Microeconomic Principles and Policy

MODULE: C357 M457 | PRODUCT: 4580

Microeconomic Principles and Policy


Module Introduction and Overview

Contents

1 Introduction to the Module 2

2 The Module Author 3

3 Study Resources 3

4 Module Overview 4

5 Learning Outcomes 7


2 University of London

1 Introduction to the Module Welcome to the module Microeconomic Principles and Policy. We hope that you will find the module stimulating and useful.

The module introduces a wider range of microeconomic theories and applica-tions than only those reflecting traditional or ‘neoclassical’ views. Some of these are more contentious than others as they have implications for public policy.

There are two narratives or theoretical approaches running through this mod-ule. The first is the traditional neoclassical approach, which is based on the assumption that all economic actors behave rationally to improve their own self-interest in markets that are competitive. So consumers want to maximise their satisfaction from the goods and services they consume, while firms want to maximise their returns or profits from the goods and services they produce and it is assumed that consumers and producers have all the information needed to make economic decisions rationally. The neoclassical approach is developed on the basis of this simplified analysis of economic behaviour, alt-hough the model can and does get more complex in order to analyse situations where the above assumptions do not hold. Over time this approach has been developed into an elegant model of economic behaviour, expressed in mathematics and also graphically.

The neoclassical narrative has become the basic economic model taught in schools and universities, albeit in some highly complex mathematical forms at post-graduate level. It is a useful model in that it enables us to analyse key economic relationships within the context of the model’s assumptions. How-ever, in the real world, economic agents do not necessarily behave rationally so as to maximise their own self-interest. For instance, consumers’ decisions may be influenced by habits or advertising, while large corporations may be motivated by wanting to acquire market concentration as well as earning prof-its.

So the second narrative running through this module covers alternative ap-proaches that have been developed to analyse economic behaviours. In particular, you will be learning about the behavioural approaches to consumer theory as well as alternative models for analysing producer behaviour and market structures.

However, it is important to note that there are no right or wrong models of eco-nomic behaviour, but rather a spectrum of approaches based on different underlying assumptions of how economic actors behave. In some cases, these models also reflect political ideologies. So, for example, the neoclassical ap-proach and its focus on the primacy of markets as the modality of economic actors’ interaction is often viewed as being aligned with more conservative-based political approaches whereas some of the alternative approaches are often viewed as being more closely aligned with more liberal political stances.


Centre for Financial and Management Studies 3

It is not the purpose of this module to promote one or other of these narratives – rather it is to introduce you to the range of models, analytical tools and ex-amples to help you to form and express your own views.

As you work through the module materials, there are various exercises that are designed to consolidate your knowledge and skills. We recommend that you do the exercises, most of which take half an hour or less, before you look at any model answers that are given in the unit.

At certain points we will ask you to reflect on various aspects of the policy and processes relevant to your own place of work. It will be valuable for you and your fellow students to share these reflections on the VLE (the Virtual Learn-ing Environment). Short notes setting out the issue and the approach will enrich your, and your fellow students’, experience of the module.

Please feel free to raise queries with your tutor and with your fellow students if there are things that are not clear to you. Do this as soon as you find a problem, because waiting will hold you up as you work through the module.

2 The Module Author Alison Johnson is an Associate of Development Finance International, which works with developing country governments to develop the full independent capacity to design and execute their own national resource mobilisation and debt strategies and policies. She also has experience in preparing analytical studies and training materials on aid and debt issues for the United Nations, African Development Bank, Commonwealth Secretariat, Oxfam and other or-ganisations.

Prior to this, she was Acting Director of the Centre for International Education in Economics (precursor of CeFiMS), with responsibility for policy and opera-tions of the postgraduate programmes in economics, finance and development by distance learning, and Lecturer in Economics at SOAS with responsibility for designing and writing distance learning economics modules. She was the convenor and principal author of the modules on economic principles, and she also has extensive experience of writing practically-focused training materials and running workshops.

3 Study Resources There are two key texts for this module:

Goodwin N, JM Harris, JA Nelson, PJ Rajkarnikar, B Roach & M Torras (2019) Microeconomics in Context. 4th Edition. New York and Abingdon UK: Routledge.

This book is designed to provide an introduction to most of the topics you will be studying in this module. However, it is different from the standard microe-conomics textbook in that its focus is wider than just the traditional neoclassical approach. Not only does it take account of alternative theories but



also its presentation is broader based, focusing on consumption and produc-tion decision-making within the context of an economic system. So it is aligned more with the traditional notion of political economy, than the nar-rower more mathematical discipline that economics became in the twentieth century.

This book is non-mathematical, as is this module. While it does use a few equations in some of its technical annexes, much of the exposition is done in terms of diagrams. At the end of the book there is a useful glossary of terms.

Pindyck RS & DL Rubinfeld (2018) Microeconomics. 9th Global Edition. Harlow UK: Pearson Education.

The Pindyck and Rubinfeld text covers all the basic theory and provides you with plenty of examples of its applications. At the end of each chapter of this book, the authors set Questions for Review and Exercises, and I recommend that you jot down at least brief answers to these.

The one drawback to these and many other textbooks is their American orien-tation. So you will find that most of the applications and real world examples quoted in the textbooks are American, with a smattering of a few from else-where. To counterbalance this, the module introduces non-American applications and examples, while noting that many of these are European-fo-cused, with the use of African, Asian and Latin American circumstances where possible.

In addition to the key texts, you will be instructed to study the module read-ings, made up of chapters and extracts of other books, and articles from respected academic economic journals, international organisations and news-papers. Some of the extracts and articles are concerned with economic models and concepts whereas others discuss applications and policy aspects of the theory.

At the end of each unit you will find a list of optional readings, which are there for you to follow up if you are interested in pursuing some of the unit topics in more detail. In addition, you are encouraged to look at the reference section of the articles included as module readings, as these too will provide you with further articles or readings to explore if you are interested. The addi-tional readings are not compulsory, but rather they are there for you to refer to if you have time and motivation.

In several of the exercises in the units you will be invited to submit summaries of your answers to the Virtual Learning Environment (VLE), and you are urged to do this, to start a dialogue with fellow students and to share your ideas and experiences of the topics studied in the module.

4 Module Overview The module is structured in the following way. Unit 1 is an introduction to Microeconomics providing an overview of market economic activity and sup-ply and demand. Unit 2 is concerned with the theory of consumer behaviour



which underpins the concept of consumer demand. As well as discussing the neoclassical model, the newer behavioural approaches to consumer demand are introduced. In addition, the second unit demonstrates how both the neo-classical and behavioural models can be used to analyse consumer saving and borrowing decisions.

Units 3 to 5 are concerned with the neoclassical model of production and costs. While Unit 3 is concerned with the basics of neoclassical cost and pro-duction theory, Units 4 and 5 focus on the firm’s pricing and output decisions in markets where there is perfect competition, monopoly and monopsony power, monopolistic competition and oligopoly. Unit 5 is devoted to the latter as the theoretical models are both more complicated and provide a better re-flection of decision making in the real world. The units discuss examples of the different market types, such as the degree of competition in Russian bank-ing, and price wars and collusion in China’s airline industry.

Unit 6 is concerned with the markets for inputs (or ‘factors of production’), in-cluding the markets for labour, manufactured capital, social capital, natural resources and finance. It looks at the neoclassical models as well as other theo-retical approaches.

Units 7 and 8 are concerned with bigger picture issues, such as alternative models of firms’ behaviour in modern industrial structures, the impact of globalisation on firms’ decision making, the role of government in market economies and economic systems. In doing so, Unit 7 looks at case studies, such as price bundling behaviour in the telecommunications industry and the economic behaviour of two very different companies – the American company Wal-Mart and Swedish company IKEA in their efforts to expand globally. Unit 8 is concerned with the role of government in a market economy and how this reflects the prevailing economic system. The module ends with a discussion of how the theoretical concepts and models of microeconomics can be used in en-vironmental economics.

Some of the units are more theoretical in nature than others, and you may find that some require more time to complete than others. This is especially the case if microeconomics is new to you. If you have previously studied microe-conomics then you will find that much of the traditional theory covered in the module is familiar to you. However, many of the readings will update the theoretical ideas and/or applications and so you are encouraged to do the readings as well as reviewing your knowledge.

Unit 1 provides an introduction to the basic concepts of demand and supply, which will be familiar if you have previously studied a microeconomics module. But if this is your first encounter with economics and microeconomics in particu-lar, you may find you need to spend a bit more time studying the unit. Unit 2 covers both the neoclassical and behavioural approaches to consumer theory and so it is going to take you longer to do all the readings, than, for example, Unit 3, which concerns the neoclassical theory of production and costs. However, this may be to your advantage as you will be probably be working on your first as-signment when you come to study Units 3 and 4.



Similarly, Units 5 and 6 may take you more time to complete than Unit 4 be-cause of the greater complexity in studying theories of oligopolistic markets and theories of factor markets, respectively.

On the other hand, you will probably find Units 7 and 8 less theoretical and more accessible, as they are concerned with present day economic problems such as the pricing behaviours of multinational firms, globalisation of business and the role of government.

Unit 1 Introduction to Microeconomics

1.1 Introduction 1.2 Markets 1.3 Supply and Demand 1.4 Elasticity 1.5 Conclusion

Unit 2 Theories of Consumer Behaviour

2.1 Introduction 2.2 Traditional Approach of Utility Theory 2.3 Limitations of the Consumer Theory 2.4 Behavioural Approach 2.5 Policy Issues 2.6 Conclusion

Unit 3 Theory of Production and Costs

3.1 Introduction 3.2 Types of Resources Used in Production 3.3 Production and Costs 3.4 Production Decisions 3.5 Analysing Costs and Production 3.6 Conclusion

Unit 4 Markets and Competition

4.1 Introduction 4.2 Perfect Competition 4.3 Non-Competitive Market Structures – Monopoly 4.4 Monopsony 4.5 Non-Competitive Market Structures – Monopolistic Competition 4.6 Conclusion

Unit 5 Oligopoly and Other Noncompetitive Markets

5.1 Introduction 5.2 Oligopoly Models of Output Decision-Making 5.3 Oligopoly Models of Price Competition 5.4 Game Theory 5.5 Collusion by Firms 5.6 Prohibiting Collusion 5.7 Case Study – China’s Airline Markets 5.8 Conclusion



Unit 6 Markets for Resources – Labour, Capital and Other Inputs

6.1 Introduction 6.2 Labour Markets 6.3 Manufacture, Natural and Social Capital Markets 6.4 Finance Capital 6.5 Conclusion

Unit 7 Industry Structures, Pricing Behaviour and Globalisation

7.1 Introduction 7.2 Alternative Theories of Firms’ Behaviour 7.3 Big Business 7.4 Pricing Behaviour 7.5 Globalisation 7.6 Conclusion

Unit 8 Microeconomics Applied to Externalities, Public Goods and Environmental Economics

8.1 Introduction 8.2 Externalities and Public Goods 8.3 Direct Public Provision: The Changing Role of State Owned Enterprises 8.4 Environmental Economics 8.5 Conclusion

5 Learning Outcomes When you have completed your study of this module, you will be able to:

• explain the principles underlying consumer demand from different perspectives

• discuss what economists mean by the ‘theory of the firm’ • spell out the implications of competitive and noncompetitive market

structures for the firm’s pricing and output decisions • evaluate how firms respond to the pricing and output decisions of other

firms in the market • debate the importance of the markets for inputs or factors of production,

such as labour, capital and natural resources • analyse how firms expand and the implications for market structure • discuss how globalisation has influenced the firm’s behaviour and the

implications for pricing and output decisions.

Assessment Your performance on each module is assessed through two written assignments and one examination. The assignments are written after Unit 4 and Unit 8 of the module session. Please see the VLE for submission deadlines. The examination is taken at a local examination centre in September/October.

Preparing for assignments and exams

The examinations you will sit are designed to evaluate your knowledge and skills in the subjects you have studied; they are not designed to trick you. If you have studied the module thoroughly, you will pass the exam.

Understanding assessment questions

Examination and assignment questions are set to test your knowledge and skills. Sometimes a question will contain more than one part, each part testing a different aspect of your skills and knowledge. You need to spot the key words to know what is being asked of you. Here we categorise the types of things that are asked for in assignments and exams, and the words used. All the examples are from the Centre for Financial and Management Studies examination papers and assignment questions.

Definitions

Some questions mainly require you to show that you have learned some concepts by setting out their precise meanings. Such questions are likely to be preliminary and will be supplemented by more analytical questions. Generally, ‘Pass marks’ are awarded if the answer only contains definitions. These questions will contain words such as:

describe contrast define write notes on examine outline distinguish between what is meant by compare list.

Reasoning

Other questions are designed to test your reasoning, by asking you to explain cause and effect. Convincing explanations generally carry more marks than basic definitions. These questions will include words such as:

interpret explain what conditions influence what are the consequences of what are the implications of.

Judgement

Others ask you to make a judgement, perhaps of a policy or a course of action. They will include words like:

evaluate critically examine

assess do you agree that to what extent does.

Calculation

Sometimes you are asked to make a calculation using a specified technique; these questions begin:

use indifference curve analysis to using any economic model you know calculate the standard deviation test whether.

It is most likely that questions that ask you to make a calculation will also ask for an application or interpretation of the result.

Advice

Other questions ask you to provide advice in a particular situation. This applies to law questions and to policy papers where advice is asked in relation to a policy problem. Your advice should be based on relevant law, applicable principles, and evidence of what actions are likely to be effective. The questions may begin:

advise provide advice on explain how you would advise.

Critique

In many cases the question will include the word ‘critically’. This means that you are expected to look at the question from at least two points of view, offering a critique of each view and your judgement. You are expected to be critical of what you have read.

The questions may begin:

critically analyse critically consider critically assess critically discuss the argument that.

Examine by argument

Questions that begin with ‘discuss’ are similar; they ask you to examine by argument, to debate and give reasons for and against a variety of options. For example:

discuss the advantages and disadvantages of discuss this statement discuss the view that discuss the arguments and debates concerning.

The grading scheme: assignments

The assignment questions contain fairly detailed guidance about what is required. All assignments are marked using marking guidelines. When you receive your grade, it is accompanied by comments on your paper, including advice about how you might improve, and any clarifications about matters you may not have

understood. These comments are designed to help you master the subject and to improve your skills as you progress through your programme.

Postgraduate assignment marking criteria

The marking scheme for your programme draws upon these minimum core criteria, which are applicable to the assessment of all assignments:

• understanding of the subject • utilisation of proper academic or other style (eg citation of references, or use

of proper legal style for court reports) • relevance of material selected and arguments proposed • planning and organisation • logical coherence • critical evaluation • comprehensiveness of research • evidence of synthesis • innovation/creativity/originality.

The language used must be of a sufficient standard to permit assessment of these aspects.

The guidelines below reflect the standards of work expected at postgraduate level. All assessed work is marked by your tutor or a member of academic staff, and a sample is then moderated by another member of academic staff. Any assignment may be made available to the external examiner(s).

80+ (Distinction). A mark of 80+ will fulfil the following criteria:

• very significant ability to plan, organise and execute independently a research project or coursework assignment

• very significant ability to evaluate literature and theory critically and make informed judgements

• very high levels of creativity, originality and independence of thought • very significant ability to critically evaluate existing methodologies and

suggest new approaches to current research or professional practice • very significant ability to analyse data critically • outstanding levels of accuracy, technical competence, organisation and

expression.

70–79 (Distinction). A mark in the range 70–79 will fulfil the following criteria:

• significant ability to plan, organise and execute independently a research project or coursework assignment

• clear evidence of wide and relevant reading, referencing and an engagement with the conceptual issues

• capacity to develop a sophisticated and intelligent argument • rigorous use and a sophisticated understanding of relevant source

materials, balancing appropriately between factual detail and key theoretical issues. Materials are evaluated directly, and their assumptions and arguments challenged and/or appraised

• correct referencing • significant ability to analyse data critically • original thinking and a willingness to take risks.

60–69 (Merit). A mark in the 60–69 range will fulfil the following criteria:

• ability to plan, organise and execute independently a research project or coursework assignment

• strong evidence of critical insight and thinking • a detailed understanding of the major factual and/or theoretical issues and

direct engagement with the relevant literature on the topic • clear evidence of planning and appropriate choice of sources and

methodology with correct referencing • ability to analyse data critically • capacity to develop a focused and clear argument and articulate clearly and

convincingly a sustained train of logical thought.

50–59 (Pass). A mark in the range 50–59 will fulfil the following criteria:

• ability to plan, organise and execute a research project or coursework assignment

• a reasonable understanding of the major factual and/or theoretical issues involved

• evidence of some knowledge of the literature with correct referencing • ability to analyse data • examples of a clear train of thought or argument • the text is introduced and concludes appropriately.

40–49 (Fail). A Fail will be awarded in cases in which there is:

• limited ability to plan, organise and execute a research project or coursework assignment

• some awareness and understanding of the literature and of factual or theoretical issues, but with little development

• limited ability to analyse data • incomplete referencing • limited ability to present a clear and coherent argument.


• very limited ability to plan, organise and execute a research project or coursework assignment

• failure to develop a coherent argument that relates to the research project or assignment

• no engagement with the relevant literature or demonstrable knowledge of the key issues

• incomplete referencing • clear conceptual or factual errors or misunderstandings • only fragmentary evidence of critical thought or data analysis.


• no demonstrable ability to plan, organise and execute a research project or coursework assignment

• little or no knowledge or understanding related to the research project or assignment

• little or no knowledge of the relevant literature • major errors in referencing • no evidence of critical thought or data analysis • incoherent argument.

The grading scheme: examinations

The written examinations are ‘unseen’ (you will only see the paper in the exam centre) and written by hand over a three-hour period. We advise that you practise writing exams in these conditions as part of your examination preparation, as it is not something you would normally do.

You are not allowed to take in books or notes to the exam room. This means that you need to revise thoroughly in preparation for each exam. This is especially important if you have completed the module in the early part of the year, or in a previous year.

Details of the general definitions of what is expected in order to obtain a particular grade are shown below. These guidelines take account of the fact that examination conditions are less conducive to polished work than the conditions in which you write your assignments. Note that as the criteria for each grade rise, they accumulate the elements of the grade below. Assignments awarded better marks will therefore have become comprehensive in both their depth of core skills and advanced skills.

Postgraduate unseen written examinations marking criteria

80+ (Distinction). A mark of 80+ will fulfil the following criteria:

• very significant ability to evaluate literature and theory critically and make informed judgements

• very high levels of creativity, originality and independence of thought • outstanding levels of accuracy, technical competence, organisation and

expression • outstanding ability of synthesis under exam pressure.

70–79 (Distinction). A mark in the 70–79 range will fulfil the following criteria:

• clear evidence of wide and relevant reading and an engagement with the conceptual issues

• development of a sophisticated and intelligent argument • rigorous use and a sophisticated understanding of relevant source

materials, balancing appropriately between factual detail and key theoretical issues

• direct evaluation of materials, and challenging and/or appraisal of their assumptions and arguments

• original thinking and a willingness to take risks • significant ability of synthesis under exam pressure.

60–69 (Merit). A mark in the 60–69 range will fulfil the following criteria:

• strong evidence of critical insight and critical thinking • a detailed understanding of the major factual and/or theoretical issues and

direct engagement with the relevant literature on the topic • development of a focused and clear argument, with clear and convincing

articulation of a sustained train of logical thought • clear evidence of planning and appropriate choice of sources and

methodology, and ability of synthesis under exam pressure.

50–59 (Pass). A mark in the 50–59 range will fulfil the following criteria:

• a reasonable understanding of the major factual and/or theoretical issues involved

• evidence of planning and selection from appropriate sources • some demonstrable knowledge of the literature • the text shows, in places, examples of a clear train of thought or argument • the text is introduced and concludes appropriately.

40–49 (Fail). A Fail will be awarded in cases in which:

• there is some awareness and understanding of the factual or theoretical issues, but with little development

• misunderstandings are evident • there is some evidence of planning, although irrelevant/unrelated material

or arguments are included.

20–39 (Fail). A Fail will be awarded in cases which:

• fail to answer the question or to develop an argument that relates to the question set

• do not engage with the relevant literature or demonstrate a knowledge of the key issues

• contain clear conceptual or factual errors or misunderstandings.

0–19 (Fail). A Fail will be awarded in cases which:

• show no knowledge or understanding related to the question set • show no evidence of critical thought or analysis • contain short answers and incoherent argument.

[2015–16: Learning & Teaching Quality Committee]

DO NOT REMOVE THE QUESTION PAPER FROM THE EXAMINATION HALL

UNIVERSITY OF LONDON

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

MSc Examination Postgraduate Diploma Examination for External Students

91DFMC357

FINANCE (ECONOMIC POLICY) FINANCE (FINANCIAL SECTOR MANAGEMENT) FINANCE (QUANTATIVE FINANCE)


Specimen Examination

This is a specimen examination paper designed to show you the type of examination you will have at the end of the year for the module Microeconomic Principles and Policy. The number of questions and the structure of the examination will be the same but the wording and the requirements of each question will be different. Best wishes for success in your final examination.

The examination must be completed in THREE hours.

Answer THREE questions, selecting at least ONE question from Section A and ONE from Section B.

The examiners give equal weight to each question; therefore, you are advised to distribute your time approximately equally between three questions.

PLEASE TURN OVER

Answer THREE questions, at least ONE from EACH section.

Section A

Answer at least ONE question from this section.

1. ‘The neoclassical approach provides a relatively simple andelegant model of how consumers make choices, but it does sounder some fairly restrictive assumptions’.

Critically assess this statement.

2. Explain how the behavioural approach to consumer theory canbe used to design public policy.

3. Discuss the main measures used to evaluate the competitivenessof markets.

4. Explain how game theory is used as an analytical tool byeconomists.

Section B

Answer at least ONE question from this section.

5. Discuss alternative theories of firms’ motivations and theirimplications for corporate behaviour.

6. Explain how globalisation has influenced the way thatbusinesses have grown.

7. Discuss why governments might intervene in the economy.

8. Discuss the theoretical approaches available for analysing themarkets for two of the factors of production.

[END OF EXAMINATION]



Contents

Unit Overview 2

1.1 Introduction 3

1.2 Markets 4

1.3 Supply and Demand 6

1.4 Elasticity 8

1.5 Conclusion 10

References 11



Unit Overview This first unit of the module contains a discussion of what economics is about and introduces the basics of market analysis – such as the supply-de-mand framework, equilibrium and price elasticities. Although these are fa-miliar topics in economics courses and textbooks, it is important to have a sound understanding of the basic concepts and tools of economic analysis before going on to learn about the more complex theories and models for an-alysing economic activity. The unit will therefore give you the opportunity to review and consolidate your knowledge of these basics if you have stud-ied microeconomics before or to master them now, if you have not.

Learning outcomes

When you have completed your study of this unit and it readings, you will be able to:

• discuss what the study of economics can encompass, and why there might be alternative approaches to economic analysis

• explain how the supply-demand framework can be used as an analytical tool

• discuss what is meant by market equilibrium, and how it is achieved • explain and apply the concept of elasticity.

Reading for Unit 1

Goodwin N, JM Harris, JA Nelson, PJ Rajkarnikar, B Roach & M Torras (2019) Chapters 1 ‘Economic activity in context’, 2 ‘Markets and society’, 3 ‘Supply and demand’ and 4 ‘Elasticity’. In: Microeconomics in Context. 4th Edition. New York and Abingdon UK: Routledge.

You are also invited to read Chapter 7 ‘Economic behavior and rationality’, and further sections of the chapters above, but those readings, though useful, are optional.

Fattouh B (2010) ‘Oil market dynamics through the lens of the 2002–2009 price cycle’. WPM, 39. Oxford Institute of Energy Studies.

Competition Commission (2011) Local Bus Services Market Investigation. London: UK Competition Commission.



1.1 Introduction Before getting involved in the detailed study of economic theory and mod-els, it is useful to take a few minutes to ask what you are trying to achieve in studying economics. Looking back over the history of economic thought, it is notable how the answer to this question has changed. In the eighteenth century, Adam Smith was writing about the ‘nature and causes of the wealth of nations’, and in doing so was seeking to explain how wealth is created principally through the value of labour invested in goods and services. Up until the late nineteenth century economists continued Smith’s focus in eco-nomic analysis.

Then a new school of economic thought, now referred to as the neoclassical or marginalist approach, sprang up. This approach is based on the notion that all economic actors behave rationally to maximise their self-interest, be it satisfaction of the goods and services consumed or profits generated from the production and sale of goods and services. One of the key as-pects of this approach is its focus on the efficiency of markets and how this is achieved through incremental changes in the use of resources. This approach has also led to the development of a more mathematical ap-proach to economics.

While the neoclassical approach remains important in understanding the modern-day study and application of economics, some economists are say-ing that there are other factors which can be important in explaining eco-nomic behaviour, such as fairness or equity of distribution of resources and wealth, environmental sustainability of natural resources, social or commu-nity relations and cooperation and people’s well-being. As a result of these different emphases on economic behaviour and activity, new approaches to the discipline are being developed and talked about. For instance there are moves in the United Kingdom, following the Bhutanese example, to design measures of national well-being which ‘will cover the quality of life of peo-ple in the UK, environmental and sustainability issues, as well as the eco-nomic performance of the country’ as an alternative to the orthodox use of Gross Domestic Product (GDP) as a measure of national wealth. (For more information about the UK well-being measures, see the ONS website (ONS, nd accessed July 2020). In 2014, it was reported that many smaller Chinese cities had abandoned GDP contribution as a performance metric for officials, in favour of ‘quality of life’ indicators focusing instead on the environment.

As well as considering why we are interested in studying in economics, we also need to look at what it is about. While there is general agreement that economic activity is about consumption, production, distribution and re-source maintenance, how these aspects are covered will vary. Traditional ne-oclassical microeconomic theory focuses mainly on consumption and pro-duction activities, whereas distribution is mainly the focus of trade theory, while resource maintenance has tended to be ignored – although this is changing with renewed interest in environmental economics in the twenty-first century.



Reading 1.1

For an introduction to the question of why we should study economics and what it is about, please read Goodwin et al Chapter 1 Sections 1–4. In addition, you should read Section 5, which outlines the key economic players – namely consumers, business and government – and which contains an overview of the ‘contextual’ approach to microeco-nomics that Goodwin and co-authors have adopted.

As you do this reading, you should ensure by making good notes that you are com-fortable about using the concepts of

efficiency externalities economic activities including production, consumption, distribution and resource

maintenance economic trade-offs, as expressed by the production possibility frontier opportunity costs.

Much of this may be familiar to you and if so you may find you can skim through this chapter quite quickly. If the study of microeconomics is new to you, take a bit more time to read and understand the concepts.

Optional Reading 1.1

Chapter 7 of Goodwin et al is about motivations that underpin economic activity, such as rational choice and self-interest, and how these impact on economic activity. In this chap-ter the authors introduce some of the ideas of the newer behavioural approach to the motivations of economic actors. You are welcome to read this chapter if you are inter-ested and you may find that it helps you to widen your understanding of what the au-thors have in mind as their ‘contextual’ approach to economics. It may perhaps help you to contextualise previous microeconomic studies, if you undertook these some time ago. You will be learning more about the behavioural approach when you study consumer the-ory in Unit 2, so this chapter is an optional reading.

1.2 Markets The conventional view of a market is a place, where people buy and sell fruit, vegetables, clothes, household goods and so on. A shop, shopping mall and eBay are, of course, other examples of markets, as is the stock exchange, or the trade in raw materials, such as copper bars or gold bullion, or a con-tainer loaded with scrap metal. However, the economic definition of a mar-ket, the one that you will use in your study of microeconomics, is the means through which buyers and sellers interact and transactions take place. So it can be physical or virtual space or an institution.

Clearly, for any market to function there must be both buyers and sellers. But usually it is much more than that. There must also be dealers who are ready to ‘make a market’. There must be rules and regulations setting out how the market operates, and there must also be a means of transmitting in-formation so that all the market participants know what is going on. In a simple market, there are usually just buyers and sellers who interact directly

Goodwin et al (2019) Sections 1–5 of Chapter 1 ‘Economic activity in context’ in Microeco-nomics in Context. pp. 20–44.



with each other. But in more complex markets, there are a whole host of roles available for intermediaries, such as brokers, dealers, market-makers, information agents and so on, whose role it is to ensure that the market func-tions by setting prices, providing information and introducing buyers and sellers.

Reading 1.2

Please read Goodwin et al Chapter 2, Sections 1 and 2, which explore the three ‘spheres’ of an economy, the core, public purpose and business spheres, and where the authors discuss the concept of the market and its institutional framework. The authors discuss types of markets in Section 3 and you are encouraged to read this section too.

Make sure your notes clarify any issues that you are unclear about.


Section 4 of Chapter 2 of Goodwin et al (2015) is an optional, but recommended, reading on the advantages and limitations of markets.

Another key element of the market is the role of prices, which provide the signals by which buyers and sellers react to each other. To the buyer, prices provide information about the availability of goods and services in the mar-ket, and decisions about the quantities to purchase are based on this infor-mation. On the other side, sellers use the information conveyed by prices to decide what quantities to sell. So prices play a key role in coordinating mar-ket decisions.

Although prices provide the signals that co-ordinate market decisions, there is no overall co-ordination of how these signals are acted upon by the vari-ous market players. In other words, there is no conscious direction to the functioning of the market. So in an atomistic market of the type described above, each buyer and seller acts alone and not as part of some centralised plan. This characteristic of the market, whereby economic decisions are co-ordinated on a decentralised basis, led eighteenth century economists to talk of a policy of laissez-faire (to ‘leave alone’). These economists used this French expression to condemn any deliberate or governmental interference in business or industry as being inappropriate and potentially harmful. To-day it is usually interpreted to mean that the economy functions best when it is largely free from government intervention and economic decisions are de-termined mainly by ‘the market’.

At the other end of the spectrum is centralised decision-making, where the state or a centralised authority coordinates how the market functions by making decisions about price and quantity. As pure laissez-faire and central-ised decision making rarely exist in the real world, most markets are some-where in between.

Goodwin et al (2019) Sections 1–3 of Chapter 2 ‘Markets and society’ in Microeconomics in Context. pp. 47–69.



1.3 Supply and Demand The theory of supply and demand in a market economy is a way of explain-ing the relationship between the price of a good or service and the quantity sellers make available to the market (or supply) and the quantity buyers purchase (or demand). The supply curve, which is two-dimensional repre-sentation of this relationship, is assumed to be upward sloping because sellers are willing to supply more of a good or service the higher the price. In contrast, the demand curve is downward sloping because buyers pur-chase less the higher the price. This theory assumes that sellers and buyers behave in this manner in response to prices.

However, the quantity of goods and services supplied and demanded is more complex than being simply a function of price. In the case of supply, the quantity supplied is also a function of other factors, such as the cost of inputs, the technology of production and prices of related goods and ser-vices. The quantity demanded is also a function of other factors including people’s tastes and preferences, income and the prices of related goods and services.

Reading 1.3

To learn more about the theory of supply and demand, please read Sections 2 and 3 of Goodwin et al Chapter 3.

As you do this reading, please ensure you can answer the following questions:

How are changes in the quantity supplied and the quantity demanded represented? What do economists mean when they refer to a change in supply and a change in

demand, and how are these represented diagrammatically? What are the non-price determinants of supply and demand, respectively? What is meant by complementary and substitute goods or services?

Having seen how the quantity supplied and demanded respond to changes in price and changes in non-price factors, we can move on to look at how markets work to equilibrate the price and quantities supplied and de-manded. That is to reach a point which economists refer to as ‘market-clear-ing equilibrium’, when the quantity supplied equals the quantity demanded. When the market is not at equilibrium, then there is a shortage when de-mand exceeds supply, or a surplus when supply exceeds demand.

In principle, the interaction of supply and demand to achieve an equilibrium appears simple and straightforward but in practice this is not necessarily the case. For instance, it may take time for firms to increase production and the quantity supplied to the market. Or demand for an item could fall away – just think of rapid falls in demand for clothing items as fashion changes, leaving producers with excess supply.

Alternatively, the market price might not be providing the appropriate sig-nals to buyers and sellers. For example, a higher price is often seen as

Goodwin et al (2019) Sections 2 and 3 of Chapter 3 ‘Supply and demand’ in Microeco-nomics in Context. pp. 81–94.



signalling a better quality product, so a buyer may decide to pay a higher price to obtain a good quality product – for example, a car which works well. This may be the case when buying a new car, but what about in the market for second-hand cars, where the seller has the advantage of knowing whether the car performs well or badly? In that case, the price may not be a reliable signal of the car’s quality. This example is sometimes known as the ‘market for lemons’ where a ‘lemon’ is an American term for a car that is found to be defective after purchase.

Reading 1.4

To learn how markets adjust and to consider an application of supply-demand analysis to the case of the market for coffee, please read Goodwin et al Chapter 3 Sections 4 and 5.

As you do this reading, you will find it useful to make notes on the following:

how markets adjust when there are surpluses or shortages what economists mean by equilibrium and disequilibrium the signalling and rationing function of markets.

In their discussion of the retail coffee market, Goodwin et al. note that using a simple supply-demand framework to analyse a market has its limitations. In particular, the authors make a number of important points about the functioning of supply and demand in the real world, namely:

• demand and supply can sometimes shift in the same direction • markets may start from a disequilibrium position due to an external

factor or event • there may be a number of prices and quantities prevailing in a market • prices and quantities may not move as would be expected.

The market for retail coffee – ‘cups of coffee’ – is the main example exam-ined. But in Box 3.2 the authors also look at the overall supply of coffee as a raw material or commodity: ‘coffee markets in the real world’. The supply and therefore price of coffee can be volatile.

Next we would like you to examine world markets for another commodity, that of crude oil. Like coffee, crude oil prices have been volatile. Some of this continuing volatility may be a response to changing supply and demand fac-tors, which are sometimes referred to by economists as the ‘market funda-mentals’. However, some of the price volatility may be because non-oil mar-ket players, such as speculators and investors, have become more involved in oil market trading. Such players are only interested in oil price move-ments – that is, oil as a financial asset – and have no interest in actual oil supply and demand. There is considerable debate about whether oil price volatility in recent years has more to do with speculation or with changing fundamentals of supply and demand.

Not only can the supply of this commodity be slow to change, as with coffee, but also the market is a particularly significant one, because oil is the basis of

Goodwin et al (2019) Sections 4 and 5 of Chapter 3 ‘Supply and demand’ in Microeco-nomics in Context. pp. 94–110.



inputs into many industrial processes as well as the transportation of many goods. We would therefore like you to read the following Summary Report on oil market dynamics, which is by Bassam Fattouh, because it is a real-life analysis of a particular market and a very significant one. It is also a com-plex market and so, as you read, we would like you to think about how far ‘supply and demand’ analysis can get us in understanding this market – and what are its limitations.

The level of discussion in this selected reading is more difficult than that of your readings from Goodwin et al (2015), reflecting its origins as a real-world piece of market analysis.

Reading 1.5

For an update on oil price markets, please read the ‘Summary Report’ of Bassam Fat-touh’s study of oil market dynamics’ (Summary, pp. 1–7).

As you read this Summary, please note the following points and their implications for the function of supply, demand and the oil market:

the changing oil supply-demand feedbacks during the 2000s the structural changes of oil markets and the different pricing regimes the role of signalling and expectations in the oil market. (Why does the author suggest

that futures markets may ‘assist price formation’ in the physical (spot) market?) Crude oil is such an important market that its ‘price cycle’ 2002–08 is argued to reflect

macroeconomic ‘boom and bust’. Do you think this is unique to the oil market or else likely to be a common factor in microeconomic analysis of specific markets?

If you are interested, please do read the remaining sections of this study, which are an optional reading.

Exercise 1.1

Now that you have read Chapter 3 of Goodwin et al and Fattouh’s ‘Summary Report’, what do you think about using the supply-demand framework to analyse the crude oil market? What are its strengths and limitations? Write a few paragraphs of notes on this.

You might like to start a conversation about this with fellow students online; so, send in your paragraphs and see what others think.

1.4 Elasticity As you have seen, the supply-demand framework enables us to analyse what is happening if there is a change in one of the factors influencing de-mand or supply. But is it possible to give any quantitative answers to such questions as ‘by how much can we expect the demand and supply for a good to change if the price of that good is halved?’

In asking this type of question, we are concerned with a measure of the sensitivity of the quantity demanded or supplied to a change in another variable. This measure of sensitivity is what economists refer to as elastic-ity, which is the measure of the responsiveness to changes in conditions.

Fattouh B (2010) ‘Oil market dynamics through the lens of the 2002–2009 price cycle’.



So economists talk about ‘price elasticity’ of demand or supply, which is a measure of the effect a change in the price has on the quantity de-manded or supplied. This concept is important when it comes to as-sessing how a change in price will affect the revenue generated from the sale of a good or service. Revenue is defined as the price times the quan-tity of a good. If, for example, the price of a good goes up, will people buy significantly less so that revenue declines? Or will the decline in quantity demanded be relatively small such that revenues do not de-cline? The answer to these questions depends on the price elasticity of demand. For instance, the price elasticity of an essential good, such as diesel oil, is relatively low as consumers and businesses will continue to need to purchase it even if there is a large price increase. On the other hand, the goods for which there are readily available substitutes are usu-ally more price-elastic.

Economists also talk about ‘income elasticity of demand’, which measures the effects of changing income on the quantity demanded. So do consumers purchase more or less as their income rises and falls?

If you did continue to read Fattouh (2010) beyond the Summary, you may have noticed that he does refer to the concepts both of price elasticity and of income elasticity (p.16):

In economists’ jargon, the global oil market is characterised by low short-term elasticity of demand and supply with respect to oil’s price (own price elasticity of demand). In contrast the income elasticity of oil demand is relatively high, especially in countries witnessing persistent high growth rates and improvements in income where each increase in GDP is associated with a more than proportional increase in demand for oil.

These are both important concepts deployed when economists examine mar-kets in detail and you will next explore (or revise) their meaning systemati-cally by looking at the way they are introduced in Goodwin et al. (2014).

Reading 1.6

Chapter 4 of Goodwin et al discusses the different ways in which economists use the con-cept of elasticity. Most of the discussion is illustrated using simple calculations which you can work through. When discussing income elasticity, Goodwin et al talk about the ‘in-come and substitution effects’ of a price change, which you should make sure you under-stand. You should read all of Chapter 4.

As you do this reading, write notes on the following questions:

If a good is price-inelastic, why will revenues change in the same direction as any price change?

Why might demand for a good or service be price-elastic? Do perfectly elastic and inelastic demand and supply exist? What do economists mean by the terms ‘normal’ and ‘inferior’ goods? What do economists mean by ‘the income and substitution effects of a price

change’, and why are these effects useful to understand? Can the price elasticity of a good or service change over time?

Goodwin et al (2019) Chapter 4 ‘Elasticity’ in Microeconomics in Con-text. pp. 115–42.



This Chapter 4 reading from Goodwin and her colleagues provides a good intro-duction to the concept of elasticity and its implications for assessing how demand responds to changes in prices and income. So the next step is to look further at how economists use the concepts of price and income elasticity to analyse con-sumer demand. A good example of this is found in the next reading, which is an analysis of the demand for local bus services in the United Kingdom. This analy-sis illustrates some of the complexities of investigating the demand for a particu-lar good or service, such as how price elasticity for a service can be different for different consumer groups, and the importance of other factors – such as the availability of alternative services, location and income.

Reading 1.7

Please read the Competition Commission (2011) article on investigating local bus ser-vices, which summarises how the demand for bus services is affected by the level of bus fares and other factors.

Exercise 1.2

When you have finished this reading, spend a few minutes noting down how you would answer the following question:

What are the implications of this demand analysis for a bus operating company?

If you have time, post a message for discussion with your tutor group online, com-menting on whether the analysis offered in the Reading has given you any insights into how the bus services in your local area are run.

1.5 Conclusion In this first unit, you have been looking at the questions of what economics is about and how the simple supply-demand model can be used to analyse markets. If you have studied economics before, much of this will be familiar to you and this unit will have primarily been a review of what you have studied in the past, although the readings will have introduced some com-plexities you may not have encountered in previous modules.

If the study of economics is new to you, then this unit will have introduced you to some of the key concepts you will be using in this module, as well as the basic supply-demand model generally.

In the next unit, you will be learning about the theories of consumer choice which underpin the demand function. As Unit 2 covers both the traditional neoclassical model and the newer behavioural approach to consumer behav-iour, it is both longer and more complex than this first unit.

Competition Commission (2011) Local Bus Ser-vices Market Investiga-tion.




Adams C and O Ajakaiye (2011) ‘Causes, consequences and policy implications of global food price shocks: Introduction and overview’. Journal of African Economics, 20, i3–i11.

This article provides an example of how elasticity is analytically in Section 3.

Porteous D (2006) Competition and Microcredit Interest Rates, Focus Note 33. Consultative Group to Assist the Poor (CGAP), February.

This article shows how the demand–supply model and elasticity can be used in assessing financial products.

References Competition Commission (2011) Local Bus Services Market Investigation. London: UK Competition Commission. Available from: https://www.gov.uk/cma-cases/local-bus-services-market-investigation-cc

Fattouh B (2010) ‘Oil market dynamics through the lens of the 2002–2009 price cycle’. WPM 39. Oxford Institute of Energy Studies, January: https://www.oxfordenergy.org/publications/oil-market-dynamics-through-the-lens-of-the-2002-2009-price-cycle-2/

Goodwin N, JM Harris, JA Nelson, PJ Rajkarnikar, B Roach & M Torras (2019) Microeconomics in Context. 4th Edition. New York and Abingdon UK: Routledge.

ONS (nd) Measuring National Well-being. [Online]. Available from: http://www.ons.gov.uk/ons/guide-method/user-guidance/well-being/index.html [Accessed 9 July 2020]

http://www.ons.gov.uk/ons/guide-method/user-guidance/well-being/index.html

http://www.ons.gov.uk/ons/guide-method/user-guidance/well-being/index.html

Microeconomic Principles and Policy

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Transcript of Microeconomic Principles and Policy