1. Practice Problem: Chapter 2 #6 The rent control agency of NYC has found that aggregate demand is QD = 160-8P. Quantity is measured in tens of thousands of apartments. Price, the average monthly rental rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from more three-person families coming into the city and demanding apartments. The city’s board of realtors acknowledges that this is a good demand estimate and has shown that supply is QS = 70+7P. What is the free market price? What is the change in city population if the agency sets a maximum average monthly rent of $300 and all those who cannot find an apartment leave the city?

2. Chapter 32©2005 Pearson Education, Inc. Chapter 2 #3 Set quantity supply = quantity demand P = 6 (convert to $600) Q = 112 (convert to 1,120,000)

3. Chapter 33©2005 Pearson Education, Inc. Chapter 2: #6 If the rent control agency sets the rental rate at $300, the quantity supplied would then be 910,000 (QS = 70 + (7)(3) = 91), a decrease of 210,000 apartments from the free market equilibrium. (Assuming three people per family per apartment, this would imply a loss of 630,000 people.) At the $300 rental rate, the demand for apartments is 1,360,000 units, and the resulting shortage is 450,000 units (1,360,000-910,000). However, excess demand (supply shortages) and lower quantity demanded are not the same concepts. The supply shortage means that the market cannot accommodate the new people who would have been willing to move into the city at the new lower price. Therefore, the city population will only fall by 630,000, which is represented by the drop in the number of actual apartments from 1,120,000 (the old equilibrium value) to 910,000, or 210,000 apartments with 3 people each.

4. Chapter 34©2005 Pearson Education, Inc. Practice Problem Suppose the agency bows to the wishes of the board and sets a rental of $900 per month on all apartments to allow landlords a “fair” rate of return. If 50 percent of any increases in apartment offerings come from new construction, how many apartments are constructed?

5. Chapter 35©2005 Pearson Education, Inc. Answer: At a rental rate of $900, the supply of apartments would be 70 + 7(9) = 133, or 1,330,000 units, which is an increase of 210,000 units over the free market equilibrium. Therefore, (0.5)(210,000) = 105,000 units would be constructed. Note, however, that since demand is only 880,000 units, 450,000 units would go unrented

6. Chapter 36©2005 Pearson Education, Inc. 0 5 10 15 20 25 30 35 40 45 Not Handed In (13) 0 Failed 1 Needs To Be Better (28) 2 Good (40) 3 Excellent (10) Homework #1 Grade Distribution

7. Chapter 3 Consumer Behavior

8. Chapter 38©2005 Pearson Education, Inc. Introduction How are consumer preferences used to determine demand? How do consumers allocate income to the purchase of different goods?

9. Chapter 39©2005 Pearson Education, Inc. Consumer Behavior - Applications 1.How would General Mills determine the price to charge for a new cereal before it went to the market? 2.To what extent did the food stamp program provide individuals with more food versus merely subsidizing food they bought anyway?

10. Chapter 310©2005 Pearson Education, Inc. Consumer Behavior Theory There are three steps involved in the study of consumer behavior 1.Consumer Preferences  To describe how and why people prefer one good to another: algebra and graphs 2.Budget Constraints  People have limited incomes/face prices

11. Chapter 311©2005 Pearson Education, Inc. Consumer Behavior 3.Consumer Choices  What combination of goods will consumers buy to maximize their satisfaction, given preferences, income and prices?

12. Chapter 312©2005 Pearson Education, Inc. Consumer Preferences How might a consumer compare different groups of items available for purchase? A market basket is a collection of one or more commodities Individuals can choose between market baskets containing different goods

13. Chapter 313©2005 Pearson Education, Inc. Consumer Preferences – Basic Assumptions 1.Preferences are complete  Consumers can rank all market baskets 2.Preferences are transitive  If they prefer A to B, and B to C, they must prefer A to C (consistent) 3.Consumers always prefer more of any good to less  More is better

14. Chapter 314©2005 Pearson Education, Inc. Majority Voting and Transitivity Person:123 Preference:Good XGood YGood Z Good YGood ZGood X Good ZGood XGood Y

15. Chapter 315©2005 Pearson Education, Inc. Consumer Preferences Consumer preferences can be represented graphically using indifference curves Indifference curves represent all combinations of market baskets that the person is indifferent to  A person will be equally satisfied with either choice

16. Chapter 316©2005 Pearson Education, Inc. Indifference Curves: An Example Market BasketUnits of FoodUnits of Clothing A2030 B1050 D4020 E3040 G1020 H1040

17. Chapter 317©2005 Pearson Education, Inc. Indifference Curves: An Example Graph the points with one good on the x- axis and one good on the y-axis Plotting the points, we can make some immediate observations about preferences  More is better

18. Chapter 318©2005 Pearson Education, Inc. The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A. Indifference Curves: An Example Food 10 20 30 40 10203040 Clothin g 50 G A EH B D

19. Chapter 319©2005 Pearson Education, Inc. Indifferent between points B, A, & D E is preferred to points on U 1 Points on U 1 are preferred to H & G Indifference Curves: An Example Food 10 20 30 40 10203040 Clothin g 50 U1U1 G D A E H B

20. Chapter 320©2005 Pearson Education, Inc. Indifference Curves Indifference curves slope downward to the right  If they sloped upward, they would violate the assumption that more is preferred to less Some points that had more of both goods would be indifferent to a basket with less of both goods

21. Chapter 321©2005 Pearson Education, Inc. Indifference Curves To describe preferences for all combinations of goods/services, we have a set of indifference curves – an indifference map  Each indifference curve in the map shows the market baskets among which the person is indifferent

22. Chapter 322©2005 Pearson Education, Inc. U2U2 U3U3 Indifference Map Food Clothing U1U1 A B D Market basket A is preferred to B. Market basket B is preferred to D.

23. Chapter 323©2005 Pearson Education, Inc. Indifference Maps Indifference maps give more information about shapes of indifference curves  Indifference curves cannot cross Violates assumption that more is better  Why? What if we assume they can cross?

24. Chapter 324©2005 Pearson Education, Inc. Indifference Maps Food Clothing B is preferred to D A is indifferent to B & D B must be indifferent to D but that can’t be if B is preferred to D U1U1 U1U1 U2U2 U2U2 A B D

25. Chapter 325©2005 Pearson Education, Inc. Indifference Curves The shapes of indifference curves describe how a consumer is willing to substitute one good for another  A to B, give up 6 clothing to get 1 food  D to E, give up 2 clothing to get 1 food The more clothing and less food a person has, the more clothing they will give up to get more food

26. Chapter 326©2005 Pearson Education, Inc. A B D E G -6 1 1 -4 -2 1 1 Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1 Indifference Curves Food Clothing 23451 2 4 6 8 10 12 14 16

27. Chapter 327©2005 Pearson Education, Inc. Indifference Curves We measure how a person trades one good for another using the marginal rate of substitution (MRS)  It quantifies the amount of one good a consumer will give up to obtain more of another good  It is measured by the slope of the indifference curve

28. Chapter 328©2005 Pearson Education, Inc. Marginal Rate of Substitution Food 23451 Clothing 2 4 6 8 10 12 14 16 A B D E G -6 1 1 1 1 -4 -2 MRS = 6 MRS = 2

29. Chapter 329©2005 Pearson Education, Inc. Marginal Rate of Substitution Indifference curves are convex (bowed inward)  As more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one Consumers generally prefer a balanced market basket

30. Chapter 330©2005 Pearson Education, Inc. Marginal Rate of Substitution The MRS decreases as we move down the indifference curve  Along an indifference curve there is a diminishing marginal rate of substitution.  The MRS went from 6 to 4 to 1

31. Chapter 331©2005 Pearson Education, Inc. Marginal Rate of Substitution Indifference curves with different shapes imply a different willingness to substitute Two polar cases are of interest  Perfect substitutes  Perfect complements

32. Chapter 332©2005 Pearson Education, Inc. Marginal Rate of Substitution Perfect Substitutes  Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant  Example: a person might consider apple juice and orange juice perfect substitutes They would always trade 1 glass of OJ for 1 glass of Apple Juice

33. Chapter 333©2005 Pearson Education, Inc. Consumer Preferences Orange Juice (glasses) Apple Juice (glasses) 2341 1 2 3 4 0 Perfect Substitutes

34. Chapter 334©2005 Pearson Education, Inc. Consumer Preferences Perfect Complements  Two goods are perfect complements when the indifference curves for the goods are shaped as right angles  Example: If you have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only Must have one right for one left

35. Chapter 335©2005 Pearson Education, Inc. Consumer Preferences Right Shoes Left Shoes 2341 1 2 3 4 0 Perfect Complements

36. Chapter 336©2005 Pearson Education, Inc. Consumer Preferences We have assumed all our commodities are “goods” There are commodities we don’t want more of - bads  Things for which less is preferred to more Examples  Air pollution  Asbestos

37. Chapter 337©2005 Pearson Education, Inc. Consumer Preferences How do we account for bads in our preference analysis?  We redefine the commodity Clean air Pollution reduction Asbestos removal

38. Chapter 338©2005 Pearson Education, Inc. Consumer Preferences: An Application In designing new cars, automobile executives must determine how much time and money to invest in restyling versus increased performance  Higher demand for car with better styling and performance  Both cost more to improve

39. Chapter 339©2005 Pearson Education, Inc. Consumer Preferences: An Application An analysis of consumer preferences would help to determine where to spend more on change: performance or styling Some consumers will prefer better styling and some will prefer better performance

40. Chapter 340©2005 Pearson Education, Inc. Consumer Preferences: An Application These consumers place a greater value on performance than styling Styling Performance

41. Chapter 341©2005 Pearson Education, Inc. Consumer Preferences: An Application These consumers place a greater value on styling than performance Styling Performance

42. Chapter 342©2005 Pearson Education, Inc. Consumer Preferences: An Application Knowing which group dominates the market will help decide where redesigning dollars should go A recent study in the US shows that over the past two decades, most consumers have preferred styling over performance

43. Chapter 343©2005 Pearson Education, Inc. Preferences and Numerical Values The theory of consumer behavior does not require assigning a numerical value to the level of satisfaction Although ranking of market baskets is good, sometimes numerical value is useful

44. Chapter 344©2005 Pearson Education, Inc. Consumer Preferences Utility  A numerical score representing the satisfaction that a consumer gets from a given market basket  If buying 3 copies of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt

45. Chapter 345©2005 Pearson Education, Inc. Utility Utility function  Formula that assigns a level of utility to individual market baskets  If the utility function is U(F,C) = F + 2C A market basket with 8 units of food and 3 units of clothing gives a utility of 14 = 8 + 2(3)

46. Chapter 346©2005 Pearson Education, Inc. Utility - Example Market Basket FoodClothingUtility A838 + 2(3) = 14 B646 + 2(4) = 14 C444 + 2(4) = 12 Consumer is indifferent between A & B and prefers both to C

47. Chapter 347©2005 Pearson Education, Inc. Utility - Example Baskets for each level of utility can be plotted to get an indifference curve  To find the indifference curve for a utility of 14, we can change the combinations of food and clothing that give us a utility of 14

48. Chapter 348©2005 Pearson Education, Inc. Utility - Example Food 10155 5 10 15 0 Clothing U 1 = 25 U 2 = 50 U 3 = 100 A B C BasketU = FC C25 = 2.5(10) A25 = 5(5) B25 = 10(2.5)

49. Chapter 349©2005 Pearson Education, Inc. Utility Although we numerically rank baskets and indifference curves, numbers are ONLY for ranking A utility of 4 is not necessarily twice as good as a utility of 2, just better There are two types of rankings  Ordinal ranking  Cardinal ranking

50. Chapter 350©2005 Pearson Education, Inc. Utility Ordinal Utility Function  Places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another  Interpersonal comparisons impossible Cardinal Utility Function  Utility function describing the extent to which one market basket is preferred to another

51. Chapter 351©2005 Pearson Education, Inc. Budget Constraints Preferences do not explain all of consumer behavior Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services

52. Chapter 352©2005 Pearson Education, Inc. Budget Constraints The Budget Line  Indicates all combinations of two commodities for which total money spent equals total income  We assume only 2 goods are consumed, so we do not consider savings

53. Chapter 353©2005 Pearson Education, Inc. The Budget Line Let F equal the amount of food purchased, and C is the amount of clothing Price of food = P F and price of clothing = P C Then P F F is the amount of money spent on food, and P C C is the amount of money spent on clothing

54. Chapter 354©2005 Pearson Education, Inc. The Budget Line The budget line then can be written: All income is allocated to food (F) and/or clothing (C)

55. Chapter 355©2005 Pearson Education, Inc. The Budget Line

56. Chapter 356©2005 Pearson Education, Inc. The Budget Line Different choices of food and clothing can be calculated that use all income  These choices can be graphed as the budget line Example:  Assume income of $80/week, P F = $1 and P C = $2

57. Chapter 357©2005 Pearson Education, Inc. Budget Constraints Market Basket Food P F = $1 Clothing P C = $2 Income I = P F F + P C C A040$80 B2030$80 D4020$80 E6010$80 G800$80

58. Chapter 358©2005 Pearson Education, Inc. The Budget Line 10 20 A B D E G ( I/P C ) = 40 Food 4060 80 = ( I/P F ) 20 10 20 30 0 Clothing

59. Chapter 359©2005 Pearson Education, Inc. The Budget Line As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other The slope of the line measures the relative cost of food and clothing The slope is the negative of the ratio of the prices of the two goods

60. Chapter 360©2005 Pearson Education, Inc. The Budget Line The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent We can rearrange the budget line equation to make this more clear

61. Chapter 361©2005 Pearson Education, Inc. The Budget Line

62. Chapter 362©2005 Pearson Education, Inc. Budget Constraints The Budget Line  The vertical intercept, I/P C, illustrates the maximum amount of C that can be purchased with income I  The horizontal intercept, I/P F, illustrates the maximum amount of F that can be purchased with income I

63. Chapter 363©2005 Pearson Education, Inc. The Budget Line As we know, income and prices can change As incomes and prices change, there are changes in budget lines We can show the effects of these changes on budget lines and consumer choices

64. Chapter 364©2005 Pearson Education, Inc. The Budget Line - Changes The Effects of Changes in Income  An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).  Can buy more of both goods with more income

65. Chapter 365©2005 Pearson Education, Inc. The Budget Line - Changes The Effects of Changes in Income  A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant)  Can buy less of both goods with less income

66. Chapter 366©2005 Pearson Education, Inc. The Budget Line - Changes An increase in income shifts the budget line outward Food (units per week) Clothing (units per week) 8012016040 20 40 60 80 0 ( I = $160) L2L2 ( I = $80) L1L1 L3L3 ( I = $40) A decrease in income shifts the budget line inward

67. Chapter 367©2005 Pearson Education, Inc. The Budget Line - Changes The Effects of Changes in Prices  If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.  If the price of food increases and you buy only food (x-intercept), then you can’t buy as much food. The x-intercept shifts in.  If you buy only clothing (y-intercept), you can buy the same amount. No change in y- intercept.

68. Chapter 368©2005 Pearson Education, Inc. The Budget Line - Changes The Effects of Changes in Prices  If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept.  If the price of food decreases and you buy only food (x-intercept), then you can buy more food. The x-intercept shifts out.  If you buy only clothing (y-intercept), you can buy the same amount. No change in y- intercept.

69. Chapter 369©2005 Pearson Education, Inc. The Budget Line - Changes ( P F = 1) L1L1 An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. L3L3 ( P F = 2) ( P F = 1/2) L2L2 A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward. 40 Food (units per week) Clothing (units per week) 80 120 160 40

70. Chapter 370©2005 Pearson Education, Inc. The Budget Line - Changes The Effects of Changes in Prices  If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change  However, the budget line will shift inward parallel to the original budget line

71. Chapter 371©2005 Pearson Education, Inc. The Budget Line - Changes The Effects of Changes in Prices  If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change  However, the budget line will shift outward parallel to the original budget line

72. Chapter 372©2005 Pearson Education, Inc. Consumer Choice Given preferences and budget constraints, how do consumers choose what to buy? Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them

73. Chapter 373©2005 Pearson Education, Inc. Consumer Choice The maximizing market basket must satisfy two conditions: 1.It must be located on the budget line  They spend all their income – more is better 2.It must give the consumer the most preferred combination of goods and services

74. Chapter 374©2005 Pearson Education, Inc. Consumer Choice Graphically, we can see different indifference curves of a consumer choosing between clothing and food Remember that U 3 > U 2 > U 1 for our indifference curves Consumer wants to choose highest utility within their budget

75. Chapter 375©2005 Pearson Education, Inc. Consumer Choice U3U3 D U2U2 C Food (units per week) 408020 Clothing (units per week) 20 30 40 0 U1U1 A B A, B, C on budget line D highest utility but not affordable C highest affordable utility Consumer chooses C

76. Chapter 376©2005 Pearson Education, Inc. Consumer Choice Consumer will choose highest indifference curve on budget line In previous graph, point C is where the indifference curve is just tangent to the budget line Slope of the budget line equals the slope of the indifference curve at this point

77. Chapter 377©2005 Pearson Education, Inc. Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is:

78. Chapter 378©2005 Pearson Education, Inc. Consumer Choice Therefore, it can be said at consumer’s optimal consumption point,

79. Chapter 379©2005 Pearson Education, Inc. Consumer Choice It can be said that satisfaction is maximized when marginal rate of substitution (of C for F) is equal to the ratio of the prices (of F to C) Note this is ONLY true at the optimal consumption point

80. Chapter 380©2005 Pearson Education, Inc. Consumer Choice Optimal consumption point is where marginal benefits equal marginal costs MB = MRS = benefit associated with consumption of 1 more unit of food MC = cost of additional unit of food  1 unit food = ½ unit clothing  P F /P C

81. Chapter 381©2005 Pearson Education, Inc. Consumer Choice If MRS ≠ P F /P C then individuals can reallocate basket to increase utility If MRS > P F /P C  Will increase food and decrease clothing until MRS = P F /P C If MRS < P F /P C  Will increase clothing and decrease food until MRS = P F /P C

82. Chapter 382©2005 Pearson Education, Inc. Consumer Choice Food (units per week) Clothing (units per week) 408020 30 40 0 Point B does not maximize satisfaction because the MRS = -10/10 = 1 is greater than the price ratio = 1/2 +10 F U1U1 -10 C B

83. Chapter 383©2005 Pearson Education, Inc. Consumer Choice: An Application Revisited Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of a car Each group has different preferences

84. Chapter 384©2005 Pearson Education, Inc. Consumer Choice: An Application Revisited By finding the point of tangency between a group’s indifference curve and the budget constraint, auto companies can see how much consumers value each attribute

85. Chapter 385©2005 Pearson Education, Inc. Consumer Choice: An Application Revisited Styling Performance $10,000 These consumers want performance worth $7000 and styling worth $3000 $3,000 $7,000

86. Chapter 386©2005 Pearson Education, Inc. Consumer Choice: An Application Revisited These consumers want styling worth $7000 and performance worth $3000 $3,000 $7,000 Styling $10,000 Performance

87. Chapter 387©2005 Pearson Education, Inc. Consumer Choice: An Application Revisited Once a company knows preferences, it can design a production and marketing plan Company can then make a sensible strategic business decision on how to allocate performance and styling on new cars

88. Chapter 388©2005 Pearson Education, Inc. Consumer Choice A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another  MRS is not necessarily equal to P B /P A

89. Chapter 389©2005 Pearson Education, Inc. A Corner Solution Ice Cream (cup/month) Frozen Yogurt (cups monthly) B A U2U2 U3U3 U1U1 A corner solution exists at point B.

90. Chapter 390©2005 Pearson Education, Inc. A Corner Solution At point B, the MRS of frozen yogurt for ice cream is greater than the slope of the budget line If the consumer could give up more frozen yogurt for ice cream, he would do so However, there is no more frozen yogurt to give up Opposite is true if corner solution was at point A

91. Chapter 391©2005 Pearson Education, Inc. A Corner Solution When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio In this instance it can be said that:

92. Chapter 392©2005 Pearson Education, Inc. A Corner Solution If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket

93. Chapter 393©2005 Pearson Education, Inc. A Corner Solution - Example Suppose Jane Doe’s parents set up a trust fund for her college education The money must be used only for education Although a welcome gift, an unrestricted gift might be better

94. Chapter 394©2005 Pearson Education, Inc. A Corner Solution - Example Original budget line, PQ, with a market basket, A, of education and other goods Trust fund shifts out the budget line as long as trust fund, PB, is spent on education Jane increases satisfaction, moving to higher indifference curve, U 2

95. Chapter 395©2005 Pearson Education, Inc. A Corner Solution - Example P Q Education ($) Other Consumption ($) U2U2 A U1U1 B Jane better off on U 2 B is corner solution MRS ≠ P OG /P E

96. Chapter 396©2005 Pearson Education, Inc. A Corner Solution - Example P Q Education ($) Other Consumption ($) U2U2 A U1U1 B If gift is unrestricted, Jane can be at point C on U 3 Better off than with restricted gift C U3U3

97. Chapter 397©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good  How much happier is the individual from consuming one more unit of food?

98. Chapter 398©2005 Pearson Education, Inc. Marginal Utility - Example The marginal utility derived from increasing from 0 to 1 units of food might be 9 Increasing from 1 to 2 might be 7 Increasing from 2 to 3 might be 5 Observation: Marginal utility is diminishing as consumption increases

99. Chapter 399©2005 Pearson Education, Inc. Marginal Utility The principle of diminishing marginal utility states that as more of a good is consumed, the additional utility the consumer gains will be smaller and smaller Note that total utility will continue to increase since consumer makes choices that make them happier

100. Chapter 3100©2005 Pearson Education, Inc. Marginal Utility and Indifference Curves As consumption moves along an indifference curve:  Additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C)

101. Chapter 3101©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Formally: No change in total utility along an indifference curve. Trade off of one good to the other leaves the consumer just as well off.

102. Chapter 3102©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Rearranging:

103. Chapter 3103©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice When consumers maximize satisfaction: Since the MRS is also equal to the ratio of the marginal utility of consuming F and C

104. Chapter 3104©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Rearranging, gives the equation for utility maximization:

105. Chapter 3105©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good. This is referred to as the equal marginal principle.

106. Chapter 3106©2005 Pearson Education, Inc. Cost-of-Living Indexes Social Security payments are given to qualifying individuals Each year the benefit increases equal to the rate of increase of the Consumer Price Index (CPI)  Ratio of the present cost of typical bundle of goods/services in comparison to the cost during a base period

107. Chapter 3107©2005 Pearson Education, Inc. Cost-of-Living Indexes Does the CPI give a good measure of inflation and therefore a measure of the cost of living changes? Should the CPI be used to measure how much cost of living has increased, determining increases in government payment programs?

108. Chapter 3108©2005 Pearson Education, Inc. Cost-of-Living Indexes The ideal cost of living index represents the cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base prices Takes into account the fact that consumers can and will substitute some goods for others

109. Chapter 3109©2005 Pearson Education, Inc. Cost-of-Living Indexes To obtain the ideal cost of living index would require too much information, such as consumer preferences as well as prices and expenditures Actual price indexes are based on consumer purchases, not preferences

110. Chapter 3110©2005 Pearson Education, Inc. Cost-of-Living Indexes Laspeyres price index  Amount of money at current year prices that an individual requires to purchase a bundle of goods/services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices  Ex: CPI

111. Chapter 3111©2005 Pearson Education, Inc. Cost-of-Living Indexes The Laspeyres price index assumes that consumers do not alter their consumption patterns as prices change Tends to overstate the true cost of living index Using the CPI to adjust retirement benefits will tend to overcompensate most recipients, requiring greater government expenditure

112. Chapter 3112©2005 Pearson Education, Inc. Cost-of-Living Indexes Paasche index  Focuses on the cost of buying the current year’s bundle  Amount of money at current-year prices that an individual requires to purchase a current bundle of goods/services divided by the cost of purchasing the same bundle in a base year

113. Chapter 3113©2005 Pearson Education, Inc. Cost-of-Living Indexes Comparison of indexes  Both are fixed weight indexes  Quantities of various goods and services in each index remain unchanged  Laspeyres index keeps quantities at base year levels  Paasche index keeps unchanged quantities at current year levels

114. Chapter 3114©2005 Pearson Education, Inc. Cost-of-Living Indexes Paasche Index understates inflation Overstates the cost of the base year bundle (current bundle at base year prices) – consumer would not have chosen that bundle with different relative prices Thus, denominator overstated and index is understated

115. Chapter 3115©2005 Pearson Education, Inc. Cost-of-Living Indexes Chain-Weighted Indexes  Cost-of-living index that accounts for changes in quantities of goods and services  Introduced to overcome problems that arose when long-term comparisons were made using fixed weight price indexes

116. Chapter 3116©2005 Pearson Education, Inc. Practice: Chapter 3, #15 15. Jane receives utility from days spent traveling on vacation domestically (D) and days spent traveling on vacation in a foreign country (F), as given by the utility function: U = 10DF. In addition, the price of a day spent traveling domestically is $100, the price of a day spent traveling in a foreign country is $400, and Jane’s annual travel budget is $4,000. Illustrate the indifference curve associated with a utility of 800 and the indifference curve associated with a utility of 1200.

117. Chapter 3117©2005 Pearson Education, Inc. Practice The indifference curve with a utility of 800 has the equation 10DF=800, or DF=80. Choose combinations of D and F whose product is 80 to find a few bundles. The indifference curve with a utility of 1200 has the equation 10DF=1200, or DF=120. Choose combinations of D and F whose product is 120 to find a few bundles.

118. Chapter 3118©2005 Pearson Education, Inc. Practice Can Jane afford any of the bundles that give her a utility of 800? What about a utility of 1200? Yes she can afford some of the bundles that give her a utility of 800 as part of this indifference curve lies below the budget line. She cannot afford any of the bundles that give her a utility of 1200 as this whole indifference curve lies above the budget line.

119. Chapter 3119©2005 Pearson Education, Inc. Practice Find Jane’s utility maximizing choice of days spent traveling domestically and days spent in a foreign country. (We will need to set the slope of the budget line equal to the slope of the indifference curve by taking two derivatives.)

120. Chapter 3120©2005 Pearson Education, Inc. Practice The optimal bundle is where the slope of the indifference curve is equal to the slope of the budget line, and Jane is spending her entire income. The slope of the budget line is -P D /P F = -1/4 The slope of the indifference curve is: MRS= -MU D /MU F = -10F/10D = -F/D Setting the two equal we get:-F/D = -1/4 We now have two equations and two unknowns:4F=D and 100D+400F=$4000 Solving the above two equations gives D=20 and F=5. Utility is 1000. This bundle is on an indifference curve between the two you had previously drawn.

121. Chapter 3121©2005 Pearson Education, Inc. Practice: Chapter 3, #4 Janelle and Brian each plan to spend $20,000 on the styling and gas mileage features of a new car. They can each choose all styling, all gas mileage, or some combination of the two. Janelle does not care at all about styling and wants the best gas mileage possible. Brian likes both equally and wants to spend an equal amount on the two features. Using indifference curves and budget lines, illustrate the choice that each person will make.

122. Chapter 3122©2005 Pearson Education, Inc. Practice Assume styling is on the vertical axis and gas mileage is on the horizontal axis. Janelle has indifference curves that are vertical. As her indifference curves move over to the right, she gains more gas mileage and more satisfaction. She will spend all $20,000 on gas mileage. This is a corner solution.

123. Chapter 3123©2005 Pearson Education, Inc. Practice Brian has indifference curves that are L- shaped. He will not spend more on one feature than on the other feature. He will spend $10,000 on styling and $10,000 on gas mileage. Styling and gas mileage are perfect complements for Brian.

124. Chapter 3124©2005 Pearson Education, Inc. Homework Due Wednesday, October 24 Exercises Chapter 3: #3, #4 and #5 Questions for Review Chapter 4: #3 and #8