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EC 3101Microeconomic
Analysis II
Instructor: Indranil ChakrabortySng Tuan Hwee
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My contact information• WEBSITE: http://profile.nus.edu.sg/fass/ecsci/
• EMAIL: [email protected]
• PHONE: 6516 3729
• OFFICE: AS2 05‐23
• OFFICE HRS: Tuesday 3pm – 5pm or by appointment
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Note: Week 3 lecture will be held on Week 2 Thursday (August 21, 6-8pm in LT11)
Textbook
Intermediate Microeconomics –A Modern Approach
(8th edition)
by Hal Varian
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Syllabus (subject to change)Week 1 Course Overview; Intertemporal Choice, Ch.10Week 2 Uncertainty, Ch. 12Week 3 Exchange, Ch.31 Week 4 Monopoly, Ch.24Week 5 Monopoly, Ch.24; Oligopoly, Ch.27Week 6 Oligopoly, Ch.27
– Recess Week –Week 7 MidtermWeek 8 Game Theory, Ch.28Week 9 Game Applications, Ch. 29Week 10 Game Applications, Ch. 29Week 11 Externalities, Ch. 34; Public Goods, Ch. 36Week 12 Asymmetric Information, Ch. 37Week 13 Review; AOB
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Assessment
• Homework, 10%
• Participation, 10%
• Midterm Exam, 40%
• Final Exam, 40%
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Homework
• Two individual problem sets
• To be posted on IVLE one week before due date (W?, W? )
• Please submit in hardcopy to tutor’s mailbox
• 20% of total possible points will be deducted each day for late submission
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Participation
• Practice Problems from week ? onwards
• To be discussed in tutorial the following week
• You will present solutions during tutorial
• Everyone needs to present at least once
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Some Ground Rules
• Attendance to be taken in tutorials (Faculty policy)
• No texting or other cellphone use during class
• Academic dishonesty is unacceptable
• Consult syllabus posted on IVLE for all other details for EC3101
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INTERTEMPORAL CHOICE
Week 1(Chapter 10, except 10.4,
10.10, 10.11)
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Chinese Idiom: Three at dawn, Four at dusk
• A Songman raised monkeys.
• He wanted to reduce the monkeys’ ration.
• He suggested giving them 3 bananas in the morning and 4 in the evening. They protested angrily.
• "How about 4 in the morning and 3 in the evening?"
• The monkeys were satisfied. 10
Intertemporal Choice
• Are the monkeys irrational?
• Is one banana in morning equivalent to one in the evening?
• Is a dollar today the same as a dollar tomorrow?
• Should I take a loan from a bank purchase an apartment and rent it out?
• Should I pay off my credit card debt today or not?
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Present and Future Values
• Begin with some simple financial arithmetic.
• Take just two periods; 1 and 2.
• Let r denote the interest rate per period.
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Future Value
• E.g., if r = 0.1 then $100 saved in period 1 becomes $110 in period 2.
• The value next period of $1 saved now is the future valueof that dollar.
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Future Value
• Given an interest rate r, the future value one period from now of $1 is
FV = 1 + r
• Given an interest rate r, the future value one period from now of $m is
FV = m(1 + r)
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Present Value• Q: How much money would have to be saved now to obtain $1 in the next period?
• A: $k saved now becomes $k(1+r) in the next period, Set k(1+r) = 1So k = 1/(1+r)
• k = 1/(1+r) is the present‐value of $1 obtained in the next period.
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Present Value• The present value of $1 available in the next period is
PV = 1/(1 + r)
• And the present value of $m available in the next period is
PV = m/(1 + r)
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Higher r leads to lower PV
• E.g., if r = 0.1 then the most you should pay now for $1 available next period is
• And if r = 0.2 then the most you should pay now for $1 available next period is
PV 11 0 1
$0 91
PV 11 0 2
$0 83
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The Intertemporal Choice Problem
• Suppose there are 2 time periods: 1 and 2
• Let m1 and m2 be incomes (in $) received in periods 1 and 2.
• Let c1 and c2 be consumptions (in physical units) in periods 1 and 2.
• Let p1 and p2 be the prices of consumption (in $ per unit) in periods 1 and 2.
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The Intertemporal Choice Problem• The intertemporal choice problem: Given incomes m1 and m2, and given consumption prices p1 and p2, what is the most preferred intertemporal consumption bundle (c1, c2)?
• For an answer we need to know:– intertemporal budget constraint– intertemporal consumption preferences
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The Intertemporal Budget Constraint
• To start, let us ignore price effects by supposing that
p1 = p2 = $1 (per unit)
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The Intertemporal Budget Constraint
• Suppose that the consumer chooses not to save or to borrow.
• Q: What will be consumed in period 1?• A: c1 = m1.• Q: What will be consumed in period 2?• A: c2 = m2.
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The Intertemporal Budget Constraint
c1
c2So (c1, c2) = (m1, m2) is theconsumption bundle if theconsumer chooses neither to save nor to borrow.
m2
m100
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The Intertemporal Budget Constraint
• Now suppose that the consumer spends nothing on consumption in period 1; So, c1 = 0 and s1 = m1.
• The interest rate is r.
• What will c2 be?
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The Intertemporal Budget Constraint
• Period 2 income is m2.
• Savings plus interest from period 1 sum to (1 + r )m1.
• So total income available in period 2 is m2 + (1 + r )m1.
• So period 2 consumption expenditure isc2 = m2 + (1 + r )m1.
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The Intertemporal Budget Constraint
c1
c2
m2
m100
the future‐value of the incomeendowment
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m2 (1 r)m1
The Intertemporal Budget Constraint
c1
c2
m2
m100
(c1, c2) = (0, m2 + (1 + r )m1) is the consumption bundle when all period 1 income is saved.
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m2 (1 r)m1
The Intertemporal Budget Constraint
• Now suppose that the consumer spends everything possible on consumption in period 1, so c2 = 0.
• What is the most that the consumer can borrow in period 1 against her period 2 income of $m2?
• Let b1 denote the amount borrowed in period 1.
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The Intertemporal Budget Constraint
• Only $m2 will be available in period 2 to pay back $b1 borrowed in period 1.
• So b1(1 + r ) = m2.
• That is, b1 = m2 / (1 + r ).
• So the largest possible period 1 consumption level is
c1 m1 m2
1 r28
BI is the present value of M2
The Intertemporal Budget Constraint
c1
c2
m2
m100
m2 (1 r)m1
m1 m2
1 r
the present‐value ofthe income endowment
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The Intertemporal Budget Constraint
• More generally, suppose that c1 units are consumed in period 1. This costs $c1 and leaves m1‐ c1 saved. Period 2 consumption will then be
• Rearranging gives us,
c2 m2 (1 r)(m1 c1)
c2 (1 r)c1 m2 (1 r)m1.
slope intercept
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The Intertemporal Budget Constraint
m2
m100
m2
(1 r)m1
m1m2
1 r
slope = ‐(1+r)
c2 (1 r)c1 m2 (1 r)m1
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c1
c2
The Intertemporal Budget Constraint
(1 r)c1 c2 (1 r)m1 m2is the “future‐valued” form of the budget constraint since all terms are in period 2 values. This is equivalent to
c1 c2
1 r m1
m21 r
which is the “present‐valued” form of the constraint since all terms are in period 1 values.
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The Intertemporal Budget Constraint
• Now let’s add prices p1 and p2 for consumption in periods 1 and 2.
• How does this affect the budget constraint?
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Intertemporal Choice
• Given her endowment (m1,m2) and prices p1, p2 what intertemporal consumption bundle (c1*,c2*) will be chosen by the consumer?
• Maximum possible expenditure in period 2 is
• So, maximum possible consumption in period 2 is
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m2 (1 r)m1
c2 m2 (1 r)m1
p2
Intertemporal Choice
• Similarly, maximum possible expenditure in period 1 is
• So, maximum possible consumption in period 1 is
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m1 m2
1 r
c1 m1
m21 r
p1
Intertemporal Choice
• Finally, if c1 units are consumed in period 1 then the consumer spends p1c1 in period 1, leaving m1 ‐ p1c1saved for period 1. Available income in period 2 will then be
so
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m2 (1 r)(m1 p1c1)
p2c2 m2 (1 r)(m1 p1c1)
PZCZ is total amt avail 4 spending in Period 2.
Intertemporal Choice
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p2c2 m2 (1 r)(m1 p1c1)Rearranging,
(1 r)p1c1 p2c2 (1 r)m1 m2
This is the “future‐valued” form of the budget constraint since all terms are expressed in period 2 values.
Equivalent to it is the “present‐valued” form:
p1c1 p2
1 rc2 m1
m21 r
The Intertemporal Budget Constraint
c1
c2
m2/p2
m1/p100
m1 m2 / (1 r)p1
(1 r)m1 m2p2
Slope = (1 r) p1p2
(1 r)p1c1 p2c2 (1 r)m1 m2
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Price Inflation
• Define the inflation rate by π where
• For example,π = 0.2 means 20% inflationπ = 1.0 means 100% inflation
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p1(1 ) p2
Price Inflation
• We lose nothing by setting p1 = 1 so that p2 = 1+ π.
• Then we can rewrite the budget constraint
as
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p1c1 p2
1 rc2 m1
m21 r
c1 11 r
c2 m1 m2
1 r
Price Inflation
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c1 11 r
c2 m1 m2
1 rrearranges to
c2 1 r1
c1 1 r1
m21 r
m1
so the slope of the intertemporal budget constraint is
1 r1
Price Inflation
• When there was no price inflation (p1=p2=1) the slope of the budget constraint was ‐(1+r).
• Now, with price inflation, the slope of the budget constraint is ‐(1+r)/(1+ ). This can be written as
(rho) is known as the real interest rate.
(1 ) 1 r1
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Real Interest Rate
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(1 ) 1 r1
gives
r 1
• For low inflation rates ( 0), r ‐ .
• For higher inflation rates this approximation becomes poor.
Real Interest Rate
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r 0.30 0.30 0.30 0.30 0.30
0.0 0.05 0.10 0.20 1.00
r - 0.30 0.25 0.20 0.10 -0.70
r 1
0.30 0.24 0.18 0.08 -0.35
Comparative Statics
• The slope of the budget constraint is
• The constraint becomes flatter if the interest rate r falls or the inflation rate rises (both decrease the real rate of interest).
(1 ) 1 r1
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Comparative Statics
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c1
c2
m2/p2
m1/p100
(1 ) 1 r1
slope =
The consumer saves.
Comparative Statics
c1
c2
m2/p2
m1/p100
The consumer saves. Anincrease in the inflation rate or
a decrease in the interest rate “flattens” thebudget constraint.
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(1 ) 1 r1
slope =
Comparative Statics
c1
c2
m2/p2
m1/p100
If the consumer saves thenwelfare is reduced by a lower
interest rate or a higher inflation rate.
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(1 ) 1 r1
slope =
Comparative Statics
c1
c2
m2/p2
m1/p100
The consumer borrows.
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(1 ) 1 r1
slope =
Comparative Statics
c1
c2
m2/p2
m1/p100
The consumer borrows. A fall in the interest rate or a rise in the
inflation rate “flattens” the budget constraint.
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(1 ) 1 r1
slope =
Comparative Statics
c1
c2
m2/p2
m1/p100
If the consumer borrows thenwelfare is increased by a lower
interest rate or a higher inflation rate.
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(1 ) 1 r1
slope =
Valuing Securities• A financial security is a financial instrument that promises to deliver an income stream.
• E.g.; a security that pays$m1 at the end of year 1,$m2 at the end of year 2, $m3 at the end of year 3.
• What is the most that you should pay to buy this security?
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Valuing Securities
• The PV of $m1 paid 1 year from now is m1/ (1+r)
• The PV of $m2 paid 2 years from now is m2/ (1+r)2
• The PV of $m3 paid 3 years from now is m3/ (1+r)3
• The PV of the security is therefore
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PV m1
1 r
m2(1 r)2
m3
(1 r)3
PV of Y1 payout + PV of Y2 payout + PV of Y3 payout.
Valuing Bonds
• A bond is a special type of security that pays a fixed amount $x for T‐1 years (T: no. of years to maturity) and then pays its face value $F upon maturity.
• What is the most that should now be paid for such a bond?
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Valuing Bonds
PV x1 r
x(1 r)2
x(1 r)T1
F(1 r)T
End of Year 1 2 3 … T‐1 T
Income Paid $x $x $x $x $x $F
Present Value x/(1+r) x/(1+r)
2 x/(1+r)3 … x/(1+r)T‐1 F/(1+r)T
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Valuing Bonds
• Suppose you win a lottery.
• The prize is $1,000,000 but it is paid over 10 years in equal installments of $100,000 each.
• What is the prize actually worth?
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PV $100, 0001 0 1
$100, 000(1 0 1)2
$100, 000(1 0 1)10
$614, 457
Valuing Consols
• A consol is a bond which never terminates, paying $x per period forever.
• What is a consol’s present‐value?
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Valuing Consols
EndofYear 1 2 3 … t …
IncomePaid $x $x $x $x $x $x
PV
… …
PV x1 r
x(1 r)2
x(1 r)t
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Valuing Consols
PV x1 r
x(1 r)2
x(1 r)3
11 r
x x1 r
x(1 r)2
11 r
x PV
Solving for PV gives PV xr
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Valuing Consols
E.g. if r = 0.1 now and forever then the most that should be paid now for a console that provides $1000 per year is
PV xr $1000
0 1 $10,000
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