Introductory Economics ECO 101
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This 5 page Class Notes was uploaded by Khalid Hagenes on Sunday October 11, 2015. The Class Notes belongs to ECO 101 at Davidson College taught by Fredric Smith in Fall. Since its upload, it has received 25 views. For similar materials see /class/221258/eco-101-davidson-college in Economcs at Davidson College.
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Date Created: 10/11/15
Economics 101 Professor Smith Consumer Theory An Example of Consumer Choice Suppose that we have our representative Davidson College Professor Professor Z and she likes to spend money on milkshakes and coffee Furthermore we ll assume that Prof Z has 30 dollars to spend on the two goods Milkshakes cost 3 per cup and coffee is 1 a cup Let us begin by creating the Professor s budget line otherwise known as the budget constraint The Budget Line The general format for a budget line is PIX PyY I Px The price of good x the good that we will place on the horizontal axis when we graph the budget line X The quantity of good X consumed Py The price of good y the good that we will place on the vertical axis when we graph the budget line Y The quantity of good Y consumed l Income the amount that the person has to spend on the two goods in question Using the general budget line we find that Professor Z has the following budget line 1C 3M 30 C number of cups of coffee that Professor Z purchases M number of milkshakes she purchases Let s graph her budget line First solve explicitly for M M 10 Figure One Okay so now we now what combinations of milkshakes and coffee Professor Z can afford Economists call these combinations bundles So here are some bundles that Professor Z can afford we assume that she spends her entire income The question that we should now ask ourselves is Which bundle should she pick To answer that we need to turn our attention to a new topic Preferences and Indifference Curves Each and every one of us has different preferences or tastes Some of us like hamburgers a lot some of us don t Some of us love coffee and others don t drink coffee Some of us like SUVs and others prefer sports cars How can economists model a consumer s preferences Economists model preferences with utility and indifference curves Before we discuss what utility is 7 and what utility has to do with indifference curves 7 we need to discuss a few of the assumptions that economists make about consumers Economists assume that consumers are rational and that consumers think More is better What does the rationality assumption mean Specifically it means that a consumer can always rank bundles of goods and that a consumer s rankings are consistent To get a better handle on these assumptions let s turn our attention back to Professor Z Professor Z faces an infinite number of bundles of milkshakes and coffees that she could consumer if she did not face her budget constraint If Professor Z s preferences are rational and we are assuming that they are then she can rank any set of bundles and she will do so in a logically consistent manner For example Professor Z likes bundle 20 milkshakes 20 coffees more than she likes bundle G 10 milkshakes lO coffees and she like both F and G more than bundle 5 milkshakes 5 coffees Notice that her preferences clearly fulfill the property of more is better What would be an example of irrational preferences Well if Prof Z told us she likes F better than G and G better than H but that she also likes H better than F then her preferences would not be very rational They would also violate the principle of more is better Now that we have considered the assumptions that economists make about consumers let s turn our attention to how economists model consumer preferences with math and graphs Definition Utility 7 Utility is a term that economists use to describe a person s well being Returning to our previous example an economist would say that bundle F gives Professor Z more utility than bundles G or H We can represent utility mathematically and we can also represent it graphically In Eco 101 we will focus on graphical analysis We will start at the beginning and work through an entire example We return to Professor Z once again Professor Z s preferences in words I like milkshakes and coffee I like to have as much asl can of each good but it is very important to me that l have some of both goods lfl have 0 cups of coffee then I would have been just as well off having nothing Based on what Professor Z has said I can create indifference curves Indifference curves are graphical devices that allow us to rank bundles of goods in this case milkshakes and coffee M C Figure Two The colored stars on the graph represent the bundles F G and H The blue star is bundle F39 the green star is bundle G39 the red star is bundle H Look at bundle H It is resting on a curve and the curve it is resting on is labeled indifference curve one 1C1 This indifference curve tells us the following Professor Z views all of the bundles of milkshakes and coffee on 1C1 as being just as good as bundle H In other words Prof Z is indifferent between having bundle H and any other bundle on that indifference curve All of the bundles on 1C1 give Professor Z the same amount of total utility What can we say about bundles G and F 7 and about the indifference curves they appear on Well all of the bundles on 1C2 including bundle G are better than the bundles on 1C1 Furthermore all of the bundles on 1C3 are better than the bundles on the other two indifference curves The indifference curves summarize information about Professor Z s utility in a very neat and compact package So how can we use indifference curves to select Professor Z s favorite bundle Optimal Choice What Professor Z wants to do is pick the best bundle that she can afford In other words she wants to pick an affordable bundle that rests on the highest possible indifference curve Questions to test your understanding 7 Are bundles F and G affordable ls Professor Z spending all of her income if she chooses bundle H Graphically the best bundle is found when Prof Z s indifference curve is just touching her budget line Specifically we say that her indifference curve is tangent to her budget line Bundle B Bundle C Bundle D FigL ree From the graph we can see that bundle C is better than bundle B or bundle D because it is on a higher indifference curve An indifference curve labeled with a larger number means that it is better but the numbers are meaningless For example 1C2 does not indicate that the bundles on that indifference curve are twice as good as the bundles on 1C1 As economists we care about the ranking of the bundles but we do not care about the utility number that each bundle gives us What is so special about bundle C Graphically we know that it is where the budget line is equal to the slope of the indifference curve What does this mean in the real world When a consumer maximizes his or her utility then they are getting the same bang for buck for the last dollar they spend on every good To understand this concept more fully we need to think about utility in a new way Indifference curve depict a person s total well being or total utility Being on a higher indifference curve means that you are getting more utility than you would be if you were consuming a bundle located on a lower indifference curve We want to maximize total utility but to do this we need to use marginal analysis Definition Marginal Utility Marginal utility is the amount of extra utility that you get from consuming one more unit of a good Holding the amount of the other good that you have constant Let s assume that the data below represent the preferences we have depicted in figure three from above All of this information is based off of a u lilyfunclian UMC You do not need to know this 7 I will not be testing you on utility functions Key Wm Marginal Utility from the last milkshake consum ed MUc Marginal Utility from the last cup of coffee consumed Pm Price of a milkshake 3 Pc Price ofa cup of coffee 1 Let s look at an entry in the table to understand what it means At point A the lIUm value is zero What does this mean in words This means that the marginal utility that Professor Z gets from that tenth milkshake is zero given that she has zero cups of coffee Notice that as Professor Z consumes more and more cups of coffee her marginal utility from the last cup that she has consumed decreases This is not a surprising result In general the more that we buy of something coffee hamburgers CDs books etc the less utility we get from consuming one more unit of that good Economists call this the Law of Diminishing Marginal Utility Based on the information in the table how can we identify bundle C as Professor Z s best bundle Remember we know that it is her best bundle because of Figure Three Well if we look at the fifth and seventh columns in the table we find each product s marginal utility divided by its price 7 this is a product s Bang for the Buck Bang for the Buck is simply a way of saying happiness or utility per dollar spent Bundle C is where the Professor s bang for the buck is the same for each good Mathematically at bundle C MUM MU 1 Pm P The final piece to the puzzle is relating the equation above equation 1 to our graph Notice that equation one can be rearranged so that it becomes the follow1ng39 MU 1 MUM P m 2 Equation two is extremely helpful39 let s see why Economists call the slope of an indifference curve the Marginal Rate of Substitution MRS Since all indifference curves in Eco 101 are downward sloping 7 hence all MRS values are actually negative numbers 7 we can deal with the absolute value of the MRS It is important to notice that the MRS on a specific indifference curve is not constant In fact if we move along one of Prof Z s indifference curves we find that the MRS declines as she increases the amount of coffee that she has Mathematically economists define the MRS in the following way MU 3 MRS MUy Once again good x is the good on the horizontal axis and good y is the good on the vertical axis Thus Professor s Z MRS is