Microeconomics: Markets, Methods and Models

Microeconomics: Markets, Methods and Models

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Microeconomics: Markets, Methods & Models Douglas Curtis and Ian Irvine

Contents

Part One: The Building Blocks .......................................................................................1 Chapter 1 Introduction to key ideas.............................................................................2 Learning Objectives .................................................................................................................2 1.1 What's it all about? .............................................................................................................2

1.1.1 The big issues...........................................................................................................2 1.1.2 Individual behaviours .............................................................................................3

Application Box: The Paradox of Thrift .................................................................4 1.1.3 Markets and government.......................................................................................5 1.2 Understanding through the use of models.....................................................................6 1.3 Opportunity cost and the market.....................................................................................7 1.4 A model of exchange and specialization .........................................................................8 1.5 Economy-wide production possibilities .........................................................................11 1.6 Aggregate output, growth and business cycles ...........................................................14 1.6.1 Aggregate output ..................................................................................................14 1.6.2 Economic growth...................................................................................................15 1.6.3 Recessions and booms .........................................................................................16 1.6.4 Macroeconomic models and policy ...................................................................18 1.6.5 Conclusion..............................................................................................................19

KEY TERMS ..............................................................................................................19 EXERCISES ...............................................................................................................19

Chapter 2 Theories, models and data ........................................................................23 Learning Objectives ...............................................................................................................23 2.1 Observations, theories and models ...............................................................................23 2.2 Variables, data and index numbers ...............................................................................25

2.2.1 Time-series data ....................................................................................................26 2.2.2 Cross-section data.................................................................................................28 2.2.3 Index numbers ......................................................................................................28 2.2.4 Composite index numbers...................................................................................30 2.2.5 Other composite price indexes ...........................................................................31 2.2.6 Using price indexes ...............................................................................................31 2.3 Testing economic models & analysis .............................................................................33 2.3.1 Evidence .................................................................................................................34 2.3.2 Fitting lines through the scatter plot...................................................................35 2.4 Diagrams and economic analysis ...................................................................................36 2.5 Ethics, efficiency and beliefs ...........................................................................................38 Application Box: Statistics for policy makers ..............................................................39 2.5.1 Revisiting the definition of economics................................................................40

KEY TERMS ..............................................................................................................42 EXERCISES ...............................................................................................................43

Chapter 3 The classical marketplace ? demand and supply....................................47 Learning Objectives ...............................................................................................................47 3.1 Trading ..............................................................................................................................47 3.2 The market's building blocks...........................................................................................48

3.2.1 Other things equal ? ceteris paribus ..................................................................49 3.2.2 Market equilibrium ...............................................................................................50 3.2.3 Supply and the nature of costs............................................................................51

3.3 Demand and supply curves.............................................................................................51 3.3.1 Computing the market equilibrium ....................................................................52

3.4 Other influences on demand .........................................................................................54 3.4.1 The prices of related goods .................................................................................54 3.4.2 Buyer incomes .......................................................................................................55 3.4.3 Tastes and networks ............................................................................................55 3.4.4 Expectations ..........................................................................................................56 3.4.5 Shifts in demand ...................................................................................................56 Application Box: Corn prices and demand shifts ...............................................57

3.4.6 Modelling other influences ..................................................................................58

3.5 Other influences on supply ............................................................................................59 3.5.1 Technology ............................................................................................................59 3.5.2 Input costs .............................................................................................................60 3.5.3 Competing products .............................................................................................60 Application Box: The price of light .......................................................................60

3.5.4 Shifts in supply.......................................................................................................61

3.6 Simultaneous supply and demand impacts..................................................................62 3.7 Market interventions........................................................................................................63

3.7.1 Price ceilings ..........................................................................................................63 3.7.2 Price floors .............................................................................................................65 3.7.3 Quotas ....................................................................................................................65 3.7.4 Modelling market interventions ..........................................................................66

3.8 Individual and market functions.....................................................................................67 3.8.1 Conclusion..............................................................................................................67 KEY TERMS ..............................................................................................................68 EXERCISES ...............................................................................................................69

Part Two: Responsiveness and the Value of Markets ..............................................72 Chapter 4 Measures of response: elasticities............................................................73 Learning Objectives ...............................................................................................................73

4.1 Price responsiveness of demand ...................................................................................73 4.1.1 Extreme cases........................................................................................................76 4.1.2 Using information on the slope of the demand curve .....................................77 4.1.3 Elastic and inelastic demands..............................................................................79 4.1.4 Determinants of price elasticity...........................................................................79 4.1.5 Using price elasticities ..........................................................................................80

4.2 Price elasticity and expenditure .....................................................................................81 4.3 The time horizon and inflation .......................................................................................83 4.4 Cross-price elasticities .....................................................................................................84 4.5 The income elasticity of demand....................................................................................84

4.5.1 Normal, inferior, necessary, and luxury goods..................................................85

4.6 Elasticity of supply ............................................................................................................87 4.7 Elasticities and tax incidence ..........................................................................................87

4.7.1 Statutory incidence ..............................................................................................90

4.7.2 Tax revenues and tax rates .................................................................................90

4.8 Identifying demand and supply elasticities ...................................................................90 KEY TERMS ......................................................................................................................91 EXERCISES .......................................................................................................................92

Chapter 5 Welfare economics and externalities.......................................................97 Learning Objectives ...............................................................................................................97

5.1 Equity and efficiency ........................................................................................................97 5.2 Consumer and producer surplus ...................................................................................98

5.2.1 Computing the surpluses .................................................................................. 100

5.3 Efficient market outcomes ........................................................................................... 102 5.4 Taxation, surplus and efficiency .................................................................................. 103

5.4.1 Elasticities and the excess burden ................................................................... 105 5.4.2 A wage tax ........................................................................................................... 105

5.5 Market failures ? externalities ..................................................................................... 106 5.5.1 Negative externalities ........................................................................................ 107 5.5.2 Positive externalities .......................................................................................... 108

5.6 Other market failures ................................................................................................... 110 5.7 Environmental policy and climate change ................................................................. 110

5.7.1 Greenhouse gases.............................................................................................. 111 5.7.2 GHGs as a common property .......................................................................... 112 5.7.3 The Kyoto Protocol ............................................................................................ 112 5.7.4 Canada's GHG emissions .................................................................................. 113 5.7.5 GHG Measurement ........................................................................................... 113 5.7.6 Economic policies for climate change.............................................................. 114 5.7.7 Incentive mechanism I: tradable permits ....................................................... 116 5.7.8 Incentive mechanism II: taxes........................................................................... 117 5.7.9 Policy in practice ? international ..................................................................... 117 5.7.10 Policy in practice ? domestic large final emitters ........................................ 117 5.7.11 Revenues from taxes and permits ................................................................ 118

5.8 Equity, justice, and efficiency ....................................................................................... 118 Application Box: Equity, ability, luck, and taxes ...................................................... 119

5.8.1 Equity versus efficiency ..................................................................................... 120 KEY TERMS ........................................................................................................... 121 EXERCISES ............................................................................................................ 121

Part Three: Decision Making by Consumer and Producers ...................................126 Chapter 6 Individual choice .......................................................................................127 Learning Objectives ............................................................................................................ 127

6.1 Rationality....................................................................................................................... 127 Application Box: Rationality and impulse ................................................................ 127

6.2 Choice with measurable utility..................................................................................... 129 6.2.1 From utility to demand ...................................................................................... 133 6.2.2 Applying the theory............................................................................................ 134

6.3 Choice with ordinal utility ............................................................................................ 135 6.3.1 The budget constraint ....................................................................................... 135 6.3.2 The budget constraint ....................................................................................... 135

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