ECON1101: Microeconomics 3 Supply and Demand Demand shifts right – equilibrium price and

University of New South Wales Market - Where buyers and sellers can facilitate quantity both rise
exchange of goods Supply shifts right – equilibrium price goes down,
1 Thinking as an Economist Demand curve – downward sloping because of quantity goes up
Economics – Study of choices under conditions of substitution effect, income effect and reservation 4 Elasticity
scarcity – how they’re made and their results
prices Price elasticity of demand/supply - % change
Micro - Individual consumers and firms; Macro -
Supply curve – upward sloping because of low in Q demanded/supplied for 1% change in P
Aggregate economy ∆ / ∆ 1
Cost benefit principle – Take action if benefit > hanging fruit and rising opportunity costs = = × = ×
∆ / ∆
cost
E < 1: Inelastic, E = 1: Unit elastic, E > 1: Elastic, E
Economic surplus – Benefit - cost
= 0: Perfectly inelastic, E = infinite: Perfectly elastic
Scarcity principle – having more of one good
means having less of another
Opportunity cost – Cost of not taking the next
best option
Pitfalls: 1. Absolute amounts vs proportions 2.
Ignoring opportunity costs 3. Sunk costs 4. Average
vs marginal costs and benefits
2 Comparative Advantage: the Basis for
Equilibrium – System at
Trade
rest, nobody wants to
Absolute advantage – Can perform task with less
change behaviour Elasticity of demand affected by – Substitutes,
resources
Demand shifts right due budget share
Comparative Advantage – Can perform task with
Elasticity of supply affected by – Number of
lower opportunity cost to drop in price of
producers, mobility of inputs, production period
Specialisation according to comparative advantage complement, rise in price length
and trade gives maximum output of substitute, increased Elasticity of demand is – 1 at mid-point of
PPC – Downward sloping because of scarcity, bow
preference by buyers, demand curve, <1 to left, >1 to right
shaped for a many person economy because of low
increased population of Cross price elasticity of demand - % change in
hanging fruit, shifts due to economic growth,
buyers and expectation of future higher prices (and Q demanded for %1 change in price of DIFFERENT
population growth, new resources and better
vice versa) good.
technology
Supply shifts right due to decrease in costs of Complement - < 0, Substitute - > 0
productive factors, improvement in technology, 5 Perfect Competition
Law of demand – Quantity demanded goes down
increase in number of suppliers and expectation of
as price goes up and vice versa
lower prices (and vice versa) Need - something that you cannot live without, e.g.
food and water
Want - something you would like to have, but don’t
need, e.g. ribs. Demand represents wants
Law of diminishing marginal utility – additional
utility (benefit) of consuming an extra unit of a good
decreases with consumption
Rational spending rule – Spend until marginal
benefit = marginal cost
Law of Supply – Quantity supplied goes up as
price goes up and vice versa
Constructing Market demand and supply
curves – Add HORIZONTALLY
Perfect competition – Profit maximizing firms,
price takers, identical products, many buyers and
sellers, no barriers to entry or exit, well informed
buyers and sellers
Fixed costs – Don’t change
Variable costs – Change with production
Profit
maximization
rule – Price =
Marginal cost
Consumer and Producer surplus – Difference 7 The Quest for Profit and the Invisible
between reservation price and price paid Hand
Accounting profit – Revenue - explicit costs;
Economic profit – Accounting profit – opp. costs
Normal profit – Economic profit = 0 (Normal profit
is opportunity cost)
Invisible Hand theory – Buyers and sellers acting
selfishly and independently will result in socially
optimal allocation of resources and best outcome for
everyone
Forms of market efficiency
Weak Semi-strong Strong
6 Efficiency and Exchange Info reflected Private Public Both
Pareto improvement – Somebody is made better in share price
off and nobody is made worse off 8 Monopoly and other forms of Imperfect
Pareto efficiency – No more Pareto improvements Competition
can occur Price taker – Firm will lose all sales if price higher
than market price. Demand curve is perfectly elastic.
Economic surplus in a market is maximized
Price setter – Firm can change price and not lose
when exchange occurs at the equilibrium price all sales. Demand curve is downward sloping.
Causes of deadweight loss – Price floors, price Three types of imperfect competition
ceilings, price subsidies, taxes Pure Oligopoly Monopolistic
monopoly competition
Single firm Few large Many firms with
firms differentiated
products
Sydney airport ANZ, CBA, Restaurants
Westpac, NAB
Monopolies arise from – Exclusive access to
resources, government, economies of scale
Economies of scale – Average cost goes down as
production goes up. Average cost = (Fixed costs +
Variable costs) / Quantity; FC/Q goes down with Q,
VC/Q goes up (diminishing marginal returns).
Diseconomies of scale when average starts to rise

Monopolist’s profit maximization rule –
= 10 Externalities and Common Resources
MR NOT Price; higher production means price must
be lowered to get sufficient demand; MR
decreasing.
Price discrimination – charging different prices to
different buyers for same good
Perfect price discrimination – Charging
customers their exact reservation price
9 Thinking Strategically
A game has – players, strategies, payoffs
Dominant strategy – Gives highest payoff no
matter what other players choose
Nash equilibrium – Every player has highest
payoff given other player choices
Prisoner’s dilemma – Every player has dominant
strategy but they are all better off if all choose
dominated strategy
The oligopoly prisoner’s dilemma – Can agree
to set price at monopolist profit maximizing level
(form a cartel), but each has incentive to lower price
to gain market share. Price war leads to lower
profits for all.
Externality – Cost (negative) or benefit (positive)
to somebody not involved in activity. Causes
deadweight loss (see graph)
Coase theorem – Problems with externalities are
solved by people negotiating prices of property
rights IF transaction costs are low
Government solutions to externalities –
Regulations, market-based instruments (taxes,
subsidies, cap and trade)
Common resources – Resources that it is difficult
to exclude people from using (e.g. a lake)
Open access – When anybody can use a common
resource
Tragedy of the commons – Common resources
with open access are used by more and more
people until total surplus drops to zero
Positional externalities - a change in one
person’s performance changes the expected reward
of another in situations where reward depends on
relative performance
Positional arms race – Positional externalities
lead to series of continually offsetting investments in
performance by 2 players, e.g. use of performance
enhancing drugs in professional sport
11 Public Goods and their financing
Rivalry – Consumption of good by one person
means there is less available for another
Excludability – People can be prevented from
using a good if they don’t pay
Rivalrous Non-rivalrous
Excludable Private goods Collective goods
Non-excludable Common goods Public goods
Free rider problem – people value public goods
but avoid paying for them because they know they
can’t be excluded. Public goods don’t get sufficient
funding if too many people do this. Solved by taxes.
Head tax – Everybody pays same amount
Regressive tax – Proportion of income paid in
taxes declines as income rises (head tax is
regressive)
Proportional income tax - all taxpayers pay the
same proportion of their incomes in taxes
Progressive tax - Proportion of income paid in
taxes rises as income rises
12 The Economics of Information
Cost of information – Opportunity cost of time
spent searching, rises as more is gained
Benefit of information – Gains in surplus from
using it, e.g. money saved finding a better deal
The optimal amount of information – Marginal
benefit = marginal cost
Gamble inherent in search – Don’t know what
the benefits of information will be (will I find a much
cheaper deal or waste my time and find nothing?)
Asymmetric information – buyers and sellers
aren’t equally informed, e.g. sellers knows quality
better
Principal – Someone who contracts another to
perform a service on their behalf
Agent – Someone who is contracted to work on a
principal’s behalf
Principal-agent problem – Principals and agents
have different values. Agent could in self-interest
against the best interests of the principal and
monitoring an agent’s actions can be costly.
The Market for Lemons model – Asymmetric
information leads to deterioration in value of goods.
Buyers offer average price for both good and bad
(lemons) goods; sellers with above average goods
leave the market because they aren’t offered good
prices, sellers of lemons flood the market to make
surplus.
Adverse selection – Buyer exploits asymmetric
information before a transaction, e.g. terminally ill
person buying life insurance
Moral Hazard – Buyer exploits asymmetric
information after a transaction, e.g. person with car
insurance drives more dangerously knowing they’re
covered