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# 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

## 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

## 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

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

x1 , x2

subject to p1 x1 p2 x2 M

## 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
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## 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

## 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

## 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

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## The Price-Consumption Curve (PCC)

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

## 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:

## 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

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## 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 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

## 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

F(K,L)

( , )
L (1, ) L

## 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 10: The Cost Function

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

## 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

## 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

0 0 L

## Deriving the Cost Function

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

such that q f ( K , L)

such that q f ( K , L)

## 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 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

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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.
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## 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)
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## 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

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## 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)
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## 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

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## 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

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## 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 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

## 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

## 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

## 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

## 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

## 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

## 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

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