microeconomics ii introductory lecture

Microeconomics IIMicroeconomics IIintroductory lectureintroductory lecture

Name of the lecturer: Petr Musil, office # Name of the lecturer: Petr Musil, office # 621 (6th floor – Department of 621 (6th floor – Department of

Economics)Economics) Office hours – Mondays 9.30 – 11.00 a.m.Office hours – Mondays 9.30 – 11.00 a.m.

Contact – Contact – [email protected]@econ.muni.cz IICQCQ: 248255928: 248255928

Course information: Study materials in IS Course information: Study materials in IS – MPE_AMI2– MPE_AMI2

ExamExam Written multiple-choice test – to pass Written multiple-choice test – to pass

you need at least 60 % scoreyou need at least 60 % score Test structure: each question Test structure: each question

includes 4 possible answers (theory + includes 4 possible answers (theory + applications), 0-4 right answers vs. applications), 0-4 right answers vs. only 1 of 4 right answers => not sure only 1 of 4 right answers => not sure yet, but will let you know in time...yet, but will let you know in time...

How to succeed: get the theory – be How to succeed: get the theory – be able to apply the theory – not to able to apply the theory – not to underestimate the preparation – use underestimate the preparation – use your own brainyour own brain

LiteratureLiterature Frank, R.: Frank, R.: Microeconomics and Behavior Microeconomics and Behavior

(whatever edition)(whatever edition)

Varian, H.RVarian, H.R.: Microeconomics: a Modern .: Microeconomics: a Modern Approach (whatever edition)Approach (whatever edition)

1. Introduction to the 1. Introduction to the consumer´s behaviour consumer´s behaviour

analysisanalysis

What is the goal of the What is the goal of the consumer´s behaviour theory?consumer´s behaviour theory?

to understand and take the terms like: to understand and take the terms like: rationality, utility, sacrificerationality, utility, sacrifice, thus..., thus...

...to understand principles of consumer´s ...to understand principles of consumer´s choice out of several alternatives (i.e. in choice out of several alternatives (i.e. in consumption)consumption)

the goal of the theory the goal of the theory ISIS NOTNOT to provide an to provide an ordinary consumer with ordinary consumer with a a „decision making „decision making manual“ – an ordinary consumer is manual“ – an ordinary consumer is responsible and knows his or her responsible and knows his or her preferencespreferences

RationalityRationalityIs the behavior of an ordinary consumer Is the behavior of an ordinary consumer rational? How do we know? → RATIONALITY rational? How do we know? → RATIONALITY AXIOMS:AXIOMS:

1.1. Axiom of instauration Axiom of instauration – consumer prefers – consumer prefers higher quantity of all goods to lower quantity higher quantity of all goods to lower quantity (in the case of „eligible“ goods)(in the case of „eligible“ goods)

2.2. Axiom of transitivity Axiom of transitivity – if cage A is – if cage A is preferred to cage B, and B to cage C, then preferred to cage B, and B to cage C, then cage A must be preferred to cage Ccage A must be preferred to cage C

3.3. Axiom of variety (diversity, convexity) Axiom of variety (diversity, convexity) – – consumer prefers an average consumption to consumer prefers an average consumption to extremes – i.e. consumption of food and extremes – i.e. consumption of food and beveragesbeverages

Can we simply say that: Can we simply say that: if all the axioms are if all the axioms are fulfilled, the consumer´s behavior is rational, fulfilled, the consumer´s behavior is rational, and if axioms are not fulfilled, the consumer´s and if axioms are not fulfilled, the consumer´s behavior is irrational?behavior is irrational?

NO! The axiom fulfillness only gives chances that NO! The axiom fulfillness only gives chances that the observed behavior is rationalthe observed behavior is rational

Consumer´s behavior might be rational in spite of Consumer´s behavior might be rational in spite of axioms are not fulfilled, i.e.:axioms are not fulfilled, i.e.:

ineligible or neutral goods (insaturation axiom ineligible or neutral goods (insaturation axiom not valid)not valid)

consumer´s specialization (variety axiom not consumer´s specialization (variety axiom not valid)valid)

saturated preferences (insaturation axiom not saturated preferences (insaturation axiom not valid)valid)

RationalityRationality

Rationality: summarryRationality: summarry rational behavior leads to maximizing rational behavior leads to maximizing

the consumer´s total utilitythe consumer´s total utility rationality is a subjective category: we rationality is a subjective category: we

cannot say that this or that behavior is cannot say that this or that behavior is rational and this or that irrationalrational and this or that irrational

in general – consumers behave in general – consumers behave themselves rationally, because they do themselves rationally, because they do their best decisions under given their best decisions under given conditions (given information, conditions (given information, disposable income, prices of goods and disposable income, prices of goods and services etc.)services etc.)

UtilityUtilityUtility = an effect resulting from the consumption Utility = an effect resulting from the consumption of specific combination of goods and (or) services of specific combination of goods and (or) services

- „variable“ showing the trend of consumer´s - „variable“ showing the trend of consumer´s preferencespreferences

Utility is not an objective category but a subjective Utility is not an objective category but a subjective oneone

How can we (can we?) measure the utility?How can we (can we?) measure the utility?

cardinalistic vs. ordinalisticcardinalistic vs. ordinalistic approachapproach

CardinalismCardinalismCARDINALISTIC APPROACHCARDINALISTIC APPROACH – utility is – utility is measureable directly, it assumes specific valuemeasureable directly, it assumes specific value

Menger, Jevons, Walras – cardinalists, but Menger, Jevons, Walras – cardinalists, but without explanation how to measure utilitywithout explanation how to measure utility

Alfred Marshall – utility measureable indirectly Alfred Marshall – utility measureable indirectly with the value of money – demand pricewith the value of money – demand price

Total Utility (TU) Total Utility (TU) – total rate of needs – total rate of needs satisfactionsatisfactionMarginal Utility (MU)Marginal Utility (MU) – change of TU induced – change of TU induced with the consumption of additional unit of goods with the consumption of additional unit of goods or servicesor services

OrdinalismOrdinalismORDINALISTIC APPROACH ORDINALISTIC APPROACH – utility – utility unmeasureable (or does not make any sence to unmeasureable (or does not make any sence to measure it), but consumer is able to consider measure it), but consumer is able to consider commodity cages from the utility point of viewcommodity cages from the utility point of view

V. Pareto, J. R. Hicks - ordinalistsV. Pareto, J. R. Hicks - ordinalists

Indifference Curve, (IC) Indifference Curve, (IC) – the set of – the set of combinations of several kinds of goods that combinations of several kinds of goods that give the consumer an equal level of total give the consumer an equal level of total utility – an instrument to draw the consumer´s utility – an instrument to draw the consumer´s preferencespreferences

Total utility - cardinalismTotal utility - cardinalism

TU=f(X,Y)

Y

X

Total utility as a function of volume of goods X and Y

Total utility - ordinalismTotal utility - ordinalism

TU1

TU2

TU3

Y

X

TU3 > TU2 > TU1

Further approaches to the Further approaches to the utility theoryutility theory

EXPRESSED PREFERENCES EXPRESSED PREFERENCES – – refuses ICrefuses IC

i.e. Murray N. Rothbard: i.e. Murray N. Rothbard: „consumer „consumer expresses his/her preferences at the expresses his/her preferences at the moment of the decision (while shopping)“moment of the decision (while shopping)“

the donkey and 2 haycocks theorem – the donkey and 2 haycocks theorem – a donkey cannot pick one of the 2 equal a donkey cannot pick one of the 2 equal haycocks... so it dies from hungerhaycocks... so it dies from hunger

What are the Eeyore´s What are the Eeyore´s preferences?preferences?

???

15 metres

15 metres

similar to ICsimilar to IC - both haycocks are the same quality - both haycocks are the same quality (equal total utility), so which one will Eeyore chose?(equal total utility), so which one will Eeyore chose?

Indifference curves Indifference curves characteristiccharacteristic

1.1. IC have a negative slopeIC have a negative slope – in case of – in case of eligible goods, results from the eligible goods, results from the insaturation axiominsaturation axiom

2.2. IC do not cross each otherIC do not cross each other – results – results from the transitivity axiomfrom the transitivity axiom

3.3. There is an IC in each spot of There is an IC in each spot of consumption situationconsumption situation

4.4. IC are convex to the axes originIC are convex to the axes origin – – results form the variety axiom – there results form the variety axiom – there are some exceptions (special shapes of are some exceptions (special shapes of IC)IC)

Marginal rate of Marginal rate of substitution substitution inin

consumption (MRSconsumption (MRSCC)) = a ratio describing the consumer´s = a ratio describing the consumer´s WILLINGNESS to substitute goods with WILLINGNESS to substitute goods with each other with constant level of total utilityeach other with constant level of total utility

= a slope (tangent)of indifference curve...= a slope (tangent)of indifference curve... ... which generally changes alongside the IC... which generally changes alongside the IC MRSMRSCC = -ΔY/ΔX = MU = -ΔY/ΔX = MUXX/MU/MUY Y (for explicit (for explicit

changes) ...changes) ... ...=(δTU/δX)...=(δTU/δX)//(δTU/δY) (for dimensionless (δTU/δY) (for dimensionless

changes)changes)

MRSMRSCC – Cobb-Douglas – Cobb-Douglas preferencespreferences

gummy bears

chocolate

6

3

2

1

1 2 3,5 5

A

B

CD

MRSC from A to B = – (6 – 3)/(2 – 1) = – 3, consumer is willing to give up 3 units of gummy bears to obtain 1 unit of chocolate: the ratio of substitution equals to 3:1

MRSC from C to D = – (2 – 1)/(5 – 3,5) = – 2/3, consumer is willing to give up 1 unit of gummy bears to obtain 1,5 units of chocolate: the ratio of substitution equals to 2:3

absolute value of MRSC decreases because of the decrease of number of gummy bears (they become more precious), so the consumer is willing to give up less units of gummy bears to obtain additional unit of chocolate

MRSMRSCC – Linear preferences – Linear preferences

milk chocolate

In this case the value of MRSC is constant, because the consumer is always willing to substitute the same volume of chocolates with each other – both kinds of chocolates are „perfect substitutes“ with ratio 1:2, MRSC = – 1/2

white chocolate

Special shapes of ICSpecial shapes of IC

X - coffee

X – Pilsner Urquell

Y - beer

Y – soda water

Coffe is ineligible goods – you have to buy coffee if you want to buy soda water

Pilsner Urquell is a neutral goods – „I drink beer but I don´t care about Pilsner Urquell“


Y Y

X X

X changes from eligible to ineligible goods – „after the 10th beer I have a stomach ache“

Specializtion in consumption – it is possible to consume only one of the two goods – „I´ll spent my vacation either on Crete or Canary Islands“


Y Y

X X

X and Y are close substitutes, i.e.: croissants-bread, vanilla ice-chocolate ice

X and Y are regular complements, i.e.: car-gassoline, bread-butter

Y Y

X ane Y are perfect substitutes, i.e.: Coca-cola - Pepsi, Nescafé-Tchibo etc.

X and Y are perfect complements – objective: skis-ski bindings, subjective: „I drink each cup of coffe with two sugars“

X X


Y

Saturated preferences – consumer endeavours the speciffic combination of two goods (commodity cage)

X

Y

X

Discrete goods – obtainable only in solid units (i.e. you cannot buy only a half of cinema ticket)


Consumer´s limits Consumer´s limits (possibilities)(possibilities)

IC represent the consumer´s IC represent the consumer´s WILLINGNESS to a specific action WILLINGNESS to a specific action (shopping, consumption etc.)(shopping, consumption etc.)

goods and services are usually not freegoods and services are usually not free the consumer has to undergo a sacrifice the consumer has to undergo a sacrifice

to get the utilityto get the utility the consumer´s possibilities are limitedthe consumer´s possibilities are limited consumer is limited with his/her:: consumer is limited with his/her::

disposable income (I) and prices of goods disposable income (I) and prices of goods and services (P) → and services (P) → budget constraintbudget constraint

Budget constraintBudget constraintEquation of budget constraint (budget line – BL):Equation of budget constraint (budget line – BL):

I = PI = PXX . X + P . X + PYY . Y . Y

or:or:

RESOURCES = USE OF RESOURCESRESOURCES = USE OF RESOURCES

consumer spends his/her entire disposable income, or, consumer spends his/her entire disposable income, or, if he/she saves, the savings are one of the „bought“ if he/she saves, the savings are one of the „bought“

goodsgoods

X

Y

BL

Budget LineBudget Line

frontier that defines the „commodity frontier that defines the „commodity space“ (lies on + under the budget line)space“ (lies on + under the budget line)

set of accessible combinations of goods set of accessible combinations of goods and servicesand services

we are interested in its: we are interested in its: distance from distance from the origin, slope, shapethe origin, slope, shape

Distance from the origin of Distance from the origin of axesaxes

if disposable income rises, BL moves if disposable income rises, BL moves rightwards, if dicreases, BL moves leftwardsrightwards, if dicreases, BL moves leftwards

X

Y

BLBL'BL''

I risesI decreases

The slope of BLThe slope of BL Marginal Rate of Substitution in Exchange Marginal Rate of Substitution in Exchange

(MRS(MRSEE)) = ratio describing the possibility to change = ratio describing the possibility to change

goods with each other on the market – tells goods with each other on the market – tells us what are the relative prices of goodsus what are the relative prices of goods

MRSMRSEE = - ΔX/ΔY = P = - ΔX/ΔY = PXX/P/PYY

X

BL BL'

BL''

PX/PY = 1/1

PX/PY = 1/2

Y

PX/PY = 2/1

The shape of BLThe shape of BLTells us if the relative prices of goods Tells us if the relative prices of goods

change with the change of bought volumechange with the change of bought volume

X

Y

BL

X

Y

BL

each additional dimensionless unit of goods is more expensive

each additional dimensionless unit of goods is cheaper

The shape of BLThe shape of BL

X

Y

BL

X

Y

BL

additional cumulated quantity of goods is more expensive

additional cumulated quantity of goods is cheaper

... Is also affected with:... Is also affected with: taxation (consumption and income taxation (consumption and income

taxes)taxes) social systemsocial system other regulation (price reg., allowance other regulation (price reg., allowance

system, etc.)system, etc.)

Budget constraintBudget constraint

Consumer´s equilibriumConsumer´s equilibrium

Consumer is in equilibirium if he/she Consumer is in equilibirium if he/she maximizes his/her total utility maximizes his/her total utility

according to his/her preferences and according to his/her preferences and possibilities (disposable income and possibilities (disposable income and

goods prices)goods prices)

Consumer´s equilibrium – case Consumer´s equilibrium – case of sole goods or serviceof sole goods or service

For equilibrium stands: MUFor equilibrium stands: MUXX = P = PXX

X

PX

MUX

PX* E

X*

if bought volume less than X*, then additional units cause relatively higher growth of total utility in comparison to the growth of total expenditures (MU>P) – motivation to buy additional units of X

if bought volume more than X*, then additional units cause relatively higher growth of total expenditures in comparison to the growth of total utility (MU<P) – motivation to decrease his/her consumption of X

E: no impulse for any change, E represents the consumer´s equilibrium

Consumer´s equilibrium – case Consumer´s equilibrium – case of two kinds of goods or of two kinds of goods or

servicesservicesFor the equilibrium stands (generally):For the equilibrium stands (generally):

MRSMRSCC = MRS = MRSEE

or:or:

MUMUXX/MU/MUYY = P = PXX/P/PYY

so:so:Consumer´s equilibrium occurs if IC Consumer´s equilibrium occurs if IC

tangents the BLtangents the BL

(Usually, but not in all cases!!!)(Usually, but not in all cases!!!)

Consumer´s equilibrium – Consumer´s equilibrium – inner equilibriuminner equilibrium

Y

X

U1

U2

U3

E

A

B

Consumer´s equilibirum in E. A and B are accessible, but not maximizing the total utility. Level of total utility U3 is

not accessible.

BL

U1

U2

U3

A

E

Y

XConsumer´s equilibirum in E. A is accessible, but not

maximizing the total utility. Level of total utility U3 is not accessible. IN THIS CASE MRSC DOES NOT EQUAL TO

MRSE !!! MRSE > MRSC - BL steeper than IC

BL

Consumer´s equilibrium – Consumer´s equilibrium – corner equilibriumcorner equilibrium

Consumer´s surplusConsumer´s surplus

a difference between the total utility a difference between the total utility acquired from the consumption and acquired from the consumption and the total expenditures spent to acquire the total expenditures spent to acquire the equilibrium volume of goods and the equilibrium volume of goods and services, or...services, or...

...a difference between the willingnes ...a difference between the willingnes to spent and the necessity to spent to spent and the necessity to spent some part of the disposable incomesome part of the disposable income

CS (Consumer´s Surplus) = TU – PCS (Consumer´s Surplus) = TU – PX X . X. X

Consumer´s surplusConsumer´s surplus

X

PX

MUX =PX

=D

109

8

3

Bought quantityBought quantity 11 22 33MUMU 1010 99 88TUTU 1010 1919 2727Total Total expendituresexpenditures

1010 1818 2424

Consumer´s surplus of equilibrium quantity of X:

CS = TU – PX . X = 27 – 24 = 3

microeconomics ii introductory lecture

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