ECO 514 - Section 1

Last Updated: 27 August 2015

Introduction
1.

My background

2.

Syllabus
a.

will try to stick to it, but will diverge

b.

exam dates only tentative

c.

problem sets

d.

3.

i.

weekly, you will grade them

ii.

work together on problem set

iii.

Please dont hunt for old answers

difficult course, but may be most important

Your responsibility is to work with me to help you learn.

a.

ask questions

b.

drop by or call office any time

c.

give me feedback

d.

enjoy, see beauty in micro theory

Chapter 1 - Economic Models

All models are wrong but some are useful (George Box).
Art is a lie that helps us see the truth. (Picasso)
Def: Economics: The study of the allocation of scarce resources among competing uses.

Scarce - implies constraints

Competing uses - alternatives for resources

Allocation - assumes that there is a rational, optimal (possibly multiple) way to distribute
resources

Rational actors who use all available information, individuals, firms, households,
government sector, etc.

All of this is what we call the Neoclassical Economics

Use of Models
We will be studying constrained optimization methods to determine the optimal allocation
- In so doing, we will use models of economic behavior
- We use models because the economic processes at work are so complex we cant include all
details. But predictions from our models are only good if the model captures the important
essence of the problem at hand. This is why economic modeling is like art simplified, not
intended to represent every detail.
1.
2.
3.

Understandable, with clear goals, constraints.

Perhaps misleadingly exact.
In principle we put our theory to test by bringing data to bear. This is perhaps one of the
most important distinctions between economics and other social science discipline. We
have an overarching theory that makes predictions which can, in principle, be tested and
confirmed or refuted: Refutable hypothesis. Example, price of gasoline rises then
quantity of gasoline demanded should fall. If it rises, then this would contradict
hypothesis/theory.

Features of models
1.

Assumptions - we are always forced to make assumptions. Always! But it is not only
economists, but all applied disciplines! For this class we will habitually employ three
maintained assumptions (hypothesis):
a.

b.

We know the objectives of agents

i.

firms profit maximize

ii.

consumers maximize utility

Economic agents are rational

i.

c.

Ex: Mercedes > Camry, Camry > Escort, => Mercedes > Escort

Ceteris Paribus - All other things equal

i.

Ex: If price of coffee rises, we predict that the quantity of coffee

demanded will fall, but we assume that the prices of tea did not change
and people did not change their preferences for coffee. Theory is so well
ingrained in our society that we take it for granted.

Caution: Do not get too impatient with these basic assumptions. This is your first graduate class
in micro theory. Advanced work does relax these assumptions.
1.

We adopt a positive approach in this class, as opposed to normative. This means that
we try and model what is rather than what ought to be. We are not divorced from
values, but we take the approach of saying: 'If firms profit maximize, then what happens
to their use of labor if there is a rise in the price of labor either because labor becomes
relatively scarce or because of an increase in the minimum wage.'

2.

For the most part, we will be doing comparative statics. We will ask questions like
what happens to the quantity demanded of coffee when the price of coffee changes?
Change is assumed to happen instantaneously. We will not in this class look at the
dynamics of change.

3.

In general, the goal of economic theory is to make predictions which can be tested in the
real world with real data. This course will, however, be mainly theoretical in nature.

Later course work will build on this theory and allow you to empirically test your models
and hypothesis.

Example: Profit Maximization

A firm can sell all the output that it wishes at a price of p per unit
a.

Total costs of production, C, depend on the amount produced, q

Profits = = pq C(q)

d
p C '(q) 0 or p C '(q)
dq

Second-order condition:

C
"(
q
)

0
or
C"(
q
*)

dq 2

dq *
d ( p C '(q*) 0)
1 C "(q*)
0
dp
dp
dq *
1

0
dp C "(q*)
First-order condition:

The profit-maximization output level, q*

First-order condition, output level for which price is equal to marginal cost, C(q)
Second-order condition:
Marginal cost must be increasing at q
Comparative Statics:
Differentiating FONC wrt p, we get: q* (optimal quantity produced) increases with price.
Remember:
q* = f(p) and all the other underlying parameters in a more complicated model

4.

Theory of value - Diamond - Water Paradox and the Marshallian Cross

a.

Value is not inherent

b.

Value is value in exchange: value = price

P*,Q* - Equilibrium price and quantities. The stars mean that these are not just any old price
and quantity but that at the price P* the quantity Qd* is demanded and equal to Qs* the quantity
supplied. P* and Q* are linked, they are functions of each other and are determined
simultaneously.
Thus, while diamonds are scarce - few relative to demand - they have a high price. Water which
is plentiful, is cheap. Thus diamonds which are not necessary for life are expensive, while water
which is necessary for life is cheap.
Numerical example:
Qd = 1000 - 100P
Qs = - 125 + 125 P
ONLY at equilibrium, Q* = Qs=Qd: => 1000 -100P = -125 + 125P

1125 = 225P, P* = 5. Check: Qd*= 1000 - 100*5 = 500, Qs* = -125 +125*5 = 500.

A more general model is

qD = a + bp
qS = c + dp

Equilibrium qD = qS
a + bp = c + dp

a = 1000,
b = -100
c = -125
d = 125

1000 125
125 100

1,125
225

What happens to the equilibrium price if either demand or supply shift?

An increase in demand (an increase in a) increases equilibrium price

1
0

An increase in supply (an increase in c) reduces price

1

0
How does this predict how an increase in the exogenous parameters (a,c,d,b) impact price? If a
goes from 1000 - 1,450

1
125

Correct?

1450 125
125 100

100

1,575
225

1
225

But, change in a is not "marginal", but incremental, so 450*(1/225) = 2

Which is what you already knew. Just reinforcing connecting the pictures and stories to the
math.