11

Welcome to Welcome to EC 209: Managerial EC 209: Managerial Economics- Group AEconomics- Group ABy:By: Dr. Jacqueline KhorassaniDr. Jacqueline Khorassani

Week FourWeek Four

22

Class OneClass One

Monday, September 24Monday, September 24

11:10-12:0011:10-12:00Fottrell (AM)Fottrell (AM)

APLIA ASSIGNMENT IS DUE APLIA ASSIGNMENT IS DUE BEFORE 5:00 PM BEFORE 5:00 PM TOMMORROWTOMMORROW

The next one is due in a weekThe next one is due in a week

33

Remember the 4 Remember the 4 properties of consumer properties of consumer preferencespreferences1.1. CompletenessCompleteness

2.2. More is BetterMore is Better

3.3. Diminishing Marginal Rate of Diminishing Marginal Rate of SubstitutionSubstitution

4.4. TransitivityTransitivity

44

How does the indifference How does the indifference curve reflect properties 1 & curve reflect properties 1 & 2?2?

3 bundles: A, B and C3 bundles: A, B and C– Consumer can say which Consumer can say which

ones she likes, dislikes ones she likes, dislikes (Property 1)(Property 1)

– Does consumer likes B as Does consumer likes B as much as A?much as A?

NoNo B (more) is better (property B (more) is better (property

2)2)

– A & C are on the same A & C are on the same indifference curveindifference curve

– B is on a higher B is on a higher indifference curveindifference curve

Represents a higher level of Represents a higher level of satisfactionsatisfaction

I.

II.

Good Y

Good X

A

C

B

1

33.33

100

3

55

How does the indifference How does the indifference curve reflect property 3?curve reflect property 3?

To go from consumption To go from consumption bundle A to B the bundle A to B the consumer is willing to give consumer is willing to give up _____units of Y to get up _____units of Y to get one additional unit of X.one additional unit of X.

To go from consumption To go from consumption bundle B to C the bundle B to C the consumer is willing to give consumer is willing to give up _____ units of Y to get up _____ units of Y to get one additional unit of X.one additional unit of X.

To go from consumption To go from consumption bundle C to D the bundle C to D the consumer is willing to give consumer is willing to give up only _____ units of Y to up only _____ units of Y to get one additional unit of get one additional unit of X.X.

I.

II.

III.

Good Y

Good X1 3 42

100

50

30 20

A

B

CD

50

20

10

66

Note: MRS = slope of Note: MRS = slope of indifference curveindifference curve

Between A to B Between A to B MRS = -50MRS = -50

Between B to CBetween B to CMRS = -20MRS = -20

Between C to DBetween C to DMRS = -10MRS = -10

How do we find the How do we find the slope at point B?slope at point B?– Slope of the tangency line Slope of the tangency line

at point Bat point B The indifference curve The indifference curve

becomes flatter from becomes flatter from the left to the rightthe left to the right

I.

Good Y

Good X1 3 42

100

50

30 20

A

B

CD

77

How does the indifference How does the indifference curve reflect property 4?curve reflect property 4?

For the three For the three bundles A, B, bundles A, B, and C, the and C, the transitivity transitivity property implies property implies that that

if C if C B B and B and B A, A, then C then C A. A.

I.

II.

III.

Good Y

Good X21

100

5

50

7

75

A

B

C

88

Can two indifference Can two indifference curves intersect?curves intersect?

What if they did?What if they did? C is better than A C is better than A

(because C represents (because C represents more)more)

Since C and B are on Since C and B are on the same indifference the same indifference curve, B should be curve, B should be better than A too; Is it?better than A too; Is it?

No, as B is on the same No, as B is on the same indifference curve as Aindifference curve as A

I.

II.

Good Y

Good X2

A C

B100

3

99

What if X and Y were What if X and Y were perfect substitutes?perfect substitutes? ExampleExample

– You don’t know the difference You don’t know the difference between Coke and Pepsibetween Coke and Pepsi

Coke

Pepsi109

8

1 2 3

A

BC

I II

III

Indifference curve is a straight line

MRS is constant

1010

What if X and Y were What if X and Y were complementscomplements

ExampleExample I never have coffee without sugarI never have coffee without sugar

sugar

coffee

1

2

2 4

A I

IIB

Always 1 coffee + 2 sugars

If 1 coffee + 4 sugars, am I better off?

No

If 2 coffee + 2 sugars, not better off

But if 2 coffee + 4 sugars better off

1111

Managerial Economics- Managerial Economics- Group AGroup A Week Four- Class 2Week Four- Class 2

– Tuesday, September 25Tuesday, September 25– 15:10-16:0015:10-16:00– CairnesCairnes

Aplia Assignment before 5 today.Aplia Assignment before 5 today.– Don’t miss it.Don’t miss it.

1212

I got a questionI got a question

I bought the book from the I bought the book from the college bookshop the other day, college bookshop the other day, but I don't think that the extra but I don't think that the extra chapter from the other book was chapter from the other book was included in the pack.included in the pack.– You can copy the extra chapter from You can copy the extra chapter from

the copies in the library. the copies in the library. Chapter 8Chapter 8 of Microeconomics by Frank of Microeconomics by Frank

1313

The Budget ConstraintThe Budget Constraint Suppose Suppose

PPy = = €5€5

PPXX = €2.5 = €2.5 M = €50M = €50

Can I afford 2Xs and 2 Can I afford 2Xs and 2 Ys?Ys?– YesYes

Opportunity SetOpportunity Set The set of The set of

consumption bundles consumption bundles that are affordable.that are affordable.

PPxxX + PX + PyyY Y M. M.

Y

XThe Opportunity Set

M/PY=10

M/PX=20

2

2

1414

The Budget LineThe Budget Line

– The bundles of The bundles of goods that exhaust goods that exhaust a consumer’s a consumer’s income.income.

PPxxX + PX + PyyY = M.Y = M.

Y

X

Budget Line

10

20

1515

What is the slope of What is the slope of budget line? budget line?

Slope of budget lineSlope of budget line– Measures the rate at Measures the rate at

which you can afford which you can afford to substitute X for Yto substitute X for Y

– For each Y you give For each Y you give up, you can buy 2Xsup, you can buy 2Xs

– Slope = -10/20 Slope = -10/20 – Slope = Market Rate Slope = Market Rate

of Substitution of Substitution

– Slope =Slope = - - PPxx / P / Pyy

Y

X

Budget Line

10

20

9

2

1616

What if budget What if budget doubles?doubles?

From 50 to 100From 50 to 100 Does the slope Does the slope

change?change? NoNo Because prices Because prices

did not changedid not change Budget increase Budget increase

leads to a leads to a parallel shift to parallel shift to the rights.the rights.

What will a What will a budget budget decrease do?decrease do?

X

Y

10

20

20

40

1717

What if price of X goes What if price of X goes down to down to €€1?1?

A decreases in the A decreases in the price of good X price of good X rotates the budget rotates the budget line counter-line counter-clockwise clockwise

An increases An increases rotates the budget rotates the budget line clockwiseline clockwise

X

Y

New Budget Line for a price decrease.10

20 50

1818

Consumer EquilibriumConsumer Equilibrium

The equilibrium The equilibrium consumption bundle is consumption bundle is the affordable bundle the affordable bundle that yields the highest that yields the highest level of satisfaction.level of satisfaction.– Consumer equilibrium Consumer equilibrium

occurs at a point whereoccurs at a point where

MRS MRS = P= PXX / P / PY.Y.

– Equivalently, the slope Equivalently, the slope of the indifference of the indifference curve equals slope of curve equals slope of the budget line.the budget line.

I.

II.

III.

X

Y

Consumer Equilibrium

M/PY

M/PX

1919

Suppose consumer is at Suppose consumer is at her equilibrium. (point A)her equilibrium. (point A)

Now let us drop the price of X

What is going to happen next?

Budget line rotates to the right

Y

X

II

I0

Y2

Y1

X1 X2

A

B

M/PX1M/PX2

M/PY1

What can you say about how X and Y are related to each other?

Complements

2020

Suppose consumer is at Suppose consumer is at her equilibrium. (point A)her equilibrium. (point A)

Now let us drop the price of X

What is going to happen next?

Budget line rotates to the right

Y

X

III0

Y2

Y1

X1

X2

A B

M/PX1 M/PX2

M/PY1

What can you say about how X and Y are related to each other?

Substitutes

2121

Suppose consumer is at Suppose consumer is at her equilibrium. (point A)her equilibrium. (point A)

Now let us increase income

What is going to happen next?

Budget line makes a shift to the right.

Y

II

I

0

A

B

X

M0/PY

M0/PX

M1/PY

M1/PXX0

Y0

X1

Y1

What can you say about the nature of X and Y?

They are both normal goods

2222

What if X was inferior What if X was inferior goodgood An increase in income will have An increase in income will have

result in fewer Xs being bought.result in fewer Xs being bought. Make sure you can show this case Make sure you can show this case

graphically.graphically.

2323

Managerial EconomicsManagerial Economics

Week Four- Class 3Week Four- Class 3– September 27September 27– 15:10-16:0015:10-16:00– TyndallTyndall

Aplia Assignment 2 is due by Aplia Assignment 2 is due by TuesdayTuesday

2424

The effects of a price The effects of a price change on quantity of change on quantity of consumptionconsumption When X becomes cheaper two things When X becomes cheaper two things

happenhappen

1.1. Your purchasing power goes up. Your purchasing power goes up. This is as if your real income went up. This is as if your real income went up. So you will be able to buy more goods So you will be able to buy more goods

(not just more X) and (not just more X) and reach a higher indifference curvereach a higher indifference curve This is called the INCOME EFFECT (IE) of This is called the INCOME EFFECT (IE) of

the price changethe price change

2525

The effects of a price The effects of a price change on quantity of change on quantity of consumptionconsumption When X becomes cheaper two When X becomes cheaper two

things happenthings happen2. Relative to Y, X is now cheaper. 2. Relative to Y, X is now cheaper.

This will make you substitute X for Y This will make you substitute X for Y This effect does not make you better This effect does not make you better

off off You stay on the same indifference You stay on the same indifference

curve curve This is called the SUBSTITUTIN EFFECT This is called the SUBSTITUTIN EFFECT

(SE) of the price change(SE) of the price change

2626

Let’s show the IE and the SE Let’s show the IE and the SE graphicallygraphically

Initially, bundle A is consumed.

What happens if the price of X goes down?

Budget line rotates counterclockwise

You will move from A to C buying 4 more Xs

Y

II

I

0

A

X

C

4 8

2727

SESE

To separate the SE from IE

Draw a line tangent to “I“ but parallel to the new budget line

A movement from A to B is the SE.

Why?

You are still on the same indifference curve (same satisfaction) but buying more just because relative to Y, X is now cheaper

Y

II

I

0

A

X

C

B

SE4 6 8

2828

IE IE

A movement from B to C is the IE.

Why?

The slope of the orange line is the same as the slope of the new budget line

Meaning that the ratio of prices are the same

So why are you buying more X?

Because your real income (purchasing power) has gone up.

Is X normal or inferior?

Normal, because income effect is positive

Y

II

I

0

A

X

C

B

SE4 6 8

IE

2929

What if X was inferior? What if X was inferior?

Income effect will be negative

How can we show it?

SE says buy 2 more Xs

But income effect says buy one less Xs

Since the substitution effect is stronger than income effect, you end up buying one more X

Y

II

I

0

A

X

C

B

SE4

6

IE

5

3030

Giffen goodGiffen good

Is an inferior good for Is an inferior good for whichwhich– SE<IESE<IE– When the prices goes downWhen the prices goes down– You buy less of itYou buy less of it– You must be able to show You must be able to show

this case graphicallythis case graphically

3131

Where does the demand Where does the demand curve for X come from? curve for X come from? Two graphsTwo graphs Top graph is Top graph is

indifference curve indifference curve and budget lineand budget line

The bottom graph The bottom graph shows quantity of shows quantity of X on horizontal X on horizontal axis and Price of axis and Price of X on vertical axisX on vertical axis

X

X

Y

P

3232

Where does the demand Where does the demand curve for X come from? curve for X come from? Originally POriginally Pxx = = €€1010

QQXX= 4= 4 Now let’s drop the Now let’s drop the

price to price to €5€5 QQXX= 6= 6 Connect A’ to B’Connect A’ to B’ You will get the You will get the

demand curve for Xdemand curve for X

X

X

Y

P

I

A

4

4

10 A’

II

B

5

6

6

B’

3333

What is the market What is the market demand curve?demand curve? the horizontal summation of individual demand the horizontal summation of individual demand

curves.curves. When P = 50, Q = 0When P = 50, Q = 0 When P = 40, Q = 3When P = 40, Q = 3

Q

$ $

Q

50

40

D2D1

2 Individual Demand Curves

Market Demand Curve

1

1

DM

2 2 3

3434

How does the demand How does the demand for a Giffen good look?for a Giffen good look?

You should be able to answer this You should be able to answer this question on your own.question on your own.

3535

Study Guide 4 containedStudy Guide 4 contained

Marginal Utility Marginal Utility – What is it?What is it?– How is it measured?How is it measured?– How does it relate to the indifference?How does it relate to the indifference?– How does that relate to consumer How does that relate to consumer

equilibrium?equilibrium? For now, we skip itFor now, we skip it