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ECON 101 Lecture Notes

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University of Waterloo
ECON 101
Eva Lau

What is Economics? September-11-12 1:00 PM Economic Problems 1. Employment 2. Scarcity (natural resources like oil and land) 3. Pollution 4. Starvation 5. Not having enough time 6. Money Problems 7. GovernmentDeficit 8. Housing 9. Debt Sample economic problems - Not having enough money to live comfortably - Having to pay too much taxes - Having difficulty in choosing the best academic plan - Unable to find a good job - Unemploymentand inflation The Commonality of your economic problems list: - Do you see that SCARCITY Is the commonalityof all your listed economicproblems? - Scarcity is related to human wants. Earn more money,spend less, or do both. Economicsis about matching unlimited wants to limited resources. - The market will allocate the scarce resources that will help to satisfy your wants. - If we all have unlimited resources: we are free to mess up one lake, one ocean and move on to others. Who cares about being unemployed? Normative and Positive Economics, Opportunity Cost, and the Production-Possibilities Curve September-13-12 1:00 PM Normative & Positive Economics - Normativeeconomics -> based on opinions - Positiveeconomics -> factual info -> allows you to make personal judgment Scarcity and Human Wants - Scarcity is not an independent problem. It is relative to human wants. The Market - Can you link your definition of economicsto the market? - In a market,there is the supply side and demand side. Choices and Scarcity - If you cannot have it all, you will need to make smart choices. - The reason that smart choices have to be made is because of the scarcity issue. - If we can relive our life over and over again with no consequences, we may not need to make careful choices. How Much Does it Really Cost? - Opportunitycost: value of the best forgone alternativeto any decision (trade-off; if you have A, you can't have B) - All actions carry opportunity costs. Opportunity costs are true economiccosts. - The cost associatedwith what you must give up to get something. - The best alternative doesn't have to be just 1 thing. - Different for everyone(e.g. eating a hamburger when you're fat and getting a heart attack (life = opportunity cost)) - Opportunity Cost lecture note (Sept. 13, 2012): 1. Opportunity cost of any action is measured by the best alternative(s)forgone. 2. Benefits foregoneis considered as an opportunity cost. 3. Opportunity cost is NOT all the possible alternatives foregone. It can be a compositecost. 4. Opportunity cost is different for everyone. 5. We can use opportunity cost to measure the value of intangibles; i.e. time saved in $ value, value of life. Total vs. Marginal Value - People sometimesmake bad decisions because they confuse the total concept with the marginal concept. - Sunk costs -> can't get back - If the Canadian Governmentundertakes a public project in Canada where total benefits exceed total cost, then, do you think that a) economicsurplus in Canada is positiveor do you think b) economic surplus in Canada is rising? a) No, we don't know what happened before. Maybe there was a deficit. Do we take this extra project or not? Taking this project means that the profit will be even higher. We are climbing out of the "hole." - 4 kinds of costs: marginal cost, total cost, opportunity cost, sunk cost - You will not incur or calculate the sunk costs. It has no relevance to your decisions. As a result, you just compare the marginal cost of this additional decision with the marginal benefit. How Clean is Clean? (Example of marginal analysis) - When it comesto cleaning up the environment,marginal analysis points out that it might not be efficient to try to ensure that the last bottle cap or the last gum wrap is removedfrom the water. - The conclusion: continue the action when MB > MC, cut back when MB < MC, stop at the point where MB = MC (MB = marginal benefit, MC = marginal cost). Thus, moreis not necessarily better. Production PossibilitiesCurve Production PossibilitiesCurve - The Production PossibilitiesFrontier (Curve) - PPC: our first economicmodel (map) - Assumptions: 1. Fixed amount of Input 2. The Input can be used to produce X and/or Y 3. Fixed production technology 4. Efficient use of Inputs - Example: 1 acre, 1 year's time x x x x x y y y y y Qy 10y F 9y M 5y 1x 5x 10x Qx - The slope somewhatrepresents the opportunity cost. 10y Δy A Δx B Δy ↓ 9x 10x Δx Thus, X is more costly to get. Outputs: finished product Inputs: required to produce outputs Straight slope for PPC -> easily switch to producing 1 product to the other Heavy prices to pay -> slope for PPC will not be straight Production-Possibilities Curve, Absolute Advantage, & Comparative Advantage September-18-12 1:00 PM - PPC represents the supply side of the market. - Linear slope/straightline = opportunity cost is constant - Slope/ratio is always negative -> giving up something - Anything that isn't efficient won't be on the PPC - In a society,only on PPC if the best resources are being utilized first. Efficiency -> you can do better 1. Straight line PPC indicates constant trade-off between good X and good Y implies that the input(s) in question is equally suitable in the production and/or Y. A bowed shape PPC implies that inputs are not equally productive in X and/or Y. 2. The slope of the PPC is called the marginal rate of transformationor MRT which measures what is given up vs what you get. It measures trade-offs. It measures the opportunity cost of X for Y, or vice versa. It measures production substitution rate. 3. Points on the PPC represents attainable production alternatives 4. When we are producing along the PPC, we have exhausted all inputs, hence full employment. 5. Any point inside the PPC represents the existence of unemployed inputs. 6. The PPC represents the supply side of the market. - Diagram (p.46) - Assumptions: 1. Fixed amount of input 2. The input can be used to produce X and/or Y 3. Fixed production technology 4. Efficient use of inputs Absolute Advantage & Comparative Advantage When you can produce more than someoneelse with a given unit of resource, you have an absolute advantage. Crusoe 1 is a better fisherman than Crusoe 2. Crusoe 2 is a better coconut harvest than Crusoe 1. (PPCs don't have to be straight lines.) Crusoe 2 has absolute advantage in getting coconutswhile Crusoe 1 has absolute advantage in getting fish. Coconuts C2 2 C1 1 F2 F1 Fishes • Who is richer? • The word "richer" needs to be defined • Distinguished positive economicsfrom normativeeconomics. ○ Normativeeconomicsdeals with norms, values, opinions, preferences, likes & dislikes, etc. ○ Positiveeconomicsdeals with facts, reasons, and evidence. - USA -> 100 cars or 1000 bananas - BR -> 1 car or 40 bananas USA Cars BR 40 1000 Bananas - USA has a comparativeadvantage in cars. BR has a comparativeadvantage in bananas. - If opportunity cost is the same, trade won't happen. Lectures Page 4 - There are apple and pear trees in a wild orchard. In an 8-hour work day, John can harvest either 10 apples OR 10 pears. Mary can harvest either 5 apples OR 20 pears. Assume constant MRT for the PPC unless-specified otherwise. Draw a PPC diagram when John and Mary are married and wish to produce as an efficient joint unit. (one curve only!) 15 14 10 10 30 Pears MRT (-) Apples Pears Mary -1 4 -2 8 . . -3 20 John -1 +1 . . . . -10 +10 Lectures Page 5 Chapter 3: Demand & Supply September-18-12 1:00 PM - * In the market, there is a demand and supply side. In a marketplace, there is a market price. In a legitimatemarket, the market price is the same for everyone. Price discriminationis not allowed. Demand alone, or supply alone, cannot determine the price. The interaction between demand & supply willbe able to determine the price. - Demand Curve: Unit Px G 0 1 2 3 4 Qx - What else is important besides demand and supply? Quality, brand, utility, style, quantity, how much we need it, income,time/season,etc. - What determines the quantity? Religion, law, etc. - If there are substitutes for a product/service,there will be competition. Px $10 Qx - Income effect - Law of demand, anything that affects your quantity, shift it --------------------------------------------------------------------------------------------------------------------------------------- September 20, 2012 1:00 PM Quiz - Suppose you were told that the quantity demanded for single family dwellings in Toronto had gone up by 80% in the last 2 years, what would happen to the market price for housing? *Not enough informationto determine the market price. The interaction between demand and supply will determine the market price. Only the demand informationis given. Demand Curve - Price changes cause QD to change. - Px goes up, QD goes down - Px goes down, QD goes up - Doesn't have to be a parallel shift - Diagram (p.63) • D0 = willing to pay • Willing to pay a lower price, demand increases - Luxury item, income increases, demand increases - Inferior good, income increases, demand decreases Supply S2 Supply S2 Px S1 = WTS 500 B 0.51 A Q1 Qx - Cost of selling each hotdog = $0.50 (Cost =/= Price, cost is what you have to pay for supply, input costs) - Market price is $0.51 - Higher price = willingness to sell increases = higher QS - Suppose the cost increases to $499 to produce 1 hot dog. - Why has supply shifted? The cost of production has gone up. - Figure 3.2 Shift between Supply Curves - Movementalong a supply curve is due to a change in price. - A shift between supply curves is due to: • A change in the size of the industry • A change in technological progress • A change in the prices of inputs • A change in the prices of related outputs The supply curve can be linear or a curve. Put emphasis on the upslope! Equilibrium Price P1 S E P2 P3 D 0 Q1 Q2 Q3 Q4 Q5 Quantity Suppose the current market price is P1, write down the information they are able to derive based on the given diagram and information. Price S P3 P2 E P1 A B D 0 Q1 Q2 Q3 Q4 Q5 Quantity Note: Q4 = point B Observations: Observations: 1. QD exceeds QS 2. Demand is high (Q3) -> comparedto supply A, but supply is low (Q1) -> compared to demand B 3. There's a deficit (QD > QS) at P1. Some people would not be able to buy the product 4. The seller would not have a problem selling their products because QD > QS. 5. The seller has moremarket power. They decide how to sell the item and who will get the item in this situation. 6. The seller gets to decide who gets the limited supply of goods at P1. 7. If there are people who must get the item, they are willing to pay more. Price will go up because they would be willing to pay more. Thus, there is tremendous pressure on the market, because of the equilibrium. 8. There is the relevant portion and irrelevant portion of the demand curve. 9. Some people are willing to pay at higher prices than P1. 10 A P1 B Q4 The tiny marks on the graph = irrelevant portion. Choke price indicated: P Q2 (at 85 degrees WTP1 0 Qx ---------------------------------------------------------------------------------------------------------------------------------------- September 25, 2012 - September 27, 2012 1:00 PM - Reasons why the supply curve shifts: prices of factors of production, prices of related goods produced, expected future prices, # of suppliers, technology,state of nature - Note (Sept. 25, 2012): 1. The original equilibrium = P1 2. An increase in consumers' taste is a right shift factor. 3. At the original price of P1, the new demand curve is DD2. 4. DD1 was the old demand curve before the taste change. It has now disappeared and is replaced by the new DD2. 5. At the original price of P1, the QD for X > the QS. 6. Those consumers who must purchase X will bid up the price of X. 7. As price rises, there is a movementalong DD2. 8. The new equilibrium price P2 will be higher than the old P1. 9. Note that the new taste scenario will result in both higher prices and larger EQ. - Price has gone up due to excess demand (shortage). When prices go up, market prices go up. - Movementsalong demand & supply curve -> price changes - Shifts along demand & supply curve -> other factors (NOT price) Equilibrium, Price Floor, Price Ceiling, Elasticity - Sometimesit takes a long time from the old equilibrium to the new equilibrium. In reality, we see some stability in the market. - Sometimesthe equilibrium stays stable because it gets "frozen" in time. - Sometimesthe equilibrium stays stable because it gets "frozen" in time. - Labour market:employerswant to hire workers (demand), employeesrepresent the supply Wages Unemployment S $10 a b Minimum wage $4 E F G $0.25 D (for employees) 100 1000 Quantity In the labour market, the demand and supply price of labour is called WAGES. Suppose the equilibrium marketwage rate is $4/hr for workers. Draw a market diagram to illustrate the effect in the unskilled labour market If the governmentset the minimum wage to $10/hr. Would all unskilled workers be grateful to the government?Distinguish the minimum wage, the effective wage and the equilibrium wage. • Unemployment-> surplus of workers -> Not everyoneis grateful for the governmentbecause they would rather work at $5/hr than not having a job. - When there is a minimum wage, is it illegal to pay more than $10? You can pay more but you can't pay less than the minimum wage (price floor: can't go lower than the price set above equilibrium). - If the minimum wage is set below the EP, it doesn't have any effect. - Effective price -> EP (if price floor is set below the EP) - Price ceiling:effectiveif set below the equilibrium - Black market: illegal market • For minimum wage: occurs when the price floor < the EP • For price ceiling: when EP > price ceiling (looking at portion below $10) in above diagram • Black market exists because of disequilibrium markets (they exist). Some are willing to earn as low as $0.25 because they don't want to be unemployed. - If the price floor is set below the equilibrium, it is NOT effective (EP = effectiveprice). Why does disequilibrium markets exist in a free marketsystem? 1. Governmentinterfering with the free markets: a) Domesticpolicy tools (e.g. min wage, rent control, fixed exchange rates, etc.) b) Foreign policy tools  quotas c) Tax revenues d) Non-market ration vs. dollar vote e) Social justice  debatable - If governmentis imposing a licence that was not part of the input price from before, it is like an increase in the cost of production (left shift of supply). Price Ceiling & Elasticity September-27-12 1:00 PM Price Ceiling S Exchange Rate 1.25 1.00 A B D $1 US Q $1 US Elasticity - Responsiveto price change -> elastic - Price elasticity of demand is a measure of relative (%) responsiveness of QD of a good to price changes. - Price elasticity of demand = % change in QD ÷ % change in price = ΔQ/Q ave÷ ΔP/P ave - Ignore any negative signs when finding the elasticity! - A numerical example: • A hamburger store raised its price of hamburger from 50₵ to 60₵. Daily sales dipped from 2000 to 1500 units. • E = 1.57 -> elastic demand - E = -4 -> %ΔQ (+40%) ÷ %ΔP (-10%) - Interpreting the coefficient: • |E| = 1 (unitary elastic) • |E| > 1 (elastic) • 0 < |E| < 1 (inelastic) • |E| = 0 (perfectly inelastic) • |E| infinity (perfectly elastic) Elasticityof Demand vs. Slope of the Demand Curve - Slope of demand curve is always negative due to the law of demand - Why is elasticity approaching 0 as you move down the curve? % change in QD w.r.t % change in price. In order to double your quantity at a low price, it is less likely for this probability to happen. Price Elasticity of Demand & Elasticity of Supply & Income Elasticity & Cross Elasticity October-02-12 1:00 PM Price Elasticityof Demand - Price elasticity of demand = % change in QD ÷ % change in price = ΔQ/Q ave÷ ΔP/P ave = ΔQ/ΔP P aveQ ave = dQ/dP P/Q - Measuring elasticity only at the midpoint of the demand curve (original & new point) - Relative responsiveness - *If shown only a graph and at the price of $10, we have points A and B. A has a smaller quantity; B has a bigger quantity. Which point is more price elastic?B has the larger quantity (smaller # for elasticity), thus B is more price inelastic. - In an equilibrium market, QS = QD. If you are given: QS = 100 + 3P and QD = 106 106 = 100 + 3P 3P = 6 P = $2 What is the price of elasticity for demand? It's 0 because the demand curve is vertical (perfectly inelastic). QD is always 106. Thus EP = $2 and EQ = 106. Elasticityof Supply - Measures the responsivenessof the QS to a change in the price of a good when all other influences on selling plans remain the same. - Price elasticity of supply = % change in QS ÷ % change in price = ΔQ/Q ave÷ ΔP/P ave = ΔQ/ΔP P aveQ ave - Law of supply: When price goes up, the QS is higher. - Its magnitude is determined by: a) profit (incentives) b) the given time span c) barriers to entry d) production flexibility - Given a longer time span, some of the shift factors (e.g. technology)may change, the supply curve may shift to the right. - NY Quality Hotel & Suites (Example): • Supply is vertical because there is a fixed supply (E = 0). • Thus, demand forces drive the price up or down. Excess demand will force up the price; excess supply will force the price to go down. - Perfectlyelastic supply (horizontal): lots of supply - World supply (example): P Q Income Elasticity - Income Elasticity= % change in QD ÷ % change in Income - Suppose income increases by 10%, we buy 25% more goodies, then this is a normal or luxury good. - If the income elasticity is positive and greater than one, it is income elastic. - If the income elasticity is between zero and one, it is income inelastic. - If the income elasticity is between zero and one, it is income inelastic. - If the income elasticity is negative, it is an inferior good. - Consumers side: Qx d I* Income Cross Elasticity - Cross Elasticity= % ΔQ xdemanded ÷ % ΔP y = (Δ Qx / average Qx) ÷ (Δ P y / average P y) - If good X and good Y are substitutes (competitors),cross elasticity is positive. - If X and Y are complements,cross elasticity is negative. - Method to rememberif + or -: • Law of demand ○ P y↑+, Qx d ↑+ - An average car sold for $20,000. The given price elasticity is -1.2 The given income elasticity is +3. During a lengthy recession where average income falls by 5%, commenton the effect of the average car market if the average price is slashed by $500.(What would happen to the equilibrium market at the price cut of $500?) Utility October-04-12 1:00 PM MaximizingConsumer's Total Utility - The Marginal Principle Equi-marginal Principle: MU a/P a= MU b/Pb MU a/MU b = Pa/Pb - Question on p.185 (bottom) - Consumers' valuation vs. markets' valuation - Utility: enjoyment,satisfaction, usefulness, happiness - Consumers are after the satisfaction (utility) they can receivefrom a product, not exactly the product itself. • Insight: If you know you're after the utility that, for example, the water offers you, you're willing to pay different prices for the same bottle of water. - Refer to Lecture Notes from Chapter 8 & 9: 1. Rememberto place emphasis on the “UTILITY” (satisfaction)derived from a product, or from services instead of the goods itself. A small bottle of water that you would pay $0.25 at mostis worth at least $500 to you after walking in the dessert for a whole day. 2. Utility Theory - Measurement - 2 methods are used : • ordinal measurement - ranking method,1 , 2 , 3 etcrd • cardinal measurement- subjective, measurable utility such as "utils." (We're staying away from a monetaryunit, so we use the term "utils.") - To understand consumer behaviour, we must distinguish total utility from marginalutility. - Total utility or total benefit is represented by all the area under the demand curve up to the QD, whereas marginal utility or marginal benefit is represented by the “incremental”happiness or “incremental”benefit. P 100 D A E P1 $1.00 B C D 100 Q Given Price = $1.00 - Which is the area representing total utility/totalbenefit? The maximum valuation is $100. If you sell 1 unit for $100,pretend that 1 person would want it. Thus, the unit is worth $100 to him/her. The total utility is $100,in market term. Thus, it's the area underneath the demand curve. This is the maximum the person is willing to pay. But at P1, area C is NOT relevant. The area representing total utility at P1 is areas A and B. B also represents the total expenditures (price  quantity) of the person. Area A is called consumer surplus (utility that you had to pay). Consumersurplus is a measure of well-being. Total utility = Consumer Surplus + Total Expenditures of the Item • Measures what you have to pay + what you think that item is worth • The consumer is valuating the item. - What is the consumer surplus of the last unit (100th unit)? It's 0 because at P1, the consumer is charged at $1 only (no surplus). - Unit 1 -> someoneis willing to pay $100 - Unit 2 -> someoneis willing to pay $80 - Total unit: worth $180 - 2nd unit only: only worth $80 (change is $80) -> marginal utility Incremental utility = marginal utility - - Totalutility is the utility from consuming all the units purchased. Marginalutility is the incremental utility from the consumption of an additional unit of X. Mathematically: TUx = f (X) and Mux = ΔTUx / Δx TUx = f (X) and Mux = ΔTUx / Δx QA TU A MU A QB TU B 1 5000 utils } 50 1 100 2 5050 2 150 3 5080 3 190 4 4000 4 191 - Marginal utility between units is gradually decreasing as more units are being consumed. - However,total utility will get larger as you consumemore. - Total utility is simply quantity. Total utility is not negative. It's way off the chart. - Figure 7.3 (p.183) - Any negative marginal utility will make the total utility worse off. - The law of decreasing marginal utility (diminishing marginal utility) is different from negative utility. • Total utility is increasing at a declining rate (increasing at a slower and slower pace). As long as the marginal utility is positive,the total utility is still rising but it will get flatter and flatter. It is NOT diminishing. It is diminishing marginal utility. Only when it is negative, the total utility will fall. • Sometimesthe law of diminishing utility doesn't show up until a certain point. - Comparing the marginal utility from having $ (e.g. Px) in your pocket vs. the marginal utility from the consumption of an extra unit of X. a) Suppose  represents the marginal utility of $1. If the price of X is Px, what does Px mean? b) If Px > MUx, are you better off to keep the money or to buy X? Keep the money. If Px = MUx, you are satisfied no matter what. You are indifferent. ------------------------------------------------------------------------------------------------------------------------------------------ October 11, 2012 1:00 PM Law of DiminishingMarginal Utility - Law of diminishing demand is not definite but it will eventually sink in, but law of increasing utility is possible -> buying the last piece of a collection to complete the set. - When making a wise decision to buy a unit of X, marginal utility will always be positive - Average utility can be misleading - Page 185 - You can't be ahead if you purchase the item that yields the highest MU -> when looking at the ratio of MUx/Px, MUx is not the only factor to look at when considering the ratio of marginal utility per dollar, price needs to be considered as well - Possible exam question: true/false: when the price of good X increases, MU increases • When price goes up, MU will likely to go down • When price goes up, MU can go up because the item becomes very valuable since there are less items on the market • When more items are consumed (with the decrease in price, more goods are purchased), the law of diminishing utility states that the item becomes less valuable because more goods are being accumulated ○ During war when food is not very valuable, the units of satisfaction increases when the bread is consumed - MARGINAL UTILITYIS DIFFERENT THAN THE PER DOLLAR WORTH OF MARGINAL UTILITY - MUx and Px alone are not useful because we are looking at the ratio between MUx and Px (the marginal utility per dollar worth) - If MUx/Px is over Muy/Py, you buy more X - With multi items in the market to choose from, consumer's equilibrium occurs when • MUx/Px = MUy/Py = MUa/Pa…….. MUn/Pn • When the price is lower (a trial size shampoo) --> the per dollar worth looks a little more attractive - *Given $100, buy 2 items (x &y) - *Given $100, buy 2 items (x &y) • X intercept = income/price of x • Y intercept = income/price of Y ○ Both X int & y int = slope • Midpoint (50,50) • The line represents the consumption possibility Budget Line & Indifference Curves October-16-12 1:00 PM The Budget Line - The budget constraint of the consumer depends on income and the prices of good x and good y. - Geometrically,the slope of the budget line: Δy/Δx = - Income/P y÷ Income/P x= -Px/Py = relative prices Q y 1/Py The Budget Line 1/Px Q x - If the weekly incomeis $100, Pxand Py are both $1 per unit. Budget line if the price of X doubles: 100y 50 0 100x Budget line if the income has doubled: 100y y* 50 M x* 0 50 100x Qy 200y 100y F x** 0 100x 200x Qx - Law of diminishing marginal utility -> e.g. buy one and get 2nd half off Indifference Curves (Preference Map) The assumption of a regular indifference curve: 1. Two goods world, good x and good y 1. Two goods world, good x and good y 2. More is preferred to less 3. Diminishing MU 4. Transitivity (being logical) Qy A 2U 2 B2 (U2) 10y A(U 1) B(U1) C (U ) TU 1 10x Qx U2 > U1 - Even if the indifference curves are close together, they will NEVER cross one another/intersecteach other. - Slope of the indifference curve (rise/run) = -Δy/Δx = MUx/Mu y = MRS • The slope of the indifference curve can be "approximated" by a movementfrom point A to point B. Qy A B Δy C TU = 100 utils A B Δx Qx - Looking at how to compensatefor the utility and the gain on utility - Figure 8.6 (p.210) • I2 > 1 > 0 • Best affordable point (point E)-> point of consumer's equilibrium (equi-marginal principle), highest level of utility ○ Best Affordable Point: Slope of Budget Line = Slope of Indifference Curve • Let's look at point E and H. Point H is slightly lower on the indifference curve (lower utility). Thus, point E is better. The points are both on the budget line, so they cost the same. Thus, they are worth the same in the market, but not to an individual. ------------------------------------------------------------------------------------------------------------------------------------------ October 18, 2012 1:00 PM - Diagram given in class: • Income Information: ○ Price of X has fallen, while the price of Y has NOT fallen. ○ The budget given to this consumer is $10 (10 units of Y can be bought). ○ Budget Line 1: Price of X is $2; Budget Line 2: Price of X is $1 • E1: marginal utility of X and Y is the same • Budget Line 1: Person picked to get 2 units of X (equilibrium point at E1). When the price of X has fallen, we go to E2. The price of X has fallen from $2 to $1, so the consumer picked to get 5 units of X. We know the person is happier when the price has fallen because they want to buy more. Income effect (feeling wealthier -> law of demand) -> more utility/satisfaction • Cannot draw demand curve for Y (price of Y has not changed) • Refer to back of diagram given in class for the demand curve of X (X is price elastic) • Y and X are substitutes -> price of X has fallen, consumer buys less of Y • Trying to maximize given budget (in this case $10) • E1 and E2 means per dollars worth of marginal utility • E2 has higher utility (lower the price, higher the utility) • How can the demand curve tell us about the utility? Consumer surplus is higher at point E2 than E1. • How can the demand curve tell us about the utility? Consumer surplus is higher at point E2 than E1. • Movementfrom E1 to E2 is an income & substitution effect. But how much is due to an income effect and how much is due to a substitution effect? Until the price is lower, a consumer will probably not be willing to consume more (law of diminishing marginal utility (buy more = lower utility -> buy extra item only when price comes down) -> demand curve is downsloping). ○ Start with E1. How much money should we be given so that we can get to U2? Move the budget line 1 to point J. Thus, this point represents the income effect (feel richer with more money/buymorewith more money).Thus, the rest is called the substitution effect. • This type of question could appear on the final exam? • Start with E2. According to budget line 2, 10 units is available to be purchased. • Example: Let's say the quantity represents the amount of housing. Boss tells you about a promotion,but you will be working in Tokyo.The companyhas a low budget it can provide to you. Budget line 2 represents your situation in Waterloo (good job, lower housing, etc.). Budget line 1 represents your situation in Tokyo (promotionfor job, double housing costs, etc.). If you go to Tokyo,you'll be unhappy. Use the Tokyo budget line. 10 units of X is our reference point because in Waterloo,you were able to purchase that much for housing. Other good reference points: J and E2(on U2). We're using U2 as a reference point because at U2, you're happy. E2 touches on the budget line and U2. U2 is basically a basket of goods. Point J costs the company the least money. When you move from budget line 1 (Tokyo),the first point you reach on U2 is J. • Example: $100 is given per week. A person can buy food, but he is alcoholic. The y-axis represents alcohol. The child only has 1 slice of bread. Refer to diagram in notes (Oct. 18, 2012).The government gives him a food stamp (buys too much alcohol, doesn't have enough to buy food). Finds out the food stamp can be sold to someone. However,he can't sell it for $100. If he sells it for $50, he gets cash. Now he has his freedom again (U3). Thus, you can assess the dollar value of freedom. Chapter 9: Production & Cost Theory October-18-12 1:00 PM - Production:process where inputs are
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