To do today. Find where on the budget line we choose to be. Need indifference curves for this. Graph equilibrium.

Transcription

1 To do today Find where on the budget line we choose to be. Need indifference curves for this. Graph equilibrium. See why this is the same equilibrium as equal MU/Price

2 TA Name Sec*on Sec*on TA Office Hours to day/*me loca*on Room # pick up exam (Thompson) James Miehls F 9:05-9:55 Draper W 10-11:30 " F 11:15-12:05 Machmer E33 Riko Rosete F 12:20-1:10 Draper Th 4 Myles Day F 10:10-11 Machmer E Du W 2:30-4:30 " F 9:05-9:55 Machmer E33 Bois Library Osman Icoz F 1:25-2:15 Draper W 3-4 " F 2:30-3:20 Draper 124 Minhea Tudoreanu F 10:10-11 Dickinson W 4-5 " F 11:15-12:05 Machmer W 23

3 Reminder: Utility maximizing rule 1. Allocate the entire available budget. 2. Make the MU divided by the price spent equal for all goods. 3. Why? If MU/price ($) for good 1 > MU/Price ($) for good 2, how can you do better in terms of utility? Buy more good 1 and less good 2.

4 We need to again go deeper: Behind MU But first: A thought experiment on MU Why does a newspaper vending machine let you reach in and take a newspaper but a candy vending machine does not? Would you take more than you pay for in either case and why or why not?

5 Utility and indifference curves The point is to find where on the budget line we are at maximum total utility. Need to know the relative levels of utility from all combinations of goods Indifference curves represent this graphically

6 Indifference curve and preference map An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. Indifferent because the combinations yield same total utility. Preference map a set of indifference curves

7 Indifference curves Note: Two goods on the axes. We trace out combinations with the same total utility

8 Indifference curves Points above the indifference curve are better than points on the indifference curve are preferred.

9 Full story with preference map Part (b) shows three indifference curves I 0, I 1, and I 2 that are part of a preference map.

10 Getting to equilibrium What do we know and where are we? Know that the level of indifference curve tells us the amount of total utility And total utility is constant along any one indifference curve But, where is MU (part of the decision rule)?

11 Marginal rate of substitution (MRS) MRS is the rate at which a person will give up good y (the good measured on the y-axis) to get more of good x (the good measured on the x-axis) and at the same time remain on the same indifference curve.

12 Diminishing MRS ad MU MRS diminishes as move down along an indifference curve Why? From diminishing MU As move down along the curve, get more x good. MUx But, get less y good, so MUy

13 Calculating MRS: the slope of the indifference curve

14 MRS measures what are willing to give up At what rate is this consumer willing to give up gum for water? packs of gum for bottles of water

15 Where is MU here? In the shape of the indifference curve! Moving down the indifference curve, the slope of tells us how much of the good on the y axis we are willing to give up to get more of the x good How do we know this amount? From the MU. Slope of the indifference curve is the ratio MUx/ MUy

16 Putting it all together: Where is equlibrium? Had equilibrium defined as MU/price = for all goods Where is information about MU and prices now? MU s from slope of indifference curve (MUx/ MUy Prices from

17 Equilibrium rule the same MUx/Px = MUy/Py Note: We can get this from the two slopes being set equal MUx/MUy = Px/Py So, equilibrium where slopes of budget line and indifference curve are equal

18

19 Why only the tangency and not intersection points? At any intersection, can move to a higher total utility (higher indifference curve) if change the allocation of consumption between the two goods. Only at the tangency can no move increase total utility (move to a higher indifference curve) because no higher curve is affordable.

20 Deriving the demand curve with indifference curves To derive demand curve for bottled water: Change the price of water Shift the budget line Work out the new best affordable point

21 The demand curve yet again Using best affordable (equilibrium) points When the price of water is $1 a bottle, best affordable point is C in part (a) and at point A on the demand curve in part (b). When the price of water is 50 a bottle, best affordable point is K in part (a) and at point B on the demand curve in part (b).

22