Micro Economic Theory

1
Micro Economic Theory

• What does it do?

2
Introduction to class

• What is Micro Economic Theory?
• The scientific method
• Assertions, Test conditions, Predictions
• The neo-classical marginalist paradigm

3
What is Micro Economic Theory?

• Framework for predicting and analysing effects on
  market prices, market quantities, and efficiency
  of markets
• Elements of the theories
• Consumers, Producers, Markets and Institutions
  Markets
• Consumers
• Theory of Choice
• Predicting how consumer choices vary with changes
  in markets
• Producers
• Theory of the Firm
• Predicting how producer choices (how much inputs
  to buy and how much output to sell) vary with
  changes in markets
• Markets and Institutions
• Rules of interaction between consumers and
  producers
• Perfectly competitive markets, less than perfect
  competition, small group interactions,
  contracting rules and legal frameworks, social
  norms and voluntary compliance

4
Most basic model
P

• Perfect Competition
• Law of Supply
• Law of Demand
• Convergence

S
D
Q
5
Moving away from the basic model

• Less than perfect competition
• Oligopoly, Monopolistic Competition, Monopoly
• Require more careful modeling of the firms
• The firm reacts to other things than just market
  price
• Expectations of reactions by other firms
• Interactive strategic situations game theory

6
Models of Consumer Choice

• Fundamental elements of consumer choice theory
• Opportunity sets
• Income, prices
• Preference axioms
• Mixed baskets of good are preferred to baskets
  with heavy reliance of one good
• Transititivity.

7
What questions can be asked in Micro Economics?

• What are the effects on markets from taxes or
  subsidies?
• What are the effects on global CO2 emissions from
  the Kyoto Agreement?
• Are there better ways of solving the global CO2
  emissions problem?
• If two firms are competing for the same limited
  market demand which institutional rules will
  maximize market efficiency?

8
This course and beyond

• In this course you will learn the details of
• The theory of the firm
• The theory of consumer choice
• Assuming
• Perfect Competition
• Monopoly
• Micro II
• Market Equilibrium (General Equilibrium)
• Oligopoly and Monopolistic Competition (Game
  Theory)
• Social Welfare and Efficiency

9
The Scientific Method

• Purpose of Theory
• Derive hypotheses that are logically valid and
  empirically refutable
• Empirical testing of the hypotheses
• Reject or not reject the theory
• Consistent failure to reject
• Use theory to predict events
• Scientists need to have good grounding in all
  three parts

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Theories and Models

• A set of assertions or postulates (A)
• Not observable
• Can only be tested if using proper scientific
  method
• Example Consumers maximize utility
• A set of assumptions or test conditions (C)
• Must be observable or theory cannot be tested
• Example income and goods prices change in
  certain ways
• Predictions of events (E)
• Consumer adjusts consumption basket

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Logical structure

• A (C E)
• A implies that C implies E
• Utility maximization implies that a higher price
  reduces consumption of that good
• Profit maximization implies that increasing taxes
  implies reduced output
• (A C) E
• Assertion A and assumption C together imply E
• Joint hypothesis

12
Scientific statement

• The postulates (A) are refutable only through
  making
• logically valid prediction
• about real, observable events
• based on these postulates
• under assumed test conditions
• and then discovering that the predictions are
  false

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• We can never prove a theory
• We can only reject invalid theories
• Concluding that A is true if C and E are both
  true
• Affirming the consequent (logical error)
• Discuss
• What is knowledge?
• What increases our knowledge most rejecting a
  theory or not?
• Deductive vs. inductive reasoning
• Empirical support for a theory can be growing
  over time
• Caution empirical tests can suffer from
  measurement and specification errors

14
The neo-classical marginalist paradigm

• Consumer choice determined by
• Opportunity sets
• Preferences
• Producer choice determined by
• Opportunity sets
• Technology
• Predictions are formulated using Comparative
  Statics exercises
• Changes at the margin

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Consumer choice

• Assertions (A)
• Preference axioms
• Test conditions (assumptions) (C)
• Marginal changes in opportunity sets
• Predictions of events (E)
• Preferences are unobservable
• Opportunity sets are observable
• Should we formulate theories that explain choices
  based on changing preferences?
• How could such a theory be refuted?
• Homework problem 1.

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Theory of the Firm

• Assertions (A)
• Profit maximization
• Cost minimization
• Test Conditions
• Technology, Input prices, Output prices
• Predicted Events
• Input demand
• Output supply

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Comparative Statics

• x f(a)
• x is endogenous
• a is exogenous
• No predictions about magnitudes, either levels or
  changes
• Only prediction about direction
• Cannot do comparative statics due to changes in
  endogenous variables

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Comparative statics of the firm

• Assertion (A) Firm maximizes profits
• Test condition (C) Tax is levied in proportion
  to output, controlling for technology and prices
• Event (E) Change in quantity supplied
• Objective function
• Modelling the assertion and the initial state of
  test conditions

19
Objective function and comparative statics
statement

• Max p R(x) C(x) tx
• Find

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Comparative Statics procedures

• Solve for the optimal x
• Perform comparative statics at this point
• Restrictions on objective function
• Has to have a stationary point that is a maximum

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• Step 1 Find x as the stationary point
• Step 2 Verify that this point is a maximum
• Step 3 Solve for xx(t)
• The explicit choice function
• Requires an inversion apply Implicit Function
  Theorem
• Step 4 Substitute x for x in FONC that is now
  an identity
• Step 5 Differentiate the identity and set to 0
• Step 6 Solve for
• Step 7 Determine the sign by referring to SOSC
  plt0

22
Objective Functions

• Specify the objective function if
• Firm operates in perfectly competitive markets
• Firm is a monopolist
• Firm maximizes total revenues
• Firm maximizes utility

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Lecture Plan

• Homework 1 based on SS chapter 1, due Sept 4
• Applications
• Vernon Smith on theory testing
• James Cox on social preferences in choice theory
  and the problem of confounds
• McDaniel and Rutström, and Cummings, Harrison and
  Rutström on assertions in consumer choice theory
  and the effect of incentives
• Theory of the Firm Unconstrained profit
  maximization in two input variables and one
  output
• Homogeneity, Le Chatelier principles and relaxing
  constraints, Constant Returns to Scale, Refutable
  hypotheses
• Homework 2 based on ch 4, due Sep 18
• Extending to NxM
• Duality of profit maximization
• Profit function (indirect objective function),
• Homework 3 based on ch 6 and 7, due Oct 1
• TEST 1 October 2
• Constrained cost minimization and its duality
  formulation
• Homework 4 based on cost minimization
• Consumer Choice
• Preference axioms
• Constrained utility maximization
• Constrained expenditure minimization