Scribd
Upload
18 views5 pages

Intermediate Microeconomics Study Guide

The document covers key concepts in Intermediate Microeconomics, focusing on consumer theory, including consumer preferences, indifference curves, utility, and budget sets. It discusses the utility maximization problem, demand functions, income and substitution effects, and compensation methods such as Slutsky and Hicksian compensation. Additionally, it explores applications like labor supply and intertemporal choice, illustrating how changes in prices and income affect consumer behavior.

Uploaded by

Jana Al-Dossari
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
18 views5 pages

Intermediate Microeconomics Study Guide

The document covers key concepts in Intermediate Microeconomics, focusing on consumer theory, including consumer preferences, indifference curves, utility, and budget sets. It discusses the utility maximization problem, demand functions, income and substitution effects, and compensation methods such as Slutsky and Hicksian compensation. Additionally, it explores applications like labor supply and intertemporal choice, illustrating how changes in prices and income affect consumer behavior.

Uploaded by

Jana Al-Dossari
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Jana A

Intermediate Microeconomics
Part I - Consumer Theory

Consumer Preferences
Ranking different bundles (combinations of goods and services) without regard to price.
1.​ Transitive: if a ≽, b and b ≽, c, then a ≽ c.
2.​ Complete: any two bundles can be ranked a ≽ b or b ≽ a or a ~ b.
3.​ Monotonic: a = (xa, ya) b = (xb, yb)
a.​ X is good if whenever xa > xb, and ya = yb, then a ≻ b
b.​ X is good if whenever xa < xb, and ya = yb, then a ≻ b
c.​ X is neutral if whenever ya = yb, then a ~ b

Indifference Curves
Set of bundles that the consumer is indifferent about.
IC(x,y) = {(x’,y’) | (x’ y’) ~ (x,y)}
1.​ Slope:
a.​ Downward sloping when both x ​
and y are good or both are bad
b.​ Upward sloping when one is good
and the other is bad
2.​ ICs cannot be thick (based on
monotonicity)
3.​ ICs cannot intersect (based on transitivity
and monotonicity)

Rate of Substitution
Represents how much y the consumer is willing to lose (Δy) to gain Δx.
Marginal Rate of Substitution: dy/dx

Utility
Ordinal (not cardinal) measure of preferences. a ≻ b if and only if it has a higher utility.
-​ Utility functions can be equivalent as long as they are positive monotonic transformations
of one another.

Marginal Utility
MUx = dU/dx , |MRS| = MUx/MUy
-​ Marginal utility is not invariant across different equivalent utility functions.
-​ MRS is invariant across different equivalent utility functions.

Some popular utility functions include: perfect substitutes, perfect complements, Cobb-Douglas,
and quasilinear.

1
Jana A

Budget Sets
Define: Px, Py unit prices of x, y and m available income.
Expenditure = Pxx + Pyy ≤ m

1.​ Change in price causes a rotation around one of the


intercepts.
2.​ Change in income causes a shift with constant slope.

Budget lines can have kinks in special cases like


consumption restrictions, taxes or discounts beyond a
certain quantity, or coupons for one of the goods.

For taxes and discounts on x > a: new intercept = a + (m - Pxa)/(Px’)

Utility Maximization Problem


First Method:
1.​ Check if U is well behaved:
a.​ Positive marginal utility for both goods
b.​ Diminishing |MRS|
c.​ U is continuous and differentiable
2.​ Find tangency point between IC and budget line (|MRS| = Px/Py)
3.​ If (x*,y*) is an interior bundle then it is the optimal bundle.

Second Method:
If U is not well behaved
1.​ Solve for tangency and calculate U(x*,y*) = u1
2.​ Calculate U(m/Px,0) = u2
3.​ Calculate U(0, m/Py) = u3
4.​ Whichever is highest from the three corresponds to the optimal bundle

Third Method:
Construct the Lagrangian: L(x, y, λ) = U(x,y) - λ[m - Pxx - Pyy]
First Order Conditions:
dL/dx = dU/dx - λPx = 0
dL/dy = dU/dy - λPy = 0
dL/dλ = m - Pxx - Pyy = 0
Solve the system of equations to obtain x*, y*, and λ (marginal utility of income).

2
Jana A

Theory of Demand
Marshallian Demand Functions: x(Px, Py, m) & y(Px, Py, m)
1.​ Demand curve represents x as a function of Px
a.​ If it is decreasing x is ordinary and satisfies the law of demand.
b.​ If it is increasing then x is Giffen.
2.​ Engel curve represents x as a function of of m
a.​ If it is increasing then x is a normal good.
b.​ If it is decreasing then x is an inferior good.

Income & Substitution Effects


Deconstructing the effects of a price change into two causes:
1.​ The consumer wants to substitute to or away from x.
2.​ The consumer’s real income (purchasing power) increased or decreased.

To isolate the substitution effect, artificially increase m to restore original purchasing power.
-​ Normality and inferiority is determined by income effects.
-​ Ordinary or Giffen based on total effect.

3 Cases (for Px increases):


1.​ SE < 0 & IE < 0 (normal) → TE < 0 (ordinary)
2.​ SE < 0 & IE > 0 (inferior)
a.​ |SE| > |IE| → TE < 0 (ordinary)
b.​ |SE| < |IE| → TE > 0 (Giffen)
* Normal good cannot be Giffen
* Everything is mirrored when Px decreases

Slutsky Compensation
Compensates the consumer enough to be able to afford the original bundle.
Δm = ΔPx ⋅ x1

Based on m’ find the intermediate bundle (x,y)


SE = x - x1
IE = x2 - x

Hicksian Compensation
Compensates the consumer enough to be able to afford the original utility level.
1.​ Find the original bundle, then original utility level.
2.​ Find the new bundle.
3.​ Find the intermediate bundle by solving the Hicksian demand functions
4.​ SE = x - x1​
IE = x2 - x

3
Jana A

Hicksian demand functions


Represent x and y values with u as the constraint: hx(Px, Py, u) & hy(Px, Py, u)
1.​ Find y in terms of x from the tangency condition.
2.​ Plug that into the utility constraint to find hx
3.​ Then find hy from the relationship you found in step 1

Expenditure Minimization Problem


Opposite of UMP - minimize Pxx + Pyy s.t. U(x,y) = u
Solution is also done using tangency: |MRS| = Px/Py
The solution is the Hicksian demand

Application: Labor Supply


h: labor hours
n: leisure hours
N: max hours available
w: hourly wage rate
m: daily unearned income
c: consumption good

Total daily income (I) = hw + m


Assuming no saving, c = I = w(N-n) + m
→ Pcc + wn = wN + m
*w is the wage rate, it is also the opportunity cost of leisure (you lose w for every hour you
spend not working)

Leisure Demand and Labor Supply (as functions of w) can be either increasing or decreasing
based on the individual’s preferences.

Backward Bending Labor Supply

Income and substitution effects for leisure (with changing w) is calculated the same way but the
way we determine inferiority flips. That is when w increases Pc increases but purchasing power
(of n and c) also increases. So if IE < 0 then n is inferior.

4
Jana A

Application: Intertemporal Choice


A consumer live in two time periods t1 and t2
c1, c2: consumption
Normalize prices p1 = p2 = 1
m1, m2: incomes
r: interest rate

c1 < m1 → Saving/lending m1 - c1
c1 > m1 → Borrowing c1 - m1

Present value eq: c1 + c2/(1+r) = m1 + m2/(1+r)


Future value eq: (1+r)c1 + c2 = (1+r)m1 + m2
* The two equations are equivalent

Changing r:
1.​ When r increases, lenders stay lenders & borrowers are worse off if they still borrow.
2.​ When r decreases, borrowers stay borrowers & lenders are worse off if they still lend.

These equations can be solved as any other utility maximization problem.

You might also like