Foundations of Microeconomic Theory Laura Onofri

1. "Valuing Cultural Diversity in Cities: Challenges to Cultural Economics", Procida (Naples, Italy), 5th of September 200 Foundations of Microeconomic Theory Laura Onofri Department of Economics University of Venice Cà Foscari and FEEM

2. Introducing the Subject: Some Challenging Questions • Why do people study different languages? • How do individuals choose the foreign language they want to learn? • Why should minority languages be protected? • What is the value that individuals attach to the preservation of a minority language? • Can we define the price/value of a (minority) language? …….

3. Lecture Motivation and Content • The present lesson aims at providing the basic, non-technical notions about economics reasoning, applied to standard, neoclassical consumer’s theory. • From preferences to utility functions to demand functions to reservation price

4. Economics and Microeconomics • Economics is the science that studies the choices of rational agents (economic agents, homo oeconomicus), in a world of scarce resources. • Microeconomics studies the choices of three main economic agents: consumers, firms and policy-makers. • We want to explain,predict and evaluate behavior and phenomena--not judge

5. The Two Dimensions of a Choice (1) • Consumers choose the optimal consumption bundle by solving a constrained maximization problem. • The optimal choice is characterised by both a psychological and a monetary dimension.

6. The Two Dimensions of a Choice (2) • The psychological dimension is represented by the notion of preferences and utility functions, which map the consumers tastes and desires. • The monetary dimension is represented by budget constraint (the income available for purchasing goods).

7. Preferences • Individuals’ tastes (preferences) determine pleasure people derive from the consumption of goods • Economists usually take tastes as given and do not judge taste • Assumptions about consumer preferences 1. completeness 2. transitivity 3. more is better

8. Three main “axioms” Completeness. Consumer can compare any two bundles of goods and services and decide which one is preferred or whether he (she) is indifferent between them. Transitivity (“rationality”). If a consumer prefers bundle x over y and y over z, then x is preferred over z. More is better(aka non-satiation). A bundle with more of one good and no less of others is preferred.

9. Indifference Curves we summarize information about an individual’s preferences using a graph and we can rank some bundles using more is better assumption Indifference curve properties 1. bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin 2. there is an indifference curve through every possible bundle 3. indifference curves cannot cross 4. indifference curves are “thin” 5. indifference curves slope down

10. Indifference Curves: Normal Goods

11. Marginal Rate of Substitution (1) Willingness to substitute; downward-sloping indifference curve: consumer is willing to substitute one good for the other marginal rate of substitution (MRS) of x for y is slope of indifference curve: MRS = δx/δy

12. Marginal Rate of Substitution (2) • MRS varies along the indifference curve • When convex UF diminish marginal rates of substitution (MRS)

13. Indifference Curves: Perfect Substitutes and Perfect Complements

14. Indifference Curves: Perfect Substitutes and Perfect Complements • Perfect substitutes straight line indifference curves if slope is –1, MRS = 1 (Coke-Pepsi) • Perfect complements right-angle indifference curves MRS = 0 (Coffee-Cream)

15. Marginal Rate of Substitution Willingness to substitute; downward-sloping indifference curve: consumer is willing to substitute one good for the other marginal rate of substitution (MRS) of y for x is slope of indifference curve: MRS = δy/δx

16. Marginal Rate of Substitution • MRS varies along the indifference curve • When convex UF diminish marginal rates of substitution (MRS)

17. Utility Functions Numerical values that reflect relative rankings of various bundles of goods Relationship between utility measure and every possible bundle of good Succinct summary of information in indifference map

18. Utility Functions

19. Utility and Marginal Utility • Marginal utility of x: change in utility from a small increase in x, holding y fixed. MU = δU/δx

20. Budget Constraint • Suppose an individual spends all her income for purchasing goods y and x. Her budget constraint is: M = pxx + pyy Rewrite as: x = (M – pyy)/px

21. Budget Constraint: Opportunity Set

22. Marginal Rate of Transformation • Slope of the Budget Constraint line: py/px • Opportunity set all bundles a consumer can buy includes bundles on and inside the budget constraint

23. Consumers’Constrained Choice (1) Consumers maximise the objective function (utility function) subject to the budget constraint Max U(x,y) s.t. M = pxx + pyy The result of the maximization problem provides the optimal bundle of goods x and y that the consumer can purchase within its possibility set.

24. Consumers’Constrained Choice (2) • Optimal bundle, two possibilities • Interior solution: buy some units of all goods (consumer buys some units of all goods optimum bundle, e, where highest indifference curve touches the budget line) 2. Corner solution: buy only one good

25. Consumers’Constrained Choice: Interior Solutions

26. Consumers’Constrained Choice: Property of the Equilibrium Solution At interior optimum, indifference curve is tangent to budget line: MRS = MRT δy/δx = - py/px • last Euro spent on x gives as much extra utility as that spent on y

27. Individual Demand Curves • The equilibrium solution indicates the optimal amount of y and x that the consumer can purchase within her possibility set. It indicates a relationship between quantity and (market) price of a good: Qx = f(px) Qy = f(py) Individual Demand Curves

28. Demand Functions • p

29. Demand Elasticity • Reservation Price • Willingness to Pay • Utility measured in monetary terms • Market Price • Market Values

30. References • Varian, Hal., R. 1992. Microeconomic Analysis 3rd Edition. W.W. Norton, New York