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Summary and Introduction to Demand
In microeconomics, demand refers to the buying behavior of a household. What does this mean? Basically, micro economists want to try to explain three things: 1. Why people buy what they buy 2. How much they're willing to pay 3. How much they want to buy Instead of looking at all consumers in the world, however, they try and model how smaller units function: instead of asking, "How does the American market function?" they ask, "What will one household do?" Each household, or small-scale decision-making unit, is affected by different factors when making choices about what to buy and how much to buy. For instance, if one household lives in Florida and another lives in Michigan, they might have different preferences for clothing, since the climates are so different. Consumer preferences weigh heavily in a household's buying decisions. Another factor that affects such decisions is income: a millionaire and an average citizen will have very different purchasing choices, since they have different budgets to work on. All buyers will try to maximize their utility, that is, make themselves as happy as possible, by spending what money they have in the best way possible. By considering both their preferences and their budget, they ensure that they end up with the best combination of goods possible. Because the household is such a small unit, no household has a significant impact on the market, and so the actions of any single household are its best effort to react to the market price and the goods available. In this unit on demand, we will learn how to work with graphical and mathematical models for demand, we will observe how changes in price or income can affect demand, we will see how consumers make choices under uncertainty, and we will apply that knowledge to calculate the optimal purchases an individual consumer can make, given their income and the prices of goods.
Aggregate Demand - The combined demand of all buyers in a market. Budget Constraint - The outermost boundary of possible purchase combinations that a person can make, given how much money they have and the price of the goods in consideration. Buyer - Someone who purchases goods and services from a seller for money. Competition - In a market economy, competition occurs between large numbers of buyers and sellers who vie for the opportunity to buy or sell goods and services. The competition among buyers means that prices will never fall very low, and the competition among sellers means that prices will never rise very high. This is only true if there are so many buyers and sellers that no one individual has a significant impact on the market's equilibrium.
Complementary Good - A good is called a complementary good if the demand for the good increases with demand for another good. One extreme example: right shoes are complementary goods for left shoes. Demand - Demand refers to the amount of goods and services that buyers are willing to purchase. Typically, demand decreases with increases in price, this trend can be graphically represented with a demand curve. Demand can be affected by changes in income, changes in price, and changes in relative price. Demand Curve - A demand curve is the graphical representation of the relationship between quantities of goods and services that buyers are willing to purchase and the price of those goods and services. Example:
A Sample Demand Curve Diminishing Returns - Concept that the marginal utility derived from acquiring successive identical goods decreases with increasing quantities of goods. Economics - Economics is the study of the production and distribution of scarce resources, and goods and services. Equilibrium Price - The price of a good or service at which quantity supplied is equal to quantity demanded. Also called the market-clearing price. Equilibrium Quantity - Amount of goods or services sold at the equilibrium price. Because supply is equal to demand at this point, there is no surplus or shortage. Expected Value (EV) - How much a buyer thinks that a good or investment will be worth after a time lapse, based on the probabilities of different possible outcomes. Usually refers to stocks and other uncertain investments. Giffen Good - Theoretical case in which an increase in the price of a good causes an increase in quantity demanded. Firm - Unit of sellers in microeconomics. Because it is seen as one selling unit in microeconomics, a firm will make coordinated efforts to maximize its profit through sales of its goods and services. The combined actions and preferences of all firms in a market will determine the appearance and behavior of the supply curve. Goods and Services - Products or work that are bought and sold. In a market economy, competition among buyers and sellers sets the market equilibrium, determining the price and the quantity sold.
Inferior Good . Risk .An economy in which the prices and distribution of goods and services are determined by the interaction of large numbers of buyers and sellers who have no significant individual impact on prices or quantities. Because resources are scarce. Indifference Curve . Also called the equilibrium price.A good for which quantity demanded decreases with increases in income.A normal good is a good for which an increase in income causes an increase in demand. but might have a higher expected value. Market-clearing Price . A very risky investment will have wide variation in possible payoffs. the change in price makes the buyer feel as if it has. a less risky investment will have a more predictable payoff. there is not enough to go around. and vice versa. lowering the quantity demanded. an increase in price causes a buyer to feel poorer. whether they be money. but a lower expected value.The price of a good or service at which quantity supplied is equal to quantity demanded. Resource .A supply of capital that can be used in an economy. Marginal Utility .Income effect describes the effects of changes in prices on consumption.Graphical representation of different combinations of goods and services that give a consumer equal utility or happiness.The process of adding together all quantities demanded at each price level to find aggregate demand Household . . Market . however. Microeconomics . Although the buyer's actual income hasn't changed.Unit of buyers in microeconomics. Optimization .A large group of buyers and sellers who are buying and selling the same good or service. Market Economy .Subfield of economics which studies how households and firms behave and interact in the market. and vice versa. or other factors. a household will make coordinated efforts to maximize its utility through its choices of goods and services. Because it is seen as one buying unit in microeconomics. goods.Refers to the amount of variation in possible payoffs. According to the income effect. Normal Good . Income Effect .Additional utility derived from each additional unit of goods acquired. The combined actions and preferences of all households in a market will determine the appearance and behavior of the demand curve.To maximize utility by making the most effective use of available resources.Horizontal addition .
since the first good has become relatively expensive." Wage .Risk-averse . Two Approaches to Demand The Graphical Approach Economists graphically represent the relationship between product price and quantity demanded with a demand curve. The buyer substitutes consumption of the second good for consumption of the first. this trend can be graphically represented with a supply curve. Utility . Someone who is risk-averse might even refuse to invest in something with a positive expected value if the variation in possible outcomes is too great.Goods. A riskneutral buyer will invest in any investment with a positive expected return.Describes the effects of changes in relative prices on consumption. and vice versa. Scarcity . Seller .Refers to a buyer who is willing to invest in an investment with wide variation in possible payoffs. Risk-loving . services. or resources are scarce if there is not enough for everyone to have as much as they would like. In extreme cases. Typically. Each individual buyer can have their own demand curve. Supply . an increase in price of one good causes a buyer to buy more of the other good. supply increases with increases in price.Refers to a buyer who is unwilling to invest in an investment with wide variation in possible payoffs. Substitute Good .Refers to a good which is to some extent interchangeable with another good.An approximate measure for levels of "happiness. demand curves are downwards sloping. Risk-neutral . buyers are less likely to be willing or able to purchase whatever is being sold. regardless of how risky it is. meaning that when the price of one good increases. because as price increases. as shown below.Supply refers to the amount of goods and services that sellers are willing to sell. a risk lover might even invest in something with a negative expected value. This graph shows what Jim's demand curve for graham crackers might be: . showing how many products they are willing to purchase at any given price.Price per unit of time when the good being sold is some form of labor or work (as opposed to a physical product). Typically. in the hopes of getting a large return. demand for the other good increases. Substitution Effect .Someone who sells goods and services to a buyer for money.Refers to a buyer who does not care about variation in possible payoffs. According to the substitution effect.
Where it intersects the x-axis (quantity) is how many boxes of graham crackers Jim will buy. prices. Your friend who has less money. There are many factors that can affect demand quantity. At the point of intersection. we would add how many they are willing to buy at price p=1 and record that as aggregate demand for p=1. they look at aggregate demand. Below are possible demand curves for you (with your big raise) . if Jim and Marvin are the only two buyers in the market for graham crackers. or they might stick with tap water. giving you total quantity demanded for that price. however. you might not mind buying a pricier soda. Then we would add how many they are willing to buy at price p=2 and record that as aggregate demand for p=2. and preferences. and so on. Jim will buy 3 boxes when the price is $2 a box. including income.Jim's Demand Curve for Graham Crackers To find out how many boxes of graham crackers Jim will buy for a given price. This results in the following graph of aggregate demand for graham crackers: Jim and Marvin's Demand Curves for Graham Crackers Aggregate Demand Curve for Graham Crackers This method is called horizontal addition because you look at a price level. extend a perpendicular line from the price on the y-axis to his demand curve. For instance. might pick a generic brand. which can vary from person to person. in the graph above. For instance. How much are you willing to pay for a cold soda? If you recently got a raise at your job. economists don't look at individual demand curves. and add the separate quantities demanded across that price level. Let's look at one good to see how this works. even if you don't need it. Aggregate Demand and Horizontal Addition Typically. the combined quantities demanded of all potential buyers. extend a line from the demand curve to the x-axis (perpendicular to the x-axis). To do this. Instead. add the quantities which buyers are willing to buy at different prices.
If preferences or income change. the quantity demanded is higher than when the price is two dollars. however. however. with a permanently higher income. all else is staying the same. demand decreases.and your friend (without your big raise). this restriction allows us to use the same demand curve. Changes in Demand with Changes in Price We have been looking at how changes in price can affect buyers' decisions: when price increases. If Conan gets a new job. What this means in the real world is that if two companies charge different prices for the same good. This model of a buyer moving up and down one demand curve is correct if the only thing that is changing is the price of the good. and he will have a higher demand curve for all normal goods. his demand curve will shift outwards. as long as he doesn't lose his new job. the company that charges a lower price will get more customers. he will always have more money. That means that he can buy more of what he likes. the demand curve can actually shift. However we have been assuming that when the price changes. We can see this on the graph on a single demand curve. For example. and that. Note that you are willing to buy more soda than your friend is: 2 Demand Curves for Soda What if soda cost a dollar yesterday and costs two dollars today? That might make you think twice about getting the same soda you drank yesterday. (Exceptions to this general rule may occur when there is a real or perceived difference in quality of the goods being sold). Likewise. let's say that Conan's initial demand curve for concert tickets looks like curve 1. When the price is a dollar. and vice versa. Why is this? Conan realizes that he has more money. you might be more willing to buy the soda than usual. with changes in demand being represented by movements up and down the same curve. . if it cost two dollars yesterday and a dollar today. to curve 2.
we plug 10 in for P and solve for Q. we just add the demand equations together. we find out that together. if we're adding Sean's demand for T-shirts to Noah's demand for T-shirts. if Sean's demand curve for T-shirts looks like this: Figure 1. reflecting his new appreciation of jazz. Sean and Noah will buy [65 . it looks like this: Figure 1. and he now likes jazz CDs much more than he did before. demand functions provide a numerical guide to consumer behavior. We have been showing demand as straight. downward-sloping lines. If Conan suddenly decides that he wants to collect jazz CDs. Shifts in demand curves are caused by changes in income (which make the goods seem more or less expensive) or changes in preferences (which make the goods seem more or less valuable). This can also occur with a change in buyer preferences. or: Q = 25 . since they have become more valuable in his eyes. and his willingness to pay more for the same CDs. The Algebraic Approach It is also possible to model demand using equations. Conan's demand is now higher than it was before the demand shift. Just as the graphs provide a visual guide to consumer behavior. While these equations can be very complex.5(10)] = 15 T-shirts. So. In this case.2P If we want to see how much Sean will buy if the price is 10.2(10)] = 5 T-shirts. [25 . When we want to find aggregate demand using the algebraic approach instead of the graphical approach. his demand curve will shift outwards. for now we will use simple algebraic equations.7: Sean's Demand Curve for T-Shirts The corresponding equation that describes Sean's demand for T-shirts is simply the equation for the line on the graph. known as demand equations or demand functions. For example. which can easily be translated into mathematical equations. .Shifts in Demand Note that for any price level. and vice versa.8: Aggregate Demand If price for T-shirts is still equal to 10.
and Joe's demand function is Q = 48 . and so you may feel like buying more.3P.2(13)] = -1 T-shirts. while they don't affect the amount of your paycheck. which influences you to buy . What if we're looking at two goods at once? For instance. always check to make sure that there will be no negative demand for the given price before adding equations together. But because Sean's demand equation would yield the answer –1. and gets another two shirts. What will their combined demand be if the price is $5? $11? [Solution] Problem 1. and Sean will buy 0 T-shirts. Practice Problems Problem 1.5: Emily decides to set aside $200 from her paycheck every month. For example. How can you explain this with a graph? [Solution] Problem 1.2: Michelle is shopping for shirts. Increases in price. but the price of hot dogs stays the same. if the price of a T-shirt is $13. adding the demand equations together would result in a wrong answer. If the price of hamburgers goes up. so she spends more money on candy every week.4: Kris and Tim's demand curves for playing cards look like this: Tim and Kris's Demand curves for Playing Cards Who wants more when the price is $3 a pack? $4 a pack? What is their combined demand at $4 a pack? [Solution] Problem 1.1: Nathan and Joe are shopping for video games. this effect is called the income effect. Sean would supposedly want to buy [25 . When using this method. and so you buy less. How will this affect her demand curve? (You don't have to use specific numbers. then notices that the shirts are on sale.One caveat in this method is that you can only add the equations together when both will result in positive demand.3(13)] = 1 T-shirt. To find how many T-shirts Sean and Noah would buy in this case. you might be more inclined to buy a hot dog. it makes hamburgers relatively expensive and hot dogs relatively cheap. [40 .3: Jenn's parents increase her allowance. Nathan's demand function for video games is Q = 30 . a fast food chain sells hamburgers and hot dogs. When the price of hamburgers goes up. How can you explain this with a graph? [Solution] Problem 1. Decreases in price make you feel richer. This tendency to change your purchase based on changes in relative price is called the substitution effect. you would only look at Noah's demand. She chooses one.4P. make you feel poorer than you were before. just explain) [Solution] Income and Substitution Effects Income and Substitution Effects Changes in price can affect buyers' purchasing decisions. Obviously that is impossible.
fewer hamburgers and more hot dogs than you usually would. the more we buy. however. That is. Table of Income and Substitution Effects While we cannot be absolutely certain about the net result. If you buy more of a good when you have more money. we tend to buy less. There are some exceptions. when the price of hamburgers goes up. if it's snowing. What do people like? When and how do they like it? Still looking at soda. Likewise. that good is a normal good. but hot dog consumption rises. we have been assuming that when we have more money. and Giffen Goods Are all goods the same? Is more always better? Up to this point. When the price of hamburgers goes up. it makes you feel relatively poorer. Thus. Another factor influencing demand is one which marketers and advertisers are always trying to understand and target: buyers' preferences. and are therefore willing to pay more for the same good. Inferior. a decrease in hamburger price would cause you to eat more hamburgers and fewer hot dogs. we call such goods normal goods. if an increase in your income causes you to buy less of a good. we will tend to buy more goods. buyers' preferences have changed: they want the soda more. the total effect is a little unclear. Because this is usually the case. since there is both an increase (substitution effect) and a decrease (income effect). or when they've been exercising. For instance. however: not all goods are normal goods. According to the income effect. so your tendency might be to buy fewer of both hamburgers and hot dogs. since both effects tend to cause a decrease. and the price they are willing to pay for a cold soda is lower. an increase in the price of hamburgers decreases consumption of both hamburgers and hot dogs. fewer people will crave a cold soda. that good is called an inferior good. Normal. or when they're eating a meal. According to the substitution effect. you buy less. In these cases. For . we cannot be sure what happens to hot dog consumption. If the price of a normal good increases. or if the price goes up. however. The income effect also affects buying decisions when there are two (or more) goods. If we have less money. while it is clear what happens to hamburger consumption. you will most likely eat fewer hamburgers and more hot dogs. It makes sense: the more money we have. Likewise. although they may be willing to pay a little extra money for a hot coffee. hamburger consumption drops. in general. or feel like we have more money. according to the substitution effect. If you look at the combined results of the income effect and the substitution effect. it makes sense that people drink more soda when it's hot. the substitution effect is stronger than the income effect. since the change in relative prices (substitution effect) affects you more than the perceived change in your income (income effect).
but consumption of B will increase. so consumption of B will increase. and good B is inferior. and an increase in consumption of good B (assuming that the substitution effect is stronger than the income effect). If good A is a normal good. however. since it is unlikely that an increase in price causes increase in demand. One possible justification for a Giffen good is that people associate higher prices with status. Income and Substitution Effects with Normal and Inferior Goods The substitution effect makes B relatively cheaper. and the price of A falls. and quality. An increase in the price of good A will cause a decrease in consumption of A. Income and substitution effects change demand differently with different types of goods. If the A is still normal and B is still inferior. however. luxury. and so consumption of A will decrease. you buy more. but very improbable. the results will be different. and the income effect will cause higher consumption of A and lower consumption of B. they might forego the cheap soda and ramen in favor of Coke and pasta. Giffen goods are theoretically possible. In this example. Income and Substitution Effects with Normal and Inferior Goods Another exception is the case where an increase in price causes an increase in demand. When they get jobs and a steady income. Why is this true? Consider the case where the price of good A goes up. then the substitution effect will cause higher consumption of A and lower consumption of B. so that a higher price might increase the perceived . the generic soda and cheap ramen are inferior goods. For instance. Because the buyer now feels richer. and the good is called a Giffen good. and consumption of A will decrease. they are less inclined to buy the inferior good. we have been looking at income and substitution effects when a buyer is faced with a choice between two normal goods. This results in an upward-sloping demand curve. you buy less. "poor college students" often satisfy themselves with generic soda and cheap ramen. when you are poor.instance. The income effect makes the buyer feel poorer. Remember that consumption of an inferior good varies inversely with income: when you are rich.
5: What is the difference between a Giffen good and a normal good? [Solution] Utility Utility and Indifference Curves We know how to represent changes in demand as price or income changes on a graph. however.2: If Marianne is grocery shopping for cheese and notices that there is a sale on Swiss cheese. the income effect makes Calvin feel poorer. too. If the income effect is very strong. because the substitution effect is almost always stronger than the income effect. however. the general public will prefer lower prices.value of a good.3: Consider the case where Katie gets a raise. then Calvin will buy more ACME Cola. This. Demand Curve for a Giffen Good Practice Problems Problem 2. because the consumption of inferior goods increases with decreases in income. When it's price increases. is unlikely. How will that affect her buying decision between Special K and Cheerios? What if both are on sale at 20% off? [Solution] Problem 2. assume that ACME Cola is an inferior good. how will that affect her demand for Swiss cheese and Emmenthal cheese? [Solution] Problem 2. and which are substitute goods? Right and left shoes? Sweaters and sweatshirts? Hot dogs and ketchup? Nickels and dimes? Ice cream and sorbet? Chips and salsa? [Solution] Problem 2. the happier . How will that affect her consumption of Spam (an inferior good) and steak (a normal good)? What if her income drops? What will happen to her Spam and steak consumption? [Solution] Problem 2. To illustrate. is on sale at 20% off. Special K.1: Which of the following are complementary goods. this effect is outweighed by the overwhelming tendency to prefer lower prices: even if a few people prefer the added cachet of a high-priced luxury good. but how can we show preferences? What makes buyers happy and how can we measure that happiness? Economists use the term utility when referring to the level of happiness or satisfaction that someone experiences from buying (or selling) goods and services: the more utility. and the substitution effect is very weak. Another possible case that could cause a Giffen good is the case in which a good is inferior and the income effect outweighs the substitution effect. In reality.4: One of Ruby's favorite cereals.
and might even trade several hats for one shirt. the extra ones don't make him much happier. if you give Jim a choice between points A and B on this indifference curve. but in his situation. he has had enough of hats. For instance. Eventually. so only a fool would choose the steak over the gold. All points on one indifference curve give the person the exact same amount of happiness. right? Thom knows this. This will continue. Generally. We all know that a bar of gold is worth more than a steak. people are willing to give up many hats to get a few shirts. After a while. and he'd rather get a shirt. An indifference curve represents all of the different combinations of two goods that generate the same level of utility. The reason for this is that most people do not like extremes: they would rather have a some shirts and some hats than many hats and no shirts. and illustrates the effects of diminishing returns. His marginal utility--the extra utility he gets with each hat--decreases with the number of hats he gets. rather than being straight lines or outward-bulging curves. If you ask Thom to choose between a bar of gold and a steak. he has so .the person. and he knows that he is choosing something that is worth less. which is why both points are on the same indifference curve. as the marginal utility from the steak will be higher than the marginal utility from a bar of gold. bar after bar. In this example. at the extremes. indifference curves bow in towards the origin. this swapping ratio decreases. they want a lot of shirts in exchange for any hats they might give up. the marginal utility he gets from the second bar of gold might not be quite as high as the marginal utility from the first bar. and he will still be happy to get another bar of gold. This changing preference results in the traditional inward-curving indifference curves. he will choose another bar of gold. The marginal utility of that first bar of gold is quite high. Thom still knows the relative values of gold and steak. diminishing returns simply means that the first hat Jim gets makes him happier than the second hat. as the numbers even out. Another example that illustrates the principle of diminishing returns would be the case in which you give Thom a choice between gold and steak. but it's still higher than the marginal utility he would get from a steak. with the added utility of each bar of gold being a little lower than the last. and then when they start moving to the other extreme. What this means is that each point on an indifference curve represents a combination of goods. Thom will start to get hungry. he won't really mind either way. One of Jim's Indifference Curves for Shirts and Hats In general. An hour later. Utility is typically represented on a graph in an indifference curve. One shirt and two hats makes him just as happy as two shirts and one hat. and so on. which makes him happier than the third. and be very excited to have a bar of gold. and if he gets hungry enough. he will probably choose the gold. he is indifferent. then he will choose the steak over the gold.
and any point on curve 3 will be preferable to any point on curves 1 or 2. and represents a higher level of utility. Different indifference curves represent different levels of utility. Thus. but curve two crosses curve 1. the happier you are. but a steak can make a large difference. but move further away from the origin with increased levels of utility. Thus. because curve 2 is further out than curve 1. Why is this true? Think about it this way: if curve 2 is supposed to make you happier than curve 1. more is better: the more goods you have.much gold that more gold makes very little difference. On the graph. you are experiencing two different levels of utility. as he is very hungry. then that means that at the point of intersection. Indifference Curves A few more important observations about one person's indifference curves: they can never cross. we see this preference for more as an indifference curve that is further away from the origin. that is. indifference curves never intersect. you are both happy and happier at the same time. any point on curve 2 will be preferable to any point on curve 1. which makes no sense. A Correct Set of Indifference Curves . and in general.
representing a higher level of utility. meaning that getting more or less of that good doesn't make them happier or unhappier? For instance. since we end up on a better indifference curve. This makes his indifference curves look like this: . How can we tell? Because more of either good increases utility. What if the consumer doesn't care about one of the goods. but an increase in the amount of Spam results in a decrease in utility. if one good is a normal good. Jim likes getting CDs. an increase in number of CDs causes an increase in utility. Starting on curve 1 and moving outwards (increasing the number of hats) or upwards (increasing the number of shirts) lands us on curve 2. For instance. and the other good is an undesirable good. such as CDs. replace the Spam with expired baseball tickets. Using different types of goods changes what indifference curves look like. such as Spam. the indifference curves will look like this. but really doesn't care how many expired baseball tickets he gets.An Incorrect Set of Indifference Curves The indifference curves we have been considering are for normal goods. with the second indifference curve being better than the first: Utility Curves for Normal and Undesirable Goods As you can see.
which means that when you have a lot of Pepsi. then you don't mind which one you get. Mittens are an extreme example of complementary goods: if you buy a right mitten. There is virtually no difference in your happiness whether you have one right mitten and one left mitten. only changing the number of CDs moves him to a different indifference curve.Indifference Curves for Normal and Neutral Goods Note that increasing or decreasing the number of baseball tickets makes no difference in his indifference curve. This shows up in the following indifference curves (note that only a simultaneous increase of right and left mittens will result in increased utility). those two goods are complementary. One example of perfect substitutes (though some might argue otherwise) could be Coke and Pepsi. Indifference Curves for Complementary Goods: Mittens What if the two goods being evaluated are pretty much the same? Such goods are called substitute goods: the buyer considers them to be interchangeable. More is still better. If you consider them to be the same thing. Demand for complementary goods is directly related. In other words. or two right mittens and one left mitten. Another instance in which indifference curves behave strangely is in the case of complementary goods. This results in indifference curves like this: . but you don't care what combination of the two you get. it is almost a sure bet that you'll buy a left mitten. buying one good increases the probability you'll buy the other good. you would not be willing to trade three cans of Pepsi for one can of Coke. eliminating the inward bend of the indifference curves. This also means that having extra stray mittens isn't likely to increase your utility.
it is simply a matter of finding out the maximum amount of the first good you can buy. and 2) the prices of the two goods being considered. then finding the maximum amount of the second good you can buy. given the amount of money she has. without buying any of the first. To draw a budget constraint. we can assume that a normal person will choose whichever combination will make them as happy as possible. Once you have both pieces of information. She is deciding how many bottles of wine and how many wine glasses she wants to buy. while the filled area includes all of her possible buying decisions. We can see this optimization if we draw in the consumer's budget constraint on the same graph as the consumer's indifference curves. without buying any of the second. then the most wine she can buy is ($100/$20)=5 bottles. If wine costs $20 a bottle and glasses cost $5 each. On the graph. Likewise. a line that shows the maximum amount of goods a buyer can purchase with their available funds. suppose Tina has $100. given their choices and their budget.Indifference Curves for Substitute Goods: Cola Utility Optimization While it is impossible to know exactly what goes on inside a buyer's head while they are making a decision. To illustrate. Mark these points on the graph and connect them. Anything not included in the colored area is out of her budget: . you need to know two things: 1) how much money they have. this means that they will choose whichever combination lands them on the highest indifference curve possible. Her budget constraint would look like the darker line. she can buy at most ($100/$5)=20 wine glasses.
In this case. never round up.Tina's Budget Constraint If we know her indifference curves. Why does it have to be the indifference curve that is tangent to her budget constraint? If it were an indifference curve that crosses her budget constraint. such as the first indifference curve. and use this tangent point as her optimal combination of wine and glasses. Optimizing Tina's Purchasing Decision It looks like Tina will buy about 12 wine glasses and 2 bottles of wine. such as the third indifference curve. (When doing such problems. For instance. we can draw her budget constraint in with them on the same graph. We can't pick a curve any further out. and 2 is all she can afford. By picking the outermost curve that still touches her budget constraint. she has to buy either 2 bottles or 3 bottles. if Tina now has $125 instead of $100. her new budget constraint will be a parallel shift out from her original budget constraint. it is the second indifference curve that optimizes her utility given her budget. budget constraints change with changes in income or price. we have maximized her utility. Obviously. Even though the optimal amount is a little more than 2 bottles. since that will land you outside of the budget constraints). it is simply a matter of finding the outermost indifference curve that is tangent to (just barely touches) her budget constraint. The yellow shaded region represents the increase in possible purchases she can make: . then we can see that the two points of intersection don't make her as happy as the single tangent point in the previous graph. since she can't afford to buy more than $100 worth of wine and glasses. After that.
Draw her budget constraint if she has $360. If soda goes on sale for $2 a bottle. her budget constraint will pivot to reflect this change: A Pivot in Tina's Budget Constraint Practice Problems Problem 3. and soda costs $3 a bottle.1: Kate has $12. Pretzels cost $2 a bag. DVD's cost $30 and CD's cost $15.A Shift in Tina's Budget Constraint On the other hand. [Solution] Problem 3. Draw her budget constraint.2: Jeannette has $300.3: J. if Tina still has only $100. but the price of wine changes from $20 a bottle to $10 a bottle.P.'s indifference curves for beer and movies look like this: . Draw her budget constraint for DVD's and CD's. what does her new budget constraint look like? [Solution] Problem 3.
J.4: Draw the indifference curves for cashmere sweaters and moth-eaten sweaters (assuming that moth-eaten sweaters are undesirable and cashmere sweaters are desirable). buyers must make a purchase decision without knowing exactly what they're getting for their money.5: Lawrence is looking for tables and chairs. buyers have to evaluate. how many tables and chairs will he buy if chairs cost $50 and tables cost $100? [Solution] Consumer Behavior in Uncertain Situations Choice Based on Expected Value In some cases. to their best ability. His indifference curves look like this: Lawrence's Indifference Curves He has $500 to spend.'s Indifference Curves Beer costs $4 and movies cost $6. Deciding whether or not to buy a good without knowing exactly what the good is worth involves some degree of risk. how much the goods are . To make these decisions. as there is variation in the possible outcome. [Solution] Problem 3.P. has $24.P. If J. how much of each will he buy? [Solution] Problem 3.
In order for Jevan to be able to calculate this expected value.5)(5) + (0. based on the probability of different outcomes. it could be a moderate success. so the probability of at least one of them occurring is equal to 1. each share will be worth $5.5 + 0. depending on how much he enjoys taking risks. since he believes it to be worth $5 a share.125)(20) + (0. making his stock worthless. moderate success. Because . What this means is that Jevan will not be willing to pay more than $5 a share for this stock. he can't be sure what will happen to the value of his stock as time passes. Jevan has to decide what is the most likely outcome. If Jevan thinks that there is a 1 in 8 chance that the startup will be a wild success. In the event of moderate success. making his stock somewhat valuable. In the event of huge success. and a 3 in 8 chance that it will fail. then he has accounted for all possible outcomes. How would we explain it if the price is lower than $5. Before he decides to buy any stock. so that the total probability will be equal to 1: let's assume that huge success. Jevan thinks that each share of stock will be worth $20. based on his assumptions about company performance. if Jevan is interested in buying stock in a new startup.375) = 1 Next Jevan has to assign values to each outcome. Jevan has to assign the stock an expected value to compare against the present price. a 1 in 2 chance that it will be a moderate success.really worth.125 + 0. In the event of failure. he needs to account for all possible outcomes. making his stock very valuable. but Jevan decides not to buy any stock? We know that he believes the stock to be worth $5. so we would expect him to buy stock if it is priced lower than $5 a share. He will probably be willing to buy stock if the price is lower than $5. multiply the probability of each event by the value of each event. The company could be a huge success. each share is worth $0. and what his stock is going to be worth: that is. This can be explained by Jevan's openness to taking risks. and sum the results: EV = (0. and failure are the only possible outcomes. or it could be a failure. since the combined probabilities are equal to 1: (0. Combining all of Jevan's assumptions gives us the following chart of his expectations: Jevan's Expectations for the Startup Stock's Performance To find out the expected value (EV) of the stock.375)(0) EV = $5 a share We find that Jevan expects the stock to be worth about $5. and then decide how much they are willing to pay for the goods. For example.
as with high risk investments. 50%. but have very large variation in possible outcomes. and Jevan's estimate is only an estimate. 30%. and stock with 0 expected value makes no difference to him at all. This would be an extreme case. $1. risk lovers will make investments that have positive expected values. he will make the purchase. not all risk lovers will invest in stocks with negative expected values. That is. the moderate yields of mutual funds. the payoff is usually higher. buyers must make their decisions based on probable outcomes and possible worth. if Jevan doesn't like taking risks. which is relatively high risk. or that it is a useless piece of junk. $5. If Jevan is risk-neutral. Even if the risk is very low. and Jevan still decides he wants to buy stock. 20%. and a high degree of predictability. even though he believes it to be worth only $5 a share. if the expected returns are negative. that is.1: Company A and Company B are both selling stock at $1 a share. and 10%. he will refuse to buy stock. the payoff is usually small. After making an estimate of expected value and assessing the risk involved. he will buy stock with positive expected value. This type of decision-making based on probable outcomes is used in many different situations: buyers decide how much they are willing to pay for a used car based on the different probabilities that it is in mint condition. buyers can then attempt to maximize their utility based on their individual preferences for goods. Students decide how much to study based on their expected performance after different amounts of studying. More commonly. and the low yields of government bonds. Even if the risk is very high. Art lovers base their decisions on the probabilities that the pieces they are looking at are genuine or forged. which are relatively moderate risk. $10. then he will not buy stock with negative expected value. if the price of the stock is over $5. Someone who is risk-averse will choose investments with little variation in possible outcomes. he is willing to enter into an expected loss on the off chance that the company will make it big. The "penalty" for taking a higher risk is the possibility of losing a lot of money if the investment fails. with respective probabilities of 20%. which are relatively low risk. as with low risk investments. that it needs minor repairs. Risk usually varies inversely with expected returns. if the expected returns are positive. and that the possible future values of B's stock are $0. and $20. and he thinks that the possible future values for Company A's stock are $0. with respective probabilities of 50%. a high risk investment will often yield a much higher potential payoff than a low risk investment. and 5%. We can see this discrepancy in the high yields (and losses) in the stock market. and when a payoff is uncertain. $1. which stock will he pick? [Solution] . he is not willing to invest in a "good" investment because he is still afraid of the possibility that he might lose money. and $100. if he is risk-averse. This difference in value can be seen as a "reward" for buyers' willingness to take a higher risk. then it may mean that he is riskloving. If risk-neutral Kenny wants to buy stock in either Company A or Company B. In any case where the exact value of a good is unclear. On the other hand. Practice Problems Problem 4. even if the expected returns are positive. When a payoff is guaranteed.the future price of the stock is uncertain. then he may choose not to buy any stock. 15%.
and 1%? [Solution] . $1. with respective probabilities of 50%. and $200. 24%. $5. and which are low risk? Gold Stocks in new companies IRA's Savings bonds Lottery tickets [Solution] Problem 4.4: If the current price of a stock is $7 a share. and $60 with respective probabilities of 25%. $5. 50%. $10. 20%. $10. $2.3: What is the expected value of a stock whose possible future values are $0.2: Which of the following are high risk investments. with respective probabilities of 10%.5: What is the maximum price that risk-neutral Tamara will be willing to pay for a stock which she believes has possible future values of $0. and $50. 20%. and 5%? [Solution] Problem 4. 50%.Problem 4. $10. and 5%? [Solution] Problem 4. 25%. 15%. will risk-neutral Andy buy any stock if he believes that the possible future values are $0.
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