Introductory lectures on Microeconomics Lecture 1 – Markets and gains from trade Department of Management 28th September 2010 Mara Airoldi

Structure of the lectures  Lecture 1 – Markets: efficiency and gains from trade Focus on models in economics  Lecture 2 – Cost functions, budgets and elasticity Focus on theory of consumption and theory of production  Lecture 3 – Markets and welfare economics Focus on market equilibrium  Lecture 4 – Expected value and discounting

Reading for lecture 1 Varian, Intermediate Microeconomics:  Chapter 1: “The Market”  Chapter 3: “Preferences”  Chapter 4: “Utility”  Chapter 30: “Exchange”

Objectives to appreciate:  Use of models and graphs in economics  Utility functions & indifference curves  Trade-offs and gains from trade: indifference curves & the Edgeworth box  Market efficiency Pareto optimality

Structure  Microeconomic theory  Graphs, trade-offs & gains from trade ‘indifference curves’ ‘Edgeworth box’  Market efficiency

Microeconomic theory and models  Models are a simplification of reality  “Art of leaving things out”  A good model is one which very little can explain a lot

Microeconomic theory & market efficiency A theory in four acts: 1.Robinson Crusoe economy  1 person economy (producer & consumer) 2.The ‘benevolent central planner’  Many producers & many consumers  ‘First best solution’: what would happen if many producers & many consumers would do what the benevolent central planner wishes them to do  Does not exist in practice

Microeconomic theory & market efficiency 3.The ‘good news’ about the market Under certain conditions  the market produces the same outcomes as the benevolent planner  & it is very ‘cheap’ 4.When market fails  Why does it fail?  Can we ‘fix’ it within a market mechanism?  Can we ‘fix’ it within a different institutional arrangement?

Structure  Microeconomic theory  Graphs, trade-offs & gains from trade ‘indifference curves’ ‘Edgeworth box’  Market efficiency

Representing the availability of two commodities of good in a graph Commodity y e.g. bottles of red wine Commodity x e.g. bottles of white wine More of x More of y More of x & y 0 “Non satiation” assumption: more is always better than less Otherwise, it is out of the area of interest of ‘economics’

Quadrants of preference: more is better Commodity y: e.g. bottles of red wine Commodity x: e.g. bottles of white wine 0 A B C D E

Quadrants of preference: more is better Commodity y: e.g. bottles of red wine Commodity x: e.g. bottles of white wine 0 North East quadrant: certainly preferred (dominant points) South West quadrant: certainly not preferred (all dominated by A) A B C D E ?? Need more info

Diminishing marginal utility  “non satiation” More is better  But the more you have the less you value increases utility Bottles of white wine

Diminishing marginal utility  The added value of the first bottle of wine is greater than  the added value of the 2 nd bottle which is greater than  The added value of the 3 rd bottle etc… utility Bottles of wine 1 u(1) u(2) 32 Added value of 2 nd bottle Added value of 1 st bottle

Indifference curves Bottles of red wine Bottles of white wine 0 A B C D E Better than A Worse than A D is as good as A (it is on the same indifference curve)

Indifference curves Bottles of red wine Bottles of white wine 0 A B C D E People prefer to be on higher indifference curves (more is better)

Utility & indifference curves utility Bottles of white wine Bottles of red wine Bottles of white wine

Structure  Microeconomic theory  Graphs, trade-offs & gains from trade ‘indifference curves’ ‘Edgeworth box’  Market efficiency

A Robinson Crusoe economy: Maria Maria’s pasta Maria’s flour Production function: How Maria turns flour into pasta Maria has this much flour to start with 0

Another Robinson Crusoe economy: Paul Paul’s pasta Paul’s flour 0

Edgeworth box - what is it? Paul’s pasta Paul’s flour Maria’s pasta Maria’s flour 0

Edgeworth box – Gains from trade Paul’s pasta Paul’s flour Maria’s pasta Maria’s flour Total pasta available Total flour available 0 0

Edgeworth box – Gains from trade Paul’s pasta Paul’s flour Maria’s pasta Maria’s flour Total pasta available Total flour available

Edgeworth box – Gains from trade Paul’s pasta Paul’s flour Maria’s pasta Maria’s flour Total pasta available Total flour available

Edgeworth box – Gains from trade Paul’s pasta Paul’s flour Maria’s pasta Maria’s flour Total pasta available Total flour available

Edgeworth box – Gains from trade Paul’s pasta Paul’s flour Maria’s pasta Maria’s flour Total pasta available Total flour available Yellow area: allocations preferred by both people

Edgeworth box – Gains from trade Paul’s pasta Paul’s flour Maria’s pasta Maria’s flour Total pasta available Total flour available Contract curve

Structure  Microeconomic theory  Graphs, trade-offs & gains from trade ‘indifference curves’ ‘Edgeworth box’  Market efficiency

Contract curve & Pareto optimality  Contract curve Links tangent points of indifference curves of A & B These points are ‘Pareto optimum’ or ‘Pareto efficient’  “Pareto efficiency” or “Pareto optimality” To compare different economic outcomes An outcome is Pareto efficient if it is not possible to make at least one person better off without making anybody else worse off

When do markets work or fail?  The market ‘works’ if it generates a Pareto efficient outcome  Under certain conditions the market works (Lecture 3)

Today we looked at:  Microeconomic theory Robinson Crusoe Benevolent central planner Market outcomes and Pareto efficiency  Graphs, trade-offs and gains from trade Utility and indifference curves Edgworth box (gains from trade)  Market ‘efficiency’

Objectives to appreciate:  Use of models and graphs in economics  Utility functions & indifference curves  Trade-offs and gains from trade: indifference curves & the Edgeworth box  Market efficiency Pareto optimality

Readings for Lecture 2  Varian, Intermediate Microeconomics Part 1: more on the theory of the consumer  Chapter 2: “Budget constraint”  Chapter 6: “Demand” Part 2: the theory of the firm (or of production)  Chapter 19: “Profit maximisation”  Chapter 20: “Cost minimisation”