Unit 6: Topics in Intermediate Microeconomics

In this unit of the course, we provide an introduction to a number of more advanced topics in microeconomics that round out our basic understanding of the economy, and are relevant in more advanced study and research. First, you will be provided with an overview of firm operation in factor markets. Next, you will learn about how consumers incorporate uncertainty into their decision-making. You will also be introduced to the analysis of international trade and capital markets.

Factor Markets

Image courtesy of Remko Tanis on Flickr.

International Trade

Image courtesy of ntknicole on Flickr.

Uncertainty

Image courtesy of Tom Morris on Flickr.

Capital Supply and Markets I

This image is in the public domain. Source: Wikipedia.

Capital Supply and Markets II

Image courtesy of B3OK on Flickr.

« Previous | Next »

Session Overview

During most of our discussion of consumer decisions and the production decisions of firms, we have focused on only labor and the decisions that individuals make about whether or not to work. We know from our study of production functions that firms also use capital to produce output. Where does capital come from? Not surprisingly, it is the result of another consumer decision, the decision of whether or not to save. This lecture analyzes the decisions consumers and firms make in the capital market.

Inflation rates change the value of a dollar from year to year. This image is in the public domain. Source: Wikipedia.

Keywords: Capital markets; intertemporal choice; present value; future value; inflation; real interest rate; compounding.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 13, “Interest Rates and the Markets for Capital and Natural Resources.”
[Perloff] Chapter 16, “Interest Rates, Investments, and Capital Markets.” (optional)

Lecture Videos

View video page
- Download video
- Download transcript

Resources

Graphs and Figures (PDF)

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

What is the price of consuming a certain good this year as opposed to next year? Note that i denotes the interest rate, and w denotes the wage.

1 + i check

The price depends on how much you are saving. close

i close

w close

The correct answer is that the price of consuming a certain good this year as opposed to next year is 1 + i. If you decide not to consume and instead save a dollar, you will receive 1 + i back in exchange for that dollar next year. Thus the price of consuming this year as opposed to consuming exactly the same good next year is 1 + i.

Question 2

When the interest rate increases, what is the impact on current consumption?

It decreases. close

It increases. close

It remains the same. close

The effect is ambiguous. check

When the interest rate increases, there are two effects on current consumption. The first is the substitution effect: current consumption is now more expensive relative to future consumption, so one should consume less. The second is the income effect: as a result of earning a higher interest rate on their savings, consumers are now richer, and may want to consume more. The overall effect is ambiguous.

Question 3

Assume you have the option to choose between receiving a given amount of money M 5 years from now or 10 years from now, and the interest rate is positive. Which option has the higher present value?

It depends on the level of the interest rate. close

Receive the money 10 years from now. close

Receive the money 5 years from now. check

Receiving M always has the same present value, independent of the timing. close

If the interest rate is positive, then it is always preferable to receive the same amount of money sooner rather than later.

Question 4

What is the definition of the real interest rate?

None of these. close

The nominal interest rate minus inflation. check

The nominal interest rate plus inflation. close

The ratio of the nominal interest rate to the wage. close

When you save money, you put dollars in the bank today in exchange for dollars in the bank tomorrow. However, a dollar may not be worth the same amount tomorrow in purchasing power terms. In particular, if the prices of the goods you want to consume are increasing very rapidly, then a dollar tomorrow may have very little value. The nominal interest rate thus captures the rate of return you earn on your savings in terms of purchasing power, and it is calculated by subtracting the rate of inflation from the nominal interest rate.

« Previous | Next »

Session Overview

Now that we understand what the cost and benefits are of different consumption and investment decisions over time, we can understand how both firms and individual consumers make decisions about how much to invest in different types of opportunities. In this lecture, we will discuss how individuals make major decisions, such as whether to attend college and how much to save for retirement.

The savings of individuals drive the growth of our economy. Image courtesy of B3OK on Flickr.

Keywords: Investment decisions; net present value; discount rate; subsidized retirement savings programs.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 13, “Interest Rates and the Markets for Capital and Natural Resources.”
[Perloff] Chapter 16, “Interest Rates, Investments, and Capital Markets.” (optional)

Lecture Videos

View video page
- Download video
- Download transcript

Resources

Graphs and Figures (PDF)

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

If a firm is making an investment decision, what measure should it use to compare two different potential projects and decide which to invest in?

Net present value. check

Present value. close

Total profits summed over time. close

Total revenues summed over time. close

The firm should calculate the net revenue from the project in each future period, and weight it by the interest rate to estimate the value of that revenue in today's dollars. Simply summing revenues or profits over time is not an accurate measure of value, because profits that accrue to the firm with a time delay are not as valuable as immediate profits.

Question 2

If the opportunity cost of attending college increases for a student (i.e., if s/he has to borrow money, rather than using family funds), does the net present value of a college education increase or decrease?

Decreases. check

Does not change. close

Increases. close

It depends on the wages earned after college. close

If the opportunity cost of attending college increases, then the net present value of a college education will certainly decrease. While the ultimate benefits of attending college in terms of discounted higher wages have not changed, the up-front costs in terms of tuition payments have increased.

Question 3

Assume two lottery winners each win a $100 million jackpot that is payable in 20 payments of $5 million each year for 20 years. Lottery Winner #1 has access to a bank account with a real interest rate of 3% annually, while Lottery Winner #2 has access to a bank account with a real interest rate of 5% annually. Which person has a higher present value of their lottery win?

It depends on their existing level of wealth. close

Present value for both winners is the same. close

Winner #1. check

Winner #2. close

The present value of the lottery win will be higher for Winner #1, because he faces a lower interest rate. As a result, he discounts future payments by a smaller factor than Winner #2. For Winner #2, future payments are relatively less valuable because he could earn a very high interest rate on payments today. The existing level of wealth is not relevant to determining the present value of a given investment.

« Previous | Next »

Session Overview

Earlier in the semester, we discussed the labor supply decisions made by consumers when deciding how much they should or should not work. However, firms have the power to decide how many workers to hire. This lecture focuses on the operation of firms in the factor markets that supply the factors (labor and capital) they use in production.
A firm made the decision to hire these workers. In this lecture, discover the determinants of this decision! Image courtesy of Remko Tanis on Flickr.

Keywords: Input markets; labor supply; monopsony; expenditure curves; wage discrimination; empirical economics.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 14, “Imperfectly Competitive Markets for Factors of Production.”
[Perloff] Chapter 15, “Factor Markets and Vertical Integration.” (optional)

Lecture Videos

Lecture 18: Factor Markets

Resources

Graphs and Figures (PDF)

Further Study

These optional resources are provided for students that wish to explore this topic more fully.

CONTENT	PROVIDER	NOTES
14.64 Labor Economics and Public Policy, Fall 2009.	MIT OpenCourseWare	An in-depth course on labor economics.

Session Overview

How many of you have received flowers for Valentine’s Day? Of course, February in New England is snowy, and those flowers are not raised locally—they are imported from other countries. International trade is hugely important in national and international economies today, but up to this point it has been excluded from our models. In this lecture, a basic introduction to the principles of international trade is provided.

Roses you receive on Valentine’s Day may have been imported from another country as a product of international trade. Image courtesy of ntknicole on Flickr.

Keywords: International trade; comparative advantage; specialization; autarky; tariffs; free trade.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[R&T] Chapter 17, “International Trade.”

Lecture Videos

Lecture 19: International Trade

Resources

Graphs and Figures (PDF)

Further Study

These optional resources are provided for students that wish to explore this topic more fully.

CONTENT	PROVIDER	NOTES
14.54 International Trade, Fall 2006.	MIT OpenCourseWare	An in-depth course on game theory.

Preparation

The problem set is comprised of challenging questions that test your understanding of the material covered in the course. Make sure you have mastered the concepts and problem solving techniques from the following sessions before attempting the problem set:

Problem Set and Solutions

Problem Solving Video

In the video below, a teaching assistant demonstrates his approach to the solution for problem 2a-b from the problem set. The teaching assistant notes common mistakes made by students and provides problem solving techniques for approaching similar questions on the problem set and exams.

Problem 2a-b Solution Video

View video page

Download video

Download transcript

« Previous | Next »

Session Overview

Up until now, our analysis of consumers and firms alike has assumed that both have perfect knowledge of the future. However, the world is filled with uncertainty. We don’t know if it will rain tomorrow, if the stock market will go up next year, or if a new business will succeed or fail. This lecture analyzes the implications of uncertainty for consumer decisions.

The economics of uncertainty impacts our decision to play the lottery. Image courtesy of Tom Morris on Flickr.

Keywords: Expected utility theory; risk aversion; expected value; gambling.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

[Perloff] Chapter 17, “Uncertainty.” (optional)

Lecture Videos

View video page
- Download video
- Download transcript

Resources

Graphs and Figures (PDF)

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

Some individuals, when facing a lottery or other situation of uncertainty, prefer not to accept gambles that are better than fair (i.e., have a positive expected return), because of the negative utility they receive from uncertainty. What is the name for this behavior?

Expected utility theory. close

Risk aversion. check

Risk loving. close

Risk neutrality. close

The correct answer is risk aversion. A risk averse individual will not enter into even gambles with positive expected value because she or he receives negative utility from uncertainty; in fact, a risk averse individual will pay to avoid gambles.

Question 2

A person who is risk-loving by definition has a utility function with what shape?

Any of these. close

Concave. close

Convex. check

Linear. close

A person who is risk-loving has a utility function that is convex. A person who is risk-neutral has linear utility, and a person who is risk-averse has a utility function that is concave.

Question 3

In general, what is true of people's risk aversion for changes in income that are marginal (i.e., very small changes in income)?

It depends on the shape of the individual utility function. close

Their risk aversion does not change. close

They are less risk averse. check

They are more risk averse. close

In general, people are less risk averse for very small changes in their income. They may experience some disutility from the uncertainty of potentially losing a dollar, but not much. Accordingly, they are more willing to accept a bet with the possibility of a loss for a very small amount of money.

Question 4

If a person is risk averse, he will pay a price for insurance even if the expected value of the insurance is lower than the price. Assume that the price of insurance is p, and the expected value (i.e., the expected payouts under the policy) is v. What is the term for the quantity p-v?

Coefficient of relative risk aversion. close

Expected utility. close

Risk premium. check

Risk-loving. close

The correct answer is risk premium. Risk-averse people will buy insurance, because they are willing to pay money to avoid even the possibility of realizing an extremely low level of insurance. This extra money paid for insurance is known as the risk premium.

« Previous | Next »

Browse Course Material

Course Info

Instructor

Departments

As Taught In

Level

Topics

Learning Resource Types

Principles of Microeconomics

Session Overview

Session Activities

Readings

Lecture Videos

Resources

Check Yourself

Concept Quiz

Question 1

Question 2

Question 3

Question 4

Session Overview

Session Activities

Readings

Lecture Videos

Resources

Check Yourself

Concept Quiz

Question 1

Question 2

Question 3

Session Overview

Session Activities

Readings

Lecture Videos

Resources

Further Study

Other OCW and OER Content

Session Overview

Session Activities

Readings

Lecture Videos

Resources

Further Study

Other OCW and OER Content

Preparation

Problem Set and Solutions

Problem Solving Video

window.addEventListener('load', function() { if (window.initVideoJS) { window.initVideoJS() } }) View video page Download video Download transcript

Session Overview

Session Activities

Readings

Lecture Videos

Resources

Check Yourself

Concept Quiz

Question 1

Question 2

Question 3

Question 4

Course Info

Instructor

Departments

As Taught In

Level

Topics

Learning Resource Types

View video page

Download video

Download transcript