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B.A. Economics (Hons.) (University of Delhi)

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ISTANBUL BILGI UNIVERSITY

Lecture Notes for EC151

Introduction to Microeconomics
Delivered by

Asaf Savaş Akat

based on
N.G.Mankiw: Principles of Economics (3th ed)

Istanbul, 2007
http://akat.bilgi.edu.tr
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Asaf Savaú Akat Lecture Notes EC 151 (2007) 1 Asaf Savaú Akat Lecture Notes EC 151 (2007) 2 Asaf Savaú Akat Lecture Notes EC 151 (2007) 3

The word Economy . . . Scarcity . . .

• Comes from a Greek word for “one who • Scarcity is a key word to understand economics
manages a household.” • It means that society has less to offer than people
• Here are some questions that need answers wish to have
TEN PRINCIPLES OF – Who will work? • Managing the resources of society is important
ECONOMICS – What goods and how many of them should because resources are scarce
be produced? • Economics is the study of how society manages
Chapter 1 – What resources should be used in their its scarce resources
production? – How people make decisions
– At what price should the goods be sold? – How people interact with each other
– Who should get the goods produced? – The forces and trends that affect the economy
• We shall see the answers during this year as a whole

Asaf Savaú Akat Lecture Notes EC 151 (2007) 4 Asaf Savaú Akat Lecture Notes EC 151 (2007) 5 Asaf Savaú Akat Lecture Notes EC 151 (2007) 6

Ten Principles of Economics Ten Principles of Economics (continued) Ten Principles of Economics (continued)
• The third group of principles look at the
• The first group of principles look at the • The second group of principles look at the behaviour of the whole society
individuals in the society interaction of individuals in the society • What happens at the whole economy has an
• Our aim is to understand how people make • Our aim is to show the effects of the way effect on individuals and their interaction
decisions of economic nature people interact with one another • How the Economy as a Whole Works
• We divide this group into four principles 5. Trade can make everyone better off 8. The standard of living depends on a
1. People face tradeoffs 6. Markets are usually a good way to country’s production
2. The cost of something is what you give organize economic activity 9. Prices rise when the government prints
up to get it 7. Governments can sometimes improve too much money
3. Rational people think at the margin economic outcomes 10. Society faces a short-run tradeoff
4. People respond to incentives between inflation and unemployment

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1. People face tradeoffs 2. The cost of something is what you 3. Rational people think at the margin
• To get one thing, we usually have to give up give up to get it
another thing • Marginal thinking plays a crucial role in
– Guns vs. butter • Decisions require comparing costs and benefits economic actions
– Food vs. clothing of alternatives • By “marginal” we mean small changes to an
– Leisure time vs. work – College vs. work existing plan of action
– Efficiency vs. equity – Sleeping vs. studying • The word “incremental” ise also used
• Efficiency means society gets the most it can – Cinema vs. football game • Individuals make decisions by comparing the
from its scarce resources • Opportunity cost is what you give up to obtain costs and benefits at the margin
• Equity means the benefits of those resources some item • The last item therefore becomes very important
are distributed fairly among the members of • The final real cost of everthing is its oportunity • An airline may sell the last ticket below
society cost average cost but still make money

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4. People respond to incentives. 5. Trade can make everyone better off 6. Markets are usually a good way to
organize economic activity
• Marginal changes in costs or benefits motivate • People gain from their ability to trade with one • Specialisation requires the exchange of products of
people to respond another specialised producers
• The decision to choose one alternative over • One way of doing it is caled the market economy
another occurs when MB > MC • If there is competition in trading, then every
party gains from trade • In a market economy
MB = Marginal Benefits – Households decide what to buy and who to work
MC = Marginal Costs • Trade allows people to specialize in what they
do best for
• When they realise that the incentives have – Firms decide who to hire and what to produce
changed, economic actors take different • Specialisation is the key to modern society
• Households and firms interact is as if guided by an
decisions • It makes possible higher levels of productivety
“invisible hand”
• Safetly belts for drivers reduce injury per leading to the high levels of income that
modern societies enjoy • More can be found in the FYI (p.10): “Adam Smith
accident but also increase the accident rate and the Invisible Hand”

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7. Governments can sometimes 8. The standard of living depends on a 9. Prices rise when the government
improve market outcomes country’s production prints too much money
• If markets fail (break down), government can • Standard of living may be measured in different • Inflation is an increase in the overall level of
intervene to promote efficiency and equity ways: prices in the economy
• Market failure occurs when the market can not – By comparing personal incomes • Some countries in some periods have high levels
allocate resources efficiently – By comparing the total market value of a of inflation
• Market failure may be caused by an externality, nation’s production • Turkey had one of the highest inflation rates
which is the impact of one person or firm’s • Almost all variations in living standards are among comparable countries in the world
actions on the well-being of a bystander explained by differences in the productivity level • Usually the growth in the quantity of money is the
• Market failure may also be caused by market of different countries major cause of inflation
power, which is the ability of a single person or • Productivity is the amount of goods and services • In other words inflation happens because
firm to unduly influence market prices produced from each hour of a worker’s time government prints too much money

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10. Society faces a short-run tradeoff Conclusion

between inflation and unemployment • When individuals make decisions, they face
tradeoffs and opportunity costs
• For many economies there exists a strong • Rational people make decisions by comparing
relation between the change in the level of marginal costs and marginal benefits THINKING LIKE AN
unemployment and change in inflation • People can benefit by trading with each other
• The Phillips Curve summarises the relation • Markets are usually a good way of coordinating ECONOMIST
ØInflation Ö ×Unemployment trade
Chapter 2
• It’s a short-run tradeoff that applies to normal • Government can potentially improve market
situations outcomes
• Higher inflation becomes the opportunity cost of • Inflation results from increases in the quantity of
lower unemployment money
• At other times the relationship may break down • Study carefully FYI (p.14): “How to Read This
Book”
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Learning economics The Scientific Method The Circular-Flow Model

• Economists have a special way of thinking
• Learning economics will allow you to • Science develops by using abstract models to • The circular-flow model is a simple way to
understand it help explain how a complex, real world operates show visually the economic transactions that
• You will begin • Theories are proposed, data is collected and occur in the economy
analysed to prove or disprove the theories • It is simple because we assume that there is no
– To think in terms of alternatives
• Theories always include abstract models government, no financial system, no outside
– To understand the cost of individual and
• Models permit to analyse a complex real world world (foreign trade), etc.
social choices
event in a simple manner • And concentrate on two categories of major
– To see how certain events and issues are
• Science uses two approaches: economic actors in the economy
related with one another
• Descriptive (reporting facts, etc.) – Households as consumers and owners of
• The economic way of thinking involves thinking
• Analytical (abstract reasoning) factors of production
analytically and objectively like the scientific
method – Firms as producers

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The Circular-Flow Diagram Microeconomics and The Production Possibilities Frontier

Macroeconomics • The production possibilities frontier is another
Market for Goods and
Services • An important distinction exist between micro example using a simple model to understand
Goods and Goods and (from Greek word small) and macro (from complex reality
Revenue Spending
services sold services bought
Greek word big) economics • It is presented by a graph showing various
• Microeconomics focuses on the individual parts combinations of output of two products that the
of the economy economy can possibly produce given the
Firms Households
• It corresponds to the first two groups among the available factors of production and technology
Ten Principles • It illustrates
• Macroeconomics looks at the economy as a – Efficiency
Wage, rent,
and profit
Inputs for
production
Labor, land
and capital
Income whole – Tradeoffs
Market for Factors of
• It corresponds to the last group among the Ten – Opportunity Cost
Production Principles – Economic Growth

Asaf Savaú Akat Lecture Notes EC 151 (2007) 25 Asaf Savaú Akat Lecture Notes EC 151 (2007) 26 Asaf Savaú Akat Lecture Notes EC 151 (2007) 27

Production Possibilities Frontier Production Possibilities Frontier Two Roles for Economists
Quantity of
•When productivity increases
Computers
Produced
Quantity of
Computers
in computer industry, it is
• Social reality imposes additional constraints on
Produced

3,000 D 4,000 possible to produce more

the economics as a discipline
cars and more computers • Economics as a science requires economists to
2,200
C 3,000
understand and explain the world
2,000
A • As such they are scientists
2,100
2,000
E • But governments also ask economists to apply
A
their knowledge to change the world
Production
1,000 B possibilities • As such they become policymakers
frontier
• Policymaking always involves politics
• The responsibilities of the economist as scientist
0 700 750 1,000 Quantity of
0 300 600 700 1,000 Quantity of Cars Produced and policymaker may easily be in conflict
Cars Produced

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Asaf Savaú Akat Lecture Notes EC 151 (2007) 28 Asaf Savaú Akat Lecture Notes EC 151 (2007) 29 Asaf Savaú Akat Lecture Notes EC 151 (2007) 30

Positive versus Normative Analysis Positive and Normative Why Economists Disagree
• The potential conflict between science and
Statements
• Economists are well known to disagree among
policy leads to an important distinction in • Here are some exemples of positive and themselves
economics normative statements by economists • There are many jokes about economists
• Positive statements are statements that describe • An increase in the minimum wage will cause a • They may disagree on theories about how the
the world as it is decrease in employment among the least- world works due to analytical premises
• Positive economics is also called descriptive skilled • At the same time usually they may hold different
analysis • Higher budget deficits will cause interest rates values and thus, different normative views
• Normative statements are statements about how to increase • Unfortunately many charlatans and cranks also
the world should be • The income gains from a higher minimum wage pose as economists and often obscure the
• Normative economics is also called prescriptive are worth more than any slight reductions in consensus among economists
analysis employment

Asaf Savaú Akat Lecture Notes EC 151 (2007) 31 Asaf Savaú Akat Lecture Notes EC 151 (2007) 32 Asaf Savaú Akat Lecture Notes EC 151 (2007) 33

Examples of What Most Economists Conclusion

Agree On
• Economics uses the scientific method
• A ceiling on rents reduces the quantity and
quality of housing available • Abstract models simplify otherwise very GRAPHING: A BRIEF
• Tariffs and import quotas usually reduce general complex real world REVIEW
economic welfare • Economics is divided into microeconomics
• Flexible and floating exchange rates offer an and macroeconomics Appendix to Chapter 2
effective international monetary framework • Economics relies on both positive and
• Printing too much money always causes normative analysis
inflation
• Economists often disagree among themselves

Asaf Savaú Akat Lecture Notes EC 151 (2007) 34 Asaf Savaú Akat Lecture Notes EC 151 (2007) 35 Asaf Savaú Akat Lecture Notes EC 151 (2007) 36

Individuals (23%)

Use of graphs Single variable graphs Private Insurers (32%)

• Economists make extensive use of graphs • There are three common single variable graphs (a) Pie Chart Other (4%)

• Graphs are used in economic theories to express • Pie charts permit to show the distribution of a 1996 Value Government (41%)

ideas that are more difficult to understand only in magnitude among its constituent items billions
(in of dollars)

General
words • Example: distribution of income among wages, $140 Electric
($126 billion)
120 Exxon
• Graphs also provide a convenient way of salaries, profits and rents (b) Bar Graph
100
($99 billion)
($68 billion)
IBM
representing data about the real world • Bar graphs help compare the same category from 80
60
General
Motors
($39 billion)
• Graphs permit to show for different units 40
20

– The breakdown into its constituents parts of a • Example: income per head in four different 0
output per hour of labor,

single variable countries Productivity Index (farm

1977 = 100)
160
– The relation between two or more variables • Time-series graphs trace the bevahiour of a variable (c) Time-Series Graph
140
120
• The latter are used more commonly in economic over a time period 100
80

theory • Example: rising productivity in the private sector 60

40
20
0
1950 1960 1970 1980 1990
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Asaf Savaú Akat Lecture Notes EC 151 (2007) 37 Asaf Savaú Akat Lecture Notes EC 151 (2007) 38 Asaf Savaú Akat Lecture Notes EC 151 (2007) 39
Price of
Novels

Two variable graphs Grade $11

(5, $10)
• Single variable graphs have only limited use Point
Average
10

• Often we try to establish a relation between two 4.0 9

(9, $9)

factors 3.5
Albert E.
8
(13, $8)

• An ordered pair makes it possible to show two 3.0 (25, 3.5) 7

(17, $7)

characteristic on the same graph 2.5

Alfred E.
6
(21, $6)

• Two dimensions require coordinates for graphs 2.0

(5, 2.0) 5 (25, $5)
1.5
• Vertical coordinate usually represents the nominal 4
Demand, D
1
1.0
variable; horizontal coordinate the quantity variable 3
0.5
• Curves are relations between two variables 2

• Their slope and what makes them shift is very 0 5 10 15 20 25 30 35 40 Study

Time
1

important in economic analysis (hours per week)

0 5 10 15 20 25 30 Quantity
of Novels
Figure 2A-3 Purchased

Asaf Savaú Akat Lecture Notes EC 151 (2007) 40 Asaf Savaú Akat Lecture Notes EC 151 (2007) 41 Asaf Savaú Akat Lecture Notes EC 151 (2007) 42
Price of
Novels Price of
$11 Novels

$11
10
(13, $8) 10
9

8
(16, $8)
When income increases,
9 INTERDEPENDENCE AND
(10, $8) (13, $8)

7
the demand curve
shifts to the right.
8

7
6 - 8 = - 2
THE GAINS FROM TRADE
6
(21, $6)
6
When income 21 - 13 -= 8
D
5 3
decreases, the
(income = D D (income = 5
1 2 Demand, D
demand curve 1
4 $20,000) (income = $40,000)
shifts to the left. 4
$30,000)
3
3

2
Chapter 3
2

1
1

0 5 10 13 15 16 20 25 30 Quantity 0 5 10 13 15 20 21 25 30 Quantity
of Novels of Novels
Purchased Purchased
Figure 2A-4 Figure 2A-5

Asaf Savaú Akat Lecture Notes EC 151 (2007) 43 Asaf Savaú Akat Lecture Notes EC 151 (2007) 44 Asaf Savaú Akat Lecture Notes EC 151 (2007) 45

What did we learn so far? What we learn in this chapter? Self sufficiency or interdependence
• In the two previous chapters we introduced some • In this chapter we look in detail into trade • Economics studies how societies produce and
basic concepts of economics • Remember Principle Five: trade can make distribute goods and services in an attempt to satisfy
• Ten basic principles of economics were organised in everybody better off the wants and needs of its members
three groups: decisions by individual, the interaction • Common sense tells us that specialisation for • One alternative would be for individuals and nations
of individuals and the economy as a whole individuals means more knowhow and therefore to produce everything they need themselves
• Then we looked into the methods used by economics more production • This is called self-sufficiency
as a science • However, specialised individuals must exchange • The other alternative is for individuals and nations
• Two models were developed as examples of macro their products to specialise and trade with one another
and micro analysis • Trading is selling something to buy something else • This leads to economic interdependence
– The circular flow of income and expenditure • We try to establish how and why specialisation and • The question before us is simple
– The production possibilities frontier trade is beneficial to individuals and nations • Which is better and why? To be self-sufficient or
• Now we will look at the meaning of trade economic interdependence?
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Interdependence and trade What determines the pattern of A parable for the modern
• We start with a general observation about the production and trade? economy
society we live in • We use a very simple model that is easy to handle
• Patterns of production and trade are based upon
• Individuals and nations rely on specialized • The model does not reflect reality but helps us
differences in opportunity costs
production and exchange as a way to address understand the issues
problems caused by scarcity • This is true within an economy among different
regions • Let us imagine a world with
• This gives rise to two questions – only two goods (potatoes and meat)
• Also among different communities and individuals
– Why is interdependence the norm? – only two people (a potato farmer and a cattle
• It is also true among nations and regions
– What determines production and trade when rancher)
individuals and nations are economically • Almost all the products we consume have been
produced by the efforts of different individuals, • What should each produce?
interdependent? • Why should they trade?
usually in many different countries of the world
• Interdependence occurs because people are better • The table in the next slide gives the production of
off when they specialize and trade with others • Most individuals do not consume at all what they
themselves produce each good by the farmer and the rancher

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Production of farmer and rancher Self-sufficiency Self-sufficiency - farmer

• What happens if the farmer and the rancher decide
Hours needed to make one pound of Amount Produced in 40 hours to ignore each other (a) The Farmer’s Production Possibilites Frontier
• There is no exchange or trade among them Meat
• Therefore each can only consume their own (pounds)
Meat Patatoes Meat Patatoes production
• In other words, for each one, the production
possibilities frontier is also the consumption
FARMER 20 hours/lb 10 hours/lb 2 lbs 4 lbs possibilities frontier 2
• Without trade, there are no economic gains
• There is no economy to talk about A
1
• But each will be loosing the prospect of using their
RANCHER 1 hour/lb 8 hours/lb 40 lbs 5 lbs respective potential fully
0 2 4 Potatoes (pounds)

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Self-sufficiency - rancher The farmer and the rancher How trade expands consumption
(b) The Rancher’s Production Possibilities Frontier specialize and trade opportunities
• Our claim is that each would be better off if they (a) How Trade Increases the Farmer’s Consumption
Meat specialize in producing the product that they are Meat
(pounds) 40 more suited to produce, and then trade with each (pounds)
other Farmer’s
A* consumption
• In our example the farmer should produce potatoes 3 with trade

B
• And the rancher should produce meat
20 2 Farmer’s
• The actual quantities will depend on factors that consumption
determine the relative price of meat and patatoes A without trade
• But an arbitrary trade bundle that is beneficial to 1
both (otherwise there is no trade) is sufficient to
0 2½ 5 Potatoes (pounds) make our point 0 2 3 4 Potatoes (pounds
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How trade expands consumption The gains from trade Measuring costs of production
opportunities • Differences in the costs of production determine
Without Trade With Trade
(b) How Trade Increases the Rancher’s Consumption the following
Production Gains from
and Production Trade Consumption – Who should produce what?
Meat 40 Consumption Trade
(pounds) – How much should be traded for each product?
Farmer 1 pound 0 pounds Gets 3 3 pounds 2 pounds • There are two ways to measure differences in costs
meat meat pounds meat meat meat of production
Rancher’s
consumption for 1 pound 3 pounds 1 pound
21 B* 2 pounds 4 pounds – The number of hours required to produce a unit
with trade potatoes
20 B potatoes potatoes potatoes potatoes of output (for example, one pound of potatoes)
Rancher’s
consumption Rancher 20 pounds 24 pounds Gives 3 21 pounds 1 pound – The opportunity cost of sacrificing one good for
without trade another
meat meat pounds meat meat meat
2½ pounds 2 pounds
for 1 pound 3 pounds ½ pound • Is it the latter that is the basis of trade between the
0 2½ 3 5 Potatoes (pounds) potatoes farmer and the rancher
potatoes potatoes potatoes potatoes

Asaf Savaú Akat Lecture Notes EC 151 (2007) 58 Asaf Savaú Akat Lecture Notes EC 151 (2007) 59 Asaf Savaú Akat Lecture Notes EC 151 (2007) 60

Absolute advantage Production of farmer and rancher - 2 Comparative advantage

• Before we move on, let us look at a different set of • Comparative advantage looks at relative costs, in
production figures for the farmer and rancher Hours needed to make one pound of Amount Produced in 40 hours other words to the opportunity costs
• In the new example, the farmer produces more • The producer who has the smaller opportunity cost
patotoes while the rancher produces more meat of producing a good is said to have a comparative
• The producer that requires a smaller quantity of
Meat Patatoes Meat Patatoes advantage in producing that good
inputs to produce a good is said to have an absolute • In our original example the rancher is able to
advantage in producing that good produce more of both goods
• This is an easy but also uninteresting situation: the FARMER 20 hours/lb 4 hours/lb 2 lbs 10 lbs • Still, the farmer has comparative advantage in
farmer will specialise in patatoes and the rancher in patatoes while the rancher has comparative
meat advantage in meat
• Our original example is interesting because the • Farmer gives up 0.5 lb. of meat to produce 1 lb. of
rancher is producing more of both patatoes and RANCHER 1 hour/lb 8 hours/lb 40 lbs 5 lbs patatoes: the ratio is 8 to 1 for the rancher
meat

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The principle of Other benefits of exchange Trade among nations

comparative advantage • What is true within a nation is also true among
• Specialisation permits each producer to have a
• Comparative advantage and differences in nations
deeper knowledge and experience about the tasks
opportunity costs are the basis for specialized • Exports are what Turkey sells to other countries
involved during production
production and trade • Imports are what Turkey buys from other countries
• Better knowledge and experience means more can
• Whenever potential trading parties have differences • The principle of comparative advantage applies in
be produced by the same amount of effort
in opportunity costs, they can each benefit from international trade
• Higher productivity benefits everyone in society
trade
• Precious talent is not wasted on doing things • Absolute advantage in international trade works in
• Individuals, regions and nations specialise because limited areas of natural differences (oil, tourism, etc)
others can also do
they have comparative advantage not absolute
• We don’t want Hagi to sing or John Lennon to • Big differences in productivity among countries does
advantage
play football not prevent international trade
• Specialisation and trade lead to higher levels of
• Our current welfare is wholly the result of high • Turkey benefits from trade with US and EU even if
consumption for all the parties that participate in
productivity due to specialisation they both have higher productivity
trade
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Conclusion PART TWO: SUPPLY AND What we learn in Part Two?

• Self-sufficiency is not desirable DEMAND I: • Part Two introduces the model of supply and
• Specialisation leads to higher productivity for the
HOW MARKETS WORK demand in a market economy
producers of goods and services
• Supply and demand is the basic tool of economic
• Interdependence and trade allow people to enjoy a
analysis
greater quantity and variety of goods and services
• In Principle Five and Chapter 3 we learned that
• The person who can produce a good with a smaller THE MARKET FORCES OF specialisation and trade makes everybody better off
quantity of inputs has an absolute advantage.
• The person with a smaller opportunity cost has a SUPPLY AND DEMAND • Principle Five tells us that markets are a good way
to organise economic activity
comparative advantage
Chapter 4 • Now we must see how markets work to achieve this
• The gains from trade are based on comparative
result
advantage, not absolute advantage
• Markets work through supply and demand
• Turkey benefits from international trade

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Plan of Part Two Plan of this chapter Market forces of

supply and demand
• There are three chapters in Part Two • We start by defining market types such as • Supply and demand are certainly the two words that
• Chapter 4: Market forces of supply and demand competition, monopoly, oligopoly, etc. economists use most often
• It introduces the concept of supply and demand • Then examine the factors that determine the demand • Supply and demand are the forces that make market
along with other basic concepts such as competition, for a good or service in a competitive market economies work efficiently
market type, etc. • Next we look at the determinants of the supply of a • Supply and demand determine the quantity of each
• Chapter 5: Elasticity and its applications good or service again in a competitive market good produced and the price at which it is sold
• It is about the relation between changes in prices and • Supply and demand come together to set the price of • Any event or policy that affects the economy will
changes in quantities the good or service and the quantity sold work through its impact on supply and demand of
• Chapter 6: Supply, demand and government policies • We establish how changes in demand or in supply some goods
• The tools of supply and demand are used to evaluate conditions affect the price and quantity • Modern microeconomics is about supply, demand,
different government policies towards markets • And look at the key role of prices in the allocation and the market equilibrium that results from their
of scarce resources of society interaction

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Markets A Competitive Market Types of markets

• The terms supply and demand refer to the behavior • Economic theory distinguishes among four different
of people as they interact with one another in • A competitive market is a market
types of markets
markets – with many buyers and sellers
• Perfect Competition
• A market is a group of buyers and sellers of a – that is not controlled by any one person
– Competitive market where products are the same
particular good or service – in which a narrow range of prices are
• Monopoly
– Buyers determine demand established that buyers and sellers act upon
– One seller, and seller controls price
– Sellers determine supply • The number of buyers and sellers are an important
• Oligopoly
• Some markets are formally organised with a part of the definition of competition
– Few sellers
building, etc. such as the Stock Market, • The second element is that a buyer or seller cannot
influence prices by his own actions alone – Not always aggressive competition
Commodities Market, etc.
• Most markets are not formally organised but they • When these two characteristics exist the market is • Monopolistic Competition
exist because buyers and sellers know them called competitive – Many sellers
• People know where to go to buy a car, bread, etc. – Differentiated products
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The Concept of Demand Demand for Ice Cream Law of Demand

• We begin our analysis of demand by examining the Price of
Ice-Cream
Price of
Ice-Cream
behaviour of buyers in the market for a good or Cone Cone

service
Price Quantity $3.00 $3.00
• The law of
• Quantity demanded is the amount of a good that $0.00 12 2.50 demand states that 2.50

buyers are willing and able to purchase 0.50 10 there is an inverse

2.00
• Quantitiy demanded will vary with the price of the 1.00 8 relationship 2.00

good in question 1.50 6 1.50 between price and 1.50

• The demand schedule is a table that shows the 2.00 4 quantity
1.00
relationship between the price of the good and the demanded. 1.00

quantity demanded
2.50 2 0.50

• The demand curve is the downward-sloping line 3.00 0 0.50

relating price to quantity demanded 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of

Ice-Cream Cones 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
• Market demand is the sum of individual demands Ice-Cream Cones

Asaf Savaú Akat Lecture Notes EC 151 (2007) 76 Asaf Savaú Akat Lecture Notes EC 151 (2007) 77 Asaf Savaú Akat Lecture Notes EC 151 (2007) 78

Determinants of Demand Demand function Demand function

• What are the factors that determine how much of a • We can present the determinants of demand by the • What is the meaning of the demand function
product is bought in the market for that product? symbols of a function Q = F ( P , Y , Pn , Pe , D )
• In the previous slides we looked at the demand for Q = F ( P , Y , Pn , Pe , D ) • We look at the relation between price and quantity
ice cream • It is called the demand function demanded while we keep other factors as constant
• What determines how much ice cream will be • In other words, P is the only independent variable,
– P = price of the good or service
bought? the others are kept constant
– Market price of ice cream – Y = income • Changes in income, other prices, price expectations
– Consumer income – Pn = prices of other goods and services and tastes will cause a shift in the demand curve
– Prices of related goods – Pe = expectations about the change in price • Whereas changes in price only affect quantities
– Tastes – D fashion and tastes of consumers • Change in prices changes the quantity demanded but
– Expectations not the demand function
– Number of consumers

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Changes in income: normal and Effect of an increase in income: Effect of an increase in income
inferior goods normal good inferior good
• Changes in income cause a shift in the demand
curve Price of Price of
Ice-Cream Ice-Cream
• Usually the direction of the shift is upward • As income Cones • As income Cones
• In other words, higher income means more demand increases the Increase
in demand
increases the
for most goods at all prices demand for a demand for
• These are called normal goods normal good an inferior
• However, for some goods, an increase in income will increase. good will Decrease
may actually result in less demand or a downward Demand decrease. in demand
Demand
shift in the demand curve curve, D 1
curve, D 2
Demand
• These are called inferior goods Demand curve, D 3
curve, D 1
• They are consumed by the very poor 0 Quantity of 0 Quantity of
Ice-Cream Cones Ice-Cream Cones
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Prices of Related Goods Ceteris Paribus Change in Quantity Demanded

• The effects of changes in the prices of related goods • Warning about one aspect of the analysis so far versus Change in Demand
depend on the characteristics of the goods • The distinction between change in demand and
• We change one constant at a time while we keep the
• Two goods are called substitutes if they represent change in quantity demanded is vital to understand
remaining unchanged
similar goods for the consumer: beans or chick peas the analysis of demand
• For example, when we look at the effect of a change • Change in Quantity Demanded
are close substitutes in income we keep the prices of related products
• A fall in the price of a substitute will reduce demand – Movement along the demand curve.
plus tastes plus price expectations unchanged – Caused by a change in the price of the product
for a good (demand curve shifts down)
• Economic theory uses a short-cut to express this • Change in Demand
• Two goods are called complements when consuming
method – A shift in the demand curve, either to the left or
one entails consuming the other: a car and tyres
• A fall in the price of a complement will increase • Ceteris paribus is a Latin phrase that means that all right
demand for a good (demand curve shifts up) variables other than the ones being studied are – Caused by a change in a determinant other than
assumed to be constant the price (income, tastes, etc)

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Change in Quantity Demanded Changes in Quantity Demanded Change in Demand

versus Change in Demand
Variables that
Affect Quantity Demanded A Change in This Variable . . . Price of
Cigarettes, Price of
per Pack A tax that raises the price of Cigarettes,
per Pack
Price Represents a movement along cigarettes results in a movement A policy to discourage
C along the demand curve. smoking shifts the
the demand curve $4.00
demand curve to the left.

Income Shifts the demand curve

A B A
Prices of related goods Shifts the demand curve 2.00 $2.00

Tastes Shifts the demand curve D2 D1

D1
Expectations Shifts the demand curve 0 12 20 Number of Cigarettes 0 10 20 Number of Cigarettes
Smoked per Day Smoked per Day
Number of buyers Shifts the demand curve

Asaf Savaú Akat Lecture Notes EC 151 (2007) 88 Asaf Savaú Akat Lecture Notes EC 151 (2007) 89 Asaf Savaú Akat Lecture Notes EC 151 (2007) 90

The Concept of Supply Law of Supply Supply Curve

Price of
• The law of supply states that there is a direct Ice-Cream
• Goods and services are supplied to the market by (positive) relationship between price and the Cone

producers who are also sellers quantity supplied Price Quantity $3.00

• Supply looks at the behaviour of the producers • At higher prices there will be higher quantities of the $0.00 0 2.50
• Quantity supplied is the amount of a good or good or service supplied 0.50 0
service that sellers are willing and able to sell • The supply schedule is a table that shows the 2.00
1.00 1
• What determines the quantity supplied? relationship between the price of the good or service
– Market price of the good or service
1.50 2 1.50
and the quantity supplied
– Input prices (of those used in its production) 2.00 3
• The supply curve is the upward-sloping line relating 1.00

– Technology (with which it was produced) price to quantity supplied 2.50 4

– Expectations about the future level of prices • Market supply curve is the sum of the supply curves 3.00 5 0.50

– Number of producers of the good or service of the individual producers 0 1 2 3 4 5 6 Quantity of

Ice-Cream Cones

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Change in Quantity Supplied Change in Quantity Supplied

versus Change in Supply versus Change in Supply Increase in Supply
• As in the demand, attention must be paid to the
difference between changes in the supply and Variables that Price of
Ice-Cream
changes in the quantity supplied Affect Quantity Supplied A Change in This Variable . . . Cone Supply
curve, S1
Supply
• Change in Quantity Supplied Price Represents a movement along curve, S2
– Movement along the supply curve the supply curve
– Caused by a change in the market price of the
product Input prices Shifts the supply curve
• Change in Supply Technology Shifts the supply curve Increase
in supply
– A shift in the supply curve, either to the left or
right Expectations Shifts the supply curve
– Caused by a change in a determinant other than Number of sellers Shifts the supply curve 0 Quantity of
price (input prices, technology, expectations, etc) Ice-Cream Cones

Asaf Savaú Akat Lecture Notes EC 151 (2007) 94 Asaf Savaú Akat Lecture Notes EC 151 (2007) 95 Asaf Savaú Akat Lecture Notes EC 151 (2007) 96

Supply and demand together Equilibrium of Supply and

Decrease in Supply • Market works by the interaction of supply and Demand
demand
Price of Price of
Ice-Cream Supply curve, S3 • Now we can see how the two come together Ice-Cream
Cone Supply Cone
curve, S1 • Market equilibrium corresponds to a price where
Supply
Decrease quantitiy demanded and supplied is equal
in supply • Equilibrium Price Equilibrium price Equilibrium
$2.00
– The price that balances supply and demand. On a
graph, it is the price at which the supply and
demand curves intersect Demand

• Equilibrium Quantity
Equilibrium
– The quantity that balances supply and demand. quantity

0 Quantity of
On a graph it is the quantity at which the supply 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones and demand curves intersect Ice-Cream Cones

Asaf Savaú Akat Lecture Notes EC 151 (2007) 97 Asaf Savaú Akat Lecture Notes EC 151 (2007) 98 Asaf Savaú Akat Lecture Notes EC 151 (2007) 99

Markets Not in Equilibrium Excess Supply Excess Demand

• To understand the meaning of market equilibrium
we can look at a market not in equilibrium
Price of Price of
• Outside of equilibrium there will be either unsold Ice-Cream Ice-Cream
Cone Cone
products or unsatisfied customer demand Excess
• Excess Supply supply Supply Supply
– Price is above equilibrium price $2.50
2.00
– Producers are unable to sell all they want at the $2.00
1.50
going price
Demand Excess
• Excess Demand demand Demand

– Price is below equilibrium price 0 4 7 10 Quantity of

0 4 7 10
– Consumers are unable to buy all they want at the Quantity Quantity Ice-Cream Cones Quantity Quantity
Quantity of
Ice-Cream Cones
demanded supplied supplied demanded
going price
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Changes in Equilibrium How an increase in demand How a Decrease in Supply

affects market equilibrium Affects the Equilibrium
• For the market equilibrium to change one or more of (a) Price Rises, Quantity Rises (b) Price Rises, Quantity Falls
Price of
the determinants of demand or supply must have Ice-Cream 1. Hot weather increases Price of
1. An earthquake reduces
Cone the demand for ice cream... Ice-Cream
changed Cone S2
the supply of ice cream...

• When faced with an event or policy that affects the S1

market Supply
New
• First, we must try to understand whether the event $2.50 New equilibrium $2.50 equilibrium
shifts the supply or demand curve (or both) 2.00 2.00 Initial equilibrium
2. ...resulting
• Then we search for the direction of the shift(s) in the in a higher Initial
equilibrium
2. ...resulting
in a higher
price...
curve(s): upward or downward D2 price...
Demand
• Only then can we determine the impact of the event D1
or policy on the equilibrium price and quantities 0 7 10 Quantity of 0 1 2 3 4 7 8 9 10 11 12 13 Quantity of
• And also the direction of the change 3. ...and a higher
quantity sold.
Ice-Cream Cones 3. ...and a lower Ice-Cream Cones
quantity sold.

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Effects of Supply and Demand Some Examples Conclusion

Shifts • Weather conditions are important for the supply of • Trade happens in markets of different types, some
most agricultural products competitive other not
No Change An Increase A Decrease • Exceptional temperatures below freezing in warm • Market economies harness the forces of supply and
in Supply in Supply in Supply climates lead to crop failures demand
• Read ITN (p.81) “Mother Nature Shifts the Supply • Demand comes from the consumers
No Change P same P down P up Curve” • Quantity demanded of a good depends on its price,
in Demand Q same Q up Q down • We have a more recent example from the US on income, on the prices of related goods, on
An Increase P up P unknown P up besides agriculture expectation, on tastes and fashion
in Demand Q up Q up Q unknown • In September 2005 Hurricane Katrina hit hard a • When we analyse demand, only the price is allowed
region with important oil refining and oil-gas to change while the other factors are kept constant
A Decrease P down P down P unknown distribution networks (ceteris paribus)
in Demand Q down Q unknown Q down • Potentially distrupting the supply of energy • Quantity demanded is a decreasing function of price
• Leading to higher prices in international oil markets

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Conclusion What we learn now?

• Changes in the other factors cause upward or • Everyday, in every market, billions of decisions are
downward shifts in the demand curve made by producers, consumers, governments, etc.
• Supply comes from producers or sellers • In Ch.4 we developed our basic model to explain the
• Quantity supplied is a function of the price, of input ELASTICITY AND ITS determination of prices and quantities in the markets
prices, of technology, etc. • By the interaction of supply and demand
• Higher prices increase quantity supplied APPLICATIONS • In Ch.5 we deal with some important characteristics
• Supply and demand together determine the prices of of supply and demand curves
the economy’s goods and services as well as the Chapter 5 • The word elasticity refers to
quantities produced – How changes in prices affect quantities?
• Market equilibrium changes when supply or demand – How changes in quantities affect prices?
(or both) shifts • Information about the reaction of prices and
• Prices are the signals that guide the allocation of quantities to one another is vital for many aspects of
resources in the market economy economic decision making
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Elasticity Price elasticity of demand Some concepts

• Elasticity is a practical measure developed by • Price elasticity of demand is the percentage change • Before we proceed, some definitions are needed
economists to enrich our understanding of the forces in quantity demanded given a one percent change in • Necessities: goods that people must buy for natural
of supply and demand and how they interact the price or similar reasons, like food, shelter, medical
• Elasticity calculates the response of buyers and • The price elasticity of demand is computed as the services, including habit forming goods such as
sellers to changes in market conditions percentage change in the quantity demanded divided cigarettes and drinks
• Through this measure producers and government by the percentage change in price • Luxuries: goods that are bought for pleasure more
gains valuable insights about the behaviour of • Attention: price elasticity of demand is a measure of than need, like fashion, travel, entertainement
different markets two points on the same demand curve • Close substitutes: different categories of food are
• We will learn about three types of elasticity Percentage Change usually very close substitutes, like beans and
– Price elasticity of demand in Quantity Demanded chickpeas
– Income elasticity of demand Price Elasticity of Demand = • Market definition: food market is broad, market for
Percentage Change green vegetables is less broad, market for spinach is
– Price elasticity of supply in Price
much narrower

Asaf Savaú Akat Lecture Notes EC 151 (2007) 112 Asaf Savaú Akat Lecture Notes EC 151 (2007) 113 Asaf Savaú Akat Lecture Notes EC 151 (2007) 114

Ranges of elasticity Perfectly inelastic demand Perfectly elastic demand

• Depending on the value of the price elasticity of
demand we can say that demand is
• Perfectly Inelastic when the quantity demanded Price Price
Demand
remains unchanged when price changes 1. At any price
above $4, quantity
• Perfectly Elastic when the quantity demanded $5 demanded is zero.
changes by very large amounts with small changes 4 $4 Demand
in price 1. An
2. At exactly $4,
• Unit Elastic when the quantity demanded changes increase
consumers will
in price...
by the same percentage as the price buy any quantity.
• Inelastic Demand when the quantity demanded does
not respond strongly to price changes 0 100 Quantity 0 Quantity
3. At a price below $4,
• Elastic Demand when the quantity demanded 2. ...leaves the quantity demanded unchanged. quantity demanded is infinite.
responds strongly to changes in price

Asaf Savaú Akat Lecture Notes EC 151 (2007) 115 Asaf Savaú Akat Lecture Notes EC 151 (2007) 116 Asaf Savaú Akat Lecture Notes EC 151 (2007) 117

Unit elastic demand Elastic demand Inelastic demand

Price Price Price

$5 $5 $5
4 4 Demand 4
1. A 22% Demand 1. A 22% 1. A 22% Demand
increase increase increase
in price... in price... in price...

0 80 100 Quantity 0 50 100 Quantity 0 90 100 Quantity

2. ...leads to a 22% decrease in quantity demanded. 2. ...leads to a 67% decrease in quantity demanded. 2. ...leads to an 11% decrease in quantity demanded.

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Price Determinants of Computing the price elasticity of

$7 Elasticity is
larger price elasticity of demand demand
6 than 1.
• Demand usually is more elastic (100 - 50)
– if the good is a luxury Price ED 100
5 (4.00 - 5.00)
Elasticity is – the longer the time period
smaller $5
4.00
4 – the larger the number of close substitutes
than 1.
3
– the more narrowly defined the market. 4 Demand
• Demand tends to be more inelastic 50 percent
2 – if the good is a necessity -2
- 25 percent
1
– the shorter the time period
– the fewer the number of close substitutes 0 50 100 Quantity Demand is price elastic
– the more broadly defined the market.
0 2 4 6 8 10 12 14 Quantity

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A better way: midpoint method Elasticity and total revenue Elasticity and total revenue
• The price elasticity of demand has very important
• Wider ranges may pose some practical difficulties
practical implications
in measuring elasticity
• Producers gain valuable information about the
• Narrow price ranges give more precise results Price
impact of price changes on their sales
• Midpoint method is a better way
• Because there is a very strong relation between
• Assume the following prices and quantities: firm’s sales (total revenue) and price elasticity $4
• Point A: Price $ 4 Quantity: 120 • Total revenue is the amount paid by buyers and
Point B: Price $ 6 Quantity: 80 received by sellers of a good
Midpoint: Price $ 5 Quantity: 100 • Computed as the price of the good multiplied by the P
P X Q = $400
(total revenue) Demand
• The formula: quantity sold
Midpoint Price Elasticity of Demand = TR = P x Q
( Q2 – Q1 ) /[ ( Q2 + Q1 ) / 2 ] • The behaviour of total revenue when prices change 0 100 Quantity
( P 2 – P 1 ) / [ ( P2 + P 1 ) / 2 ] depend on the price elasticity of demand Q

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Effects on total revenue Elasticity and total revenue: Elasticity and total revenue:
• With an elastic demand curve, an increase in price elastic demand inelastic demand
leads to a decrease in quantity demanded that is
proportionately larger Price Price
Price Price
• Producers facing elastic demand curves have
– decreasing revenues when prices go up
– increasing revenues when prices go down $5
• With an inelastic demand curve, an increase in price $4
leads to proportionately smaller decrease in quantity Demand Demand $3

• Producers facing inelastic demand curves have Revenue = $200 Revenue = $100
Revenue = $240
– increasing revenues when prices go up $1
Revenue = $100 Demand Demand
– decreasing revenues when prices go down 0 50 Quantity 0 20 Quantity 0 100 Quantity 0 80 Quantity
• Unit elasticity means constant revenues
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Some examples Income elasticity of demand Types of income elasticity

• Reducing the price of a toll-road (paral otoyol) • There exists another elasticity of demand besides • Income elasticity of demand tells us about the
may increase total revenue received by the owners price elasticity behaviour of demand when income changes
(private or public) • Income elasticity of demand measures how much • Higher income raises the quantity demanded for
• If the price elasticity is higher than one the quantity demanded of a good responds to a normal goods but lowers the quantity demanded for
• Read ITN (p.98) “On the Road with Elasticity” change in consumers’ income. inferior goods
• The same is also true for a Museum • It is computed as the percentage change in the • Goods consumers regard as necessities usually have
• Reducing the admission price for a Museum may quantity demanded divided by the percentage low income elasticity of demand
result in such an increase in the number of visitors change in income. – Examples include food, fuel, clothing, utilities,
that total revenue will be higher Percentage Change in and medical services.
• Again it means price elasticity is higher than one Quantity Demanded • Goods consumers regard as luxuries usually have
Income Elasticity of Demand = high income elasticity of demand
• Read CS (p.98) “Pricing Admission to a Museum” Percentage Change
• It is possible to think of other such examples in Income – Examples include sports cars, furs, and expensive
foods

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Price elasticity of supply Ranges of supply elasticity Perfectly inelastic supply

• Price elasticity of supply measures the response of • Perfectly Elastic
quantity supplied to changes in price ES = f horizontal Price
• Price elasticity of supply is the percentage change in • Relatively Elastic Supply
quantity supplied resulting from a one percent ES > 1 flat
change in price $5
• Unit Elastic
• The price elasticity of supply is computed as the ES = 1 4
percentage change in the quantity supplied divided 1. An
by the percentage change in price • Relatively Inelastic increase
ES < 1 steep in price...
Percentage Change in • Perfectly Inelastic
Quantity Supplied
Elasticity of Supply = ES = 0 vertical
Percentage Change 0 100 Quantity
in Price 2. ...leaves the quantity supplied unchanged.

Asaf Savaú Akat Lecture Notes EC 151 (2007) 133 Asaf Savaú Akat Lecture Notes EC 151 (2007) 134 Asaf Savaú Akat Lecture Notes EC 151 (2007) 135

Inelastic supply Unit elastic supply Elastic supply

Price Price Price

$5 $5 $5

4 4 4
1. A 22% 1. A 22% 1. A 22%
increase increase increase
in price... in price... in price...

100 110 Quantity 100 125 Quantity 100 200 Quantity

2. ...leads to a 10% increase in quantity supplied. 2. ...leads to a 22% increase in quantity supplied. 2. ...leads to a 67% increase in quantity supplied.
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Perfectly elastic supply Determinants of Application of elasticity

elasticity of supply • How do we apply elasticity to real world events
• Price elasticity of supply measures the speed of the • In case of a change in price, start by examining
Price whether the shift is in the supply or demand curve
change in the production of a good or service
1. At any price or both
above $4, quantity demanded in the market
$5 supplied is infinite. • The availability or non-availability of a good is • Determine the direction of the shift of the curve(s)
4 influenced by many factors • Use the supply-and-demand diagram to see how the
– Beach-front land is limited by nature (inelestic market equilibrium changes
1. A 22% 2. At exactly $4,
increase producers will
supply) • You may want to distinguish between the short run
in price... supply any quantity. – Books, cars, and most manufactured goods can and the long run
be produced at will (elastic supply) • We now look at three exemples
• Time period – Farming
100 Quantity
3. At a price below $4, – Supply is more elastic in the long run. – Drugs
quantity supplied is zero. – Oil

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Elasticity and farming income An increase in supply in the Reducing drug use
• Can good news for farming be bad news for farmers? market for wheat • The second example is from harmful drugs
• What happens to wheat farmers and the market for Price of
1. When demand is inelastic, • Let’s evaluate two alternative policies to fight drugs
Wheat
wheat when university agronomists discover a new an increase in supply...
– Better policing and the interdiction
wheat hybrid that is more productive than existing S1 S2 – Better education of potential drug addicts
varieties? 2. ...leads $3 • The first cause a reduction of supply: supply curve
• Key to solution: price elasticity of both supply and to a large
shifts to left
fall in
demand is very low (inelastic) for food products price...
2
• Price of drugs and profits of drug dealers go up but
• The innovation increases supply: shifts the supply the quantity used is not affected
curve to the right Demand • The second cause a fall in demand: demand curve
• The result will be more production of wheat but shifts to left
0 100 110 Quantity of Wheat
lower incomes for farmers • Both the price of and quantity drugs fall
3. ...and a proportionately smaller
• Farmers’ dilemma: the more they produce, the increase in quantity sold. As a result,
• Price elasticity shows to policymakers the
revenue falls from $300 to $220.
poorer they become intelligent method of fighting drugs

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Fighting drug addiction OPEC and the price of oil

(a) Drug Interdiction (b) Drug Education
• Organisation of Petroleum Exporting Countries (a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
Price of Price Price
Price of
Drugs Drugs
(OPEC) has control over the price of oil in the short of Oil 1. In the short run, when supply of Oil 1. In the long run,
1. Drug interdiction reduces 1. Drug education reduces and demand are inelastic, when supply and
the supply of drugs... the demand for drugs... run because it can cut oil production a shift in supply... demand are elastic,
S2 a shift in supply...
S2 Supply • In the short run the price elasticity of both demand S1
S2
P S1 S1
2 P1 and supply is very low for oil (inelastic) P 2. ...leads
2. ...leads 2 to a small P2
P1 P2
• Small cuts in production imply big jumps in price to a large
increase P increase P1
in price. 1 in price.
2. ...which
raises the
2. ...which
reduces
• OPEC is successful in increasing the oil revenues of
Demand
price... Demand the price...
D2
D1 its members in the short run Demand
0 Q 2 Q 1 Quantity of Drugs 0 Q2 Q 1 Quantity of Drugs • In the long run both supply and demand of oil is 0 Quantity of Oil 0 Quantity of Oil
3. ...and reduces the 3. ...and reduces the
quantity sold. quantity sold. elastic as new wells come in and consumers switch
to other sources of energy
• OPEC finds it difficult to maintain high prices in
the long run
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Conclusion What we learn now?

• Elasticity is a practical measure that helps producers • In Ch.2 we mentioned two roles for economists:
and policymakers – As scientists they try explain the world
• Price elasticity of demand measures how much the – As policymakers they try to change the world
quantity demanded responds to changes in the price SUPPLY, DEMAND, AND • Ch.4 and Ch.5 analysed objectively how supply and
• If a demand curve is elastic, total revenue falls demand works in markets
when the price rises GOVERNMENT POLICIES • In Ch.6 we analyse various types of government
• If it is inelastic, total revenue rises as the price rises policy towards the markets
• The price elasticity of supply measures how much Chapter 6 • To that purpose we will only use tools of supply and
the quantity supplied responds to changes in the demand that we just developed
price • The analysis will yield some surprising insights
• In most markets, supply is more elastic in the long about how markets work
run than in the short run • Common sense and economic analysis may give
opposing advise to policymakers

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Supply, demand, and government Price controls Price ceilings

• In a free, unregulated market system, market forces • Price control: government sets an upper or lower • Price ceilings limit the maximum price that sellers
establish equilibrium prices and quantities limit (or both) to the price of good or service can charge to their customers
• The market equilibrium may be efficient, but it may • Price controls are often used in many countries • In other words, market price can be lower but can
not leave everyone satisfied • Price controls are enacted by governments because not be higher than the price fixed by government
• Those who consider themselves to be losing from there is a demand for them from some sections of • Two outcomes are possible when the government
the market outcomes will ask for government to the public imposes a price ceiling
intervene in the market • Who, either as buyers or sellers feel that the existing • The price ceiling is not binding if it is set above the
• Government intervention in the markets may take market price is unfair to them equilibrium price
several ways, depending on the circumstances • We will distinguish between two types of controls • It will have no impact on the market
• We will look at two different cases of direct • Price Ceiling: a legally established maximum price • The price ceiling is binding if it is set below the
government involvement in markets: at which a good can be sold. equilibrium price
– Price controls • Price Floor: a legally established minimum price at • It will lead to shortages in the market as demand
– Taxes levied on goods and services which a good can be sold exceeds supply at that price

Asaf Savaú Akat Lecture Notes EC 151 (2007) 151 Asaf Savaú Akat Lecture Notes EC 151 (2007) 152 Asaf Savaú Akat Lecture Notes EC 151 (2007) 153

A price ceiling that is not binding A price ceiling that is binding Effects of price ceilings
• A price ceiling prevents the price to rise further even
Price of Price of if demand is high
Ice-Cream
Ice-Cream
Cone Cone • A binding price ceiling creates shortages because
Supply Supply Q D > QS .
Equilibrium • Example: there was a margarine shortage in Turkey
Price price
$4
ceiling during 1978-79 crisis because the price was fixed
3 $3 too low to cover the costs of producers
Equilibrium • Shortages result in non-price rationing such as long
price 2 Price
Shortage
ceiling lines in front of the shops, discrimination by sellers
and as a rule the formation of a “black market”
Demand
Demand • In Turkey there was a black market for dollars
0 100 Quantity of 0 75 125 Quantity of
Ice-Cream
before 1980s because the government had fixed the
Ice-Cream Quantity Quantity
Equilibrium
quantity Cones supplied demanded Cones exchange rate below the market equilibrium rate
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Price ceiling on gasoline Rent control: short and long run Price floors
(a) Rent Control in the Short Run (b) Rent Control in the Long Run
• Price floors set the minimum price that buyers must
Price of
(a) The Price Ceiling on Gasoline Is Not Binding

Price of
(b) The Price Ceiling on Gasoline Is Binding

S 2 Rental
(supply and demand are inelastic)
Rental
(supply and demand are elastic) pay for a product
Gasoline Gasoline 2. ...but when
supply falls...
Price of
Apartment Supply
Price of
Apartment
• Market price can be higher but not below the price
1. Initially,
Supply, S 1
P 2
S 1 set by the government
Supply
the price
ceiling
is not
• When the government imposes a price floor, again
binding...
P 1
Price ceiling
P 1
Price ceiling
3. ...the price
two outcomes are possible
4. ...
resulting
ceiling becomes
binding...
Controlled rent Controlled rent

Demand
• The price floor is not binding if it is set below the
in a Shortage

0 Q1
Demand
Quantity of
shortage.
0 QS QDQ 1
Demand
Quantity of
Shortage
Demand
equilibrium price
Gasoline Gasoline
0 Quantity of 0 Quantity of • It has no effect on the market
Apartments Apartments

A fall in supply turns an unbinding price ceiling • The price floor is binding if it is set above the
Controling rents cause bigger shortages in the equilibrium price
into a binding ceiling and causes shortages of
long run because new construction becomes • It leads to a surplus because demand is less than
gasoline
unattractive, reducing long run supply supply at that price

Asaf Savaú Akat Lecture Notes EC 151 (2007) 157 Asaf Savaú Akat Lecture Notes EC 151 (2007) 158 Asaf Savaú Akat Lecture Notes EC 151 (2007) 159

A price floor that is binding Effects of a price floor

A price floor that is not binding • A price floor prevents price to fall even if demand is
Price of
Ice Cream
very low
Price of
Ice-Cream
Cones Supply • When the market price hits the floor, it can fall no
Cone Supply
Surplus further, and the market price equals the floor price
Equilibrium $4 Price floor • A binding price floor causes a surplus of supply
price over demand because at that price
3
$3
Q S > Q D.
Equilibrium • Agricultural support prices are typical examples
Price price
2
floor • When set above market levels, they result in large
Demand
unsold stocks (tobacco?)
Demand
0 80 120 Quantity of
• Minimum wage laws also set price floors for wages
0 100 Quantity of Quantity
demanded
Quantity
Supplied
Ice Cream
Cones
• Binding minimum wages prevent wages to go down
Ice-Cream
Equilibrium
quantity Cones and therefore cause unemployment

Asaf Savaú Akat Lecture Notes EC 151 (2007) 160 Asaf Savaú Akat Lecture Notes EC 151 (2007) 161 Asaf Savaú Akat Lecture Notes EC 151 (2007) 162

Minumum wage law and employment Letting the price system work Taxes: impact
• Most economists believe in the superiority of the • Taxes levied on goods and services are called
(a) A Free Labor Market (b) A Labor Market with a Binding Minimum Wage
price system in solving most problems indirect taxes
Wage Wage
• Therefore dislike government interference with the • The amount of tax fixed by the government is added
Labor
supply Labor surplus
Labor
supply working of the price mechanism to the price and paid everytime the good is sold
Minimum
(unemployment) • Even in the case of natural disasters • Taxes discourage market activity
wage

Equilibrium
• Read ITN (p.119) “Does a Drought need to Cause a • When a good is taxed, the quantity sold is smaller
wage
Water Shortage” • Buyers and sellers share the tax burden
Labor
demand
Labor
demand
• The author argues that increasing the price that • Tax incidence is the study of who bears the burden
0 Equilibrium
employment
Quantity of
Labor
0 Quantity
demanded
Quantity
supplied
Quantity of
Labor
consumers pay for water would be a better way of of a tax
allocating scarce water in case of a major drought • Taxes result in a change in market equilibrium
Minimum wage legislation increases both the real • A drought is always a natural event • Buyers pay more and sellers receive less, regardless
wage of employed and the number of unemployed • A water shortage is always a man-made event of whom the tax is levied on
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The burden of a payroll tax

Impact of a 50¢ tax on buyers Impact of a 50¢ tax on sellers • Taxes from the wages that firms pay to their
employees are called “payroll taxes”
Price of Price of
Ice-Cream
Ice-Cream
A tax on sellers
• Income tax, contribution to Social Security and to
Cone
Price Cone Supply, S1 Price
buyers Equilibrium S2 shifts the supply Unemployment Insurance are typical payroll taxes
buyers with tax curve upward by
pay
$3.30
pay
S1 the amount of • When the Parliament passes legislation about these
Equilibrium without tax $3.30 the tax ($0.50).
3.00 Price 3.00 Tax ($0.50) taxes, the issue of “who pays the tax” comes up
2.80 without 2.80 Equilibrium without tax
tax • Read CS (p.127) “Can Congress Distribute the
Price
Equilibrium Price
Burden of a Payroll Tax”
sellers
receive with tax sellers
receive
• Whether the tax is legally levied on employees or
Demand, D1
employers makes little difference
D1
D2
• Conditions in the labour market and the elasticities
of demand and supply determine who pays the tax
0 90 100 Quantity of 0 90 100 Quantity of
Ice-Cream Cones Ice-Cream Cones

Asaf Savaú Akat Lecture Notes EC 151 (2007) 166 Asaf Savaú Akat Lecture Notes EC 151 (2007) 167 Asaf Savaú Akat Lecture Notes EC 151 (2007) 168

Payroll tax and the labour market The incidence of tax Elasticity and tax incidence
Wage • Tax incidence tries to establish who pays the tax in • Elasticity enters the picture because total revenue in
the end? the market depends on the price elasticity of demand
Labor supply
• In other words, in what proportions is the burden of and price elasticity of supply
the tax divided between buyers and sellers? • We can distinguish among three major cases
Wage firms pay • Alternatively, how do the effects of taxes on sellers – If demand is inelastic while supply is elastic, then
Tax wedge compare to those levied on buyers? a larger share of the tax will fall on the buyers
Wage without tax
• This is an opportunity for us to see how the measure – If demand is elastic while supply is inelestic, then
Wage workers of elasticity can be used in economics a larger share of the tax will fall on the sellers
receive
• Because the answers to these questions depends on – If demand and supply are unit elastic, buyers and
the elasticity of demand and the elasticity of supply. seller will share the tax burden equally
Labor demand
• We shall show that the burden of a tax falls more • Knowing the price elasticities of demand and supply
0 Quantity
of Labor
heavily on the side of the market that is less elastic permits the government to target correctly those
whom it wishes to pay the tax

Asaf Savaú Akat Lecture Notes EC 151 (2007) 169 Asaf Savaú Akat Lecture Notes EC 151 (2007) 170 Asaf Savaú Akat Lecture Notes EC 151 (2007) 171

Elastic supply, inelastic demand Inelastic supply, elastic demand Taxing luxuries or necessities?
• There is always a demand from the public to tax
luxuries but not necessities
Price 1. When demand is more
1. When supply is more Price elastic than supply... • Taxing goods that are considered luxuries is popular
elastic than demand...
Price buyers pay
both with the public and governments
Price buyers pay Supply
Supply • Unfortunately luxury goods usually have high price
Price without tax 3. ...than on consumers.
2. ...the elasticity of demand (bigger than 1)
Tax Tax
incidence of the
tax falls more
• Therefore taxes reduce the consumption of luxuries
Price without tax heavily on
Demand
• Tax revenue is much lower than expected
consumers...
Price sellers receive Price sellers receive 2. ...the • In turn, necessities have low price elasticity of
incidence of
3. ...than on Demand the tax falls more demand (smaller than 1)
heavily on producers...
producers. • And yield high tax revenues to the government
0 Quantity 0 Quantity • In order to obtain revenues the government ends up
by taxing necessities in Turkey
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Asaf Savaú Akat Lecture Notes EC 151 (2007) 172 Asaf Savaú Akat Lecture Notes EC 151 (2007) 173 Asaf Savaú Akat Lecture Notes EC 151 (2007) 174

Conclusion PART THREE

What did we learn so far?
• The economy is governed by two kinds of laws: • Part One introduced us to some basic concepts as
– The laws of supply and demand SUPPLY AND DEMAND – II well as tools of economics as a science
– The laws enacted by government MARKETS AND WELFARE – Ten principles (Ch.1)
• Prices can be controled by ceilings or floors – Thinking like an economist (Ch.2)
• Price ceilings cause shortages and black market – Exchange and trade (Ch.3)
• Price floors result in surpluses and unsold stoks held CONSUMERS, PRODUCERS, • Part Two introduced us to markets and how they
by the government work through the forces of supply and demand
• Taxes raise revenue to the government
AND THE EFFICIENCY OF – Supply and Demand (Ch.4)
• Taxes create new price equilibriums in which buyers MARKETS – Elasticities (Ch.5)
and sellers share the tax – Markets and government policies (Ch.6)
• The incidence of the tax depends on the price Chapter 7 • Part Three looks on the welfare implications of the
elasticity of demand and supply market system
• Necessities are taxed to get more revenue

Asaf Savaú Akat Lecture Notes EC 151 (2007) 175 Asaf Savaú Akat Lecture Notes EC 151 (2007) 176 Asaf Savaú Akat Lecture Notes EC 151 (2007) 177

What do we learn in this part? Market equilibrium revisited Welfare economics

• We search for an answer to the following question • Market equilibrium reflects the way markets • Welfare economics study how the allocation of
• Are markets a good way to organise the social allocate scarce resources resources affects economic well-being in society
process of production? • Supply and demand determines the equilibrium • It uses a new concept called “surplus”
• To answer it we develop the concepts of consumer price and quantity for each good • And shows that buyers and sellers both receive
surplus, producer surplus and total surplus • Thus the resources that goes into its production as benefits from taking part in the market
• They allow us to explain market efficiency well as who shall benefit from its consumption • Therefore the equilibrium in a market maximizes the
• We then apply our new tools to understand the costs • The next question is to find out if the equilibrium total welfare of buyers and sellers
of taxation and the benefits of international trade price and quantity maximize the total welfare of • Consumer surplus measures economic welfare from
• Part Three is made of buyers and sellers? the buyer side
• Ch.7 : Consumers, producers and market efficiency • Welfare economics answers this question • Producer surplus measures economic welfare from
• Ch.8 : Application: Costs of taxation • And determines whether the market allocation is the seller side
• Ch.9 : Application: International trade desirable or not from the perspective of society • Together they allow us to evaluate the allocation of
scarce resources by markets

Asaf Savaú Akat Lecture Notes EC 151 (2007) 178 Asaf Savaú Akat Lecture Notes EC 151 (2007) 179 Asaf Savaú Akat Lecture Notes EC 151 (2007) 180

Willingness to pay Consumer surplus Willingness to pay with four

• Willingness to pay is the maximum price that a • Consumer surplus is the key concept of welfare possible buyers
buyer is willing and able to pay for a good or service economics
• It corresponds to the value attributed by the buyer to • The market demand curve shows the various
the good or service demanded quantities that buyers would be willing and able to Buyer Willingness to Pay
• The willingness to pay cannot always be directly purchase at different prices
• As the price goes down, the quantity bought goes up John $100
measured in the market but it is still there
• How much a buyer will be willing to pay for a good • Consumer surplus is the difference between the Paul 80
or service is the maximum price at which he/she will willingness to pay for the good or service and the
purchase that good or service actual spending for it George 70
• What determines the maximum price? • Consumer surplus is the amount a buyer is willing
• The benefits that the buyer expect to receive from to pay for a good minus the amount the buyer Ringo 50
the consumption of that good or service actually pays for it
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Willingness to pay with four Measuring consumer surplus with Consumer surplus, demand and price
possible buyers the demand curve • Consumer surplus is the area that lies below the
demand curve and above the market price
Price Buyer Quantity Price of • Consumer surplus depends on the demand curve,
Album
Demanded $100
which represents the willingness to pay
John’s consumer surplus ($30) • And the market price which represents market
More than $100 None 0 80
Paul’s consumer surplus ($10) equilibrium
70
$80 to $100 John 1 Total
• Ceteris paribus, changes in price and demand affect
50 consumer consumer surplus
$70 to $80 John, Paul 2 surplus ($40)
– Lower market price increases consumer surplus
$50 to $70 John, Paul, George 3 Demand – Higher market price reduces consumer surplus
– Higher demand increases consumer surplus
$50 or less Ringo 4 0 1 2 3 4 Quantity of – Lower demand reduces consumer surplus
Albums

Asaf Savaú Akat Lecture Notes EC 151 (2007) 184 Asaf Savaú Akat Lecture Notes EC 151 (2007) 185

How the price affects consumer Willingness to sell

surplus • We can now apply the concept of surplus to the
Price
producers
A • Market supply curve shows the various quantities
that producers would be willing and able to sell at
Initial different prices
consumer
surplus • It may be seen as a measure of supplier costs, that
C Consumer surplus
P1
B to new consumers is, the opportunity cost of supplying various
F
quantities of the good.
P2
D
Additional
E • The marginal opportunity cost of production
consumer
surplus to increases as market output expands
initial Demand
consumers • Because a producer’s cost is the lowest price he/she
will accept, cost is a measure of his/her willingness
0 Q1 Q2 Quantity
to sell

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