Economics 1 (EC107) 2011-12: Micro (Term 1)
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
•The circular flow model
Agent:
Households
Market:
Goods/Services
Market:
Inputs
Agent:
Firms
Demand
Demand
Supply
Supply
1
See Handout (contains whole of lectures 3-5)
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
•Demand
•Consider a Demand Relation:
•What are the influences on Demand for a good . . . ?
X
px
D
apo
Xo
How does a change in some other influence affect the demand curve?
What does the slope of the demand curve tell us?
b
2
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
We can write the demand relation as:
( | , , ,...)
Note the crucial difference between
(i) A movement along the demand curve
(ii) A shift in the demand curve
d dX X p p p Mx y z
3
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
We can also write the (inverse) demand relation as:
( | , , ,...)
This is best thought of as the equation that determines the price the firm can charge for particular levels of output.
dp p X p p Mx x y z
4
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
As a particular example of an inverse demand curve:1( ).
This can be re-written as
.
How would you interpret the parameters 'a' and 'b'?How would you draw this demand curve?
dX a pb
dp a bX
5
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
Supply
•Consider a Supply Relation:
•What are the influences on Supply a good . . . ?
X
px
S
apo
Xo
How does a change in some other influence affect the Supply curve?
What does the slope of the Supply curve tell us?
b
6
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
We can write the (inverse) supply relation as:
( | ,...).
This is best thought of as the equation that determines the price the firm requires in orderto induce it to supply particular levels of o
sp p X px x y
utput.Example:
.sp c dX
7
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
Putting together Supply and Demand:
X
px
S
pe
Xe
What is meant by the ‘market equilibrium’?
What are the possible properties of a market equilibrium?
D
8
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
Comparative Statics:
X
px
S
pe
Xe
What is the effect on market equilibrium of a shift in demand?
D
9
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
Comparative Statics:
X
px
S
pe
Xe
What is the effect on market equilibrium of a shift in supply?
D
10
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
Uniqueness of equilibrium and price bubbles:
X
px
S
pe
Xe
Suppose D is the Willingness to Pay for housing. It’s likely to depend on Consumer Confidence (CC). (i) What happens if CC rises? (ii) What might cause CC to rise? What is the implication of this?
D
11
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
Putting together supply and demand:
(1) ,
(2) .
How many equations do we have?And how many unknowns?
dp a bX
sp c dX
12
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
There is a 3rd equation:
(3) .
What is this equation, in terms of its Economic meaning?
We can now solve:
d sX X
13
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
It is straightforward to show that:
and
.
In other words, . . .
a cXb d
ad bcpb d
14
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 3
Knowing the values of the parameters givesus the values of price and quantity traded in equilibrium.
We can also carry out the comparative static exercises in order to see the effects of changes in the parameters on the equilibrium values of price and quantities.
How would you do this?
15
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4
Demand Analysis (or analysis of ‘Consumer Choice’)
Choice is based on . . .
. . . Preferences and
. . . Constraints
We’ll analyse each of these in turn.
16
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4
Demand Analysis: Preferences
Suppose your happiness depends on just 2 commodities
(that you might buy in the market):
e.g., ???
17
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4
Demand Analysis: Preferences
E.g., Books and Food
We assume that you have preferences over these goods and that the nature of your preferences satisfies various properties:
(i) Non-satiation . . . . . . in words:
(ii) Ordinal Ranking
(iii) Transitivity
(iv) Completeness
18
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4
Demand Analysis: Preferences
Non-satiation . . . in a diagram.
F
B
F1 F2
B1
19
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
Our assumptions about the properties of preferences imply that we can represent preferences using Indifference Curves. These ICs will have properties which depend upon the properties of the underlying preferences.
F
B
F1 F2
B1
We can show that an IC must slope downwards because of non-satiation.
20
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
We can show that ICs cannot cross under the assumptions we have made about preferences:
F
B
IC1
IC2
21
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
The slope of the IC is the MRS between the 2 goods (refer to earlier slides).
F
B
IC1
22
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
If the IC is linear, this means that the MRS is constant.
F
B
IC1
23
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
It is more common to assume that the MRS is diminishing: why is this and what does it imply about the IC?
F
B
24
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
It is more common to assume that the MRS is diminishing: why is this and what does it imply about the IC?
F
B
IC1
25
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
What would it mean if the IC was upward-sloping?
F
B
IC1
26
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
What would this mean?
F
B
IC1
27
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
Under the assumption of completeness, there is an IC passing through every possible point:
F
B
IC1
IC2
28
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 4Demand Analysis: Preferences
The consumer would like to get to the highest possible IC: what limits this?
F
B
IC1
IC2
ICn
29
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constraints
We said that our understanding of Consumer Choice rests on the analysis of Preferences and Constraints. Let’s now turn to consider Constraints.
X
Y
Xmax0
Ymax
30
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constraints
We can represent a budget set and a budget frontier (or constraint)
X
Y
Xmax0
Ymax
31
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constraints
We can represent a budget set and a budget frontier (or constraint)
X
Y
Xmax0
Ymax
What equation can we give this constraint?
32
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constraints
The equation tells us that if we spend all our money income, M, on X and Y, our spending be equal to:
M xp ypx y
33
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constraints
Re-arranging, the equation for the budget constraint is:
How do you interpret this equation? And Graphically?
y
pM xy xpp
y
34
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constraints
The equation of the budget constraint:
X
Y
Xmax0
Ymaxy
pM xy xpp
y
35
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constraints
Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences:
X
Y
Xmax0
Ymax
36
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constrained choice
Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences:
X
Y
Xmax0
Ymax
IC1 IC2
IC3
37
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constrained choice
Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences:
X
Y
Xmax0
Ymax
ICmax
38
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constrained choice
Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences:
X
Y
Xmax0
Ymax
X*
Y*a
39
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Constrained choice
So, by bringing together preferences and constraints, we have a model which predicts/explains the consumer’s choices (demands) for X and Y . . . given . . .?
X
Y
Xmax0
Ymax
X*
Y*a
40
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Comparative Statics
What will happen to the optimal choices of X and Y if there are relevant changes to the parameters of the model?
X
Y
Xmax0
Ymax
X*
Y*a
What are the ‘relevant parameters’?
41
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Comparative Statics
What will happen to the optimal choices of X and Y if there are relevant changes to the parameters of the model?
X
Y
Xmax0
Ymax
X*
Y*a
Consider a change in money income. How do we show this?
42
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Change in money income
X
Y
Xmax0
Ymax
X*
Y*a
43
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Change in money income
X
Y
Xmax0
Ymax
X*
Y*a
â
What can you say about the demand for X as M↑?
And the demand for Y?
44
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Change in money income
X
Y
Xmax0
Ymax
X*
Y*a
â
What can you say about the demand for X as M↑?
And the demand for Y?
45
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Change in money income
X
Y
Xmax0
Ymax
X*
Y*a
â
What can you say about the demand for X as M↑?
And the demand for Y?
46
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Change in money income
X
Y
Xmax0
Ymax
X*
Y*a
â
What can you say about the demand for X as M↑?
And the demand for Y?
47
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 5
Demand Analysis: Change in money income
X
Y
Xmax0
Ymax
X*
Y*a
â
What can you say about the demand for X as M↑?
And the demand for Y?
48
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X
X
Y
Xmax0
Ymax
X*
Y*a
What can you say about the demand for X as Px↓?
49
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 1)
X
Y
Xmax0
Ymax
X*
Y*a
What can you say about the demand for X as Px↓?
IC1 IC2
â
50
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 1)
X
Y
Xmax0
Ymax
X*
Y*a
What is the implication for the shape of the demand curve for X: in (Px, X)–space?
What is held constant along this demand curve?
IC1 IC2
â
51
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 2)
X
Y
Xmax0
Ymax
X*
Y*a
What is the implication for the shape of the demand curve for X: in (Px, X)–space?
What is held constant along this demand curve?
IC1
IC2
â
52
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 2)
X
Y
Xmax0
Ymax
X*
Y*a
What is the relationship between the price of X, its demand, and the demand for Y?
IC1
IC2
â
53
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 3)
X
Y
Xmax0
Ymax
X*
Y*a
IC1
IC2
â
What is the implication for the shape of the demand curve for X: in (Px, X)–space?
54
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 3)
X
Y
Xmax0
Ymax
X*
Y*a
IC1
IC2
â
What is the relationship between the price of X, its demand, and the demand for Y?
55
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 4)
X
Y
Xmax0
Ymax
X*
Y*a
IC1 IC2
â
What is the implication for the shape of the demand curve for X: in (Px, X)–space?
56
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
Xmax0
Ymax
X*
Y*a
â
There are 2 reasons for the rise in demand for X following the fall in its price:
(i) Disposable (or ‘real’) Income Effect
(ii) Relative Price Effect
57
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6
Demand Analysis: Change in price of X (CASE 3 Revisited)
There are 2 reasons for the rise in demand for X following the fall in its price:
(i) Disposable (or ‘real’) Income Effect
The budget constraint shifts outwards and hence the individual can achieve higher ‘utility’; that is, move on to previously unobtainable Indifference Curves. They are able to buy more of both X and Y: whether or not they do so will depend on their preferences over X and Y. If X is normal, for example, the Real Income Effect will cause the individual to buy more X.
(i) Relative Price Effect
X is now relatively cheaper than previously relative to Y. The individual is therefore likely to switch from Y towards X, to some extent.
58
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
Xmax0
Ymax
X*
Y*a
â
We would now like to be able to distinguish between these two effects in the diagram.
(i) Real Income Effect
(ii) Relative Price Effect
59
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
Xmax0
Ymax
X*
Y*a
â
Consider first the Relative Price Effect.
Suppose relative prices had changed, but that there had been no Real Income Effect of the price change.
What point in the diagram could represent such a position?
60
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
Xmax0
Ymax
X*
Y*a
â
Consider first the Relative Price Effect.
Suppose relative prices had changed, but that there had been no Real Income Effect of the price change.
What point in the diagram could represent such a position? ‘b’
b
61
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
Xmax0
Ymax
X*
Y*a
â
Relative Price Effect.
What change is causing the consumer equilibrium to move from ‘a’ to ‘b’?
What is not changing between ‘a’ and ‘b’?
Hence, ‘a’ to ‘b’ represents a pure relative price effect.
bAs ‘a’ and ‘b’ lie on the same IC, there is no ‘Real Income’ change in moving from ‘a’ to ‘b’.
62
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
Xmax0
Ymax
X*
Y*a
â
Relative Price Effect.
‘a’ to ‘b’ represents a pure relative price effect. More commonly, we refer to it as a substitution effect
b
S
Xs
63
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
Xmax0
Ymax
X*
Y*a
â
Real Income Effect.
We claimed that the Total Effect of the price change (i.e., from ‘a’ to ‘â’) is made up of a Relative Price (Substitution) Effect and a Real Income Effect.
b
S
Xs
As ‘a’ to ‘b’ is the substitution effect, can we show that ‘b’ to ‘â’ is the Real Income Effect?
64
Robin Naylor, Department of Economics, Warwick
Topic 1: Lecture 6Demand Analysis: Change in price of X (CASE 3 Revisited)
X
Y
0
Ymax
X*
Y*a
â
Real Income Effect.
Compare ‘b’ and ‘â’. What have they got in common? What is different between them? Your answers should confirm for you that ‘b’ to ‘â’ captures the Real Income Effect.
b
S
Xs
As ‘a’ to ‘b’ is the substitution effect, can we show that ‘b’ to ‘â’ is the Real Income Effect?
I
X**
65
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The total effect of the price change is to move the consumer’s choice from ‘a’ to ‘â’.
If we plot this into the lower diagram, what are we plotting?
Deriving demand curves
66
Topic 1Lecture 7
See Handout
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The total effect of the price change is to move the consumer’s choice from ‘a’ to ‘â’.
If we plot this into the lower diagram, what are we plotting? â
67
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The total effect of the price change is to move the consumer’s choice from ‘a’ to ‘â’.
If we plot this into the lower diagram, what are we plotting? â
?
68
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The total effect of the price change is to move the consumer’s choice from ‘a’ to ‘â’.
If we plot this into the lower diagram, what are we plotting? â
What can you say about the slope of this curve? Must it be –ve?
CMIDC
69
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
If we plot this into the lower diagram, what are we plotting?
b
S
S ?
70
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
If we plot this into the lower diagram, what are we plotting?
b
S
S CUDC/CRIDC
71
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
b
S
S CUDC/CRIDC
Must this curve have a –ve slope?
72
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
b
S
S CRIDC
The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.
The Substitution Effect determines the CRIDC.
The Substitution Effect combined with the Income Effect determines the CMIDC.
I
I
73
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
b
S
S CRIDC
The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.
The Substitution Effect determines the CRIDC.
The Substitution Effect combined with the Income Effect determines the CMIDC.
I
I
â
CMIDC
74
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
b
S
S CRIDC
The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.
The Substitution Effect determines the CRIDC.
The Substitution Effect combined with the Income Effect determines the CMIDC.
I
I
â
CMIDC
The difference between the CRIDC and the CMIDC is the Income Effect.
In this diagram, X is a Normal Good.
Therefore, the CMIDC is more elastic than the CRIDC
75
Topic 1Lecture 7
See Handout
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
b
S
S CRIDC
The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.
The Substitution Effect determines the CRIDC.
The Substitution Effect combined with the Income Effect determines the CMIDC.
I
I
â
CMIDC
The difference between the CRIDC and the CMIDC is the Income Effect.
In this diagram, X is a Weakly Inferior Good.
Therefore, the CMIDC is less elastic than the CRIDC
76
Topic 1Lecture 7
See Handout
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
b
S
S CRIDC
The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.
The Substitution Effect determines the CRIDC.
The Substitution Effect combined with the Income Effect determines the CMIDC.
I
I
â
CMIDC ?
The difference between the CRIDC and the CMIDC is the Income Effect.
In this diagram, X is a Strongly Inferior Good.
Therefore, the CMIDC is +vely sloped.
77
Topic 1Lecture 7
See Handout
Robin Naylor, Department of Economics, Warwick
X
X
Px
Px
a
a
b
â
The Substitution Effect of the price change is to move the consumer’s choice from ‘a’ to ‘b’.
b
S
S CRIDC
The Income Effect of the price change is to move the consumer’s choice from ‘b’ to ‘â’.
The Substitution Effect determines the CRIDC.
The Substitution Effect combined with the Income Effect determines the CMIDC.
I
I
â
CMIDC
The difference between the CRIDC and the CMIDC is the Income Effect.
In this diagram, X is a Strongly Inferior Good.
Therefore, the CMIDC is +vely sloped.
(Giffen Good)
78
Topic 1Lecture 7
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
Market Demand
X
p
01 02 0M
D2D1
p p
?
79
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
Market Demand
X
p
01 02 0M
D2D1
p p
80
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
Market Demand
Horizontal Summation (Why?)
(Note: we’ll see a case of vertical summation later in the module)
Notice than in the 2-person case above, the market demand curve is ‘kinked’.
X
p
01 02 0M
D2D1
p p
DM
81
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
Consumer Surplus
Interpret the ‘Marginal Willingness to Pay’ (Marginal Benefit, Marginal Valuation)
X0
p
p*
X*
S
D
82
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
Consumer Surplus
Consumer Surplus on ‘first unit’.
X0
p
p*
X*
S
D
83
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
Consumer Surplus
Consumer Surplus on ‘all units’.
A
0
p
p*
X*
S
D
84
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8Demand Elasticity
We have already said that the Price Elasticity of Demand for a Good is a measure of the sensitivity or responsiveness of demand for a good to a change in its price. More precisely:
. . . Percentage change in demand Percentage change in price
. 100 or . .
. 100
Note: 0.
Consider the special case of the linear demand curve . . .
p e d
dx dxdx p dx px x
dp dp x dp dp xp p
85
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8Demand Elasticity
. . . Percentage change in demand Percentage change in price
or .
Consider the special case of the linear demand curve:
1, or;
1It follows that:
And h
p e d
dx p
dp x
ap a bx x p
b bdx
dp b
1ence that: . ,
where is the slope of the linear demand curve.
Can you work out what happens to as we move down along the demand curve?
p
b xb
86
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8Demand Elasticity
. . . Percentage change in demand Percentage change in price
or .
Consider the following examples:
(i) 0.
(ii) 1; implying . 1, or
(iii) 1< <0.
(iv)
p e d
dx p
dp x
dx p dx dp
dp x x p
< < 1.
How would you interpret each of these?
87
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
(i) 0.
(ii) 1; implying . 1, or
(iii) 1< <0.
(iv) < < 1.
dx p dx dp
dp x x p
1< <0
Demand Elasticity
0-1
< < 1
88
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 8
Notice that:
Inelastic demand: 1 0 and 1
Elastic demand: 1 and 1.
So, with elastic demand, is 'smaller' in the sense of being more negative,
but is 'bigger' in the sense of the absolute val
ue, .
1< <0
Demand Elasticity
0-1
< < 1
89
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Importance of Elasticity
Suppose the Government raises the indirect tax on this commodity. How do we show this?
X0
p
p*
X*
S
D
90
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Importance of Elasticity
What is the Tax Revenue . . . ?
X0
p
p*
X*
S
D
ST
91
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Importance of Elasticity
What is the Tax Revenue?
What is the Tax Burden?
X0
p
p*
X*
S
D
ST
AB
92
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Importance of Elasticity
What is the Tax Burden?
How would the shares of the tax burden change with a different price elasticity of demand for the good?
X0
p
p*
X*
S
D
ST
AB
S
ST
0 X*
p
93
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Importance of Elasticity
What is the Tax Burden?
How would the shares of the tax burden change with a different price elasticity of demand for the good?
X0
p
p*
X*
S
D
ST
AB
S
ST
0 X*
p
D
94
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 9
Importance of Elasticity
How would the shares of the tax burden change with a different price elasticity of demand for the good? Why is this?
X0
p
p*
X*
S
D
ST
AB
S
ST
0 X*
p
D
AB
95
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10Applications of Consumer Choice Theory
1. Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
96
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
Time Constraint: Tmax
0
Labour Supply0
97
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
Tmax
Tmax
Wage Constraint: w (wage per hour)
0
Labour Supply0
w
98
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
Tmax
Tmax
Wage Constraint: w (wage per hour)
And Non-labour income, N.
0
Labour Supply0
w
N
99
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
Optimisation, given w, N and Tastes.
Total Income = Labour Income +
Non-Labour Income
Total Income = Y + N
0
Labour Supply0
w
N
L*
N
Y
100
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
Optimisation, given w, N and Tastes.
What happens to optimal Labour Supply if N rises (why might it?)?
0
Labour Supply0
w
N
L*
N
Y
101
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
What happens to optimal Labour Supply if N rises
0
N
102
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
What happens to optimal Labour Supply if N rises?
Under what assumption?
Why?
0
N
IC*a
b
103
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Labour Supply: The Income-Leisure Trade-off
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
w
N
L*
N
Y
w
L, Labour
Supply
What happens to optimal Labour Supply if w rises?
aa
L*
w
104
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
w
N
L*
w
L, Labour
Supply
What happens to optimal Labour Supply if w rises?
aa
L*
105
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
w
L*
w
L, Labour
Supply
What happens to optimal Labour Supply if w rises?
aa
L*
a*
106
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
L*
w
L, Labour
Supply
What is the implied shape of the Labour Supply curve in this case?
aa
L*
a*a*
107
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
L*
w
L, Labour
Supply
What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply?
a Ls
L*
a*
108
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
IC
Tmax
Tmax
0
Labour Supply0
L*
To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects.
To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .
a
a*
109
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects.
To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . .
a
a*
110
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
To understand how labour supply responds to a change in the wage rate, it is useful to exploit the distinction between Income and Substitution Effects.
To do this, we need to shift back the new Budget Line until it is just a tangent to the original Indifference Curve . . . with the move from ‘a’ to ‘a*’ split into:
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
a
a*b
S
I
111
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
a
a*b
S
I
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.
112
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
How would you interpret the Income Effect in words?
And the Substitution Effect
(Hint: exploit the concept of the Opportunity Cost)
a
a*b
S
I
113
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
‘a’ –> ‘b’; Substitution Effect,
‘b’ –> ‘a*’; Income Effect.
When the Substitution and Income Effects just cancel each other out, the rise in the wage rate has no net effect on Labour Supply and the derived Labour Supply curve is vertical, as we have seen.
What about if the Substitution Effect dominates?
What is the shape of the Labour Supply curve in this case?
a
a*
b
S
I
114
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
w
L, Labour
Supply
What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply?
aLs
L*
a*
I S
When the S-effect dominates the I-effect
a
a*
115
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
w
L, Labour
Supply
What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply?
a
Ls
L*
a*
I S
When the S-effect dominates the I-effect
a
a*
S I
116
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
Leisure
Income
Tmax
Tmax
0
Labour Supply0
L*
w
L, Labour
Supply
What is the implied shape of the Labour Supply curve in this case? And the elasticity of Labour Supply?
a
Ls
L*
a*
I S
When the I-effect dominates the S-effect
a
a*
I S
117
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 10
I S
S I
Labour Supply: the evidence . . .
And for most people?
And the implication for income tax cuts?
w
L
Ls
S I
118
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Applications of Consumer Choice Theory2. Inter-temporal Choice
I1 , C1
I0 , C0
Think of an ‘Endowment Point’ and add it to the diagram.
119
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can Saving take you?
And Borrowing?
E
I0
I1
120
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can Saving take you?
(And Borrowing?)
E
I0
I1
121
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can Saving take you?
(And Borrowing?)
E
One Euro saved this period yields one Euro plus (one Euro times the rate of interest) next period. Or . . .
I0
I11
1+i
122
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can Saving take you?
E
Or . . .
0 0 0 0( ) saved yields (1 )( ) next period.I C i I C
I0
I1
123
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11
0 0 0 0( ) saved yields (1 )( ) next period.I C i I C
0 0( )I C
Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can Saving take you?
E
Or . . .
I0
I1
0 0(1 )( )i I C
C0
C1
124
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11
0 0 0 0( ) saved yields (1 )( ) next period.I C i I C
0 0( )I C
Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can Saving take you?
What is the slope of the budget constraint?
E
Or . . .
I0
I1
0 0(1 )( )i I C
C0
C1
125
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11
0 0 0 0( ) borrowed reduces consumption by (1 )( ) next period.C I i C I
Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can Borrowing take you?
E
Or . . .
I0
I1
C0
C1
126
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
From the Endowment Point, where can all possible Saving or Borrowing take you?
This is the inter-temporal budget constraint.
E
I0
I1
Slope = (1 )i
127
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
What is the value of C1?
(Note the value of the slope.)
E
I0
I1
(1 )i
C1
C0
1 1 0 0 +(1 )( ).C I i I C
128
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
Re-arranging:
E
I0
I1
(1 )i
C1
C0
1 1 0 0
1 10 0
+(1 )( )
+(1 )
C I i I C
I CC I
i
129
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
This is the horizontal intercept of the budget constraint. What is its interpretation?
E
I0
I1
10 (1 )
II
i
C1
C0
1 10 0
1
10 0
+(1 )
If we now let =0, then:
+(1 )
I CC I
i
C
IC I
i
130
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11
10 (1 )
II
i
Inter-temporal Choice
I1 , C1
I0 , C0
How would you show the effect on the inter-temporal budget constraint of a fall in the rate of interest?
E
I0
I1
C1
C0
(1 )i
131
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11
10 (1 )
II
i
Inter-temporal Choice
I1 , C1
I0 , C0
What happens to the Present Value of E after a fall in the rate of interest?
E
I0
I1
C1
C0
(1 )i
132
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
How would you represent an individual’s preferences over consumption today and tomorrow?
E
I0
I1
133
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
What does the slope of the indifference curve represent?
If the MRTP is high (low), what does this mean?
E
I0
I1
134
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
Optimisation.
E
I0
I1
A
C0
C1
135
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
Is this person saving or borrowing?
E
I0
I1
A
C0
C1
136
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
How will they respond to a fall in the rate of interest?
E
I0
I1
A
C0
C1
137
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
How will they respond to a fall in the rate of interest?
Consider the substitution effect.
E
I0
I1
A
C0
C1
138
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
Borrowing is cheaper and so the borrower borrows more (Substitution effect).
They are also better off (why?): so there is an Income effect.
Which way does Income effect go?
E
I0
I1
A
C0
C1
139
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
Borrowing is cheaper and so the borrower borrows more (Substitution effect).
They are also better off (why?): so there is an Income effect.
Which way does Income effect go?
E
I0
I1
A
C0
C1
‘S’ ‘I’
B
140
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
So fall in the rate of interest leads Borrower to borrow more: unless Consumption today is a . . . . ‘?’ Good.
E
I0
I1
A
C0
C1
‘S’ ‘I’
B
141
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
How would you show the effect on a Borrower of a rise in the interest rate?Will the Borrower borrow more or less? On what does your answer depend?E
I0
I1
A
C0
C1
142
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
How would you show the effect on a Saver of a rise in the interest rate?
Will the Saver save more or less? On what does your answer depend?
E
I0
I1
A
C0
C1
143
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Inter-temporal Choice
I1 , C1
I0 , C0
How would you show the effect on a Saver of a fall in the interest rate?
Will the Saver save more or less? On what does your answer depend?
E
I0
I1
A
C0
C1
144
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 11Intertemporal Choice
10
1 20 2
We saw earlier that .(1 )
Suppose that there are more than the 2 periods:
... .(1 ) (1 ) (1 )
Suppose the stream of Income from an Investment is constant and net of costs:
nn
IPV I
i
II IPV I
i i i
NPV I
2
... .(1 ) (1 ) (1 )
If the income is in Perpetuity, then we have the remarkably simple result that:
.
What is the implication of this for the effect of on Investment?
n
I I I
i i i
INPV
ii
145
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider an industry in an Autarkic country:
X
p
Sd
Dd
Xd
pd
What is the extent of Consumer Surplus in this case?
146
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider an industry in an Autarkic country:
X
p
Sd
Dd
Xd
pd
What is the extent of Consumer Surplus in this case?
A
147
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider an industry in an Autarkic country:
X
p
Sd
Dd
Xd
pd
And Producer Surplus in this case?
A
148
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider an industry in an Autarkic country:
X
p
Sd
Dd
Xd
pd
And Producer Surplus in this case?
A
B
149
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider an industry in an Autarkic country:
X
p
Sd
Dd
Xd
pd
Suppose that in the Rest of the World, the World Price of X, pw, was higher than pd.
What would this mean?
pw pw
150
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price exceeds the Domestic Autarkic price:
X
pSd
Dd
Xd
pd
Domestic Firms would not be prepared to sell any units at the low price of pd.
They will sell at the World Price by exporting to the Rest of the World at the World Price of pw.
Domestic Demand (and sales) are equal to Xdt at the world price.
pw pw
Xdt
151
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price exceeds the Domestic Autarkic price:
X
pSd
Dd
Xd
pd
Domestic Firms would not be prepared to sell any units at the low price of pd.
They will sell at the World Price by exporting to the Rest of the World at the World Price of pw.
Effectively, the Domestic Firms’ Supply curve becomes the one in bold. Be sure you can explain this to yourself.
pw pw
Xdt
152
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price exceeds the Domestic Autarkic price:
X
pSd
Dd
Xd
pd
Effectively, the Domestic Firms’ Supply curve becomes the one in bold. Be sure you can explain this to yourself.
Total Domestic Firm sales are given by Xt. Exports are equal to Xt – Xdt.
pw pw
Xdt Xt
153
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price exceeds the Domestic Autarkic price:
X
pSd
Dd
Xd
pd
What has happened to CS and PS, and hence total welfare, in this country under the equilibrium with trade compared to the total welfare (CS+PS) in this country under Autarky?
So Who Gains and Who Loses from Trade (and by how much in each case)?
Work it out for yourself.
pw pw
Xdt Xt
154
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider an industry in an Autarkic country:
X
p
Sd
Dd
Xd
pd
Suppose that in the Rest of the World, the World Price of X, pw, was lower than pd.
What would this mean?
pw pw
155
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price is less than the Domestic Autarkic price:
X
p
Sd
Dd
Xd
pd
Domestic buyers would not be prepared to buy any units at the high price of pd.
They will want to buy at the World Price by importing from the Rest of the World at the World Price of pw.
Domestic Supply (and hence sales) are equal to Xdt at the world price.
pw pw
Xdt
156
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price is less than the Domestic Autarkic price:
X
p
Sd
Dd
Xd
pd
Domestic buyers would not be prepared to buy any units at the high price of pd.
Effectively, the Domestic Buyers’ Demand curve becomes the one in bold. Be sure you can explain this to yourself.
pw pw
Xdt
157
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price is less than the Domestic Autarkic price:
X
p
Sd
Dd
Xd
pd
Effectively, the Domestic Buyers’ Demand curve becomes the one in bold. Be sure you can explain this to yourself.
Total Domestic Buyers’ consumption is given by Xt. Imports are equal to Xt – Xdt.
pw pw
Xdt Xt
158
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price is less than the Domestic Autarkic price:
X
p
Sd
Dd
Xd
pd
What has happened to CS and PS, and hence total welfare, in this country under the equilibrium with trade compared to the total welfare (CS+PS) in this country under Autarky?
So Who Gains and Who Loses from Trade (and by how much in each case)?
Work it out for yourself.
pw pw
Xdt Xt
159
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1 Lecture 12
Gains from Trade
Consider trade. Suppose the World Price is less than the Domestic Autarkic price:
X
p
Sd
Dd
Xd
pd
In the case of a country where there are imports, there might be calls for tariffs or import quotas.
What would be the welfare effects of each of these?
What factors influence the magnitudes of the effects?
pw pw
Xdt Xt
160
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1Key Concepts
• The circular flow model
• A simple model of a market
• Consumer choice: basic setup
• Preferences, indifference curves and utility
• Budget constraints
• Consumer equilibrium: utility maximization
• The algebra of consumer equilibrium
• Income consumption curves
• Price consumption and the derived demand curves
161
See Handout
Robin Naylor, Department of Economics, Warwick
Topic 1Key Concepts
• The algebra of deriving the demand curve
• The compensated demand curve
• Income and substitution effects of a price change
• Normal, inferior and Giffen goods
• Consumer surplus
• Market demand
• The price elasticity of demand
• Tax incidence
• Winners and Losers from Trade
• Labour supply by the household
• Capital supply by the household
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Robin Naylor, Department of Economics, Warwick
Topic 1Key Readings
• Frank, Chapters 1-5
• Estrin, Laidler and Dietrich, Chapters 1-6
• Online resources:
• http://www.bized.ac.uk/current/index.htm
• http://www.bized.ac.uk/learn/economics/index.htm
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Robin Naylor, Department of Economics, Warwick
Topic 1
Seminar Questions: weeks 4, 6(Note Questions in bold (i.e., 1, 2, 6, 8, 11,17) are the questions on which Seminars should focus. Other questions are preparatory and would be good self-study questions to address ahead of seminar meetings)
1. Explain what economists mean by the term ‘market equilibrium’.
2. What is meant by the following properties of an equilibrium:
a. Existence
b. Uniqueness
c. Stability
3. What is likely to happen to the demand curve if money incomes of consumers rise, ceteris paribus? (What is meant by ceteris paribus?)
4. What factors are held constant along the demand curve?
5. What factors are held constant along the supply curve?
6. Explain the difference between a movement along the demand curve and a shift of the demand curve.
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Robin Naylor, Department of Economics, Warwick
Topic 1
Seminar Questions weeks 4, 6 continued
7. What are the comparative static properties of a typical market equilibrium (for example, what is likely to happen to the market equilibrium if there is an increase in consumers’ money income)?
8. What are the principal properties of indifference curves? How do these properties relate to the assumptions we make regarding the consumer’s underlying preferences?
9. Using indifference curve analysis, show how the demand for a good responds to a rise in money income, for each of the following cases:
a) A normal good
b) A necessity
c) An inferior good
10. Using indifference curve analysis, show how the demand for a good might respond to a change in the price of that good.
11. Show how to decompose the effects of a price change into both income and substitution effects, for each of the possible cases you have considered.
12. Explain intuitively what income and substitution effects are.
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Robin Naylor, Department of Economics, Warwick
Topic 1
Seminar Questions weeks 4, 6 continued
13. Why is the market demand curve derived by horizontal (rather then by vertical) summation of the individuals demand curves?
14. Is the market demand curve necessarily kinked (like in the figure in the lecture notes)?
15. Define what is meant by Consumer Surplus. How do you represent Consumer Surplus in a diagram?
16. Define what is meant by the (own-) price elasticity of demand for a good.
17. What happens to the elasticity of demand as we move along the linear demand curve?
18. If a proportional tax rate on labour income is cut, what are the possible implications for the optimal labour supply choices of workers? Explain your answer using diagrams and be careful to distinguish between Income and Substitution Effects.
19. If the rate of interest rises, will savers save more? Will borrowers borrow less?
Further Self-study question suggestions:
Try as many as you can of the discussion questions at the end of each of the chapters in Katz and Rosen (or Morgan et al.) and of the problems at the end of each of the chapters in Estrin et al..
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