Ec2066 ch1-4 PDF

Microeconomics
E. Manzoni
EC2066, 2790066
2011
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
E. Manzoni, Department of Economics, University of Bocconi.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
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Published by: University of London
University of London 2011
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Contents
Contents
Chapter 1: Introduction .......................................................................................... 1
Prior knowledge ............................................................................................................ 1
Learning outcomes ........................................................................................................ 1
Syllabus......................................................................................................................... 2
How to use this guide .................................................................................................... 2
Contents of the guide .................................................................................................... 3
Essential reading ........................................................................................................... 4
Further reading.............................................................................................................. 4
Online study resources ................................................................................................... 5
Study advice .................................................................................................................. 6
Examination advice........................................................................................................ 6
Chapter 2: What does microeconomics do? ........................................................... 9
Learning outcomes ........................................................................................................ 9
Essential reading ........................................................................................................... 9
A general overview ........................................................................................................ 9
The role of models and assumptions ............................................................................ 11
A reminder of your learning outcomes.......................................................................... 13
Chapter 3: Consumer theory ................................................................................ 15
Learning outcomes ...................................................................................................... 15
Essential reading ......................................................................................................... 15
The theory of individual choice ..................................................................................... 15
Preferences (and assumptions over preferences) .......................................................... 16
Maximising utility: the uncompensated demand ........................................................... 18
Minimising expenditure: the compensated demand ...................................................... 21
Welfare analysis .......................................................................................................... 22
Sample examination questions ..................................................................................... 25
Chapter 4: Labour supply and the effect of taxes ................................................ 27
Labour supply .............................................................................................................. 27
Labour supply curve ..................................................................................................... 29
The effect of taxes on labour supply ............................................................................. 29
Chapter 5: Saving, investment and choice over time ........................................... 33
Inter-temporal choice ................................................................................................... 33
Present value............................................................................................................... 35
66 Microeconomics
Chapter 6: Choice under uncertainty.................................................................... 37

Optimal choice under uncertainty ................................................................................. 37
Expected utility ............................................................................................................ 40
Insurance .................................................................................................................... 40
Chapter 7: The firm ............................................................................................... 43
Production................................................................................................................... 46
Costs........................................................................................................................... 48
The short run ............................................................................................................... 51
Chapter 8: Competition and monopoly ................................................................ 55
Perfect competition...................................................................................................... 55
Monopoly.................................................................................................................... 58
Chapter 9: Game theory: an introduction............................................................. 63
Static games................................................................................................................ 63
Dynamic games ........................................................................................................... 68
Repeated games.......................................................................................................... 70
Chapter 10: Oligopoly and strategic behaviour ................................................... 75
A general overview ...................................................................................................... 75
Bertrand duopoly ......................................................................................................... 76
Cournot duopoly ......................................................................................................... 77
Stackelberg duopoly .................................................................................................... 78
Collusion ..................................................................................................................... 79
Chapter 11: General equilibrium and welfare economics .................................... 83
General equilibrium .................................................................................................... 83
ii
Contents
Chapter 12: Asymmetric information ................................................................... 93

A general overview ...................................................................................................... 93
Adverse selection ........................................................................................................ 94
Signalling and Screening.............................................................................................. 95
Moral hazard ............................................................................................................... 97
Chapter 13: Externalities and public goods ....................................................... 101
Learning outcomes .................................................................................................... 101
Essential reading ....................................................................................................... 101
A general overview .................................................................................................... 101
Externalities .............................................................................................................. 101
Public goods.............................................................................................................. 104
A reminder of your learning outcomes........................................................................ 105
Sample examination questions ................................................................................... 106
Chapter 14: Government and public choice ....................................................... 107
Learning outcomes .................................................................................................... 107
Essential reading ....................................................................................................... 107
Preferences, voting and decisions ............................................................................... 107
A reminder of your learning outcomes........................................................................ 112
Sample examination questions ................................................................................... 112
Appendix A: Sample examination paper ............................................................ 113
Appendix B: Advice on how to answer examination questions ......................... 117
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66 Microeconomics
Notes
iv
Chapter 1: Introduction
This subject guide enables you to fully interpret the published syllabus for
66 Microeconomics. It identifies what you are expected to know within
each area of the syllabus by emphasising the relevant concepts and models
and by stating where in specific textbooks that material can be found. This
guide aims to help you make the best use of the textbook to secure a firm
understanding of the microeconomic analysis covered by the syllabus, and
to give you an intuitive introduction to the concepts that are presented in
the textbook. This guide is not a substitute for textbooks.
Prior knowledge
The syllabus and guide assume that you are competent in basic economic
analysis up to the level of the prerequisite courses 02 Introduction to
economics and 05a Mathematics 1 or 174 Calculus. They build
on the foundations provided in those courses by specifying how your
understanding of the microeconomic principles developed so far should
be deepened and extended. Like 02 Introduction to economics, 66
Microeconomics is designed to equip you with the economic principles
necessary to analyse a whole range of economic problems. To maximise
your benefit from the subject, you should continue to think carefully about
economic models your assumptions, internal logic and predictions and
about how economic principles can be applied to solve particular economic
problems. The appropriate analysis will depend on the specific facts of a
problem. However, you are not expected to know the detailed facts about
specific economic issues and policies mentioned in textbook examples.
Rather, you should use these examples (and end-of-chapter sample
examination questions) to aid your understanding of how economic
principles can be applied creatively to the analysis of economic problems.
If you are taking this course as part of a BSc degree you will also have
passed 05a Mathematics 1 or 174 Calculus before beginning this
course. Every part of the syllabus can be mastered with the aid of diagrams
and relatively simple algebra. The guide indicates the minimum level of
mathematical knowledge that is required. Knowledge (and use in the
examination) of sophisticated mathematical techniques is not required.
However, if you are mathematically competent you are encouraged to
use mathematical techniques when these are appropriate, as long as you
recognise that some verbal explanation is always necessary.
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should:
be able to define and describe:
the determinants of consumer choices, including inter-temporal
choices and those involving risk
firms behaviour
how firms behaviour differs in different market structures and may
help to determine those structures
how firms and households determine factor prices.
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66 Microeconomics
be able to analyse and assess:

efficiency and welfare optimality of perfectly and imperfectly
competitive markets
the effects of externalities and public goods on efficiency
government policies aimed at improving welfare.
be prepared for further courses which require a knowledge of
microeconomics.
Each chapter includes a list of the learning outcomes that are specific to it.
However you also need to go beyond the learning outcomes of each single
chapter by developing the ability of linking the concepts introduced in
different chapters, in order to approach the examination well.
Syllabus
The course examines how economic decisions are made by households
and firms, and how they interact to determine the quantities and prices
of goods and factors of production and the allocation of resources. It
also investigates the principles of microeconomic policy and the role of
government in allocating resources. The topics covered are:
Consumer choice and demand, including utility functions and
indifference curves, income and substitution effects.
Taxation and the effect of taxes on the labour supply.
Producer theory: production and cost functions, firm and industry
supply.
Market structure: competition, monopoly and oligopoly.
Game theory: static and dynamic games, strategic interaction between
agents, Nash equilibrium and subgame perfect equilibrium.
General equilibrium and welfare: economic efficiency and equity;
competitive equilibrium; welfare criteria.
Inter-temporal choice: savings and investment choices.
Uncertainty and the economics of information: choice under
uncertainty, insurance markets, and asymmetric information.
Welfare economics: market failures arising from monopoly, externalities
and public goods.
Government and the theory of public choice.
A knowledge of constrained maximisation and Lagrangian functions as
covered in course 05a Mathematics 1 would be helpful for students
taking this course.
How to use this guide

Each chapter of the subject guide has the following format.
The learning outcomes show you what you should be able to do by the
end of the chapter and the relevant reading.
The Essential reading lists the relevant textbook chapters and sections
of chapters, even though a more detailed indication of the required
reading is listed throughout the chapter.
The general overview defines the scope of the topic and gives you a
broad map of the chapter, and explains the connection between the
new topics and the ones covered in previous chapters.
2
The sections that follow specify in detail what you are expected to
know about each topic. Important concepts and models are introduced
and explained intuitively. The relevant sections or page numbers of
the recommended textbooks are referred to. Wherever necessary,
the sections integrate the textbook with additional material and
explanations. Finally, they draw attention to any problems that occur in
textbook expositions and explain how these can be overcome.
The boxes that appear in some of the sections give you examples of
possible applications of the topics, or real life examples of the issues
that are discussed in the chapter.
The Sample examination questions section gives examples of the types
of questions that can be expected in the examination in each of the two
sections of the paper.
Contents of the guide

We start by analysing the behaviour of individuals in the economy. Chapter
3 analyses the behaviour of agents as consumers, when they face the
decision of what to purchase given that they earn a certain income. In this
chapter we also discuss what happens to the consumers welfare when
prices and/or income change, and what are the appropriate measures to
evaluate these changes. Chapter 4 looks at individuals choice of labour
supply, discussing how this is affected by the price of the consumption of
goods and by the structure of the taxes that are imposed on workers. The
following two chapters describe the individuals choice in more general
settings. Chapter 5 focuses on agents who have to act over time, for
example when deciding an investment plan or a savings plan. Chapter
6 models the agents behaviour in a situation in which he is not certain
about the future consequences of his choices (for example you are by
definition not sure of the consequences of your actions when you bet on a
football match, given that you do not know ex ante whether you will win
or not), with particular attention to the insurance problem.
We then consider the production side of the economy. In this respect,
Chapter 7 describes the structure of the firm, its goals and its choices in
terms of output produced and inputs chosen for production; in particular
we focus on the costs that the firm faces and on the implications that
different cost functions have on the optimal production choices. Chapters
8 and 10 describe different environments in which firms operate. Chapter
8 focuses on the two extreme environments: perfect competition,
where there is a large number of firms that cannot influence the market
price, and monopoly, where there is only one firm in the market, the
monopolist, who faces no competition whatsoever. Chapter 10 considers
an intermediate case, the oligopoly, in which there are few firms in the
market, and they strategically fix the price, taking into account that a
higher price will increase the revenue on each unit sold, but that it may
induce some consumers to switch and buy the item from a different seller.
The way in which firms interact in an oligopoly is modelled using the tools
introduced by a branch of economics called game theory. For this reason,
Chapter 9 introduces the basic notions of game theory and the basic
equilibrium concepts, in order to provide you with a deeper understanding
of the mechanisms of an oligopolistic market.
In Chapter 11, we combine all the elements introduced before in a general
equilibrium model, which describes the economy in its entirety, with
the interactions between producers and consumers, between workers
and producers, among consumers themselves and among producers
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66 Microeconomics
themselves. To understand this chapter it is essential that you have a

detailed knowledge of the chapters on consumers and producers.
Chapter 12 presents you with the problems that may arise in a market
situation (markets for goods, or the labour market), when some agents are
better informed than others. In particular we will focus on the consequences
of one party being more informed on the quality of the goods that are
tradable (adverse selection), and on the problems related to the difficulty of
monitoring your employees (moral hazard).
The last two chapters focus on the relations between individual choices
and the welfare of society, paying particular attention to the possibility
and advisability, of public intervention. Chapter 13 discusses how
individual choices can affect the utility of others, and the problems related
to the provision of public goods. Chapter 14 analyses how to aggregate
individuals preferences to have a notion of social welfare, and how the
way in which you aggregate preferences influences the optimal public
intervention.
Essential reading
This guide is specifically designed to be used in conjunction with the
textbook:
Morgan, W., M.L. Katz and H.S. Rosen Microeconomics. (Boston, Mass.: Irwin/
McGraw-Hill, 2009) [ISBN 9780077121778]. Referred to as MKR in this
guide.
The textbook is more adequate for some parts of the syllabus while less so
for others; as a consequence we integrate some topics more with the extra
material provided in the subject guide.
The textbook employs verbal reasoning as the main method of presentation,
supplemented by diagrammatic analyses. Descriptive legends accompany
the diagrams and can often be very helpful in reviewing the main points
of a topic. The textbooks use of algebra is less satisfactory. Mathematically
proficient students will find it helpful to study the mathematical sections
that appear as appendices to some of the chapters in the subject guide.
The textbook has discussion questions and exercises that provide challenges
for further thought and problem solving. It is worthwhile to consider the
chapter summaries at the end of each chapter to verify your acquired
knowledge of the topic.
Detailed reading references in this subject guide refer to the edition of the
set textbook listed above. New editions of the textbook may have been
published by the time you study this course. You can use a more recent
edition of any of the textbooks; use the detailed chapter and section
headings and the index to identify relevant readings. Also check the virtual
learning environment (VLE) regularly for updated guidance on readings.
Further reading
Although you will obtain more benefit from this guide by having access
to the above textbook by Morgan, Katz and Rosen rather than others
because, by referring to particular sections, it specifies what you are
expected to know there is no harm in using other intermediate level
textbooks that cover the syllabus. Indeed, you will benefit from sampling
a variety of textbooks in order to find those whose style and presentation
suits you. In particular you may find the following textbook useful for its
chapter on game theory.
4
Perloff, J.M. Microeconomics: theory and applications with calculus. (Prentice Hall,
2007) [ISBN 9780321277947].
Online study resources

In addition to the subject guide and the Essential reading, it is crucial that you
take advantage of the study resources that are available online for this course,
including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave on your
application form. You have probably already logged in to the Student Portal in
order to register! As soon as you registered, you will automatically have been
granted access to the VLE, Online Library and your fully functional University
of London email account.
If you forget your login details at any point, please email:
uolia.support@london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a sense
of community. It forms an important part of your study experience with the
University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials and
conclusions.
Recorded lectures: For some courses, where appropriate, the sessions from
previous years Study Weekends have been recorded and made available.
Study skills: Expert advice on preparing for examinations and developing
your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we are
expanding our provision all the time and you should check the VLE regularly
for updates.
Making use of the Online Library

The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
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66 Microeconomics
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the Online
Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Study advice
Given the emphasis of the 66 Microeconomics syllabus on using
analytical methods to solve economic problems, you are encouraged to
spend a considerable amount of time doing the problems or questions given
in the textbooks. Learning by doing is likely to be more profitable than
simply reading and re-reading textbooks.
Nevertheless, a thorough reading of, and careful note-taking from, the
recommended textbook and the subject guide is a prerequisite for successful
problem solving. The guide aims to indicate as clearly as possible the key
elements in microeconomic analysis that you need to learn. For each topic,
you should consult the relevant chapter in the guide for a preliminary
presentation of the material, and for tips on tackling the reading and on
overcoming any problems of textbook exposition as well as for statements
on how you are expected to deepen and extend your understanding of
economic analysis. However, you should then rely on the suggested reading
to explain the economic principles involved.
Most of the course deals with situations that are analysable with the use of
graphs (two consumers, two goods, two producers). The understanding of
the graphical representation of a problem is often, in this course, the key
tool for gaining command of the material. Even students who prefer to rely
on the mathematical representation of the models should try to understand
the intuition behind the graphs, as it helps to overcome those situations in
which the use of mathematics alone may be misleading.
Unless otherwise stated in the guide, a thorough understanding of the
material covered in the recommended passages in the textbooks is essential
if you are to maximise the benefits you derive from the subject.
Examination advice
Format of the examination
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow those
instructions.
In this examination you should answer eleven of sixteen questions: eight
from Section A (5 marks each) and three from Section B (20 marks each).
6
The Appendix to this subject guide contains a full Sample examination

paper.
Types of questions
Examples of the types of questions which will appear on the examination
paper appear not only in the Sample examination paper at the end of this
guide, but also at the end of chapters. However, in the examination you
should not be surprised to see some questions which are not necessarily
specific to one particular topic. For example, a question may require
knowledge about markets which are oligopolistic as well as those which
are monopolistic or competitive.
Numerical questions will sometimes require the use of a calculator. A
calculator may be used when answering questions on the examination
paper for this course and it must comply in all respects with the
specification given in the Regulations.
Questions will not require knowledge of empirical studies or institutional
material. However, you will be awarded some marks for supplementary
empirical or institutional material which is directly relevant to the
question.
Specific advice on approaching the questions

You should follow all the excellent advice to candidates which is published
in the annual Examiners commentaries. For this course, the following
advice is also worth noting:
Prepare thoroughly for the examination by attempting the problems/
questions in the textbooks and in this subject guide and, in particular,
past examination papers (for which there are Examiners commentaries
where you can check Examiners responses).
Occasionally you may be unsure exactly what a question is asking. If
there is some element of doubt about the interpretation of a question,
state at the beginning of your answer how you interpret the question.
If you are very uncertain of what is required, and the question is in
Section B, do another question.
Explain briefly what you are doing: an answer that is simply a list of
equations or numbers will not be credited with full marks even if it gets
to the correct solution; moreover, by explaining what you are doing,
you will be awarded some marks for correct reasoning even if there are
mistakes in some part of the procedure.
It is essential to attempt eight questions in Section A. Even if you think
you do not know the answer, at least define any terms or concepts
which you think may be relevant (including those in the question!)
and, if possible, present the question in diagrammatic or algebraic
form. The same applies to a specific part of a multi-part question
in Section B. The Examiners can give no marks for an unattempted
question, but they can award marks for relevant points. A single mark
may make the difference between passing and failing the examination.
Although you should attempt all the questions and parts of questions
that are required, to avoid wasting time you should make sure that you
do no more than is required. For example, if only two parts of a threepart question need to be answered, only answer two parts.
Note the importance of key words. In some of the Section A questions
of the True, false, or uncertain? type, the words must, always, never
or necessarily usually invite you to explain why the statement is false.
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66 Microeconomics
Notice that this is simply a way in which you can start approaching the
problem, but there is no way to know in advance the correct answer
without analysing every specific question.
You should use your intuition and common sense in checking your
answers to the type of question referred to in the previous point. The
results of some economic analyses are counterintuitive but most are
not.
Good answers to most questions require relevant assumptions to be
stated and terms to be defined. Also, do use the term ceteris paribus
(meaning other things being equal) where appropriate. If you are
asked to examine the effects of a change in a particular exogenous
variable, you should not complicate your answers unnecessarily by
positing simultaneous changes in other exogenous variables.
For many questions, good answers will require diagrammatic and/
or algebraic analysis to complement verbal reasoning. Good diagrams
can often save much explanation but free-standing diagrams, however
well drawn and labelled, do not portray sufficient information to the
Examiners. Diagrams need to be explained in the text of the answer.
Similarly, symbols in algebraic expressions should be defined and the
final line of an algebraic presentation should be explained in words.
Microeconomics is a subject that deals with economic principles:
the Examiners are primarily looking for analytical explanations, not
descriptions. On reading a question, your first thought should be what
is the appropriate hypothesis, theory, concept or model to use?.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
Chapter 2: What does microeconomics do?
Chapter 2: What does microeconomics

do?
Learning outcomes
By the end of this chapter, and having completed the Essential reading,
you should be able to:
outline the purpose of an economic model, and in particular of a
microeconomic one
discuss the role of prices in microeconomic models
outline the problems related to the more common economic
assumptions (rationality, equilibrium reasoning, optimisation)
explain the distinction between the implications of direct and indirect
validity.
Essential reading
Morgan, Katz and Rosen Chapter 1.
A general overview
See MKR Sections 1.1 Scarcity and economics and 1.3 The working of a price
system: a preview.
Suppose you are an entrepreneur and you own Cool Snickers, a company
producing shoes. You would like to know whether increasing the price of
your shoes is going to make you richer. There are a few considerations you
have to make:
How likely are your customers to switch to a different brand, Tennis
Shoes, as a consequence of the increase in price?
How will Tennis Shoes respond to your increase in price? Will it take
the opportunity to increase its price as well, or will it try to get a higher
share of the market for shoes?
If you lose customers, will you be overall better off selling fewer shoes
at a higher price, or will you lose from it?
Clearly the profitability of an increase in price depends on the answers to
all these questions. So, one thing you can do, as manager of Cool Snickers,
is to consult an economist, Mr. Answer, and ask him to write a model to
study what you should do to increase your profits.
To provide a successful report, and useful guidance, Mr. Answer will ask
himself questions like the following:
How does the consumption of shoes affect your customers? How do
they spend their money?
What are the products that can substitute for your shoes if you increase
the price (other brands of shoes, sandals, food, theatre tickets)? How
do different customers react to the presence of possible substitutes?
What else can you do to increase your profits? Can you change your
product? Can you reduce your costs?
66 Microeconomics
The above example illustrates some of the questions that microeconomics

tries to address; for example this discipline investigates how people
(seen as consumers) choose what to buy and how to spend their income,
how firms choose what to produce and how to price their products, how
governments choose fiscal and redistributive policies.
In this introductory chapter we will consider the main elements that
characterise the microeconomic analysis of a given situation (with a
particular attention to the role of prices); we will then discuss in detail
what is an economic model, the problems related to the trade-off between
tractability of the model and the validity of it, and the difference between
normative and positive theories.
Economic agents
Microeconomics studies the behaviour of individual agents in the economy.
It is therefore necessary, in order to understand what comes next, to clarify
who these economic agents are, and why they are so important to us. We
are going to focus, mainly, on three categories of agent:
Consumers: they are usually endowed with some income that they
need to spend. They have preferences over consumption goods (they
know what they like, and which bundles (combinations) of goods they
like the most), and they choose what to purchase according to these
preferences.
Firms: they form the productive side of the economy. They need
to choose what to produce, how much of each input to use, how to
position themselves in terms of competition with other firms.
Government: in the type of microeconomic models you will study
it is considered an independent agent which is concerned about the
welfare of its citizens. It can choose which kind of economic activities
to tax, and which kinds to subsidise, in order to influence the choices of
consumers and firms, and in order to redistribute wealth to the poorer
or more disadvantaged agents.
Scarcity, prices and the role of the market

Economics can be defined as the science that studies how to allocate
scarce resources. The problem of scarcity is what makes understanding the
behaviour of economic agents interesting and important.
Given the scarcity of resources, society has to understand how to use those
available amounts. As MKR explains, then, the main questions that need to
be answered are therefore:
What is to be produced?
How is it to be produced (i.e. with which input combination)?
Who should get the output?
To answer these questions we need at first to understand what the
economic agents like, or, to say it in microeconomic terms, what their
preferences are. We also need to find a criterion to compare different
individuals, in order to be able to talk about the preferences of society over
the allocation of output. Most of this course will try to give you tools to
analyse these preferences.
Given the scarcity of resources, we are also in need of a mechanism that
allows them to be allocated to economic agents. This mechanism is the
market: consumers and producers of a particular good learn the market
price and decide how much to trade. If the demand for a good is lower
than its supply, prices will go down, then demand will increase and supply
10
will decrease. Vice versa, when the demand is higher than the supply,
producers will be able to obtain a higher price, then supply will go up and
the demand will decrease.
Prices are a very important component in the models of a market economy.
They cover several roles that are needed for the correct functioning of
the system. You can look at Section 1.3 of MKR for a complete analysis of
the role of prices; in particular, we focus now on the fact that prices have
an allocative role. As we discussed above, resources are scarce; prices
therefore have the effect of rationing them and decreasing the demand for
a particular good (e.g. gold) as it becomes scarcer. Government can use
this role of prices: by introducing a tax (on cigarettes, for example) they
can try to reduce the consumption of a particular good; or they can try to
increase its consumption by introducing a subsidy.
The allocative role of prices: an example from the road tax in Singapore
In the section above you have learnt that prices can have an allocative role: for
example, given the scarcity of resources, they can limit the consumption of a particular
good when it becomes too scarce. We already explained how governments can induce
a higher price in order to limit the consumption of a particular good. An example
of this is the road tax in Singapore. To limit the usage of cars, in particular in peak
times, the Singaporean government levies a tax on the usage of cars. This tax has the
characteristic of being lower (much lower, around 1/10 of the original value) if the
car is used only off-peak. This has the effect of changing the citizens consumption
towards a larger usage of public transport and a lower usage of cars, in particular at
peak times.
The role of models and assumptions

See MKR Sections 1.2 Models, and 1.3 The working of a price system.
Economic models are useful because they allow us to represent the real
world in a simplified way. When we build an economic model, we have
to make assumptions about the nature of the agents reasoning and
their preferences. In order to make the model tractable, the assumptions
we make may be simplistic or too strong. Here we present two of the
main assumptions we will use throughout the guide, optimisation and
rationality of choices, after which we will discuss the meaning of the
concept of validity for an economic model which incorporates strong or
simple assumptions.
Rational choice and optimisation

In general we will assume that the agents in an economic model will
choose their actions in a rational way. An intuitive way to describe rational
choice is to follow the description in Rubinstein (2006):
The (rational) agent decides what action to take through a process in
which he
asks himself What is desirable?
asks himself What is feasible?
chooses the most desirable from among the feasible alternatives.
As you can see from the definition, a rational agent is one who is able to
infer what are the consequences of his actions, and to choose the action
that delivers the best outcome. Notice that this does not impose any
constraint on what the agent evaluates as the best outcome.
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66 Microeconomics
In general this will be modelled as a process of maximisation of an

objective function. Depending on the context, the objective function
will be a consumers utility (and we will model agents that choose their
consumption bundles in order to maximise their utility), or the profit
of a firm (and then we will analyse the problem of a firm that has to
decide how much output to produce, and which inputs to use, in order to
maximise its profit), or the welfare of society.
Validity
Another interesting aspect of economic models is related to their external
validity. A question can be asked as to whether the models we study are
a realistic description of the real world, and if they are able to predict the
choices of the agents they describe. There are two concepts of validity of
models, related to the two questions described before:
Direct validity: a model satisfies this validity concept if the
assumptions it makes describe the conditions of the economy and the
decision processes of the agents truthfully; the direct validity concept
can be thought as validity of the assumptions.
Indirect validity: a model is indirectly valid if, despite making
unrealistic assumptions, it is able to predict the agents choices (or the
aspects of the agents choices that the economist is interested in) in a
correct way. It is, in a sense, a concept of validity of the conclusions of
the model.
The vast majority of the economic models you will study are primarily
interested in being indirectly valid. In particular, you will soon discover
that some of the assumptions you will study are unrealistic either
because they are too simplistic and do not take into account the specific
characteristics of the individual agents (for example when we assume that
every consumer has the same utility function), or because they ask too
much from the individual agent (rationality assumption) or because they
describe a particular, and probably unrealistic, procedure that guides the
agents choice (optimisation assumption).
You can now understand that this is done in order to have models that can
still have predictive power and where, for example, the consequences of
policy choices can be identified in a tractable way.
Equilibria
Another important aspect of the economists way of modelling is
equilibrium reasoning. In order to understand the predictions of a specific
model, you will always consider what happens in equilibrium. What
exactly is an equilibrium? As your intuition may suggest, an equilibrium
situation is a stable one, in which every agent finds it optimal to maintain
his current behaviour.
For example, consider the problem of the firm Pink Chopsticks, that needs
to hire 20 workers to produce the amount of good that it needs to sell.
This implies that its demand for labour is fixed at 20 units, no matter what
wage it has to pay. Suppose that the labour supply is described by the
following graph:
12
20
1000
where on the horizontal axis we have the wage w, and on the vertical
axis the amount of labour offered for every level of wages, L. Then a
1000 wage is the equilibrium wage, because it allows the firm to hire the
amount of workers it needs.
In this example, we considered the labour supply as given; in general the
equilibrium reasoning will be more complicated, because it will involve
verifying that the firm finds it optimal to offer a specific wage given the
labour supply, and that the workers find it optimal to offer that specific
amount of labour, given the existing conditions.
The equilibrium analysis does not consider how the economic agents
learn to behave as equilibrium players; moreover, in case more than one
equilibrium exists, it does not consider how they learn which equilibrium
is playing. The great strength of equilibrium reasoning, however, is
understanding that whenever we happen to be in an equilibrium situation
we will remain there.
A reminder of your learning outcomes

Having completed this chapter, and the Essential reading, you should be
able to:
outline what is the purpose of an economic model, and in particular of
a microeconomic one
discuss the role of prices in microeconomic models
outline the problems related to the more common economic
assumptions (rationality, equilibrium reasoning, optimisation)
explain the distinction between the implications of direct and indirect
validity.
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66 Microeconomics
Notes
14
Chapter 3: Consumer theory

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
draw indifference curve diagrams starting from the utility function of a
consumer
explain the implications of the assumptions on the consumers
preferences
use indifference curve diagrams to analyse the effect of price and
income changes
solve the consumers utility maximisation problem and derive the
uncompensated demand for a consumer with a given utility function
and budget constraint
explain the consumers expenditure minimisation problem and the
compensated demand functions
evaluate the change in consumer surplus, the equivalent variation and
the compensating variation as measures of the welfare impact of price
changes
use the more appropriate measure of welfare to analyse the effect of a
price change in a given economic situation
define the Laspeyres and Paasche price indices, and discuss their
limitations as measures of consumer welfare.
Essential reading
Morgan, Katz and Rosen Chapters 24.
(Appendix 3.A.2 is optional, and is suggested for those students who are
familiar with the Lagrange multiplier method.)
The theory of individual choice

See MKR Sections 2.1 Basic set-up, 2.2 Tastes and 2.3 Budget constraints.
In this chapter we try to understand and describe the behaviour of an

individual who has to choose what it is that he wants to purchase and
consume. To do this, as explained in detail in Section 2.1 of the textbook,
we need to analyse two separate sides of the problem, and then put them
together. The first thing to do is to understand what the consumer wants.
This is simply to say that we would like to know, for example, whether
he prefers to watch two movies and go to a live concert, or go to two live
concerts; in general, we want to be able to understand his preferences,
described in terms of which option he prefers when he has to compare
any two alternative consumption bundles. The other aspect we need to
analyse is what the consumer can do. One thing is to say that a consumer
prefers a Ferrari to a Peugeot 207, another one is to discuss whether he
can actually afford to buy a Ferrari instead of the Peugeot 207. Finally, we
want to combine what he wants to do and what he can do, to understand
what he is going to do.
The following paragraphs will introduce the tools needed to answer the
first two questions, while the next section will deal with the consumers
actual choice.
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66 Microeconomics
Preferences (and assumptions over preferences)

There are three essential properties of individuals preferences that we are
going to assume for the whole course. These are:
Completeness: preferences are complete if it is always possible for
the individual to compare different bundles. For example, the consumer
should be able to compare three apples and one pear to two apples and
two pears. (He should also be able to compare 1 pair of shoes, 1 candy
bar and 1 car to 1 scooter, 10 pairs of shoes, 1 pair of trousers and a
piece of cake; the comparison has to be possible for every bundle that
the consumer may be asked to evaluate.)
Transitivity: preferences are transitive if whenever the consumer
prefers bundle A to bundle B and bundle B to bundle C the consumer
also prefers bundle A to bundle C.
Non-satiation: preferences satisfy non-satiation if the consumer
always prefers a bundle with more of either good to a bundle with less.
(Figure 2.3 in MKR shows perfectly what the graphical implications
are of the non-satiation assumption.) The textbook provides a
detailed explanation of the reasons for which this assumption is less
fundamental than transitivity and completeness.
Indifference curves and utility

By introducing the completeness property, we assumed that the individual
is able to compare all possible bundles that he may have to consider.
Suppose that Karl has 3 pairs of shoes and 1 book. We may be interested
in knowing what are the bundles that make Karl as happy as he is now.
For example, it may be that Karl is indifferent between 3 pairs of shoes
and 1 book, and 2 pairs of shoes and 3 books. To investigate this kind of
question, we introduce the concept of the indifference curve.
Definition. An indifference curve is the set of all bundles between which the
consumer is indifferent.
Moreover, we might be interested in the rate at which the consumer is

willing to trade shoes for books. Such a rate is represented by the slope of
the indifference curve.
Definition. The marginal rate of substitution of good y for good x (MRSyx) is
the rate at which the consumer is willing to substitute good y for one additional
unit of good x. It is equal to the absolute value of the slope of the indifference
curve.
Indifference curves have two important properties: they cannot cross, and,
if preferences satisfy non-satiation, they are downward-sloping. You should
read the textbook carefully for an explanation of these two properties;
in particular, you should consider Figures 2.72.8 and 2.102.12 for a
graphical analysis of the properties.
The shape of the indifference curve tells us some important characteristics
of the goods we are considering. You should read carefully the description
contained in Section 2.2 of MKR of the cases in which the goods are
perfect substitutes and perfect complements, and you should also be able
to identify whether a good is a perfect substitute or a perfect complement
by looking at their indifference maps.
16
In order to analyse the consumers choice by using mathematical tools, we

need a function, which we call a utility function, that represents the
consumers preferences; we also define the marginal utility of a good.
Definition. The utility function u(x, y) is a function that assigns to each bundle
(x, y) a utility level for the consumer. It does so in a way that represents the
consumer preferences, that is, u(x, y) > u(x, y) if and only if the bundle (x, y) is
preferred to the bundle (x, y).
Definition. The marginal utility of good x, MUx, is the marginal increase in
the utility generated by a marginal increase in the consumption of x, and it can
be measured as the partial derivative of u(x, y) with respect to x.
The VLE contains examples of utility functions. In particular you should

look at the Cobb-Douglas utility function, and at the utility functions
associated with goods that are perfect complements and perfect substitutes
before moving on to the following sections.
Now that we have defined the utility function, we can compute the
marginal rate of substitution:
u(x,y)
MUx
x .
MRSxy =
=
MUy u(x,y)
y
Activity 3.1.
Compute the marginal rate of substitution for consumers characterised by the following
utility functions:
u(x, y) = xy
u(x, y) = log x + log y
u(x, y) = x + y
Budget constraints
So far we have described the preferences of the consumer, but we have
not considered the fact that the consumer may not be able to purchase her
most preferred bundle. Suppose you are in a music shop and you want to
purchase the CDs you like the most. What makes your decisional problem
interesting is the fact that you only have a certain amount of money to
spend, and possibly that not all the CDs have the same price.
In this section therefore we introduce the concept of a budget
constraint which helps us to describe the set of choices that are feasible
for the consumer.
Definition. A budget constraint represents the bundles among which the
consumer may choose given the prices that she faces and her money.
The textbook provides a good explanation, also through graphs, of

the effects of a change in income or a change in prices on the budget
constraint. At the end of this section you should be able to draw a budget
constraint and to discuss how it changes after an increase or a decrease of
the income level of the consumer, or a change in one or both prices by a
fixed amount or by a certain proportion.
In order to understand the consumers choice, we now need to combine
the consumers tastes (utility) and her possibilities (budget constraint).
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66 Microeconomics
Maximising utility: the uncompensated demand

See MKR Sections 1.2 Models, 1.3 The working of a price system, 2.4 The
consumers equilibrium and 3.1 Price and income changes.
In the previous section we introduced the two elements of the consumers

problem: her preferences and her possibilities. Now we need to
understand how these two pieces of the story interact, in order to find
the consumers (uncompensated) demand. The demand that we analyse
in this section is called uncompensated demand to distinguish it from the
compensated demand that will be introduced in the next section.
We introduced above the concept of consumer preferences, and the budget
constraint. When she has to decide which bundle she wants to purchase,
the consumer will try therefore to find the bundle that satisfies the budget
constraint (i.e. that is feasible), and that lies on the highest indifference
curve. Let us see now how we can find such a bundle for consumers with
different utility functions.
Computing the uncompensated demand

In order to compute the uncompensated demand we need to find
the point on the highest indifference curve that satisfies the budget
constraint. Below you can find the methodology for the computation of
the uncompensated demand in the case of a Cobb-Douglas utility function,
and in the case of a consumer with perfect complements preferences.
On the VLE you will find more examples of utility functions and their
uncompensated demands. You should also familiarise yourself with the
difference between interior solutions and corner solutions that you
can find in your textbook.
Activity 3.2: Computing the uncompensated demand for a Cobb-Douglas
utility function
Consider a consumer who has income m and who derives utility from the consumption
of good x and y, according to the utility function u(x,y) = xayb, with a, b > 0. His
consumption problem is therefore:
max xayb
x,y
s.t. pxx + py y m.
To solve this problem you can use the Lagrange multipliers method, if you are sufficiently
familiar with this optimisation method. Otherwise you can consider the following graph:
y
I2
I1
x
18
You have to think that the consumer is trying to find the highest indifference curve that
touches the budget constraint. The budget constraint is kept fixed.
You can see that the maximum utility is achieved at the point where the indifference
curve I1 is tangent to the budget constraint, that is at point E. What do we know about
this point?
We know that the indifference curve has the same slope as the budget constraint.
We also know that E is on the budget constraint.
The first condition implies that the MRS (the slope of the indifference curve) is equal
to px / py (the slope of the budget constraint); the second condition implies that
px x + py y = m.
Therefore, to find the uncompensated demand, we need to solve the following system of
equations:
ay px
=
bx py
px x + py y = m
You can do it as an exercise, and check that the uncompensated demands are:
x(px, py, m) =
am
px (a + b)
y(px , py , m) =
bm
(a + b) py
Activity 3.3: Computing the uncompensated demand for perfect complements

Consider a consumer who has income m and who derives utility from the consumption
of good x and y in fixed proportions, according to the utility function u(x, y) = min{ax,
by}, with a, b > 0. His consumption problem is therefore:
max min {ax, by}
x,y
s.t. pxx + py y m
Let us consider, as we did before, the graph that represents the indifference curves and
the budget constraint:
y
I2
E
I1
x
Here, as before, you have to think that the consumer is trying to position herself on the
highest possible indifference curve that touches the budget constraint.
You can see that the maximum utility is achieved at the point where the indifference
curve I1 is tangent to the budget constraint, that is at point E. What do we know about
this point?
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66 Microeconomics
We know that we are at the kink of the indifference curve.

We also know that E is on the budget constraint.
Therefore, to find the uncompensated demand, we need to solve the following system of
equations:
ax = by
px x + py y = m .
You can do it as an exercise and check that the uncompensated demands are:
x(px, py, m) =
bm
bpx + apy
y(px, py, m) =
am .
bpx + apy
Notice that the uncompensated demand is a function of income and prices.

This depends on the fact that the consumer is constrained by the budget
constraint, which is characterised by the income level and by the prices of
the two goods.
Income and price changes

Once we have derived the demand we can ask ourselves how it changes
in relation to price changes or to income changes. This allows us to
understand some properties of the goods, and of the relationships between
goods.
Let us start by asking ourselves what happens if income increases. In
this case, the behaviour of demand depends on the type of good we are
considering:
normal good is a good for which an increase in income increases
consumption, other things equal
inferior good is a good for which an increase in income decreases
consumption, other things equal.
Let us now consider what happens to the demand of good x when py
increases. Depending on the effect of an increase of py on x we say that
good x and y are:
substitutes: if the demand of x increases when py increases
complements: if the demand of x decreases when py increases.
You should look at the textbook for the graphical explanations of these
concepts and for some examples.
Elasticity of demand
When we want to measure the responsiveness of demand to changes in
prices or income, we find it useful to introduce the concept of elasticity.
The elasticity of demand measures the proportional change in demand
given a proportional change in another variable (own price, income, or the
price of the other good).
This is particularly useful when we want to compare demands for goods
that are expressed in different units of measurement (such as, for example,
apples and beer) or goods that are traded in countries where prices are
expressed in different currencies.
The main types of elasticity that we will use in this course are:
Own price elasticity measures the negative of the percentage
change in the quantity of good x divided by the percentage change in
the price of good x.
20
Cross-price elasticity measures the percentage change in the

quantity of good x divided by the percentage change in the price of
good y.
Income elasticity measures the percentage change in the quantity of
good x divided by the percentage change in income.
The textbook provides several graphs that explain in detail these concepts
of elasticity, and presents a wide discussion of the determinants of the
price elasticity of demand, such as the presence of close substitutes, the
budget share of the commodity, and the time frame we are considering.
Minimising expenditure: the compensated demand

See MKR Section 4.4 Consumer surplus subsection compensated demand.
In the previous section we introduced the (uncompensated) demand

function and the consumers optimisation problem. The consumers
problem, however, can also be seen from a different viewpoint. You can
ask yourself what is the optimal choice of the consumer when he wants to
reach a certain level of utility without being constrained by income.
Compensated demand and the expenditure function

The demand function that describes how the choice of the consumer
changes when we vary prices and the level of utility u that has to be
attained is called compensated demand. Compensated demand, basically,
solves the consumers problem from an opposite perspective: as can be
seen in the following figure, it holds the indifference curve fixed, and,
given the price ratio of the two goods, it looks for the lowest expenditure
level that is sufficient to reach the indifference curve, by purchasing the
bundle E.
Notice that, given the way in which it is derived, compensated demand
only displays the substitution effect, and not the income effect (as the
income level of the consumer is allowed to vary when the prices of
the goods vary). Figure 4.14 in the textbook shows a graphical way of
obtaining compensated demand by looking at the substitution effect.
The function that describes the minimum amount of money that is
required to reach the utility level u is called the expenditure function.
y
x
As discussed above, compensated demand only includes the substitution
effect, while uncompensated demand displays both the income and
substitution effects. As a consequence, the sensitivity of the two demands
to a change in price is different. Section 4.4 explains thoroughly which
21
66 Microeconomics
demand is flatter and which is steeper in the case of a normal good and in
the case of an inferior good.
Welfare analysis
See MKR Chapter 4: Price changes and consumer welfare.
The main issue that remains to be analysed in this section is the issue of
welfare economics. Suppose that you are a policy-maker in your country.
Suppose you want to introduce some policy that involves changing the
price of one or several goods. One question you have to ask yourself is
what this implies in terms of the welfare of your citizens.
Income and substitution effects

The first step to understanding the changes in consumers welfare is to
analyse the effects that a change in the price of one good has on the
consumers optimal choice.
Consider the choice of a consumer, Rebecca, who has to choose between
two goods, rice and pasta. Suppose that you have computed her optimal
choice; now let the price of rice increase. Will Rebecca purchase more or
less rice than before?
This price increase has two effects. The first one, called the substitution
effect, is the effect on quantity due to the fact that the relative price has
changed. Given that rice is now relatively more expensive than pasta,
Rebecca will increase her consumption of pasta. The second effect, the
income effect, is due to the fact that with the increase in the price of
rice Rebeccas feasible set is reduced.
The substitution effect always goes in the same direction: an increase
in the price of a good will reduce its consumption. The income effect,
however, can go in either direction. Remember the definitions of a
normal good and inferior good that we introduced above; the direction
of the income effect depends on whether the good is normal or inferior.
If the good is normal, the income effect of a price increase decreases the
quantity of the good that is demanded by the consumer; in this case, the
substitution effect and the income effect go in the same direction, and
the price increase decreases overall the quantity of the good that the
consumer purchases. On the contrary, if the good is inferior, the income
effect of a price increase increases the demand for that good. In this case
the substitution effect and the income effect go in opposite directions,
and the overall effect is ambiguous. We call a Giffen good the (inferior)
good that has an upward-sloping demand curve, where the income effect
prevails on the substitution effect and the overall effect of a price increase
is an increase in the demand for the good.
Section 4.1 has a detailed description of both these effects, for normal
goods, inferior goods and Giffen goods, explained with the use of graphs
that you should carefully look at, understand and be able to reproduce. It
is important that you understand these effects, because we will use them
to evaluate several policies including, for example, the introduction of an
income tax on labour supply, that will be analysed in the next chapter.
Compensating and equivalent variation

When the price of a good increases, the utility of the consumer decreases.
A policy-maker has to be interested in evaluating how much the
consumers utility has been reduced by the implementation of a specific
policy.
22
Let us now consider Rebeccas situation, as described above, when the

price of rice increases. We can evaluate her welfare change from two
different points of view:
We can ask ourselves how much money we need to give Rebecca
in order to bring her back to her original level of utility given the
new prices of rice and pasta; in this case we are computing the
compensating variation, since we are studying how much money
is required to compensate Rebecca for the change in prices.
We can also ask ourselves how much money we should take away from
Rebecca in the original situation to have a decrease in her utility level
that is equivalent to the one induced by the change in prices; in this
case we are computing the equivalent variation.
You should look at the graph contained in Section 4.2 that shows the
equivalent variation, and try to replicate it for the compensating variation.
Notice that these measures of welfare will give you different results. They
are both sensible measures; which one is more appropriate will depend
on the type of welfare analysis that the policy-maker requires. Section 4.3
presents some examples of applications of these two concepts.
Consumer surplus
The compensating and equivalent variations are useful tools. However,
in order to be computed, they require the policy-maker to know a lot of
information about the consumers preferences. It is therefore convenient,
in some situations, to have a welfare measure that can easily be computed
starting from the consumers demand function.
The consumer surplus is the difference between the maximum amount the
consumer is willing to pay and the amount that he has to pay. It can be
computed directly from the consumers demand. What we call consumer
surplus is what the book calls Marshallian consumer surplus.
Section 4.4 shows you how to find the consumer surplus also in a
graphical way and discusses some examples of its application.
Price indices
The last welfare measures that we can consider are price indices. As the
prices of the commodities he consumes and his money income change,
we would like to compare changes in the general price level of the
commodities (the cost of living) with changes in the consumers money
income. Ideally, changes in the cost of living would be measured by the
change in money income that is necessary for the consumer to achieve
the same level of utility in the given year as in the base year (that is,
compensating variation). Then, if the consumers money income increases
more (less) than this measure of the cost of living we can say he is better
(worse) off. Given insufficient information on individual preferences,
this ideal measure of the cost of living cannot be used. Instead we use
approximations, such as the Laspeyres price index (L) and the Paasche
price index (P).
The Laspeyres price index (L) is the ratio of the sum of given-year prices
weighted by the base-year quantities of commodities to the sum of baseyear prices weighted by base-year quantities. If we consider an individual
who consumes only two commodities, x and y, in two different years, 0
and 1, the L index is:
L=
p1x x 0 + p1y y 0.
p0x x 0 + p0y y 0
23
66 Microeconomics
You should be able to explain that L tends to overstate increases in the

(true) cost of living. Using base-year quantities to weight the prices of
goods in a different year, L does not allow for the fact that a consumer
tends to substitute away from goods that become relatively more
expensive. This implies that an individual whose money income rises
relatively as much as L, and therefore can purchase the same bundle of
goods in the given year as in the base year, cannot be worse off and is
likely to be better off in the given year. In turn, this suggests that if an
individual can be better off when his income rises as much as L, he may
also be better off if the rise in income is (slightly) less than the increase
in L.
Thus, we can only say unambiguously that if R > L, where R is the ratio of
income in the given year to income in the base year, then the consumer is
definitely better off in the given year.
The Paasche price index (P) is the ratio of the sum of given-year prices
weighted by given-year quantities to the sum of base year prices weighted
by given-year quantities. For an individual who consumes only two
commodities, this would be:
P=
p1x x 1 + p1y y 1
.
p0x x 1 + p0y y 1
You should be able to explain why P tends to understate increases in the

(true) cost of living. The index is a minimum estimate of the increase
in the (true) cost of living since it assumes, erroneously, that, had the
consumer received, in the base year, an amount of income equal to the
sum of the base-year prices weighted by given-year quantities he would
have bought the given-year quantities. Instead, the consumer would have
tended to buy relatively more of the commodities which became (in the
given year) relatively more expensive. This implies that an individual
whose income rises relatively as much as P, and therefore could have
purchased the same bundle of goods in the base year as he does in the
given year, cannot be better off and is likely to be worse off in the given
year. In turn, this suggests that if an individual can be worse off when
his income rises as much as P, he may also be worse off if the rise in
income is (slightly) more than the increase in P. Thus, we can only say
unambiguously that if R<P, then the consumer is definitely worse off in
the given year. Indifference curve/budget line diagrams can be used to
illustrate these points. (You should be aware that quantity indices can also
be used to make similar points, but you are not expected to demonstrate
that.)
What determines the magnitudes of the errors in the Laspeyres and
Paasche price indices? The answer depends on the extent to which
relative prices change during the period in question, and on the extent
to which the consumer substitutes between commodities when relative
prices do change. If relative prices do not change much, or if substitution
possibilities are limited, both indices will be reasonably accurate. You
should note that the analysis made so far depends on the assumption that
L and P are computed for a particular individual. However, any practical
price index is based on some average bundle of commodities, which, it
is hoped, applies approximately to everyone in the relevant population.
Given that not all people consume the same bundle of commodities,
clearly a given price index may be unrepresentative for some individuals.
24

Having completed this chapter, and the Essential reading and activities,
draw indifference curve diagrams starting from the utility function of a
consumer
explain the implications of the assumptions on the consumers
preferences
use indifference curve diagrams to analyse the effect of price and
income changes
solve the consumers utility maximisation problem and derive the
uncompensated demand for a consumer with a given utility function
and budget constraint
explain the consumers expenditure minimisation problem and the
compensated demand functions
evaluate the change in consumer surplus, the equivalent variation and
the compensating variation as measures of the welfare impact of price
changes
use the more appropriate measure of welfare to analyse the effect of a
price change in a given economic situation
define the Laspeyres and Paasche price indices, and discuss their
limitations as measures of consumer welfare.
Sample examination questions

Section A
1. Bob likes to drink cappuccino in the morning. He likes his cappuccino
made with one part of coffee and two parts of milk. Write Bobs utility
function, and draw his indifference curves. What type of preferences
does Bob display?
2. Tara has 100 to spend, and she can buy shoes and t-shirts. The price
of a pair of shoes is 50, and the price of a t-shirt is 20. Draw the
budget constraint. What happens if prices and Taras income grow by
20%?
3. The uncompensated demands for a consumer with Cobb-Douglas
preferences come from an interior solution. Can you intuitively explain
why this is the case?
Section B
1. Consider an individual with the following utility function:
u(x,y) = xy
a. Show that the individuals preferences satisfy non-satiation.
b. Compute the uncompensated demands for goods x and y.
c. Does the uncompensated demand for good x display both
substitution effects and income effects? Explain.
2. If a Laspeyres index rises more than your income, are you necessarily
worse off? Would your answer differ if the word Paasche replaced the
word Laspeyres? Explain your answers.
3. a. Define a normal good.
b. Define equivalent variation.
25
66 Microeconomics
c. Consider a consumer, whose preferences are described by u(x1,x2),

who faces a price increase for good 2. Show on a graph the
equivalent variation and the change in consumer surplus for such a
consumer, assuming that the good is normal.
26
Chapter 4: Labour supply and the effect of taxes
Chapter 4: Labour supply and the effect

of taxes
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
draw the budget constraint and the indifference curves for an
individual who works and consumes his income, both with and without
income tax
derive a labour supply curve
explain the income and substitution effects of a change in the wage
rate, and of the introduction of an income tax or benefit
derive the effects of such a change on labour supply.
Essential reading
Morgan, Katz and Rosen Section 5.1.
Labour supply
See MKR Section 5.1 Labour supply.
An important application of the theory of individual choice is in the

explanation of how many hours people work. Individuals are faced with a
choice between leisure and the goods that can be purchased with money
income. By giving up leisure (i.e. by working) they obtain money income,
and, hence, goods.
Budget constraints and indifference curves

The first step to understand the optimal time allocation between work and
leisure is to know how to derive the budget constraint for this problem.
In order to have a graphical representation that resembles the one we are
used to, we represent on the horizontal axis the amount of leisure (n), and
on the vertical axis the consumption of a composite good (c), that is of a
unit of a consumption bundle. The price of the composite good is P and
the hourly wage is W. We define the real wage w = W / P. The number of
hours of work can be obtained by the simple expression T n where T is
the individuals endowment of time. If we are considering a year as the
time horizon, T = 24 * 365 = 8760.
There are several equivalent ways to define the budget constraint. The first
one, which is the closest to the budget constraint we have seen before, is
the following:
Pc + Wn = WT,
that is, the amount that the individual spends on c, plus the amount of
money that the individual spends on leisure, has to be equal to the total
income, that in this case is the value of the time endowment. Notice
that W can be seen as the price of one hour of leisure, given that it is
the reduction in income associated with the consumption of one hour of
leisure. Alternatively, the budget constraint can be written as follows:
Pc = W(T n),
27
66 Microeconomics
that is, the total amount of money spent on consumption has to be

equal to the total amount of money earned. If we normalise the budget
constraint by dividing everything by P, we obtain:
c = w(T n),
c
We can see that the budget constraint meets the horizontal axis at
n = T, and has slope -w. Given this traditional representation of the
budget constraint, and that the individual has a utility function u(c, n),
that depends on the quantity of the composite good, and on the quantity
of leisure that the individual consumes, the indifference curves are
represented in the traditional way, and their shape depends, as usual, on
the functional form of the utility function.
Income and substitution effects

When we were considering the consumers choice between two goods,
we discussed the effect of a price increase, and we distinguished two
effects of such an increase: the income and substitution effects. We are
now interested in the analysis of the effects that an increase in the price of
leisure (wage) has on the final working choice of the individual.
If we increase the wage, leisure becomes relatively more expensive so,
as before, the substitution effect reduces its consumption. However,
an increase in wage also has the effect of tilting the budget constraint
outwards, because it increases the individuals income earned for a given
number of hours of work. Therefore, if leisure is a normal good, the
income effect increases its consumption.
As a consequence we are not able to predict the overall effect that an
increase in wage has on the consumption of leisure (and therefore on
the number of hours worked). You should look carefully at the graphs
included in Section 5.1 because they show the possible effects of a wage
increase and of a wage decrease. A comprehension of such graphs is
necessary to understand the following analysis of the effect of taxes on the
labour supply.
Activity 4.1.
Consider a government that wants to introduce an unemployment benefit. Describe its
possible concerns about the effects that the benefit may have on labour supply. What will
happen to the labour supply of rich citizens? What will happen to the labour supply of
really poor citizens?
28
Labour supply curve

From the leisure demand curve we can derive the labour supply curve.
As the textbook says, this is a schedule showing the relationship between
the quantity of labour supplied and the wage rate, ceteris paribus. The
graphs contained in the textbook show how to derive an upward-sloping
supply curve, a downward-sloping one, and a backward-bending one. You
should be able to understand and explain why you can get all these three
shapes of labour supply curve when you assume that leisure is a normal
good.
The effect of taxes on labour supply

See Section 5.1 Labour supply.
So far we have introduced the main ingredients for analysing labour

supply. The aim of this section is to enable you to understand how you can
evaluate government policies that may affect labour supply, in particular
taxes and benefits.
Some useful definitions

We will now start from some useful definitions.
Definition. The marginal tax rate, t, is the tax rate that is applied to the extra
pound you may earn.
Definition. The average tax rate, a, is the ratio of the total amount of taxes
paid, divided by overall income.
Definition. The benefit withdrawal rate, b, is the rate at which the benefit you
receive is reduced when you earn one extra pound.
Definition. The effective marginal tax rate, m, is equal to the sum of the
marginal tax rate and the withdrawal rate, m = b + t.
The effective marginal tax rate is therefore a measure of how much of your
extra pound earned has to go to the government, in the form of taxes, or
in the form of a reduction of your benefit.
Notice that, for a given tax system, different individuals may have
different values of all the variables defined above. For example, in a tax
system where incomes below 5000 are not subject to taxation, and
incomes above 5000 are subject to a 13% tax rate, the marginal tax rate
of an individual who earns 4500 is 0, while the marginal tax rate of an
individual who earns 40000 is 0.13.
Budget constraint
When we introduce an income tax or benefit, we first need to understand
how the budget constraint is modified by the presence of the tax. You
have to be able to draw the budget constraint for leisurework choices in
the case in which there are income taxes or benefits. Let us consider two
examples.
29
66 Microeconomics
Activity 4.1. The introduction of a tax benefit

Consider an individual with a real wage w = 10. Draw the budget constraint for the
case in which there is a benefit of 3,000 associated with a benefit withdrawal rate
b = 1, and no income tax. Draw the budget constraint.
income
after
taxes,
87600
3000
8460
8760
We start by noticing that the total endowment of time (in hours) per year is still
24 * 365 = 8760. Now, however, when the leisure time is 8760, the individual
experiences a possible consumption of 3,000 given the benefit. If he works one hour,
he earns 10 but he loses w * b = 10 from his benefit. Therefore his budget constraint
will be flat up to n = 8,760 300, given that he has to work 300 hours to lose all the
original benefit he had. Above that, the slope of the budget constraint is w.
Activity 4.2. An income tax
Consider now the following tax system:
Annual income ()
Marginal tax rate
<20000
2000084000
15%
>84000
40%
in an economy where the real wage rate is w = 20. Draw the budget constraint.
income
after
taxes,
129120
74400
20000
4560
30
7760
8760
The first thing we can notice is that the budget constraint now has three different slopes,
one for each income bracket. The slope of the budget constraint in each bracket is
w(1 t), where t is the marginal tax rate. When n is greater than 7760 the worker
earns less than 20,000, and therefore does not pay any taxes. For n smaller than 7760
but greater than 4560, the worker earns an annual income in the second income bracket,
and therefore he pays a 15% marginal tax rate. As a consequence, when n = 4560, the
income before taxes is (8760 4560) * 20 = 84000, but the income after taxes is
84000 9600 = 74400, given that the worker has to pay a 15% tax rate on the income
between 20000 and 84000. The overall tax paid in this bracket is therefore (84000
20000)*0.15 = 9600. Similarly we get that the income after tax of an individual who
works 8760 hours is 129120.
Effect of taxes on labour supply

The overall effect of the introduction of a tax or a benefit on the labour
supply depends on the income and substitution effects that such an
introduction implies. We can see the two different effects both graphically
and by looking at the marginal tax rate and at the average tax rate.
If the marginal tax rate goes up, the fraction of the extra pound
earned that the worker can retain for himself goes down. As a
consequence, leisure becomes relatively cheaper, and therefore the
substitution effect implies that the worker consumes more leisure
(labour supply goes down).
If the average tax rate goes up, it means that, at the same number of
hours worked, the worker is poorer, and therefore the income effect
implies that the worker consumes less leisure, assuming that leisure is a
normal good (labour supply goes up).
In this case we could conclude that labour supply goes down. However,
you could find a change in the tax system that increases the marginal tax
rate for a worker, but decreases his average tax rate; or a change that
does not affect his marginal tax rate but increases the average tax rate,
and so on and so forth. Therefore when you want to evaluate the effect
of a change in the tax system you have to consider, either graphically or
numerically, what happens to the marginal and average tax rates.

Having completed this chapter, and the Essential reading and activities,
draw the budget constraint and the indifference curves for an
individual who works and consumes his income, both with and without
income tax
derive a labour supply curve
explain the income and substitution effects of a change in the wage
rate, and of the introduction of an income tax or benefit
derive the effects of such a change on the labour supply.
31
66 Microeconomics
Sample examination questions

Section A
1. Discuss the effects that the introduction of a benefit may have on
labour supply.
Section B
1. a. Does leisure have to be an inferior good for an increase in the wage
rate to result in an increase in the number of hours worked by an
individual? Explain your answer.
b. Explain why an increase in the basic wage rate per hour offered to a
worker may decrease the number of hours she wishes to work while
an overtime premium offered to the same worker may increase the
number of hours she wishes to work.
2. The wage rate in the Country of Sweetness is w = 10. This country has
the following tax system:
Annual income ()
Marginal tax rate
< 5000
5000 25000
20%
> 25000
30%
a. Draw the budget constraint.

b. Define the marginal tax rate and the effective marginal tax rate.
What is the marginal tax rate of an individual who earns 15000?
And the effective marginal tax rate?
c. Suppose now that the government of the Country of Sweetness
increases the range of the first tax bracket from 5000 to 6000, so
that individuals with an annual income below 6000 now pay zero
tax. How does this affect the labour supply of someone working
550 hours per year? How does this affect the labour supply of an
individual who works 1000 hours per year?
32

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Microeconomics

University of London International Programmes

Chapter 6: Choice under uncertainty.................................................................... 37

Chapter 12: Asymmetric information ................................................................... 93

be able to analyse and assess:

How to use this guide

Contents of the guide

themselves. To understand this chapter it is essential that you have a

Online study resources

Making use of the Online Library

The Appendix to this subject guide contains a full Sample examination

Specific advice on approaching the questions

Chapter 2: What does microeconomics do?

Chapter 2: What does microeconomics

The above example illustrates some of the questions that microeconomics

Scarcity, prices and the role of the market

Chapter 2: What does microeconomics do?

The role of models and assumptions

Rational choice and optimisation

In general this will be modelled as a process of maximisation of an

Chapter 2: What does microeconomics do?

A reminder of your learning outcomes

Chapter 3: Consumer theory

Chapter 3: Consumer theory

The theory of individual choice

In this chapter we try to understand and describe the behaviour of an

Preferences (and assumptions over preferences)

Indifference curves and utility

Moreover, we might be interested in the rate at which the consumer is

Chapter 3: Consumer theory

In order to analyse the consumers choice by using mathematical tools, we

The VLE contains examples of utility functions. In particular you should

The textbook provides a good explanation, also through graphs, of

Maximising utility: the uncompensated demand

In the previous section we introduced the two elements of the consumers

Computing the uncompensated demand

Chapter 3: Consumer theory

Activity 3.3: Computing the uncompensated demand for perfect complements

We know that we are at the kink of the indifference curve.

Notice that the uncompensated demand is a function of income and prices.

Income and price changes

Chapter 3: Consumer theory

Cross-price elasticity measures the percentage change in the

Minimising expenditure: the compensated demand

In the previous section we introduced the (uncompensated) demand

Compensated demand and the expenditure function

Income and substitution effects

Compensating and equivalent variation

Chapter 3: Consumer theory

Let us now consider Rebeccas situation, as described above, when the

You should be able to explain that L tends to overstate increases in the

You should be able to explain why P tends to understate increases in the

Chapter 3: Consumer theory

A reminder of your learning outcomes

Sample examination questions

c. Consider a consumer, whose preferences are described by u(x1,x2),

Chapter 4: Labour supply and the effect of taxes

Chapter 4: Labour supply and the effect

An important application of the theory of individual choice is in the

Budget constraints and indifference curves

that is, the total amount of money spent on consumption has to be

Income and substitution effects