Download MICROECONOMICS Classroom Lecture Notes by Zeke Wang

MICROECONOMICS
Classroom Lecture Notes
(3 credits, as of 2004)
based on Hal R. Varian’s
Intermediate Microeconomics,
Sixth Edition,
referring to Pindyck and Rubinfeld’s
Microeconomics,
Fourth Edition.
Chapter 0
The source of all
economic problems is
scarcity.
Problem of trade-off, and choice.
Economics, as a way of thinking,
as a dismal science.
Problems
- solutions
- hidden consequences.
Main decision-making agents:
1
2
3
individuals (household),
firms, and
governments.
Objects of economic choice are
commodities,
including
goods and services.
Main economic activities:
Consumption,
Production, and
Exchange.
Microeconomics and
macroeconomics:
to show the market mechanism
(the invisible hand),
to supplement it.
The circular flow of economic
activities.
product market
factor market
The product market and
the factor market.
The market relation is mutual
and voluntary.
Positive issues and normative
issues.
Marginal analysis
Relations
between
Total magnitudes,
Average magnitudes, and
Marginal magnitudes.
1, MM is the slope of the TM curve;
2, AM is the slope of the ray from the
origin to the point at the TM curve;
TM
MM(x*)
AM(x*)
x*
x
3, TM increasing (decreasing)
if and only if
MM > 0 ( MM < 0 );
4, If TM is at maximum or minimum,
then MM = 0;
5, AM increasing (decreasing)
if and only if
MM > AM ( MM < AM );
6, If AM is at maximum or minimum,
then MM = AM,
or
MM cuts AM at the latter’s
maximum or minimum.
Chapter 1
Economics proceeds by developing
Models of social phenomena.
By a model we mean a simplified
representation of reality.
Exogenous variables:
taken as determined by
factors not discussed in a model.
Endogenous variables:
determined by forces described
in the model.
The optimization principle:
People try to choose what’s
best for them.
The equilibrium principle:
Prices adjust until
demand and supply are equal.
The demand curve:
A curve that relates the quantity
demanded to price.
The reservation price:
One’s maximum willingness
to pay for something.
From people's reservation
prices to the demand curve.
Fig.
Similarly, the supply curve.
Pareto efficiency:
A concept to evaluate different
ways of allocating resources.
A Pareto improvement is a
change to make some people
better off without hurting
anybody else.
 An
economic situation is
Pareto
efficient
 or
Pareto optimal
 if there is already no way to make
any more Pareto improvement.
Short run and long run
in the short run
(some factors are unchanged)
and in the long run.
Equilibria
Chapter 2
 * Vector
variables and vector functions.
 * The inner product of two vectors.
 * With the price vector p = ( p1, …, pn ),
the value of
the commodity bundle x = ( x1, …, xn )
is pTx = Σi pixi.
However, two goods are often
enough to discuss.
The
budget constraint:
p1 x1 + p2 x2 ≤ m.
The
budget line and the budget set
(the market opportunity set).
The
slope of the budget line:
d x2 /d x1 = – p1 / p2 .
How
the budget line moves
when the income changes, or
when a price changes.
Budget line and budget set
x2
m/p2
Budget line
Slope = -p1/p2
Budget set
m/p1
x1
Increasing income
x2
m’/p2
Budget line
m/p2
Slope = - p1/p2
m/p1
m’/p1
x1
Increasing price
m/p2
Budget line
Slope = - p1/p2
Slope
= - p’1/p2
m/p’1
m/p1
Taxes, quantity taxes, value taxes
(ad valorem taxes), and lump-sum taxes.
A subsidy
is the opposite of a quantity tax.
Rationing.
Their effects on the budget set.
Chapter 3
* Prerequisite:
A binary relation R on X is said to be
Complete if xRy or yRx for any pair
of x and y in X;
Reflexive if xRx for any x in X;
Transitive if xRy and yRz imply xRz.
Rational agents and stable
preferences
 Bundle
x is strictly preferred (s.p.),
or weakly preferred (w.p.), or
indifferent (ind.), to Bundle y.
(If x is w.p. to y and y is w.p. to x, we
say x is indifferent to y.)
Assumptions about Preferences
Completeness: x is w.p. to y or y is
w.p. to x
for any pair of x and y.
Reflexivity: x is w.p. to x for any
bundle x.
Transitivity: If x is w.p. to y and y is
w.p. to z, then x is w.p. to z.
The indifference sets, the
indifference curves.
Fig.
They cannot cross each other.
indifference curves
x2
x1
Perfect
substitutes and
perfect complements.
Goods, bads, and neutrals.
Satiation.

Figs
Perfect substitutes
Blue pencils
Indifference curves
Red pencils
Perfect complements
Left shoes
Indifference
curves
Right shoes
Well-behaved
preferences are
monotonic (meaning more is
better) and
convex (meaning average are
preferred to extremes).

Figs
Monotonicity
x2
Better
bundles
(x1, x2)
Better
bundles
x1
 The
marginal rate of substitution
(MRS) measures the slope of the
indifference curve.
 MRS
= d x2 / d x1, the marginal
willingness to pay ( how much to give
up of x2 to acquire one more of x1 ).
 Usually

negative.
Fig
Convex
indifference curves
exhibit a diminishing marginal
rate of substitution.
Fig.
Convexity
x2
(y1,y2)
Averaged
bundle
(x1,x2)
x1
Chapter 4
(as a way to describe preferences)
Utilities
Essential
versus
convenient
functions.
ordinal
cardinal
utilities,
utility

Cardinal utility functions:
u ( x ) ≥ u ( y ) if and only if
bundle x is w.p. to bundle y.
 The
indifference curves are
the projections of contours of
u = u ( x1, x2 ).
Fig.
Utility
functions are indifferent
up to any
strictly increasing transformation.
Constructing
a utility function in the
two-commodity case of well-behaved
preferences:
Draw a diagonal line and label each
indifference curve with how far it is
from the origin.
Examples of utility functions
u
(x1, x2) = x1 x2 ;
u (x1, x2) = x12 x22 ;
u (x1, x2) = ax1 + bx2
(perfect substitutes);
u (x1, x2) = min{ax1, bx2}
(perfect complements).
Quasilinear preferences:
All indifference curves are vertically (or
horizontally) shifted copies of a single
one, for example u (x1, x2) = v (x1) + x2 .
Cobb-Douglas
preferences:
u (x1, x2) = x1c x2d , or
a
1-a
u (x1, x2) = x1 x2 ;
and their log equivalents:
u (x1, x2) = c ln x + d ln x2 , or
u (x1, x2) = a ln x + (1– a) ln x2
Cobb-Douglas
Marginal
utilities
MU1 and MU2.
MRS
along an indifference curve.
Derive MRS = – MU1 / MU2
by taking total differential along
any indifference curve.
Marginal analysis
MM is the slope of the
TM curve
AM is the slope of the ray from the origin
to the point at the TM curve.
Reservation
price
500
490
480
The demand curve
Number of apartment
From peoples’ reservation prices to
the market demand curve.
Equilibrium
P
P*
supply
E (P*,Q*)
Demand
Q*
Q
Equilibrium
p
supply
E
Demand
q
x2
Rationing
Budget line
Budget
Marketset
opportunity
R*
x1
MRS
x2
Indifference
curve
Slope = dx2/dx1
dx2
dx1
x1
Chapter 5
Choice of consumption
Optimal
choice is at the point
in the budget line with highest
utility.
The tangency solution of an
indifferent curve and the
budget line:
MRS = – p1 / p2.
Fig.
Basic
equations:
MU1 / p1 = MU2 / p2 and
 p1 x1 + p2 x2 = m.
Figs.
(
How if negative solutions.)
Interior
solutions, and
Boundary (Corner) solutions.
Kinky tastes.
Figs.
Three
approaches to
the basic equations:
Graphically;
As-one-variable;
*Lagrangian.
The
optimal choice is the
consumer’s demanded bundle.
The
demand function.
Examples:
perfect
substitutes,
perfect complements,
neutrals and bads,
concave preferences.
Figs.
Cobb-Douglas
demand
functions.
*
Choosing taxes.
(By *Slutsky decomposition.)
Figs.
Chapter 6
Demand
Demand
functions:
x1 = x1 (p1, p2, m),
x2 = x2 (p1, p2, m).
Normal
and inferior goods
(by income);
Fig.
Luxury and necessary goods
(by income).
Fig.
Ordinary and Giffen goods
(by price).
Fig.
The
income expansion path
or the income offer curves,
and the Engel curve.
Figs.
The
price offer curve
and
the Demand curve.

Figs.
Substitutes
and complements.
Cobb-Douglas preferences.
Quasilinear preferences.
*
Homothetic preferences:
if (x1, x2) is preferred to (y1, y2),
then (tx1, tx2) is preferred to
(ty1, ty2) for any t > 0.
Thus both the income offer curves
and the Engel curves are all rays
through the origin.
Example:
Quasilinear
preferences
lead to
vertical (horizontal) income
offer curves and
vertical (horizontal) Engel
curves.
Chapter 8
Slutsky Equation
How
the optimum moves
when the price of a good
changes?
Decomposition:
the
total effect =
the substitution effect
+ the income effect.

p139
The
pivot gives
the substitution effect,
the shift gives
the income effect.
P103andp137
Slutsky
identity, pivoting the
budget line around the original
choice.
Fig.
Hicks decomposition, pivoting
the budget line around the
indifference curve.
Fig.
Chapter 9
Buying and Selling
for a consumer with an
endowment ω
Net and gross demands, net supply.
Offer curve and demand curve.p164
p1
x2
ω
ω1
x1
ω1
x1
Labor supply
$
p174
W
E
Leisure R
Labor
Chapter 10
Intertemporal Choice
 Suppose
for example in a 3-period
model,
the consumption is ck and
the interest rate is rk in period k,
 then the present value of
consumptions is
c1 + c2
 p190
the
/ (1+r1) + c3 / (1+r1) (1+r2).
Chapter 12
Uncertainty
Utilities and probabilities.
Expected
utility functions, or
von Neumann-Morgenstern
utility functions.
They are indifferent up to
any positive affine transformation.
(affine transformation: y = a + bx).
Risk
aversion and risk loving.
U
U
$
Concave vs convex utility.
The second derivatives.
$
Chapter 14
Consumer’s
surplus
Net Surplus
p
消费者得益
r1
r2
r3
r4
r5
r6
总收益
1
2
3
4
5
6
Consumers’ Surplus p250
Producer’s surplus p259
P
Producer’s
surplus
P*
Supply curve
Q*
Q
P
P’’
P’
Change in producer’s
surplus
R
Supply curve
T
Q’
Q’’
Q
The water-diamond paradox
Pd
Pw
Q
Calculating gains and losses
B
T
Change in consumers’ surplus
Chapter 15
Market
Demand
One can think of the
market demand as the
demand of some
“representative consumer”.
Adding up demand curves:
The horizontal
summation principle.
+
=
Horizontal summation
The market demand curve
PRICE
DEMAND CURVE
D(p)
QUANTITY
It is the sum of the individual demand curve
The price elasticity of demand:
ε= (Δq / q ) / (Δp / p)
= ( p / q ) / (Δp /Δq), or
ε= ( d q / q ) / ( d p / p)
= ( p / q ) / ( d p / d q)
= slope of ray / slope of curve .
A good has an
elastic ( inelastic, unitary)
demand
if
|ε| > 1 ( |ε| < 1 , |ε| = 1 ).
Elasticity and revenue.
R = pq, ΔR = qΔp + pΔq , and
then
ΔR/ Δp = q [ 1 +ε(p) ]
where
ε( p ) = ( pΔq ) / (qΔp).
The elasticity of a linear demand curve
p=a–bq
PRICE
︱ε︱=∞
︱ε ︱>1
a /2
︱ε ︱=1
︱ε ︱<1
︱ε ︱=0
a / 2b
QUANTITY
p267
Strikes and profits.
The Laffer curve.
Similarly,
MR = ΔR / Δq
= p (q) [ 1 + 1 /ε(q) ]
where
ε( q ) = ( pΔq ) / (qΔp).
The income
elasticity of
demand.
The arc elasticity
and
the point elasticity.
Marginal revenue p275
PRICE
a
Slope=-b
Slope=-2b
a/2
Demand, AR
a/2b
a/b
QUANTITY
MR
Marginal revenue for a linear demand curve.
Marginal revenue
PRICE
D, AR
MR = p(q)[1-1/e]
QUANTITY
MR for a constant elasticity demand curve
Chapter 16
Equilibrium
The
market supply curve.
The
competitive equilibrium.
Pareto
efficiency.
Pareto efficiency p301
Willing to
buy at this
price
PRICE
Supply
P’d
Pd=Ps=P*
Demand
P’s
Willing to
sell at this
price
Q’
Q*
QUANTITY
Market supply and market shortage
price
supply
demand
P*
equilibrium
P’
Qs
Q*
Market shortage
Qd
quantity
Shortage is not scarcity.
Special cases of equilibrium p291
PRICE
PRICE
Demand curve
Supply curve
Demand
curve
p*
q*
A
QUANTITY
Supply curve
p*
q*
B
QUANTITY
Algebra
of the equilibrium.
Comparative statics.
Shifting both curves. p294
Taxes.
Distinguish
Pp , the price paid by consumers,
Pr , the price received by
producers,
and
Po , the original price.
The deadweight loss of a tax p301
Demand
PRICE
Amount Pp
of tax
revenue:
Pr
A+C
Supply
A
C
B
D
QUANTITY
Q*
The deadweight loss of the tax: B+D
Chapter 17
Technology
Inputs and outputs.
Factors of production:
land, labor, capital,
raw materials,
and so on.
A production set p307
Y=
Output
Y = f (X ) = production function
Production set
X = Input
Examples of technology
(isoquants analysis):

Fixed proportions,
 Perfect substitutes,
 Cobb-Douglas.

Figs. p308
Fixed proportion
x2
Isoquants
x1
Perfect subsitutes
x2
Isoquants
x1
Assumptions of technology:
monotonic (free disposal),
and convex. p310
x2
a2
(a1/2 + b1/2 , a2/2 + b2/2)
b2
isoquant
a1
b1
x1
The marginal
product,
MPi = d y / d x i . Y is output
The technical
rate of
substitution (TRS):
 With
d y = 0 along any isoquant,
TRS (x1, x2 ) = d x2 / d x1
= – MP1 (x1, x2) / MP2 (x1, x2 ).
The long run (LR)
and
the short run (SR)
Returns to scale:
Increasing, decreasing, and
constant:
>
f(tx)<tf(x)
=
Chapter 18
Profit
Maximization
The organization of firms:
Proprietorships,
partnerships,
corporations.
SR profit maximization
π=
py - w1x1 - w2x2
 y = π/ p + w2x2 / p + w1x1 / p
describes isoprofit lines,
max x1π gives pMP1 = w1.

Fig. p323
Profit maximization
Isoprofit lines
slope = w1/p
Output
y*
y = f (x1, x2)
π/p+w2x2/p
Production function
x1*
x1
Optimum lies on the
tangency of an isoprofit line
and the production function.
P324 Comparative statics:
 Increasing
p increases x1 and then y.
 Increasing
w1 reduces x1,
and thus the factor demand curve follows.
 LR:
both x1 and x2 are variable.
 Figs.
Comparative statics
产品价格
要素价格
f(x1)
f(x1)
High w1 Low w
1
A
x1
Low p
High p
B
x1
Chapter 19
Cost
Minimization
Basic model:
min x1, x2 w1 x1 + w2 x2
subject to f (x1 , x2 ) = y
gives
c ( w1 , w2 , y )
Isocost lines: p337
x2 = C/w2 – w1x1/w2.
Tangency of an isocost line and
an isoquant.
– MP1 (x1, x2) / MP2 (x1, x2 )
= TRS(x1, x2 ) = – w 1 / w 2
x2
Optimal choice
x2*
.
Isocost lines
slope= – w 1 / w 2
Isoquant
f (x1 , x2 ) = y
x 1*
x1
Minimizing costs for
y = min{ax1 , bx2};完全互补
y = ax1 + bx2; 完全替代
a
b
and y = x1 x2 . Cobb-
Fixed
and variable costs.
(FC and VC)
Total, average, marginal, and
average variable costs.
(TC, AC, MC and AVC)

MC > (<) AC if and only if
AC is increasing (decreasing)
 MC cuts AC (AVC) at AC’s
(AVC’s) extreme.
MC
AC
AVC
MC
.
.
AC
AVC
y
Chapter 20
Cost
Curves
The area under MC
gives VC:
∫MC = VC
MC
MC
Variable costs
y
Division of output
among plants of a firm.
MC1
MC2
Typical cost
curves.
Example:
2
c (y) = y + 1.
MC
AC
MC
AVC
2
AC
AVC
.
1
The cost curves for c (y) = y 2 + 1
y
LR and SR
cost curves.
AC
SAC=C(y1, k* )/y
.
LAC=C(y)/y
y*
y
Short-run and long-run average costs
Short-run average
cost curves
AC
y*
Long-run
average
cost curves
y
Short-run and long-run average costs
Sunk costs
are costs that are not recoverable.
A special kink of fixed costs.
Chapter 21
Firm Supply
Pure competition.
Price Taker..
The demand curve facing
a competitive firm. p368
Market demand
P
Market
price P*
Demand curve
facing firm
Q
The supply decision:
FOC: MC ( y* ) = p.
SOC: MC ’ ( y* ) ≥ 0.
The firm’s supply curve is
the upward-sloping part of MC
that lies above the AVC curve.
The part of MC is also seen as the
inverse supply function.
MC
AC
AVC
MC
AC
AVC
firm’s supply
curve
P
y1
y2
y
Three equivalent ways to
measure the producer’s surplus
( = R – VC =π + FC ).
p375
P377 Example:
2
c ( y ) = y + 1.
LR: p = MC ( y, k ( y ) )
vs
SR: p = MC ( y, k )
Chapter 22
Industry
Supply
Horizontal summation
gives
the industry supply.
P
S1
S2
S1 + S2
Y
Entry and
exit.
The
“zero profit”
theorem.
Free entry
vs
barriers to entry.
Rent seeking.
Economists versus
lobbyists
Chapter 23
The
coincidence of the
inverse demand curve D
and the average revenue
curve AR.
Fig.

With
MR = d R / d y = p (y ) [ 1 + 1 /ε(y) ],
p ( y ) = MC ( y ) / [1 – 1 / |ε( y ) | ].
Two
equivalent ways to
determine the equilibrium:
MC = MR, or
AR = MC / ( 1– |ε| ).
FOC: MC = MR.
SOC: MC ’ ≥ MR ’.
Figs.
The
impact of taxes on
a monopoly. p411
Inefficiency
of monopoly.
Fig. p412
Deadweight loss of monopoly.
Fig,
Inefficiency of monopoly
Price
Deadweight lost
pm
pc
Mc
Demand, AR
MR
y m yc
output
Deadweight loss of
monopoly
PRICE
垄断收益
MC
Monopoly
Price P*
A
Competitive
price
B
C
Demand, AR
MR
output
Natural monopoly.
Figs. p417
What causes monopolies: by nature
or by permission.
The minimum efficient scale factor.
Regulation of monopoly: AC = AR.
Chapter 24
Price
discriminations
of first-degree (perfect),
of second-degree (bulk discounts),
and
Price discrimination of third-degree
 (market segmentation): Figs.
MC(y1+y2)
= MR1(y1) = MR2 (y2)

gives
 p1 [ 1 – 1 / |ε1 ( y1 )| ]
= p2 [ 1 – 1 / |ε2 ( y2 )| ].
Fig!
Chapter 26
Oligopoly,
mainly Duopoly
 Quantity
or price competitions.
Identical products:
p = p (Y ), Y = y1 + y2 .
Sequential games.
Backward solution.

Quantity leadership:
– Stackelberg model.
MR2 = p (y1+y2) + y2 dp / dy2 = MC2
gives the follower’s
reaction function
y2 = f 2 (y1) ;
then
max y1 p (y1+ f2 (y1 )) y1 – c1 ( y1 )
determines y1.
Example:
p ( y1 + y2) = a – b ( y1 + y2) ,
c = 0.
Price leadership:
The leader is supposed to set p first,
then max y2 py2 – c2 (y2)
gives
S2(p).
Now, the leader goes as a monopolist
facing the residual demand
R(p) = D(p) - S2(p).
Example:
D(p) = a – bp,
c2 ( y2 ) = y22 / 2,
c1 ( y1 ) = c y1.
Simultaneous
games.
Bertrand price competition
leads to p = MC even only
two firms.
Thus only quantity setting
consideration.
Cournot
model of quantity
competition:
max yi p( yi + yje) yi – ci ( yi ),
where yje is the output of Firm
j expected by Firm i,
gives yi = fi (yje),
then the consistence determines
the equilibrium.
Adjustment
to an equilibrium.
Several firms in Cournot equilibrium:
Y = y1 + … + y n ,
p (Y) [1 – si / |ε(Y)| ] = MCi(yi)
where si = yi / Y.
Chapter 27
Game Theory
Three fundamental elements
to describe a game:
Players,
(pure)
strategies or actions,
payoffs.
Color Matching
B
A
b
r
b
r
1, -1
-1, 1
-1, 1
1, -1
Payoff matrices
for Two-person games.
Simultaneous(-move) games.
Finite games: Both the
numbers of players and of
alternative pure strategies are
finite
The Prisoner’s Dilemma
B
Confess
A
Deny
Confess
Deny
-3*, -3*
0, -5
-5, 0
-1, -1

Dominant strategies, and
dominated strategies.

Method of iterated
elimination of strictly
dominated strategies.
Prisoner’s Dilemma
shows also that a Nash
equilibrium does not
necessarily lead to a Pareto
efficient outcome.
The
Two-win
games.
A pair
of strategies is a
Nash equilibrium if A’s choice
is optimal given B’s choice,
and vice versa.
Nash is a situation,
or a strategy combination of
no incentive to deviate unilaterally.
Battle of Sexes
Girl
Soccer
Ballet
Soccer
2*, 1*
0, 0
Boy Ballet
-1, -1
1*, 2*
Method
of underlining
relatively advantageous
strategies.
Double underlining gives Nash.
There
can be no, one, and
multiple (pure) Nash equilibria.
Price Struggle
Pepsi
L
L
Coke H
3*, 3*
1, 6
H
6,
1
5, 5
How
if there is no Nash
of pure strategies?
Mixed
strategies
(by probability).
Method
of response
functions.
Color Matching again
B
A
b p
r 1-p
b
q
r
1-q
1, -1
-1, 1
-1, 1
1, -1
With
EUA = 1 pq + (-1)p (1-q)
+ (-1) (1-p) q + 1 (1-p) (1-q)
= pq - p + pq - q + pq + 1 - p - q + pq
= 4 pq - 2 p - 2 q + 1
= 2 p (2 q - 1) + (1 - 2 q ) ,
we have
1
if q > 1/2 ,
p=
[0, 1]
if q = 1/2 ,
0
if q < 1/2 .
Similarly,
0
if p > 1/2 ,
q=
[0, 1] if p = 1/2 ,
1
if p < 1/2 .
q
1
N
0
1
p
Method
of response functions:
The intersections of response
functions give Nash equilibria
((p*, q*) = (1/2, 1/2) in example)
Nash Theorem:
There is always a ( maybe
“mixed”) Nash equilibrium
for any finite game
Sequential
Games
games.
in extensive form
versus
in normal form.
Battle of Sexes again
Girl
Ballet
Boy
Ballet
Soccer
( 1, 2)
( -1, -1)
Ballet
( 0, 0)
Soccer
( 2, 1)
Soccer
Strategies as Plans of Actions.
Boy’s strategies: Ballet, and Soccer.
Girl’s Strategies:
Ballet strategy;
Soccer strategy;
Strategy to follow; and
Strategy to oppose.
Chapter 28
Exchange
Partial equilibrium
and
general equilibrium
Edgeworth box p497
A pure
exchange model of
two goods, two consumers
with fixed endowments w.
Region of mutual advantages.
 Pareto set and the contract curve.
 Bargaining for relative prices.
 Gross demand x (p) ,
 Net or excess demand
z (p) = x (p) - w (p).

GOOD 2
wB1
xB1
Person B
x A2
xB2
M
wA2
wB2
Endowment
Person A
x A1
wA1
GOOD 1
Contract
curve
GOOD 2
A Pareto efficient
allocation
Person A’s indifference
curve
Person B’s
indifference curve
Person A
Person B
Endowment
GOOD 1
From
disequilibrium to the
competitive equilibrium.
Which good is too cheap?
Offer curve
approach.
The existence problem of
equilibrium.
Equilibrium price
A’s offer curve
Good 1 is
Too cheap
E
B’s ind. curves
B’s offer curve
A’s ind, curves
W
Chapter 29
Production
The Robinson Crusoe economy
Coconuts
Indifference
curves
C*
Production function
L*
Labor
Production possibilities set
(Two outputs case)
COCNUTS
SLOPE=MARGINAL RATE
OF TRANSFORMATION
C*
PRODUCTION
POSSIBILITIES
SET
F*
FISH
C
P
A
Trade leads to
Separation of prod. and coms. (P/C),
Production specialization(A P), and
Wealth improvement( A C).
Heckscher-Ohlin theory on
international trade,
under many idealization assumptions.
*
Costs of exchange.
* Price difference between
selling and buying.
Fig.
*
GATT and WTO.
Chapter 30
Welfare
The social preference.
Two kinds of voting:
majority,
and
rank-order.
The social welfare
function.
 Benthamite:
W (u1, … ,u n ) = a 1u 1 + … + a n u n .
 Rawlsian:
W (u1, … ,u n ) = min {u1 , … , u n }.
Three requirements on a social
decision mechanism:
1, It should be complete, reflexive, and
transitive;
2, If everyone prefers X to Y, then the
society should prefer X to Y;
3, The preferences between X and Y
should depend only on how people rank
X versus Y, and not on how they rank
other alternatives.
Arrow's Impossibility Theorem
 If
a social decision mechanism
satisfies properties 1, 2, and 3,
then it must be a dictatorship:
all social rankings are the
rankings of one individual.
Chapter 31
Externalities
The lack of markets
for externalities
causes problems.
With externalities,
the market will not necessarily
result in a Pareto efficient
provision of resources.
However, some other
social institutions can
"mimic"
the market mechanism.
The model of
smokers
and nonsmokers
(showing excellent analysis techniques).
Possible
SMOKE
endowment E’
Person B
Bad
Possible
equilibrium X’
Possible
equilibrium X
A’s
indifference
curves
Person A
Possible
endowment E
Good
MONEY
The practical problems with
externalities generally arise
because of poorly defined
property rights.
Caose Theorem
Chapter 35
Asymmetric
Information
Common knowledge
and
private information.
The latter leads to
Asymmetric information,
or
Asymmetry of information.
Akerlof model:
the market for lemons.
Density
Quality
Adverse selection
as a hidden information problem.
Moral hazard
as a hidden action problem.
Signaling
Two roles of education:
To raise and to distinguish
Productivities
Spence model
$
C(Y) for L
wage system
C(Y) for H
Y*
Best Choice of L,
and of H
Y
Graph to show
separating equilibria
and pooling equilibria.
END
and
Thanks