Principles of Economics

1. PrinciplesofEconomics Class 2 Demandandconsumerbehavior

2. Utility • Utility (u or TU)is a pleasure that consumer gains when he consumes goods and services. • Marginal utility MU is an increase in utility when quantity of consumed products increases by one unit. • Law of diminishing MU states that MU becomes diminishes when the amount of consumed goods increases. • Observation of marginal values was started in 1870’s bz Jevons, Menger and Walras.

3. Total utility and marginal utility

4. Indifference curves map • Indifference curve is a curve that connects all the baskets (combinations) of goods that give the same value of pleasure to a consumer. • Its slope is Marginal rate of substitution MRS which tells what is the amount of good Y a consumer is willing to give up in order to get additional unit of X staying on the same level of utility.

5. qy Indifference curves map Δqx = 1 Δqy = MRSxy u4 u3 u2 u1 0 qx

6. Budget • Consumer can buy only those combinations of goods that satisfy the following rule: (where p = price and q = quantity) • The slope of a budget line equal to ratio of prices • The area below and on the budget line is affordable with the income I.

7. qy 0 qx

8. Consumer equilibrium • The equilibrium is obtained when budget line is tangent to indifference curve. • In that case there is no other consumer basket on the budget line that can yield higher utility.

9. qy u3 Affordable area u2 u1 0 qx

10. Changes in the equilibrium qy Price of X falls Price-consumption curve u2 u1 0 qy qx Income increases Income-consumption curve u2 u1 0 qx

11. Income and substitution effect • INCOME EFFECT is the change in the consumer’s equilibrium due to a change in the purchasing power. • SUBSTITUTION EFFECT is the change in the consumer’s equilibrium due to a change in relative prices while retaining the same utilitz level.

12. qy Substitution effect Income effect u2 u1 0 qx

13. Deduction of an individual demand qy Px falls u2 u1 0 qx px The smaller the price of X, the greater its demanded quantity d 0 qx

14. Deduction of the market demand p Market demand is a horizontal summation of individual demands (competitive good) dM 0 q

15. Causes of demand shifts • Price of complement rises, • Price of substitute falls • Income falls (normal good), • Income rises (inferior good) • Good becomes less useful or more substitutable p • Price of complement falls, • Price of substitute rises • Income rises (normal good), • Income falls (inferior good) • Good becomes more useful or less substitutable d 0 q

16. Consumer’s and producer’s surplus p Consumer surplus is the difference between the price consumer pays and the price he was willing to pay. s Consumer’s surplus E Producer surplus is the difference between the price the seller charges and the price at which he was willing to sell. Producer’s surplus d q 0

17. Exercise 1 • Consumer buys 3 goods, A, B and C. The pleasure of consumption of these goods increases as THE consumer increases the quantity: Calculate marginal utilities for each good If the consumer has 52$ and prices of goods A, B and C are 1$, 2$ and 4$ respectively find the optimal consumption basket when consumer spends the entire income. What if income falls down to 36$? Draw TU and MU for good B

18. Exercise 2 • 1)Let a consumer have the income of 150$ which can be spent on shirts and pullovers. Price of a shirt is 5$ and price of a pullover is 24$. He spends the entire income. • a)When consumers maximizes his utility? • MUx/Px=MUy/Py

19. 3 combinations=> 1) 3(s) and4(P) -> 3*5$ + 4*25$ = 115$ 2) 5(s) and5(P) -> 5*5$ + 5*25$ = 150$ 3) 7(s) and6(P) -> 7*5$ + 6*25$ = 185$ • Consumer maximizes his utilitz when he buys 5 shirts and 5 pullovers • Total utility (TU) =TU(p)+TU(s)=250+1500 = 1750

20. b)Pri kojoj kombinaciji košulja i pulovera potrošač maksimizira svoju korisnost ako se dohodak smanji na 115$ i kolika je ukupna korisnost? • Potrošač max. svoju korisnost pri kombinaciji od 4 pulovera i 3 košulja! • Ukupna korisnost(TU) =TU(p)+TU(k)=1300+165 = 1465

21. c)Is it possible to acquire the same level of utility if price of shirt 10$ and price of pullover 50$ having the income of 280$? • TU =1750 for A) 5 pullovers and5 shirts (5*10$+5*50$) = 300$ B) 7 pullovers and0 shirts (7*50$+0*10$) = 350$ • It is no longer possible to maintain the previous level of utilitz with the given prices and income. • Note: by how much changed prices and the income? It can give you an immediate answer to c)!

22. Exercise 3 • James is ready to pay 10 kn for the first bottle of coke, for the second 8 kn, 3rd 6 kn and 4th 4kn. Find his consumer surplus if the current price of a bottle of coke is 4 kn. • TABLICA • CS =6+4+2+0 = 12! b)If the price went up to 6 kn what is the amount of consumer’s surplus? • 4+2+0 = 6!

23. Exercise 4 • Demand and supply equations are qd = 10 – 2p and qs = 0.5p. Find CS, PS and the equilibrium price and quantity. • 10 – 2p = 0.5p => p*= 4, q*= 2. • CS = (5 – 4)*2/2 = 1 • PS = (4 – 0)*2/2 = 4 • TS = 5