Economic Choice Modeling

CHAPTER 1 – THE PRINCIPLES AND PRACTICE OF ECONOMICS

An economic agent is an individual or a group that makes choices. For example, a consumer chooses to eat bacon
cheeseburgers or tofu burgers. A parent chooses to enroll her children in public school or private school. A student
chooses to attend his classes or to skip them. A citizen chooses whether or not to vote, and if so, which candidate to
support. A worker chooses to do her job or pretend to work while texting. A criminal chooses to hotwire cars or
mug little old ladies. A business leader chooses to open a new factory in Chile or in China.
The second important concept to understand is that economics studies the allocation of scarce resources. Scarce
resources are things that people want, where the quantity that people want (if the resources were being given away for
free) exceeds the quantity that is available.

We are now ready to define economics precisely.

Economics is the study of how agents choose to allocate scarce resources and how those choices affect society.
Understanding people’s choices is practically useful for two key reasons. Economic analysis
1. Describes what people actually do (positive economics): Positive economics is analysis that generates objective
descriptions or predictions, which can be verified with data.
2. Recommends what people, including society, ought to do (normative economics): Normative economics is
analysis that recommends what an individual or society ought to do.
The first application is descriptive, and the second is advisory.

There is one other distinction that you need to know to understand the scope of economics. Economics can be divided
into two broad fields of study, though many economists do a bit of both. Microeconomics is the study of how
individuals, households, firms, and governments make choices, and how those choices affect prices, the allocation of
resources, and the well-being of other agents.
Macroeconomics is the study of the economy as a whole. Macroeconomists study economywide phenomena, like the
growth rate of a country’s total economic output, the inflation rate, or the unemployment rate.

Economists emphasize three key concepts:

 Optimization means picking the best feasible option, given whatever (limited) information, knowledge,
experience, and training the economic agent has. Economists believe that economic agents try to optimize but
sometimes make mistakes.
All optimization problems involve trade-offs. Trade-offs arise when some benefits must be given up in order
to gain others. Economists use budget constraints to describe trade-offs. A budget constraint is the set of
things that a person can choose to do (or buy) without breaking her budget.

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 We are now ready to introduce another critical tool in the optimization toolbox: opportunity cost. Evaluating
trade-offs can be difficult, because so many options are under consideration. Economists tend to focus on the
best alternative activity. We refer to this best alternative activity as the opportunity cost. This is what an
optimizer is effectively giving up when she allocates an hour of her time. Recall your own best alternative to
surfing the Web. That’s your opportunity cost of time online.
Let’s use opportunity cost to solve an optimization problem. Specifically, we want to compare a set of feasible
alternatives and pick the best one. We call this process cost-benefit analysis. Cost-benefit analysis is a
calculation that identifies the best option by summing benefits and subtracting costs, with both benefits and
costs denominated in a common unit of measurement, like dollars. Cost-benefit analysis is used to identify the
alternative that has the greatest net benefit, which is the sum of the benefits of choosing an alternative minus
the sum of the costs of choosing that alternative.
 Equilibrium is the special situation in which everyone is simultaneously optimizing, so nobody would
benefit personally by changing his or her own behavior, given the choices of others.
 Empiricism is analysis that uses data—evidence-based analysis. Economists use data to develop theories, to
test theories, to evaluate the success of different government policies, and to determine what is causing things
to happen in the world.

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CHAPTER 2 - ECONOMIC METHODS AND ECONOMIC QUESTIONS
Empiricism—using data to analyze the world—is at the heart of all scientific analysis. The scientific method is the
name for the ongoing process that economists, other social scientists, and natural scientists use to:
1. Develop models of the world: A model is a simplified description of reality. Sometimes economists will refer
to a model as a theory. These terms are usually used interchangeably. When conducting empirical analyses,
economists refer to a model’s predictions as hypotheses. Whenever such hypotheses are contradicted by the
available data, economists return to the drawing board and try to come up with a better model that
yields new hypotheses.
2. Evaluate those models by testing them with data.

The mean (or average) is the sum of all the different values divided by the number of values.
The median value is calculated by ordering the numbers from least to greatest and then finding the value half-way
through the list.
Causation occurs when one thing directly affects another. Scientists refer to a changing factor or characteristic, like
the temperature of water in a tea kettle, as a variable. Scientists say that causation occurs when one variable (for
instance, the volume of natural gas burning on a stovetop) causes another variable (the temperature of water in a tea
kettle) to change.
Correlation means that two variables tend to change at the same time. Correlations are divided into three categories:
positive correlation, negative correlation, and zero correlation.
 Positive correlation implies that two variables tend to move in the same direction;
 Negative correlation implies that the two variables tend to move in opposite directions;
 When two variables are not related, we say that they have a zero correlation.
There are two main reasons we should not jump to the conclusion that a correlation between two variables implies a
particular causal relationship:
1. Omitted variables: An omitted variable is something that has been left out of a study that, if included,
would explain why two variables are correlated.
2. Reverse causality: Reverse causality occurs when we mix up the direction of cause and effect.

One method of determining cause and effect is to run an experiment—a controlled method of investigating
causal relationships among variables.
Randomization is the assignment of subjects by chance, rather than by choice, to a treatment group or a control
group.
A natural experiment is an empirical study in which some process—out of the control of the experimenter—has
assigned subjects to control and treatment groups in a random or nearly random way.

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CHAPTER 3 – OPTIMIZATION
Economists use optimization to predict most of the choices that people, households, businesses, and governments
make.
Do People Really Optimize? There is even a branch of economics that specializes in studying this question. Behavioral
economics explains why people optimize in some situations and fail to optimize in others. Behavioral economists
model this range of behavior by combining economic and psychological theories of human decision making.

Economists call the best feasible choice the optimum, which you can see labeled on the total cost curve. To sum up
our discussion so far, optimization using total value has three steps:
1. Translate all costs and benefits into common units, like dollars per month.
2. Calculate the total net benefit of each alternative.
3. Pick the alternative with the highest net benefit.

Optimization using marginal analysis is often faster to implement than optimization using total value, because
optimization using marginal analysis focuses only on the ways that alternatives differ.
Economists use the word marginal to indicate a difference between alternatives, usually a difference that represents
one “step” or “unit” more. The fifth day of vacation is the difference, or margin, between a 4-day vacation and
a 5-day vacation. A cost-benefit calculation that focuses on the difference between one feasible alternative and the
next feasible alternative is called marginal analysis. Marginal analysis compares the consequences—costs and benefits—
of doing one step more of something. Thinking back to our apartment example, marginal analysis can be used to study
the costs and benefits of moving one apartment farther away from the city center. In general, marginal cost is the
extra cost generated by moving from one feasible alternative to the next feasible alternative.

The Principle of Optimization at the Margin states that an optimal feasible alternative has the property that moving
to it makes you better off and moving away from it makes you worse off.
To sum up, marginal analysis has three steps:
1. Translate all costs and benefits into common units, like dollars per month.
2. Calculate the marginal consequences of moving between alternatives.
3. Apply the Principle of Optimization at the Margin by choosing the best alternative with the property that moving
to it makes you better off and moving away from it makes you worse off. Marginal analysis—in other words, the three
steps outlined above—can be used to solve any optimization problem.

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CHAPTER 4 – DEMAND, SUPPLY AND EQUILIBRIUM
A market is a group of economic agents who are trading a good or service plus the rules and arrangements for
trading. If all sellers and all buyers face the same price, that price is referred to as the market price. In a perfectly
competitive market, (1) sellers all sell an identical good or service, and (2) any individual buyer or any
individual seller isn’t powerful enough on his or her own to affect the market price. This implies that buyers and
sellers are all pricetakers (A price-taker is a buyer or seller who accepts the market price— buyers can’t bargain for a
lower price, and sellers can’t bargain for a higher price). In other words, they accept the market price and can’t
bargain for a better price. Very few, if any, markets are perfectly competitive. But economists try to understand such
markets anyway.
In order to understand the properties of markets that are perfectly competitive (identical goods and market
participants who can’t influence the market price on their own) we’ll ask three questions:
1. How do buyers behave?
2. How do sellers behave?
3. How does the behavior of buyers and sellers jointly determine the market price and the quantity of
goods transacted?

BUYERS BEHAVIOR – THE DEMAND

We want to study the relationship between the price of a good and the amount of the good that buyers are willing
to purchase. At a given price, the amount of the good or service that buyers are willing to purchase is called the
quantity demanded.
A demand schedule is a table that reports the quantity demanded at different prices, holding all else equal. (Holding
all else equal implies that everything else in the economy is held constant. The Latin phrase ceteris paribus means
“with other things the same” and is sometimes used in economic writing to mean the same thing as “holding all else
equal”).
We’ll often want to plot a demand schedule. That is what the demand curve does. The demand curve plots the
relationship between prices and quantity demanded. The demand curve has an important property that we will see
many times. The price of gasoline and the quantity demanded are negatively related, which means that they move in
opposite directions. In other words, when one goes up, the other goes down, and vice versa. Almost all goods have
demand curves that exhibit this fundamental negative relationship, which economists call the Law of Demand: the
quantity demanded rises when the price falls.
Willingness to pay is the highest price that a buyer is willing to pay for an extra unit of a good.
Diminishing marginal benefit: as you consume more of a good, your willingness to pay for an additional unit
declines.
To study the behavior of the worldwide energy market, economists need to study the worldwide demand curve for
gasoline, which is equivalent to the sum of all individual demand curves. Economists call this adding-up process the
aggregation of the individual demand curves.
the market demand curve. It is the sum of the individual demand curves of all potential buyers.
The market demand curve plots the relationship between the total quantity demanded and the market price, holding
all else equal.
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When we introduced the demand curve, we explained that it describes the relationship between price and quantity
demanded, holding all else equal. It’s now time to more carefully consider the “all else” that is being held fixed.

The demand curve shifts when these five major factors change:
 Tastes and preferences
 Income and wealth
o For a normal good, an increase in income shifts the demand curve to the right (holding the good’s price
fixed), causing buyers to purchase more of the good.
o For an inferior good, an increase in income shifts the demand curve to the left (holding the good’s price
fixed), causing buyers to purchase less of the good.
o Two goods are substitutes when a rise in the price of one leads to a rightward shift in the demand curve
for the other.
o Two goods are complements when a fall in the price of one leads to a rightward shift in the demand
curve for the other.
 Availability and prices of related goods
 Number and scale of buyers
 Buyers’ beliefs about the future
The demand curve shifts only when the quantity demanded changes at a given price. If a good’s own price changes
and its demand curve hasn’t shifted, the own price change produces a movement along the demand curve. The only
reason for a movement along the demand curve: A change in the price of the good itself.

SELLER BEHAVIOR – THE SUPPLY

We want to analyze the relationship between the price of a good and the amount of the good that sellers are willing to
sell or supply. At a given price, the amount of the good or service that sellers are willing to supply is called the
quantity supplied.
A supply schedule is a table that reports the quantity supplied at different prices, holding all else equal. The supply
curve plots the quantity supplied at different prices. A supply curve plots the supply schedule. Two variables are
positively related if the variables move in the same direction.
In almost all cases, quantity supplied and price are positively related (holding all else equal), which economists
call the Law of Supply.
Willingness to accept is the lowest price that a seller is willing to get paid to sell an extra unit of a good. At a
particular quantity supplied, willingness to accept is the height of the supply curve. Willingness to accept is the same
as the marginal cost of production. Adding up quantity supplied works the same way as adding up quantity
demanded. We add up quantities at a particular price. We then repeat this at every possible price to plot the market
supply curve. The market supply curve plots the relationship between the total quantity supplied and the market
price, holding all else equal.
Recall that the supply curve describes the relationship between price and quantity supplied, holding all else equal.
There are four major types of variables that are held fixed when a supply curve is constructed.

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The supply curve shifts when these variables change:
 Prices of inputs, good or service used to produce another good or service, used to produce the good
 Technology used to produce the good
 Number and scale of sellers
 Sellers’ beliefs about the future.
The supply curve shifts only when the quantity supplied changes at a given price. If a good’s own price changes and
its supply curve hasn’t shifted, the own price change produces a movement along the supply curve. The only reason
for a movement along the supply curve is a change in the price of the good itself.

SUPPLY AND DEMAND IN EQUILIBRIUM

The competitive equilibrium is the crossing point of the supply curve and the demand curve.
The competitive equilibrium price equates quantity supplied and quantity demanded.

The competitive equilibrium quantity is the quantity that corresponds to the competitive equilibrium price.
When the market price is above the competitive equilibrium price, quantity supplied exceeds quantity demanded,
creating excess supply

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When the market price is below the competitive equilibrium price, quantity demanded exceeds quantity supplied,
creating excess demand.

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CHAPTER 5 – CONSUMERS AND INCENTIVES
The first question that we explore is “How do consumers decide what to buy?” We can frame this question as a
problem—the buyer’s problem.
Economists identify three essential ingredients of the buyer’s problem:
1. What you like
2. Prices of goods and services
3. How much money you have to spend:he budget constraint
The budget set is the set of all possible bundles of goods and services that a consumer can purchase with her income.
Economists usually describe the budget set in the context of another concept—the budget constraint. The budget
constraint represents the goods or activities that a consumer can choose that exactly exhaust her entire budget and it is
a straight line.

Since the budget constraint is a straight line, its slope is constant. This means that your opportunity cost is constant.
And how, exactly, do we define that opportunity cost? We can think of it, very simply, as the number of sweaters you
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have to give up when you buy an additional pair of jeans. Mathematically, we can express this idea as a simple
formula:
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑗𝑒𝑎𝑛𝑠 = 𝑙𝑜𝑠𝑠 𝑖𝑛 𝑠𝑤𝑒𝑎𝑡𝑒𝑟𝑠
An optimizing buyer makes decisions at the margin. 𝑔𝑎𝑖𝑛 𝑖𝑛 𝑗𝑒𝑎𝑛𝑠
When optimizing, the marginal benefit that you gain from the last dollar spent on each good is equal. This decision
rule can be summarized via a simple equation:

𝑀𝐵𝑗 𝑀𝐵𝑠
𝑃𝑗 𝑃𝑠

where MBs is the marginal benefit from sweaters, MBj is the marginal benefit from jeans, and Ps and Pj are the
respective prices of sweaters and jeans.
Consumer surplus is the difference between the willingness to pay and the price paid for the good such as what he
actually pays.

ELASTICITY OF DEMAND
As we discussed, economists are often interested in what happens after a certain variable changes; here, we’ll talk
about how to quantify these effects using a concept called elasticity.
Elasticity measures the sensitivity of one economic variable to a change in another. In other words, it tells us how
much one variable changes when another changes. More precisely, elasticity is a ratio of percentage changes in
variables. Note that elasticity is not the same as the slope of a line. By measuring changes in percentage terms,
elasticity goes a step deeper than the slope relationship. Elasticity is an important concept because it takes into account
not only the direction of change but also the size of the change. Elasticities come in many forms, but in this chapter
we focus on the most important ones associated with demand curves:
1. The price elasticity of demand
2. The cross-price elasticity of demand
3. The income elasticity of demand
The price elasticity of demand measures the percentage change in quantity demanded of a good due to a percentage
change in its price.
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

Because of the importance of the price elasticity of demand, economists have developed a terminology to classify goods
based on the magnitude of the price elasticity:
 Goods that have elastic demand have a price elasticity of demand greater than 1.
 A very small increase in price causes consumers to stop using goods that have perfectly elastic demand.
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 Goods that have unit elastic demand have a price elasticity of demand equal to 1.
 Goods that have inelastic demand have a price elasticity of demand less than 1.

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  Quantity demanded is unaffected by prices of goods with perfectly inelastic demand.
Economists have pinpointed three primary reasons for elasticity differences:
1. Closeness of substitutes: as the number of available substitutes grows, the price elasticity of demand increases.
2. Budget share spent on the good: In general, as you spend more of your budget on a good, the price elasticity
of demand increases.
3. Available time to adjust: consumers, in general, respond much less to price changes in the short run than in
the long run.

The cross-price elasticity of demand measures the percentage change in quantity demanded of a good due to a
percentage change in another good’s price.

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑥

𝐶𝑟𝑜𝑠𝑠 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑦

The income elasticity of demand measures the percentage change in quantity demanded due to a percentage change
in income.

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝐼𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

When income rises and consumers buy more of a good, it is a normal good. Normal good: if the quantity
demanded is directly related to income; when income rises, consumers buy more of a normal good.
When income rises and consumers buy less of a good, it is an inferior good. A good is inferior if the quantity
demanded is inversely related to income; when income rises, consumers buy less of an inferior good.

CHAPTER 4 – UTILITY (Varian)

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UTILITY FUNCTIONS AND INDIFFERENCE CURVES
A utility function is a way of assigning a number to every possible consumption bundle such that more-preferred
bundles get assigned larger numbers than less-preferred bundles.

x < y: x is preferred strictly to y.

x > y: x and y are equally preferred.
x ≳y: x is preferred at least as much as y.

A preference relation that is complete, reflexive, transitive, and continuous (Continuity means that small changes to a
consumption bundle cause only small changes to the preference level) can be represented by a continuous utility
function. A utility function u(x) represents a preference relation if and only if:

 𝑥’ > 𝑥’’. 𝑢(𝑥’) > 𝑢(𝑥’’)

 𝑥’ ≳ 𝑥’’. 𝑢(𝑥’) ≧ 𝑢(𝑥’’)
 𝑥’ ∽ 𝑥’’. 𝑢(𝑥’) = 𝑢(𝑥’’)

Utility is an ordinal (i.e. ordering) concept.—> E.g., if u(x) = 6 and u(y) = 2 then bundle x is strictly preferred to
bundle y. But x is not preferred three times as much as is y.
An indifference curve contains equally preferred bundles. Having equal preference means having the same utility level;
therefore, all bundles on an indifference curve have the same utility level.

Comparing all possible consumption bundles gives the complete collection of the consumer’s indifference curves, each
with its assigned utility level.
This complete collection of indifference curves completely represents the consumer’s preferences.
There is no unique utility function, we have different kinds of utility functions.

The collection of all indifference curves for a given preference relation is an “indifference map.”
It does not exist an unique utility function.

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We know that a typical indifference curve is just the set of all x1 and x2 such that 𝑘 = 𝑥1𝑥2 for some constant k.
𝑘
Solving for x2 as a function of x1, we see that a typical indifference curve has the formula: 𝑥2 =
𝑥1

 If you suppose
 𝑢(𝑥1, 𝑥2) = 𝑥1 ∗ 𝑥2
 𝑢(2,3) = 6; 𝑢(4,1) = 4; 𝑢(2,2) = 4
 Since 𝑢(2,3) > (4,1) ∽ (2,2)

Let’s consider another example. Suppose that we were given a utility function 𝑣(𝑥1, 𝑥2) = 𝑥12𝑥22
What do its indifference curves look like? By the standard rules of algebra we know that:

𝑉(𝑥1, 𝑥2) = 𝑥12𝑥22 = (𝑥1𝑥2)2 = 𝑢(𝑥1, 𝑥2)2

Thus, the utility function 𝑣(𝑥1, 𝑥2) is just the square of

the utility function 𝑢(𝑥1, 𝑥2).
This means that the utility function 𝑣(𝑥1, 𝑥2) is just the
square of the utility function 𝑢(𝑥1, 𝑥2).
This means that the utility function 𝑣(𝑥1, 𝑥2) =
𝑥12𝑥22 has to have exactly the same shaped.
Indifference curves as those depicted for the utility
function 𝑢(𝑥1, 𝑥2) = 𝑥1𝑥2
The labeling of the indifference curves will be different—
the labels that were 1,2,3,··· will now be 1,4,9,··· — but
the set of bundles that has 𝑣1(𝑥1, 𝑥2) = 9 is exactly the
same as the set of bundles that has 𝑢(𝑥1, 𝑥2) =. Thus
𝑣(𝑥1, 𝑥2) describes exactly the same preferences as 𝑢(𝑥1, 𝑥2) since it orders all of the bundles in the same way.

 If you suppose:
 𝑢(𝑥1, 𝑥2) = 𝑥1 ∗ 𝑥2— ≫ (2,3) > (4,1) ∽ (2,2)
 Define 𝑉 = 𝑢2 —> 𝑉(𝑥1, 𝑥2) = 𝑥12𝑥22— ≫ (2,3) = 36 > (4,1) = 16 ∽ (2,2) = 4
 V preserves the same order as u and therefore represents the same preferences.

 If you suppose:
 𝑢(𝑥1, 𝑥2) = 𝑥1 ∗ 𝑥2 → (2,3) > (4,1) ∽ (2,2)
 Define 𝑊(𝑥1, 𝑥2) = 2𝑥1𝑥2 + 10 → (2,3)) = 22 > (4,1) = (2,2) = 18
 W preserves the same order as u and therefore represents the same preferences.

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if f is a strictly increasing function, then V = f (u) is also a utility function representing the same preference relation.
This is known as a “monotonic transformation.”
 A good is a commodity which increases utility with additional consumption.
 A bad is a commodity which decreases utility with additional consumption.
 A neutral is a commodity which does not change utility with additional consumption.

UTILITY FUNCTION OF PERFECT SUBSTITUTE GOODS

A typical utility function for perfect substitute goods is: 𝑢(𝑥1, 𝑥2) = 𝑥1 + 𝑥2
 Of course, this isn’t the only utility function that we could use. We could also use the square of the number of
goods: 𝑣(𝑥1, 𝑥2) = (𝑥1 + 𝑥2)2 = 𝑥12 + 𝑥22 + 2𝑥1𝑥2
 The utility function can also takes the form: 𝑢(𝑥1, 𝑥2) = 2𝑥1 + 𝑥2
In general, preferences for perfect substitutes can be represented by a utility function of the form:

𝑢(𝑥1, 𝑥2) = 𝑎𝑥1 + 𝑏𝑥2

Here a and b are some positive numbers that measure the “value” of goods 1 and 2 to the consumer. Note that the
slope of a typical indifference curve is given by −a/b.

UTILITY FUNCTION OF PERFECT COMPLEMENTS

This is the left shoe–right shoe case. In these preferences the consumer only cares about the number of pairs of shoes
he has, so it is natural to choose the number of pairs of shoes as the utility function. The number of complete pairs of
shoes that you have is the minimum of the number of right shoes you have, x1, and the number of left shoes you
have, x2.
Thus the utility function for perfect complements takes the form: 𝑢(𝑥1, 𝑥2) = min{x1, x2}
 𝑢(𝑥1, 𝑥2) = min{x1, x2} is a possible utility function to describe perfect complements. As usual, any
monotonic transformation would be suitable as well.
 Min{x1, ½x2} is an uility function of perfect complement goods too.

15
In general, a utility function that describes perfect-complement preferences is given by:

𝑢(𝑥1, 𝑥2) = min{𝑎𝑥1, 𝑏𝑥2} 𝑤ℎ𝑒𝑟𝑒 𝑎 > 0 𝑎𝑛𝑑 𝑏 > 0

QUASI LINEAR UTILITY FUNCTION

The general form of the quasi linear utility function is:

𝑢(𝑥1, 𝑥2) = 𝑘 = 𝑓(𝑥1) + 𝑥2

It is linear only in x2, therefore it is called quasi-linear.

 Specific examples of quasilinear utility would be 𝑢(𝑥1, 𝑥2) = √𝑥1 + 𝑥2 or 𝑢(𝑥1, 𝑥2) = 𝑙𝑛𝑥1 + 𝑥2

16
COBB-DOUGLAS UTILITY FUNCTION
The typical form of a Cobb-Douglas utility function is:

𝑢(𝑥1, 𝑥2) = 𝑥1ᶜ + 𝑥2ᵈ 𝑤𝑖𝑡ℎ 𝑐 > 0 𝑎𝑛𝑑 𝑑 > 0

 Examples of Cobb-Douglas utility functions are: 𝑢(𝑥1, 𝑥2) = 𝑥1½𝑥2½ 𝑎𝑛𝑑 𝑣(𝑥1, 𝑥2) = 𝑥1𝑥23

THE MARGINAL UTILITY

The marginal utility of commodity i is the rate of change of total utility as the quantity of commodity i consumed
changes.
𝛿𝑢
𝑀𝑈𝑖 =
𝛿𝑥𝑖
 If you suppose 𝑢(𝑥1, 𝑥2) = 𝑋11 2𝑥22 𝑡ℎ𝑒𝑛 𝑀𝑈𝑥1 = 2𝑥1 −12𝑋22

THE MARGINAL RATE OF SUBSTITUTION

17
MRS = −f’ (x1) does not depend upon x2 so the slope of indifference curves for a quasi-linear utility function is
constant along any line for which x1 is constant. What does that make the indifference map for a quasi-linear utility
function look like?

18
CHAPTER 5 – CHOICE (Varian)
THE ORDINARY DEMAND
The most preferred affordable bundle is called the consumer’s “ordinary demand” at the given prices and budget.
Ordinary demand will be denoted by
𝑥1∗ = (𝑝1, 𝑝2, 𝑚) 𝑎𝑛𝑑 𝑥2∗(𝑝1, 𝑝2, 𝑚)
When x1* > 0 and x2* > 0 the demanded bundle is “interior.” If buying (x1*, x2*) costs $m then the budget is
exhausted.

𝑚 = 𝑝1𝑥1 + 𝑝2𝑥2

 The most preferred, affordable bundle for a consumer with Cobb-Douglas preferences with an utility function
which is :𝑢(𝑥1, 𝑥2) = 𝑥1𝑎𝑥2𝑏 are:
𝑎
 𝑥1∗ = 𝑚
𝑎+𝑏
𝑏 ∗ 𝑃1
 𝑥2∗ = 𝑚
𝑎+𝑏 ∗ 𝑝2

When x1* > 0 and x2* > 0 and (x1*, x2*) exhausts the budget and indifference curves have no kinks, the ordinary
demands are obtained by solving:
𝑝1𝑥1∗ + 𝑝2𝑥2∗ = 𝑦

The slopes of the budget constraint, (–p1/p2), and of the indifference curve containing (x1*,x2*) are equal at (x1*,
x2*).

CORNER SOLUTIONS
If either x1*=0 or x2*=0 then the ordinary demand (x1*, x2*) is at a corner solution to the problem of maximizing
utility subject to a budget constraint.

PERFECT SUBSTITUTE GOODS CORNER SOLUTION

So, when 𝑢(𝑥1, 𝑥2) = 𝑥1 + 𝑥2 the most preferred, affordable bundle
is:
𝑚
 (𝑥1∗, 𝑥2∗ ) = ( , 0) 𝑖𝑓𝑝1 < 𝑝2
𝑝1
𝑚
 (𝑥1∗, 𝑥2∗ ) = (0, ) 𝑖𝑓𝑝1 > 𝑝2
𝑝2

19
PERFECT COMPLEMENT KINKY SOLUTION
The solutions for perfect complement goods
 𝑚 = 𝑝1𝑥1 + 𝑝2𝑥2
 𝑥2∗ = 𝑎𝑥1∗
𝑚
 (𝑥1∗𝑥2∗) = ( 𝑎𝑚
𝑝1+𝑎𝑝2 , 𝑝1+𝑎𝑝2 )

𝑚
 𝑥1∗ =
𝑝1+𝑎𝑝2

𝑎𝑚
 𝑥2∗ =
𝑝1+𝑎𝑝2

20
CHAPTER 6 – DEMAND (Varian)
OWN-PRICE CHANGE
Comparative statistic is the studying of how a choice responds to changes in the economic environment. Specifically,
we are going to see how the demand functions 𝑥1∗(𝑝1, 𝑝2, 𝑚), 𝑥2∗(𝑝1, 𝑝2, 𝑚) change as prices (p1) and (p2) and
the income (m) change.

 Suppose only p1 changes from p’ to p’’

The curve containing all the utility-maximizing bundles traced out as p1 changes, with p2 and y constant, is the p1-
price offer curve.

21
PRICE OFFER CURVE FOR COBB-DOUGLAS PREFERENCES
 Take the utility 𝑈(𝑥1, 𝑥2) = 𝑥1𝑎𝑥2𝑏
𝑎
 Demand function for commodity 1: 𝑥1∗(𝑝1, 𝑝2, 𝑚) = 𝑎+𝑏 ∗ 𝑝1
𝑚

𝑚 —> Notice that x2* does not vary with p1 so

𝑎
 Demand function for commodity 2: 𝑥2∗(𝑝1, 𝑝2, 𝑚) = 𝑎+𝑏 ∗ 𝑝2
the p1 price offer curve is flat.

PRICE OFFER CURVE FOR PERFECTLY COMPLEMENTARY UTILITY FUNCTION

 The utility function is 𝑢(𝑥1, 𝑥2) = min{x1, x2}
𝑚
 Then the ordinary demand function is 𝑥1∗(𝑥1, 𝑥2, 𝑚) = 𝑥2∗(𝑥1, 𝑥2, 𝑚) = 𝑝1+𝑝2
 With p2 and y fixed, higher p1 causes smaller x1* and x2*.
𝑚
 𝐴𝑠 𝑝1 → 0 𝑥1∗ = 𝑥2∗ →
𝑝2

 𝐴𝑠 𝑝1 → ∞ 𝑥1∗ = 𝑥2∗ → 0

PRICE-OFFER CURVE FOR A PERFECT-SUBSTITUTES UTILITY FUNCTION

 The utility function is: 𝑢(𝑥1, 𝑥2) = 𝑥1 + 𝑥2
 Then the ordinary demand function for commodity 1 is:
 Then the ordinary demand function for commodity 2 is:

22
INVERSE DEMAND FUNCTION
Taking quantity demanded as given and then asking what must be price describes the inverse demand function of a
commodity.
𝑎𝑚
 A Cobb-Douglas example: 𝑥1∗ = (𝑎+𝑏)𝑝1 is the ordinary demand function
𝑎𝑚
 the inverse demand function is: 𝑝1 = (𝑎+𝑏)𝑋1∗

𝑚
 For perfect complement the demand function is: 𝑥1 = 𝑝1+𝑝2
𝑚
 And the inverse demand is 𝑝1 =𝑥1 − 𝑝2

ENGEL CURVE
The Engel curve is a graph of the demand for one of the goods as a function of income, with all prices being held
constant.
 Suppose to fix p1 and p2 —> let’s see the effect of the income changes
 When we plot the optimal choice of good 1 against income, m, we get the Engel curve

23
ENGEL CURVE FOR COBB-DOUGLAS FUNCTION
 Take the utility 𝑈(𝑥1, 𝑥2) = 𝑥1𝑎𝑥2𝑏
𝑎
 Demand function for commodity 1: 𝑥1∗(𝑝1, 𝑝2, 𝑚) = 𝑎+𝑏
𝑚
∗ 𝑝1
𝑎
 Demand function for commodity 2: 𝑥2∗(𝑝1, 𝑝2, 𝑚) = 𝑎+𝑏
𝑚
∗ 𝑝2
(𝑎+𝑏)𝑝1
 Engel curve for commodity 1 is: 𝑚 = 𝑎 𝑥1∗
(𝑎+𝑏)𝑝2
 Engel curve for commodity 1 is: 𝑚 = 𝑏 𝑥2∗

ENGEL CURVE FOR PERFECT COMPLEMENTARY GOODS

 The utility function is 𝑢(𝑥1, 𝑥2) = min{x1, x2}
𝑚
 Then the ordinary demand function is 𝑥1∗(𝑥1, 𝑥2, 𝑚) = 𝑥2∗(𝑥1, 𝑥2, 𝑚) = 𝑝1+𝑝2
 Then the Engel curve for x1 is:𝑚 = (𝑝1 + 𝑝2)𝑥1
 And the Engel curve for x2 is 𝑚 = (𝑝1 + 𝑝2)𝑥2

ENGEL CURVE FOR PERFECT SUBSTITUTES GOODS

 The utility function is: 𝑢(𝑥1, 𝑥2) = 𝑥1 + 𝑥2
 Then the ordinary demand function for commodity 1 is:
 Then the ordinary demand function for commodity 2 is:
𝑚
 Suppose p1<p2 then 𝑥1∗ = 𝑝1 𝑎𝑛𝑑 𝑥2∗ = 0
 Therefore the Engel curve is: 𝑚 = 𝑝1𝑥1∗

24
HOMOTHETICITY
All of the income offer curves and Engel curves that we have seen up to now have been straightforward—in fact
they’ve been straight lines! This has happened because our examples have been so simple. Real Engel curves do not
have to be straight lines. In general, when income goes up, the demand for a good could increase more or less rapidly
than income increases. If the demand for a good goes up by a greater proportion than income, we say that it is a
luxury good, and if it goes up by a lesser proportion than income we say that it is a necessary good.
If the MRS depends only on the ratio of the amounts of the two goods, the utility function is homothetic.
A consumer’s preferences are homothetic if and only if: (𝑥1, 𝑥2) < (𝑦1, 𝑦2) → (𝑘𝑥1, 𝑘𝑥2) < (𝑘𝑦1, 𝑘𝑦2) for every
k > 0. That is, the consumer’s MRS is the same anywhere on a straight line drawn from the origin.
The three examples of preferences—perfect substitutes, perfect complements, and Cobb-Douglas—are all homothetic
preferences.

QUASILINEAR INDIFFERENCE CURVES

Quasilinear preferences are not homothetic. Each curve is a vertically shifted copy of the others and each curve
intersects both axes.

INCOME CHANGES
 A good for which quantity demanded rises with income is called normal; therefore a normal good’s Engel
curve is positively sloped.

25
A good for which quantity demanded falls as income increases is called income inferior; therefore an income-inferior
good’s Engel curve is negatively sloped.

PRICE CHANGES
 A good is called ordinary if the quantity demanded of it always increases as its own price decreases.
 If, for some values of its own price, the quantity demanded of a good rises as its own price increases then the
good is called Giffen

CROSS PRICE EFFECT

 If an increase in p2
o increases demand for commodity 1 then commodity 1 is a gross substitute for commodity 2.
o reduces demand for commodity 1 then commodity 1 is a gross complement for commodity 2.

CROSS PRICE EFFECT FOR PERFECT COMPLEMENTS

26
 𝑚
 The ordinary demand function is 𝑥1∗(𝑥1, 𝑥2, 𝑚) = 𝑥2∗(𝑥1, 𝑥2, 𝑚) = 𝑝1+𝑝2
𝛿𝑥1 𝑚
 So, = − 2
<0
𝛿𝑝2 (𝑝1+𝑝2)
 Therefore commodity 2 is a gross complement for commodity 1.

CROSS PRICE FOR COBB-DOUGLAS

𝑎
 𝑥2∗(𝑝1, 𝑝2, 𝑚) = 𝑚
𝑎+𝑏 ∗ 𝑝2
𝛿𝑥2
 Therefore,𝛿𝑝1 = 0
 Therefore commodity 1 is neither a gross complement nor a gross substitute for commodity 2.

EFFECTS OF A PRICE CHANGE

Price effect Income effect Substitution effect
Normal goods Negative Negative Negative
If Δpx>0 —> Δ If Δpx>0 If Δpx>0
xp<0 —> Δxi <0 —> Δxs<0
And viceversa
And viceversa And viceversa
Inferior goods Negative Positive Negative
If Δpx>0 —> Δ If Δpx>0 —> Δ If Δpx>0 —> Δxs
xp<0 xi>0 <0
And viceversa with And viceversa And viceversa
Δxs>Δxi
Giffen goods Positive Positive Negative
If Δpx>0 —> Δ If Δpx>0 —> Δxi If Δpx>0 —> Δ
xp>0 >0 xs<0
And viceversa with And viceversa And viceversa with
Δxs<Δxi
CHAPTER 8 – SLUTSKY EQUATION (Varian)
27
What happens when a commodity’s price decreases?
o Substitution effect: the commodity is relatively cheaper, so
consumers substitute it for now relatively more-expensive other
commodities.
The substitution effect is sometimes called the change in
compensated demand. The idea is that the consumer is being
compensated for a price rise by having enough income given back
to him to purchase his old bun- dle. Of course if the price goes
down he is “compensated” by having money taken away from him. We’ll generally stick with the
“substitution” termi- nology, for consistency, but the “compensation” terminology is also widely used.
More precisely, the substitution effect, Δxs1, is the change in the demand for good 1 when the price of good 1
changes to p′1 and, at the same time, money income changes to m′:

𝛥𝑥𝑠1 = 𝑥1(𝑝1’, 𝑚’) − 𝑥1(𝑝1, 𝑚)

o Income effect: the consumer’s budget of $m can purchase more than before, as if the consumer’s income rose,
with consequent income effects on quantities demanded.
More precisely, the income effect, Δxn1 , is the change in the demand for good 1 when we change income
from m’ to m, holding the price of good 1 fixed at p’1

𝛥𝑥𝑛1 = 𝑥1(𝑝1’, 𝑚) − 𝑥1(𝑝1’, 𝑚’)

Slutsky discovered that changes to demand from a price change are always the sum of a pure substitution effect and an
income effect.
Slutsky isolated the change in demand due only to the change in relative prices by asking “What is the change in
demand when the consumer’s income is adjusted so that, at the new prices, she can only just buy the original bundle?”

28
29
We have seen that the income and substitution effects can be described graphically as a combination of pivots and
shifts, or they can be described algebraically in the Slutsky identity:

𝛥𝑥1 = 𝛥𝑥𝑠 + 𝛥𝑥𝑛

SLUTSKY’S EFFECT FOR NOMAL GOODS

Most goods are normal (i.e. demand increases with income); In
this case the substitution and income effects reinforce each other
when a normal good’s own price changes.
Since both the substitution and income effects increase
demand when own price falls, a normal good’s ordinary
demand curve slopes down.
The law of downward-sloping demand therefore always applies
to normal goods.

𝛥𝑥1 = 𝛥𝑥𝑠 + 𝛥𝑥𝑛

(+) (+) (+)

SLUTSKY’S EFFECT FOR INFERIOR GOODS

Some goods are income-inferior (i.e., demand is reduced by higher income); The substitution and income effects
oppose each other when an income- inferior good’s own price changes.

𝛥𝑥1 = 𝛥𝑥𝑠 + 𝛥𝑥𝑛

(+) (−) (+)

The Law of Demand: If the demand for a good increases when income increases, then the demand for that good must
decrease when its price increases.

30
CHAPTER 9 – BUYING AND SELLING (Varian)
ENDOWMENT AND BUDGET CONSTRAINTS
The list of resource units with which a consumer starts is his endowment; This is how much of the two goods the
consumer has before he enters the market. A consumer’s endowment will be denoted by the vector, ω (omega).
 E.g. 𝜔 = (𝜔1, 𝜔2) = (10,2) states that the consumer is endowed with 10 units of good 1 and 2 units of
good 2.
 If p1=2 and p2=3 the value of the endowment is: 𝑝1𝜔1 + 𝑝2𝜔2 = 2 ∗ 10 + 3 ∗ 2 = 26
For which consumption bundles may the endowment be exchanged? For any bundle costing no more than the
endowment’s value.
So, given p1 and p2, the budget constraint for the endowment 𝜔 = (𝜔1, 𝜔2) = 𝑝1𝜔1 + 𝑝2𝜔2 is:

{(𝑥1, 𝑥2)𝐼𝑝1𝑥1 + 𝑝2𝑥2 ≤ 𝑝1𝜔1 + 𝑝2𝜔2, 𝑥1 ≥ 0, 𝑥2 ≥ 0

The budget constraint can be rewritten as:

𝑝1(𝑥1 − 𝜔1) + 𝑝2(𝑥2 − 𝜔2) = 0

Let us make a distinction here between the consumer’s gross demands and his net demands.
The gross demand for a good is the amount of the good that the consumer actually ends up consuming: how much of
each of the goods he or she takes home from the market.
The net demand for a good is the difference between what the consumer ends up with (the gross demand) and the
initial endowment of goods.
If we let (x1, x2) be the gross demands, then (x1 − ω1, x2 − ω2) are the net demands.
The net demand for a good is simply the amount that is bought or sold of the good. That is, the sum of the values of a
consumer’s net demands is zero.

The overall change in demand caused by a change in price is the sum of:
 a pure substitution effect
 an ordinary income effect
 an endowment income effect
31
LABOR SUPPLY
A worker is endowed with $m of nonlabor income and R hours of time which can be used for labor or leisure.

𝜔 = (𝑅, 𝑚)

The consumption good’s price is pc. w is the wage rate.

The worker’s budget constraint is 𝑝𝐶 = 𝑚 + 𝑤𝐿 or similarly 𝑝𝐶 + 𝑤𝐿 = 𝑚
where C denotes consumption and L represents labor supplied.
 If we denote L to be the maximum amount of labor supply possible and add wL to each side, we can rewrite
this constraint as: 𝑝𝐶 + 𝑤(Ḹ − 𝐿) = 𝑚 + 𝑤Ḹ
𝑚
 If we define Č = 𝑝as the potential consumption with no wor, the constraint becomes:
𝑃𝐶 + 𝑤(Ḹ − 𝐿) = 𝑝Ĉ + 𝑤Ḹ
R will be defined as leisure (relaxation) and is equal to (Ḹ-L). Ȓ =Ḹ,
 therefore the constraint can be written as:

𝑝𝐶 + 𝑤𝑅 = 𝑝Ĉ + 𝑤Ȓ

32
CHAPTER 10 – INTERTEMPORAL CHOICES (Varian)
PRESENT AND FUTURE VALUES
Persons often receive income in “lumps”; e.g., monthly salary.
How is a lump of income spread over the following month (saving now for consumption later)?
Or how is consumption financed by borrowing now against income to be received at the end of the month?
 Begin with some simple financial arithmetic. Take just two periods, 1 and and let “r” denote the interest rate
per period.
Given an interest rate r the future value one period from now of $m is 𝐹𝑉 = 𝑚(1 + 𝑟) —> Capitalization
𝑚
The present value of $m available at the start of the next period is: 𝑃𝑉 = 1+𝑟 — > Discounting

INTERTEMPORAL BUDGET CONSTRAINT

 m1 and m2 are the incomes received in periods 1 and 2. c1 and c2 are consumptions in periods 1 and 2.
 p1 and p2 are prices of consumption in periods 1 and 2. ignore price effects by supposing that p1=p2=$1
 Suppose that the consumer chooses not to save or to borrow. So c1=m1 and c2=m2
 Now suppose that the consumer spends nothing on consumption in period 1; that is, c1 = 0 and the consumer
saves all his income: s1=m1
 Savings plus interest from period 1 sums to (1 + r)m1 so total income available in period 2 is
𝑚2 + (1 + 𝑟)𝑚1 So, period 2 consumption expenditure is 𝑐2 = 𝑚2 + 𝑚1(1 + 𝑟)

 Now suppose that the consumer spends everything possible on consumption in period 1, so c2 = 0.
 What is the most that the consumer can borrow in period 1 against her period 2 income of $m2?
 Let b1 denote the amount borrowed in period 1.
 Only $m2 will be available in period 2 to pay back $b1 borrowed in period 1.
𝑚2
 So 𝑏1(1 + 𝑟) = 𝑚2 and, 𝑏1 = 1+𝑟
𝑚2
 So the largest possible period 1 consumption level is: 𝑐1 = 𝑚1 +1+𝑟

 Suppose that c1 units are consumed in period 1. This costs $c1 and leaves m1 – c1 saved.
Period 2 consumption will then be: 𝑐2 = 𝑚2 + (1 + 𝑟)(𝑚1 − 𝑐1)

33
 If 𝑚1 − 𝑐1 > 0—> saving; if 𝑚 − 𝑐1 < 0 –>borrowing
𝑝2 𝑚2
 Now let’s add prices p1 and p2 for consumption in periods 1 and 2. 𝑝1𝑐1 + 1+𝑟
𝑐2 = 𝑚1 +
1+𝑟
𝑝1
The slope is: −(1 + 𝑟) ∗𝑝2

PRICE INFLATION
 Define the inflation rate by π where 𝑝1(1 + 𝑟) = 𝜋
 We lose nothing by setting p1 = 1 so that p2 = 1+p
1+𝜋 𝑚2
 We can rewrite the budget constraint as: 𝑐1 + 𝑐2 = 𝑚1 +
1+𝑟 1+𝑟

 When there is no price inflation (p1 = p2 = 1), the slope of the budget constraint is –(1+r).
1+𝑟
 Now, with price inflation, the slope of the budget constraint is: −1+𝑝
1+𝑟
 This can be written as −(1 + 𝜌) = −1+𝜋
𝑟−𝜋
 This is the slope of the budget constraint. ρ is known as the real interest rate: ρ=1+𝜋

34
CHAPTER 6 – SELLERS AND INCENTIVE
We begin our study of how firms make decisions by assuming that they do so in perfectly competitive markets. Three
conditions characterize perfectly competitive markets:
 No buyer or seller is big enough to influence the market price.
 Sellers in the market produce identical goods, so an individual seller can’t influence the market price by selling
a unique product.
 There is free entry and exit in the market.

THE SELLER’S PROBLEMS

The seller main goal is to maximize profit, but in order to do that he must solve three problems:
 Making the goods: Production is the process by which the transformation of inputs (such as labor and
machines) to outputs (such as goods and services) occurs. The relationship between the quantity of inputs
used and the quantity of outputs produced is called the production function.
To produce labor and physical capital are needed. Physical capital is any good, including machines and
buildings, used for production.
While hiring and firing workers can be done in a short period of time, altering physical capital takes much
longer. Economists refer to the short run as a period of time when only some of a firm’s inputs can be varied—
for The Cheeseman, labor. Alternatively, the long run is defined as a period of time wherein a firm can
change any input. This means that physical capital is a fixed factor of production—an input that cannot
change in the short run—and that labor is a variable factor of production—an input that can change in the
short run.
We can define marginal product as the additional amount of output obtained from adding one more unit of
input: the Law of Diminishing Returns states that at a certain point of successive increases in inputs, marginal
product begins to decrease.

 The cost of doing business: The cost of production is what a firm must pay for its inputs. there is a natural
division in the total cost of production: 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 + 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
This equation has three parts. Total cost is the sum of variable and fixed costs.
Variable costs (VCs) are those costs associated with variable factors of production.
In contrast to VCs, a fixed cost (FC) is a cost associated with a fixed factor of production, such as structures or
equipment, and therefore does not change with production in the short run.
Average total cost (ATC) is the total cost divided by the total output.
Average variable cost (AVC) is the total variable cost divided by the total output.
Average fixed cost (AFC) is the total fixed cost divided by the total output.

35
 Marginal cost (MC) is the change in total cost associated with producing one more unit of output.

 The rewards of doing business: the revenue of a firm is the amount of money it brings in from the sale of its
outputs. Revenue is determined by the price of goods sold times the number of units sold:
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑝𝑟𝑖𝑐𝑒 ∗ 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑜𝑙𝑑
Remember that in a competitive market firms have no control over price and are therefore price takers and can
only decide the quantity to produce.

PROFITS
Now that we have the three components of the seller’s problem in place, we can use them to show how a firm
maximizes its profits, since that is the goal of the seller. The profits of a firm are the difference between total revenues
and total costs:
𝑝𝑟𝑜𝑓𝑖𝑡𝑠 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑢𝑒 = 𝑃 ∗ 𝑄
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝐴𝑇𝐶 ∗ 𝑄
𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑃 ∗ 𝑄) − (𝐴𝑇𝐶 ∗ 𝑄) = (𝑃 − 𝐴𝑇𝐶) ∗ 𝑄

 Accounting profits are equal to total revenue minus explicit costs.

 Economic profits are equal to total revenue minus both explicit and implicit costs.

36
ELASTICTY OF SUPPLY

37
Price elasticity of supply is the measure of how responsive quantity supplied is to price changes.

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑

𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

Elasticity of supply will be greater:

 The more inventory the firm has
 The more easily the firm can hire workers
 The longer the time horizon

With an understanding of how quantity supplied responds to price changes, we can con- sider extreme market
situations, such as when the firm should shut down, or suspend, operations.
A shutdown is a short-run decision to not produce anything during a specific time period. The decision to stop
producing in the short run occurs if price falls below AVC.
If the firm stays open it has to pay the variable and the fixed costs.

So, the short-run supply curve is the marginal cost curve starting from the point in which MC=AVC

PRODUCER SURPLUS
The Producer surplus is the difference between the market price and the marginal cost curve it is the area above the
MC and below the price.

38
RETURNS TO SCALE
 Economies of scale occur when ATC falls as the quantity produced increases.
 When there are constant returns to scale ATC does not change as output increases.
 Diseconomies of scale occur when ATC rises as the quantity produced increases.

39
CHAPTER 19 – TECHNOLOGY (Varian)

A technology is a process by which inputs are converted to an output. How to compare technologies?
 Xi denotes the amount used of input i. An input bundle is a vector of the input levels: (x1,x2,…xn)
 Y denotes the output level;

PRODUCTION FUNCTION
The technology’s production function states the maximum amount of output possible from an input bundle:
𝑦 = 𝑓(𝑥1, 𝑥2, . . 𝑥𝑛)

A production plan is an input bundle and an output level (x1,…xn,y).

A production plan is feasible if: 𝑦 ≤ (𝑥1, 𝑥2, … 𝑥𝑛)
The collection of all feasible production plans is the technology set.

40
TECHNOLOGIES WITH MORE INPUTS
 When there is more than one input, and the
two inputs are x1 and x2, the production
function can appear as:
𝑦 = 𝑓(𝑥1, 𝑥2)
1 1
= 2𝑥13 ∗ 𝑥23
 For example, the maximal output level possible
from the input bundle
(x1, x2) = (1, 8) is 8

ISOQUANTS
The y output unit isoquant is the set of all inputs bundles that yield at the most the same output level y.

The complete collection of isoquants is the isoquant map.

1 1
The isoquant map is equivalent to the production function—each is the other. (Ex: 𝑦 = 𝑓(𝑥1, 𝑥2) = 𝑥13 𝑥23)

COBB-DOUGAS PRODUCTION FUNCTION

 The for of a Cobb Douglas production function is:
 𝑌 = 𝑓(𝑥1, 𝑥2) = 𝐴𝑥1𝑎𝐵𝑥2𝑏

PERFECT COMPLEMENTS PRODUCTION FUNCTION

 If there are factors that are perfect complements we have a fixed proportions production function that is of the
form:
 𝑦 = 𝑚𝑖𝑛{𝑎𝑥1, 𝑏𝑥2}
 Ex. 𝑌 = 𝑚𝑖𝑛{𝑥1,2𝑥2}

PERFECT SUBSTITUTES PRODUCTION FUNCTION

 A perfect substitutes production function is of the form:
41
  𝑌 = 𝑎𝑥1 + 𝑏𝑥2
 Ex: 𝑦 = 𝑥1 + 4𝑥2

MARGINAL PRODUCT
The marginal product of input i is the rate of change of the output level as the level of input i changes, holding all
other input levels fixed. That is:

𝑀𝑃𝑖 = 𝜕𝑦
𝜕𝑥𝑖

The marginal product of input i is diminishing if it becomes smaller as the level of input i increases. That is, if
𝜕𝑀𝑃𝑖 𝜕 𝜕𝑌 𝜕2𝑦
𝜕𝑥
= ( ) <0
= 2

𝑖 𝜕𝑥𝑖 𝜕𝑥𝑖 𝜕 𝑥𝑖
Marginal products describe the change in output level as a single input level changes.

RETURNS TO SCALE
Returns to scale describes how the output level changes as all input levels change in direct proportion.
 The technology exhibits constant returns to scale if: 𝐹(𝑘𝑥1, 𝑘𝑥2 … 𝑘𝑥𝑛) = 𝑓𝑘(𝑥1, 𝑥2, . . 𝑥𝑛)
 The technology exhibits increasing returns to scale if: 𝐹(𝑘𝑥1, 𝑘𝑥2 … 𝑘𝑥𝑛) > 𝑓𝑘(𝑥1, 𝑥2, . . 𝑥𝑛)
 The technology exhibits diminishing returns to scale if: 𝐹(𝑘𝑥1, 𝑘𝑥2 … 𝑘𝑥𝑛) < 𝑓𝑘(𝑥1, 𝑥2, . . 𝑥𝑛)

The perfect substitutes production function exhibits constant returns to scale, as does the fixed proportion production
function. —> 𝑦 = 𝑎𝑥1 + 𝑏𝑥2 Expand all input levels proportionately by k.
The output level becomes: 𝑦 = 𝑘(𝑎𝑥1 + 𝑏𝑥2) = 𝑘𝑦
In a Cobb-Douglas production function (𝑦 = 𝑎1𝑥𝑎 + 𝑎2𝑥𝑏) the returns to scale is:
1 2

 Constant if a+b=1,
 Increasing if a+b>1,
 Decreasing if a+b<1.

TECHNICAL RATE OF SUBSTITUTION

The slope of the isoquant is its technical rate of substitution
The technical rate of substitution is the rate at which input 2 must b given up as input 1 increases so as to keep the
output level constant. It is the slope of the isoquant:
𝜕𝑦
dx2 𝜕𝑥1
dx1 = 𝜕𝑌
dx2
−𝑎𝑥
 In a cobb-Douglas function it is equal to: 𝑏𝑥12
42
A well-behaved technology is monotonic and convex.
Monotonicity: more of any input generates more output
Convexity: Technical rate of substation increases as x1 increases

LONG RUN AND SHORT RUN

The long run is the circumstance in which a firm is unrestricted in its choice of all input levels.
Examples of restrictions that place a firm into a short run:
 temporarily being unable to install, or remove, machinery
 being required by law to meet affirmative action quotas
 having to meet domestic content regulations

There are many possible short-runs: A short run is a circumstance in which a firm is restricted in some way in its
choice of at least one input level.

43
CHAPTER 20 – PROFIT MAXIMIZATION (Varian)

o A firm uses inputs j=1,...,m to make products i=1,...,n.

o Output levels are y1, . . . , yn.
o Input levels are x1, . . . , xm.
o Product prices are p1, . . . , pn.
o Input prices are w1, . . . , wm.
Competitive firms takes all output prices p1…pn and all input prices w1,…wn as given constants.

ECONOMIC PROFIT
The economic profit generated by the production plan (x1,…xm,y1…yn) is

𝜋 = 𝑝1𝑦1 + 𝑝𝑛𝑦𝑛 − 𝑤1𝑥1 … − 𝑤𝑚𝑥𝑚

Output and input levels are typically flows.

Consequently, profit is typically a flow also; for example, the number of dollars of profit earned per hour.

SHORT-RUN ISOPROFIT LINE

A competitive firm seeks to maximize its present value.
∼
In short run circumstances in which 𝑥2 = 𝑥2
∼
The short run production function is: 𝑦 = 𝑓(𝑥1, 𝑥2)
∼
The firm’s fixed costs is 𝐹𝐶 = 𝑤2 𝑥2
∼
And its profit function is: 𝑦 = 𝑝𝑦 − 𝑤1𝑥1 − 𝑤2𝑥2
An isoprofit line contains all the production plans that yield a profit level of $𝜋.
∼
The equation of an isprofit line is: 𝜋 = 𝑝𝑦 − 𝑤1 𝑥1 − 𝑤2𝑥2
𝑊1
𝑦= 𝑥 ∼
𝜋 + 𝑤2𝑥2
𝑝 1 + 𝑝
𝑤 𝜋+𝑤2𝑥∼2
This line has a slope of 1 And an intercept of:
𝑝 𝑝

44
SHORT-RUN PROFIT MAXIMIZATION
The firm’s problem is to locate the production plan that attains the highest possible isoprofit line, given the firm’s
constraint on choices of production plans. What is this constraint? The production functio
𝑀𝑃1 𝑤1
= 𝑝 ↔ ∗ 𝑝 = 𝑤1
𝑀𝑃1

𝑝 ∗ 𝑀𝑃is the marginal revenue product of input 1, the rate at

which revenue increases with the amount used of input 1.
 If 𝑝 ∗ 𝑀𝑃 > 𝑤1 then the profit increases with x1
 If 𝑝 ∗ 𝑀𝑃 < 𝑤1 then the profit decreases with x1

COBB-DOUGLAS SHORT RUN PROFIT MAXIMIZATION

 Production function: 𝑦 = 𝑥1⁄3𝑥1⁄3
𝜕𝑦
 𝑀𝑃𝑖 = 1 2
1 −2⁄3 1⁄3
= 𝑥 𝑥 𝑃 3⁄2 ∼1⁄2
3 1 2
 The profit
𝜕𝑥1
maximization condition is: 𝑥∗ = ( )
1 𝑥
3𝑤1
 Solving
𝑤 for 𝑃 3⁄2 ∼1⁄2
1𝑃 =( ) 𝑥
 Then y∗ = ( 3
1⁄2 ∼
) 𝑥
1⁄2
3𝑤1
An increase in p causes a reduction in the slope, and a reduction in the vertical intercept; in addition it causes an
increase in the firm’s output level (the firm’s supply curve slopes upward), and an increase in the level of the firm’s
variable input (the firm’s demand curve for its variable input shifts outward).

LONG-RUN PROFIT MAXIMIZATION

Now allow the firm to vary both input levels. Since no input level is fixed, there are no fixed costs.
 Suppose x1 and x2 are variable.
 Think of the firm as choosing the production plan that maximizes profits for a given value of x2, and then
varying x2 to find the largest possible profit level.
𝑤
 The equation of a long run isoprofit line is: 𝑦 = 1 𝑥 𝜋𝑤2𝑥2 so, an increase in x2 causes no change to the
+
1
slope, and an increase in the vertical intercept. 𝑝 𝑝

 Profit will increase as x2 increases so long as the marginal profit on input 2. 𝑃 ∗ 𝑀𝑃2 − 𝑤2 > 0
 The profit-maximizing level of input 2 therefore satisfies 𝑃 ∗ 𝑀𝑃2 − 𝑤2 > 0 and
𝑃 ∗ 𝑀𝑃2 − 𝑤2 = 0 (Satisfied in any short run). So, in the long run, marginal revenue equals marginal cost
for all inputs.

45
CHAPTER 21 – COST MINIMIZATION (Varian)
THE COST FUNCTION
A firm is a cost minimizer if it produces any given output level y≥0 at the smallest possible total cost.
C(y) denotes the firm’s smallest possible total cost for producing y units of output. C(y) is the firm’s total cost
function.
When the firm faces given input prices w = (w1, w2, . . . , wn), the total cost function will be written as

𝑐(𝑤𝑖, 𝑤2, . . 𝑤𝑛, 𝑦)

 Consider a firm using 2 inputs to make one output. The production function is: 𝑦 = 𝑓(𝑥1, 𝑥2)
 Take the output level y≥0 as given.
 Given the input prices w1 and w2, the cost of an input bundle (x1,x2) is 𝑤1𝑥1 + 𝑤2𝑥2 Subject to
𝑓(𝑥1, 𝑥2) = 𝑦
 For given w1,w2 and y, the firm’s cost minimization problem is to solve min 𝑤1𝑥1 + 𝑤2𝑥2
 The levels x1*(w1,w2,y) and x2*(w1,w2,y) in te least-costly input bundle are the firm’s conditions demands for
inputs 1 and 2.
 The smallest possible total cost for producing y output units is therefore
𝑐(𝑤1, 𝑤2, 𝑦) = 𝑤1𝑥1∗(𝑤1, 𝑤2, 𝑦) + 𝑤2𝑥2∗(𝑤1, 𝑤2, 𝑦)

ISOCOST LINES
A curve that contains all of the input bundles that cost the same amount is an isocost curve.
For example, given w1 and w2, the $100 isocost line has the equation: 𝑤1𝑥1 + 𝑤2𝑥2 = $100
Generally given w1, and w2, the equation of the $c isocost line is:

𝑤1𝑥1 + 𝑤2𝑥2 = 𝑐
𝑤1 𝑐
Or, 𝑥2 = − 𝑥1 +
𝑤2 𝑤2

Then, the slope is −𝑤1

𝑤2

46
COBB-DOUGLAS COST MINIMIZATION
1 2

 If a firm has a Cobb Douglas production function𝑦 = 𝑥3𝑥3

𝜕𝑦
 𝑊1 𝜕𝑥1 𝑥2
𝑤2 =− 𝜕𝑦 − 2𝑥1
𝜕𝑥2

 Substituting we obtain:
2
𝑤2 3
 𝑥1 = ( )𝑦
2𝑤1
2𝑤1 31
 𝑥2 = ( )𝑦
𝑤2
 So, the firm’s total cost function is:
1
𝑤1𝑤22 3
𝑐(𝑤1, 𝑤2, 𝑦) = 𝑤1𝑥1∗(𝑤1, 𝑤2, 𝑦) + 𝑤2𝑥2∗(𝑤1, 𝑤2, 𝑦) = 3 )𝑦
( 4

PERFECT COMPLEMENTS EXAMPLLE OF COST MINIMIZATION

 The production function is: 𝑦 = 𝑚𝑖𝑛 (4𝑥1, 𝑥2)
𝑦
 The conditional input demands are: 𝑥1 = 4 𝑎𝑛𝑑 𝑥2 = 𝑦
 So the firm’s total cost function is 𝑐(𝑤1, 𝑤2, =𝑦 𝑤1 ) + 𝑤2𝑦
𝑦) (
4
AVERAGE TOTAL COST
For positive output levels y, a firm’s average total cst of producing y units is

𝑐(𝑤1, 𝑤2, 𝑦)
𝐴𝐶(𝑤1, 𝑤2, 𝑦)
= 𝑦
RETURNS TO SCALE
If a firm’s technology exhibits constant returns to scale, then doubling its output level from y′ to 2y′ requires doubling
all input levels.
Total production cost doubles. Average production cost does not change.

If a firm’s technology exhibits decreasing returns to scale then doubling its output level from y′ to 2y′ requires more
than doubling all input levels.
Total production cost more than doubles. Average production cost increases.

If a firm’s technology exhibits increasing returns to scale then doubling its output level from y′ to 2y′ requires less
than doubling all input levels.
Total production cost less than doubles. Average production cost decreases.

47
CHAPTER 7 – PERFECT COMPETITION AND THE INVISIBLE HAND

RESERVATION VALUE AND SOCIAL SURPLUS

Efficiency is about getting the mot out of scarce resources.
Reservation value is the price at which a trading partner is indifferent between making the trade and not doing so.

In the iPhone market, we have seven buyers and seven sellers, each with their own reservation values for an iPhone.
Together, the seven buyers make up the market demand for iPhones and the seven sellers compose the market supply
for iPhones. The price equilibrium is $40, while the quantity is 4 (Madeline, Katie, Sean and Dave are willing to pay at
least $40).
An important outcome from buyers and sellers optimizing in perfectly competitive markets is that social surplus is
maximized. Social surplus is the sum of consumer surplus and producer surplus.
In the example above mentioned the total consumer surplus is 60$ ($20 Katie + $30 Madeline), while the supplier
surplus is $60 (Tom 10, Mary 20 and Jeff 10, so the total social surplus is $120

48
PARETO EFFICIENCY
Pareto efficiency is a particular kind of equilibrium. An outcome is Pareto efficient if no individual can be made better
off without making someone else worse off. The invisible hand directs consumers and
producers to maximize their surplus and leads to the highest level of social welfare.
So we can say that in a perfectly competitive market, the first distinct function of the equilibrium price is that it
efficiently allocates goods and services to buyers and sellers.

Short run economic profits in one industry will attract profit-seeking producers in industries experiencing economic
losses. In this way, free entry ad exit allows reallocation of assets to their greatest valued uses even across industries.

49
THE INVISIBLE HAND AND DEADWEIGHT LOSS
The invisible hand directs firms to seek out profits,

Prices are central to the invisible hand.

Economists call the decrease in social surplus that results from a market distortion a deadweight loss.

In the market there are mainly two problems:

 Coordination: bringing together self-inetrestedeconomic agents to form markets
 Incentive problems: how to motivate agents to participants in the market.
The solutions are:
 Market economy: prices direct flow of resources, provide incentives for participants
 Command economy: central agency directs

EQUITY AND EFFICIENCY

Equity addresses the issue of a fair distribution of resources across society.
Perfectly competitive markets are efficient.
One of the roles of government in our economy is to address efficient outcomes that we may not consider to be
equitable. If market does not conform to perfectly competitive characteristics the outcome is not Pareto-optimal
(Examples: when a firm pollutes, or a firm has the ability to set prices).
So, the challenge is to strike a balance between government involvement and free market ideals.
50
CHAPTER 9 – EXTERNALITIES AND PUBLIC GOODS

Externalities are reasons of the market failure.

An externality occurs when an economic activity has either a spillover cost to or a spillover benefit for a bystander.
Negative externalities impose an additional cost on society that is not explicitly recognized by the buyers and sellers in
the market.

Positive externalities create external social benefits that are reaped by others.

A pecuniary externality occurs when a market transaction affects other people only through market prices.

51
SOLUTIONS TO EXTERNALITIES
When externalities are present, the market outcome is inefficient. The problem is: how to address inefficient
outcomes?
 Private solutions, proposed by Coase.
Coase theorem states that private bargaining will result in an efficient allocation of resources.
 Government solutions

One fundamental theme unites the multiple solutions to externalities, whether public or private: internalizing the
externality. When individuals or companies take into account the full costs and benefits of their actions because of
some public or private incentive, economists say that they are internalizing the externality. When the external effects
of their actions are internalized, the general result is that the market equilibrium moves toward higher social well-
being.

GOVERNMENT SOLUTIONS TO EXTERNALITIES

Governments respond to externalities in two main ways:
1. Command-and-control policies, in which the government directly regulates the allocation of resources. Command-
and-control regulation either directly restricts the level of production or mandates the use of certain
technologies.
2. Market-based policies, in which the government provides incentives for private organizations to internalize the
externality

A Pigouvian tax, or a corrective tax, named after economist Arthur Pigou, is a tax designed to induce agents who
produce negative externalities to reduce quantity toward the socially optimal level.
Corrective subsidies, or Pigouvian subsidies, are designed to induce agents who produce positive externalities to
increase quantity toward the socially optimal level.

PUBBLIC GOODS
To understand the nature of a public good, it is useful to compare and contrast public goods and private goods in
more detail. There are two characteristics that differentiate them:
 Excludability. Private goods are excludable, meaning that people can be kept from consuming them if they
have not paid for them. Public goods are non-excludable, meaning that once such goods are produced, it is not
possible to exclude people from using them.
 Rivalry in consumption. Private goods are rival in consumption, meaning that they cannot be consumed by
more than one person at a time. Public goods are non-rival in consumption, meaning that one person’s
consumption does not preclude con- sumption by others.
To summarize, we can say that private goods are excludable and rival in consumption and public goods are non-
excludable and non-rival in consumption.

52
 1. Ordinary private goods, shown in the upper-left corner of Exhibit 9.10, are both highly excludable and highly
rival in consumption.
2. In the lower-left corner of the exhibit, we find another category of goods—those that are highly excludable but
non-rival in consumption. We call such excludable, non- rival goods club goods; A club good is non-rival but
excludable.
3. The upper-right corner shows a category of goods called common pool resource goods, which are non-
excludable but rival in consumption.
4. A much different class of goods appears in the lower-right corner of the exhibit—public goods. Recall that

they are goods that are non-rival in consumption and are non-excludable.

PRIVATE PROVISION OF PUBLIC GOODS

Although governments importantly provide public goods, they are not the sole provid- ers. Many public goods are
routinely provided through other channels, such as private donations, which are indeed an effective way to provide
public goods. Private provision of public goods refers to any situation in which private citizens make contributions to
the production or maintenance of a public good.

COMMON POOL RESOURCE GOODS

The tragedy of the commons results when common pool resources are dramatically overused —> too much water is
extracted from aqui- fers, too many trees are cut on public lands, too many communications devices jam air- waves,
too many donuts are eaten by one individual from the office donut box, and so on.

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CHAPTER 15 – TRADE-OFFS INVOLVING TIME AND RISK
Let’s consider a simple example. Imagine that you deposit $100 in a bank account. The amount of an original investment—
in this case $100—is referred to as principal. Interest is the payment received for temporarily giving up the use of
one’s money. The sum of principal and interest is referred to as future value.

𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 ∗ (1 + 𝑟)𝑡

with t periods is the compound interest equation or future value equation calculates the future value of an investment
with interest rate r that leaves all interest payments in the account until the final withdrawal in year T.

The present value of a future payment is the amount of money that would need to be invested today to produce that
future payment. Economists say that the present value is the discounted value of the future payment. The present
value equation is:

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 = 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒

(1 + 𝑟)𝑡

Suppose there is some future activity that will generate pleasure or some other form of well-being. Suppose that this
benefit is not money—for instance, the pleasure of getting a massage. Economists refer to general well-being as utility.
A util is a single unit of utility. Suppose that people discount utility that will occur 1 year from now by multiplying
those future utils by 1>2. A multiplicative weight (between 0 and 1) is called a discount weight— a discount weight
multiplies delayed utils to translate them into current utils.

PROBABILITY AND RISK

Risk exists when an outcome is not known with certainty in advance.
If something is risky, then it is said to have a component that is random.

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A probability is the frequency with which something occurs. When two random outcomes are independent, knowing
about one outcome does not help you predict the other outcome.
Now that you’ve had an introduction to probabilities, we can put these ideas to work. We are going to calculate an
expected value, which is the sum of all possible outcomes or val- ues, each weighted by its probability of occurring.

Loss aversion is the idea that people psychologically weight a loss much more heavily than they psychologically weight
a gain.
Consider a person choosing between two investments with the same expected rate of return but one investment has a
fixed return and the other investment has a
risky return. When people are risk averse, they prefer the investment with the fixed return. When people are risk
seeking, they prefer the investment with the risky return. When people are risk neutral, they don’t care about the level
of risk and are therefore indifferent between the two investments.

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CHAPTER 16 – ECONOMICS OF INFORMATION
In a market with asymmetric information, the information available to sellers and buyers differs.
Hidden characteristics exist when one party in a transaction observes characteristics of the good or service that the
other doesn’t observe.
Hidden actions occur when one side takes actions that are relevant for, but not observed by, the other party.
In a market with adverse selection, one agent in a transaction knows about a hidden characteristic of
a good and decides whether to participate in the transaction on the basis of this information.
A warranty is an example of signaling, in which an individual with private informa- tion takes action—sends a
signal—to convince someone without the information that his services or his products are high quality. Therefore,
Signaling refers to an action that an individual with private information takes in order to convince others about his
information.

Moral hazard is another term for actions that are taken by one party but are relevant for and not observed by the other
party in the transaction.
The party with the hidden action (thus with the private information) is the agent. The uninformed party, who can
design a contract before the agent chooses his action, is the principal. In a principal–agent relationship, the principal
designs a contract specifying the payments to the agent as a function of his or her performance, and the agent takes an
action that influences performance and thus the payoff of the principal.

MARKET SOLUTIONS TO MORAL HAZARD IN THE LABOR MARKET: EFFICIENCY WAGES

Efficiency wages are wages above the lowest pay that workers would accept; employers use them to increase motivation
and productivity.
There are several ways to accomplish such an alignment of payoffs between poli- cyholders and insurers.
 Deductibles form the portion of claims that policy holders must pay for out of their own pockets. A person
with a $500 deductible on his auto insurance, for example, who causes an accident leading to $5,000 of
damage, will obtain only $4,500 from the insurer. By imposing some of the costs of claims directly on
policyholders, the insurer gives them an incentive to take actions that reduce the likelihood of claims.
 Co-payments work similarly. These are payments (most commonly applied in health insurance markets) that
the policyholder makes whenever filing a claim. The $5 or $10 fee you pay for each prescription you obtain
through a prescription drug plan, for example, is a common type of co-payment.
 In coinsurance, the responsibility for paying claims is split between the insurer and the policyholder on a set
schedule. Many health insurance policies, for instance, pay 80 percent of costs. The policyholder remains
responsible for the other 20 percent.

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