Econ 452

Comparative Statics

Comparative Static Analysis

1. What?
- compare equilibria
- model gives equilibrium conditions
- first order conditions
- frequently in implicit form
- if exog. variables change, how does
new eq'm compare to original?
- check changes in endog.
variables wrt exog. variables
through use of eq'm conditions .
2. Why?
- comparative dynamics are hard
- belief that economic system is in
equilibrium

Example: basic consumer theory:

- 2 goods, (x,y);
- budget set given by { p x , p y , M }
- choose x,y to max u(x,y) s.t.
px x + p y y M
- properties of demand functions?

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 Econ 452
Comparative Statics

1. set up Lagrangean, obtain FOC's

ux ( x, y) px = 0
u y ( x, y) py = 0
px x + p y y M = 0
These 3 equations implicitly define
Marshallian/Walrasian demand
functions x ( p x , p y , M ), y ( p x , p y , M ), and
the marginal utility of income,
( p x , p y , M ).

2. Totally differentiate equations wrt

exog variables ( px , p y , M ) and endog
variables ( x, y, ) ; write in matrix form.

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u xx u xy px dx dpx

u yx u yy p y dy = dp y
px py 0 d xdpxx + ydp y dM

Determinant of LHS matrix can be signed:

SOC for constrained maximization > 0

3. Can find slopes of demand curves and

engel curves using Cramer's rule.

Alternative (if only two choice variables):

- use constraint-as-equality (from
theory) to eliminate one variable
here: y = ( px x)/ py

so u( x, y) = u( x, y( x)) = u( x, M p px x )
y
- treat as unconstrained max'm

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problem: FOC is

du dy
= u x ( x, y ) + u y ( x, y )
dx dx
px
= u x ( x, y ) + u y ( x, y )( ) = 0
py
ux px
=
This yields FOC for max: u py
y

- once again, can derive properties of

demand functions, recognizing that
FOC defines x ( p x , p y , M ) , and
x ( p x , p y , M ) = ( M px x ( px , p y , M )) / p y
Sometimes, need to do more:

Demand for insurance - with no

asymmetric information:

Contingent commodities / state space

Consider the standard insurance model

- accident occurs with prob. 0 < p < 1

- loss of L

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- Individual's endowment point, E, (if

buys no insurance):
- if accident (state 1), ind'l has
y = y L;
1 0
- if no accident(state 2), ind'l has
y2 = y0

- If individual buys insurance paying

out I in state 1, at cost per dollar:

- state 1: has
y1 = y0 L I + I = y0 L + (1 )I
- state 2: has y = y I
2 0
EU without insurance?

EU = pU ( y0 L) + (1 p)U ( y0)

EU with insurance?

EU = pU ( y0 L + (1 )I ) + (1 p)U ( y0 I )

Optimal insurance? Choose I to max

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Comparative Statics

EU = pU '( y )(1 ) (1 p)U '( y ) = 0

I 1 2

pU '( y1)
I* satisfies =
(1 p)U '( y2) 1

What is value of delta?

Cost of insurance:

Assume: 1. identical individuals

2. risk neutral firms
3. competitive insurance markets
4. no administrative costs

(1) + (2) implies firm max's expected

profit on representative contract;

Eprofit = p( I I ) + (1 p) I
= I ( p(1 ) + (1 p) )

(3) implies Eprofit = 0

Therefore: in competitive insurance

market,

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p =
(1 p) (1 )

Sub'g this back into FOC for consumer,

tells us

U '( y1)
I* satisfies =1 : RA individual
U '( y2)
will buy full insurance if "fair insurance" is
available.

Suppose insurance is unfair, so > p .

Then Eprofit > 0 on the average contract
(assuming no fixed costs).

Will consumer still want full insurance?

Comparative statics of insurance:

From above, FOC for optimal insurance is

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pU '( y0 L + (1 )I *)(1 ) (1 p)U '( y I *) = 0

0

Rearranging:
(1 )U '( y0 L + (1 ) I *) (1 p )
=
U '( y0 I *) p

This defines demand for insurance as the

implicit function I * = f ( y , L, , p) .
0

Properties of this function?

1. How much insurance?
i) if = p , ind'l buys full insurance at
all income levels.
ii) if > p , so insurance is unfair (and
ins. firm makes strictly positive
profit), then ind'l buys less than
full insurance, so y < y .
1 2
2. How does insurance vary with y?
- totally differentiate FOC wrt I* and
endogenous & exogenous variables
- look at partial wrt initial income:

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dI * = (1 p)U "( y2) p(1 )U "( y1)

dy0 (1 )2 pU "( y1) + 2(1 p)U "( y2)

Sign? denominator <0, numerator.?

- sign depends on relative sizes of U",

evaluated at different income levels.
- coeff. of ARA useful
- to use, need to bring in U'( ) - how?

i) rearrange FOC to solve for

p(1 )U '( y1)

(1 p) =
U '( y2)

ii) sub. into (dI */ dy0) to obtain

U "( y2) U "( y1)
p(1 )U '( y1)[ ]
U '( y2) U '( y1)

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= p(1 )U '( y1)[ A( y1) A( y2)]

iii) sign depends on term in [ ],

which is coeff. of ARA at two
values;
- have y > y , so
2 1
- CARA - no change in
insurance
- DARA - I* down as y up
- IARA - I* up as y up

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