Model Based Policy Analysis (Subject) / 4. Review of microeconomic theory (Lesson)

microeconomic theory needed for policy modeling

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• Explain the principles of utility maximization. Principles of utility maximization -          Individuals maximize their utility through consumption -          There is a budget constraint -          Non-satiation: all income is spent -          Positive marginal utility --> more is always better -          Individuals choose bundles of goods for which the rate of tradeoff between any two goods (marginal rate of substitution MRS) is equal to the ratio of the good’s markets prices -          Demand functions can be mathematically derived using Lagrangian multiplier -          Income and prices determine consumption decision
• What is an indirect utility function? Indirect utility function -          Can be computed from the individual’s utility function -          Gives the individual’s maximal attainable utility s.t. the good’s prices and the amount of income -          Refers to the primary problem = utility maximization -          The derivate of the indirect utility function leads to the Marshallian demand function (Roy’s Identity) -          Maximizing the direct utility function leads to the optimal utility maximizing values for all goods considered. These goods in turn are indirectly dependent on a set of prices and income.
• What does expenditure minimization mean? Expenditure minimization -          Dual problem -          Minimize expenditure to reach a certain level of utility dependent on a set of prices -          Leads to expenditure function:   -          The derivate of the expenditure function leads to the Hicksian demand function (Shepard’s Lemma) -          Expenditure is the inverse of the indirect utility function at a specific utility level u
• Uncompensated vs. compensated demand Uncompensated vs. compensated demand -          Uncompensated “Marshallian” demand: 1.       Primary problem: result of utility maximization 2.       Demand dependent on prices and income 3.       Can be observed and is subject of most empirical studies 4.       Substitution and income effect -          Compensated “Hicksian” demand: 1.       Dual problem: result of expenditure minimization with constant utility 2.       Cannot be observed 3.       Only shows substitution effects following a price change and therefore useful for decomposing price effects
• What are the properties of demand functions? Properties of demand functions Adding-up, Homogeneity, Symmetry, Negativity Homogeneity -          Demand functions are homogenous of degree zero in all prices and income è Changing all prices and income proportionally will not change the physical quantities demanded è No money illusion through inflation
• What are income effects? Income effects -          Income elasticity of demand: proportionate change in quantity demanded in response to a proportionate change in income -          Normal goods: income elasticity ≥ 0 ; an increase in income will lead to an increase in demand -          Luxury goods: income elasticity > 1 -          Inferior goods: income elasticity < 0 ; increase in income leads to decrease of demand
• What are own price effects? Own price effects -          Slutsky equation: Price changes always have two effects: 1.       Substitution effect (always negative) 2.       Income effect (positive or negative) -          Income effect positive = normal good -          Income effect negative = inferior good -          Substitution effect + income effect is almost always < 0 à price increase leads to a lower quantity demanded -          Exception: giffen goods, here a price increase leads to a higher quantity demanded. The income effect outweights the substitution effect.
• What is own price elasticity? Own-price elasticity -          Is always negative (except for Giffen goods) -          Own-price elasticity ??,?? = -1 : demand is unt elstic. A 1% price increase leads to a 1% decrease in quantity demanded. -          Own-price elasticity ??,??  < -1 : demand is elastic. Quantity changes are proportionally larger than price changes. -          Own-price elasticity ??,??  > -1 : demand is inelastic. Quantity changes proportionately smaller than price changes.
• Adding-up: Engel aggregation Adding-up: Engel aggregation -          All income is spent à sum of budget shares = 1! -          Sum of marginal budget shares (budget shares time income elasticity) = 1! -          Weighted average of all income elasticities for all consumed goods must add up to 1 -          Important rule for demand system in CGE
• What are cross-price-effects? What is cross-price-elasticity? Cross price effects -          Gross cross price effect: income and substitution effect -          Net cross price effect: substitution effect only Gross effects can be asymmetric due to income effects: I can be a gross substitute for j, but j can be a gross complement for i. Examples? Cross-price elasticity -          Proportionate change in quantity demanded in response t a proportionate change in the price of another good

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