Theoretical Tools Flashcards
Theoretical Tools
techniques that economists use to model the economy
empirical tools
techniques that economists use to study data
Constrained Utility Maximization
a mathematical model of how people make decisions, specifically how people make decisions by maxing their utility with their budget constraint
steps for constrained utility maximization
1) preferences and utility functions
2) indifference curves
3) marginal utility & marginal rate of substitution
4) budget constraint
5) find where BC is tangent to IC (MRS (-qy/qx)= -px/py)
preferences
what a person likes or doesn’t like
utility function
a mathematical function that captures a person’s preferences, Reveals the amount of utility gained from consuming a given set of goods
Indifference Curves
the set of bundles of goods that make a person equally well off
Non-satiation
the assumption that “more is better
Non-satiation Indifference Curves Properties
1) People prefer higher indifference curves (farther out from the origin
2) Indifference curves are downward sloping
Marginal Utility
The addit. utility from consuming one more unit of a good
Utility functions usually exhibit diminishing marginal utility
Consuming an additional unit gives less extra utility than was gained from the previous unit
Mathematically, ∂u/∂Xj decreases with Xj
Marginal Rate of Substitution
the slope of the indifference curve
→ The rate at which a consumer is willing to trade the good on the vertical axis for the good on the horizontal axis
Budget Constraint
mathematical representation of the bundles of goods
that a person can afford if she spends her entire income
Substitution Effect
the impact on choices of a change in the price
ratio if we hold utility constant
- Y so that the person can stay on the same IC
- Choose less of the good that suffered the price
Income Effect
The impact on choices that is due to the fact that a
price ↑ reduces a person’s purchasing power
- reflects that we don’t compensate people for price ↑s
- Choose less of all goods
Individual demand curve
the demand curve for a single person
- Specifically: a function that relates the price of a good to the quantity that a person would choose to purchase
Aggregate Demand Curve
the demand curve for the economy as a whole
- Specifically: a function that relates the price of a good to the total quantity that is demanded in the market
The Elasticity of Demand
the % change in demand for a good caused by a 1% change in the price
(% change in quantity demanded) / (% change in price)
Individual Supply Curve
function that relates the price of a good to the
quantity that a firm is willing to sell
- Outcome of the firm’s profit maximization problem
→ sell until marginal cost rises up to the market price of the good
⇒ Firm’s supply curve is its marginal cost curve
Elasticity of Supply
% change in supply caused by a 1% change in the
price of a good:
(% change in quantity demanded) / (% change in price)
Aggregate Supply Curve
function that relates the price of a good to the total quantity that is supplied in the market
- The horizontal sum of each firm’s individual supply curve
- For each price, add up each firm’s quantity supplied over all firms
market eq
where aggregate supply and aggregate demand meet (are equal)
Consumer Surplus
the benefit (in $) that consumers gain from the market
- I.e., the difference between:
1. The price that a consumer is willing to pay for a unit (demand)
2. The price that the consumer actually pays (the market price), summed over all units purchased
- Graphically, the area below the demand curve and above the market price
Producer Surplus
The benefit (in $) that firms gain from the market
- I.e., the difference between:
1. The price that a firm is willing to receive for a unit (supply)
2. The price that the firm actually receives (the market price),
summed over all units sold
– the area above the supply curve and below the market price
First Welfare Therom
When there are no market failures, the market maximizes the total surplus & is efficient
– it returns the largest benefits that consumers and firms can get, given their budget (and cost) constraints
Limitations of the First Welfare Theorem
1) The FWT applies only if there are no market failures (No externalities, Perfect competition, Perfect information, Agents are rational)
2) Efficiency says nothing about distribution (equality)
Social Welfare
the level of wellbeing in society
- Depends on: (i) whether resources are used efficiently and (ii) how resources are allocated across people
Because of diminishing marginal utility of consumption
For any set amount of resources, social welfare will be higher if the resources are distributed more equally
Social welfare function
A function that combines each person’s utility into a measure of the overall level of well-being in society
social welfare maximization problem
Maximize social welfare subject to the society-wide budget constraint
Utilitarianism
maximize the sum of individual utilities
- calls for redistribution, since MU higher for poor than rich
Rawlsian
maximize the utility of society’s worst-off members
- Calls for strong redistribution
Commodity egalitarianism
meet everyone’s basic needs
- Provide education, healthcare, retirement/disability benefits as “rights”
- Thereafter, don’t worry about distribution
Equality of opportunity
give everyone the same chance to succeed
- Compensate people for inequalities that they’re not responsible for (e.g., family background, inheritance, ability)
- Don’t compensate for inequalities they are responsible for (being lazy)
bigger focus on efficiency vs social welfare bc
1) seems more impartial
2) many types of social welfare theorems so it’s hard to decide which one to use
