Lecture 8(iii) Announcements

Start working on “Consumer Theory” worksheet (at week 9 on Canvas)

Lecture Continuing Consumer Theory from Lec 8(ii)

1. Review last class: PerfectSubstitutes case

2. Perfect Complements.

3. Goldy Gopher. In betweenextreme cases.

4. Impact on demand from changein income.

5. Impact on demand from changein price. (Income and SubstitutionEffects)

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Last Class: drew 3 indifference curves

Indifference curve through Qbeer = 12 and Qpizza = 0

Indifference curve through Qbeer = 14 and Qpizza = 0

Indifference curve through Qbeer = 6 and Qpizza = 0

Rule: pick the bundle on the budget constraint that gets to the highest indifference curve

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0 1 2 3 4 5 6 7 8 9 1011121314Pizza

Beer

The slope of indifference curve is The Marginal Rate of Substitution

Here one for one. (value of one more pizza slice in terms of beer).

Look again at Qbeer = 12 and Qpizza = 0 on the budget constraint. At this point:

Value of one more unit of pizza: one beer

Cost of one more unit of pizza: two beers

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How many meals can he buy?

So Qpizza = 4 and Qbeer = 4 in optimal consumption bundle.

Picture?

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10111213141516

0 1 2 3 4 5 6 7 8 9 1011121314Pizza

Beer

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10111213141516

0 1 2 3 4 5 6 7 8 9 1011121314Pizza

Beer

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Suppose PBeer = $2, PPizza = $4, I = $24

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0 1 2 3 4 5 6 7 8 9 1011121314

Beer

U=2

U=3

At optimum two conditions:

(1) On budget constraint and

(2) Ppizza

MRS = _______Pbeer

Marginal benefit of pizza (in beer)

=

Marginal cost of pizza (in beer)

What are we doing here? Constructing Demand Curves

Demand for pizza depends upon? Own price (here $4) price of other stuff (here price of beer= $2) Income (here $24) Preferences (Here Goldy)

Put this together, get point A Quantity demanded = 3 Pizza

(and 6 beers)

Point where: (1) On budget constraint and

(2) MRS = Ppizza/Pbeer

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0 1 2 3 4 5 6 7 8 9 1011121314

Beer

U=2

U=3A

We use the new graph to determine our old graph (Demand Curve from the beginning

of the semester)

Lower price to $1, move alongdemand

Change income, shift demand At Income = $40: Pick optimal consumption bundle and label it B

Ppizza

Qpizza

4

11

3 5 12

At Income = $40, Goldy consumes:

____ Pizza

____ Beer

Pizza and beer

are _________ goods

But what would an inferior good look like on new graph?

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t

sp

I =

I =

Forglet’sthe o

pam =

= $2

= $4

get Bs suponly

= $2,

24 in

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, Pste

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0 1 2 3 4 5 6 7 8 9 1011121314

Steak

Spam

1. Income and Substitution Effects

At optimum two conditions: (1) Ppizza

MRS = _______Pbeer

(2) On budget constraint

If initially at optimum and price of pizza falls, then both conditions are messed up.

Breaking things down into incomeand substitution effects, we fix things one at a time. (1) Fix MRS=price ratio condition(2) Shift to fix budget constraint.

Definitions:

1. Substitution effect. Effect ofchange in opportunity cost (byspending power held fixed so stay onsame indifference curve)

buy more if price falls

2. Income effectThe effect of change in incomeholding opportunity cost fixed at thenew level.

direction of effect depends upon whether normal or inferior

Let’s start with the total effect. That should be easy

Our old graph of demand curve from the beginning of the semester

Start at price equal $4, lower price to $1, is a movement along demand

Ppizza

Qpizza

4

11

3 5 12

I = $24 and PBeer=$2 fixed

PPizza = $4: Label OCB A

PPizza = $1: Label OCB C

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0 1 2 3 4 5 6 7 8 9 101112131415161718192021222324

Beer

PizzaWe will do income and substitution part next week.

(OCB is Optimal Consumption Bundle)

Movement A to C is total effect of price decrease

Breakdown into substitution effect: New opportunity cost, but original indifference curve.

Label this S

Substitution Effect is movement from A to S

Income Effect is movement from S to C

When price falls:

Substitution effect: buy more (because opportunity cost is lower)

Income effect (since original bundle is cheaper than before so have income left over)

normal good: buy more inferior good: buy less

So if normal, Sub and Inc work same way

If inferior, Sub and Inc go different ways.