Microeconomics Semester 1 - Week 1-5 Flashcards
(118 cards)
1
Q
What is a production function?
A
A production function shows how a input (factor of production) translates into a certain amount of an output, while holding other factors constant.
It describes how differing technologies are able capable of producing the same thing.
2
Q
What is marginal product?
A
This is the change in output per unit change in input, and is represented graphically by the gradient of the tangent at a specific point.
3
Q
What is the average product?
A
This is the average output per unit of input.
4
Q
What is diminishing marginal product?
A
This is when the marginal product begins to fall as the inputs increase, when this occurs, the production function curve will get flatter (e.g concave).
If the marginal product is smaller the average product, then the average product will decrease.
5
Q
What is an indifference curve?
A
An indifference curve is a curve that shows all the different combinations of goods (bundles) that give the same utility.
The further an indifference curve is from the origin, the higher the level of utility experienced.
6
Q
What are the 4 properties of preferences?
A
1)Completeness
2)Consistency
3)Non-station
4)Diminishing marginal rate of substitution
7
Q
How is completeness a property of preferences?
A
Consumers will rank different bundles of goods based of the satisfaction and utility which they provide. Either bundle A>B, B<A, or A~B. The further away a bundle is from the origin, the more complete it is assumed to be.
8
Q
How is consistency a property of preferences?
A
As indifference curves will never cross each other, then this means bundles will be consistent, at no point will one bundle which was better than another become a worse bundle, no matter the combination of goods used.
9
Q
How is non-satiation a property of preferences?
A
A consumer is always assumed to prefer more goods to less goods. Having too much of one good will never reduce utility, since the excess goods can simply just be discarded.
10
Q
How is the diminishing marginal rate of substitution a property of preferences?
A
As we learn that the utility on an indifference curve is constant, then diminishing quantities of one good must be sacrificed in order to increase the quantity of the other good, while keeping utility constant.
11
Q
What is the marginal rate of substitution?
A
This is the quantity of a good Y (vertical axis) that an individual must sacrifice in order to increase the quantity of good X (horizontal axis) by one unit without changing total utility.
12
Q
What happens to the MRS (marginal rate of substitution) on an indifference curve when you move further towards a heavy ratio of one of the two goods (towards the right)?
A
The marginal rate of substitution will decrease (and the curve will become flatter), because you already have more of good X, and as a result will be less willing to give up some of good Y to gain even more good X.
13
Q
What is a preference?
A
A preference is a description of the benefit or cost we associate with each possible outcome.
14
Q
How is the marginal rate of substitution calculated?
A
To calculate the MRS, you have to see how far down the y axis (dy) you have to go, and divide this by 1 (ie gaining one whole unit of what ever good is in the x-axis.
MRS is also given in modulus for |dy/dx|, so the value of MRS will always be positive.
15
Q
How are preferences presented mathematically?
A
A utility function, for example if ‘y’ was free time, and ‘t’ was final grade, the equation would be U(y,t) = c. C has to be a constant, since one of the properties on an indifference curve is consistency, and this means the total utility must remain constant.
16
Q
How can the marginal rate of substitution be calculated?
A
The marginal rate of substitution is the slope of the indifference curve, and can be calculated using implicit differentiation. For the full understanding of this, see example on OneNote (lesson 1 micro).
17
Q
What does it mean when you find the partial derivative?
A
When we use the partial derivative, we are working out the change in utility when one variable of the production function changes, while the other variable of the production function remains constant.
18
Q
What is an opportunity cost?
A
An opportunity cost is the net benefit of the next best alternative action.
19
Q
What is the economic cost?
A
The economic cost is monetary (physical out of pocket costs) + opportunity cost.
20
Q
What is economic rent?
A
If the benefit of the action you take exceeds the economic cost of it, you are said to receive an economic rent from choosing it.
21
Q
What does a feasible frontier show?
A
A feasible frontier shows the maximum output that can be achieved in a given amount of input.
22
Q
What is the marginal rate of transformation?
A
The marginal rate of transformation (MRT) is the slope of the feasible frontier and represents the trade offs an individual faces. Essentially, the MRT measures the trade-off experienced between two goods.
23
Q
How is the MRT calculated?
A
The MRT is calculated by using the production function, and differentiate the function using the chain rule.
24
Q
What is the difference between the marginal rate of substitution and the marginal rate of transformation?
A
The MRS is the amount of one good that an individual is willing to trade for a unit of another, where as the MRT is amount of one good the individual will actually lose to gain a unit of another.
25
When is the point of optimal utility reached?
This occurs when the MRS = MRT, this is because at this point the feasible frontier will be at maximum utility, and you will also be producing on the indifference curve with the greatest possible utility, so you have reached the point where the two are maximised.
26
What preference will an individual make if the MRS and the MRT do not match at the point where the feasible frontier and indifference curve meet?
The individual will go for the option with the lowest opportunity cost. If for example, the MRS is greater than the MRT, so the individual is more willing to lose marks for an hour of free time, compared to study an hour and gain less marks than the student values the free time for, there is an opportunity cost in not taking the hour of free time, so the student will make this choice.
27
Do indifference curves have to be downwards sloping?
-No, if you have a ‘bad good’ on the y-axis, and a likeable good on the x-axis, then the graph will probably be a upwards sloping linear equation.
-If two goods are perfect substitutes, then the equation will be a linear downwards sloping lime.
-There is will be a right angled kink in the curve if two goods are perfect compliments
-If you have no preference of the good on the y-axis, the indifference curve will also go vertically upwards.
28
What is the feasible set?
This is all the combinations of the things under consideration that a decision-maker could choose given the economic, physical or other constraints they face. This will be represented by the area below and on the feasible frontier.
29
How can a technological improvement change the production function?
An improvement in technology will mean that more of a good can be produced in a given amount of time, and therefore production function will shift. The technologies improvement will cause the rate of diminishing productivity of labour to decrease, so a greater output will be achieved as hours worked rise.
As a result, this will also expand the feasible set.
30
What is a budget constraint?
A budget constraint is the equation that represents all the combinations of goods and services that one could acquire that exactly exhaust one’s budgetary resources.
31
What is the income effect?
This is the effect that the additional income would have if there was no change in the price or opportunity cost. For many people, this will cause you to take more free time since the increase in wage means you now can work less hours to receive the same, or higher, wage.
32
What is the substitution effect?
The substitution effect is the effect that is only due to changes that occur to the price or the opportunity cost, given the new level of utility.
If your wage increases, the budget constraint will become steeper, and as a result the opportunity cost of free time will now be higher (the MRT has increased). As a result, you will take less free time since the MRT = MRS at a point on the new budget constraint which is closer to the axis.
33
What is the two effects of a wage increase?
It will have two affects on the choice of free time:
-The income effect, which would be the effect if there was no change in the opportunity cost.
-The substitution effect, which is the effect which will occur because MRT rises and the opportunity cost of free time grows.
The overall impact will depend on the size of the income and substitution effect, which is dependent on the individual’s preferences.
34
What is money?
-Money is a medium of exchange which is used to purchase goods/services.
-This allows purchasing power to be transferred among people, and will only work when everyone trusts that others will accept your money as payment, this is different from a barter economy, where a direct swap of two goods would happen.
35
What is wealth?
Wealth is a stock things owned or value of that stock.
It includes buildings, land, machinery and capital goods, as well as debts owned to you, minus debts you owe to others.
You can think of wealth as the largest amount which you could consume without borrowing.
Wealth can also provide income, from the profits and interest or dividends from assets owned.
36
What is income?
Income is an amount of money one receives over some period of time ( a flow).
This could be from market earnings, investment, or social benefits from the government. **In this unit we will always consider income as disposable income, income after tax**
37
What is disposable income?
Disposable income (also just called income in this module) is the maximum amount of income that one could consume while leaving wealth unchanged.
38
What does borrowing and lending allow?
Borrowing and lending allows for us to rearrange our capacity to buy goods and services overtime.
However, if we borrow during period 1 (present), we will have to pay interest on what we borrowed, and as a result there will be an opportunity cost of being able to spend less during period 2 (the future).
This can be represented on a feasible frontier, since the trade off between current and future consumption will have a MRT.
39
What does how much consumption an individual will bring forward depend on?
-Consumption smoothing: we assume that an individual will want to consume partially in both time periods, rather than consume all in just one of the two.
-Pure Impatience
40
What two reasons for pure impatience?
-Myopia (short sightedness): people get more satisfaction from present consumption rather than the same amount of future consumption,
-Prudence: People know they might not be around in the future, and therefore want to consume now.
41
How does the gradient of the indifference curve impact the ratio of present:future spending?
The steeper the indifference curve, the more impatient you will be and therefore the more willing you will be to consume now, rather than save for the future.
42
What are the diminishing marginal returns of consumption?
This is the idea that the value of additional consumption will decline, the more current consumption an individual already has.
43
What is the discount rate?
The discount rate is the MRS, and it measure the persons impatience. This is calculated by doing the MRS - 1, so a slope of the indifference curve of |-1.5| implies a discount rate of 50%. So they would be willing to lose 1.5 units of future consumption for 1 unit of current consumption.
44
What is the optimal decision making point for the choice between current and future spending?
MRS = MRT, discount rate = interest rate.
1 + p (discount rate) = 1 + r (interest rate)
p = r
45
What is a collateral?
An asset that a borrower pledges to a lender as a security of a loan. If the borrower is not able to make the loan payment as promised, then the lender becomes the owner of the asset.
46
What is human capital?
Human capital is the stock of knowledge, skills, behavioural attributes, and personal characteristics that determine an individual’s labour productivity.
The term wealth will sometimes be used in a broader sense to include this immaterial wealth, however in this section we will only refer to wealth as material wealth.
47
What is pure impatience?
This is a characteristic of someone who values consumption now over consumption later, when the value of consumption remains constant.
It will occur when a person is impatient to to console,e more now because they place less value on future consumption due to myopia, weakness of will, or other reasons.
48
What two factors does the discount rate depend on?
The discount rate depends on:
-The individuals desire to smooth consumption (which is affected by the situation the individual is in)
-The individuals pure impatience as a person, since the discount rate will depend on the individual’s own psychology.
49
What is a reservation indifference curve?
A reservation indifference curve is an indifference curve which indicates allocations (combinations) of goods that are as highly valued as one’s reservation options.
For someone who has a guaranteed future income, but no current income, this likely be a very steep line, since they are desperate to smooth their consumption and have some consumption during period 1.
For someone with period 1 income, the curve will likely be flatter, since they value future consumption more, and would therefore be happy to give up more current income since they value the future income more.
50
How can investing income from period 1 expand a feasible frontier?
If you don’t want to spend period 1 income right away, inflation as well as deterioration of the good the wealth is stored in could cause the maximum period 2 income to fall.
However, by finding a trustworthy borrower, you could lend them your money, which would be repaid at an interest rate. This interest rate would then cause the value of the total period 1 consumption to be worth more if all the money was lent and spent in period 2, meaning the feasible frontier would expand.
51
What will cause a feasible frontier to shift outwards when investing and borrowing?
If a individual has an initial income, they will be able to invest that income in order to achieve a greater income in the future. Then, as the individual knows they will have a greater income in the future, they are (as a result) able to borrow from that future income to also increase their current spending. The feasible frontier will expand if the investment rate is greater than the rate at which they have to borrow.
Of course, in reality there would be a risk that this future income would be lost due to bad investment, leaving the individual bankrupt in this case.
52
Why do people engage in the movement of consumption between periods?
-They can increase their utility by consumption smoothing.
-By lending and investing, they can increase consumption in both periods,
53
Why do some people borrow, and some lend?
-This is because they may have differences in their situation, for example having an income now or later will affect their discount rate as well as their opportunities. Similarly, not all will have investment opportunities if they don’t have land and capital to invest on.
-People will also have different levels of pure impatience.
54
What is a social dilemma?
This is a situation in which actions taken independently by individuals in pursuit of their own private objectives results in an outcome which is inferior to some other feasible outcome that could’ve occurred if people had acted together, rather than as individuals.
55
What is the free rider issue?
This issue occurs when someone benefits from the contributions of others to a cooperative project without contributing themselves.
This was explained by the ‘tragedy of the commons’, where common property and resources are often over-exploited.
56
What is altruism?
This is the willingness to bear a cost in order to benefit somebody else, and could be a solution to many of the social dilemmas we face, and can be implemented through government policy, or simply just someone’s own actions, for example in irrigation communities where people some will maintain canals, and all use the available water sparingly.
57
What is Game Theory?
This is a branch of mathematics that studies interactions, meaning that situations where each actor knows that the benefit they receive depends on the actions taken by all.
58
What are social interaction?
These are situations in which the actions taken by each person affect other peoples outcomes all well as their own.
59
What is strategic interaction?
This is a social interaction in which the participants are aware of the ways that their actions effect others (and vice versa).
60
What is strategy?
This is an action that a person may take when that person is aware of a mutual dependence on the results for herself and for others. The outcomes not only depend on that person’s decisions, but also the decisions of others.
61
What is included in the description of a game?
1)The Players
2)Feasible strategies: Which actions are open to the players
3)The information: What each player knows when making a decision
4)The payoffs: What the outcomes will be for each of the possible combinations of actions.
62
What is a dominant strategy in game theory?
This is when a dominant strategy yields the highest pay-off no matter what the other players do. If both players in game theory have a dominant strategy, then there will be what is known as a ‘dominant strategy equilibrium’.
63
What is a Nash Equilibrium in game theory?
In game theory, a Nash equilibrium is when a set of strategies (one per player), such that each player’s best response to the strategies chosen by everyone else. No one has an incentive to deviate unilaterally.
Unlike a dominant strategy equilibrium, there may be more than one Nash equilibrium.
64
What are some examples other than altruism of humans being unselfish?
-Reciprocity: A preference to be kind to someone else who has been helpful/kind to you, but not helping those who haven’t been helpful to you.
-Inequality aversion: A dislike of outcomes in which some individuals receive more than others.
65
What is a prisoners dilemma in game theory?
This occurs when the dominant strategy equilibria is lower in total (both pay offs combined), than a different square in the game, which would be the social optimum since it yields the highest pay off.
However, this social optimum will never be achieved since it would be unfavourable for a player not to pick their dominant strategy.
66
What is a prisoners dilemma in game theory?
This occurs when the dominant strategy equilibria is lower in total (both pay offs combined), than a different square in the game, which would be the social optimum since it yields the highest pay off.
However, this social optimum will never be achieved since it would be unfavourable for a player not to pick their dominant strategy.
67
What 3 factors cause the prisoners dilemma to occur?
-No value is placed on the pay-off of the other individual, and as a result they do not consider the cost of their actions on the other player.
-No one can make anyone else pay for any externalities which come as a result of the strategies.
-Since no agreement of what each player will do can be made before hand, it is impossible to simply agree on the social optimum.
68
What are social preferences?
These are preferences that place a value on what happens to other people, even if it results on a lower payoff for the individual. This forms the basis of altruism.
69
What is a zero sum game?
This is a game in which the pay-off gains and losses of the individuals all sum to zero, for all combinations of the strategies they may peruse.
70
What shape would the indifference curve of someone completely selfish be.
Vertical, if the benefit to the individual was on the x axis, and benefit to others was on the y-axis, this would mean that the individual is gains no utility from the other person/people benefiting, so his indifference curves will be vertical. This also means that he will gain the most utility at the point where the feasible frontier crosses the x-axis, as here his vertical indifference curve will be further from the origin, so the highest achievable utility.
71
What shape would the indifference curve be if the individual was not completely selfish?
The indifference curve would be curved, and the flatter the indifference curve is, the more altruism the individual has. As the IC is curved, the point at which MRS = MRT (optimal allocation) will occur at a point in the middle of the IC (not one extreme or the other), as the individual is willing to share their income/good.
These indifference curves can also be used to resolve the prisoners dilemma.
72
What is a public good?
A public good is a good for which use by one person does not reduce its availability to others. These are both non-rivalry and non-excludable.
73
What is a public goods game?
-A public goods game shows how an individual will receive different pay-offs when they contribute to the funding of a public good (such as an irrigation project) at different points.
-As the good is public, they cannot be excluded, and may receive a better pay off by not contributing to the production of the good (which will often be the dominant strategy), and only receiving the benefits of it.
74
How can the free rider problem be solved in the public goods game?
-In some cases, laws will be implemented (such as being forced to pay taxes or facing jail time).
-However, in other cases, it is simply social norms which ensure that the free rider issue doesn’t occur. Many cultures have history of trust and cooperation which encourages all to co operate.
-Obviously, this won’t always occur, especially in communities with severe inequities.
75
What are social norms?
These are the understanding that is common to most members of a society about what people should do in a given situation when their actions affect others.
76
Why do better social outcomes often come from repeated games?
-Game theory is a one-shot game, however when there is repeated interactions, we will often see better cooperation. This is due to social norms, reciprocity and peer punishment.
-The fact that the game is repeated means that there may no longer be a dominant strategy to behave selfishly.
77
What did one study show about peer punishment and public good contributions?
-Although results differed massively between cities (due to social norms), a lab study showed that the contribution of a % of a sum of money towards a public good would often start relatively high, but then fall as those involved realised there was not as much reciprocity between players, so by later rounds the amount contributed fell (also due to the co operation coming to a close soon, so the benefit would be less meaningful later on).
-However, when anonymous peer punishment ($3 fine for low contribution) was involved, contributions were far higher and more consistent across all rounds, since people would lose more in the long run as they would be fined to contribute less, even if it cost $1 for a peer to report them. This is altruism, as the reporter was losing a dollar themselves for the benefit of everyone else in the study as the public good would receive more funding with the deterrent of a fine.
78
What are institutions?
Institutions are the written and unwritten rules that govern:
-What people do when they interact in a joint project
-The distribution of the products of their joint effort
79
What is an incentive?
An incentive is an economic reward or punishment, which influences the benefits and costs of alternative courses of action.
80
Why is power important in economic interaction?
As institutions determine who can do what, and how payoffs are distributed, they determine the power individuals have to get what they want in interactions with others.
In economics, power takes two main forms:
-It may set the terms of an exchange, by making a take it or leave it offer.
-It may impose or threaten to impose heavy costs: forcing one party to act in a way another one wants them to.
81
What is bargaining power?
Bargaining power is the extent of a person’s advantage in securing a larger share of the economic rents made possible by an interaction.
82
What would cause bargaining power to increase?
The prosper’s power will increase if there is more than one responder in an exchange, since if one of the responders denies an offer, they risk the other respondent accepting that price. This fear in the respondents causes the bargaining power to increase.
In real life, this would mean when there is high demand for a job, employers have a bargaining power to offer a lower wage since if you reject a lower wage, there is a chance another member of the unemployed would accept the salary, and you lose the job opportunity.
83
What is an allocation?
An allocation is a description of who does what, the consequences of their actions, and who gets what as a result.
84
What does Pareto dominant mean?
Allocation A would be Pareto dominant over allocation B if A allowed at least one party to be better off than at B, without anybody else becoming worse off.
85
What does Pareto efficient mean?
-Pareto efficient means that there is no feasible alternative allocation which would allow for one party to become better off without another party becoming worse off as a result.
-There will often be more than 1 Pareto efficient allocation, and pareto efficiency has nothing to do with fairness, so just because an allocation is Pareto efficient, doesn’t always mean we should approve.
-
86
What else can we use to evaluate outcomes other than Pareto criterion?
Justice, and wether or not a decision is fair. Allocations can be judged as unfair for two different reasons:
-Substantive judgement in fairness: Judgements based on the characteristics of the allocation itself, not how it was determined (such as income and freedom)
-Procedural judgment in fairness: An evaluation of an outcome based on how the allocation came about, and not on the characteristics of the outcome itself. (E.g a referee being biased in football, or voluntary exchange of private property due to inheritance)
87
What is one theory on how we could find
fairness in values in society?
John Rawls said we should:
1) Adopt the principles that fairness applies to all people
2) Imagine a veil of ignorance, so that we don’t consider anyone to be different from anyone else
3) Make a judgment from behind the veil of ignorance, so if you imagine you become apart of the society that you have endorsed, you can judge from the outside if you would be happy to take up any position within it.
88
What can economics actually help to clarify about values?
-How dimensions of unfairness may be connected
-The trade offs between the dimensions of fairness
-Public policies to address concerns about fairness
89
How does a combined feasible frontier work?
A combined feasible frontier works by having a point either within or on the feasible frontier. The amount of the good which the worker will receive is represented by the distance between the x-axis and the marked point, and the distance between the marked point and the feasible frontier vertically above that point is what the land owner will receive, often known as the rent.
90
What is a technically feasible set?
A technically feasible set is a set of allocations which lie within the limits set by technology and biology.
91
What does biologically feasible mean?
This means that the allocation is capable of sustaining the survival of those involved. This means that the minimum a landowner/manager can give their employees is the amount they need to sustain themselves (e.g not starve) for the given number of hours they’re working.
92
What is economic rent?
This is a payment or other benefit received above and beyond of what the individual would have received in his or her next best alternative.
This is also occasionally known as gains form exchange.
93
When will economic rent be maximised for a landowner on a combined feasible frontier with a constraint?
This will occur at the point along the x-axis where the MRT of the feasible frontier is equal to the MRS of the biological constraint or reservation indifference curve.
94
What is private property?
This is the right and expectation that one can enjoy one’s possessions in ways of one’s own choosing, exclude others from their use, and dispose of them by gift or sale to their who can become their owners.
95
What is private property?
This is the right and expectation that one can enjoy one’s possessions in ways of one’s own choosing, exclude others from their use, and dispose of them by gift or sale to their who can become their owners.
96
What is the joint surplus?
This is the sum of the economic rents of all involved in the interaction, how they will share this surplus however, is dependent on bargaining power.
97
What is a reservation option?
This is a person’s next best alternative among all options in a particular transaction.
98
What is a reservation indifference curve?
This is a curve which indicates all the different allocations which are valued just as highly as the individuals reservation option.
99
What is the economically feasible set on a combined feasible frontier?
This is the area between the reservation indifference curve and the feasible frontier. The point of allocation within this area will depend on the landowners willingness to share. If completely selfish, he will offer no higher than the reservation indifference curve, but if he feels altruistic, he may offer a greater ratio of the surplus.
100
What is a Pareto improvement?
A Pareto improvement was a change that benefits at least one person without making anyone else worse off. However, it does not mean that both parties will benefit equally from the improvement.
101
What is the difference between coercion and take it or leave it?
During coercion, the landowner is able to force what he wants upon the other party as long as the allocation is technically feasible, however in a take it or leave it situation, an offer can be refused by other parties, so there is more bargaining power.
102
How can laws affect a reservation indifference curve?
If there was previously no minimum wage, an individual may have one indifference curve, but if a minimum wage for 4 hours of work was introduced, then this would cause the reservation indifference curve to change to go between these points. This is because as this higher wage is now feasible, the employee would not settle for anything that she deems to be less than equal to this as her bargaining power has increased, so the economically feasible set would shrink.
103
What is the Pareto efficiency curve?
This is the efficiency curve in which the set of all allocations which are Pareto efficient. Often referred to as the contract curve, even in social interactions in which there is no contract, which is why we avoid the term.
104
Why can an indifference curve not slope back in an upwards direction at the end of the curve?
This would suggest that you like the combination of less of both goods the same as more of same goods, which when referring back to the indifference curve property of ‘completeness’, does not match.
105
What would occur if you have a concave indifference curve (very rare)?
If you have a concave indifference curve, this would cause mean that you would take the indifference curve which hits the budget constraint with the greatest utility. In this case, it would actually occur at the corner solution of the budget constraint.
106
If someone receives income (m1 and m2) in both periods (1 and 2), and consumes (c) less in period 1, how much consumption will they have for period 2 with interest (r) on savings?
C2 = m2 + (1 + r)(m1 - c1)
Or if they borrow (spend more than they receive in period 1:
C2 = m2 + (1 + r)(m1 - c1), but in this c1>m1
107
How can we express the budget constraint of a borrower or lender in present and future value? Both in the form P1X1 + P2X2 = P1M1 + P2X2
Remember, to get a future price in present value, this means you work out how much that future amount of money would be worth today, so you have to divide by the additional cost of repayment the debt to borrow it. And to find future value of current money, we times by the interest rate so we know how much more present money is worth in the future.
Present value (assuming the price today is 1):
C1 + C2/(1-r) = M1 + M2/(1+r)
Future value (assuming the price tomorrow is 1):
(1 + r)C1 + C2 = (1+r)M1 + M2
108
If someone (based on their optimal choice on the IC compared to their endowment) is a lender and the interest rate rises increases, what will happen?
They will remain a lender, since their indifference curve will just shift further up the budget constraint (lending more of their endowment than before). If the interest rate goes down, if will depend on to what extent is decreases to if a lender remains a lender.
Similarly, an increase in an interest rate may mean that a borrower will become a lender, as the cost of borrowing has increased. A borrower will remain a borrower if the interest rate goes down.
Although this can be worked out graphically, it can also be worked out using the income and substitution effect.
109
What is an edgewarth box?
An edgewarth box shows how many goods two people will have combined. The total amount of goods will remain fixed, and all that changes is the share of the two goods between the two people.
110
Where in the edgewarth box will there be a Pareto-efficient allocation?
This will occur when you reach your highest possible indifference curve given the indifference curve of the other person. If there is an area between the two indifference curves, then you can move to be in a pareto dominant position to the previous position. However, to reach any point outside this area, you will make both individuals worse off.
There will be multiple difference Pareto efficient allocations within the box, and you can draw a line between these, which is called the ‘contact curve’.
111
How can market trade be implemented into an edgewarth box?
-Assume there there is a price for good 1 and a price for good 2.
-There will be a point W (the endowment), which is the initial amount of the two good that the agents hold (and their price will be the price of the combined good). This endowment will be equal to any point along the budget constraint (which will be a straight line across the edgewarth box).
-Gross demand the amount a person will want to consume (where their IC hits the budget constraint) and net demand is the amount of both goods they want to purchase relative to their endowment.
-As the gross demand’s are not equal this means that the market prices were wrong and the market was not fully cleared, and so the quantity of the goods will not be fully optimised.
-For the example on OneNote (workshop week 5), good 1 was too expensive, and good 2 was too cheap as good 1 was under consumed, and good 2 was over consumed.
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What is net income?
Net income = gross income (money earned before taxes and other deductions) - depreciation.
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What is the ‘best response’ in game theory?
This is the strategy that yields the highest pay-off, given the other players strategy.
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What is a dominated strategy in game theory?
A strategy for a player will be dominated if there is at least one strategy better than it no matter what strategy the other player decides to take.
If there is a dominant strategy for a player, the non-dominant response will be the dominated strategy.
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What are revealed preferences?
A way of studying preferences by reverse engineering the motives of an individual (her preferences) from observations about her or his actions.
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What is a quasi linear preference?
In a quasi linear utility function, the change in the combination of the two goods to remain at a constant utility (MRS) will only be dependent on one of the two variables in the utility function, as one of them will be constant. E.g U(t, c) = v(t) + c.
Here, the marginal utility of consumption will be 1 (as c is constant in the utility function), so the MRS (partial derivative of t/partial derivative of c), will be the partial derivative of t/1. Therefore, the MRS will only be dependent on the marginal utility of t (free time).
As a result, at any given value of t, the all the different indifference curves will have the same gradient, no matter what what the value of c is, as all MRS depends on is t.
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What is the benefit of a quasi linear preference?
As the utility is in the form of ‘constant + something’, it will measure in the same units as the constant (in our example, consumption).
The ability to measure utility against consumption is a benefit to us, since it allows us to give a monetary value to the utility. This means we can measure the monetary value of gains and losses of utility in economic contexts.
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How do we work out the opportunity cost?
We do the value of the benefit of the forgone activity, take away the monetary value of having/experiencing this activity/action.
