Microeconomics and Policy Analysis PUAF 640

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Microeconomics and Policy Analysis PUAF 640

• Professor Randi Hjalmarsson
• Fall 2008
• Lecture 1

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Class Outline Chapter 1

• Introduction Administrative Tasks
• Cost-Benefit Principle
• Supply and Demand Model
• Supply and Demand Curves
• Shifts in curves
• Equilibrium (graphically)
• Price ceilings and floors

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Introduction Administrative Tasks

• A little bit about myself
• Print names on name cards please bring these to
  class throughout the semester!
• Use UMEG email distribution list if you want to
  receive emails to a different address, please
  edit your email in the system.

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TAs and Sections

• We have two TAs
• Allen Lo allenlo_at_umd.edu
• Seracia Arter sarterlsu_at_gmail.com
• Discussion Section Times
• Tuesdays 700 930 with Allen
• Wednesdays 130 400 with Seracia

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Syllabus see handout

• Class participation (let me know you are awake)
• Ask questions!
• Answer questions!
• Stop me if Im going too fast .
• Course materials
• Katz and Rosen textbook
• Class lecture notes (primary resource)
• Articles given out in class
• Selected assigned readings/articles to be done
  before class

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The Economic Naturalist In Search of
Explanations for Everyday Enigmas

• Robert Frank
• Collection of student essays
• Assignment Use principle from course to answer
  an interesting question about events or behaviors
  that you observe.
• Economics is relevant for everyday life.
• Sometimes its obvious, but not always
• Will discuss some of the key principles taught in
  this course with references to The Economic
  Naturalist (EN)

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A word of caution

• We draw LOTS of graphs in this class!
• Power point may make it seem easier than it is.
• Practice drawing the graphs in the lecture
  notesyou WILL be expected to replicate them.

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Lets get started

• What is microeconomics?
• Study of the allocation of resources, goods, and
  services from the individuals point of view.
• Individual can be consumer, firm, household, etc.
• Why must you study micro in a policy school?
• Examine the role of the government
• How does policy affect resource allocation and
  individual decisions/behavior?

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How do government activities and policies affect
resource allocation?

• As purchasers/suppliers of activities
• 30 of GDP goes to taxes
• 21 is spent directly on state, local, and
  federal government activities schools, roads,
  hospitals...
• Regulate market activities
• Price controls rent control, minimum wage
• Quality controls consumer safety
• Quantity controls quotas (visas), pollution
  permits

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How do government activities and policies affect
resource allocation?

• Develop and maintain legal system to define
  property rights e.g. patents
• Redistribution of income and services, since
  market may not originally allocate in fairest or
  best possible way
• Farm subsidies
• Poverty programs (rich to poor)
• Social security (young to old)

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Cost-Benefit Principle (EN)

• Take an action if and only if the extra benefit
  from taking it is greater than the extra cost.
• Will see throughout the course!

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Cost-Benefit (EN) Example 1

• You are about to buy a 20 alarm clock at the
  campus store next door when a friend tells you
  the same clock is available for 10 at the Kmart
  downtown. Do you go downtown and get the clock
  for 10? Or do you buy it at the nearby campus
  store? Either way, if the clock malfunctions
  under warranty, you must send it to the
  manufacturer for repairs.
• No right or wrong answer. Each of you must weigh
  the relevant benefits and costs.
• Most people in Franks experience say Kmart.

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Cost-Benefit (EN) Example 2

• You are about to buy a laptop for 2510 at the
  campus store next door. You can get the same
  laptop downtown at Kmart for 2500 (and it comes
  with the same guarantee). Where would you buy the
  laptop?
• Now most people say the campus store.
• By itself, not a wrong answer.

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Cost-Benefit (EN) Example 2 (contd)

• But, the cost-benefit principle indicates that a
  rational person should choose to do the same
  thing in both cases.
• Benefit of going downtown is always 10.
• Cost is whatever you assign to the hassle of
  going downtown.
• People seem to think that saving 50 on the clock
  is better than saving 10 on the 2510 laptop.
• Thinking in terms does not work well here.

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Cost-Benefit (EN) Example 3

• You have two business trips coming up and a
  discount coupon you can use on only one of them.
  You can save either 90 on your 200 trip to
  Chicago or 100 on you 2000 trip to Tokyo. For
  which trip should you use your coupon?
• Tokyo saving 100 is better than 90.

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Supply and Demand Model

• Model
• Describe phenomena while abstracting away from
  reality. They are greatly simplified!
• Can be mathematical, verbal, or graphical.
• Supply and Demand (S/D) model is the most
  important tool of this class!
• Very simple but explains much about resource
  allocation.

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Supply and Demand Model

• The S/D model is a means to determine how a good
  is allocated in a market.
• The distributive tool is the price (though it
  doesnt have to be)
• College Park rental apartment market.
• How many of you would rent a 1 bedroom for 2000?
• If this is the price, then consumers will find
  alternative options, there will be a stock of
  empty apartments, and prices will be pushed down.

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Characteristics of the market

• Numerous buyers, all are price takers.
• Numerous sellers, all are price takers.
• Every agent is very small.
• The good is relatively homogenous abstract away
  from quality.
• There are two sides to a market
• Buyers (demand side) and sellers (supply side)

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Demand Side

• Demand Schedule
• Tells us how much is purchased at each and every
  price (holding all else equal).
• Quantity is a function of the price QDf(P)
• Measure of how much people are willing to pay for
  a product or a summary of the benefits they feel
  they receive from consuming it.
• People will keep buying more of a product as long
  as the value they assign to the last unit
  consumed is at least as great as its price
  (cost-benefit principle again!).

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Demand Schedule CD Market

• We can also graphically depict a demand schedule
  as a curve.
• Demand curve.

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Drawing a demand curve
P
8
5
3
QD
1
Q (000s)
20
40
60
80
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Demand Curve Comments

• Price informs quantity!
• But P is always on the y-axis!
• Yes, this is backwards of what you would expect
  from your graphing experience.
• As Price Increases, Quantity Demanded Decreases.
• That is, Demand Curves slope down.
• (There are exceptions, but rare. 2-3 not always
  true.)

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Demand Curves Continued

• Law of Demand
• This is the notion that price and quantity
  demanded are inversely related.
• We move along a demand curve as we change the
  price of a good, holding all else equal.
• The quantity demanded changes. The demand curve
  itself doesnt change.
• Giffen Goods As price increases, quantity
  demanded increases.
• Law of demand not satisfied. Demand curves do not
  slope down.

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What would cause a shift in the demand schedule
(i.e. the demand curve moves)?

• Change in consumer income people can afford to
  buy more at the same price
• Normal goods versus Inferior goods.
• Prices of other products
• Complements versus Substitutes.
• Changes in consumer tastes or preferences

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Changes in consumer income

• Normal Good Increase in income leads to an
  increase in the quantity demanded.

• Inferior Good Increase in income leads to a
  decrease in the quantity demanded.

D2
D1
D1
D2
P1
P1
Q11
Q21
Q11
Q21
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Normal versus Inferior Goods

• Most goods are normal goods!
• Examples of inferior goods
• Potatoes
• Ramen noodles

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Prices of other products

• Complements If the price of good X increases,
  then the demand for good Y will decrease if X and
  Y are complements
• Examples
• Gasoline and cars
• Peanut butter and jelly

• Consider market for peanut butter and increase in
  price of jelly.

D1PB
PB
D2
PB
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Prices of other products (contd)

• Substitutes - If the price of good X increases,
  then the demand for good Y will increase if X and
  Y are substitutes
• Ex. If price of bread increases, maybe expect
  increase (rightward shift of demand) for
  crackers.
• Other examples
• Hondas and Toyotas
• Beer and wine

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Changes in consumer preferences

• Example Atkins craze
• People dont want carbs
• Demand curve for goods like donuts shifts left.
• At each price, the amount of bread demanded
  decreases.
• Other examples
• Fashion trends?
• Changes in taste for discrimination?

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Review Change in Quantity Demanded versus Change
in Demand

• A Change in this Variable
• Represents a movement along a demand curve
• Shifts a demand curve.
• Shifts a demand curve.
• Shifts a demand curve.
• Shifts a demand curve.

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Policy Question What is the effect of alcohol
policies on marijuana use?

• Drinking age, taxes, campus drinking policies
  are meant to raise the price of underage
  drinking.
• What effect do you expect the increase in the
  price of alcohol to have on demand for marijuana?
• What does the answer depend on?
• Many empirical studies look at this relationship.
  At least one finds that alcohol and marijuana are
  complements.

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Supply Side

• Supply Curve (not to scale)

QS
5
1
(000s)
73
9
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Supply Curve Comments

• Supply curves slope up. Why?
• As prices increase, firms can make greater profit
  (will come back to this later).
• QS f(P)
• Supply schedule is the relationship between the
  market price and the amount producers are wiling
  to produce, holding all else equal.
• As price of a good increases, we move along a
  supply curve.
• Producers will keep offering products as long as
  the price for which they sell it is at least as
  great as their marginal cost (cost-benefit
  again!).

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What causes shifts in the supply schedule?

• Changes in technology improving technology
  allows producers to produce more at a given price.

S1
S2
P1
Q2
Q1
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What causes shifts in the supply schedule?

• Changes in prices of inputs if the price of
  flour increases, then firms will be willing to
  produce less bread at a given price.
• Increase in the price of an input shifts supply
  curve inward.

S2
S1
P1
Q1
Q2
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Combining supply and demand sides

• Equilibrium
• Situation that persists because no one has any
  incentives to change behavior
• Equilibrium in S/D model
• There exists a price at which the quantity
  demanded equals the quantity supplied.
• QD(P) QS(P)
• Hear economists say that a market must clear
• There is a price at which QD QS the market
  clearing price.

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Graphical Example of Equilibrium

• What happens at P31?

QS
P 32
QD
Q700
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Shifts in Supply or Demand Curves Yield New
Equilibriums

• SUV Market
• Increase in price of gas
• SUVs and gas are complements
• What happens to SUV demand?
• Decreases (left shift)
• New equilibrium
• Lower price and quantity

QS
SUV
P1
P2
QD1
QD2
Q2
SUV
Q1
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The Great Xbox Shortage of 2005

• Phenomenon Supply shortage of most popular toys
  at Christmas.
• What is the economic puzzle?
• Puzzle is not the shortage itself.
• Why dont companies raise prices when supply is
  short? Shortage only occurs if price is to low.
• Potential explanations for the puzzle?

S
P
D
QD
QS
If price is set below equilibrium or market
clearing price, then there will be a supply
shortage or excess demand (difference between QD
and QS).
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Rent Control Market Distorting Policy

• Price ceiling Legal max. on the prices that may
  be charged for a commodity.
• No ceiling ? P, Q.
• Ceiling ? excess demand or a housing shortage.
• Only occurs if PC
• Problems from rent control?
• Discrimination in choosing tenants.
• Bribes.
• Poor maintenance.

(Rent)
S
P
PC
D
Q
QD
QS
H
Housing Shortage
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Minimum Wage Market Distorting

• Price Floor A legal minimum below which a
  commodity price cannot fall.
• Should there be a sub-minimum wage for teens?

• Adult Labor Market Teen Labor Market

SA
w
w
ST
W
DA
wmin
W
DT
QEmploy
QEmploy
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Minimum Wage Market Distorting

• At common minimum wage, adult market equilibrium
  is above minimum wage.
• But there is excess supply of workers in the teen
  market. There is teen unemployment.
• Raising the minimum wage would increase teen
  unemployment.
• Maybe an argument to have a lower minimum wage
  for teens?

w
ST
wmin
W
DT
QEmploy
QD
QS
UNEMPLOYMENT
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Some In-Class Exercises (1)

• Quote from Financial Times article
• Two years ago, a camel cost little more than a
  goat, which is nothing. The price has since
  tripled. (in India)
• Why are market prices for these ships of the
  desert rising?
• Rising oil prices!
• Substitute from tractors (which become more
  expensive) to camels.

camels
S
P
P
D
D
Q
Q
camels