14.54 International Trade Lecture 3: Preferences and Demand
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1 14.54 International Trade Lecture 3: Preferences and Demand Week 2 Fall (Week 2) Preferences and Demand Fall / 29
2 Today s Plan 1 2 Utility maximization Budget set Preferences Solution Relative demand Homothetic Preferences 1 Definition 2 Properties 3 Examples The small graphs on slides 3-5, 7-19, 21, and are courtesy of Marc Melitz. Used with permission (Week 2) Preferences and Demand Fall / 29
3 Budget Set 2 goods: Cloth (C ) and Food (F ); Consumption level D = (D C, D F ) Given prices p C and p F and income I Budget set is set of consumption bundles such that p C D C + p F D F I p C /p F is the relative price of C (measured in units of F ) (Week 2) Preferences and Demand Fall / 29
4 Budget Set With Endowment In a trading environment, income is determined by value of endowment E = (E C, E F ) (bundle of goods that can be traded) So budget line is given by p C p F p C p F p C D C + p F D F = p C E C + p F E F D C + D F = E C + E F Only relative price p C /p F matters! ( nominal prices are irrelevant) (Week 2) Preferences and Demand Fall / 29
5 Preferences Represented by a utility function U(D C, D F ) Recall that utility is an ordinal concept, so units don t matter (only ranking) U + a, a.u, U 2, U, logu, eu all represent the same preferences Marginal utility of each good are assumed to be non-negative: U (D C, D F ) U (D C, D F ) MU C = 0 and MU F = 0 D C D F Preferences are completely summarized by an indifference curve map U(D C, D F ) = U for any U: (Week 2) Preferences and Demand Fall / 29
6 Marginal Rate of Substitution At any point on an indifference curve, the marginal rate of substitution is defined as MRS = MU C /MU F Important note: to avoid confusion, will always refer to MRS in absolute value (a positive number) You may have seen it defined as MRS = MU C /MU F The MRS at any consumption point is the slope of the tangent to the indifference curve at that point In words: MRS is the amount of F a consumer is willing to trade for one unit of C That is, leaves the consumer on the same indifference curve (utility level remains constant) It is the consumer s valuation of a unit of C measured in units of F The MRS captures the substitutability between C and F at the current consumption point (Week 2) Preferences and Demand Fall / 29
7 Marginal Rate of Substitution (Cont.) Further assumption on preferences: they are (weakly) convex Indifference curves are bowed out to the origin MRS is decreasing as consumption of C increases The more C is consumed, the less valuable it becomes relative to F (Week 2) Preferences and Demand Fall / 29
8 Example: Linear Preferences U(D C, D F ) = ad C + bd F Consumer is always indifferent between ΔD C = b and ΔD F = a MRS is constant at a/b What does this imply about the substitutability of C and F? (Week 2) Preferences and Demand Fall / 29
9 Example: Leontief Preferences U(D C, D F ) = min {ad C, bd F } Consumer always wants to consume b units of C with a units of F MRS is undefined What does this imply about the substitutability of C and F? (Week 2) Preferences and Demand Fall / 29
10 Utility Maximization At an interior optimum, MRS = p C /p F Whenever MRS > p C /p F, consumer wants to trade F for C Whenever MRS < p C /p F, consumer wants to trade C for F (Week 2) Preferences and Demand Fall / 29
11 Tangency of Budget Line and Indifference Curve at the Interior Optimum Why is this a necessary condition? (Week 2) Preferences and Demand Fall / 29
12 Corner Solutions to Utility Maximization Problem D C = 0 is an optimum if MRS < p C /p F at that point. Why? Consumer wants to trade C for F, but there is no more C left to trade! (Week 2) Preferences and Demand Fall / 29
13 Corner Solutions to Utility Maximization Problem D F = 0 is an optimum if MRS > p C /p F at that point. Why? Consumer wants to trade F for C, but there is no more F left to trade! (Week 2) Preferences and Demand Fall / 29
14 Utility Maximization and Relative Demand Given preferences and endowment E, optimal (util. max) demand D can be calculated for any given relative price p C /p F (Week 2) Preferences and Demand Fall / 29
15 Utility Maximization and Relative Demand Given preferences and endowment E, optimal (util. max) demand D can be calculated for any given relative price p C /p F (Week 2) Preferences and Demand Fall / 29
16 Utility Maximization and Relative Demand Given preferences and endowment E, optimal (util. max) demand D can be calculated for any given relative price p C /p F (Week 2) Preferences and Demand Fall / 29
17 Utility Maximization and Relative Demand (Cont.) This pattern of demand can be represented as a relative demand curve i.e. D C /D F as a function of p C /p F : In general, a relative demand curve (RD) will depend on the consumer s endowment point E (Week 2) Preferences and Demand Fall / 29
18 Homothetic Preferences Definition: MRS is constant along any ray from the origin A single indifference curve summarizes all the information about preferences (Week 2) Preferences and Demand Fall / 29
19 Important Property of Homothetic Preferences for Demand Changes in income are proportionally reflected in the optimal demand for all goods (holding prices fixed) This leads to some very important aggregation properties across consumers with different income levels (Week 2) Preferences and Demand Fall / 29
20 Special Examples of Homothetic Preferences Cobb-Douglas preferences: U(D C, D F ) = (D C ) a (D F ) b with a, b > 0 Consumer always spends a constant share of his/her income on both goods: Linear preferences Leontief preferences p C D C a p F D F b = and = p C D C + p F D F a + b p C D C + p F D F a + b (Week 2) Preferences and Demand Fall / 29
21 Homothetic Preferences and Relative Demand If consumers have the same homothetic preferences, then they will always consume the same relative amount of C and F regardless of differences in their endowments Thus, the RD curve for any homothetic preferences is independent of the consumer s endowment (Week 2) Preferences and Demand Fall / 29
22 Aggregation Property of Homothetic Preferences Consider N consumers indexed by i = 1..N For each consumer i : pdi C + D i = pe i F C + E F i (budget constraint) where p = p C /p F is the relative price Now sum the budget constraints: N N N N p D C i + D F i = p E C i + E i F pd C + D F = pe C + E F i=1 i=1 i =1 i =1 where D = (D C, D F ) is aggregate demand and E = (E C, E F ) is the aggregate endowment over all N consumers Also, DC i /DF i = RD(p) for all consumers i so this must also hold in the aggregate: D C /D F = RD(p) Aggregate demand is the same as if it were generated by a single consumer who owns the aggregate endowment E and shares the same homothetic preferences as the individual consumers (Week 2) Preferences and Demand Fall / 29
23 Aggregation Property of Homothetic Preferences (Cont.) Can capture all the properties of aggregate demand for a country by modeling the demand of a single consumer Furthermore, this aggregate demand is independent of the distribution of endowments (hence incomes) across consumers Important note: If the welfare of this aggregate consumer is increasing (or decreasing) then this will imply that overall welfare is also increasing (or decreasing) But this does not mean that the welfare of all individual consumers is increasing (or decreasing) (Week 2) Preferences and Demand Fall / 29
24 Homothetic Preferences and Relative Demand (Redux) Recall that any homothetic preferences can be exactly described by the associated relative demand curve (since it is independent of endowments) (Week 2) Preferences and Demand Fall / 29
25 Some Additional Examples Consider 2 consumers with different homothetic preferences (1 and 2): Who likes C relatively more? Consumer 2 does: at same p C /p F, he/she will always demand relatively more C (DC 1 /DF 1 D 2 /D 2 ) < C F (Week 2) Preferences and Demand Fall / 29
26 Some Additional Examples (cont.) Consider 2 consumers with different homothetic preferences (1 and 2): Who likes C relatively more? What is main difference between preferences? Consumer 1 considers C and F to be relatively closer substitutes (than consumer 2 does) his/her demand is more elastic (Week 2) Preferences and Demand Fall / 29
27 Some Additional Examples Consider 4 consumers with different homothetic preferences (1-4): What are the relative demands? (Week 2) Preferences and Demand Fall / 29
28 Some Additional Examples Consider 4 consumers with different homothetic preferences (1-4): What are the relative demands? (Week 2) Preferences and Demand Fall / 29
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