Week 2 Flashcards
What are we building up to do in this week?
We are looking at individual demand which will eventually aggregrate to get market demand.
When ronny goes to the supermarket what does he have to think about?
A theory of optimal consumption
What is the theory of optimal consumption?
Consumption bundles
Preference/utility
Budget line
Lines of equal preferences
Rationality/optimal consumption
What do we mean by consumption bundles?
All the products you decided to buy on that day.
What do we mean by preference/Utility?
How you enjoy different bundles of consumption
What do we mean by Budget line?
Constraints that economic agents face, money-income
What do we mean by lines of equal preferences?
Indifference curves( points of consumption bundles that give ronny the same level of happiness or utlitiy.
What do we mean by Rationality/Optimal consumption?
Optimal or maxmise consumption bundle.
What is our theory about how ronny will make decisions in the supermarket?
It involves the theory of rationality, a rational agent will always consume a consumption bundle that optimises his preferences given his income and the prices of goods that are avaliable
Lets Ronny is hiking but there is a fence and he can’t go passed it but wants to get to the top of the mountain, there are contour lines on the map, describing the steepness of the hill, what can we say about the highest point that Ronny can go on which is on the fence?
At the highest point of the slope of the fence is equal to the slope of the altutide lines(or contour lines)
Lets change ronny instead of going north or east, lets change axis to Pink lady apples and Granny smith apples, that ronny can buy with a budget of £100. Lets think of the mountain as a line of preferences, the higher he is the more happy he is. Let the altutide lines or contour lines be the lines of equal preferences. What do we mean by this?
The line of equal preferences here means that as we travel along these contour lines or altitude lines, i.e changing consumption bundle, ronny has the same level of happiness, from all these points on the same line. (indifference curves)
Lets change ronny instead of going north or east, lets change axis to Pink lady apples and Granny smith apples, that ronny can buy with a budget of £100. Lets think of the mountain as a line of preferences, the higher he is the more happy he is. Let the altutide lines or contour lines be the lines of equal preferences. What is the fence?
It is the budget line.
How can we draw the budget line with kilos of pink lady apples on y axis and Kilos of granny smith apples on x axis and what is equation, with a budget of £100.
Where Ppink is the price of pink lady apples time Y is how many kilos and Pgranny is price times X is how many kilos of it.
If pink lady apples where 4 pounds and Granny smith was £5 and the equation is Ppink x Y + Pgranny x X = £100. What is the maxmium pink lady apples and maximum granny smith apples, ronny could get, draw the diagram.
If ronny was to choose a point below the line, can he afford it?
He would spend less than £100 meaning that he can afford it.
If Ronny was to choose a point above the line, would he be able to afford it?
No as he is going to need to spend more than £100 and he doesn’t have that so he cannot afford it.
If ronny was to choose a point on the budget line, can he afford it?
Yes he can because he is spending exactly £100.
What 3 assumptions here do we make about Ronny and the pink lady apples assumption?
Apples are goods
Non-satiation
No saving
What do we mean by apples are goods and non-satiation ?
Apples are goods: Ronny always enjoys Pink lady apples and Granny smith apples
Non-satiation: Ronny would always strictly prefer to get an extra pink lady or an extra granny smith apple( wants to maxmise utlitiy)
What do we mean by no saving?
Ronny has no use for extra money left over from his shopping in the supermarket.
With these 3 assumptions draw the indifferences curves on the budget line diagram?
Why are indifference curves always decreasing?
This is because as the consumer increases the consumption of a particular commodity (X), he or she must sacrifice units of the other commodity (Y) to maintain the same level of satisfaction.
(in other words the only way of keeping ulitity constant when consuming more of one good, is to consume less of another. )
What does a higher indifference curve line mean?
This corresponds to a higher level of utilitiy, same with the map a higher line corresponds to being higher on the mountain
So to calculate the optimal consumption bundle, what would we have to do?
Draw indifference curve on budget line and this corresponds to the optimal consumption bundle.
What can we say about the optimal consumption bundle?
The slope of the budget line = the slope of the indifference curve
What is another equation of thinking about the the optimal consumption bundle of pink and granny smith apples?
Mu Granny / Pgranny = MU pink/ Ppink
The marginal utility of consuming one less granny smith per pound = Marginal utlity of consuming one more pink lady per pound
What is another equation of thinking about the the optimal consumption bundle of pink and granny smith apples? Includes exchange rates?
Exchange rate in market ( price ratio of the two goods) = Exchange rate in preferences ( exchange rate in my head (how do you trade off these type of good)
What do we mean by exchange rate in preferences?
It is the exchange rate in ronnys head, if you take one pink lady apple away from ronny he will be sadder, but how many pink lady apples do you need to give him to maek him have the same utlitiy as before.
What is the slope of the indifference curve also known as?
The marginal rate of subsitution, which means the rate at which you are willing to forgo good x to get one more of good y, whilst keeping the same utlitiy.
Why is that as you go down the indifference curve, the marginal rate of subsistution falls?
Each addtiional unit you consumer will provide you less utility than previous one
What question does demand answer using pink lady apples ?
If the price of pink lady apples in the UK is P, how many kilos of pink lady apples will be brought in the UK
What is the demand curve good for?
Companies use it to determine prices
The courts use it to determine monopoly power
Why cant indifference curves intersect each other?
This is because we are saying the combination of goods at the intersection point at the time have the same level of utility which they do not.
What does this diagram show?
This diagram shows ronny’s optimal consumption for 2 different prices, there are 2 different price ratios e.g. the upper budget line the price ratio is 4 and 5 and the one below shows that the price of pink lady apples went up but price of Granny smith didnt change e.g. (6 and 4), meaning Ronny changes his optimal behaviour
How do we move from Ronny indifference curves with change in price of Pink lady apples to Ronny’s individual demand curve?
Show the 2 different price changes or more and take the optimal consumption points and then draw a line with the 2 points, holding fixed the price of granny smith doesn’t change .
So with the demand curve what is pitval about it?
Demand is derived when holding fixed prices of other products as well as income and tastes
Lets say we want to look at the demand for Pink lady apples in the whole of the UK, how can we find it
We aggregrate them by choosing any prices and add them all up.
The market demand is a horizontal summation of the individual demands
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal. What would this mean first of all?
Q of nights out would be fixed and the quanitiy of nandos would reduce by half so 10 nandos.
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal.
What are the 2 ways parents can compensate for this ?
Slutsky method or Hicks method
What is the slutsky method?
Compensate the student just enough so that they can still consume what they have consumed before Brexit. This is fair, as the compensation implies that they could be as well off as they were before
What is the Hicks method?
Compensate the student just enough so that in their new optimal consumption after the compensation and price change, they are on the same indifference curve as they were before Brexit and the price change. This is fair, as the compensation implies that they will be exactly as well off as they were before.
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal.
Draw the diagram with indifference curve to show this
Nights out in clubs stays fixed.
So as you can see the indifference curve is lower, meaning they are less happy than before
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal.
Draw slutsky method ( compensate just enough so that they can still consumer what they consumed before?
(2 X 20) + (10x12) = 160
160/20 = 8 (NIGHTS OUT)
160/10 = 16 ( NANDOS)
Draw the new budget line
Or shift new budget line parralel from the point where they at, before compensation to and add money till you get to the point till it passes through point A, as they are rational, you find new optimal point, which is tangent to indifference curve, with new budget line, so consume at point F.
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal.
Draw hicks method compensate them just enough so that their new opitmal consumption after compensation and price change are on the same indifference curve as they were before price change and brexit.
You draw parralel line from before compensation ie brexit, untill you hit the indifference curve or tangent to the orginal indifference curve they were at before brexit. If they are rational they will consume at F’, so you give them enough money so they are on the same smiley face line.
So what is the difference between slutsky and Hicks method?
As you can see Slutsky is giving more money to the student, whereas Hicks is giving less money.
Also with Slutsky it is clear how much money you need to pay to the student ,With Hicks you need to know how their indifference curve exactly looks like to know how much money)
The diagram shows slutsky and Hicks together
What is the difference between slutsky and Hicks in terms of level of utlitiy?
With Slutsky the student is better off than before the price change, with Hicks the same as before the price change.
What do the 2 methods also imply about the good whose price went up?
The two methods will imply that the student will buy less of the good whose price went up!
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal. (income and subistution effect)
What affect does this have?
Income effect, hence he is sadder as in real terms he is pooer, there is also subsitution affect, as now clubbing is relatively cheaper in terms of price ratio.
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal.
Using Slutsky method how can we show subsitution effect and income effect?
As slutsky gives more money the transition from A to F is due to a subsitution effect, because by giving more money, as clubbing is more cheaper, you consumer more nights out and less nandos. and the transition from F to B is an income effect, as you are taking money away from son from the higher budget line to the lower one, making son do less clubbing and less nandos.
Consider the following situation. An LSE student’s weekly budget is 100 pounds (GBP). The student consumes only clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
As this is an LSE economics student, he/she is rational. Suppose that at the above prices they optimally consume 2 nights out in the club and 12 meals at Nandos.
Due to Brexit, prices have changed and now a meal at Nandos is more expensive, 10 pounds a meal.
Using Hicks method how can we show subsitution effect and income effect?
As the price of nandos goes up there is a subsitition effect to get the same level of utlitiy from A to F’ and also there is an income effect from F’ to B. as you are taking money away.
What is the difference between hicks and slutsky in terms of the income effect?
The income effects will be different between the two methods. As we saw, with Slutsky the income effect was higher than with Hicks ( as they gave more money)
What is the difference between hicks and Slutsky in terms of the subsitiution effect?
The substitution effect was different under both methods. ○ The two methods will always have the same sign for the substitution effect: The consumer’s substitution effect will always pull the student to buy more of the relatively cheaper product under the new prices!
Question 1 Which of the following statements are true?
A. A rational consumer will always use coupons when shopping in the supermarket.
B. A rational consumer always maximises her preferences given the amount of money she has to spend and the products available to her.
C. A line of equal preferences connects all the possible combinations of consumption that the consumer is indifferent between.
D. The budget line represents all the consumption combinations that the consumer can buy when she spends all her income
B C and D are all correct
Which of the following statements about the budget line are true? A. An increase in income shifts the budget line upwards and to the right.
B. The consumer can afford to buy anything that is above and to the right of the budget line.
C. The slope of the budget line depends on both the prices and the income of the consumer.
D. A fall in one of the products’ prices will change the slope of the budget line.
A and D
Why not C? does depend on price but not income
We are now going to explore a giffen good, What is a giffen good?
As price rises, you buy more of the good.
As we are now looking at giffen goods we want to show from here if Py goes up can we buy more can we buy more of Y, so first of all what happens when Py goes up?
The budget constraint changes, whilst X is fixed. Interesting to see is that i draw an indifference curve at optimal point B in such a way that consumption of Y and B is higher than the consumption of Y and A. ( this is not wrong to draw)
As we are now looking at giffen goods we want to show from here if Py goes up can we buy more can we buy more of Y, so first of all what happens when Py goes up? Now show using HICKS method of compensation show it in a diagram.
Draw a parallel line from the change in price of Good Y up towards when it touches the orginal ulitiy of this inidividual ( i.e A), this person will have a new optimisation point A’ ( the move from A to A’ is the subsitution effect ( leads consumer to buy more of X, as it is relatively cheaper and less Y)
Whats different is that when you have the income effect from A’ to B, as you take away money, the consumer is lowering consumption of X and increasing consumption of Y.
Thus X is a normal good and Y is an inferior good because they experienced fall in income and brought more of good of Y.
So it is possible for an individual to get an giffen good effect if ( ie buying more of good Y, when the price of Y increases) if what conditions apply?
Y is an inferior good
And if the income effect is bigger than the subisitution effect
( As the subistiution effect implies buying less of Y and income effect implies buying more of Y. so in order for this individual to buy overall more Y, we need income effect to be stronger)
What are complements and subsitutes?
And what do the shape of the indifference curves show?
Complements are commodity pairs which are consumed jointly( shoes and socks)
Subsitutes are commodity pairs where one commodity is consumed to the exclusion of the other ( margarine and butter)
The shape of the indifference curve shows how commodities are complements or subsitutes
How does an indifference curve look when goods are compliments
What do indifference curves look like when goods are perfect compliments?
Why is the shape of perfect compliments fully convex?
My consumption of the goods are not to be very sensitive to price changes, or lets say the Y axis is a left shoe and X axis is a right shoe,and they have different prices, i don’t care about the price of left or right shoe is, i only care about the sum of theh 2
IF you change the budget line ( e.g. more expensive for one show), will you change consumption bundle
( you don’t care how many extra left shoes you get or right shoe, your indifferent)
Thus the marginal rate of subistution for a perfect compliments is what?
MRS for perfect complements is same along a vertical or horizontal strip.
How does subsitutes indifference curve look like?
When goods become more and more subsitues the curve becomes less and less convex
How do perfect subsitutes look like on an indifference curve?
Why are perfect subsitutes less convex?
You are really sensitive to price changes with Perfect subsitutes as you don’t care which you consume, you go for the cheaper.
What does this show
You will end up buying only hillingdon water, as hillingdon water is relatively cheaper
What does this show?
If evian is relatively cheaper i will change and switch and only buy evian water
What happens with the marginal rate of subsitution(slope of indiifference curve) for Perfect subsitutes? Using example of 2 5 dollars and £10 note
The MRS is going to be equal everywhere on the curve, there is no diminishing marginal returns effect e.g. you are always willing to exchange 2 5 dollars for 1 10 dollar note, we have the same utitlity for both.
What is Cross price elastcitiy?
Apples go from £2 to £2.50 and the quantity of pears go from 30 to 50 work out the Xped?
Measures the responsiveness of demand for good A when good B changes price.
% change in quantity demanded of good A/ %change in price of good B
% change in quantity demanded of good A/ %change in price of good B
20/30 x 100 = 66.7%/ 25% = 2.7%
What is the Xped for compliments and Why?
It is negative ( if you increase price of one good, you increase price of the whole bundle, so you have less of the good)
What is the Xped for subsitutes and why?
It is postitve, if you increease the price of the good, i will increase my consumption of the other good.
What is another way of interpreting the demand curve?
The demand curve is the willingness to pay for the additional unit of good
We know by Aggregration the summation of demand we can find total demand in the UK, and we know what Consumer surplus is, but should we be happy with this?
The triangle correpsponds to many people consumer surpluses, it does not take into account distrubtional aspects.
E.g one person is way more happy than the rest
Calculate CS
30 = 100 - Q
Q = 70
1/2 (bXH)
1/2 (70 X 70) = 4900/2
=2450
(Problem set)
Consider the following situation. A student’s weekly budget is 100 pounds. The student can spend their money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds. Answer each of the following questions.
A. Draw the budget line of the student, where the number of meals at Nandos is on the X axis and the number of nights clubbing is on the Y axis.
Consider the following situation. A student’s weekly budget is 100 pounds. The student can spend their money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds. Answer each of the following questions.
b) What is the slope of the budget line?
Consider the following situation. A student’s weekly budget is 100 pounds. The student can spend their money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
C. Show in your diagram where the optimal consumption of the student is, by drawing the line of equal preference passing through the optimal point.
Consider the following situation. A student’s weekly budget is 100 pounds. The student can spend their money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
What is the slope of the line of equal preferences you drew at the point of optimal consumption?
The slope of the line equal preferences = -1/4. This is because at the point of optimal consumption, the slope of the budget line is equal to the slope of the line of equal preferences.
The student is not consuming optimally because at the point of consumption the slope of the line of equal preferences is not equal to the slope of the budget line. This means that the student can change her consumption and increase her preference.
Consider the following situation. A student’s weekly budget is 100 pounds. The student can spend their money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds.
F. C a n y o u s u g g e s t t o t h e s t u d e n t a b e t t e r c o n s u m p tio n b u n dle ? Will t h a t b u n dle involve consuming more or less Nandos?
Which of the following statements are true? A. To get the demand curve for a particular good
A, we need to understand both consumers and firms behaviour in the market for A.
B. When analysing a particular demand curve, we are assuming that others things in the economy such as the prices of other goods and the income of individuals are fixed.
C. The demand curve is a curve that represents the relation between the quantity of a good that is demanded by the population to the price of another good.
D. The demand curve is a curve that represents the relation between the prices of a particular good and the quantity of that good that is demanded by the population.
B and D
A student’s weekly budget is 100 pounds. The student can spend her money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds. The student has no benefit from saving money from week to week and the student always likes to consume more Nandos and more clubbing if possible.
Choose one or more correct options below.
Select one or more:
a. If the student spends all her money on Nandos she can eat there 20 times.
b. If the student spends all her money on clubbing, she can go out clubbing (only) four times a week.
c. Consuming 4 meals at Nandos and going out clubbing 4 times a week is on this student’s budget line.
d. This student cannot consume 10 meals at Nandos and 3 nights out clubbing.
A and D
A student’s weekly budget is 100 pounds. The student can spend her money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds. The student has no benefit from saving money from week to week and the student always likes to consume more Nandos and more clubbing if possible.
Suppose that initially, the student chose to consume both products. Choose one or more correct options below.
Select one or more:
a. The student union offers a 10% discount on clubbing, this must make the student better off.
b. The student’s grandparents send 20 pounds extra. Surely the student will go out clubbing more often that week.
c. Nandos prices and clubbing costs both go up by 10%. The student’s parents give the student 10 more pounds a week. The student will not change her consumption of Nandos and clubbing.
d. At the original prices, the student is consuming 3 meals at Nandos and going out clubbing 4 times a week. The student has no benefit from saving money. This student is not rational. Why is A right?
A and c and D
Contiuation
A student’s weekly budget is 100 pounds. The student can spend her money on either clubbing or Nandos. Each meal at Nandos costs 5 pounds and each night in the club is 20 pounds. The student has no benefit from saving money from week to week and the student always likes to consume more Nandos and more clubbing if possible.
Suppose that initially, the student chose to consume both products. Choose one or more correct options below.
Select one or more:
a. The student union offers a 10% discount on clubbing, this must make the student better off.
b. The student’s grandparents send 20 pounds extra. Surely the student will go out clubbing more often that week.
c. Nandos prices and clubbing costs both go up by 10%. The student’s parents give the student 10 more pounds a week. The student will not change her consumption of Nandos and clubbing.
d. At the original prices, the student is consuming 3 meals at Nandos and going out clubbing 4 times a week. The student has no benefit from saving money. This student is not rational.
Why is B wrong
Question 3 Choose one or more correct options below.
A. The student union offers a 10% discount on clubbing, this must make the student better off.
B. The student’s grandparents send 20 pounds extra. Surely the student will go out clubbing more often that week.
C. Nandos prices and clubbing costs both go up by 10%. The student’s parents give the student 10 more pounds a week. The student will not change her consumption of Nandos and clubbing.
D. At the original prices, the student is consuming 3 meals at Nandos and going out clubbing 4 times a week. This student is not rational.
Why is C right
Nandos prices and clubbing costs both go up by 10%. The student’s parents give the student 10 more pounds a week. The student will not change her consumption of Nandos and clubbing.
Note that both prices and Income have increased by 10%. This means that the way we draw the budget line has not changed. Preferences have not changes as well, so the consumer’s problem is exactly the same!
