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Microeconomics 111 (ECON 110 WINTER) Exam Review

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Queen's University
ECON 111
Ian James Cromb

Econ 111 Exam Review Chapter 1 Introduction Chapter 2 Chapter 33 (pgs 842 - 855) Chapter 3 Supply and Demand Chapter 4 Chapter 5 Household Behaviour Chapter 6 (incl. Appendix) Supplementary Chapter: Other Household Decisions Chapter 7 Producer Theory Chapter 8 (omit Appendix) Chapter 9 Additional Topic from MyEconLab website: "The Long- Market Structures and Run Industry Supply Curve" Efficiency Chapter 10 Chapter 11 Chapter 12 Trade and Protectionism Chapter 33 (pgs 855 - 866) Chapter 34 Factor Markets Chapter 13 Chapter 1 – Economic Issues and Concepts Economy – a system in which scarce resources are allocated among competing uses -Self interest is the foundation of economic order, a free market is self organizing Main characteristics of market economies: 1. self interest – individuals pursue their own self interest, buying ad selling what seems best for them 2. Incentives – sellers want to sell more when prices are high, buyers want to buy more when prices are low 3. Market prices and Quantities – are determined in the free markets in which would-be sellers compete to sell their products to would-be buyers 4. Institutions – all these activities are governed by a set of institutions largely created by government. The natures of private property and contractual obligations are defined by laws passed by legislations Economics – the study of the use of scarce resources to satisfy unlimited human wants 3 basic questions: 1. What gets produced and how? -MICRO 2. What is consumed and by whom? -MICRO 3. Why are resources sometimes left idle? – MACRO 4. Is productive capacity growing and how does this come about? -MACRO Factors of production – resources used to produce goods and services; frequently divided into the basic categories of land, labour, and capital Goods are tangible commodities and services are intangible commodities Scarcity implies that choice must be made, and making choices implies the existence of costs. Everytime a choice is made, opportunity costs are incurred Opportunity cost – the cost of using resources for a certain purpose, measured by the benefit given up by not using them in their best alternative use i.e. if resources that could have produced 20km of road are best used instead to produce one hospital, then the opportunity cost of a hospital is 20 km of road Production Possibilities Boundary – a curve showing which alternative combinations of commodities can be attained if all available resources are used efficiently; it is the boundary between attainable and unattainable output combinations -scarcity is indicated by the unattainable combinations outside the boundary -choice is indicated by the need to choose among the available alternative points along the boundary -opportunity cost is demonstrated by the negative slope of the boundary Points A, B and C are attainable Point Y is unattainable (unless there is an increase in technology Point X is inefficient -the shape of the PPB implies that an increasing amount of product A must be given up to achieve equal successive increases in product B. This shape (concave to origin) indicated that the opp cost of either good increases as we increase the amount of it that is produced. A straight line boundary would mean that the opp cost is constant. -this shape occurs because each factor of production is not equally useful in producing all goods. i.e. land might be particularly well suited to growing wheat and as you shift more and more, you might be using land that is more suited to the production of clothing, so the extra amount of clothing that must be foregone rises and the opportunity cost of producing one good of wheat rises as more wheat is produced -when an economy grows, the PPB shifts outward and can produce more of both goods Resource allocation – the allocation of an economy’s scarce resources among alternative uses Microeconomics – the study of the causes and consequences of the allocation of resources as it is affected by the workings of the price system Macroeconomics – the study of the determination of economic aggregates such as total output, the price level, employment, and growth -consumers and producers who are maximizers make marginal decisions – whether to buy or sell a little bit more or less of the many things that they buy and sell Product market – a market in which products are sold by firms and bought by households Factor market – a market in which households sell and firms buy factors of production -the red line shows the flow of goods and services, and the blue line shows the payments made to purchase these Specialization of labour – the specialization of individual workers in the production of particular goods or services. The economy’s total production is greater when people specialize than when they all try to be self-sufficient Division of labour – the breaking up of production process into a series of specialized tasks, each done by a different worker. (specialization within the production process of a particular product) -specialization must be accompanied by trade, People who produce only one thing must trade most of it to obtain all the other things they want Barter – an economic system in which goods and services are traded directly for other goods and services. Requires a double coincidence of wants. -money facilitates specialization and trade Types of Economic Systems  Traditional Economies – economies in which behaviour is based mostly on tradition i.e. the feudal system  Command Economies – economies in which most economic decisions are made by a central planning authority i.e. Soviet Russia  Free Market Economies – economies in which most economic decisions are made by private households and firms; market determined prices, resource allocation and income distribution; no public goods (i.e. defence, police protection, health care)  Mixed Economies – economies in which some economic decisions are made by firms and some by the government. Public goods still provided i.e. Canada Chapter 2 – Economic Theories, Data, and Graphs Normative statement – a statement about what ought to be; depend on value judgments, what ‘should be’, happen etc i.e. Unemployment is a more impt social problem than inflation Positive Statement – a statement about what actually is, was, or will be; fact that can rely on evidence. Positive statements need not be true. The inclusion of a value judgment in a statement does not necessarily make the statement itself to be normative (we could conduct a survey to see what people prefer) i.e. Govt financial assistance to the auto sector is ineffective at preventing job losses Endogenous variable – a variable that is explained within a theory, like a dependent variable Exogenous variable – a variable that is determined outside the theory, like an independent variable i.e. the price and quantity of eggs are endogenous variables in the theory of the egg market, but the state of the weather is an exogenous variable (the state of the weather is not influenced by the market for eggs) The scientific approach is central to the study of economics: empirical observation leads to the construction of theories, theories generate specific predictions, and the predictions are tested by more detailed empirical observation -correlation does not equal causation! Chapter 33 (pages 842-855) – The Gains from Int’l Trade An open economy engages in international trade while a closed economy has no foreign trade (autarky) -without trade, everyone must be self sufficient; with trade, people can specialize in what they do well and satisfy other needs by trading Gains from trade – the increased output attributable to the specialization according to comparative advantage that is made possible by trade Absolute advantage – the situation that exists when one country can produce some commodity at a lower absolute cost than another country i.e. Wheat (kg) Cloth (m) Canada $1 per kg $5 per m EU $3 per kg $6 per m -but does absolute advantage mean that high cost countries stand no chance of being successful producers, and will low cost countries produce everything? No, because of comparative advantage Comparative advantage – the situation that exists when a country can produce a good with less forgone output of other goods than can another country Opportunity Costs Wheat (kg) Cloth (m) Canada .2 m of cloth (1/5) 5 kg of wheat (5/1) EU .5 m of cloth (3/6) 2 kg of wheat (6/3) -Even though a country may have an absolute advantage in all goods, it cannot have a comparative advantage in all goods. The gains from specialization and trade depend on the pattern of comparative, not absolute, advantage -World output increases if countries specialize in the production of the goods in which they have a comparative advantage -Specialization of production against the pattern of comparative advantage leads to a decline in total output -When opportunity costs are the same for all products in all countries, there is no comp advantage and no possibility of gains from specialization/trade. When opp costs differ there are always possibilities to increase production of both products Economies of scale – when production costs fall as the scale of output increases because of division of labour and more efficient large scale machinery -in industries with significant scale economies, small countries that do not trade will have low levels of output and therefore high costs. With international trade, small countries can produce for the large global market and thus produce at lower costs. Learning by doing – the reduction in unit costs that often results as workers learn through repeatedly performing the same tasks Sources of Comparative Advantage:  Different Factor Endowments – different countries are endowed with different factors of production I,e, forests, abundant labour, etc  Different Climates  Human Capital  Acquired Comparative Advantage Chapter 3 – Demand, Supply, and Price Quantity Demanded - the amount of a good or service that consumers want to purchase during some time period. Is a desired qty and may differ from the amount that consumers actually succeed in purchasing. Ceteris Paribus – other things being equal -the price of a product and quantity demanded are related negatively: the lower the price, the higher the quantity demanded Demand curve – the graphical representation of the relationship between qty demanded and the price of a commodity Demand – the entire relationship between the qty of a commodity buyers want to purchase and the price of that commodity. A single point on the demand curve is the qty demanded at that point. Shifts in demand -a shift to the right is an increase in demand, a shift to the left is a decrease in demand 1. Consumers Income – if average income rises, consumers as a group can be expected to desire more of most products. Goods for which the qty demanded increases when income rises are called normal goods. Goods for which the quantity demanded falls are called inferior goods. 2. Prices of Other Goods – if the price of a substitute good falls, then the demand for our good will decrease. If the price of a substitute good increases, then the demand for our good will increase. i.e. if the price of carrots fall, the demand for broccoli falls If the price of a complement good increases, the demand will decrease for both goods. If the price of a complement good decreases, the demand for both goods increases. i.e. if the price of golf clubs falls, the demand for both golf clubs and golf balls increase Substitute goods – goods that can be used in place of one another to satisfy similar needs or desires i.e. Coke and Pepsi Complement goods – goods that tend to be consumed together i.e. flights to Calgary and ski lift tickets, electric stoves and electricity etc. 3. Tastes- a change in tastes in favour for a product shifts the demand curve to the right, a change in tastes against some product shifts the demand curve to the left. Tastes include any changes in customers perception of quality of the product i.e. change in tastes from VCRs to DVD players, change in tastes to red wine after medical studies indicate it could have positive health effects 4. Population – if there is an increase in population with purchasing power, the demands for all the products purchased by the new people will rise 5. Expectations about the future – the demand curve can shift today in anticipation of a future event i.e. if you think that the price of a vacation home in Canmore is going to rise, you increase your demand today so as to make the purchase before the rise in price happens Change in demand – a change in the quantity demanded at each possible price of the commodity, represented by a shift in the whole demand curve Change in quantity demanded – a change in the specific quantity of the good demanded, represented by a change from one point on a demand curve to another point, either on the original demand curve or on a new one Quantity supplied – the amount of a commodity that producers want to sell during some time period -the price of a product and the quantity supplied are positively related – the higher the product’s own price, the more its producers will supply; the lower the price, the less its producers will supply Supply – the entire relationship between the quantity of some commodity that producers wish to sell and the price of that commodity, ceteris paribus -a change in any of the variables other than the products own price that affects the quantity supplied will shift the supply curve to a new position 1. Prices of Inputs – the higher the price of any input used to make a product, the less will be the profit from make that product, and therefore the less the firm will produce and offer for sale at any given price (shifts supply curve to the left) 2.Technology – any technological innovation that decreases the amounts of unputs needed per unit of output reduces production costs and hence will increase the profits that can be earned at any given price of the product; increased profitability leads to increased willingness to produce, which shifts the supply curve to the right i.e. extreme weather events are similar to a deterioration of technology for the agricultural sector 3. Government Taxes or Subsidies – if a government subsidy decreases firms costs, supply will shift to the right. If a government tax increases firms costs, supply will shift to the left. 4.Prices of other products – a reduction in the price of a substitute will lead to an increase in supply of your product. i.e. if the price of oats decreases, the supply of wheat will increase because it is more profitable to produce wheat. If the price of a complement rises, the supply of a complementary product will also rise. i.e. if the price of natural gas rises, more producers will drill for natural gas, and as more wells are drilled usually more oil and natural gas will be discovered and produced, so the supply of oil increases as well 5. Number of Suppliers – if current firms are earning profits, then more firms will enter the industry, the effect of this increase in suppliers shifts the supply to the right. Change in supply – a change in the quantity supplied at each possible price of the commodity, represented by a shift in the whole supply curve Change in the quantity supplied – a change in the specific quantity supplied, represented by a change from one point on a supply curve to another point, either on the original supply curve or a new one Market – a situation in which buyers and sellers can negotiate the exchange of goods or services Excess demand – a situation in which, at the given price, quantity demanded exceeds quantity supplied – causes upward pressure on price Excess supply – a situation in which, at the given price, quantity supplied exceeds quantity demanded – causes downward pressure on price Equilibrium price – the price at which quantity demanded equals quantity supplied. Also called market clearing price. Disequilibrium price – a price at which quantity demanded does not equal quantity supplied Disequilibrium – a situation in a market in which there is excess demand or excess supplied Absolute price – the amount of money that must be spent to acquire one unit of a commodity (money price) Relative price – the ratio of the money price of one commodity to the money price of another commodity Chapter 4 - Elasticity -Demand is elastic when quantity demanded is quite responsive to changes in price -Demand is inelastic when quantity demanded is relatively unresponsive to changes in price Price elasticity of demand – a measure of the responsiveness of quantity demanded to a change in the commodity’s own price  = Percentage change in quantity demanded Percentage change in price = Q/Q avg = Q x P avg P/P avg Qavg P -elasticity is unit free Elasticity = 0 – vertical demand curve; a change in price and no change in qty demanded Elasticity > 1 – elastic demand (flatter sloped demand curve) Elasticity < 1 – inelastic demand (steeper demand curve) Elasticity = 1 – unit elasticity Elasticity =  - completely elastic, horizontal line Elasticity = 0 – completely inelastic, vertical line - a demand curve (even when linear) usually does not need to have a constant elasticity, even if it has a constant slope - products with close substitutes tend to have elastic demands, products with no close substitutes have inelastic demands - narrowly defined products have more elastic demands than do broadly defined products (more substitutes for Diet Pepsi than for beverages in general, so more elastic demand) - a demand that is inelastic in the short run may prove to be elastic in the long run; the elasticity of demand is greater the longer the time span Total Expenditure = Price x Quantity -the change in total expenditure depends on the relative changes in the price and quantity -when demand is elastic, total expenditure will rise; if the price rises the quantity demanded will increase by a proportionally larger amount -when demand is unit elastic, total expenditure is at a maximum, and any increase in price calls for a proportionate decrease in quantity demanded -when demand in inelastic, total expenditure will fall as price decreases; the price decrease leads to an increase in quantity demanded but not by as high a percentage of the price decrease (the same amount of goods are being sold for less money) Price elasticity of supply  –sa measure of the responsiveness of quantity supplied to a change in the product’s own price s= percentage change in quantity supplied percentage change in price = Q/Q avg = Q x P avg P/P avg Q avg P Elasticity of supply > 1, elastic supply Elasticity of supply < 1, inelastic supply Elasticity of supply = 0, vertical supply (completely inelastic) Elasticity of supply = , horzontal supply (completely elastic) - if a producer can easily shift to producer a new products whose price has risen, then the supply of both products will be more elastic - if the costs of producing a unit of output rise rapidly as output rises, then supply will tend to be inelastic - the long run supply for a product is more elastic than the short run supply Excise Tax - a tax on the sale of a particular commodity Tax incidence – the location of the burden of the tax – who bears the tax. The burden of an excise tax is distributed between consumers and sellers depending on the relative elasticities of supply and demand -after the imposition of an excise tax, the difference between the consumer and seller prices is equal to the tax -when demand is inelastic relative to supply, consumers bear most of the burden of excise taxes. When supply is inelastic relative to demand, producers bear most of the burden Income elasticity of demand – a measure of the responsiveness of quantity demanded to a change in income Income elasticity of demand  = PYrcentage change in quantity demanded Percentage change in income Normal good – a good for which quantity demanded rises as income rises Inferior good – a good for which quantity demanded falls as income rises If income elasticity > 1, is a normal good and income elastic If income elasticity < 1, is a normal good but income inelastic If income elasticity < 0 (negative income elasticity), is an inferior good Necessities – products for which the income elasticity of demand is positive but less than one i.e. vegetables, bread Luxuries – products for which the income elasticity of demand is positive and greater than one i.e. high quality cuts of meat, wine, etc. -the more necessary an item is in the consumption patterns of consumers, the lower is its income elasticity Cross elasticity of demand  – a measure of the responsiveness of the XY quantity of one commodity demanded to the changes in the price of another commodity XY = Percentage change in quantity demanded of good X Percentage change in the price of good Y -If the cross elasticity of demand is positive, then the goods are substitutes – the price increase of Y leads to an increase in quantity demanded of X -If the cross elasticity of demand is negative, then the goods are complements – the increase in price of good Y leads to a decrease in quantity demanded of good X Chapter 5 – Markets in Action Feedback - a change in one market will lead to changes in many other market. The induced change in these other markets will in turn lead to changes in the first market – this is feedback. Partial equilibrium analysis – the analysis of a single market in isolation, ignoring any feedbacks that may come from induced changes in other markets General equilibrium analysis – the analysis of all the economy’s markets simultaneously, recognizing the interactions among the various markets -at any disequilibrium price, quantity exchanged is determined by the lesser of quantity demanded or quantity supplied. i.e. if there is a shortage, supply determines the quantity exchanged Binding price floors – when a minimum permissible price that can be charged for a particular good/service is set above the equilibrium price. Leads to excess supply. Either an unsold surplus will exist, or someone (usually govt) must enter the market and buy the excess supply Binding price ceilings – when a maximum permissible price that can be charged for a particular good/service is set below the equilibrium price. Leads to excess demand Black market – a situation in which gods are sold illegally at prices that violate a legal price control. Black market thwart govt objectives for imposing price ceilings Effects of Rent controls - housing shortage - shortage will lead to alternative allocation schemes – by seller’s preferences, security of tenure laws - black markets will appear i.e. landlords may force tenants out and may illegally require tenants to pay extra money - in the long run, the housing shortage will worsen as it wont be profitable to build new houses - supply of housing is inelastic in short run but very elastic in long run, so over time the supply of housing shrinks - existing tenants in rent controlled accommodations gain - landlords suffer, as well as potential future tenants (cant find a place to live) -view demand as value and supply as cost to determine how society benefits by consuming/producing any given amount of product: the highest price consumers are willing to pay and the lowest price producers are willing to accept -for each unit of a product, the price on the mkt demand curve shows the valueto consumers from consuming that unit -for each unit of a product, the price on the mkt supply curve shows the lowest acceptable price to firms for selling that unit – reflects the additional cost to firms from producing that unit Economic surplus – for any given quantity of a product, the area below the demand curve and above the supply curve shows the economic surplus associated with the production and consumption of that product. It is the net value that society as a whole receives by producing/consuming an amount of a good. It means that firms and consumers have taken resources that have a lower value and transformed them into something valued more highly i.e. the value from consuming 100 pizzas is greater than the cost of the resources necessary to produce the pizzas – cheese, flour, tomatoes, labour etc. -economic surplus is maximized at the free market equilibrium quantity and price -binding price floors and price ceilings lead to a reduction in overall economic surplus (as shown by images above) and thus to market inefficiency. The shaded area shows the deadweight loss created by price control Deadweight loss – the overall loss of economic surplus to society -when a government establishes an output quota, it restricts total output to a certain quantity and then distributes quotas – licenses to produce – among producers. The output restriction leads to an increase in the product’s price, as well as a decrease in producer’s costs (since output decreases) – a clear benefit to producers. However to purchase quotas is expensive. -an output quota leads to deadweight loss: Chapter 6 – Consumer Behaviour Utility – the satisfaction or well-being that a consumer receives from consuming some good or service Total utility – the total satisfaction resulting from the consumption of a given commodity by a consumer Marginal utility – the additional satisfaction obtained from consuming one additional unit of a commodity Law of diminishing marginal utility – the utility that any consumer derives from successive units of a particular product consumed over some period of time diminishes as total consumption of the product increases (if the consumption of all other products is unchanged) i.e. as you consume more and more water, your marginal utility will decrease A utility maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal MU X = MU Y or MU x = p x Px py MU Y = p y -the right side of the second equation is the relative price of the two goods, the left side is the relative ability of the two goods to add to your utility -a rise in the price of a product will lead each consumer to reduce the quantity demanded of that product (since the relative prices change, you must change your consumption.. as you consume less, the MUx rises and so you will reduce your consumption so that the ratios are equal) Real income – income expressed in terms of the purchasing power of money income – that is, the quantity of goods and services that can be purchased with the money income Substitution effect – the change in the quantity of a good demanded resulting from a change in its relative price. The substitution effect increases the quantity demanded of a good whose price has fallen and reduces the quantity demanded of a good whose price has risen. i.e. if price of ice cream falls, to maximize your utility you have to increase your consumption of ice cream Income effect – the change in the quantity of a good demanded resulting from a change in real income (holding relative prices constant). The income effect leads consumers to buy more of a product whose price has fallen, provided that the product is a normal good. -Because of the combined operation of the income and substitution effects, the demand curve for any normal commodity will be negatively sloped. Thus, a fall in price will increase the quantity demanded -For a normal good, the income and substitution effect work in the same direction -For most inferior goods, the income effect only partially offsets the substitution effect -For Giffen goods, the income effect outweighs the substitution effect so that the demand curve is positively sloped. Giffen goods are really only theoretical.. Consumer surplus – the difference between the total value that consumers place on all units consumed of a commodity and the payment that they actually make to purchase that amount of the commodity -for any unit consumed, the consumer surplus is the difference between the max amount the customer is willing to pay (WTP) and the price the customer actually pays -for any given quantity, the area under the demand curve and above the price line shows the consumer surplus received from consuming those units -because the market price of a product depends on both demand and supply, there is nothing paradoxical in there being a product on which consumers place a high total value (such as water) selling for a low price and hence having a low marginal value (i.e vs. something like diamonds, which consumers may place less value on even though they pay so much more. Since diamonds are scarce the price is high, whereas water has a low price but a high total value and so a higher consumer surplus) i.e. (2, labour) professional hockey players earn a lot more than doctors, even though most consumers probably place higher total value on health care. However pro hockey player have a set of skills that are in much shorter supply than doctors Indifference Curves Indifference curves show the combinations of two goods that yield equal utility and between which the consumer is indifferent. Any point above the indifference curve is preferred to any point along the same curve, and any point on the curve is preferred to any point below it. An indifference map consists of a set of indifference curve. Utility is higher the farther the curve is from the origin. note: indifference curves never cross!!! Budget line – shows the quantities of goods available to a consumer given money income and the price of goods A consumer starts with given money income I, and faces prices (p , p , …1 p 2 n Possible consumption bundles must satisfy a budget constraint: (p1x q 1 + (p 2 q )2+ … + (p xnq ) n I We assume only two goods, x and y, so our budget constraint: pxx + pyy  I the boundary of this constraint is the budget line, and its equation is given by pxx + p y = I, in the form of y = mx + b y = I - p x p y p y -the slope of the budget line is the relative price of x (px/py) Marginal rate of substitution – the amount of one product that a consumer is willing to give up to get one more unit of another product -marginal rate of substitution is negative and diminishing, because if you have a lot of product a, the more of product a you get the less product b you would be willing to give up to get it -mrs is the slope of the BL, so MRS = x /py Utility Maximization -the consumer’s utility is maximized at the point where an indifference curve is tangent to the budget line. At that point, the consumer’s marginal rate of substitution for the two goods is equal to the relative prices of the two goods -a change in income will shift the budget line out (if income increases) or in (if income decreases) in a parallel manner -a change in the price of a product will pivot the budget line either out or in. For example, if the price of product x (on the x axis) increases, the budget line will pivot in, towards the origin since the intersection point with the x axis is x/P -however, a change in the price of one product generally causes a substitution effect toward or away from all other goods M In the diagram to the left, income increased, shifting the BL to the right. L If both x and y are normal goods, you will choose to consume between points P L and P. N If x is normal and y is inferior, you will consume between P and N If x is inferior and y is normal, you will consume between M and L -- In a two good world, at most only one good can be inferior Substitution/Income Effect for a normal good -price decrease in x -the slope of the budget line changes, which increases purchasing power, so there will be both an income effect and a substitution effect First: sub effect (more x, less y) -move from point A to point C, where the old indifference curve has the new slope (of the new budget line) Second: income effect (more x, more y) -parallel shift out from point C to point B Substitution/Income Effect for one normal and one inferior good -price decrease in x (in this case, x is inferior and y is normal) First: Sub Effect (more x, less y) -move from point A to point C, where the old indifference curve has the slope of the new budget line Second: Income Effect (less x, more y) -move from point C to B, on the new budget line so that there is less x Indifference Curves - perfect substitutes i.e. x = ½ pint of beer, y = 1 pint of beer -linear indifference curves – constant marginal rate of substitution Indifference Curves – perfect complements i.e. x = left shoes, y = right shoes -equilibrium is always at the angle as they’re always consumed in the same proportion -we know that MRS = p /p x y If y is all other goods, then y = I so that mrs = px ..WHAT? Supplementary Chapter – Other Household Decisions -our two goods are leisure and consumption, (l,c) -the endowment is not income, Y, but a certain amount of time, H, which you can spend in leisure (l) or labour (L) – leisure is a good, while labour is a ‘bad’ (time spent at work) H = l + L -each unit of labour earns a wage w, the after tax wage measure in $ / hr or week income earned = Y = wL = w(H-l) since supplying labour is the household’s only source of income, then consumption C = Y, so the budget line is given by C = w (H – l) -so you know that the opportunity cost of leisure is the wage, w mrs ICp = l = w p c 1 -with large enough non labour income (i.e. inheritances, lottery winnings, govt programs), you will provide L = 0 and your l  H ex. Changes in Non Labour Income Suppose that the consumer receives an increase (from none to some) in non-labour income equal to $X per period. The budget line will shift up by X and the new equilibrium will follow the income effect for normal goods (more C and more l) The new equilibrium will fall between A and B – implies that labour supply falls since the person is using more leisure time in their allotment of hours Ex. Wage Changes -suppose the customer faces an increase in wages from w to w’. the budget line will pivot out around the l=H intercept because the customer can increase consumption -as with any other price change, there will be a sub effect and an income effect First: Sub effect (less l, more L, more C) -since wages rise, leisure is relatively more expensive, so you will move from point E1to S (on the old indifference curve with the slope of the new budget line) Second: Income effect (more l, less L, more C) -since both goods are normal, your possibilities expand so there will be a parallel shift from S to new equilibrium (between A and B) -with a wage increase, consumption always increases. The effect on leisure and labour depends on whether the substitution or income effect is stronger – it is based on tastes Reservation Wage * W , reservation wage, is the wage below which the household will supply no labour (L = 0 or l = H). It the wage w* budget line is tangent to the indifference curve at point N If the wage rises to w’, then the household will move to point E, supplying some labour Individual Household Labour Supply Curve -for wages near (just above) w*, the sub effect outweighs the income effect to that the supply curve is upward sloping. Eventually a wage (like w’) may be reached where the income effect of further wage increases outweighs the sub effect, giving us the backward bending supply curve -as your wage gets above a certain point, you demand more leisure and more consumption (income effect), which outweighs the sub effect (which would want more labour and more consumption) – you will actually work less -the market labour supply curve wouldn’t necessarily look like this; given the opposing nature of the income and substitution effects, we would expect the market supply to be fairly inelastic Supply of Saving -there are two goods, C (cpnsumption in the present/working life) and C f (consumption in the future/retirement) which we can make an indifference curve with. Both are assumed to be normal goods. -the endowment is the income earned in the present, I, which is available for C or S p (saving) -S is transferred to the capital markets to C f Budget Line: C + Sp= I Cf= (1 + r)S (r is after tax rate of interest earned on saving) So S = C f << substitute this into the budget line 1 + r Cf= (1 + r)I – (1 + r)C p It should be clear that the opportunity cost of C is epual to the total return to saving (1 + r) (plus, it makes sense if you think about the opportunity cost of present consumption) -the intercepts of the budget line are I on the C (or x) axis, and (1+r)I on the C (y) p f axis -consumer maximizes utility by choosing the highest possible indifference curve where it is tangent to the BL: mrs pfp = p1 + r) = (1 + r) pf 1 Income Changes -if the consumer receives an increase in endowment income I  I’, the budget line shifts out -with both goods normal, there is a new equilibrium with more C and more p , f impying that savings rises -the consumer takes some of the new wealth in the form of consumption today, and some in increased future consumption -with no change in r, S is the only way to raise C f Interest Rate changes -suppose the consumer faces an increase in interest rates from r to r’ -the budget line pivots out around the C = Ipintercept – there is a sub effect and an income effect First: sub effect (less C ,pmore S, more C ) f -since the interest rate rises, C is pelatively more expensive -sub effect goes from point E to point S, where the old indifference curve has the slope of the new budget line Second: Income effect (more C , lesspS, more C) f -possibilities expand, and since both goods are normal there is a parallel shift from S to a new equilibrium on the new BL between A and B -overall, with an increased interest rate there will be more C , the effecf on C p depends on whether the sub effect or income effect is stronger -note: it is possible for C tofrise if S falls since C = (f + r)S (so if the interest rate increases, each dollar of saving is ‘more productive’ in delivering C f Household Borrowers -suppose the household has endowment income both now and in the future – this raises the possibility that the household will be a borrower rather than a saver i.e. if a household has no present income I = 0, butpwith future income I f Budget line: C + (1f+ r)B = I f C p B (where B is borrowing) So C f (1 + r)C = p f The budget line intercepts the x axis (C axis) ap I /(1 + r)f And the y axis (C axif) at I f (draw in graph): Chapter 7 – Producers in the short run Single Proprietorship – a firm that has one owner
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