INTRODUCTION TO ECONOMIC REASONING: PRINCIPLES OF

ECONOMICS
MIDTERM NOTES
SYLLABUS
MID-TERM REVISION QUESTIONS

Session 1: Thinking like an Economist + primer on growth (DAPHNÉ)

Outline:
1. What is economics?
2. What are the big issues in economics: macro stylized facts (growth)?
3. How do economists tackle microeconomic issues (causality)?

Key Concepts
1. Capitalism and markets;
2. Growth, technology and innovation;
3. Inequalities and the State

→ Extensive notes on the reading assignment here

→ REALLY extensive notes on the slides here
→ Summary of most important considerations below

Définitions
1. Economics – the study of choices under constraints
2. Microeconomics – the study of a single, agent, firm, or market
3. Macroeconomics – the aggregated consequences of society making optimal decisions for themselves
4. Gross Domestic Product – the measure of the market value of the output of the economy in a given
period
5. Models – stylized world that explains how certain variables we are interested in are affected by a
limited number of factors

Modelling
- To study decisions and their consequences requires the measurement and modelling of variables of
interest – but one impediment on the measurement of two variables X and Y may be the fact that they
are endogenous (X may affect Y but both are affected by Z)
- Hence, this can be addressed by looking at natural experiments – or particular situations where a
change in X is exogenous (it is known that a change cannot be driven by Z, so any change must be
because of Y)

GDP
- Y (total output) = C (consumption) + I (investment) + G (government expenditure) + X (exports)
– M (imports)
- Methods of definition
1. Expenditure approach – total spending on all final goods and services produced in
the economy
 2. Income approach – all income received by economic agents contributing to
production
3. Value-added approach – sum of value added to goods and services across all
productive units in the economy – value added = the increase in the value of goods as
a result of the production process

Session 2: Long-Term economic growth —Luna

Graphs and key concepts:
Terminology: y= output per worker, L, is number of workers, c*=subsistence, A=
technology

“In a capitalist economy, innovation creates temporary rewards for the innovator, which
provides incentives for improvements in technology and reduce costs”
Economic models: How to see more by looking at less
Fisher’s hydraulic apparatus and the flow of the economy: Fisher demonstrating how prices
of goods depend on how much is supplied—demonstrates economic equilibrium, where the
price is determined
1. Demonstrated how interactions in the economy lead to an equilibrium price
→ Equilibrium: a situation that is self-perpetuating, ceteris paribus
→ Subsistence level is an equilibrium: wage or income that provides for bare necessities of
life
- “Movements away from subsistence equilibrium are self-correcting” because they
“automatically lead back to subsistence income”
2.3 Basic concepts: Prices, costs, and innovation rents
Ceteris paribus (prices of inputs, transparency in knowledge, risk knowledge), incentives,
relative prices, economic rent (the basis of how people make choices)
→ Economic rent = gains made from selling goods and services above the production costs
(economic profits)
- Goods that are more expensive entail market power and a deadweight loss since
price is above marginal cost

2.4 Modelling a dynamic economy: Technology and costs

Malthus and his theory: “Malthusian Trap to

the Industrial Revolution”: the period in which
the population rise is more significant than the
agricultural growth, leading to poverty and
starvation—when history overcomes this, there
is GDP growth
- The notion that the Industrial
Revolution ended the Malthusian trap in
Europe

The Malthusian Model

1. Capital is fixed (K)
2. The marginal product of labor is decreasing (productivity)
3. Endogenous population size: population increases
a. Thus, output per worker is lower. The industrial revolution and
technological innovation sees the increase in output per worker.
Malthusian model in relation to the diminishing average product of labour
- Diminishing average product of labour (diminishing returns), where the increase in
the factors of production lead to an eventual fall in AP. This depends on the
production function—relationship between output and input.
- Production function for farming: the amount of output produced by any given number
of farmers on a given amount of land—all other outputs are fixed (land) and output
varies with the amount of labour

KEY: The production function is Y=f(X), Y is a function of f(X), and X is the amount of
labour devoted to farming (the x value, variable), and Y is the output that results.
PRODUCTION FUNCTION DEMONSTRATES HOW INPUT CHANGES OUTPUT

Diminishing law of returns is foundational to the Malthus model: AP labour is

output/labour
- AP labour falls as the denominator increases
 - In relation to farming and Malthus: the concern that when each farmer had more
children, the input labour would go up, and with the input going up, the average
harvest would fall, and land may still be fixed
- Thus, incomes (per capita of the family) fall with the decrease in average
production
- Can relate diminishing law of returns to the flat part of the hockey stick
Malthus in relation to living standards and population increase
- Living standards depend on the population size, with a positive correlation between
the two—populations increase when they have enough means of subsistence (act of
supporting themselves)
- When there are higher living standards there are less complications in life and
hence, more offspring can be created however because of competition,
population growth plateaus and living standards fall (less food per capita)
- Applied: we have fixed supply of agricultural land, well-fed times will lead to
increased populations but eventually, incomes would fall due to the law of
diminishing returns. Then, the fall of living standards will lead to slow
population growth due to increased death and decreased birth, incomes
falling leads to…
- Incomes being fixed at the subsistence level (a standard of living (or
wage) that provides only the bare necessities of life)
- The subsistence level is an equilibrium income (self-perpetuating),
ceteris paribus (based on fixed population and income level)

The above graph explanation

1. At the medium population level, the wage is at point A, and the wages are higher at
point B, where the population is smaller because average product of labour is higher
2. “Real wage” diagram demonstrates that when wages are high, population growth is
positive and vice versa
 3. Point A: medium size population, A is the subsistence level. Population growth is at
A’, which is “0” which means no change—thus at A, population is constant and
wages are stable
4. Point B: higher wage lower population, where at B’, the population is
rising (positive)
5. Then, as population rises, the economy sees a decrease in wages, until equilibrium
is met again at A
a. Decrease in wages = decrease in population = equilibrium

Malthus in relation to technological improvement

- Consider that living standards did not improve that much in Britain during the
Industrial Revolution

Above graph explanation

1. Economy starts at A, medium sized population and wage at subsistence level
2. Technological improvement leads to an increase in the average product of labour,
wage is therefore increasing
3. Real wage line shifts upwards initially to point D—the diagonal shifts entirely upon
increase in tech improvement because real wages in general increase
 4. Population has not yet increased, thus it is at point D—here, population begins to
grow to D’
5. However, this leads to the diminishing average product of labour, and the economy
moves down the real wage curve to C
a. Stays on the purple line because the “general” real wages still remain due to
the technological improvement
b. Hence, C coincides with the population at A’ or C’, where there is no change,
however it flatlines at a higher point of C rather than A (plateaus rather than
falls)
Malthus in relation to long-term economic stagnation
Principle idea that wages will always return to subsistence level—this leads to an
“oscillation” effect in population and wages, with many ups and downs. This can be the case
as it was in Britain from the 13th to 16th centuries.

Case study of Britain in relation to the hockey stick economic phenomenon

- Bubonic plague of 1348-50 kills off 25 percent of the population and labour supply
falls
- Consequently, wages rise after the plague calms down because of the
economic benefit for farmers and workers who survived—better land, workers
could demand higher wages: decline in the number of people working on the
farms leads to increase in agricultural productivity
- City wages also increase to attract workers from rural areas who now
enjoyed higher incomes
- This was the action of the market, however King Edward lll times to limit wage
increases, but this fails after peasant rebellions
- Middle of the 15th century: wages have doubled by then
- Increased wages allows the population to restore itself
- However, this also leads to the fall of incomes per Malthusian theory
 - By 1600, wages have fallen to pre-300 year levels: wages did not increase in the
long run, farmer wages fall again and farmers are now significantly poorer compared
to their landlords

Understanding the Industrial Revolution

1. Waves of innovation
a. Such as the rise of inventions such as the spinning jenny
b. Few workers, lots of capital goods, energy, labour-saving, capital-intensive,
energy intensive—this was incentivized by how the cost of labour increased
relative to the cost of energy, people switched to energy to allow for
decreasing the amount of labour (theory)
2. Rising wages, migration to the manufacturing sector
3. Urbanization
4. The agricultural revolution that made farmers more productive
→ Relative prices of production of factors created incentives to innovate
- High cost of labor and low cost of energy
- Innovation rent—profits made by business resulting from new processes (raising
comparative revenues until the new technology is more widely adopted and prices
adjust)
Wages and the Industrial Revolution: key idea that the cost of labour was high which
incentivized industrial production. Wages relative to capital goods—wages were higher than
capital goods (revenue), so many in England and France switched to less labour-intensive
modes of production.
- Population and wage increased at the same time
Escaping from Malthusian stagnation
- Malthus did not consider that the rate of technological development could increase
faster than the population, therefore leading to increased production (thus
diminishing average product of labor theory is null)
The “permanent technological revolution” demonstrates that:
Two influences on wages: how much is produced, and the share going to workers*
*Depends on workers’ bargaining power (to change wages—dependent on labor unions,
etc), and competition for the job (desirability for the job)
 - Population and real wages simultaneously increased around 1800, known as the
“Escape” from the Malthusian trap, occurred due to the technological, capitalist
revolution—technological improvement leads to increased productivity (noting that
productivity is what falls under the law of diminishing returns)

2.11 Capital and Investment

Capital—input into the production process, that accumulates in the economy
- Limited lifetime (machinery)
- This process is called depreciation—this is denoted with δ denoting the
percentage loss of capital
- Capital also has decreasing marginal returns, in that a double in the input (physical,
human, technological capital) does not equal a double in the output
Production function Y=f(X) — “X” as the capital per worker (capital per capita), also denoted
as “k”, hence f(k) = K/L (K=capital and k=capital per capita)

Productivity is denoted with the letter A, and we assume that it increases output
ceteris paribus— y=Af(k) denotes the positive proportional relationship between how good
technology is, productivity and f(k), the output (bear in mind that f(k)=f(X), where k and X are
output per capita)
In y=Af(k), y is the total output and A represents productivity and therefore indirectly
represents technological improvement

Investment is done by entrepreneurs to increase their capital stock

Per IB Notes:
- Investment in physical capital goods is important because it allows for a larger
quantity and quality of physical capital such as infrastructure, machinery, technology,
and roads. Physical capital is defined as produced factors of production.
- Quality of physical capital depends on technological advancement — one of
the most important sources of economic growth over lng periods of time
- Investment in human capital through education, training, sharing of knowledge can
increase the productivity and size of the labour force, the quality of labour
- Investment in natural capital (natural resources) such as trees, clean water, solar
energy, leads to sustainable production of goods

kt+1 is the “next period capital stock” and It

is “sum of investment” and (1 - δ)kt is
capital’s net of depreciation
- δ, as stated above is the capital
depreciation, so it is one minus that
figure, It is capital investment (added to the function) and Kt is the present capital
stock
- The capital acculumation equation (also known as the S olow growth model)
Explanation of the Solow growth model (see paper notes/graph)
- Demonstrates the changes in the output depending on population, savings, and
technological progress
 - The model assumes that population grows at a constant rate, that savings are
represented by a constant s, and that all firms produce output using the same
technology that takes in capital and labour as its inputs.
- Model further assumes that production function sees constant returns to scale (input
increases in proportion to output)

The question of how much the entrepreneur is to invest

Assuming that total investment is “s”, a fraction of total output per capita (that is not
spent on consumption, C)
- “s” similarly as the savings rate, since savings=investment, as long as the
economy is closed
- An open economy leads to exports/imports, while a closed economy
can only increase wealth by accumulating new capital
- Generally, in an open economy the savings will not be equal to
investments

Capital investment is calculated by the

formula above. Investments are equal to savings x productivity x function of capital stock

2.12 Capital Accumulation and Growth

What drives economic growth? Using the production function, we can study output and
that…
Whenever capital level increases, so does output—see IB Economics Notes

Economic growth:

An increase in real GDP over a given period of time usually annually measured by
percentage
PPC:
1. A movement within the PPC towards the production possibility demonstrates an
increase in actual output which can be due to the decrease in the costs of production
or a decrease in unemployment
2. A movement of the PPC outwards demonstrates an increase in production
possibilities such as consumer and capital goods and demonstrates an increase in
the quality or quantity of resources
3. A shift of the LRAS demonstrates an increase in potential output which can be due to
the reduction of production costs, an increase in the quantity or quality of resources

Examining capital accumulation and the production function

The economy’s capital stock over time: In economics, capital stock is the plant, equipment,
and other assets that help with production.
Key: the change in the capital stock = the sum of depreciation and investment (investment in
capital stock and the depreciation of the capital)
Considering/given that investment is a fraction s of total output, investment per unit of capital
is investment divided by capital(investment as displayed numerically in the formula 2 above,
divided by the units of capital).

Investment per unit of capital decreases and depreciation is a constant.

The intersection: k* is the “steady state level of capital”, or the equilibrium amount of
capital in an economy—this is where depreciation per unit is just as high as investment per
unit.
Why?
- Consider in comparison with the Malthusian economy
- In the figure above, suppose that capital stock is lower than the equilibrium
level
- In that case, investment is higher than depreciation
- Due to this, the capital stock grows as investment is higher than what
is being removed
- Removes towards the steady level k* as there is more to depreciate
- On the other hand, if capital stock is higher than k*, depreciation exceeds
investment
- In this case, capital stock will fall, thus returning to the equilibrium
ceteris paribus
- This particular model supposes that there is no growth due to capital accumulation in
the long run
- However, may not always be true due to technological progress and the
subsequent growth
- So to say that, increased opportunities for growth are found, and the
investment curve therefore tilts upwards—indicates that less investment leads
to higher capital stock, same amount of investment yields higher capital stock
- In other words, the shift of the long run aggregate supply curve lol
- Economic growth is equal to capital accumulation—growth therefore requires
continued technological progress

Convergence puzzle: convergence prediction holds when looking at similar

regions/countries but does not hold when looking at the whole sample of countries (do
economies converge or not)
- Holds even without any flow of capital between countries
 - There is a higher marginal product of capital in countries with low k, in that one
additional unit of capital is more useful with low k (consider this in relation to
countries with low capital)

-
- Countries with higher level of capital per capita and higher TFP have higher marginal
product
- Investment is lower, the constant is of the Solow growth model is lower, and the
marginal product of capital is lower with lower TFP

Conditional convergence is where the TFP (total factor productivity is a measure of

productive efficiency in that it measures how much output can be produced from a certain
amount of input) is the same across all countries
 - Countries with different TFP will not converge, that is why only similar countries
converge
Implications on the Solow growth model:
- Return on capital in poorer countries is higher than in rich countries
- Within countries there is a higher rate of growth at lower levels of capital, and small
or negative levels of growth at high levels ot capital

Session 3: Resources and Economic decisions - Elyne

Lecture 3: Resources and Economic Decisions -- Consumer Behavior

Key Terms + Definitions

- Bundles = baskets = combination of two goods
- MRS: slope of the IC // how much of vertical good you’d be willing to give up to buy horizontal good
- MRT: slope of the production possibility frontier // shows that for the production of every additional
unit of one good, more and more units of other good has to be sacrificed.
- Budget Line: a feasible frontier containing all possible combinations of goods purchased given income
+ price
- Choice: is under constraint of how resources are scarce
1. Current vs. future consumption
2. Production of goods between 2 firms
3. Response of P and Q to revenue changes
- Marginal Product: change in output from +1 unit of input
- Slope of curve on output over input graph
- Feasible Allocation: set of basket of goods and services that can be produced given their inputs (scarce)
- Demonstrated with a feasibility frontier
- Production Possibility Frontier: demonstrates an output of two goods
- Anything outside is impossible; inside is inefficient

Understand the notion of opportunity cost and its difference from accounting cost
- Opportunity Cost: every economic decision has an opportunity cost equal to the value of the next best
alternative that is given up
- Accounting Cost: recorded cost of an activity

Understand the notion of preferences and its properties

- Complete: all bundles are ranked (of any two bundles, an agent
can say either A>B, B>A, or A~B)
- Transitive (personally rational/internally consistent): if A>B and
B>C, then A>C
- Non-satiation (more is better): if B has more units of one good
and at least the same number of units of the other good than A,
then B>A
- Preference of diversity: the willingness to give up a good for
another is higher when you have more of the good and lower when you have less of the good

Understand and justify the shape of indifference curves using the properties of preferences:
- Understand that bundles on the same IC represent the same utility level; IC curves further from the
origin represents higher utilities [bc higher budget]
 - ICs are convex (preference for diversity → the consumer begins to increase his or her use of one good
over another, the curve represents the marginal rate of substitution),
downward sloping (cannot be upward due to non-satiation) and do not cross
(intersection point will have two utility levels + violation of transitivity)

- Convex: consumers prefer variety, ex. Eating both sandwiches and

burritos during a week. Assuming you eat sandwiches everyday for
a week, you would probably be willing to give up lots of
sandwiches for a few burritos and vice versa.
- If you had reasonable amounts of of both, you’d trade
closer to a 1:1 ratio.
- Preference for variety implies IC are bowed in.
- Downward sloping: imagining an upward sloping IC curve, two
bundles on the same IC (A and B), but B has more burritos and
sandwiches than A does → violates the assumption of more is
better, implying that they are downward sloping
- Do not cross: Bundle A represents more of both goods than bundle
C on the other curve
- Because B is on the same curve as C, they should both be
equally preferred and thus A should be preferred to B and
C
- B also represents more of both goods than D and thus
should be preferred to D.
- However since D is on the same IC as A, B should be
preferred to A.
- Since neither can be preferred than the other at the same
time, this violates assumptions of transitivity and more is
better.

- Slope of the ICs is the MRS (the amount of vertical good I am ready to give up to get one unit of
horizontal good) → decreases along an IC (due to preference for diversity and convexity)

Special indifference curve:

- perfect complements are goods that consumers want to consume only in fixed proportions [two goods
which completement each other ex. Butter and jam; ipods and earphones]
- Example: Ipods are useless w/o earphones and earphones are
useless w/o ipods, however put together, they become a portable
stereo which is worth a lot.
- Extra earphones do not increase the usefulness of the
ipod and vice-versa → therefore these are consumed in
a fixed proportion.
- Two sets of earbuds and one ipod is no better than one set of
earbuds and one ipd, so bundle B lies on the same IC. [same
reasoning for buncle C]

- ICs are L-shaped curves with the link of the L all lined up in a straight line that passes through
the origin (the slope of this straight line represents the proportions in which two goods must be
consumed) = utility can only increase in fixed proportions

- If perfect substitutes: goods about which consumers are indifferent as to

which to consume [you can easily substitute them ex. McD fries and KFC
fries; Dominos and Pizza Hut]
 - One unit of a good is just as good as one unit of another good
- Example: Morton and Diamond Crystal are both salt brands → for most consumers, a
teaspoon of one salt is as good as the other regardless the amount possessed by the consumer
→ “perfect substitutes”
- ICs are downward sloping straight lines + MRS is constant (can interchange between two
goods at the MRS-rate at any quantity of either good)

Understand budget constraints and the price ratio: 𝑝𝑥𝑞𝑥 + 𝑝𝑦𝑞𝑦 = 𝑅

- Describes all the combinations of the goods that agents can consume given their revenue and the price
of the goods

- States that expenditures of the agent cannot exceed their income

- Possible but irrational to spend less R (since what is not consumed is lost)
- As PaA and PbB < R, we are stating that the cons cannot spend more than his income but can
spend less → focus on the frontier of the budget (consistent with the more-is-better
assumption if you can consume more you should because you will be better off), we can then
write the budget constraint as:
- PaA + PbB = I
- Budget line: indicates the possible bundles the consumer can buy when spending all his income
- Slopes downward, constant slope → if you buy more of one good, you’ll have less of the other
good
- The rate at which you can trade one for the other is determined by the price of the two goods,
and they don’t change.
- Slope of the BL: rearrange PaA + PbB = I to isolate B on one side:

-
- I/Pb is the vertical intercept [max quantity of B that can be bought with this
budget]
- -(Pa/Pb) is the slope of the coefficient on A
- Slope represents the OC of consuming more of A because it describes how
much of B the consumer has to given up to consume more of A
- Price ratio: slope the budget line is the ratio of prices → the rate at which
you can trade one good for the other in the marketplace

- In graphical representation, the BC (budget constraint) is downward sloping with the

magnitude of the slope −𝑝𝑥/𝑝𝑦 , as the price ratio, horizontal intercept 𝑅/𝑝𝑥 (which is the max. quantity of
𝑥 that can be bought with this budget) and vertical intercept 𝑅/𝑝𝑦 (which is the max quantity of 𝑦 that
can be bought with this budget)
- Understand that allocations under the BC are feasible, but the rational agents choose to consume their
full budget, so the optimal allocation must be on the BC (non-sation: more is better) → anything that is
not consumed is lost

Understand that the optimal choice is when the BC is tangent to the IC

- At the optimal point, MRS = the magnitude of the slope of the IC = the magnitude of the slope of the
tangent = the magnitude of the slope of the BC = the price ratio
- Understand what the equivalence of MRS = price ratio implies: whatever we want to give up of vertical
good for the one unit of horizontal good is possible at this market price ratio
 - Understand what happens if MRS > price ratio (want to give up more vertical good than what we
actually need to pay, so we can use the excess to get more of the horizontal good) and if MRS < price
ratio (want to give us MRS amount of vertical good but we don’t have enough to pay, so we need to
lower the amount of horizontal good we want)
- MRS = how much B the agent would be willing to renounce in order to get one more C
- MRT = how much B it would cost the agent to get one more C
- If MRS>MRT: benefit from a small increase in C is higher than cost from a small increase in
C
- optimal for the agent to buy more C and less B
- If MRS<MRT: benefit from a small increase in C is lower than cost from a small increase C
- optimal for the agent to buy less C and more B
- if MRS=MRT: benefit from a small increase in C is exactly equal to its cost
- no deviation from this point could increase utility

Understand what happens to the BC, IC and the optimal point given a change in revenue or price
- Substitution effect: how consumers’ consumption changes by changing relative prices.
- Always negative regardless the nature of product --- when P ↑, Qd ↓; when P↓, Qd ↑
- Income effect: how consumers’ consumption changes when consumers’ purchasing power (real
income) changes due to change in price of one good.
- When price of Product A falls, consumer’s real income ↑.
- Increase in revenue = pure income effect: BC shifts outwards, and new optimal point on a higher IC
(quantity of good consumed increases if revenue increases if good is normal, and decreases if inferior)
- Increase in income shifts the BC outwards + optimal bundle lies on a higher IC
- Within the optimal bundle, either qb or qc both increase (normal goods) or one may increase
while the other decreases (normal good + inferior good)

- Increase in price of horizontal good = both income and substitution effect: BC

pivots inwards along horizontal axis, and new optimal point is on a lower IC
- Substitution effect: Pc increase → SE always negative → Qd of C
increases
- Income effect: (assuming it’s a normal good) → IE always positive, real
income decreases, Qd decreases → can afford less

- Understand that the substitution effect switches consumption from the more
expensive horizontal good to the less expensive vertical good
- Understand that the net effect is the agents consume less of the horizontal good (unambiguously) but
that effect on the vertical good is ambiguous depends on which of the income or the substitution effect
dominates (quantity of good consumed increases if its price decreases if good is ordinary, and
increases if its price increases if good is Giffen)
Understand the production possibility frontier and the feasible set from the perspective of a production agent
- Understand that the PPF represents the tradeoff between producing different output for a given amount
of input
- Understand that the magnitude of slope of the PPF is the marginal rate of transformation: how much of
the vertical output must we not produce in order to be able to produce an extra unit of the horizontal
output
- Understand that the PFF is concave because of the diminishing marginal productivities of the input in
producing different output (if each marginal unit of input produces less marginal output, then at higher
levels of output, we need more input for each additional unit of output, and so the MRT increases (the
slope decreases) as the amount of the horizontal good increases
- Understand that the optimal bundle is still the tangent point between the PPF and the IC (MRS =
MRT): the amount of the vertical good is willing to give up for an extra unit of the horizontal good
(MRS) is exactly the amount of the vertical good the agent would need to not produce in order to
produce that extra unit of horizontal good (MRT)
- MRS = how much B the agent would be willing to renounce in order
to get one more C
- MRT = by how much the agent need to reduce the production of B
to increase the production of C by one unit
- If MRS > MRT: benefit from a small increase in production of C is
higher than cost from this small increase in C
- Optimal for the agent to produce more C and less B
- If MRS < MRT: benefit from a small increase in production C is
lower than cost from this small increase in C
- Optimal for agent to produce less C and more B
- If MRS = MRT: benefit from a small increase in the production of
C is exactly equal to its cost
- No deviation from this point could increase utility

- Understand that the BC is in fact a special PPF where the MRT is constant and the input is money
(money’s value does not change in the quantity of goods we produce; money has no diminishing
marginal returns)
- Consumer’s budget constraint and society’s production possibilities frontier → budget
constraint and the PP show the constraint that each operates under
 - Both show tradeoff between having more one good but less of the other
- 1. Marginal rate of substitution (MRS) is the slope of Indifference curve whereas Marginal
rate of transformation (MRT) is the slope of the production possibility frontier.
- 2. Marginal rate of substitution (MRS) is the rate at which a consumer is willing to
substitute one good for each additional unit of the other good whereas MRT shows
that for the production of every additional unit of one good, more and more units of
other good has to be sacrificed.
- 3. As we move along the IC ,value of MRS keeps on decreasing whereas As we
move along the PPC, the value of MRT keeps on increasing
-

Understand the working hours model with leisure and consumption

- Understand that the input variable here is time (and again that time like money does not have
diminishing marginal returns)
- Understand that a change in wages generates the same effects a price change in the canonical model:
hour’s worth of wage costs one hour of our time, so if wages increase, then we can get the original
wage for less time, so this is as if wage is less expensive in terms of time or that the time-price of
wage has fallen + this generates both a substitution effect and an income effect (with ambiguous
effects on the hours worked and a clear increase in consumption)

- Understand how the empirical implications of this model on the evolution of wages and working hours:
- at times of low economic development, any wage increase, if transformed primarily into
consumption instead of leisure, and people worked more to benefit -- so the substitution effect
dominated; with high economic development, any wage increase is then spent more on leisure
and so working hours fell -- large income effect offsets substitution effect

Session 4: Social Interactions and Institutions - Trish

Key concepts in this chapter [check conclusion of this chapter on Moodle]

- Game
- Rational Players
- Actions
- Payoffs
 - Best response
- Dominant strategy equilibrium
- Social dilemma
- Altruism
- Reciprocity
- Inequality aversion
- Nash equilibrium
- Public good
- Prisoners’ dilemma
- Institutions
- Power
- Bargaining power
- Allocation
- Pareto criterion/domination/improvement
- Pareto efficiency
- Substantive and procedural concepts of fairness

Key Terms
- Game Theory
- Social Interaction: two or more people + their actions taken by each person affects both their
outcome and people’s outcome\
- Pay off: the incomes two players would receive if hypothetical rows and column actions were
taken.
- Common Knowledge of Rationality: every player knows every other player is trying to
maximize their utility
- When two or more agents interact knowing that their outcomes depend not just on
their own actions and strategies but also on the actions of others
- Self-interest
- Fairness for all
- Concern for others
- Social Dilemma → when people don’t take adequate account of the effects of their decisions
on others like climate change
- ‘Business as usual’ - Stern
- ‘Tragedy of the Commons’, Hardin: goods that are common property (atmosphere or
fish) are easily overexploited unless we control access in some way
- Free Riders

Game Theory
- 3 important terms:
- Strategic interactions: ppl engage in social interaction and are aware of how their
actions affect others
- Strategy: action that a person may take when that person is aware of mutual
dependence of results for themselves → outcome depends on their and other ppl’s
actions
 - Games: models of strategic interactions; a way of understanding how people interact
based on the constraints that limit their actions, their motives, and their beliefs about
what others will do
- Important Motives: self-interest, a concern for other, preference for fairness
- Interactions involve a conflict of interest but also opportunities for mutual gain
- Self-interest can sometimes lead to results that are good for all of bad for all
- Self-interest can be controlled for the general good in market: govt limiting people’s
actions, peers imposing punishments
- 4 elements:
- Players: How many agents interact
- Actions: what is the set of actions that each agent can take?
- Payoffs: what is the utility that each agent derives from the actions he can take, given
the actions others can take?
- Information: what do agents know when they take action?
- Simultaneous move: all agents decide on their action at the same time, this
w/o observing the actions of the others
- Sequential move: agents take their actions sequentially, and each observes the
action of its predecessors
- Assumptions:
- Stable preferences: utility from a given action does not change during the course of
the game
- Aim to max own utility [depends on what others are getting, doesn’t necessarily
imply selfishness]
- Each agent knows/expects other agents to seek their own max utility as well
- General modelization:
- Does not limit the number of actions (can even be a continuum of actions as in the
case of wage-setting)
- Can have more than two players with different set of action sand payoffs
- Can have more than one period (e.g. sequential moves with different sequences,
repeated game)
- Information is not necessarily complete
Solution Concepts
- Best response:
- The action that maximizes his utility for a given action of the other player
- Dominant strategy:
- The action that is is always a best response for any action of the other player (may
not exist)
- Dominant strategy equilibrium:
- As the equilibrium in which each player pays his dominant strategy
- This does not always happen but when it does we predict these are the strategies that
will be played as it is not affected by what they expect the other person to do
- Although they independently pursued their self-interest, they were guided ‘as if by an
invisible hand’ (4.2) to an outcome that was in both of their best interests
- Nash equilibrium
- Situation in which each player’s action is the best response to the others’ action (but
not necessarily to all possible others’ actions as in a dominant strategy equilibrium)
→ mutual best responses to each other
 - Gives us a prediction of what we should observe → expect to see other players giving
the best they can since the others are too
- Stable since no player finds it optimal to deviate
- A dominant strategy equilibrium is always NE but a NE does not always have to be a
dominant strategy
- A dominant strategy is the best response if others are playing their best response to
this action
- NE is a stability notion not a preference notion
- If there are more than one Nash eq, and ppl choose their actions independently, an
economy can get ‘stuck’ in a Nash equilibrium in which all players are worse off than
they would be at the other eq.

Prisoner’s Dilemma
- Strategic interaction: when players’ payoff will depend not only on what choice they make
but also on the other’s choice
- Prisoners’ dilemma: two players who are separated and unable to communicate choose to
protect themselves at the expense of the other participant.
- Thus the predicted outcome is not the best feasible outcome and both participants find
themselves in a worse state than if they cooperated with each other
- The tension between individuality (focusing on your optimal choice), rationality (knowing
that the other player is trying to maximize their utility as well), and social optimality (what is
the best option for both but not necessarily the NE as players have an incentive to unilaterally
deviate)
- Careful with conflating cooperation with equilibrium as sometimes it is not clear they are
cooperating. It may just be financially driven, etc.
- The contrast between the invisible hand game and prisoners’ dilemma
- Self-interest can lead to favorable outcomes but can also lead to outcomes that
nobody would like.
- Help us understand how markets can harness self-interest to improve the workings of
the economy but also the limitations of markets.

Infinitely Repeated Games

- The repeated game can be finitely repeated or infinitely repeated
- Strategy = set of actions taken conditional on what the other has played
- A strategy is an action (no observation of the actions of the other before)
- Permanent retaliation: possibilities of punishment, in response to the action taken by the other
player in the past
- Cooperation is impossible in a one-shot game as it is not the NE
- However, when repeated games are modelized with:
- Perfect recall (players remember exactly what was repeated this far)
- Multiple period strategy (no longer action per player but action per period per player)
- Both players denouncing is an NE → assuming that robber 2 denies, robber 1
will denounce; assuming that robber 2 denounces, robber 1 will denounce;
assuming robber 1 denies, robber 2
denounces; assuming robber 1 denounces,
robber 2 denounces
- Always denying regardless of what the other
player does is not an NE → because it is
 unstable since there is an optimal to deviate to
- A threat of future punishment in infinitely repeated games can sustain
cooperation (deny/deny) → permanent retaliation
- Play deny if the other player has been playing deny, play denounce if
not
- Deviating to denounce might benefit you this round (getting 0 instead
of -1) but in future rounds you get (-4 instead of -1) because of the
above rules → short-term profitable deviation vs. long-term
punishment
- This play creates a negative social mechanism to counter the
individually rational response to choose denounce

Altruism
- Altruism/Altruistic Preferences: willingness to
bear a cost in order to increase the
satisfaction/utility of another person
- People generally do not care only about
what happens to themselves but also
happens to others
- An example of social preference. Spite
and envy are also social preferences.
- Model: one player derives utility from both its
own outcome and the outcome of the other
player
- Rehashing of payoffs as a weighted
average of a player and his opponent’s
payoffs
- Note that the presence of a subsequent equilibrium is fully dependent on the choice of
weight
- Intuitively, if every agent internalizes the consequences of their actions on others, then the
outcome should be more efficient for society
- Altruistic and non-altruistic preferences can be represented in an indifference curve on a
graph of the two agents’ payoffs’

Social Outcomes and Norms

- Social Norms: an understanding what is common to most members about what people should
do in a given situation
- Role of social norms (fairness, inequality) in generating cooperative behavior
- Three dimensions: efficiency, equality, fairness
- The Ultimatum game → (two-person one-shot) is a common tool to study social preferences
- Take it or leave it offer
- Sharing economic rents
- The game tree is a useful way to represent social interactions → clarifies who does
what, when they choose, and what are the results
- Sequential game vs simultaneous game
- Minimal acceptable offer:
 - The offer at which the pleasure of getting the money is equal to the
satisfaction the person would get from refusing the offer
- Getting no money but being able to punish the Suggest for violating the norm
of 50-50.
- Theoretical result:
- Proposed will accept as long as they are given more than 0 because if he
rejects he still gets 0
- Proposer knows this so they propose the bare minimum
- Reality:
- People have an expectation of fairness so the typical offer is 70-30
- But is fairness driven by pro-social feelings or punishment? Is it specific to
culture and relationship with the other person?
- Dictator game: where fairness and punishment are intertwined
- Same setup but proposal cannot be rejected
- The offer generally shifts to 80-20
- 4.8: Fair farmers, self-interested students?
- Theory: responder in the ultimate game who cares only about your own
payoff, accept any positive offer →
self-interested world, can be expected
for the responder to accept anything,
even the minimum possible amount
- Reality: does not happen → example
with fractions of pie being offered to
US uni students and keynan farmers
- Kenyan farmers unwilling to
accept low offers, regarding
them as unfair, whereas US
students accepted it
- Indicates attitude towards
what is fair and how
important fairness is + no one
was willing to accept an offer
of 0, even though by rejecting
it they would also get 0
- Ultimatum game experiments: outcome of a negotiation could be different if it’s
affected by competition or adding people [ex. Professor looking for a research
assistant could consider different applications]
- In the case where a Proposer offers a two-way split of $100 to two
respondents, how would the money be split?
- When there is competition [i.e. more than one player], responders are
less likely → behavior like self-interested individuals concerned
about their own monetary payoffs
- When they reject a low offer, they get a zero payoff; unsure whether
proposer will be punished since the other responder can take the
lower offer
- Fair-minded people will accept low offers to avoid the worst outcome
[nothing]
 - Proposers knowing this will make low offers which the responders
will accept
- Small change in the rules or situation can have a big effect on the
outcome

Pareto Criterion
- Pareto Efficiency: you cannot make anyone better without making someone worse off
- Static concept
- Anything that cannot be Pareto improved on
- Pareto Improvement: any change that makes everyone at least as well off and at least one
person strictly better off
- Comparative concept (needs to be compared to an original allocation
- If an allocation is Pareto Efficient, there is no alternative allocation in which at least one party
would be better off and nobody worse off:
- Limitations;
- Often more than one PE allocation
- Does not tell us which PE is better
- If Allocation is PE, does not mean we should approve of it as the concept has
nothing to do with fairness
- How to check if outcome is PE:
- Point on graph: choose any point on the boundary of the feasible set of outcomes, and
draw the rectangle with its corner at that point: there are no feasible points above and
to the right
- Game: check that it is impossible to make someone better off with a different
allocation without making other players worse off + check that there are no Pareto
improvements possible
- Any proposal that is accepted in the ultimatum game is Pareto efficient: any redistribution
must make one person worse off
- Not really possible to compare Pareto efficient outcomes
- No fairness consideration in the definition of Pareto efficiency

Lorenz Curve + Gini Coefficient

- Lorenz Curve: a measure of income/ wealth
disparity in a population
- Characteristics
- Horizontal axis: ranks
individuals from poorest to
richest
- Vertical axis: cumulative
wealth
- (x, y) → the poorest x% of
the population hold $y of the
total wealth
- Shape
- Curve bows downwards: at
the upper end of the ranking they add substantially more to the cumulative
wealth of the economy (the rich are substantially richer)
- The deeper the bowl the bigger the disparity
 - Gini Coefficient: used to numerically calculate the size of the disparity
𝑎𝑟𝑒𝑎 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝐿𝑜𝑟𝑒𝑛𝑧 𝑐𝑢𝑟𝑣𝑒 𝑎𝑛𝑑 𝑡ℎ𝑒 45−𝑑𝑒𝑔𝑟𝑒𝑒 𝑙𝑖𝑛𝑒
- 𝑡ℎ𝑒 𝑎𝑟𝑒𝑎 𝑜𝑓 𝑡ℎ𝑒 𝑤ℎ𝑜𝑙𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑡𝑟𝑖𝑎𝑛𝑔𝑙𝑒 𝑢𝑛𝑑𝑒𝑟 𝑡ℎ𝑒 45−𝑑𝑒𝑔𝑟𝑒𝑒 𝑙𝑖𝑛𝑒

Evaluating Fairness
- Pareto efficiency + Gini’s coefficient are objective criteria about efficiency and inequality
- Fairness is a subjective criteria that depends heavily on what values you have as an individual
and community
- Substantive judgments of fairness: inequality based on the characteristics
of the allocation itself, not how it was determined
- Is the result/outcome fair for all players?
- Based on inequality
- Income: reward in money [or equivalent] of the indv’s
command over valued g/s
- Happiness: economists have developed indicators by which
subjective wellbeing can be measured
- Freedom: how much one can do w/o socially imposed limits
- Procedural fairness: evaluating an outcome based on how the allocation
came about, and not on the characteristics of the outcome itself
- Is the set-up fair for all players?
- Rules of the game that brought about the allocation evaluated
through:
- Voluntary exchange of private property acquired by
legitimate means: were actions leading to allocation a result
of freely chosen actions? Or was fraud or force involved?
- Equal opportunity for economic advantage: did ppl have
equal opportunity to have a large share of the total to be
divided up, or were they subjected to some form of
discrimination?
- Deservingness: did the rules of the game that determine the
allocation take account of the extent to which an indv worked
hard, or upheld social norms?
- No definite threshold to fairness, but something that is too unequal is deemed unfair → some
inequalities are fair and some are unfair
- Evaluating fairness: John Rawls’ ‘Veil of Ignorance’
- Adopt the principle of fairness that applies to all people
- Imagine a veil of ignorance: not knowing the position that we would occupy in the
society we are considering
- Behind the veil of ignorance, we can make a judgement:
- Veil of ignorance allows you to consider the situations of people different
from you --? Able to evaluate constitutions, laws, inheritance, etc impartially
- Assume you forgot everything about yourself, is the institution setup still fair?

Extras from Textbook

- 4.5: Public goods, free riding, and repeated interaction

- Ex: Spain and SEA farmers rely on a shared irrigation facility to produce their crops.
It requires constant maintenance and investment but each farmer faces the decision of
 how much to contribute to these activities. It benefits the entire community, and the
farmer can choose not to contribute but others can still do the work anyway.
- The irrigation system would be an example of a public good
- Social dilemma (free-riding): there is a higher payoff when you don’t contribute so
not contributing becomes a dominant strategy
- Public goods are a prisoners’ dilemma with more than two players
- Everyone would benefit if everyone cooperated but irrespective of what other
do, each farmer is better by free-riding on others
- Altruism could help solve the free-rider problem but if many people are involved in a
public good game it is less likely that altruism would be sufficient to sustain a
mutually beneficial outcome
- In the real world, farmers and fishers have faced public goods in many cases with
great success
- Eg: irrigation projects in India and Nepal shows that the degree of
cooperation vary based on socio-economic factors and historical context.
Overall, the less unequal a village was the easier it was the maintain the
irrigation systems
- Repeated games:
- Ongoing relationships are an important feature of social interactions so free
riding today can have consequences on the future
- How might players change their decisions over time?

- 4.6: Public good contributions and peer punishment

- An experiment showed that people can sustain high levels of cooperation in a public
goods game as long as they have the opportunity to target free-riders once it becomes
clear who is contributing less than the norm
- Most plausible explanation is not altruism but rather that people adjusted their
contribution depending on how much others for putting in and whether they were free
riding on them
- High contributors liked to punish the low contributors for their unfairness
- Since the payoffs of free riders depend on total contribution, the only way to
punish free riders is to stop contributing → tragedy of the commons

- 4.11: Institutions and power:

- We’ve seen: how the game is played, how the size of the total payoff available to
those participating, how this total is divided
- We will now consider how:
- Power is the ability to do and get the things we want in opposition to the
intentions of others
- Interactions between economic actors can result in mutual gains, but also in
conflicts over how the gains are distributed
- Institutions influence the power and other bargaining advantages of actors
- The criteria of efficiency and fairness can help evaluate economic institutions
and the outcomes of economic interactions
- Changing the rules of the game changes outcome → when two responders in the
ultimatum, more likely to accept lower offers bc neither is sure of what they will do
→ proposer offers lower, makes higher payoff
 - Power in economics takes two main forms:
- It may set the terms of an exchange:by making a take it or leave it offer (as in
the ultimatum game)
- It may impose or threaten to impose heavy costs: Unless the other party acts
in a way that benefits the person with power.
- Rules of the ultimatum game determine the ability that the players have to maintain a
high payoff -- the extent of their advantage when dividing the pie -- a form of power
called bargaining power.
- Power to make a take-it-a-leave-it offer gives the Proposer more bargaining
power than the responder, results in proposer’s bargaining power in limited
because the Responder has the power to refuse → there are two responders,
the power to refuse is weaker, so Proposer’s bargaining power is increased.
- Role Proposer or Responder, gene assignment of bargaining power, is usually
done by change → real economies, assignment of power is not random
- In labor market, power to set the terms of exchange typically is w/
businesses/factories: they proposes wages and other terms of unemployment
- Those seeking employment [responders], and w more than one person is
applying for the same job, their bargaining power may be low, just like
ultimatum game with more than one responder
- The power to say no:
- If Proposer simply divides a pie in any way, without anyway for the
Responder to influence this process
- Proposer has all bargaining power, responder none → dictator game
- Examples: The Democratic People’s Republic of Korea (North
Korea), and slavery, as it existed in the US prior to the end of the
American Civil War in 1865; criminal organizations involved in
drugs and human trafficking
- Institutions exist to protect people against violence and coercion, ensuring
that economic interactions are conducted voluntarily

Session 5: The firm and its employees/customers - Meggie

The firms and their employees

1. Explain the structure of a firm in terms of its hierarchy and power structure, and its
need for contracts

2 ways to coordinate economic actions in capitalist system:

Firm
Market

Firm: Form of coordination between agents characterized by

- Contracts between agents to coordinate work
 - Hierarchy with some agents having authority over others

Commercial organization that:

- Employs individuals
- Invests in equipment or intangibles to increase productivity
- Buys inputs
- Produces goods and services
- Sets its prices (at or above production cost)

Hierarchical structure:
Separation of
- Ownership (shareholders)
- Control (CEO/managers)
- Production (workers)

Top-down decision-making structure: Owners and managers have power over workers and
owners have power over CEO/managers
Contracts specify actions for contracting parties and coordinate activities
Divergents interests between different groups may arise

2. Explain how workers come up with a best response between how much effort into
optimally put in for a given wage

Claim: The higher the cost of job loss to an employee, the higher the effort level

Worker takes into account costs such as lost income, social stigma, loss of non-wage
benefits but also benefits to not working such as time and unemployment benefits

—> reservation wage = minimum wage level at which worker will start to produce an effort
(below this level they are indifferent between having and not having a job)

Best response curve shows optimal amount of effort worker will exert for each wage offered

Best response curve = firm’s feasibility frontier

 3. Explain the shape of the worker’s best response curve as concave and increasing:
effort increases as wage increases but marginally less so each time (diminishing
marginal effort in terms of wage)

Optimal effort by worker increases with wage offered by firm

Concave: Wage level is high increase does not raise effort as much as low wage level
—> diminishing marginal effort in terms of wage

4. Explain that the slope of the worker’s best response curve is its MRT: which is the
rate of transformation of wage int effort- here it is the amount of effort you’d put in
after receiving an extra unit of wage

Slope of worker’s best response curve is marginal rate of transformation of wage into effort
—> slope flattens with higher hourly wages —> MRT decreases with wage

5. Explain how firms choose a combination of effort per worker e, number of identical
workers N, and wage w to give by maximizing either total effort Ne or effort per wage
e/w subjet to a fixed budget S = Nw

S… amount firm can spend on its wage bill (we assume firm has fixed budget to spend on
wages) = Nw (= number of workers times wage)
N… number of workers (each of them get wage w=S/N)
Maximize profit: Maximize Ne (Ne = total effort)
Trade-off between magnitude of effort and number of workers

Ne = e/w x Nw = S x e/w

To maximize total effort, firm must maximize effort per wage

Shows a trade-off between magnitude of effort and numbers of workers

Many workers —> low wage —> low effort but lots of workers
Few workers —> high wage —> high effort but few workers
Irrelevant to firm because it aims to maximize total effort Ne

6. Explain how the isoprofit curve of a for represents a given total effort level (= total
profit level) and the combinations of wage for few workers or low wage for many
workers that achieve this total effort or profit level

Isoprofit curve: all the combinations of wages and effort that yield the same amount of total
effort Ne

Idea of isoprofit curve: if person exerts twice as much effort when firm pays her twice as
much, it is same thing to firm to have two people each put in half the effort

7. Explain how the slope the isoprofit curve is the effort per wage and that firms are
maximizing by pivoting isoprofit curves from the hirozontal axis in a
 counter-clockwise directions (steeper isoprofit curve higher profit) and that this slope
is the MRS of the firm between wage and effort (how much effort do we get out of an
increase in wage by one unit (since an increases in wage decreases the amount of
workers a firm can employ for a given budget, this increases the amount of effort the
firm would want to obtain from each worker)

The steeper the isoprofit curve, the higher the profit

Slope of isoprofit curve = MRS (marginal rate of substitution)

The slope tells us what increase in effort would compensate for the decrease in workers
when the firm raises wages by one unit (one dollar for example) and keep total effort
constant

(Stems from idea that firm has fixed budget and there is a trade-off between wage level and
number of workers)

8. Explain how a wage-setting equilibrium is reached when the isoprofit curve of the firm
is tangent to the best response curve of the workers, at which MRS = MRT

Wage-setting equilibrium always higher than reservation wage

Point where MRS = MRT —> isoprofit curve is tangent to best response curve =
efficiency wage = Nash equilibrium

Firm would like to produce at a higher isoprofit curve but this is outside of the feasible
frontier —> the highest point it can reach is where the isoprofit curve is tangent to the best
response curve
 9. Reconcile that at any wage-setting equilibrium, the wage is higher than the
reservation wage of the worker but then this means that fewer jobs are created due
to the firm constraint, such that there must be a certain level of involuntary
unemployment in the economy

The wage at equilibrium is always higher than the reservation wage as workers would not be
producing any effort at the reservation wage

Since all workers will work for a wage that is higher than their reservation wage there is
involuntary unemployment (workers not indifferent between working and not working,
there is a cost to job loss)

10. Explain what the costs and benefits of eventually losing a job are, what the concept
of a reservation wage is, and what an employment rent is, and explain how an
increase/decrease in unemployment rate or a decrease/increase in unemployment
benefits leads to a leftward/rightward shift in the best response, lowering the
reservation wage and also increasing the effort a worker puts in for a given wage

Costs:
- loss of income (potentially lower income with next job, loss of income during
unemployment)
- Cost required to start new job (relocation…)
- Loss of non-wage benefits (health insurance…)
- Social cost (stigma to being unemployed)

Benefits:
- Time
- Unemployment benefits

Reservation wage: Minimum wage level at which worker will start producing an effort
(before this, wage level is so low that people don’t care about keeping this job; no costs of
job loss)

Employment rent: difference between value of individual’s current job (wage minus disutility
of work) and value of what she could get elsewhere (next best option)

Employment rent per hour = wage - reservation wage - disutility of effort

Decreases/increases in unemployment rate or unemployment benefits shifts the best

response curve by changing the reservation wage
Increase in unemployment rate —> reservation wage decreases because jobs are scarcer
and people fear losing them more (= they will work for less) —> best response curve shifts
left
- Longer period of time to find a job after being fired —> Unemployment benefits tend
to decrease with time

Decrease in unemployment rate —> reservation wage increases because there are more
jobs, therefore its easier to find one —> best response curve shifts right

Increase in unemployment benefits —> reservation wage increases because the alternative
to working (= receiving unemployment benefits) is more lucrative —> best response curve
shifts right; higher average expected benefit per hour of unemployment

Decrease in unemployment benefits —> reservation wage decreases because loss of job
comes at a higher cost —> best response curve shifts left; lower average expected benefit
per hour of unemployment

Rightward shift: At any given wage level, worker puts in less effort
Leftward shift: At any given wage level, worker puts in more effort

11. Explain how an increase in unemployment rate (decrease in unemployment benefit)

makes workers put in more effort per give wage (or take less wage for a given effort)
and firms exploit this to produce a higher total effort level (= steeper isoprofit curve) +
explain how the new optimal point is now at a lower effort level and lower wage level
because firms choose to hire more workers and make them all work less for a lower
wage to exploit marginal productive effort of these workers
At higher unemployment or lower unemployment benefits workers put in more effort per
given wage —> positive relation between employment and wage
(Higher employment forces firm to pay higher wage and vice versa)
—> aggregate effect of wage-setting interactions between workers and firms

Firm can choose to hire more workers and make them all work less for lower wage —>
exploits marginal productive effort of workers: firms can move to higher isoprofit curve as
best response curve shifts left

12. Explain how an increase in unemployment and a lower wage translates into the wage
curve (negative correlation between wage and unemployment level/positive
correlation between wage and employment level)

Wage curve: relation between employment rate and average wage in the economy

How wage curve is derived:

X-axis: unemployment rate

We see that lower unemployment in the economy generates a higher wage and vice
versa—> convex and upward sloping
 The firms and their consumers
1. Establish that total cost and variable cost are both convex and increasing + marginal
cost is also increasing (each unit costs more to produce than the previous (note that
the convexity of TC/MC are both assumptions we make in this model that we need
not always hold)

Fixed costs: Costs that do not depend on the level of output, denoted F
Variable costs: Costs that increase with the level of output produced, denoted Cv(Q)

Total costs = sum of fixed and variable costs

C(Q) = F + Cv(Q)

Marginal costs: Costs of producing one additional unit of a good or service at any given
level of output = slope of cost function

Producing one more unit of good is more costly when quantity already produced is
higher

Examples of reasons:
- Cost of storage rises
- Firm has to start using less motivated employees or using lesser quality inputs
because all top employees/ inputs are already used

2. Establish that average cost is a tick-shaped curve:

Average cost: Cost per unit of output, denoted CM(Q)

Downward sloping section: The amortization of fixed costs decreases AC more than the rise
in a variable costs (F/Q becomes smaller and smaller at first which has an overwhelming
effect on the average cost and leads to a downward sloping AC curve)

Upwards sloping section: The amortisation of fixed costs is less and less effective and the
rise in variable costs is substantial (since MC is also increasing) so AC rises

3. Establish that at the minimum, AC is when the marginal cost just offsets the
amortisation of fixed costs such that producing the next unit will not change the
average costs

At the minimum AC = MC
—> The MC curve intersects the AC curve at its minimum
 4. Define total revenue as quantity of goods sold times the price of each good

TR = Q x P

5. Establish two versions of the profit equation

Profit (denoted π) = P x Q - C(Q)

Price = AC + π/Q (price = cost + profit)

Profit = PQ - C(Q) = total revenue - total cost

6. Understand how an isoprofit curve here is all combinations of price and quantity that
generate the same profit and the shape of an isoprofit curve depends on the shape of
the average cost curve

Isoprofit curve: Curve that links all combinations of price and quantity that give same profit

The lowest isoprofit curve = AC curve —>is the one with zero profit
All higher isoprofit curves are shifts of the AC curve further away from the horizontal axis (a
shift by the value of the profit)
 7. Understand that the magnitude of the slope of an isoprofit curve is the MRS between
preferring a higher price to offering a high quantity while making the same profit (the
change in price needed in order to seek one extra unit of quantity)

Slope of isoprofit curve = MRS between making profit from high price and low quantity or
low price and high quantity

8. Understand that the magnitude of the slope is also the ratio of profit margin over
quantity (how much more profit you can get per extra unit of quantity produced)

Π = PxQ - C(Q)
Implies that P = ∏/Q + CM(Q) —> expresses price as function of quantity at each level of
profit

The further away the isoprofit curve is from the origin (0,0), the higher the profit

9. Understand that the MC curve intersects the AC curve at its minimum and thus all is
profit curves at their minimum

MC curve intersects all profit curves at their minimum

Price > marginal cost —> selling one additional unit increases profit (firm must increase
output)

Price < marginal cost —> selling one additional unit decreases profit

Isoprofit reaches minimum when P = MC

 10. Understand how demand is the production possibility frontier for the isoprofit curves
of the firm, with slope as the MRT between price and quantity

Demand curve: How many units of a good would be bought by consumers at each price
level

Demand curve represents the number of consumers who have a given willingness to pay:
the higher the price, the fewer the buyers (downward sloping)

Depends on Willingness to pay (WTP): The satisfaction that a consumer derives from using
a good
- if satisfaction > price —> buys good
- WTP differs from consumer to consumer
- As price decreases, more and more consumers want it —> demand curve downward
sloping

Slope = MRT in the production of profit from price and quantity

Demand curve is PPF for isoprofit curves of firm because beyond it consumers would not be
willing to pay for the good

11. Understand how the optimum point is the tangent point between the demand curve
and the highest possible isoprofit curve for the firm: at this point, MRS = MRT (the
 amount that the price would need to come down by both allows more consumers to
buy and the firm to produce more)

Optimum point = tangent point between demand curve and highest possible isoprofit curve
for the firm —> MRS = MRT

MRS > MRT —> decreasing price by one unit would increase quantity sold by more than
increase that would keep profit constant = profit would increase

MRS < MRT —> increasing price by one unit would decrease quantity sold by less than
decrease that would keep profit constant —> profit could be increased by increasing price

12. Understand that since the demand curve is downward sloping, MRT can only equal
MRS on the downward sloping section of the isoprofit curve, and thus so the
equilibrium is always at a price > MC

Slope of demand curve always decreasing

Slope of isoprofit curve is only decreasing when price is above marginal cost
—> P > MC at optimum

13. Explain that the marginal revenue is the revenue gained from selling an extra unit

Marginal revenue: Change in revenue from selling an additional unit, denoted Rm

—> equal to the amount the firm gain from the extra unit but at a new lower price (= losses
made on the lower price at which all the other previous quantities must be sold)

Marginal Cost: Cost of producing one additional unit, denoted Cm

14. Explain that if MR > MC, then the marginal profit is positive and the firm should
continue to produce and if MR < MC, then we are marginal profit is negative and the
firm should produce less

MR > MC or Rm > Cm —> possible to increase profit by producing one additional unit above
what it costs to produce it

MR < MC or Rm < Cm —> Possible to increase profit by producing one less unit, since its
sold above what it costs to produce it

MR = MC or Rm = Cm —> profit maximized

 15. Explain how consumer surplus is the difference between the willingness to pay of a
consumer and the price they actually pay

Consumers benefit from the satisfaction they derive from the use of a good (WTP is higher
than price)

Consumer surplus: WTP - P

Total consumer surplus: Sum of the surplus of all the consumers who buy the good

16. Explain how producer surplus is the difference between the price they charge and the
marginal cost it took to pay, which is thus the profit + any fixed cost (which does not
appear in the graphical representation)
Producer surplus = Profit + fixed costs
Π = PQ - C(Q) > 0
Alternative definition: The difference between the price the firm got for their product and the
lowest price they were willing to accept (which covers their costs of production)

17. Explain how at the price > MC, there is deadweight loss in surplus generated that is
Pareto inefficient since the firm is choosing not to produce a quantity of good where
there are willing buyers and the firm could afford to produce

Deadweight loss (DWL): Loss in total surplus resulting from the price-setting strategy
chosen by the firm
—> triangle pointing towards intersection of demand and marginal cost curve

P = MC would be Pareto efficient but firm chooses to produce at point where P > MC
—> It is never optimal for a firm alone in the market to set price at P = MC
Reason: Slope of demand curve (MRT) is always negative so there cannot be a point where
MRS (slope of isoprofit curve) = MRT

18. Explain how forcing a single firm in such an economy to produce at the quantity
where P = MC would be Pareto efficient but not a Pareto improvement on the
monopolistic equilibrium since it would require the firm to give up producer surplus to
the consumer that is often not enough to compensate gains in surplus from
producing P = MC (can be made into a PI with transfers from consumers to
producers)
If firm were forced to produce where P = MC (intersection of demand and marginal cost
curve) part of current producer surplus would become consumer surplus
(loss of producer surplus equal to rectangular yellow area but gain only equal to small
triangle —> firm is worse off); Consumers better off

However, situation would be Pareto efficient as consumers or producers could both not
become better off without the other one becoming worse off

19. Define elasticity

Definition 1: The percentage change in quantity demanded divided by the percentage

change in price
Demand elastic if elasticity > 1
Demand inelastic if elasticity < 1

Definition 2: The responsiveness of the quantity demanded to a change in price

Careful: Elasticity varies along a straight-line demand curve and is not the same as the slope

20. Show that more elastic demand does not allow firms to raise prices since price
changes lead to large decreases in quantity and show that elasticity and profit
margins are negatively correlated

Elastic demand means that a raise in price will decrease total revenue for the firm as the
quantity demanded will decrease proportionally more than the increase in price

Inelastic demand means that a raise in price will increase total revenue for the firm as
the increase in price will affect the quantity demanded proportionally less
 Session 6: Competitive markets, market failures and public policies - Clotilde christie

Outline:

1. Market and competitive equilibrium

2. Market failures: market power
3. Market failures: price distortion
4. Market failures: Externalities and public goods
5. Market failures: information asymmetries

Key concepts:

- Competitive market
- Optimal choice
- Supply and demand
- Pareto-efficiency
- Price distortion
- Externalities
- Public goods
- Typology of goods
 - Asymmetric information

Shortcuts:
P : Price
Q : Quantity
MC : Marginal Cost
G: Good
≠ : differences

Definitions:

Competitive market: a situation where there is -

- HOMOGENEOUS goods and services are exchanged

- LARGE NUMBER of sellers and buyers
- Sellers and buyers all act INDEPENDENTLY of one another (no agreements
- Information about prices is EASILY ACCESSIBLE to all agents
(Les cinq hypothèses de la compétition pure et parfaite 5th one is transparency - information is clear
on both sides)

market failures:
- public goods
- market control
- externalities
- imperfect information

When a firm is the only one to produce or sell a good we say that it has MARKET POWER
- the firm is price maker
- consumers are price taker
On a perfectly competitive market:
- both firms and consumers are price taker

price maker: can choose combinations of price and quantities

price taker: can only choose the quantity that they want to buy but have no say on the price at which
they can buy

Optimal choice of quantity for a firm in a competitive market

Why are firms price-taker in a competitive market?

- many other firms that sell the same good
- if a firm sets its price above the market price, no consumer would want to buy it
- at the market price, a firm can sell as much as it produces (many consumers) - there are no
incentives to set its price below the market price to gain consumers
THUS:
 - the demand curve addressed to a single firm in a competitive market is HORIZONTAL
- optimal to produce until the point where the slope of the isoprofit curve is tangent to the
demand curve => optimal to produce untilt the point where an isoprofit curve has slope zero -
where it reaches its minimum
- at the minimum point: Q and P are such that MC associated with this quantity
- MC(Q) = P

Wait… but what IS an isoprofit curve?

- isoprofit curves represent a given profit level: the further from the HORIZONTAL axis, the higher the profit.
- since P = AC + profit/unit, we have that each isoprofit curve are just upward shifts of each other, w profit
per unit the size of the shift from the zero-profit curve (AC curve)
- the slope represents the MRS between preferring a high price to preferring a high quantity in making the same
profit
- MRS = Marginal Rate of Substitution
- the marginal rate of substitution between good B and good C is the amount of good B that an
agent is willing to give up to get one additional unit of good C (i.e. value of ∆qB for a unit
change in qC (∆qC = 1))
- for example: a consumer must choose between pasta and rice, to determine the MRS, the
consumer is asked what combinations of pasta and rice provide the same level of satisfaction
- for example, two cups of rice and one plate of pasta could provide the same
satisfaction as two plates of pasta and one cup of rice
- or how many cups of rice would provide the satisfaction of one plate of pasta

Back to optimal choice of quantity for a firm in a competitive market:

recall:
- A firm that can set at the same time its Q and its P (price-making firm) chooses a P above MC
- does not reduce its P to the MC, because selling one more unit means decreasing
the P on all previous unit sold
- increases Q sold until the point where, the decrease in P associated with one
additional unit sold is equal to the decrease in price that keeps profit constant
- could produce one more unit and sell it with a positive profit, but that would imply a
decrease in profits on the first units sold that is larger than the profit made on the
marginal unit sold
- this effect no longer plays out in a competitive market:
- the firm does not have to decrease its P to attract more customer, so selling more does not
not affect the profit realised on the first units(no trade off between P and Q)
- it produces until it cannot sell an additional unit without loss = unit MC(Q) = P

SUPPLY AND DEMAND (in a competitive market)

supply curve:
- the total supply of a good is the sum of the Q produced by each firm at this P level
- supply curve = relation between the price of a G and the total supply of this G
- The supply of each firm increases with the price level (they can produce more before
their MC = P level when this level is higher)
- therefore the total supply increases with the P level
- the supply curve is increasing
demand curve:
- demand from consumers decreases with the P of the G
- when the P level gets highers, less of them have a WTP above the P
- the demand curve is decreasing
BEWARE: although the demand curve addressed to each particular firm in a competitive market is
flat - the demand curve in the economy is decreasing.
As the P offered by all firms at the same time increases, the demand for the good decreases

competitive equilibrium:

a perfectly competitive market equilibrium is a pair of P and Q that

- firms and consumers in the economy are bother price-takers; they choose Q that they find
optimal taking the prevailing market price as given
- supply = demand at this P

This equilibrium is stable to disparities in Q demanded and supplied as the P adjusts accordingly to go
back to the equilibrium -
- if for a given price, demand is higher than supply, then firms can supply more to these willing
buyers but would need a higher pride to do so in order to offset the increased costs of
production; they do so until supply = demand and no incentive to sell more
- if for a given price, demand is lower than supply, then there are not enough buyers for the
supply that firms have produced, so firms produce less and only require a lower price to offset
the costs of production; again, they do so until supply = demand
- The equilibrium will change if there are exogenous non market shifters in demand or supply
- demand shifters are changes in preferences, income or even the demand of other
related goods
- example: the new trend in Dalgona sweets in SK following Squid Game is
such that the demand is higher for any possible price aka people a higher
WTP or more people have a given WTP)

- supply shifters are changes in technology or costs of production or the supply of other
related goods
- example: the arrival of the conveyor belt nanotechnology meant that we
could produce nanomachines fasters, so, at each price, we can now have a
higher supply

technology improves: a positive supply shifter

- supply curves moves from S to S’ - qty supplied increases for each price
- at old price, there is now excess supply so firms want the price to fall
- demand curve is unchanged BUT qty demanded increases to clear the market and can do so
with lower prices
- new eqm is at a lower p + higher qty

increased pref for goods: a positive demand shifter

- demand curves move from D to D’: qty demanded increases for each price
- at old price, there is now excess demand, so more buyers are WTB at this price
- supply curve is unchanged but the qty supplied increases to clear the market but need to do so
with higher prices
 - new eqm is at higher p + higher qty

Gains from trade:

- firms and consumers only trade is they benefit from it

- firm surplus comes from the profits + fixed costs = total revenue - total marginal costs
- consumer surplus comes from the usm of all the ≠ between WTP and actual price
paid
- social surplus is the sum of consumer surplus and firm surplus

- at the competitive equilibrium, the total surplus is maximised = no deadweight loss

- this is pareto-efficient, because it is impossible to produce more surplus + any
re-allocation of this same surplus would mean reducing the surplus of any agent
- however, producer’s surplus here is lower in competitive equilibrium than in the one
with market
- this means that going from the market power equilibrium to a competitive
equilibrium is not a Pareto improvement (even if it means getting a Pareto
efficient outcomes°
- which might explain why the GAFAM really struggle to let go of their market power
and allow more firms to enter

Pareto-efficiency:

- is a competitive equilibrium maximizes total surplus

- equilibrium is Pareto-efficient because impossible to produce more surplus - any other
allocation of this same surplus would mean reducing the surplus of some agent
- producers’ surplus is smaller than it would with one producer setting its combination of Q/P
In neoclassic economics, a pareto-efficient outcome is an outcome that harms no one and at least helps
one person

A situation is pareto-efficient if the only way to make one person better off is to make another person
worse off

Failure #1
Market power:

- assumption of the competitive market model = firms are price-taker

- a firm has market power when it can set its P and Q together = when its price-maker
- in that case: the firm sets its Q below the market Q, and its P above the competitive market P
- deadweight loss of total surplus
- this market-power equilibrium is not Pareto-efficient

Causes of market power:

- advertisement/marketing
- new models, innovations
- differentiate a product/make it uniques
 - other causes = entry barriers on the market
- natural obstacles to competition
- man-made obstacles to competition: authorization, licenses, patents, collusion and
cartels

Natural monopoly and natural oligopolies:

- a monopoly that is subsidized or that makes a zero profit has no incentives to try to innovate
or produce at minimum cost
- a monopoly with regulated prices has interest in misreporting its prices to the regulator and
inflating them ( = info asymmetries)

- the state can set up entry barriers on some markets

- necessity of an authorization (supermarkets)
- licenses
- patents
- possible benefits other than gains from trade on these markets
- but does give market power to firms in regulated sectors

Failure #2
Price distortion

things to know:

Social surplus is the sum of consumer surplus and producer surplus.

Total surplus is larger at the equilibrium quantity and price than it will be at any other quantity and
price.

Deadweight loss is loss in total surplus that occurs when the economy produces at an inefficient
quantity.

Price-floor - Minimum price:

- to protect producers/sellers
- regulator can choose to impose a minimum P (above market price)
- example: €pean agricultural policy included a minimum P on some agricultural products
- surplus of producer can increase, but total surplus always decreases thus it is not
Pareto-efficient

Price-ceiling - Maximum price:

- to protect consumers
- regulator can choose to impose a maximum P
- example: rent control
- the consumer surplus can increase, but the total surplus always decreases (not
Pareto-efficient)
Effect of tax:
- level tax t on a given G
- for each unit of the good they buy, a consumers pays P + t
- a producer receives P
- the regulator receives t
- in that case: total surplus = consumers surplus + firms surplus + regulator revenue form the
tax
tax creates a decrease in consumer surplus and firm surplus and an increase in regulator surplus but a
decrease in total surplus
-> loss of total/social surplus because some beneficial transactions no longer take place (not
Pareto-efficient)

Implementing price control or taxes, in a competitive market reduces total surplus - it’s
pareto-inefficient

this does not mean that these interventions are always to be avoided as markets are not always
perfectly competitive and even if they are, some other benefits/ policy objectives can compensate the
loss in social surplus

Failure #3
Externalities
Public goods

Externality: a cost or benefit resulting from an economic transaction that affects a third party not
involved in the economic transaction, and such that the effect of the transaction on this third party
is not internalized by the parties involved in the transaction

- negative externality if the effect is a cost for the third party

- example: pollution, congestion
- the social cost is above the private cost for the producer
- over-production as compared to what would be optimal, when Q/P are
decided on a competitive market that ignores the negative externality
- positive externality if the effect is a benefit for the third party
- example: vaccination, education, innovation
- the social benefit is above the private benefit for the consumption
- under-production as compared to what would be optimal, when Q/P are
decided on a competitive market that ignores the positive externality
What are the solutions?

- pigovian tax = tax applied to a G that generates negative externalities (subsidy in the case
of positive externalities)
- objective is to make produces internalize the externalities
- t = MC of the third party at the Q corresponding to the socially optimal quantity
- makes the private and social marginal costs equal at the socially optimal quantity
- limit = this requires that the regulator has a lot of information
- Rq : similar solution = setting quotas (quantity produced cannot be above the socially optimal
quantity) but requires information as well (and additional surplus does not necessarily goes to
the third party)

- open negotiations between the 3rd party, the producers and the consumers
- alternatively: open a market for the externality (the polluter could buy rights to pollute from
the third party, who can decided how much pollution to allow + get compensation for the
pollution he/she allows)
- limit 1 = works only if transactions costs are small (cost of opening negotiations/set up a
market I
- limit 2 = the final distribution of surplus depends on how the new good (rights to pollute) are
initially distributed (to whom are they given ?)

Public goods

types of goods:

- pure public goods are rare

- there is often congestion effects but they can be relatively small
- for goods, other than private goods: Q and P that would be obtained from a competitive
market equilibrium are not Pareto-efficient
- production of club goods produces positive externalities
 - difficulty of any private firm to make consumers pay for consumption of
non-excludable goods: no firm would produce them: under production
- = free rider problem
- even if common goods were freely produced, as consumers would not internalize the
negative externalities of their free consumption to other: over consumption

Position goods

- Veblen effect = consumption aims at distinguishing oneself from the others I position goods =
goods such that the satisfaction derived from them depends negatively from the quantities
consumed by others (everyone wants to be the only one to consume them, or to consume such
a high quantity of them)
- ⇒ negative externality associated with the consumption of these goods : it reduces the
satisfaction of others (over-consumption of position goods, Pareto-inefficient)

Failure #4
Information asymmetries

Symmetric information Asymmetric information

no agent has access to a piece of info to which some agents have access to pieces of info that
other agents do not have access others do not have

the characteristics of a G that are known by the when an action or characteristic is observed by
seller are also known by the buyer and vice certain agents but not by others, we say that it is
versa privately observed

does not necessarily imply perfect info, both

parties can be uncertain about the good but they
are uncertain to the same extent

2 types of asymmetries:

moral hazard: hidden action adverse selection: hidden attributes

the actions of one party are not perfectly
observed by the other party involved
example: employer cannot perfectly observe the
effort of the employee : they can agree on a
level of effort that the employee will not exert
afterwards
the attributes of a person/ a G are not perfectly
observed by one of the parties involved (but
they are by other other party)
example: insurance market, insurer might not
perfectly observe the pre existing health of
condition of the insuree
 - competitive markets are usually pareto-efficient in the presence of information asymmetries
- general theory about info asymmetries that has many possible implications:
- goods markets : quality better known by the seller
- labor markets : effort of the employee imperfectly observed by the employer
- financial markets : insider trading
- insurance markets : the insuree knows his/her risks better than the insurer
- natural monopolies : the monopoly knows its costs better than the regulator
- fiscality : agents that have to pay a tax can hide some of their taxable revenue/assets
from the regulator

The market for Lemons

refer to Lecture 6 Slides 63 to 68
short description: Akerlof which examines how the quality of goods traded in a market can degrade in
the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind.
Lemons - bad quality cars