1 Chapter 1 Appendix

2 Indifference Curve Analysis Market Baskets are combinations of various goods. Indifference Curves are curves connecting various market basket combinations of goods that make an individual equally happy.

3 Assumptions about Preferences Persons can rank market baskets. Rankings are transitive. More is preferred to less. The marginal rate of substitution is diminishing.

4 Figure 1A.1 Indifference Curves B1B1 50 B2B2 U1U1 U2U2 U3U3 Expenditure on Other Goods per Month (Dollars) 0 Gasoline per Month (Gallons) QxQx

5 The amount of expenditure on other goods that a person will give up in order to get an additional unit of one good is called the marginal rate of substitution or the marginal benefit of a good. The Marginal Rate of Substitution

6 The Budget Constraint The budget constraint is the combination of goods that a person can afford.

7 The Budget Constraint in Algebraic Terms I = P x Q x +  P i Q i Where: I is income P i is the price of good i Q i is the amount of good i purchased

8 Figure 1A.2 The Budget Constraint Expenditure on Gasoline per Month Expenditure on All Other Goods Except Gasoline per Month C F D 100 A B Expenditure on Other Goods per Month (Dollars) Gasoline per Month (Gallons) 0 QxQx

9 Figure 1A.3 Consumer Equilibrium U1U1 U3U3 U2U2 E Expenditure on Other Goods per Month (Dollars) Gasoline per Month (Gallons) 0QxQx A B

10 Equilibrium Condition P X = MB X

11 Figure 1A.4 Changes in Income A B Expenditure on Other Goods per Month (Dollars) Q x per Month 0 A' B'

12 Figure 1A.5 Changes in the Price of Good X A B '' B ' B Expenditure on Other Goods per Month (Dollars) 0 Q x per Month

13 Income and Substitution Effects The income effect is the change in the monthly (or other period) consumption of a good due to changing purchasing power of fixed income caused by the good’s price change. The substitution effect is the change in the monthly (or other period) consumption of the good due to the change in its price relative to other goods.

14 Figure 1A.6 Income and Substitution Effects QxQx 100 The Substitution Effect Expenditure on Other Goods per Month (Dollars) Gasoline per Month (Gallons) The Income Effect U2U2 U1U1 E' 45 E1E E2E2

15 The Law of Demand The demand curve slopes downward. As the price rises, the quantity demanded falls.

16 Figure 1A.7 The Law of Demand D = MB Price Q x per Month0

17 Price Elasticity of Demand % Change in Quantity Demanded % Change in Price E D = QD/QDQD/QD P/PP/P =

18 Consumer Surplus Net benefit that consumers obtain from a good Total benefit to consumers from obtaining a good, less the money they give up to get the good.

19 Figure 1A.8 Consumer Surplus Consumer Surplus A D = MB Price Gasoline per Month 0 1 Q P B Market Price

20 Figure 1A.9 The Work Leisure Choice U3U3 U2U2 U1U1 E A B 24 Leisure Hours per Day Income per Day 0

21 Budget line for time allocation I = w(24 – L) Where: I is income W is wage L is the amount of time devoted to leisure