Updated:24.02.2006
ECON 501:
MICRO-ECONOMICS
Lecture 1
Topics that is covered:
a. Theory of Supply and Demand
b. Rationality
c. Utility
d. Inconsistent Preferences
e. Slope of Indifference Curve
f. Diminishing MRS
g. Indifference Curves
h. Income Constraint
i. Demand Curves
ECON 501
Nicholson Chapter 3, Part 1
INTRODUCTION
The fundamental issue in microeconomics is to understand how the market works. It is really the
“core” of economics and it’s called “price theory” at University of Chicago. Price theory tries to
explain/predict organization of consumers, producers and factors of production
The price theory is also the core of the whole economic science, maybe 90% of it, and
microeconomics has also drifted into macroeconomics.
True macroeconomics, in fact, is mostly “monetary economics” which is determination of price
level.
THEORY OF SUPPLY AND DEMAND is the main concept of microeconomics:
P
-
S
E
How we arrive at equilibrium?
What are the forces behind?
What shapes the demand and supply curves?
Pm
D
Q
Quantity
Ex: Water demand in Famagusta. What is the relative price of drinking to washing water? It is
15/1 including the coping costs, with proportions of 4% for drinking and 96% for washing
water.
How to alleviate the water shortage in Famagusta? Possible solution: raise the water prices
and increase the quality of water in the water system. Consumers will get a better water
service and still pay less than for water from the alternative sources they use now, i.e.
vendors.
Demand and supply concept can be applied to most market situations, even for complex cases.
But, first we have to look behind the demand curve, and examine what is the nature of the
economic model, which determines how the relative prices, incomes, tastes and preferences cause
a certain combination of goods and services to be demanded.
Fundamental assumption – individuals can and do make RATIONAL choices in order to
maximize their overall satisfaction.
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Second assumption – individuals live in a “certain” world and their decisions are based on full
information available to them. In “economics of information” we address the issue of uncertainty
and the trade-off between reducing the uncertainty and the cost of obtaining information.
WHAT DO WE MEAN BY BEING “RATIONAL”?
This means that we can organize our world into order. Assumption of perfect information may
not be true, but this still allows our models to work. Under “rationality” of consumer decisions,
there are three important rules which must be satisfied:
1.
Completeness Rule.
A
B
B
P
>
P
>
=
Consumers can make decisions either:
B,
or
A,
A.
or
and we can not make a choice with:
A
B
P
>
P
>
B,
and, at the same time
A.
2.
Transitivity Rule.
Is the imposition of internal consistency in consumer’s choices. If
A is preferred to B and B is preferred to C, then A is preferred to C.
If
A
B
A
P
>
P
>
P
>
B,
and
C,
then:
C.
3.
Continuity Rule.
If A is preferred to B, than given any little incremental change
around A, this new A’ is also preferred to B. It is implied that the function is smooth:
If
A
P
>
B,
A’ = A ± ΔA ,
A’
P
>
and
then:
B.
UTILITY
All three rules are used together to describe the concept of “utility”. It is a relative comparison,
we do not measure the satisfaction from consumption itself, but we compare one situation with
another.
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Utility Theory
It is possible to rank satisfaction from the consumption of a combination of goods according to
their “utility”:
P
If
A
B,
then:
>
U(A)
P
>
U(B).
We don’t try to measure the utility per se, but rather compare bundles A and B in terms of
quantity of goods consumed. Assume that both X and Y are “goods,” not “bads”. Our starting
point is A with quantity X0 and Y0 consumed, described as U(Y0,X0).
If any movement from point A is to be made, then it would change the well-being of the
consumer. Consumer will be better off if with the same quantity of Y0 he can have more of X,
U(Y0,XN) P> U(Y0,X0)
and this can be presented by line AB.
At the same time, consumer will be also better off if he can have more of Y with quantity of
being X0 constant, as depicted by line AC. Any point in the space between AB and AC will also
make consumer better than A, and this direction would be preferred. U(YN,X0) P> U(Y0,X0)
Consumer will be definitely made worse off if he is forced to consume less of both goods, which
would be presented by movement to any location in area OY0AX0.
Behavior of consumer is not clear in the case when consumption of one good is increasing while
consumption of the other good is decreasing. Such cases are presented by shaded areas X0ABXN
and Y0ACYN, and they also contain the “indifference curve.”
good Y
C
Y2
Y1
Y0
Indifference
Area
YN
Preferred
Area
A
B
Indifference
Area
Non-Preferred
Area
I
O
X0
X1
X2
XN
good X
The indifference curve is a combination of goods where the consumer is indifferent between the
combinations of goods. On the curve a consumer is trading-off consumption of one good for the
other good, while keeping his total satisfaction constant.
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good Y
Y0
Y1
Y2
Y3
I
O
X0 X1 X2
X3
good X
Indifference curve maps out the space of a basket with two goods. It is a set of points with the
same utility, regardless of how we actually measure utility. There are infinite many indifference
curves – each representing a certain level of utility.
INCONSISTENT PREFERENCES
If A is preferred to B with A having the same number of Y but more of X. Then, E and D also
belong to the same utility level U1 as point A. Assume that C belongs to the same utility level U2
as B, and point E is also included into set of points U2. But if point C has the same number of Y
but more X, then C is preferred to D.
good Y
U1 U2
Y2
D
C
E
A
Y1
B
U1
U2
O
good X
Therefore:
C
P
>
D,
while
A
P
>
B,
This is a contradicting statement if C = B and D = A. Such preferences are inconsistent.
u (C) = u (B) and u(D)= u(A)
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SLOPE OF INDIFFERENCE CURVE
Slope of indifference curve is important. What is the slope of indifference curve?
Slope = (Y1-Y0)/(X1-X0) = (1-3)/(5-4) = - 2
Taking a negative of the slope of indifference curve gives us the marginal rate of substitution
(MRS) of Y for X. Marginal rate of substitution simply indicates how many units of Y consumer
is ready to give up to get one more unit of X.
MRS 
 Y
X UU1
Ex:
Y0 = 3
X0 = 4
Y1 = 1
X1 = 5
MRS = - (1-3) / (5-4) = 2/1 =2
good Y
Y0
Meaning that at this point consumer is
equally happy if he trades 2Y for 1X.
However, if we move further, the MRS
Y1
will decline:
Y2
Y1 = 1
X1 = 5
Y2 = 0.5
X2 = 6
MRS = - (0.5-1) / (6-5) = 0.5
Y3
O
5
I
X0 X1 X2
X3
good X
DIMINISHING MRS
Concept of diminishing MRS holds for both goods: as we expand consumption of X we will be
willing to give up less and less of Y. This requires continuity in the shape of the indifference
curve. NO KINKS ! In figure below, A and B represent linear consumption of two goods. Any
point in between A and B, let’s say C, will be preferred to A or B.
Concept of diminishing MRS is assumed as normal behavior. Exclusion to this rule is the case of
an addiction to something (drugs, etc.) Addictive behavior, however, can also be modeled.
good Y
Y0
Y1
Y2
Y3
I
O
X0 X1 X2 X3
(X1–X0) = (X2–X1) = (X3–X2)
(Y1–Y0) > (Y2–Y1) > (Y3–Y2)
MRS1 > MRS2 > MRS3 > MRSN
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good X
DIFFERENT TYPES OF INDIFFERENCE CURVES
There are two cases that are the extremes which bound our analysis. If indifference curve has a
constant, not diminishing MRS, then this is a “perfect substitutes” case.
MRSA = MRSB = MRSC = MRSD
Ex: different brands of gasoline, different brands of bottled water…
good Y
A
B
C
D
I
U1 U2
O
U3
good X
If indifference curves look as in the figure below, this is a case of “perfect compliment” goods.
When consumer has Y0 and X0, then adding more of X or Y alone does not increase utility.
Ex: bicycle and tires, creamer and coffee…
good Y
U2
U1
U0
Y0
O
X0
X1
X2
good X
INCOME CONSTRAINT
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There are constraints on the “wish-list” of the consumer. For our course, we analyze only “this
period” preferences, but we can easily model “life-time” preferences. One of the problems in
society is that people TODAY may not care about people who will be living TOMORROW, i.e.
there is budget constraint that applies over time.
Concept of “over-lapping generations”. Social security in many countries (Europe, Italy,
Germany, partly US, TRNC) is suffering from this inter-generation problem. But some countries
addressed this issue long ago (UK), others are still trying to ignore it.
Let’s start with a budget constraint where we need to specify 3 things:
I
income during period
Px
price X
Py
price Y
which give us the budget constraint:
I = Px*X + Py*Y
Ex:
I
= 10 income during period
Px
=1
price of Soft drink
Py
=2
price of kebab
which give us the budget constraint:
10 = 1*X + 2*Y
If X = 0 (no soft drinks), then Y = 5, and if Y = 0 then X = 10.
good Y
5
I/PY
Non-Affordable
Affordable
I/PX
O
10
If we have 3 goods, and Pz = 0.5 which is the price of a salad:
10 = 1*X + 2*Y + 0.5Z
If
X=0
and
Y=0
then
Z=20
If
X=0
and
Z=0
then
Y=5
If
Z=0
and
Y=0
then
X=10
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good X
With 3 goods we have a plane, rather than a budget line. The consumer will consume at a point
where utility hits the budget plane.
good Y
5
20
good Z
10
good X
The figure below shows a case when only one good will be consumed, the whole income will be
spent on X. Slope of budget line is Py/Px = 5/10 = ½
If only one good is consumed, it means the price of the second good is too high, and only when
the price of the second good changes – consumer will start purchasing the second good.
good Y
U0
U1 U2
U3
5
10
O
good X
DERIVING DEMAND CURVES FROM INDIFFERENT CURVES
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It was thought that demand curves derive their slope from diminishing marginal utility, however
this is not necessarily true.
Indifference curve allows us to get the same result as if we had the assumption of diminishing
marginal utility.
Given the fixed amount of income and fixed price of X, if price of Y changes, the budget line
changes its slope, which translates into more units of Y consumed. Quantity of Y demanded
increases. This is also called a change in the quantity demanded.
Py0 > Py1 > Py2
Y0 < Y1 < Y2
Price Y
good Y
I/PY2
Y2
Y1
u2
I/PY1
Y0 I/PY
P Y0
P Y1
u1
0
u0
P Y2
I/PX
With Oan increase in income of10the consumer, we see the demand
curve
O
Y0 shifting
Y1 Yat2 each
10 price
good Y
good X
level. Notice, that prices of the goods are kept constant and only income is changed. This is
illustrated below and called a “change in demand.”
good Y
Price Y
D2
Y2
D1
Y1
Y0
O
D0
I2
I1
PY0
I0
O
good X
Y0
Y1
Y2
good Y
DEMAND FUNCTION IS NOT RELATED TO THE UTILITY INDEX USED
The same set of indifference curves will give us the same demand function. The utility index used
does not matter as long as it is a monotonic transformation, i.e. ordering of choices is preserved.
Indifference curves allow us to derive a demand curve without giving a specific value to utility.
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Any monotonic transformation of the values given to the indifference curves give us the same
demand curve.
I3
good Y
good Y
I2
I2
I1
I1
100
I0
I3
130
I0
80
95
65
60
40
40
O
O
good X
MU of income is constant
good Y
MU of income is increasing
I3
I2
I1
70
I0
63
55
40
O
good X
good X
MU of income is decreasing
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