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Econ 301 MT 1 motes

- DQs for PublicFinance
- ch12
- Exchange (Chapter 17)
- gdp
- Macroeconomics Solutions 2005
- micro 8
- 02 Public Sector and Mixed Economy
- Unit-I Economics
- ch2
- Housing Policies for Asia: A Theoretical Analysis by Use of a Demand and Supply Model
- Practice Multiple Choice1
- Why We Buy What We Buy
- Ch_7
- Flashcards
- walras
- Part 1 - Microeconomics(1)
- Consumer
- Blinder_ Solow - JME (1976)
- Indian Electricals Limited (Complete)1
- Ubc Homework 6

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Utility Maximization

Utility is a purely theoretical construct defined as:

- If an individual prefers bundle x-(x1,x2) to another bundle y(y1,y2) then an individual is said to get a higher level of utility

from bundle x than bundle y

- If an individual is indifferent between a bundle x and another

bundle y, then an individual is said to get the same level of

utility from bundle x and y

The only property of a utility assignment that is important is how it

orders the bundles of goods

This is a theory of ordinal utility

A utility function U is just a mathematical function that assigns a

numeric value to each possible bundle such that:

- If an individual strictly prefers bundle x to bundle y, then

U(x1,x2)>U(y1,y2)

- If an individual is indifferent between a bundle x and y,

U(x1,x1)=U(y1,y2)

All bundles in an indifference curve have the same utility level

If U(x1,x2) is a utility function, then any positive monotonic

transformation of it is a utility function that represents the same

preferences

Examples of Utility Fcns

There is no unique utility fcn representation of a preference relation

Perfect substitutes- Linear utility functions:

U(x1,x2)= ax1 + bx2, with a> and b> 0

Perfect complements- Liontief utility functions

U(x1,x2) = min{ax1, bx2} , with a> and b>0

Quasilinear utility functions

U(x1,x2) = k = v(x1) +x2

Eg. U(x1,x2) = root(x1) + x2

or

U(x1,x2)= lnx1 + x2

U(x1,x2) = x c1 x d2 or V(x1,x2) = c lnx1 + d lnx2) with c>0 and d>0

MU1 = c x1^c-1 x2^d

MU2 = d x1^c x2^d-1

MRS = - c x2/ d x1

MU1 = c/x1

MU2= d/x2

MRS= - c x2/ d x1

Marginal Utility

The marginal utility of commodity i is the rate-of-change of total utility

as the quantity of commodity i consumed changes

U

M Ui=

xi

M U i - the partial derivative of the utility fcn with respect to good i

Ex/

- The slope of an indifference curve at a particular point, and

- The negative ratio of the MU at that particular point

to substitute a small amount of x2 for x1

Optimal Choice

Economic theory assumes individuals choose their most preferred

bundle, or equivalently the bundle that gives them the most utility,

that is in their budget set

Consider a consumer who has the choice between 2 goods x1 and x2

at the cost p1 and p2 respectively, and an endowment m

Using Econ 201 analysis and logic, the consumer reaches an optimal

bundle when he/she does not have any further incentives to shift

consumption among the goods in the bundle

At the optimal choice (x*1 and x*2) the indifference curve is tangent to

the budget line

The optimal bundle (x*1 and x*2) satisfies 2 conditions:

1. The budget is exhausted p1x1* + p2x2* = m

2. The slope of the budget constraint, -p1/p2, and the slope of the

indifference curve containing (x1* , x2*) are equal at (x1*, x2*)

While graphs are informative we often want to solve things analytically

For two-good analysis, for each good i, we can find analytically function

xi(p1,p2,m) that map prices and endowment into an amount of that

good

Can use the constrained optimization approach from Econ 211

The problem of the consumer is basically to solve:

This implies that they want to find x1* and x2* s.t. U(x1*, x2*) >=

U(x1,x2) for all values of x1 and x2 that satisfy the equation p1x1 +

p2x2 = m

Objective function U(x1,x2)

Constraint p1x1 + p2x2 = m

There are 2 main ways to find the above optimal constrained choice:

1. Write down the optimality conditions and solve the system

2. Substitite the constraint into the objective function to yield an

unconstrained problem

3. Use Lagranges method

EX/ Find the optimal choice for a consumer who has a Codd-Douglas

utility fcn who has $m and p1 and p2

Lec 3

Consumer Demand Functions

In analyzing the consumers behaviour regarding their optimal choice

of a bundle of goods, we can derive the consumers demand function

for each of the goods in the bundle:

X1 = x1(p1,p2,m)

X2 = x2(p1,p2,m)

These derived demand functions tell us all we need to know about the

consumer behaviour

Comparative statics analysis of ordinary demand function:

- The study of how ordinary demands change as prices and

income changes

goods

Slutsky Equation

What happens when a commoditys price decrases?

- A change in the relative prices occurs

- The total purchasing power o the consumers increase

The Slutsky equation says that the total change to demand from a

price change is the sum of a pure substitution effect and an income

effect

- Substitution effect: the commodity is relatively cheaper , so

consumers substitute it for now relatively more expensive other

commodities

- Income effect: the consumers budget of $m can purchase more

than before, as if the consumers income rose, with consequent

income effects on quantities demanded

When the price of good 1 change and income stays fixed, the budget

line pivots around the vertical axis

budget line around the original choice, and then shift this line outward

to the new demanded bundle.

Y denotes the optimal choice on the pivoted line

The movement from X to Y is the substitution effect

The movement from Y to Z is the income effect

The movement from X to Z is the total change in demand

Income Effect:

- Isolated change in demand due only to the change in purchasing

power

- Slutsky asserted that if, at the new prices, less (more) income is

needed to buy the original bundle then real income is

increased (decreased)

- Income effect can be either +ve or ve

Pure Substitution Effect:

- Isolated change in demand due only to the change in relative

prices

- What is the change in demand when the consumers income is

adjusted so that, at the new prices, they can only just buy the

original bundle?

- Substitution effect is always negative (opposite to the direction

of price change)

Slutskys Effect for Normal Goods

- The substitution and income effects reinforce each other when a

normal goods own price changes

to normal goods

- The substitution and income effects oppose each other when an

income-inferior goods own price changes

- The income effect may be larger in size than the substitution

effect, causing quantity demanded to increase as own-price rises

=> Giffen goods

Example- Demand change, Sub and Income effects

Lec 4

Profit Maximization

Short-Run PM

The firms problem is to locate the production plan that attains the

highest possible isoprofit line, given the firms constraint on choices of

production plans

A

= pyw1 x 1w2 x2

Product price is p and input prices are w1 and w2

Given p, w1 and x2 = x2-bar the short-run profit-maximizing plan is

FOC:

Now the firm can vary both input levels and the profit-maximization

problem can be posed as

FOCs:

The choices of inputs that yield the maximum profit for the firm,

x1*(w1,w2,p) and x2*(w1,w2,p), are the profit maximizing factor

demand functions

Cost Minimization

Standard assumption: firms make decisions to maximize profits, or

maximize total revenue minus total costs

Decision process can be broken up into 2 parts:

1. For any given level of output, what combination of inputs should the

firm use?

-Minimizing costs of production a given level of

output

2. Given the optimal combination of inputs, how much should the firm

produce/supply?

For given w1, w2, and y, the firms cost-minimization problem is to

solve

bundle are the firms conditional demands for inputs 1 and 2

The (smallest possible) total cost for production y output units is

therefore

Given w1, w2 and y, how is the least costly input bundle located?

And how is the total cost function computed?

A curve that contains all of the input bundles that cost the same

amount is an isocost curve

The equation of the $C isocost line is

C = w1x1 + w2x2

It can also be rearranged to give

Slope is w1/w2

Of all input bundles yielding y units of output. Which one is the

cheapest?

Tangency condition:

The technical rate of substitution must equal the factor price ratio

The choices of inputs that yield minimal costs for the firm,

x1*(w1,w2,y) and x2*(w1,w2,y), are the conditional factor demand

functions or derived factor demands

Recall that we can use several analytical techniques to solve this kind

of problem

1. Write down the optimality conditions and solve the system

2. Substitute the constraint into the objective function to yield an

unconstrained problem

3. Use Lagranges method

Short-Run & Long-Run Total Costs

In the long-run a firm can vary all of its input levels

The long-run cost-minimization problem is

Consider a firm that cant change its input 2 level from x2-bar units

The short-run cost-minimization problem is

How does the short-run total cost of producing y output units compare

to the long-run total cost of producing y units of output?

- In general the short-run total cost exceeds the long-run total cost

of producing y output units

The short-run cost-min problem is the long-run problem subject to the

extra constraint that x2=x2-bar

- If long-run choice for x2 was x2-bar then the long-run and shortrun total costs of production y output units are the same

- If long-run choice for x2 != x2-bar then the extra constraint

x2=x2-bar prevents the firm in the short-run from achieving its

long-run production cost

Lec 5-6-7

General Equilibrium of Exchange Economy

Exchange

Consider an island with 2 consumers A and B, 2 goods 1 and 2

Their endowments of goods 1 and 2 are wA= (w1A, w2A) and

wB=(w1B, w2B)

6+2=8 units of good 1

4+2=6 units of good 2

Consider first each persons well-being in the absence of any market

Each person must simply consume his endowment

What is wrong with this allocation of island resources?

Edgeworth Box

Are there feasible allocations that make both individuals better off than

simply consuming what they are endowed with?

How do we picture all of the feasible allocations?

Edgeworth and Bowley devised a diagram, called an Edgeworth box, to

show all possible allocations of the available quantities of goods 1 and

2 between two consumers

What allocations of the 8 units of good 1 and the 6 of good 2 are

feasible?

Starting an Edgeworth Box

box diagram?

Endowment allocation

allocation

Other feasible allocation

All points in the box, including the box boundary, represent feasible

allocation of the combined endowments

Which allocations will be blocked by one or both consumers?

Which allocations make both consumers better off?

Adding preferences to the box

Trade

What is the region of the box where A and B are both made better off?

Presumable, A and B will trade to some point in this region

Pareto Efficient Allocations

An allocation of the endowment that improves the welfare of a

consumer without reduction the welfare of another is a Paretoimproving allocation

Trade improves both As and Bs welfare; this is a Pareto-improvement

over the endowment allocation

Where are the Pareto-improving allocations?

outcomes from exchange are Pareto-improving allocations

trade?

Pareto Optimality

New mutual gains-to-trade region is the set of all further Paretoimproving reallocations

An allocation is Pareto-optimal(or Pareto efficient) when the only was

one consumers welfare can be increased is to decrease the welfare of

the other consumer

The allocation is Pareto-optimal since the only way one consumers

welfare can be increased is to decrease the welfare of the other

consumer

At any Pareto efficient allocation, the indifference curves of the 2

agents must be tangent in the interior of the box

Why is that the case?

Further trade from point M cant improve both A and Bs welfares

An allocation where convex indifference curves are only just back-toback is Pareto-optimal

The contract curve is the set of all Pareto-optimal allocations

In a typical case, the contract curve will stretch from As origin (OA) to

Bs origin (Ob

But to which of the many allocations on the contract curve will

consumers trade?

That depends upon how trade is conducted

In perfectly competitive markets? By one-on-one bargaining?

The core is the set of Pareto-optimal allocations that are welfareimproving for both consumers relative to their own endowments

Rational trade should achieve a core allocation

But which core allocation?

- Again , that depends upon the manner in which trade is

conducted

Core allocations

Each consumer is a price-taker trying to maximize her own utility given

p1, p2 and her own endowment

For consumer A, that is

The gross demand of agent A for goods 1 is the total amount of the

good that he wants at the going prices

The net demand of agent A for good 1 is the difference between his

total demand and the initial endowment of good 1 that agent A holds

So given p1 and ps

markets for commodities 1 and 2 to clear

always occur

and an excess demand for commodity 2

Neither market clears so the prices p1 and p2 do not cause a general

eqm

Since there is an excess demand for commodity 2, p2 will rise

Since there is an excess supply of commodity 1, p1 will fall

The slope of the budget constraints is p1/p2 so the budget constraints

will pivot about he endowment point and become less steep

Which Pareto Optimal allocations can be achieved by competitive

trading?

Walrasian equilibrium

equilibrium

Trading in competitive markets achieves a particular Pareto-optimal

allocation of the endowments

We can describe the equilibrium as a set of prices (p1,p2) such that

This is equivalent to

Lets denote the net demand functions or excess demand for good 1 by

consumer A and B as follows

aggregate excess demand for good 1

way and describe an equilibrium (p1,p2), by saying that aggregate

demand for each good is zero

Walras Law

Walras Law states that

Every consumers preferences are well-behaved so, for any positive

prices (p1,p2), each consumer spends all of his budget

This is Walras Law- it says that the summed market value of excess

demands is zero for any positive prices p1 and p2

Implications of Walras Law

One implication of Walras Law for a 2 commodity exchange economy

is that is one market is in equilibrium then the other market must also

be in equilibrium

Proof:

economy is than an excess supply in one market implies an excess

demand in the other market

All competitive market equilibria are Pareto efficient: a result known as

the first fundamental thm of Welfare Economics

First Fundamental Theorem of Welfare Economics

Given that consumers preferences are well-behaved, trading in

perfectly competitive markets implements a Pareto-optimal allocation

of the economys endowment

An easy proof can be based on the previous graph of the equilibrium in

the Edgeworth box

If all agents have convex preferences, any Pareto-optimal allocation

can be achieved by trading in competitive markets provided that

endowments are first appropriately rearranged amongst the consumers

This theorm is illustrated in the following graph:

The First Welfare thm shows that the particular structure of competitive

market has the desiriable property of achieveing a Pareto efficient

allocation

- competitive markets economize on the info needed for efficient

resource allocation

The Second Welfare thm implie that the problems of efficiency and

distribution can be separated

- Prices should be used to reflect scarcity and income transfers should

be used to adjust for distributional goals

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