Econ326

Intermediate
Microeconomics
Fall 2011
Instructor: Ginger Z. Jin
http://kuafu.umd.edu/~ginger
TA: Aaron Szott

Lecture 1
Course

introduction

Syllabus
Teaching

style and expectations

Textbook

Chapter 1, 2.1-2.3

Goal of the class

Teach

you to think like a micro-economist

Labor market issues

Industrial organization
Public policies
International trade

Derive

the major concepts and intuitions

from introductory microeconomics

We

will emphasize analytic logic and

mathematical rigor.

Class will cover:

Consumer

demand

Describe consumer preference

Derive consumer demand
Market vs. individual demand
Consumer welfare

Firm

production

Production technology
Firm choice of input and output
Cost and profit
How

demand meets supply?

Exchange economy
Market structure
Market failures: monopoly, asymmetric info, externality
Policy interventions

Example: rental market in

College Park
Product

definition:

one bedroom apt

off-campus rental
in College park
Players:

tenants, landlords, city government? University?

Actions

and incentives

Tenants: reservation price/willingness to pay

Landlords: cost, earn money if possible
Market

outcomes:

price, vacancy rate, tax revenue?

Monthly rent

supply
equilibriu
m

demand

Why is the demand downward sloping?

Units
available

Monthly rent
supply

equilibriu
m

demand

When will we observe a fixed supply?

Units
available

Market scenario 1: convert some

apartments to condos
supply
Monthly rent

demand

Both demand and supply get reduced, the effect

on market equilibrium price is unclear

Units
available

Market scenario 2:
impose $50/month tax on landlord
supply
Monthly rent

demand
Units
available
No change in demand and supply thus no change in
price
ONLY TRUE with fixed supply

Market scenario 3:
non-discriminating monopoly
supply
Monthly rent

demand
Units
available
The monopolist may want to restrict the supply so that he
can charge higher price not efficient from the society
point of view

Market scenario 4:
rent control
supply
Monthly rent

demand

Keep the price down, but create excessive

demand
How to allocate the limited supply to excessive

Units
available

At the end of this class,

You

know how to derive a simple

demand curve given individual
preference
You know how to derive the supply
decision of each firm
You know how to compute market
equilibrium under different market
structures
You can compute who gains and who
loses by how much under a simple
policy intervention

Syllabus
on

my personal website

http://kuafu.umd.edu/~ginger/
click on Econ326
Also

available on elms.umd.edu

Prerequisites very strict rules

by Economics Department
(1) have completed Econ300 with a grade of
"C" (2.0) or better,
OR
(2) have completed or are concurrently taking
Math 240 or Math 241.
If you satisfy either (1) or (2), you should have
already completed ECON200, ECON201, and Calculus
I. But completion in these four courses are not
sufficient for enrollment in Econ326.
For those who do not meet the prerequisites but
believe that an exception could be made, please talk
to Shanna Edinger in Tydings 3127B.

Syllabus
Textbook:
Pindyck and Rubenfeld, Microeconomics,
Edition 7

Evaluation
Three problem sets, 10 points each
Two midterms, 20 points each
One cumulative final, 30 points
Five random in-class quizzes, 2 bonus points
each
Total 110 points

Fixed grade definition

(No curve, no rounding)
F: <40
D: [40,45)
D+ [45,50)
C-: [50,55)
C:
[55,60)
C+: [60,65)
B-: [65,70)
B:
[70,75)
B+: [75,80)
A-: [80,90)
A:
[90,100)
A+: [100,110].

Important dates
Sept. 8: Handout problem set 1
Sept. 22 Problem set 1 due
Oct. 4 Midterm 1
Oct. 11
Handout problem set 2
Oct. 28 Problem set 2 due
Nov. 8 Midterm 2
Nov. 15Handout problem set 3
Dec. 8 Problem set 3 due
????
Final exam
There will be 5 in-class quizzes at
unannounced dates.

Exam policies
If you miss exams for reasons in
line with university policy, you
can take makeup exams or roll
over your missed points to final
For other reasons to miss the
exam, you are allowed to skip at
most one midterm (with points
rolled over to final) upon onemonth written notice to the

Problem sets
Hard

copy distributed in class, soft

copy available on elms
You can turn in problem sets in
class or in your TAs mailbox (in
3105 Tydings) by 4pm of due date.
Graded problem sets will be
returned in TA sessions
Collaborative discussion on problem
sets is ok but outright copying is
cheating. Everyone should turn
in individual problem sets.

Teaching Assistant: Aaron

Szott
Office:

0124F Cole Field House

Office

Hours

Monday 2:15-3:15pm, Friday 23pm

Office

Phone

301-305-9259

Change of office hours

for Sumedha

Teaching Style
Power

point lecture notes are

posted on elms (subject to
update)
More details and examples may
be covered during the class
Handouts, problem sets, answer
keys will be posted on elms. I will
also distribute handouts and
problem sets in class
Graded work will be returned in

Expectation on You
Attend

the class

Mute your cell phone at least

If you have to use your computer, make sure it is
muted and you do not bother others
Read

related textbook chapters

date-specific chapter numbers are available in

syllabus
Attend

TA sessions (will be very useful)

Sharpen your calculus
Ask for help EARLY if you encounter difficulty
Feel free to give us feedback any time so we
can improve during the class

Lecture 2
Utility

Theory
Consumer preferences
Constructing Indifference
curves
Properties of Indifference
curves
Textbook

chapter 3.1-3.2

Intuition of consumer theory

How

does a consumer choose the

best things that she can afford?
What is the best
Afford budget constraint
How to choose constrained
optimization

Examples:

Individual choice of work time

Apple rolls out iphone4
Tax cut at the end of 2010

Axioms of preferences
Completeness

A > B, B > A, A ~ B for all bundles A, B

Transitivity

A > B and B > C => A > C

Otherwise we wont be able to tell which bundle is
the best
Non-satiation:

more is preferred to less. Goods are always good

Counter examples: bad (dislike), neutral goods
(indifferent)
Balance:

averages preferred to extremes

Also called convex preference

Utility
Definition

of Utility

Numerical score representing the

satisfaction that a consumer gets
from a given basket of goods.
In

what unit?

ordinal versus cardinal

Marginal Utility
the

increase in utility you get

when you consume one more unit
of good X
Units of
Apples

Total utility
(TU)

Marginal
Utility (MU)

5-0=5

9-5=4

12

12-9=3

14

14-12=2

15

15-14=1
One common property:
Diminishing marginal

Show MU in graph
Total
Utility U

Units of
apples (X)

Exercise:
compute MU, diminishing MU?
U=5(X+1)
U=5ln(X+1)
U=X0.3
U=100-X2
U=X0.4Y0.6

Ordinal vs Cardinal
Ordinal

Utility

the measurement of satisfaction that only requires

a RANKING of goods in terms of consumer
preference.
This is the concept of utility that is embodied in
the so-called "utility function" that forms the basis
of CONSUMER THEORY
Utility

Function

Utility function that generates a ranking of market

baskets in order of most to least preferred.
This function is defined up to an order-preserving,
monotonic transformation

Exercise:
monotonic transformation of U
function?

Note:
1. monotonic
transformatio
U=5(X+1) vs U=5ln(X+1)
n does not
change the
U=5X+5Y vs. U=5lnX+5lnY
order of
preference,
U=X0.5Y0.5 vs U=XY
2. it may change
the property
of MU
U=XY vs U=lnX+lnY
3. It does NOT
change the
U=X+Y2 vs U=X+Y
relative
tradeoff
U=5X

vs U=5(X+1)

How to graph utility of two goods

U(X,Y)

U(X,Y)

Y
0

Indifference curves
Definition

of Indifference Curve:

the set of consumption bundles

among which the individual is
indifferent. That is, the bundles all
provide the same level of utility.
each

indifference curve
corresponds to a specific utility
level
Indifference curves never cross
each other

Axioms of preferences
Completeness

A > B, B > A, A ~ B for all bundles A, B

Transitivity

A > B and B > C => A > C

Otherwise we wont be able to tell which bundle is
the best
Non-satiation:

more is preferred to less. Goods are always good

Counter examples: bad (dislike), neutral goods
(indifferent)
Balance:

averages preferred to extremes

Also called convex preference

Examples of indifference
curves
U(X,

Y)=X * Y

poin X
t

16

Typical convex preference

Satisfy all four axioms of preference

Examples of indifference
curves
U(X,

Y)=X + Y

poin X
t

5
7

4
8

2
1

Perfect substitutes
Violate balance because avg is not better
than extremes

Examples of indifference
curves
U(X,

Y)=min(X, Y)

poin X
t

Perfect complements
Violate non-satiation sometimes
U is not always differentiable, MU is not well

Lecture 3
Marginal

rate of substitution
Properties of indifference curves
Shape of indifference curves
Special examples
Textbook

Chapter 3.1 & 3.2

Assign problem set #1

Marginal rate of substitution

(MRS)
Definition:

Marginal Rate of Substitution (of X for Y)

= -dy/dx | same satisfaction (i.e. same U)
How

many units of Y would you like to

give up to get one more unit of X?
Can be interpreted as marginal
willingness to pay for X if Y is numeraire
(money left for other goods)

Marginal rate of substitution

(MRS)
Y

Slope = - MRS at
point A
X

Diminishing MRS
(MRS of X for Y diminishes with X)

Consistent with diminishing

marginal utility

Mathematical derivation
of MRS
U=U(X,Y)
Total differentiation:
dU = MUx * dX + MUy * dY =0

-dY/dX = MUx / MUy = MRS (of X for Y)

MRS and ordinal utility

Calculate

MRS:

U=XY
U=lnX + lnY
U=X+Y
U=X+Y2
U=(X+1)(Y+2)
U=X2 Y2

Which

and which are monotonic

transformations of each other?

Properties of indifference curves

for typical preferences
Indifferent

curves are downward

sloping
Violate non-satiation if upward
sloping
Indifference

curves never cross

Violate transitivity if they cross

Indifference

curves are convex

Violate balance if they are concave

or linear

How would the indifference curves

(on apples and bananas) look like if:
Like

apples and bananas

Like apples up to a satiation level
Like apples, but dislike bananas
Like apples, but indifferent to
bananas
Must eat one apple with one
banana
Dislike apples, dislike bananas
Like both apples and bananas up

Like apples and bananas

bananas
U

apples

Like apples up to a
satiation level
bananas
U

What happens if one likes both apple and

banana up to a satiation level?

apples

Like apples but dislike

bananas
bananas

What if one dislikes both apples and bananas?

apples

Like apples but indifferent to

bananas
bananas

apples

Must eat one apple with one banana

(perfect complements)
bananas

Locus line

What determines the locus line?

What if one must each two apples with one
banana?

apples

Always willing to exchange one apple

for one banana (perfect substitutes)
bananas

What determines the slope of the indifference

curve?
What if one is always willing to exchange two
apples for one banana?

apples

Cobb-Douglas Utility
Typical functional form:
U=Xc Yd
Transformations:
U=c*lnX + d*lnY
or
U= Xa Y1-a where a=c/(c+d)
Calculate MRS at point (X,Y)

Lecture 4:
Budget

constraints

definition
Shocks to consumer budget
Kinked consumer budget
Textbook

Chapter 3.1 & 3.2

Budget constraints
Definition:

The budget constraint presents the

combinations of goods that the
consumer can afford given her
income and the price of goods.
Equation:

Px * X + Py * Y = I

Rearrange:

Y = I/ Py + (- Px / Py )

*X
interce
pt

slope

Graph budget constraint

Y
I/Py
Slope = - Px / Py

I/Px

Px/Py = the rate at which Y is traded for X in the

marketplace

Exercise
My

11-year-old son has 20 dollar

allowance each month.
He likes bakugan balls and
pokemon cards
Bakugan ball is $5 each
Pokemon card is $2 each
Draw his budget line

What happens with income tax

cut?
Tax

cut more income

I/Py

Does the
intercept on Y
change?
Does the
intercept on X
change?
Does the slope
of the budget
line change?

Slope = - Px / Py
I/Px

What happens if gasoline price

goes up? (assume gasoline is X)
Px

increases

I/Py

Does the
intercept on Y
change?
Does the
intercept on X
change?
Does the slope
of the budget
line change?

Slope = - Px / Py
I/Px

Examples of kinked budget

constraints
(if price depends on how many
units to buy)
Assume

income = $2000
Two goods: X=food, Y=health
care
Prices:
Px= $2,
Py = $1 if Y<=500 (deductible $500)
Py = $0.2 if Y> $500 (coinsurance
20%)

Y (health care)
8000
Slope = -Px /Py = -2/0.2=-10

Slope = -Px /Py =

-2

500
750

1000

X (food)

Example 2: 1979 food stamp

program
Income

I=2000
Two goods: food (X), other (Y)
Px =1, Py = 1
A household is granted $200 food
stamp
But the food stamp can only be
used for food

other

2000

2000

2200

food

What happens if there is a black market

to trade food stamps?

Example 3: role of financial

market

#1: no financial
market

Y (tomorrow)

2*I

2*I

X
(today)

#2: a financial
market allows
saving and
borrowing at
interest rate r

Y (tomorrow)

The opportunity cost

of not saving today
makes one feel as if
todays price is
increased to (1+r).

X
(today)

Y (tomorrow)

Now we have a kink

due to the
asymmetric terms of
borrowing and saving

X
(today)

Recap so far
Indifference curves describe
consumer preference
Budget constraints describe what
consumers can afford
Put the two together to determine
the best bundle one can afford

Graphical presentation
Y
MRS > Px/Py

I/Py
A

Slope = - Px / Py
C
B

MRS < Px/Py

I/Px

Px/Py = the rate at which Y is traded for X in the

marketplace

At the best choice:

Must

spend every penny (assume

no savings, goods are divisible)
Equal Marginal Principle
MRS = the rate at which the
consumer is willing to trade Y for
one extra unit of X
Px / Py = the rate at which Y is
traded for X in the market place
MRS = Px / Py MUx /Px = MUy
/Py

Mathematical derivation
Max

U(X, Y) by choosing X and Y

Subject to I = Px * X + Py * Y
Define Lagrangian function
L = U(X,Y) + (I Px * X Py * Y)
is an additional variable, now
need to choose X, Y,

Mathematical derivation

We

get the equal marginal

principle back!

is the shadow price of the

budget constraint
Tell us how much the objective
function will increase if the budget
constraint is relaxed by one dollar
((dL/dI = dU/dI when I is binding)
Therefore, is also called the
marginal utility of income when

Exercise: find the best choice

when
U

(Food, Clothes) = ln (F) + ln (C)

Price of food = $2
Price of clothes =$1
Income=100
Answer: F=25, C=50

Lecture 5
Consumers

optimal choice

Inner solution, corner solution

Cobb-Douglas

utility
Price and consumer choice
Income and consumer choice
Normal, inferior and giffen goods
Textbook

4.1-4.4

Chapter 4 appendix,

Typically: Inner solution

Y

I/Py

At the optimal
choice:
MRS = Px/Py
I=Px * X + Py * Y

I/Px

What if the equal marginal

principle cannot be satisfied?
corner solution
Y
I/Py

Spend every penny:

I=Px * X + Py * Y
Check which corner
gives higher utility

I/Px

Example 1 of corner solution:

perfect substitutes
Y

10
0

10
0

U=X+2Y
Px=10
Py=10
Income=1000

Example 2 of corner solution:

perfect complements
U
Y

U=min(X,2Y)
Px=10
Py=10
Income=1000

10
0

10
0

Demand
Optimal

choice

X=f(Px, Py, Income)

Properties:

Homogenous degree of zero

Typically depends on income, own
price, price of other goods

Special example:
Cobb-Douglas Utility

Two
equation
s
Solve for
two
unknow
ns (X
and Y)

Demand only
depends on own
price, not price
of other goods

Homothetic
preferences:
MRS only
depends on the
ratio of X and Y

Fixed share of
income for each
good

Graph consumer choice in response

to:
Price

changes
Income changes

Two goods:
food, clothing
Price of food
drops

Two goods:
food, clothing
Income increases
Note that
incomeconsumption
curve is not
necessarily linear

Normal

goods

Consumers want to buy more quantity of

normal goods as their incomes increase.
Inferior

goods

Consumers want to buy fewer quantity of

inferior goods as their incomes increase.
Examples?

Hamburger is a normal good from A to B,

but an inferior good from B to C

Engel curve

Giffen goods
Normal

and inferior goods are

defined by how consumer choice
changes in response to income
change
Giffen goods depend on price
change
Typical goods have downward
sloping demand curve
Giffen goods have upward sloping
demand curve: as price increases,
consumers buy more; as price

Lecture 6
Decompose

income and
substitution effects in response to
price change
Slusky Equation
Textbook chapter: 4.3-4.4
Handout #1: an example

Food

price falls
Initial choice A new choice B
Imaginary D: same utility as A, but face new price

Slusky Equation

Total
effects

Substitutio Income
n effects
effects

What if X is an inferior good?

income effect works against the substitution
effect

What if X is a Giffen good?

income effect works against and
more than cancels off the substitution
effect

Example 1:

Example 2: Introduction of
health insurance
X=food,

Y=health care, Px=$2,

Py=$1 if no insurance,
Income=2000
Benchmark: no insurance
Scenario #1: insurers pay 80% of
the cost of any medical service
Scenario #2: insurers pay 80%
after $500 deductible

1000
0

Y (health care)

A: choice with no
insurance
C: choice with
insurance

Slope = -Px /Py = -2/0.2=-10

A to B: substitution
effect
B to C: income
C
effect

B
A
Slope = -Px /Py =
-2
1000

X (food)

Scenario #1: insurers pay 80% of the cost of any medical

service

Y (health care)
8000
Slope = -Px /Py = -2/0.2=-10

Scenario #2:
insurers pay 80%
after $500
deductible

Slope = -Px /Py =

-2

500
750

1000

X (food)

How would the insurance coverage affect those who are

healthier and do not need more than $500 health care before

Lectures 7-8
Application

to labor supply
Individual and market demand
Demand elasticity and cross
elasticity
Textbook chapter: 4.3-4.4

Individual demand
A

consumers optimal choice of a

good depends on
The price of this good
The price of other goods
Income

Example

Two goods

Income

(24w+y)/
Pc

C*

L*

24

24+y/w

1
0.
5

4.
8

24

Pc

1
0.
5

19.2
42.7

More generally:
Market demand Q(P)= sum of individual demand Qi(P)

Textbook example of market

demand

How to summarize market

demand?

Meaning of demand
elasticity

Classify demand by demand

elasticity

Market demand If you are the

Q(P)

producer, why
do you want to
know demand
elasticity?

50

Example:

Q=100-2P
100
What is demand elasticity at p=10,20,30?
At what price is the demand isoelastic?

Special cases
P
Completely
inelastic demand

Infinitely elastic
demand

Other elasticities

Example

More on cross elasticity

X

and Y are substitutes

If an increase in Px leads to an increase in
the quantity demanded of Y.

and Y are complements

If an increase in Px leads to a decrease in the
quantity demanded of Y.

and Y are Independent

If Px does not affect the quantity demanded
of Y
Cobb-Douglas utility independent goods

Consumer surplus
Individual consumer
surplus = difference
between what a
consumer is willing to
pay for a good and the
amount actually paid
Total consumer surplus
= sum of individual
consumer surplus

For six consumers, CS = $6+$5+$4+$3+$2+

$1=$21

Total Consumer Surplus

= *(20-14)*6500=19,500

Textbook example of market

demand

Calculate the
demand
elasticity of total
demand and
total consumer
surplus at p=18.

To summarize
Consumer

preference (utility function)

Budget Constraint
optimal choice X=X(Px, Py, I)
Income-consumption curve, priceconsumption curve, engel curve, demand
curve
Income and substitution effects
Sum of Individual demand=market demand
Demand elasticity, income elasticity, cross
elasticity
Consumer surplus

Lecture 11
Risk and Consumer behavior
Describe

risk
Preferences towards risk
Demand for risky assets

Risk, Uncertainty, and Profit, by Frank

Knight (1921)
Risk:

random events that can be

quantified in probability

Uncertainty:

random events that

cannot be quantified in probability

Today

we focus on risk only

Describe risk
Outcome:

a random event is
associated with multiple
outcomes, for instance:
head/tail when we flip a coin
gain/loss when we invest in a risky
asset
Healthy or sick in the future

Probability:

likelihood that a
given outcome will occur
Payoff: value associated with a

Describe risk
Expected

value: probability-weighted
average of the payoffs associated with
all possible outcomes
E(X)=Prob1*X1+ Prob2*X2 ++ Probn*Xn

Variance:

Extent to which possible

outcomes of a risky event differ
Var(X)= Prob1*(X1-E(X))2
+ Prob2*(X2 -E(X))2 ++ Probn*(Xn

-E(X))2

Standard

deviation: square root of

variance, same unit as X

Example
Job1:

50% probability with income $2000

50% probability with income $1000
Job2

99% probability with income $1510

1% probability with income $1500
Calculate

expected values,
variance, standard deviation

Job1 is riskier

Preferences toward risk

For

outcome Xi, utility = U(Xi)

Expected utility
EU=Prob1*U(X1)+ Prob2*U(X2)
+.+Probn*U(Xn)

Risk

averse: prefers a certain given outcome

to a risky event with the same expected
value: EU(X)<U(E(X))
Risk neutral: indifferent between a certain
given outcome and a risky event with the
same expected value: EU(X)=U(E(X))
Risk loving: prefer a risky event to a certain
outcome with the same expected value:
EU(X)>U(E(X))

Example
Eric

now has a job with annual

income $15000
He is considering a new job:
50% prob with income $30,000
50% prob with income $10,000

Risk averse (EU(X)?,

U(E(X))?)

Risk neutral (EU(X)?,

U(E(X))?)

Risk loving (EU(X)?,

U(E(X))?)

Risk premium: maximum amount of money that a

risk averse person will pay to avoid taking the risk

Indifference curves for a risk

averse person
Like

higher expected value,

But dislike risk (measured in
standard deviation)
U

How would the

indifference curves
look like if the person
is risk neutral?
What if he is risk
loving?

How to reduce risk?

Diversification

Practice of reducing risk by

allocating resources to a variety of
activities whose outcomes are not
closely related
Most effective if the activities are
negatively correlated (examples?)
Insurance

Pay insurance premium to avoid

risky outcomes
Actuarially fair: the insurance
premium is equal to the expected

Choosing between risk and

return
Risk free asset: Rf
Asset with market risk: Rm, m
( Rm Rf )
Portfolio p: Rp= Rf +-------------- * p
m

Choice

of a risk averse person

Exercise: Chapter 5,
Question 7

Suppose two investments have the same three

payoffs, but the probability of each payoff differs:
payoff

Prob (investment
A)

Prob (investment
B)

$300

0.10

0.30

$250

0.80

0.40

$200

0.10

0.30

Find the expected return and standard deviation

of each investment.
Jill has the utility function U=5*X where X
denotes the payoff. Which investment will she
choose?
Kens utility function is U=5*X0.5, which
investment will he choose?
For Ken, whats the risk premium of investment
A? Whats the risk premium of investment B?

Lectures 12, 13
Technology

of production

Production function
Average product, marginal product
Law of diminishing marginal return
Malthus and the food crisis

Production

with two inputs

Isoquant curve
Marginal rate of technical
substitution
Returns to scale

Technology of Production
Production

function: shows the

highest output that a firm can
produce for each specified
combination of inputs
Single input (labor): q=F(L)
Two inputs (capital, labor): q=F(K,L)

Short-run:

time in which
quantities of one or more inputs
cannot be changed
Long-run: time needed to make

Single-input production
q=F(L)
Average

product: q /L
Marginal product: dq /dL

0
1
2
3
4
5

0
10
30
60
80
95

Avg product
q/L

Marginal product
dq/dL

Graphically:

Marginal Product (MP) and Average

Product (AP)
Total product q = q (L)
Marginal Product = dq / dL
Average Product = q / L
Question: How does AP change with L?

If MP>AP, AP increases with L

If MP<AP, AP decreases with L
AP=MP at the maximum of AP

Law of diminishing marginal

returns
As

the use of an input increases with other

inputs fixed, the resulting additions to
output (i.e. marginal product) will
eventually decrease.
This is different from technological
Example:
Malthus
improvement
and the food crisis

How to describe production with

more than one inputs?
Isoquant

curve: shows all possible

combinations of inputs that yield the
same output
Similar to indifference curve for
consumer utility

Marginal rate of technical

substitution (MRTS)
Amount

by which the quantity of

one input can be reduced when
one extra unit of another input is
used so that output remains
constant.
MRTS of L for K = - dK/dL | same
q = MPL / MPk
MRTS

= - slope of isoquant curve

Diminishing MRTS
Similar to MRS in consumer utility

Example
Plot

isoquant curve for K=2, L=1,

calculate marginal product of
labor, marginal product of capital
and MRTS at this point
q=3KL
q=3K+L
q=min(3K, L)

Diminishing MRTS

Special case #1:

K and L are perfect substitutes if
production function is linear, MRTS is
always a constant

Special case #2:

K and L are perfect complements if
production function is min(f(K), g(L),
MRTS is not well defined at the kink
(i.e when f(K)=g(L))

Cardinal vs Ordinal

Consumer

utility is ordinal because we

only care about the relative preference
on bundles and it is hard to compare
utility across individuals

Production

function is cardinal
because the absolute scale matters

Cobb-Douglas

production:

technological factor
return to scale

Returns to scale
Rate

at which output increases as

ALL inputs are increased
proportionally
Note it is different from marginal
product
It is a property of a given production
function, also different from
technological improvement

Simple

rule of thumb: will the output

double when all the inputs double?
q more than double Increasing

Constant return to scale

scale

Increasing return to

Can you think of any real-world examples that have

constant, increasing or decreasing returns to scale?

Cobb-Douglas production
Why does represent returns to scale?

Suppose K increases to xK, L increases

to xL
Let q denote the new production by xK
and xL

If decreasing returns to scale

If constant returns to scale

Example: are these production

functions decreasing, increasing or
constant returns to scale?
q=3KL
q= K0.5L0.3
q=0.5lnK + 0.8lnL
q=3K+L
q=min(3K, L)
q= 3KL + 3KL2

Lecture 14, 15 and 16

Cost functions
Firm

decision

Given production technology

Given input prices of input
firm decides on optimal choice of
inputs
cost function
Short run
Long run

Cost
w

= wage rate
r = capital rental cost
Both could be opportunity cost
Cost

function C (q) = w*L(q) +

r*K(q)
Firms decision does not include
sunk cost after the cost is sunk
Example?

Fixed vs. Variable Cost

w

= wage rate
r = capital rental cost
In the long run when every input
is variable
In

the short run, if K is fixed at ,

Variable cost

fixed cost

How to determine cost with only

one variable input?

Example:

More generally
Total production
function

Total cost function

Marginal cost (MC) and avg cost

(AC)

Total cost function

Marginal cost MC = dC/dq

Average Variale cost = VC/q
Average total cost = TC/q =
(VC + FC)/q

When MC=AC, it is the minimum

of AC

How to determine cost with two

variable inputs?

Choose L and K in order to

minimize
Subject to


Define

Lagrangian function

First order conditions

Graphically:
Isoquant curve at q

Isocost curves

Special case 1: when K and L are perfect

substitutes, we may get corner solutions

If capital is cheaper, hire

all capital and zero labor
If labor is cheaper, hire
all labor and zero capital

Special case 2: when K and L are perfect

complements, we always use the perfect
proportion of K and L

Optimal inputs are at the kink of the isoquant curve

Follow the previous example

In
In

the short run when we find

the long run when both L and

K are variable:

Long run AC and MC

Inflexibility of short run

Short run and long run

costs

Exercise
Production

function q=10KL
Wage w=10, rental cost of capital
r=20
Total, average and marginal cost
of producing q units in the short
run when K is fixed at 5?
Total, average and marginal cost
of producing q units in the long
run?
What happens if wage rate

Lectures 16 & 17
Profit Maximization of competitive firms
So

far we know how to choose

inputs and derive cost function
for a specific level of production
under a specific technology, but
how does a firm determine how
much to produce?
This class:
Competitive market
Profit maximization of competitive
firms
Total revenue, marginal revenue

Perfectly competitive market

Homogenous goods
must charge same price

Free entry and exit of producers

Price-taking:
numerous firms in the market so no firm's
individual supply decision affects price.
All firms face perfectly elastic demand

Any example that violates the above

assumption(s)?

Individual firms vs. the industry

Demand curve faced

by a competitive firm
(perfectly elastic)

Demand curve
faced by the
industry

Profit-maximizing firms
We

assume a for-profit firm aims

to maximize profit

Total

profit = total revenue total

cost

The

firm chooses q to maximize

total profit

Graphic illustration of profit

maximization

Algebraically:
Choose
First

At

q in order to maximize

order condition:

the optimal choice of q,

MR=MC

For

a competitive firm, pricetaking implies:

About fixed cost

In

the short run, fixed cost does

not vary by q, so it does not
affect the optimal choice of q,
what matters is marginal cost
(MC).
In the long run, fixed cost occurs
if and only if the firm enters the
market. So it may affect the

Graphic example

Exercise
Output

price p=10
Total cost = 100 + q + 0.5 * q2
Write down FC, VC, AC and MC.
How much should the firm
choose to produce in the short
run (after it incurs FC)?
Should the firm shut down in the
long run?
At what price will the firm enter
the market?

Short run supply curve of a

competitive firm

How will the supply curve change in the long run?

Industry supply curve in the short run

Producer surplus
Sum

over all units produced by a

firm of differences between the
market price of a good and the
marginal cost of production

Producer surplus for a firm

Producer surplus for the industry

in the short run

Long run profit maximization for

an individual firm

More flexible in input choices production can

be more cost-efficient in the long run
Can shut down and exit the market if the expected
profit is lower than the fixed cost

Long run competitive equilibrium

for the industry three conditions
1. All firms are maximizing profit.
2. No firm has an incentive to entry or exit
because all firms earn zero economic profit
Zero economic profit represents a
competitive return for the firms
investment of financial capital
3. The price of the product is such that the
quantity supplied by the industry is equal to
the quantity demanded by consumers.

Continue the previous example for

the whole industry
start with p=40

The industrys long run supply

curve

Constant cost industry

All firms face same cost
Every firm is small as compared to the market
Long run supply curve is horizontal

The industrys long run supply

curve

increasing cost industry

The prices of some or all inputs increase as
the industry expands
Long run supply curve is upward sloping

Is it possible for the industrys long run

supply curve to be downward sloping?

Yes, for decreasing cost industry

The prices of some or all inputs may fall
as the industry expands and takes
advantage of the industry size to obtain
cheaper inputs

Price elasticity of supply

In a constant cost industry, is

infinitely large.
In an increasing cost industry, is
positive and finite, with magnitude
depending on the extent to which
input costs increase as the market
expands.

Exercise

Suppose

that a competitive firm has a

total cost function .
If the market price is P=$115 per unit,
find the level of output produced by
the firm, the level of profit and the
level of producer surplus.
Suppose all firms are identical. At
P=115, is the industry in long-run
equilibrium? If not, find the price and
every firms production associated
with long-run equilibrium .

Lecture 18
Competitive market equilibrium
Demand

equal to supply
Consumer surplus
Producer surplus
Dead weight loss
Consequence of price regulations

Competitive market
equilibrium
Every

consumer is a price-taker
and a utility-maximizer
Every firm is a price-taker and a
profit- maximizer
Free entry and exit
Demand equal to supply

Consumer surplus and producer

surplus

Consumer

surplus = sum of (consumer

willingness to pay price paid) over all units sold
=
Producer surplus = sum of (market price
marginal cost) over all units sold =

Price control #1:

impose a maximum price that is
below the market clearing price

Price control #2:

impose a minimum price that is
above the market clearing price

Regulating price away from free-market

price (in either direction) will introduce
some deadweight loss.

Exercise:
Demand:

P=100-Q
Supply: P=1+2Q
Calculate market price, quantity
sold, consumer surplus, producer
surplus and total welfare
Suppose the government
imposes a price ceiling of $50.
How would market price, quantity
sold, consumer surplus, producer
surplus and total welfare change?

More about price

regulation
Price regulation will distort the market and
generate dead weight loss in total welfare
Price regulation will also generate a
redistribution between consumers and
producers
What if you care more about consumer
surplus than about producer surplus?
Lower price may lead consumers to suffer
a net loss if the demand is sufficiently
inelastic
With price ceiling,
new CS=old CS-B+A

Example:
the market of kidney and the
National Organ Transplantation
Act

Market clearing price is 20,000. The law makes the price zero.
At market price, total welfare=(D+B+)+(A+C)
At regulated price, total welfare=(D+.A+..)+0

Other regulations: supply

restriction
Limited

taxi licenses
Trade barriers

At world price, buy

Qs from domestic,
and import Qd-Qs
If import is not
allowed, price rises
to P0
How much is the
deadweight loss?
How much is the loss
of consumer surplus?

What if there is an import quota?

At world price, buy
Qs from domestic,
and import Qd-Qs
If import is only
allowed up to the
quota, price rises to
P*
How much is the
deadweight loss?
How much is the loss
of consumer surplus?
What about domestic
and foreign
producers?

What about we impose a lump

sum tax on gasoline?
Changes in CS?
Changes in PS?
Gov revenue?

Impact of tax depend on demand

and supply elasticity

Lecture 19 Exchange
economy
Edgeworth

box
Determination of trade price and
trade amount
Contract curve
Textbook: Chapter 16

Edgeworth box
2

individuals
No production, exchange only
Every one is price taker

Contract curve

Pareto optimal (pareto

efficient)
There

is no way to make one

better off and the others not
worse off
Every point on the contract curve
is pareto optimal.

Competitive equilibrium

Example: Handout
Two

individuals: A and B
Two goods: X and Y
Endowment: each one has 5
unites of X and 5 units of Y
Utility: UA=XA*YA, UB=XB2*YB.
Question:

is there a trade? How

much to trade? Market price?

Lecture 20
First

welfare theorem
Reasons for market failure
Monopoly: Marginal revenue =
MC
Monoposony: Marginal
expenditure = MC

First theorem of welfare

economics:
Competitive

equilibrium is the

best!
More formally, textbook Page
597:
If everyone trades in the competitive
marketplace, all mutually beneficial
trades will be completed and the
resulting equilibrium allocation of
resources will be economically
efficient.

Three reasons for market

failure
Market

power: some party is not

price taker
Monopoly: one seller, non price taker
Monoposony: one buyer, non price
taker

Asymmetric
Externality

information

Monopoly
Keep

market demand as given

A single seller (or a group of
colluding sellers)
Maximize profit by choosing
output
Total revenue

Total cost

First order condition:

Marginal revenue < price

restrict supply
Monopoly choice
competitive choice

MC

The Principle of Monopoly pricing

Rewrite

it, we get

Mark up

Inverse of demand elasticity

This implies:
The

more elastic the demand is,

the lower the monopoly mark up.
Demand elasticity limits the
monopolists market power

Monopolist

will always choose to

operate at an elastic part of the
demand curve.

Example
Demand:

P=100-Q
Total cost: TC = 20+4Q
Competitive P and Q?
Monopoly P and Q? Demand
elasticity at this point? Confirm
the Lerner rule.
Loss of CS due to monopoly?
Change of PS due to monopoly?
Total welfare changes?

Exercise:
Drug

innovation needs FC=5

billion
Demand per month P=1000.0001Q
Marginal cost =$2
If we grant X years of monopoly
power for the inventor, what
should X be?

Lecture 21 Price
discrimination
Price

discrimination the practice of

selling a particular good at different
prices to groups with different
valuations.

When

does price discrimination occur?

1. The seller has some market power (i.e.

facing downward demand)
2. Sellers can distinguish different types of
consumers
3. No arbitrage

Types of Price
discrimination
1st degree

charge each consumer their maximum

willingness to pay

2nd degree
dont know who is willing to pay more,
offer a menu of deals to sort out
consumers

3rd degree: offer

different prices according to consumers
observable attributes (age, gender, )

Can you think of examples for each?

Third degree of price

discrimination
Two

types of demand:

Monopolists

Profit

profit:

maximization leads to:

Third degree of price

discrimination

Profit

maximization leads to:

Which

type of consumers get

charged more?

Who

benefits from price

discrimination?

Who

loses?

Example: Chapter 11,

Exercise 8

Sals

satellite company broadcasts TV

to subscribers in Los Angeles and New
York. The demand functions for each
group are:

Cost
Price

of production:

and quantity with price

discrimination?
What if the firm must charge the same

Recap on competitive equilibrium and

monopoly
Competitive

equilibrium:

Both sellers and buyers are pricetakers

Demand = supply
P=MC
Monopoly

Buyers are price takers, but the

seller is not
MR=MC>P
Seller has market power, will push
price up to consumer willingness to

Lecture 22 Monoposony
Monopoly

one seller vs. competitive buyers

The seller realizes his power to set
market price
This power is only useful when demand
is downward sloping (rather than
horizontal)
Monopsony:
one buyer vs. competitive sellers
The buyer realizes his power to set
market price
This power is only useful when supply is

Mathematically

Monopsony

First

tries to maximize

order condition:

Willingness to pay for the

marginal unit of q =
inverse demand p(q)

if MC is upward sloping

Graphically
-> marginal
expenditure >MC

-> supply
curve MC

-> demand
curve

Compare monopsony with monopoly

Monopoly
pushes price to
demand curve

Monopsony
pushes price to
supply curve

Monopoly is
more powerful
if demand is
inelastic

Monopsony is
more powerful
if supply is
inelastic

Monopsony leads to dead weight

loss

Exercise:
Walmart

is a monopsony of apparel in
China. There are many sellers of apparel in
China.
Based on US demand for apparel, Walmart
is willing to pay P=500-0.1Q for Q units of
apparel.
The supply of apparel is P=80+0.2Q
Calculate P and Q in competitive
equilibrium
Calculate P and Q in monopsony
equilibrium
Welfare consequence of monopsony

Lectures 23 and 24
Imperfect competition
Recall

conditions for perfect

competition
Homogenous goods
Every one is price taker
Free entry and exit

We

talked about two extremes:

perfect competition and
monopoly (monopsony)
Between the two extremes:
Monopolistic competition

Monopolistic competition
large

number of small firms

freedom of entry and exit
perfect info
Differentiated products
What does this imply?
1. Every firm faces downward
sloping demand have some
power is setting price above MC
2. Every firm earns zero economic
profit

Monopolistic competition in
short-run and long-run

Short run

Long run

Inefficiency in monopolistic
competition
sloping demand
market power to set price above
MC dead weight loss

Downward

P>MC

and Zero profit in the long

run operate at AC>MC extra
capacity, economy of scale not
fully exploited

Oligopoly
a

market structure in which

a small number of firms serve

market demand.
The industry is characterized by
limited entry.
Homogenous goods
Simplest

case

duopoly (i.e. only two sellers)

Each aware of the existence of the
other firm
Compete instead of collude each
firm has market power less than

Nash Equilibrium
Each

firm is doing the best it can

given what its competitors are
doing.
No one has incentive to deviate
at the equilibrium

Cournot model of Duopoly

Two

profit maximizing firms

produce the same goods (e.g.
gasoline)
Both firms try to set its own
output separately and
simultaneously
each firm treats the output level
of its competitor as fixed when
deciding its own output

Solve Cournot equilibrium

Reaction

curves:

Example: textbook p453

Market

demand: P=30-Q
MC=0 for both firms
How much to produce in Cournot
equilibrium? What is the market
price?
What if the two firms collude so
they together act like a
monopolist?
Compare these two cases with
competitive equilibrium

Cournot: firm 1s point of

view
First order condition with respect to Q1
while taking Q2 as given:

Firm 1s reaction curve:

Cournot: firm 2s point of

view
First order condition with respect to Q2
while taking Q1 as given:

Firm 1s reaction curve:

Put the two together:

Compare to monopoly if the two

firms collude
MR=P+P(Q)*Q=30-Q-Q=30-2Q

30-2Q=0 Q=15
The two firms together produce
15, so each produce 7.5.
P=30-Q=15.
MR=MC

Compare to perfect
competition
P=MC

30-Q=0 Q=30, P=0.

Graphically

Variation 1: What if the two firms do

not choose output simultaneously?
Stackelberg

model:

One firm sets its output before other

firms do. first move advantage
Difference

between Cournot and

Stackelberg models
The leading firm will consider how
the other firms adjust output
according to his choice of output

Continue the previous

example
Demand:

P=30-Q, MC=0 for both

firms
Firm 1 chooses Q1 first, firm 2
chooses Q2 next
Firm 2s best choice of Q2 given
Q1 firm 2s reaction curve
Firm 1 anticipates firm 2s
reaction curve
- First order condition: =0

Variation 2: What if the two firms choose

price instead of output simultaneously?
Demand:

P=30-Q, MC=0 for both

firms
As long as the other firm charges
above MC, this firm has incentive
to undercut
At the end, each charges MC and
earns zero profit!
This is called Bertrand
competition!
What if the two firms have

Simple Game Theory

Nash

Equilibrium: no one has

incentive to deviate given the
other parties strategy.
Dominant strategy: it is the
players best strategy no matter
what strategy the other players
adopt
Confess
Not confess
Prisoners dilemma
Confess
-10, -10
-5, -15
Not confess

-15, -5

-6, -6

Examples of prisons
dilemma

firms collude each has

incentive to secretly cut price or
expand output collusion is
fundamentally unstable
Any other example?
Two

Pure

strategy vs. Mixed strategy

Mixed: randomize between

strategies
Example:

Inspection game
Detect

Not Detect

Comply

-5,-5

-5,0

Not comply

-10, 5

0, 0

No

pure strategy equilibrium,

the only equilibrium is 50%
probability detect, 50%

Lecture 25 Asymmetric
Information
Adverse

Selection

Problem
solution
Moral

Hazard

Problem
Solution
Adverse

Hazard

selection and Moral

Recall: Reasons for market

failure
Imperfect

competition

Monopoly, monopsony, oligopoly,

monopolistic competition
Asymmetric

information

Situation in which a buyer and a

seller possess different information
about a transaction.
Externality

The market for lemons

Suppose

used car quality is

uniformly distributed between 0
(completely dysfunctional) and 1
(same as brand new)
Suppose a typical buyer is willing
to pay X for quality X.
Problem: the buyer cannot
observe car quality before
purchase (no test drive.)
0

0.25

0.5

Adverse selection
Cause:

Products of different
qualities are sold at a single price
because sellers observe product
quality but buyers do not
Consequence: too much of the
low quality product (so called
lemons) and too little of the
high quality product (so called
peaches) are sold.
Other examples?

Solutions to adverse
selection
Return

and warranty

Blanket return policy

Hyundai offers 10-year warranty
Signaling

workers may signal their ability by

education
Reputation

Reputable restaurants (e.g.

McDonald) have more to lose if they
cheat
Third

party certification

Moral hazard
One

party engage in hidden

actions
This action affects the probability
or magnitude of a payment
associated with an event
Example: principal-agent
problem

Solutions to principal-agent
problem
Close

monitoring
Incentive contract
Textbook example: revenue from
making watches
Bad Luck
(50%)

Good Luck
(50%)

Low effort
(a=0)

$10,000

$20,000

High effort
(a=1)

$20,000

$40,000

Cost of low effort=0, cost of high

effort=10,000
What kind of contract can solicit high

Incentive contract
Any

fixed wage does not yield high effort.

Let wage conditional on revenue.
Consider: w=max(R-18000,0)
At low effort, expected wage is
0*0.5+(20000-18000)*0.5=1000
At high effort, expected wage is (2000018000)*0.5+(40000-18000)*0.5=12000
The net gain to the worker with high effort
= 12000-10000=2000>1000, so the
worker will commit to high effort
When the worker engages in high effort,
the principals net gain =
20000*0.5+40000*0.5-12000=18000.

Adverse selection and moral

hazard
They

are different

Adverse selection: info asymmetry

before contract
Moral hazard: info asymmetry after
contract
They

can co-exist

Unsecured consumer credit

Insurance
Employment

Lecture 26: Externality

Definition
Negative

externality
Positive externality
Solutions

Externality
Definition:

Action by either a producer or a

consumer which affects other
producers or consumers but is not
accounted for in the market price
Negative

externality

Examples?
Positive

externality

Examples?

Inefficiency of negative
externality
MC:

marginal cost facing the producer

MSC: marginal social cost of
production facing the whole society
MSC-MC=marginal external cost
Externality over production

Solution
Restrict

production in light of
negative externality
Emission standard
How can EPA know the optimal
standard?
Enforcement cost is high

Charge

emission fee
Tradeable emissions permits

Example: Chapter 18
Exercise #6
Demand

for paper: Qd=160,000-

2000P
Supply for paper:
Qs=40,000+2000P
Marginal external cost of effluent
dumpting: MEC=0.0006Qs
Calculate P and Q assumption no
regulation on the dumping of
effluent.
Determine the socially efficient P

Inefficiency of positive
externality
Consider

home repair and landscaping

MB=Marginal benefits for the home
owner
Marginal social benefits=MB+marginal
external benefit for neighbors
Positive externality under provision of
public goods

Public goods
Definition:

the marginal cost of provision

to an additional consumer is zero and
people cannot be excluded from
consuming it
Two properties:
Nonrival: zero cost to additional
consumers
Nonexclusive: cannot exclude people
from using the public goods
Examples: national defense, light house,
air quality, information
Private provision of public goods suffers

A comprehensive example
Stephen

J. Dubner and Steven D.

Levitts blog on 4/20/2008 titled
Not so-free ride
http://www.nytimes.com/2008/04
/20/magazine/20wwln-freakonomi
cs-t.html?pagewanted=1

Course overview
Three

main blocks

Consumers problem
Producers problem
Market equilibrium
Extras

uncertainty, game theory,

asymmetric information, externality
The

review below focuses on the

most basic points that you should
master, it is not meant to be
exhaustive of all materials

Consumers problem
Utility

function
Budget constraint
Write out and solve consumers utility
maximization problem
How does consumer choice change in
response to changes in price or income?
Derive individual demand and market
demand
Calculate demand elasticity
Special cases: perfect substitutes and
perfect complements

Producers problem
Production

function and related

concepts
Solve firms cost minimization
problem
How does firms choice change in
light of production change or
input price change?
Cost function and related
concepts
Derive individual and market

Market equilibrium
Perfect

competition (demand =
supply, price=MR=MC)
2-person exchange economy
(Edgeworth box)
Monopoly (MR=MC<price)
uniform pricing, price discrimination
Monoposony

(ME=WTP>Price)
Duopoly (Cournot, Bertrand,
Stackelberg)
Monopolistic competition

Extras
Uncertainty

Expected value, expected utility and risk

preferences
Simple game theory
Concept of Nash Equilibrium, dominant
strategy, mixed strategy
Simple examples in class
Asymmetric Information
Adverse selection
Moral hazard
Externality
Negative externality

Course evaluation please

CourseEvalUM.umd.edu

OPEN in the last two weeks

of the semester

Thank you!