Chapter One

Lecture Outline

Recall Supply and Demand

Law of Demand – When the price goes up, the quantity demanded goes down.
(Negative correlation)
-Economists believe that the law of demand is nearly always true.

Factors affecting demand – Income, Tastes & Preferences, Price of

related goods (complements & substitutes), Price expectations

Law of Supply – When the price goes up, the quantity supplied goes up.
(Directly related)

Factors affecting supply – Input prices, Technology, Price expecations

Equilibrium

Sales tax – Causes the demand curve to shift downward parallel to itself by the amount
of the tax.
-Imposing a sales tax reduces the equilibrium quantity. A sales tax of 5 cents per
item causes the equilibrium price to fall by some amount less than 5 cents per item.

Excise tax – A tax on suppliers of goods. It causes the supply curve to ship upward
parallel to itself by the amount of the tax.
-It will affect the equilibrium by the price rising by an amount less than 5 cents.

Who bears the burden of the tax? – Supplier. If you are a demander, would
you choose to have an excise tax of 5 cents or a sales tax of 5 cents? The price to
demanders in both situations is equal.

It doesn’t matter where the tax is legally collected.

Who bears more of the burden?

Elasticity – Measure of responsiveness
-Tells us how responsive consumers are to a change in price
- For a given elasticity of supply, the more elastic the demand
curve, the smaller proportion of the tax is paid by the buyer.
-When demand is very inelastic, buyers pay more of the tax
-When demand is perfectly inelastic, the buyers pay 100% of tax.
-When demand is elastic, buyers pay a little tax
-When demand is perfectly elastic, the sellers pay 100% of tax.

Chapters Three and Four

Lecture Outline
Assumption of rational behavior by consumers – Consumers behave rationally to try
and better ourselves by the interpretation of their actions.
- Individuals engage in activities because we are trying to achieve some “end”
-Purposeful behavoir

Economics: a general theory of human action – The study of human choice

Consumer choice
Wants – unlimited
Resources – scarce

Preferences
Assume:
At the moment of choice, there is a set of feasible alternatives
And
The chooser can rank his or her preferences over those alternatives
-People rank in an ordinal way (1st, 2nd, 3rd, 4th, etc.)

Preferences over two goods must satisfy two axioms and one assumption:
Axiom of Completeness

Axiom of Transitivity – If A is preferred to B, B is preferred to C, then A is

preferred to C.

Assumption of Non-satiation – Preferences: more is better than less,

preference is in a North East.

Indifference curves – An individual’s preference on a basket of goods is indifferent

-They can NEVER cross (Axiom of Transitivity)
-Can tell us whether certain trades are desirable
-Convex
-Determines a consumers tastes

Slope of indifference curve – Marginal value is the slope of the indifference curve (the
marginal value that you place on good X is defined to be the number of Ys for which
you’d be just willing to trade one X)

Marginal Rate of Substitution (Landsburg calls this marginal value)

Convexity of indifference curves – We assume they are convex.

Indifference map -

Note ordinal ranking, not cardinal values

Direction of increasing preference

Preferences and indifference
Indifference curves cannot cross

Special cases:
perfect substitutes
perfect complements
economic “bad”

Constraint: budget line shows a basket of what the consumer can afford
Equation = Px times x + Py times y = I
Px = the price of X in dollars
x = quantity of good x
Py = the price of Y in dollars
y = quantity of good y
I = Income
Slope of constraint

Changes in prices and income

-A change in income causes a parallel shift of the budget line
-A change in the price of X causes the budget line to pivot around its Y-intercept
-A rise in the price of X causes the budget line to pivot inward
-A fall in the price of X causes the budget line to pivot outward

Consumer’s optimal choice - The basket the consumer chooses will always be
located where his budget line is tangent to one of his indifference curves.

MRSyx = Px / Py

Corner solutions – When the consumer’s optimum occurs in a corner of the diagram.
The consumer would spend all of his income on one good and none on the other.
-If a consumer has a nonconvex indifference curve he will end up with a corner
solution

Comparative statics

Own-price changes

Demand curve for individual

Price elasticity of demand = Percent Change in quantity / Percent Change in Price

-Highly elastic when the price elasticity of demand has a large absolute value

Cross price changes (subs and comps)

Cross price elasticity of demand – Demand for X changes because the price of some
other good Y
-The percent change in consumption of X divided by the percent change in the
price of Y
-If demand for X with respect to Y is positive, X and Y are substitutes
-If negative, compliments
Income changes
normal good – When income rises, if X increases respectively it is normal.
inferior good – When income rises, if X decreases it is an inferior good.

effects of a price increase (Exhibit 4.11 on p. 95)??

substitution effect – When the price of a good rises, you adjust your
consumption downward so as to avoid buying goods whose price is now above their
marginal value.
income effect – When the price of a good goes up, the income effect leads you
to consume either less of it (normal good) or more of it (inferior good).
-A price increase in a sense makes you poorer.
decomposition of a price change
in-kind transfers
Christmas is inefficient

Recall that elasticity ≠ slope

Suggested study:
Review questions Ch 3 (p. 67): R1, R3, R5, R9
Review questions Ch 4 (pp. 103-104): R1, R2, R4, R6, R7, R8, R15