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Chapter 5

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ECON 212
Arthur E Stewart

Chapter 5: Optimal Choice and Demand Optimal Choice and Demand (138-158) The Effects of a Change in Price Looking at an Optimal Choice Diagram  Saw before that a decrease in the price of one good increases a consumer’s consumption possibilities by seeing a rotation outwards of the BL  and opposite for increase in price  One way to describe how changes in the price of one good affect the consumer’s purchases of both goods is to draw a curve connecting all of the baskets that are optimal o This is called the Price Consumption Curve Changing Price: Moving Along the Demand Curve  New change in price for good x means new quantity demanded  We can use these baskets to create an individual demand curve for the consumer  A decrease in price leads the consumer down and to the right along the demand curve The Demand Curve is also a “Willingness to Pay”  When you have a lot of x, the consumer is willing to give up a lot of it to get y o This is the MRS and it is different at every point in the demand curve  So a consumer’s willingness to pay for an additional unit of y falls as they buy more and more of the good y The Effects of Changing Income  Saw already that a change in income leads to a parallel shift in the budget line which leads the consumer to buy different bundles depending on income  Like above, we can connect these new optimal bundles  income consumption curve Changing Income: Shifting the Demand Curve  The price of both goods are held constant but you have more money to spend on it  Price constant, quantity demanded at that price increases  demand curve shifts left Engel Curves  This is a graph relating the amount of the good consumed to the level of income  Easy way to determine if a consumer considers the good to be normal or inferior o If increases to right  normal; if decreases to right  inferior  If a good is normal, its income elasticity of demand is positive (like stated before) The Effects of a Change in Price or Income: An Algebraic Approach  Refer to in class notes, this part of the book is only examples Change in the Price of a Good: Substitution and Income Effects  The substitution effect is the change in the amount of a good that would be consumed as the price of that good changes, holding other prices and utility constant  The income effect is the change in the amount of a good that a consumer would buy as purchasing power changes, holding all prices constant The Substitution Effect  This is the amount of addition units of the good the consumer would buy in order to stay on the same level of utility  Step 1: Find the initial basket using the initial BL and ICoptimization problem  Step 2: Find the final basket using the new BL and IC  optimization problem  Step 3: Find a budget line that is parallel to the final BL but is tangent to the initial IC  The substitution effect can be shown by taking the quantity of x purchased in step 3 and subtracting the quantity of x purchased in step 1 The Income Effect  Th
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