18/09/2017

EC204
Economics 2

University of Warwick
Department of Economics
2017-2018

Part 1: Microeconomics

Welcome!!

 Term 1: Professor Elizabeth Jones

− Microeconomics
− Social Sciences S2.120
− [email protected]
 Term 2: Jennifer Smith
− Macroeconomics
− Social Sciences S0.79
− [email protected]

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Welcome!!

 EC204
− Follows on from EC107
− Some of you may have done EC106
− Some of you may have done neither
− Assumes mathematical skills from EC120
or equivalent
 Don't panic about the maths
− It combines a graphical, mathematical and
intuitive approach

Resources
 The Microeconomics Syllabus
 The website
 Lectures
 Class and Class Tutors
 Textbooks
 Online resources
 HowCloud Forum

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Organisation
 20 x 1 hour lectures (term 1)
− Wednesday 12 – 1pm in L3
− Thursday 3 – 4pm in OC0.03
 20 x 1 hour lectures (term 2)
− Monday 1 – 2pm in L3
− Thursday 2 – 3pm in L3
 16 x 1 hour classes (weeks 3-10 and 17-24)
− You may NOT switch to another group
without the permission of the UG office
− Your class tutor does NOT have permission to
allow you to switch groups

Assessment
 Essay (one micro and one macro)
− Each essay is worth 10%
− 2000 word limit and online submission
− Further details will be made available by
week 6 for the microeconomics essay
 Exam (worth 80%)
− Format is the same as last year (note a
new lecturer for macro
− Short and long answer questions
− Past papers are available online

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Module Aims
 Develop analysis which combines
mathematical, graphical and intuitive skills
 Teach theoretical concepts and analytical
tools
 Understand how theoretical concepts can be
applied to various economic situations
 Develop critical analysis skills and an ability
to question rational economic thought
 Understand the policy implications of
microeconomic theory

Microeconomics Textbooks
 'Intermediate Microeconomics' by Varian, (WW
Norton, 8th edition)

− The main text (the classic 2nd year

book)
 'Intermediate Microeconomics' by Nicholson,
Snyder, Luke and Wood (Cengage, 1st European Edition)
− Some nice examples
 'Microeconomic Theory’ by Snyder (Cengage 11th
edition)

− More technical

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Topics

 Consumer Theory
 Choice under uncertainty
 Competition, Firm Behaviour and Oligopoly
 General Equilibrium
 Market Failure

Final thoughts
 I don’t like reciting textbooks in lectures…
 Some say the course moves too quickly,
others say it moves too slowly!
 Some say there's too much maths, others
say there's not enough maths!
 Some say it's too difficult, others say it's too
easy!
 You are a heterogeneous group
− Please make use of all the resources
− There are resources to suit everyone

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EC204: Topic 1

Consumer Theory
Varian Chapters 1 – 10 and 14

11

Consumer Theory

 Utility and preferences

 Budget Constraints
 Optimisation
 Changes in welfare
 Applications

12

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What you already know…

 Given 2 bundles of goods, X and Y
− Is X ≻ Y? Is Y ≻ X? Is X ∽ Y?
 What assumptions are made to give rationality
and to allow us to define a utility function?
 A utility function U(...) represents ≽ if
− for all X, Y: X ≽ Y ↔ U(X) ≽ U(Y)

 With 2 goods and bundles consisting of these

goods, we use indifference curves to represent
the preferences 13

/ /
, =

14

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Ranking consumption bundles

- What does monotonicity tell
us?

- What does convexity tell us

if the person is indifferent
between A and B?

- Indifference curves can

never cross. Which
assumption would this
violate?

Trousers
15

Budget constraints(V2)
 For a given income and given prices, we can
construct a budget constraint.
Number
of skirts
20
B The bundle of skirts and
tops that lies on AB is
the set of bundles that
leaves the consumer
C with no unspent
10
income. This is the
D
6 'budget constraint'.

A
16
5 7 10 Number of tops

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The optimum consumption point

DVDs
Point e gives utility
f maximisation, where the
slope of the budget line =
slope of indifference curve.
e It yields a higher level of
utility than points f and g.

Books 17

One side: Utility Functions

 A utility function assigns numbers to points.
For a function to represent someone's tastes,
higher numbers must be assigned to more
preferred bundles, which are composed of
multiple goods.
 The types of goods in the bundle will
determine the utility function.
 Perfect Substitutes
 Perfect Complements
 Cobb-Douglas preferences 18

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Perfect Substitutes
Consider two goods that a consumer cannot tell apart – like
Coke and Pepsi
Pepsi Indifference curves for perfect
substitutes are linear – with the
same MRS at every bundle.

What matters for a

consumer's happiness?

How can we represent

these preferences?
Coke

19

Perfect Complements
Two goods that must be consumed together.

The indifference map for perfect

Packs
of complements consists of L-
sugar
shaped indifference curves.

- What is the MRS?

- What matters for a

consumer's happiness?

- How can we represent

Glasses these preferences?
of iced 20
tea

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Cobb-Douglas
U(x1, x2) = x1γ x2δ Where γ > 0 and δ > 0.

Perfect complements and perfect

substitutes are extremes, but
Y

they allow us to compare

indifference maps with relatively
more or relatively less
substitutability.

Cobb-Douglas
 We can transform a C-D utility function without
changing the shape of the indifference curves
 Consider u(x1, x2) = x1γ x2δ
 Take to the power 1
( γ + δ )

 u(x1, x2) = (x1γ x2δ )1/(γ + δ) >> x1γ/(γ + δ) x2δ /(γ + δ)

 If α = γ/(γ + δ) >> x1α x21 - α

 When the exponents sum to 1, we can use
u(x1, x2) = x1α x21 - α
22

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Cobb-Douglas
U(x1, x2) = x1αx21-α where 0 < α < 1

How do we calculate
the MRS?

23

Monotonic transformation
 Applying monotonic transformations to a utility
function creates a new function with the same
preferences
− Transforms a set of numbers into another set,
while preserving the order
 Consider a utility function , ,…, .
Some examples of monotonic transformations:
log( , ,…, ) exp , ,…,
, ,…, + ( ( , ,…, ))
, ,…, n , ,…,
24

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Utility Functions
 Consider U(x1, x2) = x12x22
− We can find optimal quantity demanded if we
know Y and P.

 Now consider V(x1, x2) = x14x24

− V(x1, x2) = x14x24 = (x12x22)2 = (U(x1, x2))2
− So, the indifference curves defined by
U(x1, x2) = k and V(x1, x2) = j
are the same shape: We simply re-label j = k2

 >> We can’t work back from optimal demand 25

quantities to find the exact utility function

The other side: Budget constraints

 The budget line is given by:

− p1x1 + p2x2 = M or = −
 The slope of the budget line is:
- p1/p2
 Budgets with n goods can be represented by:
− p1x1 + p2x2 + … + pnxn= M

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Utility Maximisation
 Say last unit of X1 gives 3 times as much utility as last
unit of X2, yet X1 only costs twice as much as X2.
 Increase utility by consuming more X1 and less X2.
 This causes MUX1 ↓ and MUX2 ↑ until: =

 For N goods therefore

…….
= = = =
…….

 If we know U, Pi and Y, we have N equations and N

unknowns and can solve for the unknowns: Xi*
(demand for each good as a function of prices) 27

The optimum consumption point

X2
Tangency occurs when
M/PX2 the slope of the budget
line equals the slope of
the indifference curve.

e
Px1 MUx1
=
Px 2 MUx 2

M/PX1 X1
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Optimising mathematically:
The Primal
 In trying to do the best she can given her
circumstances, a consumer
− Chooses a bundle (x1, x2)
 To maximise utility u(x1, x2)
− Subject to the budget constraint

 For the typical 2-good consumer problem, this

is written formally as

Max u(x1, x2) subject to p1x1 + p2x2 = Y

x1, x2
29

An example

 My tastes are represented by:

− u(x1, x2) = x10.5 x20.5.
− P1 = 20; P2 = 10 and Y = 200.
 Solve for x1 and x2.
 Three approaches
− The equi-marginal principle
− The Lagrange
− Convert into an unconstrained optimisation
30

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An example continued
 What are x1 and x2 if my tastes are given by:
− u(x1, x2) = x12x22.
− P1 = 20; P2 = 10 and Y = 200.
 Or:
− u(x1, x2) = x14x24.
− P1 = 20; P2 = 10 and Y = 200.

>> We can’t work backwards from optimal

demand quantities to find the exact utility
function 31

Corner Solutions
If optimal choice involves
Food
consuming both goods, the
tangency condition must hold.

At A, the tangency condition

doesn’t hold as MRS < ⁄ for
all x.

With diminishing MRS, the slopes

will never be equal

Clothes The consumer optimises at A

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Non-convexity
A tangency is necessary for
Food
optimality, but not sufficient unless
preferences are convex.

Points A, B and C are all interior

tangencies.

Only A and B are optimal

Clothes

Revealed Preferences
Assume optimising consumer chooses (X1, X2)
over (Y1, Y2)
P1X1 + P2X2 = M and P1Y1 + P2Y2 ≤ M
X2
>> P1X1 + P2X2 ≥ P1Y1 + P2Y2

If this inequality is satisfied and

X1, X2 (X1, X2) is a different bundle
from (Y1, Y2) then:

(X1, X2) is directly revealed

Y1, Y2
preferred: (X1, X2) ≻ (Y1, Y2) 34
X1

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WARP and SARP

If (X1, X2) is preferred to (Y1, Y2), then (Y1, Y2)
cannot be preferred to (X1, X2)

At prices (P1, P2), say (X1, X2) is bought when

(Y1, Y2) is affordable.
So if (Y1, Y2) is purchased at prices (Q1, Q2), it
must be the case that (X1, X2) is unaffordable.
P1X1 + P2X2 ≥ P1Y1 + P2Y2
And NOT
Q1Y1 + Q2Y2 ≥ Q1X1 + Q2X2 35

Other indifference maps(V4 and 6)

To be covered in class questions

 Useless goods
 'Bad' goods
 Satiation
 Essential goods

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Homothetic tastes

 A situation where the consumer’s preferences

depend solely on the ratio of good 1 to good 2
 Homothetic tastes give rise to indifference
maps where is MRS is constant along any ray
from the origin.
, ≻ ,
, ≻ ,
 When income rises, demand rises by the
same proportion 37

Homothetic tastes
 Tastes for which the MRS depends only on the
relative quantity of each good in the bundle

Since the relative

quantity of each good
remains constant along
any ray from the origin,
homothetic tastes give
rise to indifference maps
for which the MRS
remains constant along
any ray from the origin.
Trousers 38

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Quasilinear tastes
 Indifference curves are vertically shifted
versions of one indifference curve
 Tastes are linear in one good (x2), but may not
be linear in the other good (x1).

∂ u /∂ x1 dv
U(x1, x2) = v(x1) + x2 >> MRS = = dx1
∂ u / ∂ x2

E.g. U(x1, x2) = x10.5 + x2 >> MRS = - 0.5 X1-0.5

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− The MRS is a function of x1, but not x2

Coke and all other consumption

• At A, MRS = -1: we
will trade $1 for 1 can
of coke.
• At B, will we value the
50th can the same as
the 25th?
• More likely that the 25th
can is valued the same
regardless of how
much in other
consumption we
undertake

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Changing the optimum consumption

point (V6 and V8)
 Income Offer and Engel Curves
 Price Offer and Demand Curves
 What happens to the budget line as
− (a) income changes?
− (b) price changes?
 What will then happen to the optimal
consumption point in each case?

Normal Goods
Units of good Y

(a)

O
Units of good X

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Units of good Y
Inferior Goods

O Units of good X

Good Y The Engel Curve

Income-consumption
curve

Good X
Income (£)

Engel curve

Good X

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(b) The effect of a price change

• Two effects make up the movement from the

original to the new consumption point
• Substitution effect
• Income effect

The Dual

 To find what consumers actually do (i.e. to find

the initial bundle), we use utility maximisation
− Maximise utility s.t. a fixed budget constraint
 To find the substitution effect, we can use
expenditure minimisation
− Minimise expenditure s.t. a fixed utility level
 To find the income effect we revert to utility
maximisation
− Maximise utility s.t. a fixed budget constraint 46

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Calculating the effects

 Say, tastes are: u(x1, x2) = x10.5x20.5
 P1 = 20; P2 = 10 and Y = 200. P1 falls to 10.
 Maximise utility s.t. a budget constraint

 Solve for:
 Utility at original consumption bundle is:
47

The substitution effect

 The change in demand resulting from the change
in opportunity costs with no change in real income
 We find the change in income needed to keep
satisfaction or utility constant
 This effect is known as the Hicksian Substitution
effect and yields the Hicksian or Compensated
Demand curve
 We keep utility constant (which is why we needed
to find utility at original bundle)
48

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Hicksian Substitution Effect

x2
Px1 ↓

X2’

BL2
X2’’

X1’ X1’’ BL1 x1

The substitution effect

 What is the least costly way of achieving the
original level of utility, following a fall in price?
 The smallest possible expenditure is the
compensated budget.
− Tastes are: u(x1, x2) = x10.5x20.5
− P2 = 10 and Y = 200. P1 is now 10.

Min (exp.) = 10x1 + 10x2 subject to x10.5x20.5 = 7.071

50

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Calculating the substitution effect

Min (exp.) = 10x1 + 10x2 subject to x10.5x20.5 = 7.071

Substitution effect: x1 increases by 2.071 51

The income effect

 The change in behaviour arising from a pure
change in income.
 Maximise utility s.t. a new budget constraint

 Solve for:

52

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Connecting the results

 In both cases, Ps and M are given and we choose
optimal
 The solutions to the primal and dual must be
consistent with each other
 Utility maximisation yields the Marshallian demands
− This gives the indirect utility function: it maps prices
and income to maximal utility
∗ ∗
= , , = , , , , ,
 Expenditure minimisation yields Hicksian demands
− It maps prices and utility into minimal expenditure:
∗ ∗
= , , = , , + , , 53

Connecting the results

Look at the symmetry

= +λ −

= + λ( − )

Constraint in primal becomes objective in dual

= , = , ( , )
= , = ( , , )

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Compensated and Uncompensated Demand

 We previously derived the Marshallian demand curve
(or uncompensated or own-price demand curve):
− As Px falls, consumer moves to a higher IC; real
income rises, while nominal income is held constant
− This curve accounts for both the income and
substitution effects
 The compensated or Hicksian demand
− As Px falls, hold real income (or utility) constant;
consumer is ‘compensated’ and force to remain on
same IC
− The curve accounts for only the substitution effect
 How do these curves vary with the type of good?
55

Slutsky
 The Slutsky substitution effect keeps purchasing
power (not utility) constant
 We find the change in income needed to make
the original bundle affordable after the price
change
 This gives us the Slutsky Demand curve

 Both substitution effects work in the same

direction, but can lead to different amounts of
'compensation' 56

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Slutsky Substitution Effect

x2

X2’

BL2

X1’ BL1 x1

Slutsky Substitution
 Use previous example to compare Slutsky:
 We know original bundle is x1 = 5; x2 = 10
 How much money does consumer need to buy
(5, 10) at new P1?
 This requires us to find how by much income
must change
M = P1 x1 + P2 x 2
M ' = P1' x1 + P2 x 2
M ' − M = P1 ' x1 − P1 x1 = x1 ∆ P1 = 5.(10 − 20) = −50 58

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Calculating the effects

 So new income after price change must be
£50 lower than original income to enable
consumer to buy original bundle at new prices:
M = 150.
L = x10 .5 x 20 .5 + λ (1 5 0 − 1 0 x1 − 1 0 x 2 )

 Using x1 = M / ( P1 + P2 )
x1 = 7 .5; x 2 = 7 .5

Slutsky Substitution effect: x1 increases by 2.5 59

Slutsky Identity
Total effect is
Substitution : ∆ x1s = x1 ( P1' , m ' ) − x1 (P1 , m )
Income : ∆ x1n = x1 ( P1' , m ) − x1 (P1' , m ' )
Total : ∆ x1 = [ x1 (P1' , m ) − x1 ( P1 , m )] = ∆ x1s + ∆ x1n
To express as rates of change, define ∆ x 1m as −∆x1n
>>> ∆x1 = ∆x1s − ∆x1m
Divide each side by ∆ P1
∆ x1 ∆ x 1s ∆ x 1m
= −
∆ P1 ∆ P1 ∆ P1
60

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Slutsky Identity
Recall from substitution effect: ∆M = x1∆P1
∆M
∆ P1 =
x1
Replace denominator in term 3 of Slutsky:
∆ x1 ∆ x 1s ∆ x 1m
= − x1
∆ P1 ∆ P1 ∆ M
1. Rate of change of x 1 following change in P 1 , holding M
fixed (total effect)
2. Rate of change in x 1 as P 1 changes, adjusting M to keep
old bundle affordable (substitution effect)
3. Rate of change of x1, holding prices fixed and adjusting M61
(income effect)

Hicksian versus Slutsky substitution

The Hicksian
substitution effect in
green and the Slutsky
substitution effect in
red.

62

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A comparison: Normal
goods
DM = Marshallian or
own price demand
curve

DH = Hicksian
Demand Curve
(keeps utility constant)

DS = Slutsky Demand
Curve (keep
purchasing power
constant)

Changes in welfare(V14)

 When prices change, we can measure the

change in welfare by finding:
− The change in consumer surplus
− The compensating variation
− The equivalent variation

64

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Compensating variation
 You are already familiar with this idea
 How much money would the government have to
give the consumer after the price change to
make him just as well off as he was before the
price change?
− How much extra income is needed to
compensate for the price change?
− How far should we shift the new budget line so
that it is just tangential to the original
indifference curve?
65

Equivalent Variation

 How much money would have to be taken

away from the consumer before the price
change to leave him as well off as he would be
after the price change?
− What is the maximum amount you are willing
to pay to avoid the price change?
− How far must we shift the original budget
line so that it is just tangential to the new
indifference curve?
66

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Compensating Variation

p1= p1’ p2 is fixed.

x2 p1= p1”
m1 = p'1x'1 + p 2x'2
"'
x 2
= p"1x"1 + p 2x"2
"
x 2
m2 = p1"x1'" + p2 x '"
2
x'2
u1 CV = m2 - m1.
u2

x"1 x'"
1 x'1 x1 67

Equivalent Variation
p1= p1’ p2 is fixed.
x2 p1= p1”
m1 = p'1x'1 + p 2x'2
= p"1x"1 + p 2x"2
x"2
m2 = p'1x'" '"
1 + p 2x 2
x'2
x "' u1
2
u2 EV = m1 - m2.

x"1 x'"
1 x'1 x1 68

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Applications

 You've seen the way in which we use

indifference analysis to consider labour
markets and the decision to work more or less
 You've also applied it to the intertemporal
model, by analysing the choice between
consumption today or tomorrow
 We now consider a couple of other uses

69

Government policy
What's the best option?
A subsidy on good x1 or a
direct income subsidy?
Which gives the individual a
higher level of utility?

What about a quantity tax on

good x1 versus a lump-sum
income tax?

70

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Winter Fuel Payments

 After introducing VAT on gas/electricity, prices
rose regardless of income
− Many pensioners are on low incomes and so
reduced their consumption >> poor health
 Winter fuel payments introduced to maintain
heating consumption at pre-tax levels
− Idea was that cost to government would be
0, as extra revenues from fuel tax would fund
it.
 What happened? Did consumption increase
71
back to its original level?

Winter Fuel Payments

x1 is pre-tax consumption. Tax (T)
pivots budget line to B2. Assuming
that £T are rebated, new budget line
is B3. Consumption rises to x3.
Why is x3 greater than x2?
Why is x3 less than x1?
Does the government's plan work?

72

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Self-study questions
 Identify the assumptions we make in consumer theory.
 Explain the equi-marginal principle in words and algebra.
 Draw an indifference map showing (a) perfect substitutes
(b) perfect complements and (c) Cobb-Douglas
preferences.
 What is the difference between quasilinear and
homothetic tastes?
 Are tastes for (a) perfect substitutes (b) perfect
complements (i) homothetic and (ii) quasilinear?
 How would you draw an indifference map for an
individual whose consumption of good x2 (measured on
the vertical axis) is non-essential? 73

Self-study questions
 If you hold a voucher that gives you 50% off the first 6
units of a good (that is normally £20) and your income is
£200, what will your budget constraint look like?
 What happens if the voucher gives you 50% off all units
after the first 6 units are bought?
 What will be the budget constraint if income = £200, P1 =
20 and P2 = 10?
 Explain the difference between utility maximisation and
expenditure minimisation.
 What is the difference between the Slutsky and Hicksian
substitution effect? Illustrate both the Slutsky and
Hicksian substitution and income effects on a diagram.
74

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Self-study questions
 What is meant by a compensated demand curve? Show
how a compensated and uncompensated demand curve
can be derived.
 What is the difference between compensating and
equivalent variation? Which will generally give you the
biggest result?
 Why, under quasilinear preferences, will the change in
consumer surplus, compensating and equivalent
variation all give the same change in welfare?
 Illustrate the income and substitution effects following an
increase in income tax on an individual's decision to work
more or less.
 In the Winter Fuel Payments case explain the income 75
and substitution effects.

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