Introductory lectures on
Microeconomics
Lecture 1 – Markets and gains from
trade
Department of
Management
28th September 2010
Mara Airoldi
Structure of the lectures
 Lecture 1 – Markets: efficiency and gains
from trade
 Focus on models in economics
 Lecture 2 – Cost functions, budgets and
elasticity
 Focus on theory of consumption and theory of
production
 Lecture 3 – Markets and welfare economics
 Focus on market equilibrium
 Lecture 4 – Expected value and discounting
Reading for lecture 1
Varian, Intermediate
Microeconomics:




Chapter
Chapter
Chapter
Chapter
1: “The Market”
3: “Preferences”
4: “Utility”
30: “Exchange”
Objectives to appreciate:
 Use of models and graphs in economics
 Utility functions & indifference curves
 Trade-offs and gains from trade:
indifference curves & the Edgeworth box
 Market efficiency
 Pareto optimality
Structure
 Microeconomic theory
 Graphs, trade-offs & gains from
trade
 ‘indifference curves’
 ‘Edgeworth box’
 Market efficiency
Microeconomic theory and models
 Models are a simplification of reality
 “Art of leaving things out”
 A good model is one which very little
can explain a lot
Microeconomic theory & market
efficiency
A theory in four acts:
1. Robinson Crusoe economy
 1 person economy (producer & consumer)
2. The ‘benevolent central planner’
 Many producers & many consumers
 ‘First best solution’: what would happen if
many producers & many consumers would
do what the benevolent central planner
wishes them to do
 Does not exist in practice
Microeconomic theory & market
efficiency
3. The ‘good news’ about the market
Under certain conditions
 the market produces the same outcomes as the
benevolent planner
 & it is very ‘cheap’
4. When market fails
 Why does it fail?
 Can we ‘fix’ it within a market mechanism?
 Can we ‘fix’ it within a different institutional
arrangement?
Structure
 Microeconomic theory
 Graphs, trade-offs & gains from
trade
 ‘indifference curves’
 ‘Edgeworth box’
 Market efficiency
Representing the availability of two
commodities of good in a graph
“Non satiation”
assumption:
more is always
better than less
More of y
Commodity y
e.g. bottles
of red wine
0
Otherwise, it is out of
the area of interest of
‘economics’
More of x
Commodity x
e.g. bottles of
white wine
Quadrants of preference: more
is better
Commodity y:
e.g. bottles
of red wine
E
C
0
B
A
D
Commodity x: e.g. bottles
of white wine
Quadrants of preference: more
is better
Commodity y:
e.g. bottles
of red wine
North East
quadrant:
certainly preferred
(dominant points)
?? Need
more info
E
C
0
South West quadrant:
certainly not preferred
(all dominated by A)
B
A
D
Commodity x: e.g. bottles
of white wine
Diminishing marginal utility
 “non satiation”
 More is better
utility
 But the more you
have the less you
value increases
Bottles of
white wine
Diminishing marginal utility
 The added value of
the first bottle of
wine is greater
than
 the added value of
the 2nd bottle
which is greater
than
 The added value of
the 3rd bottle etc…
utility
u(2)
u(1)
Added value
of 2nd bottle
Added value
of 1st bottle
1
2
3 Bottles
of wine
Indifference curves
Better
than A
Bottles
of red wine
E
Worse
than A
C
0
B
A
D
Bottles of white wine
D is as good as A (it is on the same indifference curve)
Indifference curves
Bottles
of red wine
E
C
0
B
A
D
Bottles of white wine
People prefer to be on higher indifference curves (more is better)
Utility & indifference curves
utility
Bottles
of red wine
Bottles of
white wine
Bottles of white wine
Structure
 Microeconomic theory
 Graphs, trade-offs & gains from
trade
 ‘indifference curves’
 ‘Edgeworth box’
 Market efficiency
A Robinson Crusoe economy:
Maria
Maria’s flour
Maria has this
much flour to
start with
0
Production function:
How Maria turns
flour into pasta
Maria’s pasta
Paul’s flour
Another Robinson Crusoe
economy: Paul
0
Paul’s pasta
Edgeworth box
- what is it?
Maria’s pasta
Paul’s flour
Maria’s flour
0
Paul’s pasta
Edgeworth box
– Gains from trade
Paul’s flour
0
Paul’s pasta
Total pasta available
Total flour available
0
Maria’s flour
Maria’s pasta
Edgeworth box
– Gains from trade
Paul’s flour
Total pasta available
Total flour available
Paul’s pasta
Maria’s flour
Maria’s pasta
Edgeworth box
– Gains from trade
Paul’s flour
Total pasta available
Total flour available
Paul’s pasta
Maria’s flour
Maria’s pasta
Edgeworth box
– Gains from trade
Paul’s flour
Total pasta available
Total flour available
Paul’s pasta
Maria’s flour
Maria’s pasta
Edgeworth box
– Gains from trade
Paul’s pasta
Total pasta available
Total flour available
Paul’s flour
Maria’s pasta
Maria’s flour
Yellow
area:
allocations
preferred
by both
people
Edgeworth box
– Gains from trade
Paul’s flour
Total pasta available
Total flour available
Paul’s pasta
Maria’s flour
Maria’s pasta
Contract
curve
Structure
 Microeconomic theory
 Graphs, trade-offs & gains from
trade
 ‘indifference curves’
 ‘Edgeworth box’
 Market efficiency
Contract curve & Pareto
optimality
 Contract curve
 Links tangent points of indifference curves of A
&B
 These points are ‘Pareto optimum’ or ‘Pareto
efficient’
 “Pareto efficiency” or “Pareto optimality”
 To compare different economic outcomes
 An outcome is Pareto efficient if it is not possible
to make at least one person better off without
making anybody else worse off
When do markets work or fail?
 The market ‘works’ if it generates a
Pareto efficient outcome
 Under certain conditions the market
works (Lecture 3)
Today we looked at:
 Microeconomic theory
 Robinson Crusoe
 Benevolent central planner
 Market outcomes and Pareto efficiency
 Graphs, trade-offs and gains from
trade
 Utility and indifference curves
 Edgworth box (gains from trade)
 Market ‘efficiency’
Objectives to appreciate:
 Use of models and graphs in economics
 Utility functions & indifference curves
 Trade-offs and gains from trade:
indifference curves & the Edgeworth box
 Market efficiency
 Pareto optimality
Readings for Lecture 2
 Varian, Intermediate Microeconomics
 Part 1: more on the theory of the
consumer
 Chapter 2: “Budget constraint”
 Chapter 6: “Demand”
 Part 2: the theory of the firm (or of
production)
 Chapter 19: “Profit maximisation”
 Chapter 20: “Cost minimisation”