intecon micro review 1
Post on 15-May-2015
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This video clip reviews the microeconomic concepts that we’ll be using in our course. -‐-‐-‐-‐-‐ Mee:ng Notes (1/22/12 08:53) -‐-‐-‐-‐-‐ In our interna:onal economics course.
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The review includes two items: (1) the mechanics of the simple model of a compe::ve market that economists use and (2) the underpinnings of the conven:onal choice theory – both collec:ve and individual.
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First off, what is a market? For our purposes here, we’ll view a market as a bunch of people trading a good on a voluntary basis. The good defines the market. If the good is oranges, then it is a market for oranges. Markets are social structures – people rela:ng to one another in certain ways (in this case, acknowledging and respec:ng their mutual property and coopera:ng with one another via trade). For more on this, see my slides on Coopera:on & Social Structures. At this point, we make the assump:on that this market is compe::ve. By this we mean, first, that the good is homogeneous. There are no differences in the quality or characteris:cs of the good. Say it is oranges. They are generic oranges. For a buyer, it doesn’t maVer who supplies the oranges, because they all look and taste and smell the same. And second, to say that the market is compe::ve is to say that there are many buyers and many sellers, so no par:cular buyer or seller has “market power” – i.e. the ability to manipulate the price individually. And since there are many and the good is the same, the sellers cannot differen:ate the good or form coali:ons. Neither can the buyers. Basically, it’s just a bunch of individual buyers and sellers trying to do the best they can for each of them individually without regard for the
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We split the people into two groups – one group, we call the buyers. These people have money and want the good. The second group is the sellers. These people have the good, but they want the money. The two groups meet and make the market by nego:a:ng prices at which they are willing to trade. There will be a single price in this market, at which all buyers will buy the good and all sellers will sell the good. Once the two groups agree on a price such that the buyers want to buy the same amount of the good that the sellers wish to sell – and we call that the “market equilibrium” – the deal is made, they shake hands, sellers hand the good to the buyers, buyers pay the sellers the money, and each group goes home happier or at least not less happy than they were before. Remember: it is a voluntary transac:on. If people felt that trading made them less happy, then why would they do it voluntarily? We construct the model in the following way: First, we study the behavior of buyers. We call that the demand side. Second, we study the behavior of the sellers. We call that the supply side. Third, we put the two together. We call that equilibrium. Fourth, we study how equilibrium is aVained. Fi]h, we shock the model by making some or other factor (other than price) affect the behavior of buyers or sellers or both, and see what the model predicts. This is the way in which we test the model. If the predic:ons of the model match what we observe in reality, then – and to that extent – we deem the model as reliable and use it in our prac:cal applica:ons.
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Demand. The ques:on we pose here is: What makes buyers buy more (or less) of a good? There are many factors. Let me limit my list to a few of these factors: Price is the first one. And in the graphic model that we use, this is the variable that is explicitly included in the analysis. Economists say that this variable, price, and the quan:ty traded (demanded and supplied) are the *endogenous* variables. Other variables, which are not explicitly visible in the analysis, are called *exogenous*. It doesn’t mean that we don’t care about them. We have ways to reflect the impact of changes on those variables on our market model – on price and quan:ty. But our liVle model cannot explain *why* they change. We are just going to assume, whenever we may deem that convenient, that these variables change and then register the effect of those changes on price and quan:ty. Price maVers here, because – and this seems like a reasonable assump:on to make, since it appears to match what we observe in the world – if the price is higher, buyers will tend to buy less of the good. If, on the other hand, the price is lower, buyers will tend to buy more. So, there’s a nega:ve or inverse rela:onship between price and quan:ty demanded – the quan:ty that buyers wish to buy given all other things.
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Here’s the graph of the demand rela:onship. This graph (the curve or line) shows directly the rela:onship between the quan:ty demanded for the good and the price of the good. It is a nega:ve rela:onship. That is why the slope of the line is nega:ve. The line is downward sloping. Now, for simplicity, I’m drawing it as a straight line. Real demand lines, if we are able to es:mate them (and there are difficul:es to es:mate them empirically), don’t need to be straight lines. This is a simplifica:on, but it is a simplifica:on that helps us clarify things nicely. Note that in this graph, we can only show two variables explicitly or directly. As I said, the two variables we care most about are the price and the quan:ty traded. So the graph only shows the link between price and quan:ty explicitly. When we consider the change in the price of the good and then the reac:on of buyers, then we say that we are “moving along” the demand line or demand curve. Let me note that we are drawing the demand curve as a straight line for convenience only. There is no reason why an actual demand curve would be linear.
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When other factors (not explicitly indicated -‐-‐ the factors that we listed before: income, tastes, other prices, expecta:ons)… when those factors change, that has an effect on the whole demand line. The demand line shi]s. For example, suppose that this is the market for oranges and the price of apples increases. Then, as a result, the en:re demand line for oranges may shi] to the right – indica:ng that for each given price, buyers are willing to buy more oranges due to the higher price of apples. This is called a rightward *shi]* of the demand line. It is easy to see that the effect of changes in the other variables listed (variables other than price and the quan:ty demanded) can be shown in this graph as a shi] of the demand line. Now, just by looking at the shi] in the diagram, we may not be able to know what cause that shi]. So, we’ll need to add separate informa:on to our diagram so that we know why the graph, the demand line shi]ed.
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Let us now consider … supply. This is the descrip:on of how the sellers (the other side of the market) behave. The ques:on here is: What makes sellers sell more (or less) of a good? There are also many factors. These are a few important ones: Price is, again, the first one. The higher the price, the more of the good the sellers would want to sell, other things equal. Suppose that the producers and, more generally, the sellers of the good are business people. They are offering the good for sale, because they want to make a profit. The profit they obtain per unit of the good is the difference between the price of the good and the cost of the good for them. Let us define here the cost of the good as the minimum price at which the sellers are willing to sell the good. Clearly, if the cost of the good is given, the higher the price, the higher their profit. On the other hand, if the price of the good is given, then the lower the cost of the good, the higher the profit. Given the price of the good, its cost is going to be their main considera:on when deciding how much of the good to sell. What is the cost: Well, if they are the producers, they need to assemble the inputs required to produce the good and pay
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Here’s the graph of the supply rela:onship. This graph (the curve or line) shows directly the rela:onship between the quan:ty supplied of the good and the price of the good. It is a posi:ve rela:onship. The supply curve or line is upward sloping. For simplicity, I draw it as a straight line. Real supply lines, also hard to es:mate empirically, don’t need to be straight lines. But we are simplifying maVers. You will note that the supply curve here is also a straight line, just like the demand curve was a straight line. Again, this is for convenience only. There is no reason why an actual demand or supply curves would be linear. Now, again, if we are studying the change in the price of the good and how sellers react to it, we are “moving along” the supply curve.
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When the other factors change, the supply curve shi]s en:rely. Suppose that this is the market for oranges and the price of labor decreases (say, there is high unemployment in the area and workers have to accept lower wages). Then, as a result, the en:re supply curve to the right – indica:ng that for each given price, sellers are willing to sell more oranges due to the lower cost of labor. This is called a rightward *shi]* of the supply curve. And when any of the other factors may change, we can do something similar to register that change and its effect on the market in our diagram.
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We are now ready to put the demand and the supply sides together. In the diagram, we show now the demand and the supply curves. Demand is downward sloping. Supply is upward sloping. As a result, they cross at a point. Let us examine the point where they cross. The demand curve shows the different quan::es of the good that buyers wish to buy at different prices (given the economic environment). The supply curve shows the different quan::es of the good that sellers wish to sell at different prices (again, given the economic environment). The point where the two curves cross is a price and a quan:ty – the price at which the quan:ty demand and the quan:ty supplied are equal. At this price, buyers and sellers agree on the quan:ty they wish to trade. We call it equilibrium, because if nothing changes in the economic environment, then there is no reason why buyers or sellers may want to be somewhere else rather than at that point. Consider the case where the price is higher than the equilibrium price – say about here. Note then that the quan:ty that buyers want to buy falls short of the quan:ty that sellers want to sell. As a consequence, there is no deal. There is a gap between the quan:ty demanded and the quan:ty supplied. Economists call that gap a glut. It
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Let us now do the algebra. The demand equa:on is this one: P = 12 -‐ .8 Qd where 12 is the ver:cal intercept and -‐0.8 is the slope. The intercept or any price above it would discourage buyers from buying the good. No buyer would pay that much for the good. The slope (.8) indicates the drop in the price that would make buyers buy one extra unit of the good. Note that the ver:cal axis shows you how much the buyers value one unit of the good. It indicates how much they benefit from it, since they would only pay the price for it if they felt that the benefit received compensates them properly.
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And here is the supply equa:on: P = 2 + .2 Qs, where 2 is the ver:cal intercept and 0.25 is the slope. At the intercept or any price below it, no seller would sell any of the good. The slope indicates the increase in the price that would lead sellers to sell one extra unit of the good. It is important to note here that the ver:cal axis also shows how much the sellers value the good. It indicates how much the good costs the sellers, since they would only sell it if they feel compensated for such cost.
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We have a system of two linear equa:ons. The demand has to sa:sfy the rule P = 12 -‐ .8 Qd and the supply the rule that P = 2 + .2 Qs. In equilibrium, the price that buyers pay is the same price that the sellers receive. And the quan:ty that the buyers want to buy is the quan:ty that the sellers want to sell. In other words, the equilibrium price and quan:ty are the values of P and Q that solve the two equa:ons simultaneously. Let us solve the system algebraically now. Since the price has to be the same for both buyers and sellers, then we can make the RHS of these equa:ons equal and then solve for Q, which is also only one Q, both quan:ty demanded and quan:ty supplied. A]er doing the algebra, we find that the quan:ty that both buyers and sellers want to trade is 10 units of the good. By plugging this value of Q in any of the original equa:ons, we find the equilibrium price, which is $4/unit. I do the subs:tu:on with both equa:ons, demand and supply, to show that the result must be the same. … The equilibrium is a pair of numbers, a price and a quan:ty: 10 units of the good and $4/unit.
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Let us use now the model for its prac:cal purpose. We need it to predict the response of the market to changes in the economic environment. Say, for example, that we want to know the effect on the market (on its Q* and P*) of a new sales tax by of $2/unit of the good. Note that the same effect would result from any other change in the economic environment leading to a le]ward shi] of the supply curve of the same size. The result is a new equilibrium. A higher price and a smaller quan:ty. I’ll leave up to you to consider what happens to the equilibrium price and quan:ty if the supply curve shi]s to the right instead. Also, what happens to the market (to Q* and P*) if the supply curve does not move, but the demand curve shi]s to the right and le]? Play with the model un:l you feel comfortable enough understanding its mechanics and implica:ons.
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Let us now do the algebra for the new condi:ons in the market. The demand equa:on stays the same. But the supply curve has a new – higher – intercept: The supply equa:on is now P = 4 + .2 Qs. Let us solve the new system for P* and Q*. Again, since the price has to be the same for both buyers and sellers, then we can make the RHS of these equa:ons equal and then solve for Q, which is also only one Q, both quan:ty demanded and quan:ty supplied. We find that the quan:ty that both buyers and sellers want to trade is 8 units of the good. Again, we plug this value of Q in any of the original equa:ons to find the equilibrium price, which is now $5.6/unit. I do this subs:tu:on in both equa:ons, demand and supply, to show again that the result is the same. The new equilibrium is 8 units of the good and $5.6/unit.
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Suppose the price in the market is $4/unit. The amount that buyers will buy at that price is 10 units. The buyers’ total benefit (so-‐called “consumer” benefit) is the area under the demand curve and bound by the quan:ty: 10 units. Now, the buyers spend in the good: P Q = ($4/unit) (10 units) = $40. They receive the 10 units of the good that yields for them the total benefit. However, a por:on of the total benefit – the rectangle represen:ng their expenditure – is not free. They pay for that. S:ll, there is the triangle above the expenditure rectangle for which buyers pay nothing. It is their net benefit or “consumer surplus.” It is the welfare that buyers receive for free from the amount of the good they buy from the sellers. They receive this net benefit or “consumer surplus” because the market exists – because there is another side to the market, because there are sellers willing to cooperate or trade with them. This is the source of the consumer surplus. The consumer surplus is represented by the area of that triangle. To calculate the area, we use the formula (b h)/2. In this case, the base is 10 units and the height is the intercept of the demand curve minus the price in the market, which is $4/unit. Therefore, it is 12-‐4 = 8, mul:plied by 10, that is 80, and 80 divided by 2 is 40. Note that the units are just dollars: $40. The values on the ver:cal axis are prices: $/unit. So $12/unit minus $4/unit = $8/unit. Now when you mul:ply $/unit :mes units, the units cancel out, and you obtain $, just plain dollars.
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Let us now calculate the producer surplus. Again, if the price in the market is $4/unit. The amount that sellers will sell at that price is 10 units. Remember that the height of the supply curve indicates the lowest price that sellers ask for one unit of the good, and that is precisely the cost of the good for them. The sellers’ total receipts or revenues are P Q = (4) (10) = $40. That is represented by this rectangle. The area below the supply curve and bound by the quan:ty: 10 units is the cost for the producers. Note that the sellers’ revenues P Q, $40, are more than the sellers’ cost. The difference of R – C = profit. The profit is also called the “producer surplus.” The consumer surplus is represented by the area of this triangle. Again, the area is (b h)/2. In this case, the base is 10 units and the height is the market price, $4/unit, minus the intercept of the supply curve, $2/unit. The height is then 4-‐2 = $2/unit. Therefore, the producer surplus is (10) (2) = 20, divided by 2: $10. So, the net welfare benefit of the sellers, their profit or producer surplus, is a measure of the welfare of sellers in the market – something they receive for free, because the market exists. It is calculated in dollars. It’s $10.
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The total surplus or the net welfare benefit that the buyers and sellers receive altogether is the sum of the consumer and the producer surpluses.
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In other words, the total surplus is equal to $40 + $10 = $50. To repeat: This is a measure of the net welfare benefits that both buyers and sellers together receive as a result of the existence of the market, which is to say, as a result of their coopera:ng with each other. It’s the fruits of their coopera:on, which – in this par:cular case – takes the form of trade. And to keep the :me of this videos short, there’s no summary. You can go back and replay the parts that you may need to study more carefully. I hope this was helpful to you. I’ll see you in class.
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