Introductory Microeconomics
ES10001
Topic 1: Introduction to Markets
1. What is Economics?

Economics is ... the study of choice.

More formal definition might be:

.... the study of the allocation of scarce
resources amongst competing users.
2
1. What is Economics?

Some of the key concepts in Economics can be
illustrated via. the Production Possibility
Frontier (PPF).

Definition: The PPF shows for each level of the
output of one good, the maximum amount of the
other good that can be produced.
3
1. What is Economics?

Definition: The PPF shows for each level of the
output of one good, the maximum amount of the
other good that can be produced.

See Figure 1
4
Figure 1: Production Possibility Frontier
Y
25
A
B
G
C
20
15
F
D
10
5
E
0
5
10
15
20
25
30
X
5
1. What is Economics?

Points on PPF are Pareto-Efficient - unable to make
one person better off without making someone worse
off

Economist's job is to move society to PPF (i.e.
efficiency)

Whereabouts on PPF is job for politicians (i.e.
equity)
6
2. Theories and Evidence

Definition: a model (or theory) makes a series of
simplifying assumptions from which it is
deduced how people will behave. It is a
deliberate simplification of reality.

Linear example:
y = a + bx
7
Figure 2: Linear Model
y
y = a + bx
Slope =
a
b
Intercept
0
x
8
2. Theories and Evidence

N.B. a = intercept; b = slope

Consider, for example, a total cost function,
where c denotes total cost and q denotes output.

i.e. Total Costs = Fixed Costs + Variable Costs

Assume a = 10, b = 2
9
Output
q
Fixed Cost
=
α
Variable Cost
+
βq
Total Cost
=
c
1
10
2
12
2
10
4
14
3
10
6
16
q
=
10
+
2q
=
c
10
Figure 3: Total Cost Function
c
c = 10 + 2q
16
14
12
10
0
1
2
3
q
11
3. Markets

Definition: A market is a set of arrangements by
which buyers and sellers are in contact to
exchange goods or services.

To understand how markets work we therefore
need to examine the behaviour of buyers and
sellers

Otherwise known as ‘Demand’ and ‘Supply’
12
3. Markets

Demand: Quantity of a good buyers wish to
purchase at every conceivable price. Thus
demand is not a particular quantity.

Supply: Quantity of a good sellers wish to sell at
every conceivable price. Thus supply is not a
particular quantity.

N.B. distinction between demand (supply) and
quantity demanded (supplied).
13
3. Markets

Demand / Supply denotes schedule of demands /
supplies at each and every conceivable price.

Quantity demanded / quantity supplied defines a
particular demand / supply at a particular price.

Hypothesis - at ‘high’ prices we have qd < qs and
at low prices the converse. Moreover, at some
intermediate ‘equilibrium’ price, p*, the market
14
clears.
3. Markets

We define the equilibrium price p* as the price
which clears the market

Thus p > (<) p* implies excess supply (demand)
and in a free market the actions of buyers and
sellers move p towards p*
15
Figure 4: Market Equilibrium
p
Supply
p*
Demand
0
q*
q
16
Figure 5: Price Floor
p
Supply
Excess Supply
p1
p*
Demand
0
qd(p
1)
q*
qs(p
1)
q
17
Figure 6: Price Ceiling
p
Supply
p*
p2
Excess Demand
0
qs(p
2)
q*
qd(p
Demand
2)
q
18
Figure 7: ‘Near Side’ is Satisfied
p
Supply
pf
p*
pc
Demand
0
q0
q*
q
19
4. Demand

The demand curve shows the relationship between
price and quantity demanded (qd) ceteris paribus

That is:
(i)
qd at particular price per unit;
(ii)
(maximum) price per unit consumers
willing to pay for a particular quantity.
20
4. Demand

Formally

qd = qd(p)

Quantity demanded depends upon price

Normal Demand Function (Curve)
21
Figure 8: Normal Demand Curve; qd = qd(p)
q
qd
0
p
22
Figure 8: Normal Demand Curve; qd = qd(p)
q
… quantity demanded at a particular price
5
qd
0
10
p
23
4. Demand

We can equivalently think of price
depending upon the quantity consumed

pd = pd(q)

Inverse Demand Function
24
Figure 9: Inverse Demand Curve; pd = pd(q)
p
pd
0
q
25
Figure 9: (Inverse) Demand Curve; pd = pd(q)
p
… buyer’s reservation (i.e. maximum price
buyer willing to pay per unit
5
pd
0
10
q
26
3. Demand

We usually (i.e. normally) write the
demand function in its normal form vis:

qd = qd(p)

But …
27
3. Demand

… we tend to draw the function in its
inverse form:

pd = pd(q)

Why? …
28
3. Demand

Inconsistency dates back over 100 years to the
printing of the first Economic textbook …

Alfred Marshall Principles of Economics (1895)

Printing error!

No real problem …
29
Figure 10: Inverse Demand Function; pd = pd(q)
p
… buyer’s reservation price (i.e. maximum
price buyer wiling to pay price per unit)
5
pd
0
10
q
30
Figure 10: Normal Demand Function; qd = qd(p)
p
… quantity demanded at a particular price
5
pd
0
10
q
31
3. Demand

But be aware …

Can cause undue algebraic problems!

Consider linear
functions …
demand
and
supply
32
3. Demand

Normal (Linear) Demand Function:
q = a - bp
d

Inverse (Linear) Demand Function:
p = ( a b ) - ( 1b ) q
d
33
Figure 11: Normal (Linear) Demand Function
q
a
0
q = a - bp
d
a
p
b
34
Figure 12: Inverse (Linear) Demand Function
p
a
p = a b - 1b q
d
b
0
a
q
35
4. Demand

Usually, we presume that qd depends negatively on
(own) price, but this is not always the case (i.e.
Giffen goods)

Note: ‘Movements Along’:Arise as a
changes in own price.

‘Shifts In’: Arise when anything else changes.

Consider the latter
result of
36
4. Demand
What
are these ‘other things’ that might bring
about a shift in the demand curve
To
answer that question, we need to look ‘behind
the demand curve’ and drop our assumption of
ceteris paribus – that other things remain equal.
Consider
each in turn
37
4. Demand

Four factors that might not remain equal:
(1)
Price of Related Goods
(2)
Consumer Incomes
(3)
Tastes
(4)
Tax
38
4. Demand

Price of Related Goods

Example: A rise in price of butter would:

Decrease quantity of butter demanded by consumers;

Increase demand for margarine at each and every price
of margarine;

Decrease demand for bread at each and every price of
bread.
39
4. Demand

That is:

Butter & margarine are substitutes for one
another

Butter & bread are complements for one another

Note: Pairs of goods; most goods are
substitutes.
40
Figure 12: Substitutes (Rise in pButter)
pMargarine
p0d
0
p1d
qMargarine
41
Figure 13: Complements (Rise in PButter)
pBread
p1d
0
p0d
qBread
42
4. Demand

Consumer Income

A normal good is a good for which demand
increases when incomes rises

A inferior good is a good for which demand
falls when income rises.
43
Figure 14: Normal Good (Increase in Incom
pPrivate Transport
p0d
0
p1d
qPrivate Transport
44
Figure 15: Inferior Good (Increase in Incom
pPublic Transport
p1d
0
p0d
qPublic Transport
45
4. Demand

Tastes

Consumer tastes or preferences regarding array
of potential consumables.

Shaped by custom, attitude, advertising.
46
4. Demand

Tax

Consider purchase tax (e.g. VAT)

Consumer liable for £x tax per unit purchased

Thus, imposition of tax will reduce consumer’s
reservation price for the good

Note: Unit / Ad Valorem
47
Figure 15: (Unit) Purchase Tax
p
pd
0
q
48
Figure 16: (Unit) Purchase Tax
p
tax
pd
ptd
0
q
49
Figure 17: (Unit) Purchase Tax
p
t = £2
5
pd
3
ptd
0
10
q
50
5. Supply

The Supply Curve Shows the relationship
between price and quantity supplied ceteris
paribus; That is:

Quantity supplied at particular price per unit;

Minimum price per unit suppliers willing to
accept for particular quantity.
51
Figure 18: (Inverse) Supply Curve
p
ps
0
q
52
Figure 19: (Normal) Supply Function; qs = qs(p)
p
… quantity supplied at a particular price
ps
5
0
10
q
53
Figure 20: (Inverse) Supply Function; ps = ps(q)
p
… seller’s reservation price (i.e. minimum price
seller wiling to accept per unit)
ps
5
0
10
q
54
5. Supply

Behind the supply curve (ceteris paribus)

Four factors:
(1)
(2)
(3)
(4)
Technology;
Input Costs;
Government Regulation;
Tax.
55
5. Supply

Technology

Improvement in technology shifts supply curve to
the right

Intuition?

Producers willing to supply higher quantity at
each and every price
56
Figure 21: Technological Advance
p
p0s
p1s
0
q
57
5. Supply

Costs

If these fall then supply curve will shift to right
for the same reason.

Government Regulation

Adverse technological change - i.e. safety /
environmental regulations will shift supply
curve to the left.
58
Figure 23: Government Regulation
p
p1s
p0s
0
q
59
5. Supply

Tax

Consider unit sales tax

Seller liable for £x tax per unit sold

Thus, imposition of tax will increase seller’s
reservation price for the good
60
Figure 24: (Unit) Sales Tax
p
ps
0
q
61
Figure 25: (Unit) Sales Tax
p
pts
tax
0
ps
q
62
Figure 26: (Unit) Sales Tax
p
pts
11
t = £2
ps
9
0
10
q
63
6. Linear Demand / Supply

Demand

Recall - the demand curve shows:

quantity demanded at particular price per unit.

(maximum) price per unit consumers willing to
pay for particular quantity
64
6. Linear Demand / Supply

Formally

qd = qd(p)

Assume demand curves are linear - i.e. straight
lines. Thus:

qd(p) = a - bp
65
6. Linear Demand / Supply

That is, when p = 0, individuals demand a
maximum number of units of the good

qd(0) = a - b·0 = a

Simplistic, but useful, assumption
66
Figure 27: Linear Demand Curve
p
q d  a  bp

bp  a  q

a 1
d
p   q
b b
a/b
0
a
q
67
Figure 28: Non-Linear Demand Curve
p
pd
0
q
68
6. Linear Demand / Supply

Now consider slope b

The slope of the demand curve tells us how
quantity demand changes in response to a
change in price

Formally
69
6. Linear Demand / Supply
q0d  a  bp0
q1d  a  bp1

(1)
(2)

(3) = (2) - (1)

d
d
q
q
= -b p1 - p0
(3) 1
0

(
)
Þ
Dq d = -bDp
70
Figure 29: Slope of Demand Curve
q d  a  bp

q0  a  bp0
p
a/b
q1  a  bp1
E0
p0
E1
p1
0
q0
q1
a
q
71
Figure 30: Slope of Demand Curve
q d  a  bp

q  bp
p
a/b
E0
p0
Dp
E1
p1
Dq = -bDp
0
q0
q1
a
q
72
6. Linear Demand / Supply

Now consider two demand curves
qid  ai  bi p

(4)

where i = x, y. Thus:
d
q
 (4a) x  ax  bx p
d
q
 (4b) y  a y  by p
73
6. Linear Demand / Supply

It must be the case that:

(5) q d  b p
i
i

If by > bx then Dq yd > Dqxd

Demand curve ‘y’ has a ‘bigger’ slope than demand
curve ‘x’

But … it is ‘flatter’!!!
74
Figure 31: Slope of Demand Curve
p
q
qid  ai  bi p
d
x

qi  bi p
p0
Dq y
Dp
q yd
p1
0
i  x, y
Dqx
q0
q1x
q1y
q
75
6. Linear Demand / Supply

Recall, we generally ‘write’ the normal demand
function but ‘draw’ the inverse demand function

And if by > bx then 1/by < 1/bx

Such that the inverse demand function
a 1
p   q
b b
d
i

(i.e. the one we draw) is flatter
76
6. Linear Demand / Supply

The inverse demand curve maps the consumers’
reservation price schedule

i.e. as quantity increases consumers are willing to
pay less per unit - diminishing marginal utility.

Also, it tells us the maximum price consumers are
willing to pay for the first unit of the good

pd(0) = a/b
77
6. Linear Demand / Supply

Supply

Recall, supply curve shows

Quantity producers willing/able to supply at
particular price per unit.

(Minimum) price per unit sellers willing to accept
78
for particular quantity.
6. Linear Demand / Supply

qs = qs(p)

Linear form:

(1) qs = c + dp

or

(2) p s = - c + 1 q
d d
79
Figure 32: (Inverse) Supply Curve
p
ps
0
c
q
-(c/d)
80
7. Equilibrium

Equilibrium

Assuming linear demands and supplies we can
solve for the equilibrium prices and quantities in
the market

qd = a - bp

qs = c + dp
81
7. Equilibrium

Recall, there is a particular price vis. the
equilibrium price, p*, at which the market clears

qd(p*) = qs(p*)

or

qd (p*) = a - bp* = c + dp* = qs(p*)
82
7. Equilibrium
q d  p   q s  p 


a  bp  c  dp


a  c   b  d  p

ac
p 
bd

83
7. Equilibrium
 ac 
q  p   a  bp  a  b 

b

d



d


a  b  d   b  a  c  ab  ad  ab  bc
q p 

bd
bd

ad  bc
d

q p 
bd
d

84
7. Equilibrium
 ac 
q  p   c  dp  c  d 

b

d



s


c  b  d   d  a  c  bc  cd  ad  cd
q p 

bd
bd

ad  bc
s

q p 
bd
s

85
7. Equilibrium

Consider the following example:
q d  p   20  4 p
qs  p   8  2 p

Thus
q
d
 p   20  4 p

*
 8 2p  q
*
s
p 


20  8   4  2  p 
86
7. Equilibrium

Such that:
a  c 20  8 12
p 


2
bd
42
6


Substituting equilibrium price, p*, into the demand
and supply functions yields equilibrium quantity
qd(p*) =20 – 4p* = 8 + 2p* = qs(p*)
87
7. Equilibrium
( )
( )
q d p* = 20 - 4 p* = 8 + 2 p* = q s p*
Þ
q d ( 2 ) = 20 - 4 ( 2 ) = 8 + 2 ( 2 ) = q s ( 2 )
Þ
q d ( 2 ) = 20 - 8 = 12 = 8 + 4 = q s ( 2 )
Þ
q d ( 2 ) = 12 = q s ( 2 )
Þ
q* = 12
88
7. Equilibrium

or:
q d  p   a  bp  20  4 p
q s  p   c  dp  8  2 p

such that:
ad  bc 20 * 2  4 * 8 40  32 72
q 



 12
b d
42
6
6
*
89
7. Equilibrium – Unit Tax

Inverse Demand Curve
p = ab d

( )q
1
b
With unit purchase tax …
p =
d
t
(
a
) ( )q
b -t -
1
b
90
7. Equilibrium – Unit Tax

Normal Demand Curve
ptd =
(
a
) ( )q
b -t -
Þ
( )q = (
1
b
a
b
1
b
)
-t - p
91
7. Equilibrium – Unit Tax

Normal Demand Curve
( )q = (
1
b
Þ
a
b
)
-t - p
)
(
q = a - bt - bp
d
t
Þ
(
qtd = a - b p + t
)
92
7. Equilibrium – Unit Tax

Inverse Supply Curve
p =s

( ) + ( )q
c
1
d
d
With unit purchase tax …
p = éë s
t
( ) + t ùû + ( ) q
c
d
1
d
93
7. Equilibrium – Unit Tax

Normal Supply Curve
pts = éë Þ
( ) + t ùû + ( ) q
c
1
d
d
( ) q = éë( ) - t ùû + p
1
d
c
d
94
7. Equilibrium – Unit Tax

Normal Supply Curve
( ) q = éë( ) - t ùû + p
1
c
d
Þ
(
d
)
qts = c - dt + dp
Þ
(
q = c+d p-t
s
t
)
95
8. Elasticity

Measuring the price responsiveness of demand

Consider problem of seller who want to maximise
sales revenue.

R = p*q

But q = q(p) and p = p(q); i.e. q depends upon p and p
depends upon q

Thus trade off!
96
8. Elasticity

Revenue increases if price is raised ceteris paribus;
but we cannot assume ceteris paribus

Strategy:

(i) sell few goods at high unit price;
or
(ii) sell many goods at low unit price

Optimal choice depends upon price responsiveness of
demand
97
8. Elasticity

We could simply look at the slope of the demand curve

Recall two individuals, x and y, where:
qxd = ax - bx p
q yd = a y - by p

And by > bx such that individual y is more responsive
to a change in price than individual x.
98
Figure 33: Slope of Demand Curve
p
q
qid  ai  bi p
d
x

qi  bi p
p0
Dq y
Dp
q yd
p1
0
i  x, y
Dqx
q0
q1x
q1y
q
99
8. Elasticity

Slope is OK but:

(i)
It is unit dependent
i.e. £, $, number of laptops, bottles of wine

(ii)
Does not convey relative strength of change
i.e. price cut from £100 to £99 increases
demand by same amount as cut from £2 to £1
100
8. Elasticity

Better concept

Elasticity of Demand

Definition: The (price) elasticity of demand is the
percentage change in the quantity of a good demanded
divided by the corresponding percentage change in its
price.
% Change in q d
E
% Change in p
101
8. Elasticity

Example: Price rises from £10 to £12 and
demand falls from 50 units to 30 units then:

E = (-40%) / (20%) = -2

In words: “A 1% rise in price will lead to a
2% fall in demand.”

N.B. For simplicity, we usually ignore the
minus sign and define E as a positive number.
102
8. Elasticity

Thus:
%q d
E
0
%p

Define:
x1  x0
%x 
100%
x0

x
%x 
100%
x0
103
8. Elasticity

Thus:
 q

 q 100% 
 0

q p0
q p0
E




0
 p

q0 p
p q0
 p 100% 
 0


Recall our linear model:
q d = a - bp
104
8. Elasticity
q0d  a  bp0

(1)
(2)

(3) = (2) - (1)

d
d
q
q
= -b p1 - p0
(3) 1
0

q1d  a  bp1
(
)
Þ
Dq d = -bDp
105
8. Elasticity

Thus:
q
q  bp 
 b
p

Such that
p0
Dq p0
E=×
=b
>0
Dp q0
q0
106
8. Elasticity

Note:

E is a number and as such it is unit dependent

E conveys the relative strength of changes in
price and demand

Along a linear demand curve, slope (i.e. b) is
constant but elasticity [i.e. b(p/q)] varies. 107
8. Elasticity

E > 1: Demand is Elastic
1% rise in p leads to a more than 1% fall in qd

E < 1:Demand is Inelastic
1% rise in p leads to a less than 1% fall in qd

E = 1:Demand is Unit Elastic
1% rise in p leads to same 1% fall in qd
108
8. Elasticity

Recall our linear function
Dq p
p
E=× =b
Dp q
q

with p = p0 and q = q0.

where is this equal to 1?

i.e. find the (p, q) at which E = 1
109
8. Elasticity

Thus, solve E for
p
E = b =1
q
( p,q )
Þ
bp = q
Þ
2bp = a
Þ
bp = a - bp
Þ
a
p=
2b
110
8. Elasticity

Such that:
q = a - bp
Þ
æ a ö
q = a - bç
÷
2
b
è
ø
Þ
a
q=
2
111
Figure 34: Elasticity of Demand
q d = a - bp
p
æ a ö æ 1ö
p =ç ÷ -ç ÷ p
è b ø è bø
E 
d
a b
E 1
æ p0 ö
E = bç ÷
è q0 ø
E 1
a
p=
2b
E 1
E 0
0
q=a 2
a
q
112
8. Elasticity

Point and Arc Elasticities

So far - point elasticities

If considering responsiveness over a
range of prices / quantities then arc
elasticity is more appropriate
113
8. Elasticity

Define:
q=

q0 + q1
p=
2
p0 + p1
2
Thus:
(q
- q0
) .100%
Dq
Dq p
Dq p
q
q
E====×
Dp
q Dp
Dp q
p1 - p0
.100%
p
114
p
1
(
)
Figure 35: Arc Elasticity of Deman
p
æ p0 ö
E = bç ÷
è q0 ø
q d = a - bp
æ a ö æ 1ö
p =ç ÷ -ç ÷ p
è b ø è bø
a b
d
æ pö
E = bç ÷
èqø
p0
p0 + p1
p=
2
q0 + q1
q=
2
æ p1 ö
E = bç ÷
è q1 ø
p1
0
q0
q1
a
q
115
8. Elasticity

Arc elasticity between, e.g., p0 and p1 (q0 and q1) is
equivalent to point elasticity at:
p=

p0 + p1
2
Or:
q=
q0 + q1
2
116
8. Elasticity

Determinants of Elasticity

Ultimately a matter of tastes - how essential is the
good; how much do individuals want it.

Also time; more elastic in long run as consumers can
substitute away.

Most important consideration is the ease with which
consumers can substitute another good that fulfils
approximately the same function
117
8. Elasticity

Applications of Elasticity

Determining price and quantity the maximises
revenue.

Seller can choose either how many goods to sell
or the price at which to sell them, but not both. i.e:

R = p*q
118
8. Elasticity

Consider effect of cut in price on Revenue (R)
(i) R falls because sell fewer goods at lower p;
(ii) R rises because sell more goods at higher p.

Thus trade off!

Question: Where is trade off optimised?
119
8. Elasticity

Recall: If E > 1 then a 1% cut in p will lead to
a more than 1% increase in qd

Thus R will rise since increase in qd
dominates fall in p

Conversely if E < 1.
120
8. Elasticity

Strategy

If E > 1 then cut price to increase revenue.

If E < 1 then raise price to increase revenue.

Optimum point is where E = 1

From this point, an x% change in p leads to same
x% change in q, such that revenue is unchanged 121
8. Elasticity

This point occurs half-way down the demand
curve at p = a 2b and q = a 2

Rectangle below demand curve at this point is
biggest rectangle possible under the demand
curve.

And since the rectangle represents sales revenue,
then this is where sales revenue is maximised.
122
Figure 36: Elasticity of Demand
q d = a - bp
p
æ a ö æ 1ö
p =ç ÷ -ç ÷ p
è b ø è bø
E=¥
a b
d
æ p0 ö
E = bç ÷
è q0 ø
a
p=
2b
E 1
Maximum
Revenue
E 0
0
q=a 2
a
q
123
8. Elasticity

Example:
q d = 20 - 4 p
Þ
20
p=
= 2.5
8
Þ
( )
q = q d p = 20 - 4 * 2.5 = 10
Þ
( )
R = p × q = 2.5* éë 20 - 4 2.5 ùû = 25
124
8. Elasticity

Strategy

If E > 1 then cut price to increase revenue.

If E < 1 then raise price to increase revenue.

Optimum point is where E = 1

From this point, an x% change in p leads to same
x% change in q, such that revenue is unchanged 125
8. Elasticity

Thus, a producer could do no better than to put 10
units of the good onto this market.

This is interesting!

Had the producer gone to market with 12 goods, it
would have been in his interest to destroy two of
them!

Intuitive??????
126
8. Elasticity

Cross Price Elasticity

Define: Cross price elasticity of demand for good i
with respect to changes in price of good j equals %
change in quantity of good y demanded divided by
corresponding % change in price of good j

i.e. Eij =
%Dqid
%Dp j
127
8. Elasticity

Eij > 0
Increase in pj leads to an increase
in qi thus goods i and j are
substitutes for one another

Eij < 0
Increase in pj leads to fall in qi
thus goods i and j are complements
for one another
128
8. Elasticity

Income Elasticity

Define:Income elasticity of demand for a good is %
change in quantity demanded divided by
corresponding % change in income (M).

EM > 0: 1% increase in M leads to rise in
demand thus the good is normal

EM < 0: 1% increase in M leads to fall in demand thus
129
good is inferior
8. Elasticity

We can distinguish:
EM > 1
Luxuries
0 < EM < 1
Necessities
130
9. Final Comments

Free markets are one way for society to solve the
basic economic questions of what, how, and for
whom to produce.

We have begun to see how the market allocates
scarce resources amongst competing users.

The market will decide:
131
9. Final Comments

How much of a good is produced
By finding price that equates demand and supply.

For whom a good is produced
Good is purchased by all those willing to pay at least equilibrium price

By whom a good is produced
Good is supplied by all those willing to supply at equilibrium price

What goods are produced
Through the supply curve
132
9. Final Comments

N.B. We will also see later in the course that the
market can tell us how goods are produced!

In conclusion, we should note that societies may
not like the answers that the market provides.

Free markets do not produce enough food for
everyone to go without hunger; or enough medical
care to treat all the sick.
133