Microeconomic Analysis

ECON 520 - SS 3-4

KFUPM - Fall-22
Dr. Muhammad Imran Chaudhry, CFA
An Economists’ Worldview
 An Economists’ Worldview
• Market Economy: An economic system where resources are
allocated through the “decentralized” decisions of households
and firms.
– Markets really determine the fundamental issues of what to produce?
how much to produce? how to produce? for whom to produce?
• Who coordinates commercial activities in market economy:
– Invisible hand: by acting in one’s own self interest, every individual
economic agents leads to the economy to best possible outcome.
– Efficient coordination of economic activities in a market economy
takes place when all agents act in their self interest!
• Isn’t human greed a necessary requirement for the success of
a capitalist system? But, greed a bad thing? Really? Why?
 Economists’ Worldview
• Prices emerge from the interaction between consumers and
producers (and sometimes government) in a market economy.
• Prices are the signal through which economic activities are
coordinated in a market economy
– Prices provide both information to economic agents and incentive to act
in a very complicated system with no body in-charge!
• Invisible Hand (or self-interest): Fails under some conditions, for
example: imperfect competition, externalities, public goods and
asymmetric information etc.
– May also fail if market prices are highly volatile, or situations of strategic
interdependence. In these circumstances government interventions can
potentially (but not necessarily) help societies achieve better outcomes.
 Modelling Markets
• A market is a platform where economic agents voluntarily sell
or buy goods/services e.g., Dhahran Mall, Noon and Amazon.
– Are Facebook, TikTok, Instagram, Youtube also markets? Why? How?
• Markets coordinate activities in our increasingly interconnected
and complex lives.
– Prices are the instrument/signal through which markets allocate scarce
goods/services between different optimizing economic agents.
– Prices in markets emerge from interactions between buyers and sellers.
• Key assumptions in a model of (perfectly) competitive markets:
– All sellers sell an identical good/service e.g., oil, spices and security etc.
– Choice of an individual buyer or seller does not affect market price of a
good or service. In simple words, buyers and sellers are price-takers i.e.,
accept the market price and can’t bargain for a better price.
 Modelling Markets-Buyers’ Behavior
• Develop a relationship between price of goods and the amount
of goods that buyers are willing to purchase:
– At a given price, the amount of goods/services that buyers are willing to
purchase is called the quantity demanded.
– Buyers are price-takers: Treat market price as a take-it or leave-it offer,
and don’t try to haggle with sellers to lower the price.
• Demand schedule: A table reporting the quantity demanded at
different prices, given that all other factors are held constant.
– Holding all else equal: All other factors (apart from products’ price) that
are known to impact products’ demand are held constant, usually called
Ceteris Paribus Latin phrase meaning “with all other things the same”.
• Demand Curve: Plotting an individuals’ demand schedule, with
price on the Y-axis and quantity demanded on the X-axis.
 Modelling Markets-Buyers’ Behavior
• Willingness to pay: Highest price a buyer is willing to pay for an
extra unit of a good.
– Height of an individual demand curve, at any given quantity, represents
the amount a person is willing to pay for that unit of the good.
– In our example, person-1’s willingness to pay for the 20th kg of chicken is
Rs. 300, and his willingness to pay for the 100th kg of chicken is Rs. 200.
• Diminishing marginal benefit: For (most) goods/services, as we
consume more of it, our willingness to pay for an additional unit
declines.
– In simple words, our willingness to pay for an additional unit of goods or
services is negatively related to the quantity that we already have.
– For example, think about pizza, the more pizza slices we have eaten, the
less we are willing to pay for an additional slice of the same pizza.
 Modelling Markets-Buyers’ Behavior
• Aggregation (i.e., sum) of individual demand curves leads us to
the market demand curve:
– Conceptually, aggregating quantities demanded by different individuals
just means fixing price, and adding quantity that each buyer demands.
• Market Demand Curve: captures the relationship between total
quantity demanded in a market (X-axis) and the market price (Y-
axis), holding all else equal.
– Put simply, market demand curve is the relationship between aggregate
quantity demanded at different market prices.
• Law of Demand: Quantities demanded and prices are negatively
related i.e., if one goes up, the other goes down, and vice versa.
– Demand curves of (almost all) goods exhibit such a negative relationship
i.e., quantity demanded falls as prices increase, all else equal.
Modelling Markets-Buyers’ Behavior
• We now look more carefully at “all else equal” assumption:
– If a good’s own-price changes, we get a movement along the demand
curve, given all other factors impacting demand are held constant.
– If at any given price, one of the many other factors impacting demand
changes, we get demand curve shifts (quantity demanded changes at
a given price) e.g., Covid-19 made people (on average) poorer.
• In a market model, we need to be clearly differentiate demand
curve shifts from a movement along the demand curve.
• In general, a change in the following factors results in a shift of
demand curve for a given good:
– (1) Income or Wealth (2) Availability and Prices of Related Goods (3)
Number and intensity of buyers (4) Buyers’ beliefs about the future (5)
Consumer’s tastes and preferences (long-run).
 Modelling Markets-Sellers’ Behavior
• Develop a relationship between price of goods and the amount
of goods that firms are willing to sell:
– At a given price, the amount of the goods/services that firms are willing
to supply is called the quantity supplied.
– Firms are price-takers: Treat the market price as given and don’t bargain
with buyers over a higher price.
• Supply schedule: Table reporting quantity supplied at different
prices, holding all else equal.
– Ceteris Paribus: All other factors, apart from a products’ price, that are
known to impact products’ supply are held constant
• Supply Curve: Plotting an individual firms’ supply schedule with
price on the Y-axis and quantity supplied on the X-axis.
 Modelling Markets- Sellers’ Behavior
• Marginal cost: additional cost incurred to produce another unit
of a good.
– If a profit-maximizing firm in a competitive industry is paid marginal cost
of production, than this firm is willing to sell another unit of that good.
• Willingness to accept: Lowest price a firm is willing to receive in
order to sell another unit of a good.
– The height of the supply curve, at a given quantity, represents the firm’s
willingness to accept for that unit of good.
– For example, farmer-1’s willingness to accept for the 10th kg of chicken is
Rs. 100 and his willingness to accept for the 50th kg of chicken is Rs. 300.
– For an optimizing firm, willingness to accept is the same as marginal cost
of production, since profit-maximizing firms will continue to supply until
its marginal cost is equal to price (marginal benefit).
 Modelling Markets-Sellers’ Behavior
• Aggregating individual supply curves of each firm leads us to the
market supply schedule :
– Conceptually, aggregating quantities supplied by different firms requires
adding the quantity supplied by all firms at a particular price. Repeat this
at every possible price to get the market supply curve.
• Market Supply Curve: represents relationship between quantity
supplied (X-axis) and market price (Y-axis), all else equal.
– Market supply curve is the relationship between total quantity supplied
and different market prices.
• Law of Supply: Quantities supplied and market prices positively
related i.e., if market price goes up, then quantity supplied also
increases, and vice versa.
– Supply curves of (almost all) goods exhibit such a positive relationship
i.e. quantity supplied increases as prices increases, holding all else equal.
 Modelling Markets-Sellers’ Behavior
• We now look more carefully at “all else equal” assumption:
– If a good’s market price changes, we get a movement along the supply
curve, given all other factors impacting demand are held constant.
– If at any given price, one of the other factors effecting supply changes,
we get supply curve shifts (quantity supplied at a given price changes)
e.g., Bird flu killed farmers broilers.
• In a market model, we need to be able to clearly differentiate a
supply curve shift from movement along the supply curve.
• In general, a change in the following factors results in a shift of
supply curve for a given good:
– Cost of factors of production and firms’ beliefs about the future (short-
run). Production Technology and number of sellers (long-run)
 Equilibrium in Markets
• To visualize equilibrium in a market we plot demand and supply
curves on the same diagram.
– As demand curves are downward sloping and supply curves are upward
sloping, the two curves cross/intersect at (only) one point.
• Economists refer to this point of intersection as the competitive
equilibrium.
– Competitive equilibrium price is the price at which quantity supplied is
equal to quantity demanded. This price is also referred to as the market
clearing price, because at this price there is a buyer for every unit that
is supplied in the market.
– Competitive equilibrium quantity is the quantity purchased/sold at the
competitive equilibrium price.
 Equilibrium in Markets
• Competitive equilibrium in markets is a very robust mechanism
and, at any price (other than competitive equilibrium price), the
quantity demanded and supplied are not equal i.e., markets fail
to clear
– When market price is above the competitive equilibrium price, quantity
supplied exceeds quantity demanded, creating excess supply.
• Sellers, each selling nearly identical goods, compete with one another for
customers by cutting prices. This continues until the market price falls back
to the competitive equilibrium price.
– When market price is below the competitive equilibrium price, quantity
demanded exceeds quantity supplied, creating excess demand.
• Buyers compete with one another by offering to pay higher prices to get
the limited quantity of goods in the market. This continues until the market
price rises to the competitive equilibrium price.
 Framework for Analyzing Markets
• Many economic outcomes can be understood by employing this
simple supply-demand model of perfectly competitive markets.
1. Clearly, define the industry or market you wish to study.
• Does the underlying market satisfy assumptions of competitive markets?
2. Sketch the demand and supply curves in market.
• Supply/demand curves represent relationship between quantity supplied
and demanded, respectively, and different prices, holding all else equal.
• Nature of underlying products will often tell us something about the slope
of the demand/supply curves (more on this next week).
3. Determine competitive equilibrium, given a certain set of conditions.
4. Study how changes in conditions affect the equilibrium outcome.
• First, determine whether supply, demand or both are impacted by a given
change. Second, shift the appropriate curve/s to reflect this change. Third,
compare the new equilibrium to the original equilibrium outcomes.