Choice. A. Optimal choice 1. move along the budget line until preferred set doesn t cross the budget set. Figure 5.1.

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1 Choice 2 Choice A. choice. move along the budget line until preferred set doesn t cross the budget set. Figure 5.. choice * 2 * Figure note that tangency occurs at optimal point necessary condition for optimum. In symbols: MRS = price ratio = p /p 2. a) eception kinky tastes. Figure 5.2. b) eception boundary optimum. Figure tangency is not sufficient. Figure 5.4. a) unless indifference are conve. b) unless optimum is interior. 4. optimal choice is demanded bundle a) as we vary prices and income, we get demand functions. b) want to study how optimal choice the demanded bundle changes as price and income change

2 Choice 22 * 2 Budget line * Figure Budget line * Figure 5.3 B. Eamples

3 Choice 23 bundles Nonoptimal bundle Budget line Figure 5.4 Slope = Budget line choice * = m/p Figure 5.5. perfect substitutes: = m/p if p < p 2 ; 0 otherwise. Figure 5.5.

4 Choice 24 * 2 choice Budget line * Figure perfect complements: = m/(p + p 2 ). Figure neutrals and bads: = m/p. 4. discrete goods. Figure 5.7. a) suppose good is either consumed or not b) then compare (,m p )with(0,m) and see which is better. 5. concave preferences: similar to perfect substitutes. Note that tangency doesn t work. Figure Cobb-Douglas preferences: = am/p. Note constant budget shares, a = budget share of good. C. Estimating utility function. eamine consumption data 2. see if you can fit a utility function to it 3. e.g., if income shares are more or less constant, Cobb-Douglas does a good job 4. can use the fitted utility function as guide to policy decisions 5. in real life more complicated forms are used, but basic idea is the same

5 Choice 25 2 choice Budget line Budget line choice 2 3 A Zero units demanded 2 3 B unit demanded Figure 5.7 Nonoptimal choice X Budget line choice Z Figure 5.8 D. Implications of MRS condition

6 Choice 26. why do we care that MRS = price ratio? 2. if everyone faces the same prices, then everyone has the same local trade-off between the two goods. This is independent of income and tastes. 3. since everyone locally values the trade-off the same, we can make policy judgments. Is it worth sacrificing one good to get more of the other? Prices serve as a guide to relative marginal valuations. E. Application choosing a ta. Which is better, a commodity ta or an income ta?. can show an income ta is always better in the sense that given any commodity ta, there is an income ta that makes the consumer better off. Figure * 2 choice with quantity ta Original choice choice with income ta Budget constraint with income ta slope = p /p 2 * Budget constraint with quantity ta slope = (p + t )/p 2 Figure outline of argument: a) original budget constraint: p + p 2 = m b) budget constraint with ta: (p + t) + p 2 = m c) optimal choice with ta: (p + t) + p 2 2 = m d) revenue raised is t e) income ta that raises same amount of revenue leads to budget constraint: p + p 2 = m t ) this line has same slope as original budget line 2) also passes through (, 2) 3) proof: p + p 2 2 = m t

7 Choice 27 4) this means that (, 2) is affordable under the income ta, so the optimal choice under the income ta must be even better than (, 2) 3. caveats a) only applies for one consumer for each consumer there is an income ta that is better b) income is eogenous if income responds to ta, problems c) no supply response only looked at demand side F. Appendi solving for the optimal choice. calculus problem constrained maimization 2. ma u(, )s.t.p + p 2 = m 3. method : write down MRS = p /p 2 and budget constraint and solve. 4. method 2: substitute from constraint into objective function and solve. 5. method 3: Lagrange s method a) write Lagrangian: L = u(, ) λ(p + p 2 m). b) differentiate with respect to,,λ. c) solve equations. 6. eample : Cobb-Douglas problem in book 7. eample 2: quasilinear preferences a) ma u( )+ s.t. p + = m b) easiest to substitute, but works each way

8 Demand 28 Demand A. Demand functions relate prices and income to choices B. How do choices change as economic environment changes?. changes in income a) this is a parallel shift out of the budget line b) increase in income increases demand normal good. Figure 6.. choices Budget lines Figure 6.

9 Demand 29 choices Budget lines Figure 6.2 c) increase in income decreases demand inferior good. Figure 6.2. d) as income changes, the optimal choice moves along the income epansion path

10 Demand 30 Income offer m Engel A Income offer B Engel Figure 6.3 e) the relationship between the optimal choice and income, with prices fied, is called the Engel. Figure changes in price a) this is a tilt or pivot of the budget line

11 Demand 3 choices Budget lines Price decrease Figure 6.9 b) decrease in price increases demand ordinary good. Figure 6.9. c) decrease in price decreases demand Giffen good. Figure 6.0. d) as price changes the optimal choice moves along the offer e) the relationship between the optimal choice and a price, with income and the other price fied, is called the demand C. Eamples. perfect substitutes. Figure perfect complements. Figure discrete good. Figure 6.4. a) reservation price price where consumer is just indifferent between consuming net unit of good and not consuming it b) u(0,m)=u(,m r ) c) special case: quasilinear preferences d) v(0) + m = v() + m r e) assume that v(0) = 0 f) then r = v() g) similarly, r 2 = v(2) v() h) reservation prices just measure marginal utilities

12 Demand 32 choices Budget lines Reduction in demand for good Price decrease Figure p Price offer p = p* Demand 2 A Price offer m/p = m/p* B Demand 2 Figure 6.2 D. Substitutes and complements. increase in p 2 increases demand for substitutes

13 Demand 33 2 Price offer p Demand Budget lines A Price offer B Demand Figure 6.3 GOOD 2 bundles at r Slope = r bundles at r 2 Slope = r 2 PRICE r r GOOD A bundles at different prices 2 B Demand GOOD 2. increase in p 2 decreases demand for complements Figure 6.4

14 Demand 34 E. Inverse demand. usually think of demand as measuring quantity as a function of price but can also think of price as a function of quantity 2. this is the inverse demand 3. same relationship, just represented differently