Econ 1010 All Class Slides

Introduction and Course Overview

The Methods of Economics

The Product and Factor Markets

Determinants of Demand for an Individual The Demand Curve for an Individual From Individual Demand to Market Demand Change in demand vs. Change in quantity demanded Determinants of Supply for an Individual Supplier The Supply Curve for an Individual Supplier From Individual Supply to Market Supply Change in supply vs. Change in quantity supplied Equilibrium

The Necessity of Equilibrium Calculating Equilibrium with Equations

EquilibriumPutting Supply and Demand Together The Necessity of Equilibrium

Price Floors

Price Ceilings

Calculating Equilibrium with Equations

Comparative Statics The Three Questions

Examples

Elasticity Price Elasticity of Demand

Elastic and Inelastic Curves

Calculating Elasticity: The Midpoint Formula

Elasticity and Slope

Other Elasticities Cross-Price Elasticity of Demand

Income Elasticity of Demand

Price Elasticity of Supply

Determinants of Individual Demand

Price Income

Normal goods: Goods whose demand increases when income increases

Inferior goods: Goods whose demand decreases when income increases

Price of Related Goods Substitutes: Demand goes up when the price of a substitute

goes up Complements: Demand goes down when the price of a

complement goes up Tastes and Preferences Expectations

Determinants of Market Demand Price Income

Normal goods: Goods whose demand increases when income increases

Inferior goods: Goods whose demand decreases when income increases

Price of Related Goods Substitutes: Demand goes up when the price of a substitute

goes up Complements: Demand goes down when the price of a

complement goes up Tastes and Preferences Expectations Number of Buyers

0D

P

Individual DemandLower Case q"

q

0D

P

Market DemandCapital Q"

Q

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for LattesThe Demand Function

P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

QD = 24 3P

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for LattesThe Demand Function

P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

QD = 24 3P P = 8 QD

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for Lattes

P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q


P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

P = 8 QD

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q


P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

P = 8 QDP = 8 (9)

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q


P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

P = 8 QDP = 8 (9)

= 5

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q


P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q


P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

P = 8 QDP = 8 (18)

= 2

0D

P

Demand and Inverse Demand Functions

Q

Numerical Demand Function: QD = 24 3P

0D

P


Q

Numerical Demand Function: QD = 24 3PInverse Demand Function: P = 8 QD

0D

P


Q

Numerical Demand Function: QD = 24 3PInverse Demand Function: P = 8 QD

8

Slope =

24

0D

P


Q

Parametric Demand Function:

Inverse Demand Function:

Slope = 1/b

Da 1P = Qb b

DQ a bP a

b

a

0D

P


Q

General Form of Demand Function:

Inverse Demand Function:

Slope =

1 DP = (Q )f

DQ (P)f

DdP

dQ

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for LattesIncrease in quantity demanded

P Qd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall

held constantTastes change more in favor of the good

P QDold

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall

held constantTastes change more in favor of the good

P QDold QDnew

$0.00 24 28

1.00 21 25

2.00 18 22

3.00 15 19

4.00 12 16

5.00 9 13

6.00 6 11

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall held constant

Tastes change more in favor of the goodDemand curve shifts right

P QDold QDnew

$0.00 24 28

1.00 21 25

2.00 18 22

3.00 15 19

4.00 12 16

5.00 9 13

6.00 6 11

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q



P QDold QDnew

$0.00 24 28

1.00 21 25

2.00 18 22

3.00 15 19

4.00 12 16

5.00 9 13

6.00 6 11

P = 8 QD

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q



P QDold QDnew

$0.00 24 28

1.00 21 25

2.00 18 22

3.00 15 19

4.00 12 16

5.00 9 13

6.00 6 11

P = 8 QD

P = 9 QD

0D

P P QD

An increase in quantity demanded is a

movement down alongthe demand curve

B

A

14

$1.00

$2.00

12

Increase in Quantity Demanded

Q

0D1

P Income (Normal goods)Income (Inferior goods)

Price of substitute

Price of complement

Changes in tastes or expectations

Number of buyers

Increase in DemandOne of the non-price determinants of D changes, causing the curve to shift right

Q

D2

0D

P P QD

An decrease in quantity demanded is a

movement up alongthe demand curve

B

14

$1.00

$2.00

12

Decrease in Quantity Demanded

Q

A

0D2

P Income (Normal goods)Income (Inferior goods)

Price of substitute

Price of complement

Changes in tastes or expectations

Number of buyers

Decrease in DemandOne of the non-price determinants of D changes, causing the curve to shift left

Q

D1

Determinants of a Firms Supply

Price

Input Prices

Technology

Expectations

Determinants of Market Supply

Price

Input Prices

Technology

Expectations

Number of Sellers

P QS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply Curve

P QS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveInput prices, technology, expectations and number

of sellers all held constant

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveP Q

S

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

QS = 5P

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveP Q

S

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

QS = 5PP = (1/5)QS

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveInput prices, technology, expectations and number

of sellers all held constant

P QS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveInput prices, technology, expectations and number of sellers all held

constantIncrease in quantity supplied

P QS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

P = (1/5)QS= (1/5)10= 2

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q



P QS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

P = (1/5)QS= (1/5)10= 2

P = (1/5)QS= (1/5)25= 5

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q



P QS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveTechnology, expectations and number of sellers still held

constant Input costs increase

P QSold QSnew$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveInput costs increase


1.00 5 0

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q



1.00 5 0

2.00 10 5

3.00 15

4.00 20

5.00 25

6.00 30

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q



1.00 5 0

2.00 10 5

3.00 15 10

4.00 20

5.00 25

6.00 30

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q



1.00 5 0

2.00 10 5

3.00 15 10

4.00 20 15

5.00 25 20

6.00 30 25

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q


Supply curve shifts to the left


1.00 5 0

2.00 10 5

3.00 15 10

4.00 20 15

5.00 25 20

6.00 30 25

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q


Supply curve shifts to the left


1.00 5 0

2.00 10 5

3.00 15 10

4.00 20 15

5.00 25 20

6.00 30 25

P = (1/5)QS

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q


Supply curve shifts to the lefta decrease in supply


1.00 5 0

2.00 10 5

3.00 15 10

4.00 20 15

5.00 25 20

6.00 30 25

P = (1/5)QS

P = 1 + (1/5)QS

3 9

P

Q0

S

$1.00 A

B$3.00

P QS An increase in quantity supplied is a movement up along the supply curve

Increase in Quantity Supplied

0S1P Technology improves

Input prices

Change in expectations

Number of producers

Increase in SupplyOne of the non-price determinants of S changes, causing the curve to shift right

Q

S2

3 9

P

Q0

S

$1.00 B

A$3.00

P QS A decrease in quantity supplied is a movement down along the supply curve

Decrease in Quantity Supplied

0S2P Technology deteriorates

Input prices

Change in expectations

Number of producers

Decrease in SupplyOne of the non-price determinants of S changes, causing the curve to shift left

Q

S1

0D

P At equilibrium E = (Q*,P*), Quantity Demanded = Quantity Supplied

EquilibriumPoint at which QS = QD

Q

S

EP*

Q*

0D

P At PH, QS > QD, which results in excess supply, or a surplus

Disequilibrium: Getting the Price WrongWhat happens when the price is too high?

Q

S

EP*

Q*

PH

QD QS

Surplus

0D

P At PH, QS > QD, which results in excess supply

There is downward pressure on price, and price declines toward P*

As P falls, QD increases toward Q*, and QS decreases toward Q*

Process stops when equilibrium is reached, and the surplus is eliminated

Disequilibrium: Getting the Price WrongWhat happens when the price is too high?

Q

S

EP*

Q*

PH

QD QS

Surplus

0D

P

Disequilibrium: Getting the Price WrongWhat happens when the price is too low?

Q

S

EP*

Q*

PL

QDQS

Shortage

At PL, QD > QS, which results in excess demand, or a shortage

0D

P

Disequilibrium: Getting the Price WrongWhat happens when the price is too low?

Q

S

EP*

Q*

PL

QDQS

Shortage

At PL, QD > QS, which results in excess demand, or a shortage

There is upward pressure on price, and price increases toward P*

As P increases, QD decreases toward Q*, and QS increases toward Q*

Process stops when equilibrium is reached, and the shortage is eliminated

0D

P At equilibrium E = (Q*,P*), Quantity Demanded = Quantity Supplied


Q

S

EP*

Q*

Calculating Equilibrium from Equations

P = 100 3QD Demand Curve

0D

P


Q



P = 25 + 2QS Supply Curve

0D

P


Q

S

0D

P


Q

S

P*

Q*




At equilibrium,

Demand = Supply




At equilibrium,

Demand = Supply100 3QD = 25 + 2QS




At equilibrium,


At equilibrium, QD = QS = Q*


P = 100 3QD Demand CurveP = 25 + 2QS Supply CurveAt equilibrium,



100 3Q* = 25 + 2Q*





100 3Q* = 25 + 2Q*

5Q* = 75




At equilibrium, QD = QS = Q*100 3Q* = 25 + 2Q*

5Q* = 75Q* = 15

0D

P


Q

S

P*

Q*= 15




At equilibrium, QD = QS = Q*100 3Q* = 25 + 2Q*

5Q* = 75Q* = 15


P = 100 3QD Demand CurveP = 25 + 2QS Supply Curve

Q* = 15

To find P*, substitute Q* into either

demand or supply equation:



Q* = 15



P* = 100 3Q* = 100 3(15) = 55



Q* = 15



P* = 100 3Q* = 100 3(15) = 55

P* = 25 + 2Q* = 25 + 2(15) = 55

0D

P


Q

S

Q*= 15

P*= 55

Comparative Statics

Start at equilibrium

Comparative Statics


Change the value of one of the non-price determinants of supply or demand

Comparative Statics


Change the value of one of the non-price determinants of supply or demand

Compare the new equilibrium to the old one

0D

P Initial equilibrium is E1 = (Q1*,P1*)Assume that the price of compact disk players declines

What happens to equilibrium P and Q in the market for compact disks?

Market for Compact Disks

Q

S

E1P1*

Q1*

Three Questions in Any Comparative Statics Problem

Which curve shifts?


Which curve shifts? Demandsince the price of a complement has changed

and that is a determinant of demand




Which way does it shift?




Which way does it shift? To the right, since a fall in the price of a complement

causes demand to increase

0D1

P


Q

S

E1P1*

Q1*

D2






What happens to equilibrium P and Q after the shift?

0D1

P The demand curve shifts rightThe increase in demand leads to an increase in equilibrium price and an increase in equilibrium quantity

Note: The increase in demand leads to an increase in quantity supplied


Q

S

E1P1*

Q1*

D2

E2P2*

Q2*






What happens to equilibrium P and Q after the shift?

P* Q*

Definition of Price Elasticity of Demand

Price elasticity of demand = eD = percentage changein quantity demanded divided by the percentage change in price



Price elasticity of demand is a measure of how sensitive quantity demanded is to changes in price




Algebraically, eD = P%Q% D




Algebraically, eD =

D

D D

Q% Q Q

P% PP




Algebraically, eD =

D

D DD

D

Q% Q Q PQ

P% P Q PP




Algebraically, eD =

D

D D DD

D D

Q% Q Q P Q PQ

P% P Q P P QP

0DI

P

Inelastic Demand Curve

Q

0DE

P

Elastic Demand Curve

Q

0DE

P

Elasticity and the Change in QD

QDI

P1

Q1

P2

QInQEl

0DPI

P

Perfectly Inelastic Demand Curve

Q

0DPE

P

Perfectly Elastic Demand Curve

Q

Calculating Price Elasticity of Demand

eD = P%Q% D

Calculating Price Elasticity of Demand

eD =

=

P%

Q% D

D DNew Old

DOld

New Old

Old

Q QQ

P PP

0D

P

Calculating eD

Q6 10

4

2A

B

0D

P

Calculating eD

2

2410

106

Old

OldNew

DOld

DOld

DNew

PPP

QQQ

4

426

610

Q6 10

4

2A

B

From A to B, eD =

= .4

2

2410

106

0D

P

Calculating eD

2

2410

106

Old

OldNew

DOld

DOld

DNew

PPP

QQQ

4

426

610

Q6 10

4

2A

BFrom A to B, eD =

= .4

2

2410

106

0D

P

Calculating eD

2

2410

106

Old

OldNew

DOld

DOld

DNew

PPP

QQQ

4

426

610

Q6 10

4

2A

BFrom A to B, eD =

= .4

From B to A, eD=

= 1.33

4

426

610

2

2410

106

Calculating Elasticity Using the Midpoint Formula

2PPPP

2QQQQ

e

OldNew

OldNew

DOld

DNew

DOld

DNew

D

0D

P

Calculating eD

Q6 10

4

2A

B

0D

P

Calculating eD

2

2410

106

Old

OldNew

DOld

DOld

DNew

PPP

QQQ

4

426

610

Q6 10

4

2A

BFrom A to B, eD =

= .75

22424

2106106

0D

P

Calculating eD

2

2410

106

Old

OldNew

DOld

DOld

DNew

PPP

QQQ

4

426

610

Q6 10

4

2A

B

From A to B, eD =

= .75

From B to A, eD=

22424

2106106

0D

P

Calculating eD

2

2410

106

Old

OldNew

DOld

DOld

DNew

PPP

QQQ

4

426

610

Q6 10

4

2A

B

From A to B, eD =

= .75

From B to A, eD=

= .75

24242

2610610

22424

2106106

Price Elasticity of Demand

eD > 1 Elastic


eD > 1 Elastic

eD = 1 Unit elastic


eD > 1 Elastic

eD = 1 Unit elastic

eD < 1 Inelastic

0D

P

Elasticity is Not Constant Along a Linear Demand Curve

Q

P = 100 QD

0D

P


Q

P = 100 QD

Slope = -1 Over the Entire Demand Curve

0D

P


Q

P = 100 QD

80

20

0D

P


Q

P = 100 QD

80

20

70

30

0D

P

Using the Midpoint Formula, Calculate the price elasticity of demand between

pts. A and B

Q

P = 100 QD

80

20

70

30

A

B

0D

P


pts. A and B

Q

P = 100 QD

80

20

70

30

A

B From A to B, eD =

= 3.00

30 2030 20

270 8070 80

2

0D

P


pts. A and B

Q

P = 100 QD

80

20

70

30

A

B From A to B, eD =

= 3.00

30 2030 20

270 8070 80

2

eD=3

0D

P


pts. C and D

Q

P = 100 QD

40

60

30

70

A

B

eD=3

C

D

0D

P


pts. C and D

Q

P = 100 QD

40

60

30

70

A

B From C to D, eD =

= .538

70 6070 60

230 4030 40

2

eD=3

C

D

eD=.538

0P


pts. C and D

Q

P = 100 QD

A

BeD=3

C

DeD=.538

eD=1

0D

P


Q

Unit Elastic

0D

P

Inelastic Curve

Q

Unit Elastic

0D

P

Elastic Curve

Q

Unit Elastic

Rules of Thumb for Price Elasticity of Demand

Demand for luxuries is more elastic than demand for necessities



Demand for a good with close substitutes is more elastic




The broader the definition of a good, the less elastic the demand

CEREALPRICE ELASTICITY

OF DEMAND

Post Raisin Bran -2.5

All family breakfast cereals -1.8

All types of breakfast cereals -0.9




The broader the definition of a good, the less elastic the demand

The longer the period of time, the more elastic is demand

Other Elasticities

Cross-price elasticity of demand

Income elasticity of demand

Price Elasticity of supply

Cross-price elasticity of demand

Cross-price elasticity of demand: measures the response of demand for one good to changes in the price of another good

Cross-price elast. of demand

=% change in Qd for good 1

% change in price of good 2

For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken)

For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software)

Other Elasticities

Income elasticity of demand: measures the response of Qd to a change in consumer income

Income elasticity of demand =

Percent change in Qd

Percent change in income

Remember: An increase in income causes an increase in demand for a normal good.

Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0.

Calculating Other Elasticities

Price elasticity of supply

eS =P%

Q% S

My Econ Lab Tricks and TipsBehind the Demand Curve: Consumer Theory The Two Factors Involved in a Consumers Decision Indifference Curves

Principles of Indifference Curves Marginal Rate of Substitution

Definition Marginal Utility

Unusually Shaped Indifference Curves

The Other Part of the Consumers Decision Process: Budget Constraints Definition Slope Opportunity Cost

Consumer Optimum: Putting Indifference Curves and Budget Constraints Together Practice Problems

MyEconLab Tips and Tricks

Key Point: Do not click Submit until you are ready to have your quiz graded. After you click submit, you cannot change your answer.



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Once you log back into MyEconLab, you will be able to continue the quiz where you left off, go back and change answers, etc.



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0D

P

Behind the Demand Curve

Q

The Two Factors in a Consumption Decision


Tastes and preferences



Budget

Utility

Utility = happiness, satisfaction or well-being

Utility


# of Pizza Slices

Total

Utility

Utility


# of Pizza Slices

Total

Utility

0 0 utils

Utility


# of Pizza Slices

Total

Utility

0 0 utils

1 150 utils

Utility


# of Pizza Slices

Total

Utility

0 0 utils

1 150 utils

2 250 utils

Utility


# of Pizza Slices

Total

Utility

0 0 utils

1 150 utils

2 250 utils

3 325 utils

Utility


# of Pizza Slices

Total

Utility

0 0 utils

1 150 utils

2 250 utils

3 325 utils

4 375 utils

Utility


# of Pizza Slices

Total

Utility

0 0 utils

1 150 utils

2 250 utils

3 325 utils

4 375 utils

5 400 utils

Utility


Marginal Utility (MU) = the additional utility you get from one additional unit of a good or service

Marginal Utility of X = X

U MUX

Marginal Utility

Marginal Utility of X =

# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils

1 150 utils

2 250 utils

3 325 utils

4 375 utils

5 400 utils

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils

1 150 utils U=150

2 250 utils

3 325 utils

4 375 utils

5 400 utils

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils

1 150 utils U=150X=1

2 250 utils

3 325 utils

4 375 utils

5 400 utils

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils

1 150 utils

2 250 utils

3 325 utils

4 375 utils

5 400 utils

X

U MUX

1501

150

X

U

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils

1 150 utils 150 utils

2 250 utils

3 325 utils

4 375 utils

5 400 utils

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils


2 250 utils

3 325 utils

4 375 utils

5 400 utils

X

U MUX

1001

100

X

U

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils



3 325 utils

4 375 utils

5 400 utils

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils




4 375 utils

5 400 utils

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils





5 400 utils

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils






X

U MUX

Utility


Marginal Utility (MU) = the additional utility you get from one additional unit of a good or service


Diminishing Marginal Utility When I dont have much of good X, MUX is high

When I am already consuming a lot of good X, MUX is low

X

U MUX

Marginal Utility


# of Pizza Slices

Total

Utility

Marginal

Utility

0 0 utils






X

U MUX

Consumption Possibilities

A B C D90 min. to France

45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home

Indifference Curves: The Consumers Preferences

Minutes to France

MinutesHome

0



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home


Minutes to France

MinutesHome

0 90



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home


Minutes to France

MinutesHome

0

A

90

10



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home


Minutes to France

MinutesHome

0

B

A

45

45



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home


Minutes to France

MinutesHome

0

C

B

A

10

90


Minutes to France

MinutesHome

0

C

B

A



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home

100 Utils



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home

100 Utils 100 Utils



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home

100 Utils 100 Utils 100 Utils


Minutes to France

MinutesHome

0

C

B

A


Minutes to France

MinutesHome

0

Indifferencecurve

C

B

A


Minutes to France

MinutesHome

0

100 Utils

C

B

A



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home

100 Utils 100 Utils 100 Utils



45 min. to France

10 min. to France

120 min. to France

10 min. home

45 min. home

90 min. home

90 min. home

100 Utils 100 Utils 100 Utils 200 Utils


Minutes to France

MinutesHome

0

100 Utils

200 Utils

C

B

A

D


Minutes to France

MinutesHome

0

I4=400 utils

I3= 300 utilsI2= 200 utils

I1= 100 utils

Principles of Indifference Curves

Higher indifference curves represent higher utility


Minutes to France

MinutesHome

0

I4=400 utilsI3= 300 utils

I2= 200 utils

I1= 100 utils



Indifference curves never cross

Indifference Curves Cannot Cross

Minutes to France

MinutesHome

0

I2= 200 utils

I1= 100 utils

A

B

C




Indifference curves usually slope downward

Upward Sloping Indifference Curve

0

B

A

Minutes to France(Bad)

MinutesHome(Good)

30

15

45

45

100 Utils




Indifference curves usually slope downward

Indifference curves are usually convexbowed inward toward the origin (sometimes called concave up)

Convexity of Indifference Curves

Minutes to France

MinutesHome

0

Indifferencecurve, I1

A

B

DC

Marginal Rate of Substitution

Marginal Rate of Substitution (MRS) measures the amount of good Y you are willing to give up to get one more unit of X



MRS measures the marginal value of one more unit of X......that value being measured in units of Y

Diminishing Marginal Rate of Substitution

Minutes to France

MinutesHome

0

100 Utils

A

B

DC

90

80

20 90

109.5

From A to B, MRS = 10

21

From C to D, MRS = .5

91




Diminishing Marginal Rate of Substitutionmeans that as you move down along an indifference curve, MRS decreases




MRS =Y

X

MU

MU




MRS =

Remember the role of diminishing marginal utility

Y

X

MU

MU

Diminishing Marginal Rate of Substitution

Minutes to France

MinutesHome

0

100 Utils

A

B

DC

90

80

20 90

109.5

21 91

At A: MUF is highsay 20 utils; but MUH is lowsay 2 utils So, MRS = MUF / MUH = 20 utils / 2 utils = 10

and slope of IC at A = MRS = 10

At C: MUF is lowsay 5 utils; and MUH is highsay 10 utils

MRS = MUF / MUH = 5 utils / 10 utils = Slope of IC at C = MRS =

Indifference Curves for Perfect Substitutes

Dimes0

Nickels

I1 I2 I33

6

2

4

1

2

Indifference Curves for Perfect Complements

Right Shoes0

LeftShoes

I1

I2

7

7

5

5

Budget Constraint

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

Budget=B= $30

Budget Constraint: Vertical Intercept

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

Budget=B= $30

B/PH=300

Budget Constraint : Horizontal Intercept

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

Budget=B= $30

B/PF= 100

B/PH=300

Budget Constraint: Slope

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

Budget=B= $30

B/PF= 100

B/PH=300

Slope = PF/PH

= 30/10

= 3

Budget Constraint: General Form

FP

B

HP

B

FP

B

X

Y

0

PX = Price of X

PY = Price of Y

B = Budget

B/PX= 100

B/PY=300

Slope = PX/PY

Slope of Budget Constraint

PXX + PYY = B


PXX + PYY = B

PYY = B PXX


PXX + PYY = B

PYY = B PXX

Y = B/PY (PX/PY)X


PXX + PYY = B

PYY = B PXX

Y = B/PY (PX/PY)X

Slope = PX/PY


PXX + PYY = B

PYY = B PXX

Y = B/PY (PX/PY)X

Slope = PX/PY

Alternatively:

Slope = Rise/Run


FP

B

HP

B

FP

B

X

Y

0

PX = Price of X

PY = Price of Y

B = Budget

B/PX

B/PY


PXX + PYY = B

PYY = B PXX

Y = B/PY (PX/PY)X

Slope = PX/PY

Alternatively:

Slope = Rise/Run

= (B/PY) / (B/PX)


PXX + PYY = B

PYY = B PXX

Y = B/PY (PX/PY)X

Slope = PX/PY

Alternatively:

Slope = Rise/Run

= (B/PY) / (B/PX)

= PX/PY

Consumer Optimum

X

Y

0

BC

IC

O

X*

Y*

Consumer Optimum

X

Y

0

BC

IC

At O: Slope of IC = Slope of BC

O

X*

Y*

Consumer Optimum

X

Y

0

BC

IC


MRS = PX/PY

O

X*

Y*

Consumer Optimum

X

Y

0

BC

IC


MRS = PX/PY

MUX/MUY = PX/PY

O

X*

Y*

Consumer Optimum

X

Y

0

BC

IC


MRS = PX/PY

MUX/MUY = PX/PY

Rearranging:

MUX/PX = MUY/PYO

X*

Y*

Consumer Optimum

0

BC

IC

PF = 30, PH = 10, B = $30


MRS = PF/PH

MUF/MUH = 30/10

Rearranging:

MUF/PF = MUH/PH

MUF/30 = MUH/10

For examplesatisfied if MUF = 60, MUH = 20.

O

60

B/PH=300

B/PF=100

120

Minutes to France

MinutesHome

Conditions for a Consumer Optimum

Optimal consumption bundle (X*,Y*) is on the budget constraint



Slope of IC = Slope of BC, which is equivalent to: MUX/PX = MUY/PY

Why Cant A Be Optimal?

Minutes to France

MinutesHome

0

O

A

BCI1

I2I3

Why Cant A Be Optimal?

Minutes to France

MinutesHome

0

A

BCI1

I2I3

At A, Slope of IC > Slope of BC, which implies that MUF/MUH > PF/PH, or

MUF/PF > MUH/PH.

For example, MUF = 90, MUH = 10, so

MUF/PF = 90/30 = 3, MUH/PH = 10/10 = 1

O

Why Cant B Be Optimal?

Minutes to France

MinutesHome

0

O

A

BBC

I1I2

I3

Why Cant B Be Optimal?

Minutes to France

MinutesHome

0

O

A

BBC

I1I2

I3

At B, Slope of IC < Slope of BC, which implies that MUF/MUH < PF/PH, or

MUF/PF < MUH/PH.

For example, MUF = 30, MUH = 30, so

MUF/PF = 30/30 = 1, MUH/PH = 30/10 = 3.

Why Cant C Be Optimal?

Minutes to France

MinutesHome

0

O

A

B

C

BCI1

I2I3

Why Cant C Be Optimal?

Minutes to France

MinutesHome

0

O

A

B

C

BCI1

I2I3

At C, Slope of IC = Slope of BC, BUT C is not on the BC

Why Cant D be Optimal?

Minutes to France

MinutesHome

0

O

A

B

C

D

BCI1

I2I3

Why Cant D Be Optimal?

Minutes to France

MinutesHome

0

O

A

B

C

D

BCI1

I2I3

D is not affordableit is outside the BC

Why Cant A, B, C or D be Optimal?

Minutes to France

MinutesHome

0

O

A

B

C

D

BCI1

I2I3

Along the BC, it is only at O that MUF/PF = MUH/PH

Practice Questions JoAnne is trying to decide how many books and how many movies to consume

each month. She has $136 to spend on the two goods. Movies cost $8 each, and books cost $20 each. Each good can only be purchased in whole numbers (not fractions of a good).

JoAnnes preferences for movies and books are summarized by the following

table:

a. Fill in the figures for marginal utility and for marginal utility per dollar

spent for both movies and books.

Movies Books No. per Total Marginal No. per Total Marginal Month Utility Utility MU/$ Month Utility Utility MU/$

1 50 1 22 2 80 2 42 3 100 3 52 4 110 4 57 5 116 5 60 6 121 6 62 7 123 7 63

JoAnnes Books vs. Movies Question

Movies BooksNo. per Total Marginal No. per Total MarginalMonth Utility Utility MU/$ Month Utility Utility MU/$

1 50 50 6.25 1 22 22 1.102 80 30 3.75 2 42 20 1.003 100 20 2.50 3 52 10 0.504 110 10 1.25 4 57 5 0.255 116 6 0.75 5 60 3 0.156 121 5 0.63 6 62 2 0.107 123 2 0.25 7 63 1 0.05




table:

b. Do JoAnnes preferences exhibit diminishing marginal utility for both

goods? Why or why not?


1 50 1 22 2 80 2 42 3 100 3 52 4 110 4 57 5 116 5 60 6 121 6 62 7 123 7 63



1 50 50 6.25 1 22 22 1.102 80 30 3.75 2 42 20 1.003 100 20 2.50 3 52 10 0.504 110 10 1.25 4 57 5 0.255 116 6 0.75 5 60 3 0.156 121 5 0.63 6 62 2 0.107 123 2 0.25 7 63 1 0.05




table:

c. Given her budget of $136, what quantity of books and what quantity of

movies will maximize JoAnnes utility? Explain how you arrived at your answer.


1 50 1 22 2 80 2 42 3 100 3 52 4 110 4 57 5 116 5 60 6 121 6 62 7 123 7 63



1 50 50 6.25 1 22 22 1.102 80 30 3.75 2 42 20 1.003 100 20 2.50 3 52 10 0.504 110 10 1.25 4 57 5 0.255 116 6 0.75 5 60 3 0.156 121 5 0.63 6 62 2 0.107 123 2 0.25 7 63 1 0.05

Graphical Question on Optimal Consumption

At her present levels of consumption of goods X and Y, Dana is spending her entire budget, and her MRSX,Y = 5. PX = $9 and PY = $2.

Is Dana consuming the optimal amount of goods X and Y?



Is Dana consuming the optimal amount of goods X and Y?


Optimal consumption bundle (X*,Y*) is on the

budget constraint



Slope of IC = Slope of BC

Consumer Optimum

X

Y

0

BC

IC


MRS = PX/PY

MUX/MUY = PX/PY

Rearranging:

MUX/PX = MUY/PYO

X*

Y*



Is Dana consuming the optimal amount of goods X and Y?At O: Slope of IC = Slope of BC

MRS = PX/PY

MUX/MUY = PX/PY

Rearranging:

MUX/PX = MUY/PY

MRS = PX / PYMRS = PX / PY

5 = PX / PY5 9 / 2

Dana is not at her consumer optimum

Danas Current Consumption

X

Y

0

O

A

BCI1

I2I3

Slope of IC = MRS = 5

Slope of BC = PX/PY = 9/2 = 4.5

So, Dana is at a point like A. She is spending too much of her budget on good Y

Dana should reallocate her budget to buy more of good X and less of good Y

Consumer Theory (cont.)

Consumer Optimum (Review)

Changes in the Budget Effect on the Budget Constraint

Effect on Consumer Optimum Normal Good

Inferior Good

Changes in Prices Effect on the Budget Constraint

Income and Substitution Effects

Deriving the Demand Curve

Why does the Demand Curve Slope Down?

Consumer Optimum

X

Y

0

BC

IC

O

X*

Y*

XY

0

BC

IC


O

X*

Y*

Consumer Optimum

XY

0

BC

IC


MRSX,Y = PX/PY

O

X*

Y*

Consumer Optimum

XY

0

BC

IC


MRSX,Y = PX/PY

MUX/MUY = PX/PY

O

X*

Y*

Consumer Optimum

XY

0

BC

IC


MRSX,Y = PX/PY

MUX/MUY = PX/PY

Rearranging:

MUX/PX = MUY/PYO

X*

Y*

Consumer Optimum



Slope of IC = Slope of BC, which is equivalent to: MUX/PX = MUY/PY


FP

B

HP

B

FP

B

X

Y

0

PX = Price of X

PY = Price of Y

B = Budget

B/PX

B/PY

Slope = PX/PY

Budget Constraint: Example

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

Budget=B= $30

B/PF= 100

B/PH=300

Slope = PF/PH

= 30/10

= 3

A Change in Budget

What if the prices of calls stay the same, but consumers budget for phone calls doubles?

Effect of a change in budget on slope of BC

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

New Budget=B= $60

Will the slope of the Budget Constraint Change?

Slope doesnt change with a change in budget

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

New Budget=B= $60

Slope = PF/PH

= 30/10

= 3

Slope doesnt change with a change in budget

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

New Budget=B= $60

Slope = PF/PH

= 30/10

= 3

What does change when the budget changes?

When budget increases, budget constraint shifts right: Vertical and horizontal intercepts increase

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

New Budget=B

= $60

B/PF= 200

B/PH=600

B/PH=300

B/PF=100

When budget decreases, budget constraint shifts left: Vertical and horizontal intercepts decrease

FP

B

HP

B

FP

B

Minutes to France

MinutesHome

0

PMin. France = 30

PMin. Home = 10

New Budget=B

= $18

B/PF= 100

B/PH=300

B/PH=180

B/PF=60

A Change in Budget

What happens to consumers calls to France and calls home when the budget for phone calls increases?

Consumer Optimum When Budget Doubles if Calls to France and Calls Home are Normal Goods

0

BC IC

PF = 30, PH = 10, B = $30, B = $60

Calls to France and Calls Home are Normal Goods

Old Optimum = O = 50 min. to France

150 min. Home

New Optimum = O = 120 min. to France

240 min. HomeO

120

B/PH=600

B/PF=200

240

BC IC

O

50

150

IC

Minutes to France

MinutesHome

What Do We Know About the Phone Calls Now?

0

BC

IC

PF = 30, PH = 10, B = $30, B = $60

O

B/PH=600

B/PF=200

BCIC

O

75

240

50

150

Minutes to France

MinutesHome

What Do We Know About the Phone Calls Now?

0

BC

IC

O

B/PH=600

B/PF=200

BCIC

O

75

240

50

150

PF = 30, PH = 10, B = $30, B = $60

Calls Home are Normal Goods (QD when B)

Calls to France are Inferior Goods

(QD when B)

Minutes to France

MinutesHome

What Do We Know About the Two Goods Now?

0

BCIC

PF = 30, PH = 10, B = $30, B = $60

O

B/PH=600

B/PF=200

BC

IC

O

120

240

50

150

Minutes to France

MinutesHome

What Do We Know About the Two Goods Now?

0

BCIC

O

B/PH=600

B/PF=200

BC

IC

O

120

240

50

150

PF = 30, PH = 10, B = $30, B = $60

Calls to France are Normal Goods

Calls Home are Inferior Goods

Minutes to France

MinutesHome

Effects of a Price Change: PH to 15

0

BC

PF = 30, PH = 15, B = $30

What happens to the Budget Constraint?B/PH=300

B/PF=100 Minutes to France

MinutesHome


0

BC

PF = 30, PH = 15, B = $30

What happens to the Budget Constraint?

It pivots around the horizontal interceptthe vertical intercept moves down

Slope changes from PF/PH = -.3/.1= -3

to PF/PH = -.3/.15 = -2

B/PH=300

B/PF=100

BCB/PH=200

Minutes to France

MinutesHome

A Change in Prices

What happens to consumers optimum consumption bundle when the price of calls home goes up to 15?


0

BC

PF = 30, PH = 15, B = $30

Optimum bundle moves from O to O, with fewer minutes home, and fewer minutes to France.

B/PH=300

B/PF=100

BC

B/PH=200

IC

O

IC

O

Minutes to France

MinutesHome

What Happens to the BC if PF to 10?

0

BC

PF=30, PF = 10, PH =10, B = $30

Budget constraint pivots around the vertical intercepthorizontal intercept increases

B/PH=300

B/PF=300

BC

B/PF=100 Minutes to France

MinutesHome

What Happens to the Consumer Optimum if PF to 10?

0

BC

IC

PF = 10, PH = 10, B = $30

O

B/PH

B/PF

BC IC

O

F F

H

H

Minutes to France

MinutesHome

Substitution and Income Effects when PF Goes Down


Calls Home Calls to France

Comments

Substitution

Effect

Income Effect

Combined

Effect




Comments

Substitution

Effect Income

Effect

Combined

Effect




Comments

Substitution

Effect These are always opposite

Income Effect

Combined

Effect




Comments

Substitution


Income Effect

These are always the same if both goods are normal

Combined

Effect


0

BC

IC

PF = 10, PH = 10, B = $30

O

B/PH

B/PF

BC IC

O

F F

H

H

Minutes to France

MinutesHome




Comments

Substitution


Income Effect

These are always the same if both goods are normal

Combined

Effect if IE > SE if SE > IE


0

BC

IC

PF = 10, PH = 10, B = $30

O

B/PH

B/PF

BC IC

O

F F

H

H

Minutes to France

MinutesHome


0

BC

IC

O

300

100

BC

IC

O

20 60

120

180O

50

PF by 30

Minutes to France

MinutesHome


0

BC

IC

Calls to France Calls Home

SE: O O by 5 by 80

O

BC

IC

O

60

120

200 O

55

PF by 30

SE

Minutes to France

MinutesHome


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE

Minutes to France

MinutesHome


SE O O by 5 by 80

IE O O


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE


SE O O by 5 by 80

IE O O by 35

Minutes to France

MinutesHome


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE


SE O O by 5 by 80

IE O O by 35 by 20

Minutes to France

MinutesHome


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE


SE O O by 5 by 80

IE O O by 35 by 20

Net

Minutes to France

MinutesHome


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE


SE O O by 5 by 80

IE O O by 35 by 20

Net Effect

O O

Net

Minutes to France

MinutesHome


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE


SE O O by 5 by 80

IE O O by 35 by 20

Net Effect by 40

O O

Net

Minutes to France

MinutesHome


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE


SE O O by 5 by 80

IE O O by 35 by 20

Net Effect by 40 by 60

O O

Net

Minutes to France

MinutesHome


0

BC

IC

O

BC

IC

O

60

120

200 O

55

PF by 30

20

180 SE

IE


SE O O by 5 by 80

IE O O by 35 by 20

Net Effect by 40 by 60

O O (SE > IE)

Net

Minutes to France

MinutesHome


X

Y

0

As PX goes down, optimum moves from O to O to O

O

X1

PX=P1

IC1

Demand Curve

q

P

0 X1

P1

XY

0

IC2


O

O

X1 X2

PX=P1

PX=P2

IC1


qP

0 X1

P1

P2

X2

Demand Curve

XY

0

IC3


OO

O

X1 X2

IC2

IC1

PX=P1

PX=P2PX=P3

X3


qP

0 X1

P1

P2

X2 X3

P3

Demand Curve

qP

0 X1

P1

P2

X2 X3

P3 D

Demand Curve

QP

0 X1

P1

P2

X2 X3

P3 D

Demand Curve

Why Does the Demand Curve Slope Down?


(1) The good is normal, so the SE and IE work in the same direction




Comments

Substitution

Effect Income

Effect

Combined

Effect




Comments

Substitution

Effect Income

Effect Combined

Effect



What if the good is inferior?

Substitution and Income Effects when PFGoes Down



Comments

Substitution

Effect

Income Effect

Combined

Effect




Comments

Substitution

Effect Income

Effect

Combined

Effect




Comments

Substitution

Effect When P,SE always makes Q

Income Effect

Combined

Effect




Comments

Substitution


Income Effect

Combined

Effect if IE > SE

if SE > IE


Calls to France are Inferior GoodsCalls Home Calls to

FranceComments

Substitution


Income Effect

Combined

Effect if IE > SE

if SE > IE

If IE>SE, PF and QD goes downthis is a Giffen Good

Giffen Goods vs. Inferior Goods

All Giffen Goods are Inferior Goods

BUT

Not All Inferior Goods are Giffen Goods


For a good to be Giffen:

(1) It must be an inferior good: and

(2) IE must outweigh SE

0P

Demand Curve for a Giffen GoodIE > SE, so as P, QD

Q

D

0P

Demand Curve for an Inferior Good for which SE > IE

QD



(2) The good is inferior, but the SE outweighs the IE

Why Does the Demand Curve Slope Down? (Review)

Choice Under Uncertainty Probability and Expected Value

Expected Utility

Attitudes Toward Risk

Insurance




Comments

Substitution

Effect Income

Effect

Combined

Effect




Comments

Substitution

Effect Income

Effect Combined

Effect



What if the good is inferior?




Comments

Substitution

Effect

Income Effect

Combined

Effect




Comments

Substitution

Effect Income

Effect

Combined

Effect




Comments

Substitution


Income Effect

Combined

Effect




Comments

Substitution


Income Effect

Combined

Effect if IE > SE

if SE > IE


Calls to France are Inferior GoodsCalls Home Calls to

FranceComments

Substitution


Income Effect

Combined

Effect if IE > SE

if SE > IE

If IE>SE, PF and QD goes downthis is a Giffen Good


All Giffen Goods are Inferior Goods

BUT

Not All Inferior Goods are Giffen Goods


For a good to be Giffen:

(1) It must be an inferior good: and

(2) IE must outweigh SE

0P

Demand Curve for a Giffen GoodIE > SE, so as P, QD

Q

D

0P

Demand Curve for an Inferior Good for which SE > IE

QD



(2) The good is inferior, but the SE outweighs the IE

Expected Value

Expected Value (EV) = Probability of Outcome 1 Value of Outcome 1

+ Probability of Outcome 2 Value of Outcome 2


+ .......

+ Probability of Outcome N Value of Outcome N

Expected Value

Example Lottery with

Outcome 1: Win $10,000 P(1) = .1

Outcome 2: Win $0 P(2) = .9

EV = Probability of Outcome 1 Value of Outcome 1


= (.1) ($10,000) + (.9) (0)

= $1,000

Another Example of EV

Two Possible Summer Jobs Option I: Work on the Local Newspaper:

Pays $2,000 for sure




EV(Option I) = 1 $2,000 = $2,000




EV(Option I) = 1 $2,000 = $2,000 Option II: Internet start-up

50% chance of making $1,000








EV(Option II) =







EV(Option II) = .5 ($1,000) + .5 ($4,000)= $2, 500

Expected Utility

Expected Utility (EU) = Probability of Outcome 1 Utility from Outcome 1

+ Probability of Outcome 2 Utility from Outcome 2

+ Probability of Outcome 3 Utility from Outcome 3

+ .......

+ Probability of Outcome N Utility from Outcome N

Expected Value vs. Expected Utility



EV(Option I) = 1 $2,000 = $2,000




EV(Option I) = 1 $2,000 = $2,000 EU(Option 1) = 1 U($2,000) = U($2,000)





Option II: Internet start-up 50% chance of making $1,000


EV(Option II) = .5 ($1,000) + .5 ($4,000)= $2, 500





Option II: Internet start-up 50% chance of making $1,000


EV(Option II) = .5 ($1,000) + .5 ($4,000)= $2, 500

EU(Option II) = .5 U($1,000) + .5 U($4,000)

EU and the Summer Jobs Example



EU(Option I) = 1 U($2,000) = $2,000 Option II: Internet start-up



EU(Option II) = .5 U($1,000) + .5 U($4,000)= $2,500

Take Option II only if:

EU(Option II) > EU (Option I)

Three Attitudes Toward Risk


Risk Aversion


Risk Aversion Diminishing Marginal Utility of Money

Utility

Risk Aversion: Diminishing Marginal Utility of Money

Money

Utility


Money1,000 4,000EV = 2,500

U(4,000)

U(1,000)

U(2,500)

EU

Utility


Money1,000 4,0002,500 = EV

U(4,000)

U(1,000)

U(2,500)

EU

CE

Three Attitudes to Risk and the Relation of EV to CE

Risk Aversion: CE < EV


Risk Aversion

Risk Neutrality



Risk Neutrality Constant Marginal Utility of Money

Utility

Risk Neutrality: Constant Marginal Utility of Money

Money1,000 4,000EV = 2,500

U(4,000)

U(1,000)

U(2,500)

Utility


Money1,000 4,000EV = 2,500

U(4,000)

U(1,000)

U(2,500) = EU

Utility


Money1,000 4,000EV = 2,500 = CE

U(4,000)

U(1,000)

U(2,500) = EU

Three Attitudes to Risk and the Relation of EV to CE

Risk Aversion: CE < EV

Risk Neutrality: CE = EV


Risk Aversion

Risk Neutrality

Risk Loving



Risk Neutrality Constant Marginal Utility of Money

Risk Loving Increasing Marginal Utility of Money

Utility

Risk Loving: Increasing Marginal Utility of Money

Money1,000 4,0002,500=EV

U(4,000)

U(1,000)

U(2,500)

EU

Utility

Risk Loving: Increasing Marginal Utility of Money

Mon

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