1. Chapter 4.3 Introduction and Indifference Analysis P104-117 Chapter 4.3 Introduction and Indifference Analysis P104-117

2. PRICE AND OUTPUT DETERMINATION We call the price that obtains in the market, the market price, We call the price that obtains in the market, the market price, or the Equilibrium price,or the Equilibrium price, and the quantity demanded and supplied equilibrium output.and the quantity demanded and supplied equilibrium output. We find this by plotting the demand and the Supply curves.We find this by plotting the demand and the Supply curves.

3. Equilibrium price and output : The Market Demand and Supply of Potatoes (Monthly)

4. Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e Supply Demand The determination of market equilibrium (potatoes: monthly)

5. Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e Supply Demand The determination of market equilibrium (potatoes: monthly) Where the two lines cross is called the equilibrium point P e =12 Q e =350

6. PRICE AND OUTPUT DETERMINATION Making sense of Economics DataMaking sense of Economics Data Why did we impose this construction on the data in table 1.Why did we impose this construction on the data in table 1.

7. P OQ 800 1000 20p 30p b a Suppose I observe two sets of prices and quantities How do I make sense of these two observations?

8. P OQ 800 1000 20p 30p b a Suppose I observe two sets of prices and quantities How do I make sense of these two observations? They may be on the same demand curve D0D0

9. P OQ S1S1 S2S2 800 1000 20p 30p b a and thus the two observations were generated by a shift in the supply curve D0D0

10. Alternative Explanation However, we are only assuming the two points were on the original demand curve. We don’t know this.However, we are only assuming the two points were on the original demand curve. We don’t know this. Consider the following possibility.Consider the following possibility.

11. P OQ S1S1 800 1000 20p 30p b a D1D1 Assume Point A was the original

12. P OQ S1S1 S2S2 800 1000 20p 30p b a D1D1 D2D2 It is possible that both the demand and the supply curve have shifted as in this example.

13. So in the second case point b lies on a different demand and supply curveSo in the second case point b lies on a different demand and supply curve Looking at raw data and trying to figure out what is going on is a difficult problem.Looking at raw data and trying to figure out what is going on is a difficult problem. The problem above is known as the identification problemThe problem above is known as the identification problem

14. Econometrics So interpreting data has many pitfallsSo interpreting data has many pitfalls In the following years you will study various statistical procedures which will help you to analyse what is really happening in the data we observe.In the following years you will study various statistical procedures which will help you to analyse what is really happening in the data we observe. The main course we do this is in Econometrics next yearThe main course we do this is in Econometrics next year IT and Applied Economics & Quantitative Methods this year will help prepare you.IT and Applied Economics & Quantitative Methods this year will help prepare you.

15. Demand In this course we want to explore in more detail what lies behind the demand and supply decisions that people make by focusing on the economics that lie behind the decisions we actually observe.In this course we want to explore in more detail what lies behind the demand and supply decisions that people make by focusing on the economics that lie behind the decisions we actually observe. First we are going to focus on DemandFirst we are going to focus on Demand

16. Happiness Happiness Basically we demand goods because they make us ‘happy’Basically we demand goods because they make us ‘happy’ Or at least we would be unhappy if we didn’t have them.Or at least we would be unhappy if we didn’t have them. Either way we get ‘JOLLIES’ from themEither way we get ‘JOLLIES’ from them Economists, being boring old farts, have a special term for Jollies – we call it UTILITYEconomists, being boring old farts, have a special term for Jollies – we call it UTILITY

17. Utility Theory Even Better – we have a theory to explain behaviour called:Even Better – we have a theory to explain behaviour called: Utility TheoryUtility Theory This theory relies on an important foundation.This theory relies on an important foundation. RationalityRationality We assume people choose their desired consumption rationally or consistentlyWe assume people choose their desired consumption rationally or consistently

18. Rationality What do we mean by RationalityWhat do we mean by Rationality We do not mean that people are fully informed or fully conscious about every consumption decision they makeWe do not mean that people are fully informed or fully conscious about every consumption decision they make Rather we mean they act (consciously or otherwise) in a consistent manner.Rather we mean they act (consciously or otherwise) in a consistent manner.

19. Total Utility Packets of crisps 01234560123456 0 7 11 13 14 13 Total Utility in Utils We imagine that consumers act as if they are trying to make themselves as happy as possible (broadly defined) given their circumstances. In the adjacent table the consumer gets ‘jollies’, called UTILS from consuming crisps. The table records his/her total utility.

20. Darren’s utility from consuming crisps (daily) Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 Utility (utils) Packets of crisps consumed (per day) TU

21. MARGINAL UTILITY THEORY Total and marginal utilityTotal and marginal utility Marginal Utility:Marginal Utility: The change in Total Utility as a result of consuming one more unit of the good.The change in Total Utility as a result of consuming one more unit of the good.

22. Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Utility (utils) Packets of crisps consumed (per day) TU Darren’s utility from consuming crisps (daily) X 1 -X 0 =3-2=1 TU 1 -TU 0

23. Utility (utils) Packets of crisps consumed (per day) TU Darren’s utility from consuming crisps (daily) X 1 -X 0 =3-2=1 TU 1 -TU 0  TU = 2  Q = 1 MU =  TU /  Q = 2/1 = 2

24. MU  TU = 2  Q = 1 Utility (utils) Packets of crisps consumed (per day) TU Alternative representation of Darren’s Marginal utility) Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0

25. MU  TU = 2  Q = 1 MU =  TU /  Q = 2/1 = 2 Utility (utils) Packets of crisps consumed (per day) TU Alternative representation of Darren’s Marginal utility) Note this is effectively measuring the slope of the curve

26. MU  TU = 2  Q = 1 MU =  TU /  Q = 2/1 = 2 Utility (utils) Packets of crisps consumed (per day) TU Alternative representation of Darren’s Marginal utility)

27. Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Utility (utils) Packets of crisps consumed (per day) TU MU Graphing Darren’s Marginal utility we get:

28. MARGINAL UTILITY THEORY Total and marginal utilityTotal and marginal utility Marginal Utility:Marginal Utility: The change in Total Utility as a result of consuming one more unit of the good.The change in Total Utility as a result of consuming one more unit of the good.

29. The principle of diminishing marginal utility Note that the Marginal Utility curve is downward –This give us: – The principle of diminishing marginal utility –As more units of a good are consumed, additional units will provide us with less additional satisfaction than previous units

30. Now lets look at two goods Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Pints of Beer TU in utils 0123456701234567 0 70 130 180 217 220 0 MU in utils - 70 60 50 37 12 0 -220

31. Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Pints of Beer TU in utils 0123456701234567 0 70 130 180 217 220 0 MU in utils - 70 60 50 37 12 0 -220 Looking at the utility from beer compared with crisps do you think Darren should spend all his money on beer?

32. Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Pints of Beer TU in utils 0123456701234567 0 70 130 180 217 220 0 MU in utils - 70 60 50 37 12 0 -220 Suppose that Crisps cost 25p And Beer cost 1.50 per pint, How should Darren allocate his income between beer and crisps

33. Bang per buck Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Pints of Beer TU in utils 0123456701234567 0 70 130 180 217 220 0 MU in utils - 70 60 50 37 12 0 -220 The crucial issue is not how many utils you get from consuming another beers or packet of crisps But rather the ‘bang per buck’ or utils per pound

34. Bang per buck Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Pints of Beer TU in utils 0123456701234567 0 70 130 180 217 220 0 MU in utils - 70 60 50 37 12 0 -220 The crucial issue is not how many utils you get from consuming another beers or packet of crisps But rather the ‘bang per buck’ or utils per pound

35. Packets of crisps TU in utils 01234560123456 0 7 11 13 14 13 MU in utils - 7 4 2 1 0 Pints of Beer TU in utils 0123456701234567 0 70 130 180 217 229 220 0 MU in utils - 70 60 50 37 12 0 -220 - 28 16 8 4 0 -4 MU/P - 46.6 40 33.3 24.6 8 0 -146.6 Allocation is that we should allocate our spending such that

36. Etc,etc

37. Alternatively we can write the condition for equilibrium as:

38. INDIFFERENCE ANALYSIS A more sophisticated way to analyse this problem is to use what is known as Indifference Analysis. For that we need to:A more sophisticated way to analyse this problem is to use what is known as Indifference Analysis. For that we need to: –Construct an indifference curve

39. Pears 30 24 20 14 10 8 6 Oranges 6 7 8 10 13 15 20 Point abcdefgabcdefg Combinations of pears and oranges that Clive likes the same amount as 10 pears and 13 oranges Constructing an indifference curve The data in this table tells us about various combinations that make ‘Clive’ equally happy. He is ‘Indifferent’ between 10 Pears and 13 Oranges And 14 pears and 10 Oranges

40. a Pears Oranges Pears 30 24 20 14 10 8 6 Oranges 6 7 8 10 13 15 20 Point abcdefgabcdefg Constructing an indifference curve

41. a b Pears Oranges Pears 30 24 20 14 10 8 6 Oranges 6 7 8 10 13 15 20 Point abcdefgabcdefg Constructing an indifference curve

42. a b c d e f g Pears Oranges Pears 30 24 20 14 10 8 6 Oranges 6 7 8 10 13 15 20 Point abcdefgabcdefg Constructing an indifference curve

43. a b c d e f g Pears Oranges Pears 30 24 20 14 10 8 6 Oranges 6 7 8 10 13 15 20 Point abcdefgabcdefg Constructing an indifference curve Joining all these points gives us AN indifference curve

44. INDIFFERENCE ANALYSIS Indifference curvesIndifference curves –constructing an indifference curve –the shape of an indifference curve

45. a b c d e f g Pears Oranges Constructing an indifference curve Notice that this curve is downward sloping Why is this and does it have any economic meaning?