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Lecture # 02-a Introduction (cont.) Lecturer: Martin Paredes

Lecture # 02-a Introduction (cont.) Lecturer: Martin Paredes. Outline. Microeconomic Modeling Elements of models Solving the models The Limits of Microeconomic Analysis. Microeconomic Modeling. All microeconomic models rely on three analytical tools: Constrained optimisation

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Lecture # 02-a Introduction (cont.) Lecturer: Martin Paredes

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  1. Lecture # 02-a Introduction (cont.) Lecturer: Martin Paredes

  2. Outline • Microeconomic Modeling • Elements of models • Solving the models • The Limits of Microeconomic Analysis

  3. Microeconomic Modeling • All microeconomic models rely on three analytical tools: • Constrained optimisation • Equilibrium analysis • Comparative statics

  4. Constrained Optimization • Constrained optimisation problems usually have two parts: • Objective function • A set of constrains

  5. The Objective Function • Definition: The Objective Function specifies what the agent cares about and wants to optimize • Examples: • A consumer cares about maximizing his satisfaction • The manager cares about: • Raising profits • Reducing costs • Increasing “power”

  6. The Constraint(s) • Definition: Limits placed on the resources available to the agent • Examples: • The manager’s budget is €1M • The consumer’s income is €3000

  7. Constrained Optimization • The behavior of an agent can be modeled as • optimizing the objective function, subject to his • various constraints.

  8. Example: Consumer purchases • The consumer • Chooses Food (F) and Clothing (C) • Take as given his Income (I), the Price of food (PF) and the Price of clothing (PC) • Satisfaction from purchases: S = (FC)1/2 • Objective function: • Max S = (FC)1/2 subject to: PFF + PCC < I • (F,C)

  9. F Example: Consumer Purchases PFF + PCC = I 0 C

  10. F Example: Consumer Purchases PFF + PCC = I (FC)1/2 = S1 0 C

  11. F Example: Consumer Purchases PFF + PCC = I (FC)1/2 = S1 (FC)1/2 = S0 0 C

  12. F Example: Consumer Purchases PFF + PCC = I S2 > S1 > S0 (FC)1/2 = S2 (FC)1/2 = S1 (FC)1/2 = S0 0 C

  13. Another Example: Advertising Spots • Suppose the manager of a beer company wants to decide the firm’s advertising spots. • Budget = €1m to allocate between TV ( T ) and radio ( R ) • Problem: Max B(T,R) • (T,R) • subject to: pTT + pRR < €1m • where: B is "barrels“ and pT, pR are the prices of TV and radio • advertising, respectively.

  14. Equilibrium Definition: Equilibrium is a state that will continue indefinitely as long as the exogenous factors remain unchanged.

  15. Price per pound Example: The Market for Coffee Beans Supply (P,W) Q* Quantity, pounds

  16. Price per pound Example: The Market for Coffee Beans Supply (P,W) • Demand (P,I) Q* Quantity, pounds

  17. Price per pound Example: The Market for Coffee Beans Supply (P,W) • P* Demand (P,I) Q* Quantity, pounds

  18. Definition: In this example, Equilibrium is defined as the point where demand equals supply in this market • (i.e., the point where the demand and supply curves cross)

  19. Comparative Statics Definition: A comparative statics analysis compares the equilibrium state of a system before a change in the exogenous variables to the equilibrium state after the change.

  20. Price per pound Example: Coffee Beans, revisited Supply (P,W) • Demand (P,I) Quantity, pounds

  21. Price per pound Example: Coffee Beans, revisited Supply (P,W) New Supply (P,W) • • Demand (P,I) Quantity, pounds

  22. Price per pound Example: Coffee Beans, revisited Supply (P,W) New Supply (P,W) • P* • P** Demand (P,I) Quantity, pounds Q* Q**

  23. Example: Consumer choice, revisited F PFF + PCC = I0 0 C

  24. Example: Consumer choice, revisited F PFF + PCC = I0 (FC)1/2 = S0 • 0 C** C* C

  25. Example: Consumer choice, revisited F PFF + PCC = I0 (FC)1/2 = S0 • • PFF + PCC = I1 0 C

  26. Example: Consumer choice, revisited F PFF + PCC = I0 (FC)1/2 = S0 • • (FC)1/2 = S1 PFF + PCC = I1 0 C

  27. Example: Consumer choice, revisited F PFF + PCC = I0 S0 > S1 I0 > I1 (FC)1/2 = S0 • F* • F** (FC)1/2 = S1 PFF + PCC = I1 0 C** C* C

  28. The Limits of Microeconomic Analysis • Definition: Positive Analysis • Can explain what has happened due to an economic policy, or • Can predict what might happen due to an economic policy. • Definition: Normative analysis is an analysis of what should be done

  29. The Limits of Microeconomic Analysis • Examples: • “Should we increase income equality rather than focus on economic efficiency?” • “Should we impose a progressive income tax or a sales tax to increase income equality?” • “Will a progressive income tax reduce aggregate hours worked?”

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