Introduction to Economics

Part II: Microeconomics

Fall 2018

Professor Christian Schubert

Schubert, Introduction, Fall 2018 1

Structure of whole course
1. Introduction: What is economics?
2. PPF and Utility
3. Circular Flow Diagram and GDP
4. Unemployment
5. Inflation
6. Aggregate Supply ansd Aggregate Demand
7. Introduction to Microeconomics; Supply and
Demand
8. Supply and Demand: Market Analysis
9. Theory of consumer choice
10. Government Intervention
11. Production theory: production side
12. Production theory: Cost side
Schubert, Introduction, Fall 2018 2
II: Microeconomics
7. Introduction to Microeconomics; Supply and
Demand
8. Supply and Demand: Market Analysis
9. Theory of consumer choice
10.Government Intervention
11. Production theory: production side
12. Production theory: Cost side

Schubert, Introduction, Fall 2018 3

“Market“:
A system of rules that allows agents to engage in voluntary
exchanges of goods and/or services

• rules: e.g. property rules (who owns what? What can I do

with my property? Etc.); liability rules; procedural rules
for adjudicating cases in court; quality standards for
goods/services; rules on how to deal with foreign imports;
etc.
• Voluntary exchange: typically creates mutual benefit,
i.e. both parties gain from the exchange (if no third party
is harmed!)
• Empirically, markets have proved, across the world, to be
powerful engines of economic growth and development.
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Schubert, Introduction, Fall 2018
1776: Adam Smith, Inquiry into the Wealth of Nations
GDP per person (“per capita“): economists‘ favored
indicator for human development
(e.g. Egypt in 2017: 2.412 USD / after PPP adjustm. 10.500 USD;
Germany: 44.400 USD;
USA: 59.500 USD)
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Schubert, Introduction, Fall 2018
 Supply and Demand:
- Sellers (firms) determine supply
- Buyers (consumers) determine demand

price

Quantity

6
Schubert, Introduction, Fall 2018
 Supply and Demand:
- Sellers (firms) determine supply
- Buyers (consumers) determine demand

price
Typically, we have a
downward-sloping demand
curve/line: when the price
falls, more people are willing
Demand (D)
to buy the product (and vice
versa)
“Law of demand“

Quantity

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Schubert, Introduction, Fall 2018
Ice cream

Quantity

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Schubert, Introduction, Fall 2018
 Market demand: aggregate of individual agents‘ demands
on a particular market

price Typically, we have a

downward-sloping demand
curve/line: when the price
falls, more people are
When D willing to buy the product
Price (and vice versa)
goes
down…
“Law of demand“

Quantity …then
quantity
increases
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Schubert, Introduction, Fall 2018
 Change of price ( p) → movement along the demand
curve/line (leading to Q)

price

When
Price
goes
down… D
Quantity
…then quantity
increases “Change of quantity demanded“
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Schubert, Introduction, Fall 2018
 In contrast, movement of the demand curve/line occurs when,
e.g., income rises, tastes change, number of buyers changes,
etc.

price
For example: As income
increases, demand for a
normal good (ice cream)
increases
D BUT demand for an
D2 inferior good will decrease
D3 (e.g. public bus rides, tap
D1 water, cheap cigarettes,…)
Quantity

“Change of demand“
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Schubert, Introduction, Fall 2018
 There‘s one exception to the law of demand: Veblen goods
(named after Thorstein Veblen, 1899) when prices rise,
some consumers buy more of some goods in order to
demonstrate their superior status

price
For example: Luxury brands
(cars, handbags,…)

People generally care

D (Veblen goods) about money and social
status. With some (rich)
people, this translates into the
Quantity Veblen (“snob“) effect

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Schubert, Introduction, Fall 2018
 Fall in price of good A causes falling demand for good B:
A and B are substitutes (e.g. black pens, blue pens)
Fall in price of good A causes rising demand for good B:
A and B are complements (e.g. hammer and nail)

price

D
D2
D3
D1
Quantity

____
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Schubert, Introduction, Fall 2018
 (Footnote)

In advanced microeconomics, the law of demand is used to

explain/predict a variety of different phenomena

For example: After the 9/11

terror attacks in 2001, the U.S.
price
tightened security measures at
airports.
the effective price (= nominal
Demand price + “hassle“) of air travel to
increased significantly.
What effect did this have on
people‘s choice of mode of
Quantity travel (e.g. cars, trains,…)?
What further effects did this
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policy change have?
 Supply and Demand:
- Sellers (firms) determine supply
- Buyers (consumers) determine demand

price
Typically, we have an upward-
sloping supply curve/line:
when the price falls, firms are
less willing to supply goods
Supply (S)
(and vice versa)
“Law of supply“

Quantity

15
Schubert, Introduction, Fall 2018
 Supplied

Supply

Quantity

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Schubert, Introduction, Fall 2018
 Price → Movement along the supply curve/line,
leading to Q

price

S
When
price goes
down…

Quantity
…then
quantity
decreases! 17
Schubert, Introduction, Fall 2018
 In contrast, movement of the supply curve/line occurs when,
e.g., technology, input prices, wages, or number of firms
change.
price

Quantity

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Schubert, Introduction, Fall 2018
Let‘s bring demand and supply together!

(their meeting determines the market price)

At 2€, the quntity demanded equals the quantity supplied!

P = 2€ is market-clearing = creates equilibrium in this
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market, symbolised by p* (and corresponding Q* = 7)
 Supply meets Demand: Equilibrium

price
(p*,Q*): equilibrium, i.e. a
situation where the market clears and
prices/quantities stop
moving
p*=2

Q*=7 Quantity

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Schubert, Introduction, Fall 2018
 What happens in disequilibrium?
I: price set too high
F
For example, p is set as a price
floor, above p* (consider some
price minimum price set by
S
government)
F
→ Excess supply (Q1-Q2)
p
p*
• Example: labor market, where
F
D p represents a minimum wage
(“price of human labor“) and
Q1 Q* Q2 Quantity excess supply represents
unemployment: employers only
demand Q1, but Q2 is supplied.
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 What happens in disequilibrium?
II: price set too low
L
For example, p is below p*
(consider some price ceiling
price set by government)
S
→ Shortage (Q4-Q3)

• Example: rent control,

p* C
where p represents a rent
pC ceiling for housing and
D shortage is reflected in
Q3 Q* Q4 Quantity queues of people standing in
line for an apartment.
Landlords only supply Q3,
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but people demand Q4.
 Market conditions change: e.g. hot
temperatures increase demand for ice cream

price D moves to the right,

S meaning that at every single
price, more ice-cream will
p2*
be demanded than before
p*
D2 New equilibrium at p2*,
corresponding to Q2*, with
D1 Q2* > Q*.
Q* Q2 * Quantity

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Schubert, Introduction, Fall 2018
 Market conditions change: e.g. increase in price of
sugar decreases supply of ice-cream

price S2 S moves to the left, meaning

that at every single price,
S1 vendors are willing to supply
p2*
less ice-cream than before
p* New equilibrium at
p2*, corresponding to Q2*,
D
with Q2* < Q*.

Q2* Q* Quantity

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Schubert, Introduction, Fall 2018
II: Microeconomics
7. Introduction to Microeconomics; Supply and
Demand
8. Supply and Demand: Market Analysis
9. Theory of consumer choice
10. Government intervention
11. Production theory: production side
12. Production theory: Cost side

Schubert, Introduction, Fall 2018 25

 Recall: A typical (downward-sloping) demand curve

price
Now, let‘s vary the demand
curve‘s slope…

Demand

Quantity

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Schubert, Introduction, Fall 2018
 Recall: A typical (downward-sloping) demand curve

price
Here, demand is elastic:
A small price change (e.g.,
price drops from p1 to p2)
leads to a larger change in
p1 quantity demanded (e.g., rises from Q1 to
p2 Q2)

Q1 Q2 Quantity

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Schubert, Introduction, Fall 2018
 Recall: A typical (downward-sloping) demand curve

price Here, demand is inelastic:

A small price change (e.g.,
price drops from p1 to p2)
Demand leads to a smaller change
p1 in quantity demanded
p2
(e.g., rises from Q1 to Q2)

Q1 Q2 Quantity

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Schubert, Introduction, Fall 2018
Elasticity:

Measure of how much buyers (and sellers) respond to

changes in price (or income)

For example:
Price elasticity of demand : given a %change in price,
how does demand respond?
%

Formally: = %

p
D = 1: demand is “unit elastic“
p
D > 1: demand is elastic
p 29
D < 1: demand is inelastic
Elasticity:

What determines Dp?

Are close substitutes available?
p
Example for calculating D :

Price of an ice cream cone increases from 20 LE to 22

LE; you respond by demanding 8 instead of 10 cones.
Your price elasticity of demand:

[(10−8)/10] 100 20%

= 2. Your demand is elastic.

[(22−20)/20] 100 = 10%

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Schubert, Introduction, Fall 2018
 Extreme case I: perfect price elasticity of demand

At p*, consumers will buy any

p
quantity. If p increases ever
so slightly above p*, demand
drops to zero
p* Demand p
D =

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Schubert, Introduction, Fall 2018
Extreme case II: zero price elasticity of demand

Consumers will demand

p
quantity Q*, whatevever the
price.
p
D =0
Demand

Q* Q

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Schubert, Introduction, Fall 2018
Total Revenue and the price elasticity of demand:

Total Revenue (TR) = pQ

How does p affect TR when demand is inelastic?

Price increase (from p1 to p2) increases TR significantly.
p
Here: price increase from
1€ to 3€ causes TR to
3€ increase from 100€ (1€ 100
units) to 240€ (3€ 80 units)

1€

80 100 Q
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Schubert, Introduction, Fall 2018
Total Revenue and the price elasticity of demand:

Total Revenue (TR) = pQ

How does p affect TR when demand is elastic?

Price increase (from p1 to p2) decreases TR significantly.
p
Here: price increase from
1€ to 3€ causes TR to fall
3€ from 200€ (1€ 200 units) to
30€ (3€ 10 units)

1€
10 200 Q
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__ Schubert, Introduction, Fall 2018