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1
www.expertsmind.com
MICROECONOMICS
2
Indifference Curves & Budget Lines
Consumers’ budgets are modelled using budget lines
Consumer preferences are modelled using indifference curves and indifference maps
3
U1
U2
Indifference Map: Goods
Food (units)
Clothing
(units)
U0
E
A
G
Indifference maps: • Comprise a set
of indifference curvesE is preferred to
A.A is preferred to G.
Direction of ___________ satisfactionincreasing
4
Recap Key Concepts from Week 1: Slope of Indifference Curve
Food (units)2 3 4 51
Clothing (units)
2
4
6
8
10
12
14
16 A
B
D
EG
-2-1
1
-6
1
1
1
-4
MRSF for C = - C/F= 6
MRSF for C = - C/F = 2
SLOPE OF INDIFFERENCE CURVE
So MRS is represented by the absolute value of slope of the indifference curve
5
L1
An increase in the price of food rotates the budget line inward.
L3
L2
A decrease in the price of food rotates the budget line outward.
Food(units)
Clothing(units)
Effects of Price Changes
6
Effects of Income Changes
An increase in income is shown by a parallel outward shift in the budget
line
Food(units)
Clothing(units)
80 120 16040
20
40
60
80
0
L2L1L3
A decrease in income is shown by a parallel inward shift in the budget line
7
Recap Key Concepts from Week 1:Slope of Budget Line Assume income of $80/week, price per unit of
food is $1 and price per unit of clothing is $2o I = $80o PF = $1o PC = $2
Budget line is PFF + PCC = I Using the formula 1F + 2C = 80
Slope= C/F or - PF/PC = -1/2
So Relative Price is represented by the slope of the budget line
Ratio of Price of F to Price of C; OR Relative Price of F to C
8
Recap Key Concepts from Week 1: Indifference Curves & Budget Lines
Consumer preferences are modelled using indifference curves
MRS (F for C) = Absolute value of slope of indifference= -C/F
Consumers’ budgets are modelled using budget lines
Relative Price of F to C = Slope of budget line = -PF/PC
9
Recap Key Concepts from Week 1: Consumer Choice Theory
Different consumers prefer different goods
Consumers have limited incomes to spend
Consumers’ choices about consumption reflect both their preferences and their budget constraints
Consumer preferences
Budget constraint
Consumer choice
10
Understand the traditional theory’s explanation of how consumers make choices
Trace the effects of price changes from consumer choice to the demand curve
Trace the effects of income changes from consumer choice to the demand curve
Gain an understanding of different types of goods demanded by consumers
Examine the effects of price changes in terms of substitution and income effects
This Week’s Learning Outcomes
Traditional theory assumes that consumers are rational, self-interested maximisers.
Consumers are assumed to choose combinations of goods and services (market baskets) that:
maximise their satisfaction (utility); & make full use of their budgets
For example, suppose I have $500 and I get to choose among 3 market baskets:
11
Consumer Choice: Maximising Consumer Satisfaction
Basket Food Clothing Price of basket
A 100 units 100 units $1000
B 20 units 20 units $200
D 50 units 50 units $500
A is unaffordable
B is affordable but does not make full use of budget
The rational consumer chooses D over A & B.
D is affordable & makes full use of budget
12
Consumer Choice: Maximising Consumer Satisfaction
Food (units)40 8020
Clothing(units)
20
30
40
0
U1
60
10
U3
U2
PLUS, D is on higher indifference curve than G or H
A
However, A is unaffordable (ABOVE budget line).
U1 gives the greatest satisfaction, followed by U2, and then U3
B is affordable but does not make full use of budget (BELOW budget line)
B
G
H
D
D, G & H are all affordable & make full use of budget (ON budget line)
Rational consumer chooses D
Question on Maximising Consumer Satisfaction
French fries4 11
Big Mac
4
7
11
0 7
The diagram brings together Grace’s budget line and indifference map. The two goods are Big Macs and orders of french fries. Which point maximizes Grace’s satisfaction?A. 11 orders of french friesB. 11 Big MacsC. 7 Big Macs & 4 orders of friesD. 4 Big Macs & 7 orders of fries E. None of the above
Easy question from a past year test which most students got right.
B
A
C
D
13
Consumer Choice: Maximising Consumer Satisfaction
14
• To fully understand the traditional theory, we need to delve more deeply into the meaning of MRS and the significance of the tangency point shown on the last diagram
15
Consumer Choice:Maximising Consumer Satisfaction
Food (units)40 8020
Clothing(units)
20
30
40
0 60
10
U2
D
Consumer satisfaction is maximised at D, where the Slope of indifference curve = Slope of budget line
Recall MRS is represented by the slope of indifference curve
Recall RELATIVE PRICE is represented by the slope of budget line
Consumer satisfaction is maximised at D when:MRS = RELATIVE PRICE
Point of tangency
MRS (F for C) = PF/PC
MRS (C for F) = PC/PF
16
Now for some more details on MRS Recall all market baskets on the same
indifference curve give the same level of utility Also recall that the slope of indifference curves
conveys information on the amount of value (utility) consumers get from the different goods
A utility function gives a numerical interpretation of these ideas If a person’s utility function is
U(F,C) = F + 2C 8 units of F & 3 units of C gives her utility of
U(F,C) = 8 + 2(3) = 14
17
Marginal utility (MU) measures the additional (marginal) satisfaction obtained from consuming 1 additional unit of a good.
It is the key measure of the consumer’s valuation of different commodities
Consumer Choice & Marginal Utility
Food Clothing Utility = F+2C MU
2 3 2 + 2(3) = 8
2 4 2 + 2(4) = 10
2 5 2 + 2(5) = 1222
Using the example of U(F,C) = F + 2C
Another really important concept!
Consumer Choice & Marginal Utility
MUF/MUC = 5
If I derive 5 times as much utility from an extra unit of food as I do from an extra unit of clothing,
then I should be willing to give up 5 units of clothing to get an
additional unit of food.
MRS (F for C) = 5
Comparing the MU of two different goods gives us MRS
MUF/MUC = MRS (F for C)
Logic: The more utility I get from a good, The more I’m willing to give up to get
more of it
19
Consumer Choice: 4 Formulas
Food (units)40 8020
Clothing(units)
20
30
40
0 60
10U2
D
Point of tangency
MRS (F for C) = PF/PC
ThereforeMUF/MUC = PF/PC
Consumer satisfaction is maximised at D, where
ThereforeMUF/PF = MUC /PC
20
Consumer Choice: Understanding the Key Formula
MUF/PF = MUC /PC MUF/MUC = PF/PCor
This tells us the extra value the
consumer will get from spending $1
extra on food
This tells us the extra value the
consumer will get from spending $1 extra on clothing
When the ratios are equal (i.e. At the point of tangency) the consumer won’t
increase her utility by spending more on clothing and less on food or vice versa
21
Consumer Choice: Understanding the Key Formula
Food (units)40 8020
Clothing(units)
20
30
40
0 60
10U2
D
MRS (F for C) ≠ PF/PC
ThereforeMUF/MUC ≠ PF/PC
Consumer satisfaction is NOT maximised at C, because
ThereforeMUF/PF ≠ MUC /PC
CU1
Consumer Choice: Understanding the Key Formula
At point C the IC is flatter than the budget line, so
22
orF F
C C
CF
F C
MU P
MU P
MUMU
P P
23
Effects of Price Changes in MILK …on Consumer Choice
“Coles instigated a price war in January by slashing the price of its no-name milk to $1 a litre, forcing Woolworths, Aldi and Franklins to also reduce prices.…. The no-name milk now accounts for 51 per cent of all milk sales and 72 per cent of full-cream milk sold in the country's supermarkets, according to the group. That is up from 25 per cent in the late 1990s.”
Annabel Hepworth, Milk wars 'could cost suppliers $730m‘, The Australian March 04, 2011
24
Consumer Choice: Understanding the Key Formula
MUF/PF <MUC /PC MUF/MUC < PF/PCor
This tells us the extra value the
consumer will get from spending $1
extra on food
This tells us the extra value the
consumer will get from spending $1 extra on clothing
When the ratios are NOT equal the consumer CAN
increase her utility by spending more on
clothing and less on food or vice versa.
Suppose at point C I’m getting 4 units of value for each $1 I’m spending on clothing and 1 unit of value from each $1 I’m spending on food.
If I spend $1 less on food and $1 more on
clothing my U will
increase by 3 ☺☺☺
25
Effects of Price Changes …. on Consumer Choice
U3
D
U2
B
Assume: I = $50, PM = $2.50, $2, $1
Milk (cartons)
Othergoods (units)
A
U1
PM=$2.50
PM=$2
PM=$1
2. One utility-maximisation point per budget line.
1. PM decreases: Budget line rotates outwards along milk axis
3. Trace utility-maximising basket at each price of milk to get Price consumption curve (PCC)
Price Consumption Curve
This joins up the utility maximising points as one price changes while holding income and the other price constant.
26
27
Effects of Price Changes …. on Individual Demand for Milk
Individual Demand Schedule for MILK
Price ($)
$2.50
$2
$1U3
D
U2
B
Milk(cartons)
Othergoods(units)
A
U1
PM=$2
PM=$1
4. Derive demand schedule for MILK using PCC
Quantity (units)
2
10
15
PM=$2.50
7
15
6
10
9
2
28
Effects of Price Changes …. on Individual Demand for Milk
Individual Demand Curve
Milk (cartons)
Priceof MILK
$2.50A
2
B
10
$2
D
15
$1
Individual Demand Schedule for MILK
Price ($)Quantity (units)
$2.50 2
$2 10
$1 15
5. Draw demand curve for MILK using demand schedule
29
Effects of Price Changes …. on Individual Demand for Milk
Increase in price = Movement up demand curve
Decrease in price = Movement down demand curve
Milk (cartons)
Priceof MILK
D
A
B
$2.50
2 10 15
$2
$1
Income Consumption Curve
This joins up the utility maximizing points as income changes, while holding all prices constant.
30
31
Effects of Income Changes …. on Consumer Choice
Food (units)
Clothing(units)
A U1
DU3
I=$10 BU2
I=$20
I=$30
Assume: PC = $2, PF = $1, I = $10, $20, $30
1. Income increases: Budget line shifts outwards in a parallel manner2. One utility-maximisation point per budget line
3. Trace utility-maximising basket at each income level to get Income consumption curve (ICC)
32
BU2
Effects of Income Changes …. on Individual Demand for Food
Individual Demand Schedule for FOOD
Price ($)
(fixed)
$1.00
$1.00
$1.00
Food (units)
Clothing(units)
A U1
DU3
I=$10
4
3
10
5
16
7
I=$20
I=$30
4.Derive demand schedule for FOOD Using ICC
Quantity (units)
4
10
16
33
Effects of Income Changes …. on Individual Demand for Food
Food (units)
Priceof
food
$1.00
D1
4
A
D2
10
B
D3
5. Draw demand curve for FOOD using demand schedule
Individual Demand Schedule for FOOD
Price ($) (fixed)
Quantity (units)
$1.00 4
$1.00 10
$1.00 16
16
D
34
Effects of Income Changes …. on Individual Demand for Food
Food (units)
Priceof
food
$1.00
4
D1
A
10
D2
B
16
D3
D
Increase in income = Shift to the right by demand curve
Decrease in income = Shift to the left by demand curve
35
Consumer wants more steak as income increases: Steak is a normal good
Consumer also wants more designer clothes as income increases: Designer clothes are normal goods
Normal good: You buy more when your income increases.
Normal goods
Designer clothes(units)
Steak(units)
10
10
4
5
ICC
16
15
U1
U3
U2
A
C
B
36
Inferior goodsBetween A & B: Both steak & hamburger are
normal goods. You buy more of both as your income increases.
Between B & C: Steak is still a normal good. Hamburgers become an
inferior good – consumer wants less hamburgers (106) as income increases.
ICC: upward-sloping between
A & B, backward-bending between B & C.
Hamburger(units)
Steak(units)
104
AU1
B
U25
9
15
U3
C
6
37
Engel Curves
Steak (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Engel curves slopeupward for
normal goods.
Engel curves relate the quantity of a good to INCOME.
38
Engel Curves
Engel curves arebackward bending for inferior goods.
Inferior
Normal
Hamburger (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
39
Income and Substitution Effects
A change in price can be broken down into 2 effects: Substitution Effect Income Effect
40
Substitution Effect
Occurs because the RELATIVE PRICE of a good changes
Example: when the price of apples increases, apples become more expensive relative to pears
You buy fewer apples but more pears, that is, you SUBSTITUTE pears for apples to keep your UTILITY CONSTANT
Definition: The substitution effect is the change in a good’s consumption associated with a change in the __________________ of the good, with the level of ____________________.RELATIVE PRICE
UTILITY CONSTANT
41
Finding the Substitution Effect
Following a price change, move the budget line back until it is just tangent to the original IC. The SUBSTITUTION EFFECT is the movement around the original IC.
42
Substitution Effect When Price Falls: Graphical Representation
Food (units)
Clothing(units)
A
U1
Recall Substitution effect: Change in relative price; Utility constant
L1 L2
The substitution is F1E (move from A to D).
D
Change in relative price Change in slope of original budget line L1
Utility constant Stay at original indifference curve U1
Substitutioneffect
E
Price of food decreases: Budget line rotates outward from L1 to L2.
U2
B
F1
Total effectF2
43
Income Effect
Occurs because consumers experience a change in REAL PURCHASING POWER when price changes
Example: when the price of apples increases, your overall ability to purchase goods decreases.
Definition: The income effect is the change in a good’s consumption brought about by a change in ___________________________.REAL PURCHASING POWER
44
Finding the Income Effect
The Income effect is the movement between the ARTIFICIAL optimum used to find the Substitution effect, and the consumer’s new utility maximising position.
45
Income Effect When Price Falls: Graphical Representation
Food (units)
Clothing(units)
A
U1
Recall Income effect: Change in overall real purchasing power
L1 L2
D
Change in real purchasing power Parallel shift from dotted red line to budget line L2
Substitutioneffect
E
U2
B
The income effect is EF2 (move from D to B).
Incomeeffect
TIP: The dotted red line must ALWAYS be PARALLEL to L2.
F1
Total effectF2
46
Income Effect When Price Falls: Normal Good
Food (units)
Clothing(units)
A
U1L1 L2
D
Substitutioneffect
EF1
U2
B
Incomeeffect
F2
This graph shows that food is a NORMAL good.
Recall: A normal good is a good you buy MORE of as your income increases.
Consumer moves from D to B, so the units of food INCREASE from E to F2
47
Income Effect When Price Falls: Inferior Good
Food (units)
Clothing(units)
A
U1L1 L2
D
Substitutioneffect
EF1
U2
B
F2
Incomeeffect
This graph shows that food is an INFERIOR good.
Recall: An inferior good is a good you buy LESS of as your income increases.
Consumer moves from D to B, so the units of food DECREASE from E to F2
48
Income Effect When Price Falls: Giffen Good
Food (units)
Clothing(units)
A
U1L1 L2
D
Substitutioneffect
EF1
U2
B
F2
Incomeeffect
This graph shows that food is a GIFFEN good.
A Giffen good is a special case of an inferior good.
The income effect is so large that it is greater than the substitution effect.
Summary of Price Falls
1. Normal Good
Income effect reinforces Substitution effect.
2. Inferior Good, Not Giffen
Income effect offsets Substitution effect but does not dominate.
3. Inferior Good, Giffen
Income effect offsets Subsitution effect and dominates.
49
50
Substitution & Income Effects When Price Rises
Food (units)
Clothing (units)
L1
U1
A
When the price of food rises, the budget line rotates inward from L1 to L2.
L2
F1E
The substitution effect is F1E (move from A to D).
U2
B
F2
The income effect is EF2 (move from D to B).
D
Incomeeffect
Substitutioneffect
Note we are assuming that food is a NORMAL good here. Why?
The income effect is going in the same direction as the substitution effect.
51
Income Effect: Normal, Inferior and Giffen Goods
Substitutioneffect
Incomeeffect
When price decreases When price increases
Normal
Inferior
Substitutioneffect
Giffen
Substitutioneffect
Incomeeffect
Incomeeffect
Total effect
Total effect
Total effect
Substitutioneffect
Incomeeffect
Substitutioneffect
Substitutioneffect
Incomeeffect
Incomeeffect
Total effect
Total effect
Total effect
Question on Substitution & Income Effects
Assume that beer is an inferior good. If the price of beer falls, then the substitution effect results in the person buying ______ of the good and the income effect results in the person buying ________ of the good.A. more, moreB. less, lessC. less, moreD. more, less
Substitution effect: Price - buy more
Income effect: Inferior good – so the income effect must work in the opposite direction from the substitution effect - buy less
52
Question on Substitution & Income EffectsYou have just won a cash award of $500 for academic excellence.A. The substitution effect of this award will be larger than its income effect.B. The income effect of this award will be larger than its substitution effect.C. The substitution and income effects will be of identical size.D. It is impossible to know whether the substitution effect is larger than the income effect or vice versa.
Almost everyone got this one wrong in a past year test!
53
Assignment Tip: A cash award OR CASH BONUS is like giving ‘income’ to someone.
54
The Australian government is proposing to tax carbon which will increase electricity prices
Substitution & Income Effects: Policy Application (Carbon Tax)
ElectricityO
All other goods
L1
U1
A
L2
F1E
Substitution effect is F1E (move from A to D).
U2
B
F2
The income effect is EF2 (move from D to B, implying that electricity is a NORMAL good).
D
Substitution effect
Income effect
NB the income effect also causes the demand for all other goods to fall
55
Substitution & Income Effects: Policy Application (Carbon Tax)
ElectricityO
All other goods
L1
U1
A
U2F2
However, the government is also planning to compensate low income families by reduced their income tax.
L2
B
F1E
When the government reduces income tax, it is giving cash back to taxpayers.
DIf it fully compensates for the effects of tax this will cancel out the income effect resulting in budget line L3.
L3
Income effect
Substitution effect
NB the tax will still affect the use of electricity, due to the substitution effects
56
Learning Outcomes
Understand how consumers maximise satisfaction Graphical representation and formula
Trace the effects of price changes from consumer choice to the demand curve Price consumption curve
Trace the effects of income changes from consumer choice to the demand curve Income consumption curve
Gain an understanding of different types of goods demanded by consumers Normal goods, inferior & Giffen goods Engel curve
57
Learning Outcomes
Examine the effects of price changes in terms of substitution and income effects Substitution effects Income effects
Tip: Learn to draw the diagrams accurately! Practice … p
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