Lecture 10 Class Notes

Theory of Optimal Choice

  • Assume consumers say "I want more of everything" until they're at the frontier, where tradeoffs become necessary
  • e.g. Dams: 100 water, 50 electricity; or 150 water, 40 electricity?
  • Slope of possibility frontier = marginal rate of transformation (MRT)
    • Linear: you gain the same amount for every unit you give up no matter how much you already have
    • Convex: diminishing returns
    • Concave: thought of as uncommon, but happens a lot, e.g. expertise: the more you do of something the better you are at it (the less it costs you)—think heart surgery, legal cases

Indifference curves

  • Value: think of it as 3D graph
    • Possibility frontier is 2D surface, height is preference (hills where it’s preferred outcome)
    • Just like topo maps: lines around areas that have about the same “height” (value)—indifference curves
    • Slope of indifference curves = marginal rate of substitution (MRS)

MRT and MRS can seem similar concepts but come from fundamentally different origins

  • MRT is what is possible in the outside world
  • MRS is what you prefer and value

Fitting curves together

  • See where possibility frontier intersects with highest indifference curve
  • Must be where there’s a point of tangency, i.e. slopes are equal (if not, there’s still somewhere we can slide to get even better off)

This provides the framework to understand all kinds of things in economics…

Consumer theory: nonsatiation (always prefer more) BUT declining MRS (the more you have the less you value additional)—true satiation is uncommon, though it does exist, e.g. food

Inferior goods: something you consume less of when your income goes up, e.g. ramen

Demand curve: can think of either axis as causal

  • Either at a certain quantity it’s worth a certain price, or at a certain price a certain quantity is desire
  • Downward sloping is pretty universal in real life; only in rare and perverse cases does it behave otherwise (unlike other curves that are simplifications and variations do reflect the complexities of reality)

Relevance: foundation allows us to identify market failures, which is where environmental and natural resource management problems occur