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					Intermediate Microeconomics


 Week 1    Introduction
           Varian, 1
                                    Budget Constraints
                                    Varian, 2
                                                            Preferences
                                                            Varian, 3
                                                                                   Utility
                                                                                   Varian, 4

 Week 2    Optimal Choice
           Varian, 5
                                    Consumer Demand
                                    Varian, 6
                                                            S. & I. Effects
                                                            Varian, 8
                                                                                   Problem Set 1

 Week 3        Exam 1               Buying & Selling
                                    Varian, 9
                                                            Intertemporal Choice
                                                            Varian, 10
                                                                                    Game Theory
                                                                                    Varian, 28

 Week 4    Intertemporal Choice
           Varian, 10
                                    Present Value
                                    Varian, 10
                                                            Choice Anomalies
                                                            Thaler, 2 & 3
                                                                                   Problem Set 2

 Week 5        Exam 2               Asset Markets
                                    Varian, 11
                                                            Uncertainty (Risk)
                                                            Varian, 12
                                                                                    Risky Assets
                                                                                    Varian, 13

 Week 6
           Risky Assets
           Varian, 13
                                    Diversification
                                    Varian, 13
                                                            Choice Anomalies II
                                                            Thaler, 6 -- 9
                                                                                   Problem Set 3

 Week 7        Exam 3               Financial markets
                                    Thaler, 10 – 13
                                                            Consumer Surplus
                                                            Varian, 14
                                                                                    Surplus, Demand
                                                                                    Varian, 14 & 15

 Week 8
           Demand, Equilibrium         Equilibrium         Auctions                Problem Set 4
           Varian, 15 & 16             Varian, 16          Varian, 17; Thaler, 5

 Week 9        Exam 4                  Exchange
                                       Varian, 31
                                                             Exchange
                                                             Varian, 31
                                                                                       Welfare
                                                                                       Varian, 33

 Week 10
               Externalities
               Varian, 34
                                  Asymmetric Information
                                  Varian, 37
                                                           Problem Set 5              Exam 5
General Equilibrium Economics and Welfare

  “Classical liberalism” and the free market argument:
  • The central focus of economics is allocation of scarce resources.
  • There are many ways to allocate resources, one of which is free
    (or unmanaged) markets.
  • In free markets, prices act as signals to participants in the
    marketplace.
  • The forces of demand and supply, which summarize the actions
    of market participants, determine prices.
  • The allocation of scarce resources determined by markets is
    superior to other allocations achieved under alternative methods.
Pure Exchange
                                         x1
                                          B
                                                               B




                                                           4
                                                          UA

                                                  3
                                                 UA
   Good 2




                                                          1
                                                         UB
                                             W
        x   2
            A           U   1
                            A            ·       U   2
                                                     A
                                                                2
                                                               xB

                                    3      2
                    4              UB     UB
                U   B



            A
                                Good 1   x1
                                          A
Pure Exchange
                                         x1
                                          B
                                                                B




                                                            4
                                                           UA

                                                   3
                                                  UA
   Good 2




                                                           1
                                                          UB
                                              W
        x   2
            A           U   1
                            A            ·        U   2
                                                      A
                                                                 2
                                                                xB

                                    3      2
                    4              UB     UB
                U   B



            A
                                Good 1
                                         x1
                                          A
Pure Exchange
                                                       x1
                                                        B
                                                                              B




                                                                          4
                                                                         UA

                                                                 3
                                                                UA
   Good 2




                                                                         1
                                                                        UB
                                                            W
        x   2
            A           U   1
                            A                          ·        U   2
                                                                    A
                                                                               2
                                                                              xB

                                    3                    2
                    4              UB                   UB
                U   B
                                             P1
                                                 P2
            A
                                Good 1
                                                       x1
                                                        A
Pure Exchange
                                         x1
                                          B
                                                                        B




                                                                    4
                                                                   UA

                                                   3
                                                  UA
   Good 2




                                                               1
                                                              UB
                                              W
        x   2
            A           U   1
                            A            ·        U   2
                                                      A
                                                                         2
                                                                        xB

                                                              P1
                    4
                                    3
                                   UB      2
                                          UB                      P2
                U   B



            A
                                Good 1
                                         x1
                                          A
Pure Exchange
                                         x1
                                          B
                                                                      B




                                                                  4
                                                                 UA
                                  X

                                  ·                         3
                                                           UA
   Good 2




                                                                 1
                                                                UB
                                              W
        x   2
            A           U   1
                            A            ·             U    2
                                                            A
                                                                       2
                                                                      xB

                                    3      2
                    4              UB     UB
                U   B
                                                      P1
                                                          P2
            A
                                Good 1
                                         x1
                                          A
A Pure Exchange Economy

          x1              1
                           B                               B
     x2

                           
     A
      2
                          ·                                B
                                                            2




                                   x
                               ·
                                                 U1
                                                  A
                                                  0
                                                 UA
                                       U1
                                        B
                                             0
                                            UB



                                                           x2
      A
                          1
                           A                          x1
The Algebra of Equilibrium
   Assumptions:
      Pure exchange economy
      Two goods: x1 and x 2
      Two agents, A and B, with …
            Identical preferences:
                        U A x1 , x2   x1 x1 
                                          
                                             2 
                                           1  
                                                   0    1
                        U B x1 , x2   x1 x2  
            Arbitrarily determined, but different, endowments:
                         A ,  B 
                                         
                       A  1 ,  A   B  1 ,  B
                             A
                                   2
                                              B
                                                    2
                                                                  
                                                                B    
   Equilibrium is defined as a consumption bundle x  x1 , x A ; x1 , x B
                                                       A
                                                             2          2
                                                                                 
   Where aggregate excess demands are zero in both markets:
                       z1  p1 , p2   0  Hence, we are seeking a set
                                           of prices,  p1 , p2  , that
                       z 2  p1 , p2   0 satisfies these equilibrium conditions.
Pure Exchange

              x1   1  6
                    B                      B
        x2

                      
   21   A
          2
                      ·                    B  6
                                            2




                                  0
                                 UA
                             0
                            UB



                                           x2
        A
                   1  3
                    A                 x1
Pure Exchange and Equilibrium

              x1        1  6
                         B        x1  4
                                   B                                  B
        x2

                           
   21   A
          2
                           ·                                          B  6
                                                                       2




   15  x A                            x
          2
                                   ·                                  xB  12
                                                                       2




                                             U1
                                              A

                                                    0
                                                   UA
                                            1  0
                                           UB UB
                                                       P1
                                                           P2
                                                                      x2
        A
                        1  3
                         A       x1  5
                                  A                              x1
Pure Exchange and Redistribution
                                      
                      1  7
                       B            x1  4.5
                                     B
                x1         1  6
                             B              x1  4
                                             B                          B
          x2

                           ’ 
    21   A
           2
                        · ·                                             B  6
                                                                         2




    15  x A                                       x
           2

           2                           x’     ·                        xB  12
                                                                         2

                                                                         2
  13.5  x A
                                       ·                                xB  13.5


                                                             U1
                                                              A

                                                               0
                                                              UA
                                                    1
                                                   UB
                                                         0
                                                        UB
                                                                        x2
          A
                           1  3
                            A                x1  5
                                              A                    x1
                      1              
                     A  2         x1  4.5
                                     A
General Equilibrium and Welfare Economics
 “In the general case … the demand function are functions of m - 1 variables
  which are too numerous to be represented in space. It seems, therefore, that the
  problem when generalized can only be formulated and solved algebraically …”
                                  Leon Walras, Elements of Pure Economics (1874)

 “Political Economy does not have to take morality into account. But one who
  extols some practical measure ought to take into account not only the economic
  consequences, but also the moral, religious, political, etc., consequences”
                               Vilfredo Pareto, Manual of Political Economy (1906)




             Leon Walras         Vilfredo Pareto     Francis Edgeworth
             1834 – 1910         1843 -- 1923        1845 -- 1926
General Equilibrium and Welfare Economics
 “How do we evaluate alternative social organizations?    There are many
  possible arrangements for meeting the needs of society and they satisfy
  many different needs … we use the notion of efficiency or optimality
  that is associated with the name of Vilfredo Pareto … Now, within this
  context, and under certain very special assumptions … efficiency can be
  achieved through a particular kind of social system, the price system.”
                               Kenneth Arrow, The Limits of Organization (1974)




   Arthur Pigou     Paul Samuelson     Kenneth Arrow        Gerard Debreu
   1877 -- 1959     1915 –             1921 –               1921 –
First and Second Theorems of Welfare Economics

  1. All market equilibria are Pareto efficient.
     “With such a definition it is almost self-evident that this so-called
      maximum [Pareto-optimality] obtains under free competition …
      But this is not to say that the result of production and exchange
      will be satisfactory form a social point of view or will, even
      approximately, produce the greatest possible social advantage.”
                          Knut Wicksell, “On the Problem of Distribution” (1902)

  2. Every Pareto efficient allocation can be achieved
     as a competitive equilibrium (given an appropriate
     initial endowment and convexity of preferences).
     “[Pareto optimality] does not define, uniquely, a best situation in
       any sense of the word … Other criteria – roughly speaking,
       those we associate with the term „distributive justice‟ – have to
       be called into play.”
                               Kenneth Arrow, The Limits of Organization (1974)
Externalities



    Positive vs. negative externalities

    Consumption vs. production externalities

       • Assignment of property rights   • Command & control approaches
       • The Coase Theorem               • Internalization of external costs
                                         • The “missing market” interpretation



    The “tragedy of the commons”

    Adverse selection as a result of externalities
Pure Exchange and Consumption Externalities
                                                 B
                                ·
                                              X’
                                              ·
    Good 2




                 X
                 ·

             A                ·
                              
                              Good 1
Pure Exchange and Consumption Externalities


                                                 B
                                ·


                 X                            X’
                 ·                            ·
    Good 2




             A                ·
                              
                              Good 1
Traditional (“Pigovian”) Analysis of a Negative Externality


         P
                                    S = MC = MPC + MSC



                                       MPC (Marginal Private Cost)
     P**
     P*

                                       D = MPB (Marginal Private Benefit)
                                       MSC (Marginal Social Cost)


                                                   Q
  Optimal Output                  Optimal Output
 -- Society’s View              -- Supplier’s View
Externalities – Internalizing the social costs…
Effects of a tax on suppliers (The so-called “Pigovian” solution)




         P       The Market                    P          The Firm MC
                                                                    1
                                S1                                  MC0
                                     S0                               ATC 1
                                                                      ATC 0
    P1                                                                  MR1
    P0                                                                  MR0

                               D
                                       Q                                q
                     Q1 Q0                                    q*
Establishment of a Pollution Rights Market
  Suppose that two utilities each release 10 tons of sulfur dioxide
  into the atmosphere, and that the government wants to reduce the
  total amount of sulfur dioxide emissions to 16 tons. Further,
  assume that it costs utilities different amounts to reduce their
  emissions:

                        Total Cost to reduce emissions to …
                Utility  9 Tons        8 Tons       7 Tons
                  A     $50,000      $125,000      $225,000
                  B     $100,000     $250,000      $450,000

  How much will the reduction to 16 tons cost if the government
  simply limits each utility to 8 tons of sulfur dioxide emissions?

  If the government issues each utility the “right” to release 8 tons
  of sulfur dioxide, and further allows the utilities to sell these rights,
  what will happen and how much will reduction to 16 tons cost?
Markets with asymmetric information
                            Varian’s “market for plums and lemons”
                       P
                                                                                   S plums : P  44Q p
                                                                                                     s




                   
           2200  Pplums

                 ˆ
           1925 Pplums


                                                                                 D plums : P  4400  44Q p
                                                                                                          d


                                                                                 Slemons : P  1100  44Qls
                  ˆ
           1375  Plemons


                    
                                                                                 Duncertain quality
           1100  Plemons
                                                                                                          
                                                                                     pr plums* D plums   prlemons* Dlemons 


                                                                                 Dlemons : P  3300  44Qld

                                    ˆ
                                    Q plums         Q
                                                     plums
                                                                    ˆ
                                                                    Qlemons
                                                                                                      Q
                                       ||              ||              ||
                                     43.75                          56.25
                                                    Qlemons
                                                       ||
                                                      50

Adapted from Varian, Intermediate Microeconomics, 7th ed., 695 – 696. His example is itself an adaptation from a famous paper by George
Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84 (1970): 485 – 500.
Markets with asymmetric information
 General categories of problems of asymmetric information:
    Adverse Selection: A situation in which individuals possess hidden information,
     leading to a market selection process that results in a pool of individuals with
     economically undesirable characteristics.
    Moral Hazard: A situation in which one party to a contact takes a hidden action that
     creates benefits at the expense of another party to the contract.
 Social institutions that help solve these market inefficiencies:
       Private agent responses to problems of asymmetric information:
          Signaling – the party possessing private information takes action to generate a
           credible signal.
          Screening – the party with imperfect information takes action to induce a
           advantageous sorting of the market.
       Public / Private sector responses to problems of asymmetric information:
          Compulsory purchase plans (insurance markets)
          Licensing and certification (note that this may also be done by private agents).
          Market regulation, including “truth” laws and “insider trading” laws.
Markets with asymmetric information: warranties as signals
  Two used car dealerships compete side by side on a main road. The first, Harry‟s Cars, sells high-quality cars
  that it carefully inspects and, if necessary, services before putting them up for sale. On average, it costs Harry‟s
  $8,000 to buy and service each car it sells. The second dealership, Lou‟s Motors, sells lower-quality cars. On
  average, it costs Lou‟s $5,000 to acquire and resell each car on its lot. Generally, as far as appearance is
  concerned, the vehicles at Harry‟s are indistinguishable from the cars at Lou‟s.

  If consumers knew the quality of the used cars they were buying, they would gladly pay $10,000 on average for
  high-quality cars, but be willing to pay only $7,000 for a low-quality car. The dealerships, however, are too new
  to have established reputations, so consumers do not know the quality of each dealership‟s cars. Consumers
  shopping at these dealerships figure that they have a 50-50 chance of ending up with a high-quality car, no
  matter which dealership they go to, and hence are willing to pay, on average, $8,500 for a car.

  Harry has an idea -- offer a warranty on all the cars he sells. He knows that a warranty lasting Y years will cost,
  on average, $500Y . He also knows that if Lou tries to offer the same warranty, it will cost Lou an average of
  $1000Y (why?). If Harry offers a one-year warranty, will this generate a credible signal of quality?


                                                                    Lou
                                                       Offer                  Don‟t Offer

                            Offer
          Harry
                         Don‟t Offer
Markets with asymmetric information: job market signals


      w, wage

                                                          clow   quality   e

                                                                                 chigh         e
                                                                                         quality

         wh                                                                                be




         wl



                                                                                                   e, amount of education
                                                            e*




Adapted from Varian, Intermediate Microeconomics, 7th ed., 703 -- 705. His treatment is itself adapted from Michael Spense, “Job Market
Signaling.” Quarterly Journal of Economics 87 (1973): 355 – 374, and Market Signaling (1974).

				
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