Section 2: Introduction to Microeconomics

Concepts you’ll learn1. Economic “Models”2. Modeling behavior of market participants

i. Demand ii. Supplyiii. Equilibrium Price

3. Social Benefit4. Dead Weight Loss5. Demand Elasticity6. Game Theory

Problems you’ll solve7. Understand the requirements of a functional economic model8. Calculate and draw demand curves, supply curves, and plot equilibrium

price points9. Calculate social benefits at market equilibrium10. Calculate certain costs associated with certain market externalities

©2014 D. M. Kaufman. All rights reserved

Remember, We’re Now Zooming In

• For the moment, we’re no longer focusing primarily on government decisions affecting entire nations’ economies.

• We’re primarily focusing instead on individual consumers, small groups of consumers, and individual businesses, but…1. …you’ll see that government policies sometimes still have a role

to play, and…2. …you should be able to relate the concepts learned in this section

back to macroeconomic behavior. We’ll explore some discussion questions at the end of this section to test out your new brain muscles.

Economic Models

• What are they and why bother?– If the previous section on Macroeconomics proved anything to you, it should have

proved that global economies are fiendishly complex.– We need a method to boil rational economic decision making down to its essence.

That is: we need models to explain why consumers and businesses behave as they do when confronted with specific sets of circumstances.

• Are economic models realistic?– Well, they do try to explain and predict real human behavior, but no, they’re not

realistic in that they leave out a ton of detail.– Think of a subway map. Is it realistic? Does the New York Subway map show all of

the city streets? Does it show all of the buildings? The trees? The people? The animals? Is it three dimensional? Of course not. That would be too much detail to make the map useful. But does it effectively show you how to get from one subway stop to any other? Yes. So, is it a “good” map? Yes.

• Okay, so, economic models do not need to be realistic to be “good.” What do they need to be? – An economic model should be simple, with just enough detail, based on as few

assumptions as possible, to illuminate the answer to a well-posed economic question.– It should be prolific, in that it should not only provide the answer to a single, uniquely

defined question, but also be readily applicable to similar, related questions with relatively few tweaks. The best models are easily applied to new situations.

– It should be robust, in that it continues to illuminate the answers to valid questions as its assumptions are changed. Since economic models try to explain and predict human behavior and decision making, they need to be able to answer that perennial question: “What if?”

An Example• Ever noticed that gas stations tend to be clustered very closely together?

There has to be a reason. Let’s create an economic model that helps illuminate it.

• What will our model need? Since we’re trying to keep it simple (therefore leaving out a lot of “real world” detail), we need good assumptions.– First, we need participants in the model – in this case, gas stations that are free to locate and move.

How many do we need? Well, one wouldn’t be sufficient to explain the clustering issue, and three is more than we need, so… we’ll assume we have two gas stations only.

– Since we’re trying to focus solely on the clustering, or location, issue, let’s leave out every other basis on which gas stations might compete – things like price, product choice, additional services, etc. In other words, excluding location, we’re assuming that the two gas stations are identical, and offer identical products at identical prices.

– Since we’re exploring a question of location, we need a geography. The simplest representation of a geography would be a dot, but that’s too simple. If the world were a point, a station’s location would be determined, not chosen. So, the next simplest geography would be a line. In such a world, each gas station can choose to locate anywhere between point 0 and point 1.

– It makes little sense for gas stations to exist if no one buys any gas, so we also need customers. It would be simplest to have a single customer, but then both gas stations would simply locate themselves on top of that customer’s house. That’s too trivial (although it does involve clustering). We’re more interested in explaining why gas stations cluster even when customers are spread out. So, let’s assume that customers are evenly distributed along the line from point 0 to point 1.

– Now the gas stations and customers need to have an objective, or purpose. It’s reasonable to assume that the gas stations’ purpose is to maximize their profits, and that the customers’ objective is to buy a tank of gas at the lowest possible cost. Since we’re assuming the two gas stations provide identical gas at identical prices, the only variable affecting their profits is the number of customers they can attract, and customer costs are governed solely by the travel expense of getting to the gas station.

– Finally, we must assume that everyone in this model behaves rationally. That is, they do whatever will best help them meet their respective objectives.

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An Example… Continued

• Drawing Conclusions– First, we need to look for “optimization results.” That is, what will each self-

interested participant do in this model we’ve created? Then, we need to look for the “equilibrium,” or the stable outcome. What outcome balances completing forces so that no one wants to change his or her choice given what all the other agents are doing?

• Start with the customers– Since the only cost variable in buying a tank of gas, per our assumptions, is

the amount of travel required to get to the gas station, we know that each customer minimizes his or her cost of getting a tank of gas by buying it from the nearest station.

– Optimization Result I: Each customer buys from the nearest station.• Now, let’s consider the gas stations

– Since the gas station makes profit on each unit of gas it sells (otherwise why stay in business), each station will try to sell as many units of gas as possible. And since customers buy from the nearest station, the way to sell the most gallons is be the closest station to the largest number of customers.

– Optimization Result II: Each station will locate directly beside its rival on the side of the geography with the most customers.

An Example… Played Out• Now, let’s look for the equilibrium outcome to the model.

– Remember, equilibrium is reached when each participant in the model is content with his or her choice, given what everyone else in the model is doing.

– So, what if Gas Station A starts at a location near point 0 in our geography. Where will Gas Station B enter the geography? Directly on the side of its rival with the most customers, right?

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A B

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B A

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A B

– Given this outcome, have we reached equilibrium? No way. Station A will want to move to the other side of Station B to get closer to the bulk of the customers evenly distributed throughout the geography…

– …and so the game would go on, until the two stations are finally located next to each other at the center of the geography, with each station closest to an equal number of customers.

• Notice that although the two types of agents have different optimization results, there is only one equilibrium point at which competing forces are balanced.

An Example… Evaluated

• Is the preceding example simple?– Yes. It’s clear, intuitive, and relies on a handful of assumptions.

• Is it prolific?– Yes. In addition to answering the gas station clustering question, it helps

explain why all sorts of competitors tend to locate closely to one another. And it can be extended to explain other competitive behaviors as well, such as why airlines tend to schedule their flights at roughly the same times, or why movie theaters tend to show movies at roughly the same times. And why do you think it is that most political candidates, over the course of their campaigns, tend to drift toward the ideological center of every debate topic? This model helps explain that as well.

• Is it robust?– Well, let’s see. Can the model easily adapt to a slightly new set of

assumptions?– What if, for example, the land between point ½ and point 1 is now assumed

to be uninhabitable, and therefore devoid of customers. Can the model predict what would happen then?

– It sure can. And with a little thought this model can adapt to all sorts of new and different assumptions, so yes, the model is robust.

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A B

Modeling Markets: Supply, Demand, and Price

• To build a market model, we need to describe the participants involved.– There will be buyers, who will demand a given amount of a given product

within a given period of time as a function of price, the price of potential substitute products, income, etc.

– There will be sellers, who are willing to supply a given amount of a given product within a given period of time as a function of price, labor required to produce the product, the cost of labor, etc.

• As we begin creating market models, we need a few guiding assumptions1. Again, as in the gas station model, we assume that all agents behave

rationally and in their own best interests.2. We assume market efficiency. That is, that buyers and sellers can

negotiate and bargain with each other directly to reach an equilibrium market condition.

3. We assume ceteris paribus, a Latin term roughly meaning, “everything else remaining as it is.” Without this final assumption, it would be impossible to focus on a specific issue, because too many changing externalities would have to be considered. You’ll see what I mean on the next foil…

Modeling Markets: Demand

• Let’s say we want to model a particular consumer’s demand for bread.– In the real, dynamic world, we might express his demand mathematically

as follows:

x1 = F(p1, p2, p3, p4,…, Pn, M)

Where x1 indicates the quantity of bread demanded, p1 is the price of bread, p2 through Pn represent the prices of other, related goods, and M represents the consumer’s income. F is the consumer’s demand function.

– We’ve got a problem. There are too many variables affecting demand for us to model it simply. We could take a crack at it with about 10,000 regression analyses (which you aren’t qualified to perform yet and won’t be learning in this class), but even then we would not have a simple, intuitive model.

– So we invoke ceteris paribus, and hold the prices of related goods and income constant, as indicated by adding horizontal lines above those items:

x1 = F(p1, p2, p3, p4,…, pn, M)

– Now we’ve essentially reduced the question to something we graph two dimensionally. Let’s start by examining the consumer’s behavior as we change p1, the price of bread itself.

Modeling Markets: Demand (cont.)• A graph that shows how the quantity of a good demanded changes as the price

of that good changes (ceteris paribus income and all other prices) is called the demand curve for that good.– So, let’s draw a graph with the price of the good per unit on the y axis, and the quantity demanded per unit of time on

the x axis.Price of the good

per unit

Quantity demanded per unit of time

0

P

Q0

p

P’

D

P

Q0

D D’

– The law of demand states that as the price of a good rises, the quantity demanded will fall, since the value of each incremental unit of a good is lower compared to other potential uses of one’s time and money. Theoretically, a demand curve could go the other way – sometimes the more expensive an item is, the more people want it – but in everyday life the law of demand is almost always satisfied. Makes sense, right? People are able to buy more of something desirable if it costs less.

– Now, when economists refer to “demand for bread,” for example, they are talking about the demand curve. As the price changes (again, assuming ceteris paribus) buyers move along the demand curve to a new quantity. We call that response a change in the quantity demanded because it leaves the demand curve intact; buyers simply move along the curve.

– But what if we unfreeze one element of ceteris paribus for a moment, and allow income to change? Say it increases. It is then reasonable to expect demand for bread at all price points to increase. So the entire demand curve now shifts outward, which we call a change in demand.

Modeling Markets: Supply • Now, let’s consider two demand curves – one for two individual market participants.

• Notice anything different about this graph? We’re now allowing for negative demand. That is, as the price increases beyond a given point for each market participant, they will start demanding negative units of bread. The only way to demand a negative quantity is to stop buying bread and to start making and selling it.

• So, why is Participant B’s demand curve below, or to the left of, Participant A’s? It could be that Participant B has a lower income, or it could be because Participant B is more skilled at making bread – if production costs are lower, lower prices are required to make a profit. The upshot is that Participant B demands less bread at any given price, and therefore has less demand for bread (and is more likely to supply bread) than Participant A. An economist would say that Participant B has a comparative advantage in providing bread. (Remember that one from the macroeconomics section? It holds true for individuals as well.)

• Now consider the price points PA and PB. At a price slightly below PA Participant A will buy a loaf of bread, since below that price it’s not worth his time and effort to bake a loaf. In other words, to Participant A, the opportunity cost of baking a loaf is equal to price PA. By making that loaf, he gives up PA worth of other value (other gainful employment, leisure, etc.). An economist might also refer to PA as A’s reservation price, or the price above which he will not buy.

• Participant B, on the other hand, is willing to bake a loaf of bread for a price slightly above price PB. His opportunity cost associated with baking a loaf of bread is equivalent to that price, so any price above it equals a benefit for him. So PB is B’s reservation price – in this case, the price below which he will not produce.

• Since Participant A is willing to pay anything below PA, and Participant B is willing to supply at any price above PB, there’s an opportunity for both participants to profit by trading with each other. But… how many loaves will they trade? It depends on the price, right? Let’s explore further on the next foil…

P

Q0DB

DAPB

PA

Remember that a supply curve is basically depicting negative demand.

Modeling Markets: Supply (cont.)

• So, how many loaves will these two bozos trade?– Remember from the graph on the preceding page that as A buys more

bread, the perceived value of each extra loaf falls. So says the law of demand, which posits that the value of extra units of a good falls relative to other potential uses of one’s time and money. So, to induce A to buy more, the price must fall.

– For B, on the other hand, the opportunity cost of supplying each incremental loaf increases, due to additional precious time and resources required to bake each one. So, to induce B to supply more, the price must increase.

– To find the equilibrium, then, we simply swivel B’s demand curve around the y axis to create a supply curve.

– The graph now depicts B’s negative demand as positive supply, with the quantity supplied increasing as the price of bread rises. Participant A will demand X’ loaves at price P’, which is the exact same quantity that Participant B finds profitable to make at that price. Supply equals demand, and so we have an equilibrium, or a stable outcome.

P

Q0

SB

DAPB

PA

P’

X’

Finding the Equilibrium Price• Of course, markets aren’t usually made up of just one buyer and one seller for a given good. The

aggregate demand curves of numerous consumers can be represented as an aggregate market demand curve (and the aggregate supply curves – or negative demand curves – of numerous producers can be represented as an aggregate market supply curve).

• Now, if the price is initially set too high, there will be excess supply, because more will be produced than consumers are willing to buy at that price. Producers will then need to underbid each other to sell the excess supply, and the price will fall. Furthermore, some suppliers may cut production or drop out of the market altogether. Meanwhile the quantity demanded will increase as the price falls. Eventually an equilibrium is established and the excess supply is cleared from the market.

• On the other hand, if the price is set too low. There will be excess demand, and the bidding process will work in reverse as consumers try to out bid each other to claim their desired units of a product in short supply. As buyers bid up the market price, producers respond by offering more of the good for sale. Eventually the equilibrium is reached.

P

Q0DA

Mr. A

P’

P

Q0DB

Mr. B

P’

P

Q0DC

Mr. C

P’

P

Q0

DMKT

Market Demand

P’+ + =

P

Q0

D

S

P’

PH

PL

Excess Supply

Excess Demand

Q’

Market Efficiency and Social Benefits• When the bidding process is allowed to achieve market equilibrium as we saw on the

previous foil, economists say that we’ve achieved a “free market” equilibrium, and that social benefit is maximized. Let’s examine why.

• In the graph below, the equilibrium price is P’, but there are consumers who are willing to pay more for a loaf of bread. So, relative to their respective reservation prices, they’re getting bread for a bargain. Economists refer to that bargain as a consumer surplus – the aggregate value represented by the total quantity of bread offered for sale at a price lower than certain customers’ willingness to pay (shown on the graph in the blue triangle “a”).

• With similar logic, there are also suppliers of bread for whom the equilibrium price is higher than that necessary to induce them to produce. So, relative to their respective reservation prices for baking bread, they’re getting a premium. Economists refer to that premium as a producer surplus – the aggregate value represented by the total quantity of bread produced and sold at a price higher than certain producers’ reservation, or required, price (shown on the graph in the green triangle “b”).

• The sum of consumer surplus and producer surplus equals the total social benefit associated with the equilibrium price and, according to this model, there is no way to further increase it.

P

Q0

D

S

P’

Q’

a

b

Screwing with Efficiency -- Externalities• Now, external forces sometimes enter competitive markets. For example, there are such things as

sales taxes. Do such taxes affect social benefit positively or negatively? Well, negatively, of course, since we just saw on the previous foil that free market equilibrium represents the maximum social benefit, but let’s examine why.

• Let’s say that a sales tax is introduced which is equivalent to the delta between PB and PS. What happens to the social benefit?

• Is there still a consumer surplus? Yes, but it is now limited to the aggregate amount consumers are willing to pay above PB as opposed to above P’ – a much smaller area.

• Is there still a producer surplus? Yes, but it is now limited to the aggregate amount producers are willing to supply below PS as opposed to below P’ – a much smaller area.

• At the new quantity produced (QT as opposed to Q’), the delta between the benefit captured by consumers and the benefit captured by producers is now captured by the government imposing the tax. That, in and of itself, is not worrisome to economists since the value is not being lost from society – it is merely being redistributed from consumers and producers to the government.

• But, because a new and lower quantity of bread is now produced because of the tax, some of the social benefit that existed under the free market equilibrium is now lost and not recovered, as represented by the triangles e and f. The sum of the areas of triangles e and f represent a dead weight loss to society.

• Taxes are not the only externality that can impact market efficiency. How about price controls? Tariffs? Quotas? Government subsidies? While there are practical purposes for each of these mechanisms, you should understand that they all dilute the ability of markets to behave efficiently and therefore almost always represent some unrecoverable social cost or dead weight loss.

P

Q0

D

S

P’

Q’

PB

QT

PS

a

b

c

d

e

f

Yet Another Concept – Demand Elasticity• One additional concept you need to grasp is that of demand elasticity, which represents the

percentage change in quantity demanded for a given percentage change in price.• For example, take a luxury product like a Bentley. Those tend to be purchased only by the very

wealthy, who tend to be able to absorb price increases very well. If they want that Bentley, and the price goes up, chances are they’re still gonna buy that Bentley. They won’t accept too many other car makes as substitutes. So the demand curve for Bentleys might look something like the graph on the left below, where a high percentage change in price yields a lower percentage change in demand.

• On the other hand, a staple, like tomato sauce, for example, has many suppliers of similar products, and is purchased by people of all economic strata – some of whom are very price sensitive. So the demand curve for tomato sauce might look something like the graph on the right below, where a low percentage change in price yields a higher percentage change in demand.

• Demand Elasticity, as measured by the percentage change in quantity demanded divided by the percentage change in price, is denoted by the symbol Epsilon (e). So,– When e > 1, we say that demand is elastic– When e < 1, we say that demand is inelastic– When e = 1, we say that demand is unit elastic

• Demand can be elastic at certain points along the demand curve, and inelastic at others, but then calculating elasticity at any point along the curve would require the use of calculus, which is beyond the scope of this course. That is why we’re focusing primarily on linear demand curves.

P

Q0

DBENTLEY

Q’

P

Q0

DTOMATO SAUCE

Q’

Section 2: Practice Problems

• Refer back to the gas station model. What do you think would happen if a third gas station entered the market?

• Suppose that demand for a certain cotton cloth is described by the equation p = 100 – Q, where p is the price buyers pay per unit and Q is the quantity demanded at that price. Suppose that the supply of this cloth is given by p = (w*l) + Q, where p is the price suppliers receive per unit, w is the hourly wage for a worker producing units, l is the number of labor hours required to produce one unit, and Q is the quantity supplied.i. Suppose the hourly wage w = 5 and that it takes four labor hours (l = 4) to make a unit of cloth.

Draw a supply-and-demand diagram to represent the market for this cloth. Is demand elastic, inelastic, or unit elastic?

ii. Find the equilibrium price and quantity traded. Calculate the total social profit created in this market. What is the total consumer surplus? What is the total producer surplus?

iii. Suppose that labor productivity increases so that it only takes two hours to produce a unit of cloth (l = 2). How would the productivity increase affect the market price, quantity traded, and social profit (in total, and for consumers and for producers)?

iv. Suppose that the government imposes a tax of 20 for each unit of cloth sold, to be paid equally by buyers and sellers. How much tax revenue will the government raise? What will happen to the market price, quantity traded, and total social profit? What is the true cost of the tax?

• What would a perfectly elastic demand curve look like? What sort of product might have a demand curve like that?

• Referring back to the prisoner’s dilemma, can you reconcile the Nash Equilibrium with the social benefit of a free market equilibrium? Can you draw any parallels to the need for certain entities in real world society?

• Can you now see why, in a competitive macro-economy, why the market sets prices for goods and services (as opposed to, say, the government)? Great. Draw a model which proves it.

• Can you see why huge increases to the money supply cause the value of money to decline? Prove it.