Microeconomics
Session 2-4
9.1
CONSUMER AND PRODUCER SURPLUS
Consumer and Producer Surplus
Figure 9.1
Consumer and Producer
Surplus
Consumer A would pay $10
for a good whose market
price is $5 and therefore
enjoys a benefit of $5.
Consumer B enjoys a
benefit of $2,
and Consumer C, who
values the good at exactly
the market price, enjoys no
benefit.
Consumer surplus
measures the total benefit
that consumers receive
beyond what they pay (the
market price).
9.1
CONSUMER AND PRODUCER SURPLUS
Consumer and Producer Surplus
Figure 9.1
Consumer and Producer
Surplus (continued)
Producer surplus is the total
benefit due to the difference
between the market price
and the marginal cost.
It is the green-shaded area
between the supply curve
and the market price.
Together, consumer and
producer surplus measure
the welfare benefit of a
competitive market.
2.4
ELASTICITIES
elasticity Percentage change in one variable resulting from
a 1-percent increase in another.
Price Elasticity of Demand
price elasticity of demand Percentage change in quantity
demanded of a good resulting from a 1-percent increase in its
price.
(2.1)
2.4
ELASTICITIES
Linear Demand Curve
linear demand curve
Figure 2.11
Linear Demand Curve
The price elasticity of demand
depends not only on the slope
of the demand curve but also
on the price and quantity.
The elasticity, therefore, varies
along the curve as price and
quantity change. Slope is
constant for this linear
demand curve.
Near the top, because price is
high and quantity is small, the
elasticity is large in
magnitude.
The elasticity becomes
smaller as we move down the
curve.
Demand curve that is a straight line.
ELASTICITIES
2.4
Linear Demand Curve
Figure 2.12
(a) Infinitely Elastic Demand
(a) For a horizontal demand
curve, Q/P is infinite.
Because a tiny change in
price leads to an enormous
change in demand, the
elasticity of demand is infinite.
infinitely elastic demand Principle that consumers will buy as much
of a good as they can get at a single price, but for any higher price the
quantity demanded drops to zero, while for any lower price the quantity
demanded increases without limit.
ELASTICITIES
2.4
Linear Demand Curve
Figure 2.12
(b) Completely Inelastic Demand
(b) For a vertical demand curve,
Q/P is zero. Because the
quantity demanded is the same
no matter what the price, the
elasticity of demand is zero.
completely inelastic demand Principle that consumers will buy a
fixed quantity of a good regardless of its price.
A change in quantity (algebra)
TR(Q) = p(Q) Q
TR(Q) = p(Q) + p(Q) Q
= p(Q) [ 1 + p(Q) Q / p(Q)]
= p(Q) [ 1 + 1/e]
where
e = p Q(p) / Q(p)
Price elasticity of demand
e = p Q(p) / Q(p)
TR(Q) = MR(Q) = p(Q) [ 1 + 1/e]
Abs(e) > 1 ; demand is elastic; TR(Q) > 0
Abs(e) < 1 ; demand is inelastic; TR(Q) < 0
Consumer Behavior
Theory of consumer behavior Description of how
consumers allocate incomes among different goods and
services to maximize their well-being.
Consumer behavior is best understood in three distinct steps:
1.
Consumer preferences
2.
Budget constraints
3.
Consumer choices
3.1
CONSUMER PREFERENCES
Indifference Curves
Figure 3.1
Describing Individual Preferences
Because more of each good is
preferred to less, we can
compare market baskets in the
shaded areas. Basket A is clearly
preferred to basket G, while E is
clearly preferred to A.
However, A cannot be compared
with B, D, or H without additional
information.
3.1
CONSUMER PREFERENCES
Indifference Maps
Indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.
Figure 3.3
An Indifference Map
An indifference map is a set of
indifference curves that
describes a person's
preferences.
Any market basket on
indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.
3.1
CONSUMER PREFERENCES
Indifference Maps
Figure 3.4
Indifference Curves Cannot Intersect
If indifference curves U1 and U2
intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be indifferent
among market baskets A, B,
and D. Yet B should be
preferred to D because B has
more of both goods.
3.1
CONSUMER PREFERENCES
The Marginal Rate of Substitution
Marginal rate of substitution (MRS) Maximum amount of a good
that a consumer is willing to give up in order to obtain one additional
unit of another good.
Figure 3.5
The Marginal Rate of Substitution
The magnitude of the slope of an
indifference curve measures the
consumers marginal rate of
substitution (MRS) between two
goods.
In this figure, the MRS between clothing
(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and
G).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS
diminishes along an indifference curve,
the curve is convex.
3.1
CONSUMER PREFERENCES
Perfect Substitutes and Perfect Complements
Figure 3.6
Perfect Substitutes and Perfect Complements
In (a), Bob views orange juice and
apple juice as perfect substitutes:
He is always indifferent between a
glass of one and a glass of the
other.
In (b), Jane views left shoes and
right shoes as perfect complements:
An additional left shoe gives her no
extra satisfaction unless she also
obtains the matching right shoe.
3.1
CONSUMER PREFERENCES
Utility and Utility Functions
utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.
utility function Formula that assigns a level of utility to individual
market baskets.
Figure 3.8
Utility Functions and Indifference Curves
A utility function can be
represented by a set of
indifference curves, each
with a numerical
indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50,
and 100, respectively)
associated with the utility
function FC.
3.2
BUDGET CONSTRAINTS
Budget constraints Constraints that consumers face
as a result of limited incomes.
Budget line All combinations of goods for which the total
amount of money spent is equal to income.
PF F PC C I
(3.1)
TABLE 3.2 Market Baskets and the Budget Line
Market Basket
A
Food (F)
0
Clothing (C)
40
Total Spending
$80
20
30
$80
40
20
$80
60
10
$80
80
$80
The table shows market baskets associated with the budget line
F + 2C = $80
3.2
BUDGET CONSTRAINTS
The Budget Line
Figure 3.10
A Budget Line
A budget line describes the
combinations of goods that can be
purchased given the consumers
income and the prices of the goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
of $80, a price of food of PF = $1
per unit, and a price of clothing of
PC = $2 per unit.
The slope of the budget line
(measured between points B and D)
is PF/PC = 10/20 = 1/2.
C ( I / PC ) ( PF / PC ) F
(3.2)
3.2
BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices
Figure 3.11
Effects of a Change in Income on the
Budget Line
Income Changes A change in
income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L1).
When the income of $80 (on L1) is
increased to $160, the budget line
shifts outward to L2.
If the income falls to $40, the line
shifts inward to L3.
3.2
BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices
Figure 3.12
Effects of a Change in Price on the
Budget Line
Price Changes A change in the
price of one good (with income
unchanged) causes the budget line
to rotate about one intercept.
When the price of food falls from
$1.00 to $0.50, the budget line
rotates outward from L1 to L2.
However, when the price increases
from $1.00 to $2.00, the line rotates
inward from L1 to L3.
3.3
CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination
of goods and services.
Figure 3.13
Maximizing Consumer Satisfaction
A consumer maximizes satisfaction
by choosing market basket A. At
this point, the budget line and
indifference curve U2 are tangent.
No higher level of satisfaction (e.g.,
market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [ (10/10) = 1]
is greater than the price ratio (1/2),
satisfaction is not maximized.
3.5
MARGINAL UTILITY AND CONSUMER CHOICE
0 MU (F ) MU (C )
F
C
(C / F ) MU / MU
F
C
MRS MU /MU
F
C
MRS P / P
F C
(3.5)
(3.6)
MU / MU P / P
F
C F C
MU / P MU / P
F F
C C
equal marginal principle
(3.7)
Principle that utility is maximized
when the consumer has equalized the marginal utility per dollar of
expenditure across all goods.
4.1
INDIVIDUAL DEMAND
Price Changes
Figure 4.1
Effect of Price Changes
A reduction in the price of food,
with income and the price of
clothing fixed, causes this
consumer to choose a different
market basket.
In (a), the baskets that
maximize utility for various
prices of food (point A, $2; B,
$1; D, $0.50) trace out the
price-consumption curve.
Part (b) gives the demand
curve, which relates the price
of food to the quantity
demanded. (Points E, G, and H
correspond to points A, B, and
D, respectively).
4.1
INDIVIDUAL DEMAND
Income Changes
Figure 4.2
Effect of Income Changes
An increase in income, with the
prices of all goods fixed, causes
consumers to alter their choice of
market baskets.
In part (a), the baskets that
maximize consumer satisfaction
for various incomes (point A,
$10; B, $20; D, $30) trace out the
income-consumption curve.
The shift to the right of the
demand curve in response to the
increases in income is shown in
part (b). (Points E, G, and H
correspond to points A, B, and D,
respectively.)
