economics

Lecture 1: Introduction & Consumer Theory I

ECON30010 Microeconomics

Monday 2 March 2015

ECON30010 Lecture 1: Introduction & Consumer Theory I Monday 2 March 2015 1 / 23

Logistics

Organisational details

I LMS is your friend.

I Online tutor will start in week 2. Please do not ask trivial questionson online tutor. If you do, it becomes useless for others.

I Math Reviews will start in week 3. Attendance is not mandatory.Stay tuned (LMS).

I Lecture slides are not a book, but a whiteboard and a study guide.


Logistics

Textbooks

I The textbook (Perloff, Microeconomics with Calculus) contains a lot ofsupplementary information. You will find it useful to refresh IntermediateMicro material, to find some background information and to read aboutreal-life cases. We will be going straight to (hard) business, with littledeviation.

I For the exam and assignments, you are only responsible for the material onslides/tutorials. However, you may find it hard if you dont have backgroundinformation (textbook) and you may find it too dry if you dont have real-lifecases (textbook).

I The editions are created to rip you off; use whatever you like (but I will givepage numbers in 3rd edition; this is what publishers hope will induce you tobuy a new edition)

I Serrano and Feldman, A Short Course in Intermediate Microeconomics withCalculus may prove to be useful. It contains very little backgroundinformation and cases, but has all the math concisely written. I do not planto reference this book in my slides this year. Kindle edition costs AUD51.20on amazon.com.au


Logistics

Overall plan

I Revisit some of the topics from Intermediate Microeconomics. Wewill only cover these parts where calculus were missing, but wouldhave been useful (that is: math heavy)

I Introduce new topics ((more of) Game Theory, Information, MarketDesign)

Math is the language of contemporary economics (whether we like it ornot). We need to get a bit more comfortable with this language.

Those of you planning to go to Honours, take Real Analysis now. This isan official departmental recommendation.


History

Classical Economics

I Adam Smith, David Ricardo, Karl Marx.

I Attempted to uncover the laws of the economy, which were thoughtto be similar to the laws of physics (e.g. Newtons laws). Forexample, distribution of wealth in the economy.

I Individual agents (individuals or firms) were not a focus.


History

Neoclassical Economics

I Leon Walras, Francis Edgeworth, Vilfredo Pareto, Alfred Marshall.

I Decision making of agents is the main focus.


On Models

Economic Agents

I Economic problems: an allocation of scarce resources.I Food to people;I Seats at schools to students;I Kidneys to patients;I Possession of a ball in football or overtime penalty kicks in soccer.

I Agents choose what is best for them, out of what is available to them(rational).Mathematically speaking, this is the problem of constrainedoptimisation.

Rationality by itself imposes too little restrictions to be useful.Rationality in conjunction with other assumptions allow us to makepredictions. The assumptions we make need to be suitable for a particularquestion. That is, our model needs to be correct.


On Models

Models I

Problem: A steel ball 5 cm in diameter is stationary and 1 meter awayfrom the surface of the Earth. Suppose that we let it fall freely. How fastit would reach the surface of the Earth?

Solution: 2xt2

= g (with correct boundary conditions) gt22 = x = 1(because ball is 1 meter from the surfance) t =2/g = 0.45175 secAssumptions: 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. Nointeractions between electrons?


On Models

Models II

A physicist has been asked to estimate the probability of a particular horsewinning the Melbourne Cup.

Physicist: Let us represent a horse as a spherical ball moving in avacuum.

Everything should be made as simple as possible, but not simpler.(Albert Einstein)


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 arecorrect, but the conclusions arewrong.


Economics

What is Economics?

I Economics is not first and foremost a fixed set of facts and principlesthat we need to learn by heart and then apply blindly.Why? Your facts and principles depend on assumptions. Assumptions may

not fit your problem.

I Economics is a way of engaging in a debate about a priori any sorts ofissues pertaining to the interaction of individuals and society.


Economics

Positive vs. Normative Economics

I When engaging in debates about the pros and cons of differentactions, or policies, it is fundamental that we distinguish betweenpositive and normative questions.

I Normative question: Should we do A or B?

I Positive question: If we do A, will C or D happen?

I Failure to recognize that there are positive questions is a source ofmajor confusion.


Economics

Normative Questions

I In public and academic debates, normative questions are important.We want to evaluate different policies (and maybe come up with apolicy prescription).

I A prescription depends on values. To give an extreme example, forsomeone who cares only about current consumption, a tax on tobaccoor climate change policies could not possibly make any sense.

I We can argue about values, but in many instances there are no rightsor wrongs. Economists are no better in value judgment than otherpeople.


Economics

Positive Questions

I Before we can evaluate the desirability of alternative actions (withinour value system), we need to understand what happens under thesealternative actions.

I Thus, we first need to answer positive questions.

I venture the judgment, however, that currently in the Westernworld, and especially in the United States, differences abouteconomic policy among disinterested citizens derive predominantfrom different predictions about the economic consequences oftaking action - differences that in principle can be eliminated bythe progress of positive economics - rather than fromfundamental differences in basic values, differences about whichmen can ultimately only fight.

Milton Friedman (1953)


Economics

Learning Goal: Developing Analytical Skills

I Understanding how some conclusion follows from a given set ofassumptions requires intellectual rigor and analytical skills.

I Acquiring the discipline (and ability) to follow the logical implicationsof some assumptions to their inevitable conclusion is a key learninggoal of this subject.

I The reason for starting tutorial in week 1 is exactly this tocoordinate students (and the instructors) expectations, and to bringeverybody up to speed.


Economics

Learning Goal: Writing Skills

I An increasingly important skill is the ability to write concise andcoherent argumentative essays.

I To foster the development of this skill, there will be an essay questionon most assignments and on the final exam.


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) andgood 2 (q2, x2, or y2). Throughout much of this subject, we will assumethat 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 aboutthe choice set (even though in this subject, it will be in the background most ofthe time).



Modeling individuals: preferencesNote: this mostly reviews the concepts you have learned in ECON20002 last year.

Once we have settled on the choice set, we need to make someassumptions 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 becompared.

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. . .



Modeling individuals: preferences


I Transitivity: if bundle x is at least as good as y and y is at least asgood 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 youprefer 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)?





I Continuity (not an exact definition): if bundle x is better than bundley 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).





I Completeness: any two bundles x = (x1, x2) and y = (y1, y2) can becompared.

I Transitivity: if bundle x is at least as good as y and y is at least asgood as bundle z, then x is at least as good as z.

I Continuity (not an exact definition): if bundle x is better than bundley 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 verypowerful math tools.



Utility Function RepresentationEven though people simply make a choice from the choice set, we canpretend that they have a utility function.

Specifically, we will assign to each bundle (such as 1 l. of red wine and 1kg of beef & pasta) a (real) number and then compare numbers instead ofbundles.

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:

TheoremIf preferences over bundles of goods x satisfy completeness, transitivity,and continuity, then there is a continuous utility function U(x) thatrepresents these preferences.

Why this theorem is important? Because mathematicians are very goodworking with functions, and we can use a lot of their tools.



Remarks on Utility Function RepresentationI Some preferences cannot be represented by a continuous utility

function (but they would not satisfy our assumptions).I If preferences are represented by a utility function, this utility function

is not unique. Any positive monotonic transformation of the utilityfunction will represent the same preferences.

Why: The only important thing about a utility function is how two numberscompare (e.g., u(x) > u(y)). But the very definition of a positivemonotonic transformation is that this inequality is preserved!

Example: I uA(q1, q2) = q1q2I uB(q1, q2) = ln(q1) + ln(q2)I uC (q1, q2) =

q1q2

I uD(q1, q2) = q21q22

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 sameholds 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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