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Econ326 Intermediate Microeconomics Fall 2011 Instructor: Ginger Z. Jin http://kuafu.umd.edu/~ginger TA: Aaron Szott Slide 2 Lecture 1 Course introduction Syllabus Teaching style and expectations Textbook Chapter 1, 2.1-2.3 Slide 3 Goal of the class Teach you to think like a micro-economist Labor market issues Industrial organization Public policies International trade Derive the major concepts and intuitions from introductory microeconomics We will emphasize analytic logic and mathematical rigor. Slide 4 Class will cover: Consumer demand Describe consumer preference Derive consumer demand Market vs. individual demand Consumer welfare Firm production Production technology Firm choice of input and output Cost and profit How demand meets supply? Exchange economy Market structure Market failures: monopoly, asymmetric info, externality Policy interventions Slide 5 Example: rental market in College Park Product definition: one bedroom apt off-campus rental in College park Players: tenants, landlords, city government? University? Actions and incentives Tenants: reservation price/willingness to pay Landlords: cost, earn money if possible Market outcomes: price, vacancy rate, tax revenue? Slide 6 Monthly rent Units available demand supply equilibrium Why is the demand downward sloping? Slide 7 Monthly rent Units available demand supply equilibrium When will we observe a fixed supply? Slide 8 Market scenario 1: convert some apartments to condos Monthly rent Units available demand supply Both demand and supply get reduced, the effect on market equilibrium price is unclear Slide 9 Market scenario 2: impose $50/month tax on landlord Monthly rent Units available demand supply No change in demand and supply thus no change in price ONLY TRUE with fixed supply What happens if the supply is not fixed? Slide 10 Market scenario 3: non-discriminating monopoly Monthly rent Units available demand supply The monopolist may want to restrict the supply so that he can charge higher price not efficient from the society point of view What if the monopolist can charge different price on different tenants? Slide 11 Market scenario 4: rent control Monthly rent Units available demand supply Keep the price down, but create excessive demand How to allocate the limited supply to excessive demand? lottery, ration, allow secondary market trade? Slide 12 At the end of this class, You know how to derive a simple demand curve given individual preference You know how to derive the supply decision of each firm You know how to compute market equilibrium under different market structures You can compute who gains and who loses by how much under a simple policy intervention Slide 13 Syllabus on my personal website http://kuafu.umd.edu/~ginger/ click on Econ326 Also available on elms.umd.edu Slide 14 Prerequisites very strict rules by Economics Department (1) have completed Econ300 with a grade of "C" (2.0) or better, OR (2) have completed or are concurrently taking Math 240 or Math 241. If you satisfy either (1) or (2), you should have already completed ECON200, ECON201, and Calculus I. But completion in these four courses are not sufficient for enrollment in Econ326. For those who do not meet the prerequisites but believe that an exception could be made, please talk to Shanna Edinger in Tydings 3127B. Slide 15 Syllabus Textbook: Pindyck and Rubenfeld, Microeconomics, Edition 7 Evaluation Three problem sets, 10 points each Two midterms, 20 points each One cumulative final, 30 points Five random in-class quizzes, 2 bonus points each Total 110 points Slide 16 F: Axioms of preferences Completeness A > B, B > A, A ~ B for all bundles A, B Transitivity A > B and B > C => A > C Otherwise we wont be able to tell which bundle is the best Non-satiation: more is preferred to less. Goods are always good Counter examples: bad (dislike), neutral goods (indifferent) Balance: averages preferred to extremes Also called convex preference Slide 26 Utility Definition of Utility Numerical score representing the satisfaction that a consumer gets from a given basket of goods. In what unit? ordinal versus cardinal Slide 27 Marginal Utility the increase in utility you get when you consume one more unit of good X Units of ApplesTotal utility (TU) Marginal Utility (MU) 00 155-0=5 299-5=4 31212-9=3 41414-12=2 51515-14=1 One common property: Diminishing marginal utility Slide 28 Show MU in graph Total Utility U Units of apples (X) Slide 29 Exercise: compute MU, diminishing MU? U=5(X+1) U=5ln(X+1) U=X 0.3 U=100-X 2 U=X 0.4 Y 0.6 Slide 30 Ordinal vs Cardinal Ordinal Utility the measurement of satisfaction that only requires a RANKING of goods in terms of consumer preference. This is the concept of utility that is embodied in the so-called "utility function" that forms the basis of CONSUMER THEORY Utility Function Utility function that generates a ranking of market baskets in order of most to least preferred. This function is defined up to an order-preserving, monotonic transformation Slide 31 Exercise: monotonic transformation of U function? U=5X vs U=5(X+1) U=5(X+1) vs U=5ln(X+1) U=5X+5Y vs. U=5lnX+5lnY U=X 0.5 Y 0.5 vs U=XY U=XY vs U=lnX+lnY U=X+Y 2 vs U=X+Y Note: 1.monotonic transformation does not change the order of preference, 2.it may change the property of MU 3.It does NOT change the relative tradeoff between two goods (MU x vs MU y ) Slide 32 How to graph utility of two goods U(X,Y) 0 0 X X Y Y Slide 33 Indifference curves Definition of Indifference Curve: the set of consumption bundles among which the individual is indifferent. That is, the bundles all provide the same level of utility. each indifference curve corresponds to a specific utility level Indifference curves never cross each other Slide 34 Axioms of preferences Completeness A > B, B > A, A ~ B for all bundles A, B Transitivity A > B and B > C => A > C Otherwise we wont be able to tell which bundle is the best Non-satiation: more is preferred to less. Goods are always good Counter examples: bad (dislike), neutral goods (indifferent) Balance: averages preferred to extremes Also called convex preference Slide 35 Examples of indifference curves U(X, Y)=X * Y X Y pointXYU 1111 2224 3339 44416 5144 6414 7236 8326 Typical convex preference Satisfy all four axioms of preference Slide 36 Examples of indifference curves U(X, Y)=X + Y X Y pointXYU 1112 2224 3336 4448 5145 6415 7235 8325 Perfect substitutes Violate balance because avg is not better than extremes MU x is a constant (not diminishing), so is MU Y 1 2 3 5 6 7 8 4 Slide 37 Examples of indifference curves U(X, Y)=min(X, Y) X Y pointXYU 1111 2222 3333 4444 5141 6411 7232 8322 Perfect complements Violate non-satiation sometimes U is not always differentiable, MU is not well defined at the kinks Slide 38 Lecture 3 Marginal rate of substitution Properties of indifference curves Shape of indifference curves Special examples Textbook Chapter 3.1 & 3.2 Assign problem set #1 Slide 39 Marginal rate of substitution (MRS) Definition: Marginal Rate of Substitution (of X for Y) = -dy/dx | same satisfaction (i.e. same U) How many units of Y would you like to give up to get one more unit of X? Can be interpreted as marginal willingness to pay for X if Y is numeraire (money left for other goods) Slide 40 Marginal rate of substitution (MRS) A Slope = - MRS at point A X Y Slide 41 Diminishing MRS (MRS of X for Y diminishes with X) Consistent with diminishing marginal utility Slide 42 Mathematical derivation of MRS U=U(X,Y) Total differentiation: dU = MU x * dX + MU y * dY =0 -dY/dX = MU x / MU y = MRS (of X for Y) Slide 43 MRS and ordinal utility Calculate MRS: U=XY U=lnX + lnY U=X+Y U=X+Y 2 U=(X+1)(Y+2) U=X 2 Y 2 Which and which are monotonic transformations of each other? Slide 44 Properties of indifference curves for typical preferences Indifferent curves are downward sloping Violate non-satiation if upward sloping Indifference curves never cross Violate transitivity if they cross Indifference curves are convex Violate balance if they are concave or linear Slide 45 How would the indifference curves (on apples and bananas) look like if: How would the indifference curves (on apples and bananas) look like if: Like apples and bananas Like apples up to a satiation level Like apples, but dislike bananas Like apples, but indifferent to bananas Must eat one apple with one banana Dislike apples, dislike bananas Like both apples and bananas up to a satiation level Slide 46 Like apples and bananas apples bananas U Slide 47 Like apples up to a satiation level apples bananas U What happens if one likes both apple and banana up to a satiation level? Slide 48 Like apples but dislike bananas apples bananas U What if one dislikes both apples and bananas? Slide 49 Like apples but indifferent to bananas apples bananas U Slide 50 Must eat one apple with one banana (perfect complements) apples bananas U Locus line What determines the locus line? What if one must each two apples with one banana? Slide 51 Always willing to exchange one apple for one banana (perfect substitutes) apples bananas U What determines the slope of the indifference curve? What if one is always willing to exchange two apples for one banana? Slide 52 Cobb-Douglas Utility Typical functional form: U=X c Y d Transformations: U=c*lnX + d*lnY or U= X a Y 1-a where a=c/(c+d) Calculate MRS at point (X,Y) Slide 53 Lecture 4: Budget constraints definition Shocks to consumer budget Kinked consumer budget Textbook Chapter 3.1 & 3.2 Slide 54 Budget constraints Definition: The budget constraint presents the combinations of goods that the consumer can afford given her income and the price of goods. Equation: P x * X + P y * Y = I Rearrange: Y = I/ P y + (- P x / P y ) * X interceptslope Slide 55 Graph budget constraint I/P x I/P y X Y Slope = - P x / P y Px/Py = the rate at which Y is traded for X in the marketplace Unlike MRS, the price ratio does not depend on consumer psyche Slide 56 Exercise My 11-year-old son has 20 dollar allowance each month. He likes bakugan balls and pokemon cards Bakugan ball is $5 each Pokemon card is $2 each Draw his budget line Slide 57 What happens with income tax cut? Tax cut more income I/P x I/P y X Y Slope = - P x / P y Does the intercept on Y change? Does the intercept on X change? Does the slope of the budget line change? Slide 58 What happens if gasoline price goes up? (assume gasoline is X) P x increases I/P x I/P y X Y Slope = - P x / P y Does the intercept on Y change? Does the intercept on X change? Does the slope of the budget line change? Slide 59 Examples of kinked budget constraints (if price depends on how many units to buy) Assume income = $2000 Two goods: X=food, Y=health care Prices: Px= $2, Py = $1 if Y $500 (coinsurance 20%) Slide 60 X (food)1000 750 500 8000 Slope = -Px /Py = -2 Slope = -Px /Py = -2/0.2=-10 Y (health care) Slide 61 Example 2: 1979 food stamp program Income I=2000 Two goods: food (X), other (Y) Px =1, Py = 1 A household is granted $200 food stamp But the food stamp can only be used for food Slide 62 food other 2000 2200 What happens if there is a black market to trade food stamps? Slide 63 Example 3: role of financial market Slide 64 X (today) Y (tomorrow) I 2*I #1: no financial market I 2*I Slide 65 X (today) Y (tomorrow) #2: a financial market allows saving and borrowing at interest rate r The opportunity cost of not saving today makes one feel as if todays price is increased to (1+r). Slide 66 X (today) Y (tomorrow) Now we have a kink due to the asymmetric terms of borrowing and saving Slide 67 Recap so far Indifference curves describe consumer preference Budget constraints describe what consumers can afford Put the two together to determine the best bundle one can afford Slide 68 Graphical presentation I/P x I/P y X Y Slope = - P x / P y Px/Py = the rate at which Y is traded for X in the marketplace MRS = the rate at which the consumer is willing to trade Y for X MRS > Px/Py MRS < Px/Py A B C Slide 69 At the best choice: Must spend every penny (assume no savings, goods are divisible) Equal Marginal Principle MRS = the rate at which the consumer is willing to trade Y for one extra unit of X Px / Py = the rate at which Y is traded for X in the market place MRS = Px / Py MU x /P x = MU y /P y Slide 70 Mathematical derivation Max U(X, Y) by choosing X and Y Subject to I = Px * X + Py * Y Define Lagrangian function L = U(X,Y) + (I Px * X Py * Y) is an additional variable, now need to choose X, Y, Slide 71 Mathematical derivation Slide 72 We get the equal marginal principle back! is the shadow price of the budget constraint Tell us how much the objective function will increase if the budget constraint is relaxed by one dollar ((dL/dI = dU/dI when I is binding) Therefore, is also called the marginal utility of income when utility is maximized Slide 73 Exercise: find the best choice when U (Food, Clothes) = ln (F) + ln (C) Price of food = $2 Price of clothes =$1 Income=100 Answer: F=25, C=50 Slide 74 Lecture 5 Consumers optimal choice Inner solution, corner solution Cobb-Douglas utility Price and consumer choice Income and consumer choice Normal, inferior and giffen goods Textbook Chapter 4 appendix, 4.1-4.4 Slide 75 Typically: Inner solution I/P x I/P y X Y At the optimal choice: MRS = Px/Py I=Px * X + Py * Y Slide 76 What if the equal marginal principle cannot be satisfied? corner solution I/P x I/P y X Y U Spend every penny: I=Px * X + Py * Y Check which corner gives higher utility Slide 77 Example 1 of corner solution: perfect substitutes 100 X Y U U=X+2Y Px=10 Py=10 Income=1000 Slide 78 Example 2 of corner solution: perfect complements 100 X Y U U=min(X,2Y) Px=10 Py=10 Income=1000 Slide 79 Demand Optimal choice X=f(Px, Py, Income) Properties: Homogenous degree of zero Typically depends on income, own price, price of other goods Slide 80 Special example: Cobb-Douglas Utility Two equations Solve for two unknowns (X and Y) Slide 81 Homothetic preferences: MRS only depends on the ratio of X and Y Fixed share of income for each good Demand only depends on own price, not price of other goods Slide 82 Graph consumer choice in response to: Price changes Income changes Slide 83 Two goods: food, clothing Price of food drops Slide 84 Two goods: food, clothing Income increases Note that income- consumption curve is not necessarily linear Slide 85 Normal goods Consumers want to buy more quantity of normal goods as their incomes increase. Inferior goods Consumers want to buy fewer quantity of inferior goods as their incomes increase. Examples? Slide 86 Hamburger is a normal good from A to B, but an inferior good from B to C Slide 87 Engel curve Slide 88 Giffen goods Normal and inferior goods are defined by how consumer choice changes in response to income change Giffen goods depend on price change Typical goods have downward sloping demand curve Giffen goods have upward sloping demand curve: as price increases, consumers buy more; as price decreases, consumers buy less. Slide 89 Lecture 6 Decompose income and substitution effects in response to price change Slusky Equation Textbook chapter: 4.3-4.4 Handout #1: an example Slide 90 Food price falls Initial choice A new choice B Imaginary D: same utility as A, but face new price Slide 91 Slusky Equation Total effectsSubstitution effects Income effects Slide 92 What if X is an inferior good? income effect works against the substitution effect Slide 93 What if X is a Giffen good? income effect works against and more than cancels off the substitution effect Slide 94 Example 1: Slide 95 Example 2: Introduction of health insurance X=food, Y=health care, Px=$2, Py=$1 if no insurance, Income=2000 Benchmark: no insurance Scenario #1: insurers pay 80% of the cost of any medical service Scenario #2: insurers pay 80% after $500 deductible Slide 96 X (food)1000 10000 Slope = -Px /Py = -2 Slope = -Px /Py = -2/0.2=-10 Y (health care) A B C A: choice with no insurance C: choice with insurance A to B: substitution effect B to C: income effect Scenario #1: insurers pay 80% of the cost of any medical service Slide 97 X (food)1000 750 500 8000 Slope = -Px /Py = -2 Slope = -Px /Py = -2/0.2=-10 Y (health care) How would the insurance coverage affect those who are healthier and do not need more than $500 health care before the insurance coverage? Scenario #2: insurers pay 80% after $500 deductible Slide 98 Lectures 7-8 Application to labor supply Individual and market demand Demand elasticity and cross elasticity Textbook chapter: 4.3-4.4 Slide 99 Individual demand A consumers optimal choice of a good depends on The price of this good The price of other goods Income Slide 100 Example Slide 101 Income Two goods Slide 102 L C L* C* 24+y/w 24 (24w+y)/Pc Slide 103 Slide 104 w L 24 8 0.5 4.8 1 Slide 105 Pc C 42.7 0.5 19.2 1 Slide 106 More generally: Market demand Q(P)= sum of individual demand Q i (P) Slide 107 Textbook example of market demand Slide 108 How to summarize market demand? Slide 109 Meaning of demand elasticity Slide 110 Classify demand by demand elasticity Slide 111 Market demand Q(P) Example: Q=100-2P What is demand elasticity at p=10,20,30? At what price is the demand isoelastic? Q P 50 100 If you are the producer, why do you want to know demand elasticity? Slide 112 Special cases Q P Infinitely elastic demand Completely inelastic demand Slide 113 Other elasticities Slide 114 Example Slide 115 More on cross elasticity X and Y are substitutes If an increase in Px leads to an increase in the quantity demanded of Y. X and Y are complements If an increase in Px leads to a decrease in the quantity demanded of Y. X and Y are Independent If Px does not affect the quantity demanded of Y Cobb-Douglas utility independent goods Slide 116 Consumer surplus Individual consumer surplus = difference between what a consumer is willing to pay for a good and the amount actually paid Total consumer surplus = sum of individual consumer surplus For six consumers, CS = $6+$5+$4+$3+$2+$1=$21 Slide 117 Total Consumer Surplus = *(20-14)*6500=19,500 Slide 118 Textbook example of market demand Calculate the demand elasticity of total demand and total consumer surplus at p=18. Slide 119 To summarize Consumer preference (utility function) Budget Constraint optimal choice X=X(Px, Py, I) Income-consumption curve, price- consumption curve, engel curve, demand curve Income and substitution effects Sum of Individual demand=market demand Demand elasticity, income elasticity, cross elasticity Consumer surplus Slide 120 Lecture 11 Risk and Consumer behavior Describe risk Preferences towards risk Demand for risky assets Slide 121 Risk, Uncertainty, and Profit, by Frank Knight (1921) Risk: random events that can be quantified in probability Uncertainty: random events that cannot be quantified in probability Today we focus on risk only Slide 122 Describe risk Outcome: a random event is associated with multiple outcomes, for instance: head/tail when we flip a coin gain/loss when we invest in a risky asset Healthy or sick in the future Probability: likelihood that a given outcome will occur Payoff: value associated with a possible outcome Slide 123 Describe risk Expected value: probability-weighted average of the payoffs associated with all possible outcomes E(X)=Prob 1 *X 1 + Prob 2 *X 2 ++ Prob n *X n Variance: Extent to which possible outcomes of a risky event differ Var(X)= Prob 1 *(X 1 -E(X)) 2 + Prob 2 *(X 2 -E(X)) 2 ++ Prob n *(X n -E(X)) 2 Standard deviation: square root of variance, same unit as X Slide 124 Example Job1: 50% probability with income $2000 50% probability with income $1000 Job2 99% probability with income $1510 1% probability with income $1500 Calculate expected values, variance, standard deviation Slide 125 Job1 is riskier Slide 126 Preferences toward risk For outcome X i, utility = U(X i ) Expected utility EU=Prob 1 *U(X 1 )+ Prob 2 *U(X 2 ) +.+Prob n *U(X n ) Risk averse: prefers a certain given outcome to a risky event with the same expected value: EU(X)U(E(X)) Slide 127 Example Eric now has a job with annual income $15000 He is considering a new job: 50% prob with income $30,000 50% prob with income $10,000 Slide 128 Risk averse (EU(X)?, U(E(X))?) Slide 129 Risk neutral (EU(X)?, U(E(X))?) Slide 130 Risk loving (EU(X)?, U(E(X))?) Slide 131 Risk premium: maximum amount of money that a risk averse person will pay to avoid taking the risk Slide 132 Indifference curves for a risk averse person Like higher expected value, But dislike risk (measured in standard deviation) U How would the indifference curves look like if the person is risk neutral? What if he is risk loving? Slide 133 How to reduce risk? Diversification Practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related Most effective if the activities are negatively correlated (examples?) Insurance Pay insurance premium to avoid risky outcomes Actuarially fair: the insurance premium is equal to the expected payout Slide 134 Choosing between risk and return Risk free asset: R f Asset with market risk: R m, m ( R m R f ) Portfolio p: R p = R f +-------------- * p m Slide 135 Choice of a risk averse person Slide 136 Exercise: Chapter 5, Question 7 Suppose two investments have the same three payoffs, but the probability of each payoff differs: Find the expected return and standard deviation of each investment. Jill has the utility function U=5*X where X denotes the payoff. Which investment will she choose? Kens utility function is U=5*X 0.5, which investment will he choose? For Ken, whats the risk premium of investment A? Whats the risk premium of investment B? payoffProb (investment A)Prob (investment B) $3000.100.30 $2500.800.40 $2000.100.30 Slide 137 Lectures 12, 13 Technology of production Production function Average product, marginal product Law of diminishing marginal return Malthus and the food crisis Production with two inputs Isoquant curve Marginal rate of technical substitution Returns to scale Slide 138 Technology of Production Production function: shows the highest output that a firm can produce for each specified combination of inputs Single input (labor): q=F(L) Two inputs (capital, labor): q=F(K,L) Short-run: time in which quantities of one or more inputs cannot be changed Long-run: time needed to make all production inputs variable. Slide 139 Single-input production q=F(L) Average product: q /L Marginal product: dq /dL LqAvg product q/L Marginal product dq/dL 00 110 230 360 480 595 Slide 140 Graphically: Slide 141 Marginal Product (MP) and Average Product (AP) Slide 142 Law of diminishing marginal returns As the use of an input increases with other inputs fixed, the resulting additions to output (i.e. marginal product) will eventually decrease. This is different from technological improvement Example: Malthus and the food crisis Slide 143 How to describe production with more than one inputs? Isoquant curve: shows all possible combinations of inputs that yield the same output Similar to indifference curve for consumer utility Slide 144 Marginal rate of technical substitution (MRTS) Amount by which the quantity of one input can be reduced when one extra unit of another input is used so that output remains constant. MRTS of L for K = - dK/dL | same q = MP L / MP k MRTS = - slope of isoquant curve Diminishing MRTS Similar to MRS in consumer utility Slide 145 Example Plot isoquant curve for K=2, L=1, calculate marginal product of labor, marginal product of capital and MRTS at this point q=3KL q=3K+L q=min(3K, L) Slide 146 Diminishing MRTS Slide 147 Special case #1: K and L are perfect substitutes if production function is linear, MRTS is always a constant Slide 148 Special case #2: K and L are perfect complements if production function is min(f(K), g(L), MRTS is not well defined at the kink (i.e when f(K)=g(L)) Slide 149 Cardinal vs Ordinal Slide 150 Returns to scale Rate at which output increases as ALL inputs are increased proportionally Note it is different from marginal product It is a property of a given production function, also different from technological improvement Simple rule of thumb: will the output double when all the inputs double? q more than double Increasing returns to scale q exactly double Constant returns to scale q less than double Decreasing returns to scale Slide 151 Constant return to scale Increasing return to scale Can you think of any real-world examples that have constant, increasing or decreasing returns to scale? Slide 152 Slide 153 Example: are these production functions decreasing, increasing or constant returns to scale? q=3KL q= K 0.5 L 0.3 q=0.5lnK + 0.8lnL q=3K+L q=min(3K, L) q= 3KL + 3KL 2 Slide 154 Lecture 14, 15 and 16 Cost functions Firm decision Given production technology Given input prices of input firm decides on optimal choice of inputs cost function Short run Long run Slide 155 Cost w = wage rate r = capital rental cost Both could be opportunity cost Cost function C (q) = w*L(q) + r*K(q) Firms decision does not include sunk cost after the cost is sunk Example? Slide 156 Fixed vs. Variable Cost Variable cost fixed cost Slide 157 How to determine cost with only one variable input? Slide 158 More generally Total production function Total cost function Slide 159 Marginal cost (MC) and avg cost (AC) Total cost function Marginal cost MC = dC/dq Average Variale cost = VC/q Average total cost = TC/q = (VC + FC)/q When MC=AC, it is the minimum of AC Slide 160 How to determine cost with two variable inputs? Slide 161 Slide 162 Graphically: Isoquant curve at q Isocost curves Slide 163 Special case 1: when K and L are perfect substitutes, we may get corner solutions Slide 164 Special case 2: when K and L are perfect complements, we always use the perfect proportion of K and L Optimal inputs are at the kink of the isoquant curve Slide 165 Follow the previous example Slide 166 Long run AC and MC Slide 167 Inflexibility of short run Slide 168 Short run and long run costs Slide 169 Exercise Production function q=10KL Wage w=10, rental cost of capital r=20 Total, average and marginal cost of producing q units in the short run when K is fixed at 5? Total, average and marginal cost of producing q units in the long run? What happens if wage rate increases to 20? Slide 170 Lectures 16 & 17 Profit Maximization of competitive firms So far we know how to choose inputs and derive cost function for a specific level of production under a specific technology, but how does a firm determine how much to produce? This class: Competitive market Profit maximization of competitive firms Total revenue, marginal revenue Choice of output given market prices Slide 171 Perfectly competitive market Homogenous goods must charge same price Free entry and exit of producers Price-taking: numerous firms in the market so no firm's individual supply decision affects price. All firms face perfectly elastic demand Any example that violates the above assumption(s)? Slide 172 Demand curve faced by a competitive firm (perfectly elastic) Demand curve faced by the industry Individual firms vs. the industry Slide 173 Profit-maximizing firms Slide 174 Graphic illustration of profit maximization Slide 175 Algebraically: Slide 176 Slide 177 About fixed cost Slide 178 Graphic example Slide 179 Exercise Output price p=10 Total cost = 100 + q + 0.5 * q 2 Write down FC, VC, AC and MC. How much should the firm choose to produce in the short run (after it incurs FC)? Should the firm shut down in the long run? At what price will the firm enter the market? Slide 180 Short run supply curve of a competitive firm How will the supply curve change in the long run? Slide 181 Industry supply curve in the short run Slide 182 Producer surplus Slide 183 Producer surplus for a firm Slide 184 Producer surplus for the industry in the short run Slide 185 Long run profit maximization for an individual firm More flexible in input choices production can be more cost-efficient in the long run Can shut down and exit the market if the expected profit is lower than the fixed cost Slide 186 Long run competitive equilibrium for the industry three conditions 1.All firms are maximizing profit. 2.No firm has an incentive to entry or exit because all firms earn zero economic profit Zero economic profit represents a competitive return for the firms investment of financial capital 3.The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by consumers. Slide 187 Continue the previous example for the whole industry start with p=40 Slide 188 The industrys long run supply curve Constant cost industry All firms face same cost Every firm is small as compared to the market Long run supply curve is horizontal Slide 189 The industrys long run supply curve increasing cost industry The prices of some or all inputs increase as the industry expands Long run supply curve is upward sloping Slide 190 Is it possible for the industrys long run supply curve to be downward sloping? Yes, for decreasing cost industry The prices of some or all inputs may fall as the industry expands and takes advantage of the industry size to obtain cheaper inputs Slide 191 Price elasticity of supply Slide 192 Exercise Slide 193 Lecture 18 Competitive market equilibrium Demand equal to supply Consumer surplus Producer surplus Dead weight loss Consequence of price regulations Slide 194 Competitive market equilibrium Every consumer is a price-taker and a utility-maximizer Every firm is a price-taker and a profit- maximizer Free entry and exit Demand equal to supply Slide 195 Consumer surplus and producer surplus Slide 196 Price control #1: impose a maximum price that is below the market clearing price Slide 197 Price control #2: impose a minimum price that is above the market clearing price Regulating price away from free-market price (in either direction) will introduce some deadweight loss. Slide 198 Exercise: Demand: P=100-Q Supply: P=1+2Q Calculate market price, quantity sold, consumer surplus, producer surplus and total welfare Suppose the government imposes a price ceiling of $50. How would market price, quantity sold, consumer surplus, producer surplus and total welfare change? How much is the dead weight loss? Slide 199 More about price regulation Price regulation will distort the market and generate dead weight loss in total welfare Price regulation will also generate a redistribution between consumers and producers What if you care more about consumer surplus than about producer surplus? Lower price may lead consumers to suffer a net loss if the demand is sufficiently inelastic With price ceiling, new CS=old CS-B+A Slide 200 Example: the market of kidney and the National Organ Transplantation Act Market clearing price is 20,000. The law makes the price zero. At market price, total welfare=(D+B+)+(A+C) At regulated price, total welfare=(D+.A+..)+0 Slide 201 Other regulations: supply restriction Limited taxi licenses Trade barriers At world price, buy Qs from domestic, and import Qd-Qs If import is not allowed, price rises to P0 How much is the deadweight loss? How much is the loss of consumer surplus? Slide 202 What if there is an import quota? At world price, buy Qs from domestic, and import Qd-Qs If import is only allowed up to the quota, price rises to P* How much is the deadweight loss? How much is the loss of consumer surplus? What about domestic and foreign producers? Slide 203 What about we impose a lump sum tax on gasoline? Changes in CS? Changes in PS? Gov revenue? Slide 204 Impact of tax depend on demand and supply elasticity Slide 205 Lecture 19 Exchange economy Edgeworth box Determination of trade price and trade amount Contract curve Textbook: Chapter 16 Slide 206 Edgeworth box 2 individuals No production, exchange only Every one is price taker Slide 207 Contract curve Slide 208 Pareto optimal (pareto efficient) There is no way to make one better off and the others not worse off Every point on the contract curve is pareto optimal. Slide 209 Competitive equilibrium Slide 210 Example: Handout Two individuals: A and B Two goods: X and Y Endowment: each one has 5 unites of X and 5 units of Y Utility: U A =X A *Y A, U B =X B 2 *Y B. Question: is there a trade? How much to trade? Market price? Slide 211 Lecture 20 First welfare theorem Reasons for market failure Monopoly: Marginal revenue = MC Monoposony: Marginal expenditure = MC Slide 212 First theorem of welfare economics: Competitive equilibrium is the best! More formally, textbook Page 597: If everyone trades in the competitive marketplace, all mutually beneficial trades will be completed and the resulting equilibrium allocation of resources will be economically efficient. Slide 213 Three reasons for market failure Market power: some party is not price taker Monopoly: one seller, non price taker Monoposony: one buyer, non price taker Asymmetric information Externality Slide 214 Monopoly Total revenue Total cost Slide 215 Marginal revenue < price restrict supply MC Monopoly choice competitive choice Slide 216 The Principle of Monopoly pricing Mark up Inverse of demand elasticity Slide 217 This implies: The more elastic the demand is, the lower the monopoly mark up. Demand elasticity limits the monopolists market power Monopolist will always choose to operate at an elastic part of the demand curve. Slide 218 Example Demand: P=100-Q Total cost: TC = 20+4Q Competitive P and Q? Monopoly P and Q? Demand elasticity at this point? Confirm the Lerner rule. Loss of CS due to monopoly? Change of PS due to monopoly? Total welfare changes? Slide 219 Exercise: Drug innovation needs FC=5 billion Demand per month P=100-0.0001Q Marginal cost =$2 If we grant X years of monopoly power for the inventor, what should X be? Slide 220 Lecture 21 Price discrimination Price discrimination the practice of selling a particular good at different prices to groups with different valuations. When does price discrimination occur? 1.The seller has some market power (i.e. facing downward demand) 2.Sellers can distinguish different types of consumers 3.No arbitrage Slide 221 Types of Price discrimination 1 st degree charge each consumer their maximum willingness to pay 2 nd degree dont know who is willing to pay more, offer a menu of deals to sort out consumers 3 rd degree: offer different prices according to consumers observable attributes (age, gender, ) Can you think of examples for each? Slide 222 Third degree of price discrimination Slide 223 Slide 224 Example: Chapter 11, Exercise 8 Slide 225 Recap on competitive equilibrium and monopoly Competitive equilibrium: Both sellers and buyers are price-takers Demand = supply P=MC Monopoly Buyers are price takers, but the seller is not MR=MC>P Seller has market power, will push price up to consumer willingness to pay (i.e. the demand curve) Slide 226 Lecture 22 Monoposony Monopoly one seller vs. competitive buyers The seller realizes his power to set market price This power is only useful when demand is downward sloping (rather than horizontal) Monopsony: one buyer vs. competitive sellers The buyer realizes his power to set market price This power is only useful when supply is upward sloping (rather than horizontal) Slide 227 Mathematically Willingness to pay for the marginal unit of q = inverse demand p(q) Slide 228 Graphically -> demand curve -> supply curve MC -> marginal expenditure >MC Slide 229 Compare monopsony with monopoly Monopoly pushes price to demand curve Monopoly is more powerful if demand is inelastic Monopsony pushes price to supply curve Monopsony is more powerful if supply is inelastic Slide 230 Monopsony leads to dead weight loss Slide 231 Exercise: Walmart is a monopsony of apparel in China. There are many sellers of apparel in China. Based on US demand for apparel, Walmart is willing to pay P=500-0.1Q for Q units of apparel. The supply of apparel is P=80+0.2Q Calculate P and Q in competitive equilibrium Calculate P and Q in monopsony equilibrium Welfare consequence of monopsony Slide 232 Lectures 23 and 24 Imperfect competition Recall conditions for perfect competition Homogenous goods Every one is price taker Free entry and exit We talked about two extremes: perfect competition and monopoly (monopsony) Between the two extremes: Monopolistic competition Oligopoly Slide 233 Monopolistic competition large number of small firms freedom of entry and exit perfect info Differentiated products What does this imply? 1. Every firm faces downward sloping demand have some power is setting price above MC 2. Every firm earns zero economic profit Slide 234 Monopolistic competition in short- run and long-run Short run Long run Slide 235 Inefficiency in monopolistic competition Downward sloping demand market power to set price above MC dead weight loss P>MC and Zero profit in the long run operate at AC>MC extra capacity, economy of scale not fully exploited Slide 236 Oligopoly a market structure in which a small number of firms serve market demand. The industry is characterized by limited entry. Homogenous goods Simplest case duopoly (i.e. only two sellers) Each aware of the existence of the other firm Compete instead of collude each firm has market power less than monopolist Examples? Slide 237 Nash Equilibrium Each firm is doing the best it can given what its competitors are doing. No one has incentive to deviate at the equilibrium Slide 238 Cournot model of Duopoly Two profit maximizing firms produce the same goods (e.g. gasoline) Both firms try to set its own output separately and simultaneously each firm treats the output level of its competitor as fixed when deciding its own output Slide 239 Solve Cournot equilibrium Slide 240 Example: textbook p453 Market demand: P=30-Q MC=0 for both firms How much to produce in Cournot equilibrium? What is the market price? What if the two firms collude so they together act like a monopolist? Compare these two cases with competitive equilibrium Slide 241 Cournot: firm 1s point of view First order condition with respect to Q1 while taking Q2 as given: Firm 1s reaction curve: Slide 242 Cournot: firm 2s point of view First order condition with respect to Q2 while taking Q1 as given: Firm 1s reaction curve: Slide 243 Put the two together: Slide 244 Compare to monopoly if the two firms collude MR=P+P(Q)*Q=30-Q-Q=30-2Q MR=MC 30-2Q=0 Q=15 The two firms together produce 15, so each produce 7.5. P=30-Q=15. Slide 245 Compare to perfect competition P=MC 30-Q=0 Q=30, P=0. Slide 246 Graphically Slide 247 Variation 1: What if the two firms do not choose output simultaneously? Stackelberg model: One firm sets its output before other firms do. first move advantage Difference between Cournot and Stackelberg models The leading firm will consider how the other firms adjust output according to his choice of output Slide 248 Continue the previous example Slide 249 Variation 2: What if the two firms choose price instead of output simultaneously? Demand: P=30-Q, MC=0 for both firms As long as the other firm charges above MC, this firm has incentive to undercut At the end, each charges MC and earns zero profit! This is called Bertrand competition! What if the two firms have different cost, say MC 1 =10, MC 2 =0? firm 2 takes the whole market, and charges slightly under 10 Slide 250 Simple Game Theory Nash Equilibrium: no one has incentive to deviate given the other parties strategy. Dominant strategy: it is the players best strategy no matter what strategy the other players adopt Prisoners dilemma ConfessNot confess Confess-10, -10-5, -15 Not confess-15, -5-6, -6 Slide 251 Examples of prisons dilemma Two firms collude each has incentive to secretly cut price or expand output collusion is fundamentally unstable Any other example? Slide 252 Pure strategy vs. Mixed strategy Mixed: randomize between strategies Example: Inspection game No pure strategy equilibrium, the only equilibrium is 50% probability detect, 50% probability comply DetectNot Detect Comply-5,-5-5,0 Not comply-10, 50, 0 Slide 253 Lecture 25 Asymmetric Information Adverse Selection Problem solution Moral Hazard Problem Solution Adverse selection and Moral Hazard Slide 254 Recall: Reasons for market failure Imperfect competition Monopoly, monopsony, oligopoly, monopolistic competition Asymmetric information Situation in which a buyer and a seller possess different information about a transaction. Externality Slide 255 The market for lemons Suppose used car quality is uniformly distributed between 0 (completely dysfunctional) and 1 (same as brand new) Suppose a typical buyer is willing to pay X for quality X. Problem: the buyer cannot observe car quality before purchase (no test drive.) 010.50.25 Slide 256 Adverse selection Cause: Products of different qualities are sold at a single price because sellers observe product quality but buyers do not Consequence: too much of the low quality product (so called lemons) and too little of the high quality product (so called peaches) are sold. Other examples? Slide 257 Solutions to adverse selection Return and warranty Blanket return policy Hyundai offers 10-year warranty Signaling workers may signal their ability by education Reputation Reputable restaurants (e.g. McDonald) have more to lose if they cheat Third party certification Unraveling results Slide 258 Moral hazard One party engage in hidden actions This action affects the probability or magnitude of a payment associated with an event Example: principal-agent problem Slide 259 Solutions to principal-agent problem Close monitoring Incentive contract Textbook example: revenue from making watches Cost of low effort=0, cost of high effort=10,000 What kind of contract can solicit high effort? Bad Luck (50%)Good Luck (50%) Low effort (a=0)$10,000$20,000 High effort (a=1)$20,000$40,000 Slide 260 Incentive contract Any fixed wage does not yield high effort. Let wage conditional on revenue. Consider: w=max(R-18000,0) At low effort, expected wage is 0*0.5+(20000- 18000)*0.5=1000 At high effort, expected wage is (20000- 18000)*0.5+(40000-18000)*0.5=12000 The net gain to the worker with high effort = 12000- 10000=2000>1000, so the worker will commit to high effort When the worker engages in high effort, the principals net gain = 20000*0.5+40000*0.5- 12000=18000. Slide 261 Adverse selection and moral hazard They are different Adverse selection: info asymmetry before contract Moral hazard: info asymmetry after contract They can co-exist Unsecured consumer credit Insurance Employment Slide 262 Lecture 26: Externality Definition Negative externality Positive externality Solutions Slide 263 Externality Definition: Action by either a producer or a consumer which affects other producers or consumers but is not accounted for in the market price Negative externality Examples? Positive externality Examples? Slide 264 Inefficiency of negative externality MC: marginal cost facing the producer MSC: marginal social cost of production facing the whole society MSC-MC=marginal external cost Externality over production Slide 265 Solution Restrict production in light of negative externality Emission standard How can EPA know the optimal standard? Enforcement cost is high Charge emission fee Tradeable emissions permits Slide 266 Example: Chapter 18 Exercise #6 Demand for paper: Qd=160,000-2000P Supply for paper: Qs=40,000+2000P Marginal external cost of effluent dumpting: MEC=0.0006Qs Calculate P and Q assumption no regulation on the dumping of effluent. Determine the socially efficient P and Q. Slide 267 Inefficiency of positive externality Consider home repair and landscaping MB=Marginal benefits for the home owner Marginal social benefits=MB+marginal external benefit for neighbors Positive externality under provision of public goods Slide 268 Public goods Definition: the marginal cost of provision to an additional consumer is zero and people cannot be excluded from consuming it Two properties: Nonrival: zero cost to additional consumers Nonexclusive: cannot exclude people from using the public goods Examples: national defense, light house, air quality, information Private provision of public goods suffers from the free-riding problem Slide 269 A comprehensive example Stephen J. Dubner and Steven D. Levitts blog on 4/20/2008 titled Not so-free ride http://www.nytimes.com/2008/04/20/maga zine/20wwln-freakonomics- t.html?pagewanted=1 http://www.nytimes.com/2008/04/20/maga zine/20wwln-freakonomics- t.html?pagewanted=1 Slide 270 Course overview Three main blocks Consumers problem Producers problem Market equilibrium Extras uncertainty, game theory, asymmetric information, externality The review below focuses on the most basic points that you should master, it is not meant to be exhaustive of all materials subject to testing Slide 271 Consumers problem Utility function Budget constraint Write out and solve consumers utility maximization problem How does consumer choice change in response to changes in price or income? Derive individual demand and market demand Calculate demand elasticity Special cases: perfect substitutes and perfect complements Slide 272 Producers problem Production function and related concepts Solve firms cost minimization problem How does firms choice change in light of production change or input price change? Cost function and related concepts Derive individual and market supply in perfect equilibrium Slide 273 Market equilibrium Perfect competition (demand = supply, price=MR=MC) 2-person exchange economy (Edgeworth box) Monopoly (MR=MCPrice) Duopoly (Cournot, Bertrand, Stackelberg) Monopolistic competition Slide 274 Extras Uncertainty Expected value, expected utility and risk preferences Simple game theory Concept of Nash Equilibrium, dominant strategy, mixed strategy Simple examples in class Asymmetric Information Adverse selection Moral hazard Externality Negative externality Positive externality, public goods, free-riding Slide 275 Course evaluation please CourseEvalUM.umd.edu OPEN in the last two weeks of the semesterCourseEvalUM.umd.edu Thank you!