RL3 Review

Exam u Date: u Room: u u Cumulative u 2 hours (120 min) u Closed book (calculators not needed) u Format: Problems as in PS (no true false q) u Course Grade: , Curve! u Preparation 1.Master all PS and past exams 2.Read slides 3.Read book

Consumer’s Theory Fix (parameter) u Budget set (plot, interpret slope) u 4 types of preferences (plot, find interpret MRS, MT) u Optimal choice (SoH, find analytically and geometrically) u Magic formula for Cobb-Douglass! (derive it) Changes in p and m u Substitution and Income effect u Ordinary and Giffen, Inferior and Normal goods Real endowments (choice) u Geometric representation u Choice – buying and selling

3 applications u Labor market - labor supply: w given Budget set, Choice, Labor Supply, Elasticity u Intertemporal Choice: r given 1)2 periods: Budget set, Choice, PV, FV, CS Consumption smoothing 2) T periods: Annuity and perpetuity: PV formula Lease or buy, loan, pension plan, value of the bond u Uncertainty: gamma given 1) Lottery, Bernoulli and VNM utility 2) Risk aversion and certainty equivalent 3) Insurance (fair insurance)

Markets and Equilibrium uMany (2) agents uEdgeworth Box

Markets: Competitive Equilibrium u Competitive Equilibrium 1) Choices optimal given prices 2) Markets clear (supply=demand) u Find CE analytically and geometrically. Tricks: 1) one price =1, 2) market clearing for only one good 3) magic formula! u FWT: Competitive equilibrium is Pareto efficient!

Competitive Equilibrium

Competitive Equilibrium (Geometry)

Are Markets Efficient?

Pareto Efficiency

Are Markets Efficient?

Competitive Producers u Producers have technology and maximize profit u Properties of F(, ): RS, MPK, MPL u Geometric representation: Isoquants u SoH for Profit Maximization, Cost Minimization u Profit maximization= cost minimization + choice of y u Derive cost functions, shapes for IRS, CRS and DRS u Supply function (also with fixed costs) u Equilibrium with N producers u Equilibrium with free entry (determine N)

Market failure 1. Market Power u One producer (Monopoly) = it has market power u Demand Cost function u Optimal choice, elasticity and markup (uniform price) u TS, CS, PS, DWL u Price discrimination (three types)

Market failure 1. Market Power u N firms u Demand Cost function

DWL

Market failure 2. Externality u Our utility/profit depends on action of others u Positive and negative externality u Problem strategic interdependence = Nash equilibrium u Equilibrium : mutual best responses u Special case of positive externality: Public good u Pareto efficiency: Too little or too much? Free riding

Market failure 3. Asymmetric Information u Adverse selection (hidden information) u Example: Buyers of cars know less then sellers 1) Separating equilibrium: good cars not traded 2) Pooling equilibrium: both cars traded u Incentives for good types to send credible signals u Credibility: for bad types too costly to pretend good ones u Moral hazard (hidden action) Insurance contracts change incentives! Insurers should take it into account