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Microeconomic Theory II

by Jorge Rojas

Contents

1 General Equilibrium 2

1.1 Walrasian Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.2 Existence of Walrasian Equilibria . . . . . . . . . . . . . . . . . . . . . . 3

1.3 Existence of Walrasian Equilibria . . . . . . . . . . . . . . . . . . . . . . 4

2 Jones Model 5

2.1 Input endowment magniﬁcation eﬀect . . . . . . . . . . . . . . . . . . . . 5

2.2 Output price magniﬁcation eﬀect . . . . . . . . . . . . . . . . . . . . . . 6

2.3 Magniﬁcation eﬀects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3 Welfare Economics 6

3.1 FIRST THEOREM OF WELFARE ECONOMICS . . . . . . . . . . . . 7

3.2 SECOND THEOREM OF WELFARE ECONOMICS . . . . . . . . . . . 7

4 Public Goods and Externalities 8

4.1 Public Goods and Competitive Markets . . . . . . . . . . . . . . . . . . . 9

4.2 Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

4.2.1 Production Externality . . . . . . . . . . . . . . . . . . . . . . . . 10

4.2.2 Common Property Rights . . . . . . . . . . . . . . . . . . . . . . 11

4.2.3 Congestion Externality . . . . . . . . . . . . . . . . . . . . . . . . 11

5 Practical Themes 12

5.1 Intertemporal Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

5.2 Robinson Crusoe (Coop-structure) . . . . . . . . . . . . . . . . . . . . . 13

5.3 Fisher Separation Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

Abstract

This is a summary containing the main ideas in the subject. This is not a

summary of the lecture notes, this is a summary of ideas and basic concepts. The

mathematical machinery is necessary, but the principles are much more important.

1

1 General Equilibrium

The single-market story is a partial equilibrium model. While in the general equilib-

rium model all prices are variable, and equilibrium requires that all markets clear.

There is a special case called “pure exchange” economy where all the economic

agents are consumers. Each consumer i is completely described:

1. the preferences _

i

or the corresponding utility function u

i

2. the initial endowment ω

i

The consumption bundle is denoted by x

i

= (x

1i

, . . . , x

ki

) and an allocation is written

as x = (x

i

, . . . , x

n

). An allocation x is a collection of n consumption bundles describing

what each of the n agents holds.

Deﬁnition 1. Feasible Allocation.

A feasible allocation is one that is physically possible, therefore:

n

i=1

x

i

≤

n

i=1

ω

i

In a two goods, two agents economy, the Edgeworth box is a useful tool to represent

the situation:

Figure 1: Edgeworth Box.

1

Without Equality in Opportunities, Freedom is the privilege of a few, and Oppression the reality of

everyone else.

University of Washington Page 2

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

1.1 Walrasian Equilibrium

Let us deﬁne p = (p

1

, . . . , p

k

) which is exogenously given. Each consumer solves the

problem:

Max

x

i

u

i

(x

i

)

s.t. px

i

= p ω

i

Notice that for an arbitrary price vector p, it might not be possible to make the desired

transactions for the simple reason that aggregate demand may not be equal to aggregate

supply:

n

i=1

x

i

(p, p ω

i

) ,=

n

i=1

ω

i

Deﬁnition 2. Walrasian Equilibrium.

We deﬁne a W.E. to be a pair (p

∗

, x

∗

) such that:

n

i=1

x

i

(p, p ω

i

) ≤

n

i=1

ω

i

p

∗

is a Walrasian equilibrium of there is no good for which there is positive excess demand.

1.2 Existence of Walrasian Equilibria

We know that the demand functions are H.O.D. zero in prices. As the sum of homo-

geneous functions is homogeneous, then the aggregate excess demand function is also

H.O.D. zero in prices.

z(p

∗

) =

n

i=1

[x

i

(p

∗

, p

∗

ω

i

) − ω

i

] ≤ 0

So, z : R

k

+

∪ ¦0¦ →R

k

Theorem 1. Walras’ Law: For any price vector p, we have p z(p) = 0, i.e., the value

of the excess demand is identically zero.

The proof is direct. z = 0 since x

i

() must satisfy the budget constraint for each agent

i.

Corollary 1. Market Clearing: If demand equals supply in (k − 1) markets, and

p

k

> 0 then demand must equal supply in the kth market.

Deﬁnition 3. Free Goods: If p

∗

is a Walrasian Equilibrium and

z

j

(p

∗

) < 0, then p

∗

j

= 0

In other words, if some good is in excess supply at a Walrasian equilibrium, it must

be a free good.

Deﬁnition 4. Desirability: If p

i

= 0, then z

i

(p) > 0 ∀i = 1, . . . , k.

The following theorem is essential to solve applied problems since we will impose

equality of the demand and the supply, almost all the time.

Theorem 2. Equality of Demand and Supply.

University of Washington Page 3

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

If all goods are desirable and p

∗

is a Walrasian equilibrium, then z(p

∗

) = 0. The

proof is done by contradiction.

Since the aggregate excess demand z(p) is H.O.D. zero, we can express everything in

terms of relative prices. Thus, we get:

p

i

=

ˆ p

i

k

j=1

ˆ p

j

,and therefore,

k

i=1

p

i

= 1

So, p ∈ (k −1)-dimensional unit simplex. S

k−1

= ¦p ∈ R

k

+

:

k

i=1

p

i

= 1¦

Theorem 3. BROUWER FIXED-POINT THEOREM

If f : S

k−1

→ S

k−1

is a continuous function from the unit simplex to itself, there is

some x ∈ S

k−1

such that x = f(x).

Another useful calculus tool is the Intermediate Value Theorem. If f is a real-valued

continuous function on the interval [a, b], and I is a number between f(a) and f(b), then

there is a c ∈ [a, b] such that f(c) = I.

Theorem I below is one of the most important theorems in modern economics (in my

opinion). This theorem can be used for the good or for the bad. So, be wise!

1.3 Existence of Walrasian Equilibria

If z : S

k−1

→ R

k

is a continuous function that satisﬁes Walras’ law, i.e., p z(p) ≡ 0,

then there exists some p

∗

∈ S

k−1

such that z(p

∗

) ≤ 0

I write the proof for this theorem given its importance in economics and the fact that

the proof for this idea took around a hundred years to exist in its formal way.

Proof:

Deﬁne g : S

k−1

→S

k−1

by:

g

i

(p) =

p

i

+ max(0, z

i

(p))

1 +

k

j=1

max(0, z

j

(p))

∀i = 1, . . . , k

Thus,

k

i=1

g

i

(p) = 1

The map g has a nice economic interpretation. Suppose that there is excess demand in

some market, so that z

i

(p) ≥ 0, then the relative price of that good is increased.

By the Brouwer’s ﬁxed-point theorem there is a p

∗

such that p

∗

= g(p

∗

). So,

p

∗

i

=

p

∗

i

+ max(0, z

i

(p

∗

))

1 +

k

j=1

max(0, z

j

(p

∗

))

∀i

=⇒

p

∗

i

k

j=1

max(0, z

j

(p

∗

)) = max(0, z

i

(p

∗

)) ∀i

University of Washington Page 4

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

we multiply by z

i

(p

∗

), we get:

z

i

(p

∗

) p

∗

i

_

k

j=1

max(0, z

j

(p

∗

))

¸

= z

i

(p

∗

) max(0, z

i

(p

∗

)) ∀i

now, we sum across all the agents, so we get:

_

k

j=1

max(0, z

j

(p

∗

))

¸

k

i=1

z

i

(p

∗

)p

∗

i

=

k

i=1

z

i

(p

∗

) max(0, z

i

(p

∗

))

By Walras’ Law, we know that:

k

i=1

z

i

(p

∗

)p

∗

i

= p

∗

z(p

∗

) = 0

=⇒

k

i=1

_

z

i

(p

∗

) max(0, z

i

(p

∗

))

¸

= 0 (1)

Each term of the sum in (1) is greater or equal to zero since each term is either 0 or

z

2

i

(p

∗

) > 0 if z

i

(p

∗

) > 0. However, if any term were strictly greater than zero, the

equality would not hold.

Hence, every term of the summation must be equal to zero, so:

z

i

(p

∗

) ≤ 0 ∀i = 1, . . . , k

2 Jones Model

The Jones Model assumes Constant Returns to Scale (CRS). This implies the zero-proﬁt

conditions. There are two inputs ¦L, T¦ that produce two outputs ¦M, F¦. Output prices

¦p

M

, p

F

¦ are exogenously given, while the endogenous variables are ¦F, M, w, r¦.

To determine the technical coeﬃcients, we solve the minimization cost problem for

each ﬁrm (we have assumed that one ﬁrm produces only one output).

Max wL

i

+rT

i

(2)

s.t. G(L

i

, T

i

) = 1

where G(L

i

, T

i

) is the production function for good i. The solution to this problem

corresponds to the technical coeﬃcients, i.e., L

∗

i

= a

Li

and T

∗

i

= a

Ti

. Recall that a

pq

is

the amount of input p that is necessary to produce one unit of output q.

2.1 Input endowment magniﬁcation eﬀect

Theorem 4. Rybczynski Theorem.

An expansion in one factor (input) leads to an absolute decline in the output of the

commodity that uses the other factor more intensively.

Assuming that:

a

LM

a

TM

>

a

LF

a

TF

⇔M is more labour intensive than F

If L increases, then F will decrease.

The proof for theorem (4) is done using the full-employment conditions, and taking

diﬀerentials.

University of Washington Page 5

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

2.2 Output price magniﬁcation eﬀect

Theorem 5. Stolper-Samuelson Theorem.

Assume M is more labour intensive than F, and p

F

is constant. An increase in

p

M

raises the return to the factor used intensively in M production by an even greater

relative amount.

M is labour intensive and p

M

increases =⇒

dw

w

>

dp

M

p

M

The proof for theorem (5) is done using the zero-proﬁt conditions, and taking diﬀer-

entials.

To avoid multiple equilibria, we impose that one output is more intensive in one input

for all (w, r) ∈ R

2

+

. Thus, the lines intersect only ones.

2.3 Magniﬁcation eﬀects

Input endowment magniﬁcation eﬀect (3). General Rybczynski theorem.

_

a

LF

a

TF

>

a

LM

a

TM

_

∧

_

dL

L

>

dT

T

_

=⇒

dF

F

>

dL

L

>

dT

T

>

dM

M

(3)

Output price magniﬁcation eﬀect (4). General Stolper-Samuelson theorem.

_

a

LF

a

TF

>

a

LM

a

TM

_

∧

_

dp

F

p

F

>

dp

M

p

M

_

=⇒

dw

w

>

dp

F

p

F

>

dp

M

p

M

>

dr

r

(4)

3 Welfare Economics

Deﬁnition 5. Pareto Eﬃciency

A feasible allocation x is a weakly Pareto eﬃcient allocation if there is no feasible

allocation x

such that all agents strictly prefer x

to x.

A feasible allocation x is a strongly Pareto eﬃcient allocation if there is no feasible

allocation x

such that all agents weakly prefer x

**to x, and some agent strictly prefers
**

x

to x.

Suppose that preferences are continuous and monotonic. Then an allocation is weakly

Pareto eﬃcient if and only if it is strongly Pareto eﬃcient.

Deﬁnition 6. Walrasian Equilibrium.

An allocation-price pair (x, p) is a Walrasian equilibrium if:

(1) the allocation is feasible:

n

i=1

x

i

≤

n

i=1

ω

i

(2) If x

i

is preferred by agent i to x

i

, then p x

i

> p ω

i

, i.e., the agent is only better oﬀ

with a bundle that cannot aﬀord.

University of Washington Page 6

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

3.1 FIRST THEOREM OF WELFARE ECONOMICS

If (x, p) is a Walrasian equilibrium, then x is Pareto eﬃcient.

Proof:

Suppose is not, and let x

**be a feasible allocation that all agents prefer to x. Then by
**

property 2 of the deﬁnition of Walrasian equilibrium, we have that:

p x

i

> p ω

i

∀i = 1, . . . , n

summing over i = 1, . . . , n and using the fact that x

**is feasible, we have that:
**

p

n

i=1

ω

i

= p

n

i=1

x

i

>

n

i=1

p ω

i

which is a contradiction.

3.2 SECOND THEOREM OF WELFARE ECONOMICS

Suppose x

∗

is a Pareto eﬃcient allocation in which each agent holds a positive amount

of each good. Suppose that preferences are convex, continuous, and monotonic.

Then, x

∗

is a Walrasian equilibrium for the initial endowments ω

i

= x

∗

i

∀i = 1, . . . , n.

Another version: The following lines are taken from MWG, pages 551-552.

Deﬁnition 7. Given an economy speciﬁed by (¦(X

i

, _

i

)¦

I

i=1

, ¦Y

j

¦

J

j=1

, ¯ ω) an allocation

(x

∗

, y

∗

) and a price vector p = (p

1

, . . . , p

L

) ,= 0 constitute a price quasi-equilibrium

with transfers if there is an assignment of wealth levels (w

1

, . . . , w

I

) with

i

w

i

=

p ¯ ω +

j

p y

∗

j

such that:

(i) ∀j, y

∗

j

maximises proﬁts in Y

j

; that is,

p y

j

≤ p y

∗

j

∀y

j

∈ Y

j

(ii) ∀i, if x

i

~

i

x

∗

i

then p x

i

≥ w

i

(iii)

i

x

∗

i

= ¯ ω +

j

y

∗

j

Theorem 6. Second fundamental theorem of Welfare Economics.

Consider an economy speciﬁed by (¦(X

i

, _

i

)¦

I

i=1

, ¦Y

j

¦

J

j=1

, ¯ ω), and suppose that every

Y

j

is convex and every preference relation _

i

is convex [i.e., the set ¦x

i

∈ X

i

: x

i

_

i

x

i

¦

is convex for every x

i

∈ X

i

] and locally non-satiated. Then, for every Pareto optimal

allocation (x

∗

, y

∗

), there is (exists) a price vector p = (p

1

, . . . , p

L

) ,= 0 such that (x

∗

, y

∗

, p)

is a price quasi equilibrium with transfers.

Exercise.

Calculating Pareto Eﬃcient Allocations.

There are two goods ¦X, Y ¦, two individuals ¦A, B¦, two inputs ¦

¯

L,

¯

T¦ (exogenously

University of Washington Page 7

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

ﬁxed), X = F(L

X

, T

X

) and Y = G(L

Y

, T

Y

). We solve the following optimization problem

to ﬁnd the locus of Pareto eﬃcient allocations.

Max u

A

(X

A

, Y

A

) (5)

s.t. u

B

(X

B

, Y

B

) = ¯ u

B

F(L

X

, T

X

) = X

A

+X

B

G(L

Y

, T

Y

) = Y

A

+Y

B

L

X

+L

Y

=

¯

L

T

X

+T

Y

=

¯

T

We form the Lagrangean:

/ = u

A

(X

A

, Y

A

) +λ[¯ u

B

−u

B

(X

B

, Y

B

)] +α[X

A

+X

B

−F(L

X

, T

X

)]

+β[Y

A

+Y

B

−G(L

Y

, T

Y

)] +γ[

¯

L −L

X

−L

Y

] +δ[

¯

T −T

X

−T

Y

]

This leads to the eﬃcient conditions.

Eﬃciency in Consumption

∂u

A

∂X

A

∂u

A

∂Y

A

=

∂u

B

∂X

B

∂u

B

∂Y

B

=

α

β

Eﬃciency in Production

∂F

∂L

X

∂F

∂T

X

=

∂G

∂L

Y

∂G

∂T

Y

=

γ

δ

Eﬃcient Product Mix

∂u

A

∂X

A

∂u

A

∂Y

A

=

∂u

B

∂X

B

∂u

B

∂Y

B

=

∂G

∂L

Y

∂F

∂L

X

=

∂G

∂T

Y

∂F

∂T

X

= MRT =

MC

X

MC

Y

where MRT is the usual “marginal rate of transformation” and MC is the “marginal

cost”.

4 Public Goods and Externalities

Deﬁnition 8. A public good is a commodity for which use of a unit of the good by one

agent does not preclude its use by other agents.

2

Suppose that X is a public good (for example, education, healthcare, “national

defense”) and Y is a private good (for example, wine, cigarettes, cars). There are two

agents in this basic model i = A, B. They face the following maximization problem:

Max

{X,Y

A

}

u

A

(X, Y

A

)

s.t. u

B

(X, Y

B

) = ¯ u

B

F(T

X

) = X

G(T

Y

) = Y

A

+Y

B

T

X

+T

Y

=

¯

T

2

Mas-Colell, Whinston and Green (MWG), page 359.

University of Washington Page 8

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

We setup the following Lagrangean:

/ = u

A

(X, Y

A

)+λ[¯ u

B

−u

B

(X, Y

B

)] +α[F(T

X

)−X] +β[G(T

Y

)−Y

A

−Y

B

] +γ[

¯

T −T

X

−T

Y

]

After solving the FOC’s, we get a general result for Pareto eﬃciency in this basic and

well-behaved model:

∂u

A

∂X

∂u

A

∂Y

A

+

∂u

B

∂X

∂u

B

∂Y

B

. ¸¸ .

Marginal Beneﬁt (agreggated)

=

G

(T

Y

)

F

(T

X

)

. ¸¸ .

Marginal Cost

(6)

Remark 1. Private goods and public goods have a diﬀerent condition for optimality.

Therefore, it is really important to make sure that public good is treated as such and not

otherwise. As a society, we must deﬁne these goods. For instance, is education a public

good or a private one?

1. Private goods =⇒MRS

A

= MRS

B

= MRT

2. Public goods =⇒MRS

A

+ MRS

B

= MRT

4.1 Public Goods and Competitive Markets

This is the case in which we let the private sector, namely, ﬁrms to provide a public good.

So, suppose the markets are competitive and we have two ﬁrms. One provides the public

good and the other one the private good. Therefore, each ﬁrm solves their maximization

problem, i.e., they try to maximise proﬁts. In general terms,

Max

{K,L}

Π

X

= p

x

F(K, L) −wL −rK (7)

So, from (7) we get the price for the good X, and likewise for good Y . Now, assume that

the consumers own the land T and the ﬁrms, so they can use the proﬁts(proﬁts are zero

if F() has CRS). Then, the consumers have to solve the problem given by:

Max

{X

i

,Y

−i

}

u

i

(X

i

+X

−i

, Y

i

) ∀i = A, B

s.t. p

x

X

i

+p

y

Y

i

= rT

i

+ proﬁts (8)

After some manipulation, we get the condition MRS

A

= MRS

B

= MRT which is

clearly diﬀerent to the Pareto Optimal condition for public goods. Therefore, competitive

markets will NOT be eﬃcient in the provision of public goods. Notice that property

rights do not play any role in this analysis. They will not change the main results.

Remark 2. If the agents are identical in their utility functions, then there is no free-

riders. However, if the agents have diﬀerent utility functions, then there will be free-

riders. In this situation, we apply the Kuhn-Tucker conditions to solve the problem.

Moreover, the free-rider will be the agent that cares less about the public good (in a model

in which there are only two goods, the public and the private ones, and only two agents.

In more general setups, game theory and mechanism designed are needed).

Remark 3. If individuals have identical homothetic utility functions, then we do not

care about the distribution of wealth (result coming from Gorman form analysis).

It seems that in Chile many leaders and economists believe that we all have the same

preferences because inequality is monstrous (Chile is top 20!)

3

.

3

Chile is the 17th most unequal country in the world, according to the CIA. Source

https://www.cia.gov/library/publications/the-world-factbook/rankorder/2172rank.html and using other

surveys we are top 10!

University of Washington Page 9

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

4.2 Externalities

Figure (2) shows an example of an externality. There are two main types of externalities:

Positive and Negative. A well-known example of negative externality in Chile is related

to the mining companies based on foreign capital. The mining companies go to the

source of mineral, extract the natural resources and generate a lot of pollution, and pay

less than 5% in taxes. The farmers and peasants who live nearby see the death of their

animals and the pollution of their water. An example of a positive externality is this note.

I am writing it for me, but I share it with anyone who wants to download from Scrib.com.

There are three main types of externalities:

1. Production externality

2. Common Property Rights

3. Congestion externality

Figure 2: Example of an externality.

4.2.1 Production Externality

Suppose that there are two ﬁrms i = A, B and they produce goods X and Y , respectively.

Firm A pollutes in its production process and this pollution aﬀects the proﬁts of ﬁrm B.

Production and Pollution

Firm A Firm B

price good X: p price good Y: q

cost function: C(X) cost function: D(Y, s)

Pollution: s = s(X)

So, in this situation, the methodology of analysis is standard. First, we analyse each ﬁrm

separately obtaining the “individual optimal outcome”. Second, we put the two ﬁrms

together and we maximise joint proﬁts. Thus, we obtain the “social optimal outcome”.

In general, the proﬁts coming from both ﬁrms working together will be greater than

summing the proﬁts from each ﬁrm working on its own (Cooperation is positive if

not needed).

Private marginal cost: C

(X)

Social marginal cost:C

(X) +

∂D

∂s

s

**(X) ←also called true MC
**

University of Washington Page 10

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

To solve the problem of externalities there are three main economic tools that can be

deployed by the government or by the private counterparts:

1. Taxes (You subtract τX from the polluter’s proﬁt function)

2. Licenses

3. Agreements between the private agents

Theorem 7. COASE THEOREM: Under zero transaction costs, if trade of the

externality can occur, then bargaining will lead to an eﬃcient outcome no matter how

property rights are allocated.

4

4.2.2 Common Property Rights

An example of this situation is ﬁshing on international waters. Suppose that each agent

has only one boat, and the cost of sending the boat is constant. Then:

Equilibrium: R(X) = C

Pareto Eﬃciency: Max XR(X) −XC

In general, when there is a negative externality, the Pareto eﬃcient outcome of ﬁshing

(production) will be less than the competitive one.

Figure 3: Social optimal versus private optimal. Graph from http://tutor2u.net

4.2.3 Congestion Externality

Suppose that there is a bridge with some demand for trips. The demand function is given

by:

X = α −βt α, β > 0 ⇒t =

α −X

β

where X is the number of crossings and t the time per trip. In addition, there is a

congestion function

t = γ +δX γ, δ > 0

4

MWG, page 357, second paragraph.

University of Washington Page 11

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

The conditions for this problem will be given by:

For Equilibrium:

α −X

β

. ¸¸ .

Marginal beneﬁt

= γ +δX

. ¸¸ .

Marginal cost

For Pareto Eﬃciency: First, we need to calculate the “true marginal cost”. This is

done as X private cost = X (γ + δX), then we just diﬀerentiate to get the MC. On

the beneﬁt side, there is no change, since the externality is fully negative.

γ + 2δX

. ¸¸ .

Social marginal cost

=

α −X

β

. ¸¸ .

Marginal beneﬁt (unchanged)

To achieve the Pareto eﬃcient outcome the government could install a toll. The idea

is to make the users pay the “true value” of their trips. Thus, the toll price should be

τ = P

Soc

−P

Op

(assuming we already translated time to money).

Figure 4: Congestion in a bridge.

5 Practical Themes

5.1 Intertemporal Approach

There is one agent that consumes at two points in time and the interest rate, r, is

exogenously given. The agent, therefore, solves the problem:

Max

{C

0i

,C

1i

}

u(C

0i

, C

1i

) (9)

s.t. p

0

C

0i

+p

1

C

1i

= p

0

ω

0i

+p

1

ω

1i

or equivalently, C

0i

+

C

1i

1+r

= ω

0i

+

ω

1i

1+r

since

p

0

p

1

= 1 +r.

University of Washington Page 12

ECON501: Lecture Notes

Microeconomic Theory II

by Jorge Rojas

5.2 Robinson Crusoe (Coop-structure)

There is one consumer and one ﬁrm that produces only one good with only one input

(labour). C: consumption

L: leisure per day

H: hours of work per day

Q = F(H): output produced

The ﬁrm wants to maximise proﬁts (it wants “more and more”):

Max

{H}

Π = pF(H) −wH (10)

while the consumer (who owns the ﬁrm) solves:

Max

{C,L}

u(C, L) (11)

s.t. pC = pC

0

+wH + Π

∗

(p, w)

H +L = 24hrs

Remark 4. A brief note on Returns to Scale.

1. DRS ⇒proﬁts are positive and the setup is compatible with “perfect competition”.

2. CRS ⇒ proﬁts are zero (zero-proﬁt conditions) and is compatible with P.C.

3. IRS ⇒ ﬁrm may run into inﬁnite size, but this setup is NOT compatible with P.C.

since the SOC’s are never satisﬁed. (IRS implies a monopoly, duopoly or another

setup).

5.3 Fisher Separation Theorem

In a Robinson Crusoe two-periods type model, but with n agents. Each agent i solves

the problem:

Max

{C

0i

,C

1i

}

u(C

0i

, C

1i

) (12)

s.t. C

0i

+

C

1i

1+r

= ω

0i

+

ω

1i

1+r

+

F

i

(I

0i

)

1+r

−I

0i

where Q

1i

= F

i

(I

0i

) and I

0i

is the amount that is invested at t = 0 to produce Q

1i

. Agent

i has an initial endowment ω

i

Irving Fisher showed that this problem can be solved in two stages:

1. maximize the value produces by the ﬁrm, i.e.,

F

i

(I

0i

)

1+r

−I

0i

2. using I

∗

0i

solve the whole consumer problem

We deﬁne the net borrowing for i as NB

i

= C

∗

0i

+I

∗

0i

(r) −ω

0i

. In equilibrium we get that

I

i=1

NB

i

= 0.

University of Washington Page 13

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