Lecture 1: Introduction & Consumer Theory I: ECON30010 Microeconomics

Lecture 1: Introduction & Consumer Theory I
ECON30010 Microeconomics
Monday 2 March 2015
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Logistics
Organisational details
LMS is your friend.
Online tutor will start in week 2. Please do not ask trivial questions
on online tutor. If you do, it becomes useless for others.
Math Reviews will start in week 3. Attendance is not mandatory.

Stay tuned (LMS).
Lecture slides are not a book, but a whiteboard and a study guide.
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Logistics
Textbooks
I
The textbook (Perloff, Microeconomics with Calculus) contains a lot of

supplementary information. You will find it useful to refresh Intermediate
Micro material, to find some background information and to read about
real-life cases. We will be going straight to (hard) business, with little
deviation.
For the exam and assignments, you are only responsible for the material on
slides/tutorials. However, you may find it hard if you dont have background
information (textbook) and you may find it too dry if you dont have real-life
cases (textbook).
The editions are created to rip you off; use whatever you like (but I will give
page numbers in 3rd edition; this is what publishers hope will induce you to
buy a new edition)
Serrano and Feldman, A Short Course in Intermediate Microeconomics with

Calculus may prove to be useful. It contains very little background
information and cases, but has all the math concisely written. I do not plan
to reference this book in my slides this year. Kindle edition costs AUD51.20
on amazon.com.au
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Logistics
Overall plan
Revisit some of the topics from Intermediate Microeconomics. We

will only cover these parts where calculus were missing, but would
have been useful (that is: math heavy)
Introduce new topics ((more of) Game Theory, Information, Market

Design)
Math is the language of contemporary economics (whether we like it or

not). We need to get a bit more comfortable with this language.
Those of you planning to go to Honours, take Real Analysis now. This is
an official departmental recommendation.
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History
Classical Economics
Adam Smith, David Ricardo, Karl Marx.
Attempted to uncover the laws of the economy, which were thought

to be similar to the laws of physics (e.g. Newtons laws). For
example, distribution of wealth in the economy.
Individual agents (individuals or firms) were not a focus.
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History
Neoclassical Economics
Leon Walras, Francis Edgeworth, Vilfredo Pareto, Alfred Marshall.
Decision making of agents is the main focus.
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On Models
Economic Agents
I
Economic problems: an allocation of scarce resources.

I
I
I
I
Food to people;
Seats at schools to students;
Kidneys to patients;
Possession of a ball in football or overtime penalty kicks in soccer.
Agents choose what is best for them, out of what is available to them
(rational).
Mathematically speaking, this is the problem of constrained
optimisation.
Rationality by itself imposes too little restrictions to be useful.

Rationality in conjunction with other assumptions allow us to make
predictions. The assumptions we make need to be suitable for a particular
question. That is, our model needs to be correct.
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On Models
Models I
Problem: A steel ball 5 cm in diameter is stationary and 1 meter away

from the surface of the Earth. Suppose that we let it fall freely. How fast
it would reach the surface of the Earth?
2
Solution: tx2 = g (with correct boundary conditions) gt2 = x = 1

p
(because ball is 1 meter from the surfance) t = 2/g = 0.45175 sec
Assumptions: 1. No air? 2. x should not be 1, but 0.95 (1 m - 5 cm) 3.
Is it in Kuala Lumpur (g = 9.76) or in Oslo (g = 9.83)? 4. No
interactions between electrons?
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On Models
Models II
A physicist has been asked to estimate the probability of a particular horse

winning the Melbourne Cup.
Physicist: Let us represent a horse as a spherical ball moving in a
vacuum.
Everything should be made as simple as possible, but not simpler.
(Albert Einstein)
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On Models
Models III
Assumptions (model): spell out what is needed for the conclusion.
We can discuss whether assumptions fit reality reasonably well or not.
Logical/mathematical arguments.
These are either correct or not.
Conclusion.
Your model is right, the proofs are
correct, but the conclusions are
wrong.
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Economics
What is Economics?
Economics is not first and foremost a fixed set of facts and principles
that we need to learn by heart and then apply blindly.
Why? Your facts and principles depend on assumptions. Assumptions may
not fit your problem.
Economics is a way of engaging in a debate about a priori any sorts of

issues pertaining to the interaction of individuals and society.
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Economics
Positive vs. Normative Economics
When engaging in debates about the pros and cons of different

actions, or policies, it is fundamental that we distinguish between
positive and normative questions.
Normative question: Should we do A or B?
Positive question: If we do A, will C or D happen?
Failure to recognize that there are positive questions is a source of

major confusion.
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Economics
Normative Questions
In public and academic debates, normative questions are important.

We want to evaluate different policies (and maybe come up with a
policy prescription).
A prescription depends on values. To give an extreme example, for

someone who cares only about current consumption, a tax on tobacco
or climate change policies could not possibly make any sense.
We can argue about values, but in many instances there are no rights
or wrongs. Economists are no better in value judgment than other
people.
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Economics
Positive Questions
I
Before we can evaluate the desirability of alternative actions (within

our value system), we need to understand what happens under these
alternative actions.
Thus, we first need to answer positive questions.

I venture the judgment, however, that currently in the Western
world, and especially in the United States, differences about
economic policy among disinterested citizens derive predominant
from different predictions about the economic consequences of
taking action - differences that in principle can be eliminated by
the progress of positive economics - rather than from
fundamental differences in basic values, differences about which
men can ultimately only fight.
Milton Friedman (1953)
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Economics
Learning Goal: Developing Analytical Skills
Understanding how some conclusion follows from a given set of

assumptions requires intellectual rigor and analytical skills.
Acquiring the discipline (and ability) to follow the logical implications

of some assumptions to their inevitable conclusion is a key learning
goal of this subject.
The reason for starting tutorial in week 1 is exactly this to

coordinate students (and the instructors) expectations, and to bring
everybody up to speed.
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Economics
Learning Goal: Writing Skills
An increasingly important skill is the ability to write concise and

coherent argumentative essays.
To foster the development of this skill, there will be an essay question

on most assignments and on the final exam.
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People and their choices
Modeling individuals: the choice set

First, we need to agree what individuals choose. In most of the subject,
they would choose two very dry commodities: good 1 (q1 , x1 , or y1 ) and
good 2 (q2 , x2 , or y2 ). Throughout much of this subject, we will assume
that there are only two consumption goods.
Why: with one good, there is no trade-off between which good to consumer; an
agent will spend all income on a single good. Three goods often add notational
complexity, with little value in terms of economics
When we model individuals, we need to be very precise and careful about

the choice set (even though in this subject, it will be in the background most of
the time).
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Modeling individuals: preferences

Note: this mostly reviews the concepts you have learned in ECON20002 last year.
Once we have settled on the choice set, we need to make some

assumptions on how agents choose from this choice set.
In most economic problems, the following assumptions seem reasonable:
I
Completeness: any two bundles x = (x1 , x2 ) and y = (y1 , y2 ) can be

compared.
There may be situations where you would say I cannot

compare these two objects what do you like better,
singing or a cylinder hat? but if you cannot compare,
do you really ever need to choose between the two?
Well, maybe, if you model Truth or Dare. . .
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Transitivity: if bundle x is at least as good as y and y is at least as

good as bundle z, then x is at least as good as z.
You prefer ECON30010 to ECON20002 (recall the notation: ECON30010

ECON20002) and you prefer ECON20002 to ECON20001, but you
prefer ECON20001 to ECON30010. This could not possibly happen!
A note on the choice of the choice set.
Suppose: red wine white wine fish & chips beef & pasta.
Hence, you prefer (red wine, fish & chips) to (white wine, beef & pasta).
Do you?
Or, maybe, the choice set (in this problem) should have been (red wine,
beef & pasta), (white wine, fish & chips), (red wine, fish & chips) and
(white wine, beef & pasta)?
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I
Continuity (not an exact definition): if bundle x is better than bundle

y and bundle z is sufficiently close to y, then x is better than z.
If you prefer (x =) 1 l. of red wine and 1 kg of beef & pasta to (y =) 1 l.

of white wine and 1 kg of fish & chips, then you would prefer x to 1.01y
(that is, to 1.01 l. of white wine and 1.01 kg of fish & chips).
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I
Completeness: any two bundles x = (x1 , x2 ) and y = (y1 , y2 ) can be

compared.
Transitivity: if bundle x is at least as good as y and y is at least as

good as bundle z, then x is at least as good as z.
Continuity (not an exact definition): if bundle x is better than bundle

y and bundle z is sufficiently close to y, then x is better than z.
What do we need it for? With these assumptions, we can start to use very
powerful math tools.
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Utility Function Representation

Even though people simply make a choice from the choice set, we can
pretend that they have a utility function.
Specifically, we will assign to each bundle (such as 1 l. of red wine and 1
kg of beef & pasta) a (real) number and then compare numbers instead of
bundles.
Formally: We say that a utility function U(x) represents the preferences if,
whenever x better than y, we have U(x) > U(y).
This leads to a very important theorem:
Theorem
If preferences over bundles of goods x satisfy completeness, transitivity,
and continuity, then there is a continuous utility function U(x) that
represents these preferences.
Why this theorem is important? Because mathematicians are very good
working with functions, and we can use a lot of their tools.
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Remarks on Utility Function Representation

I
I
Some preferences cannot be represented by a continuous utility

function (but they would not satisfy our assumptions).
If preferences are represented by a utility function, this utility function
is not unique. Any positive monotonic transformation of the utility
function will represent the same preferences.
Why: The only important thing about a utility function is how two numbers
compare (e.g., u(x) > u(y )). But the very definition of a positive
monotonic transformation is that this inequality is preserved!
I uA (q1 , q2 ) = q1 q2
Example:
I
I
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uB (q1 , q2 ) = ln(q1 ) + ln(q2 )
uC (q1 , q2 ) = q1 q2
uD (q1 , q2 ) = q12 q22
all represent the same preferences.

How could you check it? Take any two consumption bundles, e.g.
(1, 3) and (2, 1), and calculate uA , uB , uC , uD for these two bundles.
Note: this is not a proof. For a proof, you need to show that the same
holds for any two bundles, (x1 , x2 ) and (y1 , y2 ); that is, if u (x) > u (y )
for one of these functions, the same holds for all the others.
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Lecture 1: Introduction & Consumer Theory I: ECON30010 Microeconomics

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Lecture 1: Introduction & Consumer Theory I

Monday 2 March 2015