Economics 111.3 Winter 14

March 5th, 2014Lecture 19

Ch. 9 Ordinal Utility:

Indifference Curve Analysis

Substitution Effect and Income Effect

Income and substitution effects: sign of an effect Effect is negative, if price and quantity move in opposite directions;Effect is positive, if price and quantity move in the same direction

𝑖𝑛𝑐𝑜𝑚𝑒𝑒𝑓𝑓𝑒𝑐𝑡 :( 𝐼𝑛𝑐𝑜𝑚𝑒𝑃↓ )↑

Income and substitution effect with an inferior good: substitution effect: opposite of price movementincome effect: same direction as price movement

𝐼𝑛𝑓𝑒𝑟𝑖𝑜𝑟 𝑔𝑜𝑜𝑑 : 𝐼𝑛𝑐𝑜𝑚𝑒↑∴𝑄↓ ,𝑖𝑛 h𝑜𝑡 𝑒𝑟 𝑤𝑜𝑟𝑑𝑠 ,𝑃↓𝑄↓−𝑒𝑓𝑓𝑒𝑐𝑡 𝑖𝑠𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒

𝐼𝑛𝑐𝑜𝑚𝑒𝑒𝑓𝑓𝑒𝑐𝑡 :( 𝐼𝑛𝑐𝑜𝑚𝑒𝑃 ↓ )↑

U1

U2

E

F

G

Good Y

Good X

Is good X inferior or normal?

Substitutioneffect Incom

eeffect

A Giffen Good

Giffen good: good for which a decrease in its price causes the quantity demanded to fall

Basketball, Tickets per year

Movies, Tickets per year

L1

L*

Total effectIncome effect

Substitution effect

L2

e1

e2

e*

I 1

I 2

Upward-Sloping Demand Curve: The Giffen Good

When food is an inferior good, and when the income effect is large enough to dominate the substitution effect, the demand curve will be upward-sloping. The consumer is initially at point A, but, after the price of food falls, moves to B and consumes less food. Because the income effect EF2 is larger than the substitution effect F1E, the decrease in the price of food leads to a lower quantity of food demanded.

A Special Case: The Giffen Good

● Giffen good Good whose demand curve slopes upward because the income effect is larger than the substitution effect.

Is Cola normal good or inferior good?

True or False

True or False

Ch. 10: up to p. 231

Some useful terminology:• Plant – a physical establishment (factory, mine, store)

that performs one or more functions in fabricating and distributing goods and services

• Firm – a business organization that owns and operates plants. A firm:– Organizes factors of production.– Produces goods and services.– Sells produced goods to individuals, businesses or

government.• Industry – a group of firms producing the same, or

similar, product.

Firms Maximize Profit

• Profit is the difference between total revenue and total cost.

Profit = Total revenue – Total cost

Profit = Total revenue –Economic cost

Economic costs• ECONOMIC COST of any

resource is the value or worth it would have in its best alternative use

• FIRM’S ECONOMIC COST – those payments a firm must make, or incomes it must provide, to resource suppliers to attract the resources away from alternative production

opportunities.

Economic costs are the sum of

Explicit Costs• Money payments a firm must

make to non-owners of the firm for the resources they supplied.

Implicit Costs• Opportunity costs of firm’s own

resources or money payments the self-employed resources could have earned in their best alternative use.