# Modeling Tradeoffs 24 hrs. (An “Endowment”) x 1 =Time (Leisure) x 2 =Income (Things) — — ? What else do we need in order to build a theory that is useful.

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Modeling Tradeoffs 24 hrs. (An “Endowment”) x 1 =Time (Leisure) x 2 =Income (Things) — — ? What else do we need in order to build a theory that is useful for analyzing decisions such as these? x2x2 — Lots of stuff

Budget Constraints x1x1 x2x2 Feasible consumption set Budget Line (efficient consumption)

Budget Constraints Price Changes Income Changes

Modeling Preferences  Fundamental axioms: 1.Completeness 2.Transitivity 3.Continuity 5.Convexity 4.Monotonicity  Supplemental axioms: Necessary for rank ordering and functional representation. Defines “well- behaved preferences.

Indifference Curves, Preferences, and Rational Ordering — —— —

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U = 16 U = 8 U = 4 U = 2 Indifference Curves and Utility 4 8 16 4 8

Bentham and Utilitarianism “B y utility is meant that property in any object, whereby it tends to produce benefit, advantage, pleasure, good, or happiness (all this in the present case comes to the same thing) or (what comes again to the same thing) to prevent the happening of mischief, pain, evil, or unhappiness to the party whose interest is considered … “The interest of the community then is what? -- the sum of the interests of the several members who compose it. “An action then may be said to be conformable to the principle of utility* … when the tendency it has to augment the happiness of the community is greater than any it has to diminish it.” An Introduction to the Principles of Morals and Legislation, 1780 *Elsewhere, the greatest happiness principle. Jeremy Bentham 1748 – 1832

Individual Demand D

SEIE Substitution & Income Effects: Normal Good The Slutsky Approach – “Pivot and Shift” A A’A’ B Price Decrease for x 1 (p 1 ↓)

Substitution & Income Effects: Normal Goods The Slutsky Approach – “Pivot and Shift” 1.3 = SEIE = 0.7 A A’A’ B 14 15.316 78 Original Demand (A): {x 1 0, x 2 0 } = {14, 78} Compensated Income, m’ = 106 Compensated Demand (A’): {x 1 ’, x 2 ’} = {15.3, 75.4} New Demand (B): {x 1 1, x 2 1 } = {16, 88} 88 75.4 x 1 (p 1, p 2, m) = 10 + m/10p 1 p 1 0 = 3 p 1 1 = 2 m 0 = 120 SE IE

Substitution & Income Effects: x 1,Normal Good; x 2, Inferior Good The Slutsky Approach – “Pivot and Shift” SEIE A A’A’ B SE IE

SE IE Substitution & Income Effects: Inferior Good The Slutsky Approach – “Pivot and Shift” A’A’ B A Price Decrease for x 1 (p 1 ↓)

SE IE Substitution & Income Effects: Giffen Good Slutsky Approach – “Pivot and Shift” A A’A’ B Price Decrease for x 1 (p 1 ↓)

SEIE Substitution & Income Effects: Normal Good The Hicksian Approach – “Rotate and Shift” A A’A’ B Price Decrease for x 1 (p 1 ↓)

Buying & Selling Net Supplier of good Net Demander of good Initial Endowment Net Demander of good Net Supplier of good Initial Endowment

Buying and Selling: Consumer Choice Theory with Endowments Decomposition of effects of a price change into substitution, ordinary income and endowment income effects: Price decrease of a good currently being demanded. OIE SE EIE The agent is a net demander of x 1 ; thus, when its price falls, the agent’s purchasing power goes up – the ordinary income effect is positive. The value of the agent’s endowment is dependent upon the price of x 1 ; thus, when its price falls, the agent’s purchasing power goes down – the endowment income effect is negative.

Buying and Selling: Consumer Choice Theory with Endowments Decomposition of effects of a price change into substitution, ordinary income and endowment income effects: Price increase of a good currently being demanded. OIE SE EIE The agent is a net demander of x 1 ; thus, when its price increases, the agent’s purchasing power goes down – the ordinary income effect is negative. The value of the agent’s endowment is dependent upon the price of x 1 ; thus, when its price increases, the agent’s purchasing power goes up – the endowment income effect is positive.

Buying and Selling: Consumer Choice Theory with Endowments Decomposition of effects of a price change into substitution, ordinary income and endowment income effects: Price decrease of a good currently being supplied. SE OIE EIE

Buying and Selling: Consumer Choice Theory with Endowments Decomposition of effects of a price change into substitution, ordinary income and endowment income effects: Price increase of a good currently being supplied. SE OIE EIE

Buying and Selling: Consumer Choice Theory with Endowments Decomposition of effects of a price change into substitution, ordinary income and endowment income effects: Price increase of a good currently being supplied. SE OIE EIE An outcome illustrating perfectly inelastic demand for x 1 …

Labor-leisure tradeoffs and labor supply Leisure = leisure, l = consumption, c l0l0 L0L0 C0C0 c0c0 C 0 + (w/p)L 0 Labor E A

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