ECON 301
SUMMER 2004
XUE QIAO
CLASS REVIEW (Chp 5-Chp 7)
June 23, 2004
Chapter 5: Applying Consumer Theory
► Deriving demand curve: For any given price, we can apply consumer constrained
choice to derive the optimal consumption bundle. Find the
combination of ( px , Qx ), and plot it, then we derive the
demand curve.
--------To derive it numerically, use formula
MRS  MRT
which can also be rewritten as
MU X PX

MU Y
PY
The above formula will derive a equation about optimal consumption
bundle, then put this equation back into budget constraint, then we can find
( x , y  ).
► Income change: cause Budget constraint to shift.
--------------- optimal consumption
--------------- Income-consumption curve
--------------- Engle curve: upward sloping implies normal good,
downward sloping: inferior good.
QY
--------------- Income elasticity:  
: >0, then normal good
Y Q
<0, then inferior good.
► Price change: Total effect = substitution effect + income effect
--------------- Decompose TE into SE and IE:
Step 1: draw a budget line BL* parallel to the new BL, and tangent to
Initial indifference curve, then we have a new tangent point e*.
Step 2: The movement from e0 (the tangent point between initial IC and
Initial budget constraint) to e measures the SE.
Step 3: The movement from e* to e1 ( the tangent point between new BC
And new IC) measures the IE.
Note: Be careful about the direction.
SE= e  e0
IE= e1  e
TE= e1  e 0
--------------- Consider the case when price of good x drops:
Normal good: SE: Q  0
IE: Q  0 Then TE >0
Inferior good: SE: Q  0
IE:
Q0
Then TE > 0 if | SE || IE |
TE < 0 if | SE || IE | (Giffen good)
► Derive Labor supply curve
--------------- H=24-N
--------------- Derive leisure demand curve by applying consumer constrained choice
--------------- Labor supply =24-demand curve of leisure
--------------- Properties of leisure decides the shape of labor supply curve
When wage is low, people view leisure as an inferior good:
W increases, labor supply increase
When wage is high, people view leisure as a normal good:
W increases, labor supply decrease
So labor supply will increase first then start to decrease, i.e., upward
Sloping first, then downward sloping.
Chapter 6: Firm and production
► Production function is defined as the maximum output by using existing inputs, so
this definition implies efficient production process.
------------ short-run: capital is fixed
------------ long-run: labor and capital can both be varied.
► Short-run production:
----------- TP, MPL ,AP
----------- the shapes of these three definitions
----------- properties of these three definitions and how to show them graphically
----------- Diminishing marginal returns: MPL is decreasing when L increases.
► Long-run production:
----------- isoquant: q  f ( L, K )
MPL
, and MRTS is decreasing
MPK
----------- shape of isoquant: straight line: perfect substitutes
right-angle : perfect complement
convex: imperfect substitutes
----------- slope of isoquant: MRTS  
► Return to scales:
f (tK , tL)  tf ( K , L )  IRS
----------- Def: f (tK , tL)  tf ( K , L )  CRS
f (tK , tL)  tf ( K , L )  DRS
----------- Tell the “return to scales” from graph: given several isoquants and
corresponding inputs bundles.
----------- Return to scales can be varied across firm’s size: IRS for small
CRS for moderate
DRS for large
Chapter 7: Costs
► Measuring cost: economical cost=explicit cost + opportunity cost
► Short-run cost: capital is fixed, so we have a nonzero FC.
----------- 7 Defs: FC, VC, TC, AFC, AVC, AC, MC
TC=VC+FC, AC=AVC+AFC, AFC=FC/Q, AVC=VC/Q,
TC
MC=
Q
----------- Properties of these 7 curves and relationship among them
----------- Be able to show them graphically.
----------- Effect on cost of a government specific tax & franchise fee.
► Long-run cost: FC=0
----------- isocost line: C  wL  rK
w
----------- slope of isocost: 
r
w
r
or Lowest isocost line
or Last dollar rule.
----------- Shape of Long-run cost(LRC), Long-run Average cost(LRAC), MC
-------- depends on “return to scales”:
CRS: LRC: upward-sloping straight line
LRAC & MC: constant
IRS: LRC: increasing, but slope is decreasing
LRAC & MC: decreasing
DRS: LRC: increasing, but slope is increasing
LRAC & MC: increasing
-------- the part where LRAC is decreasing is called “economies of scale”
increasing
“diseconomies ….”
Constant
“ no economies …”
------------ Long-run expansion path and short-run expansion path
Read practice IV.
----------- derive the cost-minimizing bundles of inputs: MRTS  
►