Supply, Demand, and Prices

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Economics 1: Supply, Demand, and Prices meet the lecturers: semester 1

Economics 1: Supply, Demand, and Prices

meet the lecturers: semester 1

Simon
Clark

Supply,
Demand,
and

Prices

Production,
Economic
Efficiency and
Market Failure

Maths for Economics

Sean
Brocklebank

David
Candon

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Economics 1: Supply, Demand, and Prices meet the lecturers: semester 2

Economics 1: Supply, Demand, and Prices

meet the lecturers: semester 2

Growth, Employment,

Inflation, and Short-run Fluctuations

Introduction to
Macroeconomics

Andreas Steinhauer

David Candon

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Economics 1: Supply, Demand, and Prices Before we start… Is Economics

Economics 1: Supply, Demand, and Prices

Before we start…
Is Economics 1

the right course for you?
We offer another economics course:
Economic Principles and Applications
Слайд 5

Economics 1: Supply, Demand, and Prices Which course? Economics 1 is

Economics 1: Supply, Demand, and Prices

Which course?

Economics 1 is for students

who
do an Economics degree (compulsory);
did Higher, A(S)-level, IB Economics or equivalent;
did Higher, A(S)-level, IB Mathematics or equivalent;
intend to transfer into a degree in economics
Otherwise,
Economic Principle and Applications (EPA) is likely to be the better course for you.
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Economics 1: Supply, Demand, and Prices There are three lectures per

Economics 1: Supply, Demand, and Prices

There are three lectures per week
Tuesday,

Thursday and Friday from 16:10 to 17:00 in this room
In semester 1, the Thursday lectures will be about maths
There is a two-hour tutorial every week
Tutorials start in week 2 and run until week 10 each semester
Times vary; you will be signed up automatically by the Student Allocator
Attendance and homework submission at tutorials is 10% of your final grade

Economics 1 LEARN site
All course information
Lecture notes and other teaching materials
Course Handbook

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Assessment 30% : four class exams (one at the end of

Assessment

30% : four class exams (one at the end of each

5-week block)
The October, February and March exams are 60 minutes, MCQ-based and potentially worth 10% each, but we only count the best 2 out of 3. They occur
Semester 1 – Saturday after week 5 (22 October)
Semester 2 – Saturday after week 5 (18 February)
Semester 2 – Early in week 11 (date to be confirmed)
The December exam is 90 minutes, MCQ and written, and counts for 10% of your final grade
10% : Tutorial attendance & homework
Details on the next slide
10% : Essay
Due in the second semester
50% : Final exam
Consists of MCQs and written questions, scheduled in the April/May diet

Economics 1: Supply, Demand, and Prices

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Tutorial attendance and engagement (10%) To earn points, students must bring

Tutorial attendance and engagement (10%)
To earn points, students must bring homework

at the beginning of their tutorial. The homework must be at least three sides of written or two pages of typed work which attempts to answer the questions from the current week’s tutorial sheet. The answers do not have to be correct; all that is necessary is that the questions are attempted. You also need to submit a ‘declaration of work’ coversheet.
Each week that a student brings homework and attends their tutorial, they earn 1 mark;
Each week that a student attends their tutorial without bringing homework, they earn 0 marks. But you should still attend. Each week students miss their tutorial, they earn 0 marks.
A maximum of 14 marks are available, (14 marks are worth 10% of your final grade; fewer marks are worth fewer points on your grade!)

Economics 1: Supply, Demand, and Prices

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Economics 1 Reading Group Optional reading group Six meetings over the

Economics 1 Reading Group

Optional reading group
Six meetings over the year
Lots of

work (reading & writing) for the chance at up to a 6% bonus on your final grade
Only makes sense if you really like reading and talking about economics
More details in the course handbook
First meeting : Wed 05 Oct @ 6:15pm
Topic of first meeting and other details have already been emailed (please contact sean.brocklebank@ed.ac.uk if in doubt)
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Economics 1: Supply, Demand, and Prices Textbooks There are two core

Economics 1: Supply, Demand, and Prices

Textbooks

There are two core textbooks
One for

micro in semester 1, one for macro in semester 2
These books will be re-used in Economics 2
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Economics 1: Supply, Demand, and Prices Math textbook There is a

Economics 1: Supply, Demand, and Prices

Math textbook

There is a suggested math

text
Most of you will want the maths book, although it is not obligatory if you are comfortable with the maths
Note that the book is in the 4th edition, but you can get any edition (they’re pretty similar)
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Economics 1: Supply, Demand, and Prices Helpdesks Twice-weekly Economics 1-only helpdesk

Economics 1: Supply, Demand, and Prices

Helpdesks

Twice-weekly Economics 1-only helpdesk staffed by

some of the best students who took Econ 1 last year
Provisionally it is on Wednesdays and Fridays from 1pm to 2pm in room G3 of 30 Buccleuch Place, but check learn for updates
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Economics 1: Supply, Demand, and Prices maths in economics: why? Many

Economics 1: Supply, Demand, and Prices

maths in economics: why?
Many economic magnitudes

are inherently numerical - prices, quantities, interest rates
maths offers a very efficient way to express relationships - between price and quantity demanded, or unemployment and inflation
maths enables us to analyse many interacting relationships at the same time
a central concept in economics – of rational maximising agents – is naturally modelled using maths
we need to formulate and test our theories using statistical techniques which require some maths
using maths to develop economic theories reduces the possibility of logical errors and inconsistencies
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Economics 1: Supply, Demand, and Prices what maths do we use

Economics 1: Supply, Demand, and Prices

what maths do we use in

Economics 1?

basic algebra solving simultaneous linear equations
logs and indices basic calculus
maximization
these techniques are developed and applied as part of the economics
on Learn:
a guide 'Mathematics for Economics' outlining the techniques used
maths exercises included in weekly tutorial sheets.
leaflet prepared by Economics Network
http://www.economicsnetwork.ac.uk/themes/maths_formula_sheet.pdf
http://www.metalproject.co.uk/, website of Mathematics for Economics: enhancing Teaching and Learning; esp. link to Teaching and Learning Guides
For a non-mathematical treatment, take
Economics: Principles and Applications (EPA)

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Economics 1: Supply, Demand, and Prices Outline of weeks 1 -

Economics 1: Supply, Demand, and Prices

Outline of weeks 1 - 5

Frank & Cartwright
Thinking Like an Economist Ch1
Supply and Demand Ch2
Rational Consumer Choice Ch3
Individual and Market Demand Ch4
week 5, Saturday, 22th October, MCQ exam
Слайд 16

Economics 1: Supply, Demand, and Prices some things to note these

Economics 1: Supply, Demand, and Prices

some things to note

these lectures will

not be repeating the text book
read the text book ahead of the lectures
if I don’t mention something in the lectures, it may still be examined
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Economics 1: Supply, Demand, and Prices to illustrate the economic approach,

Economics 1: Supply, Demand, and Prices

to illustrate the economic approach, consider

some interesting problems:
the market for lemons
the prisoners’ dilemma
ice cream wars
the demand for things without a market
e.g. good state schools
Слайд 18

Economics 1: Supply, Demand, and Prices the market for lemons a

Economics 1: Supply, Demand, and Prices

the market for lemons

a seller

has a car that is either good (a plum) or bad (a lemon)
plum lemon
value to buyer 3,000 1,500
value to seller 2,500 1,000
the difference of 1,500 between plum and lemon reflects repair costs to convert a lemon to a plum
with complete information:
a plum would sell for between 2,500 and 3,000
a lemon would sell for between 1,000 and 1,500
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Economics 1: Supply, Demand, and Prices what if the quality of

Economics 1: Supply, Demand, and Prices

what if the quality of the

car is private information and hence unknown by the buyer?
if the buyer cannot tell a plum from a lemon then there cannot be separate prices for the two types
So, how much would a buyer pay for a car of unknown type?
Recall:
plum lemon
value to buyer 3,000 1,500
value to seller 2,500 1,000
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Economics 1: Supply, Demand, and Prices if the proportion of plums

Economics 1: Supply, Demand, and Prices

if the proportion of plums and

lemons offered for sale is 50-50, then a randomly selected car would have an expected or average value to the buyer of ½ (3000+1500) = 2250
this is the maximum price a buyer would be willing to pay for a randomly selected car
but at this price or less no owner of a plum would be willing to sell, since he values a plum at 2,500
only lemons are offered for sale
this is a severe case of adverse selection
theory developed by Akerlof in 1970s (got Nobel prize in 2001)
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Economics 1: Supply, Demand, and Prices Suppose the proportion of plums

Economics 1: Supply, Demand, and Prices

Suppose the proportion of plums and

lemons offered for sale is ¾ and ¼ and a buyer is offered a randomly selected car.
What is the maximum price a buyer would be willing to pay?
1 1,000
2 1,500
3 2,025
4 2,625
5 3,000

Question

reminder:
plum lemon
value to buyer 3,000 1,500
value to seller 2,500 1,000

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if the proportion of plums and lemons offered for sale is

if the proportion of plums and lemons offered for sale is

¾ and ¼ , then a randomly selected car would have an expected or average value to the buyer of
¾ x 3000 + ¼ x 1500 = 2625
at this price, both sellers of plums and lemons are willing to sell
a buyer might get lucky or unlucky
but he or she is willing to take the risk
note: we are implicitly assuming risk neutrality
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Economics 1: Supply, Demand, and Prices market failure if the maximum

Economics 1: Supply, Demand, and Prices

market failure

if the maximum price a

buyer is willing to pay is less than 2500, only lemons are offered for sale
buyers realise this (or find out through various sources)
and hence would not be prepared to pay more than 1,500
only lemons are sold, even though there is a potential gain from a market in plums
owners of plums cannot convince buyers that their cars are plums
mere verbal assurances about quality are not convincing since this is a tactic that can be costlessly imitated by owners of lemons
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Economics 1: Supply, Demand, and Prices the ubiquity of (possible) adverse

Economics 1: Supply, Demand, and Prices

the ubiquity of (possible) adverse selection

insurance

markets careful/reckless drivers
healthy/already ill people
labour markets conscientious/lazy workers
capital markets entrepreneurs with high/low risk projects
asset markets car owners know if the clutch is no good
house sellers know where the dry rot is
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Economics 1: Supply, Demand, and Prices adverse selection and liquidity banks

Economics 1: Supply, Demand, and Prices

adverse selection and liquidity

banks selling bundles

of debt (CDOs) know if the underlying loans are toxic or not
here, market failure means a breakdown of secondary financial markets and a possibly severe loss of liquidity
this can be contagious and have macro (economy wide) consequences
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Economics 1: Supply, Demand, and Prices signalling: one way to overcome

Economics 1: Supply, Demand, and Prices

signalling: one way to overcome adverse

selection

an informative signal of quality is one that it is not worth the owner of a lemon imitating
e.g. the seller of a plum can offer a warranty that a lemon owner would find unprofitable
in labour markets, education can be seen as a signal of productivity
not because education makes you productive
but because only productive workers can acquire education at low cost
this view of education developed by Spence, who shared the 2001 Nobel prize with Akerlof and Stiglitz

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Economics 1: Supply, Demand, and Prices the prisoners’ dilemma deny -10,

Economics 1: Supply, Demand, and Prices

the prisoners’ dilemma
deny
-10, -10
0, -25
confess
-25, 0
-20,

-20

confess

deny
first prisoner
second prisoner
two prisoners are questioned separately by police
the police have some evidence and each prisoner can deny or confess
each cell shows 1st then 2nd prisoner’s payoff (negative of prison sentence)

Слайд 28

Economics 1: Supply, Demand, and Prices Question : what happens? deny

Economics 1: Supply, Demand, and Prices

Question : what happens?
deny
-10, -10
0, -25
confess
-25,

0
-20, -20

confess

deny
first prisoner
second prisoner

assume this situation occurs only once, and they do not meet again
the numbers capture all aspects of the prisoners’ preferences
they cannot make binding agreements before they are caught
1 they both confess
2 they both deny
3 one confesses and
one denies

Слайд 29

the prisoners’ dilemma: the economist’s answer deny -10, -10 0, -25

the prisoners’ dilemma: the economist’s answer
deny
-10, -10
0, -25
confess
-25, 0
-20, -20

confess

deny
first prisoner

second prisoner

1 they

both confess
Слайд 30

Economics 1: Supply, Demand, and Prices the payoffs in the prisoners

Economics 1: Supply, Demand, and Prices

the payoffs in the prisoners dilemma

have a very particular structure
importantly:
there are no binding agreements
payoffs are completely given by the numbers
the game is only played once
Слайд 31

Economics 1: Supply, Demand, and Prices the Prisoner’s dilemma is a

Economics 1: Supply, Demand, and Prices

the Prisoner’s dilemma is a metaphor

for a wide range of situations,
where cooperation is mutually beneficial but not individually rational
collusion in cartels restrict or expand output
set high or low prices
trade wars low or high tariffs, quotas
overfishing restrict or expand catch
CO2 emissions restrict or expand pollution
arms races, advertising
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Economics 1: Supply, Demand, and Prices What if the situation is

Economics 1: Supply, Demand, and Prices

What if the situation is repeated?

Does cooperation emerge?
How can we test this theory?
Experimental economics is now a very active research area
In practice, people do seem to cooperate more than the theory suggests? Why? Maybe economics does not have the answer to everything!

some interesting questions to consider

Слайд 33

Economics 1: Supply, Demand, and Prices ice cream wars 2 ice-cream

Economics 1: Supply, Demand, and Prices

ice cream wars
2 ice-cream sellers simultaneously

choose a location on a beach
consumers are distributed evenly along the beach, and buy from the nearest seller
each seller’s profits is proportional to sales
where do they go?
Слайд 34

Economics 1: Supply, Demand, and Prices Question: where do they go?

Economics 1: Supply, Demand, and Prices

Question: where do they go?

1 0 and

1
2 0.25 and 0.75
3 0.33 and 0.67
4 both at 0.5
5 none of the above

0 0.25 0.33 0.5 0.67 0.75 1

Hint:
Both sellers know what you know.
Test your answer by asking if either seller can do any better, given the position of the other.

Слайд 35

Economics 1: Supply, Demand, and Prices where do they go? 1

Economics 1: Supply, Demand, and Prices

where do they go?

1 0 and

1
2 0.25 and 0.75
3 0.33 and 0.67
4 both at 0.5
5 none of the above

0 0.25 0.33 0.5 0.67 0.75 1
4 both at 0.5

Слайд 36

Economics 1: Supply, Demand, and Prices again, this can be seen

Economics 1: Supply, Demand, and Prices

again, this can be seen as

a metaphor for many other situations
we have to reinterpret what we mean by ‘the beach’ (known as the
Hotelling line)
a common application is to explain a lack of product variety, e.g. cars,
breakfast cereals
in models of political parties, the beach could be a Left-Right spectrum,
parties choose a political position, and consumers are voters

life’s a beach

Слайд 37

Economics 1: Supply, Demand, and Prices some interesting extensions to consider

Economics 1: Supply, Demand, and Prices

some interesting extensions to consider

what if

there are 3 or more sellers?
what if the beach is not a line but the circumference of a circle, or the whole circle, or some other space
how would we introduce transport costs?
and what do transport costs mean in a non-geographic setting?
how do we combine competition in both price and variety?
Слайд 38

Economics 1: Supply, Demand, and Prices the demand for things without

Economics 1: Supply, Demand, and Prices

the demand for things without a

market

a common problem is how to estimate the benefits of a project or policy e.g. a new bridge, or laws restricting traffic speed
if available, data on existing prices and quantities is a starting point
if not, behaviour in other markets may give some information e.g. travel costs
implicitly it costs time, fuel etc to access some resources, such as a country park
if people pay these costs this reveals something about how they value the resource
can we use data on time, fuel costs etc to infer these values?

Слайд 39

Economics 1: Supply, Demand, and Prices hedonic pricing people are prepared

Economics 1: Supply, Demand, and Prices

hedonic pricing
people are prepared to pay

more for goods of higher quality, or that embody desired characteristics
or will accept less pay for jobs that provide valued benefits
require more pay for jobs that have costs or disadvantages
think of goods or jobs as a bundle
can we put a value on each component of the bundle?
Слайд 40

Economics 1: Supply, Demand, and Prices using house prices a house:

Economics 1: Supply, Demand, and Prices

using house prices

a house: price reflects
size,

style, number of rooms
location:
proximity to amenities (parks, transport links, access to state schools)
local environment (e.g. noise etc)
implicitly there is a market for ‘peace and quiet’, or access to good state schools’
we can collect data on prices and characteristics
then statistically disentangle influence on price of each characteristic
Слайд 41

Economics 1: Supply, Demand, and Prices house prices and school quality

Economics 1: Supply, Demand, and Prices

house prices and school quality

Cheshire and

Sheppard, (Economic Journal Nov 2004)
looked at house prices in Reading in 1999/2000
price: min=£45,000 max=£385,000 mean=£127,000
price depends on (inter alia):
detached, semi, terrace etc size of plot
no. of bedrooms, baths etc if near Thames
distance from centre of town if near industry
transport links ethnic mix
quality of primary school (success rate at Key Stage 2)
quality of secondary school (success rate at GCSEs)
Слайд 42

Economics 1: Supply, Demand, and Prices after much statistical analysis, they

Economics 1: Supply, Demand, and Prices

after much statistical analysis, they worked

out ‘the price of quality’
Слайд 43

Economics 1: Supply, Demand, and Prices conclusions from the study For

Economics 1: Supply, Demand, and Prices

conclusions from the study

For the average

house the difference between the best and worst schools is
secondary: 19% or £23,750.
primary: 34% or £42,550.
Home buyers discount for risk: the more the variability in a school’s past results, the less is paid for current school quality. i.e. they are risk averse
Only the 'best' (top 10%) state schools command major money: being in the catchment area of an average school compared to even that of the very worst has little impact on prices.
The added cost for a home with access to the best state schools is close to the total cost of school fees for comparable private schools.
Слайд 44

Economics 1: Supply, Demand, and Prices conclusions from these problems simple

Economics 1: Supply, Demand, and Prices

conclusions from these problems

simple numerical examples

can be very enlightening
simple models can be enlightening – no need for lots of complications
eventually we do need to test the models with data
some concepts appear in totally different settings
apparently unrelated problems sometimes have a common structure
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