Microeconomic Theory 1 Lecture 2 PDF

MICROECONOMIC THEORY 1 Lecture 2: Ordinal Utility Approach To Demand Theory Lecturer: Dr. Priscilla Twumasi Baffour Twitter: @pristwumasi Priscilla T. Baffour (PhD) 11/16/2024...

MICROECONOMIC THEORY 1 Lecture 2: Ordinal Utility Approach To Demand Theory Lecturer: Dr. Priscilla Twumasi Baffour Twitter: @pristwumasi Priscilla T. Baffour (PhD) 11/16/2024 1 Microeconomics 1  Content ▪ Curvature of Indifference curves ▪ Satiation ▪ Monotonic Preferences ▪ The budget Constraint ▪ Consumer equilibrium Priscilla T. Baffour (PhD) 11/16/2024 2 Microeconomics 1  Reading List Chapter 4 – Jeffery M. Perfloff (2012). Microeconomics (Sixth edition), Pearson Education Ltd. Chapter 3 – Hal R. Varian (2011). Intermediate Microeconomics, W. W. Norton and Company. Priscilla T. Baffour (PhD) Microeconomics 1 Slide 3  Bads A commodity the consumer dislikes. Noise Sleep 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 4  Neutrals The consumer doesn’t care about it in one way or the other Noise Sleep 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 5  Satiation A situation is where there is some overall best bundle (x1, x2) for the consumer, and the closer she is to that bundle, the better off she is in terms of her own preferences. In this scenario ICs have a negative slope when the consumer has “too little” or “too much” of both goods and a positive slope when he has “too much” of one of the goods. – Having too much of one of the goods makes it a bad, reducing the consumption of the bad good moves her closer to the “bliss point” – If she has too much of both goods, they both become bads, so reducing the consumption of both moves her closer to her “bliss point” 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 6  Satiated Preferences 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 7  Monotonic Preference Premised on the idea that more is better, and that, we are examining conditions before the consumer reaches a satiation point. Monotonicity implies that indifference curves have a negative slope. Averages are preferred to extremes. 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 8  Monotonic Preference More of both goods is better for this consumer X2 Better bundles Worse bundles X1 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 9  Budget Constraint Budget line (or budget constraint) - the bundles of goods that can be bought if the entire budget is spent on those goods at given prices. Opportunity set - all the bundles a consumer can buy, including all the bundles inside the budget constraint and on the budget constraint. 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 10  Budget Constraint (cont.) If Lisa spends all her budget, Y, on pizza and burgers, then pBB + pZ Z = Y – where pBB is the amount she spends on burgers and pZZ is the amount she spends on pizzas. This equation is her budget constraint. – It shows that her expenditures on burgers and pizza use up her entire budget. 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 11  Budget Constraint (cont.) How many burgers can Lisa buy? – To answer solve budget constraint for B (quantity of burgers): PB B + PZ Z = Y PB B = Y − PZ Z Y − PZ Z B= PB 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 12  Budget Constraint (cont.) From previous slide we have: Y − PZ Z B= PB – If pZ = $1, pB = $2, and Y = $50, then: $50 − ($1 Z ) B= = 25 − 0.5Z $2 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 13  Figure 4.7: Budget Constraint Amount of Burgers  From previous slide we have that consumed if all income if: Burgersper semester is allocated for Burgers. – pZ = $1, pB = $2, and Y = $50, a then the budget constraint, L1, 25 = Y /pB is: b 20 $50 − ($1 Z ) B= = 25 − 0.5Z L1 $2 c Amount of Pizza ,B 10 consumed if all income Opportunity set is allocated for Pizza. d 0 10 30 50 = Y / pZ Z , Pizzas per semester 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 14  Changes in the Budget Figure 4.8(a) Constraint: Price of Pizza Doubles Slope = -$1/$2 = -0.5 B= Y - PZ = $1 $2 Z per semester PB PB 25 If the price of pizza doubles, (increases from L 1 (p Z = $1) B, Burgers $1 to $2) the slope of r the budget line increases Loss L2 (pZ = $2) This area represents the bundles she can no longer afford 0 25 50 Z , Pizzas per semester Slope = -$2/$2 = -1 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 15  Figure 4.8(b): Changes in the Budget Constraint: Income Doubles PZ B = $100 $50 - Z PB PB B, Burritos per semester If Lisa’s income increases 50 by $50 the budget line L 3 (Y = $100) shifts to the right (with the same slope!) 25 This area represents the Gain new consumption L 1 (Y = $50) bundles she can now afford!!! 0 50 100 Z , Pizzas per semester 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 16  Recap on Taxes, Subsidies & Rationing Forms of Taxes 1. Quantity (specific) tax 2. Ad valorem (value) tax 3. Lump sum tax Forms of Subsidies Specific subsidy Ad valorem Lump sum Rationing 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 17  Taxes, Subsidies and Rationing Quantity (specific) tax Ad valorem (value) tax Lump sum tax Quantity tax is imposed per unit of quantity bought. Thus quantity tax ‘t’ cedis per unit of quantity purchased. The price of X moves from Px to Px+t (this is viewed as an increase in price that rotates the budget line −(𝑃𝑥+𝑡) inwards). Slope of new BL is 𝑃𝑦 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 18  Taxes, Subsidies and Rationing 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 19  Taxes, Subsidies and Rationing Ad valorem taxes are imposed as a percentage tax on the price of a commodity. Thus a tax of t% is imposed on X. The new price of X becomes 1 + 𝑡 𝑃 since the price of X increases after the imposition of the tax, thus the effect on the budget line is a rotation inwards. − 1+𝑡 𝑃𝑥 Slope of the budget line after the tax is 𝑃𝑦 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 20  Taxes, Subsidies and Rationing Lump sum taxes are fixed amounts taken from the consumer with no regard to the consumer’s income. This shifts the budget line inwards with no effect on the slope of the budget line 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 21  Rationing Restriction of consumption Problem: A government rations water, setting a quota on how much a consumer can purchase. If a consumer can afford to buy 12 thousand gallons a month but the government restricts purchases to no more than 10 thousand gallons a month, how does the consumer’s opportunity set change? 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 22  Solved Problem 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 23  Consumer equilibrium Constrained Optimization – the maximum utility derived from the combination of goods based on the budget of the consumer. The consumer maximizes utility at a point where the slope of the indifference curve (MRS) is equal to the slope of the budget constraint. At the chosen point we have tangency of the indifference curve and the budget constraint, px/py = MRS = MUx/MUy, i.e., MUx/px = MUy/py. 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 24  Figure 4.9 Consumer Maximization, Interior Solution (cont.) ▪ The budget constraint and the indifference curve have the same slope at the point e where they touch. B , Burritos per semester  Therefore, at point e: MU Z PZ MRS = − =− = MRT 25 MU B PB Slope of I2 e Slope of BL I2 0 50 Z , Pizzas per semester 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 25 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 26  Corner solution: Boundary-optimal solution with only commodity x2 being consumed 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 27  Corner solution for perfect substitutes 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 28  Corner solution with strictly concave preferences 11/16/2024 Priscilla T. Baffour (PhD) Microeconomics 1 29