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ECO205Y5 (10)
Chapter 1-7

Chapters 1-7

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University of Toronto Mississauga
Yasin Janjua

th Eco205 Monday, 10 September 2012 Chapter 1 Economic Models What is Microeconomics? Economics is the study of the allocation of scarce resources among alternative uses Microeconomics is the study of the economic choices individuals and firms make and how of these choices create markets. Models are simple theoretical descriptions that capture the essentials of how the economy works. Few Basic Principles 1. Resources are scarce 2. Scarcity involves opportunity costs 3. Opportunity costs are increasing (what does it mean when its increasing) 4. Incentives matter 5. Inefficiency involves real costs 6. Whether markets work well is important Uses of Microeconomics The supply and demand model – how a good’s price is determined by the behaviour of the individuals who buy the good and of the firms that sell it Diminishing Returns – hypotheses that the cost associated with producing one more unit of a good rises as more of that good is produced. How economists verify theoretical models Two methods are used to provide such a test of economic models. Testing assumptions looks at the assumptions upon which a model is based; testing predictions, on the other hand, uses the model to see if it can correctly predict real world events Chapter 2 Utility and Choice Utility – satisfaction that a person receives from his or her economic activities Theory of choice - The interaction of preferences and constraints that causes people to make the choices they do Ceteris paribus assumption - In economic analysis, holding all other factors constant so that only the factor being studied is allowed to change Assumptions about Preferences Completeness - The assumption that an individual is able to state which of any two options is preferred Transitivity of Preferences - The property that if A is preferred to B, and B is preferred to C, then A must be preferred to C. More is better – more of good is, by definition, better Voluntary Trades and Indifference Curves Indifference curve - A curve that shows all the combinations of goods or services that provide the same level of utility Marginal rate of substitution (MRS): The rate at which an individual is willing to reduce consumption of one good when he or she gets one more unit of another good. The negative of the slope of an indifference curve Indifference curve map - A contour map that shows the utility an individual obtains from all possible consumption options. Showing Utility Maximization Budget constraint - The limit that income places on the combinations of goods that an individual can buy Generalizations Many goods – people buy more than two goods Composite good - Combining expenditures on several different goods whose relative prices do not change into a single good for convenience in analysis First problem is how we are to measure a composite good. The only way to add up all of the individual items that constitute ‘‘everything else’’ is to do so in dollars (or some other currency). But one might have some lingering concerns that, because such adding up requires us to use the prices of individual items; we might get into some trouble when prices change. This then leads to a second problem with composite goods—what is the ‘‘price’’ of such a good. In most cases, there is no need to answer this question because we assume that the price of the composite good (good Y) does not change during our analysis. Chapter 3 Demand Curves Homogeneous demand Function - Quantity demanded does not change when prices and income increase in the same proportion. If the prices of X and Y and income (I) were all to double (or to change by any identical percentage), the amounts of X and Y demanded by this person would not change. The budget constraint would remain the same. This is an important result: The amounts a person demands depend only on the relative prices of goods X and Y and on the ‘‘real’’ value of income. Proportional changes in both the prices of X and Y and in income change only the units we count in (such as dollars instead of cents). They do not affect the quantities demanded. Individual demand is said to be homogeneous (of degree zero) for proportional changes in all prices and income. Changes in Income As a person’s total income rises, assuming prices do not change, we might expect the quantity purchased of each good also to increase Normal good - A good that is bought in greater quantities as income increases Inferior goods - A good that is bought in smaller quantities as income increases Changes in Good’s Price Changing the price geometrically involves not only changing the intercept of the budget constraint but also changing its slope. Moving to the new utility-maximizing choice means moving to indifference curve and to a point on that curve with a different MRS. When a price changes, it has two different effects on people’s choices: there is a substitution effect that occurs even if the individual stays on the same indifference curve because consumption has to be changed to equate the MRS to the new price ratio of the two goods. There is also an income effect because the price change also changes ‘‘real’’ purchasing power. People will have to move to a new indifference curve that is consistent with their new purchasing power. Substitution and Income Effect from the fall in Prices Initially, the person maximizes utility by choosing the combination X*, Y* at point A. When the price of X falls, the budget line shifts outward to the new budget constraint. Remember that the budget constraint meets the Y-axis at the point where all available income is spent on good Y. Because neither the person’s income nor the price of good Y has changed here, this Y- intercept is the same for both constraints. The new X- intercept is to the right of the old one because the lower price of X means that, with the lower price, this person could buy more X if he or she devoted all income to that purpose. The flatter slope of the budget constraint shows us that the relative price of X to Y (that is, PX/PY) has fallen. Substitution Effect The movement to this new set of choices is the result of two different effects. First, the change in the slope of the budget constraint would have motivated this person to move to point B even if the person had stayed on the original indifference curve U1. A relatively lower price for X causes a move from A to B if this person does not become better off as a result of the lower price. This movement is a graphic demonstration of the substitution effect. Even though the individual is no better off, the change in price still causes a change in consumption choices. Another way to think about the substitution effect involved in the movement from point A to point B is to ask how this person can get to the indifference curveU1 with the least possible expenditures. With the initial budget constraint, point A does indeed represent the least costly way to reach U1—with these prices every other point on U1 costs more than does point A. When the price of X falls, however, commodity bundle A is no longer the cheapest way to obtain the level of satisfaction represented by U1. Now this person should take advantage of the changed prices by substituting X for Y in his or her consumption choices if U1 is to be obtained at minimal cost. Point B is now the least costly way to reach U1. With the new prices, every point on U1 costs more than point B Income Effect The further move from B to the final consumption choice, C, is the change in income. Because the price of X has fallen but nominal income (I) has stayed the same, this person has a greater ‘‘real’’ income and can afford a higher utility level (U2). If X is a normal good, he or she will now demand more of it. This is the income effect. Notice that for normal goods this effect also causes price and quantity to move in opposite directions. When the price of X falls, this person’s real income is increased and he or she buys more X because X is a normal good. A similar statement applies when the price of X rises. Such a price rise reduces real income and, because X is a normal good, less of it is demanded. Of course, as we shall see, the situation is more complicated when X is an inferior good. But that is a rare case, and ultimately it will not detain us very long. The Importance of Substitution Effect It is the availability of substitute goods that primarily determines how people react to price changes. One reason for the relative importance of substitution effects is that in most cases income effects will be small because we are looking at goods that constitute only a small portion of people’s spending. A second reason the economists tend to focus mainly on the substitution effects of price changes is that the sizes of these effects can be quite varied, depending on which specific goods are being considered. Giffen’s paradox - A situation in which an increase in a good’s price leads people to consume more of the good The Lump-Sum Principle Specifically, taxes that are imposed on general purchasing power will have smaller welfare costs than will taxes imposed on a narrow selection of commodities. This ‘‘lump-sum principle’’ lies at the heart of the study of the economics of optimal taxation Substitutes and Complements Whether two goods are substitutes or complements of each other is primarily a question of the shape of people’s indifference curves. The market behavior of individuals in their purchases of goods can help economists to discover these relationships. Two goods are complements if an increase in the price of one causes a decrease in the quantity consumed of the other. For example, an increase in the price of coffee might cause not only the quantity demanded of coffee to decline but also the demand for cream to decrease because of the complementary relationship between cream and coffee. Similarly, coffee and tea are substitutes because an increase in the price of coffee might cause the quantity demanded of tea to increase as tea replaces coffee in use. Individual Demand Curves An individual demand curve shows the ceteris paribus relationship between the quantity demanded of a good (say, X) and its own price (PX). Not only are preferences held constant under the ceteris paribus assumption (as they have been throughout our discussion in this chapter), but the other factors in the demand function (that is, the price of good Y and income) are also held constant. In demand curves, we are limiting our study to only the relationship between the quantity of a good chosen and changes in its price. Shape of the Demand Curve The precise shape of the demand curve is determined by the size of the income and substitution effects that occur when the price of X changes. A person’s demand curve may be either rather flat or quite steeply sloped, depending on the nature of his or her indifference curve map. If X has many close substitutes, the indifference curves will be nearly straight lines and the substitution effect from a price change will be very large. The quantity of X chosen will fall substantially in response to a rise in its price; consequently, the demand curve will be relatively flat. On the other hand, a person’s demand curve for some goods may be steeply sloped. That is, price changes will not affect consumption very much. This might be the case if the good has no close substitutes. For example, consider a person’s demand for water. Because water satisfies many unique needs, it is unlikely that it would have any substitutes when the price of water rose, and the substitution effect would be very small. Shifts in an Individuals Demand Curve An individual’s demand curve summarizes the relationship between the price of X and the quantity demanded of X when all the other things that might affect demand are held constant. The income and substitution effects of changes in that price cause the person to move along his or her demand curve. If one of the factors (the price of Y, income, or preferences) that we have so far been holding constant were to change, the entire curve would shift to a new position. The demand curve remains fixed only while the ceteris paribus assumption is in effect. When income increases, people buy more X even if its price has not changed, and the demand curve shifts outward. Panels b and c in Figure 3.9 record two possible effects that an increase in the price of Y might have on the demand curve for good X. In panel b, X and Y are assumed to be substitutes—for example, coffee (X) and tea (Y). An increase in the price of tea causes the individual to substitute coffee for tea. More coffee (that is, good X) is demanded at each price than was previously the case. At P1, for example, the quantity of coffee demanded increases from X1 to X2. On the other hand, suppose X and Y are complements—for example, coffee (X) and cream (Y). An increase in the price of cream causes the demand curve for coffee to shift inward. Because coffee and cream go together, less coffee (that is, good X) will now be demanded at each price. This shift in the demand curve is shown in panel c—at P1, the quantity of coffee demanded falls from X1 to X2. The movement downward along a stationary demand curve in response to a fall in price is called an increase in quantity demanded. A shift outward in the entire curve is an increase in demand. A rise in the price of a good causes a decrease in quantity demanded (a move along the demand curve), whereas a change in some other factor may cause a decrease in demand (a shift of the entire curve to the left) Consumer Surplus Demand Curves and Consumer Surplus Each point on the demand curve can be regarded as showing what a person would be willing to pay for one more unit of the good. Demand curves slope downward because this ‘‘marginal willingness to pay’’ declines as a person consumes more of a given good. Because a good is usually sold at a single market price, people choose to buy additional units of the good up to the point at which their marginal valuation is equal to that price Consumer surplus - The extra value individuals receive from consuming a good over what they pay for it. What people would be willing to pay for the right to consume a good at its current price. Consumer Surplus and Utility The concept of consumer surplus can be tied directly to the theory of utility maximization we have been studying. Specifically, consumer surplus provides a way of putting a monetary value on the effects that changes in the marketplace have on people’s utility Conclusion —that consumer surplus provides a way of putting a dollar value on the utility people gain from being able to make market transactions Market Demand Curves The market demand for a good is the total quantity of the good demanded by all buyers. The market demand curve shows the relationship between this total quantity demanded and the market price of the good, when all other things that affect demand are held constant. The market demand curve’s shape and position are determined by the shape of individuals’ demand curves for the product in question. Market demand is nothing more than the combined effect of economic choices by many consumers. Elasticity Price Elasticity of Demand Although economists use many different applications of elasticity, the most important is the price elasticity of demand. Changes in P (the price of a good) will lead to changes in Q (the quantity of it purchased), and the price elasticity of demand measures this relationship. Specifically, the price elasticity of demand (eQ,P) is defined as the percentage change in quantity in response to a 1 percent change in price. In mathematical terms, Price elasticity of demand = Percentage change in Q/Percentage change in P Because P and Q move in opposite directions (except in the rare case of Giffen’s paradox), eQ,P will be negative. Probably the most important thing to remember is that the price elasticity of demand looks at movements along a given demand curve and tells you how much (in percentage terms) quantity changes for each percent change in price. You should also keep in mind that price and quantity move in opposite directions, which is why the price elasticity of demand is negative Price Elasticity and Substitution Effect Our discussion of income and substitution effects provides a basis for judging what the size of the price elasticity for particular goods might be. Goods with many close substitutes (brands of breakfast cereal, small cars, brands of electronic calculators, and so on) are subject to large substitution effects from a price change. For these kinds of goods, we can presume that demand will be elastic (eQ,P < 1). On the other hand, goods with few close substitutes (water, insulin, and salt, for example) have small substitution effects when their prices change. Demand for such goods will probably be inelastic with respect to price changes (eQ,P > 1; that is, eQ,P is between 0 and 1). Of course, as we mentioned previously, price changes also create income effects on the quantity demanded of a good, which we must consider to completely assess the likely size of overall price elasticities. Still, because the price changes for most goods have only a small effect on people’s real incomes, the existence (or nonexistence) of substitutes is probably the principal determinant of price elasticity. Price Elasticity and Total Expenditures The price elasticity of demand is useful for studying how total expenditures on a good change in response to a price change. Total expenditures on a good are found by multiplying the good’s price (P) times the quantity purchased (Q). If demand is elastic, a price increase will cause total expenditures to fall. When demand is elastic, a given percentage increase in price is more than counterbalanced in its effect on total spending by the resulting large decrease in quantity demanded If demand is unit elastic (eQ,P ¼ 1), total expenditures stay the same when prices change. A movement of P in one direction causes an exactly opposite proportional movement in Q, and the total price-times- quantity stays fixed. Even if prices fluctuate substantially, total spending on a good with unit elastic demand never changes. Finally, when demand is inelastic, a price rise will cause total expenditures to rise. A price rise in an inelastic situation does not cause a very large reduction in quantity demanded, and total expenditures will increase Demand Curves and Price Elasticity A more accurate way of speaking is to say that ‘‘at current prices, the price elasticity of demand is …’’ and, thereby, leave open the possibility that the elasticity may take on some other value at a different point on the demand curve. Income Elasticity of Demand Another type of elasticity is the income elasticity of demand (eQ,I ). This concept records the relationship between changes in income and changes in quantity demanded: Income elasticity of demand eQ,I = Percentage change in Q / Percentage change in I For a normal good, eQ,I is positive because increases in income lead to increases in purchases of the good. Among normal goods, whether eQ,I is greater than or less than 1 is a matter of some interest. Goods for which eQ,I > 1 might be called luxury goods, in that purchases of these goods increase more rapidly than income On the other hand, Engel’s Law suggests that food has an income elasticity of much less than 1. If the income elasticity of demand for food were 0.5, for example, then a 10 percent rise in income would result in only a 5 percent increase in food purchases. Considerable research has been done to determine the actual values of income elasticities for various items, and we discuss the results of some of these studies in the final section of this chapter. CROSS-PRICE ELASTICITY OF DEMAND Earlier, we showed that a change in the price of one good will affect the quantity demanded of many other goods. To measure such effects, economists use the crossprice elasticity of demand. This concept records the percentage change in quantity demanded (Q) that results from a 1 percentage point change in the price of some other good (call this other price P 0 ). That is, Cross-price elasticity of demand eQ,P = Percentage change in Q / Percentage change in P If the two goods in question are substitutes, the cross-price elasticity of demand will be positive because the price of one good and the quantity demanded of the other good will move in the same direction. Chapter 4 Uncertainty Probability and Expected Value The probability of an event happening is the relative frequency with which it occurs. For example, to say that the probability of a head coming up on the flip of a fair coin is 1/2 means that if a coin is flipped a large number of times, we can expect a head to come up in approximately one-half of the flips. Similarly, the probability of rolling a ‘‘2’’ on a single die is 1/6. In approximately one out of every six rolls, a ‘‘2’’ should come up. Of course, before a coin is flipped or a die is rolled, we have no idea what will happen, so each flip or roll has an uncertain outcome. The expected value of a gamble with a number of uncertain outcomes (or prizes) is the size of the prize that the player will win on average Risk Aversion Risk aversion - The tendency of people to refuse to accept fair gambles It is the gamble’s utility (what Bernoulli called the moral value) associated with the gamble’s prizes that is important for people’s decisions. If differences in a gamble’s money prizes do not completely reflect utility, people may find that gambles that are fair in dollar terms are in fact unfair in terms of utility Willingness to Pay to Avoid Risk Diminished marginal utility of income means that people will be averse to risk. Among outcomes with the same expected dollar values ($35,000 in all of our examples), people will prefer risk-free to risky ones because the gains such risky outcomes offer are worth less in utility terms than the losses. In fact, a person would be willing to give up some amount of income to avoid taking a risk. For example, a risk- free income of $33,000 provides the same utility as the $5,000 gamble (U2). The individual is willing to pay up to $2,000 to avoid taking that risk. There are a number of ways this person might spend these funds to reduce the risk or avoid it completely, which we will study below. Saying that someone is ‘‘very risk averse’’ is the same as saying that he or she is willing to spend a lot to avoid risk. The shape of the utility-of-income curve, such as U, provides some idea of how risk averse the individual is. If U bends sharply, then the utility the individual obtains from a certain outcome will be well above the expected utility from an uncertain gamble with the same expected payoff. The less U bends (that is, the more linear U is), the less risk averse is the person. In the extreme, if U is a straight line, then the person will be indifferent between a certain outcome and a gamble with the same expected payoff. In other words, he or she would accept any fair gamble. A person with these risk preferences is said to be risk neutral. Even for a very risk-averse person with a utility-of-income curve that is sharply bent, if we took a small piece of the curve, say that between incomes $33,000 and $35,000, and blew it up to be able to see it better, this piece looks almost like a straight line. Because straight lines are associated with risk-neutral individuals, this graphical exercise suggests that even people who are risk averse over large gambles (with, say, thousands of dollars at stake) will be nearly risk neutral over small gambles (with only a few dollars at stake). People are not very averse to small risks because even the worst case with a small risk does not reduce the person’s income appreciably. Methods for Reducing Risk and Uncertainty Insurance The underlying motive for insurance purchases is: Here, we have repeated the utility-of-income curve, but now we assume that during the next year this person with a $35,000 current income (and consumption) faces a 50 percent chance of having $15,000 in unexpected medical bills, which would reduce his or her consumption to $20,000. Without insurance, this person’s utility would be U1—the average of the utility from $35,000 and the utility from $20,000. Diversification A second way for risk-averse individuals to reduce risk is by diversifying. This is the economic principle underlying the adage, ‘‘don’t put all your eggs in one basket.’’ By suitably spreading risk around, it may be possible to raise expected utility above that provided by following a single course of action. This possibility shows the utility of income for an individual with a current income of $35,000 who must invest $15,000 of that income in risky assets. Let’s consider a diversified strategy in which the investor buys 7,500 shares of each stock. There are now four possible outcomes, depending on how each company does. Each of these outcomes is equally likely. Notice that the diversified strategy only achieves very good or very bad results when both
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