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Sen 1997

Light does not know that it is minimizing distance, but it behaves as if it does

The Final

15 Multiple Choice (30 Marks) 4 Short Answer (20 Marks) 3 Long Answer (50 Marks)

Pen, Pencils and a non-programmable calculator

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

The Market Ch. 11: Perfect Competition Ch. 12: Monopoly Ch. 13: Game Theory & Oligopoly Ch. 16: General Equilibrium

We covered the consumers problem The budget constraint and indifference curves

How to solve the consumers problem

x1 , x2

subject to p1 x1 p2 x2 M

U U MU x1 MU x2 x1 x2 or p1 p2 p1 p2

U p x 1 1 U p2 x2

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

Completeness Non-Satiation

Transitivity Convexity

Indifference Curves

2

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

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

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

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

The Market Ch. 11: Perfect Competition Ch. 12: Monopoly Ch. 13: Game Theory & Oligopoly Ch. 16: General Equilibrium

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

2

From the Optimal Choice to the Price-Consumption Curve and Demand Curve

2

1 1 3 1 4 1

2 1

1 1 2 1 3 1 4 1

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.

Aggregating; Adding up; Summing up Going from Individual Demand Curves to the Market Demand:

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 measures how sensitive the quantity demanded is to a change in price The price elasticity of demand:

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

Slide 22

Slide 23

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

The Market Ch. 11: Perfect Competition Ch. 12: Monopoly Ch. 13: Game Theory & Oligopoly Ch. 16: General Equilibrium

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

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.

Marginal product of an input (MPinput) Marginal = extra Example: the marginal product of capital =

F ( K , L) MPK K

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 (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

Output doubles too constant returns to scale Output less than doubles decreasing returns to scale Output more than doubles increasing returns to scale

Consider the function = , = But in the short run (say K=1) it will look like:

Q F(1,L)=L

F(K,L)

( , )

L (1, ) L

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

We discussed the producers problem Short run and long run cost functions

How much you produce to satisfy demand Which is isoquant you are on

The prices of inputs such as capital and labour The define the slope of the isocost line

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

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)

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

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

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

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

L

such that q f ( K , L)

such that q f ( K , L)

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

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

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

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

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

48

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

49

Short Run Some factors are fixed Long Run All factors mobile

Some firms can make profit or loss Demand = supply Consumers maximize utility Firms maximize profit

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

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

The sources of monopoly power Basic profit-maximizing problem of the monopolist How to solve the monopolist problem

Exclusive control over crucial inputs Economies of scale AVC decreases natural monopolies Network economies Patents temporary monopoly rights

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

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

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

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

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

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

Firm 1s objective:

q1

Firm 2s objective:

q2

Firm 1s choice

max P(q1 q2 )q1 C1 (q1 )

q1

Optimal q1 depends on q2, Firm 2s output Optimal q1 as function of q2 = reaction function of firm 1

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

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

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

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?

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)

max P(q1 R2 (q1 ))q1 C1 (q1 )

q1

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

$/Q

13

=7

Monopoly Cournot

= 5

= 4

MR = 4

Stackelberg

Bertrand/Perfect Competition

12 Q

The Individual Ch. 3 & 3A: Individual Demand Ch. 4 & 5: Market Demand The Firm Ch. 9 & 9A: The Production Function

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

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

Definition: Competitive equilibrium [in an exchange economy]: set of prices, and the corresponding allocation, such that:

1.

they choose optimal bundles, i.e. bundles which maximize utility given prices and initial endowment

2.

In other words, (net) demand = (net) supply for all goods In other words, markets are in equilibrium

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