1/12/15

first 3 or 4 classes we will cover the apendex to the book (but read chapters 1-3)
p.573-558 of 9th edition
p. 542-565 of 7th edition
intro micro
*demand curve
a change in Px (from 7 to 5) causes a movement along the demand curve (a change in
quantity demanded, from 20 to 25, but not a change in demand)
suppose the income of consumers increase:
D shifts outward, assuming butter is a normal good
*D2
D^
increase in demand from D to D'
an increase in quantity deamnded for each value of Px (from 30 to 38 at Px=7)
suppose the price of margerine increases:
what happens to D for butter?
D shifts inward (decrease in demand for butter), since butter and margerine are
substitutes
*S
height of S = MC of each firm in the industry
suppose the wager rate of farm workers increases:
*S2
S^
farm labor is an input used in producing butter
there is a decrease in the supply of butter

What effect does this have on the market for butter?

*S3
S^ > (P^ & Xv)
the equillibrium quantity of butter decreases from Xe to Xe'
the equillibrium price of butter incerases from Pe to Pe'
an elastic demand curve
*E
relatively flat
an inelastic demand curve
*E2
relatively steep
ECO 5000 material
consumer preferences
X and Y are two goods. We consider a single consumer
X = # of hamburgers consumed per month
Y = # of bags of french fries consumed per month
*CP
the more preferred bundle is the one with a higher level of utility attached to it
any point uch as (2,2), can be called a consumption bundle (commodity bundle)
as long as X and Y are both goods, then more is better than less
good= an item you can purchase for which more is better than less
more is better than less means the same thing as nonsatiation or monotonicity
more is better than less = if there are two consumption bundles, and one has more of both
goods, or more of one good and the same amount of the other good, then it is preferred
(has a higher level of utility than the other consumption bundle)
*CB

A = (3, 3)
B = (4, 4)
C = (5, 3)
D = (6, 2)
which of the following is necessarily true?
B is preferred to A? Yes
C is preferred to A? Yes
D is preferred to A? No, D has 3 more hamburgers but 1 less french fries. So it is not
necessarily true
*U
all points on the same indifference curve have the same utility
we have an indifference curve, which is a curve that connects consumption bundles
between which the consumer is indifferent
there are many different indifference curves, corresponding to different levels of utility
*U2
infinitely many and they do not cross
a higher indifference curve corresponds to a higher level of utility
B is preferred to A since more is better than less (from *U2)
C is preferred to A
C is indifferent to B (same indifference curve)
B is preferred to A (more is better than less)
consequently C is preferred to A (we're using something called transitivity)
any point on a higher indifference curve is preferred to any point on a lower indifference
curve. (The point on the higher indifference curve corresponds to a higher level of
utility).
It is important to note that two different indifference curves do not intercept
*U3
does not happen
indifference curves normally have the following sort of curvature (convex to the origin,
bowed out towards the origin)

*I
indifference curve convex to origin
marginal rate of substitution (MRS)
MRS = (absolute value of) the slope of an indifference curve = how many units of Y a
consumer is willing to give up in order to get one more unit of x
MRS = marginal rate of substitution
normal assumption about indifference curves is that there's a diminishing MRS
this means that the MRS gets smaller as you move down and to the right along an
indifference curve
*I2
bc change in X-axis is on bottom of denominator the MRS gets smaller as you move
down an indifference curve
the MRS represents how many units of Y the consumer is willing to give up to get one
more nit of x
indifference curves do NOT (except under unusual cases) have the following sort of
shape:
*I3
concave to the origin
*I4
a line segmeant btwn to ponts on an indifference curve lies entirely above the curve
if U(A) = U(B) and C is half way between A and B, then U(C) > U(B). (C is on a higher
indifference curve than A or B)
a consumer tends to prefer averages to extremes
the budget line
what consumption bundles can the consumer afford?
X = one good (hamburgers)
Y = another good (french fries)
Px = price of X = price of one unit of X

Py = price of Y = price of one unit of Y

I = money income of the consumer (in dollars)
expenditures of the consumer:
=Px(X) + Py(Y)
=expenditures on X + expenditures on Y
the budget constraint is:
Px(X) + Py(Y) </= I
budget line is:
Px(X) + Py(Y) = I
consumption bundles that satisfy the budget constraint are said to be attainable
consumption bundles. The consumer can afford these bundles. These are bundles on or
inside the budget line.
The consumer cannot afford points that lie outside the budget line
What does the budget line look like?
Suppose X = 0
then Py(Y) = I
Y = I/Py
y-intercept
suppose Y = 0
then Px(X) = I
X = I/Px
x-intercept
*B
straight downward sloping line points underneath or on are attainable
ignore the possibility of saving for the future
the consumer will choose to spend all of income and end up on the budget line since
more is better than less
what is the slope of the budget line?

Px(X) + Py(Y) = I
Py(Y) = I Px(X)
y = I/Py (Px/Py)X
another way to write the equation of the budget line
slope of budget line = -(Px/Py)
EX w/numbers
I = 240
Px = 10
Py = 24
I/Px = 240/10 = 24
I/Py = 240/24 = 10
*EX
slope of budget line = -5/12
suppose I increases to 360
what happens to the budget line?
I/Px = 360/10 = 36
I/Py = 360/24 = 15
*EX2
budget line moves out, slope unchanged
the budget line shifts out, but the new budget line is parallel to the old budget line (the
slope of the old budget line equals the slope of the new budget line)
suppose I decreases
the budget line shifts in, with the new budget line parallel to the old budget line
suppose Px increase to 20
I/Px = 240/20 = 12
I/Py = 240/24 = 10

*EX3
y-axis same, line rotates inward
the budget line rotates in, with the vertical intercept unchanged, and the new budget line
is steeper than the old budget line (note that Px/Py has increased)
suppose Px decreases to 5
*EX4
rotates out
suppose Py increases to 30
I/Px = 240/10 = 24
I/Py = 240/30 = 8
*EX5
becomes flatter, pivoting inward on its x-axis
slope of budget line = -(Px/Py)
since Px is unchanged and Py ^, then Px/Py decreases, so the budget line becomes flatter
suppose Py decreases to 16
*EX6
pivots to steeper on its x-axis
Which consumption bundle does the consumer choose?
As argued before, the consumer chooses a point on the budget line
the consumer chooses the point on the budget line which allows him (her) to reach the
highest level of utility possible
equivelantly, the consumer chooses the point on the budget line which allows him (her) to
reach the highest indifference curve possible
as long as the consumer ends up choosing a positive amount of each good, he (she)
chooses the point on the budget line where an indifference curve is tangeant to the budget
line
*EX7
consumer chooses consumption bundle on the indifference curve that is tangeant to the
budget line

1/26/15
*EX7
consumer chooses consumption bundle A, which is the bundle (x*, y*)
why does the consumer choose A?
Why not G?
G is outside the consumers budget line, so the consumer cannot afford it (not enough
income)
Why not H?
It's on a lower indifference cure. A is better because more is better than less and because
its on a higher indifference cure
Why nto D or F?
They are on a lower indifference curve
At point A, an indiffernece cure is tangent to the budget line
the absolute value of the slope of an indifference curve = MRS
the absolute value of the slope of the budget line = Px/Py
tangency implies that these two slopes are equal to each other
two conditions for determining the point A
1.

PxX* + PyY* = I
since A should be on the budget line

1.

MRS = Px/Py
where MRS is evaluated at the point (x*, y*). This is the tangency condition
the parameters that play a role in determining X* and Y* are:
Px Py and I
what happens to the consumption bundle the consumer chooses if one of these parameters
changes?

Suppose that I ^ (increase)

I ^ from I0 to I1
*A
there is a parallel outward shift of the budget line
A = old consumption bundle
B = new consumption bundle
the consumer reaches a higher level of utility than before (u1 > u0)
the consumer chooses more of x than before (x1* > x0*)
where
x0* is the old amount of x
x1* is new amount of x
the consumer chooses more of y than before (y1*>y0*)
where
y0* is old amount of y
y1* is new amount of y
is it necessarily true that x* and y* both increase?
No, but its usually true
x* increases and y* increases if x and y are both normal goods
a good is a normal good if an increase in income causes the consumer to choose more of
the good (assuming prices are constant)
x* increases and y* decreases if x is a normal good and y is an inferrior good
x* decreases and y* increases if x is an inferior good and y is a normal good
if there are only two goods that the consumer consumes. They cannot both be inferior
goods

diagram of case where x is an inferior good, and I ^

*B
suppose that Px ^ (increase) from 10 to 15
*C
budget line pivots in moving along the x-axis
A = old consumption bundle
A = (x0*, y0*)
B = new consumption bundle
B = (x1*, y1*)
it is almost certainly the case that x1* < x0*, but it is not at all clear whether y1* is
smaller or larger than y0*
clearly the utility level of the consumer decreases (u1 < u0) since the consumer ends up
on a lower indifference curve
we can use the information on the last diagram to graph x* versus Px. This gives the
individual; consumers demand cure for good x
*D
it is almost certainly downward-sloping, or at least not upward-sloping (it is conceivably
horizontal or vertical)
substitution and income effects of an increase in Px from 10 to 15
the overall effect (movement from A to B) can be broken down into a substitution effect
and an income effect.
Substitution effect
what happens as the result of the fact that Px/Py increases from 10/Py to 15/Py, assuming
we do not allow the utility level of the consumer to go down
x is now more expensive relative to y, so x v > y ^
income effect
the consumer is worse off than before (utility v, or real income v, even though money
income is unchanged)

the income effect stage is equivelant to a decrease in I with no change in prices

x v and y v
assuming that x and y are both normal goods
suppose Px increases, and x and y are both normal goods
substitution effect: x v & y ^
income effect: x v & y v
overall effect x v & y ?
suppose I v but there is no change in prices, and suppose x and y are both normal goods
substitution effect: none
income effect: x v & y v
overall effect: x v & y v
chapter 3 (very brief)
pure exchange economy
analyzed with the use of the edgeworth box diagram
(don't worry about the details too much)
one basic efficicency conditon for a pure exchange economy is equal MRS for each
consumer
if jim and angela are two consumers, and x and y are two goods, then
MRSjim = MRSangela >> basic efficiency condition for a pure exchange economy
in an economy with both exchange and production, things are more complicated, there
are several efficiency conditions (don't worry about details)
an economy is a pareto efficient (pareto optimal) state if the only way in which one
consumer can be made better off is to make another consumer worse off
if an economy is not in a pareto efficient state, then things can be improved on by making
one (or more) consumers better off without making anyone worse off

it is desirable for an economy to be in a pareto efficient state (sometimes we just say

efficient state)
some pareto efficient states might not be very fair, because a few people might have
most of the goods
it might be desirable to have the government move the economy from a pareto efficient
state that is very unequal to a pareto efficient state that is somewhat more equitable
first fundamental theorem of welfare economics
an economy in which all consumers and firms take prices as given, and in which there are
no taxes, subsidys, public goods, or externalities, is pareto efficient
under what conditions does the first fundamental theorem not apply?
1 market power is present
a a monopolist does not take prices as given
b oligopolists do not take prices as given
c a monopsonist does not take input prices (wages) as given
2 public goods

goods which are consumed in such a way that one consumer's enjoyment of the good
does not reduce another consumers enjoyment of the good
- chapter 4

it is very hard for private markets to produce an appropriate level of a public good (or in
some cases to produce the public good at all)
3 externalities

a situation where one persons actions affect other people in a way that is not taken into
account in the market system

air polution

water polution

traffic congestion

noise

chapter 5
appendix
consumer and producer surplus
*E
if P = P0, then CS = consumer surplus = area 1 (on diagram)
CS is a measure of how much more the good is worth to consumers than what they
actually pay for it
height of D (demand cure) is the MV = marginal value
MV = how much one more unit of the good is worth to a consumer's
if P = P1, then CS = 1 + 2 (from *E)
as the result of a decrease in P from P0 to P1, the CS increases by area 2
consider S, the supply cure.
Height of S = MC = marginal cost
*F
if P = P2, then PS = producer surplus = 3 (from *F)
if P = P3, then PS = 3 + 4
If P increases from P2 to P3, then PS increases by area 4
PS is a measure of the gain to firms from being able to sell their good at some price as
opposed to not being allowed to sell anything = profit of firms + fixed cost of firms
if the PS goes up by some amount, then profit goes up by the same amount
*G
Pe = equillibrium price
xe = equillibrium quantity

1 = CS
2 = PS
overall benefits from exchange in the market for x = CS + PS = 1 + 2
this supply and demand equillibrium is efficient
if u had:
1 a monopolization of the x-industry, or
2 a tax is imposed, than either of those might change the overall benefits from exchange
chapter 4
public goods
a private good is a good which, if consumed by one person, that particular unit of the
private good cannot be consumed someone else
if I eat a hamburger u cannot eat the same hamburger
a pure public good is a good for which one person's use of the public good does not
diminish another person's use of the public good (consumption of the good is nonrival, or
noncongestible)
ex:
-natural defense
-lighthouse
-t broadcast
sometimes a pure public good is defined as a good which is nonrival and nonexcludable
(it is not feasable to prevent the person from using the public good if the person does not
pay)
a good might be a private good even if the good is provided by the government (public
housing, public health care)
an example of supply and demand for a private good
x = number of hamburgers
50 consumers of type 1, with the individual demand curve
MV = 10 - 0.1x
(MV = marginal value)

P = 10 0.1x
0.1x = 10 P
x = 10 P/0.1 = 10(10 P) = 100 10P
x = 100 10P
*H
demand curve
50 consumers of type 2, with the individual demand curve
P = 10 0.2x
0.2x = 10 P
x = (10 P)/0.2 = 5(10 P) = 50 5P
*I
steeper demand cure
how do we find the aggregate (or market) deamand function for x?
How do we add the demand curves of individual consumers?
We add them horizontally (for a private good). In other words, we express x as a function
of P for each consumer, and add all of the values of x to find the total quantity deamanded
at each value of P
total quantity demanded = 50(100 10P) + 50(50 5P) = 5000 500P + 2500 250P =
7500 750P = 750(10 P)
x = 7500 750P
consider two cases
case 1 MC = 2
market supply cure is horizontal at a height of 2
case 2
market supply cure is x = 2250P 4500

2/9/15
an example of suply and demand for a private good
50 consumers of type 1
MV = 10 0.1X
P = 10 0.1X
X = 100 10P
50 consumers of type 2
MV = 10 0.2X
P = 10 0.2X
X = 50 5P
aggregate (market) demand curve
X = 50(100 10P) + 50(50 5P)
X = 7500 750P
case 1
MC = 2
the supply curve has the equation P = 2 (a horizontal line of height 2)
*J
firm demand curve,
if P = 0 then X = 7500
if X = 0 then 10 = 7500 750P
P = 7500/750 + 10
what are the equillibrium price and quantity (the coordinates of point E)?
two equations

X = 7500 750P
P=2
thus we have P = 2
substitute this into the demand equation
X = 7500 750P
=7500 750(2) = 6000
what about a single consumer of type 1?
P = 10 0.1X
X = 100 10P
use the second equation
X = 100 10(2) = 100 20 = 80
what about a single consumer of type 2?
X = 50 5P = 50 5(2) = 40
50(80) + 50(40) = 4000 + 2000 = 6000
sp things check out okay
different consumers can consume different amounts
the equillibrium quantity in th emarket is the sum of the quantities consumed by different
consumers
it is important to note that:
MV1 = marginal value of a consumer of type 1
= 10 0.1X
=10 (0.1)(80)
=10 8
=2

MV2 = marginal value of consumer of type 2

= 10 0.2X = 10 (0.2)(40)
=10 8 = 2
we have the condition that
MV1 = MV2 = P = MC
true in the competitive equillibrium for a private good
note the conditions
MV1 = MV2 = MC
is to the books condition...
case 2
the market supply curve is x = 2250P 4500
if x = 0 then
0 = 2250P 4500
P = 4500/2250 = 2
*K
X = 2250P 4500
2250P = 4500 + X
P = 4500/2250 + X/2250
P = 2 + X/2250
MC = 2 + X/2250
what are the equillibrium price and quantity?
We have two equations
D: X = 7500 750P
S: X = 2250P 4500

set quantity demanded equal to quanity supplied

X=X
7500 750P = 2250P 4500
12000 750P = 2250P
12000 = 3000P
P = 1200/300 = 4
Xe can be found by substituting P = 4 into the supply curve or demand curve
Xe = 7500 750P
= 7500 750(4)
=7500 3000 = 4500
for a single consumer of type 1, x1 = 100 10P = 100 10(4) = 60
for a single consumer of type 2
Xe = 50 5P = 50 5(4) = 30
50(60) + 50(30) = 3000 + 1500 = 4500
so everything is consistent
once again, it can be shown that it is true that
MV1 = MV2 = P = MC
each of these is 4 in this example
when you're dealng with a private good, you do nto add the demand curves of consumers
vertically (you do not find the total price at each quantity)
when you derive the aggregate demand curve
HW:
200 consumers with the MV function:
MV = 20 0.02X

marjet supply function is

X = 80,000 + 5,000P
what are the market equillibrium values of X and Pif X is a private good? How much of
X is consumed by each consumer?
Suppose we have a public good
firework display in a stadium
x = number of fireworks
fireworks are a public good (asuming no congestion)
50 consumers of type 1
MV1 = 10 0.1X
*L
the maximum amount a consumer of type 1 could be willing to pay for the 70th firework
is $3
the striped area is the maximum willingness to pay (for a consumer of type 1) for a whole
fireworks display of 70 fireworks
50 consumers fo type 2
MV2 = 20 0.2X
*M
the maximum amount that a consumer of type 2 would be willing to pay for the 70th
firework is $6
suppose that the marginal cost of an extra firework is MC = 300
*N
how much is the 70th firework worth to all of the consumers?
Mvt = total marginal value to all 100 consumers
= 50(3) + 50(6)
=150 + 300 = 450

450 > 300 so its worthwhile to have the 70th firework

(since MVt > MC)
we want to find the total willingness to pay at each value of X
Mvt = total marginal value of all 100 consumers
=50MV1 + 50MV2
=50(10 0.1X) + 50(20 0.2X)
=500 5X + 1000 10X
Mvt = 1500 15X
this would be equivelent to finding the total price at each value of X
Pt = 50P1 50P2
=50(10 0.1X) + 50(20 0.2X)
=500 5X + 1000 10X
= 1500 15X
either way, what we are basically doing is to add vertically the demand curves of all the
individual consumers (total marginal value, or price, at each value of X)
basic efficiency conditions
MV t = MC
50MV1 + 50MV2 = MC
1st exam: March 9 (pushed back from the 2nd due to snow day) through the chapter on
taxation
fireworks example (public good)
MVt = MC
where
Mvt = sum of the marginal values of all the different consumers
=50MV1 + 50MV2

note this is essentially the same as the books condition that: sum of the MRS of all
consumers = MRT
what does the basic efficiency condition lead to in this example?
Mvt = 1500 15X
MC = 300
Mvt = MC
1500 15X = 300
1500 = 300 +15X
1200 = 15X
X = 1200/15 = 80
80 = efficient number of fireworks
with a public good different consumers consume the same amount
int his example each consumer consumes (views) 80 fireworks
Mvt = 1500 15X
=1500 15(80)
=1500 1200 = 300
for each consumer of type 1,
MV1 = 10 0.1X
=10 (0.1)(80) = 2
for each consumer of type 2,
MV2 = 20 0.2X
=20 (0.2)(80) = 4
note that

50(2) + 50(4)
1)
=100 + 200 = 300
as expected
the Mvt of 300 is made up of 50 consumers who value the 80th firework at $2and 50
consumers who valuethe 80th firework at $4
In contrast to the case of a private good, in the case of a public good (such as the
fireworks example just given)
i different consumers have different marginal values for the last unit of X
ii diferent consumers have the same value of X (X = 80)
to pay for the fireworks display, the government could charge each consumer of type 1 $2
for each firework
ii each consumer of type $4for each firework and each consumerwould have a
significantamount of consumer surplus from this firework display
there are some problems with charging cusgtomers this way, however
how does the government know the mv function (demand function) of each consumer?
Each consumer has the incentive to pretend he (she) doesnt like fireworks very much so
he doesnt have to pay very much
the government has a difficult time charging each consumer different prices even if it
knows their MV functions
the governemnt may have a hard time figuring out the optimal value of X (since it doesnt
know the consumers MV functions)
these problems did not exist in the case of a private good
can a public work (sych as a fireworks display) be funded by the contributions of private
individuals)
maybe. But see the books discussion of the free rider problem
public versus private education
the choice of a family to send their kid to a private school or public school

assumptions:
family income = I
the family pays income taxes, T, to support the public school systemwhether or not they
go to public school
if the kid goes to public school, educational quality = Eq
education can be purchased in the private school system at a price of P per unit of E
the utility of a family is a function of E and Y, where Y is all other goods which have a
price of 1.0there are indifference curves with e and Y on the two axes
suppose the kid goes to public school then
E = Ep
y=IT
suppose the kid goes to private school the family chooses E to maximize its utility subject
to the budget constraint
y + pe = I T
choice of e for private school (the family chooses a school which provides the level of e
shown in the following diagram).
*O
problem:
200customes with the MV function
MV = 20 0.02X
where X is the number of fireworks (a public good)
the MC function for fireworks is
MC = 1000
what is the efficient number of fireworks
suppose E0 < Ep

*P
the family sends the kid to the public school system (point B)
the family can choose point B (public school) or any point along the budget line (private
school) but the overall budget constraintconsists of pointB and the budget line. In
thiscase, the family chooses point B (public school)
suppose e0 > Ep:
case 1: (case shown in book)
*Q
this family send their kid to public schools
at point A you have more of e but less of y than at point B
but B is on a hgiher indifference curve so the family chooses B over A
case 2:
*R
the family send their kid to private school (point A)
different families might have different values of income
a family with a higher value of I might be more likely to send its kid to a private school
than a family with a lowe value of I (assuming the families have the same set of
indifference curves)
chapter 14
partia equillibrium analysis of a per unit tax (unit tax) in a perfectly competitive market
suppose there is a tax u on each unit x that is sold
let Q0 and P0 be the mrket equillibrium quantity and price in the absence of the tax
*S
the statuatory incidence of the tax can be on consumers or producers
stauatory incidence = who pays the tax directly to the government
economic incidence = who was hurt by the tax and by how much

the economic incidence is oftensignificantly different than the statuatory incidence

for example, if the statuatory incidence is on producers, they might shift the burden of the
tax onto consumers (tax shifting)
statuatory incidence on producers:
the unit tax (u) causes the supply curve to shift uniformly up by an amount u
why? The height of the supply curve is equal to the MC (marginal cost) and if a f9irm has
to pay the government u for eachunit, this increases the effective MC by u
*T
new intersection of supply and demand is at
quantity Q1
price Pg
the price paid by consumers to producers is Pg. This is the efective price for consumers
Pg = gross price = demand price = consumer price
what is the effective price received by producers?
Producers receive Pg from consumers and pay u to the government for each unit of the
good
let Pn be the net price = supply price = producer price
Pn = amount kept by producers after paying the tax = Pg u
Pn = Pg u
note that in the diagram Pn is below Pg by exactly u since the vertical distance between S
and S' is u
2/16/15
200 customers with the MV function
MV = 20 0.02x

market supply function is

x = 80,000 + 5,000P
what are the market equillibrium values of X and P if x is a private good? How much of
x is consumed by each consumer?
MV = 20 0.02x
demand function of one consumer is
P = 20 0.02x
P + 0.02x = 20
0.02x = 20 P
x = 1/0.02(20 P)
=50(20 P) = 1000 50P
the market demand function is
x = 200(1000 50P)
=200,000 10,000P
set x = xsing the market demand and supply functions:
x=x
200,000 10,000P = 80,000 5,000P
120,000 10,000P = 5,000P
120,000 = 15,000P
P = 120,000/15,000 = 8
use market demand or supply equation
x = 80,000 + 5,000P
=80,000 + 5,000(8)
=80,000 + 40,000

=120,000
for an individual consumer,
x = 1,000 50P
=1,000 50(8)
=1,000 400 = 600
the tax reduces the equillibrium quantity from Q0 to Q1
what are the efficiency effects of the tax?
Method 1:
before the tax is imposed
CS = consumer surplus = 1 + 2 + 3 + 7 (area on graph from last week)
PS = producer surplus = 4 + 5 + 6 + 8 (area on graph from last week)
after the tax is imposed
CS = 1
PS = 6
tax revenue = u (Q1) = area of a rectangle on the diagram = 2 + 3 + 4 + 5 (area on graph
from last week)
as the result of the tax:
CS = change in CS = 1 (1 + 2 + 3 + 7) = -(2 + 3 + 7) (area on graph from last week)
PS=changeinproducersurplus=6(4+5+6+8)=(4+5+8)(areaongraphfrom
lastweek)
yougettaxrevenuesyoudidn'thavebefore
efficiencygainofthetax=CS+PS+taxrevenue
=(7+8)(areaongraphfromlastweek)
thetaxresultsinanefficiencyloss(deadweightloss,excessburden)=7+8

theamountbywhichconsumersandproducersarehurtisgreaterthantheamountofthe
taxrevenue
economicincidenceofthetax
someofthetaxburdenisonconsumers,sincePg>P0(CShasdecreased)
someofthetaxhasbeenshiftedontoconsumers
someoftheburdenisonproducers,sincePn<P0(PShasdecreased)
method2(ofexaminingefficiencyissues):
supposeoutputisreducedfromQ0toQ1
thechangeinthetotalvalueoftheoutputproducedtoconsumers=areaunderD
=TV=(7+8+9)
thechangeinthetotalcostofproducingoutput
=thechangeintheareaunderthemarginalcostcurve(thesupplycurve)=TC=9
efficiencygain=TVTC
=(7+8+9)(9)
=(7+8)
onceagain,efficiencyloss=deadweightloss=excessburden=7+8
inanefficiencysense,thetaxmakestheeconomyworseoff
problem
200customerswiththeMVfunction
MV=200.02x
wherexisthenumberoffireworks(apublicgood)theMCfunction(restofproblem
isin2/9notes)
thetotalmarginalvalueisthenumberofconsumerstimestheMVofeachconsumer's

Mvt=200MV
=200(200.02x)
=40004x
setMVt=MC
4,0004x=1,000
4,000=10004x
3,000=4x
x=3000/4=750
firstexamismarch9
theMVofeachconsumerforthe750thfireworkis
MV=200.02x
=20(0.02)(750)
=2015=5
notethat200MV=200(5)=1,000
wichisconsistentwiththefactthatMC=1000andthefactthatMVt=1000forthe750th
firework
partialequillibriumofaunittax(perfectlycompetitivemarket)
statuatoryincidenceonconsumers
theunittaxucausesthedemandcurvetoshiftuniformlydownbyanamountu(see
book)
*U
demandcurveshiftsdownbytheamountofthetax
P0andQ0=equillibriumpriceandquantitywithnotax
u=unittax

oncethetaxisimposed,
Q1=equillibriumquantity
Pn=netprice
Pg=grossprice
thepricepaidbyconsumerstoproducersisPnthisistheeffectivepriceforproducers
(suppliers)
whatistheeffectivepricepaidbyconsumers?
ConsumerspayPntoproducers
andpayutothegovernment(foreachunitofthegood)
Pg=totalamountpaidbyconsumers=Pn+u
Pg=Pn+u
notethatinthediagramPgisabovePnbyexactlyu,sincetheverticaldistancebetween
DandD'isexactlyu
thepricepaidfromconsumerstoproducersisdifferentdependingonweatherthe
statuatoryincidenceisonproducersorconsumers
however,Q1,Pg,andPnareexactlythesamewhethertheincidenceisonconsumersor
producers
theeconomicincidenceofaunittaxisindependentofthestatuatoryincidence
consumersarehurtthesameamount(bearthesameburden)eitherway
producersarehurtthesameamount(bearthesameburden)eitherway
examplewithstraightlinesupplyanddemandcurves
S:P=20+0.1Q
D:P=800.2Q
P=P

20+0.1Q=800.2Q
0.1Q=600.2Q
0.3Q=60
Q=60/0.3=600/3=200
Q0=200
substitutethatvalueofQintothedemandorsupplycurve
P=20+0.1Q
=20+(0.1)(200)
=20+20=40
P0=40
nowimposeataxu=6withastatutoryincidenceonproducers
S'(newsupplycurve)is:

P=20+u+0.1Q
=20+6+0.1Q
=26+0.1Q
D:P=800.2Q
P=P
26+0.1Q=800.2Q
0.1Q=540.2Q
0.3Q=54
Q=54/0.3=540/3=180
Q1=180

notethatQ1<Q0,asexpected

useequationofDtocalculatePg
Pg=800.2Q1
=80(0.2)(180)
=8036=44
useequationofS(theoldsupplycurve)tocalculatePn
Pn=20+0.1Q1
=20+(0.1)(180)
=20+18=38
twogeneralformulae(thetwoequationswillbegivenontest,butthevariableswillnot
bedefined)
let
ms=slopeofthesupplycurve
md=absolutevalueoftheslopeofthedemandcurve
(PgP0)/u=functionoftheburdenofthetaxthatfallsonconsumers=md/(md+ms)
(P0Pn)/u=fractionoftheburdenofthetaxthatfallsonproducers=ms/(md+ms)
notethatthesumofthesetofractionsisequalto1
dotheseformulaeworkfortheexample?
(PgP0)/u=(4440)/6=2/3
md/(md+ms)=0.2/(0.2+0.1)=2/3
(P0Pn)/u=(4038)/6=1/3

ms/(md+ms)=0.1/(0.2+0.1)=1/3
sotheformulaedoworkfortheexample
twomoregeneralformulae(thetwoequationswillbegivenontest,butthevariableswill
notbedefined)
let
Es=elasticityofsupply
Ed=elasticityofdemand
(PgP0)/u=Es/(Es+Ed)
P0Pn)/u=Ed/(Es+Ed)
sheetonexam:
(PgP0)/u=md/(md+ms)=Es/(Es+Ed)
(P0Pn)/u=ms/(ms+md)=Ed/(Es+Ed)
nothandedoutonexam:
Pg=grossprice=consumerprice(effectivepricetoconsumers)
Pn=netprice=producerprice(effectivepricetoproducers)
Problem
D:P=6000.2Q
S:P=300+0.3Q
whatareQ0andP0?
Supposeu=40
whatarePg,Pn,andQ1afterthetaxisimposed
note
Es=(Q/Q)/(P/P)=(P/Q)(Q/P)=(P/Q)/(P/Q)=(P/Q)/ms

andsimilarlyforEd
Ifms=0thenEs=
horizontalsupplycurve
ifmy=thenEs=0
verticalsupplycurve
elasticsuply
msrelativelysmall
Esrelativelylarge
relativelyflatupwardslopingsupplycurve
1<Es<
inelasticsupply
msrelativelylarge
Esrelativelysmall
relativelysteepupwardslopingsupplycurve
0<Es<1
Ed=(P/Q)/md
ifmd=0thenEd=
horixontaldemandcurve
ifmd=thenEd=0
verticaldemandcurve
elasticdemand
mdrelativelysmall

Edrelativelylarge
relativelyflatdownwardslopingdemandcurve
1<|Ed|<
inelasticdemand
mdrelativelylarge
Edrelativelysmall
relativelysteepdownwardslopingdemandcurve
0<|Ed|<1
(pgPn)/u=Es/(Es+Ed)=([P/Q]/ms)/([P/Q]/ms+[P/Q]/md)...
=(md)(ms)/ms]/[([md][ms]/ms)+([md][ms]/md)]=md/(md+ms)
conclusion:
(PgPn)/u=Es/(Es+Ed)=md/(md+ms)
supposeweknowP0,ms,md,andu.whatarePgandPn
(PgP0)/u=md/(md+ms)
PgP0=[md/(md+ms)](u)
Pg=(u)(md/[md+ms])+P0
inthelastexample,
Pg=40+[0.2/(0.2+0.1)](6)
=40+(2/3)(6)
=40+4=44
similarly,
(P0Pn)/u=ms/(ms+md)

P0Pn=(u)(ms/[ms+md])
PnP0=(u)(ms/[ms+md])
Pn=P0(u)(ms/[ms+md])
inthelastexample,
Pn=40(0.1/[0.1+0.2])(6)
=40(1/3)(6)
402=38
3/2/15
problem
supposeEs=7andEd=3
supposeataxu=30isimposed
whichchangesPgorPn?
Whatis(PgPn)/(PoPn)
Answer
method1
(PgPo)/u=E/(Es+Ed)=7/(7+3)=7/10
=>PgP0=(7/10)u=(7/10)30=21
(P0Pn)/u=Ed/(Es+Ed)=3/(3+7)=3/10
=>P0Pn=3/10*30=9
ThusPgincreasebymorethanPndecreasesand,
(PgPn)/(PgPn)...

method2
(PgP0)/(P0Pn)=[(PgPn)/u]/[(PnP0)/u]
=[Es/(Es+Ed)]/[Ed/(Ed+Es)]
=Es/Ed=7/3>1
=>(PgP0)/(PgPn)>1
PgP0>PgPn
thusPgincreasesbymorethanPndecreases
examoneweekfromtoday
^^^MIDTERM^^^
VVVFINALVVV
chapter5
inthebookandinthelecture,weusethewordexternalitytorefertoatechnological
externality
thereisalsosomethingknownasapecuniaryexternalitybutwewillignoreit
asituationwithanexternailityisnormallyassociatedwithamarketfailure
(privatemarketsusuallydonotleadtoanefficientoutcomeinthepresenceofan
externality)
governmentinterventionisnormallyrequiredforefficiency
externality=asituationwhereoneeconomicagent'sactions(personorfirm)affectsthe
welfareofothers(usuallyadversley)inawaythatisnottakenintoaccountbymarket
prices
examplesofexternalities:
1airpolution
2waterpolution
3trafficcongestion
4noisepollution

5smokinginacrowdedroom
firstexample(frombook)
*V
thewaterpollutionfrombart'sfactoryadversleyaffectslisa'sfishery
theususalsituation,intheabsenceofanygovernmentintervention,isthatbart'sfactory
willpollutetheriverbeyondtheefficientlevelofpollutionsincebarthasnoincentive
tocareaboutthefactthathispollutionhurtslisa'sfishery
secondexample
supposethatairpollutionresultsfromthemanufacturingofsteel
simplifyingassumption:foreachunitofsteelproduced,thereisagivenfixedamountof
airpollutionthatisgenereated
consequenceofthesimplifyingassumptionisthattheonlywaytoreduceairpollutionis
toreducetheproductionofsteel
note:intherealworldvariousthkngscanbedonetoreducethepollutionthatresults
fromtheproductionofeachunitofsteel
weassumethefollowingthreetypesofeconomicagentsinametropolitanarea
1steelproducingfirms
2demandersofsteel(probablyfirmsthatusesteelasaninput,suchasconstructions
firmsorautoplants
3residentsofthemetropolitanareawhoarehurtbypollution
*W
d=demandcurveforsteel
theheightofDistheMV(marginalvalue)orMB(marginalbenefit)ofanextraunitof
steeltodemanders
MPC=marginalprivatecost
thehieghtofMPCistheMC(marginalcost)oftheextracapital,laborandrawmaterials
theMPCcurvedoesnottakethecostsofpollutionintoaccount
MD=marginaldamages

theheightofMDisthedollaramountwhichcorrespondstohowmuchresidentsarehurt
bytheextraammountofpullutionthatisgeneratedbytheproductionofonemoreunitof
steel
note:inthediagramandinthebooksdiagram,itisassumedthatMD=0forthefirstunit
ofsteelproduced(thisneednotbethecase)
alsoitisassumedthatoneextraunitofpollutioncausesmoreincrimentaldamageifthe
elvelofpollutionisalreadyhigher(sinceMDslopesup)
MSC=marginalsocialcost
=MPC+MD
=marginalprivatecosts+marginaldamages
=overallcoststosocietyoftheprodductionofoneextraunitofsteel
*X
Q1andP1arethemarketequillibriumquantityandpriceintheabsenceofany
governmentaction(MPC=MB)
Q*=thesociallyoptimaloutputofsteel(MSC=MB)
MB=heightofthedemandcurve=marginalbenefit=marginalvalue
atoutputQ1MSC>MB
soitmakessensetoreduceoutputuntilyouareatQ*
isthereanefficiencygainfromreducingQfromQ1toQ*?
ignoreresidentsforaminuteandconsideronlysteelproducingfirmsanddemandersof
steel
ifQdecreasesfromQ1toQ1*

reductioninpollutioncosts=(3)+(4)
=areaunderMPC
thevaluetodemandersofsteeloftheQ1Q*unitsthatarenolongerproduced=area

underD(MB)
=(2)+(3)+(4)
tentativeefficiencyloss=(2)
butwehavenottakenaccountofthepollutionyet
thereductioninpollutiondamagestoresidents=areaunderMD
=(4)
=areabetweenthemarginalprivatecostsandthemarginalsocialcosts
=(1)+(2)
overall,thereductioninQfromQ1toQ*isassociatedwithanefficiencygainof(1)+
(2)tentativeefficiencyloss
=(1)+(2)(2)
=(1)
ifitispossibletovarytheamountofpollutionproducedperunitofsteelproduced,then
itwouldalsobethecasethatinthesociallyefficientsituation,therewouldbeless
pollutionperunitofsteelproducedthaninthefreemarketsituation
whatcanbedonetoreducethelevelofoutputfromQ1toQ*?
1.)

onepossibilityisamergerbetweenthepolluterandthevictimofthepollution.This
mightverywellworkinexample1(bartandlisa)
asdiscussedinthebook,thisisanexampleofinternalizinganexternality
howeverthiscouldnotreallyworkinexamples2(steelmarket)
whatcanbedonetoreducethelevelofoutputandpollutionfromQ1toZ1(freemarket
levels)toQ*andZ*(thesociallyoptimallevels)

1.)
mergerbetweenthepolluterandthevictimofpollution
2.)
pigouviantaxation
thegovernmentimposesataxoneachfirmthatisproportionaltotheammountofsteel
produced(or,betteryet)proportionaltotheammountofpollutionproduced

drawthepreviousdiagram
thegovernmentnowimposesanoptimalpiguviantax,t,whichisaunittaxwhichis
equaltotheheightofMDatQ*,andalsoequaltotheheightdifferencebetweenMSC
andMPCatQ*
theeffectivemarginal(private)costtosteelproducersgoesupbyt,becomingMPC+t
thenewmarketequillibriumvalueofQisdeterminedbytheinteraction...
Astheresultofthetax,themarketendsupproducingatQ=Q*
thenewpriceofsteelisP*,whichishigherthanthepriceintheabsenceofthetax(see
earlierdiagram)
note:P*isthenewgrossprice
*Y
P*newgrossprice
Pnnewnetprice
taxrevenues=(5)+(6)
=(t)(Q*)
steelproducingfirmsareworseoff,sincePsvbyarea(6)plusbottompartofarea(2)
demandersofsteelareworseoff,sinceCsvbyarea(5)plustoppartofarea(2)
resdentsarebetteroff(sincepollutionv)
thereisanetefficiencygainequaltoarea(1)asaresultofthetaxation
thicontradictswithchapter14whereataxwasassociatedwithanetefficiencyloss
thetaxgivesfirmsanincentivetoproducelesssteeland(ifthetaxisonpollutionitself)
italsogivesfirmsanincentivetoemitlesspollutionperunitofsteel
anotherwaytoseeefficiencygain
itisequalto
taxrev+CS+PS+benefitsoflesspollutiontoresidents

=(5)+(6)[(5)+(6)+(2)]+[(1)+(2)]
=(1)
1.)

asubsidy
thegovernmentgiveseachfirmasubsidyforeachunitofsteelthatitreducesits
productionby(oreachunitofpollutionthatitreducesitspollutionby)
thereareanumberofreasonsthatasubsidyprogramislessdesireablethanapiguvian
taxationprogram.Someoftheseexamplesaregiveninthebook
midterm:
9thedition:
ch4,7,14,appendix
7thedition:
ch4,12,appendix
donotworryaboutchapters1and2
inchapter3,focusonthealstpart,beginningwithmarketfailure
there'sgonnabesomechoiceontheexam
theremightbeacouplequestionsbasedonthebookthatwillnotbefromthelecture
notesthoughthesewillbeavoidablebecauseofthechoicesontheexam
diagramsandproblemsbutcouldsomeshortessays
continuing...
whatcanbedonetoreducetheelvelofoutputfromQ1toQ*(andreducethelevelof
pollutionfromz1toz*)?
z1=levelofpollutionwithafreemarket
z*=optimallevelofpollution

1.)

transferablepollutionpermits
whichisverysimilartocapandtrade

(a)supposethereisafixedamountofpollutionforeachunitofoutput.Thenthe
governmentcansellQ*permits,eachallowingafirmtoproduceandsell1unitof
output,auctioningtheseofftothefirmsthatarewillingtopaythemarketclearingprice
supplyanddemandforpermits
*Z
PP*=marketclearingpriceofapermittoproduceoneunitofoutput
presumably
PP*=t
wheretistheoptimalpiguviantaxthatthegovernmentwouldhaveimposedifitused
taxationinsteadofpermits
thepermitsystemisequivelanttoapiguviantaxsystem,atleastunderperfect
information
firmswouldbeallowedtobuyorsellthepermitsamongthemselves
note:ifthereisafixedamountofpollutionforeachunitofoutput,thenZ1/Q1=Z*/Q*
(b)supposetheamountofpollutionperunitofoutputcanbevaried,then
Z*/Q*<Z1/Q1
(lesspollutionperunitofoutputintheoptimalsituationthaninthefreemarketsituation)
inthiscase,thegovernmentcansellz*permits,eachallowingafirmtoemitoneunitof
pollution,auctioningthemofftothefirmsatamarketclearingprice
*AA
supplyanddemandforpermits
pz*=marketclearingpriceofapermittoemitaunitofpollution
withapiguviantaxortransferablepermits,pollutionisreducedinthemostcosteffective
way
thegovernmentneedslesinformationthanisthecasewithsubsidiesorregulation
thegovernmentstillneedsasignificantamountofinformationtochoosetheappropriate

levelofthepiguviantax,ortochoosetheappropriatelevelofz*
whatisQ*?
whatist?
Whatisz*?
suppose...
*AB
thenthegovernmentshouldjustimposeapiguviantaxof:
t=MD0
anditdoesnotneedanyotherinfo
inthiscaseapiguviantaxmakesmoresensethanapermitsystem
supposetheMDlooksfollows:
*AC
inthiscaseitmightmakemoresensetouseapermitsystem(andchoosez*as
illustrated)thntousepiguviantaxation
1.)

establishpropertyrights
mightworkinthefirstexample(bartandlisa)
either:
(a)barthastherighttopolluteandlihispollutiontotheefficientlevel
(or)lisahasthepropertyrightstotheriverandbartspayshertopolluteuptotheefficient
level
undercertainassumptions,thingsworkoutrightaslongasoneofthem(bartorlisa)has
propertyrightstotheriver
coasetheorem
thiscertainlywouldntworkinthesecondexample(steelmarket)becausethereare

severalfirmsthatpolluteandmanyresidentswhoarehurt,andnegotiationamongall
theseconomicagentsisnotpractical
1.)

regulationofpollution
seethebookfordiscussionofthis(sometimescalledcommandandcontrolregulation)
notnormallyfavoredbyeconomists
needmuchmoreinformationthanothersolutionsorelsehavemuchmoreinefficiencies
approachthatisusedinU.S.
3/9/15
chapter6:publicchoice
majorityvotingrules
example1zoo
threedirectorsofthezoo:a,b,&c
eachahsonevote
thezoohasenoughmoneyandspacetobuy1animal
Tjaguar
Llion
Ttiger
whichanimalwilltheybuy?
Example1.1
choice

1st

2nd

3rd

VoteonLversusT:
avogesforL
BandCvoteforT
Twins21
VoteonLversusJ:
AandBvoteforJ
CvotesforL
Jwins21
supposethereisavotebetweenanytwoandthewinnerfacestheremainingchoice
thentheJwillendupbeingthewinner
thisisaneasycasesince2ofthe3votershaveJastheirmostpreferechoice
example1.2
choice

1st

2nd

3rd

LvT:
candavoteL
bvotesT
Lwins21
LvJ:
BandCforL
AforJ

Lwins21
tv.J:
BandCvoteT
AvotesJ
Twins21
theultimatewinnerwillbethelion
example1.3
choice

1st

2nd

3rd

VoteonLv.T:
AandCvoteforL
BvotesforT
Lwins21
voteonLv.J:
CvotesforL
AandBvoteforJ
Jwins21
voteonJv.T:
avotesforJ
BandCvoteforT

Twins21
LbeatsT
TbeatsJ
JbeatsL
IfyouhaveLv.Tfirst,withwinnerfacingtheJ,then
LbeatsT
LversusJ
Jistheoverallwinner
IfyouhaveLversusJandthewinnerfacestheT,then
JbeatsL
JversusT
TbeatsJ
Tisoverallwinner
ifyouhaveJv.TandthewinnerfacesL,then
Lisoverallwiner
paradoxically,theorderofthevotesignificantlyeffectstheoutcome
insomesense,thecommunity's(zooleadership)preferencesareinconsistent,even
thoughthepreferencesofeachindividualdirectorareconsistent
votingparadoxically
hapensinexample1.3
notinexamples1.1or1.2
cycling=canoccurinexample1.3ifvoteskeepbeingtaken,withtheremainingchoice
alwayschallengingthewinnerofthelastvote
LversusT

Lwins
JcahllengesL
Jwins
TchallengesJ
Twins
LchallengesT
Lwins
example2:
threeresidents:A,B,&C
threechoicesforapark
JSmallpark
Lmediumpark
Tlargepark
examples2.1,2.2,and2.3havethesametablesasexamples1.1,1.2,and1.3
ifallvotershaveSINGLEPEAKEDpreferencesthenthevariousparadoxesdonotoccur
example2.2
sametableasexample1.2
*AD
inthiscaseallvotershavesinglepeakpreferences,soeverythingisok(noparadoxesor
cycling)
example2.3:
sametableas1.3

*AE
voterbdoesnothavesinglepeakpreferenceandthisiswhatallowthepossibilityofthe
votingparadoxandcycling
medianvotertheorem:
supposethatallvotershavesinglepeakedpreferencesforthequantityofsomepublic
good.Thentheresultofthepoliticalprocess,ifbasedonmajorityvoting,willbethatthe
preferencesofthemedianvoterwillprevail
example:
5voters:A,B,C,D,andE
A

10acres

20acres

30acres

50acres

90acres

*AF
singlepeakedpreferences
themediansizeoftheparksthatthedifferentvoterspreferis30acres
theaverage(meansize)fotheparksthatthedifferentvoterspreferis(10+20+30+50
+90)/5=40acres
whatsrelevantformajorityvotingisthemedian,notthemean
thecommunitywillendupdoingaparkof30acres,accordingtothemedianvotermodel
thisassumesthateachvoterhassinglepeakpreferencesoverparksize
seethebookforanexplanationofwhyitmightbethecasethatavoterspreferencesfor
thesizeofthepublicparkmightnotbesinglepeaked
3/23/15
chapter5:

terminologyforsomeofthemethodsforreducingpollution
2.)piguiviantax=isataxperunitofoutput
emissionstax=taxperunitofpollution
efficienttax=ataxperunitofwaterpollution
1.)

transferablepollutionpermitsalsocalledtradeablepollutionpermitsorcapandtrade
thisgenrealmethodissometimesusedforfisheriestopreventoverfishing

1.)

whatthe7theditioncallsregulationiscalledcommandandcontrolregulationinthe
9thedition(itcallsemissionstaxesandcapandtradeincentivebasedregulations)
Problem6.4(seehandout)
considerandexample
totalcosts(TC)ofreducingemissionsforeachcountryare
canada

mexico

10.00%

100

40

15.00%

250

100

20.00%

450

200

OverallTCifeachcountryreducesemissionsby15%are
250+100=350
OverallTCofCanadareducesemissionsby10%andmexicoreducesemissionsby20%
are
100+200=300
supposecanadapaysmexico125somexicoreducesemissionsby20%andcanadahasto
reduceemissionsbyonly10%
TCtocanadaarenow
100+125=225
whichislessthan250,socanadaisbetteroff

TCtomexicoarenow
200125=75
whichislessthan100,somexicoisbetteroff
chapter12:
incomeredistribution
generalquestion:shouldthegovernmentredistributeincomefromhigherincometo
lowerincomeconsumers,andifso,towhatextentshoulditdothis?
Yi=incomeofconsumerI(afteranyredistribution)
Ui=utilityofconsumerI=U(Yi)
w=levelofsocialwelfare
utilitariansocialwelfarefunction:
W=F(U1,U2,,Un)
wheren=numberofconsumers
Fissomefunction
additivesocialwelfarefunction(aspecialcaseofabove)
W=U1+U2++Un
considerthefunctionU(y)
totalutility
TU(y)=U(y)
marginalutility=howmuchextrautilityyougetifyisincreasedby$1
=slopeoftheU(y)function
onepossibility

constantmarginalutility
*AG
ifyouhavetwiceasmuchincome,youhavetwiceasmuchutility
MU=slopeofTU
butTU(y)isastraightupwardslopingline
thusMUisaconstant
*AH
anotherpossibility
decreasingmarginalutility(diminishingmarginalutility)
*AI
ifyouhavetwiceasmuchincome,thenyouhavelessthantwiceasmuchutility
asyincreases,theslopeofTU(y)decreases
*AJ
supposethereareonlytoconsumers(forsimplicity)
A=ann
B=bob
assumeanadditivesocialwelfarefunction
W=U(Ya)+U(Yb)
assumethatU(y)hasdiminishingmarginalutility
yA0=valueofyAbeforeredistribution
yB0=valueofyBbeforeredistribution
W0=valueofWbeforeredistribution=U(yA0)+U(yB0)

*AK
weareassumingthatyA0<yB0
yc=(1/2)(yA0+yB0)
U(yA0)=areaunderMUA=(1)=totalutilityforAnn
U(yB0)=areaunderMUB(startingfromtherightend)=(4)+(3)

supposethegovernmenttaxesanammountT=YcyA0
=(1/2)(yA0+yB0)yA0=(1/2)(yB0yA0)
awayfrombobandgivesittoAnn
AssumethiscanbedonewithoutchangingyA0orYB0
thenweendupwith
yA=yB=yC=(1/2)(yA0+yB0)
thisiscompleteincomeredistribution
u(yA)=(1)+(2)+(3)
U(yB)=(4)
note:(1)+(2)+(3)=(4)
aftertheredistribtion,
W=(1)+(2)+(3)+(4)
thisredistributionhasincreasedsocialwelfarebyarea(2)
thissortofargumentsuggeststhatincomeshouldberedistributeduntilallconsumers
havethesameincomeafterredistribution
secondexamprobablyapril13th
whatisthesinglebigestproblemwithredistributingtheincome?

Ifbobknowsthatanamountofincome
yB0yc
isgoingtobetakenawayfromhim,hehasanincentivetoworklesshardandthushavea
lowervalueofyB0
ifannknowsanamountofincome
ycyA0
isgoingtobegiventoher,shehasanincentivetoworklesshardandthushavealower
valueofyA0(andthusgetabigertransferofincome)
youcoulddoananalysisoftheoptimalredistributionofincome,takingintoaccountthe
incentivestoworklessasaresultofmoneybeingtransferredtoorfromeachworker=
optimalincometaxation
firstdonesuccessfullybyMirrlees(1971),publishedintheReviewofEconomicStudies
optimalincometaxationconclusion:

youdowanttoredistributeincome
youdonotwanttocompletelyequalizeincomes
Rawlsiansocialwelfarefunction
W=minimum(U1,U2,,Un)
thesocialwelfareisequaltotheutilityoftheconsumerwiththelowest(aftertransfer)
income
Problem
supposethedemandcurveforsteelis
MB=1400.2Q
themarginalprivatecostcurveforproducingsteelis
MPC=80+0.2Q
Themarginaldamagescurvefromthepollutiongeneratedis

MD=0.1Q
whatarethe
(I)

freemarketequillibriumvaluesofQandP(Q1andP1)

(i)

sociallyoptimalvalueofQ(Q*)

(i)

theoptimalpiguviantaxneededtoreachQ*andthecorrespondingvalueofP(P*)
chapter13
expenditureprogramsforthepoor
beforediscussingtheseprograms,Ipresentabasicmodelofaconsumer'schoiceamong
laborhours,leisurehours,andconsumptiongoods
suposethattheutilityofaconsumerdependson
z=hoursofleisureperday
y=dollarsofconsumptiongoods
theconsumerutilityfunctionisU(z,y)
*AL
L=numberofhoursofworkperday
L+Z=24timeconstraint
y=dollarsofconsumption
=dollarsofincome
=wL
where
w=wagerate
wehavetwoequations:

L+z=24
y=wL
Fromthefirstequation
L=24z
wesubstitutethisintothesecondequation
y=wL
y=w(24z)
=24wwz
y=24wwz
wz+y=24wbudgetconstraint
24w=fullincome
=whattheconsumerwouldmakeiftheyworkedallthetime
priceofy=1
priceofz=w
wisthewagerate,anditisthepriceofleisure
wz+1y=24w
ifz=0,then
1y=24w
y=24w
ify=0,then
wz=24w
z=24w/w=24

*AM
y*,z*andL*arethevaluesofy,z,andLchosenbytheconsumer
supposewehaveawelfareprogramwiththefollowingcharacteristics
ifsomeonedoesnotworktheygetawelfarebenefitequaltoB0(somenumberof$)
ifaconsumerworksLhoursperdayatwagew,thewelfareis
B=B0wL
ifB0wL=0
B=0ifB0wL=0
inotherwords,thewelfarebenefitisreducedby$1forevery$1theconsumerearns
whatdoesthebudgetconstraintlooklikewiththewelfareprograminplace?
Thebookarguescarefullywhatitshouldlooklike
problem
zoodirectorsA,B,andCgetthefollowingutilitiesfromtheiranimals
L

80

100

10

40

30

50

60

50

25

Whichanimal,ifany,wouldbepaidbyanysequenceofpairwisevote?
Whatdoesthebudgetconstraintlooklikewiththewelfareprograminplace?
Thebookarguescarefullywhatitshouldlooklike
inthefollowingdiagramsimaginethat
B0=30($30/day)
w=6($6/hour)

wL=B0ifL=5(hoursperday)
*AN
atpointA,L=0
soy=B0=30
AtpointC,L=2
so,
y=B+wL
=(B02w)+2w
=B0=30
atpointD,L=5
so,
y=B+wL
=(B05w)+5w
=B0=30
note:asdrawninthediagram,B0=5w
B0=wL
L=B0/w=30/6=5
basicquestion
whateffectdoesthewelfareprogramhaveonthenumberofhoursthattheconsumer
works?
Firstcase
*AO
intheabsenceofthewelfareprogram,theconsumerwouldchoosepointD,with21

leisurehoursand3laborhours
withthewelfareprogram,theconsumercouldwork3hours,receiveawelfarebenefitof
B03w,andendupatpointC
theconsumerprefersCtoD(U(c)>U(D)),sinceListhesameandyisgreateratCthan
D
ButA,wheretheconsumerdoesnotworkatallandgetsbenefitsB0,andhas
consumptiony=B0,givestheconsumerahigherutilitylevelthanC
theconsumerprefersAtoCsinceyisthesamebutleisurehoursaregreateratAthanC
thustheconsumerchoosespointAanddoesnotworkatall
L0b0]isthenumberof[laborleisure]hoursforwhichBdropsto0.B0=19from
diagram
L0=24z0=S
intheabsenceofthewelfareprogram,theconsumerwouldchoosepointD,withz1
leisurehoursz1=21
L1=24z1=3
acrucialfeatureofthisfirstcase:
L1<L0
inthiscase,thereisasignificantworkdisincentiveofthewelfareprogram(theconsumer
works0hoursinsteadofL1hours)
secondcase
*AP
intheabsenceofwelfare,theconsumerchoosespointC,withz=14andL=10
intheabsenceofthewelfareprogram,theconsumerstillchoosespointC,sinceCisona
higherindifferencecurvethanA
inthiscase,theconsumerbehaviorisnoteffectedbythewelfareprogram(theconsumer
doesnotusewelfare)

withoutwelfare,theconsumerwouldchoosepointC,with
z=z1=14
L=L1=24z1=10
Inthiscase,
L1>L0
whereL0=24z0
=2419=5
3/30/15
problem
considerabasicwelfareprogramwithabenefitgivenby
B=B0wLifB>0
drawcarefullywithallrelevantnumbersthebudgetconstraintforaconsumerwithwage
ratew=10assumingthatB0=60
youshouldhavelaisuredrawnperdayonthehorizontalaxisanddollarsofconsumption
ontheverticalaxis
answer
B=B0wL=6010Lifthisis>0
B=0when6010L=0
60=10L
L=60/10=6
whenL=6,z=24L=246=18
andy=B+wL=0
10(6)=60

whenL0,z=24L=240=24andy=B+wL
=B0wL+wL
=60(10)(0)+(10)(0)=60
whenL=24,z=24L=2424=0
andy=B+wL=0+10(24)=240
*AQ
problem
supposethedemandcurveforstealis
MB=1400.2Q
theamrginalproducecostforproducingstealis
MPC=800.2Q
themarginaldamagescurvefromthepollutiongeneratedis
MD=0.1Q
1.)
2.)
3.)

whatarethe
freemarketequillibriumvaluesofQandP(Q1andP1)
sociallyoptimalvalueoQandP(Q*andP*)
theoptimalpigouviantaxneededtoreachQ*andthecorrespondingvalueofP*
answer
(1)
MB=MPC
140+0.2Q=800.2Q
140=800.4Q
60=0.4Q
Q=60/0.4=180thisisQ1
tofindP1,useMBorMPC

P1=MBhenQ=Q1=450

(2)
MB=MSC
=MPC+MD
80+0.2Q+0.1Q
80+0.3Q
1400.2Q=80+0.3Q
140=80+0.5Q
60=0.5Q
Q=60/0.5=120thisisQ*
(3)
theoptimalpiguviantax,t*,thatisneededtoreduceQtoQ*is
t*=MDwhenQ=Q*
=0.1Q*
=(0.1)(120)=22thisist*
tofindP*,useMBorMSC
P*=MSCofQ=Q*
80+0.3Q*
=80+(0.3)(120)
=80+36=116thisisP*
theeffectivenetpricetoproducersofstealis

Pn=P*t*=12622=104
awelfareprogramwithabasicbenefitof
B0=$30/day
weareconsideringitseffectonaconsumerwithwagerate
w=$6/hour
thebenefitisreducedby$1foreach$1theconsumerearns
thebudgetconstrainttheconsumerfacesis
*AR
z=19means19hoursofleisureperday,or5hoursoflaborperday
thirdcase
*AS
L0=24z0=2419=5
=amountolaborhoursforwhichBdropsto0
L1=24z1=2417=7
withoutawelfaresystem,theconsumerchoosespointC,withz1(17)hoursofleisure
andL1(7)hoursoflabor
inthiscase,asincase2,L1>L0
unlikecase2,ifwelfareisavailable,theconsumergoesonwelfareendingupatpointA
withutilitylevelU2(notethatU2>U1)
inthiscase,theconsumergoesonwelfareeventhoughwL1>B0(eventhoughearnings
atpointCaregreaterthanthewelfarebenefitatpointA)
problem
zoodirectorsA,B,andCgetthefollowingutilitiesfromtheseanimals

80

100

10

40

30

50

60

50

35

Whichanimal,ifany,wouldbepickedbyanysequenceofpairwisevotes?
Answer
fromtheseutilitynumberswecanfigureoutthemostpreffered,secondmostpreffered,
andleastprefferedofeachzoodirector
A

Inavotebetweenthelionandthetiger.AvotesforthetigerbutBandCvoteforthe
lionsoLwins21
inavotebetweenTandH,AandCvoteforT,butBvotesforH,soTwins21
inavotebetweenLandH,BvotesforH,butAandCvoteforLsoLwins21
thenLwouldbechosenbyanysequenceofpairwisevotes
basicwelfareprograminclassified
moreorlessthesameastheoldAFDCprogram
moreorlessthesameasaTANFforwhichthereisa100%taxonearnings
seebookwhatAFDCandTANFstandforAFDCistheprogramthatusedtobeused.
TANFisusednow,thoughvariesbystate
negativeincometaxprograminclass
moreorlessthesameasaTANFprogramforwhichthereisNOTa100%taxon
earnings(seebook)
analternativeprogramforlowincomeconsumers

negativeincometax
benefitgiventoaconsumerintheformofanincomegrant=B
B=B0a(wL)
aslongasthisis>0
(a=1inbasicwelfareprogram)
let'sassumethat
B0=$20/day
a=
thus,
B=20(1/4)(earnignsperday)
=20(1/4)(wL)
aslongasthisis>/=0
supposeforagivenconsumerw=$8perhour
B=20(1/4)(8)L
=202L
overallincome(andexpenditure)oftheconsumer=y
y=B+wL
=20(1/4)(wL)+wL
y=20+(3/4)wL
=20+(3/4)(8)L
=20+6L
B=20(1/4)wL=202L

B=0ifL=10(z=14)
ifL>/=10(z</=14)theny=wL=8L
L

B=202L

20

20

10

(80(5)+10=50

10

(8)(10)=80

15

(8)(15)=120

20

(8)(20)=160

Budgetconstraintifw=8
*AT
case1
*AU
theconsumerchosespointDifthereisnoengativeincometaxprogram
theconsumerchoosespointCifthereisanegativeincometaxprogram(heusesthe
programatpointC)
theconsumerworkslessatpointCbuthasahigherlevelofutility
withthenegativeincometaxprogram,thereareincentivestoworkless,butnottothe
sameextentasthewelfareprogramexaminedpreviously
case2
*AV
Adisthenegativeincometaxsegmentofthebudgetline
AtA,B=20
atD,B=0
theconsumerchoosespointC,thusnotusingthenegativeincometax,sincethe
indifferencecurvethroughCiscompletelyabovethesegmentAD

overall,theincometaxprogramcreatessomedegreeofworkdisincentives,butnot
nearlyasmuchasthewelfareprogramexaminedfirst
thewelfareprogramexaminedfirstisesentiallyanegativeincometaxprogramwitha
100%taxrateonearnings(a=100%=1)
theengativeincometaxprogramthatweexaminednexthasa25%taxrateonearnings(a
==25%)
problem
consideranegativeincometaxprogramwithabenefitgivenby
B=B0a(wL)ifB>/=0
whereB0=60,a=andthewagerateisw=20
drawcarefully,withallrelevantnumbers,thebudgetconstraintfortheconsumer,with
leisurehoursperday(z)onthehorixaontalaxisanddollarsofconsumptionperday(y)
ontheverticalaxis
chapter8
costbenefitanalysis
supposethegovernmentisconsideringaninvestmentproject.Istheprojectworthwhile?
Assumeuntilfurthernoticethatthereisnoinflation
ristheannualinterestrate
supposeyouput$1inthebankinyear0
inoneyearuhave$(1+r)
Moneyinthe
bankinyear0

1/(1+r)

R/(1+r)

Moneyinthe
bankinyear1

1+r

R(1+r)

10

0.909.

9.09

Ifr=0.10=10%(peryear)
Year0

Year1

1.1

11

10

Presentvalueof$1receivedoneyearfromnowis$1/(1+r),because1/(1+r)depositted
todaygrows...
thepresentvalueof$RreceivedoneyearfromnowisR/(1+r)
leavesmoneyinthebankfor2years(ormore)
Year0

Year1

1+r

Year2

(1+r)(1+r)=(1+r)2

Year3

(1+r)3

(1+r)2=1+2r+r2
where1isoriginaldollar,2ris2yearsofinterestandr2isinterestoninterest
thepresentvalueof$1receivedtwoyearsfromnowis$1/(1+r)2,since$1/(1+r)2
deposittedtodaywillgrowtobecome$1in2years
$1growstobecome$(1+r)ninnyears
RgrowstobecomeR(1+r)ninnyears
thepresentvalueof$1receivednyearsfromnowis1/(1+r)n
therpesentvalueof$RreceivednyearsfromnowisR/(1+r)n
supposeyouhavearevenuestreamof
R0inyear0
R1inyear1
R2inyear2
(andsoon)
RTinyearT
whatisthePV(presentvalue)ofthisrevenuestream?

PV=R0+R1/(1+r)+R2/(1+r)2++RT/(1+r)T
Tcouldbe1,or2,or20,oreveninfinity.Tisthelastyearinwhichyougetrevenues.
Aspecialcaseofthisformula
R0=0
R1=R
R2=R
Rn=Rforeveryvalueofn>/=1
T=infinity
thenPV=R/r
supposeyouhaveapotentialinvestmentproject
C0=costinyear0
C1=costinyear1
C2=costinyear2
(andsoon)
CT=costinyearT
B0=benefitinyear0
B1=benefitinyear1
B2=benefitinyear2
(andsoon)
BT=benefitinyearT
wecanusethepreviousformulaifweset
Pn=BnCn

thepresentvalueoftheprojectis
PV=B0C0+(B1C1)/(1+r)+(B2C2)/(1+r)2++(BTCT)/(1+r)T
basicruleadopttheprojectifandonlyifthePV>0
aprojectisadmissibleifitsPVispositive
iftwoprojectsareadmissibleandtheyaremutuallyexclusive,theprojectwiththehigher
PVshouldbeadopted
simpletwoyearinvestmentproject
C0=netcostinyear0
B1=netbenefitinyear1
r=interestrate
PV=C0+B/(1+r)
adopttheprojectifthePV>0butnotifPV<0
adopttheprojectifPV>0
C0+B1/(1+r)>0
B1/(1+r)>C0
B1>C0(1+r)
adopttheprojectifthebenefitinyear1ismorethanenoughtocovertheinitialcostplus
interest
ifyoudonotadopttheprojectandputC0inthebank,thenyouhave
C0(1+r)inyear1
ifyouadopttheprojectthenyouhavesomethingworth
B1inyear1
adopttheprojectif

B1>C0(1+r)
example
C0=202
B1=220
r=0.10=10%
shouldthisprojectbeadopted?
PV=C0+B1/(1+r)
=202+220/(1+0.10)
=202+220/1.1
=202+200=2<0
PV<0sodonotadopttheproject(theprojectisnotadmissible)
noteiftheinterestratewas0.05=5%,thenitwouldbethecasethatPV>0,sothenthe
projectshouldbeadopted
alternativemethodforthisexample
C0(1+r)
=(202)(1+0.10)
=(202)(1.1)=222.2
B1=220
222.2>220sotheprojectshouldnotbeadopted
problem
consideragovenrmentinvestmentprojectwiththecoststream
C0=400C1=480

andletthebenefitstreambe
B1=120B2=1350
shouldthegovernmentadoptthisprojectifr=50%?
4/6/15
threeyearinvestmentproject
C0=netcostinyear0
B1=netbenefitinyear1
B2=netbenefitinyear2
PV=C0+B1/(1+r)+B2/(1+r)^2
ifPV>0youadopttheproject
ifPV<0youdonotadopttheproject
example
C0=100
B1=B2=60
r=0.10=10%
PV=C0+B1/(1+r)+B2/(1+r)^2
=(100)+(60)/(1+[.1])+(60)/(1+[.1])^2
=100+60/1.1+60/1.1^2
=100+60/1.1+60/1.21
=100+59.55+49.56
=100+104.14
=4.14>0

PV>soweadopttheproject
problem
consideranegativeincometaxprogramwithabenefitgivenby
B=B0a(wL)ifB=0
whereB0=60,a=andthewagerateisw=20
drawcarefullywithallrelevantnumbers,thebudgetconstraintforatheconsumer,with
leisurehoursperdayonthehorizontalaxisandthedollarsofconsumptionperdayonthe
verticalaxis
answer
BB0a(wL)=60.5(20L)
=6010L(ifthisis20)
B=0when6010L=0
60=10L
L=60/10=6
whenL=6,z=24L=246=18
andy=B+wL=0+20(6)=120
whenL=0,z=24L=240=24
y=B+wL
=B00.5(wL)+wL
600+0=60
whenL=24,z=24L=2424=0
andy=B+wL=0+20(24)=480
*AW

infiniteperiodinvestmentproject
C0=netcostsinyear0
B=netbenefiteveryyearstartinginyear1
PV=C0+B/(1+r)+B/(1+r)^2++B/(1+r)^n+
(n=infinity)
PV=C0+B/r
ifPV>0thenadopttheproject
ifPV<0thendonotadopttheproject
ifPV=0you'reindifferent
adopttheprojectifPV>0
Co+B/r>0
B/r>C0
B=C0r
whydoesthisformulamakesenseintuitively
supposeyoustartoutwithCoinperiod0
therearetwothingsyoucandowiththemoney
1.)

adopttheprojectandgetbenefitsofBeachyearstartingwithyear1

1.)

donotadopttheproject.Putthemoneyinthebank.KeepC0inthebankandtakeout
interestC0reveryyearstartingyear1
twopossibleinvestmentprojects
theyaremutuallyexclusivesoonlyoneofthemcanbedone(thisiswhatweare
assuminginthefollowingexample)
project1andproject2
foranygivenvalueofrwecalculatethepresentvalueofeachproject

(a)ofPV<0forbothprojects,thenanotherprojectisadmissible,sodoniether
(b)ifPV>0foroneprojectonly,thenonlythisprojectisadmissible,sodothisproject.
(theonewiththepositivePV)
(c)ifPV>0forbothprojects,thenbothareadmissible,sodotheonewiththehigherPV
project1
C0=100=costofmakingfireworks
C1=50=costofgivingafireworkdisplayinyear1
B1=200=thevaluethatconsumerspalceonwatchingthedisplay
PV1=C0+(B1C1)/(1+r)
=100+(20050)/(1+r)
=100+150/(1+r)
ifr=1.00=100%
then
PV1=100+150/(1+1)
=100+75=25
ifr=0.25=25%
then
PV1=100+150/(1+0.25)
=100+150/1.25
=100+120=20>0
PV1<0ifr=100%
PV1>0ifr=25%

project1
r

PV1

100.00%

25

80.00%

16.7

60.00%

6.25

50.00%

40.00%
30.00%
25.00%
20.00%
18.00%
15.00%
PV1>0ifr<50%
PV1<0ifr>50%
ifrvpv1^
ifrvthenthebenefitsthatoccurinthefuturearediscountedless(areworthmore)
project2
C0=100=costofmakingapublicpark
C1=C0=C1=C2==10
=C=costofmaintainingtheparkeachyearstartingyear1
B1=B2=B3==30
=B=benefitsineachyearstartingwithyear1
PV2=C0+(B+C)/r
=100+(3010)/r
=100+20/r

ifr=0.50=50%
then
PV2=100+20/0.5
=100+40=60
project2
r

PV2

100.00%

80

80.00%

75

50.00%

60

40.00%

50

30.00%

38.75

25.00%

20

20.00%

18.00%

11.1

15.00%

...

10.00%
5%
ifr>20%
thenPV2<0
ifr<20%thenPV>0
asrVPV2^(aswastrueofproject1too)
ifr>50%thenPV1<0andPV2<0
soneitherprojectshouldbeadopted
if20%<r<50%
then
PV1>0butPV2<0

soproject1shouldbeadopted
ifr<20%thenPV1>0andPV2>0
andtheprojectwiththehigherpresentvalueshouldbeadopted
ifr=18%thenadoptproject1(since27.12>1.1)
ifr=15%thenadoptproject2(beause33.33>20.43)
forwhatvalueofrdotheprojectshavethesamePV?
PV1=PV2
100+150/(1+r)=100+20/r
150/(1+r)=20/r
100+150/(1+r)=100+20/r
150/(1+r)=20/r
150=20/r(1+r)
150r=20(1+r)
150r=20+20r
130r=20
r=20/130=.1538=15.38%
overallconclusions
ifr>50%thenadoptneitherproject
if15.38%<r<50%thenadoptproject1
ifr<15.38%thenadoptproject2
lowinterstratesareespeciallybenefitialforaprojectwhosebenefitsextendfarintothe
future

internalrateofreturn
theinternalrateforeturnisthe,delegatedasp(roe),isthevalueforrforwhichthePVof
aprojectis0
usuallyitisthecasethat
(a)ifr>p(roe)thenPV<0,sotheprojectisnotadmissible
(b)ifr<p(roe)thenPV>0,sotheprojectisadmissible
exampleproject1
PV=100+50/(1+r)
toclaculatep(roe),setPV=0andreplacerbyp(roe)
0=100+150/(1+p)
100=150/(1+p)
100(1+p)=150
100+100p=150
100p=50
p=50/100=.5=50%
thisisthesameasthevalueforrforwhichPV=0inthetableearlieron
answer(assignedlastweek)
consideragovernmentnvestmentprojectwiththiscoststream
c0=400
c1=480
andthebenefitstream
B1=120
B2=1350

shouldthegovernmentadoptthisprojectifr=50%?
answer
PV=B0C0+(B1C1)/(1+r)+(b2C2)/(1+r)^2
=0400+(120480)/(1+.5)+(13500)/(1+.5)^2
=400+360/1.5+1350/1.5^2
=400240+1350/2.25
=640+600=40<0
theprojectisnotadmissible.Donotadopttheproject
^^^midterm2^^^
VVVFINALVVV
secondexamnextclass
chapter5,6,7,8,11
or
chapter5,6,12,13,8
inthecostbenefitchapter,youcanbetestedonanythingassignedexceptfordealing
withinflation
effectsofinflation
supposethatintheabsenceofinflationtheinterestrate(annualinterestrate)isr
supposeinsteadof0inflationthere'sasteadyannualinflationrateofpie(constantover
time)
thentherearetwothingswecouldmeanbytheinterestrate
itisareasonableassumptionthattherealinterestratemightremainunchangedatr
independentofpie
nominalinterestrate=theinterestrateactuallyobserved

realinterestrate=nominalinterestratecorrectedforinflation
rR=rNpieE
iftheseareallsmallnumbers
rR=realinterestrate
rN=nominalinterestrate
pieE=expectedinflationrate
ifinflationisconstantoveralongperiodoftimethen
pieE=pie
wherepie=actualinflationitisareasonableassumptionthatifinflationchangesfroma
steadyrateof0toasteadyrateofpie,thentherealinterestrate,whichwecallrR,
remainsunchanged.However,thenominalinterestrateincreasesfromrNtoavlaue
whichis
rN=(1+r)(1+pie)1
=1+r+pie+rpie1
r+pie+rpie
=r+pie
ifrpieisaverysmallnumber
example
(highervaluesofrandpiethanarerealisticfortheu.s.)
r=0.25=25%
pie=0.20=20%
whatisthenominalinterestrateforthiscase?
Nominalinterstrate=rN
=(1+r)(1+pie)1

=(1.25)(1.20)1
=1.51
=0.50=50%
notethatr+pie=45%inthiscase
recallproject1fromearliertonight,withpie=0
C0=100
C1=50
B1=200
r=0.25=25%
PV=100(20050)/(1+.25)=20
whatahppensifpie=0.20=20%insteadofbeing0
r=0.25=25%
pie=0.20=20%
rN=50%
whathappenstoC0,C1,andB1asaresultofinflation?
SupposeC0isunchangedat100
itisreasonabletoassumethattherealvaluesforC1andB1,correctedforinflation,are
unchanged
howeverthenominaldollarvaluesfoC1andB1aremultipliedby(1+pie)
inthefollowingpages,C1andB1aretherealvaluesofC1andB1(measuredinyear0
dollars)
C1NandB1NarethenominalvaluesofC1andB1(measuredinyear1dollars)
thenominalvalueforthecostsandbenefitsarenow

C0N=100
C1N=C1(1+pie)
=50(1+0.2)
=60
B1N=B1(1+pie)
=200(1+0.2)
=240
ifyouknowthevaluesofC1NandB1N,theycanbecorrectedforinflation(converted
intoyear0dollars)asfollows
C1+C1N/(1+pie)=60/(1+.2)=50
B1=B1N/(1+pie)=240/(1+0.2)=200
twolegitimatewaystoevaluatethisinvestmentproject
method1
userealvaluesforC0,C1,B1,andtheinterestrate
PV=C0+(B1C1)/(1+r)
P=100+(20050)/(1+0.25)
=100+150/1.25
=100+120=20>0
PV>0sotheprojectisadmissible
method2
usenominalvaluesthroughout
PV=C0N+(B1NC1N)/(1+rN)
notethat

rN=(1+r)(1+pie)1
1+rN=(1+r)(1+pie)
thus
PV=100+(24060)/(1+0.50)
=100+100/1.5
=100+120
=20>0
andthisisthesamevalueofPVwecalculatedthefirstway
therearetwowrongmethods
method3(wrong)
usenominalvaluesforcostsandbenefitsbutusearealinterestrate
PV=C0N+(B1NC1N)/(1+r)
=100+180/1.25
=100+144
=44
andthisoverstatesthepresentvalueoftheproject
method4(wrong)
userealvaluesofthecotsandbenefitsbutuseCN
PV=C0+(B1C1)/(1+rN)
=100+(20050)/(1+0.5)
=100+150/1.5
=100+100=0

andthismethodunderestimatesthePVoftheproject