Microeconomics: Optimization Principle

Class 1: Behavior is Optimization

• Microeconomics focuses on individual decision-making, interactions, and economic policy.
• A central theme in microeconomics is determining the appropriate level of government intervention in the economy.
• Behavior is fundamentally about optimization, where individuals and firms make choices to maximize benefits relative to costs.
• Parents optimize by scheduling C-sections before December 31 to take advantage of tax incentives.
• Changes in sexual behavior may be attributed to shifts in perceived risks, evolving social norms, and access to contraception.
• Decreasing AIDS death rates led to increased risky sexual behavior due to a lower perceived risk of AIDS.
• Mandatory seatbelt laws, while intended to reduce fatalities, paradoxically led to more accidents as individuals felt safer and drove more recklessly.
• The Optimization Principle states that individuals and firms make choices by weighing costs and benefits.
• Economic agents include individuals, families, firms, universities, and nations.
• Resource scarcity constrains decision-making.
• Psychology posits that human decisions are influenced by emotions, biases, and cognitive limitations.
• Economics assumes that people are rational and aim to maximize their utility (happiness, well-being).
• Utility maximization is mathematically expressed as max U.
• The rationality assumption enables clear, mathematical modeling of decision-making.
• While useful, the economic rationality assumption is not always realistic.
• Psychological insights can enhance behavioral models.

Class 2: Marginal Analysis & Consumer Choice

• Marginal analysis involves examining small changes to make optimal decisions.
• The concept of "behavior is optimization" can predict choices by looking at marginal costs versus marginal benefits.
• A "good" can be a physical commodity, a service, or even an intangible benefit.
• A "bad" requires modifications to economic models.
• Total Willingness to Pay (TWP) is how much a consumer is willing to pay for a good.
• Marginal Willingness to Pay (MWP) is the extra amount a consumer is willing to pay for one more unit of a good.
• Consumers should buy as long as MWP > Price.
• Demand curves, derived from MWP schedules, show how many units a consumer buys at different prices.
• Demand typically decreases as price increases, illustrating the law of demand.
• Net Benefit, or consumer surplus, = Total Willingness to Pay - Total Cost.
• Consumers must make decisions by comparing the net benefit with and without membership.
• Marginal Analysis is a key tool in economic decision-making.
• Consumers optimize by equating marginal benefits to marginal costs.
• Demand curves show the relationship between price and quantity demanded.
• Consumer surplus measures the benefit consumers derive from purchases.

Class 3: Consumer Choice with Multiple Goods

• Key Economic Questions: How are resources allocated in an economy, and what role does the government play in this?
• The assumption is that people make rational decisions by weighing costs and benefits.
• People choose the action that maximizes net benefit (Total Benefit - Total Cost).
• Consumers do not maximize marginal benefit or net marginal benefit; they maximize total net benefit.
• Consumer Decision-Making Steps include establishing objectives (preferences), understanding constraints (budget), and optimizing to make the best affordable choice.
• The Budget Constraint (BC) describes the combinations of goods a consumer can buy.
• The budget line shows maximum possible purchases when spending equals income.
• The slope of the budget line (-p1/p2) represents the opportunity cost of good 1 in terms of good 2.
• An increase in income leads to a parallel shift outward.
• A Price Increase causes an inward rotation for the good whose price increased.
• The Indifference Curve (IC) shows combinations of goods that provide equal satisfaction.
• Properties of ICs: Cannot cross, higher ICs are preferred, and are usually convex (diminishing marginal rate of substitution, MRS).
• The Marginal Rate of Substitution (MRS) shows willingness to trade one good for another.
• Diminishing MRS: As you consume more of one good, you’re willing to give up less of the other.

Class 4: Optimal Choice and Marginal Rate of Substitution (MRS) Condition

• Consumers choose the highest possible IC they can afford.
• The optimum is the point where the budget line just touches the highest indifference curve.
• The optimum is expressed mathematically as MRS = p1/p2.
• Consumers trade off goods until the rate at which they are willing to trade equals the market rate.
• Income Increase → Moves to a higher IC.
• Price of a Good Increases → Optimal consumption shifts, reducing the consumption of that good.
• Consumer choice is determined by budget constraints and preferences.
• The optimum occurs when the highest IC just touches the BC.
• Understanding the tangent condition (MRS = price ratio) is key to analyzing consumer decisions.

Class 5: The Competitive Model of Interaction

• The course explores resource allocation in a market economy.
• Understanding how consumers interact in markets is necessary to predict outcomes.
• The model consists of two goods and two types of agents (A and B), each with initial endowments.
• Trade happens in a market, leading to final consumption allocations.
• The model is one-period (no future savings considerations).
• Trade Happens because of different endowments & preferences.
• The New Budget Constraint: p1x1 + p2x2 = p1e1 + p2e2.
• Consumers sell their endowments and buy what they prefer.
• The budget line passes through the endowment point.
• Consumers choose the point where their BC and IC are tangent.
• Different preferences lead to different optimal choices.
• An increase in p1 rotates the budget constraint and alters consumption choices.
• Trade allows consumers to reach a better allocation than their initial endowment.
• The market determines equilibrium prices and allocations.
• Understanding how individual choices aggregate into market outcomes is crucial for economic analysis.

Class 6: Competitive Equilibrium

• Key Question: What allocation results when agents interact in markets?
• Concepts Covered: Market interactions between Type A and Type B agents, competitive equilibrium (CE), trade and voluntary exchange, and the role of prices and efficiency.
• The Market Model includes two types of agents (A and B), each with a certain amount of two goods, and trade takes place in a market.
• One-period model: Agents trade and consume within one period.
• Definition: An allocation (X) is feasible if total goods allocated = total goods available.
• This is represented mathematically and using Edgeworth’s Box.
• Competitive Equilibrium (CE) includes a set of prices and an allocation where each agent makes an optimal choice, taking prices as given, and the allocation is feasible.
• Key Assumptions: Trade is voluntary, people optimize their choices, many buyers and sellers exist, and no single agent can set prices.
• Everyone faces the same prices (law of one price).
• Prices adjust to ensure no excess demand/supply.
• Equilibrium means no one wants to trade more or less.
• If not at CE, some agents would still want to trade.
• Prices adjust until equilibrium is reached.
• At CE, no one has an incentive to change behavior.

Class 7: Pareto Efficiency

• Key Question: Is the competitive equilibrium (CE) allocation good?
• Answer: Pareto efficiency (PE) helps determine.
• Concepts Covered: Pareto efficiency (PE), understanding waste and inefficiency, and application to Edgeworth’s Box.
• Pareto Efficiency (PE) is an allocation where it is impossible to make one person better off without making someone else worse off.
• Different Ways to Define PE: No mutually beneficial trades exist, if you switch allocations, someone will complain
• It only focuses on efficiency, not fairness.
• Pareto Inefficiency is an allocation where there exists an alternative allocation where at least one person is better off without making anyone worse off, indicating waste and potential gains from trade exist.
• Many allocations are NOT Pareto efficient.
• The Pareto Set represents all PE allocations.
• Pareto Efficiency: No one can be better off without hurting someone else
• Inequality: PE does not mean fairness
• Efficiency Focus: Market economies aim for efficiency, not equality
• Next Step: Evaluating if competitive equilibrium is Pareto efficient

Class 8: The First Welfare Theorem

• Key Question: Is the CE allocation Pareto efficient?
• Answer: Yes! This is the First Welfare Theorem.
• Concepts Covered: First Welfare Theorem (FWT), efficiency in market economies, & role of prices in efficient allocation.
• Statement: In a perfectly competitive market, the CE allocation is Pareto efficient.
• Key Implication: Market economies do not waste resources.
• Important Caveat: PE says nothing about equality—markets can be efficient but still unequal.
• Prices act as an invisible hand.
• Everyone faces the same prices.
• Each agent buys up to the point where the marginal valuation equals the price.
• Since prices reflect how much others value goods, individuals act as if they consider others when making purchases.
• No one ends up with something that someone else values more.
• No further opportunities for trade exist
• Therefore efficiency is achieved.
• Command Economy: Allocations are dictated by a central planner leading to inefficiencies due to a lack of knowledge of individual preferences & prices not reflecting valuations, likely resulting in Pareto inefficient allocations.
• Market Economy: Prices emerge naturally from trade, avoiding waste.
• Theorem: Society can achieve any Pareto efficient allocation through redistributing initial endowments (e.g., taxation) and allowing trade in markets.
• Implication: Market economies can be adjusted to address inequality without sacrificing efficiency.
• Taxes can create inefficiencies (e.g., reducing work incentives).
• If inequality is a concern: Use redistribution, not abolishing markets
• Final Question: If markets are efficient, why is the government involved in 30-60% of economic activity?

Microeconomics studies individual decision-making and economic policy, emphasizing optimization. Individuals and firms make choices to maximize benefits relative to costs. Examples include parents scheduling C-sections for tax benefits, changes in sexual behavior due to perceived risks, and the impact of seatbelt laws on driving behavior.