Module 1 Advanced Microeconomics

Atty. Roentgen Jude Paolo L. Ignacio

The Market
As economists we create economic models to simply realities. These models have exogenous and
endogenous variables
Exogenous variables- a variable that exists outside the model. These are independent variables of
the model
Endogenous variable- a variable in an economic model whose value is determined by the model.
These are independent variables of the model
Optimization Principle – people try to choose the best patterns of consumption that they can
afford.
- It is reasonable to assume that people will try to choose things that they want rather than
things they don’t want

Equilibrium Principle- Prices adjust until the amount that people demand of something is equal
to the amount that is supplied
Reservation price- the highest price that a given person will accept and still purchase the good or
the price at which he or she is just indifferent between purchasing or not purchasing the good
Let’s Imagine the Market for Apartment for rent

In advanced microeconomics, we now consider timeframes, now we are focusing on the short
run. Since apartments cannot be built instantly, the short run supply curve of apartments is fixed.
Hence it is graphically represented with a straight line.
Now how will we distribute apartments?
Competitive Market
 - There are many independent landlords who rent out their apartments for the highest price
the market will bear.
- Since it is a competitive market, the price will be dictated by the market equilibrium
which is seen at the intersection of the supply and demand curves the same as the graph
above
o at this price, each consumer who is willing to pay at least P* is able to find an
apartment to rent and each landlord will be able to rent apartments at the going
market price
o this is where both renter and agree on the price

Discriminating monopolist
- Monopoly- a situation where a market is dominated by a single seller of a product
- A discriminating monopolist would sell or rent his product or services in accordance with
the ability of a consumer to pay
- This would mean that consumers would pay different levels of prices
- When we apply this in our current situation of distributing apartment units, the graphical
illustration would be akin to that of a competitive market
- Note however in reality a discriminating monopolist rarely exists because for one to be a
discriminating monopolist you need to either have the patience to auction off your
products/goods and services every now and then or to have access to information on the
ability and willingness to pay of every consumer

Ordinary Monopolist
- An ordinary monopolist would sell or rent of his products or services at the same price
- Applying in our current scenario, he’ll be faced with 2 options
o Option A- he will choose a low price to rent more apartments but end up making
less money
o Option B- choose a high price to rent less apartments but end up making more
money
- A monopolist would end up with a revenue box as shown below

- A monopolist would have to choose a revenue that represents the area of the revenue box
which is denoted by ^p x D(^p)
 o This revenue box represents the highest price that a monopolist would set at ^p
and at the same time it would show that not all units of apartment would be rented
out since there is a space between the quantity D(^p) and the straight supply
curve.
o The reason why not all of the apartments would be rented is that not everyone can
afford the price set by the ordinary monopolist

Rent Control
- When a rent control will be set, there will be an excess demand that would resort in to a
shortage of rental apartments

Budget Constraint

A budget constraint is the total number of items one can afford with the current budget.
A consumption bundle is the collection of all the goods and services consumed by an individual
and we will indicate it by (x1 , x2 )
- The above will be a list of two numbers that tells us how much the consumer is choosing
to consume units of good 1 (denoted by x1 ) and how much the consumer is choosing to
consume units of good 2 (denoted by x2)
- Of course, these goods and services consumed by the consumer is not free so there will
be prices along side which would denoted as (p1 , p2 ) and the amount of money that the
consumer spends which is denoted as m

The equation would be written as:

p1 x1 + p2 x2 < m

- p1 x1 would be the amount of money that the consumer is spending on good 1 and p2 x2
would be the amount of money the consumer is spending on good 2
- the budget constraint of the consumer requires that the amount of money spent on the two
goods be no more than the total amount the consumer has to spend which is denoted in
our equation as m
- the consumer’s affordable consumption bundles are those that don’t cost any more than
m

In studying the budget constraint, 2 goods are often enough.

- in this scenario x1 would be good 1 then, x2 would stand for everything else a consumer
would want to consume.
- When we adopt this scenario, the budget constraint will take the form:

p1 x1 + x2 < m
 - x2 would be called a composite good, since it stands for everything else a consumer might
want to consumer other than good 1
- note that p2 is missing in this equation. This is because, the combination of other goods’
prices are yet to be known, hence the price is still unknown

Budget line
- when discussing the budget line, we will be assuming that the entire income will be
exhausted on the 2 goods
- The budget line is then a set of bundles that cost exactly m,

p1 x1 + p2 x2 = m

- These are the bundles of goods that just exhaust the consumer’s income. This is
graphically depicted below

- When we rearrange the budget line in the previous equation, it would give us the
following:

x2 = m – p1 x1
p2 p2

- This is the equation for a straight line with a vertical intercept of m/p2 and a slope of
-p1/p2
- The slope of the budget line shows the rate at which the market is willing to substitute
good 1 for good 2

Mathematical illustration of Opportunity cost

- Let’s take for example that a consumer will increase her consumption of good 1 by Δx1 of
course this will affect her consumption of good 2, since she has to satisfy the limits of her
budget constraint.
- We will denote the change in the consumption of good 2 by using Δx2
 - Remember that any change in our consumption will need to satisfy the limit of our
budget line.

p1 x1 + p2 x2 = m

- From this equation we’ll have to subtract

p1( x1 + Δx1) + p2(x2 + Δx2) = m

- This second equation has taken into account the changes in consumption stated awhile
ago and from the subtraction, we are given this equation

p1Δx1 + p2Δx2 = 0

- This equation tells us that the total value of the change in her consumption must be zero.
- Now we must solve for Δx2 / Δx1, the rate at which good 2 can be substituted for good 1
while still satisfying the budget constraint.
- This will give us:

Δx2 = -p1
Δx1 p2

- Notice that the right hand side of the equation is just the slope of the budget line
- There is a negative sign since this shows the opportunity cost of consuming 1 good
o When you consume more of good 1, you have to consume less of good 2 and vice
versa

Changes in the Budget line

1. Changes in Income
- An increase in income will cause an outward shift of the budget line, while a decrease in
income will cause an inward shift in the budget line
- Below is shown an increase in income
2. Changes in prices
- Change in the price of one good will not shift the budget line, but will cause a pivot, for
example, there is an increase in the price of good 1, while the income and the price of
good 2 doesn’t change

- Since the price of good 1 has increased, this has made the budget line steeper, as seen
above, consumption of good 1 decreased
- However when the price of both goods will increase, there will be won’t changes in the
budget line.
- Mathematically this is proven in the following method, supposed the prices of both goods
are increased by t
- So we have the original budget line

p1 x1 + p2 x2 = m

- Now both prices has become t times larger, this means we’ll have to multiply both prices
by t

tp1 x1 + tp2 x2 = m

this equation is the same as

p1 x1 + p2 x2 = m
t
- This means that by multiplying both prices by a constant amount t, is just like dividing
income by the same constant t. It follows that if we multiply both prices by t and we
multiply income by t, then the budget line won’t change at all

3. Taxes, Subsidies and Rationing

- Taxes
o Quantity tax- consumer has to pay a certain amount to the government for each
unit of good purchased
 This is mathematically shown as p1 +t
  This makes the budget line steeper as shown awhile ago
o Value taxes or ad valorem taxes- this is a tax on the price of a good rather than the
quantity purchased
 This is mathematically shown as (1 + T )p1
 In effect this will increase the price of a good, making the budget line
steeper
o Lump sum tax- government takes away a fixed amount of money, regardless of
behavior, in effect this will decrease income, it will shift the budget line inwards
- Subsidies
o Quantity subsidy- government gives an amount to the consumer based on the
amount of good purchased
 This effectively decreases the price of goods, making the budget line
flatter
 Mathematically shown as p1 - s
o Ad Valorem subsidy- subsidy based on the price of the good being subsidized
 This again makes the budget line flatter as there would be a decrease in
price
 Mathematically shown as (1 – σ )p1
o Lump sum Subsidy- opposite of a lump sum tax, this will effectively increase
one’s income hence, the budget line will shift outward
- Rationing- this means that the level of consumption of some good is fixed to be no larger
than some amount
o For example in our scenario good 1 would be rationed to no more than x̅ 1 could be
consumed by a given consumer

o As seen the effect is that the budget set has a piece lopped off
o The lopped off piece con consists of all the consumption bundles that are
affordable but have x1 > x̅ 1