Topic 1: Lecture 3

Economics 1 (EC107) 2011-12: Micro (Term 1)

Robin Naylor, Department of Economics, Warwick

Topic 1: Lecture 3

•The circular flow model

Agent:

Households

Market:

Goods/Services

Market:

Inputs

Agent:

Firms

Demand

Demand

Supply

Supply

1

See Handout (contains whole of lectures 3-5)


Topic 1: Lecture 3

•Demand

•Consider a Demand Relation:

•What are the influences on Demand for a good . . . ?

X

px

D

apo

Xo

How does a change in some other influence affect the demand curve?

What does the slope of the demand curve tell us?

b

2


Topic 1: Lecture 3

We can write the demand relation as:

( | , , ,...)

Note the crucial difference between

(i) A movement along the demand curve

(ii) A shift in the demand curve

d dX X p p p Mx y z

3


Topic 1: Lecture 3

We can also write the (inverse) demand relation as:

( | , , ,...)

This is best thought of as the equation that determines the price the firm can charge for particular levels of output.

dp p X p p Mx x y z

4


Topic 1: Lecture 3

As a particular example of an inverse demand curve:1( ).

This can be re-written as

.

How would you interpret the parameters 'a' and 'b'?How would you draw this demand curve?

dX a pb

dp a bX

5


Topic 1: Lecture 3

Supply

•Consider a Supply Relation:

•What are the influences on Supply a good . . . ?

X

px

S

apo

Xo

How does a change in some other influence affect the Supply curve?

What does the slope of the Supply curve tell us?

b

6


Topic 1: Lecture 3

We can write the (inverse) supply relation as:

( | ,...).

This is best thought of as the equation that determines the price the firm requires in orderto induce it to supply particular levels of o

sp p X px x y

utput.Example:

.sp c dX

7


Topic 1: Lecture 3

Putting together Supply and Demand:

X

px

S

pe

Xe

What is meant by the ‘market equilibrium’?

What are the possible properties of a market equilibrium?

D

8


Topic 1: Lecture 3

Comparative Statics:

X

px

S

pe

Xe

What is the effect on market equilibrium of a shift in demand?

D

9


Topic 1: Lecture 3

Comparative Statics:

X

px

S

pe

Xe

What is the effect on market equilibrium of a shift in supply?

D

10


Topic 1: Lecture 3

Uniqueness of equilibrium and price bubbles:

X

px

S

pe

Xe

Suppose D is the Willingness to Pay for housing. It’s likely to depend on Consumer Confidence (CC). (i) What happens if CC rises? (ii) What might cause CC to rise? What is the implication of this?

D

11


Topic 1: Lecture 3

Putting together supply and demand:

(1) ,

(2) .

How many equations do we have?And how many unknowns?

dp a bX

sp c dX

12


Topic 1: Lecture 3

There is a 3rd equation:

(3) .

What is this equation, in terms of its Economic meaning?

We can now solve:

d sX X

13


Topic 1: Lecture 3

It is straightforward to show that:

and

.

In other words, . . .

a cXb d

ad bcpb d

14


Topic 1: Lecture 3

Knowing the values of the parameters givesus the values of price and quantity traded in equilibrium.

We can also carry out the comparative static exercises in order to see the effects of changes in the parameters on the equilibrium values of price and quantities.

How would you do this?

15


Topic 1: Lecture 4

Demand Analysis (or analysis of ‘Consumer Choice’)

Choice is based on . . .

. . . Preferences and

. . . Constraints

We’ll analyse each of these in turn.

16


Topic 1: Lecture 4

Demand Analysis: Preferences

Suppose your happiness depends on just 2 commodities

(that you might buy in the market):

e.g., ???

17


Topic 1: Lecture 4


E.g., Books and Food

We assume that you have preferences over these goods and that the nature of your preferences satisfies various properties:

(i) Non-satiation . . . . . . in words:

(ii) Ordinal Ranking

(iii) Transitivity

(iv) Completeness

18


Topic 1: Lecture 4


Non-satiation . . . in a diagram.

F

B

F1 F2

B1

19


Topic 1: Lecture 4Demand Analysis: Preferences

Our assumptions about the properties of preferences imply that we can represent preferences using Indifference Curves. These ICs will have properties which depend upon the properties of the underlying preferences.

F

B

F1 F2

B1

We can show that an IC must slope downwards because of non-satiation.

20



We can show that ICs cannot cross under the assumptions we have made about preferences:

F

B

IC1

IC2

21



The slope of the IC is the MRS between the 2 goods (refer to earlier slides).

F

B

IC1

22



If the IC is linear, this means that the MRS is constant.

F

B

IC1

23



It is more common to assume that the MRS is diminishing: why is this and what does it imply about the IC?

F

B

24



It is more common to assume that the MRS is diminishing: why is this and what does it imply about the IC?

F

B

IC1

25



What would it mean if the IC was upward-sloping?

F

B

IC1

26



What would this mean?

F

B

IC1

27



Under the assumption of completeness, there is an IC passing through every possible point:

F

B

IC1

IC2

28



The consumer would like to get to the highest possible IC: what limits this?

F

B

IC1

IC2

ICn

29


Topic 1: Lecture 5

Demand Analysis: Constraints

We said that our understanding of Consumer Choice rests on the analysis of Preferences and Constraints. Let’s now turn to consider Constraints.

X

Y

Xmax0

Ymax

30


Topic 1: Lecture 5


We can represent a budget set and a budget frontier (or constraint)

X

Y

Xmax0

Ymax

31


Topic 1: Lecture 5


We can represent a budget set and a budget frontier (or constraint)

X

Y

Xmax0

Ymax

What equation can we give this constraint?

32


Topic 1: Lecture 5


The equation tells us that if we spend all our money income, M, on X and Y, our spending be equal to:

M xp ypx y

33


Topic 1: Lecture 5


Re-arranging, the equation for the budget constraint is:

How do you interpret this equation? And Graphically?

y

pM xy xpp

y

34


Topic 1: Lecture 5


The equation of the budget constraint:

X

Y

Xmax0

Ymaxy

pM xy xpp

y

35


Topic 1: Lecture 5


Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences:

X

Y

Xmax0

Ymax

36


Topic 1: Lecture 5

Demand Analysis: Constrained choice


X

Y

Xmax0

Ymax

IC1 IC2

IC3

37


Topic 1: Lecture 5



X

Y

Xmax0

Ymax

ICmax

38


Topic 1: Lecture 5



X

Y

Xmax0

Ymax

X*

Y*a

39


Topic 1: Lecture 5


So, by bringing together preferences and constraints, we have a model which predicts/explains the consumer’s choices (demands) for X and Y . . . given . . .?

X

Y

Xmax0

Ymax

X*

Y*a

40


Topic 1: Lecture 5

Demand Analysis: Comparative Statics

What will happen to the optimal choices of X and Y if there are relevant changes to the parameters of the model?

X

Y

Xmax0

Ymax

X*

Y*a

What are the ‘relevant parameters’?

41


Topic 1: Lecture 5

Demand Analysis: Comparative Statics

What will happen to the optimal choices of X and Y if there are relevant changes to the parameters of the model?

X

Y

Xmax0

Ymax

X*

Y*a

Consider a change in money income. How do we show this?

42


Topic 1: Lecture 5

Demand Analysis: Change in money income

X

Y

Xmax0

Ymax

X*

Y*a

43


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y*a

â

What can you say about the demand for X as M↑?

And the demand for Y?

44


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y*a

â



45


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y*a

â



46


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y*a

â



47


Topic 1: Lecture 5


X

Y

Xmax0

Ymax

X*

Y*a

â



48


Topic 1: Lecture 6

Demand Analysis: Change in price of X

X

Y

Xmax0

Ymax

X*

Y*a

What can you say about the demand for X as Px↓?

49

See Handout


Topic 1: Lecture 6

Demand Analysis: Change in price of X (CASE 1)

X

Y

Xmax0

Ymax

X*

Y*a

What can you say about the demand for X as Px↓?

IC1 IC2

â

50


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

What is the implication for the shape of the demand curve for X: in (Px, X)–space?

What is held constant along this demand curve?

IC1 IC2

â

51


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a


What is held constant along this demand curve?

IC1

IC2

â

52

See Handout


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

What is the relationship between the price of X, its demand, and the demand for Y?

IC1

IC2

â

53


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

IC1

IC2

â


54

See Handout


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

IC1

IC2

â

What is the relationship between the price of X, its demand, and the demand for Y?

55


Topic 1: Lecture 6


X

Y

Xmax0

Ymax

X*

Y*a

IC1 IC2

â


56

See Handout


Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)

X

Y

Xmax0

Ymax

X*

Y*a

â

There are 2 reasons for the rise in demand for X following the fall in its price:

(i) Disposable (or ‘real’) Income Effect

(ii) Relative Price Effect

57

See Handout


Topic 1: Lecture 6

Demand Analysis: Change in price of X (CASE 3 Revisited)

There are 2 reasons for the rise in demand for X following the fall in its price:

(i) Disposable (or ‘real’) Income Effect

The budget constraint shifts outwards and hence the individual can achieve higher ‘utility’; that is, move on to previously unobtainable Indifference Curves. They are able to buy more of both X and Y: whether or not they do so will depend on their preferences over X and Y. If X is normal, for example, the Real Income Effect will cause the individual to buy more X.

(i) Relative Price Effect

X is now relatively cheaper than previously relative to Y. The individual is therefore likely to switch from Y towards X, to some extent.

58

See Handout



X

Y

Xmax0

Ymax

X*

Y*a

â

We would now like to be able to distinguish between these two effects in the diagram.

(i) Real Income Effect

(ii) Relative Price Effect

59

See Handout



X

Y

Xmax0

Ymax

X*

Y*a

â

Consider first the Relative Price Effect.

Suppose relative prices had changed, but that there had been no Real Income Effect of the price change.

What point in the diagram could represent such a position?

60



X

Y

Xmax0

Ymax

X*

Y*a

â

Consider first the Relative Price Effect.

Suppose relative prices had changed, but that there had been no Real Income Effect of the price change.

What point in the diagram could represent such a position? ‘b’

b

61



X

Y

Xmax0

Ymax

X*

Y*a

â

Relative Price Effect.

What change is causing the consumer equilibrium to move from ‘a’ to ‘b’?

What is not changing between ‘a’ and ‘b’?

Hence, ‘a’ to ‘b’ represents a pure relative price effect.

bAs ‘a’ and ‘b’ lie on the same IC, there is no ‘Real Income’ change in moving from ‘a’ to ‘b’.

62



X

Y

Xmax0

Ymax

X*

Y*a

â

Relative Price Effect.

‘a’ to ‘b’ represents a pure relative price effect. More commonly, we refer to it as a substitution effect

b

S

Xs

63



X

Y

Xmax0

Ymax

X*

Y*a

â

Real Income Effect.

We claimed that the Total Effect of the price change (i.e., from ‘a’ to ‘â’) is made up of a Relative Price (Substitution) Effect and a Real Income Effect.

b

S

Xs

As ‘a’ to ‘b’ is the substitution effect, can we show that ‘b’ to ‘â’ is the Real Income Effect?

64



X

Y

0

Ymax

X*

Y*a

â

Real Income Effect.

Compare ‘b’ and ‘â’. What have they got in common? What is different between them? Your answers should confirm for you that ‘b’ to ‘â’ captures the Real Income Effect.

b

S

Xs

As ‘a’ to ‘b’ is the substitution effect, can we show that ‘b’ to ‘â’ is the Real Income Effect?

I

X**

65


X

X

Px

Px

a

a

b

â

The total effect of the price change is to move the consumer’s choice from ‘a’ to ‘â’.

If we plot this into the lower diagram, what are we plotting?

Deriving demand curves

66

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b

â


If we plot this into the lower diagram, what are we plotting? â

67

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â



?

68

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â



What can you say about the slope of this curve? Must it be –ve?

CMIDC

69

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â

The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.


b

S

S ?

70

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â



b

S

S CUDC/CRIDC

71

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â


b

S

S CUDC/CRIDC

Must this curve have a –ve slope?

72

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â


b

S

S CRIDC

The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.

The Substitution Effect determines the CRIDC.

The Substitution Effect combined with the Income Effect determines the CMIDC.

I

I

73

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC

74

Topic 1Lecture 7


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC

The difference between the CRIDC and the CMIDC is the Income Effect.

In this diagram, X is a Normal Good.

Therefore, the CMIDC is more elastic than the CRIDC

75

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC


In this diagram, X is a Weakly Inferior Good.

Therefore, the CMIDC is less elastic than the CRIDC

76

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC ?


In this diagram, X is a Strongly Inferior Good.

Therefore, the CMIDC is +vely sloped.

77

Topic 1Lecture 7

See Handout


X

X

Px

Px

a

a

b

â


b

S

S CRIDC




I

I

â

CMIDC


In this diagram, X is a Strongly Inferior Good.

Therefore, the CMIDC is +vely sloped.

(Giffen Good)

78

Topic 1Lecture 7


Topic 1 Lecture 8

Market Demand

X

p

01 02 0M

D2D1

p p

?

79

See Handout


Topic 1 Lecture 8

Market Demand

X

p

01 02 0M

D2D1

p p

80


Topic 1 Lecture 8

Market Demand

Horizontal Summation (Why?)

(Note: we’ll see a case of vertical summation later in the module)

Notice than in the 2-person case above, the market demand curve is ‘kinked’.

X

p

01 02 0M

D2D1

p p

DM

81


Topic 1 Lecture 8

Consumer Surplus

Interpret the ‘Marginal Willingness to Pay’ (Marginal Benefit, Marginal Valuation)

X0

p

p*

X*

S

D

82

See Handout


Topic 1 Lecture 8

Consumer Surplus

Consumer Surplus on ‘first unit’.

X0

p

p*

X*

S

D

83


Topic 1 Lecture 8

Consumer Surplus

Consumer Surplus on ‘all units’.

A

0

p

p*

X*

S

D

84


Topic 1 Lecture 8Demand Elasticity

We have already said that the Price Elasticity of Demand for a Good is a measure of the sensitivity or responsiveness of demand for a good to a change in its price. More precisely:

. . . Percentage change in demand Percentage change in price

. 100 or . .

. 100

Note: 0.

Consider the special case of the linear demand curve . . .

p e d

dx dxdx p dx px x

dp dp x dp dp xp p

85

See Handout




or .

Consider the special case of the linear demand curve:

1, or;

1It follows that:

And h

p e d

dx p

dp x

ap a bx x p

b bdx

dp b

1ence that: . ,

where is the slope of the linear demand curve.

Can you work out what happens to as we move down along the demand curve?

p

b xb

86

See Handout




or .

Consider the following examples:

(i) 0.

(ii) 1; implying . 1, or

(iii) 1< <0.

(iv)

p e d

dx p

dp x

dx p dx dp

dp x x p

< < 1.

How would you interpret each of these?

87

See Handout


Topic 1 Lecture 8

(i) 0.

(ii) 1; implying . 1, or

(iii) 1< <0.

(iv) < < 1.

dx p dx dp

dp x x p

1< <0

Demand Elasticity

0-1

< < 1

88

See Handout


Topic 1 Lecture 8

Notice that:

Inelastic demand: 1 0 and 1

Elastic demand: 1 and 1.

So, with elastic demand, is 'smaller' in the sense of being more negative,

but is 'bigger' in the sense of the absolute val

ue, .

1< <0

Demand Elasticity

0-1

< < 1

89

See Handout


Topic 1 Lecture 9

Importance of Elasticity

Suppose the Government raises the indirect tax on this commodity. How do we show this?

X0

p

p*

X*

S

D

90

See Handout


Topic 1 Lecture 9


What is the Tax Revenue . . . ?

X0

p

p*

X*

S

D

ST

91


Topic 1 Lecture 9


What is the Tax Revenue?

What is the Tax Burden?

X0

p

p*

X*

S

D

ST

AB

92


Topic 1 Lecture 9



How would the shares of the tax burden change with a different price elasticity of demand for the good?

X0

p

p*

X*

S

D

ST

AB

S

ST

0 X*

p

93


Topic 1 Lecture 9



How would the shares of the tax burden change with a different price elasticity of demand for the good?

X0

p

p*

X*

S

D

ST

AB

S

ST

0 X*

p

D

94


Topic 1 Lecture 9


How would the shares of the tax burden change with a different price elasticity of demand for the good? Why is this?

X0

p

p*

X*

S

D

ST

AB

S

ST

0 X*

p

D

AB

95


Topic 1 Lecture 10Applications of Consumer Choice Theory

1. Labour Supply: The Income-Leisure Trade-off

Leisure

Income

IC

96

See Handout


Topic 1 Lecture 10

Labour Supply: The Income-Leisure Trade-off

Leisure

Income

IC

Tmax

Tmax

Time Constraint: Tmax

0

Labour Supply0

97


Topic 1 Lecture 10


Leisure

Income

Tmax

Tmax

Wage Constraint: w (wage per hour)

0

Labour Supply0

w

98


Topic 1 Lecture 10


Leisure

Income

Tmax

Tmax

Wage Constraint: w (wage per hour)

And Non-labour income, N.

0

Labour Supply0

w

N

99


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

Optimisation, given w, N and Tastes.

Total Income = Labour Income +

Non-Labour Income

Total Income = Y + N

0

Labour Supply0

w

N

L*

N

Y

100


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

Optimisation, given w, N and Tastes.

What happens to optimal Labour Supply if N rises (why might it?)?

0

Labour Supply0

w

N

L*

N

Y

101


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

What happens to optimal Labour Supply if N rises

0

N

102

See Handout


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

What happens to optimal Labour Supply if N rises?

Under what assumption?

Why?

0

N

IC*a

b

103


Topic 1 Lecture 10


Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

w

N

L*

N

Y

w

L, Labour

Supply

What happens to optimal Labour Supply if w rises?

aa

L*

w

104

See Handout


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

w

N

L*

w

L, Labour

Supply


aa

L*

105


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

w

L*

w

L, Labour

Supply


aa

L*

a*

106


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply

What is the implied shape of the Labour Supply curve in this case?

aa

L*

a*a*

107


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply

What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply?

a Ls

L*

a*

108


Topic 1 Lecture 10

Leisure

Income

IC

Tmax

Tmax

0

Labour Supply0

L*

To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects.

To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .

a

a*

109

See Handout


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*


To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .

a

a*

110


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*


To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . . with the move from ‘a’ to ‘a*’ split into:

‘a’ –> ‘b’; Substitution Effect,

‘b’ –> ‘a*’; Income Effect.

a

a*b

S

I

111


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

a

a*b

S

I



When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.

112


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*



How would you interpret the Income Effect in words?

And the Substitution Effect

(Hint: exploit the concept of the Opportunity Cost)

a

a*b

S

I

113


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*



When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.

What about if the Substitution Effect dominates?

What is the shape of the Labour Supply curve in this case?

a

a*

b

S

I

114


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply


aLs

L*

a*

I S

When the S-effect dominates the I-effect

a

a*

115


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply


a

Ls

L*

a*

I S

When the S-effect dominates the I-effect

a

a*

S I

116

See Handout


Topic 1 Lecture 10

Leisure

Income

Tmax

Tmax

0

Labour Supply0

L*

w

L, Labour

Supply


a

Ls

L*

a*

I S

When the I-effect dominates the S-effect

a

a*

I S

117

See Handout


Topic 1 Lecture 10

I S

S I

Labour Supply: the evidence . . .

And for most people?

And the implication for income tax cuts?

w

L

Ls

S I

118

See Handout


Topic 1 Lecture 11Applications of Consumer Choice Theory2. Inter-temporal Choice

I1 , C1

I0 , C0

Think of an ‘Endowment Point’ and add it to the diagram.

119

See Handout


Topic 1 Lecture 11Inter-temporal Choice

I1 , C1

I0 , C0

From the Endowment Point, where can Saving take you?

And Borrowing?

E

I0

I1

120



I1 , C1

I0 , C0


(And Borrowing?)

E

I0

I1

121



I1 , C1

I0 , C0


(And Borrowing?)

E

One Euro saved this period yields one Euro plus (one Euro times the rate of interest) next period. Or . . .

I0

I11

1+i

122



I1 , C1

I0 , C0


E

Or . . .

0 0 0 0( ) saved yields (1 )( ) next period.I C i I C

I0

I1

123


Topic 1 Lecture 11


0 0( )I C

Inter-temporal Choice

I1 , C1

I0 , C0


E

Or . . .

I0

I1

0 0(1 )( )i I C

C0

C1

124


Topic 1 Lecture 11


0 0( )I C


I1 , C1

I0 , C0


What is the slope of the budget constraint?

E

Or . . .

I0

I1

0 0(1 )( )i I C

C0

C1

125


Topic 1 Lecture 11

0 0 0 0( ) borrowed reduces consumption by (1 )( ) next period.C I i C I


I1 , C1

I0 , C0

From the Endowment Point, where can Borrowing take you?

E

Or . . .

I0

I1

C0

C1

126

See Handout



I1 , C1

I0 , C0

From the Endowment Point, where can all possible Saving or Borrowing take you?

This is the inter-temporal budget constraint.

E

I0

I1

Slope = (1 )i

127



I1 , C1

I0 , C0

What is the value of C1?

(Note the value of the slope.)

E

I0

I1

(1 )i

C1

C0

1 1 0 0 +(1 )( ).C I i I C

128

See Handout



I1 , C1

I0 , C0

Re-arranging:

E

I0

I1

(1 )i

C1

C0

1 1 0 0

1 10 0

+(1 )( )

+(1 )

C I i I C

I CC I

i

129



I1 , C1

I0 , C0

This is the horizontal intercept of the budget constraint. What is its interpretation?

E

I0

I1

10 (1 )

II

i

C1

C0

1 10 0

1

10 0

+(1 )

If we now let =0, then:

+(1 )

I CC I

i

C

IC I

i

130


Topic 1 Lecture 11

10 (1 )

II

i


I1 , C1

I0 , C0

How would you show the effect on the inter-temporal budget constraint of a fall in the rate of interest?

E

I0

I1

C1

C0

(1 )i

131

See Handout


Topic 1 Lecture 11

10 (1 )

II

i


I1 , C1

I0 , C0

What happens to the Present Value of E after a fall in the rate of interest?

E

I0

I1

C1

C0

(1 )i

132



I1 , C1

I0 , C0

How would you represent an individual’s preferences over consumption today and tomorrow?

E

I0

I1

133

See Handout



I1 , C1

I0 , C0

What does the slope of the indifference curve represent?

If the MRTP is high (low), what does this mean?

E

I0

I1

134



I1 , C1

I0 , C0

Optimisation.

E

I0

I1

A

C0

C1

135

See Handout



I1 , C1

I0 , C0

Is this person saving or borrowing?

E

I0

I1

A

C0

C1

136



I1 , C1

I0 , C0

How will they respond to a fall in the rate of interest?

E

I0

I1

A

C0

C1

137



I1 , C1

I0 , C0

How will they respond to a fall in the rate of interest?

Consider the substitution effect.

E

I0

I1

A

C0

C1

138

See Handout



I1 , C1

I0 , C0

Borrowing is cheaper and so the borrower borrows more (Substitution effect).

They are also better off (why?): so there is an Income effect.

Which way does Income effect go?

E

I0

I1

A

C0

C1

139



I1 , C1

I0 , C0

Borrowing is cheaper and so the borrower borrows more (Substitution effect).

They are also better off (why?): so there is an Income effect.

Which way does Income effect go?

E

I0

I1

A

C0

C1

‘S’ ‘I’

B

140



I1 , C1

I0 , C0

So fall in the rate of interest leads Borrower to borrow more: unless Consumption today is a . . . . ‘?’ Good.

E

I0

I1

A

C0

C1

‘S’ ‘I’

B

141



I1 , C1

I0 , C0

How would you show the effect on a Borrower of a rise in the interest rate?Will the Borrower borrow more or less? On what does your answer depend?E

I0

I1

A

C0

C1

142

See Handout



I1 , C1

I0 , C0

How would you show the effect on a Saver of a rise in the interest rate?

Will the Saver save more or less? On what does your answer depend?

E

I0

I1

A

C0

C1

143

See Handout



I1 , C1

I0 , C0

How would you show the effect on a Saver of a fall in the interest rate?

Will the Saver save more or less? On what does your answer depend?

E

I0

I1

A

C0

C1

144

See Handout


Topic 1 Lecture 11Intertemporal Choice

10

1 20 2

We saw earlier that .(1 )

Suppose that there are more than the 2 periods:

... .(1 ) (1 ) (1 )

Suppose the stream of Income from an Investment is constant and net of costs:

nn

IPV I

i

II IPV I

i i i

NPV I

2

... .(1 ) (1 ) (1 )

If the income is in Perpetuity, then we have the remarkably simple result that:

.

What is the implication of this for the effect of on Investment?

n

I I I

i i i

INPV

ii

145

See Handout


Topic 1 Lecture 12

Gains from Trade

Consider an industry in an Autarkic country:

X

p

Sd

Dd

Xd

pd

What is the extent of Consumer Surplus in this case?

146

See Handout


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

What is the extent of Consumer Surplus in this case?

A

147


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

And Producer Surplus in this case?

A

148


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

And Producer Surplus in this case?

A

B

149


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Suppose that in the Rest of the World, the World Price of X, pw, was higher than pd.


pw pw

150

See Handout


Topic 1 Lecture 12

Gains from Trade

Consider trade. Suppose the World Price exceeds the Domestic Autarkic price:

X

pSd

Dd

Xd

pd

Domestic Firms would not be prepared to sell any units at the low price of pd.

They will sell at the World Price by exporting to the Rest of the World at the World Price of pw.

Domestic Demand (and sales) are equal to Xdt at the world price.

pw pw

Xdt

151


Topic 1 Lecture 12

Gains from Trade


X

pSd

Dd

Xd

pd

Domestic Firms would not be prepared to sell any units at the low price of pd.

They will sell at the World Price by exporting to the Rest of the World at the World Price of pw.

Effectively, the Domestic Firms’ Supply curve becomes the one in bold. Be sure you can explain this to yourself.

pw pw

Xdt

152


Topic 1 Lecture 12

Gains from Trade


X

pSd

Dd

Xd

pd

Effectively, the Domestic Firms’ Supply curve becomes the one in bold. Be sure you can explain this to yourself.

Total Domestic Firm sales are given by Xt. Exports are equal to Xt – Xdt.

pw pw

Xdt Xt

153


Topic 1 Lecture 12

Gains from Trade


X

pSd

Dd

Xd

pd

What has happened to CS and PS, and hence total welfare, in this country under the equilibrium with trade compared to the total welfare (CS+PS) in this country under Autarky?

So Who Gains and Who Loses from Trade (and by how much in each case)?

Work it out for yourself.

pw pw

Xdt Xt

154

See Handout


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Suppose that in the Rest of the World, the World Price of X, pw, was lower than pd.


pw pw

155

See Handout


Topic 1 Lecture 12

Gains from Trade

Consider trade. Suppose the World Price is less than the Domestic Autarkic price:

X

p

Sd

Dd

Xd

pd

Domestic buyers would not be prepared to buy any units at the high price of pd.

They will want to buy at the World Price by importing from the Rest of the World at the World Price of pw.

Domestic Supply (and hence sales) are equal to Xdt at the world price.

pw pw

Xdt

156


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Domestic buyers would not be prepared to buy any units at the high price of pd.

Effectively, the Domestic Buyers’ Demand curve becomes the one in bold. Be sure you can explain this to yourself.

pw pw

Xdt

157


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

Effectively, the Domestic Buyers’ Demand curve becomes the one in bold. Be sure you can explain this to yourself.

Total Domestic Buyers’ consumption is given by Xt. Imports are equal to Xt – Xdt.

pw pw

Xdt Xt

158


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

What has happened to CS and PS, and hence total welfare, in this country under the equilibrium with trade compared to the total welfare (CS+PS) in this country under Autarky?

So Who Gains and Who Loses from Trade (and by how much in each case)?

Work it out for yourself.

pw pw

Xdt Xt

159

See Handout


Topic 1 Lecture 12

Gains from Trade


X

p

Sd

Dd

Xd

pd

In the case of a country where there are imports, there might be calls for tariffs or import quotas.

What would be the welfare effects of each of these?

What factors influence the magnitudes of the effects?

pw pw

Xdt Xt

160

See Handout


Topic 1Key Concepts

• The circular flow model

• A simple model of a market

• Consumer choice: basic setup

• Preferences, indifference curves and utility

• Budget constraints

• Consumer equilibrium: utility maximization

• The algebra of consumer equilibrium

• Income consumption curves

• Price consumption and the derived demand curves

161

See Handout


Topic 1Key Concepts

• The algebra of deriving the demand curve

• The compensated demand curve

• Income and substitution effects of a price change

• Normal, inferior and Giffen goods

• Consumer surplus

• Market demand

• The price elasticity of demand

• Tax incidence

• Winners and Losers from Trade

• Labour supply by the household

• Capital supply by the household

162

See Handout


Topic 1Key Readings

• Frank, Chapters 1-5

• Estrin, Laidler and Dietrich, Chapters 1-6

• Online resources:

• http://www.bized.ac.uk/current/index.htm

• http://www.bized.ac.uk/learn/economics/index.htm

163

See Handout

http://www.bized.ac.uk/current/index.htm

http://www.bized.ac.uk/learn/economics/index.htm


Topic 1

Seminar Questions: weeks 4, 6(Note Questions in bold (i.e., 1, 2, 6, 8, 11,17) are the questions on which Seminars should focus. Other questions are preparatory and would be good self-study questions to address ahead of seminar meetings)

1. Explain what economists mean by the term ‘market equilibrium’.

2. What is meant by the following properties of an equilibrium:

a. Existence

b. Uniqueness

c. Stability

3. What is likely to happen to the demand curve if money incomes of consumers rise, ceteris paribus? (What is meant by ceteris paribus?)

4. What factors are held constant along the demand curve?

5. What factors are held constant along the supply curve?

6. Explain the difference between a movement along the demand curve and a shift of the demand curve.

164

See Handout


Topic 1

Seminar Questions weeks 4, 6 continued

7. What are the comparative static properties of a typical market equilibrium (for example, what is likely to happen to the market equilibrium if there is an increase in consumers’ money income)?

8. What are the principal properties of indifference curves? How do these properties relate to the assumptions we make regarding the consumer’s underlying preferences?

9. Using indifference curve analysis, show how the demand for a good responds to a rise in money income, for each of the following cases:

a) A normal good

b) A necessity

c) An inferior good

10. Using indifference curve analysis, show how the demand for a good might respond to a change in the price of that good.

11. Show how to decompose the effects of a price change into both income and substitution effects, for each of the possible cases you have considered.

12. Explain intuitively what income and substitution effects are.

165

See Handout


Topic 1

Seminar Questions weeks 4, 6 continued

13. Why is the market demand curve derived by horizontal (rather then by vertical) summation of the individuals demand curves?

14. Is the market demand curve necessarily kinked (like in the figure in the lecture notes)?

15. Define what is meant by Consumer Surplus. How do you represent Consumer Surplus in a diagram?

16. Define what is meant by the (own-) price elasticity of demand for a good.

17. What happens to the elasticity of demand as we move along the linear demand curve?

18. If a proportional tax rate on labour income is cut, what are the possible implications for the optimal labour supply choices of workers? Explain your answer using diagrams and be careful to distinguish between Income and Substitution Effects.

19. If the rate of interest rises, will savers save more? Will borrowers borrow less?

Further Self-study question suggestions:

Try as many as you can of the discussion questions at the end of each of the chapters in Katz and Rosen (or Morgan et al.) and of the problems at the end of each of the chapters in Estrin et al..

166

See Handout

Topic 1: Lecture 3

Documents

Transcript of Topic 1: Lecture 3