micro a p 2007-2008

Microeconomic Analysis and Policy

Westminster International University in Tashkent

Module Handbook

BSc Economics

Level 5

4UZE502

Lecturer:Alexey Kim

Contact details: e-mail: [email protected]

tel: 138-74-09 1

Content:

Syllabus 3

Assessment Schedule 7

“The Real Reason I went into Economics” by Dr Steven D Levitt.

Lecture 1. Demand Analysis.

Utility maximization and Indifference curve analysis

10

13

Tutorial 1. Demand Analysis.

Utility maximization and Indifference curve analysis

18

Lecture 2. Consumer's surplus and Marshalian Consumer Theory 20

Tutorial 2. Consumer's surplus and Marshalian Consumer Theory 25

Case study. Social Security Reforms in Russia. 26

Lecture 3. The Individual Supply of Labour. Brands and Branding. 28

Tutorial 3. The Individual Supply of Labour. Brands and Branding. 32

Lecture 4. Properties of the Production Function 33

Tutorial 4. Properties of the Production Function 37

Lecture 5. Cost Functions 39

Tutorial 5. Cost Functions 43

Lecture 6. Perfect Competition, Equilibrium models and Applications 45

Tutorial 6. Perfect Competition, Equilibrium models and Applications

Case study. Organ donor market.

51

52

Lecture 7. Monopoly and monopolistic competition 54

Tutorial 7. Monopoly and monopolistic competition 58

Case study. Mean Vending Machines. 59

Lecture 8. Oligopoly. Further Analysis 62

Tutorial 8. Oligopoly. Further Analysis 65

Lecture 9. Strategy and Game Theory 67

Tutorial 9. Strategy and Game Theory 71

Case study. Pepsi and Coke’s secret formula.

Case study. A treatise on dating: the Prisoner’s Dilemma

72

73

Lecture 10. The Demand for Factors of Production in Competition 76

Tutorial 10. The Demand for Factors of Production in Competition 79

Lecture 11. Monopoly and Monopsony 80

Tutorial 11. Monopoly and Monopsony 82

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Full Module Title: MICROECONOMIC ANALYSIS AND POLICY Short Module Title: MICRO A. & P. Module Code: 4UZE502 Module Level: 5 Academic credit weighting: 15 School/Department: Faculty of Business Length: One semester Module Leader(s): Alexey Kim e.mail: [email protected] Site: Tashkent Host course: BSc Economics Status: Core Relevant course titles/pathways: Subject Board: Economics Pre-requisites: Microeconomics level 4 (2UZE401) or equivalent Co-requisites: none Assessment: 70%examination/30%coursework Special features: none Access restrictions: none Summary of Module content: Recently there have been significant developments in areas of microeconomic policy, such as privatisation and competition policy and also in a number of key issues in corporate governance. These are likely to have important implications for corporate objectives and the interests of the main stakeholders of firms. The module covers the conceptual tools and underlying framework necessary to appreciate the key factors involved in these issues and to apply analysis to specific situations. This involves exploring further the fundamental decisions made by economic agents as consumers, producers and suppliers of factors of production. Module Aims This module extends and enhances the microeconomic analysis studied at level 4. It enables students to appreciate the coherence, rigour and, in some cases, the limitations of microeconomic theory. In order to achieve these aims in each part of the module the main theoretical concepts and tools are applied to particular real-world cases. Learning Outcomes On successful completion of this module students should be able to:

1. Explain the neoclassical model of the economy at the microeconomic level 2. Demonstrate an understanding of the theory of prices and markets 3. Explain the main models of market behaviour, with particular reference to

oligopoly markets 4. Provide an analysis of factor markets 5. Choose the appropriate tools and methods for solving particular microeconomic

problems.

3

Indicative syllabus content The scope and purpose of microeconomic theory Consumer choice: further demand analysis; utility maximisation and indifference curve analysis; Lancaster’s characteristics approach; application examples: empirical demand functions; brands and branding Production and costs: further analysis of production and cost decisions; economies of scale and scope and measurement; learning effects; application examples: empirical cost functions Market models: further analysis of market behaviour; strategic and structural barriers to entry and exit; monopolistic competition; oligopoly markets and Cournot analysis; cartels and co-operative behaviour; application examples: competition policy; contestable markets; price leadership Factor market analysis: demand and supply of factors; competitive factor markets; monopoly and monopsony power; application examples: inequality and poverty; minimum wage legislation; impact of trade unions Teaching and Learning Methods The module will be taught by a combination of lectures and seminars. The lecture provides an overall summary of the key material for each topic, while the seminar takes the form of exercises and group discussions based on questions and case studies. The lecture introduces a particular topic and the seminar aims to reinforce and extend understanding through the use of questions and cases and by examining any issues that might arise. Assessment rationale The module will be assessed by coursework and examination. The coursework consists of an assignment that tests students’ grasp of key concepts and issues and enables feedback on progress in time for remedial action if required. The examination provides a more general assessment of students’ knowledge by testing their ability to analyse microeconomic behaviour and its applications. Assessment criteria In the coursework students will be expected to demonstrate an understanding of key microeconomic concepts and to show their ability to employ these in support of a particular argument or case. They should also demonstrate an appreciation of microeconomic relationships and be able to use relevant economic reasoning. In the examination students will be expected to write under time constraints and to show an understanding of microeconomic analysis and its applications by answering specific questions using appropriate analysis and reasoning. Assessment Methods and Weightings

Assessment Description Weighting Learning outcomes

Student time

Coursework A 2000 word essay requiring microeconomic reasoning and explanation of a particular case or example using relevant data or analysis

30% 1,2,3,5 20 hours

4

Examination A time-constrained closed-book examination consisting of one compulsory question plus a choice of two from approximately five questions requiring essay-type answers

70% 1,2,3,4,5 2.15 hours

Sources Essential reading: W. Nicholson, ‘Intermediate Microeconomics and its Applications’, 9th edition, 2004, Thomson Learning Further reading: D. Besanko and R. Braeutigam, ‘Microeconomics: Theory and Applications’, 2001, Wiley H. Varian, ‘Intermediate Microeconomics, 6th edition, 2002, Norton S.Estrin and D. Laidler, Microeconomics, 4th edition, 1995, Pearson Education A.Koutsoyiannis, ‘Modern Microeconomics, 1979, Macmillan Periodical references: Economic Journal; Review of Economics and Statistics; Econometrica; American Economic Review; Quarterly Journal of Economics WWW references: Office of Fair Trading: www.oft.gov.uk Competition Commission: www.competition-commission.org.uk Federal Trade Commission: www.ftc.gov US Dept. of Justice: www.usdoj.gov Statistics: www.statistics.gov.uk OECD: www.oecd.org Date of initial Validation: July 2004

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MODULE CODE 4UZE502 MODULE TITLE Microeconomic Analysis and Policy Skills assessment weighting % of whole

assessment t p a % Short description

Verbal – one2one Presentations Written reports x x x Coursework e-mail etc Giving and receiving feedback x x Coursework, seminar

Communication

Relationships within groups Leadership Task-centred working x x x Coursework, seminars Group communication Electronic Groups

Team Working

Research x Coursework Problem formulation Methods and tools x x Seminars Options and outcomes Decision making x x Examination

Information for Decisions

Functions of ICT in business; DP Everyday software x Coursework Databases for daily use Using the Internet Working away from home base

ICT in Business

Self confidence, social ease x Sensitive to others/situations x Self/time management x x x Examination Flexibility; working with uncertainty Learning abilities Self-awareness; opportunities Evidence of abilities Personal Development Plan An appetite for life long learning Transfer skills into new situations

Personal Skills Career Career Management Skills

Opportunities – risks and rewards x x Lectures, seminars Customers – the marketing approach x x Lectures , seminars Cost and cash management Operations, logistics, supply chains x x Managing people in organisations The total business environment The competitive environment x x Lectures , seminars Economic, social, political forces x x Lectures, seminars Legal issues Technological changes Environmental/sustainability issues Globalisation, internationalisation The ethical dimension of business Strategic overview

Business Awareness

Module specific skills

6

Westminster International University in Tashkent Microeconomic Analysis and Policy - Assessment Schedule Lecturer: Alexey Kim Course: Economics Module Code: 4UZE502 Module Title: Microeconomic Analysis and Policy Session: 2006/2007 Semester: One Assessment: 30% coursework 70% exam Schedule Summary Assessment Component 1. Coursework 2. Final Exam Date Set - Deadline To be specified Value 30% 70% Feedback To be specified Results Date To be specified Notes on the summary Assessment Component

Your assessment on this module consists of one or more parts – we call them components. A component might be a test, an essay, an exam or some other type of activity.

Date Set This is the date by which your Module Leader will give you a detailed description of the component.

Deadline This is the date that you have to submit your work. You must submit your work to the Registrar’s Office - see below for more information on submitting your work

Value This is the value of the component as a percentage of the overall module mark

Feedback This entry describes the method and date by which your Module Leader will provide you with feedback after the deadline. For example they might provide you with a model answer or a list of the things that you did well and the things that you did badly. Also you should have the chance to discuss the coursework in class with your tutor. Remember that the purpose of assessment is to help you learn…we know that you will be waiting impatiently to have your grade but listening to the feedback and thinking about the strengths and weaknesses of your work is actually more important than knowing your mark.

Results Date This is the date by which we will publish your mark. It may take three or four weeks to do this because your work has to be seen by several people. Your Module Leader or your tutor will mark it, and then it may be second-marked by another member of staff. Samples of work are sent to the University of Westminster for their approval and comments.

How to contact Alexey Kim Phone: 138-74-09 Email: [email protected] Office Hour is: Friday at 16.00 during term-time

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Component Descriptions

Component one-Coursework Coursework is a 2000 word essay requiring microeconomic reasoning and explanation of a particular case or example using relevant data or analysis.

In the coursework students will be expected to demonstrate an understanding of key microeconomic concepts and to show their ability to employ these in support of a particular argument or case. They should also demonstrate an appreciation of microeconomic relationships and be able to use relevant economic reasoning.

Tested learning outcomes are:

1. Explain the neoclassical model of the economy at the microeconomic level

2. Demonstrate an understanding of the theory of prices and markets

3. Choose the appropriate tools and methods for solving particular microeconomic problems.

Component two-Final Exam A time-constrained closed-book examination consisting of one compulsory question plus a choice of two from approximately five questions requiring essay-type answers. In the examination students will be expected to write under time constraints and to show an understanding of microeconomic analysis and its applications by answering specific questions using appropriate analysis and reasoning. Deferrals

• If - as a result of submitting extenuating circumstances - you are offered a deferral in any of the components then you will be responsible for finding out from the Registrar’s Office about the deadline and other details of the deferred assessment.

Calendar of Assessments: Microeconomic Analysis and Policy 2006/2007

Date Teaching Week

Lecture Deadline

01 Oct. 2007 1 Basics of Consumer Theory 08 Oct. 2007 2 Consumer’s Surplus and Marshalian Consumer Theory

15 Oct. 2007 3 The Individual’s Supply of Labour. Brands and Branding.

Advertisement.

22 Oct. 2007 4 Properties of the Production Function. 29 Oct. 2007 5 Cost Functions.

05 Nov.2007 6 Perfect Competition. Equilibrium models. Applications. 12 Nov.2007 7 Monopoly and Monopolistic Competition. 19 Nov.2007 No classes Independent Learning Week. 26 Nov.2007 8 Models of Oligopoly. 03 Dec.2007 9 Theory of Games

10 Dec.2007 10 Factor market Analysis. Demand and supply of factors. Competitive

factor markets.

17 Dec.2007 11 The Demand for Factors of Production: Monopoly and Monopsony.

24 Dec.2007 12 Revision week. 31 Dec.2007 New Year Holiday. 07 Jan.2007 Consolidation Week: no classes, time for you to reflect and revise 14 Jan.2007 21 Jan.2007

Assessment Weeks 1-2

28 Jan 2007 04 Feb. 2007

Marking Weeks 1-2

11 Feb.2007 Semester 2 Begins

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Important notes Submission of work

You must submit your work via the Registrar’s Office on or before the published deadline. The Registrar’s Office will keep a record of all work submitted. Never give your work directly to the lecturer.

Late work Work which is submitted late, but no more than 24 hours late, will score a maximum mark of 40% (unless there are extenuating circumstances). Work which is submitted more than 24 hours late will automatically score zero (unless there are extenuating circumstances). If you cannot submit your work on time then you must always submit it as soon as you possibly can even if there are extenuating circumstances.

Extenuating circumstances affecting any coursework/class test If there are extenuating circumstances which mean that:

• You are unable to attend a test • Your performance in a test is adversely affected • You cannot submit your work on time

Then you must fill an extenuating circumstances form. The correct form must be collected from and returned to the Registrar’s Office. The deadlines for submission of extenuating circumstances forms are

• 17.00 4 February 2007 for assessments with a deadline in Semester One • 17.00 10 June 2007 for assessments with a deadline in Semester Two

For more information refer to your course handbook and student handbook. You must provide strong evidence to support your case. In the case of illness you will need a medical certificate.

Reassessment The pass mark for this module is 40%. You do not have to pass each and every component but you do have to achieve an overall mark of 40%. Additionally you must achieve a minimum of 30% in any component worth 30% or more of the module mark. If you fail to achieve 40% overall or if you have less than 30% in a component, then you have not passed the module but you may be offered a referral (a referral is a second chance to pass the module with the final mark capped at 40%). It is your responsibility to check your results (published by the Registrar’s Office at the end of the semester) and to find out about any referrals that you might have been offered. Referrals usually take place the next time the module runs (i.e. in the next academic year).

Keeping a copy of work You must keep a copy of every piece of work handed in (a printed copy as well as an electronic copy).

Standard format for submission of work Unless otherwise stated, coursework must be submitted as follows:

• We would prefer word-processed work rather than hand-written work • Include a cover page with the assessment title, and your student registration number. NO NAME.

Never put your name. Registration number only. • Include a contents page giving the headings and page numbers of each section • Pages should be numbered • Work should be kept to the minimum number of pages possible • Please do not submit any loose pages • Put one staple in the top left-hand corner, please do not bind or cover your report • VERY IMPORTANT: your name should not appear on the cover page or anywhere else. We

will be operating a system of anonymous marking (when the lecturer marks your work they will not see your name). Please put your registration number on the cover page and nowhere else.

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Dear Students, Just a food for thought given to you by famous economist Dr. Steven D. Levitt. The real reason I went into economics1

They teach you a lot of things when you study economics: about marginal cost, incentives, dynamic optimization, etc. But up until now, the real reason for why people study economics had been a closely held secret known only to economists—kept carefully hidden away from the hoi polloi. Well, it turns out Joey Cheek, of all people, is the one who blew the secret. You may remember Joey Cheek as a gold medal speed skater from the Winter Olympics. It turns out he is also quite smart. He was admitted to Yale, Princeton, and Stanford. (Harvard, however, turned him down.) Parade magazine quotes Cheek as saying that he plans to study economics. And then he goes on to blow the secret we economists have so carefully guarded for all these years. He plans to study economics because “that’s what gets the chicks.” (My wife Jeannette adds that I am living proof.) Posted by Steven D. Levitt @ 10:40 pm on Sunday, May 21, 2006 in General 23 Responses to “The real reason I went into economics” melissa Says: May 21st, 2006 at 11:34 pm When I declared an economics major, I admittedly thought some of my male economics professors were really quite attractive and even noticed my female professors had some good looking husbands. dachisb Says: May 22nd, 2006 at 1:32 am That’s because economists do it with models! shining Says: May 22nd, 2006 at 2:11 am Then why do women study econ? Speedmaster Says: May 22nd, 2006 at 6:31 am LOL! I’ve taken a lot of econ classes, and as I looked around the room, it looked only marginally better than the computer science classes! Monkeydarts Says: May 22nd, 2006 at 9:02 am On the other hand… 1 http://www.freakonomics.com/blog/2006/05/21/the-real-reason-i-went-into-economics/#comments

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Dave Meleney Says: May 22nd, 2006 at 9:52 am He doesn’t say the othere econ students are hot…. he says they know how to (or have what it takes to)get the chicks. Which is a lot more interesting, no? StCheryl Says: May 22nd, 2006 at 10:24 am I think he’s confusing economics and finance. Just a thought. kkwan Says: May 22nd, 2006 at 11:55 am ‘Tis true. I went to Yale. Majored in Economics. Met my wife in Macro. I got my BA, she got a MRS. ciara86 Says: May 22nd, 2006 at 2:19 pm I can testify that it doesn’t work the other way around. I’m a girl studying Financial Maths and Economics and when I tell men this they PHYSICALLY step away from me…. tim in tampa Says: May 22nd, 2006 at 2:49 pm when I tell men this they PHYSICALLY step away from me…. That’s funny, I’ve been looking for an econ major my whole life. You’re talking to the wrong men, I think Newfred Says: May 22nd, 2006 at 5:14 pm I put this down to an apparent predeliction amongst British economists for long hair in extravagant styles, evidenced by the economics correspondents for all major UK networks. Grant Says: May 22nd, 2006 at 5:23 pm I never thought this concept to be the case in my economics class… Of course, what do I know? I’m just an engineer. ciara86 Says: May 22nd, 2006 at 6:03 pm That’s probably true but until I start talking to the right men I’m going to keep on pretending I study nursing zbicyclist Says: May 22nd, 2006 at 10:17 pm So, who are the top 10 sexiest economists? Photo link must accompany nomination. Any sex or sexual orientation is eligible. kkwan Says: May 23rd, 2006 at 11:31 am Dear God, I hope no one includes Greenspan. synapticmisfires Says: May 23rd, 2006 at 5:58 pm

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“That’s because economists do it with models!” Harimau Says: May 24th, 2006 at 3:13 am ciara86, i kind of know how you feel. I’m a (male) actuarial studies student, and almost half the girls i meet always take a physical step back every time i tell them i do actuarial studies. Suddenly they don’t seem as interested before… Does this happen to economics students as well? Leviathan Says: May 24th, 2006 at 2:07 pm woe is you. Try getting a masters in accounting. It works like magic when you’re out on saturday night. I guess I have to back to school. Again. Aaron_B Says: May 25th, 2006 at 7:39 pm Heheh. Saying you “study economics” doesn’t get the girls. Using the concepts you learn as an economist in addition to telling them you “enchance and measure human happiness”, however, does. johnleemk Says: May 28th, 2006 at 8:53 am To those saying that the people in their economics class are unattractive, I thought what Cheek (and dear Dr. Levitt) is saying is that being an economics students gets you chicks (who don’t have to be economics students themselves). Indeed, it might even be subtly implied that economics students are physically unattractive, but their study of supply and demand lends them an aura of desirability. There are couple of things I know for sure: 1. I have yet to get a date in college despite repeatedly stating my interest in economics; 2. None of the girls in my economics class are hot. saibhin Says: June 1st, 2006 at 11:17 am ok first of all, in my experience economists aren’t the sexiest creatures alive. in fact, i’d rank engineers, advertising creatives, architects and doctors and trust fund layabouts all much higher. however, i would like to draw your attention to the first rule of freakonomics which is that just because two variables are related doesn’t mean that you can assume which causes what. so. people back away from you at parties. is this because you’re an economist and the very idea of dating an economist is anathema to gorgeous guys and hot chicks OR is it because geeky types are atracted to economics in the first place? i work in advertising. i heard a few years ago that people who worked in advertising had the shortest life expectancy of any profession. i immediately asked myself whether this is because advertising is bad for your health or because advertising attracts live life on the edge over indulgent stress-heads?! i think the latter. just askin…

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Microeconomic analysis and policy

Lecture 1.

BASICS OF CONSUMER THEORY

Agenda

• Consumer choice, budget constraint.• Consumer’s tastes• Solution to the choice problem• Income and price consumption curves• Engel’s curve• Hicks and Slutsky real income• The idea of revealed preference

Consumer choice, budget constraint

• Two goods case

• The budget constraint equation is:

YpXpM YX +=

Budget constraint

X

Y

The consumer’s tastes.

• Recall core assumptions about consumer preferences.

• Preferred bundles.

• Indifference curves must - have a negative slope and- to be convex to the origin.

• Indifference curves cannot intersect.

Consumer preferences: assumptions

Completeness. For any pair of bundles A and B, either A ≥ B or B ≥ A (or both).

It implies that given some bundle X, every other bundle can be put into one of three sets:

1.The set of bundles preferred to X, which is called the “better set” for X;

2.The set of bundles indifferent to X, which is called the indifference set of X;

3.The set of bundles to which X is preferred, which is called the “worse set” for X.


• Transitivity. For any three bundles A, B, C, if A ≥B and B ≥ C then A ≥ C.

It implies that indifference set have no intersection.• Reflexivity. A ∼ A.It ensures that every bundle belongs at least one

indifference set.• Continuity. The graph of an indifference set is a

continuous surface.It implies that the surface has no gaps or breaks at

any point.

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• Strict convexity. Given any consumption bundle A, its better set is strictly convex.

The reason is principle of diminishing marginal utility.

A

B

xa1

xa2

xb2

xb1 X 1

X 2

Consumer preferences phenomena

Cup of coffee and bit of sugar

Seats in the theatre and ticket pricing

Consumer preferences phenomenaLondon Coliseum Consumer tastes.

The shape of indifference curve represents a

law of diminishing marginal rate of substitution

between the goods.

Solution to the Choice problem

• Consumer wishes to maximize utility, subject to a budget constraint.

• See the attachment 1.

X

Y1

B

A

X1

Y

Maximum satisfaction

The income consumption curve

• As the consumer income increases consumption shifts from A to B.

• (A) is an increase in consumption of both goods: they are normal.

• (B) consumption of X falls: it is an inferior good, Y-normal. • (C), X is normal, Y is inferior.

X

B

A

Y

(A)X

B

A

Y

(B)

BA

X

Y

(C)

14

Income-consumption curve

• Y is everywhere normal

• X is normal at low levels of income, but becomes inferior at higher levels.

X

Y

Income consumption curve

Price consumption curves

• As the price of X falls the consumer moves along a price consumption curve.

• (A) X and Y are complements • (B) X and Y are substitutes • (C) X is a “Giffen” good

X

Y

(A)

Price consumption

curve

X

Y

(B)

Price consumption

curve

X

Y

(C)

Price consumption

curve

The Engel curve.

The relationship between a consumer’s income and the quantity of good bought.

Income (Y)

X

(B)

Engel Curve

2

1

Y

(A)

3

1X 2X 3X

YPM /1

YPM /3

YPM /2

Income Consumption

Curve

1X

2X

3X

3M2M1M

The demand curve.

Demand curve is easily derived through the elasticity concept.

X

Y

(A)

Price consumption

curve

X

Y

(B)

Demand Curve

1X 2X 3X1X 2X 3X

3P

2P

1P

1 2 3

Income and Substitution Effect

X

Y

Price consumption

curve

A

C

B

Income consumption

curveI

I

II

II

0X 2X 1X

0Y

2Y

Constant Real Income and the Compensating Variation in Money Income

(a)

X

Y

1

1X 2X3X

2

3

X

Y

1X 2X3X

2p

1p

Constant real incomeDemand curve

Normal (constant money income)Demand curve

(b)

15

Two measures of real income.

• Hicks real income

• Slutsky real income.

Two Measures of Real Income

• (a) An alternative way to analyse the income and substitution effects.

• (b) X is a normal good.• (c) X is an inferior good.

X

Y

Income consumption

curve

AC

B

21 3

Price consumption

curve

X

p

1X

`1p

X

p

1X

`1p

(a) (b) (c)

S

S

S

S

H

H

H

H

Constant Real Income and Equivalent Variation in Money Income

X

Y

Income consumption

curve

A

C

B

21 3

Price consumption

curve

(a)X

Y

Income consumption

curve

A

C

B

21 3

Price consumption

curve

(b)

The Idea of Revealed Preference

X

Y

AC

21 3

B

b

b

Reading

• Laidler D., Estrin S. 1995. Introduction to Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 1,2,3, pp1-39.

• Varian H. 2002. Intermediate Microeconomics. 6th Edition, Norton&Company: New York. Ch 2, 3,4,5,6,7,8,14,15 pp20-155, 245-279.

• Nicholson W. 2004. Intermediate Microeconomics and its applications. 9th Edition, Thomson Learning. Ch 1,2,3,4. pp3-148.

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Lecture 1. Consumer Theory.

Attachment 1. An algebraic solution to the choice problem.

Here: M is the consumer’s money income; X and Y are goods, and money prices and . xp yp

Hence any pattern of expenditure which satisfies the inequality below is feasible:

YpXpM yx +≥ (1.1)

The consumer’s utility is: ),( YXuU = (1.2)

Taking the total differential of (1.1)

dYYUdX

XUdU

∂∂

+∂∂

= (1.3)

The utility is constant when 0=dU , therefore:

0=∂∂

+∂∂ dY

YUdX

XU (1.4)

Rearranging the (1.4) YUXU

XY

∂∂∂∂

=∂∂

−// (1.5)

Since XY∂∂ is the slope of the indifference curve (the way in which Y changes when X changes).

The Choice problem is to maximize (1.2) subject to (1.1). Let’s limit the analysis to situation in which the consumer is on the budget constraint, so that (1.1) becomes:

0=−− YpXpM yx (1.6) using the Lagrange multipliers, by forming the function:

)(),( YpXpMYXuV yx −−+= λ (1.7) λ is the Lagrange multiplier. The first order conditions for (1.7) to be maximized are:

0=−∂∂

=∂∂

xpXU

XV λ (1.8)

0=−∂∂

=∂∂

ypYU

YV λ (1.9)

0=−−=∂∂ YpXpMV

yxλ (1.10)

Equation (1.10) tells us that consumer must choose a bundle of goods on the budget constraint to maximize utility. Dividing equation (1.8) by (1.9) yields:

y

x

pp

YUXU

=∂∂∂∂

// (1.11)

the right had side is the ratio of prices of the two goods, and the left-hand side is the ratio of marginal utility of X to that of Y.

Equations (1.8) and (1.9) taken together yield: yx p

YUp

XU ∂∂=

∂∂=

//λ .

17

TUTORIAL 1. DEMAND ANALYSIS.

Task 1. Golfer’s problem.

Derive the relationship between the quantity of X and the price of X, if the

consumer’s indifference map compared with X and Y has curves concave to the origin.

Let X be games of golf per annum and Y all other goods. Draw the indifference map and

budget constraint of:

(a) An amateur who pays to play golf;

(b) A professional who is paid to play golf.

May we conclude that golfers turn professional because they dislike the game?

Task 2. Ticket Scalping.

Tickets to major concerts or sporting events are not usually auctioned off to the

highest bidder. Instead promoters tend to sell most tickets at “reasonable” prices and then

ration the resulting excess demand either on a first-come-first-served basis or by limiting

the number of tickets each buyer can purchase. Such rationing mechanism create the

possibility for further selling of tickets at much higher prices in the secondary market-that

is, ticket “scalping”.

Describe the situation using indifference map analysis.

Scalping is just one example of the “black markets” that arise when goods are

rationed by means other than price. What are a few other examples? Are these black

markets undesirable?

Task 3. Engel’s Law.

One of the most important generalization about consumer behaviour is that the

fraction of income is spent on food tends to decline as income increases. Table 1 illustrated

the data that Engel used. They clearly show that richer families spent a smaller fraction of

their income on food.

Table 1. % total expenditure on various items in Belgian families in 1853.

Annual Income Expenditure Item $225-$300 $450-$600 $750-$1000

Food 62% 55% 50% Clothing 16% 18% 18%

Lodging, light, and fuel 17% 17% 17% Services (education, legal, health) 4% 7.5% 11.5%

Comfort and recreation 1% 2.5% 3.5% Total 100% 100% 100%

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Recent data.

Recent data for US consumers (table 2) tend to confirm Engel’s observation.

Wealthy families devote a smaller proportion of their purchasing power to food than do

poor families. Comparisons of the data from table 1 and table 2 also confirm Engel’s law-

even current low-income US consumers are much more affluent than 19th century Belgians

and, as might be expected spend a much smaller fraction of their income on food.

Table 2. % total expenditure on various items by US consumers in 2000.

Annual Income (000) Expenditure Item $15-$20 $40-$50 $70+

Food 15.4% 14.7% 11.4% Clothing 4.8% 4.7% 5.3% Housing 32.9% 30.4% 30.2%

Other Items 46.9% 50.2% 53.1% Total 100% 100% 100%

Hint: Reverse % into dollars and the Engel’s curve will appear.

Question: The data in table 2 includes food both eaten at home and in restaurants. Do you think eating at restaurants follows Engel’s law?

Task 4. Crime and Punishment.

You may hear many times that bribery increases when government tries to tackle

the problem of corruption. For example, government announces the policy to reduce

corruption among officials, although such a policy only increases the amount of bribe

taken. Can you explain such a paradox, taking into account the information below?

Economist looks at crime as a rational act of an economic agent, who faces the

problem of allocating time between legal and illegal activities. Suppose that a person must

decide whether to be a criminal or not. Anyway he will work for 8 hours a day and must

allocate these 8 hours between legal and illegal activities.

If the person is honest he will receive an hourly wage of (honest wage). If the

person is dishonest his wage will be (dishonest wage). The person has some ethics and

therefore has preferences how he earns his income. However money is money and

dishonest £ is just as good as honest £.

hw

dw

If the person engages in criminal activities there is a chance for him to be caught

and sent to jail. Hence such a risk makes illegal activity less attractive. The cost of the

person being put in jail isπ , which is subtracted from his dishonest wage. The π will

depend on certain factors like the number and efficiency of police, person’s distaste for

spending time in jail.

19

Lecture 2.

CONSUMER’S SURPLUS.

MARSHALIAN CONSUMER THEORY

Agenda.

• The “Standard of Living” and the ”Cost of Living”.• Measuring Changes in the Cost of Living • The Concept of Consumer’s Surplus.• An application of Consumer’s Surplus.• Marshalian Consumer Theory.• Marshalian Analysis and Indifference Curves.• The Algebra of Marshalian Analysis.• The Idea of Duality.

The Standard of Living and the Cost of Living

X

0Y''C

CB

A

2Y

1Y

1 2

3

''3

Measuring Changes in the Cost of Living

X

0Y '''C

'C BA

4Y

3Y

1 2'3 '''3X

B

A

Y

1

2 3

4

Indexes

)()(

0000

0101

YpXpYpXpLaspeyres

YX

YX

++

=

)()(

1010

1111

YpXpYpXpPaasche

YX

YX

++

=

Reservation price and consumer’s surplus.

1r

Quantity

Price

Quantity

Price

2r1r

3r4r5r6r

1 2 3 4 5 6

1r

2r3r

4r

6r5r

1 2 3 4 5 6

p

A) Gross Surplus B) Gross Surplus

20

Approximating a continuous demand

Quantity

Price

p

x Quantity

Price

p

xA) Approximation to Gross Surplus B) Approximation to Net Surplus

The change in consumer’s surplus.

'p

''p

'x''x x

p

RT

Demand Curve

Change in Consumer’s

Surplus

Producer’s surplus

Producer’s surplus Change in

producer’s surplusS S

P P

p`

p’`p*

x* x` x``

Cost-benefit analysis (Impact of price ceiling)

S

D

Price

CS

PS

Pe

Po

Pc

Qc = Qe Qo Quantity

An Application of Consumer’s Surplus

X

0Y

2Y

1Y

0X1X

Marshalian Consumer Theory.

X1X

A

BMU

21

Marshalian Consumer Theory

(a) The consumer’s surplus from so doing is given by the area SBA.

(b) The gain in consumer’s surplus as a result of the price of X falling from p1 to p2 is given by p1A1A2p2.

X1X

A

BMU

X2X

1A

Bp

2X

C

S SD

1X

1p2A1p

2p2p

D

(a) (b)

Marshalian Analysis and Indifference Curves

X

1A

Y

2A

0A

3A2Y3Y

1Y

0Y

12

34

The Algebra of Marshalian Analysis. Idea of Duality.

• See the attachments 1 and 2.

Attachment 2.

X

Y

O

),,(* uppY YX

*X

u

A

X

XY

Y

ABC

D

da

c b

4B

1D

1B 2B

3B

11p

01p

2/ pEV

2/ pCV

01h 1

1h

2I1I

X

Y

2p

1p

*1X *

2X

A

B C

D E

G

F

Compensated demand curve

through 1p

Compensated demand curve

through 2p

Uncompensated demand curve

through

22

Reading• Laidler D., Estrin S. 1995. Introduction to

Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 2,3, pp39-65.

• Varian H. 2002. Intermediate Microeconomics. 6th

Edition, Norton&Company: New York. Ch 14, pp245-263.

• Nicholson W. 2004. Intermediate Microeconomics and its applications. 9th Edition, Thomson Learning. Ch 3. pp89-124.

23

Lecture 2. Consumer’s Surplus and Marshalian Consumer Theory . Attachment 1. The Algebra of Marshalian Analysis.

We need to find a specific form of the utility function which has the following characteristics: 1. Interdependence of the marginal utilities of X and Y 2. Constancy of the marginal utility of Y 3. Tendency of the marginal utility of X to decline with its quantity

Such a utility function is given by: (1.1) 1 , <+= αα bYaXUWe may write the budget constraint as: 0=−− YpXpM yx (1.2) Forming the Lagrangian expression: (1.3) )( YpXpMbYaXV yx −−++= λα

Taking the partial derivatives of (1.3) with respect to X, Y, andλ , and setting it equal to zero gives us first-order conditions for a maximum:

01 =−=∂∂ −

xpaXXV λα α (1.4)

0=−=∂∂

ypbYV λ (1.5)

0=−−=∂∂ YpXpMV

yxλ (1.6)

Eq (1.5) may be rearranged to yield:

Yp

b=λ (1.7)

If we hold the price of Y constant (hence (1.5) is λλλ ==−=−=∂∂ bbpb

YV

y ;01 ), we may

define it as being equal to unity and (1.4) becomes 01 =−−

xbpaX αα (1.8) We can solve the equations (1.6) and (1.8) for the unknowns Y and X as functions M and . xpEquation (1.6) may be rearranged as:

Xp

YMX −= (1.9)

and (1.8) as

(1.10) )1/(1 −= α

xRpXwhere

)1/(1)( −= α

αabR (1.11)

Substituting (1.9) into (1.10) gives us the demand for Y a function of M and : xp

(1.12) )1/( −−= αα

xRpMYand substituting this back into (1.9) gives us the demand function for X:

)1/(1)1/( /][ −− =+−= αααxxx RppRpMMX (1.13)

24

TUTORIAL 2. CONSUMER’S SURPLUS AND

MARSHALIAN CONSUMER THEORY.

Task 1. Ambiguous Altruists. As you know consumer’s choice theory is based on certain assumptions. One of such assumptions is the selfishness of people in other words people are egoistic. Some economic activity that looks altruistic on the surface still satisfies the selfishness assumption if one takes a long-term view on the situation. For example, consider the action of office workers who set up a voluntary coffee club. They agree to pay 50 cents for each cup they drink and to make coffee when the pot is empty. Clearly, when no one is looking, it is possible to drink the last cup, not make any more coffee, and not contribute the 50 cents owed for the cup that was consumed. Despite their ability to cheat and make a “clean gateway”, people usually do not take advantage of the opportunity. Compliance with the voluntary rules of the coffee club is not motivated by unselfishness but by a fear that failing “to do one’s part” will break the socially beneficially norm of the contribution and cause the coffee club to cease operations. Of course, this would deprive everyone in the office of the advantage of convenient and cheap cups of coffee. Selfish people are capable of acting in what appears to be a socially considerate manner while pursuing their own self-interest. Are the members of the coffee club altruists or not? Task 2. Calculating the Indexes.

The following observations are taken on a consumer’s behaviour on two successive weeks:

Week 1: price of X =£10 Quantity of X bought =10 units per week price of Y = £10 Quantity of Y bought =10 units per week Week 2: price of X =£5 Quantity of X bought =20 units per week price of Y = £20 Quantity of Y bought =5 units per week 1. Has the consumer’s money income changed between the two weeks? 2. Calculate the Laspeyres price index for week 2 taking its value in week 1 to be 100. 3. Calculate the Paasche price index for week 2 taking its value in week 1 to be 100. 4. Has the cost of living risen between week1 and week2? Task 3. Car and Consumer’s Surplus. Suppose that it costs 12 pence a mile in direct operating costs to run a car. Let X be miles per week and p be measured in pence and an individual’s demand curve for car transport is given by:

p=400-4Q (a) How many miles a week will be driven? (b) How much consumer’s surplus will be gained from operating the car? (c) Would the person be wiling to pay a fixed cost, over and above variable costs, of

£60 per week to operate the car? (d) Suppose the direct cost of operating a car rose to £2 per mile because of increase

in the price of petrol. How would your answers to questions (a), (b), (c) change? Use the Marshalian demand curve assumptions in answering this question.

25

Task 4. TV Watching and Electricity Costs. Starting with individual’s Marshallian demand curve for hours of television watching and the knowledge that each hour’s watching uses a given amount of electricity, show how a fall in the price of electricity will affect:

(a) the amount an individual is willing to pay to rent a television; (b) the market demand curve for rented television.

Task 5. Should I turn down my stereo? You have settled into a comfortable chair and are listening to your stereo when you realize that the next two tracks on the album are ones you dislike. If you had a compact disk player, you would have programmed it not to play them. But you don’t and so you must decide whether to get up and turn the music down or to stay put and wait it out. The benefit of turning it down is not having the songs you don’t like blare away at you. The cost, in turn, is the inconvenience of getting out of your chair. If you are Extremely comfortable and the music is only mildly annoying, you will probably stay put. But if you haven’t been settled for long or if the music is really bothersome, you are most likely to get up. Can you translate the costs and benefits into a monetary framework, using the notion of reservation price? Task 6. Calculating CV and EV. A consumer chooses weekly quantities of X and Y in order to maximize the utility

function: 21

21

YXU = . Total income over the week is $100, and the prices of X and Y are $5 and $10 respectively.

(a) How much of X and Y will the consumer buy? (b) What happens to the demand for X if the price for X rises to $10? (c) What happens to the demand for Y if the price of X rises to $10? (d) What is the equivalent and compensating variation from the increase in the price of

X from $5 to $10? (Hint: calculate the utility levels at each price combination and apply the formulas in eq. (2.9) and (2.10) in your lecture attachments).

Task 7. Social Security Reforms in Russia1. Please read the following article and think about the social security reforms in Russia. Did this reforms benefit people? Answer this question using the CV and EV.

“On Friday, Duma First Deputy Speaker Lubov Sliska said that she does not rule out that Mikhail Fradkov’s government will resign. She said that anything is possible, commenting on pensioners and invalids protesting across the country against substitution of benefits and discounts by cash payouts. Sliska said that there are already grounds for resignation. The government is reforming the social security system, removing the outdated Soviet system of non-cash benefits and discounts. Pensioners and invalids receive discounts for local telecom services, transportation, housing services, etc. In total, annual benefits that the government by law should pay amount to two or three years of federal budget receipts. The government implemented legislation, which eliminated benefits from 1 January 2005. Simultaneously, it increased social cash payments that are to be paid later

1 www.mdmbank.com, Equity Markets Daily 17 January 2005

26

this year. The difference in timing led to protests. For some reason that we cannot fathom, this was a surprise for the government. Although social reforms are very difficult for any government, social protests indicate that the government’s work was not very effective. Last autumn, the president called for smooth implementation of social reform but the government failed. Now, the ministries are trying to correct the situation. Later, Duma Speaker and head of the Yedinstvo party Boris Gryzlov downplayed Sluska’s comments. He suggested that the party and the government should cooperate to solve problems with reform. Various political groups started to call for the government to resign. This reform already led to the decline of the government’s and President Putin’s rating. People are dissatisfied with their work. In some regions, pensioners, a very politically active group, started to demand the resignation of Putin. Eventually, Putin may have to make some hard decisions because of the reform. After the Beslan tragedy, this reform is the second development decreasing faith in Putin. This could restrain the government’s ability to implement other reforms. On the other hand, it could give the president grounds to change the government sooner. We would also point out that in the five years of Putin’s rule, this is the first serious protest.”

27

Lecture 3.

THE INDIVIDUAL’S SUPPLY OF LABOUR.

BRANDS AND BRANDING

Agenda.• The Nature of the Choice Problem.• Variations in the Wage Rate.• Overtime Payments• The effect of fixing the length of the working week• Household Production and the Labour Market.• Household Production and the Labour Supply Function.• Lancaster’s Characteristic Approach• Goods, Attributes and Choice• The Basic Framework• Brand Loyalty and Branding• Product Differentiation and Market Research• Advertising

The Nature of the Choice Problem

• The object of choice are income and leisure.

• Constraint upon the choice is the total number of hours in a week.

• Individual’s tastes are the usual bundles of two goods (leisure and income).

Indifference map and the choice.

2Y

0Y

0L1L

Y

L0

2L

1Y

)(A 0L

Y

L0

)(B

Variations in the Wage Rate

0Y

0L1L

Y

L0

2L

2W

)( 20 LL −0

1W

3L

A

B

2

1

W

hours worked

S

(A) (B)

)( 30 LL −


0Y

0L1L

Y

L0

2L

2W

)( 20 LL −0

1W

3L

AB

2

1

W

hours worked

S

(A) (B))( 30 LL −

28


0Y

0L1L

Y

L0

A

B

2

1

1Y

3

C

Overtime Payments

0Y

0L1L

Y

L0

A

B

2

1

1Y

3

C

1I

2L

3Y2Y

Household Production: the Simple Case.

2Y

0Y

0L1L

Y

L0

2L

1Y

2Y

0Y

0L1L

Y

L0

2L

1Y

3L

A

B

C

Household Production: The Simple Case

2Y

0Y

0L1L

Y

L0

2L

1Y B

A

C

Household Production and the Labour Market.

0Y

0L1L

Y

L02L

1YB

A

12L

'EE

'DD

Household Production and the Labour Market

0Y

0L1L02L

3Y

B

A

'2L

'D D''D

2

1

3

'3Y

2Y

'2Y

''2Y

'3L ''

2L3L

29

Household Production and the Labour Supply Function

0Y

0L1L02L

3YB

A

'2L

'DD

2

1

'3Y

2Y'

2Y

'3L

3L

Goods, Attributes and Choice

• Individual gets satisfaction in consumption:- not from the goods themselves, - but rather from their attributes.

• The constraint upon choice is determined by income, prices and the technical characteristics of the goods.

• The demand for goods and services is:- not a result of choice making behaviour, - but an indirect result of more fundamental choice-making process.

The Basic Frameworkbrand 1

brand 2

brand 3

R

SO

1X

2X

3X1I

2I

3I

*2X

A Simple Application-Brand Loyalty

“Brand Loyalty” is the phenomenon of continuing to buy a particular brand even though its price may have risen relative to others.

An Elaboration-Combining Brands

brand 1

brand 2

brand 3

R

SO

1X

2X

3X

'0X

A '2X

B

0X

Product Differentiation and market Research.

brand 1

brand 2

brand 3

R

SO

1X

2X

3X

brand 4

A

30

Advertising• Consumers are usually unfamiliar with the

technical characteristics of each particular brand.

• Advertising informs consumers about brands, where and at what price they are available, and their attributes.

• Advertising attempt to change consumer’s tastes and can be interpreted as informative tool.


Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 5,8, pp69-80, 111-122.




31

TUTORIAL 3. THE INDIVIDUAL SUPPLY OF LABOUR. BRANDING.

Task 1. Perfect Substitutes. Suppose that income and leisure are perfect substitutes. Use indifference curve and budget line diagrams to illustrate the cases when:

(a) The individual will work for every hour available. (b) The individual will not work at all. (c) The individual will work an indeterminate number of hours.

Task 2. Income Tax and Individual Supply of Labour. An individual is known to increase the hours per week worked when non-wage income is decreased. What will happen to the hours worked if:

(a) A proportional income tax is levied on wage income; (b) A proportional income tax is levied on total income; (c) A proportional tax on wage income is used solely to finance an increase in non-

wage income? Would any of your answers differ if the individual were known to decrease working hours when non-wage income decreased? Task 3. Numerical Example. Draw the budget constraints on the work/leisure choice implied by the following information: (a) non-wage income=$100 per week; wage rate=$4 per hour. (b) non-wage income=$200 per week; wage rate=$2 per hour. (c) non-wage income=$200 per week; wage rate for first 40 hours=$2 per hour. (d) non-wage income=$0 per week; for 40-hour week with no hours less than 40 = £120 per week. Overtime payment rate=$5 per hour. Task 4. Substitutes, Complements and Branding. A fall in the price of a particular brand of good could lead to less of it being demanded. Where the good in question has two attributes, R and S (a) could this happen if R and S were substitutes for each other; and (b) must it happen if they are complements?

32


Lecture 4.

Properties of the Production Function.

Agenda• Activities and the Isoquant• Production Function• Long-run and Short-run Analysis• Returns to Scale and Variable Returns to Scale• Substitutability and Elasticity of Substitution• The Short-run Production Function and Returns

to a Factor• Cobb-Douglas Production Function.

Introduction• Production is a very general term. It is:- not only the production of physical goods,- but also services.

• It will be assumed the production of good to be (X) and two inputs to production.

• These are factors of production:- capital (K) and- labour (L).

Think of these:• Production of housing services

(child care, home maintenance, cooking etc.)• Production of health

(purchased medical care and own time to produce health)

• Production of children(children have both quantity and quality dimensions, optimum combination?investment is an irreversible process, hence people view it as a quite risky investment.)

Activities and the Isoquant

K

LO

K

LO

13X

23X

21X

12X A

22X

B

11X

14X

15X

24X25X

1

2

1 2

3

4

13X

23X33X

43X

(A) (B)

Production Function

LO

KR

1X

2X3X

4X5X

33

The long-run production function.Assumptions:

• is monotonic function, so that if X rises, then either L or K, or both rises.

• Free disposal

• Average product of labour or labour productivity is (X/L)

• Average product of capital or capital productivity is (X/K)

• Marginal product of labour :

• Marginal product of capital is:

),( KLfX =)(⋅f

LX ∂∂ /

KX ∂∂ /

Returns to Scale and Homogenous Functions

• If and vary in the same proportion, these are constant returns to scale.

• Production function is homogenous of degree if :

where k is constant, t>0 and .

),( tKtLfX =α

αt

k

),(),( tKtLfKLftXt kk ==L

O

K

2X

3X

4X

Substitutability• It is the rate at which the

capital can be used to replace labour or vice versa.

• Leontief technology

),min(),( KLKLfX ==

LO

K

2X

1X

3X

Substitutability

If capital and labour are perfect substitutes then:

bKLKLfX +== α),(

OL

K

2X1X

3X

The Elasticity of Substitution.

The slope of the isoquant is marginal rate of technical substitution (mrts) between inputs.

The Derivation of Elasticity of Substitution

• The precise measure of the mrts is :

• then

• Denoting the elasticity of substitution by we have:

dKKXdL

LXdX

∂∂

+∂∂

=

LXKX

KLmrts KL ∂∂

∂∂−=

∂∂

=//

LKLK

LKLK

mrtsmrts

LKLK

LK

LK

∂∂∂∂∂∂

≡∂∂

≡/

)/(/

),()(/

)/(σ

σ

34

Short-run production function and returns to a factor

OL

X

lpa

lpm

),( KLfX =

L

X

The Cobb-Douglas Production Function

• See the attachment.

Policy Implications1. It is possible to find the returns to scale

characteristics over different ranges of output.

2. Technology can be measured by the elasticity of substitution.

3. In the short-run competitive firms always operate in the region of the production function, where the returns to a factor diminish.


Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 10, pp131-150.




35

Lecture 4. Attachment. Cobb-Douglas Production Function.

The Cobb-Douglas Production Function takes the form,

βα KALKLfX == ),( (1) Taking Logs we get:

KLAX lnlnlnln βα ++= (2) First, suppose that:

1=+ βα so αβ −=1 Hence the Cobb-Douglas production function takes the form:

KKLAX

α

⎟⎠⎞

⎜⎝⎛= (3)

If we increase L and K in the same proportions, their ratios doesn’t change, so the term remains the same. However K has change by a given proportion, and equation (3) implies that X will change in the same proportion. So that, doubling its inputs will double output. Therefore the assumption that

α)/( KLA

1=+ βα implies that Cobb-Douglas function displays constant returns to scale. Considering the Cobb-Douglas production function in more general terms, we can take differential of equation (1):

dKKALdLKALdX a 11 −− += βαβ βα (4)

Considering that βα KALX = and substituting, the equation (4) can be written as:

dKKXdL

LXdX βα += (5)

The concept of returns to scale refers to the way in which output changes as both inputs vary holding factor proportions, the ratio K/L, constant. Suppose then, that

KdK

LdL

= (6)

Hence equation (5) becomes:

)()( βαβα +=+=KdKX

LdLXdX (7)

or

)()( βαβα +=+=KdK

LdL

XdX (8)

if 1=+ βα , output increases in strict proportion to labour (or capital) input so long as the capital-labour ratio is held constant, and we have constant returns to scale. If 1fβα + , output increases in strict proportionally more than labour (or capital) input and we have increasing returns to scale. On the other hand, 1pβα + implies diminishing returns to scale. In the Cobb-Douglas case, so long as α and β are each less than one, the marginal products of factors decline as their use increases, and bear a constant proportion to average products.

36

TUTORIAL 4. PRODUCTION FUNCTION.

Task 1. Proper management? Roy Dingbat is the manager of a hot-dog stand that uses only labour and capital to produce hot-dogs. The firm usually produces 1000 hot dogs a day with 5 workers and 4 grills. One day a worker is absent but the stand still produces 1000 hot-dogs. What does this imply about the 1000 hot-dog isoquant? Why do Roy’s management skills justify his name? Task 2. Microeconomics Examination. Ben Fail wrote the following answer on his micro exam. “Virtually every production function exhibit diminishing returns to scale because my lecturer said that all inputs have diminishing marginal productivities. So when all inputs are doubled, output must be less than double.” How would you grade Ben’s answer and why? Task 3. Desert and Production. Assume that you are stranded on a desert island and you have exactly 100 hours of labour to allocate between producing good X and good Y. Your output of goods X and Y depends solely on the hours of labour you spend in the following way:

XLX = and YLY = a. If you can sell your output of goods X and Y at the fixed prices =10 and =5, how

much of goods X and Y would you produce to maximize your profits? XP YP

b. Now assume further that you have the following utility function: XYU 10=

If you can trade a bundle of goods X and Y that you produce in the market at fixed prices of =10 and =5, what bundle would you produce and what bundle would you consume to maximize your utility? Are you a net demander and a net supplier of the two goods? Draw a diagram to depict what is happening.

XP YP

Task 4. Leontief Technology and vineyard owner. Grapes must be harvested by hand. This production function is characterized by fixed proportions-each worker must have one pair of stem clippers to produce any output. A skilled worker with clippers can harvest 50 pounds of grapes per hour.

a) Sketch the graph production isoquants for q=500, q=1000, q=1500 and indicate where on these isoquants firms are likely to operate.

b) Suppose a vineyard owner currently has 20 clippers. If the owner wishes to utilize fully these clippers, how many workers should be hired? What should grape output be?

c) Do you think the choices described in part b are necessarily profit-maximizing? Why might the owner hire fewer workers than indicated in this part?

d) Ambidextrous harvesters can use two clippers-one in each hand-to produce 75 pounds of grapes per hour. Draw an isoquant map (for q=500, 1000, 1500) for ambidextrous harvesters. Describe in general terms the considerations that would enter into an owner’s decision to hire such harvesters.

37

Task 5. Mixing technologies in Goat Lawn Company. Power Goat Lawn Company uses two sizes of mowers to cut lawns. The smaller mowers have a 24-inch blade and are used on lawns with many trees and obstacles. The larger mowers are exactly twice as big as the smaller mowers and are used on open lawns where maneuverability is not so difficult. The two production functions available to Power Goat are:

Output per hour (square

meter) Capital input (no. of 24''

mowers) Labour input

Large Mowers 8000 2 1 Small

Mowers 5000 1 1

a) Graph the q=40,000 square meter isoquant for the first production function. How much K and L would be used if these factors were combined without waste?

b) Answer part a for the second function. c) How much K and L would be used without waste if half of the 40,000 square foot lawn

were cut by the method of the first production function and half by the method of the second? How much K and L would be used if three-fourths of the lawn were cut by the first method and one-fourth by the second? What does it mean to speak of fractions of K and L?

d) On the basis of your observations in part c, draw a q=40,000 isoquant for the combined production functions.

38


Lecture 5.

Cost Functions

Agenda• Expenditure on inputs and the cost function• Long-run cost minimisation• Long-run total cost and the expansion path• The Cobb-Douglas case• Average and marginal costs in the long-run• Long-run costs with varying returns to scale• Short-run cost functions• Short- and Long-run average cost-the Envelope• From production to cost function in the short-run• Managerial Inputs and Principal Agent problem

Introduction

• To keep analysis manageable we deal with homogenous (at least homothetic) production functions.

• Firm minimizes costs to maximize profit.

Expenditure on inputs and the Cost function.

• Price for labour is the wage per week (hour) worked, denoted w.

• Price for capital, denoted r, is:- not the price of a new machine, - but a weekly (hourly) rental price of a machine

Price for a machine is an opportunity cost of owning the machine.

• Total cost is: C=wL+rK

• Cost Function: C=C(X,w,r)

Long-run Cost Minimisation• minC=wL+rK; subject to X=f(L,K)

• Tradeoffs between inputs available to the firm are formalised interms of isocost curves.

K

L20L

10K

O

Long-run total cost and the expansion path.

K

O

A

B

C

3X

4X

5X3C

4C

5C

39

The Cobb-Douglas Case• Cobb-Douglas function is homogenous and hence

homothetic.

• The mrts between labour and capital is and the ratio of prices is exogenous for the firm, and fixed at w/r

• In equilibrium:and

)/)(/( KLαβ−

rwKL /=

−αβ

αβ

wr

LK −

=

Average and marginal costs in the long-run

TC

XO

LTC

(b)(a)3X 4X 5X

3C4C

5C

TC

O

LTC

3X

3C

X(c)

TC

O

LTC

3C

3X X

Long-run costs with Varying returns to scale

TC

O

LTC

*X**X

The concept of short-run

• In the short-run we assume that at least one factor input is fixed.

• Labour input is more likely to change in the short-run. (It is easy to change labour, rather than install new machinery).

• However it is a naïve assumption, since for example labour can be on long-term contract or it is easier sometimes to install new equipment.

Short-run cost functions

K

O

A B

D

4X

3X1X

*K*K

AC BCDC

Long-run expansion

path

Short-run expansion

path

Short-run cost functions

TC

O

LTC

0CDCAC

BC

1X 3X 4X

A

B

D

STC

40

The relationship between long and short-run average and marginal costs

ACMC

O X3X

A

SMC

LMC

SAC

LAC

Shifts in the cost curves

• Changes in input prices

• Technological Innovation

• Economies of Scope

From Production to Cost Functions in the short-run. A formal treatment.

See the attachment.

The U-shaped Average Cost Curve and Managerial Inputs

• The production process is:- not only engineering matter, - but also administrative issue.

• When firm increases inputs equiproportionally, the managerial inputs are usually held constant.

• When there is a low level of production, the managerial skills are underutilised and vise versa.

Principle Agent Problem

Owner’s constraint

Agent’s constraint

Quantity

Profits

B

MAXB***π

**π*π

*B **B

MAXπ

1U2U


Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 11, pp152-168.


Edition, Norton&Company: New York. Ch 19-23, pp326-413.

• Nicholson W. 2004. Intermediate Microeconomics and its applications. 9th Edition, Thomson Learning. Ch 6, 7. pp187-249.

41

Lecture 5. Attachment. From Production to Cost Functions in the short-run. A formal treatment. In the short-run, with capital costs fixed at the total cost of function (C=wL+rK ) becomes

)( CoCo =Kr

C=wL+Co and variable costs (VC) are given by wL.

),( KLfX =The short-run production function is of course: Which, since there is only one variable factor, can be represented as:

),(1 KXfL −=

So with capital fixed, the level of output is unambiguously determined by employment only and vice versa. For given w, average variable cost (AVC) is inversely associated with average product.

XwL

XVCAVC ==

while short-run marginal cost is also specified as depending on the wage and the marginal product of labour.

XLw

XC

∂∂

=∂∂

The relationship between average and marginal cost will not in general remain constant as output changes. Although, in the Cobb-Douglas case, marginal costs are a constant multiple of average costs, with

and

so that

αα1

==∂∂

XwL

XwL

XVC

XC

XwLVC

=aXwL

XC=

∂∂

X

42

TUTORIAL 5. COST FUNCTION. Task 1. Businessman thoughts. Since an entrepreneur can always built the same factory next door, there is no reason to believe that long-run average costs will actually even increase as output rises. Discuss. Task 2. Hospital and restriction on beds. A medical centre produces health services using two inputs: hospital beds and labour. There is a government regulation restricting the number of beds to B. Assume that the medical centre is currently using B beds and L units of labour to produce Q1 units of health services. Also assume that the medical centre plans to expand its output to Q2 units of health services. Prepare a diagram to show how this government regulation restricting the number of hospital beds would affect the efficiency of delivering health services. (Hint: Show the expansion path with and without this government regulation.). Task 3. Long and short-run cost curves. Suppose that a firm has long-run total cost of $1000 for producing 100 units of output. The two inputs of production are labour and capital. Labour costs $10 per unit, and capital costs $10 per unit. The firm is currently producing 100 units of output and is using the cost-minimizing combination of 50L and 50K for labour and capital.

a) On an isoquant diagram, show that an increase in output from 100 units to 150 units will result in higher short-run than long-run total costs, average costs, and marginal costs.

b) Show that a decrease in output from 100 units to 50 units will result in higher short-run than long-run total costs and average costs, but higher long-run than short-run marginal costs.

c) Give an intuitive explanation for these relationships between the short-run and long-run cost curves.

Task 4. Trucking firm. A trucking firm’s output is measured by the number m of truck-miles moved per day. The firm’s operating costs are as follows: i. Wages of truckers, $w per hour. ii. Cost of gasoline, $p per gallon. iii. Fuel consumption, g=A+Bs, where g is gallons of gasoline per truck mile, s is the speed at which a truck is driven, and A and B are constants.

a. Derive the total variable cost function of the firm if it has an unlimited number of trucks.

b. What does the cost function look like if the firm has only one truck and that truck can be driven for a maximum of 10 hours per day?

43

Task 5. Skateboards production. The long-run total cost function for a firm producing skateboards is:

qqqTC 43040 23 +−= where q is the number of skateboards per week.

a) What is the general shape of this total cost function? b) Calculate the average cost function for skateboards. What shape does the graph of this

function have? At what level of skateboard output does average cost reach minimum? What is the average cost at this level of output?

c) Find the marginal cost function and show that this marginal cost curve intersects average cost at its minimum value.

d) Graph the average and marginal cost curves for skateboard production. Task 6. Principal-Agent Problem. Suppose that candidates for managerial positions at Fly-by-Night Waterbeds, Inc., can command salaries of $10,000 per year in other employment, but on those jobs they are not able to play golf during working hours. Fly-by-Night, however is located next to a golf course, so it is possible for managers to sneak off to play, though this does harm the company’s profits. Suppose that a potential manager’s utility function is given by:

gsUtility 21.0 += Where s is the manager’s annual salary and g is the number of golf games he or she can play each week during the year, whose value can be only 0, 1, or 2. Annual profits for the firm prior to paying the manager are $19,000 if g=0, $16,000 if g=1, and $8,000 if g=2. a). Suppose that Fly-By-Night can write a contract that specifies precisely how much golf its manager may play. What will be the profit-maximizing combination of salary and golf that will allow the firm to hire a manager? What will the firm’s net profits be in this situation? b). Suppose that a manager is hired under the contract specified in part (a) but that the firm’s owners cannot monitor how much golf the manager actually plays. What will the manager do? What will the firm’s net profits be? c). Suppose that the firm’s owner’s recognize the principal-agent problem that arises in part (b) and decides to use a profit sharing contract to ameliorate the problem. If the manager’s salary is to be based only on a share of the firm’s profits, what share must be paid? How much golf will the manager choose to play with this contract? Will the firm choose to offer this contract to the manager?

44


Lecture 6.

Models of market equilibrium.Perfect Competition and

Applications to the Competitive Model

Agenda

• Very short-run• Short-run• Long-run• Price controls and shortages• Tax incidence

Very short-run Short-run

Ethanol Subsidies in Brazil

Ethanol – ethyl alcohol. It is used in fuel for automobiles and reduces air pollution.

Ethanol is made of sugar cane in Brazil.

Government subsidized the production of ethanol.

Ethanol Subsidies

S1

D

Q1 Q2 Quantitymln gallons

S2

P1

P2

Subsidy

Price$/gallon

45

Long-run equilibrium (constant cost case) Movie rentals (constant cost case)

The VHS revolution.

No significant barriers to entry (rent, shelves, low wage workers).

More than 70% of US households owned VHS players by the end of 1980.

Industry perfectly elastic long run supply curve met increase in demand with no increase in price.

Movie rentals (constant cost case)

DVD – new technology.

Mid 1990s was a critical threshold of DVD player owners. Hence the market quickly emerged.

Internet also enhanced supply response.

Absence of barriers to entry resulted in constant cost model

Movie rentals (constant cost case)

Future technology?

Internet, cable TV, Satellite (charge per view).

Advantages: no repeated trips by customers, cost saving.

Disadvantages?

Increasing cost case. Increasing costs (examples)

• Firms may increase demand for scarce inputs (natural resources, skilled labour).

• Additional firms may impose external costs such as air or water pollution, road congestion, etc.

46

Decreasing cost case Decreasing cost case (Network externalities)

• Telecommunications. The larger the number of people using phone or fax, the greater the benefits of having it.

• Software. The greater the number of users for the software, the larger the benefits. Microsoft and Windows Operating System and related applications.

• Internet. Ability to deliver all kinds of digital files.

Price controls and shortages Tax incidence. (Constant cost case)

Tax incidence (Increasing cost case)Reading

• Nicholson W. 2004. Intermediate Microeconomics and its applications. 9th

Edition, Thomson Learning. Ch 8-9. pp253-300.

47

Attachment for lecture 6. Production functions, cost functions and the demand for factors of production.

1. From Production to Cost Function in the Long-run.

rKwLC += (1.1)

),,( rwXCC = (1.2) There are two ways to think about linking costs to output for given input prices. The first method, if we fix the level of cost atC , the cost-minimisation problem becomes an output-maximization problem. So as to maximize:

),( KLfX = (1.3) subject to

rKwLC += (1.4) we can therefore form the Lagrange function:

)(),( 11 rKwLCKLfH −−+= λ (1.5) where 1λ is the Lagrange Multiplier. The first order conditions are:

011 =−

∂∂

=∂∂ w

LX

LH λ (1.6)

011 =−

∂∂

=∂∂ r

KX

KH λ (1.7)

01

1 =−−=∂∂ rKwLCHλ

(1.8)

from (1.6) and (1.7),

KXr

LXw

∂∂=

∂∂=

∂ //1

1λ (1.9)

As we know, the expression (LX

w∂∂ /

) defines marginal cost in the short-run. Therefore the

Lagrange Multiplier 1λ is equal to short-run marginal cost. Rearranging terms in (1.9), we have

rw

KXLX=

∂∂∂∂

// (1.10)

As we know the ratio of marginal products equals the slope of the isoquant,

theLXKX

dKdLmrtsKL ∂∂

∂∂−==

// . Hence since

KXLX

dLdK

∂∂∂∂

−=// (1.11)

we have established that

rwdLdK /−= (1.12)

Output maximisation for a given cost requires that the ratio of relative input prices equals the mrts between them. Another way, with exactly the same result can be obtained by minimizing cost for a given level of output X. The problem here is to choose capital and labour inputs to:

rKwLCMin KL +=, (1.13)

subject to

48

),( KLfX = (1.14) The Lagrangian is

)),((22 KLfXrKwLH −++= λ (1.15) with first order conditions:

022 =

∂∂

−=∂∂

LXw

LH λ (1.16)

022 =

∂∂

−=∂∂

KXr

KH λ (1.17)

0),(2

2 =−=∂∂ KLfXHλ

(1.18)

From (1.16) and (1.17) we derive

KXr

LXw

∂∂=

∂∂=

//2λ (1.19)

from which (1.12) can be derived as usually.

1X

*X

2X3X

1X2X

3X

*X

*X

*X

*X

2C1C

3C

CCC

rC /

rC /3

rC /

rC /2rC /1

2. Fixed Proportions Technology. (Leontief Production Function)

),min( KLX θγ= (2.1) and the isoquants are L-shaped as in the figure below.

1'1 / rC

2'1 / rC

1'2 / rC

2'2 / rC

1'3 / rC

2'3 / rC

2X

1X

3X

'O

A

BC

L

K

49

To produce each unit of X, we therefore need both γ/X of labour and θ/X of capital, at a cost of w and r respectively. The minimum cost is therefore:

θγXrXwC += (2.2)

rearranging as:

⎟⎟⎠

⎞⎜⎜⎝

⎛+=θγrwXC

θγrw

XC

+=∂∂ (2.3)

We can also examine the relationship between costs and input prices at a given level of output. Differentiating (2.2) by each input price,

0>==∂∂ LX

wC

γ (2.4)

0>==∂∂ KX

rC

θ (2.5)

We know from the production function that γX is the amount of labour services L, and

θX is

the amount of capital services, K, being used to produce X units of output. 3. Perfect Substitutability

This time we assume that labour and capital are perfect substitutes in the production process. As we know the production function takes the form:

bKaLX += (3.1) and the isoquants are straight lines, as it is shown in the figure below.

1XA

BC L

K

1X

D

The cost minimising firm will, choose the cheaper option, so that cost function is

Xbr

awC ⎟

⎠⎞

⎜⎝⎛= ,min (3.2)

50

TUTORIAL 6. Perfect Competition, Equilibrium models and Applications

Task 1. New drug and the price for wool fibers. An Australian researcher has discovered a drug that weakens a sheep’s wool fibers just above the sheep’s skin. The drug sharply reduces the cost of sheering (cutting the wolf off) sheep because the entire coat pulls off easily in one piece. The world wool market is reasonably close to the model of perfect competition in both the product and factor sides. Trace out all of the effects of the introduction of this new drug. Task 2. The case of perfect substitutability. Suppose that the weekly production function takes the form X=2L+K, with the firm facing a weekly wage rate of $100 and capital rentals of $300.

a) Will the firm use any labour at all in the production process? b) Suppose that output of X is 500 units per week. What are the marginal costs? What are

the average costs? c) Suppose that the wage rate increases by 60%. What happens to the cost of production?

What happens to average and marginal costs?

Task 3. The case of fixed proportions technology. Suppose that the production function takes the form X=min(10L,5K) and that a competitive firm faces a wage rate of $60 per week and a weekly capital rental of $32.

a) How much must the firm spend to produce 100 units of output, and what is the average cost of production when X=100?

b) What is the incremental cost of producing the 101st unit of output? c) What happens to the cost of producing 100 units of output if the wage rate and the

rental cost of capital rise by 25 % each? What happens to the average and marginal cost?

d) What happens to the cost of producing 100 units of output if the wage rate increases by $1, or if the cost of capital increases by $1.

Task 4. Competition and School choice. Would introducing competition into our educational system improve the quality of our schools? What are the pros and cons of competition in educational system? Do you think it is appropriate to apply economic models of competition to education?

51

Task 5. Organ Donor Market.1 Is America Ready for an Organ-Donor Market? Probably not. But, in what is either a very odd coincidence or some kind of concerted effort to get out the organ-market message, there are OpEds in both the N.Y. Times and Wall Street Journal today arguing the case. The first one, headlined “Death’s Waiting List,” is by Sally Satel, a psychiatrist and American Enterprise Institute scholar. Satel herself received a kidney transplant and is now arguing that the delivery system is terrible and that the Institute of Medicine’s new report, “Organ Donation: Opportunities for Action,” is even worse. “Unfortunately,” Satel writes, “the report more properly should be subtitled ‘Recommendations for Inaction.” Satel’s main point is that the conventional argument against an organ market—i.e., that no part of the human body should ever be “for sale”—has been made obsolete, and then some, by the “markets for human eggs, sperm, and surrogate mothers.” The WSJ piece, headlined “Kidney Beancounters” (abstract only), is by Richard Epstein, the University of Chicago legal scholar and Hoover Institution fellow. Epstein is even more hostile to the IOM’s report (though maybe the Journal just let him get away with more than the Times let Satel get away with), saying the report is “so narrowminded and unimaginative that it should have been allowed to die inside the IOM.” Epstein writes further that “The major source of future improvement lies only in financial incentives; yet the IOM committee (which contains one lawyer but no economist) dismisses these incentives out of hand … The key lesson in all this is that we should look with deep suspicion on any blanket objection to market incentives—especially from the high-minded moralists who have convinced themselves that their aesthetic sensibilities and instinctive revulsion should trump any humane efforts to save lives.” Though his OpEd doesn’t say so, I am pretty sure that Epstein is an advisor to LifeSharers, a self-described “non-profit voluntary network of organ donors” that seeks to use non-financial incentives to encourage organ donation. A while ago, we received an e-mail from David Undis, the executive director of LifeSharers. He wrote: Incentives are missing in organ donation. That’s one of the reasons so many people are dying waiting for organ transplants. A free market in human organs would save thousands of lives a year, but politically speaking it’s a pipe dream. There’s very little likelihood Congress will legalize buying and selling organs in the foreseeable future.

1 http://www.freakonomics.com/blog/2006/05/page/3/

52

I formed LifeSharers to introduce a legal non-monetary incentive to donate organs—if you agree to donate your organs when you die then you’ll receive a better chance of getting an organ if you ever need one to live. It is surprising to me, and to many people much closer to the subject than me, that so little headway has been made in reforming the organ-donation process. I have never heard a single person say they were happy with the way things are—and, while I am sure Undis is right when he writes that a free market in organs is, politically speaking, a pipe dream, it seems that things are starting to move at least a bit in that direction. As Satel writes in her Times piece today, “Ethics committees of the United Network for Organ Sharing, the American Society of Transplant Surgeons and the World Transplant Congress, along with the President’s Council on Bioethics and others, have begun discussing the virtues” of offering organ donors incentives such as “tax breaks, guaranteed health insurance, college scholarships for their children, deposits in their retirement accounts, and so on.” It is interesting that, while all these incentives are financial, none of them are in the form of cold hard cash, which may make them more palatable. I wouldn’t be surprised if, between these two OpEds,

53


Lecture 7.

Monopoly and Monopolistic competition

Agenda• Monopoly’s profit maximization• Linear Demand Curve and Monopoly• Deadweight Loss of Monopoly• Natural Monopoly• Price Discrimination• The idea of monopolistic competition.• The firm in monopolistic competition.• Monopolistic competition and Efficiency• Formal analysis of monopolistic competition.• Mark-up pricing• Criticism of Monopolistic Competition

Linear Demand Curve and Monopoly

Suppose that monopolist faces a linear demand curve: p(y)=a-b(y)

• The revenue function is:• The marginal revenue function is: MR(y)=a-2by

2)()( byayyypyr −==

MCAC

O

P

Output*y

*p

a π=Profits

MR (slope=-2b)

Demand(slope=-b)

Markup Pricing

• The optimal pricing policy for monopolist can be expressed through elasticity concept:

• The markup is given by:

)(/11)()(

*

yyMCypε−

=

)(/111

yε−

MC

Demand

O Output*y

1p

Priceε/11−

MC

Deadweight Loss of Monopoly

MC

O

P

Output*y

DemandCompetitive price

*pMonopoly

price

MR

A BC

A

Natural Monopoly

MC

O

P

OutputACy

Demand

ACpLosses to

the firm from marginal cost pricingMCp

MCy

AC

54

First- degree price discrimination• Selling each unit of output for the highest price

obtainable.• Extracts all of the consumer surplus available in a

given market.

Willi

ngne

ss to

pay

Quantity

MC

A

A

Willi

ngne

ss to

pay

Quantity

MC

B

B

Second-degree price discrimination• It is also known as non-linear pricing.• The price per unit of output is not constant but

depends on how much you buy.

Willi

ngne

ss to

pay

Quantity

A

A

B

C Willi

ngne

ss to

pay

Quantity

B

A

B

C Willi

ngne

ss to

pay

Quantity

C

A

B

CD

Second degree price discrimination.

• Mobile phone call packs.

• Buy two get one free.

• Monthly, weekly bus tickets.

• One way air tickets or return tickets.

Third-degree price discrimination

• It is the most common form of price discrimination.

• E.g. students’ discount at shops, senior citizens’ discounts at the drug stores.

The Idea of Monopolistic Competition• There are quite a large number of firms.

• Firms are independent from each other in decision-making and there is freedom of entry of new firms into the industry.

• The product is differentiated.

• Spatial economics better motivates the monopolistic competition.

• Although spatial economics is not the only source of downward sloping demand curve.

A Location Model of Product Differentiation

• Panel (a) shows the socially optimal location pattern.• However each vendor will find in its private interests to

move toward the middle.• Hence the only equilibrium location is for both vendors

to be in the middle (panel (b))

R RL L

Market Share of Vendor L

Market Share of Vendor R

Market Share of Vendor R

Market Share of Vendor L

a b

55

Product Differentiation• Suppose now that market is large and vendors’ market

areas don’t overlap.• Thus vendors will sit at both ends of the line and would

be monopolists.• Although the similar situation can occur in product

differentiation• Each firm want to differentiate the product from their

competitors and convince customers, that there are no substitutes, hence charge higher price.

• Such a “product positioning” is much like the two vendors locating far away from each other, in order to avoid head-to-head competition.

More Vendors• Suppose there are three vendors.• At least one vendor is located between the other two• Two vendors at the end will move to the middle• But if they get too close, the third one will jump to the

right or left.• Hence there is no pure strategy equilibrium with 3

vendors.• Now, think what will happen if there are more than 3

vendors.

RL

Shift right Shift left

Jump right

The firm in monopolistic competition

LMC

LAC

MRD

O

P

X

1AC

1X

1p

LMC

LAC

MRD

O

P

X1X

1p

Monopolistic Competition and Efficiency

• It is argued that a firm in monopolistic competition is inherently less efficient than the firm in perfect competition.

• The reason is that a former firm ends up producing output at more than minimum average cost, while the latter at the bottom of LAC.

Mark-up Pricing

• Output price is set by adding a fixed mark-up to average costs.

• The more inelastic demand is, the greater the mark-up on costs to reach the selling price.

Criticism of Monopolistic Competition.

• Critics argue that monopolistic competition is just a special case of monopoly.

• There is also a problem at levels too.

• Monopolistic firms produce similar products, but how similar they are.

• Critics argue that the notion of monopolistic competition adds little to our ability to understand firms’ behaviour.

56

Reading


Edition, Norton&Company: New York. Ch24- 25, pp415-455.

• Laidler D., Estrin S. 1995. Introduction to Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 15-16, pp224-262.

57

TUTORIAL 7. MONOPOLY AND MONOPOLISTIC COMPETITION. Task 1. Author’s dilemma. An Author has signed a contract in which the publisher promises to pay her $10000 plus 20% of gross receipts from the sale of her book. True or False: If both the publisher and the author care only about their own financial return from the project, then the author will prefer a higher book price than the publisher. Task 2. Price discrimination. Consider an island served by one Ferry Company. There are two types of people who visit the island, day trippers who come in the morning to enjoy the island’s beaches on a Saturday or Sunday (or sometimes a weekday) and permanent summer residents who work in the city during the week but come to the island on Friday night to spend the weekend and then leave on Monday to return to work. The ferry has the following rate schedule: $6.50 for a same-day round trip and $5 for a one-way trip. There are no round-trip savings for people who don’t travel both ways on the same day.

a. Given the description of the two groups who visit the island, do you think that price discrimination could work here?

b. Is the rate schedule of the ferry company an effective price-discrimination device? Why or why not?

c. If so, what will be the round trip cost for the permanent summer residents? What will be the round-trip cost for the day-trippers?

Task 3. Water-vendors and spatial economics. Two mineral water-vendors, A and B, occupy fixed locations at opposite ends of a 1-mile beach. There are 1000 people distributed uniformly over the beach and each person buys one bottle of mineral water from the vendor whose inclusive price (money price plus round-trip transportation cost) is lowest. Unit transportation cost is equal $0.25/mile. If the marginal cost of mineral water is zero, and A is committed to charge money price of $1, what is the profit-maximizing price for B? Task 4. Taxes on monopoly. Consider the following possible schemes for taxing a monopoly:

a. A proportional tax on profits. b. A tax on each unit produced. c. A proportional tax on the gap between price and marginal cost.

1. Explain how each of these taxes would affect the monopolist’s profit maximizing output choice. Would the tax increase or decrease the deadweight loss of the monopoly? 2. Graph your results for these three cases.

58

Task 5. Numerical Exercise. A monopolist can produce at constant average and marginal costs of AC=MC=5. The firm faces a market demand curve given by Q=53-P. The monopolist’s marginal revenue curve is given by MR=53-2Q. a. Calculate the profit-maximizing price-quantity combination for the monopolist. Also calculate the monopolist’s profits and consumer surplus. b. What output level would be produced by this industry under perfect competition (where price-marginal cost)? c. Calculate the consumer’s surplus obtained by consumer in part b. Show that this exceeds the sum of the monopolist’s profit and consumer surplus received in part a. What is the value of the “deadweight loss” from monopolization? Task 6. Price Discrimination1. Imagine a vending machine that charges a different price for a can of soda depending on how hot is outside! Well, that’s exactly what Coca-Cola ha din mind when it was considering putting thermostats in their wending machines. Please read the article below “Mean Vending Machines”. Use a graph to illustrate and discuss the economic rationale behind Coca-Cola’s pricing scheme. Be sure to apply the notion of elasticity. Which consumers would be better off and which would be made worse off by this pricing scheme? Suppose instead of thermostats, Coca-Cola installed a mechanism that would increase the price of the soda as the number of cans left in the machine decreases. Would this be a form of price discrimination? Explain why or why not. Mean Vending Machines. Posted by John Irons at November 03, 1999 02:39 PM This past weekend the news wires were all buzzing about the latest idea to come from the world of soft drinks. Coca-Cola is apparently considering creating a new kind of vending machine that would test the outside temperature and adjust the price of a can of soda upwards when it is warmer outside. Here's some of the typical reactions to the idea: "a cynical ploy to exploit the thirst of faithful customers" (San Francisco Chronicle) "lunk-headed idea", (Honolulu Star-Bulletin) "Soda jerks" (Miami Herald) "latest evidence that the world is going to hell in a handbasket" (Philadelphia Inquirer) "ticks me off" (Edmonton Sun) What did they think the Coca-Cola company was doing anyway? Selflessly providing the world with a glorious beverage to further the goals of all mankind? Why should all these people be suddenly offended by a company trying to maximize profits? "Price discrimination" is the term economists use to describe the practice of selling the same good to different groups of buyers at different prices. In the Coke case, the groups of buyers are segmented by the outside temperature (i.e. Jill when it is hot outside vs. Jill when it is 1 Intermediate Microeconomics and its Applications, Walther Nicholson, 9th edition, p. 361.

59

cold). If possible, a company would like to charge a high price to those who place a high value on the good, while charging less to those that do not. So, are you personally offended by Coke's plan to charge more for soda's when it is warm outside? Well, you had better get over it pretty quickly, there is already plenty of price discrimination out there, and there is MUCH more to come. Rampant Price Discrimination Price discrimination is quite common. Ever wonder why hardcover books are produced first and are so much more expensive than paperback books? Or, why it is so much cheaper to buy airline tickets far in advanced? Or, why there are student discounts? Or, why matinee prices are cheaper for movies? Ever tried to buy a soda from a vending machine at a hotel or at a movie theater? All these examples are attempts by sellers to charge different people different prices for the same good. Much of the price discrimination in the economy may in fact be quite hidden. How do you know that the Crate and Barrel catalogue you just received has the same price for you as for someone living in another zip code? Perhaps those with a 90210 zip code see higher prices on their catalogues. Why is the Vending Machine different? In principle, the temperature sensitive vending machine is no different from any other form of price discrimination. Although, I do think the idea that the process is automatic generates some additional discomfort - it is the idea that technology can effectively gauge our buying interests. The heat sensitive machine is a small step toward applying machine "intelligence" to profit maximization. If you think that the vending machine idea is worrisome, just wait - the internet will be the most sophisticated price discriminator the world has ever seen. Smart vending machines will be the least of your worries. Online vendors such as Amazon.com may know quite a lot about you - your past purchasing habits, your internet preferences, your zip code, etc, - and they may want to use this information to adjust prices. Did you buy a Stephen King book last month? Maybe you'd like to buy another, more expensive, Grisham novel this month with a smaller "discount" chosen just for you. The internet is much better than the "real world" at price discrimination, because it is so much easier to change prices. In fact they can set a price just for you. It's hard to imagine a traditional store doing this ("Hey, here comes John. Quick, raise the price of the new Krugman Book."). But for an on-line e-commerce store, this is feasible and, with a clever programmer on the payroll, quite easy. Not all bad: Discrimination means increased efficiency

60

Actually, price discrimination can actually increase the overall efficiency of a market. A loss of economic efficiency may occur when a company has some abililty to set prices and there is no discrimination. The seller must pick a price that balances their desire to charge a high price to those that really want a product, with their desire to sell a higher overall quantity to those that are not willing to pay very much for it. Because of this, there are trades which would benefit both buyer and seller that do not happen - the resulting price is "too high" and the total quantity traded is "too low". By identifying individual groups of consumers, a seller can provide an additional unit at a lower price to someone who before would have been priced out of the market. The company would now be willing to do this since they would not have to sacrifice profits by lowering prices for the high-demand group. In the Coke case, some consumers - those who drink Cokes on hot days - will be worse off since they must pay a higher price, while some consumers - those who drink Coke on cold days - will be better off since they will receive a lower price. The Coca-Cola company, of course, will be better off. The sum total will be positive (pick your favorite Introduction to Economics textbook to see why). Would you really be as offended if it was described as a discount on cold days? So, if you are still stewing about the potential of higher Coke prices, I suggest you stock up the refrigerator and put some of that retirement money into Coca-Cola stock.

61


Lecture 8.

Oligopoly

Agenda

• The concept of Oligopoly• Kinked Demand Curve• Quantity Leadership• Price Leadership• Simultaneous Quantity Setting

The Concept of Oligopoly

Key features

• There are various barriers of entry.

• Interdependence of the firms.

Kinked Demand Curve

LMC

MR dO

P

X1X

1pa

D

d

mr

mrD

Choosing a Strategy• For simplicity assume a duopoly.

• There are four variables of interests: the price each firm charges and the quantity each firm produces.

• The classification scheme gives us four possibilities:

- price leadership, - quantity leadership, - simultaneous price setting or - simultaneous quantity setting.

Quantity Leadership

• Such a model also called Stackelberg model.

• The Stackelberg model is often used to describe industries in which there is a dominant firm or a natural leader.

• See the Attachment 1 for formal Analysis.

62

Derivation of a reaction function

)( 12 yf

1y =output of the firm 1

2y =output of the firm 2

Isoprofit lines for firm 2

1y

)( 12 yfReaction

curve

Stackelberg Equilibrium

1y

2y

Price LeadershipFor a formal analysis see attachment 2

*p

*Ly

MC of Leader

Follower’s supply

Market demand Demand curve

facing leader (residual demand)

MR facing leader

*ry

Price

Quantity

Comparing Price and Quantity Leadership

• Firm which is able to make an investment in capacity first is naturally modelled as a quantity leader.

• Suppose that prices are more important than capacity choices. So it is natural to think of this firm as a price setter.

Simultaneous quantity setting

• Leader-follower model is asymmetric: one firm is able to make decisions before the other firm.

• However if two firms are simultaneously trying to decide which quantity to produce, they have to forecast what the other firm’s output will be.

• An equilibrium in forecasts is examined through Cournot Model.

Cournot Equilibrium.

1 1 firmofoutputy =

2 2

firmofoutputy =

*1y

*2y

)( CurveReaction

21 yf

)( CurveReaction

12 yf

),( 21tt yy),( 1

21

1++ tt yy

),( 22

21

++ tt yy),( 3

23

1++ tt yy

),( 42

41

++ tt yy

63

Simultaneous Price Setting

• The Bertrand Equilibrium has a very simple structure-competitive equilibrium, where price equal MC.

• The result seems paradoxical, however this model can be considered as the model of competitive bid.

Collusion and Cartel

• Cartel is a group of oligopolists that set prices and quantities as if they are monopolist.

• Cartel is inherently instable and Cartel members will try to cheat each other.

• Firms need to detect and punish cheating.

2y

1y

ba2

ba2

Isoprofit curves for firm 2

Isoprofit curves for firm 1

Output combinations that maximize total

industry profit

Punishment Strategies• Firm will choose to cheat if :

• As long as the interest rate is sufficiently small, so that the prospects of future punishment is sufficiently important, it will pay the firms to stick to quotas.

md ππ f

rm

mππ +=behaviour cartel of luePresent va

rc

dππ +=cheating of luePresent va

rrc

dm

mππππ ++ f

md

cmrππππ

−−

p

Comparison of the solutions.

• Collusion results in the smallest industry output and the highest price.

• Bertrand Equilibrium-highest output and lowest price.

• Other models gives results in between the two extremes.

Reading



• Laidler D., Estrin S. 1995. Introduction to Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 17, pp264-284.

• Nicholson W. 2004. Intermediate Micoreconomics and its applications. 9th Edition, Thomson Learning. Ch 11, pp362-385.

64

TUTORIAL 8. OLIGOPOLY. FURTHER ANALYSIS. Task 1. Forming a Cartel. Consider an industry with five suppliers. One is very large relative to total supply, with the capacity, in the relevant price range, to supply a significant proportion of market supply on its own. The remaining suppliers comprise two middle size firms and two that are relatively small. The largest and the smallest firms each have relatively low (constant) unit costs, but average costs are somewhat higher for the two middle size firms. Discuss the problems that the five suppliers will face in forming and maintaining a cartel. Task 2. Cournot Equilibrium. There are two identical firms in the industry, 1 and 2, each with cost function , i=1, 2. The industry demand curve is P=100-5X where industry output, X is the sum of the two firms outputs (

ii XC 10=

21 XX + ).

(a) If each firm makes its output decisions on the assumption that the other will not react to its choices (the Cournot assumption), what is the equilibrium output for each firm. What is the equilibrium output for each firm? What is the equilibrium price?

(b) Suppose that each firm takes it in turn to choose its level of output, on the assumption that the other’s output level is fixed. Would the process of adjustment be stable?

(c) Suppose that firm 1 introduces a cost saving innovation, so that its cost curve becomes . Firm 2’s cost curve and the industry demand curve are unchanged. What happens to the equilibrium quantity produced by each firm and to market price?

11 8XC =

Task 3. Stackelberg Game. Suppose the two firms in task 2 are now playing a Stackelberg game, with firm 1 as a leader and firm 2 as a follower. What are the equilibrium levels of output and industry price? How does your answer change if firm 1 has the cost function given in Task 2 (c). Task 4. Clorox case. In the Clorox case, Procter&Gamble was alleged to be a potential entrant into the liquid bleach market and was therefore prevented from buying Clorox Company. Can you devise any way to use firm’s cost curves and the demand curves facing the firms to differentiate among actual entrants? Potential entrants? No entrants? Use your analysis to suggest what the court should have looked for in the antitrust case.

65

Task 5. Crude oil market. Suppose that the total market demand for crude oil is given by:

QD=-2000P+70000 Where Q is the quantity of oil in thousands of barrels per year and P is the dollar price per barrel. Suppose also that there are 1000 identical small producers of crude oil, each with marginal costs given by:

MC=q+5 where q is the output of the typical firm.

a. Assuming, that each small oil producer acts as a price taker, calculate the typical firm’s supply curve (q=…), the market supply curve (QS=…) and the market equilibrium price and quantity (where QD=QS).

b. Suppose a practically infinite supply of crude oil is discovered in New Jersey by a would-be price leader and that this oil can be produced a constant average and marginal cost of AC=MC=$15 per barrel. Assume also that the supply behaviour of the competitive fringe described in part a is not changed by this discovery. Calculate the demand curve facing the price leader.

c. Assuming that the price leader’s marginal revenue curve is given by MR=-Q/1500 +25

How much should the price leader produce in order to maximize profits? What price and quantity will now prevail in the market? d. Graph your result indicating the market demand curve, the supply curve for the

competitive fringe, and the price leader’s demand, MR, and MC curves. e. Does the consumer surplus increase as a result of the New Jersey oil discovery?

How does consumer surplus after the discovery compare to what would exist if the New Jersey oil were supplied competitively?

66


Lecture 9.

Strategy and Game Theory

Agenda• The Payoff Matrix• Nash Equilibrium• Mixed Strategies• Prisoner’s Dilemma• Repeated Games• Enforcing a Cartel• Sequential Games• Games of Entrance Deterrence

Basic ConceptsAll games have three basic elements:

1. Players (individuals, firms, nations)

2. Strategies (another card in poker, antimissile defense)

3. Pay-offs (utility, profits, self-esteem)

Games may be cooperative (binding agreements) or non-cooperative (no agreements).

The Payoff Matrix of the Game• Dominant Strategy is Bottom Left.

1;02;1Bottom

0;11;2Top

Player A

RightLeft

Player B

Nash Equilibrium

1. A game may have more than one Nash equilibrium

2. A game may not have Nash equilibrium

1;20;0Bottom0;02;1Top

Player A

RightLeft

Player B

Two Simple Gamesa. Rock, Scissors, Paper-No Nash Equilibria

b. Battle of the Sexes-Two Nash Equilibria

0;0-1;11;-1Paper1;-10;0-1;1Scissors-1;11;-10;0Rock

Player A

PaperScissorsRock

Player B

1;20;0Seaside0;02;1Mountain

Player A

SeasideMountain

Player B

67

Mixed Strategies

• If each agent chooses a strategy once and for all it is called a pure strategy.

• A chooses to play top 50% of the time and bottom 50% of the time, while B might choose to play left 50% of the time and right 50% of the time. This is a mixed strategy.

-1;31;0Bottom0;-10;0Top

Player A

RightLeft

Player BA game with no Nash Equilibrium (in pure

strategies)

Mixed StrategiesSee Attachment

1;20;0Bottom

0;02;1Top

Player A

RightLeft

Player B

0

1/3

2/3 1

1c

r

Row’s best response

Column’s best response

Best Response Curves

Prisoner’s Dilemma• Nash Equilibrium is for both to confess, although it is

not Pareto efficient.• Prisoner’s Dilemma can be applied to many real world

situations. Excessive advertising, “bonus mileage” in airline companies and cartel agreements.

1 Year; 1 Year10 Years; 6 MonthsDeny

6 Months; 10 Years3 Years; 3 YearsConfess

Player A

DenyConfess

Player B

Repeated Games• In the prisoner’s dilemma agent plays a single time.

And both to confess is the Nash Equilibrium.

• The situation is different if the game is played repeatedly. Then opponent can be “punished” for “bad” behaviour.

• However it is not the case if the game is to be played definite number of times.

• The best strategy is “tit-for-tat” in the indefinite number of plays.

Enforcing a Cartel

• If each firm charging a zero price is a Nash Equilibrium in pricing strategies is also a Bertrand equilibrium.

• Tit-for-tat strategy is able to support the cartel arrangement for some time.

Sequential Games

• Player A has to choose first, and B has to observe A and then choose the best possible outcome.

2;10;0Bottom

1;91;9Top

Player A

RightLeft

Player B

68

Extensive form of the game

Player Achooses

Player Bchooses

Player Bchooses

Top

Bottom

Left

Left

Right

Right

A;B

1;9

1;9

0;0

2;1

A Game of Entry Deterrence• Monopolist and the threat of new entrant

EntrantChooses

Incumbent Chooses

Stay Out

Enter

Fight

Don’t Fight

Entrant;Incumbent

1;9

1;9

0;2

2;1

Fight

Don’t Fight

Incumbent Chooses

Games of Coordination• Battle of the Sexes.• Prisoner’s Dilemma.• Assurance Games:1. US-USSR arms race and assurance to refrain.2. Chicken and Macho.• How to coordinate?:1. Cooperate at an equilibrium that both like (assurance

games).2. Cooperate at an equilibrium one of you likes (battle of

the sexes).3. Make a choice leading to your preferred outcome

(chicken).

Other Games

• Games of Competition (Penalty Point in Soccer)• Games of Coexistence (Hawk-Dove game)• Games of Commitment (Frog and the Scorpion,

Kidnapping, Hold-up)• Bargaining (Nash and Rubinstein bargaining)

Reading• Varian H. 2003. Intermediate Microeconomics. 6th

Edition, Norton&Company: New York. Ch 28, 29, pp497-539.



69

Lecture 9. Strategy and Game Theory Attachment 1.

• r-probability that row plays top; • (1-r)-probability that row plays bottom • c-probability that column plays left; • (1-c)-probability that column plays right • The pure strategies occur when r and c equal 0 or 1.

Combination Probability Payoff to Row

Top, Left rc 2 Bottom, Left (1-r)c 0 Top, Right r(1-c) 0

Bottom, Right (1-r)(1-c) 1 The Row’s payoff = 2rc+(1-r)(1-c)

Row’s payoff=2rc+1-r-c+rc

Suppose that row contemplates increasing r by r∆ .

∆ payoff to row=2c r∆ - r∆ +c r∆ =(3c-1) r∆

This expression will be positive when 3c>1 and negative when 3c<1.

Row will want to increase r whenever c>1/3, decrease r when c<1/3, and be happy with

any value of when c=1/3. 10 ≤≤ r

The Column’s payoff=cr+2(1-c)(1-r)

∆ payoff to column=r +2r -2c∆ c∆ c∆ =(3r-2) c∆

Column will want to increase c whenever r>2/3, decrease c when r<2/3, and be happy

with any value of when r=2/3. 10 ≤≤ c

70

TUTORIAL 9. STRATEGY AND GAME THEORY. Task 1. Nash Equilibrium. The following table reports the payoff matrix for an advertising game. Explain why the strategy pair “A: high, B: low” is a Nash equilibrium in this game and all the other strategy pairs are not.

B's strategy

High Low

High A:5; B:2 A:3; B:3

A's strategy Low A:4; B:3 A:2; B:4 Task 2. Game Theory and Cournot Equilibrium. “The common characteristic of the Cournot model is that assumes a common pattern of reaction by competitors in each period which, despite the fact that the expected reaction doesn’t in fact materialize, is never altered. This assumption that firms never learn from their past experience is excessively naïve.” Discuss with reference to the distinction between Cournot behaviour and the Cournot equilibrium, and in the light of the insights that game theory yields about the character of the Cournot equilibrium. Task 3. Healthy cigarettes. Two firms (A and B) are considering bringing out competing brands of a healthy cigarette. Payoffs to the companies are as follows (A’s profits are given first):

Firm B

Produce Don't

produce

Produce 3,3 5,4

Firm A Don't produce 4,5 2,2

a. Does this game have a Nash equilibrium? b. Does this game present any first mover advantages for either firm A or firm B? c. Would firm B find it in its interest to bribe firm A enough to stay out of the market?

71

Task 4. Threat of new entrant. The Wave Energy Technology (WET) company has a monopoly on the production of vibratory waterbeds. Demand for these beds is relatively inelastic-at a price of $1000 per bed, 25000 will be sold; whereas, at a price of $600, 30000 will be sold. The only costs associated with waterbed production are the initial costs of building a plant. WET has already invested in plant capable of producing up to 25000 beds, and this sunk cost is irrelevant to its pricing decisions.

a. Suppose a would-be entrant to this industry could always be assured of half the market but would have to invest $10 mln in a plant. Construct entrant’s strategies (enter; don’t enter). Does this game have Nash equilibrium?

b. Suppose WET could invest $5mln in enlarging its existing plant to produce 40000 beds, Would this strategy be a profitable way to deter entry by its rival?

Task 5. Strategic substitutes and complements. Game theorists sometimes use the terms “Strategic complements” and “Strategic substitutes” to describe the relationship between the strategic choices made by two firms. Firm’s activities are strategic substitutes if and when firm A increases the activity and firm B reduces it. The activities are strategic complements if an increase in the activity by firm A causes firm B to increase the activity as well. Use these definitions to provide intuitive proofs of the following propositions:

a. In the Cournot model, quantities (or production capacities) are strategic substitutes. b. In the Bertrand model, prices are strategic complements.

Task 6. Pepsi and Coke’s secret formula.1 How much would Pepsi pay to get Coke’s secret formula? A few days back some dastardly Coca-Cola employees got nabbed trying to sell corporate secrets to Pepsi. Pepsi turned the bad guys in and cooperated in the sting operation. Did the executives at Pepsi give up the chance to make huge profits at Coke’s expense in order to “do the right thing?” I had lunch with my friend and colleague Kevin Murphy yesterday. He made an interesting point: knowing Coke’s secret formula is probably worth almost nothing to Pepsi. Here is the logic. Let’s say that Pepsi knew Coke’s secret formula and could publish it so that anyone could make a drink that tasted just like Coke. That would be a lot like what happens to prescription drugs when they go off patent and generic drug companies come in. The impact would be that the price of real Coke would fall a lot (probably not all the way to the price of the generic Coke knockoffs). This would clearly be terrible for Coke. It would

1 http://www.freakonomics.com/blog/2006/07/page/5/

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probably also be bad for Pepsi. With Coke now much cheaper, people would switch from Pepsi to Coke. Pepsi profits would likely fall. So if Pepsi had Coke’s secret formula, they wouldn’t want to give it away to everyone. What if they instead kept it to themselves and made their own drink that tasted exactly like Coke? If they could really convince people that their drink was identical to Coke, then the new Pepsi-made version of Coke and the Real Thing would be what economists call “perfect substitutes.” When two goods are essentially interchangeable in consumers’ minds, that tends to lead to fierce price competition and very low profits. Neither Coke nor the Pepsi knockoff of it would be very profitable as a consequence. With the price of Coke lower, consumers would switch away from the original Pepsi to either Coke or the new Pepsi-made Coke knockoff, which would be far less profitable than original Pepsi anyway. In the end, both Coke and Pepsi would likely be worse off if Pepsi had Coke’s secret formula and acted on it. So, maybe the executives at Pepsi were acting morally and honorably when they turned in the criminals stealing Coke’s secrets. Or maybe they are just good economists. Task 7. Prisoner’s dilemma2. A treatise on dating: the Prisoner’s Dilemma By Joshua Steinman March 12, 2004 in Viewpoint, Chicago Maroon online edition – student newspaper. After reading V.R. Dupont’s hilariously honest contribution on Tuesday (“The Economics of Meat Markets: Addressing the Question of Efficiency”), I felt compelled to stand up for the social sciences (in particular, international relations) and share with you a portion of a theory I’ve been working on. At moderately large schools like Chicago where social interactions (read: attempts to get digits) rarely happen repeatedly between two people, there is a disproportionate incentive for all individuals involved to show disinterest toward each other, regardless of the reality. “Wait, really?” you ask. “So that girl in my Hum class who was blowing me off at Bar Night might actually be interested?” Rein in the stallions, Casanova. In reality, it was probably the Bartlett breath that turned her off. But you’ve read this far, so I owe you an explanation. This theory is based on the “Prisoner’s Dilemma.” The theory scenario consists of two “players” of a simple game where the goal is to acquire points. There are two options: truth or deception. If both choose truth, both experience a point gain. If both choose deception, there is no gain. But if one chooses truth and the other deception, the player who chose deception will gain, and the one who chose truth will remain at status quo (and will experience a relative loss).

2 http://maroon.uchicago.edu/

73

We (students) are the players, because even though you crush on that girl in Hum every day, as far as romantic overtures are concerned, you two are strangers. And the “points” are actually a rough estimation of each player’s exclusivity. Exclusivity works as a reward system because girls brag to each other about how many guys hit on them at the last ultimate frisbee party, and guys brag about how many drunken girls they turned down at the last Psi U bash. Similarly, girls communicate when they fail in attracting a guy, and guys do the same. In each situation, the players use communication to establish exclusivity, thus increasing their own desirability or communicating failure. When both parties express interest, the mutual gain is the exchange of contact information (or perhaps a quick make-out session behind University Church). When neither party shows interest, the result is status quo. When one player attempts to get the other’s digits and is rebuffed, the player who “turned down” the other experiences a gain in exclusivity. Let us apply this concept now to your typical, possible male-female interaction at a random College Programming Office event. Side note: typical U of C students will claim they “pre-gamed” in order to lower expectations of exclusivity, when in fact they are stone-cold sober, since they want to read Heidegger for pleasure on the third floor of the Reg after the event is over. So you’re standing there, munching on a mini-croissant with a cup of tea, when all of a sudden you spot that cutie that you haven’t seen since O-Week. You’re gazing, when all of a sudden, she catches your glance, and lo! smiles back at you. Let’s look at the possibilities for interaction through the lens of the Prisoner’s Dilemma. For both parties, there are two options (assuming both are interested)—deception or truth. Since neither can know if the other is definitely interested, interaction has the following result matrix: “Truth” on the part of one player and “deception” on the part of the other player will lead to heightened exclusivity for the second player, who will return to his/her peer group and brag about the failed attempt by the other party, thus increasing their exclusivity. Truth from both parties will lead to a positive interaction, such as getting his/her number. Deception will yield the status quo. A truth-teller (assuming they are interested) will experience a gain one-third of the time, status quo one-third of the time, and a loss of exclusivity one-third of the time, whereas deception will yield a gain in exclusivity one-third of the time and status quo two-thirds of the time. Thus, there are risks only when either player makes the decision to interact truthfully. The benefits and detriments are heightened when one party is not interested. Denial of interest in this situation yields positive ancillary benefits (“that drunk loser just tried to hit on me! Ewww!” or “What a ho”), similarly increasing perceived exclusivity. The benefits resulting from the denial of interest are the only constant benefits that can occur in the male-female interaction scenario. Just like the Prisoner’s Dilemma, in a situation where you’re not dealing with certain individuals on a regular basis (which would allow for them to develop a relationship wherein there will be external repercussions for deceptive behavior), and where your reputation among the opposite sex is determined by exclusivity, the only constant action that consistently yields either status quo or a positive benefit is the denial of interest.

74

So, what should you do next time? The answer is simple: nothing! I call this tactic “pre-emptive protection of exclusivity.” Personally, I use my predictive abilities (I’m honing them for a career in law) and realize that I’ll likely be shot down. And that she’ll probably brag to her friends about how “the columnist” tried to hit on her. So I do nothing. This is my way of really sticking it to girls whom I think aren’t interested in me. Unfortunately I can’t really complete the comparison, because in international relations, there’s no corollary event to walking home alone. But if the outlook seems bleak (and believe me, it does), check back next quarter, when I extend the theory and find a solution to what I’m calling “The Dating Dilemma.”

75


Lecture 10.

The Demand for Factors of Production

Agenda

• Physical products and revenue products• Factor demand in the short-run• The firm’s factor demand in the long-run• Industry demand for labour• Factor payments and the value of output

Profit-maximizing behavior and the hiring of inputs.

• MEK=MRK

• MEL=MRL

Price taking behaviour:• r=MEK=MRK

• w=MEL=MRL

Substitution and Output effects of a decrease in price of labour

• Substitution effect is a move from A to B.• Output effect is a move from B to C.

1L 2L LO

2K

1K

1q 2qO

P

MC

(a) Input choice (b) Output decision

/MC

1q

2q

A

B

C

Capital per week

Price

Output per week

Physical products and revenue products

K

1L 2L 3L LO

*K*K

**K**K

X1X2

X3


1L 2L 3L LO

X1

X2

X3 L

X

(a)

1L 2L 3L LO

APMP

(b)

LMPLAP

76


0L LO

TFOTR,

(a)

LO

w

(b)

TR

TFO

ARPMRPMFO

MFOw =

0L

ARP

MRP

Algebraic notation• For competitive firm:

• Profit maximization requires that marginal factor outlay=wage in competitive labour market=MRP of labour:

LXwmcp∂∂

==/

LXpw∂∂

=

Factor demand in the short-run

w

1L 2L LO

2w

1w

D ∑ 2MRP∑ 1MRP

The firm’s factor demand in the long-runw

1L 2L LO

2w

1w

D1MRP

2MRP

Industry demand for labour

w

1L 2L LO

2w

1w

D

w

1L 2L LO

2w

1w

D∑ 2MRP

∑ 1MRP

(a)

∑ 2MRP

∑ 1MRP

(b)

Influences on the elasticity of factor demand

• The greater the degree of substitutability, the more elastic is the demand for that factor.

• The larger the increase in output as a result of fall in wages, the greater change in the demand for labour.

• The greater the proportion of production costs made up of wages, and the more elastic the demand for the final output, the more elastic will be the demand for labour.

• The elasticity of supply of other factors. The higher it is, ceteris paribus, the higher is the elasticity of demand for labour.

77

Minimum wage – good or bad? Minimum wage – good or bad?• Empirical evidence shows that changes in

minimum wage law have serious effects in increasing teenage employment.

• Theoretical models predict that higher minimum wages should reduce employment.

• However empirical studies have disputable conclusions.

Factor payments, the value of output and the Euler theorem

• Shaded area available for payments to capital.

w

1L LO

1w

LMRP


• The ratio of factor prices is given by the slope of the isocost line II=ratio of marginal productivities of the inputs given by the slope of the isoquant at point A

K

1L LO

1K1K

1L

I

I

A


• Shaded area available to meet the wage bill.

r

1K KO

1r

KMRP

Reading





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TUTORIAL 10. THE DEMAND FOR FACTORS OF PRODUCTION. Task 1. Discussion. “In competitive equilibrium, workers always earn less than their average product”. Discuss. Task 2. Analysis. Analyse the effect of an increase in the price of capital on the demand for labour when the elasticity of substitution between labour and capital is low and the elasticity of the demand for output is high. Task 3. Minimum wage. What will be the effect on the following of fixing a minimum wage above the market equilibrium level:

a. Employment in a perfectly competitive industry in which all firms are equally efficient;

b. The number of firms operating in the industry; and c. Employment in a firm that, prior to the fixing of the minimum wage, faced an

upward-sloping supply curve of labour? Task 4. The Economics of Superstars. Why the “Three Tenors” receive vast amount of money, while others with similar voice characteristics receive much less? Why tennis, soccer, hockey superstars receive enormous profits?

79


Lecture 11.

Monopoly and Monopsony.

Agenda

• The monopolist’s factor demand curves

• Monopsony and Discriminating Monopsony

• Transfer price and Rent

The monopolist’s factor demand curves

2L1L

1w

w

MRPVMP

Monopsony

L

w

S=AFO

L

TFO TFO

(a) (b)

Monopsony

2L1L

1w

w

MRP

MFO

S=AFO

Monopsony

2L 1L

1w

w

MRP

MFO

S=AFO

2w VMP

80

Discriminating Monopsony

*w

w

1w

2w

w w

*L1L 1*L 2

*L 2L

1MFO

21 SS +

2MFOMFO1S

2SA

B

C D E

F

G

D

LO

Why is the wage inequality increasing?

• Over the past 30 years wage inequality among workers increased substantially.

• Average ratio of high to low salary was 4.3 in 1965 and 5.4 in 1995 in the US and UK.

• What do you think is the cause of inequality?

Transfer price and rent

1L

1w

w

D

rent

S

rent

Transfer price and rent

1L

1w

w

D

S

1L

1w

w

D

S

rent

(a) (b)

Reading• Varian H. 2003. Intermediate Microeconomics. 6th


• Laidler D., Estrin S. 1995. Introduction to Microeconomics. 4th Edition, Cambridge University Press: Cambridge. Ch 22, 23, pp325-341.


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Tutorial 11. Monopoly and Monopsony. Task 1. Monopsonist in the input market. How would you measure the strength of a monopsonist in an input market? Would a monopsony necessarily be very profitable? What would you need to add to the figure below in order to show a monopsonist profit graphically? W

age ME

S MVP 1

w w 1 D

Task 2. A monopsonist in the labour market faces a relatively inelastic supply of female labour and hence pays its female employees a lower wage than its male employees even though the two groups are equally productive. What will be the effect on: a. the wage level paid to women b. the number of women employed c. the wage level of men d. the number of men employed, of legislation forcing the firm to pay the same wage to all employees.

Labour hours per week

L 1 L

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micro a p 2007-2008

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