"Valuing Cultural Diversity in Cities: Challenges to Cultural Economics", Procida (Naples,
Italy), 5th of September 200
Foundations of Microeconomic Theory
Laura OnofriDepartment of Economics
University of Venice Cà Foscari and FEEM
Introducing the Subject: Some Challenging Questions
• Why do people study different languages?• How do individuals choose the foreign language
they want to learn? • Why should minority languages be protected? • What is the value that individuals attach to the
preservation of a minority language?• Can we define the price/value of a (minority)
language?
…….
Lecture Motivation and Content
• The present lesson aims at providing the basic, non-technical notions about economics reasoning, applied to standard, neoclassical consumer’s theory.
• From preferences to utility functions to demand functions to reservation price
Economics and Microeconomics
• Economics is the science that studies the choices of rational agents (economic agents, homo oeconomicus), in a world of scarce resources.
• Microeconomics studies the choices of three main economic agents: consumers, firms and policy-makers.
• We want to explain,predict and evaluate behavior and phenomena--not judge
The Two Dimensions of a Choice (1)
• Consumers choose the optimal consumption bundle by solving a constrained maximization problem.
• The optimal choice is characterised by both a psychological and a monetary dimension.
The Two Dimensions of a Choice (2)
• The psychological dimension is represented by the notion of preferences and utility functions, which map the consumers tastes and desires.
• The monetary dimension is represented by budget constraint (the income available for purchasing goods).
Preferences
• Individuals’ tastes (preferences) determinepleasure people derive from the
consumption of goods• Economists usually take tastes as given
and do not judge taste• Assumptions about consumer preferences
1. completeness2. transitivity3. more is better
Three main “axioms”
Completeness. Consumer can compare any two bundles of goods and services and decide which one is preferred or whether he (she) is indifferent between them.
Transitivity (“rationality”). If a consumer prefers bundle x over y and y over z, then x is preferred over z.
More is better(aka non-satiation). A bundle with more of one good and no less of others is preferred.
Indifference Curves
we summarize information about an individual’s preferences using a graph and we can rank some bundles using more is better assumption
Indifference curve properties1. bundles on indifference curves farther from the origin are
preferred to those on indifference curves closer to the origin
2. there is an indifference curve through every possible bundle
3. indifference curves cannot cross4. indifference curves are “thin”5. indifference curves slope down
Indifference Curves: Normal Goods
Marginal Rate of Substitution (1)
Willingness to substitute;
downward-sloping indifference curve:
consumer is willing to substitute one good
for the other
marginal rate of substitution (MRS) of x for y is slope of indifference curve:
MRS = δx/δy
Marginal Rate of Substitution (2)
• MRS varies along the indifference curve
• When convex UF diminish marginal rates of substitution (MRS)
Indifference Curves: Perfect Substitutes and Perfect Complements
Indifference Curves: Perfect Substitutes and Perfect Complements
• Perfect substitutes
straight line indifference curves
if slope is –1, MRS = 1 (Coke-Pepsi)
• Perfect complements
right-angle indifference curves
MRS = 0 (Coffee-Cream)
Marginal Rate of Substitution
Willingness to substitute;
downward-sloping indifference curve:
consumer is willing to substitute one good
for the other
marginal rate of substitution (MRS) of y for x is slope of indifference curve:
MRS = δy/δx
Marginal Rate of Substitution
• MRS varies along the indifference curve
• When convex UF diminish marginal rates of substitution (MRS)
Utility Functions
Numerical values that reflect relative rankings of various bundles of goods
Relationship between utility measure and every possible bundle of good
Succinct summary of information in indifference map
Utility Functions
Utility and Marginal Utility
• Marginal utility of x: change in utility from a small increase in x, holding y fixed.
MU = δU/δx
Budget Constraint
• Suppose an individual spends all her income for purchasing goods y and x. Her budget constraint is:
M = pxx + pyy
Rewrite as:
x = (M – pyy)/px
Budget Constraint: Opportunity Set
Marginal Rate of Transformation
• Slope of the Budget Constraint line: py/px
• Opportunity set
all bundles a consumer can buy includes bundles on and inside the budget constraint
Consumers’Constrained Choice (1)
Consumers maximise the objective function (utility function) subject to the budget constraint
Max U(x,y) s.t. M = pxx + pyyThe result of the maximization problem
provides the optimal bundle of goods x and y that the consumer can purchase within its possibility set.
Consumers’Constrained Choice (2)
• Optimal bundle, two possibilities
1. Interior solution: buy some units of all goods (consumer buys some units of all goods optimum bundle, e, where highest
indifference curve touches the budget line)
2. Corner solution: buy only one good
Consumers’Constrained Choice: Interior Solutions
Consumers’Constrained Choice: Property of the Equilibrium SolutionAt interior optimum, indifference curve istangent to budget line:
MRS = MRT δy/δx = - py/px
• last Euro spent on x gives as much extra utility as that spent on y
Individual Demand Curves
• The equilibrium solution indicates the optimal amount of y and x that the consumer can purchase within her possibility set. It indicates a relationship between quantity and (market) price of a good:
Qx = f(px) Qy = f(py)Individual Demand Curves
Demand Functions
• p
• Demand Elasticity
• Reservation Price
• Willingness to Pay
• Utility measured in monetary terms
• Market Price
• Market Values
References
• Varian, Hal., R. 1992. Microeconomic Analysis 3rd Edition. W.W. Norton, New York