Microeconomics

A brief introduction

Microeconomics is one of the 2 branches of economics (or political economy) whose object is to study economic systems = the way by which for ex. a country organizes its production, consumption and distribution of goods, basically the way by which we live.

We live in a market economy = the main element that characterize our economy is what we call the market.

There are other types of economic systems that used to exist, for example a centralized economy in what was the Soviet Union.

Of course, there is more than the market in an economic system, and sometimes this has problems, it may → not be efficient or not be functioning as well as it should; we have two possibilities of intervention.

We said that economics has two branches:

• Microeconomics – Related to the individual agents that are in the economy, so the individual decision made inside of the economy, for ex. a firm deciding what to produce or how much to produce, or a household deciding how much to spend, an individual deciding how much to consume or how much to save → we relate to the process by which any individual unit will take a decision.
• Macroeconomics – Related to the study of large/big economic aggregates = we are talking about the economic system as a whole, ex. the government’s expenditure, inflation, employment, GDP, rates of growth of the economy, how to spend a recovery fund etc.

So, we need to talk about individual units and how they make choices, choices are based on some important elements:

• Scarcity
• Opportunity cost
• Trade-offs
• Marginal analysis

We also have to take into consideration that while we have single individual taking choices, we also have the interaction between them, therefore choices are not made by an individual only for itself, but they are related to the fact that we have interaction between individuals, for ex. a firm will produce goods that will then be purchased by consumers (= interaction between producers and consumers).

So, when we talk about the exchange, meaning the possibility of trading goods and services, we can see that this brings to benefits = it is good to have an exchange.

We will talk about the existence of an equilibrium → the market equilibrium.

We also have to consider what is the relation between what we call efficiency and what we called equity.

Representation of the market

Important because it means that everything that will be put inside the graph will connect quantity and price.

Q = quantity

P = price

D = demand → result of decision made by individual consumers, people need to buy something.

S = supply → result of the decision made by producers or producing units.

In this case there are 2 different interests, the one in producing (by the firms) and the one in buying (by consumers) → there is an interaction which is beneficial because what is produced by the firms will be purchased by the consumers and in the end, we look at an equilibrium, we want both sides to be in equilibrium with each other.

Individual choice

Individual choice: a decision of a single decision unit (a consumers, a household, a firm, etc.) on what to do (ex. what to buy in order to consume etc.).

The basic principles on choices are:

1. Scarcity → resources are scarce (resources are everything that can be used to produce something else) = when we look at the possibilities that an individual has in choosing, we will see that there are some limits in the range of choices, we can’t do whatever we like, there are limits because, for what regard economy, things are not unlimited ex. there are not enough money to buy everything / not enough raw material to produce everything.
2. Real cost of something → opportunity cost = important to understand that we are talking about real cost which is different from monetary cost. Opportunity cost must be expressed in things that you have to give up in order to do something, it is the value associated with what you can’t do because you are doing something else ex. real cost of going to class is the value associated with the things we are losing to go to class like sleep. Every time you do something you are giving up something else.
3. How much to produce, how much to consume → what is the level of our choice, when we decide what to do we’ll see that the decision is taken in the margin = marginal analysis ⇒ every time we take a decision we are talking about the fact that we want to buy one unit more or less, it is not important what you have done up until that point but it is important whether you decide to increase or decrease your consumption, ex. you have decided to consume 30 apples, the marginal decision would be to decide if you want to consume an additional one or one less. This approach is typical neoclassical approach to economics.
4. People will use any possible opportunity to improve their condition → the idea is that when people are trying to decide what to do, they are trying to get the best out of their decision.

Interaction: how economy works

Individuals take decision but they also interact with each other → this will imply that there is a sort of mutual influence (ex. producers take decision on producing, consumers will take decision on consuming and they then interact because we consume what they produce).

The possibility of exchange and interaction between individuals is called mutual influence.

The basic principles related to this idea are:

5. Exchange between individuals produces benefits → taking the same example again (producers and consumers) if we exchange goods and services with different sectors and markets we can do better than if we just decide on our own, basically if we leave it to other people to produce goods and services or at least some and then we just buy them afterwards we’ll be better off than if we tried to do everything by ourselves = self-sufficiency not very good but interaction among people is beneficial, produces benefits – this will lead to the fact that in economy there are people that specialize in doing something and others in doing something else, not everybody does everything.
6. Markets and the economy tend to be in equilibrium (= situation in which no one has an incentive to move away from that situation, there is no opportunity for anybody to change, decide to do something else, there is no opportunity to be exploited, in this situation there is no way to move away from it without making some people worse off). Everything that happens in the equilibrium will bring a new equilibrium, it is not forever but it depends on external/other condition.
7. Resources should be used in the most efficient way → we want to use resources and take decision that are efficient, this concept is quite objective, there are elements that are able to tell us that we are doing something efficiently but the idea is that it is the market system that is giving the right signal to people to behave efficiently ex. let’s take the market price, if this is increasing the signal that it is given is that there is some sort of scarcity of something = price goes up. The price increases because you are trying to find the person that will pay the highest price for that specific good.
8. Markets are important but efficiency is not everything, we also have to talk about equity, is the economic system doing things in the right way? Concept of equity is subjective = different people have different concepts of fairness therefore to put together efficiency and equity it’s not realistic because there is not one single solution but it depends on our concept of equity, ex. if we have a disabled parking slot in a very congested area some may think this is fair because it allows people with disabilities to find a parking spot and it makes it easier for them to reach the destination, on the contrary others could argue that this is not fair because in a moment when there are no disabled people coming to the place that is a waste of parking spots because they will stay empty.
9. Markets can be very efficient and usually are but not always, when they are not = market failure → there is something that the market is not able to do, this happens for ex. when people are only looking at their benefits and not the bigger picture an ex. is pollution, there is the need of an intervention, you need the law to say that you can’t pollute or there is no way of reducing it. There are a lot of situation in which we have market failure in this case addressing the market equilibrium can be good, in order to fix the problem ex. sugar tax on coca cola, no sense in an economic point of view because there would be a distortion on the market working but from other point of views it may be justified by other objectives.

Consumer theory

Talking about decisions made by consumers, meaning decision about how much to consume.

Consumer theory = to study how much will the consumer decide to consume, it is the basis of the construction of the definition of market demand.

Each consumer will have its own individual demands, if we put them all together we get the market demand.

We will consider choices by taking into account 3 elements:

1. Each consumer will have “constraints” → to limit the possibility of choice.
2. Consumption of goods will give us “pleasure” → I’ll buy my 10th Ferrari because I want one more.
3. A rule of choice → how to decide what to do = choosing what gives us more pleasure.

1 - Constraints

• Object of choice of consumer = consumption bundle = group of goods (tangible)/services (non).

x_n goods = quantity of each good (i) x, x, …, x₁, x₂, x_n.

Supposing n=2.

A (2,3) ≡ (x₁, x₂).

The consumption bundle → there are 2 units of good 1 and 3 units of good 2.

B (4,1) ≡ (x₁, x₂) → there are 4 units of good 1 and 1 unit of good 2.

We only use this quadrant because we have positive numbers. Any combination of numbers (point) is a consumption bundle.

Which one is better? A or B? To decide I use a constraint.

• 1st is the amount of money I have = budget → m.
• 2nd is the prices of the goods I want → (P₁), P₂, …, P_n.

If combined, we have the expenditure → P₁x₁ = expenditure on x₁.

P₂x₂ = expenditure on x₂.

P₁x₁ + P₂x₂ = total expenditure on x₁ and x₂.

The expenditure can’t exceed m = we can’t spend more than that we have.

Any bundle that respects this quality will be a possibility, those that ¿ are won’t.

Bundle A is (3 ∗ 5) + (8 ∗ 2) total expenditure – A (x₁; x₂) ≡ (2; 3) affordable > 16 + 15.

(P₁; P₂) ≡ (8; 5) = 31 < 50.

m = 50.

Bundle C is not (5 ∗ 6) + 8 ∗ 2 total expenditure – C (x₁; x₂) ≡ (5; 6) > 40 + 30 affordable.

(P₁; P₂) ≡ (8; 5) = 70.

70 > 50.

m = 50.

There needs to be a distinction between affordable and non-affordable bundles → the infinity of possible bundles can be divides into affordable and non.

Affordable bundle: P₁x₁ + P₂x₂ ≤ m.

Not affordable bundle: P₁x₁ + P₂x₂ > m.

The set of all affordable bundles is called consumption choice set = set of all bundles x so that the expenditure is not greater than the budget.

The idea behind the consumer theory is that consumers/individuals can’t do anything about prices (they are set, given by somebody else) or about the income.

{x / P₁x₁ + P₂x₂ ≤ m}

We want to represent the consumption choice set ≡ P₁x₁ + P₂x₂ ≤ m.

To do this we use the budget line = limit of consumption set → it allows us to divide affordable and non affordable bundles.

P₁x₁ + P₂x₂ = m introduces just affordable bundles → by explicating x₂ I’m able to find the equation for the budget line.

P₂x₂ = m − P₁x₁.

x₂ = m/P₂ − (P₁/P₂)x₁.

Remember in the equation of a line y = a + bx.

a = the intercept.

b = slope.

The intercept = point in which the line intercepts the y axes meaning = the quantity of good 2 that I can buy if I only buy that good.

The coordinates will be (0; m/P₂) → this would be a just affordable bundle.

Point in which the line intercepts the x axes has the same meaning = the quantity of good 1 that I can buy if I only buy that good.

The coordinates will be (m/P₁; 0) → this would be a just affordable bundle.

These two are extreme consumption bundles and if we connect them, we get the budget line.

–– is the budget line.

Bundle A is affordable.

Bundle B is just affordable.

Bundle C is not affordable.

The consumption choice set is the area below the budget line.

The slope = it’s a downward line = there is an inverse relation between x₁ and x₂ if you want to buy more of good 2 you are going to have to buy less of good 1 the ratio between them is important.

It’s the derivative.

Suppose we want to increase the consumption of good 1 by 1 unit, we would have to give up some quantity of good 2, in order to be able to afford 1 more unit of x₁ I need $8, where do I find them? I give up 1 unit of good 2 I get $5 (not enough) → I have to give up more. I have to give up the opportunity cost of x₁ which is 8/5.

The opportunity cost of good 2 in terms of units of good 1 is 5/8.

Comparative statics

We are going to consider what is going to change if any of the given variables changes → exogenous variables (income and budget).

P₁, P₂, m.

P₁, P₂, m.

8, 5, 50 → 8, 5, 60.

Change in income → increasing the income is good for us but how does it affect the budget line?

m’ > m.

1st situation.

Budget line → x₂ = m/P₂ − (P₁/P₂)x₁.

• Same slope: −P₁/P₂.
• Different intercept: m/P₂ = 1st / 2nd situation.

Was not affordable before it is now; this means that the budget line will move in a parallel way, having the same slope but moving the budget line means that the opportunity cost between the goods is not changing but there is an expansion of the possibilities.

More money = more choice.

• Consumption choice set 1st and 2nd.
• If income decreases = fewer choices.

m’ < m.

Change in price → there are various possibilities.

P₁, P₂, m.

P’₁, P₂, m.

8, 5, 50 → 10, 5, 50.

P’₁ < P₁.

1. One price changes this is bad for us.

1st situation.

Budget line → x₂ = m/P₂ − (P₁/P₂)x₁.

• Same intercept: m/P₂.
• Different slope: −P₁/P₂ = 1st / 2nd situation.

Could afford before can’t anymore; this means that things that we could afford before are now not affordable → this is the area called reduction of purchasing power.

• The consumer choice set decreases.
• If price decreases = more choices.

P’₁ < P₁.

Why do prices and income change?

→ one example could be taxes – they are a clear instrument by which we can change the price.

There are two types of taxes:

1. Quantity tax (specific tax) → it is a fixed amount of money charged on the price, it depends in the n° of units, it is called fixed because the amount of tax per unit is fixed. ex. plastic or sugar tax 0.10€/kg.
2. Ad-valorem tax → it is a percentage on the price, an example is IVA (imposta valore aggiunto), in this case tax per unit is not a fixed amount, only tax rate is.

Sugar tax is 10% if the price is 5€ the tax would be 5€ * 0.10 = 0.50 €/kg if the price changes 6€ tax would be 6€ * 0.10 = 0.60€/kg.

The idea is that the price is given by price + tax → tax will increase the price meaning that the budget line will rotate.

If for example tax rate = α = 25%.

If the initial price is P by adding α will have the new price of P + (α * P).

α = 25% = 0.25 P = 100 → 100 + (100 * 0.25) = 100(1 + 0,25).

The effect of a uniform tax-rate (α)

Suppose we introduce an ad-valorem tax and it’s affecting everything → negative effect.

Before: x₂ = m/P₂ − (P₁/P₂)x₁.

P₁, P₂, m before tax – after tax – budget line.

After: x₂ = m/[(1 + α)P₂] − [(1 + α)P₁ / (1 + α)P₂]x₁.

• Same slope: −P₁/P₂ = when we change 2 prices with the same tax rate price after = the ratio between the goods does not change, as a consequence also the opportunity cost (p.2) stays the same.
• Different intercept: m/[(1 + α)P₂] = 1st / 2nd.

What happens is that increasing both prices we can afford less of both goods.

This is the same thing that happened when we had a change in income → increasing the prices, we reduce the choice of consumers.

As a matter of fact, if we consider the new budget line, if we divide both sides per alpha, we see that it reduces budget this is why it has the same effect.