1 Welcome to EC 209: Managerial Economics- Group A By: Dr. Jacqueline Khorassani Week Four

2 Class One Monday, September 24 11:10-12:00 Fottrell (AM) 11:10-12:00 Fottrell (AM) APLIA ASSIGNMENT IS DUE BEFORE 5:00 PM TOMMORROW The next one is due in a week

3 Remember the 4 properties of consumer preferences 1. Completeness 2. More is Better 3. Diminishing Marginal Rate of Substitution 4. Transitivity

4 How does the indifference curve reflect properties 1 & 2? 3 bundles: A, B and C 3 bundles: A, B and C –Consumer can say which ones she likes, dislikes (Property 1) –Does consumer likes B as much as A? No No B (more) is better (property 2) B (more) is better (property 2) –A & C are on the same indifference curve –B is on a higher indifference curve Represents a higher level of satisfaction Represents a higher level of satisfaction I. II. Good Y Good X A C B

5 How does the indifference curve reflect property 3? To go from consumption bundle A to B the consumer is willing to give up _____units of Y to get one additional unit of X. To go from consumption bundle A to B the consumer is willing to give up _____units of Y to get one additional unit of X. To go from consumption bundle B to C the consumer is willing to give up _____ units of Y to get one additional unit of X. To go from consumption bundle B to C the consumer is willing to give up _____ units of Y to get one additional unit of X. To go from consumption bundle C to D the consumer is willing to give up only _____ units of Y to get one additional unit of X. To go from consumption bundle C to D the consumer is willing to give up only _____ units of Y to get one additional unit of X. I. II. III. Good Y Good X A B C D

6 Note: MRS = slope of indifference curve Between A to B Between A to B MRS = -50 Between B to C Between B to C MRS = -20 Between C to D Between C to D MRS = -10 How do we find the slope at point B? How do we find the slope at point B? –Slope of the tangency line at point B The indifference curve becomes flatter from the left to the right The indifference curve becomes flatter from the left to the right I. Good Y Good X A B C D

7 How does the indifference curve reflect property 4? For the three bundles A, B, and C, the transitivity property implies that For the three bundles A, B, and C, the transitivity property implies that if C  B if C  B and B  A, and B  A, then C  A. then C  A. I. II. III. Good Y Good X A B C

8 Can two indifference curves intersect? What if they did? What if they did? C is better than A (because C represents more) C is better than A (because C represents more) Since C and B are on the same indifference curve, B should be better than A too; Is it? Since C and B are on the same indifference curve, B should be better than A too; Is it? No, as B is on the same indifference curve as A No, as B is on the same indifference curve as A I. II. Good Y Good X 2 A C B 100 3

9 What if X and Y were perfect substitutes? Example Example –You don’t know the difference between Coke and Pepsi Coke Pepsi A B C I II III Indifference curve is a straight line MRS is constant

10 What if X and Y were complements Example Example I never have coffee without sugar I never have coffee without sugar sugar coffee A I II B 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

11 Managerial Economics- Group A Week Four- Class 2 Week Four- Class 2 –Tuesday, September 25 –15:10-16:00 –Cairnes Aplia Assignment before 5 today. Aplia Assignment before 5 today. –Don’t miss it.

12 I got a question I bought the book from the college bookshop the other day, but I don't think that the extra chapter from the other book was included in the pack. I bought the book from the college bookshop the other day, but I don't think that the extra chapter from the other book was included in the pack. –You can copy the extra chapter from the copies in the library. Chapter 8 of Microeconomics by Frank Chapter 8 of Microeconomics by Frank

13 The Budget Constraint Suppose Suppose P = €5 P y = €5 P X = €2.5 P X = €2.5 M = €50 M = €50 Can I afford 2Xs and 2 Ys? Can I afford 2Xs and 2 Ys? –Yes Opportunity Set Opportunity Set The set of consumption bundles that are affordable. P x X + P y Y  M. Y X The Opportunity Set M/P Y =10 M/P X =20 2 2

14 The Budget Line –The bundles of goods that exhaust a consumer’s income. P x X + P y Y = M. P x X + P y Y = M. Y X Budget Line 10 20

15 What is the slope of budget line? Slope of budget line Slope of budget line –Measures the rate at which you can afford to substitute X for Y –For each Y you give up, you can buy 2Xs – Slope = -10/20 –Slope = Market Rate of Substitution –Slope = - P x / P y Y X Budget Line

16 What if budget doubles? From 50 to 100 From 50 to 100 Does the slope change? Does the slope change? No No Because prices did not change Because prices did not change Budget increase leads to a parallel shift to the rights. Budget increase leads to a parallel shift to the rights. What will a budget decrease do? What will a budget decrease do? X Y

17 What if price of X goes down to €1? A decreases in the price of good X rotates the budget line counter-clockwise A decreases in the price of good X rotates the budget line counter-clockwise An increases rotates the budget line clockwise An increases rotates the budget line clockwise X Y New Budget Line for a price decrease

18 Consumer Equilibrium The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. –Consumer equilibrium occurs at a point where MRS = P X / P Y. –Equivalently, the slope of the indifference curve equals slope of the budget line. I. II. III. X Y Consumer Equilibrium M/P Y M/P X

19 Suppose consumer is at 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 I 0 Y2Y2 Y1Y1 X1X1 X2X2 A B M/P X 1 M/P X 2 M/P Y 1 What can you say about how X and Y are related to each other? Complements

20 Suppose consumer is at 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 I 0 Y2Y2 Y1Y1 X1X1 X2X2 A B M/P X 1 M/P X 2 M/P Y 1 What can you say about how X and Y are related to each other? Substitutes

21 Suppose consumer is at 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 M 0 /P Y M 0 /P X M 1 /P Y M 1 /P X X0X0 Y0Y0 X1X1 Y1Y1 What can you say about the nature of X and Y? They are both normal goods

22 What if X was inferior good An increase in income will have result in fewer Xs being bought. An increase in income will have result in fewer Xs being bought. Make sure you can show this case graphically. Make sure you can show this case graphically.

23 Managerial Economics Week Four- Class 3 Week Four- Class 3 –September 27 –15:10-16:00 –Tyndall Aplia Assignment 2 is due by Tuesday Aplia Assignment 2 is due by Tuesday

24 The effects of a price change on quantity of consumption When X becomes cheaper two things happen When X becomes cheaper two things happen 1. 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 (not just more X) and So you will be able to buy more goods (not just more X) and reach a higher indifference curve reach a higher indifference curve This is called the INCOME EFFECT (IE) of the price change This is called the INCOME EFFECT (IE) of the price change

25 The effects of a price change on quantity of consumption When X becomes cheaper two things happen When X becomes cheaper two things happen 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 off This effect does not make you better off You stay on the same indifference curve You stay on the same indifference curve This is called the SUBSTITUTIN EFFECT (SE) of the price change This is called the SUBSTITUTIN EFFECT (SE) of the price change

26 Let’s show the IE and the SE graphically 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

27 SE 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 SE 4 68

28 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 SE 4 68 IE 

29 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 SE 4 6 IE 5

30 Giffen good Is an inferior good for which Is an inferior good for which –SE<IE –When the prices goes down –You buy less of it –You must be able to show this case graphically

31 Where does the demand curve for X come from? Two graphs Two graphs Top graph is indifference curve and budget line Top graph is indifference curve and budget line The bottom graph shows quantity of X on horizontal axis and Price of X on vertical axis The bottom graph shows quantity of X on horizontal axis and Price of X on vertical axis X X Y P

32 Where does the demand curve for X come from? Originally P x = €10 Originally P x = €10 Q X = 4 Q X = 4 Now let’s drop the price to €5 Now let’s drop the price to €5 Q X = 6 Q X = 6 Connect A’ to B’ Connect A’ to B’ You will get the demand curve for X You will get the demand curve for X X X Y P I A A’ II B B’

33 What is the market demand curve? the horizontal summation of individual demand curves. the horizontal summation of individual demand curves. When P = 50, Q = 0 When P = 50, Q = 0 When P = 40, Q = 3 When P = 40, Q = 3 Q $$ Q D2D2 D1D1 2 Individual Demand Curves Market Demand Curve 1 1 DMDM 2 2 3

34 How does the demand for a Giffen good look? You should be able to answer this question on your own. You should be able to answer this question on your own.

35 Study Guide 4 contained Marginal Utility Marginal Utility –What is it? –How is it measured? –How does it relate to the indifference? –How does that relate to consumer equilibrium? For now, we skip it For now, we skip it