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Prelims Micro 2010

INTRODUCTION TO MICROECONOMICS Trinity College, Oxford


Chris Wallace, Michaelmas Term 2010

Welcome (back) to Trinity! This handout contains the ten topics with the readings, questions, and essays that make up the Microeconomics part of the rst-year Economics Course for PPE and E&M (or second year for MEM and third year for EEM). The tutorials and classes will be held in my oce, (staircase 3, room 3) at Trinity College. Tutorials and Classes Each of the ten topics corresponds to one week of work: the course runs throughout Michaelmas Term and for the rst two weeks of Hilary Term. In the (odd) weeks that correspond to a tutorial, the assigned work must be handed in by 5.00pm the day before the tutorial to my pigeon hole at Trinity. I will mark your work and return it during the tutorial. Each tutorial (of 2 students) will be one hour long. There are ve classes (of 4 students) which will be two hours long. In (even) weeks corresponding to classes, you are not required to hand in the assigned work (you may if you wishand I will mark it): but you must attempt it! The work will be discussed in class, and it will quickly become obvious if you have not done it. Textbooks The text for the course is Varian (2005) which you should buy if at all possible. Older editions of the text (particularly the 5th and 6th) are virtually identical to this and may be substantially cheaper. The chapter numbers may have changed however, so take care to check you read the correct material (I refer to the 7th edition). In addition, the library has multiple copies. We will be working steadily through most of this book. For mathematics, the book I shall refer to most often is Anthony and Biggs (1996). A more advanced text for those comfortable with mathematics already is Simon and Blume (1994). Finally, if you have not done much mathematics before, and you would like a companion text to the rst book, try Renshaw (2005), although this book alone is not sucient. A very useful resource is the departments maths workbook. Working through the problems contained therein is certainly sucient. It can be found at: http://www.economics.ox.ac.uk/index.php/ . . . . . . intranet/undergraduate maths workbook

Prelims Micro 2010 Lectures Please go to the Introduction to Microeconomics Lectures; this is the best way to nd out what will be on the exam. Students who are less familiar with mathematics should also attend the introductory mathematics lectures provided. The lecture lists contain times and places; more details may be found at the departments sites: http://www.economics.ox.ac.uk/index.php/undergraduate/ . . . . . . details/introductory microeconomics/ . . . details/prelims elementary mathematical methods/ Oce Hours I have an oce hour on Wednesdays in Trinity at 11.30-12.30. Feel free to come along if you have any problems or questions (academic or otherwise). If you cannot make this time, get in touch, and we can sort out alternative times. My contact details are below. Mailing address Prof. C. C. Wallace Trinity College Oxford OX1 3BH email address christopher.wallace@economics.ox.ac.uk Website http://malroy.econ.ox.ac.uk/ccw/ Phone number 01865 2 71062

Prelims Micro 2010 Consumers I: Preferences and Representation


One-Hour Tutorials

MT Week 1

Suggested Reading The main reading is Varian (2005, Ch. 1-7). If you have never done economics before, you may nd Begg, Fischer, and Dornbusch (2008) useful (or any earlier edition). Another text to glance at as a complement is Morgan, Katz, and Rosen (2005). Take notes on: Preferences and Utility Representations. Indierence Curves and the Marginal Rate of Substitution. Budget Constraints and Choice. Consumer Demand, Substitutes, and Complements. Normal, Inferior, and Gien Goods. Revealed Preferences.

Much of the mathematics you will need for this week may be found in Varian (2005). Also try Anthony and Biggs (1996, Ch. 1-3, 7), or the more advanced Simon and Blume (1994, Ch. 1-2). The workbook contains the appropriate material as well: see Ch. 1-4. The same material (at a gentler pace) may also be found in Renshaw (2005). Questions and Essay You must hand in your work by 5pm the day before the tutorial to my pigeon hole at Trinity. Please answer the following questionskeep your answers short! (1) Suppose a consumer consumes a quantity x of good X and a quantity y of good Y . Write the consumption bundle as (x, y). The consumer is equipped with a strict preference relation and with an indierence relation . The consumer has the following preferences: (3, 3) ... (3, 1) (1, 3) (2, 2) (3, 0) (0, 3) (1, 1) (4, 0) (0, 4) (2, 1) (1, 2) (2, 0) (0, 2) (1, 0) (0, 1) ... (0, 0).

(a) Construct a utility representation for these preferences. With x = 0 what are the values of the marginal utility of good Y for your representation? (b) Construct a dierent utility representation for the same preferences. Again, calculate the marginal utility values for good Y when x = 0. Comment. (c) Plot indierence curves for these preferences on a graph. (d) Suppose the consumer is currently consuming (2, 1). How much of good X is the consumer prepared to give up in order to get an additional unit of Y ? What is the associated marginal rate of substitution? (e) Does the marginal rate of substitution depend upon the utility representation you use to describe preferences? Does marginal utility? Comment.

Prelims Micro 2010 (2) Now suppose the consumer has the following preferences: (3, 3) (4, 0) (2, 2) (3, 1) (1, 3) (2, 2) and (4, 0) (0, 4) (2, 1) (1, 2).

MT Week 1

Is there a utility representation for these preferences? Why, or why not? (3) Returning to the preferences of question (1), suppose that the consumer has an income of 2 and that the price of X (pX ) is equal to that of good Y (pY ) and both have price 1. Draw the associated budget line in your graph. What is the optimal choice of the consumer? Suppose the consumers income increases to 3. Now what is the optimal choice? At this optimal choice, what is the market exchange rate? What is the consumers marginal rate of substitution? Comment. (4) Draw several indierence curves for each of the following utility functions: u(x, y) = x1/2 y 1/2 ; u(x, y) = ln x + ln y ; u(x, y) = x + y ; u(x, y) = min{x, y}. What sorts of preferences do these utility functions represent? (5) Illustrate the dierence between normal, inferior, ordinary, and Gien goods using income-oer curves, Engel curves, price-oer curves, and demand curves. (6) Write a short essay (fewer than four written sides including diagrams) entitled: People do not spend their lives solving mathematical problems, so the microeconomic theory of consumer choice has little to oer. Discuss.

Prelims Micro 2010 Consumers II: Decompositions and Demand


Two-Hour Classes

MT Week 2

Suggested Reading The main reading is Varian (2005, Ch. 8-11, 14-16). Take notes on: Income, Substitution, and Endowment Eects. The Slutsky and Hicks Decompositions and Demand Curves. Labour Supply, Intertemporal Choice, and Asset Markets. Consumer Surplus, Compensating and Equivalent Variations. Market Demand and Elasticities. Market Equilibrium and Comparative Statics.

The mathematics you will need for this week may be found in Anthony and Biggs (1996, Ch. 1-2, 6-7, 9), Simon and Blume (1994, Ch. 2-3), or the workbook Ch. 1-6. Questions and Essay If you would like to hand in work, please do so by 5pm the day before the tutorial (you do not have to hand in work this weekbut you must attempt the questions!) (1) Illustrate the income and substitution eects on a graph. Hence distinguish between inferior, normal, and Gien goods. Explain the endowment income eect. (2) Graphically compare and contrast the Slutsky and Hicks decompositions of the eect on demand of a price change. (3) If leisure is an inferior good, what can be said about the slope of labour supply? (4) Graphically compare and contrast compensating variation with equivalent variation, drawing on their relationship with substitution and income eects. (5) Suppose that the quantity demanded of a commodity is given by qD = 10 p where p is price. Suppose that supply is given by qS = 2 p. 3 (a) Calculate the equilibrium price and quantity for this market. Calculate the consumer surplus, producer surplus, and revenue at this equilibrium. (b) Now suppose supply shifts to qS = p. Perform the same calculations for the new equilibrium. By how much have consumer surplus and revenue changed?
9 (c) Now suppose that supply shifts back to qS = 11 p. Calculate the new equilibrium. What is the price elasticity of demand at this equilibrium?

(d) What is the marginal revenue from increasing production from 4 to 5 units in this market? How does this relate to the elasticity found in part (c)? (6) Find the price elasticity of demand for the following demand functions: qD = 1p; qD = p1 ; qD = Ap , where A > 0 and > 0.

Prelims Micro 2010

MT Week 2

(7) Suppose that the quantity demanded of a commodity is given by qD = 100 p 1 where p is price (in pounds). Suppose that supply is given by 25 + 2 qS = p. (a) Find the equilibrium price and quantity for this market. Calculate the consumer surplus and the producer surplus. (b) Suppose the government imposes a 15 tax per unit, collected from the suppliers. Now how much do consumers pay? By how much has consumer surplus fallen? (c) How much do the suppliers receive (after the tax is collected) for each unit they sell? What is the new producer surplus? Who actually pays the tax? (d) What is the governments revenue from the tax? What is the deadweight loss associated with the introduction of the tax? (e) Illustrate your answers in a graph. (8) Write an essay plan (you do not need to write the essay) entitled: How do the elasticities of demand and supply aect the impact of a tax on (a) revenue, (b) consumer surplus, and (c) deadweight loss?

Prelims Micro 2010 Producers I: Profits and Costs


One-Hour Tutorials

MT Week 3

Suggested Reading The main reading is Varian (2005, Ch. 18-21). Take notes on: Production Possibility Sets and Production Functions. Technical Rates of Substitution and Marginal Products. Increasing, Decreasing, and Constant Returns to Scale. Fixed and Variable Factors: the Short and Long Run. Prot Maximisation and Cost Minimisation. Average Cost, Variable Cost, and Marginal Cost Functions. Marginal Costs and Supply Functions.

The mathematics you need may be found in Anthony and Biggs (1996, Ch. 6-10), Simon and Blume (1994, Ch. 2-5), or the workbook, Ch. 5-6. By the end of the week it is very important that you fully understand calculus with one variable. In particular, you should be able to dierentiate functions of one variable, and nd their maxima and minima. Questions and Essay You must hand in your work by 5pm the day before the tutorial to my pigeon hole at Trinity. Please attempt all of the following questions. (1) Under what conditions does the production function f (K, L) = AK L , where A > 0, exhibit constant, increasing, and decreasing returns to scale? (2) Is it possible to have decreasing marginal products for every input and yet increasing returns to scale? If so, give an example; if not, prove it. (3) Can a prot-maximising competitive rm operating with constant returns to scale make positive prots in equilibrium? (4) Suppose a rms costs are given by c(q) = 100 + 15q 6q 2 + q 3 , where q is output. (a) What exactly is a cost function? How is it derived? (b) Derive algebraic expressions for xed, variable, average, marginal, average xed, and average variable costs. Sketch these functions for q = 0 to q = 10. (c) At what output does minimum average cost occur? What about minimum average variable cost? What is the value of marginal cost at these outputs? (d) What is the supply curve of this (perfectly competitive) rm? (5) Is it true that in the long-run a rm always operates at the minimum level of average costs for the optimally sized plant to produce a given amount of output?

Prelims Micro 2010

MT Week 3

(6) Write a short essay (fewer than four written sides including diagrams) entitled: How does the prot-maximising output of a perfectly competitive rm change in the short and long run following an increase in the wage rate? How does its demand for labour change? Explain how your answer might dier if it were the price of capital that increased.

Prelims Micro 2010 Producers II: Perfect Competition and Monopoly


Two-Hour Classes

MT Week 4

Suggested Reading The main reading is Varian (2005, Ch. 22-24). Take notes on: Perfect (or Pure) Competition. Prots and Producers Surplus. Industry Supply in the Short and Long Run. Economic Rent. Monopoly Prot Maximisation and Supply. Monopoly Ineciency and Deadweight Losses. Comparative Statics in the Short and Long Run.

The mathematics you need for this week may be found in Anthony and Biggs (1996, Ch. 11-13), Simon and Blume (1994, Ch. 13-14, 17), or the workbook, Ch. 7-8. It is important to be able to partially dierentiate functions of more than one variable, and to make a start on nding minima and maximaa theme returned to in the coming weeks. Questions and Essay If you would like to hand in work, please do so by 5pm the day before the tutorial (you do not have to hand in work this weekbut you must attempt the questions!) (1) A (perfectly competitive) rm has a production function f (K, L) = K 1/3 L1/3 . Suppose the price of capital is 1 and the price of labour is 1. Output sells for 9. (a) Write down the rms prots in terms of K and L. How much of each factor will the (prot-maximising) rm employ in production? (b) How much output does the rm produce as a result? (c) Write down costs in terms of K and L. Using the fact that output (labelled q) is given by q = K 1/3 L1/3 , substitute for L in terms of q and K. (d) Hence show that the cost function is given by c(q) = 2q 3/2 . (e) Write down prots in terms of q and nd the optimal output. Comment. (2) How does a perfectly competitive rm make its supply decision? Illustrate your answer on a graph. Can the rm make positive prots? (3) A perfectly competitive industry is composed of 60 rms. The industry demand curve is Q = 1100 40P , where P is price and Q is the total market demand. Firms have identical costs: C = 50 + 5q + 1 q 2 , where q is the rms output. 2 (a) What is the market price and level of each rms output in the short run? (b) How much prot does each rm make? Comment. (c) How many rms operate in the long run? How much prot do they make?

Prelims Micro 2010

MT Week 4

(d) The government imposes a per-unit sales tax of 5. What happens to each rms output in the short run? How many rms will survive in the long run? (e) With this tax, how much does each rm produce in the long run? Comment. (f) The government changes its mind, scraps the tax, and introduces a lump-sum subsidy of 32 for each rm. What happens in the short and long run? (4) How does a monopolist make its supply decision? Illustrate your answer on a graph. Can the rm make positive prots? (5) Using a diagram, illustrate the deadweight loss associated with monopoly production. How is this aected by the elasticity of the demand curve? (6) Suppose industry demand is Q = 100 P , where P is price and Q is the quantity demanded. A rm has costs C = 10q, where q is the quantity it produces. (a) What is the long run equilibrium quantity produced in a perfectly competitive industry? How much would a monopolist produce? Comment. (b) How much deadweight loss results in either case? Illustrate in a diagram. (7) A monopolist has two plants, A and B, whose outputs of the same good are qA 2 and qB respectively, and whose total costs are CA = 50 + 8qA + qA and CB = 2 50+22qB +qB . Total demand for the good is P = 1002q where P is price. What is the prot-maximising price and division of output between the two plants? (8) Write an essay plan (you do not need to write the essay) entitled: Outline the main dierences between perfect competition and monopoly. Under what conditions is each of these likely to occur?

Prelims Micro 2010

MT Week 5

Producers III: Monopolistic Competition and Factor Markets


One-Hour Tutorials

Suggested Reading The main reading is Varian (2005, Ch. 19, 25-26). Take notes on: First, Second, and Third Degree Price Discrimination. Monopolistic Competition in the Short and Long Run. Comparative Statics in the Short and Long Run. Factor Demand Curve Derivation. Perfect Competition and Factor Demands. Monopoly and Factor Demands. Monopsony.

There is no new mathematics required for this week. You should continue to get to grips with the material on partial dierentiation and optimisation outlined last week. Questions and Essay You must hand in your work by 5pm the day before the tutorial to my pigeon hole at Trinity. Please attempt all of the following questions. (1) Explain why a rst-degree price discriminating monopoly generates no deadweight loss. What is second-degree price discrimination? Give examples of this practice. (2) A monopolist has total costs given by C = 1000 + 10q + 1 q 2 , where q is the 6 quantity produced. There are two markets for this good, A and B, with demand qA = 110 pA and qB = 100 2pB respectively. pA and pB are the prices charged in markets A and B; qA and qB are the quantities sold in each of the markets. (a) If the monopolist can third-degree price discriminate, how much will it sell to market A? How much will it sell to market B? What are prots? (b) If the monopolist must charge the same price in both markets, how much will it produce? Now how much prot is made? Comment. (c) What happens if xed costs double? Briey, do you think the government ought to legislate against price discrimination? (3) How are the factor demand curves of a perfectly competitive rm related to its production function? Why are there no Gien factors of production? (4) How are the factor demand curves of a monopolist determined? How do these compare to those derived in your answer to question (3) above? (5) A rm sells a good in a perfectly competitive market, but is the only buyer of the (single) factor used in its production. Illustrate the optimal factor-demand for this monopsony in a graph. Show any associated eciency losses in your diagram.

Prelims Micro 2010

MT Week 5

(6) Write a short essay (fewer than four written sides including diagrams) entitled: How does the imposition of a (i) lump-sum tax and (ii) quantity tax aect the supply decision of a monopolistically competitive rm in the short and long run? What happens to the number of rms?

Prelims Micro 2010 Producers IV: Games and Oligopoly


Two-Hour Classes

MT Week 6

Suggested Reading The main reading is Varian (2005, Ch. 27-29). Take notes on: Games and Game Theory. Nash Equilibrium. Cournot Competition. Bertrand Competition. Comparative Statics. Stackelberg Leadership.

There is no new mathematics required for this week. You should now be comfortable with optimisation and dierentiation for multivariate functions. You may like to look ahead to next weeks very important topic: constrained optimisation, see Anthony and Biggs (1996, Ch. 21-22), Simon and Blume (1994, Ch. 18-19), or the workbook Ch. 9. Questions and Essay If you would like to hand in work, please do so by 5pm the day before the tutorial (you do not have to hand in work this weekbut you must attempt the questions!) (1) What is a (strategic-form) game? How are games applied in economics? (2) In each of the following representations of strategic-form games, player 1 chooses between the rows, and player 2 chooses between the columns. Player 1s payo is in the bottom-left corner of the cell, player 2s payo is in the top-right corner. C C D 3 3 1 4 2 1 2 D 4 S R 5 0 4 3 S 5 0 3 R 4 H T 1 1 1 1 H 1 T 1 1 1

Find the Nash equilibria of each. What do you think will happen in these games? (3) There are two rms (A and B) in an industry. Firm A has costs C = F + cqA and rm B has costs C = F + cqB , where qA and qB are the amounts produced by the respective rms. Market demand is Q = a P , and total supply is Q = qA + qB . (a) Write down the prots for each rm, and hence nd their reaction or bestresponse curves. What would rm A produce if rm B set qB = 0? (b) Identify the Nash (Cournot) equilibria of this game. (c) What is the market price at equilibrium? What are prots?

Prelims Micro 2010

MT Week 6

(d) Suppose both rms chose to produce qA = qB = (a c)/4. How much prot would they make? Why is this not a Nash equilibrium? (e) Calculate the output that would be sold under perfectly competitive conditions in this market. What would a monopolist produce? How does Cournot competition compare with perfect competition and monopoly? (f) Illustrate your answers to (a)-(e) using a diagram. (4) Two rms with identical marginal costs and no xed costs simultaneously choose prices. The rm with the lower price serves the entire market. If prices are equal, the rms share the market equally. What is the Nash (Bertrand ) equilibrium? (5) Two rms compete in quantities. What happens if the marginal cost of one of the rms rises? How does your answer change when the rms compete in prices? (6) A man with a hand grenade comes up to you in the street and says, Give me one pound, or I will pull the pin. What should you do? This game might be represented by the following game tree. , . .. Pull Pin ..............
. .. ..... ..... ..... .... . ...... .. ... ...... ..... ..... .... .... . .... ...... ..... ..... ..... ..... ... .. .......... ........... ..... ..... ..... ..... .. .. ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ... ..... ... ..... ..... ..... ..... ..... ... ... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ..... ... ..

R.I.P R.I.P

Dont

Man

You

Dont

0, 0

Give Cash

1, 1

The notation indicates a very big (in absolute value) negative payo. Interpret the elements in the game tree above. How might you solve this sort of game? Does the solution suggested by this method for the game above seem reasonable to you? What should you do? (7) Compare market prices, quantities produced, and prots generated when rms choose quantities sequentially (Stackelberg) rather than simultaneously (Cournot). (8) Write an essay plan (you do not need to write the essay) entitled: Why do rms that set prices make positive prots?

Prelims Micro 2010 Mathematical Interlude: Lagrangians


One-Hour Tutorials

MT Week 7

Suggested Reading There is no new reading from Varian (2005) specically. The aim this week is to understand constrained optimisation, and Lagrangian techniques in particular. Focus on: Constrained Optimisation Problems. Objective Functions. Constraints. The Lagrangian Technique. First Order Conditions. Lagrange Multipliers. Complementary Slackness.

A good starting place is Anthony and Biggs (1996, Ch. 21-22), or the workbook, Ch. 9. An excellent (if advanced) treatment can be found in Simon and Blume (1994, Ch. 18-22). Constrained optimisation is very important in economics, and is not something you will have learnt elsewhere. You should be able to use the Lagrangian method (see the theorem stated in the mathematical appendix to this handout for a correct, if technical, statement of this method), although not necessarily understand why it works. Questions and Essay You must hand in your work by 5pm the day before the tutorial to my pigeon hole at Trinity. Please have a go at as many of the following questions as you can. (1) An individual consumes x1 of good 1 and x2 of good 2. Utility is given by 1/2 1/2 u = x1 x2 . Suppose income is 40, the price of good 1 is 4 and the price of good 2 is 2. By writing down an appropriate Lagrangian, what quantities maximise the consumers utility? What is the marginal utility of income? (2) A rms production is Q = K 1/3 L2/3 where Q is output, and K and L are the two inputs. The cost of a unit of K is r and the cost of a unit of L is w. What inputs minimise the cost of producing an output of 32 units when w = 5 and r = 20? Give an economic interpretation of the Lagrange multiplier in this example. (3) A students utility is u = i2/3 l1/3 s1/2 , where i, l, and s are the number of hours spent idling, lazing about, and sleeping respectively. A day contains 24 hours. (a) In a given day, how should the student allocate their time to maximise utility? (b) Once a week the student is required to spend an hour at a tutorial (from which utility is zero). How much less time is spent sleeping that day?

Prelims Micro 2010

MT Week 7

(4) A consumer has utility given by u = ln x + ln y where x and y are the amounts consumed of two goods (X and Y respectively). The price of good X is p and the price of good Y is 1, and the consumer has a money income of m. However, the government, in its innite wisdom, has forbade the consumption of more than x of good X. Suppose that x < m/p. (a) What is the budget set faced by the consumer? Draw it in a graph. (b) Write down all the constraints faced by the consumer, and hence construct an appropriate Lagrangian. (c) Suppose initially that x > m/2p. Find the consumers optimal demands for the two goods and illustrate them in your graph. What are the values of the Lagrange multipliers in your solution? Interpret them in terms of the consumers marginal utility. (d) Now suppose x < m/2p. What are the consumers optimal demands now? What are the values of the multipliers? Illustrate your solution in the graph. (e) What happens when x = m/2p? (5) A consumer obtains utility u(x, y) from consuming a quantity x of good X and a quantity y of good Y . Suppose income is m and prices are pX and pY respectively. Solve the consumers maximisation problem in each of the following cases: (a) u(x, y) = xy; (b) u(x, y) = x + y; (c) u(x, y) = ln(x + y); (d) u(x, y) = x2 + y 2 ; (e) u(x, y) = (x )1/2 (y )1/2 , where > 0; (f) u(x, y) = (x + )1/2 (y )1/2 , where > 0. In part (e) what happens if pX = pY = 1 and m = ? How big does m need to be? In part (f) what happens if pX = pY = 1 and m 2? What about m < 2? (6) Write a very short essay (fewer than three sides including diagrams) entitled: What is a constrained optimisation problem? Why are such problems important in economics and how may they be solved? What economic concepts are captured by Lagrange multipliers?

Prelims Micro 2010 Equilibrium I: Market Success and Efficiency


Two-Hour Classes

MT Week 8

Suggested Reading The main reading is Varian (2005, Ch. 31-33). Take notes on: Competitive General Equilibrium. Edgeworth Boxes and Exchange Economies. Robinson Crusoe Economies. Pareto Eciency and Social Welfare. The First Welfare Theorem. The Second Welfare Theorem.

The mathematics this week continues to apply the Lagrangian technique introduced in last weeks tutorial. Practice makes perfect. Questions and Essay If you would like to hand in work, please do so by 5pm the day before the tutorial (you do not have to hand in work this weekbut you must attempt the questions!) (1) Illustrate a two-person exchange economy in an Edgeworth box. Identify the initial endowment, prices, nal allocation, and bundles consumed by the two agents. (2) Carefully dene a competitive (general or Walrasian) equilibrium. Identify an equilibrium in the two-person economy illustrated in your answer to (1) above. (3) What is a Pareto ecient allocation? Identify all such allocations in the twoperson economy illustrated in your answer to (1) above. (4) What exactly does the rst welfare theorem say about the relationship between equilibrium and eciency? Carefully state any assumptions required. (5) What exactly does the second welfare theorem say about the relationship between equilibrium and eciency? Carefully state any assumptions required. (6) Consider a two-person two-good exchange economy. Consumers (A and B) have identical utility functions given by uA = ln xA + ln yA and uB = ln xB + ln yB , where xA and yA are the quantities A consumes of the two goods (X and Y ), and xB and yB are the quantities B consumes. Normalise the price of good X to 1, and write p for the price of good Y . Suppose consumer A has an endowment of 10 units of good X whilst consumer B has an endowment of 10 units of good Y . (a) Draw this economy in an Edgeworth box. Identify the initial endowment. Sketch in a budget line and some indierence curves for each consumer. (b) Write down the budget constraints for the two consumers. (c) Carefully write down the consumers constrained optimisation problems.

Prelims Micro 2010

MT Week 8

(d) Solve each consumers problem using a Lagrangian. Evaluate the consumers demand curves for X and Y . What does the Lagrange multiplier represent? (e) Write down two market clearing conditions. (f) Hence nd the general equilibrium. Sketch it in your diagram. Is it ecient? (7) An economy contains a single turnip farmer who has one unit of (perfectly divisible) time available for work and leisure, and a eld. The farmer has preferences represented by u(t, l) = ln t + ln(1 l), where t is the number of turnips consumed and l is labour supply. Normalise the turnip price to 1; write w for the wage and r for the rental price of the eld. (a) Argue that the farmers budget constraint may be written t wl + r. (b) Hence (using a Lagrangian) nd the farmers optimal demand for turnips and supply of labour in terms of r and w. When is labour supply positive? There is only one industry in this economyturnipswhich requires two inputs: labour and elds. Turnips are competitively produced with a production function f (L, F ) = L1/2 F 1/2 , where L is labour and F is the number of elds used. (c) If the industry employs a total labour input of L and F elds, what are costs? (d) Using a Lagrangian with multiplier , solve the cost-minimisation problem and deduce the factor demand curves for labour and elds. Interpret . (e) Remember that the supply of elds is FS = 1. Find turnip supply in terms of r/w. Using three market-clearing conditions, nd the general equilibrium. (8) Write an essay plan (you do not need to write the essay) entitled: What do the rst and second welfare theorems say? Why are they important, and why are they true?

Prelims Micro 2010 Equilibrium II: General Equilibrium and Optimisation


One-Hour Tutorials

HT Week 1

Suggested Reading There is no new reading this week. Use the vacation to go over all the material that was covered last term! Bring your questions to the tutorials. Questions and Essay You must hand in your work by 5pm the day before the tutorial to my pigeon hole at Trinity. Please attempt both of the following questions. (1) A corn producing economy consists of landowners and peasants. There is one acre of land in total, which is equally divided amongst n landowners. There are m peasants, who own no land. Both landowners and peasants have one unit of (perfectly divisible) time available for work and leisure. They have identical preferences over consumption and leisure: u (c, l) = ln (c) + ln (1 l) where c is an individuals consumption of corn and l is labour supply. (a) Normalise the price of corn to 1 (as numeraire) and let the wage rate be w. Let q be the rental price of land (i.e. the amount per acre that an owner of land earns each period). Write down an appropriate budget constraint for the peasants. How does the budget constraint of the landowners dier? Find the optimal consumption/leisure trade-o for the peasants and landowners by maximising u subject to the relevant budget constraint. (b) How low does the price of land need to be for landowners to choose to work? (c) The technology for producing corn with a total labour input L and a total stock of land S is Y = L1/2 S 1/2 , where Y is the total output of corn. Corn is produced competitively. Write q/w in terms of the total labour input L. (d) Find the value of q/w which clears the labour market when both peasants and landowners choose to work. How would you compute the general equilibrium? (e) Find conditions on n and m such that the landowners choose not to work. (2) This weeks essay should be a more substantial eort. Remember to use diagrams in your essay, and feel free to make it as long as you like (within reason!) An economy in which people selshly pursue their own objectives can never achieve the objectives of a fair society. Competitive markets are ecient, so we should not attempt to change them. Adjudicate.

Prelims Micro 2010 Equilibrium III: Market Failure and Externalities


Two-Hour Classes

HT Week 2

Suggested Reading The main reading is Varian (2005, Ch. 34-37). Take notes on: Consumption and Production Externalities. Property Rights and Missing Markets. The Tragedy of the Commons. Correcting Externalities with Taxation. Public Goods: Non-Excludable Goods and Non-Rival Goods. Free-Riding and Ecient Provision. Asymmetric Information and the Market for Lemons.

There are no new mathematical techniques to be learnt this week. Continue getting to grips with constrained optimisation and Lagrangians. Questions and Essay You must hand in your work by 5pm the day before the tutorial to my pigeon hole at Trinity. Please attempt all of the following questions. (1) What is the Tragedy of the Commons? Use a diagram to explain why it occurs and how it might be resolved. Give some examples from the real world. (2) What is the dierence between marginal private cost and benet and marginal social cost and benet? How can this dierence result in welfare losses to society? (3) How might a Pigouvian tax alleviate the problems arising in markets for goods with negative externalities? Is there any other way to alleviate these problems? (4) A student who lives in college has one hobby: listening to Mahler. The students hi- system can produce noise levels of up to 100 decibels. His utility depends on the loudness of Mahler, measured in decibels D, and the amount of money he has, MS , so that preferences are represented by the utility function uS = 10D1/2 + MS . (a) Term is over and the student has run out of money. What is his utility? (b) A fellow lives on the same staircase. She is irritated by loudly played Mahler. Her utility function is uF = 10(100 D)1/2 + MF , where MF is the amount of money she has. What would be a Pareto-ecient noise level? (c) The fellow has 100. What is the maximum bribe she is willing to pay the student to turn down the music to a Pareto-ecient level? Is 50 enough? (d) Draw an Edgeworth box to illustrate this problem. In your diagram, carefully indicate the initial endowment, the contract curve, and the outcome if the 50 bribe is accepted.

Prelims Micro 2010

HT Week 2

(5) What is a non-rival good? What is a non-excludable good? Give examples of goods that have both, either, and neither of these properties. (6) Why might a public good be under-provided by the market? (7) What is the market of lemons? How does such asymmetric information result in eciency losses in such markets? Suggest some solutions to this problem. (8) Write an essay plan (you do not need to write the essay) entitled: How ought a government intervene in markets with externalities?

Prelims Micro 2010 A Mathematical Appendix: Kuhn-Tucker For those of you who are a little uneasy with the presentation of constrained optimisation in the lectures, workbook, and some textbooks, here is a more general statement of the appropriate theorem (which, although you will use, you need not understand in any depth at this stage). Let the problem to which you seek a solution be P1, so that P1 : max f (x1 , . . . , xn ) s.t. gi (x1 , . . . , xn ) ki , i = 1, . . . , m.
x1 ,...,xn

The associated Lagrangian is L = f (x1 , . . . , xn ) + P2 : 1. 2. 3. 4. L/xj = 0 i 0 ki gi (x1 , . . . , xn ) 0 i {ki gi (x1 , . . . , xn )} = 0

k i=1

i {ki gi (x1 , . . . , xn )} .

for for for for

j = 1, . . . , n i = 1, . . . , m i = 1, . . . , m i = 1, . . . , m

P2 are sometimes called the Kuhn-Tucker conditions (1. rst-order conditions, 2. nonnegative multipliers, 3. constraints, and 4. complementary slackness). The following theorem (cd means continuously dierentiable) is often referred to as either Kuhn-Tucker (which technically it is not) or better, as the concave programming theorem. Theorem: If (i ) the objective, f : X R, is a concave cd function, (ii ) for every i = 1, . . . , m the constraint, gi : X R, is a convex cd function, (iii ) there is some (x1 , . . . , xn ) such that gi (x1 , . . . , xn ) < ki for all i = 1, . . . , m and (iv ) X is a convex subset of Rn (R is the reals) then the solution, (x , . . . , x ), to P1 and P2 coincides. 1 n The last two assumptions for the theorem are technical and almost always satised. The rst two (concavity and convexity) are crucialalways check them. There are many dierent versions of this theorem: this is the most general statement I think you will need. It reduces to the various versions you have seen in lectures and textbooks. Usefully, solutions to P1 are very often solutions to P2: when the conditions in the theorem fail, solve P2 anyway and check which candidate solution maximises f .
References Anthony, M., and N. Biggs (1996): Mathematics for Economics and Finance. Cambridge University Press, Cambridge. Begg, D., S. Fischer, and R. Dornbusch (2008): Economics. McGraw-Hill, London, 9 edn. Morgan, W., M. L. Katz, and H. S. Rosen (2005): Microeconomics: European Edition. McGrawHill, London. Renshaw, G. (2005): Maths for Economics. Oxford University Press, Oxford. Simon, C., and L. Blume (1994): Mathematics for Economists. Norton, New York. Varian, H. R. (2005): Intermediate Microeconomics: A Modern Approach. Norton, New York, 7 edn.