Microeconomic Principles &

Policy

product: 4345 | course code: c357

Microeconomic Principles and Policy

Centre for Financial and Management Studies
SOAS, University of London
This edition: 2013
All rights reserved. No part of this course material may be reprinted or reproduced or utilised in any form or by any electronic,
mechanical, or other means, including photocopying and recording, or in information storage or retrieval systems, without written
permission from the Centre for Financial & Management Studies, SOAS, University of London.

Microeconomic Principles and Policy

Course Introduction and Overview

Contents
1
Introduction

3

2
Course Content

3

3
The Structure of the Course

4

4
The Course Author

7

5
Course Materials

7

6
Studying the Course

Assessment

Microeconomic Principles and Policy

University of London

Course Introduction and Overview

Introduction
Welcome to the course Microeconomic Principles and Policy. We hope that you
will find the course stimulating and useful.
When you have completed the course you will be able to
explain the principles underlying consumer demand from different
perspectives
discuss what economists mean by the theory of the firm
spell out the implications of competitive and noncompetitive market
structures on the firms pricing and output decisions
evaluate how firms respond to the pricing and output decisions of other
firms in the market
debate the importance of the markets for inputs or factors of production,
such as labour, capital and natural resources
analyse how firms expand and the implications for market structure

discuss how globalisation has influenced the firms behaviour and the
implications for pricing and output decisions.
The course introduces a wider range of microeconomic theories and applications, some of which are more contentious than others as they have
implications for public policy.

Course Content
There are two narratives or theoretical approaches running through this
course. The first is the traditional neoclassical approach, which is based on the
assumption that all economic actors behave rationally to improve their own
self-interest in markets that are competitive. So consumers want to maximise
their satisfaction from the goods and services they consume, while firms want
to maximise their returns or profits from the goods and services they produce
and it is assumed that consumers and producers have all the information
needed to make economic decisions rationally. This neoclassical approach is
developed on the basis of this simplified analysis of economic behaviour ,
although the model can and does get more complex in order to analyse
situations where the above assumptions do not hold. Over time this approach
has been developed into an elegant model of economic behaviour, expressed
in mathematics and graphically.
The neoclassical narrative has become the basic economic model taught in
schools and universities, albeit in some highly complex mathematical forms at
post-graduate level. It is a useful model in that it enables us to analyse key
economic relationship within the context of the models assumptions. However, in the real world, economic agents do not necessarily behave rationally
so as to maximise their own self-interest. For instance, consumers decisions
may be influenced by habits or advertising, while large corporations may be
motivated by wanting to acquire market concentration as well as earning
profits.

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Microeconomic Principles and Policy

So the second narrative running through this course covers alternative approaches that have been developed to analyse economic behaviours. In
particular, you will be learning about the behavioural approaches to consumer
theory as well as alternative models for analysing producer behaviour and
market structures.
However, it is important to note that there are no right or wrong models of
economic behaviour, but rather a spectrum of approaches based on different
underlying assumptions of how economic actors behave. In some cases, these
models also reflect political ideologies. So, for example, the neoclassical
approach and its focus on the primacy of markets as the modality of economic
actors interaction is often viewed as being aligned with more conservativebased political approaches whereas some of the alternative approaches are
often viewed as being more closely aligned with more liberal political stances.
It is not the purpose of this course to promote one or other of these narratives
rather it is to introduce you to the range of models, analytical tools and
examples to help you to form your own views

The Structure of the Course

The course is structured in the following way. Unit 1 is an introduction to
Microeconomics providing an overview of market economic activity and
supply and demand. Unit 2 is concerned with the theory of consumer behaviour which underpins the concept of consumer demand. As well as discussing
the neoclassical model, the newer behavioural approaches to consumer
demand are introduced. In addition, the second unit demonstrates how both
the neoclassical and behavioural models can be used to analyse consumer
savings and borrowing decisions.
Units 3 to 5 are concerned with the neoclassical model of production and
costs. While Unit 3 is concerned with the basics of neoclassical cost and
production theory, Units 4 and 5 focus on the firms pricing and output
decisions in markets where there is perfect competition, monopoly and
monopsony power, monopolistic competition and oligopoly. Unit 5 is devoted
to the latter as the theoretical models are both more complicated and provide
a better reflection of decision making in the real world. The units discuss
examples of the different market types, such as the degree of competition in
Russian banking, and price wars and collusion in Chinas airline industry.
Unit 6 is concerned with the markets for the input or factor of productions,
including the markets for labour, manufactured capital, social capital, natural
resources and finance. It looks at the neoclassical models as well as other
theoretical approaches.
Units 7 and 8 are concerned with bigger picture issues, such as alternative
models of firms behaviour in modern industrial structures, the impact of
globalisation on firms decision making, the role of government in market
economies and economic systems. In doing so, Unit 7 looks at case studies ,
such as price bundling behaviour in the telecommunications industry and the
economic behaviour of two very different companies the American company
Wal-Mart and Swedish company IKEA in their efforts to expand globally.

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Course Introduction and Overview

Unit 8 is concerned with the role of government in a market economy and

how this reflects the prevailing economic system. The course ends with a
discussion of how the theoretical concepts and models of microeconomics can
be used in environmental economics.
Some of the units are more theoretical in nature than others, and you may find
that some require more time to complete than others. This is especially the
case if microeconomics is new to you. If you have previously studied microeconomics then you will find that much of the traditional theory covered in
the course is familiar to you. However, many of the readings will update the
theoretical ideas and/or applications and so you are nonetheless encouraged
to do the readings.
Unit 1 provides an introduction to the basic concepts of demand and supply,
which will be familiar if you have previously studied an economics course.
But if this is your first encounter with economics and microeconomics in
particular, you may find you need to spend a bit more time studying the unit.
Unit 2 covers both the neoclassical and behavioural approaches to consumer
theory and so it is going to take you longer to do all the readings, than, for
example, Unit 3, which concerns the neoclassical theory of production and
costs. However, this may be to your advantage as you will be probably be
working on your first assignment when you come to study Units 3 and 4.
Similarly, Units 5 and 6 may take you more time to complete than Unit 4
because of the greater complexity in studying theories of oligopolistic markets
and theories of factor markets, respectively. On the other hand, you will
probably find Units 7 and 8 less theoretical and more accessible, as they are
concerned with present day economic problems such as the pricing behaviours of multinational firms, globalisation of business and the role of
government
Unit 1 Introduction to Microeconomics
1.1
1.2
1.3
1.4
1.5

Introduction
Markets
Supply and Demand
Elasticity
Conclusion

Unit 2 Theories of Consumer Behaviour

2.1
2.2
2.3
2.4
2.5
2.6

Introduction
Traditional Approach of Utility Theory
Limitations of the Consumer Theory
Behavioural Approach
Policy Issues
Conclusion

Unit 3 Theory of Production and Costs

3.1
3.2
3.3
3.4

Introduction
Types of Resources Used in Production
Production and Costs
Production Decisions

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Microeconomic Principles and Policy

3.5 Analysing Costs and Production

3.6 Conclusion
Unit 4 Markets and Competition
4.1
4.2
4.3
4.4
4.5
4.6

Introduction
Perfect Competition
Non-Competitive Market Structures Monopoly
Monopsony
Non-Competitive Market Structures Monopolistic Competition
Conclusion

Unit 5 Oligopoly and Other Noncompetitive Markets

5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8

Introduction
Oligopoly models of output decision-making
Oligopoly models of price competition
Game theory
Collusion by firms
Prohibiting collusion
Case study Chinas airline markets
Conclusion

Unit 6 Markets for Resources Labour, Capital and Other Inputs

6.1
6.2
6.3
6.4
6.5

Introduction
Labour Markets
Manufacture, Natural and Social Capital Markets
Finance Capital
Conclusion

Unit 7 Industry Structures, Pricing Behaviour and Globalisation

7.1
7.2
7.3
7.4
7.5
7.6

Introduction
Alternative Theories of Firms Behaviour
Big Business
Pricing Behaviour
Globalisation
Conclusion

Unit 8 Economic Systems and Microeconomics Applied to Environmental Economics

8.1
8.2
8.3
8.4
8.5

Introduction
Externalities and Public Goods
Economic Systems
Environmental Economics
Conclusion

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Course Introduction and Overview

The Course Author

Alison Johnson is an Associate of Development Finance International, which
works with developing country governments to develop the full independent
capacity to design and execute their own national resource mobilisation and
debt strategies and policies. She also has experience in preparing analytical
studies and training materials on aid and debt issues for the United Nations,
African Development Bank, Commonwealth Secretariat, Oxfam and other
organisations.
Prior to this, she was Acting Director of the Centre for International Education
in Economics (precursor of CEFIMS), with responsibility for policy and
operations of the postgraduate programmes in economics, finance and
development by distance learning, and Lecturer in Economics at SOAS with
responsibility for designing and writing distance learning economics courses.
She was the convenor and principal author of the courses on economic principles, and she also has extensive experience of writing practically-focused
training materials and running workshops.

Course Materials
The textbook for this course is
Neva Goodwin, Julia Nelson, Frank Ackerman and Thomas Weisskopf
(2009) Microeconomics in Context, Second edition, New York & London:
ME Sharpe.
The textbook is designed to provide an introduction to most of the topics you
will be studying in this course. However, it is different from the standard
microeconomics textbook in that its focus is wider than just the traditional
neoclassical approach. Not only does it take account of alternative theories but
also its presentation is broader based, focusing on consumption and production decision-making within the context of an economic system. So it is
aligned more with the traditional notion of political economy, than the narrower more mathematical discipline that economics became in the twentieth
century.
The textbook is non-mathematical, as is this course. While it does use a few
equations in some of its technical annexes, much of the exposition is done in
terms of diagrams. At the end of the book there is useful glossary of terms.
The one drawback to this and many other textbooks is its American orientation. So you will find that most of the applications and real world examples
quoted in the textbook are American, with a smattering of a few from elsewhere. To counterbalance this, the course introduces non-American
applications and examples, while noting that many of these are European
focused, with the use of African, Asian and Latin American circumstances
where possible.
In addition to the textbook, the course materials include other readings, made
up of chapters and extracts of other books, and articles from respected academic economic journals, international organisations and newspapers. The
articles and extracts are found in the Course Reader. Some of the extracts and

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Microeconomic Principles and Policy

articles are concerned with economic models and concepts whereas others
discussion applications and policy aspects of the theory.
At the end of each unit you will find a list of Additional Readings, which are
there for you to follow up if you are interested in pursuing some of the unit
topics in more detail. In addition, you are encouraged to look at the reference
section of the articles included as course readings, as these too will provide
you with further articles or readings to explore if you are interested. The
additional readings are not compulsory, but rather they are there for you to
refer to if you have time and are particularly interested.
In several of the exercises in the units you will be invited to submit summaries
of your answers to the Online Study Centre, and you are urged to do this, to
start a dialogue with fellow students and to share your ideas and experiences
of the topics studied in the course.

Studying the Course

As you work through the course materials, there are various exercises that are
designed to consolidate your knowledge and skills. We recommend that you
do the exercises, most of which take half an hour or less, before you look at
any model answers that are given in the unit.
At certain points we will ask you to reflect on various aspects of the policy
and processes relevant to your own place of work. It will be valuable for you
and your fellow students to share these reflections on the OSC (the online
study centre). Short notes setting out the issue and the approach will enrich
your, and your fellow students, experience of the course.
Please feel free to raise queries with your tutor and with your fellow students
if there are things that are not clear to you. Do this as soon as you find a
problem, because waiting will hold you up as you work through the course.
We hope that you will find the course instructive, useful and occasionally
challenging.

Assessment
There are two assignments for this course, one after four weeks and one
after eight weeks. Together they account for 30% of the grade for the course.
In addition there is a three-hour written examination, which counts for the
other 70%. The specimen examination, which shows the format of the final
exam but not the questions you will get, is printed at the end of this Course
Introduction.
Your performance on each course is assessed through two written assignments
and one examination. The assignments are written after weeks four and eight of
the course session and the examination is written at a local examination centre
in October.
The assignment questions contain fairly detailed guidance about what is
required. All assignment answers are limited to 2,500 words and are marked

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Course Introduction and Overview

using tutor-marking guidelines. When you receive your grade it is accompanied by comments on your paper, including advice about how you might
improve, and any clarifications about matters you may not have understood.
These comments are designed to help you master the subject and to improve
your skills as you progress through your programme.
The written examinations are unseen (you will only see the paper in the
exam centre) and written by hand, over a three hour period. We advise that
you practice writing exams in these conditions as part of you examination
preparation, as it is not something you would normally do.
You are not allowed to take in books or notes to the exam room. This means
that you need to revise thoroughly in preparation for each exam. This is
especially important if you have completed the course in the early part of the
year, or in a previous year.

Preparing for assignments and examinations

There is good advice on preparing for assignments and exams and writing
them in Sections 8.2 and 8.3 of Studying at a Distance by Talbot. We recommend that you follow this advice.
The examinations you will sit are designed to evaluate your knowledge and
skills in the subjects you have studied: they are not designed to trick you. If
you have studied the course thoroughly, you will pass the exam.

Understanding assessment questions

Examination and assignment questions are set to test different knowledge and
skills. Sometimes a question will contain more than one part, each part testing
a different aspect of your skills and knowledge. You need to spot the key
words to know what is being asked of you. Here we categorise the types of
things that are asked for in assignments and exams, and the words used. All
the examples are from CeFiMS examination papers and assignment questions.
Definitions
Some questions mainly require you to show that you have learned some concepts, by
setting out their precise meaning. Such questions are likely to be preliminary and be
supplemented by more analytical questions. Generally Pass marks are awarded if the
answer only contains definitions. They will contain words such as:

Describe
Define
Examine
Distinguish between
Compare
Contrast
Write notes on
Outline
What is meant by
List

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Microeconomic Principles and Policy

Reasoning
Other questions are designed to test your reasoning, by explaining cause and effect.
Convincing explanations generally carry additional marks to basic definitions. They will
include words such as:

Interpret
Explain
What conditions influence
What are the consequences of
What are the implications of

Judgment
Others ask you to make a judgment, perhaps of a policy or of a course of action. They will
include words like:

Evaluate
Critically examine
Assess
Do you agree that
To what extent does

Calculation
Sometimes, you are asked to make a calculation, using a specified technique, where the
question begins:

Use indifference curve analysis to

Using any economic model you know
Calculate the standard deviation
Test whether

It is most likely that questions that ask you to make a calculation will also ask for an
application of the result, or an interpretation.
Advice
Other questions ask you to provide advice in a particular situation. This applies to law
questions and to policy papers where advice is asked in relation to a policy problem. Your
advice should be based on relevant law, principles, evidence of what actions are likely to be
effective.

Advise

Provide advice on

Explain how you would advise
Critique
In many cases the question will include the word critically. This means that you are
expected to look at the question from at least two points of view, offering a critique of each
view and your judgment. You are expected to be critical of what you have read.
The questions may begin

10

Critically analyse
Critically consider
Critically assess
Critically discuss the argument that

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Course Introduction and Overview

Examine by argument
Questions that begin with discuss are similar they ask you to examine by argument, to
debate and give reasons for and against a variety of options, for example

Discuss the advantages and disadvantages of

Discuss this statement
Discuss the view that
Discuss the arguments and debates concerning

The grading scheme

Details of the general definitions of what is expected in order to obtain a
particular grade are shown below. Remember: examiners will take account of
the fact that examination conditions are less conducive to polished work than
the conditions in which you write your assignments. These criteria
are used in grading all assignments and examinations. Note that as the criteria
of each grade rises, it accumulates the elements of the grade below. Assignments awarded better marks will therefore have become comprehensive
in both their depth of core skills and advanced skills.

70% and above: Distinction, as for the (6069%) below plus:

shows clear evidence of wide and relevant reading and an engagement
with the conceptual issues
develops a sophisticated and intelligent argument
shows a rigorous use and a sophisticated understanding of relevant
source materials, balancing appropriately between factual detail and key
theoretical issues. Materials are evaluated directly and their assumptions
and arguments challenged and/or appraised
shows original thinking and a willingness to take risks

6069%: Merit, as for the (5059%) below plus:

shows strong evidence of critical insight and critical thinking
shows a detailed understanding of the major factual and/or theoretical
issues and directly engages with the relevant literature on the topic
develops a focussed and clear argument and articulates clearly and
convincingly a sustained train of logical thought
shows clear evidence of planning and appropriate choice of sources and
methodology

5059%: Pass below Merit (50% = pass mark)

shows a reasonable understanding of the major factual and/or
theoretical issues involved
shows evidence of planning and selection from appropriate sources,
demonstrates some knowledge of the literature
the text shows, in places, examples of a clear train of thought or
argument
the text is introduced and concludes appropriately

4549%: Marginal Failure

shows some awareness and understanding of the factual or theoretical
issues, but with little development
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Microeconomic Principles and Policy

misunderstandings are evident

shows some evidence of planning, although irrelevant/unrelated
material or arguments are included

044%: Clear Failure

fails to answer the question or to develop an argument that relates to the
question set
does not engage with the relevant literature or demonstrate a
knowledge of the key issues
contains clear conceptual or factual errors or misunderstandings
[approved by Faculty Learning and Teaching Committee November 2006]

Specimen exam papers

Your final examination will be very similar to the Specimen Exam Paper that
is printed at the end of this Introduction. It will have the same structure and
style and the range of question will be comparable.
CeFiMS does not provide past papers or model answers to papers. Our
courses are continuously updated and past papers will not be a reliable guide
to current and future examinations. The specimen exam paper is designed to
be relevant to reflect the exam that will be set on the current edition of the
course

Further information
The OSC will have documentation and information on each years
examination registration and administration process. If you still have questions, both academics and administrators are available to answer queries.
The Regulations are also available at www.cefims.ac.uk/regulations.shtml,
setting out the rules by which exams are governed.

12

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Course Introduction and Overview

UNIVERSITY OF LONDON
CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES
MSc Examination
Postgraduate Diploma Examination
for External Students

91DFMC357

MICROECONOMIC PRINCIPLES AND POLICY

SPECIMEN EXAMINATION

This is a specimen examination paper designed to show you the type of

examination you will have at the end of the year for the course Microeconomic
Principles and Policy. The number of questions and the structure of the examination will be the same but the wording and the requirements of each
question will be different. Best wishes for success in your final examination .

The examination must be completed in THREE hours.

Answer THREE questions, selecting at least ONE question from EACH
section. The examiners give equal weight to each question; therefore, you are
advised to distribute your time approximately equally between three questions.

DO NOT REMOVE THIS PAPER FROM THE EXAMINATION ROOM. IT MUST

BE ATTACHED TO YOUR ANSWER BOOK AT THE END OF THE
EXAMINATION

University of London, 2013

Centre for Financial and Management Studies

PLEASE TURN OVER

13

Microeconomic Principles and Policy

Answer THREE questions, at least ONE from EACH section. Answer all
parts of the questions.

Section A
(Answer at least ONE question from this section)
1

The neoclassical approach provides a relatively simple and

elegant model of how consumers make choices, but it does so
under some fairly restrictive assumptions.
Critically assess this statement .

Explain how the behavioural approach to consumer theory can

be used to design public policy.

Discuss the main measures used to evaluate the competitive of

markets.

Explain how game theory is used as an analytical tool by

economists.

Section B
(Answer at least ONE question from this section)
5

Discuss alternative theories of firms motivations and their implications for corporate behaviour.

Explain how globalisation has influenced how businesses have

grown.

Discuss why governments might intervene in the economy.

Discuss the theoretical approaches for analysing the markets for

two of the factors of production.

[END OF EXAMINATION]

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Microeconomic Principles and Policy

Unit 1 Introduction to
Microeconomics

Contents
1.1
Introduction

3

1.2
Markets

4

1.3
Supply and Demand

5

1.4
Elasticity

8

1.5
Conclusion

9

References and Websites

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Microeconomic Principles and Policy

Unit Content
This first unit of the course contains a discussion of what economics is about
and introduces the basics of market analysis such as the supply-demand
framework, equilibrium and price elasticities. Although these are familiar
topics in economics courses and textbooks, it is important to have a sound
understanding of the basic concepts and tools of economic analysis before
going on to learn about the more complex theories and models for analysing
economic activity. The unit will therefore give you the opportunity to
review and consolidate your knowledge of these basics if you have studied
microeconomics before or to master them now, if you have not.

Learning Outcomes
When you have completed your study of this unit and it readings, you will
be able to
discuss what the study of economics can encompass, and why there
might be alternative approaches to economic analysis
explain how the supply-demand framework can be used as an
analytical tool
discuss what is meant by market equilibrium, and how it is achieved
explain and apply the concept of elasticity.

Reading for Unit 1

Textbook
Neva Goodwin, Julie Nelson, Frank Ackerman and Thomas Weisskopf
(2009) Microeconomics in Context, set sections of Chapters 1 Economic
Activity in Context, 3 Market Institutions, 4, Supply and Demand,
5 Working with Supply and Demand and 6 Capital Stocks and Resource
Maintenance.
You are also invited to read Chapter 2 Economic Actors and
Organizations, and further sections of the chapters above, but those
readings, though useful, are optional.

Course Reader
Bassam Fattouh (2010) Oil Market Dynamics through the Lens of the 20022009 Price Cycle
Competition Commission (2011) Local Bus Services Market Investigation.

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Unit 1 Introduction to Microeconomics

1.1 Introduction
Before getting involved in the detailed study of economic theory and models, it is useful to take a few minutes to ask what you are trying to achieve in
studying economics. Looking back over the history of economic thought, it
is notable how the answer to this question has changed. In the eighteenth
century, Adam Smith was writing about the nature and causes of the wealth
of nations, and in doing so was seeking to explain how wealth is created
principally through the value of labour invested in goods and services. Up
until the late nineteenth century economists continued Smiths focus in
economic analysis.
Then a new school of economic thought, now referred to as the neoclassical
or marginalist approach, sprang up. This approach is based on the notion
that all economic actors behave rationally to maximise their self-interest,
be it satisfaction of the goods and services consumed or profits generated
from the production and sale of goods and services. One of the key
aspects of this approach is its focus on the efficiency of markets and how
this is achieved through incremental changes in the use of resources. This
approach has also led to the development of a more mathematical approach to economics.
While the neoclassical approach remains important in understanding the
modern-day study and application of economics, some economists are
saying that there are other factors which can be important in explaining
economic behaviour, such as fairness or equity of distribution of resources
and wealth, environmental sustainability of natural resources, social or
community relations and cooperation and peoples well-being. As a result
of these different emphases on economic behaviour and activity, new
approaches to the discipline are being developed and talked about. For
instance there are moves in the United Kingdom, following the Bhutanese
example, to design measures of national well-being which will cover the
quality of life of people in the UK, environmental and sustainability issues,
as well as the economic performance of the country1 as an alternative to the
orthodox use of Gross Domestic Product (GDP) as a measure of national
wealth.
As well as considering why we are interested in studying in economics, we
also need to look at what it is about. While there is general agreement that
economic activity is about consumption, production, distribution and
resource maintenance, how these aspects are covered will vary. Traditional
neoclassical microeconomic theory focuses mainly on consumption and
production activities, whereas distribution is mainly the focus of trade
theory, while resource maintenance has tended to be ignored although this
is changing with renewed interest in environmental economics.

For more information about the UK well-being measures, see

http://www.ons.gov.uk/ons/guide-method/user-guidance/well-being/index.html

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Microeconomic Principles and Policy

Reading
For an introduction to the question of why we should study economics and what it is
about, please read Goodwin et al. Chapter 1 Sections 14. In addition, you should read
Section 5.15.3, which outlines the key economic players namely consumers, business
and government and Section 6, which contains an overview of the approach to
microeconomics that Goodwin and co-authors have adopted in the textbook we will be
using for this course.

Neva Goodwin, Julie

Nelson, Frank
Ackerman and Thomas
Weisskopf (2009)
Microeconomics in
Context, prescribed
sections of Chapter 1
Economic Activity in
Context.

 As you do this reading, you should ensure by making good notes that you are
comfortable about using the concepts of
 efficiency
 externalities
 economic activities including production, consumption, distribution and resource
maintenance
 economic trade-offs, as expressed by the production possibility frontier
 opportunity costs.
Much of this may be familiar to you and so you may find you can skim through this
chapter quite quickly. If the study of microeconomics is new to you, take a bit more time
to read and understand the concepts.
Optional reading
Chapter 2 of Goodwin et al. is about motivations that underpin economic activity, such as
rational choice and self-interest, and how these impact on economic activity. In this
chapter the authors introduce some of the ideas of the newer behavioural approach to
the motivations of economic actors. You are welcome to read this chapter if you are
interested and you may find that it helps you to widen your understanding and perhaps
to contextualise previous microeconomic studies, if you undertook these some time ago.
You will be learning more about the behavioural approach when you study consumer
theory in Unit 2, so this chapter is an optional reading.

1.2 Markets
The conventional view of a market is a place, where people buy and sell
fruit, vegetables, clothes, household goods and so on. A shop, shopping mall
and eBay are, of course, other examples of markets, as is the stock exchange,
or the trade in raw materials, such as copper bars or gold bullion, or a
container loaded with scrap metal. However, the economic definition of a
market, the one that you will use in your study of microeconomics, is the
means through which buyers and sellers interact and transactions take place.
So it can be physical or virtual space or an institution.
Clearly, for any market to function there must be both buyers and sellers.
But usually it is much more than that. There must also be dealers who are
ready to make a market. There must be rules and regulations setting out
how the market operates, and there must also be a means of transmitting
information so that all the market participants know what is going on. In a
simple market, there are usually just buyers and sellers who interact directly
with each other. But in more complex markets, there are a whole host of
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Unit 1 Introduction to Microeconomics

roles available for intermediaries, such as brokers, dealers, market-makers,

information agents and so on, whose role it is to ensure that the market
functions by setting prices, providing information and introducing buyers
and sellers.

Reading
Please read Goodwin et al. Chapter 3, Sections 1 and 3, where they discuss the concept
of the market and its institutional framework. The authors discuss types of markets in
Section 5 and you are encouraged to read this section too.

 Make sure your notes clarify any issues that you are unclear about.

Neva Goodwin, Julie

Nelson, Frank
Ackerman and Thomas
Weisskopf (2009)
Microeconomics in
Context, set sections of
Chapter 3 Market
Institutions.

Sections 2 and 4 of Chapter 3 are optional, but recommended, reading.

Another key element of the market is the role of prices, which provide the
signals by which buyers and sellers react to each other. To the buyer, prices
provide information about the availability of goods and services in the
market, and decisions about the quantities to purchase are based on this
information. On the other side, sellers use the information conveyed by
prices to decide what quantities to sell. So prices play a key role in coordinating market decisions.
Although prices provide the signals that co-ordinate market decisions, there
is no overall co-ordination of how these signals are acted upon by the
various market players. In other words, there is no conscious direction to the
functioning of the market. So in an atomistic market of the type described
above, each buyer and seller acts alone and not as part of some centralised
plan. This characteristic of the market, whereby economic decisions are coordinated on a decentralised basis, led eighteenth century economists to talk
of a policy of laissez-faire (to leave alone). These economists used this
French expression to condemn any deliberate or governmental interference
in business or industry as being inappropriate and potentially harmful.
Today it is usually interpreted to mean that the economy functions best
when it is largely free from government intervention and economic decisions are determined mainly by the market.
At the other end of the spectrum is centralised decision-making, where the
state or a centralised authority coordinates how the market functions by
making decisions about price and quantity. As pure laissez-faire and centralised decision making rarely exist in the real world, most markets are
somewhere in between.

1.3 Supply and Demand

The theory of supply and demand in a market economy is a way of explaining the relationship between the price of a good or service and the quantity
sellers make available to the market (or supply) and the quantity buyers
purchase (or demand). The supply curve, which is two-dimensional representation of this relationship, is assumed to be upward sloping because
sellers are willing to supply more of a good or service the higher the price.

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Microeconomic Principles and Policy

In contrast, the demand curve is downward sloping because buyers purchase less the higher the price. This theory assumes that sellers and buyers
behave in this manner in respond to prices.
However, the quantity of goods and services supplied and demanded is
more complex than being simply a function of price. In the case of supply,
the quantity supplied is also a function of other factors, such as the cost of
inputs, the technology of production and prices of related goods and services. The quantity demanded is also a function of other factors including
peoples tastes and preferences, income and the prices of related goods and
services.

Reading
To learn more about the theory of supply and demand, please read , Sections 2 and 3 of
Goodwin et al. Chapter 4.

 As you do this reading, please ensure you can answer the following questions:

Neva Goodwin, Julie

Nelson, Frank
Ackerman and Thomas
Weisskopf (2009)
Microeconomics in
Context, Sections 2 and
3 of Chapter 4 Supply
and Demand.

 How are changes in the quantity supplied and the quantity demanded represented?
 What do economists mean when they refer to a change in supply and a change in
demand, and how are these represented diagrammatically?
 What are the non-price determinants of supply and demand, respectively?
 What is meant by complementary and substitute goods or services?
Having seen how the quantity supplied and demanded respond to changes
in price and changes in non-price factors, we can move on to look at how
markets work to equilibrate the price and quantities supplied and demanded. That is to reach a point which economists refer to as marketclearing equilibrium, when the quantity supplied equals the quantity
demanded. When the market is not at equilibrium, then there is a shortage
when demand exceeds supply, or a surplus when supply exceeds demand.
In principle, the interaction of supply and demand to achieve an equilibrium
appears simple and straightforward but in practice this is not necessarily the
case. For instance, it may take time for firms to increase production and the
quantity supplied to the market. Or demand for an item could fall away
just think of rapid falls in demand for clothing items as fashion changes,
leaving producers with excess supply.
Alternatively, the market price might not be providing the appropriate
signals to buyers and sellers. For example, a higher price is often seen as
signalling a better quality product, so a buyer may decide to pay a higher
price to obtain a good quality product for example, a car which works
well. This may be the case when buying a new car, but what about in the
market for second-hand cars, where the seller has the advantage of knowing
whether the car performs well or badly? In that case, the price may not be a
reliable signal of the cars quality. This example is sometimes known as the
market for lemons where a lemon is an American term for a car that is
found to be defective after purchase.

University of London

Unit 1 Introduction to Microeconomics

Reading
To learn how markets adjust and to consider an application of supply-demand analysis to
the case of the crude oil market in the United States, please read Goodwin et al. Chapter
4 Sections 4 to 6.

 As you do this reading, you will find it useful to make notes on the following:

Neva Goodwin, Julie

Nelson, Frank
Ackerman and Thomas
Weisskopf (2009)
Microeconomics in
Context, Sections 4 to 6
of Chapter 4 Supply
and Demand.

 how markets adjust when there are surpluses or shortages

 what economists mean by equilibrium and disequilibrium
 the signalling and rationing function of markets
 what is meant by price floors and price ceilings, and their implications for marketclearing equilibrium.

In Section 6 Goodwin and her colleagues use the supply-demand framework

to analyse the US crude oil market, and in doing so they talk about the
implications of the pricing policies of the Organisation of Oil Exporting
Countries (OPEC), which is an organisation of producers who can collude to
affect prices. We will return to the subject of cartels and collusion by producers in Unit 5.
In their discussion of the oil market, Goodwin et al. note that using a simple
supply-demand framework to analyse a complicated market, like that for
crude oil, has its limitations. In particular, the authors make a number of
important points about the functioning of supply and demand in the real
world, namely:
demand and supply can sometimes shift in the same direction
markets may start from a disequilibrium position due to an external
factor or event
there may be a number of prices and quantities prevailing in a market
prices and quantities may not move as would be expected.
These authors analysis of US crude oil markets cover the years up to 2004.
Since then, crude oil prices have continued to be volatile. Some of this
continuing volatility may be a response to changing supply and demand
factors, which are sometimes referred to by economists as the market
fundamentals. However, some of the price volatility may be because non-oil
market players, such as speculators and investors, have become more
involved in oil market trading. Such players are only interested in oil price
movements that is, oil as a financial asset and have no interest in actual
oil supply and demand. There is considerable debate about whether oil price
volatility in recent years has more to do with speculation or with changing
fundamentals of supply and demand.

Reading
For an update on oil price markets, please read the Summary Report of Bassam
Fattouhs study of oil market dynamics.

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Bassam Fattouh (2010)

Oil Market Dynamics
through the Lens of the
20022009 Price
Cycle, a paper from the
Oxford Institute of
Energy Studies
reprinted in the Course
Reader.

Microeconomic Principles and Policy

 As you read this Summary, please note the following points and their implications
for the function of supply, demand and the oil market:
 the changing oil supply-demand feedbacks during the 2000s
 the structural changes of oil markets and the different pricing regimes
 the role of signalling and expectations in the oil market.
If you are interested, please do read the remaining sections of this study, which are an
optional reading.

 Now that you have read Section 6, Explaining Real-World Prices and Quantities, of
Chapter 4 of Goodwin et al. and Fattouhs Summary Report, what do you think about
using the supply-demand framework to analyse the crude oil market? Write a few
paragraphs of notes on this.

You might like to start a conversation about this with fellow students on the Online
Study Centre; if so, send in your paragraphs and see what others think.

1.4 Elasticity
As you have seen, the supply-demand framework enables us to analyse
what is happening if there is a change in one of the factors influencing
demand or supply. But is it possible to give any quantitative answers to such
questions as by how much can we expect the demand and supply for a
good to change if the price of that good is halved?
In asking this type of question, we are concerned with a measure of the
sensitivity of the quantity demanded or supplied to a change in another
variable. This measure of sensitivity is what economists refer to as
elasticity, which is the measure of the responsiveness to changes in
conditions.
So economists talk about price elasticity of demand or supply, which
is a measure of the effect a change in the price has on the quantity
demanded or supplied. This concept is important when it comes to
assessing how a change in price will affect the revenue generated from
the sale of a good or service. Revenue is defined as the price times the
quantity of a good. If, for example, the price of a good goes up, will
people buy significantly less so that revenue declines? Or will the decline
in quantity demanded be relatively small such that revenues do not
decline? The answer to these questions depends on the price elasticity of
demand. For instance, the price elasticity of an essential good, such as
diesel oil, is relatively low as consumers and businesses will continue to
need to purchase it even if there is a large price increase. On the other
hand, the goods for which there are readily available substitutes are
usually more price-elastic.
Economists also talk about income elasticity of demand, which measures
the effects of changing income on the quantity demanded. So do consumers
purchase more or less as their income rises and falls?

University of London

Unit 1 Introduction to Microeconomics

Reading
Chapter 5 of Goodwin et al. discusses the different ways in which economists use the
concept of elasticity. Most of the discussion is illustrated using diagrams, although
Section 2.4 presents a more mathematical approach, which you encouraged to read. It is
also recommended that you spend a few minutes working through the numerical
examples in the Math Review box. When discussing income elasticity, Goodwin et al. talk
about the income and substitution effects of a price change, which you should make
sure you understand. You should read all of Chapter 5.

Neva Goodwin, Julie

Nelson, Frank
Ackerman and Thomas
Weisskopf (2009)
Microeconomics in
Context, set sections of
Chapter 5, Working
with Supply and
Demand.

 As you do this reading, write notes on the following questions:

 If a good is price-inelastic, why will revenues change in the same direction as any
price change?
 Why might demand for a good or service be price-elastic?
 Do perfectly elastic and inelastic demand and supply exist?
 What do economists mean by the terms normal and inferior goods?
 What do economists mean by the income and substitution effects of a price
change, and why are these effects useful?
 Can the price elasticity of a good or service change over time?
This Chapter 5 reading from Goodwin and her colleagues provides a good
introduction to the concept of elasticity and its implications for assessing
how demand responds to changes in prices and income. So the next step is
to see how economists use the concepts of price and income elasticity to
analyse consumer demand. A good example of this is found in the next
reading, which is an analysis of the demand for local bus services in the
United Kingdom. This analysis illustrates some of the complexities of
investigating the demand for a particular good or service, such as how price
elasticity for a service can be different for different consumer groups, and
the importance of other factors such as the availability of alternative
services, location and income.

Reading
Please read the article on investigating local bus services, which summarises how the
demand for bus services is affected by the level of bus fares and other factors.

 When you have finished this reading, spend a few minutes noting down how you
would answer the following question:

Competition
Commission (2011)
Local Bus Services
Market Investigation, a
UK Competition
Commission study
reprinted in the Course
Reader.

 What are the implications of this demand analysis for a bus operating company?

 If you have time, post a message for discussion with your group on the Online Study
Centre, commenting on whether the analysis offered in the Reading has given you any
insights into how the bus services in your local area are run.

1.5 Conclusion
In this first unit, you have been looking at the questions of what economics
is about and how the simple supply-demand model can be used to analyse
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Microeconomic Principles and Policy

markets. If you have studied economics before, much of this will be familiar
to you and this unit will have primarily been a review of what you have
studied in the past, although the readings will have introduced some complexities you may not have encountered in previous courses.
If the study of economics is new to you, then this unit will have introduced
you to some of the key concepts you will be using in this course, as well as
the basic supply-demand model generally.
In the next unit, you will be learning about the theories of consumer choice
which underpin the demand function. As Unit 2 covers both the traditional
neoclassical model and the newer behavioural approach to consumer
behaviour, it is both longer and more complex than this first unit.

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University of London

Unit 1 Introduction to Microeconomics

References and Websites

Competition Commission (2011) Local Bus Services Market Investigation,
UK Competition Commission, London; accessed at
http://www.competitioncommission.org.uk/assets/competitioncommission/docs/pdf/inquiry/r
ef2010/localbus/pdf/summary_of_demand_estimation_analysis.pdf
Fattouh B (2010) Oil Market Dynamics through the Lens of the 2002-2009
Price Cycle, WPM 39, Oxford Institute of Energy Studies, January;
accessed at http://www.oxfordenergy.org/wpcms/wpcontent/uploads/2010/11/WPM39OilMarketDynamicsThroughTheLensofthe2002-2009PriceCycleBassamFattouh-2010.pdf
Goodwin N, JA Nelson, F Ackerman and T Weisskopf (2009)
Microeconomics in Context, Second edition, New York: ME Sharpe.

Additional Readings
Adams C and O Ajakaiye (2011) Causes, Consequences and Policy
Implications of Global Food Price Shocks: Introduction and Overview,
Journal of African Economics, Vol 20, Oxford University Press; accessed at
http://ideas.repec.org/cgibin/htsearch?q=Adams+C+and+O+Ajakaiye+
&ul=%2Foup%2Fjafrec This article provides an example of how elasticity
is analytically in Section 3.
Porteous D (2006) Competition and Microcredit Interest Rates, Focus Note
33, Consultative Group to Assist the Poor (CGAP), February; accessed at
http://www.cgap.org/gm/document-1.9.2575/FN33.pdf This article
shows how the demand supply model and elasticity can be used in
assessing financial products.

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Microeconomic Principles and Policy

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University of London