Microeconomics Summary Notes: Demand, Externalities, and Market Failure

Demand

Market

● Market ○ Where buyers and sellers come together to carry out an economic transaction

Demand

· Demand o Quantity of a good or service that consumers are willing and able to purchase at different prices in a given time period

Law of Demand

· Law of Demand ○ As the price of a product falls, the quantity demanded of the product will usually increase, ceteris paribus · Demand Schedule A table changing the quantity demanded as the price changes ○ · Demand Curve 0 Curve that shows the relationship between the price of a product and the quantity demanded of the same product over time · Movement Along Demand Curve ○ Change in the price of a product · Shift of Demand Curve ○ Change in the non price determinants of demand

Non-Price Determinants of Demand

· Income ○ Normal goods As income rises, demand for product rises ○ Inferior goods Demand for product falls as income rises · Price of Related Goods ○ Substitutes Change in the price of one of the products will lead to a change in the demand for the other product o Completments Products purchased together Change in the price of one product leads to a change in the demand of the other product o Unrelated Goods Change in price of one product will have no effect upon the demand for the other product · Tastes and Preferences · Future Price Expectations · Number of Consumers

Movement along and Shift of Demand Curve

Price of safety helmets ($) C Quantity (of safety helmets) Figure 3.7 The demand for safe- ty helmets Price of soccer boots ($) p P: D 0 q. Quantity of soccer boots Figure 3.6 The demand for soccer boots

Individual Consumer's Demand & Market Demand

· Horizontal summing ○ Constructing demand curve for whole market ○ Adding individual demands at each price -> total market demand Consumer A Consumer B Price ($) Price ($) 5 5 5 5 4 3 2 Du 1 0 100 200 300 400 500 600 O 100 200 300 400 500 600 Quantity Quantity Consumer C Total market Price ($) Price (S) 700 1000 1600 2000 Quantity Quantity

Explaining Law of Demand

· Income Effect Price of product falls -> Increase in real income ○ Reflects the amount that income can buy · Substitution Effect ○ Satisfaction : Price Will substitute products that take advantage of this relationship · Cheaper product even if slightly less utility

Assumptions behind Theory of Demand

· Assumes that consumers behave rationally o Consumers able to consider all possible options and work out option that will provide most utility 0 Consumer seek to maximise utility ○ Consumers act in own self interest ○ Consumers have access to all relevant information about choices (perfect information) 1 1 DB De 1 0 100 200 300 400 500 600 4 3 3 3 2 2 2 DA D D 0 p 4 4 0 Consumer -> homo economicus

Behavioural Economics

Econs (non-existent, according to Thaler] Humans (all of us!] . Are rational · Have perfect information · Are extremely intelligent, and able to perform complex calculations quickly · Seek to maximize their own utility · Make decisions based on their own self- interest · Have consistent preferences over time · Have no self-control problems · Are unbiased . Have bounded rationality · Have incomplete information · Are not as intelligent as Econs · Have limited ability to carry out complex calculations · Are social beings, and make decisions in a social context · Change their tastes over time · May have self-control issues

Assumptions of Rational Consumer Model

· Perfect Information ○ All economic agents have access to all same information at same time ○ Price and quality of products in market ○ Problems: Information asymmetries · Different economic agents have different levels of information available to them where economic transactions are concerned Processing information · Humans face limits in how can process available information · Internet -> Information overload o -> Consumers make decision based on imperfect information · Bounded Rationality ○ Rationality of consumers is limited by the information that they have, and that they do not have the time or cognitive abilities to consider all options · Bounded Selfishness Humans do not always act in own-self interest as assumed by neoclassical model ○ · Bounded Self Control O Natural tendency to give into temptation

Dual System Model

· System 1: Fast Thinking System ○ Fast decisions ○ Automatic ○ Subconscious · System 2: Slow Thinking System O Slow ○ Controlled decisions

Cognitive Biases & Decision Making

· Availability Bias ○ Availability of recent information and examples tends to over-influence people's decision making · Anchoring Bias 0 Use value of something as reference point to influence future choices or decisions · Framing Bias o The way that information is presented to us influences our choices · Social Conformity/Herd Behaviour The way that others behave can exert a powerful influence on our own choices ○ · Status Quo/Inertia Bias ○ If faced with bewildering set of choices, would prefer to maintain the status quo by doing nothing · Loss Aversion Bias Humans feel that losses are far more significant than gain ○ · Hyperbolic Discounting o Tendency for humans to prefer smaller short-term rewards over larger later rewards

Behavioural Economics & Choices

· Choice Architecture o Theory that the decisions we make are heavily influenced by the ways in which the choices are presented to us . Default Choice ○ Pre-set option that is effectively selected if decision maker does nothing · Mandated Choice People required by law to make a choice in advance ○ · Nudge Theory ○ Choice architecture offered to people can be carefully designed to gently encourage people to voluntarily choose the option which is better for them o Consumer Sovereignty The right to choose is maintained

Elasticity of Demand

Elasticity of Demand

· Elasticity ○ A measure of how much something changes when there is a change in one of the determinants ○ Measure of responsiveness · Elasticity of Demand ○ A measure of how much the demand for a product changes when there is a change in one of the factors that determine demand Price elasticity of demand (PED) Income elasticity of demand (YED)

Price Elasticity of Demand

· Price Elasticity of Demand o A measure of how much the quantity demanded of a product changes when there is a change in the price of the product PED = Percentage change in quantity demanded of the product Percentage change in price of the product · Range of Values 0 0- 00 · PED = 0 ○ Change in the price of a product will have no effect on the quantity demanded ○ Demand is perfectly inelastic · PED = 00 O Demand is perfectly elastic o Any change in the price of a product will result in an infinitely larger change in the quantity demanded · 0 change in price won't lead to a change in revenue Price of product (S) D P P -- 0 0 Price of product ($) P C Quantity demanded of product Price of cartons ($) 0 11.20 a 1.00 b C 0 10.8 12 Quantity of cartons (000s) Price of hot dogs ($) 2.10 a 2.00 b C D 0 180 200 Quantity of hot dogs Price of meals (S) b D 0 Quantity of meals

Elasticity on Curves

· Straight line downward sloping demand curve o PED falls as price falls Price ($) PED = 3.3 (elastic) 20 b 15 PED = 0.625 0 10 Demand becomes less elastic (inelastic) d 5 D 0 50 100 150 200 250 Quantity (units)

Determinants of Price Elasticity of Demand

· Number and Closeness of Substitutes ○ More substitutes -> More price elastic · Necessity of product and how widely product is defined · Proportion of Income Spent on Good o "Cheap" -> Inelastic "Expensive" -> Elastic ○ · Time Period Considered ○ PED inelastic in short term o PED elastic in long term

Knowledge of Price Elasticity of Demand

· Firms ○ Predicting effects of pricing decision on quantity demanded -> total revenue · Government o Consequences of imposing indirect taxes -> total government revenue & unemployment

Price Elasticity of Demand: Commodities and Manufactured Goods

· Primary Commodities (raw materials) Inelastic demand -> necessities, few/no substitutes ○ Consumed by manufacturing industries · Manufactured Goods o Elastic -> substitutes available to consumers Product can be differentiation by different producers

Income Elasticity of Demand

. Income Elasticity of Demand o A measure of how much the demand for a product changes when there is a change in the consumer's income YED = Percentage change in quantity demanded of the product Percentage change in income of the consumer · Range of Values o Normal Goods: YED is positive, Inferior Goods: YED is negative 0 income inelastic . KYED<00 -> income elastic o Necessity Goods Products that have low income elasticity o Superior/Luxury Goods Products that have high income elasticity · Engel Curve O Shows relationship between income and the demand over time Quantity of potatoes demanded 0 Income Type of good YED value Meaning Inferior YED < 0 A given increase in income will lead to a proportionately smaller fall in demand Necessity 0< YED < 1 A given increase in income will lead to a proportionately smaller increase in demand Luxury YED >1 A given increase in income will lead to a proportionately larger increase in demand

Knowledge of Income Elasticity of Demand

· Decision Making by Firms o Planning which markets to enter & which product to sell ○ 1 YED -> large increase in demand as income levels in country rise · Explaining Sectoral Changes in Structure of Economy o Primary sector Primary products (raw materials) o Secondary sector Manufacturing (processing raw materials) o Tertiary sector Services o Sectoral change Shift in relative share of national output and employment that is attributed to each of the production sectors as an economy develops over time for a product