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Microeconomics . Price Theory How much does Windows 7 sell for? How much does Linux sell for? If a negligent driver kills an 85 year old woman, how much money will the jury award the estate of the family? In a similar accident, but involving a 20 year old man, how much will the award be?

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Microeconomics
Microeconomics

  • Price Theory

    • How much does Windows 7 sell for?

    • How much does Linux sell for?

    • If a negligent driver kills an 85 year old woman, how much money will the jury award the estate of the family?

    • In a similar accident, but involving a 20 year old man, how much will the award be?

    • How much more money does a white male make compared with a white female make doing similar work?

    • How much more money can you expect to earn over your lifetime with a Master’s Degree from Chulalongkorn University compared with if you did not go to school?


Supply demand
Supply & Demand

  • One of the most persuasive models in the business, social, and behavioral sciences.

  • Wide applications in fields such as

    • Economics

    • Finance

    • Labor

    • Statistics

    • Health

  • Major Goal: Price Determination.


The law of demand
The Law of Demand

  • An inverse relationship between a measure of price and a measure of the quantity demanded.

  • As the price of something goes up less of that something is demanded.

  • What is price?

  • What is demand?


Prices
Prices

  • In microeconomics a price is a ratio that represents terms of trade.

  • Prices, in micro, are real.

  • Opportunity costs represent real prices.

    • In order to get something you have to give something up.

  • We will use monetary units for convenience. Thus Baht or Dollars represent a medium of exchange…dollars per shirt or dollars per baht represent the price of shirts (in $’s) or the price of baht (in $’s).


A model
A Model

  • Maybe your first economic model was the PPF model…it represents prices in real terms:


PPF

  • In this model we see the terms of trade, i.e., how much Y we get (or give up) when we give up (or get) some amount of X.

  • Did you notice the curvature of the PPF? It doesn’t need to be this way, but the curve represents increasing marginal cost. That is a standard (and useful assumption):

    • As we get more X we have to give up increasing amounts of Y.


Goods services
Goods & Services

  • Production is transformation.

  • It might be a physical transformation of resources.

  • It might be a spatial transformation of resources.

  • It might be a temporal transformation of resources.


The law of demand1
The Law of Demand

  • Intuitive.

  • Applicable to individual decision making.

  • Applicable to market activity.

  • Applicable to non-market activity:

    • Demand for drunk driving.

    • Demand for quality of life.


Demand
Demand

  • Demand exists in the output market.

    • For example: demand for automobiles.

  • Demand exists in the input market.

    • For example: demand for labor.

  • Some goods & services are both inputs and outputs.

    • For example: tomatoes.


Market demand
Market Demand

  • Generated from individual demand.

    • For example, at a price of 10 baht

      • Miss Kawita wants 5 units

      • Mr Chayanin wants 4 units

      • Mr Satta does not want any units

      • Miss Utumporn wants 1 unit

    • At this price 10 units are demanded.


Demand may be binary
Demand may be binary

  • At a price of Bt 3.95 million (Mercedes E220 CDI)

    • Richard has zero effective demand – is not in the market

    • Miss Ungkana has non-zero effective demand – is in the market (do not let BMW know this!)

  • Aggregation of many zeroes and ones leads to market demand


The law of demand2
The Law of Demand

  • Sometimes we can quantify Qd and P

  • We might model Qd

  • QdRichard = f(…,P,YRichard, …)

  • QdRichard = a + bP + cY

  • b might be -5

  • c might be .025

  • a represents other determinants


Law of demand
Law of Demand

  • QdRichard = a + bP + cY

  • This is a linear model and looks like this:


Linear demand
Linear Demand

  • If we examine our demand function holding Y constant (=1000) then we have

  • Qd = 35 – 5P

  • This is the same as

  • P = 7 – Qd/5

  • Graphing P against Q – Alfred Marshall


P 7 q d 5
P = 7 – Qd/5

  • Which Graphs as:


Demand as willingness to pay
Demand as Willingness to Pay

  • The demand function for an individual represents the maximum amount of money that a person would be willing to pay to purchase a given quantity of a good or service.

  • The law of demand in this case is a reflection of diminishing marginal utility.

  • Marginal: incremental.


The supply function
The Supply Function

  • If I offered to buy all the chocolate chip cookies you brought to class on Saturday for Bt 1000 each, how many cookies would you bring?

  • If I offered to buy all of the cookies you brought for Bt 2 each, how many would you bring?

  • In this sense, the Supply Function represents the minimum amount of money a person would be willing to accept to provide a given quantity of a good or service.


Supply preview
Supply Preview

  • Because of the profit motive there is a direct or positive relationship between the quantity supplied of a good or service and its price.

  • We might model this like:

    • Qs = f(…, P, …)

    • Qs = 10P, for example.


Equilibrium
Equilibrium

  • When we have a demand function (Qd) and a supply function (Qs) we can think about the price (P) which equilibrates Qd and Qs. This is Pe.

  • Typically when an observed price Po is greater than Pe we see excess supply and when Po < Pe we have excess demand. Does this make sense to you?


Q d 10 p q s p p e 5
Qd = 10 – P; Qs = P; Pe = 5


In labor economics
In Labor Economics

  • There is a demand for labor by firms and there is a supply of labor by households.

  • The price of labor is the wage.

  • The demand for labor depends on what sorts of things?

  • The supply of labor depends on what sorts of things?


Wage determination
Wage Determination

  • As we will see, the demand for labor is called a derived demand. As more consumers want a particular good or service that creates demand for labor in the industry that produces that particular good or service.

  • What is We in a particular industry?


Commodification of labor
Commodification of Labor

  • Note that it is theoretically easy to treat labor as we would any other classical input into production such as tomatoes, steel, seeds, or capital.

  • In the course of your studies you might want to think about this from time to time.


Labor
Labor

  • How mobile is labor?

  • Do prevailing wages adjust to excess supply or demand for labor?

  • Can certain kinds of labor easily be discriminated against?

  • What important institutions influence labor supply and/or labor demand decisions?


From here where
From Here Where?

  • Now that we have previewed some aspects of micro theory we will explore methods used to model demand and supply functions.

  • What goes on behind the demand function?

  • What goes on behind the supply function?


From here
From Here…

  • Price determination might be a reflection of optimal decision making by consumers and producers.

  • Micro theory can be used as a guide:

    • Descriptive models of behavior

    • Prescriptive models of behavior

      • Ethical Models

      • Optimal Models


Step one
Step One

  • We build are skills by first looking at the demand function.

  • We will need a few mathematical tools to help us understand how the demand function expresses optimal consumer choice.

  • Consumers choose among baskets of commodities in order to maximize utility subject to budgetary constraints.


Step two
Step Two

  • After we derive the demand function we will do similar exercises for the firm – to discover how the supply function represents maximal profit decision making.

  • The model is a bit asymmetrical, as we will see.


Steps three four
Steps Three, Four, …

  • Once we are familiar with the basics of supply & demand

    • What are industries?

    • What is meant by economic welfare?

    • When do markets work and when do markets fail?

    • How would we measure failure?

    • When is their a role for government?


Calculus
Calculus

  • Derivatives measure the slopes of lines.

  • For example, curves do not have slopes, but lines tangent to curves do.

  • Notice something about curves that have peaks and troughs:

    • At the peaks and the troughs, the lines tangent at these points have zero slope.


First order conditions
First Order Conditions

  • Finding where the derivatives are equal to zero constitute the first order conditions for maxima and/or minima of functions.


Second order conditions
Second Order Conditions

  • If we find a candidate for a maximum or a minimum, how do we tell?

  • SOC’s help us determine if we have found a max, a min, or something else.

  • Why are we doing this when we could just graph it?

    • Multiple dimensions

    • Econometric specification


Calculus1
Calculus

  • Now watch this example…after the presentation we will slow down and learn how to use the rules of calculus. We will have many simple examples and lots of practice problems.


F x x 3 25x 2 3x 3
f(x) = x3 - .25x2 – 3x + 3


F x 3x 2 5x 3
f’(x) = 3x2 – .5x - 3


F x 3x 2 5x 31
f’(x) = 3x2 – .5x - 3

  • At x = 1.0868 f’(x) = 0

  • At x = -0.9201 f’(x) = 0

  • These are called the critical values of f(x).

  • Note that at 1.0868 , f(x) reaches what we call a local minimum.

  • At -0.9201, f(x) reaches a local maximum.


F x 6x 5
f’’(x) = 6x - .5

  • At x=1.08, f’’(x) = 6.0279 which is a positive number.

  • At x=-0.92, f’’(x) = - 6.0279, which is a negative number.

  • These are examples of FOC and SOC, finding a local min and a local max.

  • Note f(x) has no global max or min.


Examples
Examples

  • f(x) = k

  • f(x) = ax

  • f(x) = ax2 + bx + c

  • f(x) = g(x)*h(x)

  • f(x) = g(h(x))

  • f(x) = g(x)/h(x)

  • f(x) = ln(x)

  • f(x) = ex


Examples1
Examples

  • f(x,y)

    • Now we have two derivatives

    • fx and fy which are called partial derivatives

  • f(x,y) = axy + by2 + c

  • fx = ay

  • fy = ax + 2by

  • FOC’s involve a simultaneous system of equations to solve:

    • fx = 0

    • fy = 0


F x y 3x 2 2y 2
f(x,y) = 3x2 + 2y2


F x y 3x 2 2y 21
f(x,y) = 3x2 + 2y2

  • Here, fx = 6x and fy = 4y

  • At the point (0,0) both of these equations are equal to zero.

  • Thus (0,0) is a critical value and we see that (0,0) is associated with a minimum value of our objective function


F x y 3x 2 2y 22
f(x,y) = 3x2 – 2y2


F x y 3x 2 2y 23
f(x,y) = 3x2 – 2y2

  • For this function there is one critical value, again at (x,y) = (0,0).

  • But note that this is not associated with a max or a min.

  • It is called a saddle point.


Great news
Great News

  • In this class (and in other econ classes you will take) the functions you deal with will be nicely behaved.

  • By nicely behaved we mean that we can easily find critical values.

  • And these critical values will be associated with maximum or minimum values.


Forest for trees
Forest for Trees

  • Let’s also remember something important. We do not want to get bogged down in the details of mathematics and forget why we are doing calculus in the first place!

  • At our level we want to come up with models of prescriptive (optimal) behavior and calculus is tool we use along the way.

  • Always remember … narrative reasoning is more convincing that equations.


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