Microeconomics B: Consumption, Production, Welfare

1. Microeconomics B:Consumption, Production, Welfare Univ. Prof. dr. Maarten Janssen University of Vienna Winter semester 2013

2. Applied Micro Theory • Microeconomics • Look at decisions of economic units and how they interact in a market environment • Units: household and firms (no economics of organization questions • Market interaction (no strategic issues, game theory) • Applied • What type of micro is used to think about economic issues in the real world • Course talks about applications (see literature list) • Theory • Theory organizes the way we think about issues. Masters curriculum cannot do without it

3. Practicalities • Slides, course description on my website • Combination of theory (textbook), some applications (articles) • Lectures (general overview), tutorials (exercises) • Try exercises, read literature • Grading • one midterm (35%), one final exam (45%) • one homework sets handed in and be active in the tutorials by providing solutions in class (10%) • write one small essay (3-4 pages) analyzing a recent issue that has been in the news from a microeconomic perspective (10%). • Interaction in class

4. Normative and Descriptive Econ • Economics is used in two ways: • Descriptive: trying to explain, predict what has happened or will happen • Normative: what should (not) happen (or what is good from some perspective) • We sometimes change perspective (when convenient)

5. Monopoly One firm serves the “relevant market” What does a firm have to decide? - How much to produce and at which price - In IO also, other choices: Which products to produce? How to make itself visible to consumers? How much to invest in R&D? Micro studies first question only Objective: maximize profits What does a firm need to know? - Revenue (demand) side - Cost side

6. Monopoly • The only firm in the market • market demand is the firm’s demand • output decisions affect market clearing price Marginal revenue from a change in price is the net addition to revenue generated by the price change = G - L €/unit Loss of revenue from the reduction in price of units currently being sold (L) P1 Gain in revenue from the sale of additional units (G) L P2 G Demand Q1 Q2 Quantity

7. Marginal Revenue Monopolist P Demand Q Q Marginal revenue = Elastic Inelastic Total Revenue (€) MR Total revenue=PQ

8. Cost Analysis Type of Costs Fixed cost (FC) Variable cost (VC) Marginal cost (MC) Total cost (TC) Sunk cost Opportunity cost

9. MC P ATC Q Two important cost curves Average total cost curves are typically first decreasing and often then increasing (when the availability of some production factors becomes a limiting factor

10. MC P ATC Q Profit maximisation Monopolist Profit PM ATC D QM MR Profit π = P(Q)Q – C(Q) Pricing rule

11. Seems we do not need much to start economic analysis, although …. • When we think more the above does not tell very much: • Where is this analysis relevant? When do we know we have a monopolist? • Does this explain or predict what a monopolist does, or is it prescriptive (normative)? • And at what level: is the price setting behaviour relevant, or the maximization of profits? Should a firm maximize profits? Or should it set these prices if it maximizes profits? • If this is descriptively (more or less) correct, should we from a society’s point of view be happy about this outcome? • Presumably define a market by closeness in substitutability of the commodities involved • how close is close? • how homogeneous do commodities have to be?

12. What is a market? • No clear consensus • the market for automobiles • should we include light trucks; pick-up SUVs? • the market for soft drinks • what are the competitors for Coca Cola and Pepsi? • With whom do McDonalds and Burger King compete? • Presumably define a market by closeness in substitutability of the commodities involved • how close is close? • how homogeneous do commodities have to be?

13. General methodology • Investigate to what extent goods are substitutes for each other • if one firm/product changes its price to what extent is demand for another firm/product affected? • If the answer is “quite a bit”, then products are in one market • One important measure is cross price elasticity • SSNIP test / cellophane fallacy

14. Example 1: printers and cartridges • There are different printer brands that can be connected to your PC. Each brand has a cartridge that only fits its own design printer • Is there a market for printers that includes the cartridges and their replacement? • Should we define a separate market for cartridges (implying that there is a separate market for every brand and that each firm has monopoly power over consumers that have bought their brand)?

15. Example 2: soft drinks delivery to bars • Bigger firms like Coca-Cola supply soft-drinks to bars (wholesale market). A bar wants to have different soft drinks on offer. Coca-Cola and Ice Tea are complements for the bar (not for the final consumer) • Is there a market for soft drinks? • But Pepsi and Coke are probably also not complements for the bar ….

16. Firm is a complex entity • Firm’s behaviour results from complicated interaction between different individuals having different motives, information • Economics of organization (principal-agent theory) • Does this imply profit maximization would just be a lucky coincidence? • If firm would not be profit maximizing, it can (or will) be taken over? • In long run only those firms survive that do maximie profits? • In this course, firm is profit max entity

17. Is monopoly outcome desirable? • From a society’s point of view, economists adopt notion of Pareto efficiency • An outcome is Pareto-efficicientif there does not exist another possible outcome such that no decision maker is worse off and at least one is strictly better off. • Decision-makers: the monopolist, consumers • Monopolist better off if it makes more profit • Consumers are better off when?

18. Demand curve is expression of consumers’ choices • Consumers want to improve their well being: at each hypothetical price they choose how many units they want to buy (instead of buying something else) • The last unit they buy improves well-being by a certain “amount”. • If price is higher, they would not buy this unit • If price is lower, they would consider buying another “unit” (if commodity is divisble) • Price equals marginal willingness to buy for additional unit

19. MC P ATC Q Is monopoly outcome Pareto efficient? Profit PM ATC D QM MR What if monopolist could produce one more unit and would be able to charge a different price just for that unit? Why would the monopolist not do that?

20. Rest of this course • Consumer choices: • To be able to make welfare judgments we have to have a measure of consumer well being and better understand how choices are made • Also choice under uncertainty • Producer choices: • Cost curve is also outcome of choice made by the firm • Markets bring consumer and producer choices together • Prices equilibrate supply and demand • Welfare economics • Pareto efficiency of perfectly competitive markets • All these topics are discussed balancing theory and applications