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L5Choices

# L5Choices - Introduction to Microeconomics Lecture 5...

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Introduction to Microeconomics Lecture 5 Choices in Action Ian Crawford

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Review Consumers choose the set of goods they most prefer, out of the set of goods they can afford. We use utility functions/indifference curves to give formal content to “most prefer” We use budget sets/constraints to give formal content to “can afford”.
Review In due course this becomes a constrained maximisation problem which you can solve mathematically “Maximise utility, subject to the budget constraint.” So far you’ve learned how to solve the problem graphically for two goods ... ( 29 1 2 1 2 1 1 2 2 , ,..., max , ,..., subject to ... n n n n x x x u x x x p x p x p x m + + +

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Review 0 x 1 x 2 Optimal choice * 1 x ( 29 * 2 * 1 , x x * 2 x Sub-optimal choice #2 Sub-optimal choice #1
Review Given an indifference curve map you can change prices and income and work out the demands each time: Keep this up and you’ll map out the Marshallian Demand Functions { } { } { } { } { } { } 1 2 1 2 1 2 1 2 1 2 1 2 , , , , , , ˆ ˆ ˆ ˆ ˆ , , , p p m x x p p m x x p p m x x % % % % % ( 29 ( 29 1 1 2 2 1 2 , , , , x p p m x p p m

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Outline Properties of Marshallian Demands Measuring changes - elasticities Income Changes Price Changes Decomposing price changes Substitution and income effects The Slutsky Equation Modelling the labour supply (leisure demand) decision - the Working Tax Credit [we may not get this far today]
Measuring the Effects of Change – “Elasticities” y depends upon x: Change x a bit: Look at the change in y: We could compare and to measure responsiveness, but the answer would depend on the units. Economists use “elasticities” instead / Proportional change in The elasticity of : / Proportional change in yx y y y x y x x x ε = = ( 29 y f x = ( 29 x x x = - ( 29 y y y = - y x

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Measuring the Effects of Change – “Elasticities” Take a Marshallian demand function: 1 1 1 2 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 1 1 1 1 1 / The own price elasticity of demand : / / The cross price elasticity of demand : / / The income elasticity of demand : / x p x p x m x x x p p p p x x x x p p p p x x x x m m m m x ε ε ε = = = = = = ( 29 1 1 2 , , x p p m
0 x 1 x 2 Measuring the Effects of Change – Income Elasticities 1 x 2 x 1 2 1 1 2 2 / 0 0 / 0 / 0 0 / 0 x m x m x x m m x x m m ε ε = = = = Both are “ Normal goods

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x 1 x 2 0 1 x 2 x Measuring the Effects of Change – Income Elasticities 1 2 1 1 2 2 / 0 0 / 0 / 0 0 / 0 x m x m x x m m x x m m ε ε < = = < = = is a normal good Is an “Inferior Good” x 1 x 2
Measuring the Effects of Change – Income Elasticities 0 Inferior Goods 1 Normal Goods “Necessities” “Luxuries” Income Elasticities 0 i x m ε < 0 i x m ε 0 1 i x m ε < < 1 i x m ε <

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x 1 x 2 Measuring the Effects of Change – Price Elasticities 0 1 x The price of good 1 falls. Demand for good 1 rises 1 1 1 1 1 1 / 0 0 / 0 x p x x p p ε = = < < Good 1 is an “Ordinary Good”
x 1 x 2 Measuring the Effects of Change – Price Elasticities 0 1 x The price of good 1 falls. Demand for good 1 falls (!) 1 1 1 1 1 1 / 0 0 / 0 x p x x p p ε = = < Good 1 is a “Giffen Good”

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