WELCOME TO ECONOMICS S-1010 : MICROECONOMIC THEORY WELCOME TO ECONOMICS S-1010 : MICROECONOMIC THEORY Summer 2009 M & W, 6:30-9:30pm Sever 110 Instructor:

WELCOMEWELCOME TOTO ECONOMICSECONOMICS S- S-10101010::

MICROECONOMIC THEORYMICROECONOMIC THEORY

Summer 2009M & W, 6:30-9:30pm

Sever 110

Instructor: Robert Neugeboren51 Brattle St, Rm 522 TA: Rajiv ShankarW 3-4 and by app’t. rshankar@fas. [email protected] Sections: T 6:30

Website: www.isites.harvard.edu/k57961

Today’s Agenda

• Go Over Syllabus• Requirements• Policies• Topics• What is Microeconomics?• An Example• Next Time

Description

Economics S-1010 presents the basic analytical tools of microeconomics. We will start by looking at the decision-making of individual consumers and ask how these decisions can be optimized, or improved. Next, we will look at how firms make and coordinate their decisions under varying market structures, including perfect competition and monopoly.

Description

Then we will look at strategic behavior in imperfectly competitive markets, making use of concepts from game theory such as Nash equilibrium. Finally, we will take up topics including (from among?) bargaining theory, information economics, externalities, public goods, and welfare analysis.

Description

ECS-1010 is taught at the intermediate level and is appropriate for students who have already completed a first-year “principles” course in microeconomics. Mathematical preparation at the level of basic algebra is a prerequisite, and familiarity with first-year calculus will be of help. Students will learn the key tools and principles economists apply to understand a wide range of phenomena, using graphical representations, some math, and plain logic to present the important ideas and solve basic microeconomic problems.

Requirements

10% Sections. Attendance mandatory.

20% Problem Sets. 4, every 1-2 weeks.

30% Midterm Exam. July 13, in class.

40% Final Exam. August 3, 3 hrs.

Graduate Credit: Additional material will be assigned on problem sets and exams.

Readings

There are several good textbooks on intermediate microeconomics. Either of the following are recommended:

Besanko & Braeutigam, Microeconomics, 2nd (Wiley).Pindyck & Rubinfeld, Microeconomics,6th(Prentice Hall).

A good alternative is Varian, Intermediate Microeconomics. Students are expected to read the assigned chapters before the corresponding class session. From time to time, additional background references and supplementary readings may be assigned.

Course Policies

Academic Honesty

Harvard takes matters of academic honesty very seriously. While you may discuss assignments with your classmates and others, make sure any written material you submit is your own work. Use of old course materials, including exams and problem sets from online sources, is prohibited. You should consult the Official Register of the Harvard Summer School and the website http://www.summer.harvard.edu to familiarize yourself with the possible serious consequences of academic dishonesty.

Course Policies

Late Policy

There will be 4 problem sets assigned roughly every other week, due in section. You can submit 1 problem set late, but only until the answer key is posted.

Topics

UNIT I CONSUMER CHOICEUNIT II FIRM BEHAVIOR

July 13 MIDTERM

UNIT III MARKETS & COMPETITIVE STRATEGYUNIT IV GAMES & INFORMATION Aug 3 FINAL EXAM

Topics

UNIT I CONSUMER CHOICE

P-R chapters

6/22 Introduction: What is Microeconomics? (1-2)

6/24 Theory of the Consumer (3)

6/29 Individual and Market Demand (4)

Topics

UNIT II FIRM BEHAVIOR

7/1 Theory of the Firm (6)

7/6 Profit Maximization (7)7/8 Perfect Competition/Review (8-9)

7/13 MIDTERM

Topics

UNIT III MARKETS & COMPETITIVE STRATEGY

7/15 Monopoly & Oligopoly (10-11)

7/20 Games and Strategic Competition (12-13)

kkk

Topics

UNIT IV INFORMATION & WELFARE

7/22 Decision under Uncertainty (5)7/27 Bargaining and Negotiation (17)7/29 Externalities and Public Goods/Review (16)

8/3 FINAL EXAM

Theory of the Consumer

• What is Microeconomics? • The Assumption of Rationality • Equilibrium & the Exchange Economy• Optimal Choice: An Example• Preferences• Indifference Curves• Next Time

What is Microeconomics?

Economists study everything from money and prices to child rearing and the environment. They analyze small-scale decision-making and large-scale international policy-making. They compile data about the past and make predictions about the future. Many economic ideas have currency in everyday life, cropping up in newspapers, magazines, and policy debates. The amount you pay every month to finance a car or new home purchase will depend on interest rates. Business people make investment plans based on expectations of future demand, and policy makers devise budgets to achieve desired social goals.


Across the broad range of topics that interest economists is a unique approach to knowledge, something common to the way all economists see the world. Economists share certain assumptions about how the economy works, and they use standard methods for analyzing data and communicating their ideas.

What is Macroeconomics?

What is Microeconomics?The Dismal Science

Since its beginning, economics has been preoccupied with the problem of scarcity. The hours in a day, the money in one’s pocket, the food the ground can supply are all limited; spending resources on one activity necessarily comes at the expense of some other, foregone opportunity.

Scarcity provides economics with its central problem: how to make choices under constraint?


We do not say that the production of potatoes is economic activity and the production of philosophy is not. We say rather that, in so far as either kind of activity involves the relinquishment of other desired alternatives, it has its economic aspect. There are no limitations on the subject matter of Economic Science save this.

- Lionel Robbins

The Assumption of Rationality

Economists approach a wide range of topics with the assumption that the behavior under investigation is best understood as if it were rational (though we know that not all behavior is, in fact, rational) and that the best explanations, models, and theories we can construct take rationality as the norm. Rationality, in the words of Frank Hahn, is the “weak causal proposition” that sets all economic analyses in motion.


Economics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences.

- Colin Camerer and Richard Thaler.


Rationality: the assumption that agents prefer more of what they want to less; Max E(U).

Agents’ wants, or preferences, are not necessarily self-interested. One can want others to be better off and rationally pursue their interests as well.

Economists assume that whatever their preferences, agents will attempt to maximize their satisfaction, subject to the constraints they face.

Equilibrium & Exchange

Whoever offers to another a bargain of any kind proposes to do this. Give me that which I want, and you shall have that which you want …; and it is in this manner that we obtain from one another the far greater part of those good offices we stand in need of. 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 self-interest.

- Adam Smith


Yet an isolated bargain is not all Smith had in mind. For one thing, it is likely that a number of terms of exchange (prices) exist which both sides would find advantageous, and it possible the outcome could be influenced by capricious or coercive means either side might have. Where instead each actor faces a very large number of bargains: the market.

In the market, each individual is powerless to set prices, which are instead determined by the interaction of very many individuals.

Equilibrium as a balance of forces


The Bargain

Buyer and Seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b < s, there is no price they can agree on:

b(uyer’s reservation price)

0 50 100 150 200 250

s(eller’s reservation price)

S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price)




The Bargain

Buyer and Seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b > s, we say there is a positive zone of agreement, or surplus:


0 50 100 150 200 250






The Bargain

Buyer and Seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b > s, we say there is a positive zone of agreement, or surplus:


0 50 100 150 200 250



In the market, each individual is powerless to set prices, which are instead determined by the interaction of very many individuals. Just as each particle seeks its center of gravity, each rational individual seeks its own satisfaction. Yet just as no particle exerts its will over the structure of the universe, no individual can influence the workings of the market. Equilibrium as a harmony of rational forces.


Smith’s Radical Idea

The way to promote the Wealth of Nations is to unleash the productive power of individuals, allowing individuals to “truck, barter, and trade.” to innovate and compete in pursuit of their interests. And while today, we often associate defense of free markets and laissez faire economics with conservative political positions, 200 years ago, Smith’s ideas were a challenge to the traditional, inherited sources of power.


A Theory of Prices

Classical economics (political economy) challenged traditional notions of a “just price,” or the king’s price, with the “theory of value.”

For contemporary microeconomics, prices are determined by the interactions of rational individuals, where the outcome, or resting point, represents a balance of self-interested forces. In equilibrium, though each individual is trying to get the best of the bargain, prices are (under certain conditions) determined independently of their efforts.


Freddie consumes only apples and oranges. Apples cost $1 and oranges cost $1.50. If Freddie has $100 to spend, how many apples and how many oranges should he buy?

What information is missing?

Freddie likes oranges twice as much as apples.

Optimal Choice: An Example

Start by asking how many apples and oranges he can buy. Call this the feasible set.

Recall: Oranges

Pa = $1 67 Po = $1.5

I = $100

100 Apples

At a point along the line, Freddie is spending his entire budget


At an interior point, Freddie isn’t spending his entire budget

Next ask how many apples and how many oranges he wants to consume. Call these preferences.

Recall: Oranges

Freddie likes oranges twice as

much as apples

25100

50 Apples

Freddie is willing to trade 2 apples for 1 orange



Recall: Oranges


much as apples

25100

50 Apples

Freddy is indifferent between any combination of apples and oranges along a line

INDIFFERENCE CURVES



Recall: Oranges


much as apples

25100

50 Apples

Each indifference curve is associated with a different level of utility, increasing farther away from the origin.

INDIFFERENCE CURVES


To maximize his utility, Freddie will choose a point on his highest feasible indifference curve.

Recall: Oranges

Freddie likes 67 oranges twice as

much as apples

100 Apples

In this case, he will choose to consume only oranges

PERFECT SUBSTITUTES


Indifference Curves

Perfect Substitutes Perfect Complements


• Preferences• Indifference Curves• Utility Functions• Optimization • Income & Substitution Effects

How do they respond to changes in prices and income?

How do consumers make optimal choices?

We have said that microeconomics is built on the assumption that a rational consumer will attempt to maximize (expected) utility. But what is utility?

Over time, economists have moved away from a notion of cardinal utility (an objective, measurable scale, e.g., height, weight) and toward ordinal utility, built up from a simple binary relation, preference.


We start by assuming that a rational individual can always compare any 2 alternatives (“consumption bundles” or “market baskets”). We call this basic relationship preference: For any pair of alternatives, A and B, either

A > B A is preferred to B

A < B B is preferred to A

A = B Indifference

Preferences

e.g., 2 apples & 3 oranges.

“Well-behaved” preferences are (i) Connected: For all A & B, either A>B; B>A; A=B

(ii) Transitive: If A > B & B > C, then A > C (iii) Monotonic: More is always preferred to less

(free-disposition)

(iv) Convex: Combinations are preferred to extremes

Preferences

Preferences

Y

X

A

B

Ya

Yb

Xa Xb

A = (Xa, Ya)

B = (Xb, Yb)

A ? B

What can we say about the relationship between A and B?

Preferences

Y

X

A C

B

Ya

Yb

Xa Xb

A = (Xa, Ya)

B = (Xb, Yb)

C = (Xb, Ya)

A ? B

C > A

C > B

What can we say about the relationship between A and B?

Now consider point C

Preferences

Y

X

A C

B

Ya

Yb

Xa Xb

A = (Xa, Ya)

B = (Xb, Yb)

C = (Xb, Ya)

A ? B ? D

D > E

D ? B

D ? A

DE

Now consider point D and E

Convexity: D > E

Preferences

Y

X

A C

B

Ya

Yb

Xa Xb

A = (Xa, Ya)

B = (Xb, Yb)

C = (Xb, Ya)

A = B = E

D > E

D > B

D > A

DE

Indifference curves

Now consider point D and E

Indifference Curves

Y

X

3

2

2 3

Generally, ICs are:

• Downward sloping

• Convex to origin

• Inc utility, further from origin

• Cannot cross

U = XYIndifference Curve:

The locus of points at which a consumer is equally well-off, U.

Indifference Curves

Y

X

3

2

2 3

Generally, ICs are:




• Cannot cross

U = 9

U = 6

U = 4

U = XY

Indifference Curves

Y

X

3

2

2 3

Generally, ICs are:




• Cannot cross

A = B; A = C; B > C !!

U = XY

A

B

C

Indifference CurvesRemember our simple example:

Recall: Oranges


much as apples

25100

50 Apples

What does his utility function look like?

Y Utility = No. of Apples + 2(No. of Oranges)

U = 1 X + 2 Y

MUx = 1 MUy = 2

X


5

4

2 4

-2

+1Generally, any set of preferences can be described by many utility functions

U = 12

Indifference Curves

Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade between 2 goods. The amount of Y he is willing to give up for 1 unit of X = MUx/MUy


U = X+2Y

MUx = 1 MUy = 2

MRS = - MUx/MUy = - ½

X


5

4

2 4

-2

+1

Indifference Curves

Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade between 2 goods. The amount of Y he is willing to give up for 1 unit of X = MUx/MUy


U = X + 2 Y

= - ½

X

X

YGenerally, this rate will not be constant; it will depend upon the consumer’s endowment.

Indifference Curves

Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade between 2 goods. The amount of Y he is willing to give up for another unit of X.


X

Generally, this rate will not be constant; it will depend upon the consumer’s endowment.

XY

Indifference Curves

OptimizationWe assume that a rational consumer will attempt to maximize her utility. But utility increases with consumption of all goods, so utility functions have no maximum -- more is always better!


U

X

Increasing utility



U

X

Indifference Curves depict consumer’s “willingness to trade”

Budget Constraint depicts “opportunities to trade”

Slope = - Px/Py


Slope = - MRS

A

At point A, can the consumer increase his utility? How?



U

X



Slope = - Px/Py


Slope = - MRS

A

At point A, MRS > Px/Py, so consumer should trade Y for X.



U

X



Slope = - Px/Py


Slope = - MRS

B

At point B, MRS < Px/Py, so consumer should trade X for Y.

OptimizationThe optimal consumption bundle places the consumer on the highest feasible indifference curve, given her preferences and the opportunities to trade (her income & the prices she faces).


U

Y*

X* X


Slope = - MRSBudget Constraint depicts “opportunities to trade”

Slope = - Px/Py

At point C, MRS = Px/Py, so consumer can’t improve thru trade.

C

Two Conditions for Optimization under Constraint:

1. PxX + PyY = I Spend entire budget

2. MRSyx = Px/Py Tangency

Optimization

MRSyx = MUx/MUy = Px/Py

=> MUx/Px = MUy/Py

The marginal utility of the last dollar spent on each good should be the same.

OptimizationArlene has $100 income to spend on food (F) and Clothing (C). Food costs $2, and Clothing costs $10. She is currently consuming 30 units of F and 4 units of C. At this point, she is willing to trade 1 unit of C for 2 units of F. Is she choosing optimally?

C Utility = No. of Apples + 2(No. of Oranges) I/Pc=10 U

4

30 I/Pf =50 F

PfF + PcC = I2(30) + 10(4) = 100

OptimizationArlene has $100 income to spend on food (F) and Clothing (C). Food costs $2, and Clothing costs $10. She is currently consuming 30 units of F and 4 units of C. At this point, she is willing to trade 1 unit of C for 2 units of F. Is she choosing optimally?

C Utility = No. of Apples + 2(No. of Oranges) I/Pc=10 U

4

30 I/Pf =50 F

Pf/Pc = 1/5

MRScf = 1/2

6/24 Theory of the Consumer (con’t)

Pindyck & Rubenfeld, Chapter 3.

Besanko & Braeutigam, Chapters 3-4.

Next Time

WELCOME TO ECONOMICS S-1010 : MICROECONOMIC THEORY WELCOME TO ECONOMICS S-1010 : MICROECONOMIC THEORY Summer 2009 M & W, 6:30-9:30pm Sever 110 Instructor:

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