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Economics Study Review: October 8, 2017

Class 1: Real and Nominal Prices, Definitions, General Assumptions

Definitionso Economics: study of incentives or of scare resourceso Microeconomics: How people and firms solve their problems with scars resourceso Macroeconomics: Study of countries and the financial system with scarce

resources General Assumptions about Economics:

o People are self-interested: people and organizations have GOALS (can be not money related) and they will do anything to achieve said goals

o Rational: decisions are made based on relative costs and benefitso Scarcity: there are limited resources available and we cannot produce or consume

everything that we want to Real vs Nominal Prices

o Real Prices: the price adjusted for inflation and the change in value over timeo Nominal prices: absolute price, what you pay in store

EX: Real and Nominal Prices (Practice Test #2)According to the Houston Chronicle, the face value (printed on the ticket) of a 2012 Super Bowl ticket was $1,200, while for Super Bowl II (in 1968) it was $12. Explain in words how you would determine whether this dramatic increase in price is really all due to changes in the underlying market for Super Bowl tickets,

Answer:To compare the prices of the tickets, I would convert the price of the 2012 Super Bowl tickets from 2012 dollars to 1968 dollars. I would do this by doing the following:

$1,200 2012$ 1968$2012$

This would convert the $1,200 into 1968$ and into a term that is comparable with the $12 from 1968.

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EX: Real and Nominal PricesHalf a gallon of ice cream when I was 10-years-old in 2006 was $3.70 but was $0.81 when my mother was 10-years-old in 1966. $5 in 2006 had the same buying value as $0.80. Did ice increase or decrease in value?

Answer:The value of the dollar was different in 1966 and 2006 so adjusting the price of ice cream in 2006 to that of 1996 means that half a gallon if ice cream now is $0.59 in 1966 dollars. So the value of ice cream has decreased.

$3.70 2006$ $0.80 in 1968$ $5 in 2006$

EX: Real and Nominal PricesTry to calculate real income for each year and see when they actually make the most.

YEAR Nominal income CPI

1980 24, 332 82.41985 32, 777 107.61990 41, 451 130.71997 53, 350 160.52000 59, 346 172.2

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Class 2: Opportunity Costs, Efficiency vs Equity, Sunk Costs Scarcity implies trade offs Opportunity costs: the things you have given up for the things you have chosen

o Implicit costs: Things that you pay without moneyo Explicit costs: Things you pay with moneyo If benefits are greater than costs, then it is worth the itemo Implicit costs can be found through the market value of items in the implicit costs,

like an hour of time is worth as much money as you can make in one hour Sunk Costs: Incurred costs that cannot be retrieved

o They should not be factored into decisions being made Efficiency vs Equity

o Efficiency: Allocating scarce resources meaning that we get the most from themo Equity: allocating scarce resources in a way that is fair

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EX: Opportunity CostsDescribe the opportunity costs of going to the One America Appeal Concert. What are the explicit and implicit costs?

Time doing homework Time sleeping Money on food (explicit) Stress of parking

EX: Opportunity CostsDescribe the opportunity costs of doing the Career Counseling workshops

Time during lunch Committees to get involved in Relationship to build

But we went to them to get money so the money is worth more than all these other things combined

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EX: Sunk Costs

A beer brewer and bottling company purchases a glass bottle maker machine for $20,000. As a part of the purchase agreement, the machine can be returned after 30 days for a refund of 50% of the purchase price. If the company returns the machine within the 30 day trial period, how much sunk costs does the company incur? If the company keeps the machine past the 30 day trial period, how much sunk costs does the company incur?

If the company returns the macine within the 30 day trial period, the sunk cost is $10,000 since it will recoup a $10,000 refund. If the machine is kept past the 30 day trial period, the full $20,000 is sunk.

Part 2:A soft drink bottling company hears that the beer brewer purchased the new bottling making machine. The soft drink company wants to try it out so that it doesn't have to spend the money up front to the manufacturer. The soft drink company offers the beer brewer $5,000 to try the machine out for 15 days to see if it is suitable for the soft drink industry. Should the beer brewer accept the offer?

Yes, the beer brewer should accept the offer assuming giving the machine away for 15 days does not have a negative impact on its production process. If the machine is returned during the first 30 days, the beer brewer would recoup $10,000 leaving $10,000 as sunk cost, but if it receives $5,000 from the soft drink company which means that you only lose $5,000 off the payment of the machine. If the machine is not returned in the first 30 days, the entire $20,000 cost is sunk and if the company receives revenue of $5,000 from the soft drink company then the loss on the machine is $15,000.

EX: Efficiency vs EquitySay that the Bush School receives 500 tickets to give away to students. Describe an efficient and a separate equitable way to divide One America Appeal concert tickets

Efficient: You give all the tickets to people who want them, first come first serve, as many tickets as people want. Equity: You give one ticket to each student and extra tickets will be raffled off.

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Class 3: Supply and Demand Supply

o Slopes upward, quantity rises as price increases (law of Supply) Demand

o Slope downwards, quantity decreases as price increases (law of Demand) Equilibrium

o Where supply and demand meeto The optimal price at which the producers want to sell as much as the consumers

want to buy Moving along the curves

o This will result from a change in price or quantity of a good Shifts in the Demand Curve

o Incomeo Tastes/ preferenceso Price of related goods (compliments, substitutes)

Compliments: items that will increase in quantity demanded together Substitutes: items that will replace each other based on income levels

Shifts in Supply Curveo Technology o Price of inputs and production (energy, labor, materials)

**** Remember that is there are opposing shifts in Price or Quantity, then there is am abigious value and we cannot determine if the price or quantity is greater than, equal to, or less than the

original price or quantity*********

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Ex Supply and demand (Practice Test #6)Esquire recently published a fascinating interview with David Bedford, the scientist at the U of Minnesota responsible for creating Honeycrisp apples. After 2 decades of steady growth, the interest has skyrocketed. Producers have been unable to change the availability as it takes 5-6 years to produce commercial quality fruit. Show on a graph what we would expect to have happened to the price and quantity of Honeycrisp apples in the short term with these market pressures. Explain and show in a diagram what you would expect to happen in the long term based on your understanding of supply elasticities.

Short term

So we have a demand greater than out supply so we will shift the price up so that demand and supply meet.

Long term

Now that we have a greater supply, we can shift our prices down back to equilibrium.

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EX: Supply and demandThe price of tea increases. At the same time, robots are developed which prove to lower the cost of the production of coffee. In the market for coffee, we should expect to see the curves shift.

The demand for coffee will increase in response to the increase in price of tea. As productions costs decrease, then the supply increases. Therefore, the supply curve shifts to the right and the demand curve shifts to the right. The quantity increases but the price is ambiguous.

EX: Supply and Demand Say the demand for business cards are y=-2x+5 and the supply is y=.5x-1. What is the equilibrium? What happens if price of business cards goes up by $1? What happens if the world no longer expected us to have business cards? Answer with numbers for the first two parts. Disclaimer that there are not real numbers in any way, I just pulled numbers out of the air.

Equilibrium is found by setting -2x+5=.5x -1 so the quantity will be 2.4 and the price will be 0.2. Is the price in business card goes up by $1, then the quantity demand will be 1.9 and the quantity demanded will be . If the world no longer expected us to have business cards, the demand would decrease shifting left.

EX: Supply and DemandWhat happened if… the price has increased and the quantity decreased?

The price increases and the quantity increases?The price decreases and the quantity increasesThe price decreases and the quantity decreases?

Demand decreaseSupply decreaseSupply increase Demand increase

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Class 4: Elasticities Formal quantitative measure of how responsive quantities are to price Unitless How much is the demand going to respond to changes in price?

Elasticity= % change in quantity demanded/ % change in price Always use new-old/old to calculate % change Factoring affecting price elasticity of demand

o Substitutes available: more substitutes, more elastico Closeness of substitutes: more close substitutes, more elastico Time to adjust behavior of consumers: more time, more elastic

Total expenditures will also be affected o TE=Price (Quantity)o If inelastic, then even if P changes, Q will not change and the TE will not change

that mucho If elastic, then if P changes a bit, then Q will change too and TE will change

Income elasticity of Demando =% change of quantity demanded/ % change of incomeo If positive, it is a normal goodo If negative, it is an inferior good

Cross price elasticityo =% change in quantity demanded of good X/ % price of good Yo If positive, they are substituteso If negative, they are compliments

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Price Elasticity of Supplyo =% change of quantity supplied/ % change of price

Factors that affect the elasticity of supplyo Are we looking that the short run or the long run?

Short run: firms have fixed factors of production that they cannot change Long run: new facilities and firms can enter the market

Use Arc elasticity is the change in price is largeo (new-old)/(.5(new+old))

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EX: You are given market data that says when the price of pizza is $4, the quantity demanded of pizza is 60 slices and the quantity demanded of cheese bread is 100 pieces. When the price of pizza is $2, the quantity demanded of pizza is 80 slices and the quantity demanded of cheese bread is 70 pieces. Can you calculate the price elasticity of demand be calculated for either good? If so, what is it?

You can calculate the pizza PED, it is -2/3 using the regular formula

EX: Income elasticityA 10 percent increase in income brings about a 15 percent decrease in the demand for a good. What is the income elasticity of demand and is the good a normal good or an inferior good?  Be able to explain your answer.

-.15/.10=-1.5. The elasticity is 1.5 and it is an inferior good since it is negative.

EX: Price Elasticity of DemandIf the price of a good increases by 8% and the quantity demanded decreases by 12%, what is the price elasticity of demand? Is it elastic, inelastic or unitary elastic?

-12%/8% = -.12/.08 = -1.5. Again, drop the negative sign, so the elasticity is 1.5. This means it is elastic (greater than one).

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EX: Price Elasticity of DemandAnna owns the Sweet Alps Chocolate store. She charges $10 per pound for her hand made chocolate. You, the economist, have calculated the elasticity of demand for chocolate in her town to be 2.5. If she wants to increase her total revenue, what advice will you give her and why? Be able to explain your answer.

Anna should lower her price. Her price elasticity of demand for chocolate is elastic (greater than one) and therefore, when she lowers her price she will sell a lot more chocolate. The greater quantity sold will make up for her lower price, increasing her total revenue. In other words, she is selling at a lower price but making up for it in volume of sales.

EX: Cross Price ElasticityIf the cross elasticity of demand between peanut butter and milk is -1.11, then are peanut butter and milk substitutes or complements? Be able to explain your answer.

Peanut butter and milk are complements because a negative cross price elasticity of demand means that as the price of milk goes up, the demand for peanut butter goes down. This would indicate that when the price of milk goes up, we buy less milk and we are also buying less peanut butter (so we must buy these together, they are compliments)

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EX: Cross Price Elasticity of DemandGood Cross-price elasticities of demand Air-conditioning units and kilowatts of electricity -0.34 Coke and Pepsi +0.63 High-fuel-consuming sport-utility vehicles (SUVs) and gasoline -0.28 McDonald’s burgers and Burger King burgers +0.82 Butter and margarine +1.54 a. Explain the sign of each of the cross-price elasticities. What does it imply about the relationship between the two goods in question? b. Compare the absolute values of the cross-price elasticities and explain their magnitudes. For example, why is the cross-price elasticity of McDonald’s burgers and Burger King burgers less than the cross-price elasticity of butter and margarine? c. Use the information in the table to calculate how a 5% increase in the price of Pepsi affects the quantity of Coke demanded. d. Use the information in the table to calculate how a 10% decrease in the price of gasoline affects the quantity of SUVs demanded.

Answer to Question: a. A negative cross-price elasticity of demand implies that the two goods are gross complements. So air-conditioning units and kilowatts of electricity are gross complements, as are sport-utility vehicles and gasoline. A positive cross-price elasticity of demand implies that the two goods are gross substitutes. So Coke and Pepsi are gross substitutes, as are McDonald’s and Burger King burgers as well as butter and margarine. b. The larger (and positive) the cross-price elasticity of demand is, the more closely the two goods are gross substitutes. Since the cross-price elasticity of butter and margarine is larger than the cross-price elasticity of McDonald’s burgers and Burger King burgers, butter and margarine are closer gross substitutes than are McDonald’s and Burger King burgers. Similarly, the greater (and negative) the cross-price elasticity of demand is, the more strongly the two goods are gross complements. c. A cross-price elasticity of 0.63 implies that a 1% increase in the price of Pepsi would increase the quantity of Coke demanded by 0.63%. Therefore, a 5% increase in the price of Pepsi would increase the quantity of Coke demanded by five times as much, that is, by 5 × 0.63% = 3.15%. d. A cross-price elasticity of −0.28 implies that a 1% fall in the price of gasoline would increase the quantity of SUVs demanded by 0.28%. Therefore, a 10% fall in the price of gasoline would increase the quantity of SUVs demanded by 10 times as much, that is, by 10 × 0.28% = 2.8%.

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EX: Price Elasticity of DemandDo you think the price elasticity of demand for Ford sport-utility vehicles (SUVs) will increase, decrease, or remain the same when each of the following events occurs? Explain your answer. a. Other car manufacturers, such as General Motors, decide to make and sell SUVs. b. SUVs produced in foreign countries are banned from the American market. c. Due to ad campaigns, Americans believe that SUVs are much safer than ordinary passenger cars. d. The time period over which you measure the elasticity lengthens. During that longer time, new models such as four-wheel-drive cargo vans appear.

Answer to Question: a. The price elasticity of demand for Ford SUVs will increase because more substitutes are available. b. The price elasticity of demand for Ford SUVs will decrease because fewer substitutes are available. c. The price elasticity of demand for Ford SUVs will decrease because other cars are viewed as less of a substitute. d. The price elasticity of demand for Ford SUVs will increase over time because more substitutes (such as four-wheel-drive cargo vans) become available.

More resourceshttp://seaver-faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set6Answers.pdf

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Class 5: Price Controls Price ceilings: maximum prices (legislated or regulated) for a good (ie rent control) Price floor: minimum price (legislated or regulated) for a good (ie minimum wage)

EX: Price Control 2. The quantities demanded and supplied at different prices in the bagel market in Yellow Springs, Ohio, are shown in the table below.

Sketch a graph to show the demand and supply for bagels in Yellow Springs. What is the equilibrium price, and what are the quantities demanded and supplied at the equilibrium price?

b. Suppose that the village mayor, David Foubert, decides that bagels are extremely healthy for villagers to eat and issues an edict that the price of a bagel in Yellow Springs is never to exceed $.40. Is Foubert establishing a price floor or a price ceiling? What are the quantity demanded and quantity supplied at this price? Is there a problem of excess demand or excess supply? How will consumers react to this policy? Bagel producers? Explain.

b. Foubert is setting a price ceiling since the $.40 per bagel price is a maximum price. Quantity demanded is equal to 140 bagels per week while quantity supplied is equal to 90 bagels per week at $.40 per bagel. There is an excess demand for bagels equal to 50 bagels per week. The

consumers who are able to purchase the 90 bagels at $.40 per bagel are happy about the policy. They save $.10 per bagel. However, consumers previously purchased 110 bagels at $.50 per bagel, so fewer healthy bagels are being eaten as a result of the policy. Producers are also frustrated by the policy because they sell fewer bagels and earn less revenue. c. The $.60 per bagel price is a price floor since it is a minimum price. At $.60 per bagel, the quantity demanded is 80 while the quantity supplied is 130 bagels per week. Under these circumstances, the village of Yellow Springs will have to purchase the 50 excess bagels supplied each week. Villagers will have to pay for these bagels with higher taxes. Moreover, bagels are more expensive for consumers in Yellow Springs. However, bakers who produce bagels love the policy. They earn more revenue as a result.

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EX: Price ControlsQuestion: In the late eighteenth century, the price of bread in New York City was controlled, set at a predetermined price above the market price. a. Draw a diagram showing the effect of the policy. Did the policy act as a price ceiling or a price floor? b. What kinds of inefficiencies were likely to have arisen when the controlled price of bread was above the market price? Explain in detail. One year during this period, a poor wheat harvest caused a leftward shift in the supply of bread and therefore an increase in its market price. New York bakers found that the controlled price of bread in New York was below the market price. c. Draw a diagram showing the effect of the price control on the market for bread during this one-year period. Did the policy act as a price ceiling or a price floor? d. What kinds of inefficiencies do you think occurred during this period? Explain in detail.

a. Panel (a) of the accompanying diagram illustrates the effect of this policy. Since the price is set above the market equilibrium price, this policy acts as a price floor: it raises the price artificially above the equilibrium. As a result, too much bread is produced: there is a surplus.b. As with all price floors above the equilibrium price, there are

several associated inefficiencies. First, there is deadweight loss from inefficiently low quantity. Some transactions that would have occurred at the unregulated market price no longer occur. Second, there is inefficient allocation of sales among bakers. Some bakers who have higher cost get to operate, while some who have lower cost do not. Third, there are wasted resources from surplus production of bread that must be given or thrown away. Fourth, there is inefficiently high quality as bakers produce bread of higher quality than consumers want. Consumers would instead prefer a lower pricec. Panel (b) illustrates the effect of the fixed price if the market equilibrium is above that price. The set price now acts like a price ceiling, preventing the price from rising to the equilibrium. There is a shortage, as occurs with every price ceiling below the equilibrium price. d. As with all price ceilings below the equilibrium price, there are several associated inefficiencies. First, there is deadweight loss from inefficiently low quantity. There is a persistent shortage of bread, and some transactions that would have occurred at the equilibrium price no longer occur. Second, there is inefficient allocation to consumers, as some who want bread very much are not able to find any, while those who value bread less are able to purchase some. Third, there are wasted resources as consumers expend resources to find bread. Fourth, there is inefficiently low quality of bread that is offered for sale.

More Resourceshttp://seaver-faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set5Answers.pdfhttp://www.cengage.com/resource_uploads/downloads/142406872X_172097.pdf

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Class 6: Consumer and Producer Surplus Consumer Surplus: net gain to consumers from the difference in maximum willingness to

pay and the price or the difference between how much you are willing to spend and how much you actually spend

o Area under the demand curve until the equilibrium priceo Marginal Benefits: gains from consuming one more unito Total benefits to consumers: under the demand curve until the priceo Total costs to the consumers: under the price and under the quantity demanded

o

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Producer Surplus: net gains to producers arising from difference in price and their minimum willingness to sell or the difference between price and the lowest that I would sell something for

o Area above the supply curveo Marginal costs: cost it takes to make one more unito In the picture below, variable cost is also considered opportunity cost

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Total surplus: sum of consumer and producer surpluso Measure of efficiency maximizing total surplus Is definition of efficiency in

output

Deadweight loss: aggregate loss in well-being resulting from lack of efficiency in output

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EX: Consumer and Producer Surplus

Where is the consumer surplus? What is the value?Where is the producer surplus? What is the value?Is there any deadweight loss? If so where and how much?

If there is a price floor set at $400, how do the answers to the previous questions change?

Consumer surplus: CVA, (.5*20*100)+(20*100)+(.5*20*100)= 4000Producer Surplus: WMP, (.5*20*100)+(20*100)+(.5*20*100)= 4000No deadweight lossAfter the price floor:Consumer surplus: C, (.5*100*20)=1000Producer surplus: VWP, (20*200)+(.5*20*100)=5000Deadweight loss: AM, (.5*200*20)=2000

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EX: Consumer and Producer SurplusQuestion: The accompanying table shows hypothetical demand and supply schedules for milk per year. The U.S. government decides that the incomes of dairy farmers should be maintained at a level that allows the traditional family dairy farm to survive. So it implements a price floor of $1 per pint by buying surplus milk until the market price is $1 per pint.

a. In a diagram, show the deadweight loss from the inefficiently low quantity bought and sold. b. How much surplus milk will be produced as a result of this policy? c. What will be the cost to the government of this policy? d. Since milk is an important source of

protein and calcium, the government decides to provide the surplus milk it purchases to elementary schools at a price of only $0.60 per pint. Assume that schools will buy any amount of milk available at this low price. But parents now reduce their purchases of milk at any price by 50 million pints per year because they know their children are getting milk at school. How much will the dairy program now cost the government? e. Explain how inefficiencies in the form of inefficient allocation to sellers and wasted resources arise from this policy.

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a. The deadweight loss is shown in the accompanying diagram by the shaded triangle.

b. With demand of D1 and supply of S, the equilibrium would be at point E1 in the accompanying diagram. However, with a price floor at $1, the quantity supplied is 750 million pints and the quantity demanded is 650 million pints. So the policy causes a surplus of milk of 100 million pints per year.

c. In order to sustain this price floor (to prevent black market sales of surplus milk below the price floor), the government has to buy up the surplus of milk. Buying 100 million pints of milk at a price of $1 each costs the government $100 million.

d. As a result of sales of cheap milk to schools, the quantity demanded falls by 50 million pints per year at any price: the demand curve shifts leftward to the new demand curve D2 . Without the price floor, the equilibrium would now be at point E2 . However, with the price floor at $1, there is now a surplus of 150 million pints. In order to sustain the price floor of $1, the government must buy up 150 million pints at $1 each; that is, it must spend $150 million. It does, however, sell those 150 million pints to schools at $0.60 each (and from those sales makes $0.60 × 150 million = $90 million), so that the policy costs the government $150 million − $90 million = $60 million.

e. Some milk producers are inefficient: if the price were allowed to reach equilibrium, they would find it too costly to produce. In their absence, milk would be produced only by the most efficient producers. Furthermore, resources are being wasted: although no milk is poured away outright, the government spends significant amounts of money on purchases of milk. This is money that might be used more effectively for purposes other than providing cheap milk to schoolchildren, such as improving the quality of public schools.

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Class 7: Indifference Curves Assumptions about Consumer Preferences

o Completeness: consumers can express a preference for A over B or B over A, or indifferent of A and B

o Transitivity: if you like A over B and B over C then you like A over Co Nonsatiation: More is better, all else is equal. The consumer always prefers more

of something to less of something Market Basket: combination of goods that the consumer can consider Indifference: a consumer is equally

satisfied by either choiceo Since A and E are on the same

indifference curve, then the consumer will be indifferent in their purchase

o Indifference curves never intersecto Indifference curves farther from

the origin are preferable to those closer, so the line with D is less preferable with the line with A and E

o Indifference curves are convex to the origin and downward sloping

Marginal Rate of Substitutiono How willing a consumer is to trade

one good for anothero At the optimal point where the

consumer is getting as much as possible, the slope of the indifference curve is equal to the MRS

o MRS is diminishing because the more we have of something, the less we want even more of it

Different people have different preferences

o People like different things so they will be more or less willing to give up good B for good A

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EX: Indifference CurvesAn economy has only two goods, bread and wine, both of which have positive economic value. The baskets (5 bread + 2 wine) and (3 bread + 6 wine) lie on indifference curve J, and the basket (6 bread + 4 wine) lies on indifference curve K. Which of the following cannot also lie on indifference curve K? A. 2 bread and 5 wine B. 1 bread and 9 wine C. 0 bread and 15 wine D. 8 bread and 1 wine E. 15 bread and 0 wine

The basket (5 bread + 2 wine) is worth less than the basket ((6 bread + 4 wine), so the indifference curve K has more utility than the indifference curve J. But the basket (3 bread + 6 wine) is worth more than the basket (2 bread + 5 wine), so it is not possible for the basket (2 bread + 5 wine) to lie on a higher indifference curve

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EX: Indifference CurvesA graph shows a consumer’s indifference curves for food vs clothing. A. How many indifference curves does the consumer have? B. Can two indifference curves intersect? C. Are indifference curves upward sloping or downward sloping? D. Are indifference curves convex or concave? E. How do indifference curves reflect the marginal utility of one good in terms of the other good? F. Are indifference curves parallel?

Part A: Any consumer has an infinite number of indifference curves, since more of a good increases utility. In practice, goods are not divisible into minutes pieces and eventually a consumer gains no more utility from an extra unit, so we might say that consumers have an uncountably large number of indifference curves. Part B: Different indifference curves have different utilities, so they cannot cross, and no basket of goods can be on more than one indifference curve. Part C: Indifference curves are downward sloping if the goods have positive economic value. If the baskets (Y, Z) and (YN, ZN) have the same utility and Y > YN, than Z < ZN. Part D: Indifference curves are convex because of decreasing marginal utility. As the units of a good increase, each additional unit of that good is less valuable to the consumer. More additional units are needed to achieve the same increase in utility Part E: The marginal utility of one good in terms of the other is the negative of the slope of the indifference curve. Part F: Indifference curves are not parallel, though they may seem parallel in the graphs. Jacob: If two curves are parallel, are they straight lines? Rachel: Parallel means the slopes are the same, though the slopes of each curve may change. Two curves are parallel if one is a linear displacement of the other. If we move the X values " units to the right or left and the Y values $ units up or down, the two curves are parallel. Example: Suppose one curve is xy – 16 = 0. A displacement of the curve might be (x – 1)(y – 1) – 16 = 0 A xy – x – y – 15 = 0

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Ex: Indifference CurvesFor the following set of problems, draw two indifference curves with U1 and U2 and U1<U2. Draw each graph placing the amount of the first good on the horizontal axisA: hot dogs and chili (the consumer likes both and has a diminishing marginal rate of substitution of hot dogs for chili)B: Sugar and SweetNLow (the consumer likes both and will accept an ounce of SweetNLow or an ounce of sugar with equal satisfaction)C: Peanut butter and jelly (the consumer likes exactly 2 ounces of peanut butter for every ounce of jellyD: Nuts (which the consumer neither likes nor dislikes) and ice cream (which the consumer likes)E: Apples (which the consumer likes) and liver (which the consumer dislikes

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Class 8: Budget Constraints, Consumer Choice, Changes in Income Budget Constraint

o Budget line: set of all market baskets the consumer can buy given their income and the prices of the goods that they spend all of their income on

o Income= PxQx + PYQY

o Slope = Px/Py

o X-intercept= income/ PX

o Y-intercept=income/PY

o Trade based on slope

Income shifts the budget line in or out

Changes in the price of goods pivots the line in or out

o If consumers have the same consumption and they are at optimal value, then they have the same MRS

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Consumer Choiceo Consumers have preferences over what they want in their market basketo Their preferences are represented by indifference curveso At optimal point, slope of budget line=slope of Indifference curve=MRSo Consumer is equally satisfied by all points of the budget lineo If something is liked more than the other, then we often see corner solutions

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EX: Budget Line1. Suppose a consumer has income of 10, and buys soda pop and movies. The price of each good is 1. A. Draw a budget line that represents the set of bundles this individual can afford if they use all their income. (Put movies on the X axis). Label the places where the budget line intercepts each axis and the slope of the line. B. Suppose that in consumer equilibrium this individual consumes 7 soda pops and 3 movies. What rules must hold in consumer equilibrium? Label this bundle in your drawing (call it point “A”). Draw an indifference curve associated with this bundle, and explain how its slope at the equilibrium point relates to the slope of the budget line. C. Consider the bundle 2 Movies and 8 Sodas. Label this point. What can you say about the slope of the indifference curve that passes through the point? (For example, is it bigger than, equal to, or smaller than -1?) D. Now suppose that income goes up to 15. Illustrate how the budget constraint will change. If both goods are normal, explain where the new equilibrium will be (your answer might consist of a region of bundles, rather than just one bundle). In consumer equilibrium, income is exhausted and MU per dollar spent is the same for all goods.

In a picture, the equilibrium bundle will be on the budget line at a point where the indifference curve is tangent to the budget line. Regarding part C, we know that at the point 8 sodas and 2 movies the slope of the IC will be steeper than the budget line, reflecting the fact that if we give up one soda, we will be able to afford so many more movies that our utility will rise. If both goods are normal, than we know that as income rises we will consume more of both goods. Thus, only points on the new budget line associated with both more movies and more soda are possible.

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EX: Indifference CurvesSuppose that utility rises as we head towards the center of these circles. Is the set of preferred bundles convex? From the picture above, is there any evidence that this person’s preferences violate the law of diminishing marginal utility? Intuitively explain how preferences might look like this (in other words, tell me what is happening to this person’s satisfaction from consuming tv and video games).

'For each indifference curve, the set of preferred bundles is the area inside the circle, and it is a convex set. There is no evidence that the law of diminishing marginal utility is violated. To see this, consider picking a point on the x-axis and moving straight up. Looking at the indifference curves as we do so shows us what happens to total utility as we increase consumption of video games—in other words, it shows us the marginal utility of video games. At first, as we move towards the innermost circles, our total utility is rising, so marginal utility is positive (and it could be either increasing or decreasing). Then, as we start to leave the innermost circles, our utility starts to fall—suggesting that marginal utility is now negative. The same logic applies if we started at the y-axis and moved horizontally to the right (in which case we would be learning about the marginal utility of hours of television). So there is nothing in the picture that suggests that the law of diminishing marginal utility is violated. Intuitively, this is a picture of an individual who most prefers a certain amount of television and a certain amount of movies, and is actually made worse off if they consume more than these most-preferred levels. We can imagine that at the center of all of the circles there is a point that gives the person the desired amount of both goods at once, this is called the “bliss point.” A person would choose this point over any other—even if offered a huge amount of video games and hours of television, they would choose the bliss point.

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EX: Budget line and Indifference CurvesAssume that there are two goods. The price of the first good is $10 and the price of the second good is $20. The income is m=200.

Determine the budget constraint.Determine the slope and the intercepts of the budget line.Graph the budget set.Assume that income increases to m=300. At the same time the price of good 1 increases to 20. Determine the equation of the new budget line.Determine the slope and the intercepts of the new budget line.Graph the new budget set.

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EX: Budget Line(1) Draw the budget set for the following parameters. m = 20, pbeer = 1, ppizza = 5. The

units for the two goods are pints and pies respectively. (2) From any interior ( = not intercept point) consumption bundle on the budget line how

many beers must be forgone for each additional pizza? (3) How many pizzas must be given up for each additional beer?(4) Show in a new picture how the budget set changes when the price of beer increases to 2. (5) Show in a new picture how the budget set changes when this consumer’s income

decreases to 15

ANSWER. The consumer’s budget set for pizza-beer consumption bundles. Note that key features are labeled: the axes with the name of their respective good and units, intercepts, the slope of the line (the MRT). The budget set itself is indicated by the shaded region. Note that the decision to put beer on the vertical axis and pizza on the horizontal is arbitrary. There is nothing especially ‘horizontal’ about pizza or beer. It does not matter which way you choose as long as the picture is well-labeled. Note further that scale for each axis need not be the same. You may represent one pint of beer as an inch and 1 pizza as a meter or vice versa as long as you are consistent. The slope of the line as visually represented has no meaning without labels indicating units. Similarly, the numeric value reported for the MRT is unit dependent. Here we have 1 pizza pie worth 1 pint of beer at the given prices. But if we had used mL as the unit for beer, we would report an MRT of 480: 1 pie per 480mL of beer.ANSWER. 5 beers per pizza as indicated by the slope of the budget line in Figure 1. ANSWER. 1 5 pizzas per beer as indicated by the inverse slope of the budget line in Figure 1

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Class 9: Composite Goods, Corner Solutions Composite Goods

o We focus on one good and the y axis is all other goods measures in $1 units. So if income is $1000, the y intercept is $1000.

Corner Solutionso MRs does not equal price ration meaning that the indifference curve and budget

line are not tangent

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EX: Corner Solutions (Practice Test #5)The city of College Station recently held a public debate on whether to allow hydraulic fracturing, extracting oil from the ground, within city limits. Some citizens oppose it because of noice and vibrations. Other support it on ground of economic development. Draw two sets of indifference curves showing preferences in fracking over the goods: neighborhood preservation and economic development. Explain which is which and why. Your answer should include a discussion of the marginal rate of substitution.

The people who want neighborhood preservation really do not want economic development through fracturing so it will take a lot of economic development to get one unit of neighborhood preservation. The MRS will be very small as the rate will be something like 1 unit of neighborhood preservation to 10 units of economic development. It would also be less than the slope of the budget line.

The people who want economic development don’t really care about neighborhood development. It would take a lot of neighborhood development for the trade of economic development for these people therefore the MRS would be large because it would be 10 units of neighborhood preservation for 1 unit of economic development. It would also be greater than the slope of the budget line.

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Class 10: Horizontal Summation, Income and Substitution Effects Horizontal Summation

o You add up individual supply or demand curves at a certain price to get the market quantity at a price

Income/ Substitution Effecto Income Effects: change in consumption from a change in real income that results

from a change in price We think of it as we have more income so we’re going to spend it Usually when a good decreases in price so we have more income to spend

on other goodso Substitution Effect: changes in price change real purchasing power when you

consider all options that you can buy, then you want to save money to spend on something else, the substitute

Changes in consumption from change in relative price, holding constant real income or well-being

Want to buy substitutes when price increases so you buy less of one product

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EX: Substitution Income EffectReturn to the analysis of my undying love for my wife expressed through weekly purchases of roses A: Recall that initially roses cost $5 each and, with an income of $125 per week, I bought 25 roses each week. Then, when my income increased to $500 per week, I continued to buy 25 roses per week (at the same price). (a) From what you observed thus far, are roses a normal or an inferior good for me? Are they a luxury or a necessity?

(b) On a graph with weekly roses consumption on the horizontal and “other goods” on the vertical, illustrate my budget constraint when my weekly income is $125. Then illustrate the change in the budget constraint when income remains $125 per week and the price of roses falls to $2.50. Suppose that my optimal consumption of roses after this price change rises to 50 roses per week and illustrate this as bundle C.

(c) Illustrate the compensated budget line and use it to illustrate the income and substitution effects.

(d) Now consider the case where my income is $500 and, when the price changes from $5 to $2.50, I end up consuming 100 roses per week (rather than 25). Assuming quasilinearity in roses, illustrate income and substitution effects. (e) True or False: Price changes of goods that are quasilinear give rise to no income effects for the quasilinear good unless corner solutions are involved.

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(Aa)As income went up, my consumption remained unchanged. This would typically indicate that the good in question is borderline normal/inferior — or quasilinear. Since the consumption at the lower income is at a corner solution, however, we cannot be certain that the good is not inferior, with the MRS at the original optimum larger in absolute value than the MRS at the new (higher income) optimum. Regardless, roses must be a necessity — whether they are borderline inferior/normal or inferior, the percentage of income spent on roses declines as income increases.

(Ab) This is illustrated in panel (a) of Graph 7.6 where A is the original corner solution, C is the new corner solution and the dashed line is the compensated budget.

(Ac) This is also illustrated in panel (a) of the graph. In this case, there is no substitution effect (in terms of roses) and only an income effect.

(Ad) This is illustrated in panel (b) of Graph 7.6 where the dashed line is again the compensated budget line. Unlike in panel (a), the entire change in roses consumption is now due to a substitution effect rather than an income effect. 191 Income and Substitution Effects in Consumer Goods Markest

(Ae) This is true. We will often make the statement that income effects disappear if we assume quasilinearity of a good — because then a good is borderline normal/inferior, which implies consumption remains unchanged as income changes. This is true so long as the consumer is at an interior solution. If quasilinear tastes lead to corner solutions, then this may give rise to income effects as we see in panel (a) of the graph.

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EX: Income Substitution effectsSuppose a consumer has income, M = 100, and faces prices, px = 2 and py = 2. Using a neat, carefully drawn and labeled diagram, show the substitution and income effects resulting from a decrease in px to 1, while M and py remain constant. Make sure that you indicate the magnitudes of the income and substitution effects.

Answer: Px decreases .The new budget line is now flatter and outside the original budget line. Let point A be the tangency point of the original budget line and an indifference curve, let point B be the tangency point of the original indifference curve and the line with the slope of the new budget line, −1/2, and let point C be the tangency point of the new budget line and an indiffence curve. Then the substitution effect is the increase in the x coordinate as we move from point A to point B, and the income effect is the change in the x coordinate as we move from point B to point C. The substitution effect is always positive for a price decrease, and the income effect will also be positive if x is a normal good. I will draw the graph in class.