|


 

Introduction

 6udget Constraint and Preferences

 Representation of preferences: utility function

 Consumer Choice: Individual and aggregate demand.

Demand properties.

 Market demand and Equilibrium

 J  ½implified representation of reality.

 Exist different types of goods in the economy

 Model needs to account for „
„

„ taken as
given) and „
„

„ determined by the forces
described by the model).

x
 


  

 People try to choose the best

patterns of consumption they can afford.

  x

 Prices adjust until the amount

that people demand of something is equal to the amount that
is supplied.
u 3
  Curve that relates demanded quantity to the
price.

 ©
 : a person¶s maximum willingness to pay

for something.
highest price that a given person will accept and still
purchase the good)

u ½
  Curve that relates the quantity supplied to
the price

 ½upply curve varies in the 

and  
.

Determined by firm¶s production costs.
 µ the one they like more¶

Consumers choose THE 6E½T bundle of

goods they CAN AFFORD

µbudget constraint¶
 -can afford´

Household¶s consumption possibilities are constrained by its

budget and the prices of the goods and services it buys.

A ¦
 describes the limits to a household¶s

consumption choices.

r ©  is the price of one good divided by the

price of another good.

2. A household¶s 
 is the household¶s income

expressed as the quantity of goods that the household can
afford to buy.
 6


u oods the consumer wants to consume: many« but we
simplify to 2 goods

CON½
MPTION 6
NDLE: x1, x2)

u e can observe price of the goods, p1 and p2, and money the
consumer has, m.

6
D ET CON½TRAINT:

p1x1 + p2x2 ” m

Money spend Money spend in

in good 1 good 2
u 6
D ET ½ET:
all consumption bundles that satisfy the budget constraint.

u 6
D ET LINE:
set of all bundles that cost exactly m

p1x1 + p2x2 = m

 
 


a. slope of the budget line

b. how budget line changes when prices change
c. how budget line changes when income changes
d. hat is the numerarie good
  
 
   



1. Taxes and subsidies:

m 6 
 : consumer pays certain amount to the
government for each unit purchased. Price becomes p+t)

m M   
  : proportional tax on the price of a

good. Price becomes p1+IJ)

m ½ ¦

: Opposite of a tax

m å   : independent of price and quantity, m-T)

2. Rationing: Level of consumption of some good fixed to be

no larger than some amount.
 µ the one they like more¶: Preferences
A household¶s preferences determine
the benefits or satisfaction a person
receives consuming a good or service.

Consumers choose THE 6E½T bundle of

goods they CAN AFFORD

µbudget constraint¶
 

u Consumers choose CON½
MPTION 6
NDLE½
u Notation:
 Consumer is INDIFFERENT between X and Y : x1, x2)~ y1,
y2)
 Consumer ½TRICTLYREFER½ X to Y:
x1, x2) ¾ y1, y2)
 If consumer prefers or is indifferent between two bundles we
say he EAKLYREFER½ X to Y:
x1, x2) • y1, y2)

x1, x2)• y1, y2) and x1, x2)” y1, y2)

imply x1, x2)~ y1, y2)

x1, x2)• y1, y2) and no x1, x2)~ y1, y2)

imply x1, x2)¾ y1, y2)
 Assumptions about preferences

r
 any two bundles can be compared.

‰   any bundle is at least as good as itself

[ ÷   if x1, x2)• y1, y2) and

y1, y2)• 1, 2) then we assume that
x1, x2)• 1, 2)
 Indifference curves

u eakly preferred set: all consumption bundles that are weakly

preferred to x1, x2).

u 6oundaries of the weakly preferred set: INDIFFERENCE

CURVE½.

 All bundles of goods that leave the consumer indifferent

to the given bundle.
 Indifference curves representing distinct levels of
preference cannot cross  that would contradict transitivity).
 ell-behaved preferences

1. More is better: J

 


we assume we have goods, no bads). Indifference curves

have negative slope.

 :
Assume that for any t ɽ ,1),
if x1, x2)~ y1, y2), then
t x1 + 1-t) y1, t x2 + 1-t) y2)• x1, x2)

set of bundles weakly preferred to X is a convex set)

 Examples of indifference curves
d



  consumer is willing to substitute one
good for the other at a constant rate.
Ex. 1 l. And 5 l. bottles of water.
   
 goods that are always consumed
together in fixed proportions.
Ex. Right and left hand globes.
6 goods that the consumer doesn¶t like.
  goods that the consumer doesn¶t care about.
 ½
exists an overall best bundle and the µcloser¶ the
consumer is to that best bundle, the better off he is in terms
of his own preferences.
Ex. Chocolate and ice-cream
’




3   instead of curves we have a µset of points¶.
 3
 
 


    

        
 

 

   

 J

 



 mdd
d
’


  J
  
   
 



 

 

  
    
 





   
    

    
  


   
 
   

    

 

      

    
    

 


 Marginal rate of substitution MR½)

Negative number: give up from one of the goods and get more from
the other to stay on the same indifference curve.

A diminishing marginal rate of substitution is the key assumption

of consumer theory.

 A 
 

 
is a general

tendency for a person to be willing to give up less of good 
to get one more unit of good , and at the same time remain
indifferent, as the quantity of good increases.

Indifference curves exhibit DIMINI½HIN MR½: -the more you

have of one good, the more willing you are to give some of it in
exchange for the other good´.

tility
u - numeric measure of a person¶s happiness´:  
is the
total benefit a person gets from the consumption of goods.
enerally, more consumption gives more utility.

u
tility function assigns a number to every possible consumption

bundle such that more-preferred bundles get assigned larger
numbers than less preferred bundles.
u x1, x2) • u y1, y2)
if and only if
x1, x2) • y1, y2)

 

only ranking matters. A monotonic
transformation of a utility function is a utility function that
represents the same preferences as the original function.
 |

attach a significance to the magnitude of
utility.
u J

change in utility when consumer gets
additional unit of good 1 holding constant amount of good 2
he has).

As the quantity consumed of a good increases, the marginal

utility from consuming it decreases. e call this decrease
in marginal utility as the quantity of the good consumed
increases the principle of 
 


.

u J
 
½lope of the indifference

curve. How consumer is willing to substitute a small amount
of good 2 for good 1.

MR½ = ratio of marginal utilities

Ratio of marginal utilities is independent of the particular

transformation of the utility function you choose to use.
The consumer¶s best affordable point:

± Is
 the budget line.

± Is
the highest attainable indifference curve.

± Has a marginal rate of substitution between the two goods

„
the relative price of the two goods.
 CON½
MER CHOICE

u ell behaved preferences: consumer will choose bundles ON the

budget line.

u |   highest possible indifference curve. ½et of preferred

bundles does not intersect with the set of bundles he can afford.

u 
Indifference curve tangent to the budget line.

 Possible problems:
- kinky tastes, boundary optimum, non-convex preferences
u ½   
r
 how many units of good 2
has the consumer to give up to get an extra unit of good 1.

u J
 
Rate at which the consumer is

willing to substitute one good for the other.

 If indifference curves are strictly convex, then there will be

only one optimal choice on each budget line.

J©½r

 3 
  function that relates the optimal choice the
quantities demanded) to the different values of prices and
income.
 Taxes

u uantity tax: price of the good is increased by the amount of

the tax,
p1 becomes p1+t)

u Income tax: new income=m-T

u uestion: for which type of preferences will the consumer be

just as happy facing an income or a quantity tax?
 Demand

u 3


give the optimal amounts of each of the

goods as a function of the prices and income faced by the
consumer.

rrr



r


u ant to know: how demand changes with prices and income.

 Changes in income
u    demand increases with income
u 
   demand decreases with income

whether a good is inferior or not depends on the income level we

are examining)

 I
„„ 

 in the x1,x2) axis, how optimal
choice changes with income.

 E„ „ in the x1,m) axis, how demand changes with
income.

u å
  if demand goes up by a greater proportion than
income.
u  
  if demand goes up by a lesser proportion
than income.
 Changes in prices
u  
  decrease in price leads to a decrease in the
demand for the good.
u 

  demand decreases with increase in price.

 
„
„  „ in the x1,x2) axis, demand of the good as
function of the price of the good.

 D„  „ in the x1,p1) axis, demand as function of

price.

u If demand of good 1 goes up when p2 increases, we say that

good 1 is a  for good 2.
u If demand of good 1 decreases when p2 increases, we say that
good 1 is a 
 for good 2
 ©xxåx3©xx©x|x½

u Objective: discover people¶s preferences from observing their

behavior.
u -choice reveals preference´: Revealed preferences what we
choose is revealed preferred to anything else that is available)

3
  

 Let x1,x2) be the chosen bundle
when prices are p1,p2), and let y1,y2) be a bundle such that
p1x1+p2x2• p1y1+p2y2. Then, if the consumer is choosing the
most preferred bundle he can afford, we must have x1,x2)>y1,y2)



  

 when we apply transitivity to
revealed preferences
   


If x1,x2) is directly revealed preferred to y1,y2), and the two

bundles are not the same, then it can not be that y1,y2) is
directly revealed preferred to x1,x2).

i.e. if x1,x2) is chosen at prices p1,p2) and y1,y2) is

purchased at prices q1,q2), then if p1x1+p2x2• p1y1+p2y2
it must NOT be the case that
q1y1+q2y2• q1x1+q2x2.
 ½
  


If x1,x2) is revealed preferred to y1,y2) and y1,y2) is different

from x1,x2), then y1,y2) cannot be directly or indirectly
revealed preferred to x1,x2).

 If observed choices satisfy ½ARP, we can always find nice,

well-behaved preferences that could have generated the
observed choices.
 Index numbers
Examine cost of a bundle in 2 different periods: b base period)
and t
u 
= w1x1t+w2x2t)/ w1x1b+w2x2b)
 If weights are base period prices: Laspeyres Index
 If weights are t period prices: Paasche Index

u  



= w1p1t+w2p2t)/ w1p1b+w2p2b)
 Period t quantities as weights: Paasche
 Period b quantities as weights: Laspeyres

u |
 
| comparison of the cost of a

standard bundle of goods over time. Each month, government
reports how much it costs to buy the bundle of goods that an
average consumer purchased in a base year.
 ½å ½ x 

Consumer¶s choice response to a change in price.

T„ 
 
„
„ 

 „

„
„„
„ „
„


„„ 
„

 „ „ 

Change in price of a good:

1)Changes rate at which you can exchange one good for another_
½
6½TIT
TION EFFECT
2) Changes total purchasing power of your income_ INCOME
EFFECT
u ½teps:

a) Change relative prices and adjust income to keep purchasing

power constant  pivot budget line around original consumed
bundle)

m¶-m)= x1p,m) p¶-p)

½
 rr

by revealed preferences, ǻx1s• whenever price decreases.

b) Adjust purchasing power with new prices shift pivoted line
out to the new demanded bundle with original income)


 rr
u   


 ½lutsky indentity

ǻx1=ǻx1s + ǻx1n=

= x1p¶,m¶)-x1p,m))+x1p¶,m)-x1p¶,m¶))

å 


If the demand for a good increases when income increases, then

the demand for that good must decrease when its price
increases

normal good, income and substitution effect reinforce each

other)
 Hicks substitution effect

u Roll around chosen point indifference curve instead of keeping

consumption bundle as feasible M¶ is enough to get a bundle
indifferent to the original one)
 6uying and selling
Consumer starts with an endowment of goods w1,w2)

   
 amount of the good the consumer actually

ends up consuming
 
 difference between what the consumer ends up
consuming and the initial endowments of goods.

6

 
p1x1+p2x2= p1w1 + p2w2
p1 x1-w1) + p2 x2-w2) = 
u If xi-wi)> Net buyer or net demander
u If xi-wi)> Net seller or net supplier

 Change in endowment similar to a change in income

 Price changes: budget line pivots around the endowment

u Net demand:

d1 p1,p2) = x1p1,p2) ± w1 if positive

= otherwise

u Net supply:

s1 p1,p2) = w1 ± x1p1,p2) if positive

=  otherwise
 ½lutsky equation revised

u Two income effects:

- ordinary income effect
- endowment income effect

u Total change in demand =

= substitution effect+
+ ordinary income effect +
+ endowment income effect

u Endowment income effect=

= change in demand when income changes x change in
income when price changes.
 
m



   

  
 


    

  
       
      
 
   

 

 
m
 


d

 
m



’ m



d
  d

 
÷ d
 
’
  m 
d 3










  









u 

  :

x,y)= vx)+y
If r units of good x are consumed, then r n<p<r n+1

ross consumer surplus= vn)= sum rn)

hen x=n, utility is given by:

n, m-pn)= vn)+m-pn

Net consumer surplus = vn)-pn

u Alternative approach:
C½= r1-p) + r2-p)+«+rn-p)= vn)-np

u Let R be the amount of money the consumer needs to receive

to exchange the n units of good x consumed for money.
v)+m+R= vn)+m-pn R=vn)-pn
 Compensating and equivalent variations

Alternative to estimate utility changes.

r | 


: How much money we would

have to give the consumer after the price change to make
him just as well off as he was before the price change.

2) x


: How much money would have to

be taken away from the consumer before the price
change to leave him as well off as he would be after the
price change. Maximum the consumer is willing to pay
to avoid the price change.
 ©
 
1) 6udget constraint

p1x1 + p2x2 = m
½lope= -p1/p2

2) Preferences

u Assumed to be complete, reflexive and transitive

u ell-behaved: monotonic more is better) and convex 
averages preferred to extremes)
u MR½= rate at which consumer is willing to substitute one
good for the other slope of the IC, diminishing MR½)

tility

u Ordinal representation of preferences

u MR½= -M
1/M
2

) Choice

u Optimality: Indifference curve tangent to the budget line

MR½=-p1/p2)
u Demand function: function that relates the optimal choice to
the different values of prices and income
Demand

u Changes in income: normal and inferior goods.

u Changes in prices: ordinary and giffen goods.
u ½ubstitutes and complements

) Revealed preferences

u Discover people¶s preferences from their behavior what we

choose is revealed preferred to anything that was feasible)
u ARP, ½ARP
 ½lutsky equation

Change in price of a good:

u Change in the rate at which you can exchange one good for
another: substitution effect.
u Change total purchasing power of your income: income effect

 ) Endowments: add an additional income effect since value of

the endowment is affected by the change in price.
 Market demand

u xi= xip1,p2,m) consumer i demand of good x

u J
:
X=Xp1,p2,m1,«,mn)
depends on prices and distribution of incomes.

u ©


:

X=Xp1,p2,M)
where M is the sum of incomes of all individual consumers.

u PX)= 



. Measures MR½ or marginal

willingness to pay of every consumer purchasing the good.
 Price elasticity of demand

The   

 
 is a units-free measure of the
responsiveness of the quantity demanded of a good to a
change in its price when all other influences on buyers¶
plans remain the same.

u Calculating Elasticity

The price elasticity of demand is calculated by using the

formula:

Percentage change in quantity demanded

--------------------------------------------------------------
Percentage change in price
u If the quantity demanded doesn¶t change when the price changes,
the price elasticity of demand is ero and the good as a  


 
.

u If the percentage change in the quantity demanded equals the

percentage change in price, the price elasticity of demand equals
1 and the good has 
 
.

u 6etween the two previous cases, the percentage change in the

quantity demanded is smaller than the percentage change in price
so that the price elasticity of demand is less than 1 and the good
has 
 
.

u If the percentage change in the quantity demanded is infinitely

large when the price barely changes, the price elasticity of
demand is infinite and the good has  
 
.
 Elasticity
u Measure of how responsive is demand to changes in prices and
income.

u   

 
 percent change in quantity
divided by the percent change in price.

İp= ǻq/ǻp) * p/q)

u x 


:
Revenue= price * quantity
ǻR=pǻq + qǻp

hen is ǻR/ǻp>? hen İp)>-1

The change in total revenue due to a change in price depends
on the elasticity of demand:

u If demand is elastic, a 1 percent price cut increases the

quantity sold by more than 1 percent, and total revenue
increases.

u If demand is inelastic, a 1 percent price cut decreases the

quantity sold by more than 1 percent, and total revenues
decreases.

u If demand is unitary elastic, a 1 percent price cut increases

the quantity sold by 1 percent, and total revenue remains
unchanged.
The  
 is a method of estimating the price
elasticity of demand by observing the change in total
revenue that results from a price change when all other
influences on the quantity sold remain the same).

u If a price cut increases total revenue, demand is elastic.

u If a price cut decreases total revenue, demand is inelastic.

u If a price cut leaves total revenue unchanged, demand is unit

elastic.
u |

 
 


pq= R , q= R/p

u x 





ǻR=pǻq + qǻp

MR=ǻR/ ǻq =p+ q*ǻp/ǻq)=p1+ 1/İ))

If objective is to maximie profits, producer wants to be on the

elastic part of the demand.
   d

md

#
d

! †

d

md

 †

†

÷© ! † d"mm
 d
!

d
 d

md md

 

d

d


! !
†  †


 
 

Income elasticity of demand= percent change in quantity over

percent change in price.

 Normal good: Income elasticity >

 Inferior good: Income elasticity <
 Luxury good: Income elasticity >1

eighted average of income elasticities:

ǻm/m) = p1x1/m) ǻx1/x1 + p2x2/m) ǻx2/x2

1= expenditure share on each good * income elasticity of
each good.


In a two good model, if one good is an inferior

good, the other must be a luxury good. True or false?
 J

± A   is any arrangement that enables buyers and

sellers to get information and do business with each other.

± A  is a market that has many buyers

and many sellers so no single buyer or seller can influence
the price.
 x


u ½
  how much individuals producers) are willing
to supply of a good at each possible market price.
e can derive the  „.

u 3
  how much individuals are willing to demand

of a good at each possible market price.  how much they are
willing to pay to get the good).
e can derive the  „ „ .

 |  each supplier and demander takes

prices as given and chooses his best response to the market
prices.
u x
  price where the supply of goods equals the
demand.
½p)= market supply
Dp)= market demand
Equilibrium price solves the equation ½3

 ½pecial cases:
i) Fixed supply
ii) Horiontal supply firm wants to supply any amount of the
good at a constant price)
iii) Inelastic demand
iv) Horiontal demand
 Price Determination

u
 



 
   




"   



  
À
{
"   



 À  {

"   



    

" 



#


   


{
 $%
††
$

†

††

!† m

!††
md
†† $ d

†  È !† 
 Taxes and equilibrium

u hen prices are introduced in equilibrium, there are two

prices to take into account: the price the supplier receives and
the price the consumer is paying. These prices differ in the
amount of the tax.

 introduce tax in supply or demand: as far is prices finally paid

by supplier and consumer, what matters is the amount of the
tax, not who is responsible for paying it.
u ½pecial cases:

i) Perfectly elastic supply: all tax is passed along to the

consumers
ii) Perfectly inelastic supply: none of the tax is passed along.
iii) If supply is nearly horiontal, much of the tax can be passed.
If the supply is nearly vertical, very little of the tax can be
passed along.

3   

Taxes change equilibrium quantities and produce a revenue for the

government.

 uestion: what is the deadweight loss of a tax when supply is

vertical?