MICROECONOMIC THEORY 1

COURSE OVERVIEW AND INTRODUCTION

WEEK 1

Course objectives

The course equips students with the necessary concepts such as verbal intuition, graphics and calculus needed to better understand the different concepts in consumer behavior, entrepreneurs, suppliers of resources, investors and even policy makers in government as they seek optimum satisfaction from limited resources.

Recap on what Economics is

• Traditional definitionEconomics is the study of the allocation of scarce resources among alternative uses

• A more modern definitionEconomics is the science of social mechanisms

we need a mechanism to allocate resources

NoticeEverything you study in School is aimed at understanding and or designing social mechanisms.

The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, anapparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusion.

--- John Maynard Keynes

Pre-requisites

• Elements of economics (Econ 211) • Good appreciation of fundamentals in:

– Consumer Theory– Production and Cost

Content

Consumer theoryAssumptions:• Rationality• Measurable utility• Constant marginal utility of money• Diminishing marginal utility • Total utility of a ‘basket of goods’ depends on

the quantities of commodities consumed by the individual.

Content Cont.

• Production (SR, LR)

• Cost theory

• Market structures

• ECON 213: Elements of mathematics for economics

Graphs (positive and negative slopes)• Optimum - maximum and minimum• Differential calculus: partial, total, rules - quotient

rule, product rule, etc. FOC, SOC

Assessment

• Class Assignments and Interim Assessment (30%)

• End-of-semester examination (70%)

Consumer Behaviour and Demand Theory

Cardinal Utility Approach

• According to Cardinalists, utility is measureable (ie utils).

• Utility is the satisfaction that a good or bundle of goods yield relative to other alternatives.

• Total utility is the total benefit or satisfaction derived from all the units of a particular commodity consumed.

• Marginal utility is the additional utility derived from the consumption of an extra unit of a good (slope of Total Utility).

Cardinal Utility Approach Cont.

• The law of diminishing marginal utility states that as more of a commodity is consumed, the addition to total utility (marginal utility) declines. Utility function of a consumer of different goods is expressed as

U=f(X1, X2,……..Xn)

Hence total utility of the commodities is given as

Un=U1(X1)+U2(X2)+…………Un(Xn)

Cardinal Utility Approach Cont.

Equilibrium of the consumer

One commodity case;

• MUx = Px or MUx = λPx

• Where λ is the (constant) utility of money

• If MUx < Px, less will be consumed

• If MUx > Px, more will be consumed

• In multiple commodities, equality of the ratios of the marginal utilities of the individual commodities to their prices result in equilibrium.

Derivation of demand

Based on the axiom of diminishing marginal utility

• An increase in Px (results in Px > Mux)

To restore equilibrium, Mux must increase, this happens only when less of x is consumed.

• When x is consumed, total utility increases but at a decreasing rate, reaches maximum and declines. Accordingly, MUx decreases continuously and after a certain point it becomes negative.

• The demand curve is the positive segment of the MU curve.

Criticisms of Cardinal Utility

• Measureable utility is unrealistic (utility is subjective)

• Constant utility of money has been questioned

• Demand curve is derived based on ceteris paribus assumption. Therefore ignores income and substitution effects.

• Lack of evidence of the law of diminishing marginal utility

Further Reading

Read on the following functions: • Concave• Convex• Quasi-concave• Quasi-convex.