EC201 Microeconomic Principles I

Welcome to the Course

Dr Dimitra Petropoulou, Department of Economics, MT 2021

 Meet the EC201 Team

Dr Dimitra Petropoulou Professor Tim Besley Ms Chiara Sotis

d.petropoulou@lse.ac.uk t.besley@lse.ac.uk c.sotis@lse.ac.uk
MT Lecturer LT Lecturer Course Manager
As well as our lovely class teachers: Agnes, Azhar, Chia-Hung, Ines, Kenan,
Linchuan, Nilmini, Tatiana, Tommaso, Will and Yasaman.
A bit about me
• I did all my studies at LSE from BSc Economics to PhD Economics (with a stint
in Management as well)

• My research interest lies in International Trade (which you might be

surprised to hear is an applied microeconomics field)

• But my primary academic interest now is in economics teaching and learning

• I am always happy to hear ideas from students – we are always

incorporating things into the course.

3
This term in a nutshell
Two big issues:
1. How do economic agents make decisions under constraints? How does
economic policy shape decisions? How can we assess welfare effects?
• Classical consumer theory; insights from behavioural economics
• Intertemporal choice; decisions under uncertainty; labour supply decisions
• Strategic decision-making

2. How do firms make decisions? How do firms interact in a market?

• Producer theory; market structure
• Game theory
• Applications to oligopoly

4
Key skills you will develop in EC201
• Analytical and reasoning skills needed to understand the models

• The ability to think critically about models and their relationship to the
world

• The capacity to understand when/why a model is useful and its limitations

• Academic reading skills; digital skills.

• Employers value all these skills

5
EC201 Lectures and classes this term
• Main lectures: Tuesdays 13:00-14:00 and Wednesday 11:00-12:00 (MT
Weeks 1-11)
• Interactive lecture: Thursdays 12:00 - 13:00 (MT Weeks 1-11) to cover
examples, past exam questions, readings and Q&A

• Classes weeks 2 – 11:

• On campus or Zoom (until 22 October 2021)
• Up until 22 October 2021: Use LSE for You to request a class change from
online to in person when you arrive in London
• Let your class teacher know if (a) you have a mask exemption, (b) you
need to self isolate and cannot attend in person; online alternative if
available will be offered.
6
Reading for EC201

• No set textbook for this course

• Recommended textbook chapters in the EC201 Reading List via

Moodle (though not necessary)

• Course readings (articles) discussed in lectures and are examinable

• Mathematics reading list (in case you need to brush up) on Moodle
8
EC201 formative work
• Weekly problem sets
• Study groups
• Group submission in advance of class
• Not marked, but shapes class and strengthens learning

• One mock exam per term (split into two Sections)

• 2 short questions (50 marks): MT week 4
• 1 long question (50 marks): MT week 7
• Marked and feedback provided

• Lecture checklists
• Test your understanding of lecture content 9
EC201 summative assessment
• 1 hour January examination (30% weight) – online/in person TBD
• 4 short questions spanning the MT syllabus (25 marks each)
• 15 minutes reading time; no calculators

• 2 hour Summer examination (60% weight) – online/in person TBD

• 1 long questions on MT syllabus
• 4 short questions and 1 long questions on LT syllabus
• Short question 25 marks and long question 50 marks (total 200)
• 15 minutes reading time; no calculators

• Coursework (10% weight) – 2.5% per component

• 1 mock exam each term
• 10-minute video each term (Week 9)
10
EC201 MT Coursework Video
Question:
How does our understanding of consumer choice over healthy and
unhealthy food items differ when using insights from behavioural
economics, as compared to neoclassical consumer theory? How
does this difference inform policy design?

• Up to 10 minutes
• Due Week 9
• Loom for Education
• Video marked on the basis of:
(i) clarity of argument,
(ii) use of relevant theory,
(iii) reference to relevant related literature.
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Student support for EC201

• The EC201 Support Lab

• In person at LSE LIFE and through Zoom from week 3

• EC201 Piazza forum

• piazza.com/lse.ac.uk/fall2021/ec201

• Piazza in the run-up to the January exam

• Revision workshops leading up to the Summer exam
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 EC201
Outstanding
Knowledge Sharing
Awards

13
 MT EC201
YouTube Playlist
 Any
Questions?

15
1.1 Consumer Theory: Preferences and Utility
The purpose of consumer theory
• To understand:
• What determines household behaviour: buying, selling,
working, saving and borrowing, accepting or alleviating risk

• How behavior is affected by changes in prices, income, wages,

interest rates, tax rates…

• How household welfare is affected by such changes

17
To analyse consumer theory we use models
• Models simplify and abstract from reality to focus on the most
salient aspects of an issue

• They leave out many things and distort others

• They have assumptions and definitions from which we use logical

argument to draw conclusions

• Conclusions help us understand the economy and design policy

18
How do we know if our model is any good?

• Models can be misleading…

• How suitable a model is depends on the context in which it is

being applied

• Important to understand limitations of models; to contrast the

assumptions and conclusions of different models - we try and do
this in EC201

19
Question: Which is the best route from St Paul’s to Barbican?

Model: Tube Map

(a) Change at Bank & Moorgate?
(b) Change at Holborn & King’s Cross?
(c) Change at Liverpool street?

20
 0
Mornington
John’s Wood Crescent
St. King’s Cross Angel
Cam
The tube map simplifies: Pancras
International
Regent’s Hoxton

Park A1
Euston King’s Cross
TER Great St. Pancras Old Street B
Baker Portland Shoreditch
Street Street High
one Euston Russell
Square Square Farringdon Street
Moorgate
Goodge Street
Regent’s Warren Liverpool
Park Street Tottenham
Edgware Court Road Holborn Street
Oxford Barbican
Road Bond Circus
Street Chancery St. Paul’s
Aldgate
Lane Bank
Leicester Covent City Fenchurch St.
Marble Arch Garden Thameslink Mansion Tower
Square House
Temple Hill
ster
e Charing
Cross Blackfriars Cannon
Hyde Green Park
Piccadilly Embankment Street Monument
Circus

A10
Park Waterloo East
Westminster 21
London Bridge
Our model gives:

22
But is there an even better model?

23
Back to consumer theory…
• Neoclassical microeconomic models assume:
• Households maximize utility or expected utility
• Firms maximize profits and minimize costs

• Do these models help us understand the world?

• Do we miss important things if we limit ourselves to these models?

• In EC201 we explore the standard models and complement them

with other approaches and behavioural economics

24
Standard critique
• Microeconomic models assume people make lightning
calculations, which they don’t
• …but perhaps they act as if they were

• Milton Friedman “Essays in positive Economics” (1953)

How do expert billiard players play?
“… the billiard player made his shots as if he knew the complicated
mathematical formulae that would give the optimal directions of
travel ….”
25
How do we perform these
minor miracles?

Billiard players learn the

consequences of the laws of
physics even though they cannot
solve the equations…

26
How do we perform these minor miracles?
• D. Kahneman “Thinking Fast and Slow” Penguin, 2011

• Modes of thinking:
• System 1 (fast, instinctive and emotional)
• System 2 (slow, deliberate, logical)

• Expert intuition is good in:

• an environment that is sufficiently regular to be predictable
• with an opportunity to learn regularities through prolonged
practice
• immediate and unambiguous feedback

• Applies to some decisions better than others 27

An (abridged) history of microeconomic theory
Alfred Marshall (1842-1924)
• 19th century orthodoxy
• University of Cambridge
• Father of neoclassical economics
• Principles of Economics, 1890

What did he achieve?

• Defined utility as the maximum one is willing to pay for a good
(when the alternative is no good); utility function and marginal utility
• the demand curve; consumer surplus
• elasticity
28
An (abridged) history of microeconomic theory
Where were the limitations?
• Lots of words, limited modelling
• No model of how the utilities of two goods
interact
• Does not examine (i) the effects of income or
changes in tastes on demand, or (ii) the effect
of changes in the price of other goods on
demand

What is utility and can it be measured in money?

• A big 19th century philosophical debate
29
An (abridged) history of microeconomic theory
John Hicks (1904 – 89)
• 20th century orthodoxy
• LSE from 1926 to 1935
• Nobel prize 1972
• Value & Capital, 1939
• Builds on Edgeworth (1881), Pareto (1909)
and Slutsky (1915)

What did he achieve?

• Started analysis with indifference curves
30
An (abridged) history of microeconomic theory
Hicks made two assumptions:
• Non-satiation (more is better)
• Decreasing Marginal Rate of Substitution (MRS)
Good 2

Good 1
0
31
Marginal Rate of Substitution (MRS)
• Hicks (and most textbooks) defines the MRS as minus the gradient of
indifference curve (at a particular point)
Good 2

0 Good 1
32
Back to Hicks…
• Indifference map but not a utility function
• Tells us whether the individual prefers one particular bundle of
goods over another… but not by how much

Good 2
● Bundle A

●
Bundle B

Good 1
0
33
In summary
• Marshall: utility from consumption of a single good

• Hicks: analysis with indifference curves

• Modern microeconomics: starts with preferences over consumption of

many goods

34
Modern assumptions on preferences and utility
• Utility depends on the quantities consumed of all goods

• Consuming 𝑥1, 𝑥2 … 𝑥𝑛 of goods 1,2 … 𝑛 (a consumption bundle) gives

utility 𝑢(𝑥1, 𝑥2 … . 𝑥𝑛), which is a number

• From now on we focus on 𝑛 = 2, without loss of generality

• Note:
• People are assumed to care only about their own consumption of goods
• In LT we extend to include other people’s consumption e.g. externalities
• Doesn’t tell us where preferences come from
• Human relationships are not part of this theory – but can be included
35
Modern assumptions on preferences over
bundles of goods

1. Completeness
2. Transitivity
3. Continuity
4. Non-satiation
5. Convexity

36
1. Completeness
As utility is a number, then for any two bundles of goods (𝑥1𝐴, 𝑥2𝐴) and
(𝑥1𝐵, 𝑥2𝐵) it follows that one of these relationships must hold:

• 𝑢(𝑥1𝐴, 𝑥2𝐴) > 𝑢(𝑥1𝐵, 𝑥2𝐵): the consumer prefers bundle (𝑥1𝐴, 𝑥2𝐴) to
(𝑥1𝐵, 𝑥2𝐵)
(𝑥1𝐴, 𝑥2𝐴) ≻ (𝑥1𝐵, 𝑥2𝐵)

• 𝑢(𝑥1𝐴, 𝑥2𝐴) = 𝑢(𝑥1𝐵, 𝑥2𝐵): the consumer is indifferent between

bundles (𝑥1𝐴, 𝑥2𝐴) and (𝑥1𝐵, 𝑥2𝐵) (𝑥1𝐴, 𝑥2𝐴) ~ (𝑥1𝐵, 𝑥2𝐵)

• 𝑢(𝑥1𝐴, 𝑥2𝐴) < 𝑢(𝑥1𝐵, 𝑥2𝐵): the consumer prefers bundle (𝑥1𝐵, 𝑥2𝐵) to
(𝑥1𝐴, 𝑥2𝐴) (𝑥 , 𝑥 ) ≺ (𝑥 , 𝑥 )
1𝐴 2𝐴 1𝐵 2𝐵 37
1. Completeness
• Diagrammatically, if a consumer is choosing between any two bundles A
and B then either:

(i) A is preferred to B (ii) B is preferred to A (iii) indifferent between A

and B

Good 2 Good 2 Good 2

● Bundle A ● Bundle A ● Bundle A

● ● Bundle B ● Bundle B
Bundle B

Good 1 Good 1 Good 1

0 0 0
38
1. Completeness
• Key implication: the consumer can make choices over the entire range
of possibilities

• Is this realistic? What could go wrong?

39
1. Completeness
• Key implication: the consumer can make choices over the entire range
of possibilities

• Is this realistic? What could go wrong?

• Consumers may find it impossible to rank some options
• Decision-making takes time and effort (e.g. grocery shopping), and
we are often unsure of what a product is and does
• We are subject to systematic biases
• The standard model is not based on psychological research;
behavioural economics is.

40
2. Transitivity
As utility is a number, then for any three bundles of goods (𝑥1𝐴, 𝑥2𝐴),
𝑥1𝐵, 𝑥2𝐵 and (𝑥1𝐶 , 𝑥2𝐶 ):

• If 𝑢(𝑥1𝐴, 𝑥2𝐴) > 𝑢(𝑥1𝐵, 𝑥2𝐵) and 𝑢(𝑥1𝐵, 𝑥2𝐵) > 𝑢(𝑥1𝐶 , 𝑥2𝐶 ), then it
follows that 𝑢(𝑥1𝐴, 𝑥2𝐴) > 𝑢(𝑥1𝐶 , 𝑥2𝐶 )

• If bundle A is preferred to bundle B, and bundle B is preferred to bundle

C, then it follows that bundle A is preferred to bundle C

• If (𝑥1𝐴, 𝑥2𝐴) ≻ (𝑥1𝐵, 𝑥2𝐵) and (𝑥1𝐵, 𝑥2𝐵) ≻ 𝑢(𝑥1𝐶 , 𝑥2𝐶 ), then it follows
that (𝑥1𝐴, 𝑥2𝐴) ≻ (𝑥1𝐶 , 𝑥2𝐶 )
41
2. Transitivity
While transitivity may seem obvious, be careful…not all relationships are
necessarily transitive.

Example 1: Is height transitive?

Example 2: Is winning at tennis transitive?

42
3. Continuity
• If bundle A is preferred to bundle B and bundle C is close to bundle B,
then bundle A is preferred to bundle C
• This can be stated far more precisely but beyond the scope of EC201

Good 2

● Bundle A

●
● Bundle C
Bundle B

Good 1
0 43
Implications of assumptions 1-3:

• Completeness, transitivity and continuity imply:

• Preferences can be represented by a utility function and indifference
curves
• Utility is ordinal i.e. different utility functions can represent the
same preferences

• You will have to take this on trust. Proving it requires mathematics

beyond the scope of EC201

44
Ordinal Utility

• Utility functions assign numbers to indifference curves

• The ordering of these numbers reflects preferences over different
bundles
• But the numbers themselves are not material, provided the ordering is
preserved

• Key implication: different utility functions can reflect the same

preferences, if ordering is preserved

45
Ordinal Utility

Example 1: Does replacing 1, 2, 3 x2 u(x1, x2) = 3

with 1, 4, 9 change preferences?

u(x1, x2) = 2

Example 2: Does replacing 1, 2, 3 u(x1, x2) = 1

by 1, 30, 14 change preferences?
0 x1

46
Ordinal Utility
• Let preferences of a consumer be represented by the utility function
𝑢 𝑥1, 𝑥2 = 𝑥1¾ 𝑥2½ (Cobb-Douglas)
• If 𝑥1 > 0 and 𝑥2 > 0, then 𝑢 > 0
• 𝑢 1,1 = 1
• 𝑢 1,4 = 2
• 𝑢 1,9 = 3
• Hence bundle (1,9) is preferred to (1,4), which is preferred to (1,1)
!⁄
• Now consider function 𝑣(𝑥1, 𝑥2) = [𝑢(𝑥1, 𝑥2) ]2 = 𝑥1 " 𝑥2
• 𝑣(1,1) = 1
• 𝑣(1,4) = 4
• 𝑣(1,9) = 9
• Again bundle (1,9) is preferred to (1,4), which is preferred to (1,1) 47
Ordinal Utility
• 𝑣(𝑥1, 𝑥2) represents the same preferences as 𝑢(𝑥1, 𝑥2) - this means
consumer decisions would be the same!

• This is because the ordering of numbers attached to the indifference

curves does not change

• A monotonic transformation is a way of transforming a set of

numbers into another set that preserves the order of the original set

• So any function 𝑣(𝑥1, 𝑥2) that is a monotonic transformation of

𝑢(𝑥1, 𝑥2) will reflect the same preferences

• Can you think of examples of monotonic transformations? 48

Checking whether two utility functions reflect the same
preferences
• Method 1: eyeballing…sometimes you can see one utility function is a
positive monotonic transformation of the other
• Example: 𝑢 𝑥1, 𝑥2 = 𝑥1¾ 𝑥2½ and 𝑣(𝑥1, 𝑥2) = ¾ 𝑙𝑛𝑥1 + ½𝑙𝑛𝑥2

• Method 2: checking the MRS

• If 𝑓 is a strictly increasing function 𝑣 𝑥1, 𝑥2 = 𝑓 𝑢 𝑥1, 𝑥2 then
𝑢 and 𝑣 represent the same preferences
• The same preferences imply the same indifference curves, which
imply the same MRS
• Check whether the two utility functions have the same MRS to see
whether they represent the same preferences!
49
Back to the Marginal Rate of Substitution
Good 2
𝑀𝑅𝑆 = − gradient of tangent line
𝜕𝑢@
𝑀𝑈$ 𝜕𝑥$
= =
𝐴 𝑀𝑈% 𝜕𝑢@
𝑥2𝐴 ● 𝜕𝑥%

0 Good 1
𝑥1𝐴 50
Back to the Marginal Rate of Substitution

• Let 𝑣 𝑥1, 𝑥2 = 𝑓 𝑢 𝑥1, 𝑥2

#$&
#%&
• For 𝑢 𝑥1, 𝑥2 , the 𝑀𝑅𝑆 = #$&
#%"
() #$
#'& #$&
#%& ($ #%& #%&
• For 𝑣 𝑥1, 𝑥2 , the 𝑀𝑅𝑆 = #'& = () #$ = #$&
#%" ($ #%" #%"

• Hence they reflect the same preferences

51
Example: Cobb-Douglas preferences
"⁄ !⁄
• Let 𝑢 𝑥1, 𝑥2 = 𝑥1 * 𝑥2 * and 𝑣 𝑥1, 𝑥2 = %⁄' 𝑙𝑛 𝑥1 + (⁄' 𝑙𝑛𝑥2

#$&
#%& "⁄ ) ,!+* ) !+* %)"
* !
• For 𝑢 𝑥1, 𝑥2 , the 𝑀𝑅𝑆 = #$& = "
!⁄ ) +* )
"
," +*
=
#%" ()!
* ! "

#'& "⁄ &&

#%& * %& %)"
• For 𝑣 𝑥1, 𝑥2 , the 𝑀𝑅𝑆 = #'& = !⁄ && = ()
#%" * %" !

• Hence they reflect the same preferences

52
4. Non-satiation
• More is better

• A consumer prefers having more of either good to having less:

• If x1B > x1A then (x1B,x2A) is preferred to (x1A,x2A)
• If x2B > x2A then (x1A,x2B) is preferred to (x1A,x2A)

• If *+@*)& > 0 and *+@*)" > 0 then increasing 𝑥1 and/or 𝑥2 increases

utility and non-satiation is satisfied

53
Example: Cobb-Douglas preferences
"⁄ !⁄
• Consider 𝑢 𝑥1, 𝑥2 = 𝑥1 * 𝑥2 *

*+ %⁄ 𝑥 ,!⁄* 𝑥 !⁄* > 0 for positive values of 𝑥1 and 𝑥2

• @*)& = ' 1 2

• *+@*)" = (⁄ 𝑥 "⁄* 𝑥 ,"⁄* > 0 for positive values of 𝑥1 and 𝑥2

' 1 2

• So the non-satiation assumption is satisfied

54
4. Non-satiation
• Key implication: indifference curve slope downwards and the preferred
set is above the indifference curve

55
4. Non-satiation
• Question: Is non-satiation satisfied for this consumer?

x2

preferred set

0 x1 56
Are these people satiated?
• Bill Gates, Queen Elizabeth II, Melinda Gates, Richard Branson, Jeff Bezos

57
5. Convexity
• Non-satiation implies the
indifference curve is downward
sloping and the preferred set lies
above it

• Convexity is satisfied if the

indifference curve is convex

• A set is convex if the straight line

joining any two points in the set
lies in the set

58
5. Convexity
• Key implication: Convexity means a preference for averages
• C is the average of A and B and is preferred to either A or B

●C

59
Non-convex preferences?
• Example: tea and coffee in the same cup!
• Key implication: A preference for extremes rather than averages

x2
● preferred
A
set

B●
0 x1
60
Checking for convexity
• Follow this method to check for convexity

• Rearrange the formula for the utility function to get x2 as a function

of x1 and u

• Find the second derivative of this function with respect to x1

• If the second derivative is positive the convexity assumption is

satisfied!

61
Example: Cobb-Douglas preferences
"⁄ !⁄
• Consider 𝑢 𝑥1, 𝑥2 = 𝑥1 * 𝑥2 *

• We have already shown that non-satiation is satisfied

"⁄ !⁄ ' *⁄ ,"⁄

• Rearrange: 𝑢 = 𝑥1 * 𝑥2 * ⇒𝑢 = 𝑥1% 𝑥2( ⇒ 𝑥2 = 𝑢 ! 𝑥1 !

*)" % *⁄ ,*⁄ * " )" $,⁄ 𝑢 *⁄! 𝑥 ,-⁄!

• @*)& = − ⁄( 𝑢 𝑥1 !
! < 0 and @*)&" = - 1 >0

• As non-satiation is satisfied a positive second derivative implies that

the preferred set is convex
62
Implications of assumptions 1-5

• We have already seen utility is ordinal and indifference curves

downward sloping and convex (preference for averages)

• The assumptions further imply that indifference curves cannot cross

(see Problem Set 1)

• Moreover, we cannot compare utility between people!

• This is import for welfare economics; we revisit this in LT.

63
Preferences we will work with regularly
• Cobb-Douglas: 𝑢 𝑥1, 𝑥2 = 𝑥1. 𝑥2/ (and in logarithmic form)

• Quasi-linear: 𝑢 𝑥1, 𝑥2 = 𝑥1 + 𝑣(𝑥2) or 𝑢 𝑥1, 𝑥2 = 𝑣(𝑥1) + 𝑥2

• Perfect substitutes: 𝑢 𝑥1, 𝑥2 = 𝛼𝑥1 + 𝛽𝑥2

• Perfect complements: 𝑢 𝑥1, 𝑥2 = min[𝛼𝑥1, 𝛽𝑥2], where 𝛼 and 𝛽 are

positive constants

• These have particular properties and implications for consumer choice and
welfare effects, which we will explore.
64
Final food for thought

• Where do preferences come from and how do they change?

• Who is the consumer? What determines ‘household preferences’ in a

household with several members?

• What is the relationship between utility and happiness or life satisfaction?

• What is the effect of other consumers on our utility?

65
Mathematical Appendix – Concavity and convexity
Concave functions
• A function is concave if any line joining two points on its graph lies
entirely on or below the graph.

f(x)

0 x
67
Concave functions
For functions with first and second derivatives:
• Concave functions are functions with decreasing first derivatives
• Concave functions are functions with negative second derivatives

f(x)

0 x

68
Concave functions
• If a function is concave and its derivative is 0 at x0 then x0
maximizes the function.

f(x)

0 x0 x

69
 01
Recall is
0)
decreasing

0 x0 x

>0 <0

f(x) f(x)
increasing decreasing

At x0 = 0 thus x0 maximizes f(x).

70
Convex functions
• A function is convex if any line joining two points on its graph lies
entirely on or above the graph
x2

0 x1 71
Convex functions
For functions with first and second derivatives
• Convex functions are functions with increasing first derivatives
• Convex functions are functions with positive second derivatives

f(x)

0 x
72
A convex set
• Mathematically a set is convex if any straight line joining two
points in the set lies in the set

• For example:

not convex A B convex

convex C D not convex

73