Lecture Slide 1

Econ 310
Princeton University

February 2012

about the class

I 10 problem sets: do them and understand them. I work them out by yourself; go over the answers to make sure

you understand them.

I read material before class, even if it is difcult to understand I check blackboard regularly I you are graded on the best 8 problem sets.

what is (micro)economics
build models consisting of trade-off talking rational economic agents (totreps)1
I totrep has preferences: for every pair of alternatives

(consumption goods, jobs,...), the preference tells us what totrep would choose.
I totreps preferences are rational that means there are no

inconsistencies.
I totrep always chooses his most preferred alternative among the

available options. use these models to analyze economic institutions and policies.

1 This

term is taken from David Kreps, Notes on the theory of choice."

Plan

I analyze totreps behavior.

I I I

optimal consumption choices of a consumer. optimal price and output decisions of a monopolist. ... what happens when totreps interact in a competitive market? what happens when one totrep sells a used car to another? what happens when oligopolistic rms run by totreps compete? ...

I analyze the interaction of totreps (equilibrium analysis.)

I

I I

Purpose:

I Develop an understanding of how economic institutions

(regulations, taxes, etc.) affect economic outcomes.

I When an economist says: this is what happens when we

institute a minimum wage, she really means: this is what happens to the choices of a population of totreps if we institute a minimum wage.
I Obvious question: are the choices of totreps a good

approximation of what really happens?

I Why this approach?

Part 1: preference and utility

Outline:

I dene preferences I introduce utility functions I what does it mean for a utility function to represent a

preference?
I book: this part is a bit different from the book; read chapter 3.

Key Takeaway: if totreps preferences have no inconsistencies then we can describe them with a utility function.

preferences

I there is a (nite) set of objects X

= {x, y, z, ...}

I for example: X could be the occupations, or consumption plans. I totrep makes pairwise comparisons, expressing a preference for

some objects over others. The symbol denotes a binary relation on the set of choices X: interpret x y as x is weakly preferred to y. totrep is indifferent between x and y if x y and y x: we write x y. totrep strictly prefers x over y if x y but we dont have y x: we write x y.

rationality

Assumption 1: The preference is complete: for all x, y in the set X we have x y or y x (possibly both). Assumption 2: The preference is transitive: x y and y z implies x z.

utility

A utility function is a convenient way to describe totreps preferences. A utility function u associates to each object in X a real number u(x). The utility function u represents the preference if x y implies u(x) u(y) and u(x) u(y) implies x y

Theorem
The preference can be represented by a utility function if and only if it satises Assumptions 1 and 2.

example

X = {MD, JD, MBA, PhD}

I MD I JD

I MBA

MBA; JD PhD

JD; MD MBA; MD PhD JD; MBA PhD

complete? transitive?

MD

JD MBA

PhD

example continued...
We have a complete and transitive preference MD JD MBA PhD

Two (of many) possible utility functions:

I Utility function #1:

u1 (MD) = 1, u1 (JD) = u1 (MBA) = 0, u1 (PhD) = -.01

I Utility function #2:

u2 (MD) = 1, u2 (JD) = u2 (MBA) = .99, u2 (PhD) = -1000

utility
Theorem
The preference can be represented by a utility function if and only if it satises Assumptions 1 and 2. We will prove this theorem. It has two parts:
I Only if part: If the preference can be represented by a utility

function, then the preference must be complete and transitive. We will do this rst (very easy).
I If part: If the preference is complete and transitive then we can

nd a utility function that represents it. This is the more difcult part. We will construct a particular utility function for the preference that does the job.

Only if part
I We have a utility function u that assigns each element of X a real

number.
I The utility function represents a preference

and only if u(x)

u(y).

. That is: x y if

First, we prove that the preference must be complete:

I take x, y then we have u(x) I In the rst case, we have x

u(y) or u(y)

u(x).

I In the second case we have y

y since u represents the preference. x since u represents the

preference.
I So,

must be complete. Easy!

Only if part continued

Next, we prove that the preference must be transitive:

I take x, y, z with x

I Since u represents the preference we know that u(x)

y and y z. We must prove that x z.

u(y) and

u(y)

u(z) u(z).

I But this implies that u(x)

I Since u represents the preference this, in turn, implies x I Therefore,

is transitive. Done!

z.

an intermediate step

if the preference is transitive then x

I rst, we show that y

z and y x imply y

z.

I next, we show that we cannot have z

z: since x z we know that x z and therefore transitivity implies y z.

I so: y

y: if z y then y x and transitivity would imply z x. But x z implies that we dont have z x and therefore z y is impossible. z and we dont have z y. This means y
z. Done!

If part
Now, we prove that a complete and transitive preference can be represented by a utility function. Dene Z(x) to be all those elements of X that are strictly worse than x Z(x) = {z 2 X|x Here is what we know about Z(x): (i) If x y then Z(x) = Z(y). Why? if x z then, since y x it follows that y x. The intermediate step now implies that y z. Conversely, if y z it follows that x z (ii) If x y then Z(y) is a subset of Z(x): every element of Z(y) is in Z(x). Why? if y z and x y then it follows from the intermediate step that x z. (iii) If x y then Z(y) is a strict subset of Z(x): at least one element of Z(x) is not in Z(y). Why? y is in Z(x) because x y. But y is not in Z(y). z}

...if part...

Here is our utility function: u(x) = number of elements in Z(x) utility of x: is the number of choices that are worse than x. We must prove that for this choice of u: (i) x y implies u(x) u(y)

(ii) u(x)

u(y) implies x y.

...if part...

(i) x y implies u(x)

I either x y or x

u(y) y.

I if x y then (as we have shown) Z(x)

= Z(y). But that means

u(x) = u(y). Good!

I if x

y then (as we have shown) Z(y) is a strict subset of Z(x). But that means u(x) > u(y). Good!

...if part....
(ii) u(x) u(y) implies x y. u(y) implies x y.

I we are trying to prove that u(x)

I which is the same as: if x is not preferred to y then u(x) is not

greater or equal to u(y).

I which is the same as: if x is not preferred to y then u(y) I by completeness: if x is not preferred to y then y I So, to complete the proof we must show that y

> u(x)

x x implies

u(y) > u(x).

I But we have already done that on the previous page! Done!

Part 2: consumers

outline

I introduce the framework of consumer choice I describe preferences by indifference curves I compute marginal rates of substitution I book: we follow the book. read chapters 3 and 4 in Varian.

consumption vectors

I in consumer theory, the alternatives are consumption vectors. I 2 goods; a vector (x1 , x2 )

and good 2. vectors

2 R2 species the quantities of good 1

I we call totrep a consumer if his preferences are over consumption I set of alternatives: all non-negative vectors in R 2 .

utility functions

Maintained assumption: the consumer has complete and transitive preferences on the non-negative vectors in R2 that can be represented by a utility function. The utility function u represents the consumers preference if
0 0 (x1 , x2 ) (x1 , x2 ) implies u(x1 , x2 ) 0 0 u(x1 , x2 )

and, conversely, u(x1 , x2 )

0 0 0 0 u(x1 , x2 ) implies (x1 , x2 ) (x1 , x2 )

transformations of utility functions

Fact: if u represents a preference then so does any strictly increasing function of u Why? If f is a strictly increasing function then u(x1 , x2 ) for example:
I u and 2 u represent the same preference I u and u3 represent the same preference I If u is always positive then u and ln u represent the same
0 0 u(x1 , x2 ) if and only if f (u(x1 , x2 )) 0 0 f (u(x1 , x2 ))

preference

indifference curves: an example

utility function is Indifference curve: all the combinations of x1 and x2 that give the same utility: u(x1 , x2 ) = x1 x2 = utility level k Therefore x2 = g(x1 ) = k x1 u(x1 , x2 ) = x1 x2

indifference curves are a family of hyperbolas

indifference curves
I for each consumption vector (x1 , x2 ) the indifference curve

through (x1 , x2 ) divides R2 into those consumptions that are + better than (x1 , x2 ) and those that are worse than (x1 , x2 ).

averages are better

I the indifference curves in our

example have a particular shape: the average of two points on the indifference curve is better than the original points.
I We say that the consumers

preferences are convex: the set of vectors better than (x1 , x2 ) is a convex set.
I Can you think of situations where

convexity makes sense?

I Can you think of situations where it

does not make sense?

marginal rate of substitution

I the marginal rate of substitution is the slope of the indifference

curve
I the slope of a curve is the derivative of the function that

describes the indifference curve.

marginal rate of substitution in the example

Recall
I u(x1 , x2 )

I the function g : R + ! R + where g(x1 )

= x1 x2 .

indifference curve

= k/x1 describes the

the derivative of g is g 0 (x1 ) = since k is the utility level, we have k = x1 x2 substitute for k: -k x x x = - 1 22 = - 2 = MRS x1 (x1 )2 (x1 ) -k (x1 )2

MRS: an alternative derivation

I for u(x1 , x2 )

= x1 x2 we found that
MRS = -

x2 x1

I Notice x2

u(x1 ,x2 ) x1

and x1 =

u(x1 ,x2 ) x2

Therefore:

x x MRS = - 2 = - u(x 1,x ) 1 2 x1

x2

u(x1 ,x2 )

Is this true for all utility functions?

...yes... as long as the MRS is well dened

Indifference curve is a function g that solves the equation u(x1 , g(x1 )) = k The indifference curve g gives us for each x1 the corresponding x2 = g(x1 ) so that utility is k. Therefore: if we change x1 , the utility must stay unchanged: u(x1 , g(x1 )) u(x1 , g(x1 )) 0 + g ( x1 ) = 0 x1 x2 and solving for g 0 we get g ( x1 ) = 0
u(x1 ,g(x1 )) x1 u(x1 ,g(x1 )) x2

= - u(x 1,x

u(x1 ,x2 ) x 1 2) x2

= MRS

other examples of utility functions...

The good x2 is money that is spent on many other goods. Utility is linear in money: u(x1 , x2 ) = x2 + v(x1 ) and v is a concave function. MRS = MRS is independent of x2 .
u(x1 ,x2 ) x1 u(x1 ,x2 ) x2

= -v 0 (x1 )

Each indifference curve is a vertically shifted version of a single indifference curve

..examples contd...
The goods are red and green pencils. The consumer cares about the total number of pencils u(x1 , x2 ) = x1 + x2 MRS = -1

the indifference curves are straight lines with slope -1

left shoe, right shoe

the goods are perfect complements; the consumer needs one of each u(x1 , x2 ) = min{x1 , x2 } In this case, we cant use our formula to compute the MRS
I the indifference

curves are L-shaped.

I if x1

x2 the additional right shoe delivers no utility. x1 the additional left shoe delivers no utility.

I if x2

useless stuff
the consumer has use for only one of the goods u(x1 , x2 ) = x1 Again, we cant use the formula to compute the MRS because the marginal utility of good 2 is zero.

I indifference

curves are vertical lines