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EC 111

CHAPTER 1
The Themes of Microeconomics
*microeconomics
-branch of economics that deals with the behavior of
individual economic units consumers, firms, workers, and
investors as well as the markets that these units comprise
*macroeconomics
-branch of economics that deals with aggregate
economic variables, such as the level and growth rate of
national output, interest rates, unemployment, and inflation.
Trade-offs
1. Consumers
-consumers have limited incomes, which can be
spent on a wide variety of goods and services, or saved for
the future
2. Workers
-workers also face constraints and make trade-offs.
First, people must decide whether and when to enter the
workforce. Second, workers face trade-offs in their choice of
employment. Finally, workers must sometimes decide how
many hours per week they wish to work, thereby trading off
labor for leisure
3. Firms
-firms also face limits in terms of the kinds of
products that they can produce, and the resources available
to produce them
Prices and Markets
-Microeconomics describes how prices are determined.
-In a centrally planned economy, prices are set by the
government.
-In a market economy, prices are determined by the
interactions of consumers, workers, and firms. These
interactions occur in markets collections of buyers and
sellers that together determine the price of a good
Theories and Models
-in economics, explanation and prediction are based
on theories.
*Theories
- developed to explain observed phenomena in
terms of a set of basic rules and assumptions.
*Model
-mathematical representation, based on economic
theory, of a firm, a market, or some other entity.
Positive versus Normative analysis
*Positive Analysis
-describing relationships of cause and effect
*Normative Analysis
-examining questions of what ought to be, not just
what you observe
What is a market?
-collection of buyers and sellers that, through their
actual or potential interactions, determine the price of a
product or set of products
*market definition
-determination of the buyers, sellers, and range of
products that should be included in a particular market.
*arbitrage
-practice of buying at a low price at one location and
selling it at a higher price in another.
-buy the goods when it is still cheap
Competitive versus Noncompetitive Markets
*perfectly competitive market
-market with many buyers and sellers, so that no
single buyer or seller has a significant impact on price
*many other markets are competitive enough to be treated
as if they were perfectly competitive
-ex. Globe and Smart (even though there are only 2
firms, they are still competitive; neither one can determine
the price in the market)
*noncompetitive markets
-individual firms can jointly affect price
*some markets contain many producers but are
noncompetitive
*market price
-price prevailing in a competitive market
*in markets that are not perfectly competitive, different firms
might charge different prices for the same product. This
might happen because one firm is trying to win customers
from its competitors, or because customers have brand
loyalties that allow some firms to charge higher prices than
other firms.
*the market prices of most goods will fluctuate over time
(sign of a competitive market), and for many goods the
fluctuations can be rapid. This is particulary true for goods
sold in competitive markets
-ex. gasoline
*extent of a market
-boundaries of a market, both geographical and in
terms of range of products produced and sold within it.
*For some goods, it makes sense to talk about a market only
in terms of very restrictive geographic boundaries
*We must also think carefully about the range of products to
include in a market
*Market definition is important for two reasons:
1. A company must understand who its actual and potential
competitors are for the various products that it sells or might
sell in the future
2. Market definition can be important for public policy
decisions
Real versus Nominal Prices
*nominal price
-absolute price of a good, unadjusted for inflation
*real price
-price of a good relative to an aggregate measure of
prices; price adjusted for inflation
-the kind of price usually looked at
*consumer price index
-measure of the aggregate price level
-tends to be larger than the producer price index
(because there are retail costs; the costs of bringing the
products to the market)
*producer price index
-measure of the aggregate price level for
intermediate products and wholesale goods



EX.
After correcting for inflation, do we find that the price of
butter was more expensive in 2010 than in 1970? To find out,
lets calculate the 2010 price of butter in terms of 1970
dollars. The CPI was 38.8 in 1970 and rose to about 218.1 in
2010. In 1970 dollars, the price of butter was
38.8/218.1 x $3.42(nominal price) = $0.61(real price)
In real terms, therefore, the price of butter was lower in 2010
than it was in 1970
CHAPTER 2: Basics of Supply and Demand

Supply and Demand
*supply-demand analysis is a fundamental and powerful tool
that can be applied to a wide variety of interesting and
important problems
*Supply curve
-relationship between the quantity of a good that
producers are willing to sell and the price of the good
*Supply curve
-shows how quantity of a good offered for sale
changes as the price of the good changes
-upward sloping
-the higher the price, the more firms are able and
willing to produce and sell (to cover up the cost)
*If production costs fall, firms can produce the same quantity
at a lower price or a larger quantity at the same price. The
supply curve then shifts to the right.
*Other factors that affect supply:
-production costs
-wages
-interest charges
-costs of raw materials
*When production costs decrease, output increases no
matter what the market price happens to be. The entire
supply curve shifts to the right

*Demand curve
-relationship between the quantity of a good that
consumers are willing to buy and the price of the good
-shows how the quantity of a good demanded by
consumers depends on its price
-downward sloping
-consumers will want to purchase more of a good as
its price goes down (lower price, higher purchasing power)
*Quantity demanded depends on:
-income (quantity demanded increases when
income rises)
-weather
-prices of other goods
*When your income increases, demand curve shifts to the
right
*substitute goods
-two goods for which an increase in the price of one
leads to an increase in the quantity demanded of the other
*complementary goods
-two goods for which an increase in the price of one
leads to a decrease in the quantity demanded of the other
Market Mechanism
*surplus (quantity supplied > quanitity demanded)
-price falls
-situation in which the quantity supplied exceeds the
quantity demanded
*shortage (quanitity supplied < quanitity demanded)
-price is bid up (consumers will say that they are
willing to buy a good at a higher price)
-quantity demanded exceeds quantity supplied
*equilibrium (market-clearing price)
- price that equates the quantity supplied to the
quantity demanded
*market mechanism
-tendency in a free market for price to change until
the market clears
Changes in market equilibrium
*lower costs result in lower prices and increased sales
*consumers disposable incomes change as the economy
grows
*the demands for some goods shift with the seasons, with
the changes in the prices of related goods, or simply with
changing tastes.
-supply and demand curve can be used to trace the
effects of these changes.
*rightward shifts of the supply and demand curves lead to a
slightly higher price and a much larger quantity.
-changes in price and quantity depend on the
amount by which each curve shifts and the shape of each
curve.

Elasticities of supply and demand
*demand for a good depends not only on its price, but also
on consumer income and on the price of other goods.
Likewise, supply depends both on price and on variables that
affect production cost.
*we want to know how much the quantity supplied or
demanded will rise or fall.
-we use elasticities
*Elasticity
-percentage change in one variable resulting from a
1-percent increase in a nother
-measures sensitivity of one variable to another
*Price elasticity of demand
-percentage change in quantity demanded of a good
resulting from a 1-percent increase in its price
-measures the sensitivity of quantity demanded to
price changes.
E
p
= (% Q) / (% P)
*percentage change in a variable is the absolute change in
the variable divided by the original level of the variable
E
p
= Q / Q = P Q
P / P Q P
*price elasticity of demand is usually a negative number
*when the price elasticity is greater than 1 in magnitude, we
say that demand is price elastic because the percentage
decline in quantity demanded is greater than the percentage
increase in price
*ir the price elasticity is less than 1 in magnitude, demand is
said to be price inelastic.
*the price elasticity of a demand for a good depends on the
availability of other goods that can be substituted for it.
*when there are close substitutes, a price increase will cause
the consumer to buy less of the good and more of the
substitute. Demand will then be highly price elastic. When
there are no close substitutes, demand will tend to be price
inelastic
*linear demand curve
-demand curve that is a straight line
-as we move down the demand curve, Q / P
may change, and the price and quantity will always change.
Therefore, the price elasticity of demand must be measured
at a particular point on the demand curve and will generally
change as we move along the curve
Q = a bP
*the steeper the slope of the curve, the less elastic is demand
*infinitely elastic demand
-principle that consumers will buy as much of a good
as they can get at a single price, but for any higher price the
quantity demanded drops to zero, while for any lower price
the quantity demanded increases without limit
*completely inelastic demand
-principle that consumers will buy a fixed quantity of
a good regardless of its price
*income elasticity of demand
-percentage change in the quantity demanded
resulting from a 1-percent increase in income
-demands for most goods usually rises when
aggregate income rises
E
I
= Q / Q = I Q
I / I Q I
*cross-price elasticity of demand
-percentage change in the quantity demanded of
one good resulting from a 1-percent increase in the price of
another
-demand for some goods is affected by the prices of
other goods. Ex: because butter and margarine can be easily
substituted for each other, the demand for each depends on
the price of the other.
E
Qb Pm
= Q
b
/ Q
b
= P
m
Q
b
P
m
/ P
m
Q
b
P
m

Q
b
quantity of butter
P
m
price of margarine
*in this example, cross-price of elasticites will be positive
because the goods are substitutes. Because they compete in
the market, a rise in the price of margarine, which makes
butter cheaper relative to margarine, leads to an increase in
the quantity of butter demanded. (Because demand curve for
butter will shift to the right, the price of butter will rise)
*Some goods are complements. Because they tend to be
used together, an increase in the price of one tends to push
down the consumption of the other.
*price elasticity of supply
-percentage change in quantity supplied resulting
from a 1-percent increase in price
-usually positive because a higher price gives
producers an incentive to increase output
*point elasticities
-elasticities as a particular point on the demand
curve or the supply curve
*point elasticity of demand
-price elasticity at a particular point on the demand
curve
*arc elasticity of demand
-price elasticity calculated over a range of prices
-Arc elasticity: E
p
= ( Q / P) (P / Q)
-rather than choose either the initial or the final
price, we use an average of the two, P. For the quantity
demanded, we use Q
Short-run versus long-run elasticities
*demand is much more price elastic in the long run than in
the short run.
-it takes time for people to change their
consumption habits
-the demand for a good might be linked to the stock
of another good that changes only slowly.
Demand and durability
-a small change in the total stock that consumers
want to hold can result in a large percentage change in the
level of purchases.
Income elasticities
-the income elasticity of demand is larger in the long
run than in the short run
-the long run elasticity will be larger than the short
run elasticity
-for a durable good, the opposite is true.
-the short run income elasticity of demand will be
much larger than the long run elasticity.
Cyclical industries
-industries in which sales tend to magnify cyclical
changes in gross domestic product and national income
-the durable goods series tends to magnify changes
in GDP
*For most products, long run supply is much more price
elastic than short run supply
*For some goods and services, short run supply is completely
inelastic
-rental housing
-in the very short run, there is only a fixed number of
rental units. Thus an increase in demand only pushes rents
up. In the longer run, and without rent controls, higher rents
provide an incentive to renovate existing buildings and
construct new ones. As a result, the quantity supplied
increases.
Supply and durability
-for some goods, supply is more elastic in the short
run than in the long run
-the long run price elasticity of secondary supply is
smaller than the short run elasticity
Understanding and predicting the effects of changing market
conditions

Demand: Q = a - bP (2.5a)
Supply: Q = c + dP (2.5b)
*Step 1: Recall that each price elasticity, whether of supply or
demand can be written as
E = (P/Q)( Q/ P)
Where change of Q/change of P is the change in quantity
demanded or supplied resulting from a small change in price.
*change of Q/change of P=d for supply
change of Q/change of P=-b for demand
*substitute the values for change of Q/change of P into the
elasticity formula:
Demand: E
D
= -b(P*/Q*) (2.6a)
Supply: E
S
= d(P*/Q*) (2.6b)
*because we have numbers for E
S
, E
D
, P* and Q*, we can
substitute these numbers in equations (2.6a) and(2.6b) and
solve for b and d
*Step 2: Since we know b and d, we can substitute these
numbers, as well as P* and Q*, into equations (2.5a) and
(2.5b) and solve for the remaining constants a and c. We can
rewrite (2.5a) as
a = Q* + bP*
and then use our data for Q* and P*, together with the
number we calculated in step 1 for b, to obtain a.
EX.
Quantity Q* = 12 million metric tons per year
Price P* = $2.00 per pound
Elasticity of supply E
S
= 1.5
Elasticity of demand E
D
= - 0.5
(the price of copper has fluctutated during the past few
decades between $0.6 and more than $3.50, but $2.00 is a
reasonable average price)
We begin with the supply curve equation (2.5b) and use our
two-step-procedure to calculate numbers for c and d. The
long run price elasticity of supply is 1.5, P* = $2.00 and Q* =
12
*Step 1: Substitute these numbers in equation (2.6b) to
determine d:
1.5 = d(2/12) = d/6
So that d = (1.5)(6) = 9
*Step 2: Substitute this number for d, together with the
numbers for P* andQ*, into equation (2.5b) to determine c:
12 = c + (9)(2.00) = c + 18
So that c = 12 18 = -6. We now know c and d, so we can
write our supply curve:
Supply: Q = -6 + 9P
We can now follow the same steps for the demand curve
equation (2.5a). an estimate for the long run elasticity of
demand is -0.5. First, substitute this number, as well as the
values for P* and Q*, into equation (2.6a) to determine b:
-0.5 = -b(2/12) = -b/6
So that b = (0.5)(6) = 3. Second, substitute this value for b and
the values for P* and Q* in equation (2.5a) to determine a:
12 = a (3)(2) = a 6
So that a = 12 + 6 = 18. Thus, our demand curve is
Demand: Q = 18 3P
To check that we have not made a mistake, lets set the
quantity supplied equal to the quantity demand and calculate
the resulting equilibrium price:
Supply = -6 + 9P = 18 3P = Demand
9P + 3P = 18 + 6
P = 24/12 = 2.00 (which is the equilibrium
price with which we
began)
*Demand might depend on income as well as price. We
would then write demand as
Q = a bP + fI
Where I is an index of aggregate income or GDP
Effects of government intervention price controls

*P
0
and Q
0
are the equilibrium price and quantity that would
prevail without government regulation. The government
however has decided that P
0
is too high and mandated that
the price can be no higher than the ceiling price, denoted by
P
max

*at this lower price, producers will produce less, and the
quantity supplied will drop to Q
1

*consumers on the other hand, will demand more at this
lower price; they would purchase the quantity Q
2

*demand therefore exceeds supply, and a shortage develops
(there is excess demand)
*amount of excess demand is Q
2
Q
1


SUMMARY
1. supply-demand analysis is a basic tool of microeconomics.
In competitive markets, supply and demand curves tell us
how much will be produced by firms and how much will be
demanded by consumers as a function of price
2. The market mechanism is the tendency for supply and
demand to equilibrate so that there is neither execess
demand nor excess supply
3. Elasticities describe the responsiveness of supply and
demand to changes in price, income, or other variables
4. Elasticities pertain to a time frame, and for most goods it is
important to distinguish between short run and long run
elasticities
5. If we can estimate, at least roughly, the supply and
demand curves for a particular market, we can calculate the
market-clearing price by equating the quantity supplied with
the quantity demanded. Also, if we know how supply and
demand depend on other economic variables, such as income
or the prices of other goods, we can calculate how the
market-clearing price and quantity will change as these other
variables change. This is a means of explaining or predicting
market behavior
6. Simple numerical analyses can often be done by fitting
linear supply and demand curves to data on price and
quantity and to estimates of elasticities. For many markets,
such data and estimates are available, and simple back of the
envelope calculations can help us understand the
characteristics and behavior of the market
CHAPTER 3: Consumer Behavior
*theory of consumer behavior
-the explanation of how consumers allocate incomes
to the purchase of different goods and services
Consumer behavior
Consumer behavior is best understood in three distinct steps:
1. Consumer Preferences
-find a practical way to describe the reasons people
might prefer one good to another
2. Budget Constraints
- consumers also consider prices
- we take into account the fact that consumers have
limited incomes which restrict the quantities of goods they
can buy
3. Consumer Choices
-consumers choose to buy combinations of goods
that maximize their satisfaction.
- these combinations will depend on the prices of
various goods
Consumer Preferences
*market baskets
-list with specific quantities of one or more goods

*because the method of measurement is largely arbitrary,
we will simply describe the items in a market basket in terms
of the total number of units of each commodity
*we will ask whether consumers prefer one market basket to
another
*some basic assumptions about preferences:
1. Completeness preferences are assumed to be
complete. Consumers can compare and rank all
possible baskets. These preferences ignore costs

2. Transitivity preferences are transitive.
transitivity means that if a consumer prefers
basket A to basket B and basket B to basket C,
then the consumer also prefers A to C. Transitivity
is normally regarded as necessary for consumer
consistency
3. More is better than less goods are assumed to
be desirable. Consumers always prefer more of any
good to less. Consumers are never satisfied or
satiated; more is always better even if just a little
better.
4. Diminishing marginal rate of substitution -
indifference curves are usually convex, or bowed
inward. The term convex means that the slop of
the indifference curve increases as we move down
along the curve. The indifference curve is convex if
the MRS diminishes along the curve

*indifference curve
-curve representing all combinations of market
baskets that provide a consumer with the same level of
satisfaction

*market basket A is preferred to basket G because A
contains more food and more clothing (more is better than
less)
*market basket E, which contains even more food and even
more clothing, is preffered to A.
*comparisons of market basket A with baskets B, D, and H are
not possible without more information about the consumers
ranking.

*this curve indicates that the consumer is indifferent among
these three market baskets. It tells us that in moving from
market basket A to maket basket B, the consumer feels
neither better nor worse off in giving up 10 units of food to
obtain 20 additional units of clothing.
*indifference curve slopes downward from left to right.
Suppose instead that it sloped upward from A to E. This
would violate the assumptions that more of any commodity is
preferred to less.
*any market basket lying above and to the right of
indifference curve U
1
is preffered to any market basket on U
1
*Indifference maps
-graph containing a set of indifference curves
showing the market baskets among which a consumer is
indifferent
*indifference curves cannot intersect

*there are an infinite number of nonintersecting indifference
curves, one for every possible level of satisfaction
*every possible market basket has an indifference curve
passing through it

*the shape of an indifference curve describes how a
consumer is willing to substitute one good for another
*starting at market basket A and moving to basket B, we see
that the consumer is willing to give up 6 units of clothing to
obtain 1 extra unit of food.
*the more clothing and the less food a person consumes, the
more clothing he will give up in order to obtain more food.
Similarly, the more food a person possesses, the less clothing
he will give up for more food
*marginal rate of substitution (MRS)
-maximum amount of a good that a consumer is
willing to give up in order to obtain one additional unit of
another good
-measures the value that the individual places on 1
extra unit of a good in terms of another
- can be written as: - C/ F ( we add the negative
sign to make the marginal rate of substitution a positive
number)
*as we move down the indifference curve in figure 3.5 and
consumption of food increases, the additional satisfaction
that a consumer gets from still more food will diminish. Thus,
he will give up less and less clothing to obtain additional food.
*consumers generally prefer balanced market baskets to
market baskets that contain all of one good and none of
another. (it will generate a higher level of satisfaction)
*an indifference curve with a different shape implies a
different willingness to substitute
*perfect substitutes
-two goods for which the marginal rate of
substitution of one for the other is constant
*perfect complements
- two goods for which the MRS is zero or infinite; the
indifference curves are shaped as right angles
*bad good for which less is preferred rather than more
- ex. air pollution
*utility numerical score representing the satisfaction that a
consumer gets from a given market basket
- device used to simplify the ranking of baskets
*utility function
-formula that assigns a level of utility to individual
market baskets
*numbers attached to the indifference curves are for
convenience only

*utility function is simply a way of ranking different market
baskets; the magnitude of the utility difference between any
two market baskets does not really tell us anything.
*ordinal utility function
-utility function that generates a ranking of market
baskets in order of most to least preferred.
*cardinal utility function
-utility function describing by how much one market
basket is preferred to another
Budget Constraints
-constraints that consumers face as a result of
limited incomes
*budget line
-all combinations of goods for which the total
amount of money spent is equal to income



*the intercept of the budget line is represented by basket A.
As our consumer moves along the line from basket A to
basket G, she spends less on clothing and more on food.
*the slope of the line, change of C/change of F = -1/2
measures the relative cost of food and clothing
*C (I/P
C
) (P
F
/P
C
) F
*The slope of the budget line, -(P
F
/P
C
) is the negative of the
ratio of the prices of the two goods.
*the magnitude of the slope tells us the rate at which the two
goods can be substituted for each other without changing the
total amount of money spent.

*what happens to the budget line when income changes?
-a change in income alters the vertical intercept of
the budget line but does not change the slope
*what happens to the budget line if the price of one good
changes but the price of the other does not?
-we can use the equation C = (I/P
C
) (P
F
/ P
C
) to
describe the effects of a change in the price of food on the
budget line.

*what happens if the prices of both food and clothing change,
but in a way that leaves the ratio of the two prices
unchanged?
-because the slope of the budget line is equal to the
ratio of the two prices, the slope will remain the same.
-the intercept of the budget must shift so that the
new line is parallel to the old one.
-ex: if the prices of both goods fall by half, then the
slope of the budget line does not change. However, both
intercepts double, and the budget line is shifted outward
*purchasing power is determined not only by income, but
also by prices
*inflationary conditions in which all prices and income levels
rise proportionately will not affect the consumers budget
line or purchasing power
Consumer Choice
*maximizing market basket must satisfy two conditions:
. 1. It must be located on the budget line
-any market basket to the left of and below the
budget line leaves some income unallocated income which,
if spent, could increase the consumers satisfaction.
-any market basket to the right of and above the
budget line cannot be purchased with available income.
-Thus, the only rational and feasible choice is a
basket on the budget line.
2. It must give the consumer the most preferred combination
of goods and services
*these two conditions reduce the problem of maximizing
consumer satisfaction to one of picking an appropriate point
on the budget line.

*the basket which maximizes satisfaction must lie on the
highest indifference curve that touches the budget line
*satisfaction is maximized (given the budget constraint) at
the point where
MRS = P
F
/ P
C

*satisfaction is maximized when the marginal rate of
substitution (of F for C) is equal to the ratio of the prices (of F
to C) Thus the consumer can obtain maximum satisfaction by
adjusting his consumption of goods F and C so that the MRS
equals the price ratio
*marginal benefit
-benefit from the consumption of one additional unit
of a good
*marginal cost
-cost of one additional unit of a good
*satisfaction is maximized when the marginal benefit is equal
to the marginal cost.
*the marginal benefit is measured by the MRS.
*If the MRS is less or greater than the price ratio, the
consumers satisfaction has not been maximized
*corner solution
-situation in which the marginal rate of substitution
of one good for another in a chosen market basket is not
equal to the slope of the budget line
*when a corner solution arises, the consumers MRS does not
necessarily equal the price ratio

Revealed Preference
*if a consumer chooses one market basket over another, and
if the chosen market basket is more expensive than the
alternative, then the consumer must prefer the chosen
market basket

Marginal Utility and Consumer Choice
*Marginal utility
-additional satisfaction obtained from consuming
one additional unit of a good
*diminishing marginal utility
-principle that as more of a good is consumed, the
consumption of additional amounts will yield smaller
additions to utility
EX. The additional consumption of food, F, will generate
marginal utility MU
F
. This shift results in a total increase in
utility of MU
F
F. At the same time, the reduced
consumption of clothing, C, will lower utility per unit by
MU
C
, resulting in a total loss of MU
C
C.
Because all points on an indifference curve generate the
same level of utility, the total gain in utility associated with
the increase in F must balance the loss due to the lower
consumption of C
0 = MU
F
( F) + MU
C
( C)
Now we can rearrange this equation so that
-(deltaC/deltaF) = MU
F
/MU
C

But because (deltaC/deltaF) is the MRS of F for C, it follows
that
MRS = MU
F
/MU
C

When consumers maximize their satisfaction, the MRS of F
for C is equal to the ratio of the prices of the two goods
MRS = P
F
/P
C
Because the MRS is also equal to the ratio of the marginal
utilities of consuming F and C, it follows that
MU
F
/MU
C
= P
F
/P
C
or MU
F
/P
F
= MU
C
/P
C

*utility maximization is achieved when the budget is allocated
so that the marginal utility per dollar of expenditure is the
same for each good
*equal marginal principle
-principle that utility is maximized when the
consumer has equalized the marginal utility per dollar of
expenditure across all goods
*only when the consumer has satisfied the equal marginal
principle will she have maximized utility
Cost-of-living indexes
*cost-of-living index
-ratio of the present cost of a typical bundle of
consumer goods and services compared with the cost during
a base period
EX. When Sarah began her college education in 1995, her
parents gave her a discretionary budget of $500 per quarter.
Sarah could spend the money on food, which was available at
a price of $2.00 per pound, and on books, which were
available at a price of $20 each. Sarah bought 100 pounds of
food (at a cost of #200) and 15 books (at a cost of $300). Ten
years, later, in 2005, when Rachel is about to start college,
her parents promise her a budget that is equivalent in buying
power to the budget given to her older sister. Unfortunately,
prices in the college have increase, food now $2.20 per pound
and books $100 each. By how much should the discretionary
budget be increased to make Rachel as well off in 2005 as her
sister Sarah was in 1995?





*the initial budget constraint facing Sarah in 1995 is given by
line L
1
in figure 3.23; her utility-maximizing combination of
food and books is at point A on indifference curve U
1
. We can
check that the cost of achieving this level of utility is $500, as
stated in the table:
%500 = 100lbs. Of food x $2.00/lb. + 15 books x
$20/book
*to achieve the same level of utility as Sarah while facing the
new higher prices, Rachel requires a budget sufficient to
purchase the food-book consumption bundle given by point B
on line L
2
, where she chooses 300 lbs. Of food and 6 books.
*the cost to Rachel of attaining the same level of utility as
Sarah is given by
$1260 = 300 lbs of food x $2.20/lb + 6 books x
$100/book
*the ideal cost of living adjustment for Rachel is therefore
$760 (which is $1260 minus the $500 that was given to Sarah)
The ideal cost of living index is
$1260/$500 = 2.52
*our index needs a base year, which we will set at 1995 =
100, so that the value of the index in 2005 is 252.
*ideal cost of living index
-cost of attaining a given level of utility at current
prices relative to the cost of attaining the same utility at base-
year prices


*Laspeyres price index
-amount of money at current year prices that an
individual requires to purchase a bundle of goods and
services chosen in a base year divided by the cost of
purchasing the same bundle at base-year prices
*laspeyres price index was illustrated in figure 3.23. buying
100 pounds of food and 15 books in 2005 would require an
expenditure of $1720 (100 x $2.20 + 15 x $100) this
expenditure allows Rachel to choose bundle A on budget line
L
3
(or any other bundle on that line)
*line L
3
was constructed by shifting line L
2
outward until it
intersected point A.
*line L
3
is the budget line that allows Rachel to purchase, at
current 2005 prices, the same consumption bundle that her
sister purchased in 1995.
*To compensate Rachel for the increased cost of living, we
must increase her discretionary budget by $1220. Using 100
as the base in 1995, the Laspeyres index is therefore
100 x $1720 / $500 = 344
*Laspeyres index is much higher than the ideal price index
*The Laspeyres index always overstate the true cost of living
index.
*The Laspeyres price index assumes that consumers do not
alter their consumption patterns as prices change.
*Paasche index
-amount of money at current-year prices that an
individual requires to purchase a current bundle of goods and
services divided by the cost of purchasing the same bundle in
a base year
-focuses on the cost of buying the current years
bundle
*fixed-weight index
-cost of living index in which the quantities of goods
and services remain unchanged
-Laspeyres and Paasche indexes are fixed-weight
-for the Laspeyres index, the quantities remain
unchanged at base-year levels
-for the Paasche they remain unchanged at current-
year levels


EX. Suppose that there are two goods, food (F) and clothing
(C) Let:
P
Ft
and P
Ct
be current-year prices
P
Fb
and P
Cb
be base-year prices
F
t
and C
t
are current year quantities
F
b
and C
b
be base year quantities
We can write the two indexes as:
LI = P
Ft
F
b
+ P
Ct
C
b
P
Fb
+ P
Cb
C
b

PI = P
Ft
F
t
+ P
Ct
C
t

P
Fb
F
t
+ P
Cb
C
t

*the Paasche index will understate the Laspeyres because it
assumes that the individual will buy the current year bundle
in the base period.
*chain-weighted price index
-cost of living index that accounts for changes in
quantities of goods and services
CHAPTER 4: INDIVIDUAL AND MARKET DEMAND
Individual Demand
Price changes

*the price of food is $1, the price of clothing $2, and the
consumers income is $20. The utility-maximizing
consumption choice is at point B. The consumer buys 12 units
of food and 4 units of clothing, thus achieving the level of
utility associated with the indifference curve U
2

*the higher relative price of food has increased the
magnitude of the slope of the budget line. The consumer now
achieves maximum utility at A, which is found on a lower
indifference curve, U
1
. (Because price of food has risen, the
consumers purchasing power and thus attainable utility has
fallen)
The individual demand curve
*price-consumption curve
-tracing the utility-maximizing combinations of two
goods as the price of one chaanges
-as the price of food falls, attainable utility increases
and the consumer buys more food
*individual demand curve
-relating the quantity of a good that a single
consumer will buy to its price
-two important properties:
(1) the level of utility that can be attained
changes as we move along the curve (the
lower the price of the product, the higher
the level of utility)
(2) at every point on the demand curve, the
consumer is maximizing utility by satisfying
the condition that the MRS of food for
clothing equals the ratio of the prices of
food and clothing (because consumer is
maximizing utility, the MRS of food for
clothing decreases as we move down the
demand curve) (relative value of food falls
as the consumer buys more of it)
Income changes
*income-consumption curve
-traces out the utility-maximizing combinations of
food and clothing associated with every income level
-the consumption of both food and clothing
increases as income increases thats why income-comsuption
curve in figure 4.2 slopes upward


Normal vs. Inferior goods
*normal goods
-when income-consumption curve has a positive
slope, the quantity demanded increases with income. As a
result, the income elasticity of demand is positive. The
greater the shifts to the right of the demand curve, the larger
the income elasticity
-consumers want to buy more of the goods as their
incomes increase
*inferior goods
-the quantity demanded falls as income increases;
the income elasticity of demand is negative
-consumption falls when income rises
-e.g. hamburger. As their income increases, they buy
less hamburger and more steak.
*for relatively low levels of income, both hamburger and
steak are normal goods. As income rises, however, the
income-consumption curve bends backward. (occurs because
hamburger has become an inferior good)



Engel Curves
-curve relating the quantity of a good consumed to
income
-income-consumption curves can be used to
construct engel curves

*In (a), food is a normal good and the engel curve is upward
sloping. In (b), however, hamburger is a normal good for
income less than $20 per month and an inferior good for
income greater than $20 per month
*the portion of the engel curve that slopes downward is the
income range within which hamburger is an inferior good
Substitutes and complements
*substitutes
-increase in the price of one leads to an increase in
the quantity demanded of the other
*complements
-increase in the price of one good leads to a
decrease in the quantity demanded of the other


Income and substitution effects
*a fall in the price of a good has two effects:
(1) consumers will tend to buy more of the good that has
become cheaper and less of those goods that are now
relatively more expensive (SUBSTITUTION EFFECT)
(2) because one of the goods is now cheaper, consumers
enjoy an increase in real purchasing power (INCOME EFFECT)
-they can buy the same amount of good for less
money, and thus have money left over for additional
purchases

Substitution effect
-change in consumption of a good associated with a
change in its price, with the level of utility held constant
-captures the change in food consumption that
occurs as a result of the price changes that makes food
relatively cheaper than clothing
*substitution effect can be obtained by drawing a budget line
which is parallel to the new budget line RT, but which is
tangent to the original indifference curve U
1
(holding level of
satisfaction constant)
*the point that maximizes satisfaction on the new imaginary
budget line parallel to RT must lie below and to the right of
the original point of tangency
Income effect
-change in consumption of a good resulting from an
increase in purchasing power, with relative prices held
constant
*the increase in food consumption from OE to OF
2
is the
measure of the income effect, which is positive, because food
is a normal good (consumers will buy more of it as their
incomes increase)
Total effect (F
1
F
2
) = Substitution effect (F
1
E) +
Income effect (EF
2
)
*direction fo the substitution effect is always the same: a
decline in price leads to an increase in consumption of the
good (income effect can move demand in either direction,
depending on whether the good is normal or inferior)

*a good is inferior when the income effect is negative: as
income rises, consumption falls
The Giffen good
-good whose demand curve slopes upward because
the (negative) income effect is larger than the substitution
effect
-income effect may be large enough to cause the
demand curve for a good to slope upward
*the giffen good is rarely of practical interest because it
requires a large negative income effect

Market Demand
*market demand curve
-curve relating the quantity of a good that all
consumers in a market will buy to its price
-horizontal summation of the demands of each
consumer
From individual to market demand



(1) The market demand curve will shift to the right as
more consumers enter the market
(2) Factors that influence the demands of many
consumers will also affect market demand
Elasticity of demand
*price elasticity of demand:
E
p
= change in Q/Q = (P/Q)(change in Q/change in P)
change in P/P
*inelastic demand
-E
p
is less than 1 in absolute value
-quantity demanded is unresponsive to changes in
price
-total expenditure on the product increases when
the price increases
*elastic demand
-E
p
is greater than 1
-total expenditure on the product decreases as the
price goes up
*isoelastic demand
-demand curve with a constant price elasticity
-although the slope of the linear curve is constant,
the price elasticity of demand is not
*unit-elastic demand curve (special case of isoelastic curve)
-demand curve with price elasticity always equal to
-1





*when demand is inelastic, a price increase leads only to a
small decrease in quantity demanded; thus, the sellers total
revenue increases. But when demand is inelastic, a price
increase leads to a large decline in quantity demand and total
revenue falls
Consumer Surplus
-difference between what a consumer is willing to
pay for a good and the amount actually paid
-measures how much better off individuals are, in
the aggregate, because they can buy goods in the market
Consumer surplus and demand

*student is indifferent about purchasing the seventh ticket
(which generates zero surplus) and prefers not to buy any
more than that because the value of each additional ticket is
less than its cost
*consumer surplus
-adding the excess values or surpluses for all units
purchased
$6 + $5 + $4 + $3 + $2 + $1 = $21
*to calculate the aggregate surplus in the market, we find the
area below the market demand curve and above the price
line

*actual expenditure on tickets is 6500 x $14 = $91,000
*consumer surplus, shown as the yellow-shaded triangle is
1/2 x ($20 - $14) x 6500 = $19,500 (total benefit to
consumers, less what they paid for the tickets)
Network externalities
*for some goods, one persons demand also depends on the
demands of other people
-a persons demand may be affected by the number
of other people who have purchased the good.
*network externality
-situation in which each individuals demand
depends on the purchases of other individuals
-can be positive or negative
The bandwagon effect
-example of positive network externality
-a consumer wishes to possess a good in part
because others do
*the more people consumers believe to have bought the
good, the farther to the right the demand curve shifts
*the greater the number of people who own a particular
good, the greater the intrinsic value of that good to each
owner
The Snob effect
-negative network externality in which a consumer
wishes to own an exclusive or unique good
-quantity demanded of a snob good is higher the
fewer people who own it
-rare works of art, sports cars, etc.