2 markets demand and supply
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7/31/2019 2 Markets Demand and Supply
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Backgroundto Demand
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Background to Demand
Marginal Utility Theory
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Total and marginal utility
meaning of total utility
marginal utility: TU/Q
diminishing marginal utility
total and marginal utility curves
MARGINAL UTILITY THEORY
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-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TU
in utils
01
23456
07
1113141413
Utility(utils)
Packets of crisps consumed (per day)
Darrens utility from consuming crisps (daily)
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-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TU
in utils
01
23456
07
1113141413
Utility(utils)
Packets of crisps consumed (per day)
TU
Darrens utility from consuming crisps (daily)
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-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TU
in utils
01
23456
07
1113141413
MU
in utils
-7
4210
-1
Utility(utils)
Packets of crisps consumed (per day)
TU
Darrens utility from consuming crisps (daily)
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-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
Packetsof crisps
TU
in utils
01
23456
07
1113141413
MU
in utils
-7
4210
-1
Utility(utils)
Packets of crisps consumed (per day)
TU
MU
Darrens utility from consuming crisps (daily)
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-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6MU
TU= 2
Q= 1
MU = TU / Q
Utility(utils)
Packets of crisps consumed (per day)
TU
Darrens utility from consuming crisps (daily)
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-2
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6MU
MU = TU / Q= 2/1 = 2
Utility(utils)
Packets of crisps consumed (per day)
TU
TU= 2
Q= 1
Darrens utility from consuming crisps (daily)
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The optimum level of consumption: the one-commodity version
consumer surplus (total and marginal)
marginal consumer surplus: MU
P
total consumer surplus: TU TE
MARGINAL UTILITY THEORY
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MU
P1
Q1O
MU, P
Q
Consumer surplus
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Total
consumerexpenditure MU
P1
Q1O
MU, P
Q
Consumer surplus
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Total
consumerexpenditure MU
Totalconsumer
surplusP1
Q1
MU, P
QO
Consumer surplus
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The optimum level of consumption: the one-commodity version
consumer surplus (total and marginal)
marginal consumer surplus: MU
P
total consumer surplus: TU TE
maximising consumer surplus: P = MU
Marginal utility and the demand curve
MARGINAL UTILITY THEORY
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MU = D
MU, P
QO Q1
P1a
Consumption atQ1
where P1 = MU
Deriving an individual persons demand curve
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Q2O
P1
Q1
a
P2
b
Consumption at Q2where P2= MU
MU, P
Q
MU = D
Deriving an individual persons demand curve
D i i i di id l d d
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P2
Q2O
P1
Q3Q1
a
P3c
Consumption at Q3where P3= MU
b
MU, P
Q
MU = D
Deriving an individual persons demand curve
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Limitations of the one-commodity versionmarginal utility affected by consumption of
other goods
marginal utility of money not constant Optimum combination of goods
the equi-marginal principle
MUA/MUB= PA/PB
deriving a demand curve
MARGINAL UTILITY THEORY
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Background to Demand
Risk, Uncertainty andInsurance
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Demand under conditions of risk anduncertainty
defining risk and uncertainty
types of odds
risk attitudes
Diminishing marginal utility of income andattitudes towards risk taking
RISK, UNCERTAINTY AND INSURANCE
T t l tilit f i
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TU
5000 10 000 15 0000
Income ()
Totalutility
U1
Total utility of income
a
T t l tilit f i
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TU
5000 10 000 15 0000
U2
U1
a
b
Income ()
Totalutility
Total utility of income
T t l tilit f i
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TU
5000 10 000 15 0000
U3
U2
U1
a
b
c
Income ()
Totalutility
Total utility of income
Total tilit of income
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TU
5000 10 000 15 0000 8000
U3
U2
U1
U4
a
b
c
Income ()
Totalutility
d
Total utility of income
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Insurance: a way of removing risks
How insurers spread risks
the law of large numbers
importance of the independence of risks
Problems for insurers
adverse selection
moral hazard
RISK, UNCERTAINTY AND INSURANCE
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Background to Demand
Indifference Analysis
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Indifference curves constructing an indifference curve
INDIFFERENCE ANALYSIS
Constructing an indifference curve
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Pears
3024201410
8
6
Oranges
678
101315
20
Point
abcdef
g
Combinations of pears andoranges that Clive likes
the same amount as
10 pears and 13 oranges
Constructing an indifference curve
Constructing an indifference curve
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0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
0 2 4 6 8 10 12 14 16 18 20 22
Pe
ars
Oranges
Pears
3024201410
8
6
Oranges
678
101315
20
Point
abcdef
g
Constructing an indifference curve
Constructing an indifference curve
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a
Pe
ars
Oranges
Pears
3024201410
8
6
Oranges
678
101315
20
Point
abcdef
g
Constructing an indifference curve
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
0 2 4 6 8 10 12 14 16 18 20 22
Constructing an indifference curve
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a
b
Pe
ars
Oranges
Pears
3024201410
8
6
Oranges
678
101315
20
Point
abcdef
g
Constructing an indifference curve
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
0 2 4 6 8 10 12 14 16 18 20 22
Constructing an indifference curve
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a
b
c
d
ef
g
Pears
Oranges
Pears
3024201410
8
6
Oranges
678
101315
20
Point
abcdef
g
Constructing an indifference curve
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
0 2 4 6 8 10 12 14 16 18 20 22
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Deriving the marginal rate of substitution (MRS)
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0
10
20
30
0 10 206
26
7
Unitso
fgoodY
Units of good X
a
bY= 4
X= 1
MRS= 4
MRS= Y/X
Deriving the marginal rate of substitution (MRS)
Deriving the marginal rate of substitution (MRS)
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0
10
20
30
0 10 20
a
b
Unitso
fgoodY
Units of good X
26
6 7
d
Y= 4
X= 1
Y =1
X= 1
MRS= 1
MRS= 4
13
14
9
c
MRS= Y/X
Deriving the marginal rate of substitution (MRS)
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An indifference map
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0
10
20
30
0 10 20
Unitso
fgoodY
Units of good X
I1I2
I3
I4
I5
An indifference map
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Indifference curves constructing an indifference curve
the shape of an indifference curve
diminishing marginal rate of substitutionan indifference map
The budget line
constructing a budget line
INDIFFERENCE ANALYSIS
A budget line
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Units of
good X
05
1015
Units of
good Y
3020100
Assumptions
PX=2
PY= 1Budget = 30
A budget line
A budget line
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Unitso
fgoodY
Units of good X
a
Units of
good X
05
1015
Units of
good Y
3020100
Assumptions
PX=2
PY= 1Budget = 30
Point on
budget line
a
A budget line
0
10
20
30
0 5 10 15 20
A budget line
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Unitso
fgoodY
Units of good X
a
b
Units of
good X
05
1015
Units of
good Y
3020100
Point on
budget line
ab
Assumptions
PX=2
PY= 1Budget = 30
A budget line
0
10
20
30
0 5 10 15 20
A budget line
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Unitso
fgoodY
Units of good X
a
b
c
Units of
good X
05
1015
Units of
good Y
3020100
Point on
budget line
abc
Assumptions
PX=2
PY= 1Budget = 30
A budget line
0
10
20
30
0 5 10 15 20
A budget line
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Unitso
fgoodY
Units of good X
a
b
c
d
Units of
good X
05
1015
Units of
good Y
3020100
Point on
budget line
abcd
Assumptions
PX=2
PY= 1Budget = 30
A budget line
0
10
20
30
0 5 10 15 20
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Indifference curves constructing an indifference curve
the shape of an indifference curve
diminishing marginal rate of substitutionan indifference map
The budget line
constructing a budget line
effect of a change in income
INDIFFERENCE ANALYSIS
Effect of an increase in income on the budget line
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Unitso
fgoodY
Units of good X
Assumptions
PX=2
PY= 1Budget = 30
Effect of an increase in income on the budget line
0
10
20
30
40
0 5 10 15 20
Effect of an increase in income on the budget line
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Unitso
fgoodY
Units of good X
Assumptions
PX=2PY= 1
Budget = 40
Budget
= 40
Budget= 30
16
7
0
10
20
30
40
0 5 10 15 20
m
n
ect o a c ease co e o t e budget e
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Indifference curves constructing an indifference curve
the shape of an indifference curve
diminishing marginal rate of substitutionan indifference map
The budget line
constructing a budget line
effect of a change in income
effect of a change in price
INDIFFERENCE ANALYSIS
Effect on the budget line of a fall in the price of good X
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0
10
20
30
0 5 10 15 20 25 30
g p g
Unitso
fgoodY
Units of good X
Assumptions
PX=2PY= 1
Budget = 30
Effect on the budget line of a fall in the price of good X
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0
10
20
30
0 5 10 15 20 25 30
g p g
Unitso
fgoodY
Units of good X
Assumptions
PX=2PY= 1
Budget = 30
Effect on the budget line of a fall in the price of good X
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0
10
20
30
0 5 10 15 20 25 30
g p g
Unitso
fgoodY
Units of good X
Assumptions
PX=1PY= 1
Budget = 30
Effect on the budget line of a fall in the price of good X
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Unitso
fgoodY
Units of good X
Assumptions
PX=1PY= 1
Budget = 30
B1
B2
a
b0
10
20
30
0 5 10 15 20 25 30
c
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The optimum consumption point
INDIFFERENCE ANALYSIS
Finding the optimum consumption
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d g t e opt u co su pt o
Unitsof
goodY
Units of good X
O
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Finding the optimum consumption
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I1I2
I3
I4I5
UnitsofgoodY
O
Units of good X
Budget line
g p p
Finding the optimum consumption
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I1I2
I3
I4I5
UnitsofgoodY
O
Units of good X
r
v
s
u
Y1
X1
t
g p p
INDIFFERENCE ANALYSIS
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The optimum consumption pointequating the marginal rate of substitution with
the price ratio
MRS = MUA/MUB= PA/PB
INDIFFERENCE ANALYSIS
Finding the optimum consumption
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I1I2
I3
I4I5
UnitsofgoodY
O
Units of good X
r
v
s
u
Y1
X1
t
g p p
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INDIFFERENCE ANALYSIS
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The optimum consumption pointequating the marginal rate of substitution with
the price ratio
MRS = MUA/MUB= PA/PB
The effect of a change in income
the incomeconsumption curve
INDIFFERENCE ANALYSIS
Effect on consumption of a change in income
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UnitsofgoodY
O
Units of good X
B1 I1
a
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Effect on consumption of a change in income
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I2
UnitsofgoodY
O
Units of good X
B1 B2 B3 B4 I1
I3
I4
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Deriving an Engel curve from an income-consumption curve
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Bread
B1 B2 B3
I3
I2I
1
CDs
Deriving an Engel curve from an income-consumption curve
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B1 B2 B3
I3
I2I
1
Income-consumptioncurve
CDs
Bread
Deriving an Engel curve from an income-consumption curve
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B1 B2 B3
I3
I2I
1
Income-consumptioncurve
CDs
Bread
Incom
e()
Deriving an Engel curve from an income-consumption curve
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B1 B2 B3
I3
I2I
1
Income-consumptioncurveB
read
Incom
e()
CDs
Qb1
Qcd1
a
Deriving an Engel curve from an income-consumption curve
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B1 B2 B3
I3
I2I
1
Income-consumptioncurveB
read
Incom
e()
CDs
Qb1
Y1
Qcd1
Qcd1
a
a
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Deriving an Engel curve from an income-consumption curve
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B1 B2 B3
I3
I2I
1
Income-consumptioncurveB
read
Incom
e()
CDs
Qb3Qb2Qb1
Y3
Y2Y1
Qcd3Qcd2Qcd1
Qcd3Qcd2Qcd1
ab
c
ab c
Deriving an Engel curve from an income-consumption curve
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B1 B2 B3
I3
I2I
1
Income-consumptioncurveB
read
Incom
e()
CDs
Qb3Qb2Qb1
Y3
Y2Y1
Qcd3Qcd2Qcd1
Qcd3Qcd2Qcd1
Engel curve
ab
c
ab c
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Deriving an Engel curve from an income-consumption curve
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B1 B2 B3
I3
I2I
1
Income-consumptioncurveB
read
Incom
e()
CDs
Qb3Qb2Qb1
Y3
Y2Y1
Qcd3Qcd2Qcd1
Qcd3Qcd2Qcd1
Engel curve
ab
c
ab c
INDIFFERENCE ANALYSIS
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The optimum consumption pointequating the marginal rate of substitution with
the price ratio
MRS = MUA/MUB= PA/PB
The effect of a change in income
the incomeconsumption curve
the Engel curve
income elasticity of demand and the incomeconsumption curve
the effect of a rise in income on the demandfor an inferior good
INDIFFERENCE ANALYSIS
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Effect of a rise in income on the demand for an inferior good
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UnitsofgoodY
(norm
algood)
O
I2
I1B1
B2
a
b
Units of good X
(inferior good)
Effect of a rise in income on the demand for an inferior good
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UnitsofgoodY
(norm
algood)
O
Income-consumption curve
I2
I1B1
B2
a
b
Units of good X
(inferior good)
INDIFFERENCE ANALYSIS
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The effect of changes in price the priceconsumption curve
INDIFFERENCE ANALYSIS
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30
Effect of a fall in the price of good X
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UnitsofgoodY
Units of good X
Assumptions
PX=2PY= 1Budget = 30
B1 I10
10
20
30
0 5 10 15 20 25 30
j
30
Effect of a fall in the price of good X
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UnitsofgoodY
Units of good X
B1 I1
j
Assumptions
PX
=1PY= 1
Budget = 30
0
10
20
30
0 5 10 15 20 25 30
a30Effect of a fall in the price of good X
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UnitsofgoodY
Units of good X
Assumptions
PX
=1PY= 1
Budget = 30
B1 I1 B2
a
j
0
10
20
30
0 5 10 15 20 25 30
I2
k
30 aEffect of a fall in the price of good X
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0
10
20
30
0 5 10 15 20 25 30
UnitsofgoodY
Units of good X
B1 I1 B2
a
j
I2
Price-consumption curve
k
INDIFFERENCE ANALYSIS
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The effect of changes in price the priceconsumption curve
deriving the individual's demand curve
INDIFFERENCE ANALYSIS
Deriving a demand curve from a price-consumption curve
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B1I1
Expenditur
eon
allothergo
ods
Units of good X
a
Deriving a demand curve from a price-consumption curve
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I2
B1 B2I1
Expenditur
eon
allothergo
ods
Units of good X
a b
Fall in theprice of X
Deriving a demand curve from a price-consumption curve
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I2
B1 B2I1
Expenditur
eon
allothergo
ods
Units of good X
a b
Further falls inthe price of X
Deriving a demand curve from a price-consumption curve
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B1 B2 B3
I3I2
I1
I4
B4
Expenditur
eon
allothergo
ods
Units of good X
a b c d
Further falls inthe price of X
Deriving a demand curve from a price-consumption curve
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B1 B2 B3
I3I2
I1
I4
B4
Expenditur
eon
allothergo
ods
Units of good X
Price-consumptioncurve
a b c d
Deriving a demand curve from a price-consumption curve
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B1 B2 B3
I3I2
I1
I4
B4
Expenditur
eon
allothergo
ods
Units of good X
a Price-consumptioncurve
b c d
Priceofg
oodX
Units of ood X
P1
Q1
a
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INDIFFERENCE ANALYSIS
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The effect of changes in price the priceconsumption curve
deriving the individual's demand curve
Income and substitution effects of a pricechange
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Income and substitution effects: normal good
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Units
ofgoodY
I1
I2
I3
I4
I5
I6
B1
f
QX1Units of Good X
Income and substitution effects: normal good
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Units
ofgoodY
I1
I2
I3
I4
I5
I6
B2
h
B1
QX1
f
Rise in the priceof good X
Units of Good XQX3
Income and substitution effects: normal good
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Units
ofgoodY
B2
Substitutioneffect
B1
QX1
h
fI
1
I2
I3
I4
I5
I6
QX
2
B1a
Substitution effectof the price rise
g
Units of Good XQX3
Income and substitution effects: normal good
-
7/31/2019 2 Markets Demand and Supply
99/110
Units of Good X
Units
ofgoodY
I1
I2
I3
I4
I5
I6
Substitutioneffect
Incomeeffect
QX1
h
f
g
B2 B1
QX2QX3
B1a
Income effect ofthe price rise
INDIFFERENCE ANALYSIS
-
7/31/2019 2 Markets Demand and Supply
100/110
The effect of changes in price the priceconsumption curve
deriving the individual's demand curve
Income and substitution effects of a pricechange
a normal good
an inferior good
-
7/31/2019 2 Markets Demand and Supply
101/110
Income and substitution effects: Inferior (non-Giffen) good
-
7/31/2019 2 Markets Demand and Supply
102/110
Units of Good X
Units
ofgoodY
f
QX1
B2
QX3
I1
I2
Rise in the priceof good X
h
B1
Income and substitution effects: Inferior (non-Giffen) good
-
7/31/2019 2 Markets Demand and Supply
103/110
Units of Good X
Units
ofgoodY
f
QX1
B2
h
QX2
I1
I2
Substitution effect
B1a
Substitution effectof the price rise
B1
g
Income and substitution effects: Inferior (non-Giffen) good
-
7/31/2019 2 Markets Demand and Supply
104/110
Units of Good X
Units
ofgoodY
f
QX1
B2
g
QX2QX3
I1
I2
Substitution effect
h
Income effect
B1a
Income effect ofthe price rise
B1
INDIFFERENCE ANALYSIS
-
7/31/2019 2 Markets Demand and Supply
105/110
The effect of changes in price
the priceconsumption curve
deriving the individual's demand curve
Income and substitution effects of a pricechange
a normal good
an inferior good
a Giffen good (a special type of inferior good)
Income and substitution effects: Giffen good
-
7/31/2019 2 Markets Demand and Supply
106/110
Units of Good X
Units
ofgoodY
B1
f
QX1
I1
I2
Income and substitution effects: Giffen good
-
7/31/2019 2 Markets Demand and Supply
107/110
Units of Good X
Units
ofgoodY
f
QX1
B2
QX3
I1
I2
Rise in the priceof good X
h
B1
Income and substitution effects: Giffen good
-
7/31/2019 2 Markets Demand and Supply
108/110
Units of Good X
Units
ofgoodY
f
QX1
B2
h
QX3
I1
I2
QX2
B1a
g
Substitutioneffect
Substitution effectof the price rise
B1
Income and substitution effects: Giffen good
-
7/31/2019 2 Markets Demand and Supply
109/110
Units of Good X
Units
ofgoodY
f
QX1
B2
h
QX3
I1
I2
g
QX2
SubstitutioneffectIncome effect
Income effect ofthe price rise
B1
B1a
INDIFFERENCE ANALYSIS
-
7/31/2019 2 Markets Demand and Supply
110/110
The effect of a change in price on thedemand for other goods
The usefulness of indifference analysis
superiority of using ordinal measures
limitations of indifference analysis
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