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Microeconomics 1

Microeconomics deals with the allocation of limited resources to unlimited human wants
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Constrained Optimisation (time and money)
Equilibrium Analysis
Comparative statistics

Consumer Surplus is the difference between what you actually pay for a good or service and what
you were willing to pay for it (e
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8 billion in consumer surplus
Revealed preferences - animal welfare, free-range organic chickens
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What to produce and quantities?
2
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Who gets the goods and services produced and how will they get them?
Economists often use models to help them understand things
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Variables that
have values determined as a result of the model's workings are endogenous variables

How would a manager hire the most possible number of workers on $100 vs How would a manager
minimize the cost of hiring 3 workers
The Objective function specifies what the agent cares about (e
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At every point on the curve the
level of satisfaction (utility) is the same
...

Normative is an analysis of what should be done
Examples:
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“Should we increase income equality rather than focus on economic efficiency?”

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“Should we impose a progressive income tax or a sales tax to increase income equality?”

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“Will a progressive income tax reduce aggregate hours worked?”

Demand and supply analysis
Prices are affected by things like drought, good weather (bumper crop), government policy, bubble
years, oil prices etc
A market for a good or service consists of the buyers and sellers of that good or service
...
Some markets are in a single time/location such as antique auctions
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There is no tendency for change

Mathematically:
Qd = 500 - 4p
Qs = -100 + 2p

p = price of cranberries ($ per barrel)
Q = demand/supply in millions of barrels

Qd = Qs
500 - 4p = -100 +2p
600 = 600 6p
100 = p
Excess demand - when demand at a given price > quantity supplied, so prices tend to rise
Excess supply - when quantity supplied > quantity demanded, so prices tend to fall

Excess Supply
Price > Equilibrium = excess supply
Price < Equilibrium = excess demand

Excess Demand

Equilibrium, Comparative Statistics and Elasticity of Demand and Supply

Long and short run demand and supply curves
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Long-run demand curve – demand curve when consumers can fully adjust their purchase
decisions to changes in price
Short-run demand curve – demand curve when consumers cannot fully adjust their purchase
decisions to changes in price
Long-run supply curve – supply curve when sellers can fully adjust their supply decisions to
changes in price
Short-run supply curve – supply curve when sellers cannot fully adjust their supply decisions to
changes in price

In the long run, your decisions are more elastic

Estimating demand and supply:
Initially Qs = 20+10P; Equilibrium price and quantity are Q = 210; P = 19
Supply curve shifts rightwards: Qs = 40 +10P; equilibrium price and quantity are Q = 220; P = 18
...


Demand curve - shows the individuals willingness to pay
You only have to pay the market price, so consumer surplus is the difference between what you
were willing to pay and what you actually pay
Consumer Surplus - the difference between what the consumer was willing to pay and what they
actually paid
Consumer Surplus Definition: The net economic benefit to the consumer due to a purchase (i
...
the
willingness to pay of the consumer net of the actual expenditure on the good) is called consumer
surplus
...
g U = Y^1/2 is as good as U = Y^1/2 + 2

Diminishing marginal utility - marginal utility falls as you consume more of a good
Think about Mac example, the first is
great, the second is good and the
third is ok and so on

A, B and C all give the consumer the same utility

Indifference curves can't
cross as this results in a
contradiction

C is preferred to A and B
A and B are indifferent
C is on a higher indifference curve (IC2)

Perfect substitutes
MUX = 0 or A

U = Amin (X,Y)

A is a positive constant

MUY = 0 or A
MRSx,y is 0 or infinite or undefined (corner)

A and B are the same utility because only 1 cup of tea can be made
C and D are the same utility for the same reason
However, C is preferred to A as you get 2 cups of tea at C and just 1 at A, so C is on a higher
indifference curve

The indifference curves have the same slope on any vertical line
The indifference curves for quasi linear preferences are parallel to each other
Budget set - the set of baskets that are affordable

Budget constraint - the set of baskets that the consumer may purchase given the limits of their
available income
Budget line - the set of baskets that one can purchase when spending all available income
PxX + PyY = I
Y = I/Py - (Px/py)X

Budget line

The shape of the budget line is the price ratio
A basket is affordable if it is on the budget line or the budget set
The location of the budget line shows what the income level is
An increase in the income will shift the budget line to the right, so more of each product becomes
affordable
A decrease in the income will shift the budget line to the left, so less of each product becomes
affordable, and vice versa
Budget set - the set of baskets that are affordable
Budget constraint - the set of baskets that the consumer may purchase given their limited income
Budget line - the set of baskets that one can purchase when spending all available income

MRS is 0 on the horizontal
MRS is infinity on the vertical

If the price of Y falls, then the consumer can afford more of good Y and the same of good x so the
budget line shifts as shown

The slope of the indifference curve = the slope of the budget line

When the budget line is steeper than the IC, the consumer picks all good Y
When the budget line is shallower than the IC, the consumer picks all good X
Equal slope condition -

MUX/PX = MUY/PY

When prices are given, with perfect substitutes, we obtain corner solution
We can also have corner solutions with diminishing MRS
Example:
U = 2X - X

+Y

MUx = 2 - 2X

MUy = 1

MRS = 2 - 2X/1 = 2 - 2X
Quasilinear, for a given amount of X, the indifference curve will be parallel

9 = 3X + Y
PR = 3/1
2 - 2X = 3
-1 = 2X
-1/2 = X

The consumer wants to consume -X values, but can't, so will have to settle for no X and being at a
lower IC curve
Perfect Complements
U = minx,y

Consuming here is pointless as it
is on a lower IC

100 = X + Y

Kink of curve at X = Y
100 = X + X
100 = 2X
50 = X so Y = 50

You can only spend vouchers on one type of good (e
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5 and X = 10

Revealed preference - suppose that preferences are not known, can we tell preferences from
purchasing behaviour?

If A is purchased, it must be preferred to all other affordable bundles
If the consumer chooses basket A when basket B costs just as much, then we know that A is weakly
preferred to B
If the consumer chooses basket A, which is more expensive, then A is strongly preferred to B

Standard preferences - all baskets Northeast of A must be preferred to A
...
This analysis is called revealed preference analysis

Because D is NE of A

Because C is NE of B

There is a contradiction, as A is preferred to C, C is preferred to B, B is preferred to D but D is
preferred to A, so this can't be transitive

Because C is NE of A
So B must be preferred to A as
C is preferred to A and B is preferred
to C

Consumers always make the optimal choice
Consumers underlying preferences do not change
Individual demand - knowing how individuals consumption choices change as prices change allows
us to derive individual demand curves
Price consumption curve - the set of optimal consumption choices for a good at every possible price
whilst holding everything else constant, like income and the price of other goods

The Price Consumption Curve shows how the demand changes as price changes, holding everything
else constant

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The consumer maximizes their utility at each point on the demand curve
The marginal rate of substitution (MRS) falls along the demand curve as the price falls
The demand curve is just the consumers’ willingness to pay

Example: U = XY
MUX = Y
Y/X = Px

I = 10

Py = 1

MUY = X

Y = PxX

10 = PxX + PyY so

10 = PxX + Y

Price ratio = Px/1 = Px

10 = PxX + PxX
10 = 2XPx
X = 10/2Px
Px = 1

10/2(1) = 5

Px = 2

10/2(2) = 2
...
5 = 5

And so on…
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Consumer sets MRS = PR where the price is Px1
y/x = 2

y = 2x

Substitute into budget constraint
10 = 2x + y

10 = 2x + 2x 10 = 4x x = 10/4

xa = 10/4

Ya = 2 x 10/4 = 5
2
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Find the decomposition basket, B
Find the level of utility the consumer obtains at basket A
Ua = XaYa Ua = 2
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5
The decomposition basket must give the consumer this level of utility
This is an Expenditure Minimisation Problem
Min PxX + PyY
St 12
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5 = xx 12
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54 yb = 3
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Calculate the income and substitution effect
IE = xc - xb
SE = xb - xa

5 - 3
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46
3
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5 = 1
...
5 = 2
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46 + 1
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5

Example:
U = x^0
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5 MUX = 1/2x^0
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5 I = 90 Py = 1 Px1 = 9 Px2 = 4
MRS = y^0
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5 PR = 9/1 y^0
...
5 = 9
90 = 9x + y

90 = 9x + 81x

Y^0
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5 y = 81x

xa = 1 ya = 81

Y^0
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5 = 4 y^0
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5 y = 16x
90 = 4x + y

90 = 4x + 16x 90 = 20x xc = 4
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5 + 81^0
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5/x^0
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5 = 4x^0
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5 + y^0
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5 + (16x)^0
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5 + 4x^0
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5
2 = 2 x^0
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5 - 4 = 0
...
5 = 3
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EV is the difference between the income needed to
purchase bundle e and a
Uc = 4
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5 + 72^0
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5/x^0
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6

y^0
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5

10
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6 x^0
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5
10
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5 + 9x^0
...
6 = 10x^0
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36 = 100x
1
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72 = 90
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12 x 81 = ye

y = 81x

Market demand is the sum of all individuals demand curves

D1 = nice person
D2 = nasty person
(free range chicken example)

Inputs and Production
Firms use productive resources to manufacture goods and services
...
Technically inefficient set is Q < f(L,K)
The production set is the curve and everything below it

Labour requirement function L = g(Q) inverting the production function e
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As we move from A to B the
MRTSl,k goes down, so we have
labour saving technological
progress

Technological progress shifts the production function by allowing the firm to produce output from a
given combination of inputs
Q = LK

Q=2

2 = LK isoquant
K = 2^1/2

L=K

MPL = K

MPK = L

L = K ray from origin

L = 2^1/2

MRTSl,k = K/L = (2^1/2)/(2^1/2) = 1

New production
Q = LK^2

MPL = K^2

2 = LK^2

L=K

K = 2^1/3

L = 2^1/3

MPK = 2LK

MRTSl,k = K/2L

MRTSl,k = 1/2

MRTS = K/2L
=L/2L = 1/2

Q = LK

Q=2

MPL = K
2 = LK

L=K

MPK = L

MRTS = K/L

L=K

K = 2^1/2

L = 2^1/2

MRTS = 1

New production
Q = KL^3

MPL = 3KL^3

MRTS = 3K/L
L = 2^1/4

2 = KL^3

MRTS = 3

MPK = L^3
L=K

K = 2^1/2

K=L

MRTS has risen with the invention

A neutral change:

Q = LK

Q = 2KL with the invention

MRTS = MPL/MPK = 2K/2L = K/L K = L

Costs
Explicit costs are those that involve a direct money outlay such as a tractor or people
Implicit costs don't involve direct money outlay such as holding money in a bank
Opportunity cost - The value of a resource in it's best alternative ( only the best alternative, not all)
Opportunity cost is the benefit associated with the best of the alternatives that aren't chosen
Opportunity cost changes with circumstances
Economic costs - implicit costs + explicit costs
Accounting costs - Total of a firms explicit costs
Economic costs are the most relevant for making policy decisions
They are unavoidable
Sunk costs are unavoidable
Non-sunk costs are only incurred if a decision is made (buying textbooks is avoided if you decide not
to go to Uni, so this is not a sunk cost) i

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