WELCOME TO ECONOMICS S-1010 : MICROECONOMIC THEORY WELCOME TO ECONOMICS S-1010 : MICROECONOMIC THEORY Summer 2009 M & W, 6:30-9:30pm Sever 110 Instructor: Robert Neugeboren 51 Brattle St, Rm 522 TA: Rajiv Shankar W 3-4 and by app’t. Sections: T 6:30 Website:

Today’s Agenda Go Over Syllabus Requirements Policies Topics What is Microeconomics? An Example Next Time

Description Economics S-1010 presents the basic analytical tools of microeconomics. We will start by looking at the decision-making of individual consumers and ask how these decisions can be optimized, or improved. Next, we will look at how firms make and coordinate their decisions under varying market structures, including perfect competition and monopoly.

Description Then we will look at strategic behavior in imperfectly competitive markets, making use of concepts from game theory such as Nash equilibrium. Finally, we will take up topics including (from among?) bargaining theory, information economics, externalities, public goods, and welfare analysis.

Description ECS-1010 is taught at the intermediate level and is appropriate for students who have already completed a first-year “principles” course in microeconomics. Mathematical preparation at the level of basic algebra is a prerequisite, and familiarity with first-year calculus will be of help. Students will learn the key tools and principles economists apply to understand a wide range of phenomena, using graphical representations, some math, and plain logic to present the important ideas and solve basic microeconomic problems.

Requirements 10% Sections. Attendance mandatory. 20% Problem Sets. 4, every 1-2 weeks. 30% Midterm Exam. July 13, in class. 40% Final Exam. August 3, 3 hrs. Graduate Credit: Additional material will be assigned on problem sets and exams.

Readings There are several good textbooks on intermediate microeconomics. Either of the following are recommended: Besanko & Braeutigam, Microeconomics, 2 nd (Wiley). Pindyck & Rubinfeld, Microeconomics,6 th (Prentice Hall). A good alternative is Varian, Intermediate Microeconomics. Students are expected to read the assigned chapters before the corresponding class session. From time to time, additional background references and supplementary readings may be assigned.

Course Policies Academic Honesty Harvard takes matters of academic honesty very seriously. While you may discuss assignments with your classmates and others, make sure any written material you submit is your own work. Use of old course materials, including exams and problem sets from online sources, is prohibited. You should consult the Official Register of the Harvard Summer School and the website to familiarize yourself with the possible serious consequences of academic dishonesty.

Course Policies Late Policy There will be 4 problem sets assigned roughly every other week, due in section. You can submit 1 problem set late, but only until the answer key is posted.

Topics UNIT ICONSUMER CHOICE UNIT IIFIRM BEHAVIOR July 13MIDTERM UNIT IIIMARKETS & COMPETITIVE STRATEGY UNIT IVGAMES & INFORMATION Aug 3FINAL EXAM

Topics UNIT I CONSUMER CHOICE P-R chapters 6/22Introduction: What is Microeconomics? (1-2) 6/24Theory of the Consumer (3) 6/29Individual and Market Demand (4)

Topics UNIT II FIRM BEHAVIOR 7/1 Theory of the Firm (6) 7/6Profit Maximization (7) 7/8Perfect Competition/Review(8-9) 7/13MIDTERM

Topics UNIT IIIMARKETS & COMPETITIVE STRATEGY 7/15Monopoly & Oligopoly(10-11) 7/20 Games and Strategic Competition(12-13) kkk

Topics UNIT IV INFORMATION & WELFARE 7/22Decision under Uncertainty(5) 7/27Bargaining and Negotiation(17) 7/29Externalities and Public Goods/Review (16) 8/3FINAL EXAM

Theory of the Consumer What is Microeconomics? The Assumption of Rationality Equilibrium & the Exchange Economy Optimal Choice: An Example Preferences Indifference Curves Next Time

What is Microeconomics? Economists study everything from money and prices to child rearing and the environment. They analyze small-scale decision-making and large-scale international policy-making. They compile data about the past and make predictions about the future. Many economic ideas have currency in everyday life, cropping up in newspapers, magazines, and policy debates. The amount you pay every month to finance a car or new home purchase will depend on interest rates. Business people make investment plans based on expectations of future demand, and policy makers devise budgets to achieve desired social goals.

What is Microeconomics? Across the broad range of topics that interest economists is a unique approach to knowledge, something common to the way all economists see the world. Economists share certain assumptions about how the economy works, and they use standard methods for analyzing data and communicating their ideas. What is Macroeconomics?

What is Microeconomics? The Dismal Science Since its beginning, economics has been preoccupied with the problem of scarcity. The hours in a day, the money in one’s pocket, the food the ground can supply are all limited; spending resources on one activity necessarily comes at the expense of some other, foregone opportunity. Scarcity provides economics with its central problem: how to make choices under constraint?

What is Microeconomics? We do not say that the production of potatoes is economic activity and the production of philosophy is not. We say rather that, in so far as either kind of activity involves the relinquishment of other desired alternatives, it has its economic aspect. There are no limitations on the subject matter of Economic Science save this. - Lionel Robbins

The Assumption of Rationality Economists approach a wide range of topics with the assumption that the behavior under investigation is best understood as if it were rational (though we know that not all behavior is, in fact, rational) and that the best explanations, models, and theories we can construct take rationality as the norm. Rationality, in the words of Frank Hahn, is the “weak causal proposition” that sets all economic analyses in motion.

The Assumption of Rationality Economics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences. - Colin Camerer and Richard Thaler.

The Assumption of Rationality Rationality: the assumption that agents prefer more of what they want to less; Max E(U). Agents’ wants, or preferences, are not necessarily self-interested. One can want others to be better off and rationally pursue their interests as well. Economists assume that whatever their preferences, agents will attempt to maximize their satisfaction, subject to the constraints they face.

Equilibrium & Exchange Whoever offers to another a bargain of any kind proposes to do this. Give me that which I want, and you shall have that which you want …; and it is in this manner that we obtain from one another the far greater part of those good offices we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. - Adam Smith

Equilibrium & Exchange Yet an isolated bargain is not all Smith had in mind. For one thing, it is likely that a number of terms of exchange (prices) exist which both sides would find advantageous, and it possible the outcome could be influenced by capricious or coercive means either side might have. Where instead each actor faces a very large number of bargains: the market.

In the market, each individual is powerless to set prices, which are instead determined by the interaction of very many individuals. Equilibrium as a balance of forces Equilibrium & Exchange The Bargain Buyer and Seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b < s, there is no price they can agree on: b(uyer’s reservation price) s(eller’s reservation price) S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price)

In the market, each individual is powerless to set prices, which are instead determined by the interaction of very many individuals. Equilibrium as a balance of forces Equilibrium & Exchange The Bargain Buyer and Seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b > s, we say there is a positive zone of agreement, or surplus: b(uyer’s reservation price) s(eller’s reservation price) S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price)

In the market, each individual is powerless to set prices, which are instead determined by the interaction of very many individuals. Equilibrium as a balance of forces Equilibrium & Exchange The Bargain Buyer and Seller try to agree on a price. Buyer is better off at a price less than b, Seller at a price above s. If b > s, we say there is a positive zone of agreement, or surplus: b(uyer’s reservation price) s(eller’s reservation price) S(urplus) = b(uyer’s reservation price) – s(eller’s reservation price)

In the market, each individual is powerless to set prices, which are instead determined by the interaction of very many individuals. Just as each particle seeks its center of gravity, each rational individual seeks its own satisfaction. Yet just as no particle exerts its will over the structure of the universe, no individual can influence the workings of the market. Equilibrium as a harmony of rational forces. Equilibrium & Exchange

Smith’s Radical Idea The way to promote the Wealth of Nations is to unleash the productive power of individuals, allowing individuals to “truck, barter, and trade.” to innovate and compete in pursuit of their interests. And while today, we often associate defense of free markets and laissez faire economics with conservative political positions, 200 years ago, Smith’s ideas were a challenge to the traditional, inherited sources of power. Equilibrium & Exchange

A Theory of Prices Classical economics (political economy) challenged traditional notions of a “just price,” or the king’s price, with the “theory of value.” For contemporary microeconomics, prices are determined by the interactions of rational individuals, where the outcome, or resting point, represents a balance of self-interested forces. In equilibrium, though each individual is trying to get the best of the bargain, prices are (under certain conditions) determined independently of their efforts. Equilibrium & Exchange

Freddie consumes only apples and oranges. Apples cost $1 and oranges cost $1.50. If Freddie has $100 to spend, how many apples and how many oranges should he buy? What information is missing? Freddie likes oranges twice as much as apples. Optimal Choice: An Example

Start by asking how many apples and oranges he can buy. Call this the feasible set. Recall: Oranges Pa = $1 67 Po = $1.5 I = $ Apples At a point along the line, Freddie is spending his entire budget Optimal Choice: An Example At an interior point, Freddie isn’t spending his entire budget

Next ask how many apples and how many oranges he wants to consume. Call these preferences. Recall: Oranges Freddie likes oranges twice as much as apples Apples Freddie is willing to trade 2 apples for 1 orange Optimal Choice: An Example

Next ask how many apples and how many oranges he wants to consume. Call these preferences. Recall: Oranges Freddie likes oranges twice as much as apples Apples Freddy is indifferent between any combination of apples and oranges along a line INDIFFERENCE CURVES Optimal Choice: An Example

Next ask how many apples and how many oranges he wants to consume. Call these preferences. Recall: Oranges Freddie likes oranges twice as much as apples Apples Each indifference curve is associated with a different level of utility, increasing farther away from the origin. INDIFFERENCE CURVES Optimal Choice: An Example

To maximize his utility, Freddie will choose a point on his highest feasible indifference curve. Recall: Oranges Freddie likes 67oranges twice as much as apples 100 Apples In this case, he will choose to consume only oranges PERFECT SUBSTITUTES Optimal Choice: An Example

Indifference Curves Perfect SubstitutesPerfect Complements

Theory of the Consumer Preferences Indifference Curves Utility Functions Optimization Income & Substitution Effects How do they respond to changes in prices and income? How do consumers make optimal choices?

We have said that microeconomics is built on the assumption that a rational consumer will attempt to maximize (expected) utility. But what is utility? Over time, economists have moved away from a notion of cardinal utility (an objective, measurable scale, e.g., height, weight) and toward ordinal utility, built up from a simple binary relation, preference. Theory of the Consumer

We start by assuming that a rational individual can always compare any 2 alternatives (“consumption bundles” or “market baskets”). We call this basic relationship preference: For any pair of alternatives, A and B, either A > B A is preferred to B A < B B is preferred to A A = B Indifference Preferences e.g., 2 apples & 3 oranges.

“Well-behaved” preferences are (i) Connected: For all A & B, either A>B; B>A; A=B (ii) Transitive: If A > B & B > C, then A > C (iii) Monotonic: More is always preferred to less (free-disposition) (iv) Convex: Combinations are preferred to extremes Preferences

Y X A B YaYbYaYb X a X b A = (Xa, Ya) B = (Xb, Yb) A ? B What can we say about the relationship between A and B?

Preferences Y X A C B YaYbYaYb X a X b A = (Xa, Ya) B = (Xb, Yb) C = (Xb, Ya) A ? B C > A C > B What can we say about the relationship between A and B? Now consider point C

Preferences Y X A C B YaYbYaYb X a X b A = (Xa, Ya) B = (Xb, Yb) C = (Xb, Ya) A ? B ? D D > E D ? B D ? A D E Now consider point D and E Convexity: D > E

Preferences Y X A C B YaYbYaYb X a X b A = (Xa, Ya) B = (Xb, Yb) C = (Xb, Ya) A = B = E D > E D > B D > A D E Indifference curves Now consider point D and E

Indifference Curves Y X Generally, ICs are: Downward sloping Convex to origin Inc utility, further from origin Cannot cross U = XY Indifference Curve: The locus of points at which a consumer is equally well- off, U.

Indifference Curves Y X Generally, ICs are: Downward sloping Convex to origin Inc utility, further from origin Cannot cross U = 9 U = 6 U = 4 U = XY

Indifference Curves Y X Generally, ICs are: Downward sloping Convex to origin Inc utility, further from origin Cannot cross A = B; A = C; B > C !! U = XY A B C

Indifference Curves Remember our simple example: Recall: Oranges Freddie likes oranges twice as much as apples Apples

What does his utility function look like? Y Utility = No. of Apples + 2(No. of Oranges) U = 1 X + 2 Y MUx = 1 MUy = 2 X Freddie is willing to trade 2 apples for 1 orange Generally, any set of preferences can be described by many utility functions U = 12 Indifference Curves

Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade between 2 goods. The amount of Y he is willing to give up for 1 unit of X = MUx/MUy Y Utility = No. of Apples + 2(No. of Oranges) U = X+2Y MUx = 1 MUy = 2 MRS = - MUx/MUy = - ½ X Freddie is willing to trade 2 apples for 1 orange Indifference Curves

Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade between 2 goods. The amount of Y he is willing to give up for 1 unit of X = MUx/MUy Y Utility = No. of Apples + 2(No. of Oranges) U = X + 2 Y = - ½ X  X  Y Generally, this rate will not be constant; it will depend upon the consumer’s endowment. Indifference Curves

Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade between 2 goods. The amount of Y he is willing to give up for another unit of X. Y Utility = No. of Apples + 2(No. of Oranges) X Generally, this rate will not be constant; it will depend upon the consumer’s endowment. XX YY Indifference Curves

Optimization We assume that a rational consumer will attempt to maximize her utility. But utility increases with consumption of all goods, so utility functions have no maximum -- more is always better! Y Utility = No. of Apples + 2(No. of Oranges) U X Increasing utility

Optimization We assume that a rational consumer will attempt to maximize her utility. But utility increases with consumption of all goods, so utility functions have no maximum -- more is always better! Y Utility = No. of Apples + 2(No. of Oranges) U X Indifference Curves depict consumer’s “willingness to trade” Budget Constraint depicts “opportunities to trade” Slope = - Px/Py Indifference Curves depict consumer’s “willingness to trade” Slope = - MRS A At point A, can the consumer increase his utility? How?

Optimization We assume that a rational consumer will attempt to maximize her utility. But utility increases with consumption of all goods, so utility functions have no maximum -- more is always better! Y Utility = No. of Apples + 2(No. of Oranges) U X Indifference Curves depict consumer’s “willingness to trade” Budget Constraint depicts “opportunities to trade” Slope = - Px/Py Indifference Curves depict consumer’s “willingness to trade” Slope = - MRS A At point A, MRS > Px/Py, so consumer should trade Y for X.

Optimization We assume that a rational consumer will attempt to maximize her utility. But utility increases with consumption of all goods, so utility functions have no maximum -- more is always better! Y Utility = No. of Apples + 2(No. of Oranges) U X Indifference Curves depict consumer’s “willingness to trade” Budget Constraint depicts “opportunities to trade” Slope = - Px/Py Indifference Curves depict consumer’s “willingness to trade” Slope = - MRS B At point B, MRS < Px/Py, so consumer should trade X for Y.

Optimization The optimal consumption bundle places the consumer on the highest feasible indifference curve, given her preferences and the opportunities to trade (her income & the prices she faces). Y Utility = No. of Apples + 2(No. of Oranges) U Y* X* X Indifference Curves depict consumer’s “willingness to trade” Slope = - MRS Budget Constraint depicts “opportunities to trade” Slope = - Px/Py At point C, MRS = Px/Py, so consumer can’t improve thru trade. C

Two Conditions for Optimization under Constraint: 1. PxX + PyY = I Spend entire budget 2. MRSyx = Px/PyTangency Optimization MRSyx = MUx/MUy = Px/Py => MUx/Px = MUy/Py The marginal utility of the last dollar spent on each good should be the same.

Optimization Arlene has $100 income to spend on food (F) and Clothing (C). Food costs $2, and Clothing costs $10. She is currently consuming 30 units of F and 4 units of C. At this point, she is willing to trade 1 unit of C for 2 units of F. Is she choosing optimally? C Utility = No. of Apples + 2(No. of Oranges) I/Pc=10U 4 30 I/Pf =50 F P f F + P c C = I 2(30) + 10(4) = 100

Optimization Arlene has $100 income to spend on food (F) and Clothing (C). Food costs $2, and Clothing costs $10. She is currently consuming 30 units of F and 4 units of C. At this point, she is willing to trade 1 unit of C for 2 units of F. Is she choosing optimally? C Utility = No. of Apples + 2(No. of Oranges) I/Pc=10U 4 30 I/Pf =50 F P f /P c = 1/5 MRS cf = 1/2

6/24 Theory of the Consumer (con’t) Pindyck & Rubenfeld, Chapter 3. Besanko & Braeutigam, Chapters 3-4. Next Time