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DUKE UNIVERSITY – FALL 2006

VANESSA VILLAMIA SOCHAT

CONTENTS

Preferences ............................................................................................................................................................... 2

Welfare ..................................................................................................................................................................... 4

CONSUMER THEORY

BUDGET CONSTRAINTS

• To draw a budget constraint, find the following points, the intercepts, where the consumer spends all of

his or her money on one good, and connect!

o I/Px = X intercept

o I/Py = Y intercept

o Slope is – Px/Py

The slope is the market exchange rate for the two goods

• A subsidy for one good will shift the BC to the right/up that amount

• A quantity discount will make the good relatively cheaper, so slope BC and intercept(s) change accordingly

• A limit on consumption (rationing) will look like a vertical or horizontal line at the limit

PREFERENCES

Ordinal Utility emphasizes the ordering of bundles of goods. We don’t care how much more bundle A is liked over

bundle B, but we know that we prefer A to B.

Cardinal Utility means that we get a certain amount of utility (happiness) from different bundles of goods, and we

care about making comparisons between goods to the extent we can say that Ernesto likes bundle A twice as much

as bundle B. Bundles can be ranked. (U(x,y) =…)

• Complete: every two bundles can be compared!

• Reflexive: any bundle is at least as good as itself

• Transitive: if I like Bundle A over B, and B over C, then I have to like A over C

Indifference Curves:

• The slope at any point on an indifference curve is the marginal rate of substitution between the two

goods.

o MRS = -MUx/MUy

o To find marginal utility, calculate ∆x/∆u

o To find the optimal consumption bundle, set –Px/Py = MRS = -MUx/MUy

At this point, the individuals willingness to substitute one good for another is equal to

the market’s, so he she doesn’t have any incentive to move!

• Indifference curves cannot cross, duh

• Perfect Substitutes means that we are indifferent between the two goods, like Coke and Pepsi. For

perfect substitutes watch out for corner solutions. Indifference curves are straight lines.

• Perfect Complements means that we only consume two goods in fixed quantities, and get no extra utility

outside of this ratio. Indifference curves are 90 degree angles.

• When we throw a bad into the mix indifference curves are usually positively sloped

• A neutral good means the consumer is completely indifferent about its consumption, so indifference

curves are either vertical or horizontal lines, pointing towards the good we care about

• In the case of satiation, consuming too much or too little of a good takes away from utility, so we have a

bliss point, or satiation point.

• Monotonicity means that more is better!

CONSUMER CHOICE

The optimization principle says that we like to maximize utility within the constraints of our budget. We look

to reach the highest indifference curve based on our budget constraint. Again, to do this set the MRS = -Px/Py

When given a utility function and good prices, to find the optimal consumption bundle:

1) find the BC by calculating –Px/Py. This is the market’s rate of substitution

2) The equation for the BC is Y = -Px/Py(X) + (Py/I)

3) Find the consumer’s MRS by calculating MUx/MUy. It is easiest to take the derivative with respect to

the appropriate term to get marginal utility

4) Set MRS = -Px/Py, and solve for either X or Y.

5) Plug value back into any equation to get quantity of other good

• basically if these two aren’t equal then we could be doing better

• Marshellian Demand

• Hicksian Demand: holds utility constant

• Slutsky Equation: total change in demand equals the substitution plus the income effect. Give the

consumer enough money to get back to the original bundle

o I like to think that the substitution effect moves along the indifference curve

o And the income effect jumps up or down to a different indifference curve

• Hicks substitution effect: keeps utility constant. Give the consumer enough money to get back to his

original level of utility. So hicksian demand is compensated demand.

• The income expansion path is a plot of optimal choices given an increase in income and constant prices.

For normal goods it is a positively sloped line.

• An Engel Curve is a graph showing demand as a function of income. So if we demand more as income

increases, (prices held constant) the slope is positive.

• Elasticity is how sensitive demand is to a change in price.

o Elasticity = p∆q/q∆p

o Inelastic means that the curve is steeper, and a change in price has little affect on demand

o Elastic means that demand is very sensitive to a change in price, and the curve is flatter. Unit

elasticity is when elasticity = 1 (negative sign is implied)

o When we look at Elasticity of Substitution, which is the change in demand of one good / the

change in price of another, we can figure out good types

A positive elasticity of substitution means that demand for one good is increasing as the

price of the other increases, (or demand is decreasing as the price of the other

decrease) so we have substitutes

A negative elasticity of substitution means that demand for one good is increasing while

price for the other is decreasing, or demand for one good is decreasing when the price

of the other good is increasing, so we have complements

• A normal good is a good for which demand increases with an increase in income

• An inferior good is a good for which demand decreases as income increases.

• A giffen good is an inferior good for which demand increases when price increases (Irish potato famine)

• A luxury good is one for which demand increases at a higher rate than income

• A necessity is a good for which demand increases at a smaller rate than income

WELFARE

• Compensating Variation: how much income do we have to give someone to compensate them for a

change in price? (so they are just as well off, ie tangent to same indifference curve)

• Equivalent Variation: how much would the consumer be willing to pay to avoid the price change?

• Consumer Surplus: area under the demand curve, about the price. The willingness to pay is the demand

curve.

INTERTEMPORAL CHOICE

- the tradeoff between consumption now and at a later date

- To graph inertemporal budget constraint:

o First find the endowment point, or the point of consumption for which there is no lending or

borrowing.

o The x intercept, or present value of current and future money, is m1 + m2/1+r

o The y intercept, or future value of current and future moolah, is (1+r)m1 + m2

o Slope of budget line is –(1+r)

If the interest rate increases then we are better off saving for the future (we earn more

interest on our savings, so present consumption is more expensive) lenders are better

off

If the interest rate decreases then we are better off spending our money in the present

(we pay less in the present to borrow money in the future) borrowers are better off

• PDV: present discounted value?

• A bond is basically a way for the government to borrow money from the people. The borrower must pay

a coupon each period, and finally, the face value of the bond on the maturation date

• A perpetuity is a type of bond that doesn’t have a maturation date. The payments are made forever!

• The no arbitrage condition says that all assets must sell for their present value.

o P0 = p1/(1+r)

• Hotelling’s Rule says that… uhh I have no clue!

• Hyperbolic Discounting takes into account the fact that people value payment at a future time less than in

the present, and suggests that the discount factor is 1/(1+kt)

Aggregation of Demand

- just add up demand curves horizontally! So add up the demands at each price to get the aggregate curve

Public Goods:

Externalities:

Income Taxation:

Isoquant: curve that indicates the combinations of inputs capable of producing a given level of output. (convex

and monotonic).

• Given a production function,

o F(K,L) = 1/2L + 2K it is easiest to draw isoquants by calculating the slope, K = 4L. Perfect

Substitutes

o F(K,L) = min[2K, K+L], complements, find corners by setting 2K = K +L

Slope of isoquant is…

Technical Rate of Substition: (TRS) = -MP1/MP2

Elasticity of Substitution:

Production Functions:

Complements: min{x1, x2}

Substitutes: x1 + x2

a b

Cobb Douglas Production Function: Ax x

Short Run: Capital fixed, labor not

Long Run: Nothing fixed!

Returns to Scale:

Multiply input by a factor of a, and see what happens. There are constant, increasing, and decreasing

returns to scale. Constant returns to scale means that long run maximum profits are zero.

(is MC*q the same as the cost eq. evaluated at q?)

Profits = pq – wL – rK

So Costs = wL + rK

MP is w/P

Fixed Costs: Like a lump sum, do not depend on how much output is produced

Variable Costs: Vary by level of output. In the short run, if we have a fixed cost, then we take the L value at

that cost, and not the value from the isocost curve

CHAPTER 20: COST MINIMIZATION

Costs = wL + rK

Isocost Line: K = C/r –w/r(L)

• Slope = -w/r

• Intercepts = C/K, C/L

• At minimum cost, -MP1/MP2 = TRS = -w/r

• Isocost lines are usually linear, isoquants are convex

AC = TC/q

CHAPTER 21: COST CURVES

Total Costs = VC + FC

MC = derivative of cost function. ∆c/∆q. Passes through min of AC and AVC curves

MC = TC(x1) – TC(x2) / x2 – x1

AFC = FC/q (decrease with output)

CHAPTER 22: FIRM SUPPLY

If P < AVC then firm cannot cover fixed costs = shut down

If P = AVC then firm is indifferent between shutting down and producing nothing, because can still cover fixed costs

Profits = pq – AC(q)*q

If Demand = a – by

Then MR = a – 2by

Second Degree Price Discrimination: Different units of output sold at different prices, but individuals that buy same

amounts pay same price. So price depends on output sold

Third Degree Price Discrimination: Output sold to different people for different prices (senior citizens, students

discounts)

Operates where MR = MC, then jumps to w on supply curve. So not employing enough, because would have to

increase wage to employ more.

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