ECN113 Principles of Economics

2019-20

Lecture notes/workbook

Note: You will need to add your own notes to these notes during and after the lectures.
Therefore, the ideal printing format is one page per A4 sheet.
Printing smaller than 2 pages per A4 sheet would make the notes largely useless.
ECN113 Principles of Economics:

some well-known points:

- scarcity is of fundamental importance for economics
- models will be better if they are more realistic
- more information gives (strategic) advantage
- monopolists can increase prices without limits
- price guarantees can only be good for consumers
- Pareto efficiency implies equality
- tax to reduce pollution is ineffective if demand price-inelastic
- credit crunch was due to mistakes of bankers

all obvious ??

note: we will question each of these points

Principles of Economics:

Economics is about

magic word:
The Economics view of reality:
Scarcity and Economics

Some reasons why one might argue 'scarcity' is not

fundamental (defining) concept of Economics:

1) often not helpful

2) "unlimited wants" ??

3) if "relative scarcity":
half-scarce = half-abundant
(half-empty = half-full)
Economics is about
'agents seeking to do the best they can',
about their actions and interactions,
and the outcomes of these (inter)actions.

Thus, to consider:

1) opportunities
actions
2) preferences

3) interactions

4) outcomes
 A production possibility curve
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5 Units of food Units of clothing

(millions) (millions)

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7m 2.2m
3 6m 4.0m
5m 5.0m
4m 5.6m
2 3m 6.0m
2m 6.4m
1m 6.7m
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 The demand curve:
The demand for potatoes (monthly)

(1) (2) (3) (4)

Price Tracey's Darren's Total market
(pence per kg) demand demand demand
(kg) (kg) (tonnes: 000s)

A 20 28 16 700
B 40 15 11 500
C 60 5 9 350
D 80 1 7 200
E 100 0 6 100
 Market demand for potatoes (monthly)
E Point Price Market demand
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A 20 700
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C 60 350
C D 80 200
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 The determination of market equilibrium
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 Effect of a shift in the supply curve
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 Stabilising speculation: initial price fall
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 Destabilising speculation: initial price fall
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The Science of Economics
- "story telling"
- theories and models are 'stories' (narratives)

- verbal
- plastic
- mathematical
- computational
- all models are 'wrong' (abstractions)
- but some are considered 'acceptable'
- some possible criteria:
- usefulness
- logically correct
- consistency with reality
- parsimony (simplicity)
 Market supply and demand

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 Measuring elasticity using the arc method


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Why does price elasticity matter?

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2)

3)

4)
 Elastic demand between two points

Expenditure falls
as price rises

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 Effect of a tax on the supply curve
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 Incidence of tax: inelastic demand
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 Minimum price: price floor
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surplus
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Effect of price control on black-market prices
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 The market for an illegal drug
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Some economic effects of making drugs illegal

Positive:
1)
2)

Negative:
1)
2)
3)
4)
5)
 Darren’s utility from consuming crisps (daily)


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 Effect of an increase in income on the budget line



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 Finding the optimum consumption
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 Effect of a rise in income on the demand for an inferior good
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 Income and substitution effects: normal good

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 Income and substitution effects: Giffen good

(where is point g?)

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Substitution and income effect

price subst. effect + income effect = total effect

Px Dx + Dx = Dx

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 Total utility of income

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asymmetric information:
one side knows more than other side
example 1: Market for lemons
suppose: second-hand cars in range £0 - £10,000
 expected value:
maybe people do not optimise as rational consumers in textbook

two questions:

1) if consumers do not optimise as in textbook,

why may textbook analysis still be useful?
- benchmark

- starting point more sophisticated analysis

- "as if" optimising as in textbook

2) if considering irrational behaviour: anything goes?

regular patterns in irrational behaviour
(e.g. Dan Ariely experiments)
Sunk costs

Suppose: concert, it rains

- Would a rational individual go?

- Should the price of the ticket matter?

Supply

essential story:
0) deriving individual supply from cost function

background, variations, etc.:

1) background to cost function: - production function

2) choice production factors: - isoquants, isocost curves

3) short run v. long run: a) LRAC

b) sunk costs: entry, exit
c) free entry: long run equil.

4) market-power: - downward-sloping demand

(Supply 0)

Total revenue for a price-taking firm

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Deriving a firm’s AR and MR: price-taking firm

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Total costs for firm X

Output TFC TVC
(Q) (£) (£)


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 2 12 16
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4 12 28
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Marginal cost
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Diminishing marginal
returns set in here
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Wheat production per year from a particular farm

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Wheat production per year from a particular farm

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isoquants and isocost curves

Two ways to combine them:

1) Given one isocost,

2) Given one isoquant,

(Supply 3a)

Deriving long-run average cost curves: factories of fixed size

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A typical long-run average cost curve

LRAC
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Average and marginal costs

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Short-run equilibrium of industry and firm under

perfect competition

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(a) Industry (b) Firm

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alternative market structures

Classifying markets by degree of competition

• number of firms
• freedom of entry to industry
• nature of product
• nature of demand curve

The four market structures

• perfect competition
• monopoly
• monopolistic competition
• oligopoly
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Finding maximum profit using total curves
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AR and MR curves for a firm facing a downward-sloping D curve

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Finding the profit-maximising output using marginal curves

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Profit maximising under monopoly

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why monopoly?
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2)
 Natural Monopoly
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 A contestable monopoly
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 First-degree price discrimination
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 Profit-maximising output under
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oligopoly
- collusion:

- models of 'not-so-strategic' interaction:

- strategic interaction:
 Profit-maximising cartel
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 Dominant firm price leadership
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Division of the market between leader and followers
 Kinked demand for a firm under oligopoly
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and quantity
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on demand curve
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case study: NYC stereo wars
• Crazy Eddie: "We will not be undersold.
Our prices are the lowest - guaranteed.
Our prices are insane"
• Newmark & Lewis: "lifetime low-price
guarantee" : if lower price found
elsewhere: refund 200% difference

• tough competition, good for consumers ! ?

• suppose:
• now: Crazy Eddie lowers price to

Where should you buy?

• You pay

• thus

• effectively
• but what about Crazy Eddie?

• 'price guarantee' solves some problems

for cartel:
-
-

Are lowest price guarantees good for

consumers?
game theory

forget:
- compromise strategy
- maximin strategy
- maximax strategy

focus on:
- best-responses:

- dominant strategies:

- Nash equilibrium:

- subgame perfect Nash equilibrium:

 The prisoners' dilemma

Amanda's alternatives
Not confess Confess

A B Nigel gets
Not 10 years
Each gets
confess Amanda gets
1 year
Nigel's 3 months
alternatives C Nigel gets D
3 months Each gets
Confess 3 years
Amanda gets
10 years
 A decision tree

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(1)
ate Airbus –£10m
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se
Airbus +£50m
0
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0 Boeing +£50m
se at er (3)
at se Airbus +£30m
e r 500
B2 400
sea
Airbus ter
decides Boeing –£10m
Airbus –£10m
(4)
 A labour market: whole market

Sall workers
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 A labour market: individual worker

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 Backward-bending supply curve of labour
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 The choice of hours worked at different wage rates

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 The profit-maximising level of employment
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 Monopsony
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 Bilateral monopoly
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employment

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efficiency:

- Pareto efficiency (=Pareto optimality):

- Pareto improvement:

Pareto efficiency:
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analysis perfectly competitive markets:

wonderful result, because:

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1)

2)
Maximum total surplus under perfect competition
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some conditions Pareto efficiency:

-
-

what to do with externalities?

1)

2)

3)
 External costs in production
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Using taxes to correct a market distortion (“first-best” world)
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public goods:

two characteristics:
1)

2)
more examples of public goods:
Monty Python's Life of Brian:
"What have the Romans ever done for us?"
1 aqueduct
2
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5
6
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 A monopolist producing less than the social optimum
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why might firms not maximise profits?

1)

2)

3)
two questions:

if firms do not optimise as in textbook,

1) why may textbook analysis still be useful?

- benchmark

- starting point for more sophisticated analysis

- perhaps firms sometimes behave "as if" optimising

along lines textbook

2) what do firms do instead?

satisficing
sales maximization
mark-up pricing
.....
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 How do UK companies determine their prices?

1st % 2nd % 3rd %

Market level 257 39 140 21 78 12

Competitors’ prices 161 25 229 35 100 15
Direct cost plus variable mark-up 131 20 115 18 88 14
Direct cost plus fixed mark-up 108 17 49 8 42 6
Customer set 33 5 52 8 47 7
Regulatory agency 1 2 3 1 5 1
 Factors leading to a rise or fall in price

Rise Number % Fall Number %

Rise in material costs 421 64 Fall in material costs 186 28

Rival price increase 105 16 Rival price reduction 235 36
Rise in demand 101 15 Fall in demand 146 22
Prices never rise 26 4 Prices never fall 75 12
Rise in interest rates 18 3 Fall in interest rates 8 1
Higher market share 14 2 Lower market share 69 11
Fall in productivity 5 1 Rise in productivity 22 3
Top 7 of Things-to-Avoid with respect to your ECN113 exam

1) Not mastering something that is included in the lecture notes

posted on QMplus.
2) Not mastering something that is included in the workshops
discussed in class.
3) Drawing Demand/Supply curves in a graph in which you put Price
on the horizontal axis and Quantity on the vertical axis.
4) Elementary numerical mistakes, such as 70 x 70 = 1400 or
or (70x70)/2 = 70.
5) Drawing linear functions as anything that is not
(approximately) a straight line.
6) Computing the Marginal Revenue or Marginal Costs by taking
the first derivative with respect to the Price rather than Quantity.
7) Adding a bunch of irrelevant curves to your graphs.