!1

EC102: MICROECONOMICS HIGHLIGHTS Theory of consumer behavior Indifference curves

Property Characteristic

Completeness: All bundles can be ranked

Ubiquitous: Each IC corresponds to a specific IC

Nonsatiation: More is better Downward sloping

Transitivity ICs do not intersect

Convexity: Moderates are preferred to extremes

ICs get flatter along the x axis

Price consumption curve

Normal goods have negative associated income and substitution effects when price increase. Inferior and giffen goods have negative substitution effects but positive income effects Rational consumer choice: Utility function

!"!! = !!"! !

!"# = ! !" !!" !

! !! !! !

= ! ! !! !

Market demand curve: Horizontal summation of individual demand curves

!" !! ! ! ! ! ! ! !

!" ! !! ! ! !!

! ! !

Price elasticity of demand

! = !!/!! !! ! = !

!

!!! !

! !

! = !!

!!! !

!"!"

Price elasticity of demand: Segment-ratio

! ! !!"#$%&()*+,-).)$,)/)%0"#

!"#$%&()*+,-).)$,)/)%0"#

Constant elasticity demand curve

! ! ! !! ! /!

! ! !! ! !!!!

Defining the aforementioned P function as an elasticity function yields ! of 1 Income elasticity of demand

! = !!! !! ! ! !

= ! !!

! !!! ! = !

!

!! !!"!"

If income effect is zero, ! ! ! Engel curve

Income consumption curve (ICC)

Cross elasticity of demand

!!" = !! ! !! !!! !! ! !

! ! !!!!! !!!!!

= ! ! !! !! !! ! !

! !!

Information Search theory Let ! and ! denote maximum and minimum acceptance levels of wage (high is better) and price (low is better), assume upper limit ! and lower limit !

!"#$%&$()*+,( ! !(! ! !)(! !! ! !

(! ! ! !2 ! !

!! ! ! ! !! !!! !) = !

!2

!"#$%&$()*+,! ! = ! (! !)(! !) ! !(! !)

!! !

!! !)!2! ! ! = !

! Successful!search = ! !2! ! ! ! OR! ! !

2(! !) One will hence spend more time searching when B-A and average values are large given constant S

Range&of&observations = ! !!OR!! !! Higher average values will give rise to smaller variation Payoff table (cell-by-cell inspection)

(Signaling: The messy room/poster problem) 1 Has$poster: !"

No entry !

Entry !"##$ !

100 ! !!""

! ! ! ! !

No entry ! ! !""

!"# !!"##$%"##!"#$%& !!"" ! !

!! !"

!"# !!"##$%"#! !" !!"#$%& !

!"" ! !

!

!"# !!"##$%"#! !"#$%&( !!" !" ! !"" ! !!"" ! ! ! ! ! !

!"" ! !!

!" !!"" ! !

!"" ! ! ! ! !! !

If messiness is desirable: The cooking/roommate problem

!"# !!"#$%&%!!"##$%"#! !"#$%&( !!" !" ! !100 ! ! ! ! ! !

!2

!" + !100 1 ! != !

Solve for m

Theory of the firm and market structure Short-run production

!" ! ! !!! !

! !!"!"

!"! = !!!

!!!

!"! ! !

!!! !

!"

!"

1!

!! ! ! !

!"!"

!! ! ! !!"

!"= !

!

Proof that !" ! ! !" ! at the maximum point of !"!

!

!"!

!"! !

!"

! !!

!

!

!"#

!"! ! ! !" ! !"#

Proof that AVC and ATC are decreasing when >MC

Long-run production

! ! ! ! ! ! ! !! !" ! ! ! !!

!" ! ! ! ! ! !" ! ! !

!"#$ ! !!" !!" !

! !! !

! =!"!" ! !

!!

Slope of isocost curve = slope of isoquant curve

!" ! !! ! !

= ! !" ! !!! !! ! ! !!"!!

! ! !

Short-run costs

!"# !!"! =

!"

!

!"# !!"!

!!"!

!"! !! ! !

!!

!" !!

!" !!"#!" = !

!"! = !

!"! !

!"/!! !/! =

!!"!!

Long-run costs

!"# = ! ! !"#! !

!!"#$

!"

!"# = !"#!

Cobb-Douglas production function

! = ! !! ! ! !!!! +=1: Constant returns to scale + >1: Increasing returns to scale +

!3

! ! !" ! !"

!"

!" =!"#

!" !"#

!" ! !! !!" = ! ! ! ! = !" = !" Market supply curve: Horizontal summation of individual supply curves

!"!:! ! ! + !! !

!"!! ! ! ! !!!

! ! Producer surplus

!" !" ! ! ! !"# ! ! ! !" ! !!" ! ! !"!

!!!"

Price elasticity of supply

! ! = !! /!! /! = !

!! ! !

!! = !

!

!! ! !!"

!"

Monopoly Profit-maximizing condition

!"!" !

!

!" !" !!

!"!" = !!" ! !!" ! ! ! ! !"

! !" Marginal revenue and elasticity

!" !! ! !! ! ! ! !! ! ! !! ! ! !

! !

! ! ! ! ! !! !

! !! ! !!

!"#$ ! !!""#$!%&()*#$ !!" = !!! ! !! !

! !! !

! ! ! ! 1 !!! !

!! !!!! !

!

!" = ! ! ! ! !! !

! !!! !

! !! !

! !! ! !!

!! !

!"#$%&(")*+,&! ! !"

!!

!

!

A monopolist will therefore never produce on the inelastic portion of its demand curve. Deadweight loss arises due to P>MC markup. The monopolist has to cannibalize revenues on infra-marginal units in order to sell more Demand (average revenue) and marginal revenue

Let !" ! ! ! !"

!" ! ! !" ! !!" ! ! ! !

!" !!"#

!"! ! ! ! !"

Marginal revenue curve has twice the slope as that of the average revenue curve Mitigating monopolists social loss

Solution Pros Cons Perfect price discrimination

Allocatively efficient output produced

Distributional issue (tax monopolist) Perfect knowledge needed

Regulation (e.g. dictates P=LAC)

Allocatively efficient output produced

Monopolist incentive to exaggerate LAC

Free entry (flat LAC)

Allocatively efficient output produced by allowing free entry

Bureaucracy and administrative costs? Upfront costs of innovation?

Subsidy or nationalization (natural monopoly)

Allocatively efficient output produced

Monopolist incentive to exaggerate costs No incentive to be efficient

Price discrimination: Perfect price discrimination (level one), price hurdle/tiered/block pricing (level two), sales to different markets (level three) Factor markets Demand for labor

! ! ! !" ! ! !!" ! ! !

!"! ! !"# !

!"# ! ! !! !

! !!! !"

! !! !

! !"

! !!

!"#

!"! ! !" ! !! !!"

Real wage, !" ! !

!

!

Externalities, public goods and welfare

Excludable Non-excludable Rival Private good Common resource

Non-rival Natural monopoly Public good Demand for public goods: Vertical summation of individual demand curves

!4

!" ! !!! ! ! ! ! ! !

!" ! !!! ! ! ! ! ! ! ! ! ! Taxation

!"#$%"&()*+,-- ! !"# !!

!! ! ! ! ! ! ! ! ! !

(Taxing externalities: Pollution permits) Auction Assume X1

!5

EC102: MACROECONOMICS HIGHLIGHTS Measures Indices

!"#$%&()*+ ! ! ! !! ! !

!

!

!"#$%&()*+ ! ! ! !

! ! !!

!

!""#$%&()*$&*+,&-./0!,&12"34) !! !

! ! !!

!

! !! ! !

!!

!"#$%&%#($)*%()+,%-.(/01!! !

! ! !!

!

! !! ! !

!!

Differences in calculated inflation arise from the use of different quantity weights (F in Paasche and B in Laspeyres, leading to understating and overstating inflation respectively)

! !! ! !

!!

! !! ! !

!!

!! !

! ! !!

!

! !! ! !

!!

! !! ! !

!!

! !! ! !

!!

!! !

! ! !!

!

! !! ! !

!!

! !! ! !

!!

! !! ! !

!!

! !

! ! !!

!

! !! ! !

!!

! ! ! ! ! ! ! ! ! ! ! ! !! !! !

General equilibrium: Level and distribution of national income

!"#$%&(#)*+%)&(#)! ! ! !" ! ! ! ! ! ! ! ! ! ! !

!"#$%"! !" ! !!

!!

! !" ! ! !

!"! ! ! ! !

!

!

!

!"#$%&"(! !" ! !!

!!

! !" ! ! !

!"! !"

!

!

! ! !

Increasing capital-labor ratio increases real wage and decreases real rent General equilibrium

! ! ! ! !"# ! ! !!"#$%&()%$#*+)

!! ! !

!"#$%&()*%+,(! ! ! ! !

!"#$%&$"&

! ! ! ! ! !

Money, banking and financial intermediation Functions of money: (1) Intertemporal store of value, (2) Unit of account, (3) Medium of exchange

!"#$% ! !"##$%&()%(&)#&"*+,)-%! !"#$%&&"()*+,* Modern reserve banking

!"#$%&"()*&+,--%* !!"#$#%&()*+,#$

!!

First banks balance sheet Assets Liabilities

Reserves !""" !! Deposits !""" Loans !""" ! ! ! !! !

!

Banking systems balance sheet Assets Liabilities

Reserves !""" Deposits !"""!!

Loans !""" ! ! ! !! !

!!

!

Personal balance sheet (before)

Assets Liabilities Cash !""" Debt ! Wealth !"""

!

Personal balance sheet (after) Assets Liabilities

Deposits !"""!!

Debt !""" ! ! ! !! !!!

Wealth !""" No wealth is created through money multiplier Money multiplier model !"#$%&())*%&+!,-.(//$#0%&+.,12$34#5&5$)"67&+2, !!

!"#$%&()*&+$) ! ! !! ! !"#"$%"#&!( !!

!

!!

! ! !

! ! !!

!! !

!!

!! !

!!

!!" ! !

!" ! !!! ! !

! ! ! ! !

(Investment projects)

!"#$%$#&()$"%*+,-*",)#*.$+$/"! ! ! ! ! !

!"#$#"%(#)(&*+,%#",(-&%.(/+0&,!!! !""#$ ! ! ! !

! !""#$ ! ! !"#$%

!"#$%&()*+#,*(#!!!!"#$"%$&()*+",*!! !""#$ ! ! ! !

! !""#$ ! ! !"#$%

(1) Determine who invests

!"#$

!"#$%&!!! ! ! ! !

!"#$%&()!!! ! ! ! !

!"#$%

!"#$%&!!! ! ! ! ! !

!"#$%&()!!! ! !!!

! ! ! !!

!

6

(2) Determine net return to lender

!"#$

!"#$%&!!! ! ! ! ! ! !

!"#$%&()!!! ! ! ! ! ! !

!"#$%

!"#$%&!!! ! ! ! ! ! !

!"#$%&()!!!

!! ! ! ! ! !

!

!! ! !

Inflation

!"#$%&%(%)*+,(+-(.+$*/(!" ! !"#

!" ! !"#$%&()*+ ! !"#$%&%(%&! !!"#$%&(

! !

!!

! !

!!

! !

!!

! !

!

!"#$$%&()*+,-.! !

!!

! !

!! ! !

! !

!!

! !

!

!"#$%&%()*+",-! ! ! ! ! ! ! !! ! ! ! ! ! ! ! ! ! !

!

!

!

!

! ! !! ! ! ! ! ! ! ! ! ! !!

!!

!"#$%&($")*! !! !

!!

! ! ! !! ! !

!

!"#$%&! ! ! ! !!

! !! !

!!

! !

!!

!

!

The open economy Open macroeconomy

! ! ! ! !"# ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

!"#$%&()*! !"#$%(! !"#$%&()*+! !"#$%&()*

! ! ! ! ! !"#$%& ! ! !"#$%& ! ! ! !"# !!"#$"%()"*+)(

! ! ! ! !"##$%&())*"%&! !"# ! !"# ! ! ! !"# ! ! Trade surpluses and deficits might not necessarily be good; may be the result of decrease in I or lack of savings which might impair I in the long run Model of the small open economy

!"#$%! !!"#$%&("! ! ! !"#$%& ! ! !"#$%&

! ! ! ! When thinking about change in r in the small open economy, level of I does not change (ie. shortfall from new I is made up with external borrowing/lending). However r is now higher/lower than before When thinking about change in r*, level of I does change (ie. difference between new and old I is

made up with external borrowing lending). r* is now higher/lower than before

!"#$%"&(#)*"%+#,"%-./"$0%!" ! ! ! ! ! ! ! Read the real exchange rate-NX model as it is

! !!"#$%& ! !"#$%&()!

!"#$%&()!

! ! !

! !

!! !

!!

! !

!!

! ! !

! !!

! !

!!

! !

!! ! ! ! !

e should be expressed in foreign currency/unit of local currency (e.g. pesos/pound). e reflects both trade and relative prices. Real exchange rates adjust to clear the demand for domestic currency in the XM sector and supply of domestic currency in SI sector Law of one price, purchasing power parity

! !! !

!

! !

!! ! ! !!"#$%&"%#!%"%(#!!

Use of price indices (e.g. Big Mac index)

! !"#$% !! !

!

! !"#$% ! ! !"#$%& ! !"##$%&()*("%+$#,-."$+

! !"#$% ! ! !"#$%& ! !"##$%&()*(+,$#,-."$/

Unemployment

!"#$%&("$"#! !" ! !" ! ! !!

! ! !

Types of unemployment

Frictional Structural

Causes

Takes time to collect information and find a job that matches abilities. Quality of match deteriorates over time due to changing needs

Real wage rigidity and mismatch between demand and supply for workers Fewer jobs than workers: Minimum wage or unemployment insurance, unions, firms with efficiency wages

Solution

Unemployment insurance and government job centres

!7

(Steady state unemployment and job centres)

! ! !

! !!" !! !!! ! !

! !!" !! ! ! ! ! ! !

! ! !! !!" !! !!! ! !

! !!" !! ! ! ! ! ! !

! ! ! ! ! ! ! ! ! ! !

! !!" !! ! ! ! ! ! ! ! ! ! ! ! ! ! !

! !!" !! ! ! ! ! ! ! ! ! ! ! ! ! ! !

! ! ! ! ! ! ! ! ! ! !! !!" !! ! ! ! ! ! ! ! ! ! ! ! !

! !!" !! ! ! ! ! ! ! ! ! ! ! ! ! ! !

!"#$"%&(#$"&"%! ! !!" !! ! ! !!" !!

! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

(Efficiency wages and quality of labor)

!"#$%&%()$%*+,%-.! ! ! ! ! ! ! !!!"#$# !! ! !! !! !

! ! ! ! ! !

! !! ! ! ! !""#$

!!!" !

! !"#$% ! ! !

!

! ! ! ! ! !

!"#$%&(&)*+,(-). !!! ! ! ! ! ! ! ! ! ! ! !

! ! ! ! ! !

! !! ! ! ! ! !

! !"#"$ !!"#$ ! ! ! ! !

!"#$%&($#") !! !

!! ! ! !"#$"%$&"(

Skill-based technical change: New capital goods are substitutes for unskilled workers, enhancing the productivity of skilled workers

! ! !" ! ! ! ! !"#$%&&( ! ! !"#$$%&! Economic growth Solow growth model

! ! ! ! ! ! ! ! ! ! ! ! !

! ! ! ! ! ! ! ! ! !

! ! !" ! ! ! !

!"#$%&(#)*+%)&(#)!!

!! !"

!

!!!

!! !"

!

!! !

! ! !" ! ! ! ! !

!"#$%()*+,%*-!!! ! ! ! ! !"

!"#$ ! ! !! !

!!

!"

!! ! ! ! ! !! !

!"#$%()*+#"!!! !

!! !

!"#$%()*+", !! !

!!

! !

!!

!

!

! ! !"

!! ! ! !

!

!

!!"

!! ! ! ! ! ! !!!"#$%%(&)*%&+!!"#$"#%(!

!"#$%&()*+(,!!"

!! ! ! !

!"#$%&""()*+*#",*- !! ! ! !!

!! ! ! !

Steady state: The level of Y/L and K/L to which the economy gravitates assuming no exogenous change

!! !!"

!! ! ! !

!

!! ! ! !

Increase in s Increase in A

Growth Short term only as s

!9

Output returns to natural level in the long run. Firms with sticky prices will adjust prices upwards or downwards in the long run. Firms with flexible prices respond to this change by increasing price and reducing output to reduce losses or decreasing price and increasing output back to natural levels to avoid losing market share to sticky-price firms that have already lowered prices Sticky wage model

! ! ! !!

!! ! !"# !

!

!! !

! ! !

!!

!! ! ! ! ! ! !

!!" !!! ! ! ! ! ! ! ! ! !

Lucas imperfect information model (Short run: Deviation from natural level of output) Output deviates from the natural level, as real money balances do not adjust enough when GPL deviates from the expected price level. Producers, on aggregate, mistake general price changes for relative changes, investing too much/too little effort in producing more/less than the natural level (Long run: Return to natural level of output) Output returns to natural level in the long run. Firms realize that price changes brought about by changes in the aggregate price level have no real effects. They readjust their production efforts and restore output back to their original levels Classical dichotomy Any short run changes in output resulting from a change in AD will be nullified by a shift of the AS in the opposite direction price expectations readjust to match actual price levels (short run price non-neutrality), but output returns to full employment levels Explaining (positive) demand shocks (1) AD shift increase in desired expenditure: Increase in desired Y (Rightward shift not as large due to increased interest rates as people sell bonds to hold more cash) (2) Movement along SRAS clearing the output market: Increase in Yd -> Excess demand -> Increase in P -> Lucas model/sticky prices -> Increase in output (3) Movement along AD clearing the money market: Increase in P -> M/P decrease -> People want to hold more money -> Sell bonds, decrease market demand for bonds -> i increase -> r increase -> I(r) decreases -> Y decrease

(4) SRAS shift change in expectations: In the LR, producers adjust their expectations upwards -> PE2=P2 -> Production is reduced for all P -> Yd returns to Y full employment (5) Movement along AD clearing the money market: In the LR, increase in P -> M/P decrease -> People want to hold more money -> Sell bonds, decrease market demand for bonds -> i increase -> r increase -> I(r) decreases -> Y decrease

Phillips curve

!" ! ! ! ! ! !!

!! ! !

!"# ! !!"#$%!! ! ! ! ! ! ! ! ! ! ! ! !

!"#$$#%&()*+,!!! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

The intellectual and practical evolution of stabilization policy Central bank loss function

!"##$%&()*"!!! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

!"#$$#%&()*+,! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

!"# ! ! !!"#$! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

!"#"$"%&()**+!" ! ! !

!"! ! ! ! ! !" ! !

! !"# !!"## ! ! ! !

! !!

! !! ! ! ! ! ! ! ! ! !

People will expect the central bank to set =a/2r to minimize its loss function. They will set their expectations accordingly, resulting in unemployment to be at its natural rate. Result: u=natural, =a/2r Optimal rules yield a more favorable outcome than optimal discretion: If people are confident that the central bank can keep to its announcement of =0,

!10

unemployment can still be set at its natural rate. Result: u=natural, =0 However, people will not expect