EC 111

CHAPTER 1

The Themes of Microeconomics

*microeconomics -branch of economics that deals with the behavior of individual economic units – consumers, firms, workers, and investors – as well as the markets that these units comprise

*macroeconomics -branch of economics that deals with aggregate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation.

Trade-offs

1. Consumers -consumers have limited incomes, which can be spent on a wide variety of goods and services, or saved for the future

2. Workers -workers also face constraints and make trade-offs. First, people must decide whether and when to enter the workforce. Second, workers face trade-offs in their choice of employment. Finally, workers must sometimes decide how many hours per week they wish to work, thereby trading off labor for leisure

3. Firms -firms also face limits in terms of the kinds of

products that they can produce, and the resources available to produce them

Prices and Markets -Microeconomics describes how prices are determined. -In a centrally planned economy, prices are set by the government. -In a market economy, prices are determined by the interactions of consumers, workers, and firms. These interactions occur in markets – collections of buyers and sellers that together determine the price of a good

Theories and Models -in economics, explanation and prediction are based

on theories.

*Theories - developed to explain observed phenomena in terms of a set of basic rules and assumptions.

*Model-mathematical representation, based on economic

theory, of a firm, a market, or some other entity.

Positive versus Normative analysis

*Positive Analysis -describing relationships of cause and effect

*Normative Analysis -examining questions of what ought to be, not just

what you observe

What is a market? -collection of buyers and sellers that, through their

actual or potential interactions, determine the price of a product or set of products

*market definition -determination of the buyers, sellers, and range of

products that should be included in a particular market.

*arbitrage-practice of buying at a low price at one location and

selling it at a higher price in another. -buy the goods when it is still cheap

Competitive versus Noncompetitive Markets

*perfectly competitive market -market with many buyers and sellers, so that no

single buyer or seller has a significant impact on price

*many other markets are competitive enough to be treated as if they were perfectly competitive

-ex. Globe and Smart (even though there are only 2 firms, they are still competitive; neither one can determine the price in the market)

*noncompetitive markets -individual firms can jointly affect price

*some markets contain many producers but are noncompetitive

*market price -price prevailing in a competitive market

*in markets that are not perfectly competitive, different firms might charge different prices for the same product. This might happen because one firm is trying to win customers from its competitors, or because customers have brand loyalties that allow some firms to charge higher prices than other firms.

*the market prices of most goods will fluctuate over time (sign of a competitive market), and for many goods the fluctuations can be rapid. This is particulary true for goods sold in competitive markets

-ex. gasoline

*extent of a market -boundaries of a market, both geographical and in

terms of range of products produced and sold within it.

*For some goods, it makes sense to talk about a market only in terms of very restrictive geographic boundaries

*We must also think carefully about the range of products to include in a market

*Market definition is important for two reasons: 1. A company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future

2. Market definition can be important for public policy decisions

Real versus Nominal Prices

*nominal price -absolute price of a good, unadjusted for inflation

*real price -price of a good relative to an aggregate measure of

prices; price adjusted for inflation -the kind of price usually looked at

*consumer price index -measure of the aggregate price level -tends to be larger than the producer price index

(because there are retail costs; the costs of bringing the products to the market)

*producer price index -measure of the aggregate price level for intermediate products and wholesale goods

EX. After correcting for inflation, do we find that the price of butter was more expensive in 2010 than in 1970? To find out, let’s calculate the 2010 price of butter in terms of 1970

dollars. The CPI was 38.8 in 1970 and rose to about 218.1 in 2010. In 1970 dollars, the price of butter was

38.8/218.1 x $3.42(nominal price) = $0.61(real price)

In real terms, therefore, the price of butter was lower in 2010 than it was in 1970

CHAPTER 2: Basics of Supply and Demand

Supply and Demand

*supply-demand analysis is a fundamental and powerful tool that can be applied to a wide variety of interesting and important problems

*Supply curve -relationship between the quantity of a good that producers are willing to sell and the price of the good

*Supply curve -shows how quantity of a good offered for sale changes as the price of the good changes -upward sloping -the higher the price, the more firms are able and willing to produce and sell (to cover up the cost)

*If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price. The supply curve then shifts to the right.

*Other factors that affect supply: -production costs -wages -interest charges -costs of raw materials

*When production costs decrease, output increases no matter what the market price happens to be. The entire supply curve shifts to the right

*Demand curve -relationship between the quantity of a good that consumers are willing to buy and the price of the good -shows how the quantity of a good demanded by consumers depends on its price -downward sloping -consumers will want to purchase more of a good as its price goes down (lower price, higher purchasing power)

*Quantity demanded depends on: -income (quantity demanded increases when

income rises) -weather -prices of other goods

*When your income increases, demand curve shifts to the right

*substitute goods -two goods for which an increase in the price of one leads to an increase in the quantity demanded of the other

*complementary goods -two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other

Market Mechanism

*surplus (quantity supplied > quanitity demanded) -price falls -situation in which the quantity supplied exceeds the quantity demanded

*shortage (quanitity supplied < quanitity demanded) -price is bid up (consumers will say that they are willing to buy a good at a higher price) -quantity demanded exceeds quantity supplied

*equilibrium (market-clearing price) - price that equates the quantity supplied to the quantity demanded

*market mechanism -tendency in a free market for price to change until the market clears

Changes in market equilibrium

*lower costs result in lower prices and increased sales

*consumers’ disposable incomes change as the economy grows

*the demands for some goods shift with the seasons, with the changes in the prices of related goods, or simply with changing tastes. -supply and demand curve can be used to trace the effects of these changes.

*rightward shifts of the supply and demand curves lead to a slightly higher price and a much larger quantity. -changes in price and quantity depend on the amount by which each curve shifts and the shape of each curve.

Elasticities of supply and demand

*demand for a good depends not only on its price, but also on consumer income and on the price of other goods. Likewise, supply depends both on price and on variables that affect production cost.

*we want to know how much the quantity supplied or demanded will rise or fall. -we use elasticities

*Elasticity -percentage change in one variable resulting from a 1-percent increase in a nother -measures sensitivity of one variable to another

*Price elasticity of demand -percentage change in quantity demanded of a good resulting from a 1-percent increase in its price -measures the sensitivity of quantity demanded to price changes. Ep = (% Q) / (% P)

*percentage change in a variable is the absolute change in the variable divided by the original level of the variable

Ep = Q / Q = P Q P / P Q P

*price elasticity of demand is usually a negative number

*when the price elasticity is greater than 1 in magnitude, we say that demand is price elastic because the percentage decline in quantity demanded is greater than the percentage increase in price

*ir the price elasticity is less than 1 in magnitude, demand is said to be price inelastic.

*the price elasticity of a demand for a good depends on the availability of other goods that can be substituted for it.

*when there are close substitutes, a price increase will cause the consumer to buy less of the good and more of the substitute. Demand will then be highly price elastic. When there are no close substitutes, demand will tend to be price inelastic

*linear demand curve -demand curve that is a straight line -as we move down the demand curve, Q / P may change, and the price and quantity will always change. Therefore, the price elasticity of demand must be measured at a particular point on the demand curve and will generally

change as we move along the curve Q = a – bP

*the steeper the slope of the curve, the less elastic is demand

*infinitely elastic demand -principle that consumers will buy as much of a good as they can get at a single price, but for any higher price the quantity demanded drops to zero, while for any lower price the quantity demanded increases without limit

*completely inelastic demand -principle that consumers will buy a fixed quantity of a good regardless of its price

*income elasticity of demand -percentage change in the quantity demanded resulting from a 1-percent increase in income -demands for most goods usually rises when aggregate income rises

EI = Q / Q = I Q I / I Q I

*cross-price elasticity of demand -percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another -demand for some goods is affected by the prices of other goods. Ex: because butter and margarine can be easily substituted for each other, the demand for each depends on the price of the other.

EQb Pm = Qb / Qb = Pm Qb

Pm / Pm Qb Pm

Qb – quantity of butter Pm – price of margarine

*in this example, cross-price of elasticites will be positive because the goods are substitutes. Because they compete in the market, a rise in the price of margarine, which makes butter cheaper relative to margarine, leads to an increase in the quantity of butter demanded. (Because demand curve for butter will shift to the right, the price of butter will rise)

*Some goods are complements. Because they tend to be used together, an increase in the price of one tends to push down the consumption of the other.

*price elasticity of supply -percentage change in quantity supplied resulting from a 1-percent increase in price

-usually positive because a higher price gives producers an incentive to increase output

*point elasticities -elasticities as a particular point on the demand curve or the supply curve

*point elasticity of demand -price elasticity at a particular point on the demand curve

*arc elasticity of demand -price elasticity calculated over a range of prices

-Arc elasticity: Ep = ( Q / P) (P / Q) -rather than choose either the initial or the final price, we use an average of the two, P. For the quantity demanded, we use Q

Short-run versus long-run elasticities

*demand is much more price elastic in the long run than in the short run.

-it takes time for people to change their consumption habits -the demand for a good might be linked to the stock of another good that changes only slowly.

Demand and durability -a small change in the total stock that consumers want to hold can result in a large percentage change in the level of purchases.

Income elasticities -the income elasticity of demand is larger in the long run than in the short run -the long run elasticity will be larger than the short run elasticity -for a durable good, the opposite is true.

-the short run income elasticity of demand will be much larger than the long run elasticity.

Cyclical industries -industries in which sales tend to magnify cyclical changes in gross domestic product and national income -the durable goods series tends to magnify changes in GDP

*For most products, long run supply is much more price elastic than short run supply

*For some goods and services, short run supply is completely inelastic -rental housing -in the very short run, there is only a fixed number of

rental units. Thus an increase in demand only pushes rents up. In the longer run, and without rent controls, higher rents provide an incentive to renovate existing buildings and construct new ones. As a result, the quantity supplied increases.

Supply and durability -for some goods, supply is more elastic in the short run than in the long run -the long run price elasticity of secondary supply is smaller than the short run elasticity

Understanding and predicting the effects of changing market conditions

Demand: Q = a - bP (2.5a)Supply: Q = c + dP (2.5b)

*Step 1: Recall that each price elasticity, whether of supply or demand can be written as E = (P/Q)( Q/ P)

Where change of Q/change of P is the change in quantity demanded or supplied resulting from a small change in price.

*change of Q/change of P=d for supply change of Q/change of P=-b for demand

*substitute the values for change of Q/change of P into the elasticity formula:

Demand: ED = -b(P*/Q*) (2.6a)Supply: ES = d(P*/Q*) (2.6b)

*because we have numbers for ES, ED, P* and Q*, we can substitute these numbers in equations (2.6a) and(2.6b) and solve for b and d

*Step 2: Since we know b and d, we can substitute these numbers, as well as P* and Q*, into equations (2.5a) and (2.5b) and solve for the remaining constants a and c. We can rewrite (2.5a) as

a = Q* + bP*

and then use our data for Q* and P*, together with the number we calculated in step 1 for b, to obtain a.

EX.

Quantity Q* = 12 million metric tons per year Price P* = $2.00 per pound Elasticity of supply ES = 1.5Elasticity of demand ED = - 0.5

(the price of copper has fluctutated during the past few decades between $0.6 and more than $3.50, but $2.00 is a reasonable average price)

We begin with the supply curve equation (2.5b) and use our two-step-procedure to calculate numbers for c and d. The long run price elasticity of supply is 1.5, P* = $2.00 and Q* = 12

*Step 1: Substitute these numbers in equation (2.6b) to determine d:

1.5 = d(2/12) = d/6

So that d = (1.5)(6) = 9

*Step 2: Substitute this number for d, together with the numbers for P* andQ*, into equation (2.5b) to determine c:

12 = c + (9)(2.00) = c + 18

So that c = 12 – 18 = -6. We now know c and d, so we can write our supply curve:

Supply: Q = -6 + 9P

We can now follow the same steps for the demand curve equation (2.5a). an estimate for the long run elasticity of demand is -0.5. First, substitute this number, as well as the values for P* and Q*, into equation (2.6a) to determine b:

-0.5 = -b(2/12) = -b/6

So that b = (0.5)(6) = 3. Second, substitute this value for b and the values for P* and Q* in equation (2.5a) to determine a:

12 = a – (3)(2) = a – 6

v v

So that a = 12 + 6 = 18. Thus, our demand curve is

Demand: Q = 18 – 3P

To check that we have not made a mistake, let’s set the quantity supplied equal to the quantity demand and calculate the resulting equilibrium price:

Supply = -6 + 9P = 18 – 3P = Demand 9P + 3P = 18 + 6P = 24/12 = 2.00 (which is the equilibrium

price with which we began)

*Demand might depend on income as well as price. We would then write demand as

Q = a – bP + fI

Where I is an index of aggregate income or GDP

Effects of government intervention – price controls

*P0 and Q0 are the equilibrium price and quantity that would prevail without government regulation. The government however has decided that P0 is too high and mandated that the price can be no higher than the ceiling price, denoted by Pmax

*at this lower price, producers will produce less, and the quantity supplied will drop to Q1

*consumers on the other hand, will demand more at this lower price; they would purchase the quantity Q2

*demand therefore exceeds supply, and a shortage develops (there is excess demand)

*amount of excess demand is Q2 – Q1

SUMMARY

1. supply-demand analysis is a basic tool of microeconomics. In competitive markets, supply and demand curves tell us how much will be produced by firms and how much will be demanded by consumers as a function of price

2. The market mechanism is the tendency for supply and demand to equilibrate so that there is neither execess demand nor excess supply

3. Elasticities describe the responsiveness of supply and demand to changes in price, income, or other variables

4. Elasticities pertain to a time frame, and for most goods it is important to distinguish between short run and long run elasticities

5. If we can estimate, at least roughly, the supply and demand curves for a particular market, we can calculate the market-clearing price by equating the quantity supplied with the quantity demanded. Also, if we know how supply and demand depend on other economic variables, such as income or the prices of other goods, we can calculate how the market-clearing price and quantity will change as these other variables change. This is a means of explaining or predicting market behavior

6. Simple numerical analyses can often be done by fitting linear supply and demand curves to data on price and quantity and to estimates of elasticities. For many markets, such data and estimates are available, and simple back of the envelope calculations can help us understand the characteristics and behavior of the market

CHAPTER 3: Consumer Behavior

*theory of consumer behavior -the explanation of how consumers allocate incomes to the purchase of different goods and services

Consumer behavior

Consumer behavior is best understood in three distinct steps:

1. Consumer Preferences -find a practical way to describe the reasons people might prefer one good to another

2. Budget Constraints - consumers also consider prices - we take into account the fact that consumers have limited incomes which restrict the quantities of goods they can buy

3. Consumer Choices -consumers choose to buy combinations of goods that maximize their satisfaction. - these combinations will depend on the prices of various goods

Consumer Preferences

*market baskets -list with specific quantities of one or more goods

*because the method of measurement is largely arbitrary, we will simply describe the items in a market basket in terms of the total number of units of each commodity

*we will ask whether consumers prefer one market basket to another

*some basic assumptions about preferences: 1. Completeness – preferences are assumed to be complete. Consumers can compare and rank all possible baskets. These preferences ignore costs

2. Transitivity – preferences are transitive. transitivity means that if a consumer prefers basket A to basket B and basket B to basket C, then the consumer also prefers A to C. Transitivity

is normally regarded as necessary for consumer consistency

3. More is better than less – goods are assumed to be desirable. Consumers always prefer more of any good to less. Consumers are never satisfied or satiated; more is always better even if just a little better.

4. Diminishing marginal rate of substitution - indifference curves are usually convex, or bowed inward. The term convex means that the slop of the indifference curve increases as we move down along the curve. The indifference curve is convex if the MRS diminishes along the curve

*indifference curve -curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction

*market basket A is preferred to basket G because A contains more food and more clothing (more is better than less)

*market basket E, which contains even more food and even more clothing, is preffered to A.

*comparisons of market basket A with baskets B, D, and H are not possible without more information about the consumer’s ranking.

*this curve indicates that the consumer is indifferent among these three market baskets. It tells us that in moving from market basket A to maket basket B, the consumer feels neither better nor worse off in giving up 10 units of food to obtain 20 additional units of clothing.

*indifference curve slopes downward from left to right. Suppose instead that it sloped upward from A to E. This would violate the assumptions that more of any commodity is preferred to less.

*any market basket lying above and to the right of indifference curve U1 is preffered to any market basket on U1

*Indifference maps -graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent

*indifference curves cannot intersect

*there are an infinite number of nonintersecting indifference curves, one for every possible level of satisfaction

*every possible market basket has an indifference curve passing through it

*the shape of an indifference curve describes how a consumer is willing to substitute one good for another

*starting at market basket A and moving to basket B, we see that the consumer is willing to give up 6 units of clothing to obtain 1 extra unit of food.

*the more clothing and the less food a person consumes, the more clothing he will give up in order to obtain more food. Similarly, the more food a person possesses, the less clothing he will give up for more food

*marginal rate of substitution (MRS) -maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good -measures the value that the individual places on 1 extra unit of a good in terms of another - can be written as: - C/ F ( we add the negative sign to make the marginal rate of substitution a positive number)

*as we move down the indifference curve in figure 3.5 and consumption of food increases, the additional satisfaction that a consumer gets from still more food will diminish. Thus, he will give up less and less clothing to obtain additional food.

*consumers generally prefer balanced market baskets to market baskets that contain all of one good and none of another. (it will generate a higher level of satisfaction)

*an indifference curve with a different shape implies a different willingness to substitute

*perfect substitutes -two goods for which the marginal rate of substitution of one for the other is constant

*perfect complements - two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles

*bad – good for which less is preferred rather than more - ex. air pollution

*utility – numerical score representing the satisfaction that a consumer gets from a given market basket - device used to simplify the ranking of baskets

*utility function -formula that assigns a level of utility to individual market baskets

*numbers attached to the indifference curves are for convenience only

*utility function is simply a way of ranking different market baskets; the magnitude of the utility difference between any two market baskets does not really tell us anything.

*ordinal utility function -utility function that generates a ranking of market baskets in order of most to least preferred.

*cardinal utility function -utility function describing by how much one market basket is preferred to another

Budget Constraints -constraints that consumers face as a result of

limited incomes

*budget line -all combinations of goods for which the total amount of money spent is equal to income

*the intercept of the budget line is represented by basket A. As our consumer moves along the line from basket A to basket G, she spends less on clothing and more on food.

*the slope of the line, change of C/change of F = -1/2 measures the relative cost of food and clothing

*C – (I/PC) – (PF/PC) F

*The slope of the budget line, -(PF/PC) is the negative of the ratio of the prices of the two goods.

*the magnitude of the slope tells us the rate at which the two goods can be substituted for each other without changing the total amount of money spent.

*what happens to the budget line when income changes? -a change in income alters the vertical intercept of the budget line but does not change the slope

*what happens to the budget line if the price of one good changes but the price of the other does not? -we can use the equation C = (I/PC) – (PF / PC) to describe the effects of a change in the price of food on the budget line.

*what happens if the prices of both food and clothing change, but in a way that leaves the ratio of the two prices unchanged? -because the slope of the budget line is equal to the ratio of the two prices, the slope will remain the same. -the intercept of the budget must shift so that the new line is parallel to the old one. -ex: if the prices of both goods fall by half, then the slope of the budget line does not change. However, both intercepts double, and the budget line is shifted outward

*purchasing power is determined not only by income, but also by prices

*inflationary conditions in which all prices and income levels rise proportionately will not affect the consumer’s budget line or purchasing power

Consumer Choice

*maximizing market basket must satisfy two conditions:

. 1. It must be located on the budget line -any market basket to the left of and below the budget line leaves some income unallocated – income which, if spent, could increase the consumer’s satisfaction.

-any market basket to the right of and above the budget line cannot be purchased with available income. -Thus, the only rational and feasible choice is a basket on the budget line.

2. It must give the consumer the most preferred combination of goods and services

*these two conditions reduce the problem of maximizing consumer satisfaction to one of picking an appropriate point on the budget line.

*the basket which maximizes satisfaction must lie on the highest indifference curve that touches the budget line

*satisfaction is maximized (given the budget constraint) at the point where

MRS = PF / PC

*satisfaction is maximized when the marginal rate of substitution (of F for C) is equal to the ratio of the prices (of F to C) Thus the consumer can obtain maximum satisfaction by adjusting his consumption of goods F and C so that the MRS equals the price ratio

*marginal benefit -benefit from the consumption of one additional unit of a good

*marginal cost -cost of one additional unit of a good

*satisfaction is maximized when the marginal benefit is equal to the marginal cost.

*the marginal benefit is measured by the MRS.

*If the MRS is less or greater than the price ratio, the consumer’s satisfaction has not been maximized

*corner solution -situation in which the marginal rate of substitution of one good for another in a chosen market basket is not equal to the slope of the budget line

*when a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio

Revealed Preference

*if a consumer chooses one market basket over another, and if the chosen market basket is more expensive than the

alternative, then the consumer must prefer the chosen market basket

Marginal Utility and Consumer Choice

*Marginal utility -additional satisfaction obtained from consuming one additional unit of a good

*diminishing marginal utility -principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility

EX. The additional consumption of food, F, will generate marginal utility MUF. This shift results in a total increase in utility of MUF F. At the same time, the reduced consumption of clothing, C, will lower utility per unit by MUC, resulting in a total loss of MUC C.

Because all points on an indifference curve generate the same level of utility, the total gain in utility associated with the increase in F must balance the loss due to the lower consumption of C

0 = MUF ( F) + MUC( C)

Now we can rearrange this equation so that

-(deltaC/deltaF) = MUF/MUC

But because –(deltaC/deltaF) is the MRS of F for C, it follows that

MRS = MUF/MUC

When consumers maximize their satisfaction, the MRS of F for C is equal to the ratio of the prices of the two goods

MRS = PF/PC

Because the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that

MUF/MUC = PF/PC or MUF/PF = MUC/PC

*utility maximization is achieved when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good

*equal marginal principle -principle that utility is maximized when the

consumer has equalized the marginal utility per dollar of expenditure across all goods

*only when the consumer has satisfied the equal marginal principle will she have maximized utility

Cost-of-living indexes

*cost-of-living index -ratio of the present cost of a typical bundle of consumer goods and services compared with the cost during a base period

EX. When Sarah began her college education in 1995, her parents gave her a discretionary budget of $500 per quarter. Sarah could spend the money on food, which was available at a price of $2.00 per pound, and on books, which were available at a price of $20 each. Sarah bought 100 pounds of food (at a cost of #200) and 15 books (at a cost of $300). Ten years, later, in 2005, when Rachel is about to start college, her parents promise her a budget that is equivalent in buying power to the budget given to her older sister. Unfortunately, prices in the college have increase, food now $2.20 per pound and books $100 each. By how much should the discretionary budget be increased to make Rachel as well off in 2005 as her sister Sarah was in 1995?

*the initial budget constraint facing Sarah in 1995 is given by line L1 in figure 3.23; her utility-maximizing combination of food and books is at point A on indifference curve U1. We can check that the cost of achieving this level of utility is $500, as stated in the table:

%500 = 100lbs. Of food x $2.00/lb. + 15 books x $20/book

*to achieve the same level of utility as Sarah while facing the new higher prices, Rachel requires a budget sufficient to purchase the food-book consumption bundle given by point B on line L2, where she chooses 300 lbs. Of food and 6 books.

*the cost to Rachel of attaining the same level of utility as Sarah is given by

$1260 = 300 lbs of food x $2.20/lb + 6 books x $100/book

*the ideal cost of living adjustment for Rachel is therefore $760 (which is $1260 minus the $500 that was given to Sarah) The ideal cost of living index is

$1260/$500 = 2.52

*our index needs a base year, which we will set at 1995 = 100, so that the value of the index in 2005 is 252.

*ideal cost of living index -cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base-year prices

*Laspeyres price index -amount of money at current year prices that an individual requires to purchase a bundle of goods and services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices

*laspeyres price index was illustrated in figure 3.23. buying 100 pounds of food and 15 books in 2005 would require an expenditure of $1720 (100 x $2.20 + 15 x $100) this expenditure allows Rachel to choose bundle A on budget line L3 (or any other bundle on that line)

*line L3 was constructed by shifting line L2 outward until it intersected point A.

*line L3 is the budget line that allows Rachel to purchase, at current 2005 prices, the same consumption bundle that her sister purchased in 1995.

*To compensate Rachel for the increased cost of living, we must increase her discretionary budget by $1220. Using 100 as the base in 1995, the Laspeyres index is therefore

100 x $1720 / $500 = 344

*Laspeyres index is much higher than the ideal price index

*The Laspeyres index always overstate the true cost of living index.

*The Laspeyres price index assumes that consumers do not alter their consumption patterns as prices change.

*Paasche index -amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in a base year

-focuses on the cost of buying the current year’s bundle

*fixed-weight index -cost of living index in which the quantities of goods and services remain unchanged -Laspeyres and Paasche indexes are fixed-weight

-for the Laspeyres index, the quantities remain unchanged at base-year levels -for the Paasche they remain unchanged at current-year levels

EX. Suppose that there are two goods, food (F) and clothing (C) Let:

PFt and PCt be current-year pricesPFb and PCb be base-year prices Ft and Ct are current year quantities Fb and Cb be base year quantities

We can write the two indexes as:

LI = PFtFb + PCtCb

PFb + PCbCb

PI = PFtFt + PCtCt

PFbFt + PCbCt

*the Paasche index will understate the Laspeyres because it assumes that the individual will buy the current year bundle in the base period.

*chain-weighted price index -cost of living index that accounts for changes in quantities of goods and services

CHAPTER 4: INDIVIDUAL AND MARKET DEMAND

Individual Demand

Price changes

*the price of food is $1, the price of clothing $2, and the consumer’s income is $20. The utility-maximizing consumption choice is at point B. The consumer buys 12 units of food and 4 units of clothing, thus achieving the level of utility associated with the indifference curve U2

*the higher relative price of food has increased the magnitude of the slope of the budget line. The consumer now achieves maximum utility at A, which is found on a lower indifference curve, U1. (Because price of food has risen, the consumer’s purchasing power and thus attainable utility has fallen)

The individual demand curve

*price-consumption curve -tracing the utility-maximizing combinations of two

goods as the price of one chaanges -as the price of food falls, attainable utility increases

and the consumer buys more food

*individual demand curve -relating the quantity of a good that a single

consumer will buy to its price -two important properties:

(1) the level of utility that can be attained changes as we move along the curve (the lower the price of the product, the higher the level of utility)

(2) at every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing (because consumer is maximizing utility, the MRS of food for clothing decreases as we move down the demand curve) (relative value of food falls as the consumer buys more of it)

Income changes

*income-consumption curve -traces out the utility-maximizing combinations of

food and clothing associated with every income level -the consumption of both food and clothing

increases as income increases that’s why income-comsuption curve in figure 4.2 slopes upward

Normal vs. Inferior goods

*normal goods -when income-consumption curve has a positive slope, the quantity demanded increases with income. As a result, the income elasticity of demand is positive. The greater the shifts to the right of the demand curve, the larger the income elasticity

-consumers want to buy more of the goods as their incomes increase

*inferior goods -the quantity demanded falls as income increases;

the income elasticity of demand is negative -consumption falls when income rises -e.g. hamburger. As their income increases, they buy

less hamburger and more steak.

*for relatively low levels of income, both hamburger and steak are normal goods. As income rises, however, the income-consumption curve bends backward. (occurs because hamburger has become an inferior good)

Engel Curves-curve relating the quantity of a good consumed to

income -income-consumption curves can be used to

construct engel curves

*In (a), food is a normal good and the engel curve is upward sloping. In (b), however, hamburger is a normal good for income less than $20 per month and an inferior good for income greater than $20 per month

*the portion of the engel curve that slopes downward is the income range within which hamburger is an inferior good

Substitutes and complements

*substitutes -increase in the price of one leads to an increase in

the quantity demanded of the other

*complements-increase in the price of one good leads to a

decrease in the quantity demanded of the other

Income and substitution effects

*a fall in the price of a good has two effects:(1) consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive (SUBSTITUTION EFFECT)

(2) because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power (INCOME EFFECT)

-they can buy the same amount of good for less money, and thus have money left over for additional purchases

Substitution effect -change in consumption of a good associated with a

change in its price, with the level of utility held constant -captures the change in food consumption that

occurs as a result of the price changes that makes food relatively cheaper than clothing

*substitution effect can be obtained by drawing a budget line which is parallel to the new budget line RT, but which is tangent to the original indifference curve U1 (holding level of satisfaction constant)

*the point that maximizes satisfaction on the new imaginary budget line parallel to RT must lie below and to the right of the original point of tangency

Income effect -change in consumption of a good resulting from an

increase in purchasing power, with relative prices held constant

*the increase in food consumption from OE to OF2 is the measure of the income effect, which is positive, because food is a normal good (consumers will buy more of it as their incomes increase)

Total effect (F1F2) = Substitution effect (F1E) + Income effect (EF2)

*direction fo the substitution effect is always the same: a decline in price leads to an increase in consumption of the good (income effect can move demand in either direction, depending on whether the good is normal or inferior)

*a good is inferior when the income effect is negative: as income rises, consumption falls

The Giffen good -good whose demand curve slopes upward because

the (negative) income effect is larger than the substitution effect

-income effect may be large enough to cause the demand curve for a good to slope upward

*the giffen good is rarely of practical interest because it requires a large negative income effect

Market Demand

*market demand curve-curve relating the quantity of a good that all

consumers in a market will buy to its price -horizontal summation of the demands of each

consumer

From individual to market demand

(1) The market demand curve will shift to the right as more consumers enter the market

(2) Factors that influence the demands of many consumers will also affect market demand

Elasticity of demand

*price elasticity of demand:

Ep = change in Q/Q = (P/Q)(change in Q/change in P) change in P/P

*inelastic demand -Ep is less than 1 in absolute value -quantity demanded is unresponsive to changes in price -total expenditure on the product increases when the price increases

*elastic demand -Ep is greater than 1

-total expenditure on the product decreases as the price goes up

*isoelastic demand -demand curve with a constant price elasticity -although the slope of the linear curve is constant, the price elasticity of demand is not

*unit-elastic demand curve (special case of isoelastic curve) -demand curve with price elasticity always equal to -1

*when demand is inelastic, a price increase leads only to a small decrease in quantity demanded; thus, the seller’s total revenue increases. But when demand is inelastic, a price increase leads to a large decline in quantity demand and total revenue falls

Consumer Surplus -difference between what a consumer is willing to

pay for a good and the amount actually paid

-measures how much better off individuals are, in the aggregate, because they can buy goods in the market

Consumer surplus and demand

*student is indifferent about purchasing the seventh ticket (which generates zero surplus) and prefers not to buy any more than that because the value of each additional ticket is less than its cost

*consumer surplus -adding the excess values or surpluses for all units

purchased

$6 + $5 + $4 + $3 + $2 + $1 = $21

*to calculate the aggregate surplus in the market, we find the area below the market demand curve and above the price line

*actual expenditure on tickets is 6500 x $14 = $91,000*consumer surplus, shown as the yellow-shaded triangle is

1/2 x ($20 - $14) x 6500 = $19,500 (total benefit to consumers, less what they paid for the tickets)

Network externalities

*for some goods, one person’s demand also depends on the demands of other people

-a person’s demand may be affected by the number of other people who have purchased the good.

*network externality -situation in which each individual’s demand

depends on the purchases of other individuals -can be positive or negative

The bandwagon effect -example of positive network externality -a consumer wishes to possess a good in part

because others do

*the more people consumers believe to have bought the good, the farther to the right the demand curve shifts

*the greater the number of people who own a particular good, the greater the intrinsic value of that good to each owner

The Snob effect -negative network externality in which a consumer

wishes to own an exclusive or unique good-quantity demanded of a snob good is higher the

fewer people who own it -rare works of art, sports cars, etc.