EC1A3.2 - Block 2 Individual Decision Making Flashcards
What is rationality?
Rationality - People decide what to do by weighing all of the known pros and cons of the different options and picking the best option.
What is equilibrium?
Equilibrium - A situation in which everyone is simultaneously optimising, i.e. when no individual thinks he/she has another course of available action that is better for them.
On a price-quantity graph, how is the demand function calculated?
The demand function results from the optimising behaviour of consumers.
On a price-quantity graph, how is the supply function calculated?
The supply function results from the optimising behaviour of companies/firms.
On a price-quantity graph, what is the equilibrium point?
The equilibrium point is such that the quantity demanded equals the quantity supplied.
- No consumer would like to buy more.
- No supplier would want to produce more.
What is nash equilibrium?
Nash equilibrium is a concept within game theory where the optimal outcome of a game is where there is no incentive to deviate from the initial strategy.
Overall, an individual can receive no incremental benefit from changing actions, assuming other players remain constant in their strategies. A game may have multiple Nash equilibria or none at all.
Based on:
- Rationality
- Beliefs are correct
What are models?
Models simplify and abstract from reality to focus on the
most salient aspects of an issue.
- They leave out many things and distort others.
- They have assumptions and definitions from which we use logical argument to draw conclusions.
- Conclusions help us understand the economy and design policy.
What is important to remember about models?
Models can be very useful but can also be misleading…
- How suitable a model depends on the context in which it is being applied.
- Important to understand the limitations of models.
- To contrast the assumptions and conclusions of different models.
What are the primitives of a model?
The primitives of a model are the things that we assume about the “setting” and they do not change throughout the course of the analysis.
What is meant by a model of rationality?
- Primitives
a) A decision-maker (DM).
b) A set of m alternatives A={a,b,…}
c) A preference over the alternatives in A, ‘≽
- The DM is aware of all these alternatives
- The DM can freely choose one of these alternatives.
2. A preference over the alternatives in A, ‘≽’ Assumptions made A. Completeness: - For any two alternatives a and b in A, the relation ‘≽’ provides an answer along the lines: - “I prefer a over b”. - “I prefer b over a”. - “I am indifferent between a and b”. B. Transitivity: - For any three alternatives a,b and c in A, - If “I prefer a over b”. - And if “I prefer b over c”. - Then “I prefer a over c”. C. Continuity (Technical).
3 Solution concept (“how the play plays out”):
- Maximisation/optimisation
- The DM will choose an alternative a* in A such that there is no other alternative b in A such that “DM prefers b to a* ”.
What is the completeness of a model?
In the completeness of a model, we assume that the individual can always compare between any two choices in their set of possible choices.
What is meant by the transitivity of a model?
For example if a, b and c are real numbers and we know that a > b and b > c then it must follow that a > c . This property of the relation is called `transitivity’
What facts have to be satisfied to be represented as a utility function?
Fact: If ‘≽’ satisfies completeness, transitivity and continuity then it can be represented by a utility function so that for any a and b in A:
- “DM prefers a to b” if and only if U(a) > U(b)
When we use utility functions to represent preferences we can Maximise them to find the solution for the Decision Maker.
- First-order condition (FOC), second-order condition…
- By making assumptions (more assumptions!) on the utility function (concavity) we can just focus on FOC!
Assume that an individual’s preferences over bundles (x,y) are represented by the utility function U(x,y) = x + y.
TRUE OR FALSE Is this individual’s preferences also represented by U(x,y) = 4.5 × ( x + y )?
Correct: Suppose (x,y) ≻ (x’,y’) so we know that
x + y > x’ + y’ ⇔ 4.5 × ( x + y ) > 4.5 × ( x’ + y’ )!
More generally ⇔ 4.5 × ( x + y ) > 4.5 × ( x’ + y’ )! : If U(x,y) represents an individual’s preferences then any increasing function of U(x,y) also represents the individual’s preferences.c
Assume that an individual’s preferences over bundles (x,y) are represented by the utility function U(x,y) = x + y.
TRUE OR FALSE Is this individual’s preferences also represented by V(x,y) = 4x + 2y?
Wrong! Example,
- Under U(x,y), (1,4) ≻ (2,2.5) as 5 > 4.5, but…
- Under V(x,y), (2,2.5) ≻ (1,4) as 13 > 12, but…
How do we think about technology (production function)?
- The firm produces a single output (Q) using two inputs: labour (L) and capital (K).
- The flow of output produced is related to the flow of inputs by the production function.
q = q(l,k), where:
- q = output/unit time.
- l = people-days labour/unit time.
- k = (machine-days)/unit time.
q(l,k) is the highest number of units of output that can be produced, given current technology, when employing l units of labour and k units of capital.
- We say “q(l,k) is the efficient level of production when employing l units of labour and k units of capital.”
What do production functions look like (2 types)?
Two “famous” production functions we will use:
- Fixed coefficients production function (pedagogical).
- Labour and capital must always be used in fixed proportions to produce output.
- For example, 2 brewer hours and 1 brewing system hour to produce 1 pint of beer per hour.
- Thus, to produce a given level of output, specific amounts of each input will be needed, e.g. 10 brewer hours to produce 5 pints of beer, provided at least 5 brewing system hours in place. - Variable coefficients production function: increasing then diminishing marginal products.
- Form of production function underlying the standard theory of the firm has the following properties:
- ASSUMPTION 1: The marginal product of each factor first increases then decreases, but always remains positive.
- ASSUMPTION 2: The marginal product of a factor depends on the quantities used of all factors. (If k increases holding l constant, then MPL rises; if l increases holding k constant, then MPK rises. We say: l and k are cooperant factors).
What is the production function?
The production function relates to the maximum amount of output that can be obtained from a given number of inputs.
What is the total product curve?
The total product (TP) curve graphically explains a firm’s total output in the short run. It plots the total product as a function of the variable input, labour.
What is the marginal product of labour?
The marginal product of labour (MPL): By how much does output increase if we employ one more unit of labour?
What is the marginal product of capital?
The marginal product of capital (MPK): By how much does output increase if we employ one more unit of capital?
What are cooperant factors?
Cooperant factors, when you employ more capital then labour becomes more productive and when you employ more labour then capital becomes more productive. These factors are codependent.
What are returns to scale?
Returns to scale, in economics, the quantitative change in output of a firm or industry resulting from a proportionate increase in all inputs.
- If we increase all our inputs, labour, and capital by x%, by what percentage would output increase?
