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Chia-Hui Chen

Lecture 4

Price Elasticity of Supply; Consumer

Preferences

Outline

1. Chap 2: Elasticity - Price Elasticity of Supply

2. Chap 3: Consumer Behavior - Consumer Preferences

Price elasticity of supply. The percentage change in quantity supplied re

sulting from one percentage change in price.

dQS

QS P dQS

EPS = dP

= .

P

QS dP

In the short run, if price increases, ﬁrms will want to produce more but cannot

hire workers and buy machines immediately, thus the supply is less elastic. In

contrast, supply is more elastic in the long run.

Example (Example in Elasticities of Demand). Assume the quantity demanded

is

QD = 14 − 3P + I + 2PS − PC .

• P - Price

• I - Income

• PS - Price of substitute

• PC - Price of complement

Calculate EPD , EI , EQPS and EQPC when P = 1, I = 10, PS = 2 and PC = 1.

Solution:

Given the values of variables, the quantity demanded is:

QD = 14 − 3 × 1 + 10 + 2 × 2 − 1 = 24.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT

OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month

YYYY].

2 Consumer Preferences 2

P dQD 1 1

EPD = = × (−3) = − ,

QD dP 24 8

I dQ 10 5

EI = = ×1= ,

Q dI 24 12

PS dQ 2 1

EQPS = = ×2= ,

Q dPS 24 6

PC dQ 1 1

EQPC = = × (−1) = − .

Q dPC 24 24

2 Consumer Preferences

� �

Consumer preferences

Consumer behavior =⇒

Budget constraints

• What amount and types of goods will be purchased.

• Origin of demand, how to decide demand.

Topics

1. Preference

2. Indiﬀerence Curve, Marginal Rate of Substitution (MRS)

3. Utility Functions

Preference

Notation

• A ≻ B: A is preferred to B.

• A∼ B: A is indiﬀerent to B.

• Completeness - can rank any basket of goods.

This assumption seems obvious, but can have contradiction (see example

below).

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT

OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month

YYYY].

2 Consumer Preferences 3

Good A 3 1 2

Good B 2 3 1

Good C 1 2 3

3 properties, assume that people will prefer one to another if 2 properties

are better. Table 1. Actually A ≻ B, B ≻ C and C ≻ A - this loop

contradicts the assumption.

• Non-satiation - more is better. (Monotonicity) Assume we discuss goods,

since in general, more is not always better.

• Convexity - given two indiﬀerent bundles, always prefer the average to

each of them. In Figure 1, the average point C is more preferred to A or

B.

Properties of indiﬀerence curves

• Downward sloping: if not, non-satiation violated. Refer to Figure 1.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT

OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month

YYYY].

2 Consumer Preferences 4

simultaneously. In Figure 1, assume there is another indiﬀerence curve

through A and D.

A ∼ B, A ∼ D =⇒ B ∼ D.

However,

B≻D

in this ﬁgure. Contradiction exists.

• Shape: describes how willing one is to substitute one good for another.

See Figure 2.

Marginal rate of substitution (MRS). How many units of Y one is willing

to give up in order to get one more unit of X.

−Δy −dy

=

Δx dx

• MRS decreasing.

• Preferred set is convex.

• The left one in Figure 2 makes more sense in the real world.

Example (Perfect complements). Buying shoes. People need both the left one

and the right one.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT

OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month

YYYY].

2 Consumer Preferences 5

Utility Functions

Utility function. Assigns a level of utility to each basket of consumption.

Example (A sample utility function).

u(x, y) = xy.

Ordinal utility function. Ranks the preferences, but does not indicate how

much one is preferred to another.

Cardinal utility function. Describes the extent to which one of the bundles

is preferred to another. Only the ordinal utility function is required in

this course.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT

OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month

YYYY].

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