Chapter 1.

The Market
Exogenous variables – factors not discussed in the particular model, endogenous variables –
factors described in the model.
Common Framework: The optimization principle: People try to choose the best patterns of
consumption that they can afford. The equilibrium principle: Prices adjust until the amount that
people demand of something is equal to the amount that is supplied.
Reservation Price – person’s maximum willingness to pay. In the short run, the Supply
Curve is vertical (for example, in the apartment market of a small town, when there are no
constructions planned for the next year, the supply quantity is fixed no matter the price).
Ways of allocating resources: (0) The Competitive Market (according to the equilibrium of
Demand and Supply). (1) The Discriminating Monopolist (a single landlord organizing auctions
and renting for different prices). Interesting point: the same people are going to get the
apartments in those 2 cases. (2) The ordinary monopolist (he cannot charge different prices, but
he is going to manipulate prices either higher/lower/equal to equilibrium to maximize his
revenue). (3) Rent control (when a certain Pmax is given under the equilibrium price, causing
excess demand).
Pareto Efficiency: If we can find a way to make some people better off without making
anybody else worse off, we have a Pareto improvement. If an allocation allows for a Pareto
improvement, it is called Pareto inefficient; if an allocation is such that no Pareto improvements
are possible, it is called Pareto efficient. The first two of resource allocating ways are efficient,
and the last two are not.

Chapter 2. Budget Constraint

Budget constraint of the consumer: p1x1 + p2x2 ≤ m. To represent the situation of 1 good x1
and all the other goods (or simply units of money) being x2: p1x1 + x2 ≤ m (as the p2=1 unit of
money). We say that good 2 represents a composite good that stands for everything else that the
consumer might want to consume other than good 1.
The budget line is the set of bundles that cost exactly m: p1x1 + p2x2 = m.
 The slope of the budget line has a nice economic interpretation. It measures the rate at
which the market is willing to “substitute” good 1 for good 2. Thus, the slope of the budget line
measures the opportunity cost of consuming good 1.

Factors changing the budget line: (1) An increase in income will result in a parallel shift
outward. (2) An increase in prices can cause a shift inward if both prices are changed, or a shift
of one of the intercepts, causing a change in the slope if a single price changed.

since the first budget line results from dividing everything by p2, and the second budget line
results from dividing everything by m. In the first case, we have pegged p2 = 1, and in the
second case, we have pegged m = 1. When we set one of the prices to 1, as we did above, we
often refer to that price as the numeraire price. The numeraire price is the price relative to which
we are measuring the other price and income.
Economic policy often uses tools that affect a consumer’s budget constraint: (1) If the
government imposes a quantity tax, this means that the consumer has to pay a certain amount to
the government for each unit of the good he purchases. (2) Another kind of tax is a value tax (ad
valorem): a tax on the value—the price—of a good, expressed in percentage terms. (3) A
subsidy is the opposite of a tax. In the case of a quantity subsidy, the government gives an
amount to the consumer that depends on the amount of the good purchased. (4) Another kind of
tax or subsidy that the government might use is a lump-sum tax or subsidy. In the case of a tax,
this means that the government takes away some fixed amount of money, regardless of the
individual’s behavior. Thus a lump-sum tax means that the budget line of a consumer will shift
inward because his money income has been reduced. Similarly, a lump-sum subsidy means that
the budget line will shift outward. (5) Governments also sometimes impose rationing
constraints. This means that the level of consumption of some goods is fixed to be no larger than
some amount.
A perfectly balanced inflation—one in which all prices and all incomes rise at the same rate
—doesn’t change anybody’s budget set, and thus cannot change anybody’s optimal choice.

Chapter 3. Preferences
Consumption bundle – the object of consumer choice.
(x1, x2) ≻ (y1, y2) should be interpreted as saying that the consumer strictly prefers (x1, x2)
to (y1, y2). If the consumer is indifferent between two bundles of goods, we use the symbol ∼
and write (x1, x2) ∼ (y1, y2). If the consumer prefers or is indifferent between the two bundles
we say that she weakly prefers (x1, x2) to (y1, y2) and write (x1, x2) ≻ (y1, y2).

1. Transitivity DOESN’T imply Reflexivity;

2. If no elements preferred to each other => preference is NOT complete;
3. Transitivity DOESN’T imply Completeness;
4. Completeness DOESN’T imply Transitivity;
5. Completeness DOES imply Reflexivity;
6. Reflexivity DOESN’T imply Transitivity;
 7. Reflexivity DOESN’T imply Completeness.

Let us pick a certain consumption bundle (x1, x2) and shade in all of the consumption
bundles that are weakly preferred to (x1, x2). This is called the weakly preferred set. The
bundles on the boundary of this set—the bundles for which the consumer is just indifferent to
(x1, x2)—form the indifference curve. Indifference curves representing distinct levels of
preference cannot cross.

Two goods are perfect substitutes if the consumer is willing to substitute one good for the
other at a constant rate. The simplest case of perfect substitutes occurs when the consumer is
willing to substitute the goods on a one-to-one basis.

Perfect complements are goods that are always consumed together in fixed proportions.
 A bad is a commodity that the consumer doesn’t like. For example, suppose that the
commodities in question are now pepperoni and anchovies— and the consumer loves pepperoni
but dislikes anchovies. But let us suppose there is some possible tradeoff between pepperoni and
anchovies. That is, there would be some amount of pepperoni on a pizza that would compensate
the consumer for having to consume a given amount of anchovies.

A good is a neutral good if the consumer doesn’t care about it one way or the other.

We sometimes want to consider a situation involving satiation, where there is some overall
best bundle for the consumer, and the “closer” he is to that best bundle, the better off he is in
terms of his own preferences. For example, suppose that the consumer has some most preferred
bundle of goods (x1, x2), and the farther away he is from that bundle, the worse off he is. In this
case, we say that (x1, x2) is a satiation point or a bliss point.
In this case, the indifference curves have a negative slope when the consumer has “too little” or
“too much” of both goods and a positive slope when he has “too much” of one of the goods.
When he has too much of one of the goods, it becomes a bad—reducing the consumption of the
bad good moves him closer to his “bliss point.” If he has too much of both goods, they both are
bads, so reducing the consumption of each moves him closer to the bliss point.
Discrete goods are only available in integer amounts.

The choice of whether to emphasize the discrete nature of a good or not will depend on our
application. If the consumer chooses only one or two units of the good during the time period of
our analysis, recognizing the discrete nature of the choice may be important. But if the consumer
is choosing 30 or 40 units of the good, then it will probably be convenient to think of this as a
continuous good.
Well-behaved indifference curves' features: (1) more is better (monotonicity); (2) averages
are preferred to extremes; (3) well-behaved preferences are convex; (4) the weighted average of
two indifferent bundles is strictly preferred to the two extreme bundles.
MRS (Marginal Rate of Substitution) = the slope of an indifference curve: the rate at which
the consumer is just willing to substitute one good for the other.

Chapter 4. Utility
A utility function is a way of assigning a number to every possible consumption bundle such
that more-preferred bundles get assigned larger numbers than less-preferred bundles.
The only property of a utility assignment that is important is how it orders the bundles of
goods. The magnitude of the utility function is only important insofar as it ranks the different
consumption bundles; the size of the utility difference between any two consumption bundles
doesn’t matter. Because of this emphasis on ordering bundles of goods, this kind of utility is
referred to as ordinal utility.
A monotonic transformation is a way of transforming one set of numbers into another set of
numbers in a way that preserves the order of the numbers.
What we are calling a “monotonic transformation” is, strictly speaking, called a “positive
monotonic transformation,” in order to distinguish it from a “negative monotonic
transformation,” which is one that reverses the order of the numbers. Monotonic transformations
are sometimes called “monotonous transformations,” which seems unfair, since they can actually
be quite interesting.
Cardinal utility theories: attach a significance to the magnitude of utility. One could propose
various definitions for this kind of assignment: I like one bundle twice as much as another if I am
willing to pay twice as much for it. Or, I like one bundle twice as much as another if I am willing
to run twice as far to get it, or to wait twice as long, or to gamble for it at twice the odds. There is
nothing wrong with any of these definitions; each one would give rise to a way of assigning
utility levels in which the magnitude of the numbers assigned had some operational significance.
But there isn’t much right about them either. Knowing how much larger doesn’t add anything to
our description of choice.
 Quasilinear Preferences: u(x1, x2) = k = v(x1) + x2.

‘c’ and ‘d’ are positive numbers describing the preferences of the consumer.
Of course, a monotonic transformation of the Cobb-Douglas utility function will represent
exactly the same preferences, and it is useful to see a couple of examples of these
transformations.

Marginal Utility:
 Chapter 5. Choice

Does this tangency condition really have to hold at an optimal choice? Well, it doesn’t hold in
all cases, but it does hold for most interesting cases. What is always true is that at the optimal
point the indifference curve can’t cross the budget line.

Here the indifference curve has a kink at the

optimal choice, and a tangent just isn’t defined, since the mathematical definition of a tangent
requires that there be a unique tangent line at each point.
The second exception is more interesting. Suppose that the optimal point occurs where the
consumption of some good is zero as in Figure 5.3. Then the slope of the indifference curve and
the slope of the budget line are different, but the indifference curve still doesn’t cross the budget
line. We say that Figure 5.3 represents a boundary optimum, while a case like Figure 5.1
represents an interior optimum.
We’ve found a necessary condition that the optimal choice must satisfy. If the optimal
choice involves consuming some of both goods—so that it is an interior optimum—then
necessarily the indifference curve will be tangent to the budget line. But is the tangency
condition a sufficient condition for a bundle to be optimal?

(sufficient - достаточный)
However, there is one important case where it is sufficient: the case of convex preferences.
The condition that the MRS must equal the slope of the budget line at an interior optimum
is obvious graphically, but what does it mean economically? Recall that one of our
interpretations of the MRS is that it is that rate of exchange at which the consumer is just willing

to stay put Suppose, for example, that the MRS is Δx2/Δx1 = −1/2 and the
price ratio is 1/1. Then this means the consumer is just willing to give up 2 units of good 1 in
order to get 1 unit of good 2—but the market is willing to exchange them on a one-to-one basis.
Thus the consumer would certainly be willing to give up some of good 1 in order to purchase a
little more of good 2. Whenever the MRS is different from the price ratio, the consumer cannot
be at his or her optimal choice.
The optimal choice of goods 1 and 2 at some set of prices and income is called the
consumer’s demanded bundle. In general when prices and income change, the consumer’s
optimal choice will change. The demand function is the function that relates the optimal choice
—the quantities demanded—to the different values of prices and incomes. We will write the
demand functions as depending on both prices and income: x1(p1, p2, m) and x2(p1, p2, m).
Perfect substitutes: If p2 > p1, then the slope of the budget line is flatter than the slope of the
indifference curves. In this case, the optimal bundle is where the consumer spends all of his or

her money on good 1.

 Perfect complements:

Neutrals and Bads: In the case of a neutral good the consumer spends all of her money on the
good she likes and doesn’t purchase any of the neutral good. The same thing happens if one
commodity is a bad. Thus, if commodity 1 is a good and commodity 2 is a bad, then the demand

functions will be
Discrete goods: Suppose that good 1 is a discrete good that is available only in integer units,
while good 2 is money to be spent on everything else. If the consumer chooses 1, 2, 3, ··· units
of good 1, she will implicitly choose the consumption bundles (1, m −p1), (2, m −2p1), (3, m
−3p1), and so on. We can simply compare the utility of each of these bundles to see which has
the highest utility.
 Concave preferences: If you have money to purchase ice cream and olives, and you don’t like
to consume them together, you’ll spend all of your money on one or the other.

Cobb-Douglas preferences: the optimal choices are

The Cobb-Douglas preferences have a convenient property. Consider the fraction of his income
that a Cobb-Douglas consumer spends on good 1. If he consumes x1 units of good 1, this costs
him p1x1, so this represents a fraction p1x1/m of total income. Substituting the demand function

for x1 we have Thus the Cobb-Douglas consumer always spends

a fixed fraction of his income on each good.
 Taxes:

Quantity tax:

Income tax:
Limitations: (1) it only applies to one consumer. The argument shows that for any given
consumer there is an income tax that will raise as much money from that consumer as a quantity
tax and leave him or her better off. However the amount of that income tax will typically differ
from person to person. So a uniform income tax for all consumers is not necessarily better than a
uniform quantity tax for all consumers (Think about a case where some consumer doesn’t
consume any of good 1—this person would certainly prefer the quantity tax to a uniform income
tax). (2) we have assumed that when we impose the tax on income the consumer’s income
doesn’t change. We have assumed that the income tax is basically a lump sum tax—one that just
changes the amount of money a consumer has to spend but doesn’t affect any choices he has to
make. This is an unlikely assumption. If income is earned by the consumer, we might expect that
taxing it will discourage earning income, so that after-tax income might fall by even more than
the amount taken by the tax. (3) we have totally left out the supply response to the tax. We’ve
shown how demand responds to the tax change, but supply will respond too, and a complete
analysis would take those changes into account as well.
Chapter 6. Demand