Review of Econ 203

Review of Econ 203
Prep for the final
Sen 1997
Light does not know that it is minimizing distance, but it behaves as if it does
The Final
December 18th, 7pm

In the GYM, rows 1-5 3 Hours
15 Multiple Choice (30 Marks) 4 Short Answer (20 Marks) 3 Long Answer (50 Marks)
Pen, Pencils and a non-programmable calculator
Extra Office Hours: Tuesday, December 17th, 1pm-4pm
How This Relates to This Course

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function
Ch. 10 & 10A: The Cost Function
The Market Ch. 11: Perfect Competition Ch. 12: Monopoly Ch. 13: Game Theory & Oligopoly Ch. 16: General Equilibrium
Chapter 3: Rational consumer choice

We covered the consumers problem The budget constraint and indifference curves
The assumptions that under lye the consumers problem

How to solve the consumers problem
Solving the Consumers Problem
Use Calculus and solve: max U ( x1 , x2 )

x1 , x2
subject to p1 x1 p2 x2 M
Exploit the following:

Slope IC = slope budget line MRS = - slope budget line

U U MU x1 MU x2 x1 x2 or p1 p2 p1 p2
U p x 1 1 U p2 x2
Solving the Consumers Problem
If ICs are enough bowed inward (e.g. multiplicative utility functions) Use graphs for rough idea, and math for actual solution: 2 equations and 2 unknowns:
(1) (2) MU x1 p1 MU x2 p2
p1 x1 p2 x2 M
If ICs are straight lines, or angular, or not enough bowed inward Use graphs and common sense
The Four Axioms of Consumer Preferences
Completeness Non-Satiation
Transitivity Convexity
Indifference Curves
2
The Slope of Indifference Curve
The marginal rate of substitution (MRS) of x2 for x1 is the amount of x2 that the consumer must add to her bundle in order to compensate for the loss of a small amount of x1 In general, the MRS is different for every different bundle (x1,x2) MRS of x2 for x1 decreases as x1increases
The Slope of Indifference Curves
Causal definition: MRS measures willingness to trade one bundle for another
Bundle A=(6 hours of sleep, 50 points) Bundle B=(5 hours of sleep, 60 points) A~B MRS for sleep in terms of grades: -(-10/1)=10 A 2 1 B
2 (sleep)
1 (points on exam)
Rational Choice
Rational Choice Trying to get the largest possible level of utility.
In mathematical terms:
max (1 , 2 )
1 ,2
Subject to 1 1 + 2 2
In words: choose the consumption bundle (1 , 2 ) that maximizes utility subject to the budget constraint, taking prices and income as given

Individual and Market Demand
How to derive individual demand (in terms of prices and income) How to derive market demand How the total effect of a price change can be decomposed into two components and how the signs of these components map into different types of goods We talked about the responsiveness of demand curves to changes in income and price
From the Optimal Choice to the PCC

2
The Price-Consumption Curve (PCC)
From the Optimal Choice to the Price-Consumption Curve and Demand Curve
2
The Price-Consumption Curve (PCC)
1 1 3 1 4 1
2 1
The Individual Demand Curve

1 1 2 1 3 1 4 1
Income Consumption Curve: Normal vs. Inferior Goods
Income Consumption Curve
A good is said to be Normal if its consumption increases when income increases
A good is said to be Inferior if its consumption declines when income increases
The Income and Substitution Effects of a Price Change
When a price increases it impacts consumers in two different ways: 1.Overall, the consumer cannot afford as many things as before. Effectively, the consumer is poorer. This leads to changes in quantities consumed that are called the Income Effects.
2. The good for which the price has increased is now more expensive relative to others. This also leads to changes in quantities consumed away from the more expensive good and towards others that are called Substitution Effects.
Market Demand: Adding up Individual Demand Curves
Aggregating; Adding up; Summing up Going from Individual Demand Curves to the Market Demand:
Market Demand: Adding up Individual Demand Curves - Example

Consumer 1s demand curve: = 10 2 Consumer 2s demand curve: = 20 5 To get the market demand curve re-arrange so quantity is on the left hand side and then sum: Demand for 1: = 10 2 Demand for 2: = 20 5 Adding up: =5
1 + 2
Q = 5 Q = 4
5 1 5
1 2 1
=9
P=
90 1 7 7
7 10
then re-arrange:
The Price Elasticity of Demand
The Price Elasticity of Demand measures how sensitive the quantity demanded is to a change in price The price elasticity of demand:
dq % change in demand q dq p dp dp q % change in price p
p 1 q slope inv. demand function
Measuring Welfare: Consumer Surplus
Another way to measure consumer welfare is through consumer surplus Consumer surplus is a dollar measure of the extent to which a consumer benefits from participating in a transaction
Useful for cost-benefit analysis of policy
Slide 22
Demand Curve Measure of Consumer Surplus
Slide 23

Chapter 9: Production
Here we talked about the first part of the producers problem: the production processes they are facing We learned about the production function, what different functions represent, and the assumptions under lying them
We learned about the short run and long run production
The Production Function

Output = Q = F(x1,x2) x1 and x2 inputs, F(x1,x2) output or production Frequently encountered inputs: Capital (K) and Labour (L)
FIGURE 9-2 The Production Function The production function transforms inputs like land, labour, capital, and manage-ment into output.
The Production Function
Marginal product of an input (MPinput) Marginal = extra Example: the marginal product of capital =
F ( K , L) MPK K
Small extra change = infinitesimally small
Interpretation: how much output do we get if we use one more (extra small) unit of an input (keeping all other inputs constant)
The Marginal Rate of Technical Substitution

The marginal rate of technical substitution (MRTS) MRTS of input 2 for input 1: The amount of input 2 that replaces the loss of an amount of input 1
=
Returns to Scale
Returns to scale: What happens if we doubled all inputs?
Output doubles too constant returns to scale Output less than doubles decreasing returns to scale Output more than doubles increasing returns to scale
Short Run vs. Long Run
Consider the function = , = But in the short run (say K=1) it will look like:
Q F(1,L)=L
In the long run:

F(K,L)
( , )
L (1, ) L

Chapter 10: The Cost Function

We discussed the producers problem Short run and long run cost functions
How to solve the producers problem
The Cost of Production Depends On
The type of production technology Level of output
How much you produce to satisfy demand Which is isoquant you are on
The factor prices

The prices of inputs such as capital and labour The define the slope of the isocost line
The Cost Function: Relating Costs and Output
Cost Function:
A function C(q,wK,wL) that tells us the minimum total cost, C, that must be incurred to produce a quantity of output q, given input prices wK and wL
General definition: A function that tells us what the minimum cost, C, is to produce q for given input prices wK and wL Note: ...minimum costs C... efficient production
Deriving the Cost Function

C(q) is obtained by first solving the cost minimization problem: In Math:

min wK K wL L
K ,L
such that q f ( K , L)
In words: choose the inputs so as to minimize the costs to produce an output amount q (assuming given input prices)
To Find the Optimal Bundle of L and K
If isoquants s are enough bowed inward (e.g. multiplicative utility functions) Use graphs for rough idea, and math for actual solution: 2 equations and 2 unknowns:
(1) MPL MPK pL pK (2) F ( L, K ) Q
If isoquants s are straight lines, or angular, or not enough bowed inward Use graphs and common sense
K 0
Optimum bundle of K and L ( (0 ), (0 ))
0 0 L
Solving this problem gives you the solutions for the amount of K and L ( and ) demanded in terms of the quantity chosen to produce (q) and the prices of K and L ( and respectively). Let K*(q) and L*(q) be the solutions to the cost minimization problem for output level q The cost function is 0 = 0 + (0 ) This is the so-called long-run cost function

K = () + ()
0
0
0 0 L
Long Run Costs
Studying cost functions Close relationship technology and cost curve also for LR cost function
CRS production technology linear cost function IRS production technology concave cost function DRS production technology convex cost function
The Long Run vs. the Short Run
Costs must be higher in the short-run than in the longrun Long-run costs cannot exceed short-run costs, because you have more flexibility in choosing inputs in the right way
Deriving the LR cost function : min wK K wL L
K ,L
Deriving the SR cost function : min wK K wL L

L

Chapter 11
We learned about profit How to get the aggregate supply curve The long run vs the short run
How to find prices and quantity in the long and short run
43
Profit
We assume that firms are trying to maximize their profit Economic Profit is different than Accounting Profit Economic Profit is the total revenues minus total explicit and implicit costs Accounting Profit is the total revenues minus the total explicit costs incurred.
44
The Assumptions for Perfect Competition

Homogeneous product (perfect substitutes) Firms are price takers
Perfect and symmetric information

Long run: Perfect factor mobility (Capital and labour flow freely) All firms face same factor prices Long run: Free entry and exit of firms (no barriers to entry)
45
The Short Run: Profit Maximization
One input is held is fixed (typically capital) This means the short-run cost function is used: = + Number of firms is fixed (no entry or exit) Firms take prices as given and choose quantity to maximize profits
46
The Short Run: Profit Maximization
Problem of the competitive firm in math:
max pq C (q)
q
The steps ( represents profit) = () = Necessary condition: marginal benefit = marginal cost.
p C ' (q) 0, that is p MC(q)
47
The Long Run: Competitive Markets
From a SR to a LR competitive market equilibrium The LR competitive market equilibrium:
48
The Long Run: Welfare
Welfare result 1: Total welfare (total surplus) is maximized Welfare result 2: Goods are produced in most efficient way The firms output qi is optimalit collectively maximizes
q1 ,...,qn
max pq C1 (q1 ) C2 (q2 ) ... Cn (qn )
49
Short vs. Long Run Competitive Equilibrium

Short Run Some factors are fixed Long Run All factors mobile
Number of firms constant

Some firms can make profit or loss Demand = supply Consumers maximize utility Firms maximize profit
Free entry and exit

All firms make zero profit Demand = supply Consumers maximize utility Firms maximize profit
Firms and Consumers take prices as given Firms and Consumers take prices as given
50

Chapter 12: Monopoly
The sources of monopoly power Basic profit-maximizing problem of the monopolist How to solve the monopolist problem
The Sources of Monopoly Power
Exclusive control over crucial inputs Economies of scale AVC decreases natural monopolies Network economies Patents temporary monopoly rights
Licensing by governments or other institutions
The Objective of the Monopolist
Same as the competitive firm, the monopolist solves

max pq C (q)
q
But in the case of the monopolist, the amount they produce effects the price, so price is a function of quantity produced
max P(q)q C (q)
q
Necessary condition : R' (q) C ' (q) 0 So, optimum q : marginal revenue marginal cost
Welfare in Monopolistic Markets

D(q) p1
p2
MC(q) q1
(p1,q1) = monopolists price and quantity = Deadweight loss of monopoly power p2 = socially optimal price (CS + PS is maximal)
MR(q)
The monopolist chooses its quantity such that MR(q) = MC(q). The monopoly price is higher than the socially optimal price. The cost of the high price of the monopolist to society is called the deadweight loss (welfare loss) of monopoly power

Games and Oligopoly
We discussed the concept of games and Nash equilibrium Discuss three important games that are played between firms when there is a small number of them
The Cournot Model The Bertrand Model The Stackelberg Model
Games and Nash Equilibrium
Best Response: is the set of strategies which produces the most favorable outcome for a player, taking other players' strategies as given Nash Equilibrium: when all players are simultaneously playing a best response to the choices of other players
http://www.youtube.com/watch?v=5Rg3spRl1IQ
The Cournot Model
Cournot Firms maximize profits Cournot conjecture: Firms choose (the price or the quantity) assuming that other firm(s) keep their quantity fixed In other words, firms compete on quantities The Cournot duopoly model Firm 1: choose q1, Firm 2: choose q2 Market price p=P(q), where q=q1+q2
The Cournot Model
Firm 1s objective:
max 1 (q1 , q2 ) P(q1 q2 )q1 C1 (q1 )

q1
Firm 2s objective:
max 2 (q1 , q2 ) P(q1 q2 )q2 C2 (q2 )

q2
Firm 1s choice
max P(q1 q2 )q1 C1 (q1 )
q1
P Necessary condition : q1 P(q1 q2 ) C1 ' (q1 ) 0 q
The Cournot Model

Optimal q1 depends on q2, Firm 2s output Optimal q1 as function of q2 = reaction function of firm 1
You would find this using the first order condition

Derive the reaction function of firm 2 (optimal q2 as function of q1) in exactly the same way The reaction function is also known as the best response function
The Bertrand Model
Bertrand Firms maximize profits Bertrand conjecture: Firms choose (the price or the quantity) assuming that other firm(s) keep their price fixed Practical matter: easiest to define strategies as prices Difference between Cournot and Bertrand model is the conjecture of how the game of competition is played Different conjectures yield radically different solutions
The Bertrand Model
Solution Bertrand model The only solution: p1 p2 c Equilibrium payoffs are zero Notes With only two firms the outcome is the perfectly competitive outcome Solution is welfare maximizing
The Stackelberg Model

Firms move sequentially The Stackelberg leader (firm 1) sets its profit-maximizing level of output first, knowing that its rival (the Stackelberg follower) will behave as a Cournot duopolist. Firm 1 will choose its output level first taking into account the effect that choice on its rivals output Suppose firm 1 knows that firm 2 will treat firm 1s output as fixed. Can it use this knowledge to its advantage?
Let firm 2s reaction function is given by 2 = the Cournot problem earlier
1 2 2
from
Firm 1 knows firm 2s optimal choices (its reaction function) So it can take that into account when choosing its profit maximizing quantity. Mathematically this means substituting the reaction function for 2 into Firms one profit equation (specifically into the market demand curve)
Firm 1 must solve:

max P(q1 R2 (q1 ))q1 C1 (q1 )
q1
So the necessary condition for the best response of firm 2 1 is 1 =0

1 1 1
From our previous example demand was given by = and firm twos best response to a given 1 2 quantity chosen by firm 1 was
2
Comparing Models
This holds not just for this example, but generally

$/Q
13
=7
Monopoly Cournot
= 5
= 4
MR = 4
Stackelberg
Bertrand/Perfect Competition
12 Q

General Equilibrium
We learned about efficient production, consumption and social allocation For the exam you only need to know conceptually about the exchange economy Know the welfare results as well
Edgeworth Box
X for Costello
9
Contract Curve
Y for Costello
Y for Elvis
3 2
X for Elvis
Core if initial allocation 0
Edgeworth Box
X for Costello
9
Contract Curve
Y for Costello
Y for Elvis
3 2
3 4
X for Elvis
Reminder: Results
Result 1: Equilibrium allocation must be individual rational allocation Result 2: Equilibrium allocations must be (Pareto) efficient Result 3: Equilibrium allocation must be in core (of the economy)
Result 4: If there are very many agents the core often reduces to single point, i.e. the competitive equilibrium allocation
Towards a Competitive Equilibrium
Definition: Competitive equilibrium [in an exchange economy]: set of prices, and the corresponding allocation, such that:
1.
Consumers each solve their consumers problem
they choose optimal bundles, i.e. bundles which maximize utility given prices and initial endowment
2.
These optimum bundles form feasible allocation
In other words, (net) demand = (net) supply for all goods In other words, markets are in equilibrium

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Review of Econ 203

Prep for the final

December 18th, 7pm

In the GYM, rows 1-5 3 Hours

Extra Office Hours: Tuesday, December 17th, 1pm-4pm

How This Relates to This Course

Ch. 10 & 10A: The Cost Function

Chapter 3: Rational consumer choice

The assumptions that under lye the consumers problem

Solving the Consumers Problem

Use Calculus and solve: max U ( x1 , x2 )

Exploit the following:

Slope IC = slope budget line MRS = - slope budget line

Solving the Consumers Problem

The Four Axioms of Consumer Preferences

The Slope of Indifference Curve

The Slope of Indifference Curves

Rational Choice Trying to get the largest possible level of utility.

How This Relates to This Course

Ch. 10 & 10A: The Cost Function

Individual and Market Demand

From the Optimal Choice to the PCC

The Price-Consumption Curve (PCC)

The Price-Consumption Curve (PCC)

The Individual Demand Curve

Income Consumption Curve: Normal vs. Inferior Goods

Income Consumption Curve

A good is said to be Normal if its consumption increases when income increases

A good is said to be Inferior if its consumption declines when income increases

The Income and Substitution Effects of a Price Change

Market Demand: Adding up Individual Demand Curves

Market Demand: Adding up Individual Demand Curves - Example

The Price Elasticity of Demand

dq % change in demand q dq p dp dp q % change in price p

p 1 q slope inv. demand function

Measuring Welfare: Consumer Surplus

Useful for cost-benefit analysis of policy

Demand Curve Measure of Consumer Surplus

How This Relates to This Course

Ch. 10 & 10A: The Cost Function

We learned about the short run and long run production

The Production Function

The Production Function

Small extra change = infinitesimally small

The Marginal Rate of Technical Substitution

Returns to scale: What happens if we doubled all inputs?

Short Run vs. Long Run

In the long run:

How This Relates to This Course

Ch. 10 & 10A: The Cost Function

Chapter 10: The Cost Function

How to solve the producers problem

The Cost of Production Depends On

The type of production technology Level of output

The factor prices

The Cost Function: Relating Costs and Output

Deriving the Cost Function

C(q) is obtained by first solving the cost minimization problem: In Math:

To Find the Optimal Bundle of L and K

Deriving the Cost Function

Optimum bundle of K and L ( (0 ), (0 ))

Deriving the Cost Function

Deriving the Cost Function