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RL 3 Review

Exam u u u u Date: May 13 th, 5: 05 -7: 05 p. m. Room: u (A-K) SS 6210, u (L-Z) Humanities 2650 Cumulative 2 hours (120 min) Closed book (calculators not needed) Format: Problems as in PS (no true false q) Course Grade: 25 -20 -20 -35, Curve! Preparation 1. Master all PS and past exams 2. Read slides 3. Read book

Consumer’s Theory Fix u u (parameter) Budget set (plot, interpret slope) 4 types of preferences (plot, find interpret MRS, MT) Optimal choice (So. H, find analytically and geometrically) Magic formula for Cobb-Douglass! (derive it) Changes in p and m u Substitution and Income effect u Ordinary and Giffen, Inferior and Normal goods Real endowments (choice) u Geometric representation u Choice – buying and selling

3 applications u u u Labor market - labor supply: w given Budget set, Choice, Labor Supply, Elasticity Intertemporal Choice: r given 1) 2 periods: Budget set, Choice, PV, FV, CS Consumption smoothing 2) T periods: Annuity and perpetuity: PV formula Lease or buy, loan, pension plan, value of the bond Uncertainty: gamma given 1) Lottery, Bernoulli and VNM utility 2) Risk aversion and certainty equivalent 3) Insurance (fair insurance)

Markets and Equilibrium u Many (2) agents u Edgeworth Box

Markets: Competitive Equilibrium u Competitive Equilibrium 1) Choices optimal given prices 2) Markets clear (supply=demand) u Find CE analytically and geometrically. Tricks: 1) one price =1, 2) market clearing for only one good 3) magic formula! FWT: Competitive equilibrium is Pareto efficient! u

Competitive Equilibrium

Competitive Equilibrium (Geometry)

Are Markets Efficient?

Pareto Efficiency

Are Markets Efficient?

Competitive Producers u Producers have technology and maximize profit Properties of F( , ): RS, MPK, MPL Geometric representation: Isoquants So. H for Profit Maximization, Cost Minimization Profit maximization= cost minimization + choice of y u Derive cost functions, shapes for IRS, CRS and DRS u Supply function (also with fixed costs) u Equilibrium with N producers Equilibrium with free entry (determine N) u u u

Market failure 1. Market Power u u u One producer (Monopoly) = it has market power Demand Cost function Optimal choice, elasticity and markup (uniform price) TS, CS, PS, DWL Price discrimination (three types)

Market failure 1. Market Power u u N firms Demand Cost function

DWL

Market failure 2. Externality u Our utility/profit depends on action of others Positive and negative externality Problem strategic interdependence = Nash equilibrium Equilibrium : mutual best responses Special case of positive externality: Public good u Pareto efficiency: Too little or too much? Free riding u u

Market failure 3. Asymmetric Information u u u Adverse selection (hidden information) Example: Buyers of cars know less then sellers 1) Separating equilibrium: good cars not traded 2) Pooling equilibrium: both cars traded Incentives for good types to send credible signals Credibility: for bad types too costly to pretend good ones Moral hazard (hidden action) Insurance contracts change incentives! Insurers should take it into account