Microeconomics: Unit 1 – Supply & Demand | MIT

Principles

Economics is the study of choice. Because choices range over every imaginable aspect of human experience, so does economics.

Scarcity

Scarcity implies decisions, constrained optimization and trade-offs.

Consumers & producers

Models of how both consumers and producers behave, they’re never precise;

Regarding consumers, the key word for them is wealth, as they’re constrained by their budget. Consumers tend to maximize their Utility, but the Utility is subject to a Budget Constraint (µ), this is called Consumer’s Utility Maximization.

Concerning Firms, they tend to maximize their profits, although their profits are subject to consumer’s demand and also input costs (π), this is called the Firm’s Profit Maximization.

Fundamental questions of microeconomics

  1. What goods and services should be produced?
  2. How to produce those goods and services?
  3. Who gets the goods and services?

The key word to understand the above questions is PRICE. Because only after defining the price of goods one can answer the questions appropriately.

Economics

Theoretical and Empirical Economics: the first build models to explains the world and the latter are testing models.

Positive and Normative Economics: the first is how things really are and the latter is how things should be.

Supply & Demand

// Demand is how much someone wants something: ↑D↑P

// Supply is how much of it there is to have

Water-diamond paradox (Adam Smith): We can’t live without water, but it’s OK not to have a diamond. So why’s the difference in price? You’ve considered only demand and not supply. In this case, the demand is high, but the supply is even higher, so the price ends up lower;

As-if principle (Milton Friedman): When you’re playing pool, you could compute the optimal angles of which to shoot the ball in order to get appropriate bounce and get the balls in. Pool players act like they solved the optimization problems.

Applying Supply & Demand

The study of microeconomics can be understood in three different levels: intuitively, graphically and mathematically.

. Demand curve:

Intuitively is the willingness of consumers to pay for the good. Graphically is a downward sloping because as the price goes up, consumers are willing to buy less of a good.

. Supply curve:

Intuitively is the willingness of producers to supply the good, how much they are going to charge for a given quantity of the good. Graphically is a upward sloping because as the price rises, they’re willing to supply more.

“As the prices rise, consumers demand less. As the prices rise, consumers produce more.”

Equilibrium

Equilibrium = happiness. It’s a point where consumers want a certain amount at a certain price. At that’s price, producers say “I’m happy” to produce at that price.

Substitute goods

Example:  substitute for pork has become more expensive; consequently, the demand for pork will increase.

Costs

  1. Efficiency loss: producers would be happy to produce more at a high price, but that’s not happening.
  2. Allocation inefficiency: somebody who wants that good for that price gets it, who doesn’t want won’t get it. In equilibrium, this problem is fixed; however the same things doesn’t happen in disequilibrium (Secondary market can evade – i.e. Kyoto Protocol)

Elasticity

How much do supply & demand respond? Do the quantities supplied and demanded respond when the price changes? How sensitive id the quantity demanded? The slope of the demand curve will be the sensitivity of quantity demanded to the price consumers face, and that will determine the market responsiveness.

// Perfectly inelastic demand: it’s all about substitutes. When there’s no substitutes, when there’s nowhere to go, it doesn’t matter what the price is. Supply shock: price goes up.

// Perfectly elastic demand: you’re indifferent between a good and a substitute.

Empirical economics: Estimating the elasticities

Causation x Correlation (Frank Fisher): the case of the cholera outbreak. Peasants observed that where there were more people dying of cholera, there were more doctors, so the peasants killed the doctors, once they thought the doctors were spreading the disease. They confused causation with correlation.

How to measure the elasticity of demand?

By shifting the demand curve along its slope so to reach the new price and the new supply curve.

Ed = variation of Q / variation of P (demand curve) –> it’s something that shifts supply

How to measure the elasticity of supply?

By shifting the supply curve along.

Es = variation of Q / Q / variation of P / P (supply curve) –> it’s something that shifts the demand

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