Fall 2002

Tu, August 20
Intro. Economic problem

- Objective function ("unlimited wants")
- Constraints ("limited resources")
 
 

Th, August 22; Tu, Sept 3
The basics of supply and demand

1) Supply and demand curves. Coordinates: Q - quantity, P - price. Functional form: Qs = Q(P), Qd = Q(P). Example: linear functions: Qd = a - bP, Qs = c +dP.

2) How demand is formed? Classroom experiment: demand for pencils. Everyone is willing to buy (exactly) one pencil and has a reservation price - the maximum one could possibly pay for a pencil. (You can think of it as a personal value of one pencil at this point in time.) Cumulative distribution of the reservation prices in the classroom is the demand for pencils.
The results:
reservation price   #agents
2                           14
4                            5
6                            4
8                            5
10                          8
market price   quantity demanded (=#agents willing to buy one pencil at this price or lower)
2                   36 (=14+5+4+5+8)
4                   22 (=5+4+5+8)
6                   17 (=4+5+8)
8                   13 (=5+8)
10                  8  (=8)

Our demand looks nearly linear for the ranges of prices: 4-10. Let’s assume it is strictly linear and calculate its parameters using two quantity-price pairs - (8,13) and (10,8).
b:   b = dQ/dP = (13-8)/(10-8) = 5/2 = 2.5 (‘d’ denotes change)
a:   13 = a - 5/2*8 = a - 20 => a=33  Qd = 33- 2.5P
For further calculations, we also need to know where demand intersects the price axis: P(0)=13.2

Now let, for example, supply is Qs = 4/5 P => Equilibrium: Q*=8, P*=10,
Consumer surplus: CS = (13.2-10)*8/2=3.2*4=12.8
Producer surplus: PS=10*8/2=40

3) Equilibrium. Market mechanism. Equilibrium price = market-clearing price. prices and quantities tend toward equilibrium. Once equilibrium is reached, market will rest there until an external shock changes the parameters of supply or demand.
Price controls -> disequilibrium (excess demand or supply.) Examples: a) Gas in the USA, b) Rent controls in big cities (all over the world), c) Everything under socialism.
Price and decision-making: "invisible hand" of market and sticky hands of governments.

4) Consumer and producer surplus. Measure benefits from participation in market exchange.
Efficiency, the notion of. Efficiency of equilibrium. Losses from price controls.

5) Elasticity of supply and demand. Price elasticity of demand (supply), E: percentage chage in Q (quantity demanded or supplied, respectively) in response to 1% change in market price, P.
E = (dQ/Q)/(dP/P), where d denotes the absolute change.
How does it help to analyze changes in market equilibrium?
Note: Implicit here is the assumption that no any single buyer or seller is able to affect market price. Otherwise, it is not correct to speak of one-way causality (response of Q to a change in P).

6) Causes of shifts in supply and demand. Interaction of two markets: substitutes and complements. Ex: cars, gas, public transportation.
 

Reading: 2, 4.4
 
 

Th, Sept 5; Tu, Sept 10.
Consumer choice problem. Basics.

1) Consumer problem: maximize utility subject to budget constraint.
Consumer preferences. Market baskets (bundles). (What you would prefer to have if prices were of no concern)
Properties of preferences: completeness, transitivity, non-satiation ("more is better")

2) Indifference curves (IC). IC is a straight line if the two goods are perfect substitutes (Ex: foods measured merely by calories per ounce). Otherwise it is a convex curve.

3) Budget constraint: B = PxQx + PyQy. (What you can buy putting your preferences aside.)
Slope = -Px/Py (relative price). Changes in price ratio. Changes in income (the size of budget).

4) Optimal solution: the best basket your money (B) can buy. Optimal solution is at the point where IC is tangent to the budget line.
Algebraic representation of optimal choice: marginal rate of substitution, MRS = -dQy/dQx.
Diminishing MRS (for all except perfect substitutes).
Tangency point: MRS = Px/Py.

5) Effect of price change on consumer choice.
Substitution effect and income effect.
Public policy and individual choice. Examples: First drink free; Taxation.

6) Relationships between two goods and ICs.
Perfect substitutes (example. Tylenol and Excedrin). U = x +y. Corner solution.
Perfect complements. (ex.: Left and right shoes; lamps and bulbs.) U = min (x,y)

Reading: 3.1-3.3, 3.5, 4.2.
 
 

Tu, Sept 12
Consumer problem. Demand.

1) Optimal choice and derivation of individual demand.
2) Price-consumption curve => demand curve.
3) Income consumption curve => Endgel curve
4) Normal and inferior goods.
5) Aggregation of individual demands => Market demand.
6*) Network externalities. Bandwagon behavior.

Reading: 4.1, 4.3, 4.5.
 
 

Tu, Sept 17
Approaching the consumer problem using the concept of utility function.
 

Generalization of preferences: utility function.
How we measure happiness: why utility is ordinal.
A simple utility function for perfect substitutes: U = x+y
A simple utility functions for imperfect substitutes: U = xy.
IC defined using utility: U( x, y) = constant. (For U = xy utility, an indifference curve is a hyperbola: xy = u, or (the same) y = u/x.)
Optimal solution defined using utility: marginal utility per expenditure $ equated (MUx/Px = MUy = ... - holds true for zillions of goods simultaneously).
Utility of one good.
Diminishing marginal utility.

Reading: relevant portions of chapter 3..
 
 

Th, Sept 19
Further issues in consumer problem.

1) Dual problem: minimization of expenditure E = PxX + PyY for a given level of utlity U.

2) Leisure-consumption choice. ICs and budget (wage income) constraint.
The problem reformulated using labor time instead of leisure ( Labor = AllYourTime - Leisure). Upward-sloping indifference curves. Labor is an economic bad.
Another example of economic bads: Pollution and consumption. (Consumption is good, pollution is bad. Budget constraint is an indirect relationship between pollution and consumption: consumption is the income from industrial production, pollution is an inevitable by-product.)

Reading: relevant portions of chapter 3.
 
 

Tu, Sept 24, Th, Sept 26,
Producer problem. One input.

1) Production with one (variable) input (e.g. labor). Production function. Revenue. Average and marginal product of labor.

2) A more general cost fucntion. Cost functions (total, average, fixed, variable, marginal).

3) Revenue function. Marginal revenue.

4) Profit maximization and output choice. Marginal cost = Marginal revenue.
 

Reading: 6.3, 7.2, 8.2-8.6.
 
 

 Tu, Oct 1.
Optimal output choice by a competitve firm.

1) Competitive market.

2) Demand curve faced by a single firm in a  competitive market is perfectly elastic. MR=P whatever ouptut is.

3) Short-run supply curve of a firm in a competitive market is its MC curve.

4) Aggregation of individual supplies => Market (industry) supply.

Reading: 6.3, 7.2, 8.2-8.6.
 
 

Th, Oct 3.
Monopoly.

1) Demand curve faced by a monopolist (= total product demand, downward sloping.)

2) Marginal revenue MR lies below (and is steeper than) average revenue (demand).

3) Optimal choice: MC=MR<P (price exceeds marginal cost). Markup.

4) Monopoly power and the elasticity of demand.

Reading: 10.1 - 10.3.
 

Tu, Oct 8.
Social costs of monopoly.  Regulation.

1) Monopoly vs. competition in terms of P, Q, profits, consumer and producer surpluses. Deadweight losses.

2) Sources of monopoly power.

3) Rent seeking

4) Regulation. Antitrust.

5) Monopsony.

Reading: 10.4, 10.7, 11.1, 11.2.
 

Th, Oct 10.
Competitive markets and government intervention.

Effects of government intervention in terms of P, Q, profits, consumer and producer surpluses. Deadweight losses.
- Taxation
- Subsidies
- Price controls

Reading: Chapter 9.
 
 

Tu, Oct 15.
Mideterm
 
 

Th, Oct 17.
Review.
 
 

Oct 22 - Oct 29.
Production with two inputs (labor and capital).

1) Production function: output as a function of two  inputs: Q = F (K,L)

2) Isoquants: lines of equal level of output (with various combinations of capital, K, and labor, L).

3) Substitution between labor and capital. MRTS. Shapes and relative position of isoquants. Returns to scale.

4) Costs of production with K and L as inputs. User cost of capital. Isocosts.

5) Long-run cost curve.

6) Long-run vs. short-run optimal choice. Long-run supply curve. Increasing- and decreasing-cost industries.

7) Long-run vs. short-run firm's expansion path.

Reading: 6.4, 6.5, 7.3, 7.4, 8.7, 8.8.
 
 
 

November - December.

Imperfect competition and economic games.

1) Monopolisitc competition. Social losses from monoply power vs. gains from stimulated innovation. Optimal duration of a patent.

2) Oligopoly (duopoly) : Bertrand (price competition), Cournot (quantity compettion), spatial (the problem of ice-cream sellers in the beach); reaction curves.

3) Two-player games in matrix form: payoff matrix, dominant strategies, Nash equilibrium.

4) Applications: market entry, invetsment (or advertising) decisions. "Prisoner's dilemma" type of games.

5) Repeated games. Discounting of future payoffs.

Reading: 12.1-12.4, 13.1-13.4 (w/o "mixed strategies"), 13.7, your lecture notes.
 
 

Labor market

1) A firm's demand for labor. Derivation. Marginal revenue product of labor.

2) Demand for labor when the output market is competitive vs. monopolistic.

3) Individual firm's demand for labor vs. industry demand for labor.

4) Competition, monopsony, monopoly in the input (labor) market

5) Preferences towards income and leisure; supply of labor.

6) Labor contracts. Efficiency wage.

Reading: Chapters 14, 17.6, your lecture notes.
 
 

Capital markets

1) Choice under uncertainty. Preferences toward risk. Expected value, expected utility. Demand for risky assets.

2) Net present value. Investment decisions.

3) Future discounting. Intertemporal utility. Savings.

4) Supply and demand for loanable funds. Equilibrium interest rate.
 

Reading: Chapters 5, 15, your lecture notes.
 

Th, Dec 12.
Final