Rutgers University














































































Important Information
to review before Prof. Blair's second exam

The exam is from 11:30 a.m. to 12:50 p.m. on Thursday, November 14. Please arrive promptly.

A review session will take place the night before the exam: Wednesday, November 13, from 7:45 to 9:30 p.m. in Ruth Adams 001, Douglass Campus. This session is entirely optional. The format will be question-and answer, so please come prepared with your questions.

Exam preparation advice

    Make sure you understand how to solve all of the problems in the relevant assignments (5 through 9). Answers and commentaries are posted on the web.
    Work with the online labs. The online labs cover most of the main concepts covered in the second part of the course.
    Do as many additional problems as time permits. You can find worthwhile problems and multiple-choice questions in the Study Guide and on the CD-ROM that came with your text.
    Take charge of what you know: whenever you answer incorrectly one of these various practice questions, make it your business to understand why. Use the text, the study guide, the course web resources, the TAs, and the instructor effectively to address your misunderstandings.
    Do not waste time re-reading the text multiple times, marking passages in a sequence of garish highlighter colors, or generating reams of index cards filled with formulas and definitions. This is pointless busywork that may make you feel as though you are preparing, but will do little to improve your problem-solving ability. Once you have read each chapter carefully once, the book should become a reference to consult when you encounter difficulty in doing problems.
    Go to bed early. Arriving at the exam with a clear head is much more useful than watching the sun rise while trying to memorize elasticity formulas.

Topic outline

    Exam coverage: The exam will cover the theory of consumer behavior, the theory of the firm, and welfare economics, that is, the material discussed in Lectures 8 through 16. It will not cover input markets.
    1. Consumer theory
      1. Point of consumer theory: tools for analyzing consumer demand behavior, in particular, why demand slopes down
      2. indifference curves
      3. budget lines: Income M = pAA + pBB; mechanics of plotting budget lines
      4. MRSAB = pA/pB: tangency condition describing optimal choice along budget line
      5. derivation of optimum bundle (or whole demand curve): solve simultaneously the two previous equations
      6. reasons for negative slope
        1. income effect (may be positive or negative)
        2. substitution effect
      7. Demand curve for a consumption good slopes downward either:
        1. when the good is normal, so the income effect reinforces the substitution effect, or
        2. when the good is inferior, so the two effects work in opposite directions, but the substitution effect outweighs the income effect. (This will be true for virtually all inferior goods.)
      8. Consumer theory applied to the labor-leisure choice
        1. deriving demand for leisure (and thus supply of labor) from indifference curves and budget lines
        2. how the income and substitution effect analysis differs in the case of labor supply: When leisure is a normal good, income and substitution effects work in opposite directions, since an increase in the price of labor makes a seller of labor better off. Thus it is easier to have a "perversely" sloped supply curve for labor than the income-and-substitution-effect analysis in the case of consumption goods would suggest.
      9. Consumer surplus: dollar measure of gains from trade
    2. Producer theory
      1. Point of producer theory: tools for analyzing cost, supply, especially when and why supply slopes up or is horizontal
      2. production functions
      3. short run cost
        1. TPL, MPL, APL (and average-marginal relationships)
        2. TVC from TPL
        3. STC
        4. AVC, AFC, SATC
        5. SMC--upward slope result of diminishing returns assumption
      4. long run cost
        1. MPL/pL = MPK/pK--equal bang for the buck cost minimization condition
        2. LTC curvature dependent on economies of scale
    3. Competitive supply
      1. price-taking behavior
        1. justification of the assumption
        2. implication: P = AR = MR
      2. short-run industry supply curve
        1. MR = SMC for profit maximization
        2. SMC rising (or else profit minimum when MR = SMC)
        3. TR > TVC, or P > AVC
        4. firm's supply curve slope is thus the result of the diminishing returns assumption
        5. horizontal summation to get industry supply curve
      3. producer surplus
      4. long-run industry supply curve
        1. 3 requirements of long-run equilibrium: no incentive for
          1. change in K (hence SATC = LAC)
          2. change in Q (hence P = SMC = LMC)
          3. exit or entry (hence P = SATC)
        2. These imply that P = SMC = SATC = LMC = LAC.
        3. Using the average-marginal relationships, it follows that a representative firm in an industry in long-run equilibrium operates at the bottom of LAC.
        4. The long-run industry supply curve is thus horizontal at height of minimum point on LAC (so long as input prices to the industry are exogenous [the "constant cost" case])
          1. Hence in doing long-run comparative statics, need to check if the change being analyzed alters this value.
        5. Dynamics of adjustment: begin with an industry in long-run equilibrium; increase demand, follow through changes as equilibrium is re-established.
    4. Welfare economics or normative economics
      1. Pareto efficiency
        1. verbal definition and interpretation
        2. equivalent marginal conditions
      2. Fundamental Theorem of Welfare Economics: relationship between competitive equilibrium allocations and Pareto efficient allocations
        1. allocative efficiency: social MB = social MC (being at right point on PPC)
          1. how profit maximizing firms, utility maximizing consumers, and price-taking behavior make this condition hold
        2. productive efficiency: being on PPC; occurs when firms minimize cost (or maximize profits)
        3. distributional efficiency: need MRS's equal across consumers: how utility maximization subject to a budget constraint when buyers all face the same prices results in distributional efficiency
      3. Be careful to distinguish the efficiency conditions themselves from the arguments about how markets can cause them to hold.