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Final - Lecture notes 13

Microeconomics (Trường Đại học Ngoại thương)

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1. Review theories on Utility and Indifferent curve-Budget line.

1.1. Utility theory:
 Utility is an amount of satisfaction that you will get from the consumption
of a product or service.
 Marginal utility of any good is an increase in utility that the consumer get
from an additional unit of that good.
 Diminishing marginal utility: the more of the good the consumer already
have, the lower the marginal utility provided by an extra unit of that good.

1.2. Indifferent curve - Budget line:

 Indifference curve represents all combinations of market baskets that
provide a consumer with the same level of satisfaction.
 Budget lines represent all combinations of goods for which consumers
expend all their income.
 The tangent of the IC and BL is an optimal choice.

2. Summary theory:
2.1. Income and substitution effect

 Income effect:
- The change in consumption of a good  Substitution effect:
resulting from an increase in purchasing - The change in consumption of a good
power, with relative prices held associated with a change in its price,
constant. with the level of utility held constant.

Ex: "Pepsi is cheaper, so my income has
greater purchasing effect. I can buy both
more pizza and more Pepsi."
Ex: "The price of Pepsi has fallen, I get
more pints of Pepsi for every pizza that I
give up. Because pizza is now relatively
more expensive, I should buy less pizza
and more Pepsi."
=> Both effect work at the same time.

2.2. Revealed preference

 The theory of revealed preference shows how the choices that individuals
make when prices and income vary can be used to determine their
preferences. When an individual chooses basket A even though he or she
could afford B, we know that A is preferred to B.

 If a consumer chooses one market basket over another, and if the chosen
market basket is more expensive than the alternative, then the consumer
must prefer the chosen market basket.

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2.3. Characteristics demand theory

 Characteristics demand theory states that
 consumers derive utility not from the actual contents of the basket but from
the characteristics of the goods in it.

 This theory was developed by Kelvin Lancaster in 1966 in his working

paper “A New Approach to Consumer Theory”

LECTURE 4: INSURANCE EXERCISE

Utility function (U) of a risk-averse person:

U(W ) = –0, 10W^2 + 8W (1)
Total wealth (W, in thousand $) of an individual: 20 including a motorbike that was
valued at 10. Assume the motorbike can be stolen at 0.2 probability. Insurance fee = 2.
*Question: Which is the maximum fee risk-averse pay for insurance?

Solution:
1. Uninsured
- E(W)= 0,8.20 + 0,2.10 = 18($);
- If the motorbike is not stolen: W1= 20 ⇒ U1= 120
- If the motorbike is stolen: W0= 10 ⇒ U0 = 70
⇒ E(U) = 120*0.8 + 70*0.2 = 110

2. Insured
- Must pay insurance fee = 2.
+ W = 20-2 = 18 ($).
+ U = 111.6 (certainly).

Because U(W2) > E(U) (111,6 > 110)

⇒ Risk-averse individual buys insurance.

3. Maximum insurance fee?

U(W3) = E(U) = 110
⇔ –0, 10W32 + 8W3 = 110
⇔ W3 = 17,64 ($).
⇒ Maximum insurance premium (fee) = W1 - W3 = 20 - 17,64= 2,36 ($).

4. Risk premium
E(W) - W3 = 18 - 17,64 = 0,36 ($).

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Question 1:

Suppose there is a perfectly competitive rice market with a market demand curve:
P =100 – (1/10) *Q where P is the market price and Q is the market quantity.
Furthermore, suppose that all the farmers in this market are identical and that a
representative farmer’s total cost is: TC = 100 + 5q + q2 where q is the quantity produced
by this representative farmer. The representative farmer’s marginal cost is: MC = 5 + 2q.
(Unit of Q : MT, unit of P : USD 1000).
a. What is the average total cost for the representative farmer?
b. In the long run, how many units will this farmer produce and what price will it sell
each unit for in this market?
c. What is the total market quantity produced in this market in the long run?
d. How many farmers are in the industry in the long run?
e. How do long-run profits change for each farmer if demand decreases? Increases?
Answer:
a. Take TC and divide by q to find ATC.
ATC = 100/q + 5 + q
b. In the long run recall that ATC = MC in the long run for the farmer.
100/q + 5 + q = 5 + 2q  q = 10.
We can then figure out the market price by remembering that in the long run this
farmer’s
MC = MR = P
Once you know the quantity the farmer will produce in the long run (10 units) you
can plug this value into the farmer’s MC curve and get P = 5 + 2*10 = $25.
c. From part (b) you know the market price is $25.
Use this price and the market demand curve to find the market quantity:
25 = 100 – (1/10) Q  Q = 750
d. Since each farmer makes 10 units and Q = 750, there are 75 farmers in the
industry.
e. Long run profits are always equal to zero. Farmers will enter and exit the industry
until this condition holds in the long run.

Question 2: A monopolist has the following information, where Q is the quantity of

goods and P is the price:
+ Market Demand: P = 300 -Q + Marginal Cost: MC = 2Q

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+ Total Cost: TC = 2 +Q^2

1. No price discrimination: calculate Q*, P*, CS, PS, DWL

2. Perfect price discrimination: calculate Q*, P*, CS, PS, DWL

3. Second-degree price discrimination: calculate $275, $250, $225, $200 for each
first, second, third, forth of 25 units block,

Answer:

150

MR

150

1. Under no price-discrimination

TR= P*Q = 300Q – Q2; MR = 300 – 2Q

Set MR = MC  300 – 2Q = 2Q  Q = 75. Hence, Q* = 75
Replace Q*=75 to market demand equation => P* = 300 – 75 = 225. Hence, P* = 225
CS = ½ * (300 – 225) * 75 = 2812.5
PS = ½ * 150*75 + (225-150) *75 =11250

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DWL = ½ * (225-150) * (100-75) = 937.5

2. Under perfect price-discrimination

P = MC  300 – Q = 2Q  Q=100. Hence, Q* = 100

Replace Q* = 100 to market demand equation  P* = 300 – 100 = 200. Hence, P*=200
CS = 0
PS = ½ * 300 * 100 = 15000
DWL = 0
3. Under second degree price-discrimination:

TR = 275*25 + 250*25 + 225*25 + 200*25 = 6,875 + 6,250 + 5,625 + 5,000 = 23,750

TC = 2 + 100*100 = $10,002
Profit = 23,750 - 10,002 = 13,748
CS = sum of violet triangle = ½ * (300-275) * 25 * 4 = 1250
DWL = 0
PS = Profit = 13,748

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Question 3:
First-Degree (Perfect) Second-Degree Third-Degree

Charge the maximum possible
price for each unit consumed
Objectives
Charge a different price for Charge a different price to
different quantities consumed different consumer groups
based on the unique
demographics.

Captures Captures all available Captures partially consumer Captures partially consumer
consumer consumer surplus surplus surplus
surplus

Almost impossible to
implement in reality.
Quite common in practice. It is The most common one in
Because it’s virtually
much easier to implement than reality, especially in the
impossible for firms to assess
first-degree discrimination service sector.
each consumer’s maximum
Practical because it requires less
willingness to pay.
information.

+ Services of doctor + Coupon discount in grocery + Bus tickets (student, normal)

+ Tuition fee + Discount for the second item + Movie tickets (age)
Examples + Real estates + Energy (water, electricity) + Buffet tickets (age)
+ Auction + Combo at fast food restaurant + Airline ticket (first-class,
(KFC, Mc Donald’s) business, economy class)
+ Used car

Question

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Use Income and Substitution Effects to explain the backward-bending labor supply
curve
1. As the wage rate increases, therefore, the price of leisure also increases. This price
change brings about both a substitution effect and an income effect.

- Substitution effect: As wage increases, leisure become relatively more expensive,

which encourages workers to substitute work for leisure (work more).
- Income effect occurs because the higher wage rate increases the worker’s
purchasing power. With higher income, the worker can buy more of leisure. If
more leisure was chosen, it is because the income effect has encouraged the
worker to work fewer hours.
When the income effect outweighs the substitution effect, the result is a backward-
bending supply curve.

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