Economics 202: Intermediate Microeconomic Theory

1. Inquiries?

2. No new reading.

3. HW #4 due next class (it’s on the website)

Utility Maximization• Maximize utility subject to a budget constraint

• Demand function: X* = dX(PX, PY, I)

• Derive demand functions for different utility functions

– C-D, quasilinear, perfect substitutes/complements, CES

Expenditure Minimization• Dual problem to “primal” utility max problem

• Minimize total expenditure necessary to achieve a given level of utility

• Expenditure function: min expenditures = E(PX, PY, U)

• Derive expenditure functions for different utility functions

– C-D, quasilinear, perfect substitutes/complements, CES

Income-Consumption & Engel Curves• Income-consumption (aka, income

offer) curve plots optimal (X,Y) bundles as income changes, holding prices constant

• Engel curve plots the optimal consumption levels of X as income changes, holding prices constant

• 1 = normal, necessity

2 = normal

3 = normal, luxury

4 = inferior

• C-D, quasilinear, perfect substitutes/complements

X

I

1

2

4

3

Income and Substitution Effects Normal Good

• Initial point = X

Credit hours

• Income Effect = a decrease in purchasing power pushes consumption lower, for superior goods

Pch “purch power” Dch if normal Z is to left of Y (Z is below Y too)

CCG

X

Z

Y

• Substitution Effect

Pch substitute toward less expensive good credit hrs Y is to left of X (Y is above X too)

• SE: X Y

IE: Y Z

Total effect: X Z(graphical analysis)

Income and Substitution Effects: Normal Good

Q credit hours

Price of credit hour

Demand

b

a

• D-curve for a normal good is necessarily downward sloping because the SE and IE reinforce one another (id est, they push consumption in the same direction)

• For Pch , SE fewer credits IE fewer credits

• For Pch , SE more credits IE more credits

Income and Substitution Effects: Inferior Good

Substitution Effect Pub substitute toward less expensive good used books Y is to right of X (Y is also below X too)

Used books

CCG

Z

X

YIncome Effect = an increase in purchasing power pushes consumption lower, for inferior Pub “purch power”

Dub , if inferior good Z is to left of Y (Z is above Y too)SE: X Y IE: Y ZTotal effect: X Z

Income and Substitution Effects: Inferior Good

• D-curve for an inferior good is also downward sloping because, although SE and IE work in opposite directions, IE < SE

• For Pub , SE fewer books IE more books

For Pub , SE more books IE fewer books• Giffen good is an inferior good for which the IE > SE, creating an UPWARD-sloping D-curve.

• No way?! IE is small for most goods, SE likely large for inferior goods. • Way. Irish potato famine.

Q used books

Price of used books

D

b

a