are willing and able to purchase.

• A demand function (curve, table) relates buyers’ quantity demanded to the price of a good at a given place and time period.

• As price increases, buyers demand less of that good, hence a downward sloping demand curve, ceteris paribus (or everything else equal).

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Example: demand table (schedule)

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• The Demand Curve– The relationship between the quantity of a

good that consumers are willing to buy and the price of the good

– Measures quantity on the x-axis and price on the y-axis

(P)QQ DD

Alternative representation: demand curve

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Price($ per slice)

Quantity(1000s of slices

per day)

Demand

8 12 16

4

2

3

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Price($ per slice)

Quantity(1000s of slices

per day)

Demand

8 12 16

4

2

3

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Movement along the demand curve

P = Price of wine ($)

Q = # bottles demanded per year

25

100

23

140

When price falls from $25 to $23, the quantity demandedincreases from 100 to 140.

It is a movement along the given demand curve.It is an increase in the quantity demanded.

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Shifts in demand

P = Price of wine ($)

Q = # bottles demanded per year

When factors other than price change, the whole demand curve shifts. In the example, the demand curve shifted to the right (or up, or north-east) –

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140 250

It is an increase in demand.

when would this happen?

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What causes shifts in demand?

• Income: normal vs inferior goods • Changes in tastes, preferences• Changes in the price of complements• Changes in the price of substitutes• Expectations about future price• Number of potential buyers

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Demand and supply together: market equilibrium

• Equilibrium is a situation in which supply and demand are in balance.

• When the market is in equilibrium, the price is called an equilibrium price and the quantity, an equilibrium quantity.

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Equilibrium

# bottles of wine

Price ofwine

Supply

Demand

equilibrium

Equil.price= 20

Equil. quantity = 250

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The Market Mechanism

• 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

• In equilibrium– There is no shortage or excess demand– There is no surplus or excess supply– Quantity supplied equals quantity demanded– Anyone who wants to buy at the current price can and

all producers who want to sell at that price can

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The Market Mechanism

• Supply and demand interact to determine the market-clearing price

• When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium

• Markets must be competitive for the mechanism to be efficient

• Competitive markets allocate goods and services where demand and supply are in balance.

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Markets not in equilibrium• Excess Supply (or surplus)• Price is above the equilibrium price. • Sellers are unable to sell all they want to sell at the

going price.• Quantity supplied exceeds quantity demanded.• Sellers respond to excess supply by cutting prices until

the equilibrium is recovered.

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Excess supply

# bottles of wine

Price ofwine

Supply

Demand

20

250

23

247 253

When the price is $23, there is excess supply of 6.

excess supply

As the price falls towards $20, quantity demanded increases and quantity supplied falls.

This continues till excess supply disappears, andthe equilibrium is recovered.

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Markets not in equilibrium

• Excess Demand (or shortage)

• Price is below the equilibrium price.

• Buyers are unable to buy all they want at the going price.

• Quantity demanded exceeds quantity supplied.

• Producers respond to excess demand by charging more until the equilibrium is recovered.

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Excess demand

# bottles of wine

Price ofwine

Supply

Demand

20

250247 253

When the price is $17, there is excess demand of 6.

excess demand

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As the price rises towards $20, quantity demanded falls and quantity supplied increases.

This continues till excess demand disappears, andthe equilibrium is recovered.

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Changes in equilibrium

• Decide whether the event shifts the supply or demand curve (or both).

• Decide whether the curve(s) shift(s) to the left or right.• Determine how the shift affects equilibrium price and

quantity.

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A change in demand

# bottles of wine

Price ofwine

Supply

Demand

P1

Q1

How does a medical report,“A bottle a day keeps the doctor away” change the equilibrium?

New demand

At the new equilibrium,

the price is higherP2

and the quantity is larger.

Q2

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A change in supply

# bottles of wine

Price ofwine

Supply

Demand

P1

Q1

A bad weather led to an increase in the price of grapes. How does it affect the wine market?

At the new equilibrium,

the price is higher

P2

and the quantity is smaller.

Q2

New supply

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Change in demand and supply• When both curves shift, the final effect on price and

quantity depends on the relative shift in demand and supply.

• Increase (decrease) in demand has potential to increase (decrease) price and quantity.

• Increase (decrease) in supply has potential to decrease (increase) price but increase (decrease) quantity.

• Combined effect – Draw demand-supply diagrams.