Microeconomics Notes (PDF)

Why is slope of Demand curve –ve? Substitution Effect: Price of electricity rises, firewood is now relatively cheap, so you cut down on electric uses & increase firewood consumption. Real Income Effect: Say tea price goes up - Increased tea price reduces real income of the person; budget is constan...

Why is slope of Demand curve –ve? Substitution Effect: Price of electricity rises, firewood is now relatively cheap, so you cut down on electric uses & increase firewood consumption. Real Income Effect: Say tea price goes up - Increased tea price reduces real income of the person; budget is constant so he can only buy less. Multiple uses of a product: Increase in price reduces the incentive to use the good for less urgent uses & you restrict your consumption to more urgent ones. You may prefer having non –cooked snacks if energy is costlier. Diminishing Marginal Utility for the product: More and more you buy, less & less satisfaction you derive from the marginal or last commodity. So, at one point you feel that departing with your money won't be worth buying the product. (Note: Demand for any commodity demand for the derivable utility, measured in terms of utils, of that commodity. I am a vegetarian, so fish or meat is useless or utility less for me, whereas if I am thirsty then one glass of water has a lot of utility for me. But how much to buy is decided based on price. What is Utility?- Want satisfying capacity of a product Marshallian Cardinal measurement of utility - Satisfaction, like temperature or distance, is assumed measurable in meaningful, absolute numbers. Early economists assumed that people are able to assign meaningful utility numbers (utils) to their satisfaction in one situation vis-à-vis their satisfaction in an alternative situation. For example, the utils generated by each chocolate you eat or book you read would be recorded as if you have “utilometer” imbedded in your system.  Concept of Margin. In a very simple way, given your level of income, taste, preference etc, you will always want to equalize the worth of the last rupee you pay and last unit you buy. (would be happy till the LHS > RHS) In economic terminology we would maximum buy till this condition is satisfied. We may rewrite it as MUX = MUM * PX MUx /Price of X = MUm Similarly, MUy /Price of y = MUm. Consumer will go on choosing between X and Y, till MUx/ Px=MUy/Py You Stop buying when MUX = MUM * PX This is what This is what we we pay in utils receive in utils What if Px increases from Rs. 10 to Rs. 20?Now we would buy upto the 5th quantity instead of 8th. This is how law of demand applies  Question? How much would you buy if you have to pay no price?  When we consume two or more commodities, how does our brain function? This can be understood taking two related commodities and seeing how we choose between them. Q: How do people choose between using Induction heater and using Chulah? If I ask you to choose combinations of Samosa and sweet that will make you equally happy, how will you choose? Samosa Milk cake Happiness 1 12 2 7 3 4 4 2 4 3 4 1  law of equi-proportional utility Algebraically, let different goods be named 1,2,3 and so on; their respective marginal utilities be equal to MU 1 , MU 2 , MU 3 and so on; and their respective prices be equal to P 1 , P 2 , P 3 and so on. The marginal utility of a rupee spent on good 1 equals MU 1 /p 1 , that on good 2 is equal to MU 2 /p 2 and so on. MU 1 /P 1 =MU 2 /P 2 =MU 3 /P 3 =… This goes by the name of the law of equip-proportional utility. The economic reason is straightforward. If, for instance, one rupee brings more marginal utility from consuming, say, good A than from consuming good B, the consumer’s total utility will be increased if more rupees are spent on good A and less on good B. This process should continue till there is no difference between the marginal utility of a rupee spent on different goods.  Indifference Curve: Starting with any alternative, an indifference curve shows all the other alternatives a consumer likes equally well. It assumes Ordinal Utility analysis. Utility roughly assessed if not measured in numbers. So, rank commodities in order of preference  Ordinal Utility Genesis… Cardinal measures are possible when incremental units are constant and reasonably objective, but utility is roughly measurable at best. As there is no one born equipped with a utilometer to precisely measure satisfaction. In the 1930s, Nobel prize-winner Sir John Hicks followed the leads of Vilfredo Pareto and Francis Y. Edgeworth to develop indifference analysis, an underpinning for the theory of consumer behavior that dispenses with cardinally-measured utility. Hicks argued that ranking our preferences is the best we can do.  Assumptions: Rational behavior of the consumer Utility is ordinal Diminishing marginal rate of substitution Goods consumed are substitutable  Utility Given these assumptions, it is possible to show that people are able to rank in order all possible situations from least desirable to most desirable ones Economists call this ranking utility – if A is preferred to B, then the utility assigned to A exceeds the utility assigned to B U(A) > U(B)  Structure of Preferences 14  Indifference Curves An indifference curve shows a set of consumption among which the individual is indifferent Quantity of Y Combinations (X1, Y1) and (X2, Y2) provide the same level of utility Y1 Y2 U1 Quantity of X X1 X2  Shape of Indifference Curve Indifference curve slope down and to the right, and the slope becomes less steep the farther right you go (this shape is sometimes described as convex or convex to the origin). Why? The curves slope down to the right because any combination on the curve would yield equal satisfaction.  Preferences and Utility Marginal Rate of Substitution, [MRSxY , substitution of X for Y]: The rate at which a consumer is willing to sacrifice one good (y) in return of another good (x). Principle of Diminishing Marginal Rate of Substitution : A rule stating that, for any convex indifference curve, when moving down the curve from the top (northwest) to the bottom (southeast), the absolute value of that curve’s slope must be continuously declining. Tangents would move from steeper to flatter.  Two Indifference Schedules SCHEDULE 1 SCHEDULE2 Good X Good Y Good X Good Y 1 12 2 14 2 8 3 10 3 5 4 7 4 3 5 5 5 2 6 4 In Schedule 2,consumer has initially 2 units of goods X and 14 units of Y. So question arises about how much of Y would consumer be ready to abandon for successive additions of X in his stock so that satisfaction remains equal as compared to his initial one i.e Utility of (2X+14Y) together.  Schedule 1 or Schedule 2? Any combination in schedule 2 will give consumer more satisfaction than in schedule 1. The reason for this is that more of a commodity is preferable to less of it. In simple terms, greater quantity of a good gives an individual more satisfaction than the smaller quantity of it, the quantity of other goods with him remaining the same.  Indifference Map Each point must have an indifference curve through it Quantity of y Increasing utility U3 U1 < U2 < U3 U2 U1 Quantity of x  Marginal Rate of Substitution MRS changes as x and y change – reflects the individual’s willingness to trade y for x Quantity of y At (x1, y1), the indifference curve is steeper. The person would be willing to give up more y to gain additional units of x At (x2, y2), the indifference curve is flatter. The person would be y1 willing to give up less y to gain additional units of x y2 U1 Quantity of x x1 x2  Marginal Rate of Substitution The negative of the slope of the indifference curve at any point is called the marginal rate of substitution (MRS)= Ratio of Marginal Utilities More is the marginal utility, less you sacrifice and vice- versa Quantity of y MRS xy= -dy/dx = -MUx/MUy y1 y2 U1 Quantity of x x1 x2  What can we conclude about these two ICS? Quantity of Veg food Quantity of Kulfi Quantity of Non Veg food Quantity of chocolates Properties of Indifference Curves Indifference curves are bowed inward/convex to origin Higher indifference curves are preferred to lower ones. Indifference curves are downward sloping. Indifference curves do not intersect with each other  Indifference curves are bowed inward. Samosa We are more willing to trade away goods that we have in 1 abundance and less willing to 4 trade away goods of which MRS = goes scarce. 6 8 A 1 4 MRS = B 3 Indifferenc 1 1 e curv e 0 2 3 6 7 Dhokla The above property implicitly assumes that average combinations are preferred over extreme combinations Vada A(2,10) C(8,7) B(14,4) Rasgulla  Higher indifference curves are preferred to lower ones. Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than do lower indifference curves. Indifference curves are downward sloping. A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy. If the quantity of one good is reduced, the quantity of the other good must increase. For this reason, most indifference curves slope downward.  Indifference curves do not cross. Quantit yof Pepsi C A B 0 Quantit yof Pizza  What are possible inferences from this graph? IC of Ram Quantity of Sweet IC of Ravi 0 Quantity of Samosa  Perfect Substitutes, MRS =1 Rs 10 coins 6 4 2 IC1 IC2 IC3 0 1 2 3 Rs 10 notes Perfect Complements, MRS =0 Lef Shoe t s IC 2 7 5 IC 1 0 5 7 Right Shoes  Budget Line or Budget Constraint Essential for understanding the theory of consumer’s equilibrium. The budget line shows all the different combinations of two goods that a consumer can purchase given his money income and price of two commodities When a consumer attempts to maximize his satisfaction, there are two constraints: – Paying the prices for the goods – Limited money income Budget Equation : Find out from the table Price of Apple Pice of Orrange Qty of Apple Qty of Orrange Budget 10 5 20 0 200 10 5 18 4 200 10 5 16 8 200 10 5 14 12 200 10 5 12 16 200 10 5 10 20 200 10 5 8 24 200 10 5 6 28 200 10 5 4 32 200 10 5 2 36 200 10 5 0 40 200  Budget Equation Px*X + Py*Y=M M := Income of the consumer Px := Price of good X Py := Price of good Y X := Quantity of good X Y := Quantity of good Y Budget Constraint  Budget Line Continued… Budget line graphically shows different combinations of goods at a given budget The combination of commodities lying to the right of the budget line are unattainable because income of the consumer is not sufficient to buy those combinations. The combinations of goods lying to the left of the budget line are attainable.  Budget Space A set of all combinations of the two commodities that can be purchased by spending the whole or a part of the given income.  Changes in Price and Shift in Budget Line Price of Y rises Price of X falls Samosa Samosa Past Past a a Changes in Income and Shift in Budget Line BL initial budget line If consumer’s income increases while prices of both X and Y remain unaltered, the price line shifts upwards i.e. B’L’ and is parallel to BL. Similarly it will shift downward i.e. B”L”, if income decreases. Slope of Budget Line and Prices of two goods Slope of budget line BL is equal to the ratio of prices of two goods. Slope of budget line = -OB/OL = -Px / Py  Consumer Equilibrium It refers to a situation in which a consumer with given income and given prices purchases such a combination of goods which gives him maximum satisfaction and he is not willing to make any change in it. Assumptions: 1) The consumer has a given indifference map exhibiting his scale of preferences for various combinations of two goods, X and Y. 2) Fixed amount of money to spend and has to spend whole of his money on two goods. 3) Prices of goods are given and constant for him. He cannot influence those prices. 4) Goods are homogeneous and divisible.  Two conditions for equilibrium At the point of equilibrium, a. Given budget line must be tangent to one of the indifference curves. There marginal rate of substitution of good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e. MRSxy = -Px/Py b. That indifference curve must be convex to the origin at the point of tangency.  Consumer Equilibrium COMMODITY Y At E, Slope of IC2 is MRSxy=-dy/dx = Slope of Budget line is -Px/Py E IC3 IC2 IC1 COMMODITY X  At A and B, MRSxy slope of budget line. Only at E, its possible Given budget maximize utility Given utility minimize expenditure A E E B  condition of convexity: The first condition is met at E, but using the same budget consumer could be at A or B which gives higher satisfaction COMMODITY Y A E B COMMODITY X Price Effect: Price Consumption Curve Under the Price Effect, there will be a change in the equilibrium position of the consumer. PCC is the Price Consumption Curve. It is sloping downwards to the right. when the price of X falls, the consumer purchases more of X and less of Y. t1, t2,t3 are subsequent decisions due to price change. PCC - Marshallian Uncompensated Demand Curve  Price Consumption Curve Shapes of Price Consumption Curve – With a fall in the price of one commodity there will be some extra income with the consumer. It can distribute this real extra income on the two commodities in different ways. So, the Price Consumption Curve will have different shapes. Below we draw the different shapes of the Price Consumption Curve. Income Effect : Income Consumption Curve The income effect means the change in consumer’s preferences of the goods as a result of a change in his money income. Income consumption curve traces out the income effect on the quantity consumed of the goods. Income effect for a good is said to be positive when with the increase in income of the consumer, his consumption of good also increases. (Normal Goods) Income effect for a good is said to be negative when with the increase in income of the consumer, his consumption of good decreases. (Inferior Goods) Income Consumption Curve Income Consumption Curve in Case of Good X being Inferior Good Income Consumption Curve in Case of Good Y being Inferior Good  Engel Curves Quantity of Quantity of Normal Good Inferior Good Income Income  Effects of a price change Substitution Effect: It is the change in the quantity of good purchased due to change in their relative prices alone, while real income of the consumer remains the same. Income effect: It is the change in the quantity of good purchased due to change in the personal income. Price effect: It is the change in quantity of good purchased due to change in the own price of the commodity. All the three concepts are different but are these effects related to each other? Lets see….  What do you think about these shaded areas? Price S D Demand and Supply Application of Consumer Theory: Find out Consumer Surplus ???  Indifference curve for Economic “bad” Pollution Noise Garbage Cloth Food Noise