Introduction to Microeconomics Class 3, Winter 2025 PDF

Introduction to Microeconomics Topic 2 A Model of Consumer Choice with Multiple Goods Recap Our motivation to study econ 101.. Government decides how 30-60% of re- sources are allocated. Is this a good thing? Why should any resources be allocated through collective decisi...

Introduction to Microeconomics Topic 2 A Model of Consumer Choice with Multiple Goods Recap Our motivation to study econ 101.. Government decides how 30-60% of re- sources are allocated. Is this a good thing? Why should any resources be allocated through collective decision making? Or should government decide how 100% of resources are allocated? For this course, the question "How Big Should Government Be?" forms the common motivating thread. We will …rst compare a market economy and a command economy. We will …rst compare a market economy and a command economy. What do we need to learn to do that comparison? 1. Who gets what in a market economy 1. Who gets what in a market economy - Consumer Choice (WEEKS 1-2) 1. Who gets what in a market economy - Consumer Choice (WEEKS 1-2) - Interaction through the Market (WEEK 3) 2. Who gets what in a command econ- omy (WEEK 4) 3. How to measure and compare well- being in the two economic systems (WEEK 4) Economists’favorite assumption: Economists’favorite assumption: - People carefully evaluate costs and ben- e…ts of each action Economists’favorite assumption: - People carefully evaluate costs and ben- e…ts of each action - Then choose the best available action Economists’favorite assumption: - People carefully evaluate costs and ben- e…ts of each action - Then choose the best available action "Behavior is optimization" Model with one good - Total willingness to pay schedule is one way to model bene…ts - Prices capture costs Optimal choice obtained through "marginal analysis" Optimal choice obtained through "marginal analysis" - Compare bene…t from additional unit against cost of additional unit - An optimizing individual keeps buying as long as "marginal bene…t marginal cost" A Review Question TRUE or FALSE? - An optimizing individual maximizes mar- ginal bene…t FALSE! - Instead, an optimizing individual max- imizes net bene…t: "total bene…t - total cost" TRUE or FALSE? We assume people maximize marginal bene…t? FALSE - That would be the same as maximiz- ing ADDITIONAL bene…t. TRUE or FALSE? We assume people maximize marginal net bene…t? FALSE - That would be the same as maximiz- ing the di¤erence between ADDITIONAL bene…t and ADDITIONAL cost. Instead: We assume people maximize total net bene…t. Marginal analysis is just a solution technique – helps us …nd the optimal decision that maximizes net bene…t. New material This week’s objective: Explain and pre- dict - consumer’s choices - how changes in price and income a¤ect choices and well-being Economists’description of a consumer’s decision-making: Economists’description of a consumer’s decision-making: 1) Objectives: what does she like? Economists’description of a consumer’s decision-making: 1) Objectives: what does she like? 2) Constraints: what does she have? Economists’description of a consumer’s decision-making: 1) Objectives: what does she like? 2) Constraints: what does she have? 3) Optimization assumption Economists’description of a consumer’s decision-making: 1) Objectives: what does she like? 2) Constraints: what does she have? 3) Optimization assumption Class 3: Steps 1 and 2. Class 4: Step 3. Introduction to Microeconomics Class 3 The Budget Constraint and Preferences First: the constraints How to describe what the consumer has? Budget constraint expenses income Budget constraint expenses income Hereafter referred to as “BC”. At the optimum expenses = income Formally p1x1 + p2x2 m p1; p2 are prices x1; x2 are quantities m is income Budget set Combinations (x1; x2) that satisfy BC. Budget line Combinations (x1; x2) that satisfy BC exactly Note that in expression (x1; x2) x1 is the quantity of good 1 (maybe apples) x2 is the quantity of good 2 (maybe oranges) Budget line formally p1x1 + p2x2 = m Budget line formally p1x1 + p2x2 = m How to draw a budget line? Rearrange budget line to get m p1 x2 = x1 p2 p2 Intercept of budget line m p2 Intercept of budget line m p2 Slope of budget line p1 p2 Intercept of budget line m p2 Slope of budget line p1 p2 [Figure 3.1] Budget line - Many ways to label axes Budget line - Depicts just a¤ordable combinations Budget line - Depicts just a¤ordable combinations - Assume: consumer lives just one day Budget line - Depicts just a¤ordable combinations - Assume: consumer lives just one day => No savings motive in the model Budget line - Depicts just a¤ordable combinations - Assume: consumer lives just one day => No savings motive in the model => Optimum (next class) will be the budget line Here (the absolute value of) p1 p2 captures how much of good 2 consumer has to give up to get 1 more unit of good 1. Slope of budget line p1 p2 captures the opportunity cost of good 1. Opportunity cost what you have to give up to get more of something else. Resources are scarce => everything has an opportunity cost. Example: - A sick kid in Hospital Example: - A sick kid in Hospital - Treatment costs $17,000,000 Example: - A sick kid in Hospital - Treatment costs $17,000,000 - Kid dies without the treament Example: - A sick kid in Hospital - Treatment costs $17,000,000 - Kid dies without the treament Should government buy the treat- ment? Unfortunately, we need to ask - What we else could we do with that money? Unfortunately, we need to ask - What we else could we do with that money? - Save 100 kids su¤ering from less ex- pensive diseases? More about drawing the BC What happens when income increases? [Figure 3.2] What happens when the price of good 1 increases? [Figure 3.3] What we just examined: Consumer’s constraints Next: Consumer’s objectives - What does the consumer want? Objectives captured by: - preferences Objectives captured by: - preferences (and the “behavior is optimization” as- sumption) Preferences rank combinations (x1; x2) relative to combinations (y1; y2) : Recall that in expression (x1; x2) x1 is the quantity of good 1 (maybe apples) x2 is the quantity of good 2 (maybe oranges) Similarly, in expression (y1; y2) y1 is the quantity of good 1 (maybe ap- ples) y2 is the quantity of good 2 (maybe or- anges) Thus the subscript 1 refers to good 1 (apples) And subscript 2 refers to good 2 (or- anges) Notation (x1; x2) (y1; y2) means that (x1; x2) is strictly preferred to (y1; y2) In other words, the consumer thinks that getting amount x1 of good 1 and amount x2 of good 2 is DEFINITELY better than getting amount y1 of good 1 and amount y2 of good 2 Notation (x1; x2) (y1; y2) means indi¤erence between (x1; x2) and (y1; y2) In other words, the consumer thinks that getting amount x1 of good 1 and amount x2 of good 2 is JUST AS GOOD as getting amount y1 of good 1 and amount y2 of good 2 Notation (x1; x2) (y1; y2) means that either (x1; x2) (y1; y2) or (x1; x2) (y1; y2). Preferences rank even combinations that aren’t a¤ordable to the consumer. Three assumptions about preferences Preferences are Complete: Any two combinations can be compared Preferences are Re‡exive: Any combination at least as good as it- self Preferences are Transitive: If (x1; x2) (y1; y2) and (y1; y2) (z1; z2) then (x1; x2) (z1; z2) Indi¤erence curve depicts combinations among which a consumer is indi¤erent [Figure 3.4] Assume: Consumers prefer more to less => Consumers prefer combinations on more outward indi¤erence curves [Figure 3.5] Result: Indi¤erence curves cannot cross [Figure 3.6] Convex preferences Average of combinations among which a consumer is indi¤erent, is preferred to the combinations themselves [Figure 3.7] Marginal rate of substitution (MRS) - “How many units of good 2 are you willing to give up to get one more unit of good 1” Marginal rate of substitution (MRS) - “How many units of good 2 are you willing to give up to get one more unit of good 1” - Willingness to trade between goods MRS = Slope of an indi¤erence curve [Figure 3.8] Result: Convex indi¤erence curves have diminishing jMRSj Result: Convex indi¤erence curves have diminishing jMRSj “the more good 1 you have, the less of good 2 willing to give up to get 1 more unit of good 1” [Figure 3.9] Does this property apply to your prefer- ences? Does this property apply to your prefer- ences? - Probably. Does this property apply to your prefer- ences? - Probably. - Can you think of a case when it does not apply? Our preferences typically have diminish- ing jMRSj => Makes sense to assume convex pref- erences Six clarifying remarks about ICs ICs (1) Depict consumer tastes (“preferences”) ICs (2) An indi¤erence curve goes through every point (I don’t have time to draw them all..) ICs (3) Usually, though not always, con- vex (in other words, exhibit diminishing MRS) ICs (4) Cannot cross! ICs (5) Not all of a consumer’s ICs need have the same shape (BUT his/her ICs still CANNOT cross) ICs (6) If two consumers’prefs are di¤erent => their ICs are di¤erent. Summary 1: - BC captures constraints (scarcity!) - Preferences + "behavior is optimiza- tion" assumption capture objectives Summary 2: - Key assumptions about preferences: 1) “More of everything is better” 2) Transitivity 3) Diminishing marginal bene…t (ICs are usually convex) Summary 3: Consumer depicted by: - BC - ICs - Optimizing behavior Next class: - Optimal choice - Describe impact of price and income changes on well-being