Intermediate Microeconomics

Professor Yongmin Chen

Topic 1. Introduction to Microeconomic Analysis

What is microeconomics?

Microeconomics studies the behavior of individual economic agents and their interactions. By economic agents we usually mean consumers and firms. To study the behavior of consumers and firms is to study how consumers make consumption choices and how firms make production decisions. It is the standard approach of microeconomics, although not without controversy, to assume that consumers seek to maximize satisfaction and firms seek to maximize profits. The mechanism through which consumers and firms interact with each other is the market. Microeconomics analyzes the determination of market demand and supply, various forms of market structures, and how they affect economic efficiency.

To give you an idea the type of questions that microeconomics deals with, let me start with a simple example. Consider some of the important decisions a firm, say Dell Computer, needs to make.

First, Dell needs to decide what kind of computers to produce: the processor, hard disk capacity, RAM, modem, CD-ROM, installed software, monitor, etc.

Second, Dell needs to decide how to produce the computers: in one location or in different locations; equipment and technologies to use; make or purchase choices, etc.

What may determine Dell’s production decision? Consumer demand; technological feasibility; costs of production; products of other computer producers, and so on.

Third, Dell needs to decide how to price its computers. This again will depend on things such as consumer demand and production costs, as well as on the prices of competitors.

Now, these decisions are not unique to Dell. Other computer producers will face the similar types of decision problems. In fact, almost all business firms need to make decisions regarding what to produce, how to produce and how to price their products. How they make these decisions is studied in microeconomics. Since these decisions are likely to depend on consumer demand, cost conditions, market structures, and the strategies of other firms, microeconomics will study demand, supply, market structures, and the strategic interactions between firms.

From our discussion so far, it should be clear that microeconomics is very important for anyone who needs to make business decisions. This can be one practical reason why we study microeconomics--we want to be well prepared if we will be in a position of making business decisions in the future. But that is not the only reason why microeconomics is an important subject. We are all consumers. Knowing how the market works is also important for a consumer. When you shop for a car, for example, it would be useful for you to know the market structure and the pricing strategies of the dealers.

More generally, microeconomics is useful for any educated member of a society. Any society has to decide how to allocate its scarce resources. Like a firm, a society needs to decide what to produce and how to produce. It also needs to answer the question of for whom to produce. Microeconomics helps us understand how these questions are answered by the markets, and how economic efficiency can be achieved, sometimes with the intervention of the government. Some issues of interests: Should two firms be allowed to merge? How to allocate spectrum rights? The debate in Boulder about how to reduce traffic congestion?

The Methodology of Microeconomics

Building and using models is the basic methodology in microeconomics. A model typically consists of a set of assumptions from which conclusions or predictions are deduced. To be useful, a model must generally simplify and abstract from the real situation. For example, to understand how consumers make consumption decisions, we may assume that a consumer only chooses from two products: food and clothing. The design of a model usually depends on the purpose of the study. To analyze how firms compete in a market, we may treat each firm as a single profit-maximizing agent. To study the internal organization of a firm, on the other hand, we may need to treat the firm as a collection of individuals, including owners(shareholders), managers, and workers, with possibly different interests.

Although I want to convince you that microeconomics is an important subject to study, I also want to let you know its limitations so that you will have realistic expectations from this course. The solution to a practical problem often relies on the knowledge of many disciplines, and microeconomics alone does not provide immediate answers to many problems. The emphasis in the course is for you to learn the right way to think about microeconomic problems.

The Organization of the Course.

The organization of the course is explained in the course syllabus.

Market Demand: Basics

1. Demand

To understand market demand is essential for microeconomic analysis. The quantity demanded on a market depends on many factors, such as the good's price, the price of other goods, consumer income, consumer's tastes, and the length of time period. The demand curve is the graph of quantity demanded as a function of price, Q = D(p). It describes the relationship between price and quantities demanded. It is the convention to draw price on the vertical axis, and quantities on the horizontal axis.

Example: Demand curve for corn.

Example: A linear demand curve: Q = 10 - p.

The demand curve is downward-sloping generally for two reasons:

(1) As the good's price rises, People will look for substitutes.

Substitute Effect: When a good's price increases, the quantity demanded for this good decreases because people use more substitutes.

(2) As the good's price increases, each dollar spent will buy few units than before. In other words, consumers' purchasing power decreases, and they will normally buy less of the good.

Income Effect: Quantity demanded for a good normally decreases when the good's price increases because consumers' purchasing power falls.

Caution: don't confuse quantity demanded with demand itself. By demand we mean the quantities demanded at each price, which is represented by the demand curve.

Example. True or false: If the price for corn increases, the demand for corn will decrease.

2. Demand Change

The demand for a good changes if determinants of demand other than the good's own price change, resulting in a shift in the demand curve.

Example. The following events are most likely to cause the demand curve for going to movies to (a) shift left; (b) shift right; or (c) remain unchanged:

i) an increase in consumers' income;

ii) a decrease in the cable subscription fee;

iii) an improvement in the quality of T.V. programs;

iv) the cost of producing a movie has gone up dramatically.

v) The movie ticket price has gone up.

3. Price Elasticity of Demand

When a good's price changes, the quantity demanded for that good will also change. To find out how sensitively the quantity demanded responds to price changes, we use a measure called the price elasticity of demand (η), which is the percentage change in quantity demanded resulting from one percent change in price. That is:

η = (dQ/Q)/(dP//p) = (dQ/dp)/(Q/P) = (dQ/dp)(p/Q)

Notice that the price elasticity of demand is a ratio of relative changes. The price elasticity of demand generally differs at different points of a demand curve. If somehow we can know the exact amount of dQ/dp and p/Q at a point of a demand curve, then we can obtain the accurate η at this point. This is possible if we know the functional form of the demand curve, (for example, it is a linear function), and we know how to take derivatives.

Example. The price elasticity of demand for a linear demand curve.

Very often, however, we can use one of the following two approximations:

(1) Point elasticity. If we know two points on a demand curve that are very close to each other (this is, of course, not an accurate statement), then we can calculate the price elasticity at these points, using ΔQ/Δp in stead of dQ/dp and the price and quantity of either point. The price elasticity so obtained is called point elasticity

Example. Suppose Q=100, p=10 and Q=102, p=9.9 are two points on a demand curve. What is the point elasticity of demand at p = 10?

(2) Arc elasticity. If we know two points on a demand curve that are not close to each other, we can still estimate the price elasticity between these two points by using the arc elasticity, using the average price and quantity.

Example. Suppose Q=100, p=10 and Q=120, p=8 are two points on a demand curve. What is the arc price elasticity of demand between these points?

(3) The demand for a commodity is said to be price elastic if η < - 1, price inelastic if -1 < η < 0, and unitary elastic if η = -1.

Example. A perfectly elastic demand.

Example. A perfectly inelastic demand

What determines the price elasticity of demand for a good. To answer this, we need to look at:

(1) the number and closeness of substitutes that are available;

(2) the importance of the commodity in consumer's budget;

(3) the length of time to which the demand curve is related.

Example. How will the price elasticity of demand change if the demand curve shifts to the left?

Example. Estimated price elasticities of demand for selected goods.

The Income Elasticity of Demand

The income elasticity of demand is the percentage change in quantity consumed caused by one percentage change in income.

Example. Estimated income elasticity for selected goods.

Cross Elasticities of Demand

The consumer's purchasing decision of a good may also depend on the prices of other goods. Suppose X and Y are two goods. The cross elasticity of demand is usually defined as the percentage change in the quantity demanded of X caused by one percent change in the price of Y.

We divide goods into two types, substitutes and complements. Two goods are substitutes if the cross elasticity of demand for them is positive. Two goods are complements if the cross elasticity of demand for them is negative.

Example. Estimated cross elasticities of demand for selected goods.

Market Supply: Basics

Market Supply: The aggregation of all firm's supplies at every price.

Supply Curve: The graph of quantity supplied as a function of price, Q = S(p). Conventionally, quantity supplied is measured along the horizontal axis and price is measured along the vertical axis.

Example. The supply curve for corn.

Example. A linear supply curve: Q = -1 + P

The supply curve is upward-sloping because higher price offers producers greater production incentives. The position and shape of the supply of a good depends on factors such as technologies, input prices, length of time period, etc. The supply for a good changes when the determinants of supply other than the good's own price change, resulting in a shift in the supply curve.

Caution: Don't confuse movements along a supply curve with supply change.

Market Equilibrium and Changes in Equilibrium

A market is in equilibrium if quantity demanded is equal to quantity supplied at some price. The price at which equilibrium occurs is called equilibrium price.

Example.

Demand: Q = D(p) = 80 - 4p

Supply: Q = S(p) = -10 + 6p

Equilibrium price: p_e = 9. Equilibrium output level: Q_e = 44.

When demand or supply or both of them change, market equilibrium changes.

Example. The effects of rent control.

Example. The price in the personal computer market.