Lecture3

# Lecture3 - Econ 208 Lecture 3 Utility and Demand page 1...

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Econ 208 Lecture 3 Utility and Demand page 1 Lecture3: Utility as an explanation of Demand Budget Lines and Opportunity Cost The calculation is the number of dollars per loaf (\$10) divided by the number of dollars per apple (\$5). 5 \$ / 10 \$ / \$ / \$ / = = Apple Loaf Loaf Apples Or P b /P a . If you go through this exercise in your head, you will never get it wrong. To repeat: if we want to determine the opportunity cost of B in terms of A, divide the price of B by the price of A. If you want to find the opportunity cost of A in terms of B, divide the price of A by the price of B. Changes in Price and the Law of Demand Suppose the price of bread falls to \$5, but apples stays the same. What does the budget line look like. Graph here. Max loafs now 20. P b/ P b = 1. Let’s look at this graph. Note that it rotates out from the end point on the Apple Axis. There is more consumption of both products possible except at the end point for A. In a very meaningful sense, this implies an increase in real income , because a household who consumes more than just A can increase consumption of one or both goods. Hold that thought.

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Econ 208 Lecture 3 Utility and Demand page 2 Let’s take a different case. Suppose that our household starts out with an Endowment of 10 apples and 5 loaves of bread. Note that it is on the budget line, since 10*5 + 5*10 = 100, the proposed money income. Suppose now that the household can actually exchange these goods in the market at the quoted prices. That means it can ‘move’ anywhere on the line between the two end points. We could say that in principle, it can choose which combination it would prefer. Now, suppose that the price of loaves falls to \$5.00 as before. What does the new budget line look like. We start at point (10A, 5B). At the new price the household gets 1 loaf per apple rather than a half loaf. Starting at 10 apples, if it sells all its apples, it can add 10 loaves, or to 15 apples at a fixed rate. [draw line] What about the other way. Previously a household that gave up a loaf got 2 apples in exchange. Now it only gets 1 apple because the loaf is worth only half as much. [draw line]
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