econ 1010 all class slides
DESCRIPTION
Harvard extension course on Microeconomics and all available slides by Professor WatsonTRANSCRIPT
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Introduction and Course Overview
The Methods of Economics
The Product and Factor Markets
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Determinants of Demand for an Individual The Demand Curve for an Individual From Individual Demand to Market Demand Change in demand vs. Change in quantity demanded Determinants of Supply for an Individual Supplier The Supply Curve for an Individual Supplier From Individual Supply to Market Supply Change in supply vs. Change in quantity supplied Equilibrium
The Necessity of Equilibrium Calculating Equilibrium with Equations
-
EquilibriumPutting Supply and Demand Together The Necessity of Equilibrium
Price Floors
Price Ceilings
Calculating Equilibrium with Equations
Comparative Statics The Three Questions
Examples
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Elasticity Price Elasticity of Demand
Elastic and Inelastic Curves
Calculating Elasticity: The Midpoint Formula
Elasticity and Slope
Other Elasticities Cross-Price Elasticity of Demand
Income Elasticity of Demand
Price Elasticity of Supply
-
Determinants of Individual Demand
Price Income
Normal goods: Goods whose demand increases when income increases
Inferior goods: Goods whose demand decreases when income increases
Price of Related Goods Substitutes: Demand goes up when the price of a substitute
goes up Complements: Demand goes down when the price of a
complement goes up Tastes and Preferences Expectations
-
Determinants of Market Demand Price Income
Normal goods: Goods whose demand increases when income increases
Inferior goods: Goods whose demand decreases when income increases
Price of Related Goods Substitutes: Demand goes up when the price of a substitute
goes up Complements: Demand goes down when the price of a
complement goes up Tastes and Preferences Expectations Number of Buyers
-
0D
P
Individual DemandLower Case q"
q
-
0D
P
Market DemandCapital Q"
Q
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesThe Demand Function
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
QD = 24 3P
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesThe Demand Function
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
QD = 24 3P P = 8 QD
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for Lattes
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for Lattes
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
P = 8 QD
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for Lattes
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
P = 8 QDP = 8 (9)
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for Lattes
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
P = 8 QDP = 8 (9)
= 5
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for Lattes
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for Lattes
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
P = 8 QDP = 8 (18)
= 2
-
0D
P
Demand and Inverse Demand Functions
Q
Numerical Demand Function: QD = 24 3P
-
0D
P
Demand and Inverse Demand Functions
Q
Numerical Demand Function: QD = 24 3PInverse Demand Function: P = 8 QD
-
0D
P
Demand and Inverse Demand Functions
Q
Numerical Demand Function: QD = 24 3PInverse Demand Function: P = 8 QD
8
Slope =
24
-
0D
P
Demand and Inverse Demand Functions
Q
Parametric Demand Function:
Inverse Demand Function:
Slope = 1/b
Da 1P = Qb b
DQ a bP a
b
a
-
0D
P
Demand and Inverse Demand Functions
Q
General Form of Demand Function:
Inverse Demand Function:
Slope =
1 DP = (Q )f
DQ (P)f
DdP
dQ
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncrease in quantity demanded
P Qd
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall
held constantTastes change more in favor of the good
P QDold
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall
held constantTastes change more in favor of the good
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall
held constantTastes change more in favor of the good
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall
held constantTastes change more in favor of the good
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall
held constantTastes change more in favor of the good
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall
held constantTastes change more in favor of the good
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall
held constantTastes change more in favor of the good
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall held constant
Tastes change more in favor of the goodDemand curve shifts right
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall held constant
Tastes change more in favor of the goodDemand curve shifts right
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
P = 8 QD
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25
P
Q
The Market Demand Curve for LattesIncomes, Price of related goods, Expectationsall held constant
Tastes change more in favor of the goodDemand curve shifts right
P QDold QDnew
$0.00 24 28
1.00 21 25
2.00 18 22
3.00 15 19
4.00 12 16
5.00 9 13
6.00 6 11
P = 8 QD
P = 9 QD
-
0D
P P QD
An increase in quantity demanded is a
movement down alongthe demand curve
B
A
14
$1.00
$2.00
12
Increase in Quantity Demanded
Q
-
0D1
P Income (Normal goods)Income (Inferior goods)
Price of substitute
Price of complement
Changes in tastes or expectations
Number of buyers
Increase in DemandOne of the non-price determinants of D changes, causing the curve to shift right
Q
D2
-
0D
P P QD
An decrease in quantity demanded is a
movement up alongthe demand curve
B
14
$1.00
$2.00
12
Decrease in Quantity Demanded
Q
A
-
0D2
P Income (Normal goods)Income (Inferior goods)
Price of substitute
Price of complement
Changes in tastes or expectations
Number of buyers
Decrease in DemandOne of the non-price determinants of D changes, causing the curve to shift left
Q
D1
-
Determinants of a Firms Supply
Price
Input Prices
Technology
Expectations
-
Determinants of Market Supply
Price
Input Prices
Technology
Expectations
Number of Sellers
-
P QS
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply Curve
-
P QS
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput prices, technology, expectations and number
of sellers all held constant
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveP Q
S
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
QS = 5P
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveP Q
S
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
QS = 5PP = (1/5)QS
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput prices, technology, expectations and number
of sellers all held constant
P QS
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput prices, technology, expectations and number of sellers all held
constantIncrease in quantity supplied
P QS
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
P = (1/5)QS= (1/5)10= 2
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput prices, technology, expectations and number of sellers all held
constantIncrease in quantity supplied
P QS
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
P = (1/5)QS= (1/5)10= 2
P = (1/5)QS= (1/5)25= 5
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput prices, technology, expectations and number of sellers all held
constantIncrease in quantity supplied
P QS
(Market)
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveTechnology, expectations and number of sellers still held
constant Input costs increase
P QSold QSnew$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput costs increase
P QSold QSnew$0.00 0
1.00 5 0
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput costs increase
P QSold QSnew$0.00 0
1.00 5 0
2.00 10 5
3.00 15
4.00 20
5.00 25
6.00 30
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput costs increase
P QSold QSnew$0.00 0
1.00 5 0
2.00 10 5
3.00 15 10
4.00 20
5.00 25
6.00 30
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput costs increase
P QSold QSnew$0.00 0
1.00 5 0
2.00 10 5
3.00 15 10
4.00 20 15
5.00 25 20
6.00 30 25
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput costs increase
Supply curve shifts to the left
P QSold QSnew$0.00 0
1.00 5 0
2.00 10 5
3.00 15 10
4.00 20 15
5.00 25 20
6.00 30 25
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput costs increase
Supply curve shifts to the left
P QSold QSnew$0.00 0
1.00 5 0
2.00 10 5
3.00 15 10
4.00 20 15
5.00 25 20
6.00 30 25
P = (1/5)QS
-
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
0 5 10 15 20 25 30 35
P
Q
The Market Supply CurveInput costs increase
Supply curve shifts to the lefta decrease in supply
P QSold QSnew$0.00 0
1.00 5 0
2.00 10 5
3.00 15 10
4.00 20 15
5.00 25 20
6.00 30 25
P = (1/5)QS
P = 1 + (1/5)QS
-
3 9
P
Q0
S
$1.00 A
B$3.00
P QS An increase in quantity supplied is a movement up along the supply curve
Increase in Quantity Supplied
-
0S1P Technology improves
Input prices
Change in expectations
Number of producers
Increase in SupplyOne of the non-price determinants of S changes, causing the curve to shift right
Q
S2
-
3 9
P
Q0
S
$1.00 B
A$3.00
P QS A decrease in quantity supplied is a movement down along the supply curve
Decrease in Quantity Supplied
-
0S2P Technology deteriorates
Input prices
Change in expectations
Number of producers
Decrease in SupplyOne of the non-price determinants of S changes, causing the curve to shift left
Q
S1
-
0D
P At equilibrium E = (Q*,P*), Quantity Demanded = Quantity Supplied
EquilibriumPoint at which QS = QD
Q
S
EP*
Q*
-
0D
P At PH, QS > QD, which results in excess supply, or a surplus
Disequilibrium: Getting the Price WrongWhat happens when the price is too high?
Q
S
EP*
Q*
PH
QD QS
Surplus
-
0D
P At PH, QS > QD, which results in excess supply
There is downward pressure on price, and price declines toward P*
As P falls, QD increases toward Q*, and QS decreases toward Q*
Process stops when equilibrium is reached, and the surplus is eliminated
Disequilibrium: Getting the Price WrongWhat happens when the price is too high?
Q
S
EP*
Q*
PH
QD QS
Surplus
-
0D
P
Disequilibrium: Getting the Price WrongWhat happens when the price is too low?
Q
S
EP*
Q*
PL
QDQS
Shortage
At PL, QD > QS, which results in excess demand, or a shortage
-
0D
P
Disequilibrium: Getting the Price WrongWhat happens when the price is too low?
Q
S
EP*
Q*
PL
QDQS
Shortage
At PL, QD > QS, which results in excess demand, or a shortage
There is upward pressure on price, and price increases toward P*
As P increases, QD decreases toward Q*, and QS increases toward Q*
Process stops when equilibrium is reached, and the shortage is eliminated
-
0D
P At equilibrium E = (Q*,P*), Quantity Demanded = Quantity Supplied
EquilibriumPoint at which QS = QD
Q
S
EP*
Q*
-
Calculating Equilibrium from Equations
P = 100 3QD Demand Curve
-
0D
P
EquilibriumPoint at which QS = QD
Q
-
Calculating Equilibrium from Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
-
0D
P
EquilibriumPoint at which QS = QD
Q
S
-
0D
P
EquilibriumPoint at which QS = QD
Q
S
P*
Q*
-
Calculating Equilibrium from Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply
-
Calculating Equilibrium from Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply100 3QD = 25 + 2QS
-
Calculating Equilibrium from Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*
-
Calculating Equilibrium from Equations
P = 100 3QD Demand CurveP = 25 + 2QS Supply CurveAt equilibrium,
Demand = Supply100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*
100 3Q* = 25 + 2Q*
-
Calculating Equilibrium from Equations
P = 100 3QD Demand CurveP = 25 + 2QS Supply CurveAt equilibrium,
Demand = Supply100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*
100 3Q* = 25 + 2Q*
5Q* = 75
-
Calculating Equilibrium from Equations
P = 100 3QD Demand CurveP = 25 + 2QS Supply CurveAt equilibrium,
Demand = Supply100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*100 3Q* = 25 + 2Q*
5Q* = 75Q* = 15
-
0D
P
EquilibriumPoint at which QS = QD
Q
S
P*
Q*= 15
-
Calculating Equilibrium from Equations
P = 100 3QD Demand CurveP = 25 + 2QS Supply CurveAt equilibrium,
Demand = Supply100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*100 3Q* = 25 + 2Q*
5Q* = 75Q* = 15
-
Calculating Equilibrium from Equations
P = 100 3QD Demand CurveP = 25 + 2QS Supply Curve
Q* = 15
To find P*, substitute Q* into either
demand or supply equation:
-
Calculating Equilibrium from Equations
P = 100 3QD Demand CurveP = 25 + 2QS Supply Curve
Q* = 15
To find P*, substitute Q* into either
demand or supply equation:
P* = 100 3Q* = 100 3(15) = 55
-
Calculating Equilibrium from Equations
P = 100 3QD Demand CurveP = 25 + 2QS Supply Curve
Q* = 15
To find P*, substitute Q* into either
demand or supply equation:
P* = 100 3Q* = 100 3(15) = 55
P* = 25 + 2Q* = 25 + 2(15) = 55
-
0D
P
EquilibriumPoint at which QS = QD
Q
S
Q*= 15
P*= 55
-
Comparative Statics
Start at equilibrium
-
Comparative Statics
Start at equilibrium
Change the value of one of the non-price determinants of supply or demand
-
Comparative Statics
Start at equilibrium
Change the value of one of the non-price determinants of supply or demand
Compare the new equilibrium to the old one
-
0D
P Initial equilibrium is E1 = (Q1*,P1*)Assume that the price of compact disk players declines
What happens to equilibrium P and Q in the market for compact disks?
Market for Compact Disks
Q
S
E1P1*
Q1*
-
Three Questions in Any Comparative Statics Problem
Which curve shifts?
-
Three Questions in Any Comparative Statics Problem
Which curve shifts? Demandsince the price of a complement has changed
and that is a determinant of demand
-
Three Questions in Any Comparative Statics Problem
Which curve shifts? Demandsince the price of a complement has changed
and that is a determinant of demand
Which way does it shift?
-
Three Questions in Any Comparative Statics Problem
Which curve shifts? Demandsince the price of a complement has changed
and that is a determinant of demand
Which way does it shift? To the right, since a fall in the price of a complement
causes demand to increase
-
0D1
P
Market for Compact Disks
Q
S
E1P1*
Q1*
D2
-
Three Questions in Any Comparative Statics Problem
Which curve shifts? Demandsince the price of a complement has changed
and that is a determinant of demand
Which way does it shift? To the right, since a fall in the price of a complement
causes demand to increase
What happens to equilibrium P and Q after the shift?
-
0D1
P The demand curve shifts rightThe increase in demand leads to an increase in equilibrium price and an increase in equilibrium quantity
Note: The increase in demand leads to an increase in quantity supplied
Market for Compact Disks
Q
S
E1P1*
Q1*
D2
E2P2*
Q2*
-
Three Questions in Any Comparative Statics Problem
Which curve shifts? Demandsince the price of a complement has changed
and that is a determinant of demand
Which way does it shift? To the right, since a fall in the price of a complement
causes demand to increase
What happens to equilibrium P and Q after the shift?
P* Q*
-
Definition of Price Elasticity of Demand
Price elasticity of demand = eD = percentage changein quantity demanded divided by the percentage change in price
-
Definition of Price Elasticity of Demand
Price elasticity of demand = eD = percentage changein quantity demanded divided by the percentage change in price
Price elasticity of demand is a measure of how sensitive quantity demanded is to changes in price
-
Definition of Price Elasticity of Demand
Price elasticity of demand = eD = percentage changein quantity demanded divided by the percentage change in price
Price elasticity of demand is a measure of how sensitive quantity demanded is to changes in price
Algebraically, eD = P%Q% D
-
Definition of Price Elasticity of Demand
Price elasticity of demand = eD = percentage changein quantity demanded divided by the percentage change in price
Price elasticity of demand is a measure of how sensitive quantity demanded is to changes in price
Algebraically, eD =
D
D D
Q% Q Q
P% PP
-
Definition of Price Elasticity of Demand
Price elasticity of demand = eD = percentage changein quantity demanded divided by the percentage change in price
Price elasticity of demand is a measure of how sensitive quantity demanded is to changes in price
Algebraically, eD =
D
D DD
D
Q% Q Q PQ
P% P Q PP
-
Definition of Price Elasticity of Demand
Price elasticity of demand = eD = percentage changein quantity demanded divided by the percentage change in price
Price elasticity of demand is a measure of how sensitive quantity demanded is to changes in price
Algebraically, eD =
D
D D DD
D D
Q% Q Q P Q PQ
P% P Q P P QP
-
0DI
P
Inelastic Demand Curve
Q
-
0DE
P
Elastic Demand Curve
Q
-
0DE
P
Elasticity and the Change in QD
QDI
P1
Q1
P2
QInQEl
-
0DPI
P
Perfectly Inelastic Demand Curve
Q
-
0DPE
P
Perfectly Elastic Demand Curve
Q
-
Calculating Price Elasticity of Demand
eD = P%Q% D
-
Calculating Price Elasticity of Demand
eD =
=
P%
Q% D
D DNew Old
DOld
New Old
Old
Q QQ
P PP
-
0D
P
Calculating eD
Q6 10
4
2A
B
-
0D
P
Calculating eD
2
2410
106
Old
OldNew
DOld
DOld
DNew
PPP
QQQ
4
426
610
Q6 10
4
2A
B
From A to B, eD =
= .4
2
2410
106
-
0D
P
Calculating eD
2
2410
106
Old
OldNew
DOld
DOld
DNew
PPP
QQQ
4
426
610
Q6 10
4
2A
BFrom A to B, eD =
= .4
2
2410
106
-
0D
P
Calculating eD
2
2410
106
Old
OldNew
DOld
DOld
DNew
PPP
QQQ
4
426
610
Q6 10
4
2A
BFrom A to B, eD =
= .4
From B to A, eD=
= 1.33
4
426
610
2
2410
106
-
Calculating Elasticity Using the Midpoint Formula
2PPPP
2QQQQ
e
OldNew
OldNew
DOld
DNew
DOld
DNew
D
-
0D
P
Calculating eD
Q6 10
4
2A
B
-
0D
P
Calculating eD
2
2410
106
Old
OldNew
DOld
DOld
DNew
PPP
QQQ
4
426
610
Q6 10
4
2A
BFrom A to B, eD =
= .75
22424
2106106
-
0D
P
Calculating eD
2
2410
106
Old
OldNew
DOld
DOld
DNew
PPP
QQQ
4
426
610
Q6 10
4
2A
B
From A to B, eD =
= .75
From B to A, eD=
22424
2106106
-
0D
P
Calculating eD
2
2410
106
Old
OldNew
DOld
DOld
DNew
PPP
QQQ
4
426
610
Q6 10
4
2A
B
From A to B, eD =
= .75
From B to A, eD=
= .75
24242
2610610
22424
2106106
-
Price Elasticity of Demand
eD > 1 Elastic
-
Price Elasticity of Demand
eD > 1 Elastic
eD = 1 Unit elastic
-
Price Elasticity of Demand
eD > 1 Elastic
eD = 1 Unit elastic
eD < 1 Inelastic
-
0D
P
Elasticity is Not Constant Along a Linear Demand Curve
Q
P = 100 QD
-
0D
P
Elasticity is Not Constant Along a Linear Demand Curve
Q
P = 100 QD
Slope = -1 Over the Entire Demand Curve
-
0D
P
Elasticity is Not Constant Along a Linear Demand Curve
Q
P = 100 QD
80
20
-
0D
P
Elasticity is Not Constant Along a Linear Demand Curve
Q
P = 100 QD
80
20
70
30
-
0D
P
Using the Midpoint Formula, Calculate the price elasticity of demand between
pts. A and B
Q
P = 100 QD
80
20
70
30
A
B
-
0D
P
Using the Midpoint Formula, Calculate the price elasticity of demand between
pts. A and B
Q
P = 100 QD
80
20
70
30
A
B From A to B, eD =
= 3.00
30 2030 20
270 8070 80
2
-
0D
P
Using the Midpoint Formula, Calculate the price elasticity of demand between
pts. A and B
Q
P = 100 QD
80
20
70
30
A
B From A to B, eD =
= 3.00
30 2030 20
270 8070 80
2
eD=3
-
0D
P
Using the Midpoint Formula, Calculate the price elasticity of demand between
pts. C and D
Q
P = 100 QD
40
60
30
70
A
B
eD=3
C
D
-
0D
P
Using the Midpoint Formula, Calculate the price elasticity of demand between
pts. C and D
Q
P = 100 QD
40
60
30
70
A
B From C to D, eD =
= .538
70 6070 60
230 4030 40
2
eD=3
C
D
eD=.538
-
0P
Using the Midpoint Formula, Calculate the price elasticity of demand between
pts. C and D
Q
P = 100 QD
A
BeD=3
C
DeD=.538
eD=1
-
0D
P
Elasticity is Not Constant Along a Linear Demand Curve
Q
Unit Elastic
-
0D
P
Inelastic Curve
Q
Unit Elastic
-
0D
P
Elastic Curve
Q
Unit Elastic
-
Rules of Thumb for Price Elasticity of Demand
Demand for luxuries is more elastic than demand for necessities
-
Rules of Thumb for Price Elasticity of Demand
Demand for luxuries is more elastic than demand for necessities
Demand for a good with close substitutes is more elastic
-
Rules of Thumb for Price Elasticity of Demand
Demand for luxuries is more elastic than demand for necessities
Demand for a good with close substitutes is more elastic
The broader the definition of a good, the less elastic the demand
-
CEREALPRICE ELASTICITY
OF DEMAND
Post Raisin Bran -2.5
All family breakfast cereals -1.8
All types of breakfast cereals -0.9
-
Rules of Thumb for Price Elasticity of Demand
Demand for luxuries is more elastic than demand for necessities
Demand for a good with close substitutes is more elastic
The broader the definition of a good, the less elastic the demand
The longer the period of time, the more elastic is demand
-
Other Elasticities
Cross-price elasticity of demand
Income elasticity of demand
Price Elasticity of supply
-
Cross-price elasticity of demand
Cross-price elasticity of demand: measures the response of demand for one good to changes in the price of another good
Cross-price elast. of demand
=% change in Qd for good 1
% change in price of good 2
For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken)
For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software)
-
Other Elasticities
Income elasticity of demand: measures the response of Qd to a change in consumer income
Income elasticity of demand =
Percent change in Qd
Percent change in income
Remember: An increase in income causes an increase in demand for a normal good.
Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0.
-
Calculating Other Elasticities
Price elasticity of supply
eS =P%
Q% S
-
My Econ Lab Tricks and TipsBehind the Demand Curve: Consumer Theory The Two Factors Involved in a Consumers Decision Indifference Curves
Principles of Indifference Curves Marginal Rate of Substitution
Definition Marginal Utility
Unusually Shaped Indifference Curves
The Other Part of the Consumers Decision Process: Budget Constraints Definition Slope Opportunity Cost
-
Consumer Optimum: Putting Indifference Curves and Budget Constraints Together Practice Problems
-
MyEconLab Tips and Tricks
Key Point: Do not click Submit until you are ready to have your quiz graded. After you click submit, you cannot change your answer.
-
MyEconLab Tips and Tricks
Key Point: Do not click Submit until you are ready to have your quiz graded. After you click submit, you cannot change your answer.
However, you can save your questions before you have submitted them simply by exiting your browserthere is no Save button or anything.
Once you log back into MyEconLab, you will be able to continue the quiz where you left off, go back and change answers, etc.
-
MyEconLab Tips and Tricks
Key Point: Do not click Submit until you are ready to have your quiz graded. After you click submit, you cannot change your answer.
Once you click Submit, however, you will not be able to change anything, and your test will be automatically graded.
After the due date, you can click the Review button, and you will be able to see your answers as well as the correct answer.
-
0D
P
Behind the Demand Curve
Q
-
The Two Factors in a Consumption Decision
-
The Two Factors in a Consumption Decision
Tastes and preferences
-
The Two Factors in a Consumption Decision
Tastes and preferences
Budget
-
The Two Factors in a Consumption Decision
Tastes and preferences
-
Utility
Utility = happiness, satisfaction or well-being
-
Utility
Utility = happiness, satisfaction or well-being
# of Pizza Slices
Total
Utility
-
Utility
Utility = happiness, satisfaction or well-being
# of Pizza Slices
Total
Utility
0 0 utils
-
Utility
Utility = happiness, satisfaction or well-being
# of Pizza Slices
Total
Utility
0 0 utils
1 150 utils
-
Utility
Utility = happiness, satisfaction or well-being
# of Pizza Slices
Total
Utility
0 0 utils
1 150 utils
2 250 utils
-
Utility
Utility = happiness, satisfaction or well-being
# of Pizza Slices
Total
Utility
0 0 utils
1 150 utils
2 250 utils
3 325 utils
-
Utility
Utility = happiness, satisfaction or well-being
# of Pizza Slices
Total
Utility
0 0 utils
1 150 utils
2 250 utils
3 325 utils
4 375 utils
-
Utility
Utility = happiness, satisfaction or well-being
# of Pizza Slices
Total
Utility
0 0 utils
1 150 utils
2 250 utils
3 325 utils
4 375 utils
5 400 utils
-
Utility
Utility = happiness, satisfaction or well-being
Marginal Utility (MU) = the additional utility you get from one additional unit of a good or service
Marginal Utility of X = X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils
2 250 utils
3 325 utils
4 375 utils
5 400 utils
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils U=150
2 250 utils
3 325 utils
4 375 utils
5 400 utils
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils U=150X=1
2 250 utils
3 325 utils
4 375 utils
5 400 utils
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils
2 250 utils
3 325 utils
4 375 utils
5 400 utils
X
U MUX
1501
150
X
U
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils 150 utils
2 250 utils
3 325 utils
4 375 utils
5 400 utils
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils 150 utils
2 250 utils
3 325 utils
4 375 utils
5 400 utils
X
U MUX
1001
100
X
U
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils 150 utils
2 250 utils 100 utils
3 325 utils
4 375 utils
5 400 utils
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils 150 utils
2 250 utils 100 utils
3 325 utils 75 utils
4 375 utils
5 400 utils
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils 150 utils
2 250 utils 100 utils
3 325 utils 75 utils
4 375 utils 50 utils
5 400 utils
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils 150 utils
2 250 utils 100 utils
3 325 utils 75 utils
4 375 utils 50 utils
5 400 utils 25 utils
X
U MUX
-
Utility
Utility = happiness, satisfaction or well-being
Marginal Utility (MU) = the additional utility you get from one additional unit of a good or service
Marginal Utility of X =
Diminishing Marginal Utility When I dont have much of good X, MUX is high
When I am already consuming a lot of good X, MUX is low
X
U MUX
-
Marginal Utility
Marginal Utility of X =
# of Pizza Slices
Total
Utility
Marginal
Utility
0 0 utils
1 150 utils 150 utils
2 250 utils 100 utils
3 325 utils 75 utils
4 375 utils 50 utils
5 400 utils 25 utils
X
U MUX
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0 90
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
A
90
10
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
B
A
45
45
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
C
B
A
10
90
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
C
B
A
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
100 Utils
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
100 Utils 100 Utils
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
100 Utils 100 Utils 100 Utils
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
C
B
A
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
Indifferencecurve
C
B
A
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
100 Utils
C
B
A
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
100 Utils 100 Utils 100 Utils
-
Consumption Possibilities
A B C D90 min. to France
45 min. to France
10 min. to France
120 min. to France
10 min. home
45 min. home
90 min. home
90 min. home
100 Utils 100 Utils 100 Utils 200 Utils
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
100 Utils
200 Utils
C
B
A
D
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
I4=400 utils
I3= 300 utilsI2= 200 utils
I1= 100 utils
-
Principles of Indifference Curves
Higher indifference curves represent higher utility
-
Indifference Curves: The Consumers Preferences
Minutes to France
MinutesHome
0
I4=400 utilsI3= 300 utils
I2= 200 utils
I1= 100 utils
-
Principles of Indifference Curves
Higher indifference curves represent higher utility
Indifference curves never cross
-
Indifference Curves Cannot Cross
Minutes to France
MinutesHome
0
I2= 200 utils
I1= 100 utils
A
B
C
-
Principles of Indifference Curves
Higher indifference curves represent higher utility
Indifference curves never cross
Indifference curves usually slope downward
-
Upward Sloping Indifference Curve
0
B
A
Minutes to France(Bad)
MinutesHome(Good)
30
15
45
45
100 Utils
-
Principles of Indifference Curves
Higher indifference curves represent higher utility
Indifference curves never cross
Indifference curves usually slope downward
Indifference curves are usually convexbowed inward toward the origin (sometimes called concave up)
-
Convexity of Indifference Curves
Minutes to France
MinutesHome
0
Indifferencecurve, I1
A
B
DC
-
Marginal Rate of Substitution
Marginal Rate of Substitution (MRS) measures the amount of good Y you are willing to give up to get one more unit of X
-
Marginal Rate of Substitution
Marginal Rate of Substitution (MRS) measures the amount of good Y you are willing to give up to get one more unit of X
MRS measures the marginal value of one more unit of X......that value being measured in units of Y
-
Diminishing Marginal Rate of Substitution
Minutes to France
MinutesHome
0
100 Utils
A
B
DC
90
80
20 90
109.5
From A to B, MRS = 10
21
From C to D, MRS = .5
91
-
Marginal Rate of Substitution
Marginal Rate of Substitution (MRS) measures the amount of good Y you are willing to give up to get one more unit of X
MRS measures the marginal value of one more unit of X......that value being measured in units of Y
Diminishing Marginal Rate of Substitutionmeans that as you move down along an indifference curve, MRS decreases
-
Marginal Rate of Substitution
Marginal Rate of Substitution (MRS) measures the amount of good Y you are willing to give up to get one more unit of X
MRS measures the marginal value of one more unit of X......that value being measured in units of Y
MRS =Y
X
MU
MU
-
Marginal Rate of Substitution
Marginal Rate of Substitution (MRS) measures the amount of good Y you are willing to give up to get one more unit of X
MRS measures the marginal value of one more unit of X......that value being measured in units of Y
MRS =
Remember the role of diminishing marginal utility
Y
X
MU
MU
-
Diminishing Marginal Rate of Substitution
Minutes to France
MinutesHome
0
100 Utils
A
B
DC
90
80
20 90
109.5
21 91
At A: MUF is highsay 20 utils; but MUH is lowsay 2 utils So, MRS = MUF / MUH = 20 utils / 2 utils = 10
and slope of IC at A = MRS = 10
At C: MUF is lowsay 5 utils; and MUH is highsay 10 utils
MRS = MUF / MUH = 5 utils / 10 utils = Slope of IC at C = MRS =
-
Indifference Curves for Perfect Substitutes
Dimes0
Nickels
I1 I2 I33
6
2
4
1
2
-
Indifference Curves for Perfect Complements
Right Shoes0
LeftShoes
I1
I2
7
7
5
5
-
Budget Constraint
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
Budget=B= $30
-
Budget Constraint: Vertical Intercept
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
Budget=B= $30
B/PH=300
-
Budget Constraint : Horizontal Intercept
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
Budget=B= $30
B/PF= 100
B/PH=300
-
Budget Constraint: Slope
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
Budget=B= $30
B/PF= 100
B/PH=300
Slope = PF/PH
= 30/10
= 3
-
Budget Constraint: General Form
FP
B
HP
B
FP
B
X
Y
0
PX = Price of X
PY = Price of Y
B = Budget
B/PX= 100
B/PY=300
Slope = PX/PY
-
Slope of Budget Constraint
PXX + PYY = B
-
Slope of Budget Constraint
PXX + PYY = B
PYY = B PXX
-
Slope of Budget Constraint
PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
-
Slope of Budget Constraint
PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
-
Slope of Budget Constraint
PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run
-
Budget Constraint: General Form
FP
B
HP
B
FP
B
X
Y
0
PX = Price of X
PY = Price of Y
B = Budget
B/PX
B/PY
-
Slope of Budget Constraint
PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run
= (B/PY) / (B/PX)
-
Slope of Budget Constraint
PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run
= (B/PY) / (B/PX)
= PX/PY
-
Consumer Optimum
X
Y
0
BC
IC
O
X*
Y*
-
Consumer Optimum
X
Y
0
BC
IC
At O: Slope of IC = Slope of BC
O
X*
Y*
-
Consumer Optimum
X
Y
0
BC
IC
At O: Slope of IC = Slope of BC
MRS = PX/PY
O
X*
Y*
-
Consumer Optimum
X
Y
0
BC
IC
At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY
O
X*
Y*
-
Consumer Optimum
X
Y
0
BC
IC
At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:
MUX/PX = MUY/PYO
X*
Y*
-
Consumer Optimum
0
BC
IC
PF = 30, PH = 10, B = $30
At O: Slope of IC = Slope of BC
MRS = PF/PH
MUF/MUH = 30/10
Rearranging:
MUF/PF = MUH/PH
MUF/30 = MUH/10
For examplesatisfied if MUF = 60, MUH = 20.
O
60
B/PH=300
B/PF=100
120
Minutes to France
MinutesHome
-
Conditions for a Consumer Optimum
Optimal consumption bundle (X*,Y*) is on the budget constraint
-
Conditions for a Consumer Optimum
Optimal consumption bundle (X*,Y*) is on the budget constraint
Slope of IC = Slope of BC, which is equivalent to: MUX/PX = MUY/PY
-
Why Cant A Be Optimal?
Minutes to France
MinutesHome
0
O
A
BCI1
I2I3
-
Why Cant A Be Optimal?
Minutes to France
MinutesHome
0
A
BCI1
I2I3
At A, Slope of IC > Slope of BC, which implies that MUF/MUH > PF/PH, or
MUF/PF > MUH/PH.
For example, MUF = 90, MUH = 10, so
MUF/PF = 90/30 = 3, MUH/PH = 10/10 = 1
O
-
Why Cant B Be Optimal?
Minutes to France
MinutesHome
0
O
A
BBC
I1I2
I3
-
Why Cant B Be Optimal?
Minutes to France
MinutesHome
0
O
A
BBC
I1I2
I3
At B, Slope of IC < Slope of BC, which implies that MUF/MUH < PF/PH, or
MUF/PF < MUH/PH.
For example, MUF = 30, MUH = 30, so
MUF/PF = 30/30 = 1, MUH/PH = 30/10 = 3.
-
Why Cant C Be Optimal?
Minutes to France
MinutesHome
0
O
A
B
C
BCI1
I2I3
-
Why Cant C Be Optimal?
Minutes to France
MinutesHome
0
O
A
B
C
BCI1
I2I3
At C, Slope of IC = Slope of BC, BUT C is not on the BC
-
Why Cant D be Optimal?
Minutes to France
MinutesHome
0
O
A
B
C
D
BCI1
I2I3
-
Why Cant D Be Optimal?
Minutes to France
MinutesHome
0
O
A
B
C
D
BCI1
I2I3
D is not affordableit is outside the BC
-
Why Cant A, B, C or D be Optimal?
Minutes to France
MinutesHome
0
O
A
B
C
D
BCI1
I2I3
Along the BC, it is only at O that MUF/PF = MUH/PH
-
Practice Questions JoAnne is trying to decide how many books and how many movies to consume
each month. She has $136 to spend on the two goods. Movies cost $8 each, and books cost $20 each. Each good can only be purchased in whole numbers (not fractions of a good).
JoAnnes preferences for movies and books are summarized by the following
table:
a. Fill in the figures for marginal utility and for marginal utility per dollar
spent for both movies and books.
Movies Books No. per Total Marginal No. per Total Marginal Month Utility Utility MU/$ Month Utility Utility MU/$
1 50 1 22 2 80 2 42 3 100 3 52 4 110 4 57 5 116 5 60 6 121 6 62 7 123 7 63
-
JoAnnes Books vs. Movies Question
Movies BooksNo. per Total Marginal No. per Total MarginalMonth Utility Utility MU/$ Month Utility Utility MU/$
1 50 50 6.25 1 22 22 1.102 80 30 3.75 2 42 20 1.003 100 20 2.50 3 52 10 0.504 110 10 1.25 4 57 5 0.255 116 6 0.75 5 60 3 0.156 121 5 0.63 6 62 2 0.107 123 2 0.25 7 63 1 0.05
-
Practice Questions JoAnne is trying to decide how many books and how many movies to consume
each month. She has $136 to spend on the two goods. Movies cost $8 each, and books cost $20 each. Each good can only be purchased in whole numbers (not fractions of a good).
JoAnnes preferences for movies and books are summarized by the following
table:
b. Do JoAnnes preferences exhibit diminishing marginal utility for both
goods? Why or why not?
Movies Books No. per Total Marginal No. per Total Marginal Month Utility Utility MU/$ Month Utility Utility MU/$
1 50 1 22 2 80 2 42 3 100 3 52 4 110 4 57 5 116 5 60 6 121 6 62 7 123 7 63
-
JoAnnes Books vs. Movies Question
Movies BooksNo. per Total Marginal No. per Total MarginalMonth Utility Utility MU/$ Month Utility Utility MU/$
1 50 50 6.25 1 22 22 1.102 80 30 3.75 2 42 20 1.003 100 20 2.50 3 52 10 0.504 110 10 1.25 4 57 5 0.255 116 6 0.75 5 60 3 0.156 121 5 0.63 6 62 2 0.107 123 2 0.25 7 63 1 0.05
-
Practice Questions JoAnne is trying to decide how many books and how many movies to consume
each month. She has $136 to spend on the two goods. Movies cost $8 each, and books cost $20 each. Each good can only be purchased in whole numbers (not fractions of a good).
JoAnnes preferences for movies and books are summarized by the following
table:
c. Given her budget of $136, what quantity of books and what quantity of
movies will maximize JoAnnes utility? Explain how you arrived at your answer.
Movies Books No. per Total Marginal No. per Total Marginal Month Utility Utility MU/$ Month Utility Utility MU/$
1 50 1 22 2 80 2 42 3 100 3 52 4 110 4 57 5 116 5 60 6 121 6 62 7 123 7 63
-
JoAnnes Books vs. Movies Question
Movies BooksNo. per Total Marginal No. per Total MarginalMonth Utility Utility MU/$ Month Utility Utility MU/$
1 50 50 6.25 1 22 22 1.102 80 30 3.75 2 42 20 1.003 100 20 2.50 3 52 10 0.504 110 10 1.25 4 57 5 0.255 116 6 0.75 5 60 3 0.156 121 5 0.63 6 62 2 0.107 123 2 0.25 7 63 1 0.05
-
JoAnnes Books vs. Movies Question
Movies BooksNo. per Total Marginal No. per Total MarginalMonth Utility Utility MU/$ Month Utility Utility MU/$
1 50 50 6.25 1 22 22 1.102 80 30 3.75 2 42 20 1.003 100 20 2.50 3 52 10 0.504 110 10 1.25 4 57 5 0.255 116 6 0.75 5 60 3 0.156 121 5 0.63 6 62 2 0.107 123 2 0.25 7 63 1 0.05
-
Graphical Question on Optimal Consumption
At her present levels of consumption of goods X and Y, Dana is spending her entire budget, and her MRSX,Y = 5. PX = $9 and PY = $2.
Is Dana consuming the optimal amount of goods X and Y?
-
Conditions for a Consumer Optimum
Optimal consumption bundle (X*,Y*) is on the budget constraint
-
Graphical Question on Optimal Consumption
At her present levels of consumption of goods X and Y, Dana is spending her entire budget, and her MRSX,Y = 5. PX = $9 and PY = $2.
Is Dana consuming the optimal amount of goods X and Y?
-
Conditions for a Consumer Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint
-
Conditions for a Consumer Optimum
Optimal consumption bundle (X*,Y*) is on the budget constraint
Slope of IC = Slope of BC
-
Consumer Optimum
X
Y
0
BC
IC
At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:
MUX/PX = MUY/PYO
X*
Y*
-
Graphical Question on Optimal Consumption
At her present levels of consumption of goods X and Y, Dana is spending her entire budget, and her MRSX,Y = 5. PX = $9 and PY = $2.
Is Dana consuming the optimal amount of goods X and Y?At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:
MUX/PX = MUY/PY
MRS = PX / PYMRS = PX / PY
5 = PX / PY5 9 / 2
Dana is not at her consumer optimum
-
Danas Current Consumption
X
Y
0
O
A
BCI1
I2I3
Slope of IC = MRS = 5
Slope of BC = PX/PY = 9/2 = 4.5
So, Dana is at a point like A. She is spending too much of her budget on good Y
Dana should reallocate her budget to buy more of good X and less of good Y
-
Consumer Theory (cont.)
Consumer Optimum (Review)
Changes in the Budget Effect on the Budget Constraint
Effect on Consumer Optimum Normal Good
Inferior Good
Changes in Prices Effect on the Budget Constraint
Income and Substitution Effects
Deriving the Demand Curve
Why does the Demand Curve Slope Down?
-
Consumer Optimum
X
Y
0
BC
IC
O
X*
Y*
-
XY
0
BC
IC
At O: Slope of IC = Slope of BC
O
X*
Y*
Consumer Optimum
-
XY
0
BC
IC
At O: Slope of IC = Slope of BC
MRSX,Y = PX/PY
O
X*
Y*
Consumer Optimum
-
XY
0
BC
IC
At O: Slope of IC = Slope of BC
MRSX,Y = PX/PY
MUX/MUY = PX/PY
O
X*
Y*
Consumer Optimum
-
XY
0
BC
IC
At O: Slope of IC = Slope of BC
MRSX,Y = PX/PY
MUX/MUY = PX/PY
Rearranging:
MUX/PX = MUY/PYO
X*
Y*
Consumer Optimum
-
Conditions for a Consumer Optimum
Optimal consumption bundle (X*,Y*) is on the budget constraint
Slope of IC = Slope of BC, which is equivalent to: MUX/PX = MUY/PY
-
Budget Constraint: General Form
FP
B
HP
B
FP
B
X
Y
0
PX = Price of X
PY = Price of Y
B = Budget
B/PX
B/PY
Slope = PX/PY
-
Budget Constraint: Example
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
Budget=B= $30
B/PF= 100
B/PH=300
Slope = PF/PH
= 30/10
= 3
-
A Change in Budget
What if the prices of calls stay the same, but consumers budget for phone calls doubles?
-
Effect of a change in budget on slope of BC
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
New Budget=B= $60
Will the slope of the Budget Constraint Change?
-
Slope doesnt change with a change in budget
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
New Budget=B= $60
Slope = PF/PH
= 30/10
= 3
-
Slope doesnt change with a change in budget
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
New Budget=B= $60
Slope = PF/PH
= 30/10
= 3
What does change when the budget changes?
-
When budget increases, budget constraint shifts right: Vertical and horizontal intercepts increase
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
New Budget=B
= $60
B/PF= 200
B/PH=600
B/PH=300
B/PF=100
-
When budget decreases, budget constraint shifts left: Vertical and horizontal intercepts decrease
FP
B
HP
B
FP
B
Minutes to France
MinutesHome
0
PMin. France = 30
PMin. Home = 10
New Budget=B
= $18
B/PF= 100
B/PH=300
B/PH=180
B/PF=60
-
A Change in Budget
What happens to consumers calls to France and calls home when the budget for phone calls increases?
-
Consumer Optimum When Budget Doubles if Calls to France and Calls Home are Normal Goods
0
BC IC
PF = 30, PH = 10, B = $30, B = $60
Calls to France and Calls Home are Normal Goods
Old Optimum = O = 50 min. to France
150 min. Home
New Optimum = O = 120 min. to France
240 min. HomeO
120
B/PH=600
B/PF=200
240
BC IC
O
50
150
IC
Minutes to France
MinutesHome
-
What Do We Know About the Phone Calls Now?
0
BC
IC
PF = 30, PH = 10, B = $30, B = $60
O
B/PH=600
B/PF=200
BCIC
O
75
240
50
150
Minutes to France
MinutesHome
-
What Do We Know About the Phone Calls Now?
0
BC
IC
O
B/PH=600
B/PF=200
BCIC
O
75
240
50
150
PF = 30, PH = 10, B = $30, B = $60
Calls Home are Normal Goods (QD when B)
Calls to France are Inferior Goods
(QD when B)
Minutes to France
MinutesHome
-
What Do We Know About the Two Goods Now?
0
BCIC
PF = 30, PH = 10, B = $30, B = $60
O
B/PH=600
B/PF=200
BC
IC
O
120
240
50
150
Minutes to France
MinutesHome
-
What Do We Know About the Two Goods Now?
0
BCIC
O
B/PH=600
B/PF=200
BC
IC
O
120
240
50
150
PF = 30, PH = 10, B = $30, B = $60
Calls to France are Normal Goods
Calls Home are Inferior Goods
Minutes to France
MinutesHome
-
Effects of a Price Change: PH to 15
0
BC
PF = 30, PH = 15, B = $30
What happens to the Budget Constraint?B/PH=300
B/PF=100 Minutes to France
MinutesHome
-
Effects of a Price Change: PH to 15
0
BC
PF = 30, PH = 15, B = $30
What happens to the Budget Constraint?
It pivots around the horizontal interceptthe vertical intercept moves down
Slope changes from PF/PH = -.3/.1= -3
to PF/PH = -.3/.15 = -2
B/PH=300
B/PF=100
BCB/PH=200
Minutes to France
MinutesHome
-
A Change in Prices
What happens to consumers optimum consumption bundle when the price of calls home goes up to 15?
-
Effects of a Price Change: PH to 15
0
BC
PF = 30, PH = 15, B = $30
Optimum bundle moves from O to O, with fewer minutes home, and fewer minutes to France.
B/PH=300
B/PF=100
BC
B/PH=200
IC
O
IC
O
Minutes to France
MinutesHome
-
What Happens to the BC if PF to 10?
0
BC
PF=30, PF = 10, PH =10, B = $30
Budget constraint pivots around the vertical intercepthorizontal intercept increases
B/PH=300
B/PF=300
BC
B/PF=100 Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 10?
0
BC
IC
PF = 10, PH = 10, B = $30
O
B/PH
B/PF
BC IC
O
F F
H
H
Minutes to France
MinutesHome
-
Substitution and Income Effects when PF Goes Down
Calls to France and Calls Home are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect
Income Effect
Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France and Calls Home are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect
Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France and Calls Home are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect These are always opposite
Income Effect
Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France and Calls Home are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect These are always opposite
Income Effect
Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France and Calls Home are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect These are always opposite
Income Effect
These are always the same if both goods are normal
Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France and Calls Home are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect These are always opposite
Income Effect
These are always the same if both goods are normal
Combined
Effect
-
What Happens to the Consumer Optimum if PF to 10?
0
BC
IC
PF = 10, PH = 10, B = $30
O
B/PH
B/PF
BC IC
O
F F
H
H
Minutes to France
MinutesHome
-
Substitution and Income Effects when PF Goes Down
Calls to France and Calls Home are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect These are always opposite
Income Effect
These are always the same if both goods are normal
Combined
Effect if IE > SE if SE > IE
-
What Happens to the Consumer Optimum if PF to 10?
0
BC
IC
PF = 10, PH = 10, B = $30
O
B/PH
B/PF
BC IC
O
F F
H
H
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
300
100
BC
IC
O
20 60
120
180O
50
PF by 30
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
Calls to France Calls Home
SE: O O by 5 by 80
O
BC
IC
O
60
120
200 O
55
PF by 30
SE
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Minutes to France
MinutesHome
Calls to France Calls Home
SE O O by 5 by 80
IE O O
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Calls to France Calls Home
SE O O by 5 by 80
IE O O by 35
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Calls to France Calls Home
SE O O by 5 by 80
IE O O by 35 by 20
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Calls to France Calls Home
SE O O by 5 by 80
IE O O by 35 by 20
Net
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Calls to France Calls Home
SE O O by 5 by 80
IE O O by 35 by 20
Net Effect
O O
Net
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Calls to France Calls Home
SE O O by 5 by 80
IE O O by 35 by 20
Net Effect by 40
O O
Net
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Calls to France Calls Home
SE O O by 5 by 80
IE O O by 35 by 20
Net Effect by 40 by 60
O O
Net
Minutes to France
MinutesHome
-
What Happens to the Consumer Optimum if PF to 60?
0
BC
IC
O
BC
IC
O
60
120
200 O
55
PF by 30
20
180 SE
IE
Calls to France Calls Home
SE O O by 5 by 80
IE O O by 35 by 20
Net Effect by 40 by 60
O O (SE > IE)
Net
Minutes to France
MinutesHome
-
Deriving the Demand Curve
X
Y
0
As PX goes down, optimum moves from O to O to O
O
X1
PX=P1
IC1
-
Demand Curve
q
P
0 X1
P1
-
XY
0
IC2
As PX goes down, optimum moves from O to O to O
O
O
X1 X2
PX=P1
PX=P2
IC1
Deriving the Demand Curve
-
qP
0 X1
P1
P2
X2
Demand Curve
-
XY
0
IC3
As PX goes down, optimum moves from O to O to O
OO
O
X1 X2
IC2
IC1
PX=P1
PX=P2PX=P3
X3
Deriving the Demand Curve
-
qP
0 X1
P1
P2
X2 X3
P3
Demand Curve
-
qP
0 X1
P1
P2
X2 X3
P3 D
Demand Curve
-
QP
0 X1
P1
P2
X2 X3
P3 D
Demand Curve
-
Why Does the Demand Curve Slope Down?
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
-
Substitution and Income Effects when PF Goes Down
Calls to France are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect
Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect Combined
Effect
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
What if the good is inferior?
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect
Income Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect if IE > SE
if SE > IE
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior GoodsCalls Home Calls to
FranceComments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect if IE > SE
if SE > IE
If IE>SE, PF and QD goes downthis is a Giffen Good
-
Giffen Goods vs. Inferior Goods
All Giffen Goods are Inferior Goods
BUT
Not All Inferior Goods are Giffen Goods
-
Giffen Goods vs. Inferior Goods
For a good to be Giffen:
(1) It must be an inferior good: and
(2) IE must outweigh SE
-
0P
Demand Curve for a Giffen GoodIE > SE, so as P, QD
Q
D
-
0P
Demand Curve for an Inferior Good for which SE > IE
QD
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
(2) The good is inferior, but the SE outweighs the IE
-
Why Does the Demand Curve Slope Down? (Review)
Choice Under Uncertainty Probability and Expected Value
Expected Utility
Attitudes Toward Risk
Insurance
-
Why Does the Demand Curve Slope Down?
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
-
Substitution and Income Effects when PF Goes Down
Calls to France are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect
Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect Combined
Effect
-
Substitution and Income Effects when PF Goes Down
Calls to France are Normal Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect Combined
Effect
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
What if the good is inferior?
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect
Income Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect Income
Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior Goods
Calls Home Calls to France
Comments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect if IE > SE
if SE > IE
-
Substitution and Income Effects when PFGoes Down
Calls to France are Inferior GoodsCalls Home Calls to
FranceComments
Substitution
Effect When P,SE always makes Q
Income Effect
Combined
Effect if IE > SE
if SE > IE
If IE>SE, PF and QD goes downthis is a Giffen Good
-
Giffen Goods vs. Inferior Goods
All Giffen Goods are Inferior Goods
BUT
Not All Inferior Goods are Giffen Goods
-
Giffen Goods vs. Inferior Goods
For a good to be Giffen:
(1) It must be an inferior good: and
(2) IE must outweigh SE
-
0P
Demand Curve for a Giffen GoodIE > SE, so as P, QD
Q
D
-
0P
Demand Curve for an Inferior Good for which SE > IE
QD
-
Why Does the Demand Curve Slope Down?
(1) The good is normal, so the SE and IE work in the same direction
(2) The good is inferior, but the SE outweighs the IE
-
Expected Value
Expected Value (EV) = Probability of Outcome 1 Value of Outcome 1
+ Probability of Outcome 2 Value of Outcome 2
+ Probability of Outcome 3 Value of Outcome 3
+ .......
+ Probability of Outcome N Value of Outcome N
-
Expected Value
Example Lottery with
Outcome 1: Win $10,000 P(1) = .1
Outcome 2: Win $0 P(2) = .9
EV = Probability of Outcome 1 Value of Outcome 1
+ Probability of Outcome 2 Value of Outcome 2
= (.1) ($10,000) + (.9) (0)
= $1,000
-
Another Example of EV
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
-
Another Example of EV
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000
-
Another Example of EV
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000 Option II: Internet start-up
50% chance of making $1,000
50% chance of making $4,000
-
Another Example of EV
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000 Option II: Internet start-up
50% chance of making $1,000
50% chance of making $4,000
EV(Option II) =
-
Another Example of EV
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000 Option II: Internet start-up
50% chance of making $1,000
50% chance of making $4,000
EV(Option II) = .5 ($1,000) + .5 ($4,000)= $2, 500
-
Expected Utility
Expected Utility (EU) = Probability of Outcome 1 Utility from Outcome 1
+ Probability of Outcome 2 Utility from Outcome 2
+ Probability of Outcome 3 Utility from Outcome 3
+ .......
+ Probability of Outcome N Utility from Outcome N
-
Expected Value vs. Expected Utility
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000
-
Expected Value vs. Expected Utility
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000 EU(Option 1) = 1 U($2,000) = U($2,000)
-
Expected Value vs. Expected Utility
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000 EU(Option 1) = 1 U($2,000) = U($2,000)
Option II: Internet start-up 50% chance of making $1,000
50% chance of making $4,000
EV(Option II) = .5 ($1,000) + .5 ($4,000)= $2, 500
-
Expected Value vs. Expected Utility
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000 EU(Option 1) = 1 U($2,000) = U($2,000)
Option II: Internet start-up 50% chance of making $1,000
50% chance of making $4,000
EV(Option II) = .5 ($1,000) + .5 ($4,000)= $2, 500
EU(Option II) = .5 U($1,000) + .5 U($4,000)
-
EU and the Summer Jobs Example
Two Possible Summer Jobs Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EU(Option I) = 1 U($2,000) = $2,000 Option II: Internet start-up
50% chance of making $1,000
50% chance of making $4,000
EU(Option II) = .5 U($1,000) + .5 U($4,000)= $2,500
Take Option II only if:
EU(Option II) > EU (Option I)
-
Three Attitudes Toward Risk
-
Three Attitudes Toward Risk
Risk Aversion
-
Three Attitudes Toward Risk
Risk Aversion Diminishing Marginal Utility of Money
-
Utility
Risk Aversion: Diminishing Marginal Utility of Money
Money
-
Utility
Risk Aversion: Diminishing Marginal Utility of Money
Money1,000 4,000EV = 2,500
U(4,000)
U(1,000)
U(2,500)
EU
-
Utility
Risk Aversion: Diminishing Marginal Utility of Money
Money1,000 4,0002,500 = EV
U(4,000)
U(1,000)
U(2,500)
EU
CE
-
Three Attitudes to Risk and the Relation of EV to CE
Risk Aversion: CE < EV
-
Three Attitudes Toward Risk
Risk Aversion
Risk Neutrality
-
Three Attitudes Toward Risk
Risk Aversion Diminishing Marginal Utility of Money
Risk Neutrality Constant Marginal Utility of Money
-
Utility
Risk Neutrality: Constant Marginal Utility of Money
Money1,000 4,000EV = 2,500
U(4,000)
U(1,000)
U(2,500)
-
Utility
Risk Neutrality: Constant Marginal Utility of Money
Money1,000 4,000EV = 2,500
U(4,000)
U(1,000)
U(2,500) = EU
-
Utility
Risk Neutrality: Constant Marginal Utility of Money
Money1,000 4,000EV = 2,500 = CE
U(4,000)
U(1,000)
U(2,500) = EU
-
Three Attitudes to Risk and the Relation of EV to CE
Risk Aversion: CE < EV
Risk Neutrality: CE = EV
-
Three Attitudes Toward Risk
Risk Aversion
Risk Neutrality
Risk Loving
-
Three Attitudes Toward Risk
Risk Aversion Diminishing Marginal Utility of Money
Risk Neutrality Constant Marginal Utility of Money
Risk Loving Increasing Marginal Utility of Money
-
Utility
Risk Loving: Increasing Marginal Utility of Money
Money1,000 4,0002,500=EV
U(4,000)
U(1,000)
U(2,500)
EU
-
Utility
Risk Loving: Increasing Marginal Utility of Money
Mon