Reasons why a person chooses different quantities at different prices. Three components of his decision: 1.

Consumers have restrictions on how they choose. Budget 2. Individual preferences determines how satisfied an individual will be with different combinations of goods and services. (Utility) 3. Given preferences and restrictions, the individual maximizes his utility of consumption.

Baskets of Goods and Budget Line A certain combinations of goods and services is called basket of goods.

Example: Two goods: Good 1 and 2 with prices p1 and p2. A basket that consists of the quantity q1 of good 1 and q2 of good 2 is written: (q1,q2) Thus: (4,3) means that we have 4 units of good 1 and 3 units of good 2. The price of basket (q1,q2) is then: p1*q1 + p2 * q2 If we have a limited amount of money to buy goods for, this will impose a restriction on how much we can buy of each good. Let M denote the amount of money available, the price of the basket chosen must not exceed M. therefore: P1*q1 + p2*q2 = M So if we solve the expression for q2, we get the function of the budget line: Q2 = (m-p1*q1)/p2 = (m/p2) (p1/p2) *q1 Thus, if the M = 60; p1 = 5; p2 = 8 and q1 = 8: following the equation the slope of q2 will be: q2 = (60- 5* 8)/8 = (60/8)-(5/8)* 8 = 2.5 = 2.5

Q1 = (m-p2*q2)/q2 = (m/p1) (p2/p1)*q2 Thus: Q1 = (60-8*2.5)/2.5 = (60/5)-(8/5)*2.5 = (60 40)/2.5 = 12 (1.6*2.5) = 20/2.5 = 12-4 =8=8 This function is a straight line that intercepts the Y axis at m/p2 and has the slope p1/p2. (Draw the budget line) All points on the budget line cost exactly M Points in the area below the budget line cost less than M Points above cost more that M. Thus: The basket the consumer with budget M can buy are the ones on and below the budget line. The SLOPE OF THE BUDGET LINE is called MARGINAL RATE OF TRANSFORMATION (MRT). MRT = -p1/p2 SUPPOSE: You have two goods: Ice cream (Price 10) and pizza (price 20). MRT will then be: -10/20 = -0.5 (Interpretation: You have to give up half a pizza up if you want to have one more ice cream (or vice versa, that you have to give up two ice creams, -20/10, to get one more pizza) So to TRANSFORM you basket into another basket with one more ice cream, you have to give up half a pizza. If income or prices change, the budget line will also change. If the price of good 1 rises, our purchasing power for good 1 will change, but we can still buy the same amount of good 2. Consequently, the budget line rotates about the intercept with the Y axis. If the price of good 2 rises, then budget line rotates about the intercept with the X axis.

When price changes, MRT also changes, since the slope changes. If the price of Ice Cream rises from 10 to 20, MRT will be -20/20 = -1 (Interpretation: you have to give up a whole pizza to get one more ice cream.) If the income increases but the prices are unchanged, the budget line will shift outward or to the right. But you still have to give up half a pizza if you want to have one more ice cream.

PREFERENCES Assume that an individual always knows what he prefers: he refers basket A to basket B, he prefers B to A, or he is indifferent between them. If we order all baskets accordingly, we have a preference order. Assumptions about preference orders: 1. Complete an individual can order all conceivable baskets of goods. 2. Transitive If the individual prefers A to B, and B to C, he also prefers A t C. There are no circles in preferences. 3. Non-satiation An individual always prefers more of a good to less. 4. Convexity If there are two baskets an individual is indifferent between, A and B, he will always prefer baskets that lie between these two baskets.

INDIFFERENCE CURVE If we only have two goods, we can illustrate different baskets that the individual is indifferent between with INDIFFERENCE CURVE. All point on an indifferent curve are baskets that the individual perceives are equally good. He is therefore, indifferent between them. INDIFFERENCE MAPS If we randomly choose four baskets, A,B, C and D. There will be some indifference curves that run through each point. Thus, we can label the indifference curves I1, I2, I3, and I4. Each represents a higher level of utility. A collection of several indifference curves in one figure is called INDIFFERENCE MAP.

After drawing the indifference curves (map), we can also compare points that do not lie to the northeast or southwest of each other. (Refer to board drawing for this) Example, if point B does not lie in the northeast area of say point A but in the southeast, point B lies on an indifference curve that is higher than the one th at runs through point A. The indifference curves have the following FOUR IMPORTANT PROPERTIES: 1. Baskets that are further away from the origin are better than the ones closer to the origin. 2. Every point has an indifference curve that runs through it, since the preferences are complete. 3. Indifference curves cannot cross each other. This follows from the assumptions of transitivity and non-satiation. 4. The indifference curve slopes downwards.

THE MARGINAL RATE OF SUBSTITUTION (MRS) If you choose one basket along the curve, how much would you be willing to give up of good 2 to get one more unit of good 1? Example: Two individuals, each have 5 apples (good 1) and 5 bananas (good 2). To get one more apple, the first is willing to give up one banana, whereas the other is willing to give up two bananas. The numerical value of the slop of an indifference curve is called MARGINAL RATE OF SUBSTITUTION (MRS), calculated as: MRS = q2/q1 Individual 2 was willing to give up 2 bananas to get one more apple. Then q2 = -2, q1 = 1, and MRS = -2/1 = -2. Because the indifference curves slopes less and less to the right implies that MRS is decreasing. One does not keep the minus sign in MRS.

MRS of Perfect Substitutes is constant. This means that they have the same slope everywhere they are straight lines sloping downwards to the right. Thus, between blue and red pens, the MRS = 1/1 = 1. Example of complementary goods (right and left shoes one has no use without the other). Indifference curves of complementary goods is L shaped.

UTILITY MAXIMIZATION: OPTIMAL CONSUMER CHOICE (Putting the indifference curve an the budget line in one figure or diagram. (refer to board drawing) At the tangency between budget line and the indifference curve, the slope is the same. Thus, MRT = MRS MRT (-P1/P2) = MRS