University of Melbourne

ECON90034
Economics of Finance

Svetlana Danilkina

Economists are people who like to work with numbers

but don’t have the personality to be accountants.

L1-1
 Subject overview
1. Objectives
 Introduce key concepts and theories in economics
 Develop the capacity to apply economics to understand
and guide decision-making in finance markets.

2. Micro/Macro economics / Finance

 Microeconomics – Study of behaviour of individual
economic agents (Consumers; Producers; Government);
and their interaction.
 Macroeconomics – Study of the performance of national
economies and of policies governments use to seek to
improve performance.
L1-2
 Subject overview

3. Assessment
 Assignments: 3 home assignments - 30%

 Final examination – 70%.

4. LMS/ Lecture notes/ Screen Capture & Audio/

Reading/ Tutorials/ Assignments/Exam
preparation webpage

L1-3
 Subject overview
5. Topics:
 Main concepts in microeconomics
 Markets and efficiency
 Consumption and investment decisions under certainty
 Choice under uncertainty
 Strategy and competition (Game Theory with applications,
including bank runs and auctions)
 Information economics
 GDP and economic growth; The business cycle; Inflation,
and its costs
 Monetary Policy
 Behavioral finance
 Review L1-4
 Svetlana Danilkina
ECON90034

Lecture 1

Topic 1.
Main concepts in
microeconomics
University of Melbourne L1-5
Overview
1. What is Economics about?
2. Core concepts in microeconomics
 scarce recourses, cost-benefit principle
 principles for the rational decision - maker; opportunity
cost, sunk cost, marginal analysis
 are we rational?
3. The concept of a perfectly competitive market
4. Demand
5. Supply
6. Market equilibrium
7. Effects of changes in demand and supply
 change in demand;
 change in supply
L1-6
 1. What is economics about?
 Economists develop theories to describe and
understand economic activity
 Theory = Model + Hypothesis

 Model = essential features of situation being

studied.
 Hypothesis = logical consequences of model

 Example: Price determination in a competitive

market
Economics is a way of thinking about the world;
the science (or maybe art?) of trade-offs. L1-7
 Why are models simplified versions of
reality?
 ‘A map is valuable precisely because it
simplifies and omits. Economic models are
maps for the market economy.’ (John Kay,
2003, The Truth About Markets, p.193)
 Why is theory valuable?
 It allows us to understand why people make
the choices they do, and hence to predict
behaviour in different environments
L1-8
 Economic models are distinguished by:
 Core assumption: Rationality – Households and
Firms have ‘well-defined’ objectives, and take
actions to achieve those objectives; and
 Same general set of modelling approaches – eg.,
demand/supply; game theory.
 Development of economic models is a
subjective process.

L1-9
 2. Core concepts in economics

 Scarce resources – agents in a society

(households, firms) must make choices about use
of resources
 How to make choices?
 Core assumption in economics is that decision-
makers use the cost-benefit principle = an
activity should be undertaken if and only if the
extra benefits of that activity outweigh the extra
costs.

L1-10
 rational decision-maker
 Generally, we assume that economic agents are
rational, that is:
a) Have a well-defined objective;
b) Know the consequences of their decisions or actions;
c) Only choose decisions or actions that make them better
off.
 For example, in representing firm behaviour it will be
assumed that a firm
a) has the objective of maximising profits,
b) knows the consequences for its level of profit of choosing
different price/quantity combinations,
c) will choose the price/quantity combination that maximises
profits
L1-11
 Principles for a rational
decision-maker

In particular, rational decision-makers:

 Use opportunity cost as a measure of cost;
 Ignore sunk costs;

 Use marginal benefit and marginal cost

analysis to assess whether to take an action

1-12
 Principle of opportunity cost

 How do we measure cost? Economics uses the

concept of opportunity cost.
 If you take a particular action => resources
used are now not available for alternative use.
 Opportunity cost of an action = value of
resources used in next best alternative use.

1-13
 Example: opportunity cost of
doing a university degree

Private costs and benefits of tertiary

education
Benefits Increase in after tax earnings from a better paying job
Higher probability of employment

Costs Foregone earnings during the period of education, if

you are studying full time
Fees

Direct costs minus government student benefits

1-14
 Ignore sunk costs!

 ‘Sunk cost effect’ - decision-makers do not

always ignore sunk costs
 Sunk cost = resources that are already used and
could not be recovered at the moment of making
a decision. (Ignore sunk cost! Do not include in
the opportunity cost!)

 Example: Buying health club or gym membership

L1-15
 Making an optimal decision
using marginal analysis
 To apply cost-benefit rule we must think about the
extra (marginal) cost and extra benefit of doing an
activity, or increasing the level of an activity.
 Marginal benefit = addition to total benefit by
doing, or increasing by one unit the level of, an
activity.
 Marginal cost = addition to total cost by doing, or
increasing by one unit the level of, an activity
 The optimal quantity is the quantity that generates
the maximum total net gain (= total benefit minus
total cost)
1-16
 Example: How many workers to hire?

Number of Total Average Marginal Total Average Marginal

workers benefit benefit benefit cost cost cost
1 5 2

2 10 4

3 15 8

4 20 14

5 25 22

Optimal number of workers maximises total benefits – total

cost.
Marginal analysis: Hire any worker with MB>MC. Do not hire
a worker with MC>MB. 1-17
 marginal this, marginal that…
Example: How many workers to hire?
Number of Total Average Marginal Total Average Marginal
workers benefit benefit benefit cost cost cost
1 5 5 5 2 2 2
2 10 5 5 4 2 4-2=2
3 15 5 5 8 2.66 8-4=4
4 20 5 5 14 3.5 14-8=6
5 25 5 5 22 4.4 22-14=8

Optimal number of workers: Maximises total benefits – total cost.

Marginal analysis: Hire any worker with MB>MC. Do not hire a
worker with MC>MB. Applying this rule results in the optimal number
of workers being hired. Hire 3 workers, profit =15 – 8 = 7
If you use AB≥AC rule instead, then you will hire all 5 workers.
The resulting profit is 25 – 22 = 3. It is way lower then 7! 1-18
Example c: How many workers to
hire?
$
MC
8

5 MB
4

Optimal number of workers

2

Number of
workers
1 2 3 4 5
1-19
 Are decision-makers always
rational?

 No, humans often make mistakes

 Existence of some decision-makers who are

not rational does not necessarily invalidate
economic theories of market outcomes – as
long as there is no systematic bias in their
mistakes, then on average the decisions
that are made may correspond to economic
theory.
L1-20
 Speaking about rationality and
logical thinking,
here is a puzzle for you:

 Most humans get it wrong!

BE47

L1-21
 3. The concept of a perfectly competitive
market; supply and demand model

 Characteristics:
• Many buyers and sellers => Are ‘price-takers’
• Homogeneous good

 Why study?
• Power as an analytic tool to study markets with
high degree of competition
• Demonstrate important lessons about
determinants of market outcomes.
L1-22
 4. Demand

 Quantity demanded and price

 Law of demand: When price of a good
increases (decreases), the quantity
demanded of the good decreases
(increases) [Other things being equal]

 Terminology: Increase in price =>

Decrease in quantity demanded
(Movement along the demand curve).
L1-23
 Demand

price

Demand

Quantity

L1-24
 Factors that affect demand:

a. Price of other goods:

• Substitute: Two goods where decrease
(increase) in price of one good causes
decrease (increase) in demand for other goods.
• Complement: Two goods where decrease
(increase) in price of one good causes increase
(decrease) in demand for other goods.
Terminology: Increase in price of substitute
=> Increase in demand (i.e. shift of the
demand curve to the right).
L1-25
 Factors that affect demand:
substitutes complements
price price of price price of
coca-cola ↑ petrol ↑

Demand Demand
for pepsi for cars

D2 D1
D1 D2

Quantity Quantity
L1-26
 Factors that affect demand:

b. Income
– Normal good: Increase (decrease) in income
causes an increase (decrease) in demand.
- Inferior good: Increase (decrease) in income
causes a decrease (increase) in demand.
c. Price expectations
d. Tastes
e. Number of buyers
L1-27
 Factors that affect demand:
normal good inferior good
price income ↑ price income ↑

Demand for Demand for

restaurant McDonalds
meals meals

D2 D1
D1 D2

Quantity Quantity
L1-28
 5. Supply

 Quantity supplied and price

 Law of supply: When price of a good
increases (decreases), the quantity supplied
of the good increases (decreases). [Other
things being equal]

 Terminology: Increase in price => Increase

in quantity supplied (i.e. the movement
along supply curve).
L1-29
 Factors that affect supply:

a. Cost of production (Price of inputs/ efficiency of

production)
Terminology: Increase in cost of production =>
Decrease in supply (i.e. shift of the supply
curve to the left).
b. Price expectations (supplier expects higher
price “tomorrow” => lower supply “today”)
c. Weather (drought leads to decrease in supply
of ...)
d. Number of suppliers
L1-30
 Supply

price price cost of input ↑

Supply
S2
S1

Quantity Quantity
L1-31
 6. Market equilibrium
 Assume outcome from trade can be
characterized as a ‘market equilibrium’:
 Market (equilibrium) price and quantity are
such that quantity demanded of a good
equals to the quantity supplied.
 Price comes from S=D, it is a result of interaction between
buyers and sellers.
 it is not a value judgment (has nothing to do with justice or
morality).
 CD: Beatles or my daughter?
L1-32
 Market equilibrium

Price Quantity Quantity

demanded supplied
6 0 12
5 2 10
4 4 8
3 6 6
2 8 4
1 10 2
0 12 0

L1-33
 Market equilibrium

price market demand market supply

Price Quantity Quantity
demanded supplied 6 excess suply =8
6 0 12
p=5
5 2 10 Market
4 4 8 equilibrium:
p*=3 demand
3 6 6 equals supply
p=2
2 8 4
1 10 2 excess demand =4

0 12 0 Q*=6 12
Quantity
Here is my drawing of “invisible hand”:
L1-34
 7. Effects of changes in
demand and supply

• An ‘event’ occurs (for example, increase

in consumer income).
• Comparative statics: study effect of
‘event’ on market outcome by
examining change in market
equilibrium.
• Demand could shift; supply could shift,
or both could shift.
L1-35
 a. Change in demand

price
market demand market supply

p↑ Q↑
p2

p1 eg. income ↑

D2
D1
Q1 Q2
Quantity

L1-36
 b. Change in supply

price
S2 market supply
S1
p↑ Q↓
p2

p1 eg. cost of inputs ↑

market demand

Q2 Q1
Quantity

L1-37
 Svetlana Danilkina
ECON90034
Topic 2
Markets and efficiency

Topic 2. Markets
2.1 perfect competition and efficiency
2.2 example: market for home loans

University of Melbourne L1-38

 Markets: equilibrium

Interaction between consumers and producers

Consumers: demand
Producers: supply
Market equilibrium (demand equals supply) :
equilibrium price and equilibrium quantity

L1-39
 2.1. Markets: Perfect competition

 Large number of firms

 Each firm is a price-taker (no strategic
interactions)
 Homogeneous product
 Perfect information
 Free entry to and exit from the market

L1-40
 Equilibrium in perfectly
competitive market
market demand market supply
(consumers) (industry)
p

Market equilibrium
pc (demand equals supply)

Qc Q

L1-41
 ‘willingness to pay’ (WTP)
of consumers
market demand market supply
p (consumers) (industry)
p1

p2
p3
Market equilibrium
pc (demand equals supply)

Market demand curve maps out

‘willingness to pay’ (WTP) of
consumers.
Qc Q

L1-42
 Consumer Surplus
market demand market supply
p (consumers) (industry)
Consumer
Surplus

Market equilibrium
pc (demand equals supply)

Market demand curve maps out

maximum ‘willingness to pay’
(WTP) of consumers.
Qc Q

L1-43
 cost of producers
market demand market supply
(consumers) (industry)
p
Market supply curve maps out
cost of producers

Market equilibrium
pc (demand equals supply)
p4
p5
p6

Qc Q

L1-44
 Producer Surplus
market demand market supply
(consumers) (industry)
p
Market supply curve maps out
cost of producers

Market equilibrium
pc (demand equals supply)

Qc Q

Producer
Surplus
L1-45
 equilibrium in perfectly competitive
market achieves efficient outcome:
market demand market supply
(consumers) (industry)
p
Market supply curve maps out
cost of suppliers

Market equilibrium
pc (demand equals supply)

Market demand curve maps out

maximum ‘willingness to pay’
(WTP) of consumers.
Q1 Qc Q2 Q

Cost-benefit principle:
Efficiency requires use of resources to produce an extra unit of a
good if: Consumer WTP ≥ Cost of production L1-46
 equilibrium in perfectly competitive
market achieves efficient outcome:
market demand market supply
(consumers) (industry)
p

Consumer
Surplus Market equilibrium
pc (demand equals supply)
Producer
Surplus

Qc Q

Total surplus (consumer and producer)

is maximised L1-47
 What can competitive
markets do?
market demand market supply
(consumers) (industry)
p Competitive markets
Reveal information
⇒
Allocation of the
resources to the
most efficient use
pc
Why?
Competition ‘forces’ buyers to
reveal their valuations,
and sellers to reveal their costs

Qc Q

Market equilibrium
(demand equals supply)
L1-48
 3. Market for home loans: how
government intervention in markets can
prevent efficient resource allocation

Should government introduce a cap (ceiling) on home

loan interest rates to make home ownership more
affordable?

Prior to mid-1980s the Reserve Bank of Australia could

impose
 ceilings on interest rate on deposits; and
 ceilings on interest rate for home loans.

Later Government removed this capacity. Why?

L1-49
 Market for home loans

Model of home loan market:

Supply of funds =
(Rate of interest on Deposits) x ($1M)
Demand for funds =
$20M - (Rate of interest on Deposits) x ($1M)

Assume: RBA intervention restricts

 rate of interest on deposits to 5% and
 rate of interest on loans to 8%.

L1-50
 Market for home loans

No RBA intervention:
i, %
supply: Qs = i
20
Market equilibrium
(demand equals supply)
Surplus to i* = 10%
borrowers Q* = 10M
10
Surplus to
lenders
demand: Qd = 20 - i

10 20 Q (in M)
L1-51
 How government intervention in
markets can prevent efficient
resource allocation
rate of interest on deposits = 5% (paid to lenders)
RBA intervention: rate of interest on loans = 8% (paid by borrowers)

i, % Surplus to Effect of intervention:

borrowers rate of interest on deposits = 5% → Qs = 5 →
20 Quality supplied ↓ from $10M to $5M.

Deadweight The level of funds in this market is below

loss the efficient level due to intervention
Lenders are worse off (surplus ↓)
supply Banks are better off (surplus ↑)
10 Borrowers – effect is ambiguous (pay lower
interest rate but quantity of funds borrowed is
8 Surplus lower)
5 to banks
Surplus to lenders demand

QS = 5 10 20 Q (in M) L1-52
 Last thoughts…

For people, postmortem examinations have shown that

education increases the number of branches among
neurons [in the brain]. An increased number of branches
drives the neurons farther apart, leading to an increase in
the volume and thickness of the brain. The idea that the
brain is like a muscle that grows with exercise is not just
a metaphor. Norman Doidge, M.D. (from The brain
that changes itself)
Study Economics of Finance to give your brain
thickness, volume and that unmistakable shine that
comes from using good economics product!