Microeconomics - Research Proposal Example

1. In the competitive equilirbium, the price clears the market, i.e., the price is so that the quantity demanded at that price equals the quantity supplied (Varian, 1999). In the diagram below, this would hold true for any price between 50 to 60 units. The quantity demanded would be 25 units which would be equal to the quantity supplied assuming that buyers with a reservation price of 25 units make the purchase and the sellers with a reservation price of 25 units sell (and also assuming that each individual demands or supplies a single unit). We have further assumed that there are 5 buyers and 5 sellers correpsonding to each reservation price. The entire triangular region made up of the green, yellow and red regions would constitute the total surplus in that case. However if the market price is below the competitive level, The market will not clear. A greater number of buyers shall be willing to purchase the good relative to the number of sellers who would wish to sell the good at that price. Thus, there will be excess demand. At a price of 30 units per quantity unit of the product 35 units will be demanded in totality whilst the supply will be 15 units, provided all buyers buy if the price is lower or equal to their reservation price and all sellers sell if the price is greater or equal to their reservation prices. The total surplus will also fall short of that present in a competitive situation. The total surplus is smaller as not all of the buyers willing to buy the product at the given price are able to acquire it given the supply shortage (Hey, 2003, p: 34). To compare the change in surplus consider the following diagram depicting the competitive equilibrium situation: Evidently, if price is below its market clearing level, the total surplus is lower than that in the competitive equilibrium. Further, the distribution of surplus also changes. While there is almost identical distribution of surplus in the competitive equilibrium situation among the buyers and the sellers, in the case where the price is set below the market clearing level, the consumers’ surplus is greater than the producers’ surplus. The change is distribution of surplus occurs due to the fact that if price is lower than the competitive level, then for a comparatively larger number of buyers the difference between their reservation prices and the existing price is greater (Hey, 2003, p: 34). However, the producers’ surplus is now lower as a lower number of buyers now can sell the product at a price greater than their reservation prices. This has an offsetting effect so that in the end result the total surplus falls short of the competitive level surplus. 2. The indifference curves shall assume unique shapes if one of the two products that the consumer consumes generates disutility for him, i.e., it is rather a “bad”. We can have two distinct cases depending upon whether there is free disposal of the bad or not. If we assume that the individual can freely dispose of the bad, i.e., he can separate it out from the consumption of the good and choose to not consume it without any costs in terms of utility the indifference curves for the good and the bad will be a straight line parallel to the axis measuring the consumption of the bad while the intercept on the good axis will represent the amount of the good consumed. This shape of the indifference curve can be best understood by perceiving the fact that since the consumer can choose to throw away the bad without any cost any higher amounts of it does not cause any disutility whilst higher amounts consumed of the good increase the utility derived. Thus, the utility gained in essence depends upon the amount of the good consumed. For any given level of the good consumed, as there is free disposal, the utility level is independent from the amount of the bad consumed. Therefore, the indifference curves assume a vertical shape. As the consumer moves rightwards along the indifference map, his utility shall rise as higher amounts of the good are consumed. The second case is of costly disposal. Here it is assumed that the consumer has to suffer the disutility of the good as choosing to dispose it is more costly in terms of utility. In this case, as the individual consumes the bad, his utility falls and thus to ensure that his utility level remains unaltered more of the good has to be consumed. Therefore, in this case the indifference curves shall be positively sloped. The curvature depends upon assumptions regarding the preferences of the consumer. If we assume that the marginal disutility of the bad rises with its increased consumption whilst the marginal utility of the good is diminishing, then since gradually more and more amounts of the good will be necessary to compensate the disutility caused by a unit consumption of the bad, the indifference curves shall be convex to the bad axis. A movement along the map towards the top left corner resembles higher utility in this case, so that higher indifference curves in this case also yield higher utility. 3. The Edgeworth box was a remarkable tool to do general equilibrium analysis with two agents. The first clever thing that Edgeworth did to construct the box was inverting the axis of the indifference map of one of the consumers so that its origin was at the top right corner. The second clever thing that Edgeworth did to facilitate general equilibrium analysis was to superimpose the inverted diagram on the indifference map of the other agent (Hey, 2003, p:113 ). This created the box with each arm representing the total endowment of a good. The width of the box is determined by the total endowment of the good that was initially plotted on the horizontal axis. In our diagram this would mean that the width of the box represents the endowment of good 1 that agent one has plus the endowment of good 1 that agent two has. Due to the particular construct of the Edgeworth Box diagram, both agents start of from the same points. Since, as is shown in the diagram, if AC represents the total endowment of good 1, i.e., the sum of endowments of the two agents and if AB is agent 1’s endowment then BC has to be agent 2’s endowment of good 1, and further as this holds true for good 2 as well, Point B reflects the starting point for both agents. The locus of the tangency points between the two sets of indifference curves represents the Pareto efficient combinations and is known as the contract curve (Hey, 2003, p: 114). If preferences are convex and identical so that the indifference map of one agent is a mirror of the other’s, then the contract curve will pass through the mid-point of the Edgeworth box. The easiest way to show this is to understand that the tangency occurs through the equality of the MRS for the indifference curves of the two agents (Varian, 1999). Now if the indifference curves are mirror images then evidently, the MRS will be equal for the two indifference curves at the respective mid points of the curves. Thus the tangency points will lie along the 45 degree line. This implies it will pass through the mid-point of the Edgeworth box. If the endowments are identical in this case as well then the initial point will be the midpoint itself. And as we have just shown that the contract curve shall pass through the mid-point in this case, this implies the initial point itself shall be on the contract curve thereby rendering any Pareto improvements impossible. Other trade starting points are definitely possible depending upon the initial endowments. In this case no further trade was possible due to the fact that given the particular preferences and endowments the initial point itself was efficient. If the endowments had been different so that the initial point was off the contract curve, then trades that bought the agents on to the contract curve would have followed. References: Hey., J.D., (2003) Intermediate Economics, McGraw-Hill, UK Varian, H.R., (1999) Intermediate Microeconomics: A modern Approach, 5th ed. W. W. Norton & Company Read More