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Recht und Ökonomie SS 2011Microeconomics Repetition Part 1 Recht und Ökonomie (Law and Economics) LVA-Nr.: SS 2011 Microeconomics (Repetition Part 1) 1 of 35 Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre

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2 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider Outline of the section on Microeconomics – Part 1 1.Basic concepts and tools 2.Consumer theory 3.Theory of the firm 4.Interactions of households and firms

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3 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.1 Basic concepts Three important concepts Optimization Maximization or minimization Equilibrium Efficiency

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4 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.2Basic concepts Maximize Sales Profits Market shares Utility Minimize Cost

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5 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.3Basic concepts Equilibrium Plans of all parties involved are realized or Ex post equals ex ante not to be confused with equality e. g. quantities sold must – by definition – always be equal to quantities bought

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6 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.4 Equilibrium in the market Quantity (per time period) D S P0P0 Q0Q0 If the price lies above the equilibrium price then: i)there will be a surplus, ii)quantity supplied will exceed quantity demanded, iii)price will start falling. P1P1 Surplus Price ( per unit)

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7 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.5 Basic concepts Efficiency in production will be reached when one cannot produce the same level of output at lower cost, i. e. using the minimal resources, valued at their (factor) prices; OR one cannot produce more output using the same set of inputs.

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8 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.6 Basic concepts Pareto efficiency or allocative efficiency will be reached when no individual can be made better off without making another person worse off.

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9 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.7 Basic tools Functions: A dependent variable (y) is a function of an independent variable (x) y = f(x) or y = y(x) or y = g(x, z) y = bx or y = a – bx or y = 10 –.5x y = a – bx + cz

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10 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 1.8 Basic tools Graphs: linear (y = a – bx) x (quantity) y (price) Linear demand curve

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11 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider U1U1 Indifference curve 1.9 Basic tools Graphs: non-linear (y = a/x) x (food) y (clothing) 50

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12 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2 Consumer theory Preferences Utility functions Indifference curves Consumer optimum Marginal benefit and marginal cost

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13 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.1Preference orderings When comparing bundles of goods, consumer preferences are supposed to fulfil the following axioms: Preferences of individuals (or households) are complete (vollständig, d.h. alle Warenkörbe sind vergleichbar und bewertbar) transitive (Warenkörbe: wenn A>B und B>C, dann ist auch A>C) non-satisfactory (mehr ist besser als weniger) (reflexive: jeder Warenkorb ist so gut wie er selbst)

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14 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.2 Utility functions Preferences can be represented by utility functions which are functions that assign higher numbers to bundles of goods which are preferred over others. Utility functions are ordinal representations of preferences.

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15 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.3 Indifference curves Another representation of preferences are indifference curves: Each bundle of goods on a specific indifference curve yields the same level of utility (for a specific consumer/household). Indifference curves have a negative slope; are (usually) convex towards the origin; cannot intersect; represent greater utility if farther away from the origin.

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16 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider U1U1 2.4 Indifference curve (graph) x (food) y (clothing) 50

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17 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider U2U2 U3U3 2.5 Indifference map x (food) y (clothing) U1U1 A B D Bundle A Is preferred to bundle B; B is preferred to D.

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18 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.6Budget constraint (1) x (food) y (clothing) An increase in income shifts the budget constraint parallel outwards (to the right). (I = 160) L2L2 (I = 80) L1L1 L3L3 (I = 40) A decrease in income shifts the budget constraint parallel inwards (to the left).

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19 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.7Budget constraint (2) x (food) y (clothing) (P x = 1) L1L1 An increase in the price of food pivots the budget constraint clockwise. L3L3 (P x = 2) (P x = 0.5) L2L2 A decrease in the price of food pivots the budget constraint counterclockwise.

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20 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.8Consumer optimum The consumers/households objective is to maximize utility, i.e. to allocate her scarce budget such that (graphically) she reaches the highest (farthest to the right) indifference curve.

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21 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider U 2.9Consumer optimum (graph) P y = 2 P x = 1 I = 80 budget constraint A At bundle A the budget constraint and the indifference curve are tangent to each other, no higher level of utility can be reached at given prices and income in A: MRS =P x P y = 0,5 x (food) y (clothing)

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22 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider Price-consumption-curve 2.10 Demand curve (1) x (food) y (clothing) U2U2 U3U3 A B D U1U The price-consumption-curve consists of all utility-maximizing bundles for different food prices.

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23 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.11 Demand curve (2) Demand curve The demand curve relates the quantity demanded by the consumer to its price. x (food) Price of food H E G 2, ,00 0,50

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24 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.12 Price elasticity of demand The price elasticity of demand (E P ) is equal to: (P … price; Q … quantity; … change in)

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25 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.13 Price elasticity of demand (graph) Q P Q = 8 - 2P E p = -1 E p = 0 The lower part of the demand curve Is less elastic than the upper part Linear demand curve Q = a - bP Q = 8 - 2P

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26 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.14 Elastic and inelastic demand When E P > 1 … elastic demand E P = 1 … unitary elastic demand E P < 1 … inelastic demand

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27 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 2.15 Marginal benefit and cost Any constrained optimum can be viewed as a situation where marginal cost equals marginal benefit i. e. MC = MB

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28 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider Marginal cost Marginal benefit MC=MB 2.16 Cost and benefit of pollution reduction Reduction in pollution

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29 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 3Theory of the firm The firms objective is profit maximization. Profit maximization implies cost minimization. Firms are constrained by the technology at any given point in time. The main task of a firm is the optimal combination of inputs. We assume the firms to face competitive markets both for their inputs and their output.

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30 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 3.1Profit maximization Profit (π) is defined as the difference between total revenue and total cost. A firm will maximize its profits by producing at an output level where marginal cost (MC) is equal to marginal revenue (MR). For a firm operating in a perfectly competitive market MR will be equal to P. Thus the above condition becomes MC = P.

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31 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider q0q0 Profit lost at q 1 < q * Profit lost at q 2 > q * q1q1 q2q2 3.2Profit maximization (graph) Price MC AVC ATC AR=MR=P Output q*q* At q * : MR = MC and P > ATC D A B C q 1 : MR > MC and q 2 : MC > MR and q 0 : MC = MR but MC falls

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32 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider Price MC Output AVC ATC P = AVC P1P1 P2P2 q1q1 q2q2 S = MC above AVC 3.3 Short-run supply of a competitive firm Shut down

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33 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 3.4 Market demand and supply Market demand is the (horizontal) sum of the individual households demand curves (derived from utility maximization). Market supply is the (horizontal) sum of the individual firms supply curves (derived from profit maximization, a section of the firms MC-curve).

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34 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 3.5 Market equilibrium (graph) D S Q1Q1 Q2Q2 P2P2 shortage Output Price Suppose the price to be P 2 : 1) Q D = Q 2 > Q s = Q 1 2) There is a shortage equal to Q 2 – Q 1. 3) Producers raise the price. 4) Quantity supplied increases, quantity demanded decreases. 5) Equilibrium will be reached at P 3, Q 3. Q3Q3 P3P3

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35 of 35 Recht und Ökonomie SS 2011Microeconomics – Repetition Part 1Prof. Dr. Friedrich Schneider 3.6Perfectly competitive markets Perfect competition implies that no individual actor can influence the market price; firms may have positive or negative profits in the short run; leads to zero profits for each firm in the long run; will result in a Pareto optimal allocation of resources in the long run.

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