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important reasons:
to understand the foundations of market demand (bake the demand curve from scratch) to address several interesting consumer theory issues that are best understood using this model rather than the aggregate demand model
What can the consumer afford? What are the consumption possibilities? Summarized by the budget constraint
Preferences:
What does the consumer like? How much does a consumer like a good? Summarized by the utility function
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budget constraint shows the consumers purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income. The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.
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mathematical expression for Lis budget constraint is: I = PW W + PR R R = I/PR - (PW / PR)W
like to refer to the |slope| of the budget line as the ERS=Economic Rate of Substitution this case it is PW / PR
I
In
For
The graph to the right shows a picture of Lis budget constraint. Each blue diamond is a point from the table. The slope is equal to -2, as shown on the last slide.
15 Rice
10
0 0 5 10 Wheat
8
15
20
increase in income only. An increase in the price of wheat only. A decrease in the price of rice only. Income doubles as do the prices of wheat and rice.
Note:
Changes in the price of wheat relative to the price of rice will change the ERS.
Preferences
Let
R = at least as good as
IN = indifferent to
B0 IN B1
B0 R B1 and B1 R B0 impli
Let
P = strictly preferred to
B0 P B1
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Preferences
Basic
av rage b ndles are at least as good as extreme b ndles: If B0 IN B1 and B2 is an average of B0 and B1, then B2 R B0 and B1
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Indifference Curves
Preferences
that satisfy the conditions I have noted above can be represented by indifference curves. The set of all indifference curves that describe an individuals preferences are referred to as an indifference curve map. An indifference curve connects all of the bundles that a consumer likes equally. We will assume only two goods when using indifference curve analysis.
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up. Indifference curves can not cross one another. Better bundles are to the northeast. Indifference curves will not be bowed out.
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An indifference curve connects all the bundles that have the same utility. Higher indifference curves indicate more utility (IC2 is preferred to IC1). Lower indifference curves indicate less utility (IC1 is preferred to IC0). The indifference curve map is FULL of indifference curves.
L s nd erence
ur es
30 25 20 I2 I1 I0
ce
15 10 5 0 0 10 20
hea
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The Marginal Rate of Substitution(MRS) tells us how much of one good Li would willingly trade for an incremental unit of the other good and remain indifferent. The MRS=|slope| of the indifference curve at a bundle. Common to assume the MRS declines as we move down an indifference curve.
L s nd erence
ur es
30 25 20 I2 I1 I0
ce
15 10 5 0 0 10 20
hea
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Get to the highest indifference curve possible Stay on the budget constraint (b/c more is better)
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The black bundle is best. The pink bundle is not the best. Li has spent all her income but is not on the highest indifference curve possible. Bundles n/e of IC0 are better and some are affordable. At (W*, R*) she is doing the best she can subject to her budget constraint.
Rice
20
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is maximized when:
is maximized when:
you are on the budget line and the slope of the indifference curve equals the slope of the budget line
Utility
is maximized when:
it measures the change in utility as we change wheat consumption by an incremental unit while holding rice constant
Let
it measures the change in utility as we change rice consumption by an incremental unit while holding wheat constant
Common
to assume that marginal utilities decline as we increase consumption - the law of diminishing marginal utility
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MRS = MUW / MUR The ERS = PW / PR At an optimal bundle: MRS=ERS Rewritten we have:
MUW / MUR = PW / PR MUW/PW = MUR/PR bang/buck in wheat = bang/buck in rice
Get
Handling a change in PW
Li wants to achieve the highest indifference curve that the budget constraints permit. The points A, B, and C represents the best that Li can do at prices of $4, $2, and $1 for wheat. The equation MRS=ERS is satisfied at each of the points.
Rice
30 25 I2 I1 I0 4 2 1 20
20 15 10 5 0 0 5 10 15
C B A
Wheat
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table shows the amount of wheat that Li demands at each price. are the points of tangency from the previous slide.
These
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Pr e
When we connect the points from the table in the previous slide we get Lis demand for wheat. The points A, B, and C correspond to the tangencies of the budget constraint and the indifference curves.
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Consider the choice at PW=$2/lb. The point B is optimal. The point A is feasible but inferior to all points on the red budget line between E and F. The point C is preferred to B but cannot be purchased with Lis $40 income at the given prices; it is above the red budget line. The point E is feasible but Li prefers more wheat and less rice (B). The point F is feasible but Li prefers less wheat and more rice (B, again). There is no combination that Li prefers to B that she is able to buy.
E B C
15 10
I2 I1 I0 2
A
5
F
0 0 5 10 heat 15 20
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Handling a change in PW
Li wants to achieve the highest indifference curve that the budget constraints permit. The points A, B, and C represents the best that Li can do at prices of $4, $2, and $1 for wheat. The equation MRS=ERS is satisfied at each of the points.
Rice
30 25 I2 I1 I0 4 2 1 20
20 15 10 5 0 0 5 10 15
C B A
Wheat
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table shows the amount of wheat that Li demands at each price. are the points of tangency from the previous slide.
These
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Price
When we connect the points from the table in the previous slide we get Lis demand for wheat. The points A, B, and C correspond to the tangencies of the budget constraint and the indifference curves.
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i
A
e a
W heat
30 25 20 I2 I1 I0 4 2 1 20
3
ice
ice
B
2 1
15 10 5 0 0 5 10
C B A
C
0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
15
Wheat
ua tit
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Economists decompose the effect of a change in price on the quantity demanded into an income and a substitution effect. Income effect: due to the increase in real income associated with a fall in prices (you can buy more with the same nominal income) or the loss of real income associated with a rise in prices (you cannot buy as much as you once did with the same nominal income). Substitution effect: due to the change in the relative price of the good, cheaper goods are substituted for more expensive ones.
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When the price of a good falls, the quantity demanded rises for two reasons. The income effect: real income is higher because the same money income buys more at the lower prices. For normal goods, then, the income effect of a price fall is positive. The substitution effect: consumers substitute the now cheaper good for ones whose price has not fallen, real income held constant. This increase in demand is called the substitution effect of a price decline.
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Graph shows the income and substitution effects of the fall in the price of wheat from $4/lb. (A) to $1/lb. (C). The movement from point A to point D is the substitution effect: Li buys less rice and more wheat, and would do so even if she had an income of only $20 (as the black budget line shows). The movement from point D to point C is the income effect, the price decline is like giving Li an additional $20 of real income.
C A D
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substitution effect is the amount by which Li's wheat consumption increased holding real income constant. Substitution effect is the difference between Li's consumption of wheat at the new and old prices holding her real income constant, that is, staying on the same indifference curve (compare points A and D).
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When the price falls from $4/lb. of wheat to $1/lb. per wheat, Li is able to buy both more wheat and more rice. The income effect is the difference between what she would have bought on the old indifference curve at the lower wheat price (point D) and what she actually did buy with her nominal income ($40) at the lower price (point C). Li increases her consumption of wheat and rice because of the increase in her real income from the price decline.
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X normal
X inferior
Total effect is the substitution effect AND the income effect working at the same time.
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demand is the sum of all individual demands in the economy. In the following example there are two consumers of wheat: Li and Juanita. The market demand, then, is the sum of the quantities demand by Li and Juanita.
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Juanitas income is also $40. Juanita faces the same price for rice as Li: $2/lb. Her preferences are different from Lis. Her demand for wheat is derived in the figure at the left.
B A
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points A, B and C correspond to Juanitas best choices given her income and the three prices of wheat illustrated. This is her demand curve for wheat.
Juanita' D 4 3 ri 2 1 0 0 2 4 6 8
and for
at
10 12 14 16 18 20 uantit
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Market Demand
The market demand (green) is the sum of Lis (blue) and Juanitas (red) demand for wheat at each price. At PW=4, Li demands 6 lbs., Juanita demands 5 lbs. and the market demand is 11 lbs. At PW=2, Li and Juanita demand 10 lbs. and the market demand is 20 lbs. At PW=1, Li demands 16 lbs., Juanita demands 18 lbs. and the market demand is 34 lbs.
Mark t for
4
h at
h at
Pri
of
0 0 20 40
Quantity of
h at
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Suppose I have the preferences illustrated at the right. Question A: If Income = $16 If Price of food = $1 If Price of shelter = $1 Food = ? Shelter = ? Indifference curve = ?
references
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7
Shelter
I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16
Food
40
Answer A
Initial oint
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7
I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16
Food
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Shelter
Question B: If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% Tax-inclusive price of shelter = ? Food = ? Shelter = ? Indifference curve = ?
Initial oint
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7
I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16
Food
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Answer B
Shelter
Point B If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% Tax-inclusive price of shelter = 2 Food = Shelter = 3.5 Indifference curve = I2
Tax Only
16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7
I6 I5 I4
B
I3 I2 I1 9 10 11 12 13 14 15 16
Food
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Question : If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% and Transfer payment = $8 Food = ? Shelter = ? Indifference curve = ?
Tax Only
16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6
Shelter
I6 I5 I4
B
I3 I2 I1 7 8 9 10 11 12 13 14 15 16
Food
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Answer C
Point C If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% and Transfer payment = $8 Food = 10 Shelter = Indifference curve = I4
Shelter
A C
I6 I5 I4
I3 I2 I1
9 10 11 12 13 14 15 16
Food
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Notice in the example that the consumer ends up on the same indifference curve after the tax and transfer program as in the initial choice (I4). In public finance (the study of tax and transfer systems) this result usually occurs when the tax and transfer system is combined with a balanced budget. In our example, tax receipts are $ per person (= units of shelter x $1 tax), while the transfer is $8 per person. This is as close to balanced as we can get and still be able to graph the consumers choice legibly. Knowledge of the substitution effect of the price change induced by the shelter tax is sufficient to predict the effect of the complete tax and transfer system.
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Consider
policies
no support $200 in food stamps $200 in cash
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Notes:
the budget line under the food stamp program is the thick black segment and the purple segment The budget line with cash is the red and purple segments the Parkers are indifferent between food stamps and cash
200
Food
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Notes:
the budget line under the food stamp program is the thick black segment and the purple segment The budget line with cash is the red and purple segments if this is the case then the Parkers prefer cash to food stamps
IC$$
ICFS
IC0
BL0 Food
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