FPM (Term I): Microeconomics

Lecture #1

24th June 2013

Introduction
Lecture #1: Lecturer: Scribe: 24th June 2013 Arnab Mukherji Dr. None

Course Goals

This course is the rst course in a series of 2 - 3 courses in microeconomics that presents foundational material that will be subsequently built on in the microeconomics courses, as well as having natural links to courses in other areas; for example Public Choice (Policy Area), Brand Selection Models (Marketing Area), Portfolio Choice Models (Finance and Control), and many others. For some of you this will be the rst and last course in microeconomics and thus, the course attempts to cover a wide spectrum of topics. To give a avor of research an attempt is also made to cover a couple of journal papers to introduce the idea of modeling research ideas that you may wish to carry into your work.

At the end of the course it is expected that: Think like an economist: formulate simple models to real-world phenomena Explain like an economist: explain incentives, costs and behavior of agents using microeconomic concepts Read like an economist: understand and explain to others crux of journal articles To do all this we will:

FPM (Term I): Lecture #1 Read articles and descriptions of real-world phenomena and locate the working of economics within it Develop a clear understanding of concepts covered in the course Read and discuss journal articles in class.

Varians wonderful piece on How to Build an Economic Model in Your Spare Time is a great place to visit to concretize many of these ideas. It is also a great place to re-visit whenever you feel the need to model some phenomena. A fairly detailed course outline is up on moodle. Please read it, and make sure you have covered readings suggested for each class, before hand. Particularly, readings out HRV. Finally, evaluation: One mid-term and one end term closed book two hour long exam. Three quizes conducted approximately every 2-3 weeks. The best two will count. Homework will be given, but not graded and are intended for your practice. Ms. Sneha Thapliyal and Mr. Vipul Mathur, senior FPM student from the CPP and ESS areas respectively, are going to be the two teaching assistants for this course. They will be grading the exams, and the quizes, and you may request them to take sessions to clarify doubts at there convenience. The key text for the course is HRV which I understand is available at the IIMB bookshop. If you are looking to use microeconomics concepts, please buy it, its a great book. I still refer to it.

Jargon

Paul Samueleson, the 1970 winner of the Nobel Prize in economics, has written a book titled Economics, that has seen close to 18 revised edition till date.1 It explains many
1

The rst version of this text was published in 1948, and the 19th version, coauthored with William

Nordhouse, was published in 2009 - spanning a remarkable 6+ decades of economic thought.If you wanted

FPM (Term I): Lecture #1

terms, ideas, and concepts used in economics and well talk of some of them during the course. Some of the ones that keep coming back are: Economics: What to produce? How to produce? For Whom to produce? Less jocular denition due to Lionel Robbins studies human behavior as a relationship between ends and scarce means which have alternative uses Trade-o: Not a Win-Win situation - you loose something in return for something else. e.g. would you buy a maruti alto? or a maruti swift? Opportunity Cost: Cost in terms of foregone alternatives for the choice you are making Rationality: Maximizing benet, Minimizing cost, acting in your interest, in the extreme self-centered or selsh even, notion of homo economicus. not real, but not a poor place to start either Optimization: given a scale of success, individuals and rms like to get to the highest possible value of that scale as possible. Intensive vs Extensive Margin: To attend course or not is a decision on the extensive margin; once you have decided to attend the course how many hours you put into the course is a decision on the intensive margin. Long-run and Short-run: context specic: contract duration of a rental shop may be long run, life of a check dam, etc. duration within which you cant change key aspects of your problem is the short term. Theory and Models: Simplied model of reality; Exogenous variable and Endogenous variable: Exogenous variables are variables that we need in our investigation, but which we have no control over; endogenous
to invest in a serious textbook that explains almost any economics concept at the level of this course, then this book continues to be good and encyclopedic in coverage.

FPM (Term I): Lecture #1 variables are those which are determined within the context of the investigation. In the context of studying crime, measures of crime like murder rates, arrest rates, etc. are endogenous, unemployment rates are exogenous (usually!) Positive Theory: Theory based on optimizing behavior Normative Theory: Theory dealing with value judgements Contract: bilateral agreement, usually over some transaction; if you agree to buy one kg of vegetables for Rs 10, you expect to have one kg of vegetables once you have paid Rs. 10

Role of Theory:

A major role of any discipline is to successful establish a causal relationship between two entities of interest - in the case of economics we are interested concepts that explain human behavior. Thus Levitt and Dubnar, in their boot titled Freakonomics, discuss the uctuations in crime rate and try and establish it with respect to the court case in the United States that legalized abortion. Role of theory arises in trying to explain causal links that are not possible through looking at data alone.

Anyone heard of Roe Vs. Wade and its potential relationship with crime?

The Apartment Market:

In this class the term apartment market refers not to a specic place or a shop but rather the set of apartments in a city that are available for rent and the set of people who want to buy apartments. For the purposes of this discussion we will make a number of simplifying assumptions: the rst of these is that all apartments are exactly iden-

FPM (Term I): Lecture #1

tical.2 Additionally, the apartment market is incomplete if either consumers or buyers are absent. Further, throughout this course we will be looking at an economy in which goods are bought and sold are assumed to occur in a private ownership economy - the goods that are being sold and obviously being bought are changing ownership from an individual agent to another individual agent (in the case of rental markets the transfer of ownership is time bound and not permanent as in the case of a sale). We distinguish this from an institutional arrangement in which the good is owned by the state (or the government) and a market transaction simply involves a transfer of possession.3 Thus, a market is dened in terms of the institutional arrangement within which it operates, the private ownership economy, the availability of apartments, the demand for apartments, and a price at which transactions take place. We dont worry about the institutional arrangement for this course, and set about describing how the rest of the components of this market works assuming that the institutions exist.4

Demand Curve : Each individual who is looking to buy an apartment has two pieces of information that is relevant for the market - 1) the number of units, or apartments he wants to buy, which we shall assume is one for now, and the 2) the most that he wants or can pay for that unit. Each person has a price point, suciently high, such that she/he is indierent between buying or not buying an apartment. This is dened as the persons reservation price. Suppose there are n people in the market, then one
2 3

In the real world this is often violated. Why? The former is consistent with an economy which sees market transactions determined by individuals

such as in most free-market economies, often also called capitalist economies, while the later is seen in socialist economies where the state owns most means of production and works on solving the allocation of goods and services in the economy (instead of having the free market decide). This is a crude caricature of both economic systems and interested readers are urged to read works of Pual Sweezy, Michio Morishima, Schumpeter and Paul Samuelson on the functioning of dierent economic systems. We will be concerned with a private ownership economy for the entire course. 4 Why could that be a problem? Read Radford (1945) to look at the economics of exchange within a PoW camp.

FPM (Term I): Lecture #1

can rank them so that each persons maximum willingness to pay for an apartment is: p1 p2 p3 . . . pn . This is sequence of reservation points, along with the number of people who have the same reservation price is called the Demand Curve.

Suppose n = 1, and p1 = Rs.1C then we look on the availability side of apartment units and see if there are owners who are willing to accept a price p1 for their apartment. If no owner wishes to sell at a price less than or equal to p1 then no market transaction takes place. If one owner is willing to accept p1 then there is one transaction in the market and the ownership of the apartment changes hands as the individual looking for the house pays the seller p1 . In case there are more than one sellers in the market who are willing to accept the price p1 it still is the case that only one transaction takes place and only one unit is sold. In this market the single buyers reservation price determines the market price. Is there are a similar reservation price for sellers in the market?

FPM (Term I): Lecture #1

Reservation Curve : The reservation price for sellers i.e. the lowest price at which they are indierent between selling and not selling, is dependent on the nature of the supply side of the market. If there are a number of sellers, and each seller independently wants to sell at the highest possible price then we have the case of a perfectly competitive market.5 The essential idea here is that for a physically nite supply of apartment units, and with no interaction between the sellers themselves, the rst person to sell would be the person with the lowest reservation price, then the next and so on as long as there is a person whose is looking to buy and whose reservation price is below the reservation price of the seller. In the case of the perfectly competitive market, if we look at the reservation price and number of apartments sold space (the x-y plane) then wed have a vertical line.

Market Equilibrium : The market is said to be in equilibrium if there is a steady price at which apartments are traded. In our little model, we can come up with this by plotting the demand curve and the supply curve on the same space and looking at the intersection.
5

This rules out the case in which sellers may be a few in number and may decide to strategically set

price to receive higher prots than the competitive case.

FPM (Term I): Lecture #1

The point of intersection gives us a point (p , q ) at which trade happens - at this price and quantity level, each person looking for an apartment has a reservation price of p or higher and each seller has a reservation price for selling which is p or lower. At exactly p all the apartments in the market are sold and there is no reason for anyone to deviate from this transaction price. Hence this is an equilibrium price. Discuss movements away from the equilibrium. Key: Apartments are assigned to buyers/renters on the basis of the equilibrium market prices. Comparative Statics : Once an equilibrium has been reached, it is often of interest to look at how this equilibrium would change if something in the specication of our problem changed. For example, suppose everyones willingness to pay rose by Rs. 0.01 C, or suppose the stock of available apartments rose. Discuss changes in demand and supply on equilibrium. Discuss idea of converting apartments to condominiums.

Alternative supply structures : Discriminating Monopolist: market dominated by a single seller; idea is to be no longer constrained by the supply curve but to work o of the demand curve - i.e.

FPM (Term I): Lecture #1

dierent persons pay dierent rates for a unit of housing based on their reservation price Ordinary Monopolist: still sole seller, but unable to charge dierent prices. what price should he charge? Maximizes his revenues by maximizing pD(p) where D(p) is the inverse demand curve. Depending on the shape of the demand curve this (surplus) will be maximized at a level below full use of the rental market. Rent Control: Set rent price below the equilibrium price. excess demand - who gets these apartments? rst come st serve .... nothing in our current theory to predict.

Fundamentally, what is dierent across each of these institutions? Sellers and buyers have dierent take homes and to be able to suggest which one is the best we need a way to look at the notion of Pareto Eciency. The basic idea is simple - take any equilibrium arrangement if one can think of another allocation that is also an equilibrium position where either the supplier or demander is better o and no one is worse o then

10

FPM (Term I): Lecture #1

we have made a Pareto improvement, and the original allocation was not Pareto ecient. However, if no such allocation can be found then the current allocation is called a Pareto Ecient allocation. Consider a cake and slice it between two people - when do we have a Pareto ecient outcome?

In our case the ordinary monopolist and the rent control case are not pareto optimal. Ordinary Monopoly - market not fully served and Rent Control because market served incompletely and arbitrarily (i.e. not on the basis of reservation prices). The market is incompletely served in the sense that sellers are forced to transact below their reservation prices.

The Consumers Basic Choice Problem

The primary problem we are trying to characterize at this point in time is the following: How does an individual agent choose the best possible outcome for himself? This question can be decomposed into a number of constituent constructs that we will be discussing in substantial detail over the next couple of lectures. We will return to this question towards the close of todays lectures, for now we will focus on the following aspects: best in terms of? best over? what is it that we are choosing? The rst question is in terms of specifying an objective function that we are trying to optimize. Consider the textbook case of choosing between apples and oranges: what is it that we derive from consuming one apple or one orange? or say two apples and one orange? Presumably part of this is to satisfy hunger, but in choosing between apples and oranges our choice is largely decided on our inherent taste for apples with respect to oranges (or vice-e-versa). What units are this taste for, or preference of, or liking for measured in? In fact what is this preference ? Part of todays lecture elaborates on this

FPM (Term I): Lecture #1 idea.

11

However, we begin with the second part of the problem - suppose we have a scale to measure peoples preferences, called utility for now, what is it that we are trying to maximize our utility over? or put in other words, what are all the available apple-orange combinations available to the consumer over which he is choosing a combination of apples and oranges. We quickly talked over this in our earlier class. First note that in this apple-orange world we can denote our consumption of any pair of apples and oranges as (x1 , x2 ) where x1 0 and x2 0. These restrictions rule out the economically meaningless part of the number line since none of us are consuming negative amounts of apples or oranges. Thus, we are really talking about all consumption bundles in the rst quadrant of the Euclidean space. Each and very possible combination of x1 and x2 is called a consumption bundle and the entire set of consumption bundles may be denoted as X = {x, y |x > 0, y > 0}.

However are all these points aordable? Economics is about studying how to make choices in the face of scarcity - and the rst way of formulating scarcity in the context the consumers choice problem is the idea of a budget constraint. A budget constraint species a ceiling on the amount of expenditure that the consumer can or is willing to make on the goods x1 and x2 . Thus, if one is prepared to make a total allocation of Rs. M on consuming apples and oranges, and the prices of the two goods are p1 and p2 , then we can specify all the feasible bundles in X from which the consumer must choose an allocation that is best for him. We denote this as: p 1 x1 + p 2 x2 M (1)

Note that this set of feasible bundles are dependent on the price-income situation, i.e. (p1 , p2 , M ), that the consumer faces. Changes in these will also lead to changes in the set of feasible bundles which Varian calls the Budget Set.

12

FPM (Term I): Lecture #1

Properties of the Budget Set

Lets graph the budget set. Assuming that you like having more of apples than less of apples and similarly more of oranges than less of oranges, one will operate on the budget line - the place where all the M is spent on buying some combination of apples and oranges. Key things to note here are: The budget line and its intersection with the x1 and x2 axis. The slope of the budget line and its opportunity cost interpretation how the budget set changes with changes in income (M ) how the budget set changes with changes in price (p1 , p2 ) Thinking about changes in the budget set is a very useful way of internalizing a number of real life scenarios that one may want to model. For example, consider t on the purchase of each unit of good 1. This tax aects the government, the shopkeeper as well as the buyer. Assuming that the shopkeeper passes on the entire tax to the buyer, we can say that while the buyer used to pay p1 x1 to buy x1 units of good 1, he would now have to pay (p1 + t)x1 . Varian calls this a quantity tax, we know this more commonly as a sales tax. What does this mean for the budget line?

Discuss value tax (ad valorem) tax.

Discuss lump-sum tax.

Discuss the idea of rationing.

Finally, we close the discussion of the budget with noting a few things; rst of all, note that while do have two prices and two commodities, we in eect have one relative price.

FPM (Term I): Lecture #1

13

Throughout the course well nd that its not the absolute prices or costs that matter, but rather the relative, and thus, we have a single relative price in a two commodity budget, two relative prices in a three commodity world, etc. The commodity whose price is used as the base for everyone else is known as the numerarie. And secondly, often we really care about specifying one commodity in relation to all other commodities one may be buying - this raises the concept of the composite good. A composite good is a combination a whole range of goods whose price is measured simply in Rs. Thinking of one of the commodities that is on the budget set as a composite good allows us to make the discussion more realistic by moving from choosing between apples and oranges, to choosing between apples and everything else that one buys.