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ECS2601 BMZ ASSESSMENT 4 SEMESTER 2 2024 MASTER In a perfectly competitive industry, the amount of output that a rm decides to sell has no effect on the market price, because… a. the rm’s output...
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Notes on lecture clipsNotes on lecture clips week 2
1. Budget lines
The inversed demand curve is determined by the optimal choice (preferences and restrictions). The
elasticity is the degree to which consumers react to price changes. Preferences determine the
demand, consumers strives for optimal utility. In this search, you face restrictions which influence
your behavior.
Bundle is a combination of goods that is preferred. It is list with specific quantities of one or more
goods. Given you budget, you can determine what you can you. Given what you like, you can
determine the indifference curves (with multiple bundles on the line). Given you budget and your
bundles, you make your optimal decision.
To find you budget line, you have to fill in the 0 units on the x-axis and y-axis, given you spent all your
income on the two goods. The larger the rise of the budget line is, the steeper the slope is. The slope
of the budget line is represented by the price ratio. If the price ratio changes, the slope of the budget
line will also change. If the price ratio is lower, the slope will be less steep. For optimization, you will
have to choose the option that is on the budget line, otherwise you don’t spent all you income. If the
price of a given good changes, the line rotates. When your real income (purchasing power) changes,
the budget line shifts to the left/right itself, parallel.
2. Preferences
Indifference curves tells us what you preferences are. The indifference curve represents (connects) all
bundles where the consumer is as well off as with bundle A. He/she has the same utility. Indifference
curves connects all bundles that the consumer is equally happy (not more, not less). The utility level
is constant on the same curve. Basic assumptions are:
- More is better – but only of the good goods, not the bads. If
there is a bad, the indifference curve is upward sloping
instead of downward sloping.
- Transitivity – if A>B and B>C then A>C
- Completeness – you can rank and compare all the different
bundles (all bundles deliver equal utility
- Convex indifference curves leading to dimishing MRS
*Completeness and more is better leads to a downward sloping indifference curve.
The marginal rate of substitution (MRS) is the amount of the good on the y-axis that the consumer is
willing to give up in order to obtain 1 extra unit of the good on the x-axis, such that you are equally
well off (moving on the indifference curve). The MRS decreases as you move downward the
indifference curve, while it is an convex indifference curve. The MRS always declines, so diminishing
marginal rate of substitution. The steeper the indifference curve, the larger the MRS. The magnitude
of the slope of an indifference curve measures the
consumers MRS between two goods.
Indifference curves cannot cross each other, because of the
transitivity assumption.
,We can have different levels of utiltity between different indifference curves, but the level of utility is
the same on one indifference curve.
If we know the utility function and the both goods, we can
measure the utility.
For both complementary and substitue goods, the
indifference curves look different. Perfect complements are
two goods for which the MRS is zero or infinite (while there is
no slope in the graph), the indifference curves are shapred as
right angles.
If with substitute goods; two goods for which the MRS
of one for the other is constant. The indifference curve
is linear, because you do not care how much you are
willing to give up.
3. Optimal choice
The preferences and restrictions determine your optimal choice. We will always try to consume a
bundle on the highest indifference curve that is attainable, given our budget line. In this optimal
outcome, the slopes of the budget line equals the slope of the indifference curve. this is while your
budget is optimal, and also the best bundle is chosen now. Satisfaction is maximized (given the
budget constraints) at the point where MRS meets the price ratio.
You need to understand the equal marginal principle (which means the price ratio equals the
marginal utility for an optimal outcome, read chapter 4). The marginal utility per euro spent must be
the same across all goods you consume. The equal
marginal principle also means that the slope op the
budget line equals the slope of the indifference curve.
Perfect complements and their optimal choice; optimal
consumption bundles are in the corners of the L-shaped
indifference curves, whatever the prices.
Perfect substitues and their optimal choice; we
find the highest indifference curve that touches
the budget line. This leads to a corner solution
(you find the best point, but it is not the official
optimum), which means that only the relatively
cheaper solution is bought, while you do not care
what good you consume (perfect substitutes), so
you choose the cheapest option.
You should also know the consumer/producer suplus in chapter 4!
, 4. Income effects (IE) and substitution effects (SE)
What happenens if the price/income changes? The optimum is reacheas when the highest
indifference curve meets the budget line. If the price of the good changes, the line rotates around the
y-axis. If income changes, the line will shift parallel to left/right. From the price-consumption curve
we can derive the inversed demand curve. The price-consumption curve represents a line through
multiple bundles that lie on different utility curves.
- Ordinary good; with an ordinary good, it is what you would expect. If the price of a good
rises, the consumption declines. And when the price drops, the consumption rises.
- Giffen goods – a rise in the price will lead to an increase in consumption (see the blue dot on
the right). Or if the price is lower, the consumption drops also. This will lead to an upward
demand curve. it is not the same as a luxury good, while giffen goods happen in poverty most
of the times (potato eaters cannot afford meat anymore).
- Inferior goods – if your income rises, your consumption drops.
When income changes (real income, purchasing power). When the income descreases and the price
ratio stays constant, the budget line shifts parallel to the left. You can buy less of all goods. Then you
find a new highest indifference curve. this is a normal good, while the consumption drops if the prices
are higher and income lower.
Income effect – the effect of price changes on your purchasing power, holding relative prices
constant. An income effect (IE) is the change in consumption of a good due to a change in purchasing
power, holding relative prices constant. With the IE you are keeping the budget constraint constant
and the utility can change. The price ratio stays the same, but we only want to know the change on
the purchasing power.
, Normal good – if the price is lower, real income rises, the consumption will also rise
Inferior good – if the price is lower, if real income rises, the consumption will fall
Substitution effect – the pure effect on demand of change in relative prices, holding utility constant.
The substitute effect (SE) is a change in consumption of a good due to a change in price, holding
utility constant. You want to isolate the effect of price changes, but you are on the same indifference
curve. you want to buy more of the good that is relatively cheaper. This excludes the purchasing
power. The SE is negative, it is opposite in the change in price.
For example (normal good), if the price of beer
increases, the budget line rotates inwards and a new
indifference curve is met. The consumptions went
down, while income stays the same. Then we know the
total effect (TE) of the price change (which is SE+IE). The
slope of the budget line represents the price ratio. Now
the slope of the budget line is more steep. While we
now look at SE, we look at the pure effect on demand,
while utility is the same. We stay at the original
indifference curve, and imagine what we would have
consumed given the slope ‘new’ budget line. The
difference is the SE.
The rest of the TE is the income effect. We keep the
relative prices constant, so we know the income increase. SE and IE are in the same direction.
We see that with a normal good and prices increase
o SE < 0
o IE < 0
o TE < 0
For example (ordinary, inferior good), the same is done as
above. The SE is again negative, as it always is. The
difference is the income effect. Income increase leads to a
higher consumption of the good (positive income effect).
The SE and IE are in opposite direction.
We see that with an inferior good and price
increase
o SE < 0
o IE > 0
o TE < 0
For example (Giffen good, inferior good), the same is done as above. A lower price leads to a higher
consumption. The new budget line is shifted towards the old indifference curve to find SE. The SE is
again negative. Higher price, lower consumption of beer because of the changes price ratio. When we
shift the new budget line towards the new indifference curve, we see that income effect is positive
and larger than SE.
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