Microeconomics

Table des matières

INTRODUCTION: MARKET EFFICIENCY....................................................................................................3
Chapter 1: Understanding perfect Competition and The Invisible Hand................................................3
Perfect Competition and Efficiency....................................................................................................3
The Invisible Hand– Adam Smith........................................................................................................3
Efficiency and Equity.......................................................................................................................5
Chapter 2: Understanding the Rational Consumer.................................................................................6
Section 1: Consumer budget..............................................................................................................6
BUDGET CONSTRAINT....................................................................................................................6
Section 2: The Consumer's Preferences.............................................................................................8
Marginal Rate of Substitution...........................................................................................................14
Section 3: What is utility...................................................................................................................15
Section 4: Rational choice.................................................................................................................18
Chapter 3: Choice under uncertainty...................................................................................................20
Introduction.....................................................................................................................................20
Chapter 4: Asymmetric Information.....................................................................................................23
Section 1: Adverse Selection and Moral Hazard.............................................................23
Section 2: Health insurance..............................................................................................................25
Application: Market failure - the case of the Healthcare market.................................................29
Chapter 5: Understanding Producers...................................................................................................31
Section 1 : Technology......................................................................................................................31
Representation of Technology......................................................................................................31
Returns-to-scale...........................................................................................................................38
Average cost.................................................................................................................................39
Section 2: Profit maximization..........................................................................................................40
Short-Run Profit Maximization.....................................................................................................40
Long-Run Profit Maximization......................................................................................................42
Cost minimization.........................................................................................................................43
Section 3: Cost minimization............................................................................................................43
Short-Run & Long-Run Total Costs...............................................................................................46
INTRODUCTION: MARKET EFFICIENCY
Which Market Outcomes Are Desirable?

Pareto efficiency, also known as Pareto optimality, is a fundamental concept in economics that
describes a situation where no one can be made better off without making someone else worse off.
In other words, it is a state of resource allocation where it is impossible to improve the welfare of
one individual without simultaneously worsening the welfare of another.

Pareto efficiency is often illustrated using the production possibility frontier (PPF), which represents
all the possible combinations of two goods that can be produced with a given set of resources. A
Pareto efficient allocation is represented by a point on the PPF, as this indicates that all resources are
being used in the most efficient way possible.

 This theory came from Vilfredo Pareto (1848-1923), an Italian economist.

 A Pareto outcome allows no “wasted welfare”: » i.e. the only way one person’s welfare can
be improved is to lower another person’s welfare.
o Example: • Jill has an apartment; Jack does not. • Jill values the apartment at €200;
Jack would pay €400 for it. • Jill could sublet the apartment to Jack for €300. • Both
gains, so it was Pareto inefficient for Jill to have the apartment.
 A Pareto inefficient outcome means there remain unrealized mutual gains-to-trade.
 Any market outcome that achieves all possible gains-to-trade must be Pareto efficient.
 In general, Pareto efficiency doesn’t have much to say about distribution of the gains from
trade.
» It is only concerned with the efficiency of the trade: whether all the possible trades have
been made.

Chapter 1: Understanding perfect Competition and The

Invisible Hand
Perfect Competition and Efficiency
 The competitive market is efficient because the market equilibrium maximizes social surplus.
o This is the best that society as a whole can do if it is simply interested in maximizing
the total size of social surplus.
 Social surplus, also known as total welfare, gains from trade, or economic
surplus, is a measure of the economic benefit that arises from market
transactions. It is equal to the sum of consumer surplus and producer
surplus.
 But we are also interested in who gets what—the allocation of surplus! One natural place to
start is to ask: in the competitive market equilibrium, can we make any individual better off
without harming someone else?
o No! This concept is called Pareto efficiency and is related to social surplus.
 An outcome is Pareto efficient if no individual can be made better off without
making someone else worse off.
o As it turns out, besides maximizing social surplus, the competitive market equilibrium
is also Pareto efficient (or Pareto optimal).

The Invisible Hand– Adam Smith

 The main actors in any market are buyers and sellers.
 - We found that each of them follows certain self-interest rule:
 o Consumers maximize utility and firms maximize profit.
 But when all of these self-interested people are put together in a competitive market, can
anything but chaos result? For Adam Smith, the answer is yes.
 At first glance it does seem as if pandemonium reigns in many markets - obvious disarray:
o bidding wars on eBay,
o stockbrokers frantically waving their arms as they try to buy or sell,
o buyers and sellers haggling over prices at flea markets.
 Adam Smith, regarded by many as the father of neoclassical economics, viewed the chaos
quite differently. He conjectured that self-interest was a necessary ingredient for an
economy to function efficiently. This view is put forth most elegantly in his treatise The
Wealth of Nations (1776):
o “It is not from the benevolence of the butcher, the brewer, or the baker, that we
expect our dinner, but from their regard to their own interest.”
 This insight has become known as the power of the “invisible hand.”
o It suggests that when all of the assumptions of a perfectly competitive market are in
place, the pursuit of individual self-interest promotes the well-being of society as a
whole, almost as if the individual is led by an invisible hand to do so.

In short, the invisible hand is a metaphor often used in economic theory to describe the unintended
positive consequences of self-interested actions. The term is often attributed to Adam Smith, who
used it in his book The Wealth of Nations to describe how individuals acting in their own self-interest
can unintentionally generate desirable social outcomes.

Smith argued that when individuals pursue their own self-interest, they are also contributing to the
overall good of society.

Example:

- we need 8 buyers and 8 sellers.

- Each wants to buy or sell a used Motorcycle,
- We further assume that all motorcycles are in excellent condition.

The market for used Motorcycles.

What is the equilibrium price in this case?

 - The equilibrium price is determined by the intersection of the market demand and market
supply curves.
- The intersection between Demand and Supply yields a price between 2400 € and 2600 €
(let’s say 2500 €) at which 5 motorcycles will be bought and sold.
- Let’s think about Efficiency:
o Note what happens here, the 5 best producers (those who can sell at very low prices)
end up selling to the best 5 consumers (those with the highest willingness to pay).

Prices Guide the Invisible Hand:

 Market prices act as the most important piece of information, leading the high-value buyers
to buy and the low-cost sellers to sell.
o For example: prices adjust until the quantity demanded of oceanfront property
equals the quantity supplied of oceanfront property.
o prices force entrepreneurs to produce their goods efficiently, that is with the lowest
cost possible.
o Workers will go to sectors with the highest rewards causes.
 So, when a government imposes a price control - by forcing a low price - during a hurricane,
it does not give producers an incentive to supply the market with water:
Indeed, why should producers service the market if they are only interested in
maximizing profits?

Efficiency and Equity

 Efficiency: A market economy has features that are remarkable at providing price signals that
guide resources in a way that maximizes social surplus and makes the economy efficient.
Market forces act to eliminate waste—guiding resources to their correct destination— and
provide incentives for all market participants to promote their own interests, which in turn
promote the broader interests of society. In this way, maximizing efficiency directs us toward
making the social surplus as large as possible.
 But it is important to recognize that the standard of maximizing social surplus is just one way
to measure the progress of an economy.
o Another consideration is how the social surplus is allocated.
 For example, many citizens might believe that every person should have
proper access to food, housing, and basic healthcare.
 Equity is concerned with how the economic pie is allocated to the various economic agents.
o Should we help the homeless man on the corner, or assist an unemployed worker?
What about starving children in Africa?
 They have virtually no income, implying that they are excluded from almost
every market because their willingness to pay is not high enough to buy
many goods.
 Just because the competitive market equilibrium maximizes social surplus, and is efficient,
does not mean that the resulting distribution is morally satisfactory.
 Of course, such redistribution of wealth is important to modern societies, and that is why
governments and private charities intervene in the functions of the market for this very
reason.
Chapter 2: Understanding the Rational Consumer.
Section 1: Consumer budget
BUDGET CONSTRAINT
 The economic model of consumer behaviour is simple:
o people choose the best things they can afford.

Consumption Choice Set :

 A consumption choice set is the collection of all consumption choices available to the
consumer.
 What constrains consumption choice?
o Budget, time and other resource limitations.

In microeconomics, the consumption choice set is a set that represents all attainable bundles of
consumption that a consumer can purchase with their available income. It is also known as the
feasible set.

In other words, it is the set of all possible consumption bundles that a consumer can choose from
given his or her income and the prices of the goods he or she wishes to consume.

The consumption choice set is important in microeconomics because it helps economists understand
how consumers make decisions about what to buy. By understanding the consumption choice set,
economists can predict how consumers will react to changes in prices, income, and preferences.

Budget Contraints :

 A consumption bundle containing x1 units of commodity 1, x2 units of commodity 2 and so

on up to xn units of commodity n is denoted by the vector (x1, x2, … , xn).
o a consumption bundle is a combination of goods and services that a consumer
chooses to consume. It represents the quantity of each good or service that the
consumer consumes.
 Commodity prices are p1, p2, … , pn.
o A commodity price is the market price of a commodity.
 When is a bundle (x1, … , xn) affordable at prices p1, … , pn?
o When p1x1 + … + pnxn <=m
 where m is the consumer’s (disposable) income.
 The bundles that are only just affordable form the consumer’s budget constraint:
o p1x1 + … + pnxn = m

Budget Set and Constraint for Two Commodities:

What does the slope mean it mean?

 -
- Increasing x1 by 1 must reduce x2 by p1/p2.
- It’s the opportunity cost of an extra unit of commodity 1.
o opportunity cost is the value of the next best alternative forgone when a choice is
made. It is the loss of potential gain from choosing one alternative over another. In
other words, it is the cost of the alternative that you did not choose.
- p1/p2 units’ commodity 2 must be forgone to allow 1 consumption of unit 1.

Budget Sets & Constraints; Income and Price Changes

The budget constraint and budget set depend upon prices and income.

What happens as prices or income change?

Income changes  Higher income gives more choice.

 Increases in income m shift the constraint outward in a parallel manner, thereby enlarging
the budget set and improving choice.
o No original choice is lost, and new choices are added when income increases, so
higher income cannot make a consumer worse off.
 Decreases in income m shift the constraint inward in a parallel manner, thereby shrinking the
budget set and reducing choice.
o An income decrease makes the consumer worse off.

Price Changes

How do the budget set and budget constraint change as p1 decreases from p1 ’ to p1 ”?

Budget constraint pivots; slope flattens from -p1’/p2 to -p1 ”/p2.

Section 2: The Consumer's Preferences
 The economic model of consumer behaviour is simple:
o people choose the best things they can afford.
 Behavioural Postulate:
o A decision-maker always chooses its most preferred alternative from its set of
available alternatives.
 So, to model choice we must model decision-makers’ preferences.
 Preferences (or tastes) refer to a consumer’s ability to compare or rank one consumption
bundle (i.e. a list of goods & services) over another.
 The idea of ranking one thing over another captures a relationship between two things:
o preferences are modelled using a mathematical concept called binary relations.
o In microeconomics, binary relations are used to represent preferences, which are
the orderings that individuals have over goods and services.
 Binary relations, examples:
o In a gathering of family members, “is a child of” relates any person with her or his
mother or father.
o In the realm of numbers, “is greater than” (the symbol ‘>’) relates any two different
numbers.
o in the realm of a social network such as Facebook, ‘is a friend of’ relates some pairs
of individuals on the network but not others –
 In the context of tastes, a binary relation is called a preference relation.

A preference relation in microeconomics is a binary relation that describes the order individuals have
over different consumption bundles. It allows economists to model and analyse consumer behaviour
and how they make decisions about what to consume.

o strict preference: X is more preferred than Y. ≻.

- Comparing two different consumption bundles, X and Y:

 X ≻ Y means that bundle X “is preferred to” or “is better than” bundle Y
o weak preference: X is as at least as preferred as Y. ≽
 X≽ Y means X “is at least as good as” Y.
o indifference: X is exactly as preferred as Y. ~
 X ~ Y means x and y are equally preferred.
- Strict preference, weak preference and indifference are all preference relations.

A preference relation is typically denoted by the symbol ≽ or ≻. The symbol ≽ means "at least as
good as" or "preferred to or indifferent to", while the symbol ≻ means "strictly preferred to".

Particularly, they are ordinal relations:  i.e. they state only the order in which bundles are preferred.

Ordinal relations, also known as weak orderings, are binary relations that capture the relative

They are typically denoted by symbols such as <, >, ≤, ≥, and ≻.

ordering or ranking of objects without specifying the magnitude of the difference between them.

When we write X ≻ Y, meaning that the consumer prefers X over Y, it is a shorthand for
writing X ≽ Y and not Y ≽ X.
-

- Similarly, C ~ D is a shorthand for C ≽ D and D ≽ C, meaning that the consumer is indifferent

between C and D.

Assumptions about Preference Relations:

There are 5 assumptions we would like the “at-least-as-good-as” relation on a commodity space (the
commodity space is the set of all possible consumption bundles that a consumer can choose from. It
is also known as the choice set or consumption set.) satisfy in order to capture a typical consumer’s
preferences.

must have either x ≻ y, y ≻ x, or x ≽ y. This assumption is necessary to ensure that the

1. Completeness: This assumption states that for any two consumption bundles x and y, we

preference relation does not leave any consumption bundles unclassified.

itself. In other words, for any consumption bundle x, we must have x ≽ x. This assumption is
2. Reflexivity: This assumption states that every consumption bundle is at least as good as

necessary to ensure that the preference relation is consistent and meaningful.

3. Transitivity: This assumption implies that if an individual prefers alternative A to B and B to
C, then they must prefer A to C. Transitivity is a fundamental assumption that helps maintain
logical consistency in the ranking of alternatives.

- Whether people’s preferences in reality are transitive or not is an empirical issue.

- While it may certainly be true that both assumptions 1 and 3 are unrealistic,
o it is standard practice to maintain these assumptions at this level.

4. Monotonic preferences: This fourth assumption is intuitive and captures the idea that

a. A binary relation ≽ is monotonic if for any two bundles X and Y, if X contains at least
“goods are good”. We will typically assume that more is better.

i. weak monotonicity implies X ≽ Y,

as much of each good as bundle Y and more of at least one good, then:

ii. Whereas strict monotonicity implies X ≻ Y

In economics, monotonic preferences are a type of preference relation that implies that a consumer
will always prefer more of a good to less of the same good. Monotonic preferences are a basic
assumption in microeconomics, as they are consistent with the idea that consumers generally prefer
to have more of the things they like.

There are two types of monotonic preferences:

Weak monotonicity: This assumption states that a consumer will never prefer less of a good to more
of the same good. In other words, for any two consumption bundles x and y, if x has more of a good
than y, then x will always be at least as good as y.

Strict monotonicity: This assumption states that a consumer will always prefer more of a good to less
of the same good. In other words, for any two consumption bundles x and y, if x has more of a good
than y, then x will strictly prefer x to y.

Given bundle A = (4, 3), monotonic preferences imply that any

bundle to the northeast of A lying in the shaded blue area (including
any bundle exactly north of A such as B = (4, 5), as well as to its east
such as C = (7, 3)) leaves the consumer as well off (in the case of
weak monotonicity) or better off (in the case of strict monotonicity).
 - So weak monotonicity of preferences captures the idea that more is never worse and could
actually be better.
- Once again, this may or may not be true in real life.
o For example, if good 1 is ice-cream and good 2 is chocolate, eating too much of
either good might make a consumer sick (i.e., worse off), so more is not necessarily
better.
- Monotonicity of preferences helps to determine the direction in which preferences are
increasing and also the direction in which they are decreasing:
o For instance, in the figure before, any point to the northeast of A is better (or at least
not worse), while every point to the southwest of A in the pink shaded area is worse
(or at least not better).
o So with strictly monotonic preferences, a bundle that is indifferent to A must lie
either in the northwest quadrant or in the southeast quadrant from A.

5. Convexity of preferences

Convex sets » A set is said to be a convex set (or a weakly convex set) if the line segment joining any
two points in that set lies within the set.

So a set is said to be convex if the line segment joining any two points in that set lies within the set.

• If this line lies strictly in the interior of the set, we say that the set is strictly
convex.
• if some part of the line overlaps with the boundary, we say the set is weakly
convex.

Indifference Curves:

- Take a reference bundle A. The set of all bundles equally preferred to A is the indifference
curve containing A. It is the set of all bundles X ~ A.
- Since an indifference “curve” is not always a curve a better name might be an indifference
“set”.

Here the indifference curve is strictly monotonic.

Slopes of Indifference Curves :

- When more of a commodity is always preferred, the commodity is a good.

- So what does monotonicity imply about the shape of indifference curves?
o It implies that they have a negative slope –
- If every commodity is a good, then indifference curves are negatively sloped.

Indifference Curves Cannot Intersect

Two indifference curves cannot intersect because it would contradict

the assumptions of consumer preferences. Indifference curves
represent combinations of goods and services that a consumer is
indifferent about. This means that a consumer would be equally happy
with any combination of goods that lies on the same indifference curve.

If two indifference curves intersected, this would imply that two

different combinations of goods could give the same level of satisfaction
to a consumer. However, this is not possible because consumer
preferences are assumed to be transitive. This means that if a consumer
prefers combination A to combination B and combination B to
combination C, then the consumer must also prefer combination A to
combination C.

The fact that indifference curves cannot intersect is a fundamental result in microeconomics. It is important for
understanding how consumers make decisions about what to consume.

IC of Perfect Substitutes

- If a consumer always regards units of commodities 1 and 2

as equivalent, then the commodities are perfect substitutes.

From IC1, Z ~ A. From IC2, Z ~ Y. Therefore Y ~ A. But from

If we are at (10, 10), and we increase the amount of the first good by one unit to 11, how much do
we have to change the second good to get back to the original indifference curve? The answer is
clearly that we must decrease the second good by 1 unit. Thus, the indifference curve through (10,
10) has a slope of −1.

IC of Perfect Complements

If a consumer always consumes commodities 1

and 2 in fixed proportion (e.g. one-to-one),
then the commodities are perfect complements
and only the number of pairs of units of the two
commodities determines the preference rank-
order of bundles.

IC of bads “goods”

Indifference curves for bads, on the other hand,

are typically upward sloping. This means that
consumers are willing to trade off less of one bad for
more of another. This is because consumers
generally prefer to have less of a bad than more of
the same bad.

IC of a neutral good:

IC of a preferences Exhibiting Satiation

In economics, preferences exhibiting satiation refer to

the concept that consumers' desires for a particular good
or service diminish as they consume more of it. This
means that there is a limit to how much of a good or
service a consumer can consume before their satisfaction
starts to decline.
Satiation is a fundamental assumption in microeconomics, as it allows economists to model how
consumers make decisions about what to consume. By assuming that consumers are satiated,
economists can avoid the unrealistic scenario of consumers wanting to consume infinitely large
amounts of a good or service.

 A bundle strictly preferred to any other is a satiation point or a bliss point.

Well-Behaved Preferences:

A preference relation is “well-behaved” if it is:

 Strictly monotonic and strictly convex.

o Strict Monotonicity:
 More of any commodity is always preferred.
 Monotonicity is violated with a satiated preference.
o Convexity:
 Mixtures of bundles are preferred to the bundles themselves.
 tx + (1 - t)y x for 0 < t < 1
 It basically means that moderates are better than extremes.

Reminder:

Preferences are strictly convex when all mixtures z are

strictly preferred to their component bundles x and y.

Preferences are weakly convex if at least one mixture z

is equally preferred to a component bundle.

Marginal Rate of Substitution

 The slope of an indifference curve is its marginal rate of substitution (MRS).
 MRS at a given bundle x is the marginal exchange rate between two goods to make the
consumer indifferent to x.

In microeconomics, the marginal rate of substitution (MRS) is a measure of how much a consumer is
willing to give up one good to get more of another. It is defined as the negative of the slope of an
indifference curve.

The MRS is important because it shows how consumers make trade-offs between different goods and
services. A higher MRS means that a consumer is more willing to give up one good for another. This is
because the consumer places a higher value on the good, they are getting in the trade-off.

How can a MRS be calculated?

Suppose that we take a

little of good 1, Δx1,
away from the consumer.
Then we give him Δx2, an
amount that is just
sufficient to put him back
on his indifference curve,
so that he is just as well off after this substitution of x2 for x1 as he was before. We think of the ratio
Δx2/Δx1 as being the rate at which the consumer is willing to substitute good 2 for good 1.

The Marginal Rate of Substitution (MRS)

refers to the rate at which a consumer is
willing to trade one good for another while
keeping their level of utility constant.
Mathematically, it is the ratio of the
marginal utility of one good to the marginal
utility of another:

MRS = MU1 / MU2

Where MU1 is the marginal utility of good 1, and MU2 is the marginal utility of good 2.

In the context of preferences, the MRS represents how much of good 2 the consumer is willing to
give up for an additional unit of good 1 while maintaining the same level of satisfaction.

For strictly convex preferences, the MRS indeed increases (becomes less negative) as the quantity of
good 1 (x1) increase. This is because with strictly convex preferences, the consumer exhibits
increasing marginal rates of substitution as they consume more of good 1.

Section 3: What is utility?

In Victorian days, philosophers and economists talked blithely of “utility” as an indicator of a
person’s overall well-being. Utility was thought of as a numeric measure of a person’s happiness.
Given this idea, it was natural to think of consumers making choices so as to maximize their utility,
that is, to make themselves as happy as possible.

- The trouble is that these classical economists never really described how we were to
measure utility.
o How are we supposed to quantify the “amount” of utility associated with different
choices?
o Is one person’s utility the same as another’s?
o What would it mean to say that an extra candy bar would give me twice as much
utility as an extra carrot?
o Does the concept of utility have any independent meaning other than its being what
people maximize?
- Because of these conceptual problems, economists have abandoned the old-fashioned view
of utility as being a measure of happiness.
o Instead, the theory of consumer behaviour has been reformulated entirely in terms
of consumer preferences,
o and utility is seen only as a way to describe preferences.
- Modern economists have come to recognize that all that matters about utility as far as choice
behaviour is concerned is:
o whether one bundle has a higher utility than another
o how much higher doesn’t really matter.
- Originally, preferences were defined in terms of utility:
o to say a bundle (x1, x2) was preferred to a bundle (y1, y2) meant that the x-bundle
had a higher utility than the y-bundle. But now we tend to think of things the other
 way around. The preferences of the consumer are the fundamental description
useful for analysing choice, and utility is simply a way of describing preferences.
o The way we think about utility and preferences has changed over time. In the past,
utility was often seen as a measure of happiness or satisfaction that consumers
derive from consuming goods and services. This led to the view that utility is the
fundamental concept that can be used to analyse consumer behaviour. Preferences
were then seen as a way of describing utility.
However, more recently, economists have come to view preferences as the
fundamental concept, and utility as a way of describing preferences. This is because
preferences are more directly observable than utility. We can observe what
consumers choose to consume, and we can use this information to infer their
preferences. Utility, on the other hand, is not directly observable. We can only infer
utility from consumer choices.

Utility Function

 A utility function is a way of assigning a number to every possible consumption bundle such
that more-preferred bundles get assigned larger numbers than less-preferred bundles. That
is, a bundle (x1, x2) is preferred to a bundle (y1, y2) if and only if the utility of (x1, x2) is larger
than the utility of (y1, y2).
 - It turns out that the level of utility itself has no special significance so long as the preference
ranking between any pairs of bundles is retained.

Constructing a Utility Function

- Consider the bundles (4,1), (2,3) and (2,2).

o Suppose that (2,3) is strictly preferred to (4,1)
o And that the individual is indifferent between (4,1) and (2,2).
o Assign to these bundles any numbers that preserve the preference ordering; e.g.
u(2,3) = 6 > u(4,1) = u(2,2) = 4.
o Call these numbers utility levels.
- An indifference curve contains equally preferred bundles:
- Equal preference Þ same utility level.
- Therefore, all bundles in an indifference curve have the same utility level.

- So the bundles (4,1) and (2,2) are on the same

indifference curve with utility level u = 4
- But the bundle (2,3) is on a higher indiff. curve with
utility level u= 6.
- On an indifference curve diagram, this preference
information looks as follows:
 - Another way to visualize this same information is to plot the utility level on a vertical axis.
3D plot of
consumption & utility
levels for 3 bundles.

This 3D visualization of
preferences can be made
more informative by adding
into it the two indifference
curves.

Comparing more bundles will create a larger collection of all indifference curves and a better
description of the consumer’ s preferences.

- As before, this can be visualized in 3D by plotting each

indifference curve at the height of its utility index.

- Comparing all possible

consumption bundles gives the complete collection of the consumer’s indifference curves,
each with its assigned utility level.
- This complete collection of indifference curves completely represents the consumer’s
preferences.

Marginal Utilities

In microeconomics, marginal utility is the additional satisfaction or pleasure that a consumer derives
from consuming one more unit of a good or service. It is a measure of the change in utility that
occurs when the consumer increases the quantity of a good or service consumed.

Marginal utility is important because it helps to explain how consumers make decisions about what
to consume. Consumers will generally consume more of a good or service if the marginal utility from
consuming it is positive. However, consumers will stop consuming a good or service if the marginal
utility from consuming it is negative.

 Marginal means “incremental”.

 Consider a consumer who is consuming some bundle of goods, (x1, x2). How does this
consumer’s utility change as we give him or her a little more of good 1?
o This rate of change is called the marginal utility with respect to good 1.

Marginal Utility (MU) = Change in Total

Utility / Change in Quantity

The marginal utility of commodity i is the rate-of-

change of total utility as the quantity of commodity i consumed changes.
The marginal utility of a particular commodity (denoted as commodity i) is indeed defined as the rate
of change of total utility with respect to the quantity of that specific commodity consumed.

Mathematically, the marginal utility (MU) of commodity i can be expressed as the derivative of the
total utility (U) with respect to the quantity of commodity i consumed (Qi):

Here, MU_i represents the marginal utility of commodity i, U is the total utility derived from
consuming various quantities of goods, and Q_i is the quantity of commodity i consumed.

This concept helps in understanding how an individual's satisfaction or utility changes as they
consume more units of a specific good. Marginal utility describes the additional satisfaction gained or
lost from consuming an extra unit of a particular commodity.

The principle of diminishing marginal utility states that as an individual consumes more of a specific
good while keeping other factors constant, the marginal utility tends to decrease. This principle helps
explain why people allocate their resources in a way that maximizes their overall satisfaction or
utility. Yes, that's correct. The marginal utility of a particular commodity (denoted as commodity i) is
indeed defined as the rate of change of total utility with respect to the quantity of that specific
commodity consumed.

Marginal Utilities and Marginal Rates-of-Substitution

- A utility function U(x1, x2) can be used to measure the marginal rate of substitution (MRS).
o MRS measures the slope of the indifference curve at a given bundle of goods.
o it can be interpreted as the rate at which a consumer is just willing to substitute a
small amount of good 2 for good 1.
- This interpretation gives us a simple way to calculate the MRS. Consider a change in the
consumption of each good, (Δx1,Δx2), that keeps utility constant.
o that is, a change in consumption that moves us along the indifference curve. Then we
must have:
• MU1Δx1 + MU2Δx2 = ΔU = 0
o Solving for the slope of the indifference curve we have

Section 4: Rational choice

- A consumer’s demand for each good is found by maximizing her preferences over her
budget, i.e.,
o by finding a consumption bundle within her budget set which is strictly better or at
least as good as any other affordable bundle.

Consumer’s problem

- Given a utility function u(x1,x2) and the following exogenous variables:

o a) m, the income of the consumer
o b) p1 and p2 which are market prices

How will the consumer behave?

  Bundle A in the interior of the budget set is certainly affordable, bundle B is also affordable
and lies on a higher indifference curve than A.
 the quantities of the two goods at B maximize the consumer’s preferences subject to the
given budget.

The indifference curve that passes through B is tangent to the budget line:

 so, the slope of the indifference curve (which is MRS) at point B equals to the slope of the
budget constraint:

 OR
 The tangency condition given in the equation above is the primary mathematical condition
used to algebraically calculate individual demands in section.

The tangency condition you're referring to is likely related to consumer choice theory, particularly in
the context of utility maximization subject to a budget constraint. This condition arises from the
principle that consumers aim to maximize their utility given their budget constraints.

In consumer theory, the tangency condition comes from the point where the highest level of utility
(satisfaction) is achieved given the budget available. This is typically illustrated using an indifference
curve (representing bundles of goods that yield the same level of satisfaction) and a budget
constraint line.

The condition for utility maximization subject to a budget constraint can be expressed as:

Where MRS represents the marginal rate of substitution (the rate at which a consumer is willing to
exchange one good for another while maintaining the same level of satisfaction), and P1 and P2 are
the prices of goods 1 and 2 respectively.

Graphically, this condition is represented by the point where the budget constraint line is tangent to
an indifference curve. The slope of the budget line (P1/P2) represents the rate at which goods can be
traded in the market, and it is equated to the slope of the indifference curve at the point of tangency,
which is the marginal rate of substitution.

By setting the marginal rate of substitution equal to the price ratio, consumers can maximize their
utility given their budget constraints. This condition helps determine the optimal quantities of goods
that a consumer will purchase.

Using this tangency condition, along with the consumer's budget constraint and the prices of goods,
economists can algebraically solve for the individual demands for various goods—that is, the
quantities of goods that maximize the consumer's utility given their budget.
This process of optimizing consumer choices through the equality of the marginal rate of substitution
and the price ratio is a fundamental concept in microeconomics for understanding individual demand
behaviour.

an "interior solution" refers

to an optimal solution that
occurs within the feasible set
or the interior of the feasible
region. This term is commonly
used in optimization
problems, including those
encountered in consumer
theory.

Must the tangency point always hold? No!

If the preference-maximizing bundle is a corner solution (or the boundary optimum) meaning that
either the quantity of x1 or that of x2 is zero.  then it doesn’t hold the tangency point.

In other words, a corner solution is one where only one good

is consumed.

a corner solution along the horizontal axis (where x*1 > 0 and
x*2 = 0) requires the indifference curve to be steeper than or

the same slope as the budget line:

Consumer Demands

The demand function is the function that relates the optimal choice— the quantities demanded—to
the different values of prices and incomes.

Demand functions depend on both prices (p1 and p2) and income (m):

- x1(p1, p2,m)
- x2 (p1, p2,m)

Chapter 3: Choice under uncertainty

Introduction
Let's say, I'm going to flip a coin:

• If it comes up heads, you get €125.

• If it comes up tails, you pay me €100.
how many of you would take this lottery/gamble?

- A useful starting point is to compute the expected value of the gamble, that is:
o EV = prob(win)125+ prob(lose)(−100) = 0.5*125− 0.5*100 =12.5€

the expected value is a measure of the central tendency of the variable's probability distribution. It
represents the average value that would be obtained from an infinite number of repetitions of an
experiment or from a large number of observations.

 Economists would categorize this lottery as being more than a fair bet!

So why is it that most individuals do not choose to take this more than fair bet?

- The answer is that individuals do not maximize expected value!

- Individuals maximize expected utility!
o Indeed: expected utility incorporates the fact that most humans are risk averse:
• Which means they will not take gambles even with small positive expected
value.
o the way economists capture this is through expected utility theory.

1. Risk-Averse:

 Definition: Risk-averse individuals are those who prefer certainty over uncertainty.
They are willing to accept a lower expected return or payoff if it means avoiding or
reducing the possibility of loss or variability in outcomes.

 Behaviour: A risk-averse person will tend to avoid or minimize risky situations and
prefer options with lower but more certain returns. They are willing to give up
potential gains to reduce the possibility of losses.

2. Risk-Neutral :

 Definition: Risk-neutral individuals are indifferent to risk. They evaluate decisions

solely based on expected values or payoffs without considering the level of risk or
uncertainty.

 Behavior: Risk-neutral individuals make decisions based purely on the expected

monetary outcome, without factoring in their attitudes towards risk or uncertainty.

3. Risk-Loving (Risk-Seeking):

 Definition: Risk-loving individuals are those who prefer uncertainty or higher risk
even when faced with lower expected returns. They are willing to take on more risk
in exchange for the possibility of higher rewards.

 Behaviour: Risk-loving individuals seek out risky situations and are attracted to
options with higher potential payoffs, even if it means facing a higher probability of
losses.

Expected utility.

- Let c1 and c2 represent consumption in states 1 and 2 and let p1 and p2 be the probabilities
that state 1 or state 2 actually occurs.
o Note that if the two states are mutually exclusive, so that only one of them can
happen, then p2 = 1− p1
 •
- This says that utility can be written as a weighted sum of some function of consumption in
each state, u(c1) and u(c2), where the weights are given by the probabilities π1 and π2.

- Expected utility incorporates the fact that most humans are risk averse!
o In other words, individuals will not take gambles even with small positive expected
value.
- The very fact that they are taking a gamble, itself, deters them from engaging in the activity.
- So economists say that what people consider is expected utility, which is:
o
- turns out to be different than Expected Value!

Lets use an example

 Let’s flip a coin again:

o If it comes up heads, you get €125.
o If it comes up tails, you pay me €100.
o your expected utility would be the probability of the expected utility of that gamble.

The reason why EU is not the same as EV is because utility functions are not linear.

Utility functions are concave; thus, they exhibit diminishing marginal utility:

• winning makes you less happy than losing makes you sad.
• So from any point you start at, getting $100 makes you less happy than losing $100 makes
you sad.

Risk Aversion
Risk Loving

Risk Neutral

The intermediate case is that of a linear utility function. Here the consumer is risk neutral:

- the expected utility of wealth is the utility of its expected value. In this case the consumer
doesn’t care about the riskiness of his wealth at all—only about its expected value.

How can we think of designing an insurance policy?

Back to our example :

- Let’s assume that you are forced to play the coin game. But now you have the option of
buying insurance to protect yourself.
- What would be the highest price you are willing to pay to get insurance?
Chapter 4: Asymmetric Information
Section 1: Adverse Selection and Moral Hazard
- Asymmetric information occurs when one party to a transaction has more information than
the other. We focus on two specific forms:
o Adverse selection
o Moral hazard
- The analysis of how asymmetric information problems affect behaviour is known as agency
theory.

Adverse Selection

1. Occurs when one party in a transaction has better information than the other party.
2. Before transaction occurs.

The Lemons Problem :

Lemons Problem in Used Cars

1. If we can't distinguish between “good” and “bad” (lemons) used cars, we are willing to pay
only an average of good and bad car values.
2. Result: Good cars won’t be sold, and the used car market will function inefficiently.
- What helps us avoid this problem with used cars?
o Two types of cars: high and low quality –
o High quality cars are worth €2000, low are worth €1000.
o Suppose that people know that in the population of used cars that ½ are high quality
• Already a strong (unrealistic) assumption • One that is not likely satisfied.
- Buyers do not know the quality of the product until they purchase.
- How much are they willing to pay?
- Expected value - Price = (1/2)€2000 + (1/2)€1000 = €1500
- Let’s assume that individuals are risk neutral and are therefore willing to pay €1500 for an
automobile.
- Would €1500 be the equilibrium price?
- Who is willing to sell an automobile at €1500?
o High quality owner has €2000 auto.
o Low quality owner has €1000.
- Only low-quality owners enter the market - what will happen?

Moral Hazard
 1. Occurs when one party has an incentive to behave differently once an agreement is made
between parties.
2. After transaction occurs.
- People tend to take more risks if they don’t have to bear the costs of their behaviour.

Principal-Agent

- Under moral hazard the uninformed party can sometimes design a contract to incentivize the
party with private information.
o Economists refer to such relationships as a principal–agent relationship. The party
with the hidden action (thus with the private information) is the agent. The
uninformed party, who can design a contract before the agent chooses his action, is
the principal. This contract determines the agent’s payoff (for example, wage or
salary when the principal is an employer and the agent a worker) as a function of his
success or failure or other indicators of his performance. The principal tries to
structure the contract so as to provide appropriate incentives to the agent (for
example, so as to incentivize the worker to work hard).
- In a principal–agent relationship, the principal designs a contract specifying the payments to
the agent as a function of his or her performance, and the agent takes an action that
influences performance and thus the payoff of the principal.

Section 2: Health insurance

What is insurance?

1. Individuals pay premiums to an insurer. Insurer promises to make a payment to the insured
if an adverse event occurs.
2. Actuarially fair premium: Is the expected payment = {probability of the adverse event} x
{payment €}

Reasons for insurance

1. Consumption smoothing (assumption)

a. Individuals tend to prefer incomes that are similar in each period to wide differences
incomes across periods.
b. Given a choice between 2 years of average consumption versus one year of very low
consumption and one year of very high consumption, individuals would choose the
first option: Excessive consumption doesn't raise utility as much as starvation lowers
it.
2. With uncertain outcomes, individuals want to smooth their consumption across outcomes.
That is, they would like consumption in one eventuality to be as similar as possible to
consumption in another eventuality.
3. Key insurance theory result: with actuarially fair pricing, individuals will demand insurance.
Thus, full insurance is the efficient market outcome.

Asymmetric information
 - In demonstrating the efficiency of competitive markets, we make an important assumption:
perfect information.
- However, in the real world, information is asymmetric when buyers or sellers have private
information about themselves that others cannot know.

Example: People who face uncertainty about personal income would want insurance against
having low future income.

- When personal effort is an individual’s private information that is unobservable to others,

insurance companies are unwilling to sell insurance against having low income because it will
be impossible to know whether future low personal income will have been due to bad luck or
to lack of personal effort.

Because of asymmetric information:

 insurance markets for personal income then may not exist.

 There is a social loss because of the benefits that the absent or “missing” markets would
have provided, if the markets were to exist.

Expected utility model

- Expected utility (EU) is the probability-weighted average of two state of the world:
o EU = p u(CA) + (1-p) u(CN)

Example: Suppose that Sam's utility function over income levels is given by

This utility function has diminishing marginal utility, as the additional utility from an additional dollar
of income becomes less and less.

Graphically, this is how the utility function looks like:

So we have decreasing marginal utility.

- Compare three situations:

o No insurance,
o partial insurance
o and full insurance.

1. With no insurance, income is 50 000€ if the accident doesn't occur and 0 if the accident
occurs. Suppose that p=0.01; there is a 1% probability of the accident occurring. Then with
no insurance, his expected utility is 0.99 x (50 000€) **1/2+ 0.01 x 0 = 221.37
 2. With full insurance, incomes in both states of the world are the same. But Sam needs to buy
insurance. We learned from above that the actuarially fair price is 500€, thus under full
insurance, Sam’s expected utility is EU = 0.99 x (50 000€ - 500€) ** 1/2 + 0.01 x (50 000€ -
500€) ** 1/2 = 222.49
3. With partial insurance that costs 250€ and pays 25 000€ in case of an accident. In this case,
Sam’s expected utility is EU = 0.99 x (50 000€ - 250€) ** 1/2 + 0.01 x (25 000€ - 250€) **1/2 =
222.39

Note that expected utility (EU) is highest with full insurance!

This is because of the shape of his utility function, which has diminishing marginal utility in income.
Another way of describing Sam (due to the shape of his utility function) is that he is risk averse. A
risk-neutral person cares only about expected income; all income distribution over states that yield
the same expected income are equivalent to such a person. A risk-loving person prefers risky income
to a sure income with the same expected income. Such a person has a convex utility function over
income. Most people seem to be risk-averse!!!

Risk aversion and risk premium

Individuals with high risk aversion will buy insurance even if it not priced at an actuarially fair price.

The risk premium = the amount that risk-averse individuals are willing to pay above the actuarially
fair price.

Adverse selection

- If individuals could fully insure themselves at actuarially fair prices in the private market,
there would be no need for government intervention.
o Yet there is a great deal of government intervention in insurance markets.
- Information asymmetry can lead to problems in insurance markets. It is the difference in
information about risk available to the insurer versus the insured.
- Adverse selection in insurance markets: buyers of insurance know more about their risk (how
long they're likely to live, how careful they are about not getting into an accident) than
sellers of insurance.
- Since sellers of insurance don't know the exact risk of each buyer, they assume buyers have
higher than average risk and price insurance accordingly.
- As a result, people who would have bought insurance at an actuarially fair premium no
longer buy it.
Therefore, some mutually beneficial trade does not take place.

Adverse selection: Example

2 groups of 50 people each.

• Group 1 doesn't pay attention when crossing the street.

o Each member of this group has 5% chance of getting hit by a car each year.
• Group 2 is careful when crossing street.
o Each member of group 2 has 0.5% chance of getting hit by a car each year.

If Full information

- Insurers have full information about who belongs to each group. Assume that income of each
person with no accident is 30 000€ and income with accident (if not insured) is 0€.
 - Then insurer would charge different actuarially fair prices to each group.
o Careless would pay 30 000 x 0.05 = 1500€ each year,
o and -Careful would pay 30 000 x 0.005 = 150€ each year in premiums.
 Insurance company would earn zero profit (because of actuarially fair insurance):
o Efficient outcome would be achieved because everyone who wants to be fully
insured, is.

If no full information

- Now the insurance company knows there are 50 careful and 50 careless people but doesn't
know which is which. They can't ask who is careful - everyone will say they are careful to get
insurance at a lower cost and the company will make a loss.
- How about insurance at an average cost?
o (1 500€ + 150€)/2 = 825€ per year
- Careful consumers will prefer to buy no insurance than to buy insurance at a premium of

$825. Indeed, assume they each have a utility function:

- If the careful buy this insurance, their expected utility is.
o EU = 0.995 x (30 000€ - 825€) ** 1/2 + 0.005 x (30 000€ - 825€)** 1/2 = 170.8
- If they do not buy insurance, their income if they are not hit will be 30000 and their income if
hit will be 0, giving an expected utility of
o EU = 0.995 x (30 000€) **1/2 + 0.005 x (0€) **1/2 = 172.3
- So, buying no insurance is preferable for the careful consumers. Thus, they drop out of the
market, leaving only the careless consumers to buy the insurance. But if only the careless
types are buying insurance, the firm makes a loss:
o Since all buyers are careless, the firm's expected payment is 0.05 x 50 x 30 000 = 75
000€, but its income is 50 x 825 = 41 250 €

Thus:

1. The firm will have to change its price of insurance to reflect the fact that only careless types
are buying insurance.
2. It will give them full, actuarially fair insurance. The price of insurance will be 30 000€ x0.05 =
1 500€.
3. All the careless types end up insured, while the careful types end up not insured.

 This situation represents a market failure: » because the careful types would have wanted
insurance as well if it could have been provided at a cheaper price.

Does asymmetric information necessarily lead to market failure?

- Not necessarily! Most individuals are risk averse and they value being insured against bad
outcomes.
- Suppose that, in the previous example, the utility functions of the careful types were all.
-
- Then their expected utility when they pay a premium of 825 will be EU = 0.005 x (30 000 –
825) **1/8+ 0.995 x (30 000 – 825) **1/8= 3.62
- Their expected utility when they buy no insurance will be EU = 0.995 x (30 000) **1/8= 3.61,
which is less.

Pooling equilibrium: one insurance policy for all!

So, depending on the utility function (the degree of risk aversion) of the lower-risk types, they could
choose to buy insurance even at a price that is higher than the actuarially fair rate for them!!!

This outcome could be problematic in the sense that the equilibrium is unstable:

- if another firm can come along and find a way and offer a better deal to the careful types
that will take them away from the original firm.
- the original firm will be stuck with the careless types and will have to change its policy (raise
the price to the careless types) to remain at zero profit.

Signalling equilibrium: different contracts for different types!

- The insurance company can also try to offer two different contracts, such that high-risk types
choose one and low-risk types choose the other.
- Suppose they offer two policies:
o -1st policy: » full coverage for the 30 000€ in medical costs due to an accident » Price
is 1500€ (which is the actuarially fair price for the careless).
o -2nd policy: » partial coverage for the 10 000€ in medical costs due to an accident »
Price is 50€ (0.5% x 10 000€ = 50€) - which is also an actuarially fair.
- Suppose that the utility functions of both careful and carless is given by

Careless

1. Their expected utility with the 1st policy is: EU = 0.05 x (30 000 – 1500) **1/8+ 0.95 x (30 000
– 1500) **1/8= (30 000 – 1500)1/8= 3.605
2. Their expected utility with the 2nd policy is: EU = 0.05 x (10 000 – 50) **1/8+ 0.95 x (30 000 –
50)**1/8 = 3.604
 Careless will choose 1st policy!

Careful

1. Their expected utility with the 1st policy is: EU = 0.005 x (30 000 – 1500) **1/8+ 0.995 x (30
000 – 1500) **1/8= (30 000 – 1500) **1/8= 3.605
2. Their expected utility with the 2nd policy is: EU = 0.005 x (10 000 – 50) **1/8+ 0.995 x (30
000 – 50) **1/8 = 3.625
 Careful will choose the 2nd policy!

Conclusion

- Like the pooling equilibrium, the separating equilibrium also leads to market failure:
o the careless are getting full insurance, while.
o the careful are not. They are not getting their first choice.
- The optimal solution is: » full coverage for both groups.

Government intervention?

In the careful/careless example, government could mandate that everyone buy full insurance at the
average price of 825€ per year.

- This leads to an efficient outcome, although at this premium, careful would prefer to be
uninsured.
- But if they did not buy insurance, the price to the careless would go up, making them worse
off.
Public provision

- Government could provide full insurance to both types of consumers. If this is paid for by
equal taxes on everyone, it would be the same as mandating full insurance at the average
price of 825€.

Application: Market failure - the case of the Healthcare market

When should the government intervene in the economy?

- There are two reasons why governments may want to intervene in the economy:
o Market failures » When any of the assumptions underlying a competitive economy
fail to be met, and as a consequence efficiency is not achieved, we say that there is
market failure.
• Examples include externalities, public goods, asymmetric information,
imperfect competition.
o Redistribution » The shifting of resources from some groups in society to others.

Example: Healthcare markets

Classic economic model: independent Supply and Demand curves lead to market equilibrium.

- Consumers know what they want to buy and how much they are willing to pay.
- Numerous producers
- Perfect information
- The intersection between Supply and Demand determines the price and quantities sold.

Classic economic model fails in healthcare markets:

- No independent demand:
o Patients rely on their doctors to tell them what they need. This leads competitive
markets to generate an inefficient allocation of resources.
o Non-market institutions (such as trust and norms) correct to some extent the
resulting inefficiencies.
- The important role of health insurance
o Health care is very expensive. Insurance pools risks of very large payments across the
population.
• Risk Pooling: Health insurance pools the financial risks associated with
healthcare expenses across a large and diverse population. By spreading the
costs among many individuals through premiums, it helps protect individuals
from the financial burden of high medical expenses that might arise
unexpectedly. This reduces the financial strain on individuals or families
facing significant healthcare costs.
o As a consequence, patients do not see the full cost of the service they choose.

Now, if fully insured patients, could consume any service at any price, we'd see very high prices
(which would not correspond to the market equilibrium price).

Indeed, doctors and hospitals could charge whatever they want to insured patients.  Without
intervention, markets fail.
Government intervention is essential to correct the market:

- In Belgium the NIHDI sets prices.

o NIHDI: National Institute for Health and Disability Insurance
o INAMI : Institut National d’Assurance Maladie-Invalidité
- Prices are established in close cooperation with stakeholders.

Redistributive Politics of Public Health Insurance

- Public health care program offering services that are available to all and financed by a
proportional income tax will redistribute income from the rich to the poor.
o Indeed, if there is not too much diversity of tastes and if consumption of health care
is independent of income, all those with incomes below average are subsidized by
those above the average.
- Redistribution can also occur from the healthy to the sick (or the young to the aged).
o The sick receive insurance in the public system that is less expensive than the
insurance they would get in the private market.
- Redistribution via health care is more efficient in targeting needy groups than redistribution
in cash.
o Healthy individuals are less likely to pretend to be unhealthy when health care is
provided in-kind than if government were to offer cash compensation to everyone
claiming to be in bad health.

Chapter 5: Understanding Producers

Section 1: Technology
Firms make choices by maximizing an objective function under certain constraints.

- We consider perfect competition:

o the firm is a price-taker with the goal of profit maximization or cost minimization,
bound by the set of production possibilities.

Representation of Technology
Describes production as the process of combining various productive resources.

Inputs are of different natures and are

grouped into two categories: » Fixed inputs
and variable inputs.
This distinction depends on the decision-making horizon:

- At the present moment, most inputs are fixed.

- In the short term, some inputs are variable.
- In the long term, all inputs are variable».

Fixed inputs and variable inputs are terms used in the theory of production in economics to
categorize factors of production based on their characteristics in the short run versus the long run.

1. Fixed Inputs:

 Definition: Fixed inputs are factors of production that cannot be easily or quickly
varied in the short run. These inputs are considered constant or fixed within a
specific production period, regardless of the level of output.

 Examples: Machinery, buildings, land, factory space, and certain types of labour that
cannot be adjusted in the short run.

2. Variable Inputs :

 Definition: Variable inputs are factors of production that can be adjusted or varied in
the short run-in response to changes in the level of output. These inputs can be
increased or decreased relatively easily within a certain time frame.

 Examples: Raw materials, labour that can be hired or laid off, energy, and other
inputs that can be adjusted based on the level of production in the short run.

The distinction between fixed and variable inputs is crucial in understanding production functions
and short-run versus long-run production decisions:

 In the short run, at least one input is typically fixed (fixed input), and the firm adjusts
production by varying the levels of variable inputs. For example, a factory may have fixed
capital equipment (fixed input), but it can adjust the number of workers (variable input) to
produce different quantities of output.

 In the long run, all inputs can be varied or adjusted. There are no fixed inputs in the long run,
and firms have flexibility to adjust all inputs, including capital and labour, to optimize
production based on changes in output levels or technology.

In general, technology is described by all the technically feasible combinations of inputs and outputs.

- Technology is represented by the production function.

- The production function expresses the relationship between the inputs (factors of
production and intermediate goods) of a firm and the quantity produced.

The production function is a fundamental concept in economics that describes the relationship
between inputs (factors of production) and output (quantity of goods or services produced) in the
production process. It represents the technological relationship showing how much output can be
produced by using various combinations of inputs.

Mathematically, a general form of the production function for a firm or an industry can be
represented as:
Where:

 Q = Quantity of output produced.

 L = Quantity of labor input.

 K = Quantity of capital input.

Production function

In this case, we say that the marginal

returns are decreasing!

The marginal product of labour (MPL)

measures the increase in production
related to the addition of an extra worker:

Marginal returns, specifically marginal

returns to an input, refer to the additional output or productivity gained from increasing the usage of
a particular input (such as labour or capital) by one unit, while holding other inputs constant.

The general principle of diminishing returns

The use of additional units of any production factor - fertilizer, labour, machinery - when the
quantities of other factors are fixed, contributes to an increase in production, but in an increasingly
smaller proportion.

Technical progress

Technical progress increases production for a given level of employment or reduces employment for
a given level of production.

- Technical progress shifts the production function:

o For the same amount of labour, more is produced (transition from A to A' and from B
to B') or the same amount is produced with less labour (for example, transition from
B to B'').
- The transition from B to B'' is the basis for the assertion that "technical progress destroys
jobs"... "machines replace humans».
 - Therefore, technical progress increases labour productivity at a given level of employment.

Complementarity and substitutability between production factors

- For the growth of the labour force to transform into increasing production, it must be able to
equip itself with tools, machines, etc. (complementarity).
- However, the adoption of new equipment also results in an increase in labour productivity
(substitutability)."

In economics, the concepts of complementarity and substitutability refer to the relationships

between different factors of production (inputs) in a production process:

1. Complementarity:

 Complementarity exists when the increase in the quantity or efficiency of one input
leads to an increase in the productivity or effectiveness of another input.

 In other words, two factors of production are complementary when they work better
together, and the presence or increased use of one factor enhances the productivity
or output of the other factor.

 Example: In manufacturing, skilled labour and advanced machinery might be

complementary. Increased use of skilled labour might result in higher efficiency and
productivity of the machinery, and similarly, better machinery might enhance the
productivity of skilled workers.

2. Substitutability:

 Substitutability exists when one factor of production can be replaced by another with
little or no impact on the overall output or productivity.

 In this case, the factors of production are substitutes for each other, and an increase
in the quantity or efficiency of one input allows for a decrease in the usage of
another input without significantly affecting the output.

 Example: Labor and capital can be substitutes in some production processes. For
instance, automation or technological advancements might allow firms to use more
machinery (capital) instead of hiring additional labour, maintaining, or increasing
output without expanding the workforce.

Production Possibilities Frontier - PPF

It is an economic model that shows

the combinations of goods (or
services) that an economy is capable
of producing based on a given amount
of available production factors and
available production technology.

The PPF is a tool that describes the different uses that a society could potentially make with all its
resources.
The concavity of the PPF comes from the diminishing marginal returns in production.

The opportunity cost

All combinations of the two goods on the frontier correspond to an efficient allocation of resources.

The expansion of the production possibilities frontier is at the heart of the economic growth process.

Example : The Specific Factors Model

- Assumptions of the model:

o Two goods, cloth and food
• Three factors of production: labour (L), capital (K) and land (T for terrain).
 Cloth produced using capital and labour (but not land).
 Food produced using land and labour (but not capital).
 Labor is a mobile factor that can move between sectors.
  Land and capital are both specific factors used only in the production
of one good.
o Perfect competition prevails in all markets.

1. Specific Factors:

 In this model, factors of production are divided into two categories: specific factors
and mobile factors.

 Specific factors are inputs that are specialized and immobile between different uses
or industries in the short run. They are dedicated or specialized in particular sectors
and cannot easily be moved or reallocated across industries.

2. Mobile Factor:

 Mobile factors, on the other hand, are inputs that can move freely between different
sectors or industries. They are not specialized and can be easily reallocated from one
sector to another.

- How much of each good does the economy produce?

- The production function for cloth gives the quantity of cloth that can be produced given any
input of capital and labor:
o QC is the output of cloth.
o K is the capital stock
o LC is the labour force employed in cloth.
- The production function for food gives the quantity of food that can be produced given any

input of land and labour:

o QF is the output of food.
o T is the supply of land
o LF is the labour force employed in food.

Production Possibilities

- How does the economy’s mix of output change as labour is shifted from one sector to the
other?
- When labour moves from food to cloth, food production falls while output of cloth rises.
- The figure below illustrates the production function for cloth.

- The shape of the production function reflects the law of

diminishing marginal returns.

o Adding one worker to the production process

(without increasing the amount of capital) means
that each worker has less capital to work with.
o Therefore, each additional unit of labour adds less
output than the last.

- The figure below shows the marginal product of labour, which is the increase in output that
corresponds to an extra unit of labour.
 The marginal product of labour (MPL) is an
economic concept that represents the change in
output or production that results from employing one
additional unit of labour, while keeping all other
factors of production constant. It measures the
additional output produced by hiring one more unit of
labour.

- We use a four-quadrant diagram to construct production possibilities frontier.

o Lower left quadrant indicates the allocation of labour.
o Lower right quadrant shows the production function for cloth.
o Upper left quadrant shows the corresponding production function for food.
o Upper right quadrant indicates the combinations of cloth and food that can be
produced.

The Production Possibility

Frontier

- Why is the production possibilities frontier curved? »

o Marginal diminishing returns to labour in each sector cause the opportunity cost to
rise when an economy produces more of a good.
o Opportunity cost of cloth in terms of food is the slope of the production possibilities
frontier – the slope becomes steeper as an economy produces more cloth.

Indeed, in the context of a Production Possibility Frontier (PPF), the opportunity cost of producing
one good (cloth) in terms of another good (food) is represented by the slope of the PPF.

When the slope of the PPF becomes steeper, it indicates an increasing opportunity cost of producing
one good in terms of the other. Specifically, as an economy produces more of one good (in this case,
cloth), it needs to give up increasingly larger amounts of the other good (food) to produce each
additional unit of the first good.
For example, let's consider an economy that can produce both cloth and food. The PPF illustrates the
maximum possible combinations of cloth and food that the economy can produce given its available
resources and technology. The slope of the PPF indicates the rate at which the economy must
sacrifice units of food to produce additional units of cloth or vice versa.

 If the PPF has a constant slope (straight line), the opportunity cost remains constant. This
implies that the economy can produce additional units of one good without sacrificing more
of the other at a constant rate.

 However, when the PPF is concave (bowed-out shape), the slope becomes steeper as the
economy produces more of one good. This indicates that to produce additional units of cloth,
the economy must give up increasing amounts of food, signifying an increasing opportunity
cost of cloth in terms of food.

- Opportunity cost of producing an extra unit of cloth is MPLF/MPLC pounds of food.

o To produce one more yard of cloth, you need 1/MPLC units (for ex hours) of labour.
o To free up one unit of labour, you must reduce output of food by MPLF pounds.
o To produce less food and more cloth, employ less in food and more in cloth: The
marginal product of labour in food rises and the marginal product of labour in cloth
falls, so MPLF/MPLC rises.

Returns-to-scale
- Marginal products describe the change in output level as a single input level change.
- Returns-to-scale describes how the output level changes as all input levels change in direct
proportion (e.g. all input levels doubled or halved).

1. Marginal Product :

 Marginal product refers to the additional output produced by employing one more
unit of a particular input (such as labour or capital), while keeping other inputs
constant.

 It measures the change in output resulting from the employment of an additional

unit of a specific input.

 For instance, the marginal product of labour (MPL) represents the change in output
when one more unit of labour is added to the production process while holding other
factors constant.

2. Return to Scale:

 Return to scale refers to the effect on output resulting from a proportional increase
in all inputs used in production.

 It analyses the relationship between an increase in all inputs (such as labour, capital,
and resources) and the resulting change in output.

 There are three types of returns to scale: increasing returns to scale, constant
returns to scale, and decreasing returns to scale.

 Increasing returns to scale occur when a proportional increase in inputs leads

to a more than proportional increase in output.
  Constant returns to scale occur when a proportional increase in inputs
results in a proportional increase in output.

 Decreasing returns to scale occur when a proportional increase in inputs

leads to a less than proportional increase in output.

While both concepts relate to input-output relationships in production:

 Marginal product focuses on the additional output generated by a specific change in a single
input while keeping other inputs constant.

 Return to scale considers the overall impact on output resulting from proportional changes in
all inputs used in production.

Constant returns to scale

We say that this is the likely outcome for the following reason: it should typically be possible for the
firm to replicate what it was doing before. If the firm has twice as much of each input, it can just set
up two plants side by side and thereby get twice as much output.

Increasing returns-to-scale

One nice example is that of an oil pipeline. If we double the diameter of a pipe, we use twice as much
materials, but the cross section of the pipe goes up by a factor of 4. Thus, we will likely be able to
pump more than twice as much oil through it.

Diminishing returns-to-scale

This case is somewhat peculiar. If we get less than twice as much output from having twice as much
of each input, we must be doing something wrong.

- So, a technology can exhibit increasing returns-to-scale even if all of its marginal products are
diminishing. Why?
o A marginal product is the rate-of-change of output as one input level increases,
holding all other input levels fixed.
o Marginal product diminishes because the other input levels are fixed, so the
increasing input’s units have each less and less of other inputs with which to work.
o When all input levels are increased proportionately, there need be no diminution of
marginal products since each input will always have the same amount of other inputs
 with which to work. Input productivities need not fall and so returns-to-scale can be
constant or increasing.

Average cost
Average cost is a key concept in economics that measures the cost per unit of output produced by a
firm or an organization. It's calculated by dividing the total cost of production by the quantity of
output produced.

Mathematically, the formula for average cost (AC) is:

Returns-to-Scale and Av. Total Costs

- The returns-to-scale properties of a firm’s technology determine how average production

costs change with output level.
- Our firm is presently producing y’ output units.
- How does the firm’s average production cost change if it instead produces 2y’ units of
output?

Constant Returns-to-Scale and Average Total Costs

- If a firm’s technology exhibits constant returns-to-scale (CRS) then doubling its output level
from y’ to 2y’ requires doubling all input levels.
- Total production cost doubles.
- Average production cost does not change.

Decreasing Returns-to-Scale and Average Total Costs

- If a firm’s technology exhibits decreasing returns-to-scale (DRS) then doubling its output level
from y’ to 2y’ requires more than doubling all input levels.
- Total production cost more than doubles.
- Average production cost increases.

Increasing Returns-to-Scale and Average Total Costs

- If a firm’s technology exhibits increasing returns-to-scale (IRS) then doubling its output level
from y’ to 2y’ requires less than doubling all input levels.
- Total production cost less than doubles.
- Average production cost decreases.
Section 2: Profit maximization
Short-Run Profit Maximization
- Suppose the firm is in a short-run circumstance in which

- Its short-run production function is

- - The firm’s problem is to maximize profit , that is:

- We proceed by doing a marginal analysis.

Marginal analysis is a fundamental economic concept used to analyse the incremental change in an
economic variable (such as cost, revenue, or utility) resulting from a one-unit change in another
related variable.

Key points about marginal analysis:

1. Marginal Concept :

 The term "marginal" refers to the additional or incremental change in a particular

variable caused by a small change in another related variable.

 For instance, marginal cost (MC) represents the change in total cost resulting from
producing one additional unit of output. Similarly, marginal revenue (MR) is the
change in total revenue due to selling one additional unit of output.

2. Principle of Diminishing Marginal Returns:

 Marginal analysis often involves the principle of diminishing marginal returns, which
suggests that as one input (e.g., labour or capital) is increased while other inputs are
held constant, the marginal output from that input will eventually diminish.

 As production increases, marginal costs tend to rise due to diminishing returns, while
marginal revenue might decrease if the firm lowers prices to sell additional units.

3. Decision-Making Tool :

 Marginal analysis helps decision-makers, whether individuals or firms, make

informed choices about resource allocation, production levels, pricing strategies, and
consumption.
  In microeconomics, firms use marginal analysis to determine the level of production
where marginal cost equals marginal revenue to maximize profits.

4. Optimization:

 Marginal analysis is often used to optimize decision-making. For instance, a firm can
optimize its profit by producing the quantity where marginal cost equals marginal
revenue.

 In consumer choice theory, individuals seek to maximize their utility by equating the
marginal utility of the last dollar spent on each good with their respective prices.

pMP (the green line) = w =

marginal revenue product
(the revenue for each x1 that
we add).

The higher green line is : if

the firm sells x1 at a higher
price

Short-Run Profit-
Maximization

Short-run profit maximization refers to the process by which a firm, operating in the short run with
fixed factors of production (like plant size or equipment), determines the level of output that will
generate the highest profit.

Key considerations for short-run profit maximization:

1. Total Revenue and Total Cost:

 Total revenue (TR) is the total income a firm earns from selling its products.

 Total cost (TC) is the sum of all costs incurred by the firm in producing a given level of
output, including both fixed and variable costs.

2. Marginal Analysis:

 Firms use marginal analysis to determine the profit-maximizing level of output.

 Marginal revenue (MR) is the additional revenue gained by selling one more unit of
output.
  Marginal cost (MC) is the additional cost incurred from producing one more unit of
output.

3. Profit Maximization Rule:

 In the short run, a profit-maximizing firm will produce the quantity of output where
marginal revenue equals marginal cost (MR = MC).

 The firm maximizes profit when producing at a level where the last unit produced
(MR) adds exactly as much to total revenue as it does to total cost (MC).

4. Determining Output Level:

 If marginal revenue exceeds marginal cost (MR > MC), the firm can increase profit by
producing more.

 If marginal cost exceeds marginal revenue (MC > MR), the firm should reduce
production to increase profit.

is the marginal revenue product of input 1, the rate at which revenue increases with the
amount used of input 1.

Long-Run Profit Maximization

Now allow the firm to vary both input levels.

- Since no input level is fixed, there are no fixed costs.

- The firm’s profit maximization problem is choosing x1 and x2 that will maximize profit:

- The argument is the same as used for the short run:

o If the value of the marginal product of factor 1, for example, exceeded the price of
factor 1, then using a little more of factor 1 would produce MP1 more output, which
would sell for pMP1 dollars.
o If the value of this output exceeds the cost of the factor used to produce it, it clearly
pays to expand the use of this factor.
- Profit will increase as x2 increases so long as the marginal profit of input 2:
- The profit-maximizing level of input 2 therefore also satisfies:

Cost minimization
If a firm is maximizing profits and if it chooses to supply some output y, then it must be minimizing
the cost of producing y.

 If this were not so, then there would be some cheaper way of producing y units of output,
which would mean that the firm was not maximizing profits.
 - This simple observation is useful in examining firm behaviour.
- Convenient to break the profit-maximization problem into two stages:

1. we figure out how to minimize the costs of producing any desired level of output y, then we
figure out which level of output is indeed a profit-maximizing level of output.

Section 3: Cost minimization

The Cost-Minimization Problem

- For given w1, w2 and y, the firm’s cost-minimization problem is:

o to minimize total cost w1x1 + w2x2 for a given level of production y = f(x1,x2)

Iso-cost Lines

- A curve that contains all the input bundles that cost the same amount is an iso-cost line.
o E.g., given w1 and w2, the $100 iso-cost line has the equation:

- Generally, given w1 and w2, the equation of the $c iso-cost line is.

The Cost-Minimization Problem

The slope of an isocost curve and the slope of an isoquant curve are fundamental concepts in
microeconomics, particularly in analysing the firm's cost minimization and production optimization
decisions.

1. Isocost Curve:

 An isocost curve represents different combinations of inputs (typically labour and

capital) that a firm can afford to hire or use at a given total cost.

 The slope of the isocost curve indicates the rate at which the firm can exchange one
input for another while keeping the total cost constant.

2. Isoquant Cure:

 An isoquant curve shows various combinations of inputs that can produce the same
level of output (constant output level or quantity).

 The slope of the isoquant curve represents the marginal rate of technical substitution
(MRTS), indicating the rate at which the firm can substitute one input for another
while keeping the level of output constant.
An output expansion path, also known as an expansion path, is a graphical representation that shows
the optimal combinations of inputs (such as labour and capital) used by a firm to produce different
levels of output while minimizing costs or maximizing production.

Key points about the output expansion path:

1. Optimal Input Combinations :

 The output expansion path demonstrates the combinations of inputs that a firm
would choose to produce various output levels efficiently.

 It illustrates the input combinations that result in different levels of output while
minimizing costs or maximizing production given the firm's technology and input
prices.

2. Relationship with Isoquants :

 The output expansion path is related to isoquants, which are curves representing
various combinations of inputs that yield the same level of output.

 The expansion path is derived from connecting the tangencies between isoquants
and isocost lines. Each point on the expansion path corresponds to a specific level of
output, representing the least-cost input combination for that output level.

Short-Run & Long-Run Total Costs

- In the long run a firm can vary all of its input levels.
- Consider a firm that cannot change its input 2 level from Z units in the short run.
- How does the short-run total cost of producing y output units compare to the long-run
total cost of producing y units of output?
- Situation 1
- The short-run cost-min. problem is the long-run problem subject to the extra constraint that
x2 = Z
- If the long-run choice for x2 was then the extra constraint x2 = Z is not really a constraint at
all and so the long-run and short-run total costs of producing y output units are the same.
- Situation 2
- The short-run cost-min. problem is therefore the long-run problem subject to the extra
constraint that x2 =Z.
- But, if the long-run choice for x2 =! Z then the extra constraint x2 = Z prevents the firm in this
short-run from achieving its long-run production cost, causing the short-run total cost to
exceed the long run total cost of producing y output units.
- Short-run total cost exceeds long-run total cost except for the output level where the short-
run input level restriction is the long-run input level choice.
- This says that a short-run total cost curve always has one point in common with the long-run
total cost curve and is elsewhere higher than the long-run total cost curve.