Welcome to ECON 101:

Microeconomics
Department of Economics
University of Auckland
Semester 2
2
Lecturer

Gamini Jayasuriya
Room 260-692 ; Phone 923-3900
Email g.jayasuriya@auckland.ac.nz
Office hours _____________
Instructions
The course book is essential if you have not
already purchased a copy, please do so after this
lecture. You can buy the course book from the
Business School Bookshop, Level 0 of OGGB.
Homework for tonight is to read the front section of
your course book, especially the Additional Course
Information section. This contains very important
information about the course, including the date of
your TEST, and instructions regarding this
assessment.
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4
Preliminary Remarks (1)
Before starting we would like to point out the
following:
We are making all the lecture slides available
in the Course Book
They will also be available on CECIL under
Lecture Slides
That does not mean that everything we
say in class will appear on the slides

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Preliminary Remarks (2)
While lecturing we will often talk about
examples or issues that may or may not
appear on the slides
As a result it is very important that
as you follow along with our
lectures you also take notes

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Preliminary Remarks (3)
Learning how to take notes is one
of the most valuable skills that you
should be picking up
It would be a good idea to start
NOW!

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Preliminary Remarks (4)
We expect this to be a semester-long
dialogue between you and us (the
teaching team)
Please feel free to ask questions
Please feel free to stay back after class
if you want to discuss something
Please feel free to utilize the office
hours of the lecturer and the tutor
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How Should You Study for this
Class?
Read the slides in the course book!
The course material is defined by what
is covered in lectures
Do the tutorial problems and attend
tutorials
Clarify anything you dont understand
by reading the text-book
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What you need to do this week
Familiarise yourself with CECIL
(www.cecil.auckland.ac.nz); there is a
pamphlet available in Business and
Economics Student Centre
Make sure you check your University of
Auckland email account (your email address
will have the form
yourUPI@aucklanduni.ac.nz)
All Cecil announcements are automatically sent to your
University of Auckland email address
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What you need to do this week
Make at least one friend in the class!
They can tell you what happened in a
particular lecture in case you miss one.
Forming a study group is a good idea.
For that also you need to make some
friends.
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Section 1
1. Preliminary Concepts
2. Demand, Supply and Market
Equilibrium
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Thinking Like an Economist:
Some preliminary concepts
Stiglitz and Walsh (Third Edition):
Chapter 2, pages 35 - 39 and 41 - 45
Stiglitz and Walsh (Fourth Edition):
Chapter 2, pages 38 - 42 and 47 - 50.

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The Study of Economics
Economics is the study of how
individuals and societies choose to
use the scarce resources that
nature and previous generations
have provided.
14
Why Study Economics?
Probably the most important reason
for studying economics is to learn a
way of thinking.
Three fundamental concepts:
Opportunity cost
Marginalism
Efficient markets
15
Trade-offs
When there is scarcity, not all needs
can be satisfied
Firms, households and individuals have
to make trade-offs between competing
objectives
Choices involve opportunity costs



16
Opportunity Cost
Opportunity cost is the best
alternative that we forgo, or give up,
when we make a choice or a decision.
Opportunity costs arise because time
and resources are scarce. Nearly all
decisions involve trade-offs.
Opportunity cost does not necessarily
have to be measured in dollars. It
could be measured in terms of time as
well.



Production Possibility Frontier
A graph illustrating the attainable choices
available to a firm or economy, assuming a
given level of resources and a given state of
technology.
It illustrates the concepts of scarcity, choice
and opportunity cost
Provides a shorthand method of illustrating
the economic problem. It also provides us
with additional information and allows
quantification.
Graph the following Production
Possibility Frontier
Possibilities
Clothing
(Units per year)
Food
(Units per year)
A 4000 0
B 3600 400
C 3000 600
D 2000 800
E 0 950
Production Possibility Frontier
Unattainable
Inefficient
Figure 3.3, p34
Crunchies and Kit Kats
You have enough resources to produce the
following combinations:
Crunchies Kit Kats
10 0
8 4
6 7
4 8
0 10
Kit Kats and Crunchies
What is needed to make these bars?
1. Chocolate (Both)
2. Hokey Pokey (C only)
3. Wafers (KK only)
4. Creamy stuff between wafers (KK only)
5. Foil to wrap (Both)
6. All of the above
Questions
If you only make Crunchies how many can you
make?
If you only make Kit Kats how many can you
make?
If you make a combination of the two, what is
the greatest number of total bars that you can
make?
Why?
Which resources are fully mobile?
Which resources are more specialised?
What happens to the specialised resources for KKs if
you choose to only make crunchies?
Shape of PPF
As the production of a good expands,
the opportunity cost of producing
additional units generally increases.
This is because resources used fall into
two categories
Those that can be used in any process
Those that have more limited use.
What are some implications of this?
Shifts in PPF
What were the assumptions?


What if these change?


How does the curve change?

Changes in Technology
St John and Stewart, 2000, p22
Other Applications
Instead of two goods, as we have been using,
we can rename the goods to show other things.
For example if we use capital goods and
consumer goods we can use the same model to
illustrate efficiency in the economy and growth.
NOTE:
Capital goods are used to produce other goods
Consumer goods are used to satisfy wants and
needs directly.
Changes in Capital Goods
Figure 3.4, p35
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Marginalism
In weighing the costs and benefits of a
decision, it is important to weigh only
the costs and benefits that arise from
the decision.
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Marginalism
For example, when deciding whether to
produce additional output, a firm
considers only the additional (or
marginal) cost, not any sunk cost.
Sunk costs are costs that cannot be
avoided, regardless of what is done in
the future, because they have already
been incurred.
30
Sunk Costs
Are expenditures to which you have
already committed.
Example: The cost of the clothes in your
drawers is sunk (why?)

Economists ignore sunk costs when
making decisions
Because, by definition, sunk costs are not
affected by decisions we are making now.




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Efficient Markets
An efficient market is one in which
profit opportunities are eliminated
almost instantaneously.
There is no free lunch! Profit
opportunities are rare because, at
any one time, there are many people
searching for them.
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More Reasons to Study
Economics
Economics involves the study of societal
and global affairs concerning resource
allocation.
Economics is helpful to us as voters.
Voting decisions require a basic
understanding of economics.
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The Scope of Economics

Microeconomics is the branch of
economics that examines the functioning
of individual industries and the behaviour
of individual decision-making units that
is, business firms and households.
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The Scope of Economics

Macroeconomics is the branch of
economics that examines the economic
behaviour of aggregates income,
output, employment, and so on on a
national scale.
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Market Forces of Supply and
Demand
Third Edition: Chapter 4, Demand, Supply
and Price
Fourth Edition: Chapter 3, Demand Supply
and Price
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The Market Forces of
Supply and Demand
Supply and demand are the two
words economists use most often.
Supply and demand are the forces
that make market economies work.
Much of modern microeconomics is
about supply, demand, and market
equilibrium.
37
Markets
A market is a group of buyers and
sellers of a particular good or service.
The market could have a real
(shopping mall) or virtual form (e.g.,
on-line auction)
The terms supply and demand refer to
the behaviour of people . . . as they
interact with one another in markets.
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Markets
Buyers determine demand.
Sellers determine supply.
39
Demand Schedule
The demand schedule is a table
that shows the relationship
between the price of the good
and the quantity demanded.

To illustrate this, we asked Jim about
his preferences for ice cream
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Jims Demand Schedule for Ice
cream
Price Quantity
$0.00 12
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0
41
Jims Demand Curve
$3.00
2.50
2.00
1.50
1.00
0.50
2 1 3 4 5 6 7 8 9 10 12 11
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream
Cones
0
Price Quantity
$0.00 12
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0
42
Demand Curve
The demand curve is the downward
sloping line relating price to
quantity demanded.
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Law of Demand
The law of demand states that there is
an inverse relationship between
price and quantity demanded.

So, as price , quantity demanded
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Doing the math
Everything else held constant (ceteris
paribus) the quantity demanded can be
expressed as a function of its own price,
Q = f(P).

We will find it easier to work with the
Inverse Demand Function.

So, we write P = F(Q).

So P is the dependent variable
45
Form of the equation
Jims demand curve is
Downward sloping; and
Linear, i.e., a straight line

So it has the form y = c - mx, where
m is the slope, and
c is the intercept

Substitute PRICE for y and QUANTITY for x to
get: P = c - mQ
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Finding m and c
Slope (m) = rise/run
= (change in price)/(change in
quantity)
= 0.50/2 = 1/4

So we can now write P = c - (1/4)Q

47
Finding m and c
What is c?
Pick any corresponding P and Q pair from the
demand schedule (e.g. P = 1.00, Q = 8) and
plug them into the above equation to solve
for c
Given P = c - (1/4)Q, if P = 1 and Q = 8,
then:
1 = c - (1/4)8 = c - 2
c = 3

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Demand curve equation
Now we can write the demand equation
P = 3 - (1/4)Q
Implications:
If P = $3.00 then Q = 0
For $0.25 change in P, Q changes by
1 ice cream
If Price goes down by 25 cents, Jim buys
1 more ice cream
49
Jims Demand Curve
$3.00
2.50
2.00
1.50
1.00
0.50
2 1 3 4 5 6 7 8 9 10 12 11
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream
Cones
0
50
Graphing the Demand Curve
Price
Quantity
A
So a demand curve can be
represented by a straight line like AB

Our Demand Equation is
P = 3 (1/4)Q

What numbers
correspond to
A and B?
B
51
Graphing the Demand Curve
Price
Quantity
A
We have already found that when
Q = 0, P = 3. So the intercept of
the demand curve on the Y-axis is $3.

The point A then corresponds to P = $3
and Q = 0
B
P = $3
Q = 0
52
Graphing the Demand Curve
Price
Quantity
A
How about the point B? At B, the
price is equal to 0. How about
quantity?

How do we find what this quantity is
at the point B?
B
53
Graphing the demand curve
Recall that we already found that the demand
curve is P = 3 - (1/4)Q
What we want to find is the value of Q when
P = 0
Set P = 0 in the above demand equation
We get 0 = 3 - (1/4)Q
Or (1/4)Q = 3
Or Q = 12
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Graphing the Demand Curve
Price
Quantity
A
B
P = $0
Q = 12
55
Graphing the Demand Curve
Price
Quantity
A
B
Thus we find that the point A corresponds
to P = $3 and Q = 0 while the point B
corresponds to P = $0, Q = 12
P = $3
Q = 0
P = $0
Q = 12
Slope = 1/4 (absolute value)
56
A Linear Approximation of
Demand
Is the demand curve always linear?
That is is it necessarily a straight
line?
No, not necessarily
It is possible (and quite likely) that the
demand curve is non-linear the
relationship between price and quantity
is more complex
57
A Linear Approximation of
Demand
The demand curve might actually look
like this

Q
P
58
A Linear Approximation of
Demand
However it is possible to approximate
this non-linear relationship by a straight
line
Q
P
59
A Linear Approximation of
Demand
A straight line makes calculations easier
Q
P
Very often we APPROXIMATE the
relationship between the price and
quantity by a straight line.
This is easier and in most
circumstances any loss in accuracy
is minimal.
60
Market Demand
Market demand refers to the sum of all
individual demands for a particular good or
service.

Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.

Horizontal, because we want to add all
quantities for a given price
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Market Demand
Ice-cream
price
Jims
demand
Kates
demand
Market
demand
$0.00 12 7 19
$0.50 10 6 16
$1.00 8 5 13
$1.50 6 4 10
$2.00 4 3 7
$2.50 2 2 4
$3.00 0 1 1
62
Demand
Aggregating Demand graphically

Q1
Q2
Q1+Q2
P1
Q3
Q4
P2
Q3+Q4
Jims Demand Kates Demand Market Demand
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Market demand curves slope down
because

A lower price causes:
1. each consumer to buy more; and
2. new consumers to enter the market
Price Jim

Kate Market
$3 0 1 1
$2.50 2 2 4
$2.00 4 3 7
$1.50 6 4 11
$1.00 8 5 13
When price falls
from $3 to
$2.50, Kate
buys more & Jim
enters the
market
64
Ceteris Paribus

Ceteris paribus is a Latin phrase that
means all variables other than the ones
being studied are assumed to be
constant. Literally, ceteris paribus
means other things being equal.
The demand curve slopes downward
because, ceteris paribus, lower prices
imply a greater quantity demanded!
65
Determinants of Demand
Price of the good itself is NOT a determinant
of demand. It is only a determinant of the
QUANTITY demanded.

Tastes and Fashion
Income
Price of related goods (complements &
substitutes)
Size and Nature of population
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Shifts of the demand curve
Changes in the following factors shift
the demand curve:
Taste
Income
Price of related goods
Size of population
Changes in price cause movement along
the demand curve - NOT a shift of the
curve


67
Change in Quantity Demanded
versus Change in Demand
Change in Quantity Demanded
Movement along the demand curve.
Caused by a change in the price of
the product.
68
Changes in Quantity Demanded
0
D
1


Price of
Cigarettes
Number of Cigarettes
Smoked per Day
A tax that raises the
price of cigarettes
results in a movement
along the demand
curve.
A
C
20
2.00
$4.00
12
69
Change in Quantity Demanded
versus Change in Demand
Change in Demand
A shift in the demand curve, either to
the left or right.
Caused by a change in a determinant
other than the price.
70
Changes in Demand (due to?)
0
D
1

Price of
Ice-Cream
Cone
Quantity of
Ice-Cream
Cones
D
3

D
2

Increase in
demand
Decrease in
demand
71
Changes in Income
If demand for a good is positively
related to income, it is called a normal
good
demand increases when income
increases
demand decreases when income falls
Examples: cars, wine, holidays?
72

Changes in Income
If demand for a good is inversely
related to income it is called an
inferior good.
demand decreases when income
increases
demand increases when income
decreases
Example: beer, public transport?
73
Substitutes and Complements
Two goods are substitutes if a rise in the
price of one increases demand for the other
(e.g. Xbox and PlayStation; butter and
margarine)
Two goods are complements if a rise in the
price of one decreases demand for the other
(e.g. Computers and software; DVD players
and DVDs)

74
PlayStation and XBox are
substitutes
Price of
PlayStation
Quantity
D after fall in
Xbox price
Demand before
change in Xbox
price
D after rise in
Xbox price
D
D
D
Demand for PlayStations
75
DVD players and DVDs are
complements
Price of
DVD Discs
Quantity
D after rise in
price of DVD
players
Demand before
change in DVD
price
D after fall in
price of DVD
players
D
D
D
Demand for DVD Discs
76
Supply
Quantity supplied is the amount of a
good that sellers are willing and
able to sell at every price.
77
Supply Schedule
The supply schedule is a table that
shows the relationship between the
price of the good and the quantity
supplied.
78
Supply Schedule
Price Quantity
$0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5
79
Supply Curve
The supply curve is the upward-
sloping line relating price to
quantity supplied.
80
Law of Supply
The law of supply states that
there is a direct (positive)
relationship between price and
quantity supplied.
81
Supply curve equation
This will be an upward sloping straight
line
Again, we write price as a function of
quantity
Hence equation of the form P = c + mQ
where m is slope, c is the vertical
intercept
82
Derivation
Slope = rise/run = change in
price/change in quantity
From supply schedule,
slope = 0.5/1 = 0.5
So we can write P = c + 0.5Q
What is the value of c?
Plug in P = 1 and Q = 1: get c = 0.5
So Supply equation is P = 0.5 + 0.5Q
83
Market Supply
Market supply refers to the sum of
all individual supplies for all sellers
of a particular good or service.
Graphically, individual supply
curves are summed horizontally to
obtain the market supply curve.
84
Change in Quantity Supplied
versus Change in Supply
Change in Quantity Supplied
Movement along the supply curve.
Caused by a change in the market price
of the product.
85
Change in Quantity Supplied
1 5
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream
Cones
0
S
1.00
A
C
$3.00
A rise in the price
of ice cream cones
results in a
movement along
the supply curve.
86
Determinants of Supply
Price of the good itself is NOT a determinant
of supply. It is only a determinant of the
QUANTITY supplied.

Costs of Production
Environment
Number of suppliers
Technology
87
Change in Quantity Supplied
versus Change in Supply
Change in Supply
A shift in the supply curve, either to
the left or right.
Caused by a change in a determinant
other than price.
88
Shifts of the supply curve
Changes in the following factors induce
a shift of the supply curve:
Costs of production
Environment
Number of suppliers
Technology used to produce the good
89
Change in technology:
example
Price of
grain ($)
Quantity of grain
(bushels)
Supply before
Genetically
Engineered
grain
S after GE
grain
introduced
S
S
Genetic
engineering
allows more
grain to be
produced
from the
same area of
land
90
Supply and Demand Together

Equilibrium Price
The price that balances supply and demand.
On a graph, it is the price at which the
supply and demand curves intersect.
Equilibrium Quantity
The quantity that balances supply and
demand. On a graph it is the quantity at
which the supply and demand curves
intersect.
91
Supply and Demand Together
Price Quantity
4 0
5 1
6 2
7 3
8 4
9 5
10 6


Price Quantity
16 0
14 1
12 2
10 3
8 4
6 5
4 6


Demand Schedule Supply Schedule
At $8.00, the quantity demanded is
equal to the quantity supplied!
92
Market Equilibrium
Demand
Supply
Q = 4
P=$8
Price ($)
Quantity
93
Disequilibrium
A well functioning market will tend to
settle at the equilibrium price

For various reasons, this might not
happen

There are two other possibilities:
Shortage of goods = Excess demand
Surplus of goods = Excess supply

94
Surplus
Quantity of
grain (bushels)
S
D
Price of
grain ($)
Q Q
P*
Q
*

Surplus
P
1
is higher than the
equilibrium price (P
*
)
At P
1
, suppliers are willing
to sell Q but buyers only
want Q

A surplus of grain equal to
(Q - Q) will exist
Suppliers will have a lot of
stock lying around
Suppliers have an incentive
to lower their price to get rid
of the surplus until P* is
reached

P
1

95
Shortage
Quantity of
grain (bushels)
S
D
Price of
grain ($)
P
1

Q Q
P
*
Q
*

Shortage
P
1
is lower than the
equilibrium price (P
*
)
At P
1
, suppliers are only
willing to sell Q but buyers
want Q

A shortage of grain equal to
(Q - Q) will exist
There will be queues of
buyers, so suppliers have an
incentive to increase their
price (until P* is reached)

96
Numerical Example


QUESTION: find equilibrium price and quantity if

The demand curve is: P = 16 - 2Q
and
The supply curve is: P = 4 + Q

97
Numerical Example


ANSWER: At the market clearing price,
demand = supply,
so we must have
16 - 2Q = 4 + Q
So: 12 = 3Q Q* = 4
Now, plug in Q=4 into Demand (or Supply) to
get
P* = $8
98
Graph of previous problem
Market Equilibrium
$16
8
Demand
$4
Supply
4
$8
Price
Quantity