Birkbeck College GDE/GDF Autumn 2007

MICROECONOMICS
Week 2 Lecture 2 and Problem Set for Week 2

Topics 1.The algebra of the tangency condition 2.Interior vs Corner Solutions 3.Income Effects 4.Price changes: income vs substitution effects 5.Limiting cases of price effects: perfect complements vs perfect substitutes 6.Deriving demand curves

1. The Algebra of the Tangency Condition Tangency Slope of indiff. curve = Slope of budget constraint (signs?) marginal rate of substitution
P2 = P 1

a) Utility U = U(X1, X2 )

U ( X 1 A , X 2 A ) > or = or < U ( X 1B , X 2 B ) ? U ( X 1 A , X 2 A ) > or = or < U ( X 1C , X 2C ) ?

Units of utility dont matter (well see why on next page) At any point on indifference curve: U(X1, X2 ) = constant

b) Marginal Utility MU1 = increase in utility from an extra unit of X1 Slope of utility mountain

U ( X 1 , X 2 ) MU1 = in calculus: X 1
For small changes,

U = MU1X1 + MU 2 X 2
But as we move along an indifference curve U = 0 !

MU1X1 + MU 2 X 2 = 0 MU 2 X1 = = MRS MU1 X 2

Look carefully at signs and suffixes Which assumption on preferences ensures that ICs have negative slope?

c) The Tangency Condition Slope of indiff. curve = Slope of budget constraint -MRS = -P2 / P1

cancel signs and substitute for MRS MU2 / MU1 = P2 / P1

(or, using calculus: U / X 2 P2 = ) U / X 1 P 1 NB Only relative MU matters, so units of utility dont matter Q: Does tangency condition always hold? A: No, may only hold as an inequality

2. Interior vs Corner Solutions

Corner solution inequalities vs tangency conditions Take two combinations of X1 and X2 that both satisfy the budget constraint:
X 1A = Y P2 A X2 ; P P 1 1 X 1B = Y P2 B X2 P P 1 1

X 1 B X 1 A = X 1 =

P2 X 2 P 1

Now look at the associated increase in utility

P U = MU1X 1 + MU 2 X 2 = MU1 2 X 2 + MU 2 X 2 1 P P = MU 2 2 MU1 X 2 P 1

Which gives a clear rule: if term in brackets is positive, increase X2; if it is negative, decrease it. At a tangency condition:
MU 2 P2 P2 = MU 2 MU1 = 0 MU1 P P 1 1

So no change in X2 can raise utility further. At the corner solution in diagram

MU 2 P2 P < MU 2 2 MU1 < 0 MU1 P P 1 1

So best to decrease X2 as far as possible: ie to zero! 7

3. Income Effects

Slope of budget constraint doesnt change: why not? Is consumer better off? What happens if income and both prices increase by same %? ie, if k is some constant YB = YA (1 + k )

P B = P A (1 + k ) 1 1 P2 B = P2 A (1 + k ) ?
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b) Income change with superior vs inferior goods

Which good is inferior? With only two goods can both goods be inferior?

4. Price changes

Which price has changed? Has it risen or fallen? (Hint: look at intercepts) Is consumer better off? Must X2 increase? (Hence must demand curves slope downwards?) Must X1 decrease? 10

Ambiguities when price changes

Is it possible that X2 < 0?

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Income vs Substitution* Effects Key result: With standard assumptions on preferences, ambiguous impact of price changes arises solely from income effects

Point C is strictly hypothetical The substitution effect is always of opposite sign to price change. For normal goods, income and substitution effects reinforce (ie, are of same sign)
*NB: Varian calls these Hicksian substitution effects

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Counter examples: a) An inferior good

X2

A to C = C to B =

? ?

Does demand curve slope downwards? For a given substitution effect will it be more or less elastic than for a normal good?

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b) A Giffen Good

In general: In all cases the substitution effect is of opposite sign to price change Income effects are of same sign for normal goods but of opposite sign for inferior goods Caveat: income effects of price changes are typically only significant for goods that have large budget shares (as in our diagrams!)

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5. Limiting Cases of Price Effects a) Initial equilibrium with. Perfect Complements

Perfect Substitutes

Neither implies initial tangency condition 15

b) Impact of price changes in limiting cases Perfect complements

Substitution effect =

Price changes do matter, but only via income effects

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Perfect Substitutes

At point A, MU2 / MU1 < or > P2 / P1 ? At point B, MU2 / MU1 < or > P2 / P1 ? Effectively, only price matters 17

6. Deriving Demand Curves a) An individuals demand curve

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b)

Market demand curves

Market demand curves are horizontal sums of individual demand curves Does each individual demand curve need to be identical? NB, for mathematicians, economists appear to draw diagrams the wrong way around!
Q ( P ) = Q2 ( P ) + Q2 ( P ) + .... + QN ( P ) = Qi ( P )
i =1 N

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More to come from the 2 Good Model Impact of taxes and subsidies Goods vs leisure Link with firms cost functions Goods today vs goods tomorrow (Eventually) general equilibrium

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Reading for Week 3 For Monday Lecture P&R (5th Edition) 7.1 (Measuring cost) [7.2 (Cost in the short run)] 8.1 (Perfectly competitive markets) up to 8.4 (Choosing output in the short run) Or Varian (6th edition) 16 (Equilibrium): 16.1 to 16.4 19 (Profit maximization): 19.1, [19.2] 22 (Firm supply) 22.1 to 22.5 For Tuesday Lecture Perloff Handout (Also available on website) P&R 3.4 (Revealed Preference) [Ch 4 appendix p144 (Duality in Consumer Theory)] Varian Chapter 7 (Revealed Preference): 7.1 to 7.3

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Class Exercise for Week 3 1. As in the last exercise, a consumer has income in current prices of Y, which she can spend on two goods, quantities of which are measured by A and B, and prices of which are PA and PB. Her preferences are well-behaved. a) Give an algebraic statement of the tangency condition. b) Show geometrically a utility-maximising equilibrium in which the consumer does not consume good A (hint: P&R also give a similar example). c) From an initial tangency condition, in a diagram with A on the yaxis and B on the x-axis, show the optimal response, using budget constraints and indifference curves, to a rise in Y, (i) if both goods are normal; (ii) if good A is inferior. d) Can both A and B be inferior goods? e) Show in a diagram the optimal response to a fall in the price of B (with the price of A unchanged), assuming that both A and B are normal goods, and show how the total change can be broken down into substitution (impact of price changes holding utility constant) and income effects. f) Show the impact of a price change if the goods are either perfect substitutes or perfect complements. g) What is the impact on the consumers choice if PA, PB, and Y all increase by the same percentage? Interpret your answer.

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h) Show how to derive the consumers demand curve for good B using an indifference curve diagram as above, with another diagram below it showing consumption of B on the x-axis, and the price of good B on the y-axis. 2. Are the following statements true or false? (i)A rise in income will always cause consumption of both A and B to rise (ii)For normal goods, substitution effects and income effects of price changes always reinforce each other (iii) For inferior goods the income effect of a price change more than offsets the substitution effect (iii)Demand curves can never slope upwards. (iv)For normal goods, a fall in the price of good B can never lead to an increase in consumption of good A. (v)If the price elasticity of demand (P/Q.Q/P) is minus 1, total spending (price times quantity) on the good will not change when its price changes. (vii)If the price elasticity of demand is less than -1 (P/Q.Q/P < 1) total spending (price times quantity) on the good will rise when price rises. (viii)Normal goods have income elasticities greater than one (ix)Inferior goods have income elasticities less than zero

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