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Microeconomics summary EUC
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Microeconomics week 1Chapter 1: thinking like an economist
Cost-benefit approach to decisions: benefits should exceed costs.
It’s important to compare the marginal benefits and costs for many decisions e.g. whether
to launch another boat- average costs and benefits won’t be beneficial in this case.
Reservation price: the price at which a person would be indifferent between doing x and not
doing x (internet: highest price consumer’s willing to pay).
Optimal amount of a continuously variable activity is the quantity for which its marginal
benefit is equal to its marginal cost. Daarboven zijn de marginale kosten hoger dan de
marginale benefits
Positive question: a question about the consequences of specific policies or institutional
arrangements. Has a definitive answer. E.g. how will demand be affected by rising prices
Normative question: a question about what policies or institutional arrangements lead to
the best outcomes. Does not have a definitive answer. Involves value judgements about
what ought/should be.
There’s a clear connection between the two: answers to positive questions can help find an
answer to normative issues. They put us in a more informed position to determine what
ought or should be.
Chapter 4: the theory of rational consumer choice
Begins with the assumption that consumers enter the marketplace with well-defined
preferences.
Bundle: a particular combination of two or more goods.
Budget constraint: the set of all bundles that exactly exhausts the consumer’s income at
given prices aka budget line.
Affordable/feasible set: bundles on or below the budget constraint; bundles for which the
required expenditure at given prices is less than or equal to the income available.
Composite goods: in a choice between good x and numerous other goods, the amount of
money the consumer spends on those other goods. (the amount one spends on goods other
than x)
Preference ordering: a ranking of all possible consumption bundles in order of preference
,5 properties of preference ordering
1) Completeness: complete if it enables consumers to rank all possible combinations of
goods and services.
2) Transitivity: if you prefer A to B and B to C, it follows that you prefer A to C.
3) More is better
4) Continuity: small changes in quantity of a good X shouldn’t be associated with jumps in
preferences: if one prefers X to Y, then any bundle sufficiently close to X is also preferred to
Y. (see p.81 2nd paragraph). Continuity helps construct indifference curves, indifference
curves in turn help compare points using the logic of transitivity.
5) Convexity: mixtures of goods are preferred to extremes. Tells us that the more one has of
a good, the more she must be given of that good before one is willing to give up a unit of
the other good. MRs declines as we move downward to the right along an IC. ICs with
diminishing rates of MRS are convex. The longer time period we use, the more likely
preferences are to become convex.
Indifference map: a representative sample of the set of a consumer’s indifference curves,
used as a graphical summary of her preference ordering.
Three important properties of indifference curves and indifference maps:
1) Indifference curves are ubiquitous: any bundle has an indifference curve passing
through it. This is assured by the completeness property of preferences.
2) Indifference curves are downward sloping. Otherwise the more-is-better property
would be violated: it would then say that a bundle with more of both goods is
equivalent to a bundle with less of both.
3) Indifference curves from the same indifference map cannot cross (see p.83 for
explanation)
Marginal rate of substitution: (at any point on an indifference curve) the rate at which the
consumer is willing to exchange the good measured on the vertical axis for the good
measured along the horizontal axis = the absolute value of the slope of the IC. Amount of Y
consumer must give up to gain 1 unit of X.
Slope of budget constraint tells us the rate at which we can substitute X for Y without
changing total expenditure. MRS on the other hand tells us the rate at which we can
substitute X for Y without changing total satisfaction.
*! Steeper IC person has preference for good X over good Y
*As long as the preference ordering satisfies completeness, transitivity and continuity we
can represent preferences using an indifference map without the preferences satisfying the
other 2 properties.
Best affordable bundle: the most preferred bundle of those that are affordable
Best affordable bundle: MRS at point X is equal to the absolute value of the slope of the
budget constraint. MRS= Ps/Pf
Corner solution: in a choice between two goods, a case in which the consumer does not
,consume one of the goods. When there’s no point of tangency: slope of MRS is not equal to
budget line’s slope anywhere
*ICS that are not strongly convex are characteristic of goods that are easily substituted for
one another – corner solutions are more likely for these goods
*if perfect substitutes:
-MRS doesn’t diminish
- ICs are straight lines
- if they happen to be steeper than budget constraint corner solution on the x-axis and
vice versa
Interior solution: in a choice between two goods, a case in which the consumer consumes a
positive amount of both goods. -often with point of tangency
Ordinal approach: rank preferences
MUf/Mus =MRS
Chapter 5: individual and market demand
Substitution effect: the change in the quantity demanded that results because the price
change alters the attractiveness of substitute goods
Income effect: the change in quantity demanded that results from the change in purchasing
power
Total effect of the price increase: sum of substitution and income effects.
Price consumption curve (PCC): holding income, preferences and the price of Y constant, the
PCC for a good X is the set of optimal bundles traced on an indifference map as the price of
X varies.
quantities
Individual demand curve price plotted against quantity
Income-consumption curve (ICC): holding the prices of X and Y +preferences constant, the
ICC for a good X is the set of optimal bundles traced on an indifference map as income
varies. Also: set of best affordable bundles
Engel curve: a curve that plots the relationship between the quantity of X consumed and
income
- is downward sloping for inferior goods and upwardsloping for normal goods
Normal good: one whose quantity demanded rises as income rises
Inferior good: one whose quantity demanded falls as income rises
*Whether a good is normal/inferior is almost always judged relative to some current or
expected level of income
The more broadly a good is defined, the less likely it is to be inferior e.g. meat/food (vs
hamburger)
, Backward-bending engel curves a.o. when switching from 2 star hotels to 3 or 4 stars when
income rises
If buying power decreases amount purchased of an inferior good increases, opposite is
true for normal goods
The substitution effect always makes the quantity purchases move in the opposite direction
from the change in price (when price goes up, quantity demanded goes down)
*! For inferior goods substitution effect and income effect work against e/o, for normal
goods the income effect reinforces the sub effect
* For consumers with the conventional indifference curve shape, the substitution effect of a
price increase will always reduce consumption of the good whose price increased.
Microeconomics lecture 2
Demand is a (downwardsloping) relationship between quantity demanded for a good and
the price of that good
Determine this relationship using rational choice model
Demand curve vs PCC
Pcc captures relationship between optimal x and y for different prices
Demand curve just captures price and quantity of good x
How quantity demand respond to Income changes engel curves
How quantity demanded responds to Price changes demand curve
For most goods, engel curves are upwardsloping
Skip mathematical derivation of substitution and income effects
Substitution is always negative
income can be both
Aggregate (market) demand
Aggregate demand: horizontal summation of individual demand curve
Elasticity:
Measures the responsiveness of one variable to changes in another
Slope depends on the unit of measurement
Chapter 7: choice under uncertainty and the economics of information
Expected value: the sum of all possible outcomes, weighted by its respective probability of
occurrence.
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