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Stokes
Goal of the Notes: Allow the student to have an outline of the key ideas and solutions
to a number of problems that will be discussed in class. Since the notes are distributed
in WORD® format, students can edit the notes.
Introduction
"Economics is the science of choice. It began with Aristotle but got mixed up with ethics in the
Middle Ages. Adam Smith separated it from ethics, and Walrus mathematized it. Alfred Marshall
tried to narrow it, and Keynes made is fashionable. Robbins widened it, and Samuelson dynamized it,
but modern science made it statistical and tried to confine it again.
But the science won't stay put. It keeps cropping up all over the place. There is an economics of
money and trade, of production and consumption, of distribution and development. There is also an
economics of welfare, manners, language, industry, music, and art. There is an economics of war and
an economics of power. There is even an economics of love.
Economics seems to apply to every nook and cranny of human experience. It is an aspect of all
conscious action. Whenever decisions are made, the law of economy is called into play. Whenever
alternatives exist, life takes on an economic aspect. It has always been so. But how can it be?
It can be because economics is more than just the most developed of the sciences of control. It is a
way of looking at things, an ordering principle, a complete part of everything. It is a system of
thought, a life game, an element of pure knowledge.
Chapter 1 Preliminaries
Microeconomics => Study of behavior of individual economic units. How they react and
how they interact to form larger units.
Economics uses theory to explain actions and predict future actions. For example if:
the Bulls are in the playoffs, then there will be a larger number of people wanting tickets
than if they have a poor season. If there is high unemployment, then at the university
more students enroll in business courses because their opportunity costs (pay loss due
to being in class) are less.
Theory does not work well all the time. The market test of theory is how well it does in
comparison to another theory. A theory must have the possibility to being proved
wrong. The statement "all unmarried men are bachelors" is a tautology and cannot be
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
proved wrong. The statement "If American Airlines lowers the ticket price to Bermuda,
an increased number of people will fly this weekend." Can be proved wrong or right.
Marginal utility theory can be used to derive the demand curve. However it will be
shown later that to get a downward sloping demand curve the only assumption needed is
that consumers buy randomly along the budget line. => a minimalist approach to
deriving an important economic concept - downward sloping demand.
Positive Economics => What will happen, not what should be done. "An increase in the
property tax in the area of UIC will tend to lower the price of apartments, everything
else equal."
Many decisions involve multiple assumptions. Book example of 1985 decision of Ford
to produce the Taurus involved:
What is a Market. A market is the collection of buyers and sellers that, through their
actual or potential interactions, determine the price of a product or set of products. A
market includes more than an industry (a collection of firms that sell the same or closely
related products). Key business decision: Determining the market for the product!
If prices differ in two markets, arbitrage may be possible. If the price of a T-bill
maturing in period t in NY is > than the price of the same T-bill in Chicago => people
will buy in Chicago and sell on the NY market. If the price of a Big-Mac is less in
Norfolk VA than Chicago, arbitrage is NOT feasible, even with fast planes.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
In a competitive market with many producers no one producer can change the industry
price. Product differentiation => power to alter price within limits. Successful
advertising => in perceived product differentiation.
Extent of the market => the boundaries, both geographical and physical of a market.
Real vs Nominal Price. Economic decisions should be made on the basis of real prices.
Money illusion => consumer looks at the nominal price not the real price. Assume two
groups: debtors and creditors. Creditors and debtors set the interest rate depending on
their expectations of price movements. Unexpected price increases (decreases) favor
debtors (creditors).
Measuring Price The CPI measures price changes by buying a market basket of goods
at different times. Three known problems are:
3. Price changes involve subtle income changes that give rise to income effects
that will alter the mix of goods bought.
n n
Pt pti q1i / p1i q1i (1)
i 1 i 1
If in place of the above equation the quantities could have been adjusted every year as in
the Paasche formula
n n
Pt pti qti / p1i qti (2)
i 1 i 1
which is not possible to calculate but would avoid the tastes bias and the relative price bias.
Table 1.2 lists the CPI and education and egg prices in both nominal and real terms. How
you get data in 2010 prices? See file ch1_1.xls for the answer? Why would one want to
make this calculation?
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Study Questions:
1. Over the past year the price inflation has been 10%. The price of a used Ford SUV has
fallen from $6,000 to $5,000. How much as the real price fallen:
((1.1 * 6000) - 5000)/(1.1*6000) = 24.24
Since last year the price of gold has risen from $120 to $420. What annual rate of
inflation would hold the price of gold fixed in rea1 terms?
(420-120)/120 = 250%
If this was over 5 years and we assume yearly compounding, what would the rate of
inflation have to be?
or (1. + r) = exp(ln(3.5)/5),
2. Suppose that the Japanese yen raises against the U. S. dollar; that is, it now takes more
dollars to buy any given amount of Japanese yen. Explain why this simultaneously
increases the real price of Japanese cars for U. S. consumers and lowers the real price of
U. S. automobiles for Japanese consumers.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
The basic model postulates that Supply responds positively to price and Demand
responds negatively to price. Qs = Qs(P) and Qd = Qd(P). At equilibrium P (P0) = Q (Q0)
and the market clears. Qs(P) > Qd(P) implies excess supply while Qs(P) < Qd(P) implies
excess demand. This is shown below
P1
P0
P2
D
Points where price is above P0 represent excess supply, while points below P0 represent
excess demand. The laws of motion of Walrus state "If there is excess demand, price will
rise." The laws of motion Marshall state "If there is excess demand, quantity will rise." P 0
is the "market clearing price." Here supply = demand. Assume that somehow the price goes
to P1. Now demand < supply. According to Marshall adjustment will proceed by a reduction
in supply, while according to Walrus price will fall. Similar arguments can be made for P2.
In a market for Old Master Paintings clearly Walrus adjustment is the only legal adjustment
mechanism. In 1969 the first man walked on the moon. The New York times printed the
edition showing this historic moment for three days until everyone got a copy. This was
Marshall adjustment.
In the above diagram it does not matter which adjustment model you use, price will go to P0.
Assume that supply now is negatively sloped or that economics of scale exist. The producer
can increase his production and lower his price. Two Models are possible.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
P D P S
Q Q
The left graph is stable according to Marshall and unstable according to Walrus.
The right graph is stable according to Walrus and unstable according to Marshall. Why?
There is a shift in supply if one of the variables held constant (not on the axis) changes and
that in turn changes the amount supplied. Assume the supply of wheat is a function of P and
R where R = rainfall.
Qs = a + 1 P + 2 R (3)
where 1 > 0 and 2 > 0. An increase in R would, everything else equal move the supply
curve right and lower the price for wheat assuming the demand curve is not flat. Assume the
demand for wheat is a function of price and income.
Where 3 < 0 and 4 > 0. An increase in Y moves the demand curve right and results in an
increase in price assuming that the supply curve is not flat and that Y => quantity
demanded .
Demand and supply curves hold tastes, prices of all other good, incomes and technology etc
constant. Over time supply and demand usually shift right. An exception would be the
demand for buggy whips! Why?
Key Concept: Given a demand curve, it can be said that there is a change in demand or
shift in the demand curve if the price of another good changes, income changes or tastes
change. If the price of the good itself changes, then there is a change in the quantity
demanded or a movement along the demand curve. In the above example Y will cause
a change in demand while P will cause a change in the quantity demanded. For supply,
P causes a change in the quantity supplied while R causes a change in supply. It is
always important to understand the difference with what moves a curve and what
causes a movement along the curve.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
.
Solve simple system:
Excel file ch2_1.xls solves this system. Using this technology. Solve the system assuming:
This is the basic template for micro analysis of supply and demand. A major research
objective is to determine what will change a, a', 1,…4. It will be made more complex as
we move forward.
Ed = elasticity of demand
= (%Q)/(%P)
= (Q/Q)/(P/P)
= (Q/P)*(P/Q) (5)
Usually d is used in place of Ed. The price elasticity is measured at a point. On a linear
demand curve the slope (Q/P) is constant.
As Q 0 => Ed -
As P 0 => Ed 0
TR = P * Q (6)
Advertising is designed to make |Ed| decrease for every price. After a successful
advertising campaign the firm will have more product differentiation and can either raise
price or increase sales at the current price. Careful analysis will tell us what to do.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
S
b
P2
P1 c d
O
Q1 e f
Firm started with demand curve a e which implied price P 1 and Q1. A major advertising
campaign moved the demand curve from a e to b f. For purposes of this example a e is | | to
b f. Price rises to P2.
At c d = (Q/Q)/(P/P)
= (Q1e/OQ1)/(OP1/OP1)
= (Q1e/OQ1)
At d d = (Q/Q)/(P/P)
= df / bd
A parallel shift right of a demand curve makes is more inelastic at each price.
Income elasticity measures the percent change in the quantity of a good for a percent
change in income.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
A good is normal if I > 0 and inferior if I < 0 . Baked beans are the classic inferior good
and the BMW car a classic normal good.
Assume an individual faces goods a to n. Let Pa be the price of good a, Pb be the price of
good b. Let A be the change in the amount of A bought and B be the change in the
amount of B bought. Assume the individual gets an increase in income I.
If we assume I = 0, the above equation defines the budget line which will be used in
indifference curve analysis.
Divide (8) through by I and then multiplying all terms on the left by I A / I A gives a key
expression. In steps
[ Pa A / I ] [ Pb B / I ] ,...,[ Pn N / I ] [ I / I ]
Finally
The cross price elasticity of demand APB measures the effect of the price of good B on
the quantity of good A.
If A is a substitute for B, then APB is > 0 or an increase in the price of B => the quantity
of A . If A is a complement of B then APB is < 0. Coke is a substitute for Pepsi while
gas is a complement for an auto.
In the long run demand is usually more elastic. When the price of gas went up in the 70's
people did not just dump their cars that got poor gas mileage BUT when they replaced them
they made sure they got a car with a higher MPG rating.
In the long run the supply of a product is usually more elastic than in the short run since in
the long run fixed factors can be changed.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Given QD = a - bP (11)
QS = c + dP (12)
And P* and Q* are equilibrium P and Q, then at equilibrium the elasticity of demand D and
elasticity of supply S are
D = -b(P*/Q*) (13)
S = d(P*/Q*) (14)
=> if we know D , S, P* and Q* we can get the supply curve and the demand curve. In the
market we observe P* and Q*.
Book shows P* and Q* are $.75 and 7.5 million D , S are -.8 and 1.6 respectively. From
equation (13) and (14) we get -b = (-.8) * (7.5/.75) = -8. and d = (1.6)*(75/.75) = 16.
Excel file ch2_2.xls solves the general case of determining the supply and demand functions
given the elasticity and P* and Q*.
In the long run supply and demand are usually more elastic. When OPEC raised price =>
discoveries went up. Users shifted to more efficient cars over time.
An effective price control will cause a shortage. If the supply curve is NOT vertical, the total
consumed will go down.
Demand for E
Problem 1.
P Qd Qs
60 22 14
80 20 16
100 18 18
120 16 20
d = (Q/P)*(P/Q)
Problem 2. T or F "Since tuition has doubled in real terms in the last 15 years this implies
the demand curve for education is vertical." FALSE may be seeing shifts of both supply
and demand.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Problem 3. File Ch2_3.xls contains simulated Data from 25 Families obtained from Stigler
Theory of Price Edition 4 page 37. Variables are expend = expenditure, pincome =
permanent income, Tincome = transitory income, oincome = observed income.
The data was generated from the model expend = f(1+.02*pincome). Tincome was
randomly added such that pincome + tincome = oincome
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Preferences are transitive => If consumer prefers basket A to B and B to C then the
consumer prefers A to C.
Indifference Curve - Locus of points showing different combinations of goods to which the
consumer is indifferent.
X
II I
III IV
b Y
Consumer starts with a of X and b of Y. Points in I => more satisfaction. Points is III => less
satisfaction.
X Complements X Substitutes
Y Y
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Y
Usual Case Utility along b > than along a
2
1 a
Ordinal ranking => A is better than B but cannot tell by how much.
Given you have relatively more X than Y => will give less Y for every additional X.
Budget line = locus of points showing different combinations of goods that can be bought
given income. Where budget lines is tangent to highest indifference curve => desired point
(a).
Y
A
a
3
2
1
B X
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Y
a
I => Budget line moves from 1 to 2 above
Px B => Budget line moves from ab to ac on left.
b c X
Total spending fixed along budget line. Object is to reach highest Indifference curve (not
drawn).
Unless there is a corner solution, MRS = Px / Py. Of in words slope of the indifference curve
= slope of budget line.
In equilibrium
MUx / MUY = PX / PY
MUx / PX = MUY / PY
(MUx / PX) > (MUY / PY) => Have too much Y relative to X
Marginal utility per dollar last dollar spent must be the same for all goods.
Gas rationing => loss of welfare. Rationing done to maintain price. In NYC rent controls
led to vast sections of the city being abandoned. Rationing once in place is hard to remove.
See Figure 3.22
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Other
Goods
OA C Gas
Consumer wants OC of gas. The government forces person to take OA and thus be on a
lower indifference curve.
n n
Pt pti q1i / p1i q1i
i 1 i 1
which overstates the amount of a price increase because the person is given enough money
to buy their old bundle even though this is NOT what they will buy since relative prices
have changed.
1
2
3
II III I
Consumer was on indifference curve 2 and budget line I. The price of X increases and the
consumer ends up on indifference curve 3 and budget line II. A subsidy is given to allow
consumer to buy old bundle of goods BUT consumer now buys relative more of good Y and
less of good X since Px/Py has risen.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
U3
beer U2
U1
U3 > U2 > U1
Hamburger
2 4 6 Hamburger
beer
Hamburger
1. Antonio buys 8 new college textbooks at a cost of $50.00 each. Used books were $30.00
each. Next year prices for new books go up 20% and used books go up 10%. Antonio's Dad
sent him $80.00 more. Is he better off?
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Relative price of new and used books last year 50/30 = 1.67
Relative price of new and used books this year (50*1.20)/(30*1.1) = 60 / 33 = 1.82
Cost this year for the two choices would be 8*60 = $480
8*33 = $264
Dad gave him money to buy 8 new books this year. Will he still buy this bundle now that
prices of new books are relatively higher?
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
2. Jane has a utility function U(F,c) = FC. Set up a table for U=12 and U = 24
Suppose Jane has $12.00 to spend and Pf = $1.00 and Pc = $3.00 Show budget line
What should she buy? (F=6 C =2 ).
Ch3_1.xls
Jane U(Fmc)=FC
Budget line is Y = Pf * F + Pc * C
MRS = -1/3
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Income
Tastes
As Px falls the budget line moves from AB to AC to AD. The possible set of goods
increases. The consumer increases x purchases and Y purchases. The above diagram is
same as figure 4.1.
Points to remember: As price of X falls there is a substutution effect that is due to the
relative price change and an income effect which is due to the increase in real income
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
due to the price decrease. If the price of X falls, the consumption of Y can increase, or
decrease.
Income Consumption Curve Traces out points of consumption of X and Y that occurs
as income increases.
If X and Y are both superior goods, as I increases the consumption of X and Y increases.
=> Demand curves for both goods shift right.
ICC
X
As Income rises X consumption first increases, then falls. As income rises the
consumption of Y increases.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Y is a normal good. X is a normal good for low incomes, an inferior good for high
prices.
In an N good world all goods can be normal goods. As a upper limit only N-1 can be
inferior. => In a 2 good world cannot have two inferior goods.
Income and substitution effects can be drawn 4 ways for a price fall and 4 ways for a
price rise assuming normal goods. For the inferior not giffen and inferior giffen there are
8 other ways each. Total number of cases = 24.
Inferior not Giffen = > good is inferior but not so inferior that the income effect out
weighs substitution effect.
Hicks method (American assumptions). => Assume base case. Prices change
causing the budget line to rotate (See figure 4.6). Helping budget line drawn tangent to
old indifference curve but parallel to new budget line.
Slutsky method (American assumptions) => Assume base case. Prices change
causing the budget line to rotate . Helping budget line drawn through old basket but
parallel to new budget line.
Hicks method (European Assumptions). => Assume base case. Prices change
causing the budget line to rotate . Helping budget line drawn tangent to new indifference
curve but parallel to old budget line.
Slutsky method (European Assumptions) => Assume base case. Prices change
causing the budget line to rotate . Helping budget line drawn through new basket but
parallel to old budget line.
For a price fall Hicks (Slutsky) method with American assumptions looks like a price
increase for Hicks (Slutsky) with European assumptions.
Assume P X falls.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
a
2
1
II III
A B B* Cc d
X
Hicks method draws helping budget line 1 tangent to old indifference curve I but
parallel to new budget line. AC broken into AB (Hicks substitution effect) and BC Hicks
income effect.
Slutsky method draws helping budget line 2 through old point. Consumer is
overcompensated and substitution effect is now AB* and income effect B*C.
Figure 4.6 shows Hicks method for a price fall of a normal good. In terms of
ABC, F1 = A, E = B and F2 = C. Figure 4.6 can be used to show the Hicks method using
European assumptions for a price increase.
Figure 4.7 shows Hicks method for an inferior good not Giffen good.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Figure 4.8 shows Hicks method for an inferior good that is Giffen.
Figure 4.9 shows the effect of a Gas tax with total rebate. Gas tax => relative price of gas
rises => relative consumption of gas falls. BUT the gas tax involves an negative income
effect. State elects to rebate the full tax to each person on an average basis. => heavy
users of gas will be at less utility, low users of gas will benefit since they will be over
compensated. Graph shows effect on heavy user. For all users relative price of gas has
increased.
Price A B C Market
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
Assuming demand curve is elastic (inelastic) => price fall inplies that revenue increases
(decreases).
For straight line demand curves elasticity = point elasticity. Not all demand curves are
straight lines.
Arc elasticity = ( Q / P )( P / Q )
Demand curves have kinks as consumers jump into the market. See figure 4.11
Domestic Demand
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
B E
C D
= AB * BE / 2
= (P * Q) / (d * 2)
d = BC / AB,
P*Q = BC * CD
Value of clean air: Would consumers maintain their cars better if the exhaust was on
front of car? Why?
Bandwagon effect => You like the good better if others get it. Bandwagon effect
makes market more elastic. Retail marketing based on creating bandwagon effect. MJ
paid to wear a special shoe.
Snob Effect => You like the good less the more others have it. Snob effect
makes market demand less elastic.
Q a B1 P B2 I
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
and
Math Treatment
(3) U ( X , Y ) ( PX X PY Y I )
If the budget constraint is satisfied => second term = 0. Differentiate Lagrangian with
respect to X, Y and and set to zero. Obtain
(4) MU X ( X , Y ) PX 0
(5) MU Y ( X , Y ) Py 0
(6) PX X PY Y I 0
where MU X ( X , Y ) U ( X , Y ) / X etc
Equations (4) and (5) indicate that the consumption of X and Y will proceed until the
marginal utility is a multiple of P or
(7) [ MU X ( X , Y ) / PX ] [ MU Y ( X , Y ) / PY ]
or
(8) MU X ( X , Y ) / MU Y ( X , Y ) PX / PY
Equation (8) expresses an equilibrium condition. This equation is satisfied where the
indifference curve is tangent to the budget line.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
(9) U ( X ,Y ) U *
(11) dY / dX MU X ( X , Y ) / MU Y ( X , Y ) MRS XY
Practical case using Cobb-Douglas utility function. This section based on Appendix
to Chapter 4.
(12) U ( X , Y ) X a Y 1 a
(15) / X a / X PX 0
(16) / Y (1 a )Y PY 0
(17) / PX X PY Y I 0
Solving (15) and (16) for PXX and PYY and substituting in the budget equation gives
(18) a / (1 a ) / I 0
(19) X (a / PX ) I
and
(20) Y [(1 a ) / PY ]I .
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
The Cobb-Douglas utility function implies that the consumption of each good depends
only on the price of that good and income, not the price of the other good or that cross
elasticities of demand are zero.
The Lagrange multiplier represents the extra utility generated by one more dollar.
Taking the total derivative
(22) dI PX dX PY dY
An example. Assume a 1 / 2 , PX=$1.00 and PY=$2.00 and I = $100. From (19) & (20)
X (a / PX ) I and Y [(1 a ) / PY ]I . Thus X = 50 and Y = 25. Since 1/ I , then
=1/100. If income were to increase to $101, X=50.5 and Y=25.25. The original utility
was .5 *log(50) .5 *log(25) 3565. while the new utility was
.5 *log(50.5) .5 *log(25.25) 3575
. . was .01 which is the exact difference in utility.
(12) implies that if the consumption of X and Y were to increase by , then total utility
goes up by . In a more general case
(25) U ( X ,Y ) X Y
(26) MU X ( X , Y ) dU ( X , Y ) / dX aX ( a 1)Y B aU ( X , Y ) / X
(27) MU Y ( X , Y ) dU ( X , Y ) / dY X aY ( 1) U ( X , Y ) / Y
Equations (27) and (28) show that if Y is fixed and X is increased the marginal utility of
each additional X will decline. An additive utility function will not have this property.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Duality in Consumption Theory states that maximizing utility for a given budget is
equivalent to minimizing the cost of obtaining a given level of utility. This can be best
seen with indifference curves and budget lines.
Discussion Problem # 1
Sally Henin has an arc price elasticity of demand for gasoline of -.8. Her income
elasticity for gas is .5. Sally has a current income of $40,000 per year and spends $800
per year for gas. The current price of gas is $1.00.
b. The Government is considering a $200.00 tax rebate. How will this impact
Sally?
c. Assume both the tax and the rebate are implemented. Is Sally worse off or
not?
On final indifference curve she spends 613.53 * 1.40 = $858.94 . With her income and the
rebate she would have 40200-858.94 = $39,341 to spend on goods.
If she bought 614 at the old price she would have had 40000-614 = $39386
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Problem # 2
The San Francisco Chronicle reported that the toll on the Golden gate bridge was raised
from $2.00 to $3.00. Following the toll increase traffic fell 5%.
Fines: Individual balances “gain from breaking the law” against expected fine
These cases imply enforcement costs = 0.0. Most drivers who do not like risk will not
double park.
In case of music piracy difficult to catch. => can have very high fines.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Chapter 6 Production
Firms turn inputs or factors of production into outputs via a production function
Q=F(K,L).
Firm uses each input as efficiently as possible. Isoquant (production indifference curves)
show different quantities of inputs (say L and K) such that output is fixed.
Q=30
Q=20
Q=10
In short run not all inputs can be changed. In the long run all inputs can be changed.
When Marginal Product > Average Product => average product is increasing.
Figure 6.1 shows relationship between AP, TP and MP. Why would a firm never operate
where MP < 0? MP reaches a peak at point of inflection. of TP curve.
Figure 6.2 shows how output per time period goes up as technology improves.
Figure 6.4 shows that cereal yield and the food price index appear to be negatively
related. Why might this be so? Except for a brief period in the 70's, food prices have
declined.
Law of diminishing returns => with other inputs fixed, MP of an input declines as the
amount of that input used increases.
Malthus believed that the earth would not support population growth. To date he has been
wrong.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Table 6.3 shows Annual Growth of Labor Productivity in various countries. It is shown
below:
Year US Japan France Germany UK
1960-1973 2.29 7.86 4.70 3.98 2.84
1974-1982 .22 2.29 1.73 2.28 1.53
1983-1991 1.54 2.64 1.50 2.07 1.57
1992-2000 1.94 1.08 1.40 1.64 2.22
2001-2009 1.90 1.50 .90 .80 1.30
A technological change raises the production function. Here it is occurring over time.
Q Ae t L K
In any particular year the aggregate value of goods and services produced by en economy
is equal to the payments made to all factors of production.
We can estimate a production function in log form with Excel. Take Data from 6.4 and fit
model. See ch6_1.xls
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.961637
R Square 0.924745
Adjusted R
Square 0.917903
Standard
Error 0.118085
Observations 25
ANOVA
Significanc
df SS MS F eF
Regression 2 3.769633 1.884817 135.1693 4.38E-13
Residual 22 0.306771 0.013944
Total 24 4.076404
RESIDUAL OUTPUT
Predicted Residual
Observation lnq s Yhat Actual Error
1 3.394232 -0.3985 29.79175 20 9.79175
2 3.72906 -0.04018 41.63997 40 1.639968
3 3.924923 0.08241 50.64917 55 -4.35083
4 4.063889 0.110498 58.20024 65 -6.79976
5 4.17168 0.145808 64.82428 75 -10.1757
6 3.72906 -0.04018 41.63997 40 1.639968
7 4.063889 0.030455 58.20024 60 -1.79976
8 4.259752 0.057736 70.79241 75 -4.20759
9 4.398718 0.043933 81.34655 85 -3.65345
10 4.506509 -0.0067 90.60499 90 0.604987
11 3.924923 0.08241 50.64917 55 -4.35083
12 4.259752 0.057736 70.79241 75 -4.20759
13 4.455614 0.044195 86.10902 90 -3.89098
14 4.594581 0.010589 98.94665 100 -1.05335
31
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
The above Excel output shows how data can be used. Figure 6.4 graphs this data.
Q* ae t (L) a (K ) ae t ( a ) La K ( a ) Q
Example: MPL= 50, MRTS = .25. What is MPK? .25 MPL / MPk 50 / MPk . =>
MPK 200
Example: Assuming Q=100(K.8L.2) starting K=4 and L=49 show MP of labor and K are
declining
32
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
33
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Economic Cost takes into account opportunity cost that has to be taken into
consideration in the decision process (It is more costly for a doctor to mow the lawn on
Monday at 10:00 than a janitor).
Valuable Alternative use of land => high opportunity cost of present use.
In the short run can change labor to increase output. Given the wage w ,
AVC wL / Q w / APL
Figure 7.1 The MC curve goes through the minimum of the ATC and AVC but not the
AFC. As Q , AFC 0 .
Isocost line (= production budget line) is locus of points shows different combinations of
inputs such that cost is fixed.
C wL rK
34
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
K (C / r ) (( w / r ) L)
Isocost slope
K / L ( w / r )
A=TC/Pk
A B=TC/PL
B L
MPL / MPk PL / PK w / r
or
MPL / w MPK / r
Figure 7.5 show effect of an effluent fee raising the relative price of the input water.
Production moves to be less water intensive.
35
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Expansion path shows the amounts of labor and capital used as firm grows (figure 7.6).
This is a long run concept.
Long Run
Short Run
Figure 7.10 Long-Run Cost with first Economies then Diseconomies of Scale. The LAC
traces tangency points of SAC curves.
Economics of scale => MC < AC. Diseconomies of scale => MC > AC. Define
Economies of scope are present when joint output of a single firm producing two
products is greater that the output of two firms each producing one product. Define
C (Qi ) as cost of producing Qi of the ith good. Economies of scope => SC > 0
36
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Learning Curve => Over time labor costs go down as more units are produced. Define L
as labor per unit, A> 0, B>0, 0< <1 and N = # of units produced. Learning curve
implies
L A BN
As N , L A
If N=1 then L=A+B or the amount of labor for first unit. If 0 there is no learning.
B
When 0 then second unit costs A which converges to A as N increases.
2
Costs can decline because of increasing returns to scale or learning. See figure 7.12
which shows cumulative number of machines on the x axis. Figure 7.13 shows
production rate.
$
Economies of scale => A to B
Learning Curve => A to C
A
B
C AC1
AC2
In the early life of a product the learning curve is steep. After while the "learning" slows
down. In chip business had a 20% learning curve. => 10% increase in cumulative
production => costs fall 2%. In aircraft industry learning curve rate was 40%.
VC Q
37
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
VC Q Q 2
MC 2Q 3Q 2
VC Q Q 2 Q 3
38
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
(2) Q0 AK L
(4) [L / K ] r / w
(6) Q0 [ AK r K / w ]
(7) K ( ) (w / r ) Q0 / A
If the cost of capital, r, increases or the marginal product of capital, , falls K will fall.
Direct substitution of (8) into (5) gives
If the wage rate, w, increases or the marginal product of labor, , falls then less labor
will be used. The firms cost function is
(10) C wL rK
At equilibrium
(11)
C w( /( )) r ( /( )) [( / ) ( /( )) ( / ) ( /( )) ]( Q / A) (1/( ))
Equation (11) shows how C is related to wages, w, cost of capital, r, and returns to scale
( ) . MATLAB can be used to calculate the appropriate derivatives
Equation (11) shows how costs are related to the production function of the firm as well
and input costs.
39
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Competitive supply => many firms, all price takers, no product differentiation, free entry
Profit is the difference between revenue and cost for a given level of output q.
(1) (q ) R( q ) C (q )
For a competitive firm P is given => d and P=MR. It can be proved that
Figure 8.1 shows profit maximization. Figure 8.2 shows firm in competitive market is a
price taker.
Figure 8.3 shows a competitive firm (MR=AR) making extra normal profits and
operating with decreasing returns.
In long run new firms will enter and firm will earn normal profits or those profits such
that no firms enter or no firms leave industry.
Figure 8.5 show that in the short run the firms MC curve is the firm supply curve.
If an input increases in price => AC curve shifts up => MC curve shifts up and firm
produces less output.
Book indicates that short run MC of petroleum has flat sections until other refineries get
on the line. See figure 8.8. ComEd's costs are constant until they start jet engine
generators.
Industry supply curve is the sum of firm MC curves in the short run.
40
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Producer Surplus = area above firm supply curve and below price. See figure 8.11.
In long run firm can alter all inputs. If industry is making extra normal profits in the short
run => new firms will enter such that in the long run all firms are making normal profits.
The long run competitive equilibrium point is P=SMC=LMC. Firm is at the minimum
point of its AC curve. Given the firm's technology, it is most efficient. It earns economic
profit (normal profit). See figure 8.13.
In long run firm tries to equate LRMC to price BUT new firms can enter the industry and
drive down price.
The long run supply of a constant cost industry is a straight line. This is a partial
equilibrium argument. As Q increases input prices will increase at some time. General
Equilibrium has all assumptions variable. Some industries are so small that they can be
assumed to have no effect on input prices. See figure 8.15
Increasing Cost Case => If extra normal profits are earned new firms will enter the
industry and input prices will increase. See figure 8.17.
Taxes. An output tax raises the MC curve. A Lump Sum Tax (such as a liquor license)
does not change the MC since it is paid no matter what. The effect of a n output tax in the
long run is to reduce industry supply.
- Price Taking
- Product Homogeneity
- Perfect Mobility of Assets
- Perfect Information
Even if only one firm in the market it may pay to act as if the firm was in a competitive
market since extra normal profits => others firms may enter to bid away profit.
41
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
What is profit?
The firm should stay in business in the short run since AVC < P:
Example: Restaurant stays open in “off hours” if it can cover labor costs.
P 75 15
.Q
P 25..5Q
25.5Q 75 15
. Q, Q 25, P 75 15
. * 25 $37.5
Note: If you use ch2_1.xls template to solve system remember that the template is set up
as: Q s f ( P), Q d f * ( P) , Q s 50 2 P, Q d 50 (1/1.5) P
42
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Figure 9.1 shows producer (area between supply curve and market price) and consumer
(area between demand curve and market price) surplus.
Price Controls: Figure 9.2 and 9.3 show changes in producer and consumer surplus
when the government put on a price control.
The more inelastic the demand curve the more the deadweight loss.
Looking at figure. Producer surplus loss = A+C. Consumer net gain = A-C-B.
Price controls can have a serious long term effect on market as was case with NY
housing.
Figures 9.4 & 9.5 contrast the effects to price being held below and above the market
price.
Kidney Market. (See figure 9.6) Supply function of Q s 16000 .4 P implies that if the
price is held to $0.0 by the 1984 National Organ Transplantation Act, and you cannot
sell an organ, only 16000 will be supplied. The demand function is Q d 32000 .4 P .
On figure 9.6 suppliers lost A+C. If supply is reduced due to not being able to sell
kidneys, the market clearing price is $40,000 and many consumers are rationed on a
"willingness to pay" A+D = total value of kidneys at new market clearing price.
Middlemen and hospitals get gain NOT donators.
43
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Minimum Prices (Government restricts market from lowering prices. Fair trade laws.
Tariffs.) (See figure 9.7).
P1
A B
P2
C
Q3 Q0 Q1
Government raises price from P2 to P1. Supplier produces Q1 not Q3 > "glut"
From free market consumer surplus loss = B. Producer surplus loss = C (Assuming
producer produces Q3)
Minimum Wage Figure 9.8 shows the analysis for minimum wage which causes
unemployment of L2-L1.
Price Supports. In contrast to minimum price laws, price supports require that
government buy farm products. Figure 9.11 shows that as a result of the purchase
program production when from Q0 to Q2 and price from P0 to Ps. Consumer surplus
reduced by = B+A. Producer gain = A+B+D. Government cost = Ps(Q2-Q1).
Change in welfare (A+B+D)-(A+B)-[Ps(Q2-Q1)].
Production Quotas. Government reduces supply (taxi licenses, bar permits). NYC has
113,150 taxi licenses. Roughly same as 1937. Medallion costs $880,000. Cost in 1947
was $2,500. In 1980 was $55,000. If supply went up current medallion owners would see
a loss of value of their medallions. Drives cab ride prices very high. See Figure 9.13. In
NYC cabs are run 24/7, not shut off at night.
Acreage limitation programs give farmers money incentive to leave land idle. Causes
farmers to farm their land more intensively. Figure 9.11 suggests cost to government
must at least equal B+C+D of the gain from planting since farmer sees new higher price
as given.
Thus PS A C B C D A B D
44
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Society would be better off if Government just gave producers A+B+D since what
government would lose farmers would gain for a zero net effect.
Book Example page 336 figure 9.12 shows how to use above theory:
Government must increase demand to raise the price. Let Qg be government demand
Given desired P, Qg is determined. If P=$3.70, => government buys 122 million 2688-
566) bushels at cost of $451.4 million. Inspect figure 9.12. Customers lose A((3.7-
3.46)*2566) + B(.5*(3.70-3.46)(2630-2566) or 616+8=624 million. Note that A is
substantially bigger that B in this problem. Total cost = 624+451.4=1075.4
Exact answers for this problem and related ones are in ch9_1.xls.
As an exercise run the problem where the desired price is $3.80. Adjust demand and
supply and see what happens.
Quotas and Tariffs. Figures 9.14 and 9.15 shows basic setup. (9.14 shows a tariff that
eliminates all imports). Consider figure 9.15. With free trade the price is Pw domestic
supply is Qs, domestic demand is Qd. Imports are (Qd.-Qs). After a tariff (or quota).
Domestic supply jumps to Q's, domestic demand falls to Q'd and imports fall to
Q'd-Q's. Trapezoid A = gain to producers. Due to higher price consumer loss is
A+B+C+D. If a tariff is imposed, Gov gains revenue D. Net domestic loss is B+C+D.
Excel file ch9_2 shows setup to analyze Sugar Case. A tariff of 83% gives book case.
Can adjust tariff to eliminate imports and thus tariff revenue (area D).
Product Taxes. Figure 9.16 and 9.17 shows effect on producers and consumers of a per
unit tax on producers. Area A + B = what buyers lose. Area D + C = what sellers lose.
Are A + D = what government collects. s = elasticity of supply. d = elasticity of
demand. A tax falls mostly on the buyer (seller) if d / s is small (large).
45
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Most luxury goods have inelastic demand => luxury good tax hits consumers hard.
Example 9.7 Tax on Gas. See figure 9.20 and Excel 9_3.xls
We are given that d .5, s .4, P * $1.00, Q* 100 . From Chapter 2 and excel
ch2_2.xls we know that
Given QD = a - bP (11)
QS = c + dP (12)
And P* and Q* are equilibrium P and Q, then at equilibrium the elasticity of demand D and
elasticity of supply S are
D = -b(P*/Q*) (13)
S = d(P*/Q*) (14)
150 25P 60 20 P
90 45P P $2.00. Q 100
After Government places a $1.00 tax the new price is $2.44 and the new quantity is 89.
The producer price falls to $1.44. The steeper the supply curve the less quantity falls and
the more the producer price falls. The more inelastic the demand curve the more the
consumer price increases. In this case a greater proportion of the tax is passed on. The
following calculations replicate the figure 9.20
46
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Problem # 12 page 354 has the demand and supply of hula beans. See p354_12.xls
Qs 50 P , Qd 100.5 P . The world trade price is $.60. Congress puts on a tariff of
$.40. Use of ch9_2.xls implies that Equilibrium P and Q are $1.00 and 50 if there was no
foreign supply. If the tariff is imposed at .666666 then the domestic producer will
produce 10. The domestic consumption will be 50 (instead of 70 at world trade price of
$.60). Deadweight loss = (70-50)*$/40*.5= area C = $4.00. Before the tariff since
domestic production is 10 and consumption is 70 => import 60. After tariff there is no
imports. Consumer surplus loss =$24.
47
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Assuming P=6-Q
P Q TR MR AR TR
6 0 0 - - - 0
5 1 5 5 5 inf 5
4 2 8 3 4 -4 8
3 3 9 1 3 -1.5 9
2 4 8 -1 2 -.667 8
1 5 5 -3 1 -.25 5
[ AR / ( MR AR)]
E B
O C D
Equilibrium at max profit requires MC=MR where MC hits MR from below. Figure 10.2
is the basic diagram. Various points:
48
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
- If MR < AR can
Possible Cases Table: Study below listed tables and be able to draw all possible cases
and prove that the I cases are not possible.
MR=AR
MC=MR
MR<AR
MC=MR
49
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
A firm makes an extra normal profit if AR>AC, a normal profit if AR=AC and a short
term loss if AR<AC.
Solution Strategy: If the functions are known set MR=MC and solve for P, Q, and
profit.
Demand (AR) P( Q) 40 Q
Solution is illustrated in figure 10.3. This is case 18 . a firm making extra normal profit
operating at greater than optimum capacity.
Since in equilibrium MC=MR and MR AR[1 (1 / d )] the markup model for pricing
is MC AR AR(1 / d ), or AR P [ MC / (1 (1 / d ))]
Figures 10.4a and 10.4b show special cases where demand can shift and leave Q fixed
and demand can shift and leave P fixed. This is usually not the case.
A per unit tax of increases MC by the same amount. Here profit is where
MR MC
The more inelastic the demand curve the higher the price after the tax. This can be tested
using toolbox file ch9_4.xls. To make the demand curve more inelastic, reduce the
coefficient on price. Toolbox file ch9_4.xls must be used in place of ch9_3.xls since the
former holds the percent tax fixed while the latter holds the dollar amount of the tax
fixed.
50
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
n
Figure 10.6 shows MCT horizontal sum of MCi MCi for a n plant system.
i 1
QT Qi
Monopoly Power. A firm in an industry with few sellers will face a more elastic demand
curve than the industry as a whole. The greater the product loyalty for that firms product,
the more inelastic the demand curve. The more inelastic the demand curve the more the
firm can raise price. Lerner's measure of monopoly power L ( P MC ) / P . L is in the
range 0-1. P=MC => L=0 and demand curve has . Since MR P[1 (1 / )] and
B A
MR=MC as || P .
B
Designer label clothing => || or higher prices. Advertising is designed to lower the
absolute value of the demand elasticity. To make the consumer less sensitive to a price
change. See figures 10.8a and 10.8b
The firm will face a more inelastic demand if the number of firms in the market is small
and there is less interaction between firms (i.e. firms do not follow a price lowering with
a price lowering). If firms collude, then prices will go up. OPEC limited supply. Some
countries cheated!!
Figure 10.10 shows Deadweight loss of monopoly power. Monopolist wants to equate
MC=MR to maximize profit. Consumers lost A+B. Producer gains A loses C.
Deadweight loss = -B-C.
Figure 10.11 shows "kink" in MR curve due to a price ceiling due to regulation. If price
is set at Pc , can get perfect competition solution. What is interesting is MC can move
within the kink and prices will not change. Problems:
51
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Rate of return Regulation. Attempts to regulate to insure a given rate of return leads to
firms that use relative more capital than labor.
Monoposony: Firms is such a large buyer of an input that it faces an upward supply
curve (average expenditure curve). On the average expenditure curve draw a marginal
expenditure curve. At equilibrium equate marginal expenditure to marginal value
product. MVP = marginal physical product * Price of output. The marginal physical
product of capital is the increase in output for one more unit of capital.
MPPk Q(l , k ) / K
Figure 10.14 shows firm with monopsoly power will buy less of an input and pay less
that if it were in a competitive input market.
The more elastic the supply curve, the less monopsony power (see figure 10.15, 10.16).
ME AE [1 (1 / s )]
s ME AE
Bilaterial Monopoly => two monopolists facing each other. Hard to tell what will
happen. Think of auto producers and parts suppliers.
Problem
Given P= 27 24 21 18 15 12 9 6 3 0
Q=0 2 4 6 8 10 12 14 16 18
52
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
MC=10
TR (18.5)(5.67) $104.83
53
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Figure 11.1 suggests that if one price is charged it would be P.* If firm was able to price
discriminate, it would charge a higher price to more inelastic market. It has been reported
that McDonald's charges more for the same item at Water Tower Place than on the South
Side!
A firm that practices first-degree price discrimination charges each customer his/her
reservation price or the maximum that the consumer would pay. Figure 11.2 shows how
in such a world the firm expands production from Q* to Q**. In this word all consumer
surplus is captured by the firm. In practice this is hard to do. Universities try to
practice this approach by giving just enough aid to get the student. If firm does not have
perfect knowledge, then a number of prices can be charged. See figure 11.3
Third-degree price discrimination occurs when firm packages same product under two
different labels and sells at a different price. Using formula MRi Pi [1 (1 / di )] and
MC MR1 MR2 , then
Table 11.1 suggests that coupon users have higher elasticity of demand than non coupon
users. Assume the non coupon users have elasticity of demand d 1 . If P1 = P2, and V =
value of coupon, then in an optimum world
Airlines price discriminate. Table 11.2 on page indicates that industry price elasticity for
First-Class, Unrestricted Coach and Discount are -.3, -.4 and -.9. Income elasticities are
1.1, 1,.2 and 1.8. Firm elasticities are > in absolute value.
Intertemporal Price Discrimination => firm charges first consumers more. Hard cover
edition of a book comes out first. Before too long soft cover comes out at a lower price.
Library buys hard cover! Nikon does this with new models! See figure 11.7
Peak-Load Pricing => charge more at a certain time in the day. See figure 11.8
Two-Part Tariff => pay to get into Great America, then, pay for each ride.
54
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Figure 11.9 shows single consumer. Usage fee is set to marginal cost. Entry fee is set
to capture entire consumer surplus. Here firm captures all surplus
Figure 11.10 Profit making usage fee is set > MC. Entry fee T* set to surplus of
customer with smaller demand. Profit = 2*T* + (P*-MC)*(Q1 + Q2).
A
II I I Consumers buy both
II Consumers buy only A
III Consumers buy neither A or B
IV Consumers buy only B
III IV
B
Mixed bundling. Sell as a package or alone. MS Office 97 is sold this way. Figure 11.18
shows that with zero MC this is even more profitable.
Luxury cars are sold with standard options bundled into the car. Vacation package
another example. Restaurants sell items a la carte and as dinners.
Tying => force customer to buy all items from one source. McDonalds at one time
required owners to get supplies from one source. Gas station has to carry full range of
products.
55
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
[( P MC ) / P]a [ A / PQ]
1 1
MC P[1 ] [( P MC ) / P ]
p p
[ A / PQ] [ A / P ]
The more inelastic the demand for the firm's output, the more advertising. In perfect
competition since p , no advertising is done.
This logic takes into account the effect of advertising on increasing sales but also adding
to costs as added units have to be produced.
Transfer Pricing is between units of a vertically integrated firm. Will show that
profits are maximized if transfer price equals marginal cost of respective upstream
division.
(Q) R(Q) Cd (Q) C1 (Q1 ) C2 (Q2 ) where each term represents revenue from sales,
firm production costs, costs from intermediate production inputs from plant 1 and costs
from intermediate production inputs from plant 2.
To maximize the net marginal revenue firm earns from one more input of Q1 and Q2
differentiate (Q) with respect to Q1 and Q2.
Each upstream firm takes price Pi as given and equates it to their marginal cost MCi.
56
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Engine problem consists of an auto firm assembling cars with the option of getting
engines from an upstream firm. Demand for autos
P 20000 Q
MR 20000 2Q
Cost of assembly
C A (Q) 8000Q
MC A 8000
engine costs
CE (QE ) 2QE2
MCE (QE ) 4QE
Net marginal revenue of engines given QE Q
NMRE MR MC A 20000 2Q 8000 12000 2Q
NMRE MCE
12000 2Q 4QE QE 2000
Optimal transfer price is marginal cost of the 2000 engines or 4QE $8000
If engines can be bought outside for $6000, then a case can be made that the firm should
buy all engines outside BUT remember the engine dept has an upward slope to MC. This
suggests equate
NMRE 6000
12000 2QE 6000 Q 3000
Here we have QE Q since we set MCE (QE ) 6000
4QE 6000
QE 1500
Firm buys 1500 outside and uses 1500 of its own engines.
57
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Monopolistic Competition => Large number of sellers each with some market power
due to selling a differentiated product. At the model level in the automotive industry we
have monopolistic competition. d in monopolistic competition.
- Many sellers
- Each seller selling a slightly differentiated product
- Entry by new firms is NOT restricted
Note: Trade theory suggested that trade would be between countries that were not
similar. However most trade is between countries such as Canada and US and Germany
and France which are similar. Krugman used monopolistic Competition Theory to rescue
trade theory.
Oligopoly => Few sellers each with market power. If one firm in an oligopoly market
were to raise price, the others would not follow and that firm would find sales fall off
rapidly. If the same firm were to lower price hoping to increase sales at the expense of the
other firms, then all other firms would lower price and the expected increase in sales
would not be realized.
- Few sellers
- Each seller selling a differentiated product.
- Each with substantial market power
- Entry is restricted by barriers (example aircraft industry)
Cartel=> Firms work together. (GE in 50's until they got caught.)
- Firms in long run operate at less than optimum (minimum average cost)
capacity (see case 13) and figures 12.1 and 12.2.
58
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Folgers -6.4
Maxwell House -8.2
Chock Full o’Nuts -3.6
In oligopoly each firm is doing the best it can, given what its competitors are doing.
Cournot Model. Two firms (duopoly) each making its decision at the same time.
Decision rule: Each treats the output level of its competitor as given.
Cournot equilibrium => Intersection of firm 1's and firm 2's reaction curve => how
firms divide up quantity. (See figure 12.4).
MCi = 0
P=30-Q
59
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Q1 15.5Q2 , Q2 15.5Q1
which are derived by setting MR1 and MR2 to zero and solving for Q1 and Q2.
Stackelberg Model => One firm moves first BUT has to take into account what other
firms will do.
Firm 2 has reaction curve Q2 15.5Q1 . Firm 1 knows this and knows its revenue
is PQ1 30Q1 Q12 Q2 Q1 . To get solution substitute form 2's reaction curve in firm 1
revenue curve
Stackleberg Model good when one firm is dominant and can move quickly to set
quantity.
60
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Cournot Model good when have more firms with no one firm dominant. Cournot model
is stable because each firm produces what maximizes its profits, given what competitors
are producing.
Bertrand Model => Firm sets price NOT quantity in a homogenious product
market.
Assume MC1=MC2 = $3.00 and market demand is P = 30-Q. Here Cournot equilibrium
(where reaction curves are jointly solved) => Q1 Q2 9 . Proof:
Under Bertrand model set marginal revenue = marginal cost and divide output.
Problem with Bertrand model. When there is a homogenious product firms compete on
quantity not price (orange growers). We assume firms divide Q. This may not be the case.
Q1 12 2 P1 P2 , Q2 12 2 P2 P1
Excel file ch12_1 solves the system for any fixed cost and marginal cost. Verify that this
file calculates correctly. Such a setup provides a 'template' for a more general decision
model. Template also shows Collusive Equilibrium.
Each firm decides to set price given the other firms price. For firm I
61
Microeconomic Study Notes (17/7/2012 Houston H. Stokes
i PQ
i i 12 Pi 2 Pi PP
2
i j 20
i / Pi 12 4 Pi Pj 0
reaction curve is
Pi 3 .25 Pj
Pi 3 .25(3 .25 Pj )
Pi (3 .75) /(1 .252 ) $4.00
collusion profit
24 P 4 P 2 2 P 2 40
/ P 0 24 4 P
P $6.00, $16.00
Use the template to solve the system assuming demand curves are now:
Q1 24 2 P1 P2 , Q2 32 2 P2 P1
Which might have resulted due to an Ad effort. Since profit is calculated, the
effectiveness of an ad effort can be calculated.
Table 12.2 shows P&G decision model assuming fixed costs of $480,000 and variable
costs of $1.00. Excel file ch12_2.xls generalizes this analysis. The base case assumes the
demand curve is
which could have been estimated using Excel if we assume natural logs of the data have
been used.
Use the template to see what would be the situation at P & G if Unilever charged $1.45
and Keo charged $1.47 and P & G investigated prices $1.10, $2.00, $1.87, $1.44
If P & G does an effective marketing effort the 3375 might be raised or the market
elasticity of -3.5 changed. Assume due to a "You got to have it…" type ad effort the
elasticity is lowered to -3.. Assuming the base case what happens to profit? How would
you determine if the ad effort was worth it?
Prisoners Dilemma
Nash equilibrium is a noncooperative equilibrium. If you hope that firm will set price at
collusive level, the other firm will find that it pays NOT to set at this level. Verify that
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
ch12_1 shows that if firm # 2 sets $4.00 and firm # 1 sets $6.00 (collusive price) then
firm # 2 makes $20.00 and firm makes $4.00.
With $6, $6 the total profit is highest ($32.00). But each firm will look at situation as "If I
charge $4.00 I will do "best" (i.e. make $12.00)." Each firm does not dare trust the other
firm to charge the higher price!!
In Oligopoly there is an incentive to keep price fixed. Figure 12.7 illustrates the kinked
demand curve. MC can move inside discontinuous section and there is no incentive to
change price or quantity. => Oligopolistic firms have price rigidity
Price signaling firm such as American Airlines announces it is raising its price. Firm
hopes that such price leadership will result in the others following. (This seems to be the
case in Hyde Park between Shell and Amoco stations which 'post' prices that seem to
agree all the time.)
Banks operate using price signaling as they "respond" to changes at the Fed.
Dominant Firm Model. Figure 12.9 shows dominant firm model. Dominant firm takes
demand curve DD as
Dominant firm draws MR on this derived demand curve and sets price. Fringe firms
take this price as given.
An Oil Cartel would not be legal in the US. Figure 12.10 shows situation. Here OPEC
derives a demand curve DOPEC and draws a marginal revenue curve. Price is set at P*
where MROPEC = MCOPEC. If OPEC were not a cartel, OPEC price would be at Pc.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Game Theory "If I believe that my competitors are rational and act to maximize theor
own profits, how should I take their behavior into account when making my Own profit-
maximizing decisions?"
Cooperative game => players can negotiate binding contracts and enforce them
Noncooperative game => players cannot negotiate and cannot enforce contracts
Want to understand your opponent's point of view and assuming your opponent is
rational deduce how he or she is likely to respond to your actions.
Answer. Offer $0.00. Assume A offers $50.00. This suggests that the share price is
between 0-50. Its expected value is $25.00. With A's management the value will rise to
$37.50 (1.5*25) which is less than the offer!!
Dominant Strategy one that is optimal for a player no matter what an opponent does
Here A does not have a dominant strategy. Depending on what B does, A will either
advertise and get 15 or not advertise and get 20. But B has a dominant strategy which si
to advertise. => A will figure that B will determine this and will advertise.
Nash equilibrium - I am doing the best I can given what you are doing. You are
doing the best you can given what I am doing.
Dominant Strategy - I am doing the best I can no matter what you do, You are
doing the best you can no matter what I do.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Firms demands for inputs are "derived" in that they are the result of production decisions
due to market demand for the final product.
Marginal revenue product = added revenue from one more unit of input I in the
production of good x. In general case
MRPi w
or
MRx w / MPPi
DL
MRP2
MRP1
hours
As other inputs increase, MPPL increases which shifts the MRP curve to the right
Each firm takes the supply price of inputs as given. As a group if aggregate demand
increases the price of inputs will increase.
The supply of labor is usually upward sloping. If wages increase, more labor will be
supplied. Above some wage, the number of hours supplied may decrease as potential
workers chose leisure over work.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Table 14.2 suggests that with home with two earners higher wages reduces (-.086) hours
worked my spouse. In one-earned with children this is seen (-.078) but not when there are
no children (.007).
Economic rent => difference between the payments made to a factor of production and
the minimum amount that must be spent to obtain the use of that factor.
An upward supply curve of labor => at the equilibrium wage some workers are obtaining
a wage that is greater than needed to get them to work. (See figure 14.11)
Land rent can be calculated on a vertical supply function (see figure 14.12). This
maximizes rent.
Figure 14.13 suggests that US Army recruitment is hampered by a wage that is below the
competitive wage. Rather that increasing the wage to the competitive wage (for all
officers and enlisted men of that rank), the military pays an enlistment bonus to keep
people in the service. The military pays a "dependents allowance" and other incentives
for those with families. Such incentives have resulted in early marriages.
Monopsony Power occurs when a firm has power over the cost on an input. In a
competitive market the marginal expenditure (ME) for an input is equal to the average
expenditure (AE). With monopsony
AEi MEi
In equilibrium
MEi MRPix
If unions restrict the number of workers, then the wages of those in the trade will be
above the wage that would occur if there was free entry. The wages of workers in the
non union labor market will fall due to the increased workers looking for work. In reality
many union workers work off the books on the weekends and nights. At university
tenured faculty are not allowed to lower their wages for the summer.
In period the relative #'s of union workers have decreased. Wages have not risen as
expected due to the increased substitution of capital for labor.
Q e t L K
t 1
then MPPL e L K Q / L
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Analysis has been based on partial equilibrium. In General Equilibrium prices and
quantities are determined in all markets at the same time.
Figure 16.5 shows an Edgeworth box. At points of tangency of the indifference curves,
such as C and D, trade is optimal. Points B and A are a positions off the contract curve
(locus of points where the indifference curves are tangent). A movement from A to C
make both better off.
In partial analysis we noted that the slope of the indifference curve for individual i was
[ MU xi / MU yi ] which was equal to the ratio of prices. If exchange is at the tangency
point of the indifference curves then the ratio of prices is the same for both individuals.
Here
[ MU xi / Px ] [ MU yi / Py ] for i 1,2
The above analysis shows exchange given that the individuals have the goods. The same
analysis can be done at production level. Assume country # 1 produces goods X and Y
and in the absence of trade will maximize utility at point A. If trades open up, country # 1
can sell ab of X for bc of Y and get to a higher indifference curve at position c.
Consider 4 possibilities between two countries producing two goods with tastes and
production conditions:
In all but first case, trade benefits both countries (individuals). (See figure 16.10 & 16.11
& 16.12).
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
b A c
Holland has absolute advantage in both goods. Italy has comparative advantage in wine.
Holland has comparative advantage in cheese,
Example: JM appears to have an absolute advantage in both baseball and basketball over
Stokes. JM has a comparative advantage in basketball over baseball.
If teams were chosen a rational coach would put JM on the basketball team and Stokes on
the baseball team.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
All but the last view requires that the leaders/government know the utility function of all
individuals.
Rawlsian view suggests that an equal distribution of resources may remove the incentive
that most productive people have to work hard. This view allows inequalities as long as
the lest well off person is better off. How might this be measured?
In individual preferences are convex, then every efficient allocation (every point on
the contract curve) is a competitive equilibrium for some initial allocation of goods.
Does the system take into account negative externalities? Would auto pollution be
reduced if exhaust pipes were mandated to be at the front of cars? Air pollution laws in
California gave a "pass" to old cars. => incentive to repair old "dirty" motors rather than
put in a cleaner new motor!!
Market Power - Producer has market power and sets MR not P equal to MC.
Incomplete Information - Customers may not know real cost on an item such as
cigarettes and thus buy too many for their own good
Insiders may know more than the public and be able to trade
stocks to their advantage. Very hard to police!!
Exteralities - Steel plant ruins stream for fishing. => Laws prohibit this.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Government now allows select firms to trade their "rights to pollute." Is this right? How
are rights given out initially?
If the Government wishing to reduce hurricane insurance costs mandates that people not
rebuild their homes near the water, then the value of land is reduced.
Recycling: Have required bottle deposits. Have imposed fees to allow use of dumps.
Property Rights. Owner of land can require that pipeline builder restore surface.
Coase Theorem 'When parties can bargain without cost and to their mutual
advantage, the resulting outcome will be efficient, regardless of how the property
rights are specified.' Farmer requires that the train company clear a path to curtain
sparks starting a fire and pay farmer for loss of land.
Public Goods - Are nonrival (have MC=0 for additional users) and are nonexclusive
(no one can be excluded from using them). Example lighthouse. Such a good is hard to
collect for use. Historically farmers maintained or did not maintain roads across their
places. Tolls were collected. This system was replaced with public roads.
NJ Toll road => get a ticket and pay when you get off.
Garden State Parkway => pay a fixed fee every so many miles.
Clean air is nonexclusive BUT rival. One person's pollution hurts the car behind!!
Public Goods - Defense. Immunization. Should select religions be allowed to reduce their
risk at the expense of others? How should this be decided?
Why are churches given tax breaks while the same is not done for pubs?
Communities have historically paid for their schools from the tax base. Some
communities have been willing to pay more. Recent policy in a number of states
mandates state level funding. Who benefits? Who loses? What will the effect of such a
policy be on high schools in poor neighborhoods, in high neighborhoods, on private
schools?
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Discussion: Historically the US has required service in the military in time of war.
In the Civil war those drafted could buy someone else to serve.
During WWII key occupations (farmers) were not drafted and others with
special skills were placed in certain positions.
During Vietnam the more well to do "hid out" in college. The poor were not
paid to go in their place.
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Linear Programming
Discussion Example
Assume you are placed in charge of a factory packing fish products. Two products
are produced: fish cakes (for human consumption) and fish meal (for animal
consumption). The production process involves Separating (take light meat off fish for
cakes), shredding, packing and canning. Workers are trained for each task. The sales
price of fish cakes is $.80 per pound and fish meal is $.70 per pound. Labor requirements
per 1,000 lb are:
As manager you want to know how to maximize profit by determining how many fish
cakes and fish mean pounds to produce. In addition you want to know how much profit
would change if you were to retrain workers from separating to shredding etc. The
reading lists shows various way to setup the problem.
Setup
The b34s setup for this problem (comments begin with /$) is:
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
With answers:
1 2
1 22.7800 13.6700
2 10.6000 8.83000
3 14.4600 17.0900
4 5.00000 5.00000
0.800000 0.700000
Primal values
2.83325 8.60335
Dual values
The answers indicate that profit = $8,288.94 and the production of fish cakes and fish
meal should be 2.83325 and 8.60335 thousand pounds respectively. Since the shadow
price of separating labor and canning labor was 0.0, this suggests that adding more labor
in this area is not needed. Depending on the prices of labor in shredding and packing,
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
more labor could be added provided that the cost of the labor is less than the shadow
price.
Given the base case = 8.288942665534615. If one more hour of shredding is allowed,
= 8.355332303514723. Note that profit has increased by the shadow price of .
066389. If one more hour of canning is added, then the objective function moves up .
00665767 to 8.295600330639099. The reader is encouraged to run the job fish.b34 to
verify these numbers.
If the primal is
Max CX
s. t . Ax B
the dual is
Min V Bw
s. t . A' w C
Sample LP programs:
Max 5x 3z
s. t 3x 5z 15
5x 2 z 10
12.36842105263158,
x = 1.05263 2.36842
w = 0.263158 0.842105
There will be no unique solution if a constraint is parallel to the objective function such
as:
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
Max 2.5x z
s. t . 3x 5z 15
3x 2 z 10
Min V 2 x 3 y
x y 4
6x 2 y 8
x 5y 4
x 3
y 3
can be written as
Max V 2 x 3 y
x y 4
6 x 2 y 8
x 5y 4
x 3
y 3
Verify that at the solution V = -4.0, the primal is ( 1.14286 , 0.571429) and
the dual is ( 0.0, 0.25, 0.50, 0.0, 0.0).
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
The Grimes Gravel Company produces three mixtures of sand, pebbles and rocks for
eventual sale in 20-kg bags to the home handy person for use in cement work. The sandy
mixture is composed of 10kg sand, 7k pebbles, and 3 kg rocks. The pebbly mixture is
composed of 6kg sand, 10 kg pebbles and 4 kg rocks. The rocky mixture is composed of
2kg sand, 8 kg pebbles and 10 kg rocks. The market prices prevailing ate $2.75 for the
sandy mixture, $2.50 for the pebbly mixture and $2.25 for the rocky mixture. Games
Gravel feels that the market prices will hold regardless of the volume of each procust it
supplies. Games Gravel wishs to maximize sales revenue from its present plant and
equipment. The constraints on output are the limited size of the storage bins for the sand,
pebbles and rocks. The bins hold 2000kg, 3000kg and 2000kg respectively and
replenishment of supplies can only be made once a week.
sm = sandy mixture
pm = pebbly mixture
rm = rocky mixture
s = sand
p = pebbles
r = rocks
10 sm + 6 pm + 2 rm LE 2000
7 sm + 10 pm + 8 rm LE 3000
3 sm + 4 pm + 10 rm LE 2000
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
1 2 3
1 10.0000 6.00000 2.00000
2 7.00000 10.0000 8.00000
3 3.00000 4.00000 10.0000
Primal values
Dual values
1 2 3
1 10.0000 6.00000 2.00000
2 7.00000 10.0000 8.00000
3 3.00000 4.00000 10.0000
Primal values
Dual values
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
The P. M. D. Light Company produces and sells three standing lamps. The contribution
to profit for these lamps is constant at the following levels regardless of output level:
Model A $8.75, Model B 13.25, Model C $16.80. All three models go through the basic
assembly process; then models A and B go through fabric installation process while
model C goes through the antique-bronzing process. The requirements of each model in
each process and the weekly availability of these processes are as follows:
If overtime labor is available for each process at $12.00 in place of the usual $8.00, what
should be done?
Model
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Microeconomic Study Notes (17/7/2012 Houston H. Stokes
1 2 3
1 0.200000 0.300000 0.350000
2 0.100000 0.120000 0.00000
3 0.00000 0.00000 0.800000
Primal values
Dual values
Summary: LP analysis can be used to allow micro theory to be used to solve real world
problems. In the oil industry and the airline industry, problems with > than 50,000
variables are common.
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