ECC2000/ECC5900/BEX5900 S2/2021 Intermediate Microeconomics

Recap Calculating Demand Uncertainty
ECC2000/ECC5900/BEX5900 S2/2021
Intermediate Microeconomics
Lecture 3
August 10th, 2021
1/36
Lecture 2: Finding the Optimal Bundle
• Two equations:
MUA p
= A (1)
MUB pB
A · pA + B · pB = I (2)
• Alternative interpretation
MUA p MUA MUB

= A =⇒ =
MUB pB pA pB
2/36
Calculating Demand: Example 1
• Consider a consumer with income of Y = 80 whose utility

1 1
function is U (A, B ) = A 2 B 2 .
• The price of an apple is PA = 4 and the price of a banana
is PB = 2.
• How should this consumer allocate her income over apples
and bananas in order to maximize her utility?
• The constrained maximization problem:
1 1
maxA 2 B 2
s.t. 4A + 2B = 80
3/36
1 1
maxA 2 B 2
s.t. 4A + 2B = 80
• There are at least three mothods to solve this constrained

maximization problem with equality constraint.
• Method 0: transfer it to an unconstrained maximization
problem
• Method 1: MRS = price ratio
• Method 2: the Lagrange multiplier method
4/36
Calculating Demand: Method 0

1 1
maxA 2 B 2
s.t. 4A + 2B = 80
• Method 0: transfer to unconstrained maximization

Solve B as a function of A: 2B = 80 − 4A =⇒ B = 40 − 2A
1 1
Plug it into the objective question: max A 2 (40 − 2A) 2
1
n 1 o
∂ A 2 (40 − 2A) 2
The first order condition: =0
∂A
1 1 1 1 1 1
=⇒ A− 2 (40 − 2A) 2 + A 2 (40 − 2A)− 2 (−2) = 0
2 2
=⇒ (40 − 2A) − 2A = 0 =⇒ A = 10 =⇒ B = 20
5/36

• Method 1
MUA p
= A (3)
MUB pB
A · pA + B · pB = I (4)
1 − 21 12
MUA 2A B B P 4
= = = A = =2
MUB 1 2 − 12
1
A PB 2
2A B
=⇒B = 2A
Substitute it into the budget constraint: 4A + 2 × 2A = 80
=⇒8A = 80 =⇒ A = 10 =⇒ B = 20
6/36

• Method 2 — Lagrange multiplier
max U (x1 , x2 ) s.t. P1 x1 + P2 x2 = Y
• Step 1: The Lagrangian is:
L = U (x1 , x2 ) + λ (Y − P1 x1 − P2 x2 )
• Step 2: The first order conditions are:

∂L
(1) = MU1 − λP1 = 0
∂x1
∂L
(2) = MU2 − λP2 = 0
∂x2
∂L
(3) = Y − P1 x1 − P2 x2 = 0
∂λ
7/36

• Method 2 — Lagrange multiplier
max U (x1 , x2 ) s.t. P1 x1 + P2 x2 = Y
L = U (x1 , x2 ) + λ (Y − P1 x1 − P2 x2 )
• Step 3: Solving the first two first order conditions for λ:

MU1
MU1 = λP1 ⇒ λ =
P1
MU2
MU2 = λP2 ⇒ λ =
P2
• Step 4: Equating the expressions for λ:
MU1 MU2 MU1 P
= or = 1
P1 P2 MU2 P2
• Step 5: Together with the third condition (the budge
constraint), we can solve for x1 , x2
8/36

1 1
maxA 2 B 2
s.t. 4A + 2B = 80

1 1
L = A 2 B 2 + λ (80 − 4A − 2B )

∂L 1 1 1
(1) = A− 2 B 2 − 4λ = 0
∂A 2
∂L 1 1 1
(2) = A 2 B − 2 − 2λ = 0
∂B 2
∂L
(3) = 80 − 4A − 2B = 0
∂λ
9/36

1 1
• Step 1: The Lagrangian is: L = A 2 B 2 + λ (80 − 4A − 2B )
∂L 1 1 1
(1) = A− 2 B 2 − 4λ = 0
∂A 2
∂L 1 1 1
(2) = A 2 B − 2 − 2λ = 0
∂B 2
∂L
(3) = 80 − 4A − 2B = 0
∂λ
1 −1 1 1 1 1
A 2 B 2 = 4λ ⇒ λ = A− 2 B 2
2 8
1 1 −1 1 1 1
A 2 B 2 = 2λ ⇒ λ = A 2 B − 2
2 4
1 −1 1 1 1 1
A 2 B 2 = A 2 B − 2 =⇒ B = 2A
8 4
• Step 5: Substitute it into the budget constraint
4A + 2 × 2A = 80 =⇒ 8A = 80 =⇒ A = 10 =⇒ B = 20
10/36

• We might want to solve for demands at any prices and
income.
• Suppose that a consumer buys 2 goods: x1 and x2 . Her
utility function is U (x1 , x2 ) = ln (x1 ) + 2 ln (x2 ).
• For a more general version of the budget line, let the prices
of the two goods be P1 and P2 , and let the consumer’s
income be Y .
max ln (x1 ) + 2 ln (x2 )

s.t. P1 x1 + P2 x2 = Y
11/36

max ln (x1 ) + 2 ln (x2 )

s.t. P1 x1 + P2 x2 = Y

L = ln (x1 ) + 2 ln (x2 ) + λ (Y − P1 x1 − P2 x2 )

∂L 1
(1) = − λP1 = 0
∂x1 x1
∂L 2
(2) = − λP2 = 0
∂x2 x2
∂L
(3) = Y − P1 x1 − P2 x2 = 0
∂λ
12/36

• Step 1: The Lagrangian:
L = ln (x1 ) + 2 ln (x2 ) + λ (Y − P1 x1 − P2 x2 )
∂L 1
(1) = − λP1 = 0
∂x1 x1
∂L 2
(2) = − λP2 = 0
∂x2 x2
∂L
(3) = Y − P1 x1 − P2 x2 = 0
∂λ
1 1
= λP1 ⇒ λ =
x1 P1 x1
2 2
= λP2 ⇒ λ =
x2 P2 x2
1 2 2P1
= =⇒ x2 = x
P1 x1 P2 x2 P2 1
13/36

max ln (x1 ) + 2 ln (x2 )

s.t. P1 x1 + P2 x2 = Y

1 2 2P1
P1 x1 = P2 x2 =⇒ x2 = P2 x1
2P1
P1 x1 + P2 · x = Y =⇒ 3P1 x1 = Y
P2 1
Y
=⇒ x1 =
3P1
2P1 Y 2Y
=⇒ x2 = · =
P2 3P1 3P2
14/36

• We can then use these demand functions to draw the
consumer demand.
P
Y
x1 = 3P1
2Y
x2 = 3P2
x1 x2
x
15/36

• We can then use these demand functions to draw the
consumer demand.
P
Y
x1 = 3P1
2Y
x2 = 3P2
x1 x2
x
15/36

• Use these demand functions to calculate elasticities.
• The price elasticity of demand for good x1
∂x1 P1
ε1 =
∂P1 x1

1 −2 P1
= − YP1 Y
3 3P
1
1 Y 3P12
=− = −1
3 P12 Y
• The income elasticity of demand for good x1
∂x1 Y
εI =
∂Y x1

1 Y
= Y
=1
3P1 3P
1
16/36
Calculating
• Demand: Example 3
√
max x1 + x2
s.t. P1 x1 + P2 x2 = Y
• Step 1: The Lagrangian:
√
L = x1 + x2 + λ (Y − P1 x1 − P2 x2 )
∂L 1 −1
(1) = x1 2 − λP1 = 0
∂x1 2
∂L
(2) = 1 − λP2 = 0
∂x2
∂L
(3) = Y − P1 x1 − P2 x2 = 0
∂λ
1 − 12 1
x = λP1 ⇒ λ = √
2 1 2P1 x1
1
1 = λP2 ⇒ λ =
P2 17/36

√
max x1 + x2
s.t. P1 x1 + P2 x2 = Y

2
P2

1√ 1 P2
2P1 x1
= P2 =⇒ x1 = 2P1 = 4P22
1
P22 Y P
P1 · + P2 x2 = Y =⇒ x2 = − 2
4P12 P2 4P1
18/36
Example 3: Demand Function

• The demand function
P
Y P2
x2 = P2 − 4P1
x2 (Y = 10, P1 = 1)
x20 (Y = 14, P1 = 1)
x20 (Y = 10, P1 = 2)
x
19/36

P
Y P2
x2 = P2 − 4P1
x2 (Y = 10, P1 = 1)
x20 (Y = 14, P1 = 1)
x20 (Y = 10, P1 = 2)
x
19/36

P
Y P2
x2 = P2 − 4P1
x2 (Y = 10, P1 = 1)
x20 (Y = 14, P1 = 1)
x20 (Y = 10, P1 = 2)
x
19/36
Example 3: Engel Curve

• The Engel Curve tracks the consumption of a Good as an
individual’s income changes.
Y
x2 (P1 inferior
= 1, P2 = 1)
normal
20/36

Y
x2 (P1 inferior
= 1, P2 = 1)
normal
20/36

Y
x2 (P1 inferior
= 1, P2 = 1)
normal
20/36

Y
x2 (P1 inferior
= 1, P2 = 1)
normal
20/36
Why bother?
• We may not be able to transfer it to an unconstrained
maximization problem.
1 1
τ1 = , τ2 =
5 (1 + exp (−p1 )) 10 (1 + exp (−p2 ))
p1 (1 + τ1 ) x1 + p2 (1 + τ2 ) x2 = Y
• Method 1 (MRS=price ratio) only applies to linear budget

constraint.
• Many economic models involve non-linear budget
constraints
• Method 1 is not applicable when there are more than one
constraint.
• There may be two or more budget constraints
• There may be non-negativity or non-positivity constraint
21/36
Calculating Demand — Watch Out!

• Perfect substitutes
U (x1 , x2 ) = ax1 + bx2
• Perfect complements
U (x1 , x2 ) = min {ax1 , bx2 }
• and more...
U (x1 , x2 ) = max {ax1 , bx2 }
U (x1 , x2 , x3 , x4 ) = min {x1 + x2 , x3 + x4 }
U (x1 , x2 , x3 , x4 ) = min {x1 , x2 } + min {x3 , x4 }
U (x1 , x2 , x3 , x4 ) = min {x1 , x2 } + max {x3 , x4 }
U (x1 , x2 , x3 , x4 ) = max {min {x1 , x2 } , min {x3 , x4 }}
22/36
Uncertainty and Expected Value

• A coin toss bet
• A situation involving uncertainty with n possible outcomes
{x1 , ..., xn } and associated probability {p1 , ..., pn }.
• The expected value is.
n
EV = ∑ pi xi
i =1
• Consider tossing a 6-sided dice and winning the amount

shown on the face of the dice.
• What is the expected value of this game?
Outcome 1 2 3 4 5 6
1 1 1 1 1 1
Probability 6 6 6 6 6 6
23/36
Expected Utility
• The expected utility is.
n
EU = ∑ pi · u (xi )
i =1
• Expected utility differs from expected value because of

diminishing marginal utility of wealth.
• Solving problems involving uncertainty typically just
involves comparing the expected utility (NOT expected
value) that the consumer will receive from various options.
• In this example,
√
• Assume your utility is U (C ) = C and starts with $100.
• Your expected utility of not participating is:
• Your expected utility of participating is:
24/36
Example: A Risk Investment
• An individual with $200, 000 of wealth has an opportunity

to undertake a risky investment for $50, 000.
• With probability p, the investment is successful and the
investor doubles the money she put in.
• With probability 1 − p the investment is not successful and
the investor loses all the money she put in.
• Suppose √that her utility function over her wealth is
U (W ) = W . What is the lowest success probability p for
which she should make the investment?
25/36
Example: A Risk Investment

• Utility of not making the investment
√
Uout (200, 000) = 200, 000 = 447
• Expected utility of making the investment

√ √
Uin = p 150, 000 + 100, 000 + (1 − p ) 150, 000
√ √
= p 250, 000 + (1 − p ) 150, 000
= 500p + 387 (1 − p )
= 387 + 113p
• To invest if
Uin ≥= Uout (200, 000)
=⇒387 + 113p ≥ 447
=⇒113p ≥ 60
=⇒p ≥ 0.53
26/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Aversion
Utility
U (W )
140
120
105
EU
Wealth Utility
70
$10 70
$26 105
$40 120
$70 140
CE EW
0 10 26 40 70 Wealth
Risk Premium
27/36
Risk Averse, U (EW ) > EU (W ), or CE < EW

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
0 W1 CE EW W2 Wealth
Risk Premium
28/36

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
Risk Premium
28/36

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
Risk Premium
28/36

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
Risk Premium
28/36

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
Risk Premium
28/36

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
Risk Premium
28/36

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
Risk Premium
28/36

Utility
U (W )
U (W2 )
U (EW )
EU
U (W1 )
Risk Premium
28/36
Risk Neutral, U (EW ) = EU (W ), or CE = EW
Utility
U (W2 )
U (EW ) = EU (gamble )
U (W1 )
W1 CE=EW W2 Wealth
29/36
Utility
U (W2 )
U (W1 )
W1 CE=EW W2 Wealth
29/36
Utility
U (W2 )
U (W1 )
W1 CE=EW W2 Wealth
29/36
Utility
U (W2 )
U (W1 )
W1 CE=EW W2 Wealth
29/36
Risk Loving, U (EW ) < EU (W ), or CE > EW
Utility
U (W2 )
EU (gamble )
U (EW )
U (W1 )
W1 EW CE W2 Wealth
30/36
Utility
U (W2 )
EU (gamble )
U (EW )
U (W1 )
W1 EW CE W2 Wealth
30/36
Utility
U (W2 )
EU (gamble )
U (EW )
U (W1 )
W1 EW CE W2 Wealth
30/36
Utility
U (W2 )
EU (gamble )
U (EW )
U (W1 )
W1 EW CE W2 Wealth
30/36
Utility
U (W2 )
EU (gamble )
U (EW )
U (W1 )
W1 EW CE W2 Wealth
30/36
Utility
U (W2 )
EU (gamble )
U (EW )
U (W1 )
W1 EW CE W2 Wealth
30/36
Utility
U (W2 )
EU (gamble )
U (EW )
U (W1 )
W1 EW CE W2 Wealth
30/36
Risk Aversion and Insurance
• Why insurance companies operate?

• Consumers are willing to accept a lower expected wealth in
order to avoid uncertainty.
√
• Consider a consumer with utility function U (W ) = W .
She faces the following uncertainty.
Wealth Probability
$144 2/3
$225 1/3
• What is the highest premium P that she would be willing to
pay?
31/36
Idiosyncratic and Systemic Risk
• Insurance basically allows the holder to transfer risk to the

insurance company.
• Why would an insurance company agree to do this?
• idiosyncratic risks vs systemic risks.
• Investment strategy.
32/36
Lottery
• Why do people still buy lotteries?
33/36
Lottery
Utility
Risk Averse
Risk Loving
W0 Wealth
33/36
Lottery
Utility
Risk Averse
Risk Loving
W0 Wealth
33/36
Lottery
Utility
Risk Averse
Risk Loving
W0 Wealth
33/36
Lottery
Utility
Risk Averse
Risk Loving
W0 Wealth
33/36
Lottery
Utility
Risk Averse
Risk Loving
W0 Wealth
33/36
Prospect Theory
Programs Outcomes of 600 people
A 200 people will be saved

1
B 3 chance 600 saved, 32 chance nobody saved
34/36
Prospect Theory
Programs Outcomes of 600 people
A 200 people will be saved

1
B 3 chance 600 saved, 32 chance nobody saved
C 400 people will die

1
D 3 chance nobody die, 23 chance 600 die
34/36
Prospect Theory
Value
100 Outcome
Loss- 100 Gain+
We feel the gain of

$100 < loss of $100
Reference point
35/36
Prospect Theory
Value
100 Outcome
Loss- 100 Gain+
We feel the gain of

$100 < loss of $100
Reference point
35/36
Prospect Theory
Value
100 Outcome
Loss- 100 Gain+
We feel the gain of

$100 < loss of $100
Reference point
35/36
Prospect Theory
Value
100 Outcome
Loss- 100 Gain+
We feel the gain of

$100 < loss of $100
Reference point
35/36
Prospect Theory
• The prospect theory:

• Kahneman, D., & Tversky, A. (1979). Prospect theory: An
analysis of decision under risk. Econometrica, 47, 263-291.
• Kahneman, D. (2011). Thinking, fast and slow. London:
Allen Lane.
• Next lecture: Producer Theory
36/36

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Recap Calculating Demand Uncertainty

August 10th, 2021

Lecture 2: Finding the Optimal Bundle

MUA p MUA MUB

Calculating Demand: Example 1

• Consider a consumer with income of Y = 80 whose utility

Calculating Demand: Example 1

• The constrained maximization problem:

• There are at least three mothods to solve this constrained

Calculating Demand: Method 0

• Method 0: transfer to unconstrained maximization

Calculating Demand: Method 1

Substitute it into the budget constraint: 4A + 2 × 2A = 80

Calculating Demand: Method 2

max U (x1 , x2 ) s.t. P1 x1 + P2 x2 = Y

• Step 1: The Lagrangian is:

• Step 2: The first order conditions are:

Calculating Demand: Example 1

• Step 3: Solving the first two first order conditions for λ:

Calculating Demand: Example 1

• Method 2: the Lagrange multiplier method

• Step 2: The first order conditions are:

• Method 2: the Lagrange multiplier method

Calculating Demand: Example 2

max ln (x1 ) + 2 ln (x2 )

Calculating Demand: Example 2

max ln (x1 ) + 2 ln (x2 )

• Method 2: the Lagrange multiplier method

• Step 2: The first order conditions are:

Calculating Demand: Example 2

Calculating Demand: Example 2

max ln (x1 ) + 2 ln (x2 )

• Method 2: the Lagrange multiplier method

Calculating Demand: Example 2

Calculating Demand: Example 2

Calculating Demand: Example 2

• The income elasticity of demand for good x1

Calculating Demand: Example 3

• The constrained maximization problem:

• Step 4: Equating the expressions for λ:

Example 3: Demand Function

Example 3: Demand Function

Example 3: Demand Function

Example 3: Engel Curve

Example 3: Engel Curve

Example 3: Engel Curve

Example 3: Engel Curve

• Method 1 (MRS=price ratio) only applies to linear budget

Calculating Demand — Watch Out!

Uncertainty and Expected Value

• Consider tossing a 6-sided dice and winning the amount

• Expected utility differs from expected value because of

Example: A Risk Investment

• An individual with $200, 000 of wealth has an opportunity

Example: A Risk Investment

• Expected utility of making the investment

Risk Averse, U (EW ) > EU (W ), or CE < EW

Risk Averse, U (EW ) > EU (W ), or CE < EW

Risk Averse, U (EW ) > EU (W ), or CE < EW