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EC201Microeconomic
PrinciplesI
MichaelmasTerm2014
LectureNotes
DrMargaretBray
EC201 Reading
Course textbook
Snyder, C. and Nicholson, W. "Microeconomic Theory: Basic Principles
and Extensions", 11th edition, South Western, 2012.
Other books
These are not appropriate for EC201 but may be
helpful as an introduction
EC102 text Morgan W., M. Katz and H. Rosen, "Microeconomics", 2nd
edition, McGraw Hill 2009
No calculus so unsuitable for EC201.
Varian, H, R. Intermediate Microeconomics, Norton, (any edition)
calculus in the appendices to chapters.
Varian, H.R. "Intermediate Microeconomics with Calculus" Norton,
(2014) incorporates these appendices into the body of the text
1.1
Reading
Snyder & Nicholson Chapter 3
or
Perlo Chapter 3
Introductory reading below the level of EC201
Morgan, Katz & Rosen, Chapters 2.1, 2.2
or
Varian Chapters 3, 4
1.2
1.3
1.4
Reading
Snyder & Nicholson Chapter 5, Extensions (following chapter
19) chapter 5
or
Perlo Chapters 4.4, 5,
Introductory reading below the level of EC201
Morgan, Katz & Rosen, Chapter 4
or
Varian Chapter 14
1.5
Reading
1.6
2
2.1
2.2
3
3.1
Industrial Organization
Perfect competition and monopoly
Introduction to industrial organization
Perfect competition
Markets with a xed number of price taking rms
Entry and exit
Entry & exit in an industry with a xed proportion production function
Entry & exit, short run & long run costs, with a u-shaped average
cost curve
Increasing and decreasing cost industries
Firms with dierent costs & economic rent
Very simple model of economic rent in a price taking oil industry
Welfare economics of a tax with supply and demand
Producer Surplus
Welfare economics of a subsidy with supply and demand
Deadweight losses from taxes and subsidies
Monopoly
Deadweight loss from a monopoly
Cartels
Price discrimination
Reading
Snyder & Nicholson Chapter 12
or
Perlo Chapters 2, 8, 9, 11,
Introductory reading below the level of EC201
Morgan, Katz & Rosen, Chapter 7
or
Varian Chapters 23, 24, 25
3.2
Reading
Snyder & Nicholson Chapters 8, 15
or
Perlo Chapters 13. 14,
Introductory reading below the level of EC201
Morgan, Katz & Rosen, Chapters 15, 16
or
Varian Chapters 27, 28
Microeconomic Principles I
Introduction to EC201
EC201
2014-15
Lecturers: Margaret Bray (Michaelmas)
Erik Eyster (Lent)
3. Industrial organization
3.1 Perfect competition and monopoly
3.2
Economic Models
Each model has assumptions.
A map is a model
The reality of Londons geography is very complicated.
1.1 Example of a
maximizing model:
internship applications
1.1 Example of a
maximizing model:
internship applications
Models in standard microeconomics assume that consumers
and producers either maximize or minimze something.
Critics of microeconomics often argue that this is a very bad
assumption.
The relevant question is whether a maximizing model is
appropriate for a particular application.
Probability of success
Assume
You make 5 internship applications.
The probability that an application is successful is 0.5.
Make a guess, which number is closest to the probability
that at least one application is successful?
Internship applications
What is the probability of getting at least one
offer?
r = 0.1
Internship applications
the student chooses the number of
applications x that maximizes
Total value total cost
r = 0.3
= V(x) px
where V(x) = N = (1 - (1 r)x )N
px = cost of x applications
r = 0.1
N = 5000, r = 0.3
total value
marginal value
= gradient of tangent line
V(0)
MV(1)
MV(2)
V(2) V(1)
MV(3)
V(3) V(2)
N = 5,000
p =200
r = 0.1
marginal cost
marginal value
marginal value
x
N = 5,000
p =200
r = 0.1
N = 5,000
p =200
r = 0.1
marginal cost
marginal cost
marginal value
marginal value
x
Internship applications
marginal conditions
If marginal value > marginal cost
increasing x increases total value total cost.
If p =200 9
If p =300 6
If p =400 3
is optimal
is optimal
is optimal
Definition of surplus
If p = 200 x = 9 is optimal
marginal cost
marginal value
x
r = 0.3
Predictions
If the cost value ratio c/N is high enough applicants with
a low probability of success r make zero applications.
r = 0.3
high c/N
low c/N
r = 0.1
Behavioural Ecology:
optimizing models in biology
Applied to many species, e.g. birds, bees and lions.
Objective is reproductive success
Evolution thought natural selection + genes
Tradeoffs
Game theory
Experiments
Evolutionary psychology
Big data
Argument
Cambridge
elasticity
consumer surplus
Marshalls theory of
consumer demand with
integer quantities,
1, 2, 3
gaps
lots of words, no modelling of
the effects of income & prices of other goods
10
Total value:
marginal value = gradient of total value graph
Total value
number of teabags
per
tea
bag
number of teabags
per
tea
bag
Shaded area
total value of 6 teabags,
area under the
marginal value curve i.e.
the integral.
number of teabags
11
Consumer surplus in
Marshalls model with
integer quantities
Internship model
Consumer Surplus
total cost
per
tea
bag
total cost
Consumer
surplus
marginal cost
marginal value
x
number of teabags
Calculus revision
12
But it has a
local max & local min.
At these points the derivative
is 0.
0
x
local min
TP
y
y
This
function
has no
maximum.
0
x
Is this function concave or convex?
i.e. the line joining any two points on the graph is below the
graph.
Concave functions have decreasing first derivatives
so concave functions have negative second derivatives
y is a concave function of x
so
dy
is decreasing
dx
dy is 0 at x = 1 and is
dx
13
dV
0
dx 2
dV
dx
d 2V
0
dx 2
2
dV
0
dx 2
= p
pA
Marginal value
= demand
xA
pA
Total
value
if
p = pA
Consumer surplus in
Marshalls model with
calculus and concavity
Marginal value
= demand
xA
14
Marshall defines
consumer surplus in
his model as
total value
- total cost
total
value
total cost
= V(x) px.
pA
Marginal value
= demand
total cost
Internship model
Measuring consumer
surplus is difficult
It requires knowing the
whole demand curve.
total cost
marginal cost
pA
pB
consumer
surplus
Marginal value
= demand
total cost
marginal value
If p = 200 x = 9 is optimal
xA
xA
pA
total cost
xA
High consumer
surplus low price,
e.g. water
low consumer
surplus high price,
e.g. diamonds
15
16
x2
u(x1, x2) = 3
u(x1, x2) = 2
u(x1, x2) = 1
x1
Pareto (1909)
Edgeworth (1891)
Slutsky (1915)
Hicks worked with indifference curves
John Hicks,
1904 89
Indifference curves
Does replacing 1, 2, 3 by 1, 4,
9 change preferences?
x2
u(x1, x2) = 3
u(x1, x2) = 2
Does replacing 1, 2, 3 by
1, 30, 14 change preferences?
u(x1, x2) = 1
x1
TP
17
x2
A
B is preferred to A because
there is more good 1 and the
same amount of good 2.
x1
B
C
x1
BC
AB
= - slope of AC
x2
= average amount of
good 2 needed to
compensate for loosing
1 unit of good 1.
0
Summary
Marshall started his analysis with a utility functions.
x1
18
Modern assumptions on
preferences:
completeness
3. Continuity
a definition
4. Nonsatiation
an intuitive explanation
5. Convexity
a critical discussion.
x2
.B
.A
she prefers A to B
si-gua
jay-lan
she prefers B to A
0
she is indifferent between A and B.
x1
mao-gua
Modern assumptions on
preferences:
transitivity
19
England
Costa Rica
beat
Italy
Italy
beat
England
TP
Modern assumptions on
preferences:
continuity
x2
If A is preferred to B
& B is very close to C
.A
either A is preferred to B,
or A and B are indifferent
or B is preferred to A
then A is preferred to C.
x1
This can be stated much more precisely but not for EC201.
20
Consumer theory:
ordinal utility
Indifference curves
Replacing 1, 2, 3 by 1, 4, 9,
does not change preferences.
x2
u(x1, x2) = 3
u(x1, x2) = 2
Replacing 1, 2, 3 by
1, 30, 14 does change
u(x1, x2) = 1
x1
preferences
Economists jargon, utility is ordinal not cardinal.
u2
if v = then
v(x1,x2) =(u(x1,x2) )2 = x13/2 x2 represents the same
preferences as u(x1,x2)
This is because the order of numbers attached to
indifference curves does not change.
if w = ln u then
w(x1,x2) = ln(u(x1,x2) ) = (3/4) ln x1 + (1/2) ln x2
represents the same preferences as u(x1,x2)
This is because the order of numbers attached to
indifference curves does not change.
21
if w = 2 u then
z(x1,x2) = 2 min [2x1, 3x2] = min[4x1, 6x2]
represents the same preferences as u(x1,x2)
This is because the order of numbers attached to
indifference curves does not change.
Modern assumptions on
preferences:
nonsatiation
.A
B
x1
22
The Queen
Bill Gates
wealth to charity.
Bill and Melinda Gates Foundation mostly funds
The Beatles
If
Ill buy you a diamond ring my friend,
If it makes you feel alright
u
x 1
0,
u
x 2
Nonsatiation is satisfied.
u
x 1
0,
u
x 2
e.g. if u = x12/5x23/5
3 / 5
1
u
x 1
u
x 2
53 x 12 / 5 x 2 2 / 5 0
2
5
convexity assumptions.
3/ 5
2
0,
23
preferred
set
x2
preferred set
x1
Modern assumptions on
preferences:
convexity
x1
TP
D
TP
x2
x2
preferred
B set
preferred
set
C
0
B is the
x1
of A and C
x1
24
preferred
Figure 1
set
x2
Figure 2
preferred
x2
x2
preferred
set
set
0
Figure 3
preferred
x1
set
set
x1
convexity
convexity
convexity
nonsatiation
nonsatiation
nonsatiation
x1
x1
Getty Images
TP
x2
convex functions
A function is convex if a
x2
A
B
preferred
set
x1
x1
x2
x1
x2
TP
x1
If nonsatiation
holds the
convexity
assumption is
equivalent to
assuming that the
indifference curve
is the graph of a
convex function.
x1
25
x2
preferred
set
x1
x1
If
u=
x12/5x23/5
then
x2 = u5/3 x1-2/3 so
x2 = - (2/3)
x1
u5/3 x1-5/3
convexity assumptions.
and
26
x2
.B
.A u(x1,x2) = 6
Transitivity
implies
indifference
curves
u(x1,x2) =4
utility than C.
x1
Marginal Rate of
Substitution (MRS)
x2
A
x2
See Consumer Theory
Worked Example 2: MRS
x1
x1
27
If x2 stays at x2A
If x1 stays at x1B
x2
u changes from u0 to u1
Then
(x1B - x1A)
so
u0
x2A
(u1 u0) u
u1
x1
u1 u0 (x1B - x1A) u
Then
x2B
(u1 u0) u
x2A
(x2A - x2B)
so
0 x1B
x1
x2
u changes from u0 to u1
x1A
x1
u0
u1
x2
u1 u0 (x2A - x2B) u
0 x1B
x2
x1A
x1
x2
x1
x2B
(x2A - x2B) u
u0
x2A
x2
x2B
B
u0
x2A
u1
u
0 x1B
x1
(x1B - x1A)
x2
u1
So slope of line AB =
(x2B - x2A)
x1A
x1
0 x1B
x1A
x1
u
x2
u
x 1
u
x 2
2 3 / 5 3 / 5
x1 x 2
5
3 2 / 5 2 / 5
x1 x 2
5
2x 2
3x 1
28
What if you have two utility functions and cannot see whether
they represent the same preferences?
Same preferences imply same indifference curves imply same
MRS.
Check whether utility functions they have the same MRS to
see whether they represent the same preferences..
See Consumer Theory Worked Example 2 on the website: Marginal rate
of substitution and ordinal utility.
x1
x2
df u
du x1 =
df u
du x2
u
x1
u
x2
Questions on preferences
and utility
TP
Regret
29
Questions on preferences
30
6. Demand curves
7. Substitutes and complements
7. Finding uncompensated demand with perfect
complements utility
8. Finding uncompensated demand with perfect
substitutes utility
9. Finding uncompensated demand with nonconvex
utility
budget line
budget
set
0
x1
Notation
quantities
x1
prices
p1 p2
px py
pi
p1 p2
income
x2
xi
Perloff
so
q1
x2 = -(p1/p2) x1 + (m/p2)
q2
Definition of
uncompensated
demand
x1
2. Definition of uncompensated
demand functions
Definition:
x2
x1
Examples of utility
maximization
(uncompensated demand)
x2
The tangency is at A
but B maximizes utility.
x2
B.
AA
x1
B
x1
Here
convexity
fails
Very important.
x2
preferred
set
A
budget
set
0
x1
x1
u
x1
MRS
u
x2
u
p
x1
1
u
p2
x2
x1
u
x1
x1
increase in utility
1 u
p1 x1
Spend 1 less on x2
fall in utility
1 u
1 u
p 1 x1 p2 x2
1 u
1 u
p 2 x2 p1 x1
1 u
p2 x2
1 u
1 u
p 1 x1 p2 x2
p 1 x1
or
p2 x2
u
p
x1
1
u
p2
x2
Finding uncompensated
demand with
Cobb-Douglas utility
x12/5x23/5
x2(p1,p2,m)
and
MRS =
2x2 = p1
3x1
p2
2 3 / 5 3 / 5
x1 x 2
5
3 2 / 5 2 / 5
x1 x 2
5
2x 2
3x 1
tangency condition
MRS =
u
x 1
u
x 2
p1
p2
3x1
x1
x 2(p1,p2,m) = 3 m
p1
5 p2
p2
Homogeneity of
uncompensated demand
set
m/p1
x1
x 2(p1,p2,m) = 3 m
p1
5 p2
That is if k > 0
x1(kp1,kp2,km) =
x1(p1,p2,m) = 2
x2(kp1,kp2,km) =
TP
x 2(p1,p2,m) = 3 m
p1
5 p2
x 2(p1,p2,m) = 3 m
p1
5 p2
x2
TP
x1
6. Demand curves
Demand
p1
x1(p1,p2,m) = 2
p1
p1
x1
p1B
p1A
x1
x1
If p2 changes there is
If income m increases
x1B x1A
p1
TP
p1
0
x1
x1
TP
x1
x1
TP
7. Elasticity
Measuring the impact of changes in prices & income
Elasticity
% change in quantity
% change in own price
Elasticity matters
for every decision on prices: e.g.
for a monopoly or oligopoly deciding on prices
x1 = x1 p1
x1 p1
p1
p1 x1
p1 x1
price of
good 1
B
p1
p1
or
x1
x1 =
x1 p1
x1 p1
p1
p1 x1
p1 x1
Some authors
makes elasticity
positive
quantity of good
x1
p1
TP
Find
Find
x1 p1
2m 5 p
2 1 p1 1
p1 x1
5 p1 2m
x1 p1
2m 5 p
2 1 p1 1
p1 x1
5 p1 2m
x1 p2
5p
0 1 p2 0
p2 x1
2m
x1 p2
5p
0 1 p2 0
p2 x1
2m
income elasticity
x1 m
2 5 p1
See Consumer
m 1Theory
m x1 5 pWorked
1 2m Example 10
income elasticity
x1 m
2 5 p1
See Consumer
m 1Theory
m x1 5 pWorked
1 2m Example 10
x 2(p1,p2,m) = 3 m
p1
5 p2
x p
2m 5 p
own price elasticity 1 1 2 1 p1 1
p1 x1
5 p1 2m
cross price elasticity
x1 p2
5p
0 1 p2 0
p2 x1
2m
income elasticity
x1 m
2 5 p1
m 1
m x1 5 p1 2m
x2
3p1 x1
2p2
x1
when income
when income
income
elasticiti ty
m x1
x 1 m
m x1
x1 m
positive if x 1 is a
negative if x 1 is an
TP
10
Estimates of elasticities
Ready to eat breakfast cereals
Own price,
Estimates of elasticities
Cars
Own price,
Median Estimates of
elasticities of demand for alcohol
own price
elasticity
beer
wine
spirits
Finding uncompensated
demand with
quasi-linear utility &
corner solutions
There are two goods x1 and x2, with prices p1 and p2.
u(x1,x2) = x11/2 + x2
Find her (uncompensated) demand for goods 1 and 2.
11
preferred
set
x2
budget
set
x1
u( x1 , x 2 ) V ( x1 ) x 2 .
0
x1
Any corner point on
the budget line with
MRS p1/p2
x1 0, x2 = 0
maximizes utility.
0
x1
Any corner point on
the budget line with
MRS p1/p2
x1 = 0, x2 0
maximizes utility.
x1(p1,p2,m)
u dV
0,
x1 dx1
u
1 0 so nonsatiation is satisfied.
x 2
x1 0, x2 0
u
dV
x1 dx1 dV
MRS
u
1
dx1
x 2
V ( x1 ) so
d 2V
2 x2
2 0 so convexity is satisfied.
dx1
x 21
preferred
set
x1 0, x2 0
preferred
set
x2
x2
u(x1,x2) = V(x1) + x2
implies parallel
indifference curves (note
arrows)
= p1/p2
x1
12
tangency condition
MRS = dV = p1
dx1
If V(x1) =
p2
x11/2
this is x1-1/2 = p1
2
p2
x1
If p1 p22
4m
x2
x1(p1,p2,m) = p22
p22
p12
x 2(p1,p2,m) =
4m
>
x1
p1
x2(p1,p2,m) =
x1
If p1 < p22
x1(p1,p2,m) = m
4p1
4p1
x2
m - p2
p2
m - p2
p2
4p12
p22
, x2
4 p12
m
,
p1
x2
m
p
2
p2 4 p1
if p1
if p1
p22
4m
p22
4m
If
p1
p22
4m
x1
13
p1
x1 = p22
When p1 p22
tangency solution
4p12
m has no effect
x1 = p22
4m
tangency solution
4p12
p22
x1 = m
(4m)
p1
income m has
on demand for good 1
corner solution
(4m2)/p22
p2 has no effect
x1
x1
x 2(p1,p2,m) = 3 m
p1
5 p2
x2
Income elasticity of
demand for good 1 is
1.
0
x1
dV
p1 = 0
dx1
p2
so x2 = (m - p1x1)/p2
and V(x1) + x2 = V(x1) (p1/p2)x1 + m
The consumer choses x1 to maximize this.
dx1
dV = p1
14
Substitutes &
complements
p2 x1
x 1 p 2
p 2 x1
x 1 p 2
3TP
Price of
good
p1
p 2 x1
x 1 p 2
Quantity of good
p2
p2
With quasilinea r utility if m 2 then x 1 22 .
4 p1
4 p1
Shift A to C.
x1
Finding uncompensated
demand with
perfect complements utility
100
if x2 = 100.
0
200
x1 wheels
Getty Images
15
frames
x2
x1 bicycle wheels,
x2 bicycle frames
x2
x2 = x1
if x2 < x1 increasing x1
does not change utility
preferred
set
x1
if x2 > x1 increasing x1
increases utility.
0
wheels
x1
frames
x2
A
0
wheels
x1
frames
x2
Calculus cannot be
used to check for
nonsatiation.
wheels
x1
budget line
p1x1 + p2x2 = m
utility maximization
frames
x2
x2 = x1
x1 bicycle wheels,
x2 bicycle frames
x2
x2 = x1
wheels
x1
if x2 < x1 increasing x1
does not change utility
if x2 > x1 increasing x1
increases utility.
wheels
x1
2m
(2p1 + p2)
x2 =
m
(2p1 + p2)
p1x1 + p2x2 = m.
16
p1 = m - p2
x1
x1
Finding uncompensated
demand with
perfect substitutes utility:
corner solutions again
Increase in p1 results in
Increase in p2 results in
Increase in m results in
TP
x2
u = 3x1 + 2x2
gradient 3/2
0
x1
x2(p1,p2,m)
u
u
2 0 so nonsatiation is satisfied.
3 0,
x1
x2
Getting x 2 as a function of u and x1 gives x2 (u
x 2
3/ 2
x1
3x1 )/ 2 so
p1x1 + p2x2 = m
and
MRS =
x2
0
x 21
2
convexity is satisfied.
MRS =
u
x 1
u
x 2
p1
Problem
p2
2 3 / 5 3 / 5
x1 x 2
5 3
3 2 /25 2 / 5
x1 x 2
5
It is better to use a
diagram.
2x 2
3x 1
3TP
17
x2
A
x2
x2
p1
B
B
C x1
x1
p1/p2 = 3/2
solution at
solution at
solution at
x1
(3/2)p2
(2m)/3p2
x1
Increase in p1,
movement along curve.
Finding uncompensated
demand if convexity is not
satisfied
p1
p1
(3/2)p2
(3/2)p2
(2m)/3p2
x1
(2m)/3p2
x1
Increase in m,
Increase in p1,
movement along curve.
Increase in demand.
x2
p1
See CT
Worked
Example 5.
x2
supply
p2
0
x1
p1 < p2
x1 = m/p1, x2 = 0
x1
p1 = p2
x1 = m/p1, x2 = 0
or x1 = 0, x2 = m/p2
x1
demand
m/p2
There is a jump in
the demand curve.
There may be no
price at which
supply = demand.
x1
p1 > p2
x1 = 0, x2 = m/p2
18
1.3 Expenditure
minimization and
compensated demand
Definitions of
compensated and
uncompensated
demand
x2
x1
Definition of the
expenditure function
x2
x1
and intuition
h2 (p1, p2,u)
so E(p1, p2,u)= p1h1 (p1, p2,u) + p2 h2 (p1, p2,u).
Getty Images
TP
Essential logic
Homogeneity of the
compensated demand
and expenditure functions
If k > 0
h1(kp1,kp2,u) = h1(p1,p2,u).
E(kp1,kp2,u) = k E(p1,p2,u).
x2
x1
h1(p1,p2,u) = h1(kp1,kp2,u)
h2(p1,p2,u) = h2(kp1,kp2,u).
h2(p1,p2,u) = h2(kp1,kp2,u).
effect B to C,
change in
demand due
The logic of
compensated
demand and the
expenditure function
effect A to B,
change in
demand due to
effect A to C change
in
demand due to
m/p1
m/p1
x1
3TP
(h1,h2) is by definition
the cheapest way of
getting utility u at
prices (p1, p2).
By definition
compensated demand h1(p1,p2,u), h2(p1,p2,u)
x2
(h1,h2) is by definition
the cheapest way of
getting utility u at
prices (p1, p2).
x2
(h1,h2)
slope
- p1/p2
0
x1
(h1,h2)
slope
- p1/p2
0
x1
Compensated demand
curves cannot slope
upwards:
geometric proof
x1
x2
(h1A,h2A)
slope
- p1A/p2
x1
x2
(h1A,h2A)
slope
- p1B/p2
0
x1
h1B,h2B cannot cost more than h1A,h2A at prices p1B,p2
so (h1B,h2B) cannot lie in the shaded area.
slope
Compensated demand
curves cannot slope
upwards:
algebraic proof
- p1B/p2
x2
(h1A,h2A)
slope
- p1A/p2
x1
p1Ah1A + p1Bh1B +
p1Ah1B + p1Bh1A
p1Ah1B + p1Bh1A
Compensated demand
and the expenditure
function with CobbDouglas utility
non-negativity constraints x1 0 x2 0
and the utility constraint u(x1,x2) = x12/5x23/5 u.
Worked example 4
Compensated demand
with convexity and a
differentiable utility
function.
h2(p1,p2,u)
Essential logic
utility u
x2
if there is a tangency
point such as A
MRS =
and utility is u
A
B
x1
this is compensated
demand
MRS =
u
x 1
u
x 2
2 3 / 5 3 / 5
x1 x 2
5
3 2 / 5 2 / 5
x1 x 2
5
p1
p2
2x 2
3x 1
utility u
x2
2x2 = p1
tangency condition
3x1
utility condition
p2
x12/5 x23/5 = u
x1
2p
3p
This gives x1 2 u x 2 1 u
3 p1
2 p2
h1 ( p1 , p2 , u ) h2 ( p1 , p2 , u )
using notation
3/ 5
x12/5
x23/5
=u
3/ 5
2x2 = p1
3x1
and
p2
2/5
3p
h2 ( p1 , p 2 , u ) 1
2 p2
h2 ( p1 , p2 , u ) 0.
2/5
u.
E ( p1 , p2 , u ) p1h1 ( p1 , p2 , u ) p2 h2 ( p1 , p2 , u )
Compensated demand
3/ 5
2p
h1 ( p1 , p2 , u ) 2 u
3 p1
2/5
2p
3p
h1 ( p1 , p2 , u ) 2 u
h2 ( p1 , p2 , u ) 1 u
p
3
1
2 p2
so the expenditure function is
Uncompensated demand
2m
3 m
x1 ( p1 , p2 , m)
x2 ( p1 , p2 , m)
5 p1
5 p2
2/5
3p
h2 ( p1 , p2 , u ) 1 u.
2 p2
3/ 5
2/5
2p
3p
p1 2 u p2 1 u
p
3
1
2 p2
3/ 5
2/5
2
3
p12 / 5 p23 / 5 u
3
2
Income and
substitution effects with
Cobb-Douglas utility
x2
Substitution effect
decreases
increases
Income effect
decreases
TP
m/p1
m/p1
x1
Uncompensated demand
x1 ( p1 , p2 , m)
2 m
5 p1
x2 ( p1 , p2 , m)
income effect
3 m
5 p21
Compensated demand
2p
h1 ( p1 , p2 , u ) 2
3 p1
3/ 5
3p
h2 ( p1 , p2 , u ) 1
2 p2
substitution effect
2/5
u.
Compensated demand
and the expenditure
function with perfect
complements utility
x1 bicycle wheels,
x2 bicycle frames
x2
x2 = x1
if x2 < x1 increasing x1
does not change utility
if x2 > x1 increasing x1
increases utility.
wheels
x1
min( x1,x2) = u
x2
x2 = x1
Expenditure minimization
implies that (x1,x2)
uncompensated demand
x1 ( p1 , p2 , m)
x2 = x1
h1 ( p1 , p2 , u ) 2u
x1 = x2 = u.
x1
2m
,
2 p1 p2
x2 ( p1 , p2 , m)
m
2 p1 p2
h2 ( p1 , p2 , u ) u
Income and
substitution effects with
perfect complements
utility
income effect
substitution effect
TP
x2
x2 = x1
A
C
0
m/p1
There is
The income effect
reduces demand for x1
and x2.
m/p1 x1
10
Compensated demand
and the expenditure
function with
quasilinear utility
Assume V( 0 ) 0,
dV
0
dx1
Example V ( x1 ) x11 / 2 .
d 2V
0.
dx12
Worked example 4
Compensated demand
with convexity and a
differentiable utility
function.
non-negativity constraints x1 0 x2 0
and the utility constraint u(x1,x2) = V(x1) + x2 u.
h2(p1,p2,u)
If there is a tangency
point such as A
x2
x2
utility = u
and utility is u
this is compensated
demand
B
0
this is compensated
demand
x1
x1
11
MRS =
p1
dx1
p2
x1-1/2 = p1
u
dV
x1 dx1 dV
MRS
u
1
dx1
x 2
p2
V(x1) + x2 = u
utility condition
p2
x11/2 + x2 = u
x2
x1-1/2 = p1
p2
and
x11/2 + x2 = u.
x1
p
p
This gives x1 2
x2 u 2
2 p1
2 p1
using notation
h1 ( p1 , p2 , u ) h2 ( p1 , p2 , u )
for compensated demand
p
h1 ( p1 , p2 , u ) 2
2 p1
h2 ( p1 , p2 , u ) u
p2
2 p1
p2
there a tangency solution
2u
2
p
p
h1 ( p1 , p2 , u ) 2
h2 ( p1 , p2 , u ) u 2
2 p1
2 p1
p
If p1 2 there is a corner solution,
2u
h1 ( p1 , p2 , u ) u 2
h2 ( p1 , p2 , u ) 0.
12
p2
compensated demand is
4u
p2
compensated demand is
4u
h1 ( p1 , p2 , u ) u 2 h2 ( p1 , p2 , u ) 0
If p1
p
p
h1 ( p1 , p2 , u ) 2 h2 ( p1 , p2 , u ) u 2
2
p
2
p1
1
so the expenditure function is
E ( p1 , p2 , u) p1h1 ( p1 , p2 , u ) p2 h2 ( p1 , p2 , u )
p1u 2 p2 0 p1u 2
p
p1 2 p2 u 2
2 p1
2 p1
2
p
p2 u 2
4 p1
p2
solution is a tangency
2u
such as A.
If p1
x2
p
If p1 2 solution is a corner C.
2u
A
C
0
If p1
p22
uncompensated demand,
4m
2
p
x1 ( p1 , p2 , m) 2 x2 ( p1 , p2 , m)
2 p1
If p1
m
p
2
p2 4 p1
p2
compensated demand
2u
p
h1 ( p1 , p2 , u ) 2
2 p1
h2 ( p1 , p2 , u ) u
p2
2 p1
x1
Income and
substitution effects
quasilinear utility
x2
Substitution effect A to B
B
decreases x1
A
increases x2.
Income effect B to C
x1
decreases x2.
There is no income effect
on demand for x1.
TP
m/p1
m/p1
x1
13
Quasilinear utility
Basic calculus, if V(0) = 0
then area under graph =
x1
V(x1)
p1
V(x1)
or A = V(x1).
V(x1) is the most the consumer is willing to pay for x1 units if
the alternative is having 0 units.
x1
14
Quasilinear utility
V(x1) = p1
V(x1)
p1
V(x1) = uncompensated =
compensated demand
x1
Quasilinear utility
Quasilinear utility
Consumer surplus
= V(x1) - p1x1
= max willing to pay for x1
amount paid for x1.
p1
V(x1) = uncompensated =
compensated demand
p1x1
x1
Properties of the
expenditure function
1, 2, 3
1. Increasing in utility
2. Increases or does not change when a price increases.
V(x1) - p1x1
p1
V(x1) = uncompensated =
compensated demand
x1
Increasing in utility
2.
3.
4.
Shephards lemma
5.
Concave in prices
E(p 1 ,p 2 , u )
p 1
h 1 (p 1 ,p 2 ,u )
15
Utility increases
from u1 to u2.
u1
E(p1,p2,u2)
p2
The expenditure
function increases.
u2
E(p1,p2,u1)
p2
u2
u1
0
x2
E(p1B ,p2,u2)
p2
E(p1A ,p2,u1)
p2
The expenditure
function increases.
x1
If k > 0
E(kp1,kp2,u) = k E(p1,p2,u).
The expenditure
function does not
change if demand
for good 1 is 0 at A.
0
Already explained.
x1
4. Shephards Lemma
Properties of the
expenditure function 4
Shephards Lemma
E(p 1 ,p 2 , u )
p 1
E(p 1 ,p 2 , u )
p 1
derivative of expenditure
The next
slides
explain
this.
h 1 (p 1 ,p 2 , u )
=
compensated
demand for good 1
function w.r.t. p1
gradient h1(p1A,p2,u)
h 1 (p 1 ,p 2 , u )
E(p1,p2,u)
u constant
p2 constant
p1 varies
p1A
p1
16
for all p1
New diagram
In this diagram (h1A,h2A) u and p2 do not vary, p1 varies.
for all p1
p1h1A + p2 h2A
is a straight line
with gradient h1A
E(p1A,p2,u)
p1 price
p1A
p1 price good 1
p1A
Shepards Lemma
E(p 1 ,p 2 , u )
p 1
E(p1,p2,u)
h 1 (p 1 ,p 2 , u )
E(p1A,p2,u)
p1A
p1 price
17
Properties of the
expenditure function 5
concave in prices
because the graph of the
expenditure function lies on or below
all its tangent lines.
p1
When
x1 ( p1, p2 , m)
p1
h1 ( p1, p2 , u)
x1 ( p1, p2 , m)
x1 ( p1, p2 , m)
p1
m
substitution effect
of change in price
on demand, at
constant utility
h1(p1, p2,u)
x2
income effect of
change in
income on
demand
2TP
x1
18
x2
Quasilinear utility
Uncompensated demand for good
1 does not depend on income
except at low levels of income and
x1
x2
x1
m
m
Total change
h1 ( p1 , p2 , u )
effect.
x1 ( p1 , p2 , m ) when m
E ( p1 , p2 , u )
But
p1
As h1 ( p1 , p2 , u )
h1 ( p1 , p2 , u )
p1
x1 ( p1 , p2 , m )
p1
E ( p1 , p2 , u )
x1 ( p1 , p2 , m ) E ( p1 , p2 , u )
m
p1
h1 ( p1 , p2 , u ) (Shephard' s lemma).
x1 ( p1 , p2 , m ) this implies that
x1 ( p1 , p2 , m )
p1
x1 ( p1 , p2 , m )
x1 ( p1 , p2 , m ) .
m
h1 ( p1 , p2 , u )
p1
x1 ( p1 , p2 , m )
x1 ( p1 , p2 , m ) .
m
p1 h1
h1 p1
Rearrangin g
x1 ( p1 , p2 , m )
p1
p1 x1
x1 p1
h 1
p1
p1
h1
p1
so
x1
p1
x1
x1 p
m
x1
x1
m
for EC201
x1
x1 p1
m
h1
p1
p1
x1
x1
m x1 p1 x1
x1 m m
Own price
Income
budget
of uncompensated
elasticity of
elasticity of
share
demand
compensated
uncompensate
demand
d demand
When m E ( p1 , p2 , u )
Slutsky equation
x1 ( p1 , p2 , m )
p1
h1 ( x1 , x 2 , u )
p1
x1 ( p1 , p2 , m )
x1 ( p1 , p2 , m )
m
p1
p1
m
multiply by p1 / x1
p1 x1
x1 p1
p1 / h1 because x1
p1 h1
h1 p1
h1
m x1 p1 x1
x1 m m
p1 x1
x1 p1
p1 h1
h1 p1
Sign?
m x1 p1 x1
x1 m m
Sign for a normal
good
Sign for an inferior
good
19
Price of
good
p1
Quantity of good
x1
TP
20
2. Substitution bias
3. Compensating variation
4. Compensating variation and change in consumer
surplus with quasilinear utility
5. Compensating variation (CV) and change in consumer
surplus with income effects
6. Equivalent variation (EV)
Inflation targeting
Adjusting levels of taxes, benefits, public pensions
Indexed government bonds (gilts)
Measurement of real wages
TP
1. Price Indices
Base weighted price index
Also called Laspeyres Price Index
Perloff uses CPI index to mean a base weighted index
Base weighted
price index
p2A
where w1 =
CPI & RPI are essentially base weighted indices but the
weights change over time as expenditure patterns change.
etc.
pnA
p1A x1A
not pensioners,
not top 4% income
not foreign visitors
not foreign students
CPI
Percentagechange
0.4
3.6
0.2
3.2
1.1
2.6
1.3
0.7
1.5
10.3
2.8
0.6
1.6
Food&nonalcoholicbeverages
Alcohol&tobacco
Clothing&footwear
Housing&householdservices
Furniture&householdgoods
Health
Transport
Communication
Recreation&culture
Education
Restaurants&hotels
Miscellaneousgoods&services
CPIAllItems
UnitedKingdom
CPI12monthratetoJuly2014
United Kingdom
CPI Annual Inflation, 1.6%, July 2014
Percentage change
-0.4
3.6
-0.2
3.2
1.1
2.6
1.3
0.7
1.5
10.3
2.8
-0.6
1.6
CPI inflation
Oil
CPI services
excluding VAT
Agriculture
Industrial metals
(a) Brent forward prices for delivery in 1021 days time in US dollars.
(b) Calculated using S&P (US dollar) commodity price indices.
Source:http://www.ons.gov.uk/ons/rel/family-spending/family-spending/family-spending-2011-edition/family-spending-2011-pdf.pdf
x2
2. Substitution bias
p1Bx1A + p2Bx2A
p1Ax1A + p2Ax2A
E(p1B,p2B,u)
E(p1A,p2A,u)
Fact
u1
m1/p2A
m3/p2B
m2/p2B
( x1A,x2A)
gradient
p1A/p2A
0
x1
E(p1A,p2A,u1)
= p1Ax1A + p2Ax2A = m1
x2
m3 = p1Bx1A + p2Bx2A
x2
gradient p1B/p2B
m3/p2B
m2/p2B
u1
m1/p2A
( x1A,x2A)
0
x1
proportional increase in income
needed to continue to buy (x1A,x2A)
after the price change
= base weighted price index.
m3 = p1Bx1A + p2Bx2A
m1
p1Ax1A + p2Ax2A
x2
u2
u1
m1/p2A
so the expenditure
function
m1 = p1Ax1A + p2Ax2A
gradient p1B/p2B
m3/p2B
m2/p2B
( x1A,x2A)
( x1B,x2B)
E(p1B,p2B,u1)
= p1Bx1B + p2Bx2B = m2
x1
(x1A, x2A) also gives utility u1 so costs the same or more than
than (x1B, x2B) at prices p1B, p2B
so m2 = p1Bx1B + p2Bx2B p1Bx1A + p2Bx2A = m3.
x2
gradient p1B/p2B
m3/p2B
m2/p2B
m3/p2B
m2/p2B
u2
u1
m1/p2A
gradient p1B/p2B
u2
u1
m1/p2A
( x1A,x2A)
( x1A,x2A)
gradient
( x1B,x2B)
( x1B,x2B)
x1
is greater than
m2 = p1Bx1B + p2Bx2B
m1
p1Ax1A + p2Ax2A
=
E(p1B,p2B,u1)
E(p1A,p2A,u1)
p1A/p2A
0
If prices change from (p1A,p2A) to (p1B,p2B) and income
changes from m1 to m2 utility does not change.
If prices change from (p1A,p2A) to (p1B,p2B) and income
changes from m1 to m3 utility increases.
x1
Substitution bias
If income grows at the same rate as a base weighted price
index utility either increases or stays the same.
If there is any possibility of substitution utility increases.
E ( p1B , p2 B , u A ) kE ( p1 A , p2 A , u A )
k
E ( p1 A , p2 A , u A ) E ( p1 A , p2 A , u A )
p1B x1 A p2 B x 2 A kp1 A x1 A kp 2 A x 2 A
k.
p1 A x1 A p2 A x 2 A
p1 A x1 A p2 A x 2 A
TP
www.freephoto1.com
Compensating variation
gradient p1B/p2
E(p1B,p2,uA)
p2
After the price change & compensation the consumer gets the
same level of utility by buying (x1B,x2B) so u(x1B,x2B) = uA.
CV
p2
uA
( x1A,x2A)
E(p1A,p2,uA)
gradient
p2
( x1B,x2B)
p1A/p2
x1
If y f ( x )
E(p 1 ,p 2 , u )
p 1
f(x)
dy
f ' ( x)
dx
h 1 (p 1 ,p 2 , u )
p1 B
E(p 1 ,p 2 ,u )
h 1 (p 1,p 2 , u )
p 1
p1
h1 ( p1 , p2 , u A )dp1
p1 A
= compensating variation
when p1 rises from p1A to
p1B.
p1B
p1A
implies that
compensated demand
curve h1(p1,p2,uA)
0
x1B x1A
x1
Compensating variation
and change in consumer
surplus with quasilinear
utility
Quasilinear utility
Consumer surplus
= V(x1) - p1x1
p1
= compensating variation
p1
V(x1) = uncompensated =
compensated demand
p1B
p1A
x1
V(x1) = uncompensated =
compensated demand
x1
Compensating
Variation ACDF
p1B
compensated demand
h1(p1,p2 ,uA)
p1A
x1
Fall in consumer
surplus ABDF
p1B
p1B
uncompensated demand
x1(p1,p2 ,m)
p1A
F
uncompensated demand
x1(p1,p2 ,m)
p1A
x1
x1
compensated demand
Change in Consumer Surplus is the area bounded by the
uncompensated demand curve.
h1(p1,p2 ,uA)
p1B
uncompensated demand
x1(p1,p2 ,m)
p1A
x1
Fall in consumer
surplus ABDF
compensated demand
p1B
h1(p1,p2 ,uA)
uncompensated demand
x1(p1,p2 ,m)
p1A
F
compensated demand
p1B
x1
h1(p1,p2 ,uA)
uncompensated demand
x1(p1,p2 ,m)
p1A
F
x1
Compensating
Variation ACDF
Compensating
Variation ACDF
Fall in consumer
surplus ABDF
compensated demand
p1B
h1(p1,p2 ,uA)
p1B
uncompensated demand
x1(p1,p2 ,m)
p1A
F
p1A
F
x1
x1
compensated demand
x2
EV = E(p1B,p2,uB) - E(p1A,p2,uB)
E(p1B,p2,uB)
h1(p1,p2 ,uB)
CV = E(p1B,p2,uA) - E(p1A,p2,uA)
p2
uB is the level of
utility that the
consumer gets with
prices (p1B,p2) and
income m.
compensated demand
EV
p2
p1B
h1(p1,p2 ,uA)
uncompensated demand
x1(p1,p2 ,m)
p1A
E(p1A,p2,uB)
p2
uB
gradient p1B/p2
uA
gradient p1A/p2
0
Indifference curve diagram
x1
x1
10
compensated demand
compensated demand
EV Equivalent Variation ABEF
h1(p1,p2 ,uB)
Normal good
EV
h1(p1,p2 ,uB)
ABEF
compensated demand
p1B
h1(p1,p2 ,uA)
uncompensated demand
x1(p1,p2 ,m)
p1A
F
h1(p1,p2 ,uA)
uncompensated demand
x1(p1,p2 ,m)
p1A
F
x1
ACDF
compensated demand
p1B
ABDF
CV
x1
Compensating variation,
equivalent variation
consumer surplus and
income effects
p1 x1
x1 p1
p1 h1
h1 p1
m x1 p1 x1
x1 m m
11
substitution
effect
p1 x1
x1 p1
budget
income effect
p1 h1
h1 p1
share
m x1 p1 x1
x1 m m
Income elasticity of
of uncompensated
of compensated
uncompensated
demand
demand
demand
Examples
A government wants to reduce CO2 generation to combat
global warming.
Fuel is a large share of expenditure so the income effect is
significant.
uncompensated
demand
p1
p1B
p1A
TP
TP
demand
p1
p1B
p1A
Diagram A
0
x1B x1A
p1
x1
uncompensated
demand.
p1B
p1A
Diagram B
x1B
x1A
x1
In which diagram is
demand more elastic
A or B?
In which diagram is
the fall in consumer
surplus bigger, A or
B?
demand curve
diagram
x1B x1A
x1
12
demand
p1
p1B
p1A
x1B x1A
1
p1 x1 A p1x1
2
x1
1
( p1B p1 A ) x1 A ( p1B p1 A )( x1 A x1B )
2
1
p1 x1 A p1x1
2
1 x p p
1 x1
p1 x1 A 1 1 1 1
p1 x1 A 1
2 p x
x
2
1A
1 1 A p1
1 p
x p
p1 x1 A 1 e 1 where e 1 1 0 elasticity
p
2
p1 x1 A
1 p
Fall in consumer surplus p1 x1 A 1 e 1
2 p1 A
Demand is elastic when it there is a good
1 p
p
1 ( p1 x1 A )1 e 1
p
1A
2 p1 A
p
where 1 proportionate price increase
p1 A
e
substitute available,
x1 p1 A
elasticity
p1 x1 A
price
D2
quantity
TP
TP
13
x2A
=m
x2B
= m
Tax revenue
x2
EV
Subtract these equations to get
(p1A x1A + x2A ) (p1Ax1B + x2B) - t x1B = 0.
So tax revenue = t x1B = (p1Ax1A + x2A) (p1A x1B + x2B)
Excess burden =
A
EV tax revenue
(x1B,x2B)
(x1A,x2A)
C
Cost of original bundle
(x1A,x2A) at prices
p1A , p2 = 1.
IC diagram, p2 = 1
x1
14
EV tax revenue
x2
of an excise tax is
IC utility uA
Budget constraint
with lump sum tax
R
(x1A,x2A)
EV
>R
IC utility uC
IC utility uB
x1
Budget constraint
with excise tax
p1Ax1 + p2 x2 = m R.
IC diagram, p2 = 1
x2
m
budget line
(x1C,x2C)
with subsidy
slope (p1A - s)
(x1A,x2A)
x1
IC diagram, p2 = 1
p1A x1A
x2A
=m
x2C
= m
TP
15
x2
Cost of subsidy?
Equivalent variation?
B
C
(x1C,x2C)
(x1A,x2A)
Cost of new bundle
(x1C,x2C) at prices
p1A, p2 = 1.
p1A, p2 = 1.
TP
x1
IC diagram, p2 = 1
2TP
Does compensating a
consumer for a price
increase imply that the
price increase has no
effect on demand?
16
x2
IC utility uA
budget
line after
price
change
IC utility uB
gradient
p1B
x1
TP
IC diagram, p2 = 1
11.
Benefits in Kind
budget line
x2
Benefits in kind
x2
x1
x2
x1D
IC
IC
x1D
TP
x1
IC diagram, p2 = 1
x1D
x1
TP
17
The last slides suggest that it is sometimes better and never worse
for a consumer to get a sum of money rather than a benefit in
kind costing the same amount.
So why are benefits in kind common?
The star at this month's Grammy ceremony was the $34,000 gift
bag (actually more of a suitcase), which contained an iPod, a
stereo system, clothing, holidays, a voucher for eye surgery and
a bottle of Trump fragrance for men.
Why do
governments
provide health and
education free at
the point of service?
Mother and daughter (18-21 months) giving
food basket to senior woman Getty Images
Students Across The UK Return To School For Start Of The Autumn Term
Clinical Trials Begin For New Vaccine Against Avian Influenza Getty Images
18
Notation
Assume that:
Utility u(c,n) depends only on consumption c and time outside
paid employment leisure n
endowment of time
e.g. one year = 365 x 24 = 8760 hours
n hours not in paid employment
(leisure)
T-n hours in paid employment
(work)
c consumption of composite good
P price of composite good
W hourly wage rate (that is earnings per hour)
w = W/P real wage rate
or
Pc + Wn WT
w = W/P
c + wn wT
price of c is 1, price of n is w
c + wn wT
An individual?
Does consumption = earnings each week in
A family?
reality?
When does consumption = earnings?
A group?
TP
Budget constraint: c + wn = wT
Where does the budget constraint meet
the axes?
A
c
wT
wT
wT
C
A
Substitution effect A to B
Income effect B to C
Income and substitution effects on labour supply work in
directions.
real
real
I argued using the Slutsky equation that the size of the
income effect on demand for good 1 is small when the
budget share p1x1/m is small.
Here the budget share of n (leisure) is
wn/wT = n/T leisure/total time.
Is this budget share small?
TP
wage
rate w
labour
supply
wage
labour
rate w
supply
labour
labour
Labour supply
increases when
the wage rate
rises
Labour supply
decreases when
the wage rate
rises
which is bigger
substitution effect or
income effect?
which is bigger
substitution effect or
income effect?
2TP
real wage
w*
labour
supply
The labour supply curve is backward-bending
linked decisions
whether to get paid employment
how many hours, child care?
people who are not on their labour supply schedule,
unemployment, conventional hours.
above w*.
Husbands Wives
Mean uncompensated labour supply
elasticity
0.207
0.169
Effects of Unemployment
0.844
The labour supply model tells us that the cost of
unemployment to a worker is lost consumption.
0.941
UK Taxes on income
Income Tax is paid on all income including income from
employment and income from investments.
Pc = W(T n) or Pc + Wn = WT
or c + wn = wT
c + 0.8 wn = 0.8wT
wT
c* + wn*
tax revenue = WT (Pc* + Wn*)
= P (wT (c* + wn*) )
=
P
0.8wT
= WT (Pc* + Wn*)
gradient - w
Price
The price of good 1 starts at p1A giving utility uA. Changes
The price of good 1 rises to p1B
and
Welfare
p2 does not change.
Taking away the equivalent variation, EV, without Slides
changing p1 from p1A has the same effect on utility as
increasing p1 from p1A to p1B without changing income.
wT
0.8wT
wT
budget constraint no
tax gradient - w
n
gradient - w
0
budget constraint no
tax gradient - w
n
wT
tax revenue =
c* + wn*
P
equivalent variation = P
0.8wT
0.8wT
budget constraint no
tax gradient - w
n
budget constraint no
tax gradient - w
n
wT
tax revenue =
c* + wn*
equivalent variation = P
excess burden =
equivalent variation - tax revenue
= P
0.8wT
wT
Taking
from the consumer as a
lump sum gives the
budget constraint
which gives the same tax revenue
as the income tax but is better for
the consumer.
c* + wn*
0.8wT
budget constraint no
tax gradient - w
n
budget constraint no
tax gradient - w
n
Income tax:
a more realistic model
Income 15 000
0 in bracket 3
20 000
10 000 in bracket 2
With this income tax scheme the marginal income tax rate
for someone earning 15000 is 20%.
Average income tax rate = total income tax
total income
If someone earning 15000 pays 2000 tax
the average income tax rate = 2000 = 13%
15 000
5 000
5000 in bracket 1
Income 30 000
Budget Constraint
15 000 in bracket 2
5,000
0
5000 in bracket 1
10 000 in bracket 3
20,000
slope - 2.4
5000
3760
consumption
c
The economists
diagram has the
advantage that
indifference
curves have
their usual
shape.
But non
economists
dont
understand it.
8760
indifference curves
gradient the other
way.
budget set
7510
leisure n
hours worked
income
after tax
income
after tax
earnings
earnings
effect on those
earning above e1
income
after tax
income
after tax
C
decrease in utility,
does this stop people
working in the UK?
e0
e1
earnings
0
no substitution effect
e0
e1
earnings
income
after tax
A
B
C
decrease in utility,
e0
e1
earnings
Getty Images
Ed Miliband
Labour party leader
We should look to do more from taxation.
We can take more from the banks and in
tackling tax avoidance.
Guardian
0 7,475
0 - 8,105 0 - 9,440
0 - 10,000
7,475 42,475
8,105 42,475
9,440 41,540
10,000 41,865
42,475 150,000
41,540 150,000
41,865 150,000
Additional
> 150,000
rate: 50%
> 150,000
N/A
N/A
Additional
N/A
rate: 45%
N/A
> 150,000
> 150,000
Basic
rate:
20%
Source HMRC This ignores the treatment of the personal allowance &
child benefit for high earners which are discussed later.
employees NIC
marginal rate
employers NIC
marginal rate
< 111
0%
111 - 805
12%
13.8%
> 805
2%
13.8%
From http://www.hmrc.gov.uk/rates/nic.htm
4TP
70%
I believe that it is fair that those who have gained the most
should contribute more ..
Marginal
income 60%
tax rate
50%
40%
30%
20%
10%
0%
0
Alistair Darling
Labour
Proposed policy
If income 100,000 get personal allowance
Income > 100, 000 no personal allowance
0%
2014 15
For income <
100,000
2014 15
For income >
100,000
0 - 10,000
Basic rate:
20%
10,000 - 41,865
0 - 31,865
Higher rate:
40%
41,865 - 100,000
31,865 - 150,000
N/A
> 150,000
Additional rate:
45%
Partial solution
80%
70%
Margina
60%
l
income
tax rate 50%
40%
Withdrawal of
personal
allowance @
100,000
30%
20%
10%
0%
0
Partial solution
Withdraw benefit gradually by increasing marginal tax rates
between 50,000 and 60,000
George
Osborne
Conservative
80%
50%
No children
4
3
2
1
40%
70%
Marginal
income 60%
tax rate
Withdrawal of
child benefit @
50,000
30%
20%
10%
0%
0
Benefits
5. Benefits
In the UK there are many different benefits including
200 - y
0
income after
taxes and
benefits
200
income
income after
taxes and
benefits
200
45
0
200
45
200
0
TP
200
y income before benefits
200
45
0
200
y income before benefits
Benefit as a
function of income
benefit
200
200 y
benefit with
100%
withdrawal
rate
200
400
D
C
income after
taxes and
benefits
200
45
0
200
400
IC
income after
taxes and
benefits
200
This person
moves from A
to B when the
withdrawal
rate falls.
Labour supply
increases.
200
400
E
F
200
This person
moves from E to
G when the
withdrawal rate
falls. Subst effect
EF and income
0
effect FG both
decrease labour
supply.
200
400
0.20
0.11
0.68
0.50
0.01
70%
Universal Credit
60%
50%
40%
30%
20%
10%
0%
-10%
200
400
600
800
1,000
1,200
5. Benefits
Universal Credit
Universal Credit
Income Support,
Jobseekers Allowance,
Employment and Support Allowance
Housing Benefit,
Child Tax Credit
Working Tax Credit.
Child Benefit
Council Tax Benefit
Disability Living Allowance
State Pension
Winter Fuel Allowance
Universal
credit will
replace
these
benefits.
Rushed timetable
Howard Shiplee
Director General, Universal Credit Programme
Accountable for implementing Universal Credit This
includes:
owning and communicating the vision of the
programme
1. Choices between
income streams
2014
2015
A 10,000
22,000
B 18,000
11,000
C 20,000
11,000
A 10,000
22,000
B 18,000
11,000
C 20,000
11,000
C is better than B.
If you start with A, borrow 10,000 in 2014, repay 11,000 in
2015 you get C.
With borrowing and lending at 10% A and C are
2TP
2TP
c1
2015
y0
y1
income
(y0, y1 )
c0
c1
c1
c0
Budget constraint c1 = y1 + (1 +r) (y0 c0) is a straight line with
gradient (1+r).
( y *0 , y *1 )
c1
(1+r)
B (y0, y1 )
y0 + y1
(1+r)
c0
y *1
(1 r )
y *0
(1+r)
c0
y0
y1
(1 r )
c0
TP
c0
c0
c1
(1 r )
c1
(1 r )
y0
*
0
y1
(1 r )
y *1
(1 r )
gradient - (1 + r)
Definition
c1
( y *0 , y *1 )
Which income
stream is
optimal at
interest rate r ?
gradient - (1 + r)
Which income
stream is
optimal at
interest rate r ?
pdv
(y0, y1 )
y0
c0
....
of
y 0 , y 1 , y 2 ... y t ,... y T ,
y1
(1 r )
y2
(1 r )2
is
.....
yt
yT
.....
(1 r )T
(1 r )t
TP
c0
....
c1
(1 r )
c2
(1 r )2
2.
3.
.....
ct
cT
.....
(1 r )t
(1 r )T
4.
If the alternatives are sell the chess set now or sell in 10 years
sell now if
5 million > 15 million
(1+r)10
Sell the chess set in 10 years if
5 million < 15 million
(1+r)10
You are indifferent between selling the chess set now
and selling it in 10 years if
5 million = 15 million
(1+r)10
asset.
How do you decide whether to sell it now or in 5 years?
Suppose everyone knows that the price now is 5 million
and the price in 10 years will be 15 million.
Selling the chess set now adds 5 million to
of your monetary wealth.
Selling the chess set in 10 years adds
million
of your monetary wealth.
TP
p0
d1
d2
d3
......
2
(1 r ) (1 r )
(1 r )3
dT
pT
T
(1 r )
(1 r )T
Assume preferences
satisfy the standard
assumptions of
completeness,
transitivity, continuity,
nonsatiation and
convexity so can be
represented by a
utility function
u(c0,c1).
The consumer
maximizes u(c0,c1)
subject to the budget
constraint
c0
c1
(1 r )
y0
5. Saving and
borrowing decisions
c1
consumption at A
gradient - (1 + r )
c1
(y0, y1 )
(y0, y1 )
gradient - (1 + r)
c0
c0
y1
(1 r )
gradient - (1 + r )
c1
Effects of an
interest rate cut
(y0, y1 )
0
c0
gradient - (1 + r )
c1
(y0, y1 )
Interest
rate cut
from r to r.
gradient
income effect B to C
c0
Income and substitution effects on
c0 work in the same direction.
increases c0.
- (1 + r)
gradient - (1 + r )
c1
A borrower is made better off by the rate cut; this has the
same effect as an increase in income.
decreases c0
consumption at date 0.
consumption at date 0.
- (1 + r)
c0
gradient - (1 + r )
c1
(y0, y1 )
C
B
gradient
(y0, y1 )
lower utility
B
C
gradient
- (1 + r)
c0
Income and substitution effects on
c0 work in the same direction.
gradient - (1 + r )
c1
A
(y0, y1 )
gradient
- (1 + r)
c0
7. Different borrowing
and lending rates
at
date 1
save
at date 0
at
date 1
borrow
(y0,y1 )
(y0,y1 )
at
date 1
neither borrow
nor save
(y0,y1 )
different
borrowing
and
lending
rates
at date 0
borrow at rate r,
steeper budget
line gradient 1 + r
save at rate r < r
at date 0
at date 1
at date 1
(y0,y1 )
at date 0
Budget constraint with different borrowing and
saving rates and a credit limit.
(y0,y1 )
(y0,y1 )
at date 0
2. Opportunity cost
3. Production function
4. Cost functions
5. Economies of scale
6. Returns to scale
They also have annual reports in which they set out objectives.
firm.
The simple model of the firm starts with either a production
function or a cost function.
It ignores the fact that a firm is an organisation run by people
who have individual objectives and agendas.
It ignores conflicts of interest between investors and senior
managers.
Risk taking
Risk management
loss.
The situation is greatly complicated by asymmetric
Thestandardassumptionisthatfirmsmaximize
the
1,100 million
presentdiscountedvalueV ofprofits,
850 million
t profitsatdatet
1
(1 r )
2
(1 r )
2014,
September
2014
3
(1 r )
August
......
2. Opportunity Cost
2. Opportunity Cost
Defined as the value of an input in its best alternative use.
Opportunity cost
can be impossible to measure accurately,
If you buy the capital good, used it and sold it, you would
have cash p next year
After using the capital good you can if you wish sell it for
price p. You then have p in cash.
The opportunity cost is rp where r is the interest rate.
Why?
If p = 1 the cost of capital is r.
This is why textbooks use notation r for the cost of capital
technical obsolescence
3. Production functions
3. Production functions
Marginal Products
In this part of the course we assume the firm produces one
output from two inputs, capital K and labour L.
With more maths this can be generalized to many inputs
and outputs.
Output q = f(K,L), f(K,L) is the production function.
gradient = f = MPL
L
f(K*,L)
f
K
f
L
If one input increases while the others are held constant the
fixed
0
labour L
f
With fixed K output increases as L increases MPL =
> 0.
L
MPL decreases as L increases,
.
Isoquants
K
q=3
x2
MRS = - gradient of indifference curve
q=1
q=2
L
Isoquant q = 1 shows all the combinations of inputs for
which f(K,L) = 1.
u
x1
MRS
u
x 2
x1
4. Cost functions
K
MRTS = - gradient of isoquant.
Using the same maths as consumer theory
f
MRTS L
f
K
4. Cost Functions
The cost function c(v,w,q) is the minimum cost of producing
output q using capital K and labour L with prices v and w.
This definition assumes that all inputs can be varied, later
we will call this a long run (as opposed to short run) cost
function.
A level material
Essential for EC201
negativity constraints K 0, L 0.
Write these as
Write these as
It depends on (p1,p2,u).
Checks
L= (2v/3w)3/5 q
Increasing in utility
1. Increasing in output q
2.
2. Homogeneous of degree 1 in
3.
Non-decreasing in prices.
4.
Concave in prices.
5.
Shephards lemma
From the
consumer
theory slides
E(p 1 ,p 2 , u )
p 1
h 1 (p 1 ,p 2 , u )
compensated demand
Cost
minimization at
a tangency
c(v,w,q1)/v
c(v,w,q)
v
K(v,w,q)
c(v,w,q)
w
L(v,w,q)
If q2 > q2
K
c(v,w,q2)/v
producing q2 costs
more than producing q1
so the cost function
c(v,w,q2) > c(v,w,q1)
c(v,w,q1)/v
A2
A1
A1
f(K,L) = q2
isoquants
c(v,w,q1)/w
f(K,L) = q1
L
c(v,w,q1)/v
A1
0
c(v,w,q1)/w
c(vA,w,q1)/vA
c(vB,w,q1)/vB
c(v,w,q2)/w
f(K,L) = q1
L
isoquants
c(v,w,q1)/w
f(K,L) = q1
L
f(K,L) = q1
0
c(vA,w,q1)/w
c(vB,w,q1)/w
5. Returns to scale
Returns to scale are a property of the production function.
Returns to scale
& economies of scale
6TP
m>1
If f(mK,mL) = mf(K,L) there are
returns to scale.
returns to scale.
returns to scale.
Returns to scale?
If a +b < 1, ma+b < m, so f(mK,mL) < m f(K,L)
Returns to scale?
Division of Labour
6. Economies of Scale
function.
Volume Effects
Division of labour on a
production line 1977
EMMA MAERSK
Length: 379 meters
Capacity: 11,000 containers
each weighing 14 tons
Source: Wikipedia
Getty Images
Economies of Scope
Learning by Doing
As firms build experience in
producing a product the average
cost of producing the product
falls.
Examples, silicon chips
aeroplanes
levels of output
curve
Price taking does not mean prices do not change.
8. Long run and short run costs and supply
Price taking is plausible if the firm has a small market
share.
2.
:
The shutdown & output rules
so
c(v, w, q)
is average cost, AC
q
c(v, w, q )
q
q q
then increasing output q increases profits.
R c
marginal cost
q q
then increasing output q decreases profits.
If marginal revenue
Why we
need to know
about
marginal
costs.
R c
marginal cost.
q q
But marginal revenue marginal cost
does not necessarily imply profit maximization.
marginal revenue
q
q
output rule, marginal revenue MC
Why we
need to know
about
marginal
costs.
When you have formulae for MC & ACyou must use the
formula when sketching a graph of MC & AC.
AC
c(v, w.q)
q
1 c(v, w, q )
(
q c(v, w, q ))
q
q2
1
(MC AC)
q
average cost at q1
AC
AC
When MC
AC
gradient of
marginal cost
c1
MC
gradient
0
q1
TP
3. Profit maximization by
a price taking CRS firm
K
q=3
q=2
q=1
0
L
isoquants with CRS
gradient = MC = AC
output q
c(v,w,mq) = mc(v,w,q).
Marginal cost = average cost
vary with input prices v and w but not with output
/unit
Profits = pq cq = (p c)q
c = MC = AC
c
output q
output q
output q
c(v,w,mq)
m c(v,w,q)
so AC at output mq = c(v,w,mq)
c(v,w,q) = AC output q
mq
AC
2c(v,w,q).
than 2.
with output.
0
output q
as q increases.
AC
as q increases.
MC
AC.
MC AC
everywhere
/unit
MC
p*
AC
MC
as q increases
q
Average cost is not u-shaped
AC
as
q increases
q1
output q
/unit
MC =
supply
AC
As c(q) is the derivative of c(q) = MC increasing marginal
cost implies that c(q) > 0
The second derivative (q) = c(q) < 0 so
(q) = pq c(q) is a concave function of q.
The first order conditions give a maximum.
0
q*
q
With DRS MC is increasing and MC > AC
If p = MC then p > AC so the shutdown rule is satisfied.
The MC curve is the supply curve.
output q
output q
MC < AC
everywhere
/unit
/unit
Because AC is
decreasing either
MC (decreases)
as q
AC
AC (increases)
as q
MC
p AC for large q.
MC
output q
Here p < AC for all q, a price taking firm cannot make a profit.
output q
Because AC is
decreasing either
p AC for large q.
MC
0
output q
Before R&D starts its costs are opportunity costs. If they are too
high the product is not profitable.
impossible
/unit
AC
very
important
q
R & D intensive industries with a fixed development
cost & constant marginal cost have economies of
scale at all levels of output.
total cost
function
total cost
function
output
AC falls when
MC falls when
AC rises when
MC rises when
AC has a minimum at
The chord is
TP
output
TP
MC
MC
AC
AC
min AC
p
output q
output q
q2 maximizes profits.
MC
AC
At q2 p = MC.
At q1 p = MC, this is a
local minimum of
profits.
min AC
0 q1
b q2
q2 maximizes profits.
MC
AC
min AC
output q
At q2 p = MC.
At q1 p = MC, this is a
local minimum of
profits.
0 q1
b q2
output q
MC
AC
AC
MC
p = min AC
output q
output q
production period.
Capital is fixed in the planning period & paid for in the
production period.
Labour is chosen and paid for in the production period.
If the firm knows output and input prices in the planning
period this makes no difference.
K and L are chosen to minimize total cost c(v,w,q).
isoquant
q2
K
c2/v
long run
expansion
path
c1/v
ci = LRTC of
output qi
LRTC = long run
total cost
(L2,K2)
(L1,K1)
q1
0
isocost line
gradient w/v
L
isoquant
q2
K
c2/v
long run
expansion
path
c1/v
K1
If given the choice between fruit & cake you chose fruit
the more restricted menu is no better.
isocost line
gradient w/v
q1
0
L1
K
s2/v
c2/v
With capital K1
isoquant
q2
c2 = LRTC of
output q2
isocost line
gradient w/v
at output q1
s2 = SRTC of
output q2
SRTC = short run
total cost
K1
s2 > c2
K1
q1
q1
0
L2
q0
q2
LRTC = SRTC.
long run
expansion At other outputs
path
LRTC < SRTC.
short run
expansion path
isoquant
L
10
c( v, w, q )
c( v, w, q )
q
c( v, w, q )
q
s( v, w, K *, q )
s ( v, w, K *, q )
q
s ( v, w, K *, q )
SRTC depend on
v,w,K*,q
so
SRAC w q 3 / 2 K* - 3 / 2 vK*q 1
SRMC w(5 / 2) q 3 / 2 K* - 3 / 2
Short run average and marginal costs depend on output.
11
SRTC
LRTC
Marginal cost is the gradient
of the total cost curve.
At q* SRTC and LRTC are
tangent so have the same
gradient.
q*
2/5
so
(2 / 3) 3 / 5 ]
SRMC
/unit
LR & SR MC
& AC with this
CobbDouglas
production
function.
SRAC is u-shaped
LRAC = LRMC
q*
minimizes SRAC
At all values of q
SRAC LRAC
5/ 2
K*
-3 / 2
vK*
SRVC w q 5 / 2 K* -3 / 2
Short run average variable cost
SRAVC SRVC/q w q 3 / 2 K* -3 / 2 0
so SRAVC is increasing in q so SRMC SRAVC
12
SRMC
/unit
SRMC
SR supply
so LRMC = LRAC.
SRAC
q*
Here SRMC > SRAVC for all q so short run supply is SRMC.
LRMC LR supply
p0
0
q*
13
SRTC
gradient
= SRMC
= LRMC
LRTC
0
q*
q
At q* the fixed level of capital K* is at the cost minimizing level
and LRTC = SRTC so LRAC = SRAC.
SRMC
SRAC
/unit
p
p*
LRAC
LRS
It makes economic
profits because K is
not an opportunity
cost in the short run.
LRAC
LRMC
SRAVC
p0
SRMC = SR supply
q*
q* output q
/unit
SRAC
SRMC
LRTC
SRTC
LRAC
gradient = LRMC = LRAC
p0
=SRMC =SRAC
0
q0
SRAVC
LRMC
q0
14
LRS
LRAC
p0
SRMC = SR supply
0
output q
Fix K = K* so q = min(3K*, L)
isoquant
q
3K*
L 3K* q = 3K*
Fixed proportion
production function
output
q = min(3K,L)
long run
expansion path
K = L/3
isocost line
L < 3K*
q=L
0
0
Output as a function of L with K =
function q = min(3K, L).
3K*
K*
15
isoquant q *= 3K*
K
Fixed proportion
production function
output
q = min(3K,L)
SRTC = wq + vK*
gradient w
long run
expansion
path
short run
expansion path
K*
LRTC = (w + v/3)q
gradient (w + v/3)
vK*
0
q*
In the SR with K fixed at K* the firm cannot produce more than 3K*.
SRAC = w + vK*/q
/unit
LRAC = LRMC
w + v/3
w
= w + v/3
SRMC = w = SRAVC
q*
SRS
SRMC = w
LRS
w + v/3
w
q*
16
Heathrow:
17
9. Monopoly
10. Cartels
nothing a firm does affects the prices it gets for output and
pays for inputs.
Withentry
andexit
Shortrun
Long runsupplycurves
Longrun
output.
See Industrial
Organization Worked
Example 1, Perfect
Competition
Marketswitha
fixednumberof
pricetaking
firms
Distinction between
longandshortrun
supply
Averysimple
modelofentry
andexit
Note
Price taking does not imply that prices do not change.
Price taking does imply that an individual buyer or seller
cannot do anything to change prices.
p = MC follows from
p = AC, follows from
Profit maximization implies firms minimize
p1
p1
q1
firm
Q1
industry
Shift in supply
Increase in demand
S1
s
p1
D2
p1
0
(
, Q from Q1 to
CRS
q1
0
industry
firm
Increase in input prices
Q1
MC.
Special
Case 1
0
Q2
Q1
s1
D1
0 q1
p1
p1
from p1 to
, Q
from q1 to
from Q1 to .
.
industry
supply
demand
MC = AC = c
q
the firms
supply
firm
0
When p = c the firm makes the same profits
(0) at any q. The firms output is not
determined.
Q
industry
future.
There is no simple formula.
Organization
Worked
Example 1,
Perfect
Competition
D
0
q
firm
Q1
industry
SRATC = w + vK*/q
SRS
Costs and
supply for a
firm
LRMC c =
LRS
LRAC = w + v/3
SRMC s = w
q*
firm SRS
firm SRS
Industry SRS
Industry SRS
p2
p2
Firm
LRS
c
s
Industry
LRS
c
s
Firm
LRS
c
s
Industry
LRS
c
s
D1
0
q*
firm
D2
Q*
industry
q*
firm
Q* Q2
industry
In the SR, price rises to p2, industry quantity Q* & firm quantity
q* do not change.
SRS1 SRS2
firm SRS
Industry SRS
p2
p2
Firm
LRS
c
s
Industry
LRS
c
s
c
s
Firm
LRS
p3
Industry
LRS
c
s
D2
0
firm SRS
TP
q*
firm
Q* Q2
D3
Q
industry
q*
firm
Q*
industry
In the SR, price falls to p3, industry quantity Q* & firm quantity
q* do not change.
firm SRS
Industry
SRS3 SRS
SRS1
Firm
LRS
c
s
firm SRS
Industry
LRS
c
s
Industry SRS
Firm
LRS
c
s
Industry
LRS
c
s
D3
0
q*
firm
Q3 Q*
D4
0
industry
q*
firm
SR, price s, Q = Q4
Industry SRS
firm SRS
LR price = c, Q = Q5
Q5 Q4 Q*
industry
pB
Firm
LRS
c
s
Industry
LRS
pA
DB
DA
0
q*
firm
0
industry
Q*
Q
Uncertain
demand
firm SRS
Industry SRS
Firm
LRS
c
s
Uncertain
supply
pB
Industry
LRS
pG
D
0
q*
firm
QB Q*QG
industry
/unit
SRAC
SRMC
LRAC
SRAVC
LRMC
q0
From the
firms, &
costs slides
LRAC
srs
SRS1
p1
p1
LRS
D1
q1
Q1
supply.
industry
firm
srs
LRAC
p2
p2
p1
p1
D2
LRS
q1 q2
firm
LRAC
p1
p1
D1
srs
SRS1
Q1
Q2 Q
industry
D2
SRS1
SRS2
LRS
D1
q1 q2
firm
Q1
Q3
industry
Fracking
Extracts gas
Profitable at current gas
prices
Starting fracking increases supply
Gas prices drop. How fast and how far?
Decision: will a well be profitable when the price falls?
firms with higher quality inputs have lower costs and higher
profits.
Economic Rent
In the simplest case all the extra profits that firms have with
high quality inputs that cant be traded go into the price of
these inputs.
Onshore
supply
Offshore
supply
Industry supply
c2
c2
c1
c1
Q1 Q2
Q1
Q1 + Q2
c2
Solve for S =D
c1
accurate diagram
c2
p
c1
Solve for S =D
accurate diagram
or find Q at p = c1 & p = c2
0
Q1
or find Q at p = c1 & p = c2
Q1 + Q2
Supply = demand
Q1
Q1 + Q2
Supply = demand
0 < Q < Q1 p = c 1
Q = Q1 c 1 < p < c 2
c2
c1
Q1
Q1 + Q2
p1
p1
supply
supply
demand
0
Q1
Q0
demand
0
Q1
Q0
CS (consumer surplus)
10
Allocation mechanisms
Administrative
Sale with a price determined by the government
Auction
Rent seeking
Activities aimed at capturing rents
Public relations
Lobbying politicians
Corruption
Crime
7. Welfare economics of
a tax with supply and
demand
11
p1
q1
p1
p1
0
q1
firm
Total revenue = p1q1 =
Producer surplus
Q1
industry
firms get p t.
c+t
c
S with tax
c+t
s no tax
price p
c+t
s with tax
supply
S no tax
demand
demand
q
firm
Q1
Q2
industry
Q2
Q1
Firms make
0 profits with
and without
tax.
12
c+t
supply
demand
Q1
= t (Q1 Q2)
1
Deadweight loss tQ
2
(the is because Q Q2
Q1 0 )
Q p pQ
pQ
tQ
e
e
Q
p
Q
p
p
p
Q p
where e elasticity
so with downward sloping
p Q
demand curves elasticity is negative.
t
1 tQ 1
1
Deadweight loss tQ te (e)(tQ)
2
2 p 2
p
t
1 tQ 1
Deadweight loss te (e)(tQ)
2 p 2
p
tQ tax revenue,
t / p proportion ate increase in price
deadweight loss
tax revenue
1
- elasticity proportion ate increase in price
Implication
It is better to raise tax revenue by taxing goods whose
demand is inelastic.
But this ignores distribution.
If the good is a large proportion of the consumption of
poor people and you want to take this into account this
argument is too simple.
The analysis can be extended to take explicit account of
distributional value judgements, but has to be done with
maths not diagrams.
Not in this course.
= t Q2
p
p-t
13
S with tax
S with tax
p2
S no tax
p1
D
p2 - t
0
q2
q1
firm
Q2 Q1
industry
industry
diagram
S no tax
p2
p1
p2 - t
Q2
Q1
tax revenue
consumer surplus =
producer surplus =
Statutory incidence
p2
p1
p2 - t
Economic incidence
S with tax
supply with tax
p
p2
p2
S no tax
p1
p2 - t
p1
p2 - t
D
supply and
demand are
elastic,
deadweight loss
is a large fraction
of tax revenue
Q2 Q1
Q2 Q1
14
S with tax
p
S no tax
p2
p1
p2 - t
D
Q2 Q1
The UK debate on
alcohol:
tax or minimum price
Liam Donaldson:
UK Chief Medical Officer (1998 2010)
arguing for a minimum price per unit alcohol
UK debate on alcohol
15
Median Estimates of
elasticities
own price
elasticity
5TP
beer
- 0.46
wine
- 0.69
spirits
- 0.80
price p
price p
p1
p1
supply
supply
demand
Q2
Q1
demand
Q2
Q1
Duty
28.22
18.74
24.03
273.31
Source: http://www.hmrc.gov.uk/
16
Is this a
sensible tax
regime?
http://www.ifs.org.uk/publications/6645
07
Average
purchase
change
%
0
-1
-2
-3
-4
-5
-6
-7
-8
-9
-10
Minimum
unit price
Tax reform
http://www.ifs.org.uk/publications/6645
Modelling issues
Imperfect competition: supermarkets are not price
takers.
Take model to data.
8. Welfare economics of a
subsidy with supply and
demand
17
Supply &
demand
with a
subsidy
price
simple
welfare
economics
of a subsidy
= cost of subsidy
gain from subsidy
price
supply no
subsidy
p2 + s
p1
supply with
subsidy
p2
p2 + s
p1
supply with
subsidy
p2
demand from
consumers
Q1
Q2
demand from
consumers
Q1
simple
welfare
economics
of a subsidy
Q2
= cost of subsidy
loss of surplus
price
Simple argument: the cost of subsidy exceeds the benefit to
farmers and consumers.
s
p2 + s
p1
p2
demand
Q1Q2
18
simple
welfare
economics
of a subsidy
With completely
inelastic supply all
the gain in surplus
goes to producers.
price
There is no
increase in quantity
or consumer
surplus There is no
deadweight loss
p1 + s
p1
demand
Q1
It is being reduced.
9. Monopoly
19
9. Monopoly
Up to now I have assumed that firms are price takers.
They are small relative to the market so their output
decisions have no effect on prices.
Now look at industries with one firm (monopoly)
Later look at industries with a small number of firms
(oligopoly).
See Industrial
Organization Worked
Example 2, Monopoly
R
p
q p
p q
)
p (1
q
p q
q
1
p (1 )
e
p q
where e
own price elasticity of demand.
q p
e 0 because demand is downward sloping
1
so marginal revenue MR p (1 ) p price
e
MR
20
the algebra
A firm is a monopoly when there is no other firm producing
the same good.
With CRS the firms total cost is cQ where c = MC = AC.
If price = a bQ profits pQ cQ = (p c)Q
= (a bQ c) Q = (a c)Q bQ2.
If a c profits are negative for all Q > 0, the firm produces 0.
Exam mistake
doing this analysis for
a perfectly
competitive industry
demand a bQ
c
MR = a 2bQ
0
Qm
a/2b
a/b Q
If a c profits < 0 for all Q > 0 the firm does not produce.
Price p = a bQ = a - (a c) = (a + c) = c + (a c) > c
21
/unit
At Qm = (a c)/b MR = MC and
price pm = a + c > c + F/q = AC.
Price and quantity are the same as
in the CRS case but profits are
/unit
(a c)2 /(4b) - F 0.
pm
pa
demand
MR
AC = c + F/q
MC = c
Qm a/2b
c
MR
QC
a/b
Comparing monopoly
and perfect competition
there is a deadweight
loss due to monopoly.
But if there are fixed
costs perfect
competition is
impossible.
/unit
pm
Qm
MC = c
AC = c + F/q
Qa a/2b
a/b
10. Cartels
Consumer surplus
10. Cartels
Suppose that there are n firms in an industry that have a cartel
agreement to maximize industry profits.
Suppose firm i has costs cqi + F.
Assume F > 0 so there are economies of scale.
Cartels
Industry profits = (a bQ - c)Q nF
= (a c) Q bQ2 nF.
If a c the industry cannot make profits.
the formula for profits is the same as with monopoly except the
fixed cost is nF not F.
22
Cartels
If Q > 0 maximizes profits Q = (a c) /b
price p = (a + c),
p and Q are the same as with a monopoly but
cartel profits (a c)2 /(4b) - nF
23
/ unit
/ unit
area = v(q)
c'(q)
v'(q)
demand curve
total
cost
q
Compared to perfect competition there is no loss of
surplus, but all the consumer surplus now goes to the
monopolist.
Make the price per unit vary with the amount purchased.
e.g, Quantity discounts, 2 for 1 offers
connection charge + price per unit (electricity)
24
ECONOMISTMAGAZINE
weekly
cost
5.00
%ofcover
price
100
126
2.42
48
155
3.00
60
MRi
Multimarket price discrimination maximizes
total revenue total cost
Ri
p
q pi
pi qi i pi (1 i
)
qi
qi
pi qi
pi (1
1
) ( ei elasiticty in market so i so ei 0) so
ei
1
) MC
ei
1
pi
is increasing in ei .
MC (1 1 )
ei
The mark up over marginal cost is higher when - ei is close to 1.
Intuition when demand is inelastic increasing price reduces
demand by less.
25
7. Multiple equilibria
8. Simultaneous (normal form) and sequential move
(extensive form) games
9. Stackelberg equilibrium
Firm 2
large
Firm
1
small
large
16, 16
20, 15
small
15,
18, 18
20
2. Prisoners' dilemma
Eyster
confess
Prisoners' dilemma
Bray
not
confess
confess
16, 16
20, 15
not
confess
15,
18, 18
20
Cournot-Nash
equilibrium
Industrial Organization
Worked Example 3
q = (a c - bs )/2b.
Solving simultaneously
a 2bq1 bq2 = c
a 2bq2 bq1 = c
gives q1 = (a c)/3b q2 = (a c)/3b
in which case a bq2 c = a bq1 c = 2/3 (a c) > 0 if a > c.
firm 1s
reaction
function
starting with
a bq2
q2
a c b 2b
q2
.
2b
This gives the same result as solving 0
for q1 and q2 from the first order conditions
but the algebra is harder.
Cournot
equilibrium
q1
firm 2s
reaction
function
firm 1s reaction
function
Cournot-Nash
equilibrium
firm 1s
reaction to
cartel output
q2
0
cartel
output
q1
firm 2s
reaction
function
4. Nash Equilibrium
q1 = 2 - 3p1 + 3p2,
Class 9
q2 = 6 - 2p2 + p1.
Bertrand or Cournot?
Which model is appropriate depends on the real world
situation you are trying to understand.
The result that price setting gives the same result as
perfect competition does not hold if
the goods the firms produce are not perfect
substitutes
or firms commit to quantity (capacity) before they
set prices.
firm output q
(a c)
(n 1 )b
n(a c)
(n 1 )b
n(a c)
(a c )
a bQ a
c
(n 1 )
( n 1)
industry output Q
nq
price p
(a c)2
(n 1 )2 b
I will come back to this when I have a model of entry.
park
legally
park
illegally
patrol
- 5,
-10
15, - 100
not patrol
0,
- 10
0,
TP
= -10w - 10(1 w)
The drivers expected payoff from illegal parking
Multiple equilibria
7. Multiple equilibria
Lessons from Game Theory 4
PC
Mac
2,
0,
PC
0,
1,
biologist
fight if there
is entry
potential
entrant
= firm
deciding
whether
to enter
not fight if
there is entry
not enter
0,
0,
enter
-1 ,
1,
Simultaneous and
sequential move games
Nash equilibrium?
not
(a, b)
(0, 9)
enter
stage 1
potential
entrant
chooses
game tree
enter
stage 2
incumbent
chooses
fight
(-1, 0)
not
(1, 1)
fight
If the potential entrant does not enter the incumbent has no choice
to make. Potential entrant gets 0, incumbent 9.
If the potential entrant enters at stage 1 what does the incumbent
do at stage 2?
What does the potential entrant do at stage 1?
9. Stackelberg equilibrium
Stackelberg equilibrium
(a c bq1 )
a c
and q1
2b
2b
(a c)
a 3c
price p a b( q1 q2 )
4b
4 4
As q2
(a c bq1 )
2b
At stage 1 the leader chooses q1 taking into
q2
q2
( p c ) q1 ( a c b( q1 q2 ) ) q1
a c bq1
a c b q1
2b
1
1
q1 ( a c ) bq1 q1
2
2
a c
which are maximized by setting q1
at stage 1.
2b
(a c)
undetermined
b
n firm
CournotNash
c + (a c) (a c)
(n+1) (n+1)b
2 firm
CournotNash
c + (a c) (a c)
3
3b
c + (a c) leader
4
(a c)
2b
follower
(a c)
4b
3(a c)
4b
leader
(a c)2
8b
follower
(a c)2
16b
3(a c)2
16b
monopoly
c + (a c) (a c)
2
2b
(a c)
2b
(a c)2
4b
(a c)2
4b
Comparisons
Price and industry profits are highest in monopoly and lowest
with perfect competition.
n2
Market Share %
Operating System
Android
iOS (Apple)
BlackBerry
Symbian
Windows
Linux
Others
Q2 2011
Q2 2012
Q2 2013
46.9
68.1
79.3
18.8
16.9
13.2
11.5
4.8
2.9
16.9
4.4
0.2
2.3
3.5
3.7
2.3
0.8
0.5
0.1
10
Eyster
confess
Bray
Repeated games
not
confess
11. Repeated
games
confess
16, 16
20, 15
prisoners'
not
confess
15,
18, 18
dilemma
20
11