Economics 349 Intermediate Micro Theory Fall 2007 Dr. Delemeester

Course Essentials Course Web Page  Grade  Exams (60%)  Problem Sets (25%)  Spreadsheet Projects (15%)

Economic Roundtable …to promote an interest in and to enlighten its members and others in the community on important governmental, economic, and social issues… Business networking opportunity Student memberships: $5 EconomicRoundtable.org

The most important determinant of my success in Economics 349 will be: a)My interest in the material b)The amount of time I put into the class c)The instructor’s ability to inspire me d)My mathematical skills e)None of the above. a)My interest in the material b)The amount of time I put into the class c)The instructor’s ability to inspire me d)My mathematical skills e)None of the above

What Do Schoolteachers and Sumo Wrestlers Have in Common? How Is the Ku Klux Klan Like a Group of Real-Estate Agents? Why Do Drug Dealers Still Live with Their Moms? Where Have All the Criminals Gone? What Makes a Perfect Parent? Would a Roshanda by Any Other Name Smell as Sweet? Increasing Residual Wage Inequality: Composition Effects, Noisy Data, or Rising Demand for Skill? Medium-Term Business Cycles Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle? Media Frenzies in Markets for Financial Information An Efficient Dynamic Auction for Heterogeneous Commodities Matching and Price Competition Paying Not to Go to the Gym On the Simple Economics of Advertising, Marketing, and Product Design

Introduction What are the key themes of microeconomics? What is a market? What is the difference between real and nominal prices? Why study microeconomics?

Themes of Microeconomics Microeconomics deals with limits  Limited budgets  Limited time  Limited ability to produce How do we make the most of limits? How do we allocate scarce resources?

Themes of Microeconomics Workers, firms and consumers must make trade-offs  Do I work or go on vacation?  Do I purchase a new car or save my money?  Do we hire more workers or buy new machinery? How are these trade-offs best made?

Themes of Microeconomics Consumers  Limited incomes  Consumer theory – describes how consumers maximize their well-being, using their preferences, to make decisions about trade-offs  How do consumers make decisions about consumption and savings?

Themes of Microeconomics Workers  Individuals decide when and if to enter the workforce Trade-offs of working now or obtaining more education/training  What choices do individuals make in terms of jobs or workplaces?  How many hours do individuals choose to work? Trade-off of labor and leisure

Themes of Microeconomics Firms  What types of products do firms produce? Constraints on production capacity and financial resources create needs for trade-offs  Theory of the Firm – describes how these trade-offs are best made

Themes of Microeconomics Prices  Trade-offs are often based on prices faced by consumers and producers  Workers make decisions based on prices for labor – wages  Firms make decisions based on wages and prices for inputs and on prices for the goods they produce

Themes of Microeconomics Prices  How are prices determined? Centrally planned economies – governments control prices Market economies – prices determined by interaction of market participants  Markets – collection of buyers and sellers whose interaction determines the prices of goods

Theories and Models Economics is concerned with explanation of observed phenomena  Theories are used to explain observed phenomena in terms of a set of basic rules and assumptions: The Theory of the Firm The Theory of Consumer Behavior

Theories and Models Theories are used to make predictions  Economic models are created from theories  Models are mathematical representations used to make quantitative predictions Black-Scholes Option Pricing Model

Theories and Models Validating a Theory  The validity of a theory is determined by the quality of its prediction, given the assumptions  Theories must be tested and refined  Theories are invariably imperfect – but gives much insight into observed phenomena

Which of the following is a normative statement? a)Solar energy will be used increasingly over the next 100 years. b)Mergers between two companies should always be allowed. c)An increase in advertising by one major auto company will affect the sales of the other auto companies. d)If the US government lifts the current sugar quotas, the price of sugar will fall and the corny syrup industry will suffer. a)Solar energy will be used increasingly over the next 100 years. b)Mergers between two companies should always be allowed. c)An increase in advertising by one major auto company will affect the sales of the other auto companies. d)If the US government lifts the current sugar quotas, the price of sugar will fall and the corny syrup industry will suffer.

Positive & Normative Analysis Positive Analysis – statements that describe the relationship of cause and effect  Questions that deal with explanation and prediction What will be the impact of an import quota on foreign cars? What will be the impact of an increase in the gasoline excise tax?

Positive & Normative Analysis Normative Analysis – analysis examining questions of what ought to be  Often supplemented by value judgments Should the government impose a larger gasoline tax? Should the government decrease the tariffs on imported cars?

What is a Market? Markets  Collection of buyers and sellers, through their actual or potential interaction, determine the prices of products Buyers: consumers purchase goods, companies purchase labor and inputs Sellers: consumers sell labor, resource owners sell inputs, firms sell goods

What is a Market? Market Definition  Determination of the buyers, sellers, and range of products that should be included in a particular market Arbitrage  The practice of buying a product at a low price in one location and selling it for more in another location

What is a Market? Defining the Market  Many of the most interesting questions in economics concern the functioning of markets Why are there a lot of firms in some markets and not in others? Are consumers better off with many firms? Should the government intervene in markets?

Which of the following markets do you think is perfectly competitive? a)The market for local phone calls. b)The world soybean market. c)The world oil market. d)b) and c) e)a), b), and c) a)The market for local phone calls. b)The world soybean market. c)The world oil market. d)b) and c) e)a), b), and c)

Market Model

Consider the demand for beer during the summer months. Let Q d = 30 – 5P I – 2R Where Q is measured in thousands of 6-packs, P is the price per 6-pack in dollars, I is income, and R is the number of rainy days during the summer. Supply is given by Q s = P a)Plot the supply and demand curves if I = $20,000 and R = 15. What is the equilibrium price and quantity? b)If I = $20,000 and R = 10, plot the new demand curve and find the new equilibrium. Compare this to the original equilibrium. Does the movement in P and Q make sense with the decline in the number of rainy days?

Real Versus Nominal Prices Comparing prices across time requires measuring prices relative to some overall price level  Nominal price is the absolute or current dollar price of a good or service when it is sold  Real price is the price relative to an aggregate measure of prices or constant dollar price

Real Versus Nominal Prices Consumer Price Index (CPI) is often used as a measure of aggregate prices  Records the prices of a large market basket of goods purchased by a “typical” consumer over time  Percent changes in CPI measure the rate of inflation

Real Versus Nominal Prices Calculating Real Prices

Real Price of College YearNom. Price CPIReal Price 1970$2, $12, $22,

You have been hired to examine whether consumption of gasoline has been affected by changes in the price of gasoline over time. To complete the analysis, you need to adjust nominal gasoline prices per gallon for changes in the overall price level. Use the data below to calculate the real price of gasoline for 1977 and 1989 using 1970 dollars. YearGasoline Price ($/gallon) CPI ( =100) Real Price of Gasoline

The Price of a College Education The real price of a college education rose 69 percent from 1970 to 2006  Increases in costs of modern classrooms and wages increased costs of production – decrease in supply  Due to a larger percentage of high school graduates attending college, demand increased

Market for a College Education Q ( millions enrolled)) P ( annual cost in 1970 dollars) D 1970 S 1970 S 2006 D 2006 $4, New equilibrium was reached at $4,276 and a quantity of 17.3 million students $2,

Price Elasticity of Demand Measures the sensitivity of quantity demanded to price changes  It measures the percentage change in the quantity demanded of a good that results from a one percent change in price

Price Elasticity of Demand Usually a negative number  As price increases, quantity decreases  As price decreases, quantity increases When |E P | > 1, the good is price elastic  |%  Q| > |%  P| When |E P | < 1, the good is price inelastic  |%  Q| < |%  P|

Price Elasticity of Demand The primary determinant of price elasticity of demand is the availability of substitutes  Many substitutes, demand is price elastic Can easily move to another good with price increases  Few substitutes, demand is price inelastic

Price Elasticity of Demand Looking at a linear demand curve, as we move along the curve  Q/  P is constant, but P and Q will change Price elasticity of demand must therefore be measured at a particular point on the demand curve Elasticity will change along the demand curve in a particular way

Price Elasticity of Demand Q P rice E p = -1 E p = 0 E P = -  Elastic Inelastic Demand Curve Q = 8 – 2P

Price Elasticity of Demand The steeper the demand curve, the more inelastic the demand for the good becomes The flatter the demand curve, the more elastic the the demand for the good becomes Two extreme cases of demand curves  Completely inelastic demand – vertical  Infinitely elastic demand – horizontal

Infinitely Elastic Demand D P*P* Quantity Price E P = 

Completely Inelastic Demand Quantity Price Q*Q* D E P = 0

Other Demand Elasticities Income Elasticity of Demand  Measures how much quantity demanded changes with a change in income

Other Demand Elasticities Cross-Price Elasticity of Demand  Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good

Price Elasticity of Supply Measures the sensitivity of quantity supplied given a change in price  Measures the percentage change in quantity supplied resulting from a 1 percent change in price

Elasticity: An Application During the 1980’s and 1990’s, the market for wheat went through changes that had great implications for American farmers and US agricultural policy Using the supply and demand curves for wheat, we can analyze what occurred in this market

Elasticity: An Application Supply: Q S = P Demand: Q D = 3550 – 266P

Elasticity: An Application Q D = Q S P = 3550 – 266P 506P = 1750 P = $3.46 per bushel Q = (240)(3.46) = 2630 million bushels

Elasticity: An Application We can find the elasticities of demand and supply at these points

Elasticity: An Application Assume the price of wheat is $4.00/bushel due to decrease in supply