PPA 723 - = lecture 1

Lecture = 1

PPA = 723

McPeak

Microeconomics:

The=20 study of the allocation of scarce resources amongst competing = alternatives.

The=20 study of how best to use limited means in the pursuit of unlimited=20 ends.

The ideas of optimization and constraints are critical here = =96 the=20 idea is constrained optimization. =20

Optimizing =96 we do the best we=20 can.

Constraints - given the limits we face.

The study of = trade-offs, and=20 the factors that influence these trade - offs.

Perloff notes three = categories=20 of tradeoffs:

1) =20 What = goods and=20 services are produced with the given resources that we=20 have

2) =20 What = particular mix=20 of resources will be used to produce these different goods and=20 services

3) =20 What will = be the=20 distribution of the goods and services we produce

Decision makers are = assumed to=20 make rational decisions that are most effective in helping them meet = their own=20 objectives, whatever they may be. =20

Models and = assumptions are=20 critical to economic analysis. =20

Models are designed = to=20 illustrate and understand relationships between different economic = variables.=20

They=20 are based on simplifying assumptions. =20

The=20 main goal of model building is to predict how changes in one variable = will=20 impact another variable of interest.

Key=20 is to model relevant features, not every detail.

Although these = models may=20 simplify in ways that eliminate some realistic aspects, the goal is to = focus on=20 only the aspects of the problem that are relevant.

Do the predictions = change=20 significantly if specific underlying assumptions are=20 relaxed?

Theories lead to = predictions=20 that can be tested.

We do this by = looking at actual=20 data

Our first model =96 the perfectly competitive=20 market

So let us begin by = considering=20 the economic model of a perfectly competitive market. This is a model of how goods = are=20 exchanged between people that have them (suppliers / sellers) and people = that=20 want them (demanders / buyers).

What assumptions = underlie a=20 perfectly competitive market?

1) =20 Both = buyers and=20 sellers are price takers. = No=20 individual buyer or seller has enough market power to determine the = going market=20 price.

2) =20 The good = in the=20 market is perfectly homogeneous. = Different suppliers are providing a good that is identical from = the point=20 of view of the consumers.

3) =20 Both = buyers and=20 sellers have full information about the quality and price of the good in = the=20 market.

4) =20 There are = no costs=20 to completing an exchange that are relevant besides the market price. = Such=20 costs, if they exist, can be called coordination costs. These can be defined as costs = of=20 obtaining and processing information related to the exchange (see point = three),=20 costs of negotiation, monitoring agreed upon behavior, or enforcing=20 contracts. =

In addition, you = might=20 wonder:

Are=20 there spatial aspects to markets? =20

We=20 assume they are not relevant in our basic model, but there may be things = to=20 think about here in reality. = Think=20 real estate.

Are=20 there temporal aspects to markets?

We=20 assume they are not relevant to our basic model, but again, worth = thinking=20 about. Is the market = appeal of a=20 SUV at low gas prices the same as at higher gas = prices?

Is=20 the market a self-contained, universally defined entity or is it = embedded in=20 institutions (cultural practices, law, =93ways of doing = things=94=85)?

We=20 assume the model can proceed without explicit reference to these. But, particularly with regard = to point=20 four in the definition, can markets exist without supporting=20 institutions?

You can probably = think of other=20 aspects that have implicit assumptions.

Note: this is a set of assumptions, = and these=20 assumptions can be relaxed. = But it=20 is better to start simple (with lots of assumptions) and then see what = happens=20 when these assumptions are violated.

&nbs= p; =20

We can begin by = considering=20 half of the market we just described: =20 the buyers. This = we call the=20 demand side.

The key element of = a model of=20 the demand side is a demand curve.

It helps if you = think of it as=20 a demand schedule that tells you what will happen under a variety of = different=20 circumstances. =20

It tells you the = quantity that=20 will be demanded for a given price level and traces out this information = for a=20 range of plausible price levels. =20

Example:

Say=20 the price of NYS red wine is 9.00 per bottle.

How=20 many bottles per day will be sold in Syracuse? =20 Let=92s say 1000.

What about if it goes to 10.00 per = bottle? Let=92s say it goes to 950 = since a few=20 people buy California red instead of NYS red = =96 note CA=20 red is a substitute for NY red.

Assume that over a period of time, we have = observed the=20 following relationship, and we are reasonably confident that all else = has=20 remained constant during this period of time = (!!!?).

Consider the following = table:

Price Per=20 Bottle

Bottles per = day=20 demanded

= 9.00

1000

10.00

950

11.00

900

12.00

850

13.00

800

What does the graph look = like?

Draw=20 graph.

What is on the = x-axis?

What is on the = y-axis?=20

What explains the = slope?

[note, use this to = review and=20 explain what is meant by slope (rise over run), x-axis and y-axis, and = also=20 stress importance of labeling] = In the example above, it = was noted=20 that the analysis went forward =93all else held constant=94, other than = the=20 relationship between price of the good and quantity demanded of the = good.

What varied was the = price and=20 the corresponding level of demand as measured in quantity. If price changed, we moved along a demand=20 curve.

A given demand = curve is a=20 relevant statement about the relationship between price of the good and = the=20 quantity demanded holding a variety of factors constant.

Changes in these = other kinds of=20 factors lead to a shift in = the=20 demand curve, so that the original curve is not longer applicable.

What are these = =93all else=20 constant=94 factors?

Some examples of = things that=20 lead to a shift in the demand curve:

Take the example of = red wine=20 produced in the Finger=20 Lakes-

[Note: in this example, increase = demand means=20 at a given price, a greater quantity is demanded, decrease demand means = at a=20 given price a smaller quantity is demanded]

1)=20 Change in consumers=92 tastes. =20

a. =20 Increase=20 demand: Consumers demand = more=20 domestic red wine since we are mad at the French.

b. = Decrease=20 demand: Consumers have = decided=20 drinking NYS red wine is =93so 2004=94 and moved on to the new trend of = drinking NYS=20 honey beer.

2) =20 Change in information.=20

a. =20 Increase=20 demand: A study was just = released=20 finding one glass of red wine per day is good for coronary=20 health.

b. = Decrease=20 demand: A study was just = released=20 finding NYS red wine makes your teeth turn green.

3) =20 Change in = the=20 prices of other goods that are logically related to the demand for the = good in=20 question

a. =20 Substitutes. A good that can replace the = good in=20 question. Increase = demand: A bad year for the Finger = Lakes=20 Chardonnay production increases the price of white wines from the area, = thus=20 leading those NYS wine diehards to switch to reds.

Decrease demand: California red production is abnormally high = given weather=20 patterns, decreasing the price of California = red.

b. = Complements. A good that enhances your = enjoyment of=20 the good in question. =20

Increase demand: =20 A bumper wheat harvest makes crackers less expensive.

Decrease demand: =20 Cheese price goes through the roof as cows go on=20 strike.

4) =20 Income.

a. =20 Increase=20 demand: Taxpayers = celebrated the=20 recent lowering of the tax rates by drinking themselves silly on NYS red = wine.

b. = Decrease=20 demand: The slowing down = of the=20 national economy leads consumers to move from NYS red wine to Milwaukee=92s = Best=20 beer.

5) =20 Government rules=20 and regulations. =20

a. =20 Increase=20 demand: The state = government=20 reduces the drinking age to 18, so college students from around the = Finger Lakes go on wine tasting tours and = develop a taste=20 for NY wines and buy them regularly.

b. = Decrease=20 demand: The state = government cracks=20 down on underage drinking on Finger = Lakes wine=20 tours.

Take a numerical = example: Perloff=92s Pigs from the = book. We are going to stick with = this example=20 for a while, so let us go into it in some depth.

Quantity demanded = of processed=20 pork.

Quantity demanded, = Q, is a=20 function, D(.), of the price of pork, p_p, the price of = substitutes=20 like the price of beef, p_b, and the price of chicken, = p_c,=20 and the income of consumers, Y.

[Note: describe = what is meant=20 by a function, and how to interpret this equation]

Using statistical = techniques,=20 some economists came up with a linear approximation of this = function.

If we just want to = focus=20 attention on the relationship between the price of pork and the quantity = demanded of pork, we hold other prices and income=20 constant.

P_b=3D4,=20 P_c=3D3.333, Y=3D12.5 (again, all this is from the=20 book)

Q=3D171-20*p_p+80+10+25

Q =3D 286 =96 = 20*p_p=20 .

Make a table of=20 this:

Price in $ /=20 kg

Quantity in = millions of=20 kg / year

286-20*5 =3D=20 186

286-20*4 =3D=20 206

286-20*3 =3D=20 226

286-20*2 =3D=20 246

286-20*1 =3D=20 266

This is the same = kind of demand=20 schedule as we were looking at in the previous discussion of red wine in = NYS.

Draw this on a=20 graph.

What is on the = y-axis? The x-axis? What is the slope of this=20 line?

What happens if the = price of=20 beef goes from 4 to 5? =20

Think about it = first =96 if the=20 price of beef goes up, should more or less pork be demanded at a given=20 price? =

More =96 a shift = out in the=20 demand curve. At a given = price,=20 more pork will be demanded. = At a=20 given quantity, the price per unit will be higher.

Check the intuitive = answer by=20 working through the math:

From the book:

=20

Let p be the price = of pork=20 after substituting other values

Original=20 scenario:

Q=3D171-20*p+(20*4)+(3*3.33)+(2*12.5)

Q=3D286-20*p

Compared=20 to:

Q=3D171-20*p+(20*5)+(3*3.33)+(2*12.5)

Q=3D306-20*p

If the price of = beef goes from=20 4 to five, and chicken price and income is constant, =

Price

Quantity

306-20*5 =3D=20 206

306-20*4 =3D=20 226

306-20*3 =3D=20 246

306-20*2 =3D=20 266

306-20*1 =3D=20 286

Draw graph. Show = shift.

Note the = distinction between a=20 shift in the demand curve = and movement along a demand = curve. This is critical for your = understanding=20 of supply and demand, so make sure you have it = clear.

A movement along a = demand curve=20 means all else is being held constant and we are moving from one point = to=20 another on a given demand schedule like in the charts we used = before. Another way to think about it = is that=20 there is a shift in the supply curve, leading to movement along the = demand=20 curve. Whatever changed = shifted=20 supply, not demand.

A shift in a demand = curve means=20 something in the all else held constant has changed, so the entire = schedule has=20 shifted and we now have a new schedule.

Note: some types of = change can=20 lead to a shift in both supply and demand (think about the price of gas = for=20 example). We will not = worry about=20 that in this course, and only focus on one shift at a time.Supply.

Supply curve: traces out the amount of the = good firms=20 are willing to sell at a variety of different price levels. Geometric representation of an = underlying supply schedule that describes the quantity supplied at a = variety of=20 given prices per unit all else held constant.

Again, the focus is = on the=20 relationship between the selling price of the commodity and the amount = sold of=20 the commodity all else held equal.

A supply curve = tends to slope=20 upward. Why?

[as we will go into = detail=20 later, as price goes up, more firms can enter the market or existing = firms can=20 produce more since they bid away resources from other alternative = uses]. Corn fields turned into = vineyards. Cattle farms turned into pig = farms.

Draw a basic supply = curve.

Again, we have an = underlying=20 relationship between price and quantity, all else held=20 equal.

What else might = matter that we=20 are holding equal in that =93all else equal=94?

Let us continue to = think of=20 pork, since we are on a roll, and call decreased supply less quantity at = a given=20 price (supply shift up or in) = and=20 increased supply more quantity at a given price (supply shift down or=20 out).

1) =20 Cost of = inputs used=20 in production.

a. =20 Decreased = supply: pig disease wipes = out hog=20 supplies, raising the price of hogs used to make = pork.

b. = Increased = supply: gas prices go = down, making=20 it lest costly to ship pigs to the pork factory.

2) =20 Technology of=20 production.

a. =20 Technology is=20 usually an increased supply story: =20 Cornell researchers develop a new pork processing machine that = reduces=20 processing waste by 4% for the same amount of = input.

3) =20 Government rules=20 and regulations influencing production.

a. =20 Decreased = supply: Government = regulations on=20 waste lagoons become stricter, raising the cost of = hogs.

b. = Increased = supply: Government = regulations on=20 overtime pay change, reducing total labor costs without reducing labor=20 input.

=20

Consider the = example of the=20 supply of processed pork presented in the book.

Where Q_s = is the=20 quantity supplied of processed pork, S (.) is the supply function, = p_p=20 is the price of processed pork, and p_h is the price of=20 hogs.

[Note the example = does not=20 follow exactly the three influences described above =96 it is assumed = there is no=20 variation in technology or regulations and the only relevant cost of = production=20 is the cost of hogs]

Through the magic = of empirical=20 methods (which you are learning in other classes and is not what we are = worried=20 about here), the following approximation of the supply function was=20 estimated.

Q_s=3D178+40*p_p-60*p_h

What does this tell = you:

The price of = processed pork=20 goes up, the quantity supplied goes up.

The price of the = input used to=20 make pork goes up, the price goes down.

There is=20 something to the idea that economics is formalizing the obvious. You are learning the language = of=20 economics, but this should be pretty intuitive. = Like we did before, we = can simplify=20 by using the sample average price of hogs of = $1.50.

This gives us the = simple=20 relationship: =20

Q^s=3D88+40*p

Price

Quantity

88+40*5=3D288

88+40*4=3D248

88+40*3=3D208

88+40*2=3D168

88+40*1=3D128

We can draw=20 this.

[graph]

Now, return to the = idea that we=20 had the all else held equal condition applied to the price of the input = of=20 hogs. What if it goes=20 up?

Let us say it goes = from $1.50=20 to $2.00.

Q_s=3D178+40*p_p-60*p_h

We go from = Q^s=3D88+40*p to=20 Q^s=3D58+40*p

Price

Quantity

58+40*5=3D258

58+40*4=3D218

58+40*3=3D178

58+40*2=3D138

58+40*1=3D =20 98

Shift is up / = left. Less is supplied at a given = price.

[graph]

Note on supply and = demand=20 graphs:

The first people in = economics=20 to draw these drew it backwards from the way math works and from the way = we have=20 been talking about it. =20

Usually in math, = the x axis is=20 the variable, and the y axis describes a function of this variable, as = in=20 y=3Df(x). Here, we talk = about=20 quantity as a function of price (q =3D f(p)) , but price is on the y = axis and=20 quantity is on the x axis. =20 Economists are a funny bunch.

However, recall = that these=20 curves describe the relationship between quantity and price.

We can think about = a change in=20 quantity leading to a change in price or a change in price leading to a = change=20 in quantity =96 either direction of causality could = apply.

We could redefine = Q^s=3D88+40*p and = Q^s=3D58+40*p by=20 rearranging terms:

Q^s=3D88+40*p,=20

so divide through = by 40,=20 (1/40)Q^s=3D(88/40)+(40/40)p, =

so (1/40)Q^s=3D2.2+p,

so = -p=3D2.2-(1/40)Q^s,=20

so p(when price of = hogs =3D=20 1.50)=3D (1/40)Q^s-2.2=20

Q^s=3D58+40*p

[repeat same steps = if=20 needed]

Leads = to:

p(when price of = hogs =3D 2.00) =3D=20 (1/40)Q^s-1.45

p=3D0 intercept for = 1.50 graph is=20 88, p=3D0 intercept for the 2 graph is 58.

Of course, p is not = ever zero,=20 so we should think of this as the logical extension of the line, but not = a=20 prediction. Sometimes = called the=20 =93tyranny of the straight line=94, or less dramatically, being off the = support of=20 the data.

Sometimes this = helps make sense=20 of the math relating to the = graph.