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M ICROECONOMICS

L ECTURE 1: I NTRODUCTION

Dr. Xiaoyong Cao

School of International Economics and Business


University of International Business and Economics

Fall, 2017

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Introduction

Department of Economics, University of International Business


and Economics

Instructor: Dr. Xiaoyong Cao

Office: Boxue Building #1111

E-mail: yongcx2000@uibe.edu.cn

Office Phone: (010)64493220

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Course Description

This course provides a rigorous analytical treatment of the


standard microeconomic models of consumer and firm behavior,
partial equilibrium, general equilibrium, and it prepares students
for further studies in the theoretical and applied fields of
economics and finance as well as equips the students with solid
background in microeconomic theory for future research in
Economics and Finance.
The emphasis of the course is on methods and analytical tools as
well as the presentation of received results. We will see how the
theory is evolved across time.
The students acquire the skills necessary to read and understand
the professional literature and to apply the theory to a wide
variety of economic problems and policies and most important is
to understand how theorist thinks about the world and how to
raise interesting questions.
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Course Description (2)

Electronic version of the class materials as well as homework


assignments will be posted on the class web page.

This class will extremely focus on the intuition behind the


economic result. It will train you how to think when facing
different types of economic circumstances.

This class provides a rigorous treatment of some of the basic


tools of economic modeling and reasoning, along with an
assessment of the strengths and weaknesses of these tools. We
will present the material not as a complete theory to be learned,
but as a work in progress, waiting to be improved upon by the
generation that has just arrived.

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Suggested Textbooks

Mas-Collel, A., Michael D. Whinston and Jerry R. Green,


Microeconomic Theory, Oxford University Press, 1995. Mainly
Chapter 2,3,4,5

Felix, Munoz-Garcia, Advanced Microeconomic Theory: An


Intuitive Approach with Examples, MIT Press, 2017.

David M. Kreps, Microeconomic Foundations I: Choice and


Competitive Markets, Princeton University Press, 2013.

Hal R. Varian, Microeconomic Analysis, W.W. Norton &


Company, 1992.

Thomas Nechyba, Microeconomics: An Intuitive Approach with


Calculus, Cengage Learning Press, 2010 (Selected lectures are
from this reference).
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Grading

Grades in the class will be determined by Class


Participation(10%), three assignments(10% for each) and a
final exam (60%)with a deduction on total points for attendance.

Assignments: I will give regular assignments in the class to help


you understanding the materials in class. The due date for each
assignment is one week after the assignment is distributed. No
latter homework will be accept.

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Microeconomics Theory

It is the analysis of the behaviour of individual economics agents and


the aggregation of their actions in an institutional framework
individual agents: typically a consumer or a firm (producer);

behaviour: traditionally utility maximization or profit


maximization;

the institutional framework: traditionally, the price mechanism


in an impersonal market place or a game theoretic setting;

the mode of analysis: equilibrium analysis.

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What do we intend to get out?

in a positive sense: a better understanding of individual agents


behaviour in certain situations.

in normative sense: the ability to intervene or not, both at the


government level and at the institutional level.

The models we analyze are highly simplified hence, although


they have some general predictive power, they are not directly
empirically testable (lab environment).

However, these models represent the building blocks of more


complex and realistic testable models.

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Preferences VS choice-based approach

The Core of this part is to model individual behavior. There are two
main apprpaches:
The first approach is the preference based, i.e., the
decision-makers tastes are the primitive characteristics of the
individual.
This theory is developed by imposing some rationality axioms on
the agents preferences and analyzing the consequences of these
preferences for his behavior (his choice).

The second approach, choice-based, treats the individuals


choice behavior as the primitive feature.
This theory relies on a consistency assumption, the weak axiom
of revealed preference (WARP).
Although attractive (assumptions are only made on observable
things - choice behavior), this approach is seldom used.

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Consumer Theory

The agent: individual (Consumer);

The activity:consume a whole set of commodities (goods and


services). We focus on L commodities l = 1, ..., L:

The framework: consumption feasible set

X RL

where x X is a consumption bundle which specifies the


amounts of the different commodities;

Time and location are included in the definition of commodity.

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Consumption Feasible Set

Let X be the set of commodity bundles that the individual can


conceivably consume given the physical constraints imposed by the
environment.

Example of physical constraints: Impossibility to have negative


amounts of bread, water,...,indivisibility.

Constraints may be physical but also institutional (legal


requirements).

Example: non-negative orthant.

X = {x BL | xl > 0, l = 1, ..., L} = R+
L

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Properties of the Consumption Feasible Set

1 Non-negativity: X RL

2 Closed set: it includes its own boundary;

3 Convexity: if x X and y X than for every [0, 1]:

x = x + (1 )y X

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Basics: Commodities, Consumption and Budget Sets

To keep things simple, we will take the consumption set to be the


L dimensional non-negative orthant:
X = RL+ = {x Rl : xl > 0, l = 1, . . . , L}

Note that the set RL+ is convex which is a natural assumption,


even if one can sometimes do without.

The consumption set describes all the commodity bundles which


are technically feasible but one has to take into account the
economic constraints of the agent.

We can then define the set of bundles the consumer can afford
given his wealth and the prices of various commodities.

We call such set Walrasian Budget Set (or competitive Budget


Set).
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Basics: Commodities, Consumption and Budget Sets

More precisely, suppose that there is a price pl for any xl ,


l = 1; . . . ; L and denote by w the wealth of the agent.

We also assume that pl > 0 and w > 0 and let p = (p1 ; . . . ; pL )


stand for the vector of prices of each commodity.

We take a price-taking assumption, i.e., we assume that prices


are beyond the influence of the agent.

The Walrasian Competitive Set is defined as all bundles x such


that p.x 6 w. More formally, the budget set can be written as

Bp,w = {x RL+ : p.x 6 w}

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Basics: Demand function and Comparative statics

Using the previous notions, the standard procedure is to figure


out which point the consumer will choose from the budget set.

We will delay this process and only define some potential


properties of the demand function (and their consequences).

We define the (walrasian) demand function x(p; w) as the choice


of the consumer when he faces price-wealth pair (p, w).

Even if the choice can be multivalued (and thus lead to a


correspondence), we restrict ourselves to the case of a single
valued solution, i.e., a function.

Note that in a Walrasian economy with fixed wealth, from the


agents perspective, p and w are the exogenous while x(p; w) is
endogenous.
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Basics: Demand function and Comparative statics

In the next chapter, we will derive two important properties of


the demand function.

Walras Law : the consumer always spends his entire budget.


Demand is homogenous of degree zero, i.e., only real
opportunities matter.

Formally, those two properties can be written as

for every p >> 0 and w > 0, p.x = w for all x x(p; w).
x(p, w) = x(p, w) for any p, w and > 0.

What are the main consequences of those natural" properties?

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Demand function and Comparative statics

Walras Law implies that the consumer will choose a bundle on


the budget hyperplane (or frontier).

If we assume that Walras Law is an identity, it is true for any p


and w and we can write the relationship as an identity:
X
L
p.x(p, w) = w or pl xl (p, w) w (1)
l=1

Question 1: How does the bundle chosen by the consumer


change if the consumers income increases by a small amount?
Differentiating both sides of (1) leads to
X
L
xl (p, w)
pl 1 (2)
w
l=1

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Demand function and Comparative statics

xl (p,w)
It is hard to know in general the sign of w since it may
depend on the type of commodity.
D EFINITION
xl (p,w)
A commodity l is normal at (p, w) if w > 0 and is inferior
otherwise

If every commodity is normal at all (p, w), then demand is said


normal.
The assumption of normal demand is quite reasonable if
commodities are large aggregates. If they are very disaggregated,
the substitution to higher-quality goods as wealth increases may
contradict this assumption.

From (2), one concludes that there is at least 1 normal good.


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Demand function and Comparative statics

Question 2: How does the bundle chosen by the consumer


change if the price vector changes? Differentiating both sides of
(1) w.r.t. the price of one commodity, pj , leads to

X
L
xl (p, w)
xj (p, w) + pl 0 (3)
pj
l=1

The LHS shows two effects.

An increase in pj increases the spending on good j at a given level


of xj .
In response to the price change, the agent will rearrange the
products he consumes, purchasing more of less of the other
products depending on whether they are substitutes or
complements to good j.

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Demand function and Comparative statics

The same comparative statics exercise can be performed in terms


of elasticities (it does not depend on price levels, only on relative
prices).

xi j p
Price elasticity is defined as ipj = pj xi
should be read as the
elasticity of demand for good i with respect to the price of good
j".

Let us define bj (p; w) = pj xj (p, w)/w as the share of the total


wealth the agent spends on good j.

Then (3) can be transformed into


X
L
bj (p, w) + bl (p, w)lpj 0
l=1

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Demand function and Comparative statics

If the price of commodity j increases, there are two effects.


If the consumer does not change its bundle, the price change
increases the consumers total spending by the proportion of his
wealth he spends on xj : this is the wealth effect.
After an increase in pj , the consumer will choose to rearrange his
consumption bundle : this is the substitution effect.

Combining both effects, total expenditure cannot change.

The change in wealth can also be expressed in terms of


elasticities (with iw = x i w
w xi ) which leads to

X
L
bl (p, w)lw = 1
l=1

If wealth by 1, total expenditure must also by 1.


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Demand function and Comparative statics

This property means that only real opportunities matter since the
consumer choice is not affected if prices and wealth are
multiplied by the same factor (it does not change the budget set).

With this property, nominal prices are meaningless in consumer


theory.

The most important thing is to see that we can normalize to 1


either one the prices or the wealth. Hence, the effective number
of arguments in x(w, p) is L.

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Demand function and Comparative statics

Demand Homogeneity leads to x(p, w) x(p, w) = 0.


Differentiating w.r.t. and taking = 1 (or using directly Euler
Formula) implies the following.
C LAIM
If the Walrasian demand function x(p, w) is homogeneous of degree
zero, then for all p and w :

X
L
xl (p, w) xl (p, w)
pk + w = 0l = 1, . . . , L (4)
pk w
k=1

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Demand function and Comparative statics

The relationship (4) can be rewritten in terms of elasticities of


demand w.r.t. prices and wealth.

X
L
lk (p, w) + lw (p, w) = 0l = 1, . . . , L
k=1

This means that an equal percentage change in all prices and


wealth leads to no change in demand.

In the next section, we will derive formally the properties of


demand function.

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