Neoclassical Theory: Consumer Behavior, Production, Equilibrium, and Uncertainty

Posted on Nov 22, 2024 in Economy

The economic problem of neoclassical theory is how it achieves the efficient allocation of resources. Equilibrium prices indicate the relative scarcity of goods and services.
The problem of the theory of consumer behavior and preferences is how to determine a way to choose among alternatives to achieve the greatest possible satisfaction.
Axioms:
Axiom of completeness: The set of consumer preferences should be complete; two food baskets can always be compared.
Axiom of reflexivity: A consumer basket is at least as preferred as itself.
Axiom of continuity: Given a preference choice set and fixed preferred preferences, the preferences are continuous if located in a closed set.
Monotonicity axiom: Individuals always prefer more assets.
The problem is how utility can identify and represent preferences, establish a set of possible baskets, and rank collections based on costs and preferences, adhering to rationality axioms.
Utility: A way to describe preferences.
Utility function: How to represent the system of preferences.
Properties:
Perfect substitutes: The Marginal Rate of Substitution (MRS) is constant.
Perfect complements: Goods always consumed together in the same proportion.
The objective of demand theory is to explain how demand changes with price and income variations.
Types of Goods:
Needed: Demand increases less than proportionally to income growth.
Luxury: Demand increases more than proportionally to income growth.
Homogeneous preferences: Demand increases proportionally to income growth.
Inferior: Demand increases with decreasing income.
Regular: Demand increases as its price decreases.
Giffen: Demand increases as its price increases.
Slutsky equation: The change in demand for X is explained by two components: the substitution effect (demand change due to price variation, changing MRS, with constant purchasing power) and the income effect (demand change due to changes in purchasing power), both in response to price changes of X.
Market demand curve: Horizontal summation of individual demand curves.
Reservation price: The maximum an individual is willing to pay.
Consumer net surplus: The difference between the total gross surplus and the actual cost to the consumer.
Variation of the surplus or loss of consumer surplus: The decrease in net surplus due to price increases.
Basic principles of the theory of production and business: a) Production is carried out by production units (firms). b) Firm size is variable. c) Firms use inputs to create a final product using a specific technique.
Business problem: Choosing the optimal production technique by analyzing costs. In perfectly competitive markets, input and output prices are determined by the market. The firm’s problem is to determine the production volume that maximizes profit given these prices.
Assumption of optimizing producer behavior: The market is perfectly competitive, and prices are given. Three optimization mechanisms: 1) Minimize production costs for a given output level. 2) Maximize production for a given cost. 3) Maximize profit.
Basic principles of general equilibrium: To explain how assets are allocated among agents.
Walrasian equilibrium: Considers all markets in an economy, simultaneously determining prices for all goods and factors of production, as well as production levels.
Normative expression of neoclassical theory: The Edgeworth box, using indifference curves of two individuals for two goods, shows where MRS equality maximizes social utility. For each fixed U2, we can find an assignment that maximizes U1, where MRS are equal.
First theorem of welfare theory: Under behavioral assumptions, market equilibrium is efficient. The outcome depends on the initial endowment distribution.
Second theorem of welfare theory: Competitive equilibria are Pareto efficient. Allocations are equilibria under convexity assumptions and fund redistribution. Maximum welfare allocations are always Pareto efficient.
Voting: Individuals may vote on the quantity of a public good.
Rating Balancing Amount: The amount of public good that satisfies most voters.
Lindahl allocation: Maintaining efficient allocation of public goods through a price system.
Treatment of Uncertainty: Uncertainty arises when decisions have multiple possible outcomes, not just one certain outcome.
Types of Variables: a) Choice variables controlled by the decision-maker. b) Variables determined by the economic system’s functioning through agent interaction. c) Environmental variables, determined externally and considered parameters.
Fundamental Properties of the Set of Nature: a) Comprehensive, containing all possible states of nature. b) Mutually exclusive elements; only one state occurs. c) States of nature are beyond the decision-maker’s control.
Expected Utility Theory: The decision-maker receives income based on the state of nature.
Lottery Ordination: Given two lotteries, the agent prefers one or is indifferent.
Certainty Equivalent: The income value that makes the agent indifferent between a lottery and a certain income.
Compound Lottery: A lottery with outcomes that are themselves lotteries.
Simple Lottery: A lottery representing the total net income of a compound lottery.
Utility function: Increasing with income, uniquely defined for securities, bounded between 0 and 1, and twice differentiable.
Voting: Individuals may vote on the amount of public good; the balance is the amount preferred by most. The voting paradox suggests any amount is most desired. The resolution is that if agents agree, the majority voting for increased public good will pay a portion if agents have quasilinear utility functions.