Micro Exam #2

What is the Substitution effect?

This is when the commodity is relatively cheaper, so consumers substitute it for other, now relatively more expensive, commodities.

What is the income effect?

The consumer’s budget of y can purchase more than before, as if the consumer’s income rose, so the consequential effect is that the consumer will treat the commodities based on feeling as if their income rose.

What does Slutsky say about a price change as it retains to income when less income is needed to purchase the original bundle?

If less income is needed, then “real income” is increased (even though real income might’ve not necessarily increased, it could just be that prices fell)

What does Slutsky say about a price change as it retains to income when more income is needed to purchase the original bundle?

If more income is needed, then “real income” decreased (even though real income might’ve not necessarily decreased, it could just be that prices rose)

What is a “Pure” Substitution Effect?

This is when lower prices make one good cheaper in comparison to another good, so you substitute the cheaper good for the relatively more expensive good. P₁ decreases, so you substitute X₁ for X_2.

If the price of a good decreases, would the substitution effect ever cause a decrease in the quantity demanded of that good?

No, that would violate the weak axiom of revealed preferences.

If the price of a good increases, would the substitution effect ever increase the quantity demanded of that good?

No

What is an overall effect?

This is when the substitution effect and income effect are both applied to the same situation.

What is the overall effect for a normal good?

When a normal good experiences income and substitution effects, they will reinforce each other. If a normal good becomes cheaper, then it will be substituted for another good. The demand for that good will go up, and more will be purchased because higher income increases with higher demand. (Reminder that Slutsky perceives “real income” as increasing if the original bundle is cheaper)

What is “The Law of Demand” (again)?

As the demand for a good increases, the price of a good decreases (and Vice versa).

What is the overall effect for a income-inferior good?

Income inferior goods have opposing substitution and income effects. The substitution effect will cause more inferior goods to be purchased when the price is lower. However, the income effect will cause no inferior goods to be purchased at a lower price because the income effect will cause the demand of the good to decreases. (Under the idea that you make enough income where you shouldn’t purchase the inferior good at the lower price and buy a normal good instead).

What is the overall effect for a Giffen Good?

The substitution effect will cause the demand of giffen goods to decrease as the price rises, however the income effect will cause demand to increase as the price falls. The substitution and income effects still work in the opposite direction, because it’s revealed that all giffen goods are inferior goods. (But not all inferior goods are giffen goods).

What is an example of short-term saving?

This is saving that usually lasts about a week or a year (short term)

What is an example of long-term saving?

Holding stocks, being a loaner, having so much saving from having it accumulated over decades.

What is borrowing?

This is when you use future disposable income in order to have more income currently.

What is the interest rate?

This is the rate of exchange between current money and money in the future. (i.e. if I don’t spend m today, then I will have m(1 +r) amount of money in the future).

What is the present value of money? What is the equation used to find the present value of money?

The present value of a dollar is the current value, we find this by dividing future income by (1 + r) or m/(1+r)

What is the equation used to find the future value of money?

The equation used is current income times (1 + r), or current income times 1 plus the real interest rate.

What is the two period model of intertemporal choice?

The two period model uses a present and future time period to make choices about ways to consume .

What is the intertemporal budget constraint of consumption in the future (or second) period?

C₂ = m₂ + (1+r) m₁

What is the intertemporal budget constraint of consumption in the present (or first) period?

C₁ = m₁ + m₂/(1+r)

What is the intertemporal budget constraint of period 2’s consumption?

C₂ = -(1+r)C₁ +m₂ + (1+r)m₁

What is the no lending/ no borrowing point of the intertemporal budget constraint?

The green dot in the image represents the no lending, no borrowing point, this is because all of current income is spent on current consumption, and all of future income is spent on future income.

What is a bond? How do we value bonds?

A bond is a special type of security that pays a fixed amount $x for T years (its maturity date), it will then pay a face value of $F. The valuing bonds table allows us to understand how bonds Present value changes over time

What is a perpetuity?

This is a bond which never terminates, paying $x per period forever.

What is an endowment?

This is the list of resources that the consumer starts with.

How are endowments denoted?

Omega sign

What must be true about endowments?

The endowment is always on the budget constraint

What is the gross demand?

The amount of the good that the consumer actually ends up consuming.

What must be true about the budget constraint

P₁ X₁ +P₂X₂ = P₁ω₁ +P₂ω₂ the consumer’s final consumption must be that the value of the bundle of goods that they go home with must be equal to the value of the bundle of goods that they came with. In other words, the budget constraint for gross demand should be equal to the budget constraint of endowment.

What is the net demand?

The net demand is the difference between gross demand and the initial endowment of goods. Net demand = Gross demand - Endowment or
(Net demand = X₁- ω₁)

Is net demand strictly positive?

Net demand can be positive or negative based on the amounts of gross demand and endowment.

What happens when net demand is positive?

When (X₁ -ω₁) is positive, we would say that the consumer is a net buyer or a net demander of good 1.

What happens when net demand is negative?

When (X₁ -ω₁) is negative, we say that they are a net seller or net supplier of a good.

What happens when the price of a bundle changes?

Price changes in a bundle that result in a new budget constraint will still have the endowment on the budget constraint.

Why is the market budget constraint always less than the budget constraint of the endowment?

P₁X₁ +P₂X₂ ≤ P₁ω₁ +P₂ω₂, this is because you can never leave the market with more than what you started with.

Is it possible to have positive net demand for both goods within a bundle?

The consumer would not have positive net demand for both of the goods. One of them has to be a negative net demand.

What is the equation for consumer surplus?

Consumer surplus = what you're willing to pay minus what you actually pay. In other words, consumer surplus is your net gain from trading.

How do we measure utility in consumer surplus?

We measure the utility from trade (consumer surplus) through dollar amounts. (i.e.- if your willing to pay $20 for a burrito bowl but you pay $17, then your consumer surplus is $3).

What is a reservation price?

This is the price your willing to pay.

What is the reservation price curve?

This is the price curve used to identify different levels of reservation prices at different quantities, assuming that the price per quantity is constant. Anything above the Pg line is the consumer surplus.

Why is the consumer surplus above the price per quantity line? Would you be willing to purchase additional units of a good if it’s below the per per quantity line?

Consumer surplus is above the price per quantity line because you aren’t able to purchase the good if the amount you're willing to pay is less than the price per quantity.

Does consumer surplus mirror the ordinary demand curve?

It will usually mirror the ordinary demand curve because demand follows the price your willing to pay as well.

If the price of a quantity increases by a certain amount, will you have lost consumer surplus by that same amount?

No, you will lose less consumer surplus than the amount that the price increased by if the consumer’s willingness to pay is within the price range.

What is producer surplus? What is the equation for producer surplus?

Producer surplus is the producer’s gains from trade. The equation for producer surplus is PS= How much the producer receives minus the amount they are willing to sell for.

How is producer surplus represented graphically?

Producer surplus is the green triangle that is above the supply curve. This is because the output price is represented by p’- this is the amount that the producer receives at different levels of output. The supply curve measures the relationship between the cost to produce and how much is produced, so consumer surplus must be the area between p’ and the supply curve.

How is the free-market equilibrium represented graphically?

The green represents consumer surplus because it shows that the consumer is willing to pay for higher prices until p is reached. The magenta represents producer surplus because it shows PS as the output paid for and how much sellers receive until p is reached.

What would happen if the government imposed a regulation that forced the price of a good to rise ?

This would cause a deadweight loss, as producer surplus would rise and consumer surplus would decrease, producers wouldn’t be able to sell more than a certain quantity as a result of consumers not wanting to purchase a certain quantity.

What would happen if the government imposed a regulation that forced the price of a good to decrease?

This would still cause a deadweight loss, as producer surplus would fall and consumer surplus would rise. Producers aren’t willing to sell the amount of goods that the consumer would be willing to purchase.

How can we denote a consumer’s ordinary demand function? When i= the consumer, and j is the commodity being demanded?

X_j^*i (p₁, p₂, mⁱ )

What is the market demand for the function of commodity j?

The image shown is a combination of all the ordinary demand functions for commodity J, which make up the market demand for commodity J.

How does market demand function with price and quantity demanded?

Market demand uses the quantity demanded as a function of the price levels.

What is the elasticity of a commodity defined as?

Elasticity measures the sensitivity of one variable with respect to another. An example is the image shown which displays the elasticity of variable X with respect to variable Y.

What is the own-price elasticity of demand?

Quantity demanded of commodity i with respect to the price of commodity i.

What is the cross-price elasticity of demand?

Demand for commodity i with respect to the price of commodity J.

What is the income elasticity of demand?

Demand for commodity i with respect to income

What is the owner-price elasticity of supply?

Quantity supplied of commodity i with respect to the price of commodity i.

What is the elasticity of supply with respect to the price of labor?

Quantity supplied of commodity i with respect to the wage rate.

How do we find the elasticity of a point (point-elasticity)? (Under the use of own-price elasticity)

The image denotes the price and commodity that consumer i is choosing multiplied by the derivative of the quantity demanded over the derivative of the price. This formula enables us to calculate an elasticity of own-price demand when we know the demand curve.

If elasticity is zero, then what must this imply about price?

Price must be zero as well, (because p₁ is the numerator of point elasticity).

Graphically, when is own-price demand elasticity considered elastic? When is it considered unit elastic? When it is considered inelastic?

When elasticity is negative, own-price demand is considered elastic, when elasticity is equal to negative 1, it is considered unit elastic, when elasticity is 0, the own-price demand is considered inelastic.

What is the condition that must be met in order for the market to be in equilibrium?

The market is in equilibrium when total quantity demanded by buyers equals total quantity supplied by sellers. (As depicted in the image when market demand is equal to market supply). (Could also be when the demand at a certain price is equal to the supply at a certain price).

What is a quantity tax?

This is a tax levied at a rate of $t, is it a tax of $t paid on each unit traded.

What is an excise tax?

This is a tax levied on sellers.

What is a sales tax?

The is a tax levied on buyers.

What conditions must be met in the market when quantity taxes are in effect?

The image depicts the quantity demanded by buyers must still be equal to the quantity supplied by sellers, the price that sellers are supplying must be equal to the price of the quantity demanded by buyers even with taxes.

Do taxes matter at market equilibrium?

A sales tax that has the same effect as an excise tax at a rate of $t won’t matter to buyers or sellers because they are both paying the same amount of taxes. (Mind you, sales tax and excise tax have to be equal at equilibrium).

What is the division of taxes amongst buyers and sellers called (when the market is not in equilibrium)?

This is known as the incidence of the tax.

How do we express a Tax Incidence in terms of own-price elasticity?

The image expresses tax incidence as price buyer pays minus the price divided by the price minus the price that sellers pay, which approximately equals the negative elasticity of supply over elasticity of demand.

Who is affected by a quantity tax?

A sales tax has the same effect as as an excise tax when quantity taxes are at play. Both buyers and seller are affected by a quantity tax. (Though normally, the saying goes that whoever can’t walk away from the trade will end up paying the quantity tax).

Why does own-price elasticity matter to taxes?

As the market demand becomes less own-price elastic, tax incidence shifts more to the buyers, even when the price elasticity of demand is equal to zero.

How is the tax incidence paid by sellers affected by own-price elasticity?

The tax incidence levied on sellers rises as supply becomes less own-price elastic or as demand becomes more own-price elastic.

What is deadweight loss?

This is the total surplus from both consumers and producers that is loss due to the tax incidence.

How is deadweight loss proportional to tax incidence?

Deadweight loss is generally considered the square of the size of the tax.

What is an Edgeworth box?

This is all possible allocations of the available quantities of goods 1 and 2 between two consumers.

What is the width of the edgeworth box equal to?

The width is equal to all the amount of good one that the two consumers are able to allocate.

What is the height of the Edgeworth box equal to?

The height is equal to all the amount of good two that the two consumers are able to allocate.

What is an endowment in an Edgeworth box?

This is starting amount of good 1 and 2 that each consumer has.

What is a Pareto improvement?

This is when allocation is optimized to make both parties better off without making anyone worse off.

What type of allocation is considered Pareto optimal or pareto efficient?

This is the point where no pareto improvements could be made as the only way for one consumer’s welfare can be increased at this point is to decrease the welfare of another consumer.

What is a contract curve?

This is the set of all pareto optimal allocations

What is the core?

The core is the set of all pareto improving allocations.

How does General equilibrium occur?

This is when prices p1 and p2 cause the markets to clear, or for supply to be equal to net demand.

What is the first Fundamental Theorem of Welfare Economics?

This is the theorem that if consumers preferences are well behaved, then trading in perfectly competitive markets will result in a pareto optimal allocation of the economy’ endowment.

What is the producer’s budget constraint?

The production function, with inputs on the x axis and outputs on the y axis.

What is a “technology”

This refers to any process by which inputs are converted into an output.

How do we denote input bundles?

X1, X2, X3 are 3 different inputs they are a vector of input levels.

What can a production function tell us about a technology?

This will state the maximum amount of output possible from an input bundle.

What is a production plan?

This an input bundle with an assigned output bundle- X1, X2, Y

What makes a production plan feasible?

A production plan is feasible if Y ≤ (X1,X2 …Xn)

What is a technology set?

This is the set of all feasible production plans.

What is a isoquant?

This is the set of all input bundles that yield at most the same output level, Y.

What is interesting about Cobb-Douglass production function?

All the isoquants in the cobb-douglas production function are hyperbolic, asymptoting too, but they never touch any axis.

What does the fixed proportions production function look like?

Fixed proportions isoquants are similar to perfect complements indifference curves.

What does the perfect substitutes production function look like?

What is the marginal product of input ?

This is the rate of change of the output level as the level of input changes aka partial derivative of y over partial derivative of x.

What makes the marginal product of input diminishing?

The marginal product of input i is diminishing if it become smaller as the level of input i increases.

What are returns to scale?

This is the relationship between inputs and outputs.

What are constant returns to scale?

This is when outputs change by the same amount that inputs change- i.e. if inputs double then outputs double.

What are increasing returns to scale?

This is when the change in output is more than the change in input (i.e. input doubles and output more than doubles)