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Practice Problem: Chapter 2 #6

Practice Problem: Chapter 2 #6.

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Practice Problem: Chapter 2 #6

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  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 2 #3 • Set quantity supply = quantity demand • P = 6 (convert to $600) • Q = 112 (convert to 1,120,000) Chapter 3

  3. 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. Chapter 3

  4. 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? Chapter 3

  5. 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 Chapter 3

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

  7. Chapter 3 Consumer Behavior

  8. Introduction • How are consumer preferences used to determine demand? • How do consumers allocate income to the purchase of different goods? Chapter 3

  9. Consumer Behavior - Applications • How would General Mills determine the price to charge for a new cereal before it went to the market? • To what extent did the food stamp program provide individuals with more food versus merely subsidizing food they bought anyway? Chapter 3

  10. Consumer Behavior Theory • There are three steps involved in the study of consumer behavior • Consumer Preferences • To describe how and why people prefer one good to another: algebra and graphs • Budget Constraints • People have limited incomes/face prices Chapter 3

  11. Consumer Behavior • Consumer Choices • What combination of goods will consumers buy to maximize their satisfaction, given preferences, income and prices? Chapter 3

  12. 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 Chapter 3

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

  14. Majority Voting and Transitivity Chapter 3

  15. 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 Chapter 3

  16. Indifference Curves: An Example Chapter 3

  17. 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 Chapter 3

  18. B 50 Clothing H E 40 A 30 D G 20 10 Food 10 20 30 40 Indifference Curves: An Example The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A. Chapter 3

  19. B 50 Clothing H E 40 A 30 D 20 G U1 10 Food 10 20 30 40 Indifference Curves: An Example • Indifferent between points B, A, & D • E is preferred to points on U1 • Points on U1are preferred to H & G Chapter 3

  20. 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 Chapter 3

  21. 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 Chapter 3

  22. Clothing D B A U3 U2 U1 Food Indifference Map Market basket A is preferred to B. Market basket B is preferred to D. Chapter 3

  23. 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? Chapter 3

  24. U1 U2 Clothing A B U2 D U1 Food Indifference Maps • 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 Chapter 3

  25. 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 Chapter 3

  26. A 16 Clothing 14 12 -6 B 10 1 8 -4 D 6 E 1 G -2 4 1 -1 1 2 Food 1 2 3 4 5 Indifference Curves Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1 Chapter 3

  27. 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 Chapter 3

  28. A Clothing 16 14 -6 12 B 10 1 -4 8 D 1 6 E -2 G 4 1 -1 1 2 Food 1 2 3 4 5 Marginal Rate of Substitution MRS = 6 MRS = 2 Chapter 3

  29. 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 Chapter 3

  30. 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 Chapter 3

  31. 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 Chapter 3

  32. 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 Chapter 3

  33. Apple Juice (glasses) 4 3 2 1 Orange Juice (glasses) 0 1 2 3 4 Consumer Preferences Perfect Substitutes Chapter 3

  34. 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 Chapter 3

  35. Left Shoes 4 3 2 1 0 1 2 3 4 Right Shoes Consumer Preferences Perfect Complements Chapter 3

  36. 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 Chapter 3

  37. Consumer Preferences • How do we account for bads in our preference analysis? • We redefine the commodity • Clean air • Pollution reduction • Asbestos removal Chapter 3

  38. 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 Chapter 3

  39. 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 Chapter 3

  40. Styling Performance Consumer Preferences: An Application These consumers place a greater value on performance than styling Chapter 3

  41. Styling Performance Consumer Preferences: An Application These consumers place a greater value on styling than performance Chapter 3

  42. 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 Chapter 3

  43. 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 Chapter 3

  44. 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 Chapter 3

  45. 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) Chapter 3

  46. Utility - Example Consumer is indifferent between A & B and prefers both to C Chapter 3

  47. 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 Chapter 3

  48. Clothing 15 C 10 U3 = 100 A 5 B U2 = 50 U1 = 25 Food 0 5 10 15 Utility - Example Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) Chapter 3

  49. 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 Chapter 3

  50. 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 Chapter 3

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