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# Ch05 - Chapter 5 The Theory of Demand The Effects of a...

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Chapter 5 The Theory of Demand

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The Effects of a Change in Price Suppose a consumer purchases only food and clothing. The price of clothing P y = \$4 and this consumer’s income is \$40. If the price of food is P x = \$4, the consumer’s optimal basket is A , x = 2 and y = 8. What happens to the consumer’s choice of food when the price of food changes? (income and the prices of clothing remain constant) Suppose: If the price of food is P x = \$2, the consumer’s optimal basket is B , x = 10 and y = 5. If the price of food is P x = \$1, the consumer’s optimal basket is C , x = 16 and y = 6. Price consumption curve: The set of utility-maximizing baskets as the price of one good varies (holding constant income and the prices of other goods)
The Effects of a Change in Price

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The Effects of a Change in Price We can use the optimal choice diagram to draw the demand curve. A decrease in the price of food leads the consumer to move down and to the right along her demand curve. Suppose the consumer is at the optimal basket A . Marginal rate of substitution of x for y is MRS x,y = 1. The consumer is willing to give up a unit of clothing for another unit of food. The price of clothing is \$4, the value of an additional unit of food is also \$4. The consumer is willing to pay \$4 for another unit of food. The demand curve is also a “Willingness to Pay” curve. MRS x,y falls to 1/2 at basket B, falls to 1/4 at basket C . Consumer’s willingness to pay falls as she buys more and more food.
Suppose the price of food is P x = \$2 and the price of clothing is P y = \$4. If the income is I 1 = \$40, the consumer chooses basket A , consuming x = 10 and y = 5. What happens to the consumer’s choices as income changes? (prices remain constant) Suppose If I 2 = \$68, she chooses basket B , consuming x = 18 and y = 8. If I 3 = \$92, she chooses basket C , consuming x = 24 and y = 11. Income consumption curve: The set of utility-maximizing baskets as income varies (and prices are held constant). An increase in income results in a rightward shift in

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Ch05 - Chapter 5 The Theory of Demand The Effects of a...

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