In doing so we found that the outcomes in a competitive market allowed gains from trade – buyers who valued the products more than the sellers were trading with each other. But there were issues:

• It assumed there were lots of potential sellers of a homogenous product whose choices have no influence on the choice of other sellers.
• It assumed there were no systematic biases in consumer choices and ignored agency problems in production.
• It took for granted full, or at least symmetric, information about the product and the market.
• It didn’t incorporate the way the choice to produce or consume could impact upon a third party (externalities).
• It assumed that the institutional structure ensured the product was excludable.

These assumptions do hold in some circumstances – and even when they don’t there could be a good reason we start with it (eg assuming a systematic bias without evidence is just assuming people are stupid – which isn’t a good starting point for trying to objectively understand their choices).

But we would like to think about other types of market structures we observe.

Since then we have built some more tools to think about choice – comparative advantage, finance, game theory, and emergent macro-phenomenon.

Armed with these tools we can return to our original market model and ask “what happens when there is only one firm – with the same motives and desires as the many firms before”. This is the case of monopoly.

One firm – one price

Our monopoly has the same motivation as the perfectly competitive firm. It minimises its costs and maximises its profit. So the monopoly we are thinking about is not subject to the agency problems we have discussed could occur – and any X-inefficiency due to this is put to the side.

Given we are comparing like-with-like we want to think about why the aggregated choice of perfectly competitive firms, and the choice of a monopolist over the same industry would differ.

For this we can use the following pieces of understanding:

• A profit maximising firm will set MR = MC (marginal revenue equal to marginal cost).
• For a competitive firm, their choice of price does not influence the price they face OR the price faced by other firms. As a result, MR = P. In a competitive industry this implies that the overall supply curve is simply the MC curve (above average variable costs).
• To put another way – if a competitive firm set a higher price it loses all its customers, if it sets a lower price it simply loses revenue (as it can sell as much as it wants at a given price), so they only ever have an incentive to set that one price.
• For a monopoly, when they produce more they lower the price they face – as a result, making one more unit and selling it involves selling at a lower price to all the customers who would have purchased at a higher price (non-discrimination).
• As a result, selling an extra unit will provide an increase of revenue equal to the price the unit is sold for minus the lost revenue from their existing customers – so MR < P.
• Given this, MR = MC < P and the monopolist will only sell output up until the point where they make a margin on cost (where cost includes the opportunity cost of production).
• The monopolist WANTS to sell to another customer at a price below the current price. A customer WANTS to buy at this price. But they do not transact because the monopolist would have to cut the price for all other customers. Therefore, some transactions that have gains from trade do not occur.

That is our process for thinking about the monopoly – no graphs and no real math. This also tells us we can ensure all gainful trade occurs by allowing first degree (perfect) price discrimination – but then all of the surplus will be received by the monopolist, and none by the consumer. So we may view this as inequitable.

Graphs

So to make sure we understand, lets do this with our graphs.

In this first graph we can see that the monopolist charges a mark-up on cost, and will produce less at a higher price that the competitive firm did (where demand equals marginal cost). The “lost surplus” for these missing transactions is coloured in yellow – we call this deadweight loss, and often term it the inefficiency in the market.

Our second graph here adds another perspective. If we have normal profits at the competitive equilibrium, then a monopolist will make supernormal profits. We know that these profits would incentivise entry – and so for entry to not occur there must be some specific nature of the industry (eg economies of scale and natural monopolies) or barrier to entry (either government or firm induced) that prevent a second firm from showing up.

Summing up

Our model of monopoly leads to an outcome we would – in many ways – view as “worse” than the competitive situation. Transactions do not occur when there are gains from trade associated with them.

But this isn’t due to some specific motivation – the monopolist is no more evil than a competitive firm in our example, there are no differences in motivates and desires. Instead the trade-off they face is different – and they respond to that.

We did noticed that entry and the potential for competition are important – and this takes us to our final topic for the course, Oligopolies!

Finance seems like an exciting topic, with a lot of the economic metrics we see flashed around day to day related to financial markets rather than the abstract markets we’ve been talking about so far. Financial security through oil and gas OT cybersecurity systems can work wonders to safeguard online financial information.

However, what do we mean when we talk about finance here, and how does it fit into what we’ve talked about so far? For the murky details of how we “do” finance I will leave you to work through the lectures (and slides here and here) – this post is just about motivating why we do those calculations.

What are we talking about with finance?

Lets not fixate on stock markets, interest rates, and some of the exciting financial gambles you see in movies. Lets not use some of the common definition of “financing an expenditure” or “dealing with large sums of money. And instead lets start at the beginning and work out what this term means for us in economics.

So far in the course we’ve been fixated on the amount of stuff we have the opportunity to consume – the real things. Ice creams, cars, coffees – all the good stuff. And in week three we described how we may want to think about these intertemporally – namely our consumption at different points in time.

With that we needed a way to magically shift consumption through time – we needed saving and borrowing.

Finance describes how we transfer and value monetary flows through time, which are then used to shift when these consumption opportunities occur. For more o n business financial management, you can use software like this online check stub maker which will make your payroll process easier.

Finance is the study of financial markets, where financial markets define how we can shift monetary sums through time and how they translate – where the translation is complicated by i) the fact we value things differently through time, ii) the payment of a nominal interest rate, iii) the change in prices [eg giving the idea that a dollar now is valued differently to a dollar in the future].

What’s this got to do with microeconomics?

Everything.

A lot of what we’ve discussed so far in class was static. There was one period of time, there was an amount of income, and we used that for consumption.

But once we admit that:

• there are multiple periods of time – some where we would really like to borrow from the future or past, and some where we don’t value additional consumption all that much,
• that we don’t necessarily have information about what will happen in the future (and so there is risk associated with a choice that uses or allocates funds that would have been available in the future),
• and that there are a variety of ways of allocating these funds through time (holding cash, holding bonds, holding other assets).

We can see that this is an important issue to explicitly think about. Once we start working in this space this expands what we can do when using our economic tools to manage payroll in 2022.

In this way, finance is an application of microeconomics that explicitly models time and the intertemporal consumption choice – or trying to understand the dynamic process behind people’s choices about when to consume and save.

Furthermore, these choices are important for macroeconomists – as they look at this behaviour when trying to understand the dynamics of the economy at large. In this way, finance is a central subject for both microeconomists and macroeconomists.

This topic is awesome, and really wish we could give it more space – in future economics you will.

So what are we thinking about here.

In our first six weeks we built a model where people’s actions didn’t influence the incentives of others – and so couldn’t influence their actions. For example, if I decided to go buck-wild buying potato chips, it wouldn’t change the the price of chips.

However, this isn’t always the case. If a firm decides to set a higher price it can still sell some product, and by doing so it will lead to other firms seeing a direct increase in their own demand. If I decide to not show up to a hockey game, our teams ability to play will be worsened by being down a player (arguably) – then other players may then have an incentive to just not bother showing up.

These are real life situations we can relate to where people’s actions are interdependent. And this is the key of what game theory is – where your payoff depends on the actions of other, and their expectations of your actions, this creates scope for strategic behaviour.

The two games we look at today in class are a prisoner’s dilemma, and a coordination game. Once you understand those games you will start to see them everywhere. See you there.

As you know this is a course on microeconomics … so it is a bit random to teach macroeconomics. However, as this is the only economics course many students do we think it is a good idea to introduce some of the jargon you will see a lot in your work life!

Usually this is a week of lectures, but given the semester is a week shorter we teach this in a single lecture – and it will be assessed as such.

So what is macroeconomic, why do we care, and what are we measuring?

What is macroeconomics

So far we’ve done microeconomics – we have looked at the behaviour or choices of individuals when faced with a trade-off due to scarcity. We have recognised that prices provide incentives – be they explicit prices or shadow prices – and that the key point to keep in mind was the opportunity cost of a choice.

This is cool. Macroeconomics wants to do the same – but the questions in macroeconomics are LARGE. Instead of asking about a few individuals, or a single market, macroeconomics asks about activity in many markets across a large area (eg an entire country).

The data we use for macroeconomics (to make testable hypotheses) are aggregates of individuals – this could be the total sum, the spread between individuals (the variance), and related changes or growth rates in these amounts.

We would like to use microeconomic intuitions – and the importance of scarcity and opportunity cost – when analysing these problems. However, these are emergent phenomenon where some of the smaller market distortions can multiple to be very large over a whole economy. So the method we often take is to start with the aggregates, decompose them, and then try to understand the behaviour of these aggregated amounts.

This is not a perfect process, and if we tried to implement policy on this basis it could be problematic (as if we haven’t described the behaviour, we don’t know how the relationships will change if we change the policy!). But it is a start – if you would like to do more, come along to ECON141 next semester

Why do we care

I’ll keep this short – a lot of you have explicitly told me you are doing economics because you are interested in where the economy as a whole is going, you are concerned about poverty or unemployment, and that you want to work in policy.

Microeconomics is essential for this – but at the same time so is macroeconomics. Microeconomics gives you the raw tools to “think systematically” in the way economists do – macroeconomics gives you specific understanding of many of the big questions that motivate a lot of economics students.

When I came in economics I was motivated by macro – even though I ended up preferring micro – and I have appreciated the importance of both since.

What do we measure

This was the main focus on our class – we measured certain aggregates: GDP, unemployment, inflation, business cycles and trends, and labour productivity. We understand, in a rough sense, what each of those things mean.

GDP = Production within a certain region (eg New Zealand)

Unemployment = Those willing to work at the current wage who can’t [Note: We also mentioned reporting bias and discouraged workers]

Inflation = Growth in the price level [Note: We also talked about our interest in a measure where this growth is in an “average basket” and how we want to take out changes in prices relative to each other – our changes in scarcity in a micro sense – to think about this idea]

Business cycles = The movement in GDP around a “trend” level due to coordination issues [Note: We stated this was the big focus of the ECON141 course]

Labour productivity = Output produced per hour of work [Note: We discussed how this has risen significantly through the last 150 years, and that this growth is another core issue of interest in macro]

That is a lot of ground to cover in one lecture! But we did it – and after seeing this idea of a “coordination issue” we are now going to do a lecture on game theory which has coordination games. Buckle in.

What we have done this week is actually quite similar – we have asked about gains from trade when the production possibilities were actually a bit different. Given that we have noted that, with different productive opportunities specialisation can generate gains from trade!

The example we use for this is international trade – and that is what we have done in the lectures here and here.

As a practice exercise, can you describe the current shock associated with COVID in terms of a Production Possibility Frontier diagram based on the Australia and NZ trade example in lectures. Graphically what does the shock look like? Could the shock increase New Zealand’s comparative advantage in making Wool? What does this mean?

I’ll put up an answer to this after you test on Monday – as this content is not in this test.

Furthermore, we are focusing on a set of assumptions – so lets start with those:

Assumptions

In the past 4 weeks we’ve built a “profit maximising” firm and a “utility maximising” consumer. For a single good or service we are going to assume it is provided by many of these sorts of firms and demanded by many of these sorts of customers.

The product provided is the same irrespective of the firm. The customers and firms have perfect information. And, in the long-run, the number of firms and the scale of the firm can change.

Why do I put these at the front? Because when we describe a real market some of these assumptions may not hold, and yet our results depend on them. However, the example with these assumptions allows us to ask “so how does the result change as we change these assumptions”. Also it gives us a specific way of thinking about gains from trade – and when market (and government) structures prevent trade that would generate gains from trade for the buyer and the seller.

Equilibrium

We have individual demand curves and individual supply curves. Add the many individuals together and you have … market demand and supply curves. Congratulations.

Our individuals were given the price – they were all forms of price takers. This is because there were many others and so the individual quantity demanded and supplied by a single agent was not sufficient to influence the price.

Given that how do we make sense of this scissors thing as a way of determining that price?

When they cross, the quantity demanded and the quantity supplied are the same – all firms are selling everything they make, while all customers and buying everything they want too. So there is no incentive for them to try to shift the price down or up, as the firm is selling the product for the highest price they can while the consumer is buying it for the lowest price they can. Nice.

What happens when prices are higher? Well the quantity supplied is greater than the quantity demanded. Each firm then faces a choice – sell a rationed amount of output for that price, or cut the price by a tiny amount and sell as much as they want. Seeing this they all start cutting prices, and the price falls.

When prices are lower we face a similar issue from the demand side – seeing they can only buy a rationed amount individual consumers offer a slightly higher price to satisfy their demand, gradually driving prices up.

This is our tendency. But so what?

Surplus

Instead of thinking about the price, lets think about the quantity.

At every quantity left of equilibrium there is a potential buyer who values the product more than a potential seller. As a result, there are gains from trade.

At every quantity right of equilibrium every potential buyer values the product LESS than every potential seller. So there are no gains from trade.

At equilibrium we have all the leftward transactions happening and none of the rightward ones – so we have the maximum gains from trade. This is the idea behind surplus that we discussed in class:

We can see that, with perfect competition (the assumptions discussed above) all the potential situations with gains from trade occur! Nifty.

Now we may have reasons why we want some transfer between the firms and consumers, and we could do that by changing the price (eg an unfair initial allocation of resources). However, a different price would lead to some “rationing” and a lower quantity – which in turn comes with a deadweight loss. This is the lost value associated with transactions that have some gains from trade not occurring.

So even if there is value from the transfer associated with changing the price – there is an unintended consequence associated with the transactions that do not occur.

Questions

• Is Matt’s hypothetical cafe, which is located close to the train station and involves chats about economics, a perfectly competitive firm?
• What are potential market failures when we have a perfectly competitive market? (Hint: Think about the two ways we discussed missing property rights)
• Do we always want to maximise surplus?
• How do rationing rules influence how we think about deadweight loss?
• How might “non-price” means for purchasing rationed products undermine our ability to help the poor by forcing firms to set low prices?

Added explanation

Just like in the previous discussion of simulating choice it is possible to think of this as a form of simulation. When we discussed what was happening “outside of equilibrium” we talked about how agents would change their behaviour and that would describe our tendency back to that equilibrium.

The Youtube channel Primer does a great job of this with an actual simulation of little blobs – I suggest giving it a watch for another perspective on how this idea works!

Marginal Revenue = Marginal Cost

Marginal Revenue = Marginal Cost

Marginal Revenue = Marginal Cost

As long as the firm covers average variable costs at this level they will operate in the short term, and produce at the Q where MR=MC.

As long as the firm covers average costs in the long term they will remain in the market, and produce at the Q where MR=MC.

If MR=MC occurs at a price greater than average cost then other firms are going to come in to get some of those supernormal profits (or the scale of the firm will increase). Still, produce Q where MR=MC.

Questions

1. Does the above discussion depend on our price taking firm assumption?
2. Is price always equal to marginal revenue?
3. What is a price taking firm?
4. Marginal revenue = Marginal Cost!
5. What is the price that incentivises producing at the lowest average cost? What can we say about economic profit at that price?
6. What are some of the reasons why a firm may not be profit maximising?

My apologies that we can’t meet in person anymore – as the university is now running classes online due to the COVID-19 quarantine. You will have seen that the lectures are already online – feel free to watch them when you can. Lecture 7 slides are here and Lecture 8 slides are here.

This week we are switching from thinking about consumers to thinking about producers. Instead of asking why someone may purchase a product, or select a set of products from an available set, we are asking about the incentive to sell those products.

As is the case with consumer theory we leave prices fixed for now so we can focus on where the scarcity is and what incentives the producer has.

This week we focused solely on costs – lets talk a bit more about those. Specifically I want to summarise some of the ideas we covered in a different way (starting at the end of the 8th lecture rather than the start of the 7th) to hopefully help tie everything together.

Production and costs

Over the two lectures we noted that a firm produces output using inputs.

Given this we know there is some cost associated with buying input. Given this cost, we can think the choice to purchase inputs. Take a fixed quantity of output – the two inputs will act as substitutes for each other. As a result, we will pick a bundle of inputs that is the lowest cost for producing our output.

But things are a bit more complex that that.

Although we called those inputs “labour” and “capital”, by the end it is clear we meant “variable” and “fixed” factor of production – as a result, employment contracts can make our labour input act more like capital, while capital goods like computers may function more like labour than the capital we discussed in class.

So in the short-run we only think about changing these variable inputs. And the cost associated with varying production in the short term only depends on those.

This implies that we can think about our short-run cost curves in terms of charging variable costs and some underling fixed cost associated with the fixed factors of production.

Choices

Then we can come back to choice. What does it cost us if we decide to make “one more unit” – just like with consumer theory we will again think in this, marginalist, way.

The cost here is the cost of purchasing enough of the variable input to make that one unit – which is the amount of the input we have to purchase times the price of that input. The amount of the input depends inversely on the marginal product of that unit (how much output we make if we use one more of the input), and since we have assumed that the marginal product of our input declines as we use more – given all other inputs are fixed – the marginal cost (given an assumption of fixed prices) rises.

As discussed in class, we will assume that these firms are profit maximising – even though this assumption is unrealistic in a number of ways, as firms are made up of a series of individuals with there own interests, it provides us an interesting starting point for thinking about how firms are designed. It will also mirror the utility maximising choice in a situation where we have a sole trading firm – which is often the type of firm we think about in competitive models.

Profit maximisation involves two steps:

• Thinking about the cheapest way to make output, at each output level (this is our cost curve)
• Considering what output level would provide the greatest output – given how changing output changes total costs (marginal costs) and total revenue.

Next week we are going to start thinking about revenue, and we are going to learn how to build this profit maximising model of firm choice.

Practice questions

• If the price of capital equipment falls (something that has happened over time) does this mean that firms will hire fewer workers over time?
• What is an example of a situation where diminishing marginal product of labour does not hold? Can you point out some of the reasons why each additional worker would lead to a larger increase in output in the situation you are thinking about?
• Can you think of a situation where increasing the number of inputs would reduce output? Why would a firm not ever select such a point if it was a profit maximising firm?
• Can we have economies of scale even if there is diminishing marginal product in every input the firm has? Why?

This is not compulsory for the course, and will not be assessed. But if you can follow the video, and understand how it relates to the concepts I list below, then you have a great grasp of the content!

The Primer channel started as a biology channel, but has already done a couple of videos about economics that I think offer an excellent way of thinking through the analytical models we build in class.

The concepts covered in the video are things that you have covered as of Week 3:

• The Production Possibility Frontier
• Diminishing Marginal Utility
• *Non-satiation/increasing utility
• Selection of the optimal bundle.

If you are keen, either comment or email me your thoughts on how where and how these concepts are covered in the video.

The blob and our models

But there is a key difference between the endowment of the blob and the endowment of our choice maker in class – the scarcity is in terms of a trade-off in collecting/producing the goods rather than in terms of a fixed “monetary income”. In this way, the discussion is closest to the allocative efficiency concept we talked about for PPFs.

Now if you have trouble following the video that is ok, you will be assessed in the way it is taught in class – with PPFs used for thinking about society, while we have a fixed monetary budget constraint for individuals. However, this other perspective may be more intuitive for some students, and may give a deeper understanding of our models to other students. For those interested in thinking more deeply on this framework I suggest looking at Edgeworth boxes.

However, there is a broader reason why I think it is useful to see this type of simulation for thinking about economic phenomenon instead of just looking at analytical rules defined from arbitrage conditions (eg the idea that someone sets the marginal utility per dollar equal for all the goods they purchase).

The risk with teaching analytical solutions is that we don’t think about the process that builds those rules, or how bounded rationality (the use of experimentation and “good enough” decision rules) fits into that. Simulation helps us think about how these other ideas fit in!

This is what we are attempting to do when we ask about what happens when we aren’t at equilibrium, or when our arbitrage conditions aren’t meet. The disequilibrium process we describe, step by step, is similar to the learning and experimenting the little blob in the video does to figure out what its best choice is.

Remember what we said in Lecture 2 – models are caricature of reality that allow us to describe something about reality. Solving our model is “simulating” an alternative world that is represented by this caricature, and as a result both this and what we do in class are very similar!

However, knowing how to simulate and experiment can also give us insights in situations where the model doesn’t have a unique equilibrium – something that will become more important when you do Game Theory and Macroeconomics later in the course.

Last week you learned about indifference curves and budget constraints, and how we could use these concepts to understand individual choice. In the end we were able to build a demand curve that related the quantity demanded by an individual to the price of the product.

This week you will go through more details about the demand curve, and then go into other examples where the budget constraint is not “monetary income at a point in time” but instead related to intertemporal consumption and the work-leisure choice with your scarce time.

These examples are a bit more complex, so if you don’t understand them at first that is normal – just keep going through them to see if you can.

With respect to demand curves a key idea is to ask what this “price-quantity” space refers to, namely what is endogenous in this graph, and what elements of our choice model are not included (and are then termed exogenous).

So when looking at a particular good (eg apples) the demand curve tells us the relationship between the price of apples and the quantity of apples demanded – holding everything else constant (ceteris paribus).

What is everything else whose changes are not included in our demand curve model? Changes in the monetary income level, the price of other goods, and consumer preferences – all the other elements that were used to build our indifference curve and budget constraint model!

If these elements did change it would shift the curve – what we call a change in demand (as compared to a change in quantity demanded from the change in the price of the good).

So we build this model of a demand curve from some underlying construct of indifference curves and budget constraints, and then by allowing the price of the good to vary we can look at how the quantity demanded of this good changes – holding everything else fixed. In the end, the demand curve is a graphical representation of this other process.

Now lets take this to the very different work-leisure choice model – which ended with a specific type of choice we were trying to understand:

• What is the quantity we are trying to describe with this model?
• Is this quantity we are describing the allocation of something that produces utility directly – if not how do we understand it?
• What is the price that determines this quantity choice?
• Did this describe a demand curve? If not, what is the demand for this quantity – and whose choice would we need to model for that?