CHAPTER 03 - PHALL-82241 PINDYCK CHAPTER 03 page 4 of 26...

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Unformatted text preview: PHALL-82241 PINDYCK CHAPTER 03 page 4 of 26 FIGURE 3.1 DESCRIBING INDIVIDUAL PREFERENCES Clothing (units per week) 50 •B 40 •H A • 30 20 •E •G •D 10 10 20 30 40 Food (units per week) Because more of each good is preferred to less, we can compare market baskets in the shaded areas. Basket A is clearly preferred to Basket G, while E is clearly preferred to A. However, A cannot be compared with B, D, or H without additional information. Fig 03-01.EPS PHALL-82241 PINDYCK CHAPTER 03 page 5 of 26 FIGURE 3.2 AN INDIFFERENCE CURVE Clothing (units per week) B 50 40 H E A 30 D 20 G U1 10 10 20 30 Food 40 (units per week) The indifference curve U1 that passes through market basket A shows all baskets that give the consumer the same level of satisfaction as does market basket A; these include baskets B and D. Our consumer prefers basket E, which lies above U1, to A, but prefers A to H or G, which lie below U1. Fig 03-02.EPS PHALL-82241 PINDYCK CHAPTER 03 FIGURE 3.3 AN INDIFFERENCE MAP Clothing (units per week) D B A U3 U2 U1 Food (units per week) An indifference map is a set of indifference curves that describes a person's preferences. Any market basket on indifference curve U3, such as basket A, is preferred to any basket on curve U2 (e.g., basket B), which in turn is preferred to any basket on U1, such as D. Fig 03-03.EPS page 6 of 26 PHALL-82241 PINDYCK CHAPTER 03 FIGURE 3.4 INDIFFERENCE CURVES CANNOT INTERSECT Clothing (units per week) U2 U1 A B D Food (units per week) If indifference curves U1 and U2 intersect, one of the assumptions of consumer theory is violated. According to this diagram, the consumer should be indifferent among market baskets A, B, and D. Yet B should be preferred to D because B has more of both goods. Fig 03-04.EPS page 7 of 26 PHALL-82241 PINDYCK CHAPTER 03 page 8 of 26 FIGURE 3.5 THE MARGINAL RATE OF SUBSTITUTION A Clothing 16 (units per week) 14 –6 12 B 10 1 8 –4 D 6 1 –2 4 E 1 G –1 1 2 1 2 3 4 5 Food (units per week) The magnitude of the slope of an indifference curve measures the consumer's marginal rate of substitution (MRS) between two goods. In this figure, the MRS between clothing (C) and food (F) falls from 6 (between A and B) to 4 (between B and D) to 2 (between D and E) to 1 (between E and G). When the MRS diminishes along an indifference curve, the curve is convex. Fig 03-05.EPS PHALL-82241 PINDYCK CHAPTER 03 page 9 of 26 FIGURE 3.6 PERFECT SUBSTITUTES AND PERFECT COMPLEMENTS (a) Perfect Substitutes Apple juice 4 (glasses) (b) Perfect Complements Left shoes 4 3 3 2 2 1 1 0 1 2 3 4 Orange juice (glasses) 0 1 2 3 4 Right shoes In (a), Bob views orange juice and apple juice as perfect substitutes: He is always indifferent between a glass of one and a glass of the other. In (b), Jane views left shoes and right shoes as perfect complements: An additional left shoe gives her no extra satisfaction unless she also obtains the matching right shoe. Fig 03-06.EPS PHALL-82241 PINDYCK CHAPTER 03 page 10 of 26 FIGURE 3.7 PREFERENCES FOR AUTOMOBILE ATTRIBUTES Space (cubic feet) Space (cubic feet) 120 120 100 100 80 80 60 60 40 40 20 20 50 100 150 (a) 200 250 Acceleration (horsepower) 50 100 150 (b) 200 250 Acceleration (horsepower) Preferences for automobile attributes can be described by indifference curves. Each curve shows the combination of acceleration and interior space that give the same satisfaction. Owners of Ford Mustang coupes (a) are willing to give up considerable interior space for additional acceleration. The opposite is true for owners of Ford Explorers (b). Fig 03-07.EPS PHALL-82241 PINDYCK CHAPTER 03 page 11 of 26 FIGURE 3.8 UTILITY FUNCTIONS AND INDIFFERENCE CURVES Clothing (units per week) 15 10 D A 5 U 3 � 100 B 5 10 U 2 � 50 U 1 � 25 Food 15 (units per week) A utility function can be represented by a set of indifference curves, each with a numerical indicator. This figure shows three indifference curves (with utility levels of 25, 50, and 100, respectively) associated with the utility function FC. Fig 03-08.EPS PHALL-82241 PINDYCK CHAPTER 03 page 12 of 26 FIGURE 3.9 INCOME AND HAPPINESS 9 Satisfaction with life 8 7 6 5 4 3 0 5000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 GDP per capita in 1996 U.S. $ A cross-country comparison shows that individuals living in countries with higher GDP per capita are on average happier than those living in countries with lower per-capita GDP. Fig 03-09.EPS PHALL-82241 PINDYCK CHAPTER 03 FIGURE 3.10 A BUDGET LINE Clothing (units per week) A ( I/PC ) = 40 Budget Line F + 2C = $80 B 30 10 D 20 20 Slope ∆C/∆F = – 1 = – PF/PC 2 E 10 G 0 20 40 60 80 = ( I/PF) Food (units per week) A budget line describes the combinations of goods that can be purchased given the consumer’s income and the prices of the goods. Line AG (which passes through points B, D, and E) shows the budget associated with an income of $80, a price of food of PF = $1 per unit, and a price of clothing of PC = $2 per unit. The slope of the budget line (measured between points B and D) is PF/PC = 10/20 = 1/2. Fig 03-10.EPS page 13 of 26 PHALL-82241 PINDYCK CHAPTER 03 page 14 of 26 FIGURE 3.11 EFFECTS OF A CHANGE IN INCOME ON THE BUDGET LINE Clothing (units per week) 80 60 40 20 L3 L1 L2 ( I = $40) ( I = $80) 40 80 ( I = $160) 120 160 Food (units per week) A change in income (with prices unchanged) causes the budget line to shift parallel to the original line (L1). When the income of $80 (on L1) is increased to $160, the budget line shifts outward to L2. If the income falls to $40, the line shifts inward to L3. Fig 03-11.EPS PHALL-82241 PINDYCK CHAPTER 03 FIGURE 3.12 EFFECTS OF A CHANGE IN PRICE ON THE BUDGET LINE Clothing (units per week) 40 L3 L1 (PF = 2) 40 L2 (PF = 1) 80 120 (P F = 1 ) 2 Food 160 (units per week) A change in the price of one good (with income unchanged) causes the budget line to rotate about one intercept. When the price of food falls from $1.00 to $0.50, the budget line rotates outward from L1 to L2. However, when the price increases from $1.00 to $2.00, the line rotates inward from L1 to L3. Fig 03-12.EPS page 15 of 26 PHALL-82241 PINDYCK CHAPTER 03 page 16 of 26 FIGURE 3.13 MAXIMIZING CONSUMER SATISFACTION Clothing (units per week) 40 B 30 D –10C A 20 +10F U3 U2 U1 20 40 80 Budget Line Food (units per week) A consumer maximizes satisfaction by choosing market basket A. At this point, the budget line and indifference curve U2 are tangent, and no higher level of satisfaction (e.g., market basket D) can be attained. At A, the point of maximization, the MRS between the two goods equals the price ratio. At B, however, because the MRS [ (10/10) = 1] is greater than the price ratio (1/2), satisfaction is not maximized. Fig 03-13.EPS PHALL-82241 PINDYCK CHAPTER 03 page 17 of 26 FIGURE 3.14 CONSUMER CHOICE OF AUTOMOBILE ATTRIBUTES Size (cubic feet) $10,000 Size (cubic feet) $10,000 $7500 $3000 $7000 $10,000 Acceleration (horsepower) (a) $2500 $10,000 Acceleration (horsepower) (b) The consumers in (a) are willing to trade off a considerable amount of interior space for some additional acceleration. Given a budget constraint, they will choose a car that emphasizes acceleration. The opposite is true for consumers in (b). Fig 03-14.EPS PHALL-82241 PINDYCK CHAPTER 03 page 18 of 26 FIGURE 3.15 A CORNER SOLUTION Frozen yogurt (cups per month) A U1 U2 U3 B Ice cream (cups per month) When the consumer’s marginal rate of substitution is not equal to the price ratio for all levels of consumption, a corner solution arises. The consumer maximizes satisfaction by consuming only one of the two goods. Given budget line AB, the highest level of satisfaction is achieved at B on indifference curve U1, where the MRS (of ice cream for frozen yogurt) is greater than the ratio of the price of ice cream to the price of frozen yogurt. Fig 03-15.EPS PHALL-82241 PINDYCK CHAPTER 03 page 19 of 26 FIGURE 3.16 A COLLEGE TRUST FUND Other consumption ($) C P B U3 U2 A U1 Q Education ($) When given a college trust fund that must be spent on education, the student moves from A to B, a corner solution. If, however, the trust fund could be spent on other consumption as well as education, the student would be better off at C. Fig 03-16.EPS PHALL-82241 PINDYCK CHAPTER 03 FIGURE 3.17 REVEALED PREFERENCE: TWO BUDGET LINES Clothing (units per month) l1 l2 A B D Food (units per month) If an individual facing budget line l1 chose market basket A rather than market basket B, A is revealed to be preferred to B. Likewise, the individual facing budget line l2 chooses market basket B, which is then revealed to be preferred to market basket D. Whereas A is preferred to all market baskets in the green-shaded area, all baskets in the pink-shaded area are preferred to A. Fig 03-17.EPS page 20 of 26 PHALL-82241 PINDYCK CHAPTER 03 page 21 of 26 FIGURE 3.18 REVEALED PREFERENCE: FOUR BUDGET LINES Clothing (units per month) l3 l1 E l4 l2 A B G Food (units per month) Facing budget line l3 the individual chooses E, which is revealed to be preferred to A (because A could have been chosen). Likewise, facing line l4, the individual chooses G which is also revealed to be preferred to A. Whereas A is preferred to all market baskets in the green-shaded area, all market baskets in the pink-shaded area are preferred to A. Fig 03-18.EPS PHALL-82241 PINDYCK CHAPTER 03 page 22 of 26 FIGURE 3.19 REVEALED PREFERENCE FOR RECREATION Other recreational 100 activities ($) 80 60 40 C A B U1 U2 20 l1 0 25 l2 50 75 Amount of exercise (hours) When facing budget line l1, an individual chooses to use a health club for 10 hours per week at point A. When the fees are altered, she faces budget line l2. She is then made better off because market basket A can still be purchased, as can market basket B, which lies on a higher indifference curve. Fig 03-19.EPS PHALL-82241 PINDYCK CHAPTER 03 page 23 of 26 FIGURE 3.20 MARGINAL UTILITY AND HAPPINESS 8.2 8 Satisfaction with Life 7.8 7.6 7.4 7.2 7 6.8 0 10000 20000 30000 40000 50000 60000 70000 80000 90000 100000 Income in 1999 U.S. $ A comparison of mean levels of satisfaction with life across income classes in the United States shows that happiness increases with income, but at a diminishing rate. Fig 03-20.EPS PHALL-82241 PINDYCK CHAPTER 03 page 24 of 26 FIGURE 3.21 INEFFICIENCY OF GASOLINE RATIONING Spending on other 20,000 goods ($) 18,000 A D C 15,000 U2 U1 E 0 2000 B 5000 20,000 Gasoline (gallons per year) When a good is rationed, less is available than consumers would like to buy. Consumers may be worse off. Without gasoline rationing, up to 20,000 gallons of gasoline are available for consumption (at point B). The consumer chooses point C on indifference curve U2, consuming 5000 gallons of gasoline. However, with a limit of 2000 gallons of gasoline under rationing (at point E), the consumer moves to D on the lower indifference curve U1. Fig 03-21.EPS PHALL-82241 PINDYCK CHAPTER 03 page 25 of 26 FIGURE 3.22 COMPARING GASOLINE RATIONING TO THE FREE MARKET Spending on other goods ($) A D G F U1 0 10,000 15,000 20,000 Gasoline (gallons per year) If the price of gasoline in a competitive market is $2.00 per gallon and the maximum consumption of gasoline is 10,000 gallons per year, the woman is better off under rationing (which holds the price at $1.00 per gallon), since she chooses the market basket at point F, which lies below indifference curve U1 (the level of utility achieved under rationing). However, she would prefer a free market if the competitive price were $1.50 per gallon, since she would select market basket G, which lies above indifference curve U1. Fig 03-22.EPS PHALL-82241 PINDYCK CHAPTER 03 page 26 of 26 FIGURE 3.23 COST-OF-LIVING INDEXES Books (per quarter) U1 25 20 A 15 10 B l3 5 0 l1 50 l2 100 150 200 250 300 350 400 450 500 550 600 Food (lb. per quarter) A price index, which represents the cost of buying bundle A at current prices relative to the cost of bundle A at base-year prices, overstates the ideal cost-of-living index. Fig 03-23.EPS ...
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This note was uploaded on 09/28/2011 for the course ECON 105 taught by Professor Prof.eco during the Spring '11 term at Indian School of Business.

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