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PE powerpoint Part BW 3

# PE powerpoint Part BW 3 - Public Economics Principles and...

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Public Economics Principles and Practice Part 3 Economic Evaluation and Public Policy Peter Abelson Applied Economics and University of Sydney

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Chapter 6 Valuing Individual Preferences “Utility and its measurement lies at the heart of political economy” Jules Dupuit Nature of Individual Preferences and Utility Deriving Demand Curves from Preferences and Budget Constraints Valuation Principles From Valuation Principles to Practice
Nature of Individual Preferences and Utility Issues in valuing preferences A good starting point: willingness to pay (WTP) = marginal benefit (MB) = opportunity cost. Complications WTP (or MB) varies with quantity consumed, so we need to know demand curve or major parts of it; WTP is also a f(income) Income (welfare) varies along a demand curve There is no observed price for non-marketed goods.

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Individual preferences and utility Preferences can be inferred from choices. Individuals may be indifferent between combinations of goods or prefer one combination to another. These preferences can be depicted in figures (see Figures 6.1 or 6.2) for any kind of trade-off or in utility equations (6.1 or 6.2).
Various indifference curves

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The marginal rate of substitution MRS yx is the marginal amount of good y that an individual is willing to sacrifice in order to obtain a unit increase in good x . This is shown by slope of curve. A convex curve implies a diminishing marginal rate of substitution. A linear curve implies complete substitutes.
Utility functions A utility function assigns a numerical value to each consumption bundle. This number is ordinal and arbitrary. Suppose that q x and q y are quantities of goods x and y , a simple linear utility function could be: U = u(q x , q y ) = q x + q y Alternatively a Cobb-Douglas utility function could be like the following: U = u(q x , q y ) = q x a q y 1-a = q x 0.7 q y 0.3

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Deriving Demand Curves To derive a demand curve we need also to know the budget constraint, relative prices, and the effect of a change in relative prices. A budget line shows how many goods an individual can consume and the rate at which an individual can trade good x for good y . An indifference curve shows the MRS, the marginal rate at which an individual is willing to trade good x for good y .
Deriving a demand curve (cont.) Each individual maximises their utility by equating their MRS with the slope of the budget line. He or she does this for each budget line, which varies with changes in relative prices. This process is shown in Figures 6.3 and 6.4. The latter shows the price consumption path that is the basis for the demand curve.

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The consumption bundle that maximises utility
The price consumption path

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Deriving demand functions Formally, an individual chooses q x and q y to maximise utility U( q x ,q y ) subject to a budget constraint (M= p x .q x + p y .q y ).
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