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Economics 349 Intermediate Micro Theory

Fall 2007 Dr. Delemeester

Course Essentials
 Course Web Page

www.marietta.edu/~delemeeg/econ349 Exams (60%) Problem Sets (25%) Spreadsheet Projects (15%)

 Grade
  

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) b) c) d) e) My interest in the material The amount of time I put into the class The instructor’s ability to inspire me My mathematical skills None of the above.

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in te re Th st e am in. ou .. Th nt e in o. st .. M ru y ct m o at he r.. N m on at e ic of .. th e ...
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     

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) b) c) Solar energy will be used increasingly over the next 100 years. Mergers between two companies should always be allowed. An increase in advertising by one major auto company will affect the sales of the other auto companies. If the US government lifts the current sugar quotas, the price of sugar will fall and the corny syrup industry will suffer.
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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 The practice of buying a product at a low price in one location and selling it for more in another location

Arbitrage

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)
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b)

d)

a)

c)

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e)

Market Model

Consider the demand for beer during the summer months. Let Qd = 30 – 5P + 0.01I – 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 Qs = -100 + 20P

f)

b)

Plot the supply and demand curves if I = $20,000 and R = 15. What is the equilibrium price and quantity? 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

RealPrice =
baseyear

CPIbase year CPIcurrent year

x Nominal Pricecurrent year

Real Price of College
Year 1970 1990 2006 Nom. Price $2,530 $12,018 $22,218 CPI 38.8 130.7 201.6 Real Price

=

38.8 * $2,530 $2,530 = 38.8

38.8 = * $12,018 $3,569 = 130.7
= 38.8 * $22,218 $4,276 = 201.6

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.
Year 1970 1977 1989 Gasoline Price ($/gallon) 0.28 0.58 1.10 CPI (1982-84=100) 38.8 60.6 124.0 0.37 0.34 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
(annual cost
in 1970 dollars)

P

S2006
New equilibrium was reached at $4,276 and a quantity of 17.3 million students

$4,276

S1970

$2,530

D1970
8.6 17.3

D2006 Q
(millions
enrolled))

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

∆Q %∆Q D ∆Q Q P E EP = =D = ∆P P ∆P ∆P % Q
D P

Price Elasticity of Demand
Usually a negative number
As price increases, quantity decreases  As price decreases, quantity increases

When |EP| > 1, the good is price elastic

|%∆Q| > |%∆P| |%∆Q| < |% ∆P|

When |EP| < 1, the good is price inelastic

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
Price 4

EP = -∞
Elastic

Demand Curve Q = 8 – 2P

2

Ep = -1 Inelastic

4

8

Q

Ep = 0

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
Price

EP = ∞
P*

D

Quantity

Completely Inelastic Demand
Price

D

EP = 0

Q*

Quantity

Other Demand Elasticities
Income Elasticity of Demand

Measures how much quantity demanded changes with a change in income

∆ Q/Q I ∆ Q EI = = ∆ I/I Q ∆ I

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

EQb Pm

∆Qb Qb Pm ∆Qb = = ∆Pm Pm Qb ∆Pm

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

%∆Q S E = %∆P
S P

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: QS = 1800 + 240P Demand: QD = 3550 – 266P

Elasticity: An Application
QD = QS 1800 + 240P = 3550 – 266P 506P = 1750 P = $3.46 per bushel Q = 1800 + (240)(3.46) = 2630 million bushels

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

P ∆QD 3.46 E = = (−266) = −.035 Q ∆P 2,630
D P

P ∆QS 3.46 E = = ( 240) = .032 Q ∆P 2,630
S P

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

QD = 3,550 − ( 266)(4.00) = 2,486

4.00 E = (−266) = −0.43 2,486
D P

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