Microeconomics

1

Prices and Markets
ECON1020 Semester 2 2020

Professor Robert Hoffmann

possible new bits

5

1. Economics
2. Market Demand
3. Price Determination

The Market
Prices and Markets: Block 1

6

1.1. Economics
1.2. Economic Method
1.3. The Economy
1.4. Economic Systems

The Market
Prices and Markets: Block 1

Lecture 1
Economics

1.1.1. Economics: Definition of Economics

Lionel Robbins

Economics is the study of the economy. It

• studies how agents choose to allocate limited resources (rationality)
• studies these issues using the scientific method (equilibrium and empiricism)
• studies how these choices affect the welfare of society (efficiency)

Definition: Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses (Lionel Robbins).

Definitions: Microeconomics is the branch of economics that studies resource allocation by individual
economic agents, markets, firms and government and the impact on efficiency. Macroeconomics is the
branch of economics that studies the performance of the economy as a whole at the national, regional and
global levels resulting from the interactions between markets, firms and government.

Definitions: Positive economics describes what economic agents actually do. Normative economics
recommends what economic agents and society should do.

Macroeconomics 1
ECON 1016

Prices and Markets
ECON 1025

em
piri

cal
Behavioural Minor

the
ore

tica
l

Phenomenon
• identification
• observation
• measurement

Model
• definitions
• assumptions
• variables

Analysis
• ceteris paribus
• equilibrium
• efficiency

Theory
• explanations
• predictions
• policy advice

Test
• hypotheses
• measurement
• statistical analysis

(econometrics)

Price Qd Qs

1 97 23

2 87 33

3 81 43

4 74 54

5 66 66

DV = ⨍(IV1, IV2 …)

1.2.1. Economic Method: Theory and Empiricism
Behavioural

Minor

1.2.2. Economic Method: Economic Thinking

Observation

Theory

Model

Evidence

Sep!mber 30, 1659.—I, poor miserable Robinson Crusoe, being shipwrecked during a dread#l s$rm, came on
shore on %is dismal, unfortuna! island, a& %e rest of %e ship’s company being drowned, and myself almost
dead. I had nei%er food, house, and in despair of any relief, saw no%ing but dea% before me—ei%er %at I
should be devoured by wild beasts, murdered by savages, or starved $ dea% for want of food.

Definition: the factors of production (FOPs) are those resources used to
produce: capital (man-made resources), land (natural resources) and labour
(the human resource).

Robinson has
resources:
• pocket knife
• papaya trees
• skills
• freshwater lake
• time (a lot!)
• wild goats
• knowledge

The allocation of scare resources in the subsistence economy
involves the following basic economic problems:

• Problem #1: What to produce?
• Problem #2: How to produce?

Production = ⨍(capital, land, labour)

1.3.1. The Economy: The Subsistence Economy

Definition: Allocating limited resources involves trade offs. Opportunity cost
is the best alternative that must be given up to obtain something.

Definition: Rationality means economic agents try to optimise and choose
the best feasible option given their information and abilities.

Robinson develops labour (skills)
I had never handled a $ol in my life; and yet, in (me,
by labour, applica(on, and con)ivance, I found at last
%at I wan!d no%ing but I could have made it,
especia&y if I had had $ols.

Robinson acquires capital
Oc$ber 1.—In %e morning I saw, $ my great surprise,
%e ship was driven much nearer %e island; I might get
on board, and get some necessaries out of her for my
relief— I %en swam on board

Production Possibility Frontier

F
oo

d
(0

00
s

kc
al

)

0

2

4

6

8

Shelter (sqm)

0 1 2 3 4 5 6 7 8

Robinson at first
Robinson with tools
Robinson with tools and new skills

Definition: the production possibility frontier (PPF) shows the various combinations
of output that the economy can produce given the available factors of production.

Definition: opportunity cost is the best alternative
that must be given up to obtain something.

Robinson must choose a point on the PPF depending
on his tastes for the two products. Going from (4,2) to
(2,3) involves a trade-off: to afford 1 extra unit of food
there is an opportunity cost of 2 units of shelter which
have to be given up in return.

Unattainable

Inefficient

1.3.2. The Economy: Economic Growth

2, 3

4, 2

Production Possibility Frontier

F
oo

d
(0

00
s

kc
al

)

0

2

4

6

8

Shelter (sqm)

0 1 2 3 4 5 6 7 8

Robinson Crusoe
“Man Friday”
Both Definitions: Absolute advantage is the ability to

produce something with fewer inputs (or more with
the same inputs). Comparative advantage is the
ability to produce something at lower opportunity cost.

To produce 1 extra unit of shelter, Friday gives up 2
units of food but Robinson only gives up 1/2 unit.
Robinson has comparative advantage in making
shelter and specialises. Friday specialises in producing
food. There is a division of labour.

The gains from trade means both are better off and
together produce (8,8). But specialised individuals
need to trade to get what each needs:
• Problem #3: How to exchange?

4,44,4

6,6

8,80,8

8,0

Definition: the production possibility frontier (PPF) shows the various combinations
of output that the economy can produce given the available factors of production.

1.3.2. The Economy: The Exchange Economy

Robinson must choose a point on the PPF depending
on his preferences. Going from (4,2) to (2,2) involves
a trade-off: 1 extra unit of food has an opportunity
cost of 2 units of shelter which have to be given up.

2,4

2,3

4,2

1.4.1. Economic Systems: Markets v. Planning
Definition: An economic system is the way which a society allocates its resources,
i.e. organises production and exchange (i.e. solves economic problems #1-3).

The free market economy The command economyThe mixed economy

FOP
ownership private public

Decision
making

individually
autonomous

centralised and
hierarchical

Coordination market central planning

increasing government intervention

Inputs for
production

Wages, rent
& profit

Labour, land
& capital

Income

Revenue

Firms

Goods &
services

sold

Households

Markets for goods
& services

Goods &
services bought

Spending

Government Markets for the FOPs

Rest of the World

Imports Exports

T
he

(
cl

os
ed

)
ec

on
om

y
T

he
(

op
en

)
ec

on
om

y

1.4.2. Economic Systems: The Circular Flow

Singapore?Laos

Economics is about how to allocate one’s resources for the best result. One of the most important issues for
a country is what it should produce: What do you use your workers, land and machines for?

Coffee is one of the most widely consumed beverages and therefore most important trade goods. It is
widely produced in countries with equatorial climates, like Laos and Vietnam.

Should Singapore grow coffee?

Let’s use some economic thinking to get to the bottom of this. Economists look at real issues through
models and theory.

Tutorial 1

Tutorial 1: Gaining from Trading
These production possibilities frontiers (PPFs) show how many units of two products 1 worker can produce in one day in two countries:

1. What is Laos’ opportunity cost of producing (a) 1 unit of electronics and (b) 1 unit of coffee beans?

2. What is Singapore’s opportunity cost of producing (a) 1 unit of electronics, and (b) 1 unit of coffee beans?

3. Which if any product(s) does Laos have an absolute advantage in? Which if any products(s) does Singapore have an absolute
advantage in?

4. Assume Laos produces 15 coffee and 5 electronics units, and Singapore produces 20 coffee units and 15 electronics units. That
means together, they produce 35 units of coffee, and 20 of electronics. Advise the countries how together they can produce more
of both. Hint: Economists use theory! Look back at your lecture notes and pick out the correct concept to help you answer.

5. Laos receives foreign aid. Show the new PPF: (a) Machinery from China that doubles Laos’ productivity in electronics but has no
other use, (b) training from Vietnam for its coffee workers that raises their productivity by one third.

6. How can any country, like Laos or Singapore, produce more? Provide a general economic model rather than specific examples.

C
of

fe
e

B
ea

ns

0

10

20

30

40

Electronics

0 5 10 15 20 25 30

C
of

fe
e

B
ea

ns

0

10

20

30

40

Electronics

0 5 10 15 20 25 30

Singapore
Laos

28

Lecture 2
Market Demand

2.1. The Market Model
2.2. The Demand Curve
2.3. Demand Elasticity
2.4. The Supply Curve

The Market
Prices and Markets: Block 1

2.1. The Market Model
Definition: The market is an institution where the buyers and
sellers of the same good or service come together to trade.

Variables in the allocation of resources
• price (p)
• quantity of output (q)

Assumptions
• rational agents
• perfect information
• zero transaction cost
• flexible prices
• property rights defined and enforced
• perfect competitionWhile they are “unrealistic” simplifications,

together they tell us under what conditions the
market will work well. They serve as a benchmark
for the design and improvement of real markets.

The market model shows the relationship between
two key variables, price and quantity, for both
demand and supply. We analyse the model for
equilibrium and efficiency.

Demand side
(buyers or
consumers)

Supply side
(sellers or
producers)

Behavioural

Minor

2.2.1. Demand Curve: of Demand

Demand schedule
P QD
14 0
12 1
10 2
8 3
6 4
4 5
2 6
0 7

Demand function: P = 14 – 2QD

QD = -(P-14)/2

Demand comprises all those consumers willing and able to buy the product. How much
people buy depends on many variables, we focus on price.

P
ric

e
(P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7

Definition: the law of
demand states that
as the price rises, the
quantity demanded
falls and vice versa
(because consumers
are relatively worse off
and substitute into
other products).

Definition: Demand shows how much consumers plan to
buy at every conceivable price. Quantity demanded (QD)
refers to purchasing plans at one particular price (P).

• slopes downward
• steepness reflects consumer price sensitivity
• position reflects the volume of demand

Q0

P

p

p’

q q’

D

2.2.2. Demand Curve: Own-Price Elasticity
Definition: Elasticity measures the responsiveness of quantity to one of its determinants. We measure
elasticity in the steepness (slope) of the curve concerned. There are many types of demand and supply
elasticity to determinants such as price of this and related products, income etc.

Definition: own-price elasticity of demand (PED) measures the
responsiveness of quantity demanded of a product to its price. It reflects
the sensitivity or responsiveness of consumer purchasing plans to price.

The steepness or slope of the demand curve is a measure of
own-price elasticity of demand. The flatter the demand curve,
the greater is the change in consumers’ purchasing plans.

PED =
% ∆ QD

% ∆ P

2.2.3. Demand Curve: Midpoint Formula

Q=2
P=10

Q=5
P=4

Q=0
P=14

P
ric

e
(P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7

Q=7
P=0

PED = (2 – 0) ⨉ (10 + 14) = 2 ⨉ 24 = -6
(10 – 14) (2 + 0) -4 2

PED = (2-5) ⨉ (10 + 4) = -3 ⨉ 14 = -1
(10-4) (2+5) 6 7

PED = (Q2 – Q1) ⨉ (P2 + P1)
(P2 – P1) (Q2 + Q1)

PED = (7 – 5) ⨉ (0 + 4) = 2 ⨉ 4 = -0.167
(0– 4) (7 + 5) -4 12

The measured elasticity between two given points of the demand curve depends on whether we calculate the
change from the higher or the lower of the two values, e.g. from P=4 to P=10 or vice versa. As a result we can
use the mid-point formula which gives the same result in either case:

PED = (5 – 2) ⨉ (4 + 10) = 3 ⨉ 14 = -1
(4 – 10) (5 + 2) -6 7

The elasticity measured at different points of a linear curve differs
because the percentage size of same absolute change (say a price
fall of 4 either from 14 to 10 or 4 to 0) differs as we go along the axis.

∆ QD

∆ P

Example calculations:

2.3.1. Demand Elasticity: Own Price

Abs. value 0 between 0 and 1 1 >1 ∞
Classification perfectly

inelastic
inelastic unit elastic elastic perfectly

elastic
∆ Q P causes ∆

QD of 0
less than

proportional
proportional greater than

proportional
total

P

Q

PED =
% ∆ QD

% ∆ P
Definition: Own-price elasticity of demand (PED) measures the
responsiveness of quantity demanded of a product to its price. It reflects
the sensitivity or responsiveness of consumer purchasing plans to price.

Necessity
Short-term
No substitutes
Wide market

Luxury
Long-term
Substitutes
Narrow market

2.3.2. Demand Elasticity: Cross Price

Definition: Cross-price elasticity of demand (CPED) measures the responsiveness
of quantity demanded of a product to changes the price of another good.

Complements have negative
cross-price elasticities.

Substitutes have positive cross-
price elasticities.

Unrelated goods have zero
cross-price elasticities.

0

0 QdP
ric

e
of

a
no

th
er

g
oo

d

0 Qd

P
ric

e
of

a
no

th
er

g
oo

d

0 Qd

P
ric

e
of

a
no

th
er

g
oo

d

CPED =
% ∆ QD

% ∆ POther

Original good (coffee) Original good (coffee) Original good (coffee)

2.3.3. Demand Elasticity: Income

Normal goods have
positive income
elasticities.

Inferior goods have
negative income
elasticities.

Necessities tend to have
small income elasticities.

Luxuries tend to have
large income elasticities.

Income (Y)

0 Qd

YED =
% ∆ QD

% ∆ Y

0 Qd

Income (Y)

0 Qd

Income (Y)

0

0 Qd

Income (Y)

Definition: income-elasticity of demand (YED) measures the responsiveness
of quantity demanded of a product to changes in consumer income.

P
ric

e
(P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7 8 9 10 11 12

Supply schedule

P QS

0

2 0

4 2

6 4

8 6

10 8

12 10

14 12

2.4.1. Supply Curve: of Supply

Supply function: P = 2 + QS

QS = P − 2

Supply comprises all those producers willing and able to produce the product.
How much these firms produce depends on many variables, we focus on price.

• slopes upward
• slope reflects producer price sensitivity
• position reflects volume of supply

Definition: the law of
supply states that as the
price rises, the quantity
supplied rises and vice
versa (because
producers substitute out
of other products).

Definition: Supply shows how much producers plan
to produce at every conceivable price. Quantity
supplied refers to one particular price level.

2.4.2. Supply Curve: Own-Price Elasticity

Q0

P

q q’

p’
p

S

A product´s own-price elasticity depends on

• availability of close substitutes
• definition of the market
• availability of inputs
• time horizon

Definition: Own-price elasticity of supply measures
the responsiveness of quantity supplied of a product to
its price. It reflects the sensitivity or responsiveness of
producer purchasing plans to price.

The steepness or slope of the supply curve is a measure of
own-price elasticity of supply. The flatter the supply curve, the
greater is the change in firms´ producing plans.

PES =
% ∆ QS

% ∆ P

Product A Product B
Price
of A Q

D QS QD

60 0 10.5 16.5
54 2 9 15
48 4 7.5 13.5
42 6 6 12
36 8 4.5 10.5
30 10 3 9
24 12 1.5 7.5
18 14 0 6
12 16 4.5
6 18 3
0 20 1.5

Tutorial 2 – Analysis of Demand
You work for a market analysis firm that uses checkout data and cost
information from producers to estimate the market demand and supply for
different products. You have collected market data about two products
one of your clients sells, product A and B. The data are shown in the
table. Your manager wants you to analyse it and present findings in a
report using suitable diagrams and calculations. You are meant to answer
the following questions:

1. How sensitive are buyers of product A to a price change in product A
from $60 to $54?

2. What is the relationship between product A and product B?
3. Interviews with customers suggest that most regard product A as a
necessity. If so, how much would the quantity demanded of product A
change if consumer income was to rise by 1%?

4. Your colleague claims he has good knowledge of the production
process and firms selling product A and claims supply is generally own-
price inelastic. Is he right?

5. Plot all the data for product A in a diagram.
6. What is the quantity of product A that you expect will be sold in this
market?

50

The Market
Prices and Markets: Block 1

Lecture 3
Price Determination

3.1. Market Equilibrium
3.2. Change in Demand and Supply
3.3. Comparative Statics
3.4. Market Efficiency

P QD QS Difference

14 0 12 12

12 1 10 9

10 2 8 6

8 3 6 3

6 4 4 0

4 5 2 -3

2 6 0 -6

0 7

In the competitive market, the equilibrium occurs at the price where QD = QS. This price
clears the market such that no shortage nor surplus exists.

The coffee market

P
ric

e
(P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7 8 9 10 11 12

Demand
Supply

3.1.1. Market Equilibrium: Demand and Supply

3.1.2. Market Equilibrium: Market Clearing

Q0

P

D

S
Definition: Equilibrium
[from Latin aequus
(equal) and lībra (level,
balance) is a balance of
opposing forces, i.e. a
stable state of a system
under prevailing
conditions.

p
qD qS

p
qDqS

oversupply

shortage

market clearingp*

q*

At first we examine partial equilibrium in a market, i.e. ceteris paribus, prices in related markets (substitutes,
complements and FOPs) are constant.

3.2.1. Change in Demand

Q0

P

Factors that change demand
• price of substitutes in consumption
• price of complements in consumption
• consumer income
• consumer tastes
• changes in population

p

q’

D’

Definition: a change (rise/fall) in demand means that at every price,
there is now a different (greater/smaller) quantity demanded.

q

D

q’’

D’’

risefall

3.2.2. Change in Supply

Q0

P

Factors that change supply
• price of substitutes in production
• price of complements in production
• taxes/FOP prices
• technology
• firm entry/exit

p

q’

Definition: a change (rise/fall) in supply means that at every price,
there is now a different (greater/smaller) quantity supplied.

risefall

S’

q

S

q’’

S’’

International Coffe prices
(kg Arabica beans in 2010 real US$)

0

1

2

3

4

5

6

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

3.3.1. Comparative Statics: Co!ee Prices
QUESTION
Coffee is now the second most traded commodity in the world after crude oil. Not only has demand for various
coffee products risen sharply in Western countries in recent years, increasingly there is also greater taste for
coffee drinks in developing countries such as China and India. In addition, by-products of coffee beans have
become popular such as coffee leaves which can be used to brew a tea with known health benefits. However, as
a natural produce, coffee plants are subject to weather conditions. Recently major producers such as Brazil have
been plagued by droughts. Using the demand-supply model, explain the likely effects of these phenomena in the
coffee bean market. How can a market analyst use this information to her advantage?

3.3.2. Comparative Statics: Co!ee Demand

Coffee producing nations

Others
19%

Peru
3%

Guatemala
3%Mexico

4%
India
4%
Ethiopia

5%
Indonesia

6% Colombia
9%

Vietnam
12%

Brazil
35%

3.3.3. Comparative Statics: Co!ee Supply

Q0

P

D

S

p1

q1

We examine the effect of a change in the prevailing conditions on the (initial) equilibrium in the market. We find the
new equilibrium and compare it to the previous one.

D’

p2

q2

S’ Commodities – The Wall Street Journal
India’s Taste for Coffee to Affect Bean Prices
Neena Rai in London and Debi Nayak in Mumbai

“The size of the Indian economy and the rate of growth of the cafe
sector, combined with rising spending power and shift in consumer
preferences present a tremendous opportunity for us” says Avani
Saglani Davda, chief executive of Tata Starbucks Ltd.

Barron’s -Leslie Josephs – Arabica-coffee prices have
surged 72% so far this year, after Brazil’s worst drought in
decades crimped output, down 8% from last year. Many
parts of Brazil’s main arabica-growing areas have received
half the normal amount of rainfall.

p3

q3

Coffee prices expected to rise as a result of
poor harvests and growing demand
Coffee bean prices top $3 a pound for first time in 34 years
(Julia Kollewe, The Guardian)

3.3.4. Comparative Statics: Co!ee Price Determination

=-
Consumer

value
Amount

paid
Consumer

surplus

Consumer surplus is the area between the demand curve and the price line.

The demand curve reflects the value consumers receive from consuming.

Definition: consumer surplus is the difference between consumers’ willingness to pay and the amount
they actually pay for it is consumers’ gains from trade, i.e. the benefit of buyers from participating in the
market.

We measure consumer value of consumption by their willingness to pay, i.e. the
price they are willing to pay at every quantity demanded.

3.4.1. Market E”ciency: Consumer Surplus

$10

$70 $4×10=$40 ($6×10)/2=$30

Demand curve: Willingness to pay

Equilibrium: The price everyone pays

Q0

$4

10

Demand

P

P

Q0

$4

Supply

10

=-Amount received Producer surplusProducer cost

The supply curve reflects the cost firms incur in producing.

We measure producer cost of production by their willingness to sell, i.e. the price
they accept at every quantity supplied.

Definition: producer surplus is the difference between producers’ willingness to
sell and the amount they actually receive for it is producers’ gains from trade, i.e.
the benefit of producers from participating in the market.

Producer surplus is the area between the supply curve and the price line.

3.4.2. Market E”ciency: Producer Surplus

($4×10)=$40 ($3×10)/2=$15

$1

$25

Supply curve: Willingness to sell

Equilibrium: The price every firm receives

P

Q0

$4

Supply

10

=+

Demand

Producer
surplus

Consumer
surplus

Total
surplus

Definition: Total surplus is a measure of the benefit of buyers and sellers from participating in the
market, the total gains from trade. It is the sum of consumer and producer surplus.

Conversely, it is the value to buyers minus the cost to sellers.

=-
Total

surplus
Producer

cost
Consumer

value

The total benefit to society is the value of consuming
the product minus the cost of producing it.

3.4.3. Market E”ciency: Total Surplus

$15$30 $45

$70 $25 $45

P

0

Demand

Q

Supply

Society should continue to produce more as long as the marginal consumer
value is greater than the marginal cost of production

This will maximise total surplus and the gains from trade in this market.

$4

10

$10

3.4.4. Market E”ciency: Marginal Surplus

Total surplus is maximal when marginal surplus is equal to the marginal cost.

1a. During the novel coronavirus (COVID-19) pandemic, people of all incomes from poor to rich are stocking up
on different types of product they regard as necessary. Suppliers cannot increase their output quickly enough.
Australian government is concerned about profiteering and affordability in the markets concerned and is
considering intervening. Using the demand-supply model, explain these phenomena in one or two markets of
your choice. Advise which market interventions, if any, government should conduct in these markets.

1b. Bangalore has become India’s third biggest city following a population explosion that doubled the number of
residents since 2000 to over 10 million. Public infrastructure development cannot keep up with this rapid
urbanisation. A water shortage is looming. As a result the city has introduced a ban of constructing new
apartments for five years. Using the demand-supply model, assess the effect on condominium unit prices. In
particular comment on the likely size of this effect considering the shape of the supply curve.

1c. Workplace automation involves systems, both software and hardware, to perform repetitive tasks reducing
the need for labor in the production process. For example automobile manufacturing plants are introducing
industrial robots with very little need fo human intervention on the assembly line. Using the demand-supply
model, explain the effect of the introduction of such industrial robots in a suitable market of your choice.

1d. During the 1993 ‘mad cow disease” or BSE outbreak in the UK, evidence emerges regarding the dangers of
eating beef from infected animals. Which markets are affected, and what are the effects?

Tutorial 3

2. Open your notes for tutorial 2. Your legal department informs you that government has introduced a per-unit
tax of $7 to be collected from the sellers in this market. Your manager is worried what that the tax will affect all
firms’ willingness and ability to produce and therefore price. What do you think? Make appropriate changes in
your graph and numbers to reflect this tax. What is the impact on the equilibrium price and quantity?

3. What can you say about the products in the following three markets?

3.1. 3.2. 3.3.
P

0 Q

Supply

Demand

P

0

Demand

Q

Supply

P

0 Q

Supply

Demand

Behavioural

Minor