Microeconomics precourse
Academic Year 2013-2014
Course Presentation
This course aims to prepare students for the Microeconomics
course of the MSc in BA. It provides the essential background in
microeconomics
PAOLO PAESANI
Office: Room B6, 3RD floor, Building B
Telephone: 06-72595701
E-mail: [email protected]
Office hours: to be agreed
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WHY ARE WE HERE ?
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Get to know each other
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Economics in a nutshell
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Cracking the nutshell open …
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It can’t be easier than this.
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Friendly advice: make sure you know this by heart !
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PRESENTATION OUTLINE
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What is economics about?
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What is microeconomics about?
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The market
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Consumer theory
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Theory of the firm
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ECONOMICS
“Political economy or economics is a study of mankind in
the ordinary business of life; it examines that part of
individual and social action which is most closely
connected with the attainment and with the use of the
material requisites of wellbeing” (Marshall 1890).
“Economics is the science that studies human behavior as a
relationship between ends and scarce means which have
alternative uses.” (Robbins 1935).
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ECONOMICS
“It seems to me that economics is a branch of logic, a way of thinking; […]
Economics is a science of thinking in terms of models joined to the art of
choosing models which are relevant to the contemporary world. It is
compelled to be this, because, unlike the typical natural science, the
material to which it is applied is, in too many respects, not homogeneous
through time. […] The object of a model is to segregate the semipermanent or relatively constant factors from those which are transitory
or fluctuating so as to develop a logical way of thinking about the latter,
and of understanding the time sequences to which they give rise in
particular cases. […] In the second place, as against Robbins, economics is
essentially a moral science and not a natural science. That is to say,
it employs introspection and judgments of value”. (Keynes 1938)
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MICROECONOMICS
Microeconomics studies:
• How individuals take rational economic decisions
• How individuals interact in a defined social context.
Individuals = Economic agents = Decision-takers / Choice-makers
Human beings, firms, policy-makers
Decisions about what? What kind of decision?
Rational economic decisions = decisions about how to best use
limited resources to achieve possibly conflicting goals
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ECONOMIC RATIONALITY
Rational agents facing economic decisions are confronted
with constrainst and alternative courses of action (COAs).
Constraints (individual, socio-cultual, economic, legal, timerelated) shape COA .
Each COA entails costs and benefits which materialise over
different time periods … short-term vs. long-term (MOTLO)
Costs and benefits associated to different COAs may be
uncertain (risk) or unknown (uncertainty)… expectations
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ECONOMIC RATIONALITY
Economic rationality is about choosing the best course of
action for a give constraint-set where best is defined with
respect to the individual’s objective function (which we
assume to be well-defined) and on the information at his
disposal (full vs. limited information).
Rationality assumption and its two motivations
More on rationality and homo economicus (Sen 1987, Smith
2008, Rodriguez-Sickert 2009)
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SOCIO-ECONOMIC CONTEXT
Free market economy:
• Well-defined property rights over available resources.
• Freedom to put available resources to the best (most profitable) use as
judged by the owner (resource allocation).
• Property rights protection.
• Freedom to transfer property rights in a regulated and organised way
(Voluntary exchange)
• Price-based resource allocation.
Modelling social interaction:
• The Robinson Crusoe economy (no interaction)
• Strategic interaction (Game theory)
• Market interaction
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ECONOMIC THEORY AND ECONOMIC MODELS (NOT THE SAME THING)
Theory: A set of statements or principles devised to explain a
group of facts or phenomena in their relation to one another.
Theories can be deduced from given axioms or be the result of
observation and conjecture, they can be empirically tested and
used to make predictions about phenomena.
Economic model: simplified representation of reality based on a
set of pre-specified simplifying assumptions and on the use of
one or more languages (the three languages of economics).
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MARSHALL ON THE USE OF MATHEMATICS IN ECONOMICS
“[I had] a growing feeling in the later years of my work at the
subject that a good mathematical theorem dealing with
economic hypotheses was very unlikely to be good economics:
and I went more and more on the rules - (1) Use mathematics as
a shorthand language, rather than an engine of inquiry. (2) Keep
to them till you have done. (3) Translate into English. (4) Then
illustrate by examples that are important in real life. (5) Burn the
mathematics. (6) If you can't succeed in (4), burn (3). This last I
did often”. [Marshall 1906]
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ECONOMIC THEORY AND ECONOMIC MODELS (NOT THE SAME THING)
“Models are objects to enquire into and to enquire with: economists enquire
into the world of the economic model, and use them to enquire with into the
economic world that the model represents” (Morgan 2012, p. 217).
“Reasoning in terms of models involves four steps “Step 1 is to construct a
model relevant for some problem of interest. Step 2 is to ask questions about
‘something in the model or in the world’. Step 3 is to ‘demonstrate the answer
to the questions using the model’s resources’. This is where manipulation
comes in: the answer is arrived at by manipulating the model. Step 4 is to add
a ‘narrative’ that ‘accompanies the demonstration to link the answers back to
the questions and to their domains”. (Morgan 2012 p. 225).
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Varian (2010)
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THE MARKET
“A mechanism for effecting purchases and sales in a relatively public manner. Thus a
market entails a way of carrying out transactions and some means of collecting and
disseminating information on the terms of the transactions, particularly price. These
two aspects are inherently interrelated. ” (Burns 1979, p. 5)
Market identification: Where ? When ? Who ? What ? How ?
Market classification:
• Markets for goods and service, factor markets, asset markets
• Spot, futures and options markets
• Perfect competition, monopolistic competition, oligopoly, duopoly,
monopoly/monopsony
• Auction markets, dealer markets, broker markets, private negotiations
• Regulated vs non-regulated (OTC) markets
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THE COMPETITIVE MARKET
• Many potential buyers and sellers, motivated by self-interest,
competing against each other and acting as price-takers.
• Traded goods are excludable (the owner can exercise property
rights on it) rivalrous (use by one necessarily prevents that of
another) and homogenous (only price matters).
• No barriers to entry and exit
• Perfect information
• No transaction costs (costs related to market participation):
search and information costs, bargaining and decision
costs, policing and enforcement costs.
• Prices are perfectly flexible and respond to imbalances
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between demand and supply.
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THE MARSHALLIAN CROSS
• y = Market price
• x = Quantity traded over a
given period of time
• DD = Demand function
• SS = Supply function
• A = Market equilibrium
• ds = Excess demand)
• sd = Excess supply)
Marshall (1890)
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THE COMPETITIVE MARKET - PARTIAL EQUILIBRIUM MODEL
P = market price , nominal price (money?), relative price (MOTLO)
Q = quantity traded over a given period of time (flow variable … MOTLO)
DD = Market Demand function (Horizontal aggregation, MOTLO)
• Inverse demand function Pd = f(Q) ; f’(Q) < 0
• Demand price the MAXIMUM price that consumers are willing to pay for the
goods and services the are planning to buy when a particular amount or
quantity is available.
• Demand function proper Qd = g(P) ; g’(P) < 0
SS = Market Supply function
• Inverse supply function Ps = h(Q) ; h’(Q) > 0
• Supply price the MINIMUM price that firms are willing to accept in return for a
particular amount or quantity of goods and services.
• Supply function proper Qs = k(P) ; k’(P) > 0
EQUILIBRIUM ; Pd = Ps or alternatively Qd = Qs
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THE COMPETITIVE MARKET – DEMAND ANALYSIS
Slope: The law of demand states that when the price of a good rises CP,
the amount demanded falls, and when the price falls, the amount
demanded rises.(MOTLO)
Position of the demand curve depends: Preferences, Disposable incomes,
Income distribution, Price of complements and subsitutes, Expected ownprice, Expected price of complements and substitutes … when one of
these EXOGENOUS VARIABLES changes the demand curve shifts up or
down.
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ELASTICITY
Price elasticity of demand: the degree to which the number of products sold
changes when the product's price changes
Marshall (1890)
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ELASTICITY
Income elasticity of demand: the degree to which the number of products
demanded changes with an individual’s income.
Brown e Deaton (1972)
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THE COMPETITIVE MARKET – SUPPLY ANALYSIS
Slope: No equivalent of the law od demand, slope of supply function in a
competitive market depends on marginal costs (MOTLO)
Position of the supply curve depends: Technology, Fixed inputs, Input prices,
Degree of sectoral integration … when one of these EXOGENOUS VARIABLES
changes the demand curve shifts up or down.
Marshall (1890)
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REACHING MARKET EQUILIBRIUM
Marshallian adjustment: if for a given initial quantity the
demand price exceeds (falls short of ) the supply price,
producers find it profitable to increase (reduce) market supply.
As quantities change so do demand and supply prices.
Walrasian adjustment: if for a given initial price the quantity
demanded exceeds (falls short of ) the quantitiy supplied,
producers find it in thier interest to reduce (increase) market
prices. As the price falls (increases), demand increases (falls)
and supply falls (increases).
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EQUILIBRIUM AND WELFARE ANALYSIS
• Efficient allocation of scarce
resources
• Welfare maximization
– Consumers surplus (*)
– Producers surplus
• Market “freedom”
• Market “democracy”
• Problems
– How long does it take to reach
market equilibrium?
– What happens to those left
behind?
– Existance? Unicity, stability?
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CONSUMER SURPLUS
Varian (2010)
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MARKET ANOMALIES
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Narrow definition (Fama 1970) “A market is efficient when prices fully reflect
available information” : Weak, Semi-strong and Strong efficiency.
Broad definition (Burns 1979): “An efficient market is liquid, orderly and wellorganised. Liquidity fosters orderly market conditions and influences a market’s
organisation. In turn, orderly market conditions and good market organization
promote market liquidity”.
Liquidity
MARKET
EFFICIENCY
Orderly market conditions
Good market organisation
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MARKET LIQUIDITY
Market liquidity, or liquidity of an asset traded on a market, has two interreated aspects:
certainty of price (with respect to underlying value) and expected marketability (inversely
related to transaction costs). Liquidity depends on:
• Breadth and urgency of demand,
• Cost of ascertating an asset quality (quality standardisation in case of commodities,
publicly available info in case of financial assets),
• Expected cost of default underlying financial assets (default risk together with
enforcement cost),
• Transport cost and cost of holding inventories (storage, deterioration, theft,
financing costs, risks of price change).
Risk of price uncertainty associated with inventory holdings one of the main factors
behind the establishement of futures and option markets and of the activities of Hedgers,
Speculators and Arbitrageurs.
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ORDERLY MARKET CONDITIONS
Disorderly market conditions are associated with:
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•
•
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Unexpectedly high price volatility (symptom, rather than cause),
Artificial barriers to entry or exit (e.g. monopoly / monopsony)
Information manipulation
Traders overreaction
Destabilising trading activity as a result of trading restrictions
Liquidity helps to prevent structural monopolies and price manipulation and together
with an appropriate organisation contributes to generating orderly market condition
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MARKET ORGANISATION
The organisation of a market embraces the institutions that service it: dealers,
brokers, clearing houses, inspection services, regulatory authorities.
Development of a market’s organisation involves applying economies of scale to
effecting transactions as well as to provide information about the terms of the
transaction.
The history of a market organisation is one of increasing specialization of
function induced by, and in turn inducing, an increase in market liquidity.
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MARKET FAILURES
A market failure is a situation where free markets fail to allocate resources efficiently. Economists
identify the following cases of market failure:
Productive and allocative inefficiency: Markets may fail to produce and allocate scarce
resources in the most efficient way.
Monopoly power: Markets may fail to control the abuses of monopoly power.
Missing markets: Markets may fail to form, resulting in a failure to meet a need or want, such as
the need for public goods, such as defence, street lighting, and highways.
Incomplete markets: Markets may fail to produce enough merit goods, such as education and
healthcare.
De-merit goods: Markets may also fail to control the manufacture and sale of goods like
cigarettes and alcohol, which have lessmerit than consumers perceive.
Negative externalities: Consumers and producers may fail to take into account the effects of their
actions on third-parties, such as car drivers, who may fail to take into account the traffic
congestion they create for others. Third-parties are individuals, organisations, or communities
indirectly benefiting or suffering as a result of the actions of consumers and producers
attempting to pursue their own self interest.
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MARKET FAILURES
Property rights: Markets work most effectively when consumers and producers are granted the
right to own property, but in many cases property rights cannot easily be allocated to certain
resources. Failure to assign property rights may limit the ability of markets to form.
Information failure: Markets may not provide enough information because, during a market
transaction, it may not be in the interests of one party to provide full information to the other
party. Information asymmetry (adverse selection, moral hazard, costly state verification) belong
to this category.
Unstable markets: Sometimes markets become highly unstable, and a stable equilibrium may not
be established, such as with certain agricultural markets, foreign exchange, and credit markets.
Such volatility may require intervention.
Inequality: Markets may also fail to limit the size of the gap between income earners, the socalled income gap. Market transactions reward consumers and producers with incomes and
profits, but these rewards may be concentrated in the hands of a few.
Source http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html
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MARKET REGULATION
Increase market efficiency by promoting liquidity, orderly market conditions and an
appropriate organization.
Correct market failures by resorting to:
• Price mechanism: change the behaviour of consumers and producers by using
the price mechanism. For example, this could mean increasing the price of
‘harmful’ products, through taxation, and providing subsidies for the ‘beneficial’
products. In this way, behaviour is changed through financial incentives, much
the same way that markets work to allocate resources.
• Legislation and force: For example, by banning cars from city centres, or having a
licensing system for the sale of alcohol, or by penalising polluters, the unwanted
behaviour may be controlled.
Source http://www.economicsonline.co.uk/Market_failures/Types_of_market_failure.html
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REFERENCE
Burns J.M. (1979) A Treatise on Markets, American Enterprise Institute,
Studies in Economic Policy, Washington DC.
Rodriguez-Sickert C. (2009) “Homo economicus”, Handbook of Economics &
Ethics, Peil, J., and Van Staveren, I. (eds.) Edward Elgar Publishing.
Sen, A. (1987) “Rational Behaviour”, The New Palgrave Dictionary of
Economics, vol 3, pp. 68-76,
Smith V. L. (2008) Rationality in Economics, Cambridge University Press,
Cambridge.
Varian H. (2010) Intermediate Microeconomics, 8° edition, W. W. Norton &
Company
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