Intermediate Microeconomics ECON 100
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This 12 page Class Notes was uploaded by Isidro Stoltenberg on Monday September 7, 2015. The Class Notes belongs to ECON 100 at University of California - Santa Cruz taught by Staff in Fall. Since its upload, it has received 211 views. For similar materials see /class/182319/econ-100-university-of-california-santa-cruz in Economcs at University of California - Santa Cruz.
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Date Created: 09/07/15
E CON 100A NOTES CHAPTER 3 RAT I ONAL CONSUMER CH OI CEZ 1 THE OPPORTUNITY SET OR as more commonly called THE BUDGET CONSTRAINT DISCUSSION BEGINS IN TERMS OF TWO GOODS BUT SOON FOCUSES ON ONE GOOD V ALL OTHERS IE TOTAL INCOME ALLOCATED BETWEEN THE GOOD IN QUESTION AND ALL OTHE QIIOW BUDGET LINEgtgtgtgtgtgtFPRICES OF THE TWO GOODS AND TOTAL INCOME yl total income given average price level X1 f y px X1 MOVEMENT OF THE BUDGET LINE 1 A FUNCTION OF PRICE CHANGES AND INCOME CHANGES THE FORMER ALTERING THE SLOPE OF THE LINE THE LATTER THE POSITION px mp deriving the budget line given income y and prices assume py 1 y 100 and px 5 then assuming total income is spentgtgtgt 100 pyy pxX or 100 y 5X ory 100 7 5X and the slnne nf the line dvdX 5 UNDER MOST ALL CIRCUMSTANCES BUDGET LINE IS ASSUMED TO BE LINEARTHA39 PRICES DO NOT CHANGE WITH QUANTITIES FRANK GIVES AN EXAMPLE OF QUANTITY DISCOUNTS IN FIGURE 36 AT THIS POINT HE DISCUSSES THE SEEMING ODD BEHAVIOR REGARDING LOOSINC MONEY VERSUS LOSING THE COMMODITY ALREADY PURCHASED THIS IS WORTH A BIT OF DISCUSSION FROM CLASS WHAT S GOING ON THAT MIGHT LEAD TO SEEMINGLY IRRATIONAL BEHAVIO THE GUTS OF ECONOMIC THEORY CONSUMER BEHAVIOR WE CAN PREDICT CONSUMER HUMAN BEHAVIOR IF WE UNDERSTAND THE NATUR CONSUMER PREFERENCESTHESE ARE ASSUMED TO BE RATIONALgtgtgtgtgtgtgtgtgtgtgtWHI IMPLIES SEVERAL ATTRIBUTES 1 COMPLETENESSIE CONSUMER IS AWARE OF ALL POSSIBLE ALTERNATIVES AVAILABLE CLEARLY ASIMPLIF YING ASS UMPT I ON WHICH ALLOWS US TO MAP THE CONSUMER PREFERENCES 2 TRANSITIVITYWHICH JUST MEANS CONSISTENT EG IF A gt B gt C THEN IT CAN T BE THAT C gt B IT IS POSSIBLE TO INCLUDE IE IF A B AND B C THEN A C WHICH MEANS AS WE SHALL SEE THAT INDIFFERENCE LINES CAN T CROSS 3 MORE IS BETTERWHILE ENVIRONMENTALISTS AND SPIRITUALISTS MIGHT QUESTION THE VALIDITY OF THIS ASSUMPTION IT SEEMS TO FIT MOST HUMAN BEHAVIORi MOST OF THE TIMEA WORD ON THIS SUBJECTAT THE END OF THE COURSEWHIC MEANS THAT UTILITY OR WHATEVER INCREASES AS WE MOVE AWAY FORM THE ORIGIN OF THE INDIFFERENCE MAP THESE THREE ASSUMPTIONS ALLOW FOR AN INITIAL DISCUSSION OF INDIF F EREN CE CUR VES including lines 1 gtgt better 3 gtgt worse thus indifference curve must lie in 2 and 4 J gt H BUT WE WANT TO BE ABLE TO SAY MORE ABOUT THE INDIFFERENCE CURVES THAN JUST IDENTIFY THE QUADRANTS IN WHICH THEY EXIST FOR THIS WE NEED THE FOURTH ASSUMPTION 4 DIMINISHING MARGINAL UTILITY OF CONSUMPTION OF A SINGLE GOODWITHOI THE FOURTH ASSUMPTION INDIFFERENCE CURVES COULD TAKE ON SEVERAL SHAF what Frank calls CONVEXITY Upper panel shows relationship between Toy consumption and TOTAL utility Q Z D L A toys In upper panel total utility is increasing in A constant in B and diminishing in C BUT ONLY C MAKES SENSE GIVEN DIMINISHING MU as the norm for most commodities WITHBUDGET CONSTRAINT AND KNOWLEDGE OF CONSUMER BEHA VIOR IT IS POSSIBLE T O PREDICT CONSUMER BEHA VI ORIE HOW THEY WILL RESPONI IN THE MARKET PLACE GIVEN THEIR INCOME AND THE PRICES THEYFACE Clearly B gt C gt A but B is not attainablegtgtgtgt C is chosen THE POINT OF TANGENCY WHICH YIELDS MAXIMUM SATISFACTION HAS THE FOLLOWING HIGHLY RELEVANT PROPERTY MRS XY PXPY see de nition in text p 85 in words the slope of the indifference curve slope of the budget line as an example in the case where the composite good costs 1 and toys are 5 each thlt slope of the budget line is 5 and the indifference curve tangent to such a line must ha the same slope at the point of tangency which means that ON THE INDIFFERENCE CURVE the consumer is willing to exchange one toy for five of the composite goodsgtgtgtgtgtthus paying the same for either choice THE ONE SITUATION WHERE EQUALITY BETWEEN lVIRS AND RATIO OF PRICES DOES NOT HOLD IS WITH THE CORNER SOLUTION toys WHICH CAN ARISE UNDER TWO CONDITIONS 1 CONSUMER HAS A VERY STRONG PREFERENCE FOR ONE OF THE CHOE AABOVE 2 GOODS IN QUESTION ARE PERFECT SUB STITUTES B ABOVE in whicl case the indifference curve would be a straight line and in a sense a third possibility where one of the goods is of no utility in this case I indifference curves would be either horizontal or verticala useful concept in talking interpersonal utilitydiscussed later in the course FRANK S DISCUSSION OF THE FOOD STAMP PROBLEM ECONOMIST S NORMALLY PREFER ALLOWING CONSUMER CHOICE RATHER THAN A PARTICULAR PACKAGE OF GOODS 1 IN FOOD STAMP MODEL FOOD STAMPS VS MONEY A MATTER OF INDIFFERENCE WHERE CONSUMERS CAN T AFFORD AS MUCH FOOD AS THEY WOULD LIKE WITHOU THE FOOD STAMPS FIGURE 318 page 94 Note Stamps are free in this discussion 2 HOWEVER WERE COMMODITY BEING SUBSIDIZED IS NOT IN VERY GREAT DEMAN AN INCOME GRANT WOULD BE SUPERIOR FIGURE 319 PROBLEMS WITH CONCLUSION UNDER 2 PREFERENCE OF CONSUMER IS ALL THAT IS CONSIDEREDWHAT ABOUT DONOR AND WHAT ABOUT EXTERNALITIES but see Frank s comment p 94 As a political matter INTRODUCING THE CONCEPT OF MARGINAL UTILITY MORE F ORMALLY MARGINAL UTILITY SAME AS SATISFACTION OF LAST UNIT SINCE THE INDIFFERENCE CURVES SHOWS THE TRADE OFF BETWEEN THE TWO GOO WITH SATISFACTION CONSTANT THE SLOPE OF THE INDIFFERENCE CURVE SHOWS T TRADEOFF WHICH IN EFFECT IS THE RATIO OF THE TWO SATISFACTIONSONE GAII ONE LOST OR THE RATIO OF THE MARGINAL UTILITIES IE MRSYX MUXMUY AND SINCE MRS RATIO OF PRICES gtgtgtgtgt MUXMUY PYPX OR MUXPX MUYPY COMMON SENSE MEANING OF THE LATTERgtgtgtgtgtPEOPLE ADJUST THEIR SPENDING PATTERNS TOWARDS THE COMMODITIES THAT FALL IN PRICE RELATIVE TO COMMODITIES THAT RISE IN PRICE it is worth reviewing the appendix on line and soon to be in class reader on class web site The generalized problem is to determine the conditions under which a consumer does indeed maximize utility assuming a non speci c form of the utility function U f X Y where X are the Toys and Y composite good as indicated in the appendix and in previous discussion there is no maximum utility since mc better presumably forever but forever stops at the budget line so that one maximizes utility su to the budget constraint which is Y py Y px X the relevant section in the appendix starts at the indication A38 using calculus to maximize utility when all is said and done using a Lagrangian multiplier utility maximization subject to the budget constraint implies the following dUdX 3x g dUdX dUdY dUdY Py PX P Y 1 00A 0L1 GOPOL Y AND IMPERF E C T COMPETITION FRANK S CHAPTER IS FAIRLY NARROW IN SCOPE OMITTING A GOOD BIT OF MORE REALISTIC MATERIAL AVAILABLE FROM PREVIOUS CONSIDERATION OF THE AREAS BETWEEN MONOPOLY AND PERFECT COIVIPETITION CENTRAL ISSUE IS THE EXTENT TO WHICH FIRMS TAKE INTO ACCOUNT BOTH THE DIRECT AND INDIRECT EFFECT OF THEIR ACTIONS DIRECT EFFECTS gtgtgt ON CUSTOMERS INDIRECT EFFECTSgtgtgt ON COMPETITORS IN MON OPOLY THERE ARE N O COMPETITORS IN COMPETITION EACH FIRM IS SO SMALL THAT THEY CAN AND SHOULD IGNORE THE INDIRECT EFFECTS N OT SO IN OLIGOPOLY THUS THE FOCUS ON GAIVIE THEORY TYPE SOLUTIONS 0L1 G 0POL Y 1 EARLY MODELS ALL SIIVIPLIFIED ASSUIVIPTIONS ABOUT COIVIPETITOR BEHAVIOR a COURNOT FIRMS ADJUST QUANTITY OTHER FIRM S OUTPUT FIXED b BERTRAND FIRMS ADJUST PRICE OTHER FIRM S PRICE FIXED c STACKLEBERG A DOIVIINANT FIRM plus 1 IMPLI CI T COLL USION not in Frank 6 nonprice competition i cartel behavior FOR SIMPLICITY 1 DISCUSSION IN TERMS OF 2 FIRMS DUOPOLY 2 COSTS ARE CONSTANT AT ZERO 3 LINEAR DEMAND CURVE DIAGRAMS FOR EA CH FRIM as follows firm 1 NOTE given p assumptions about cost etc competitive output will be at qc I I I I I I I I I I I I V 2 ql qc In the first round if firm 1 sells nothing and firm 2 incorrectly assumes that firm 1 will continue to do so firm 2 will set output at the monopoly level ie where profits are a maximum ql But now let firm 2 enter the game assuming that firm 1 sells half of the market leaving of the market available P firm 1 profits arrow points to that part of the market left for firm 2 namely 7 of the total market It will assuming incorrectly that firm 1 produces 7 will maximize its profits by producing 7 of the remaining market bnt now firm 1 has been mistakenit will adinst its Intgntl assumingI incorrectly that firm 2 produces at the market etc etc are both Qroven correct until the Equilibrium assuming that both firms IGNORE the indirect effects will occur when both firms produce 13 of the market at that point neither firm has an incentive to alter its behavior and both firms for the wrong reasons are proven correct that is if firm 1 produces 13 of the market leaving 23rds available then firms 2 will maximize profits producing for half of this market ie 13 of the total and then firm1 has no reason to alter its behavior MAJOR IMPLICATIONS COURNOT T ENDS TOWARDS COMPETITIVE OUTPUT AS THE NUMBER OF FIRMS INCREASE IE N N 1 where N number of firms monopoly produces 12 of competitive output duopoly 23rds etc A version of Bertrand where firms make PRICE decisions you can get uctuating prices although Frank s version assumes that prices can only fall assuming that each firm can produce for the entire market one firm starts and sets the monopoly price the next firm under cuts and the first firm retaliates prices fall to competitive level in some discussion where each firm can only supply a portion of the market it is possible that once the competitive price is reached it will pay one firm to raise pricein this case prices might well uctuate between the monopoly and competitive price in STACKLEBERG MODEL ISSUE IS THE FACTORS WHICH DETERIVIINE DOIVIINANT FIRM DI SCUSSED MORE RECENTLY IN TERMS OF THE PRICE LEADERSHIP MODEL footnote MAKING SOME SENSE OUT OF FIGURE 132 p 447 Assume a market demand curve P 100 2 Q Thus ab 500 aZb 250 and a3b 167 Looking at Firm 2 s Reaction Curve if Firm 1 sells 500 units the entire market Firm 2 sells nothing but if Firm 1 sells nothing Firm 2 sells the profit maximizing quantityz 250 Exactly the same is true in terms of Firm 1 s reaction curveBut then Firm 1 responds and the equilibrium is where each sells 13rd of the market ENTER GAME THEORY HIGHLY POPULAR TODAY BUT WITHOUT FIRM OUTCOIVIES MAINLY DEMONSTRATES THE DIFFICULTY OF MODELING BEHAVIOR WHERE MUTUAL INTERACTION IS A SIGNIFICANT FACTOR IE IN THE COIVIPETITIVE ATOIVIISTIC WORLD THE ASSUIVIPTION OF THE ISOLATED INDIVIDUAL PROVIDES A LOT OF DEFINITUDEDEFINITY BUT PERHAPS LESS REALISM BACK TO LESTERIVIACHULP AGAIN CONCEPTS OFTEN MENTIONED l DOMINAN T STRATEGYbest for you no matter what 2 NASH EQUILIBRIUM choice that prevails for each given what the other does 3 COOPERATION TITFORTAT 4 SEQUENTIAL STRATEGY 5 CONTESTED MARKETS ISSUE HERE IS THE EXTENT TO WHICH ENTRY IS POSSIBLE HERE FRANK DOES THE DISCUSSION IMPLICITLY IE WHAT ARE THE BARRIERS TO ENTRY 1 COST OF INVESTMENT 2 PATENTS ETC 3 CREATING A PLACE IN THE MARKET EN T ER ADVERTISING FRANK S TREATMENT PRETTY GENTLE welfare aspects of advertising discussed brie y following material on imperfect competition below
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