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Introduction to Economics

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Introduction to Economics ­ECO401
VU
Lesson 4.4
BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED................)
Normal Goods and Giffen Good:
A normal good is one whose consumption increases when income increases, while inferior
good is one whose consumption decreases with increase in income.
A Giffen good is a sub-category of inferior goods; its consumption increases when it's price
increases. This is because of its very strong income effect.
Both normal and inferior goods have downward sloping demand curves.
The Income Consumption Curve (ICC) and Price Consumption Curve (PPC):
The income consumption curve (ICC) can be used to derive the Engel Curve, which shows the
relationship between income and quantity demanded.
The price consumption curve (PCC) traces out the optimal choice of consumption at different
prices. The PCC can be used to derive the demand curve, which shows the relationship
between price & quantity demanded.
When the price of one good change, two things happen:
·  One the purchasing power of consumer changes i.e., the budget line shifts (leads to
income effect).
·  Secondly, the slope of budget line changes due to a change in the relative price ratio
(leads to substitution effect).
The substitution effect of a price rise is always negative, while the income effect of a price
rise on the consumption of a normal good is negative. The income effect for an inferior good
is positive. The income effect of a Giffen good is so positive that it offsets the negative
substitution effect, therefore.
Limitation of Indifference Approach:
The indifference curves approach has the following limitations:
a. Indifference curve analysis is only possible for 2 or at best for 3 goods.
b. It is almost impossible to practically derive indifference curves.
c. The consumer may not always behave rationally.
d. The consumer may not always realize the level of utility (ex-post) from consumption,
that she originally expected (ex-ante).
e. Indifference curve analysis can not help when one of the goods (X or Y) is a durable
good.
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Introduction to Economics ­ECO401
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END OF UNIT 4 - EXERCISES
Do you ever purchase things irrationally? If so, what are they and why is your
behaviour irrational?
A good example is things you purchase impulsively, when in fact you do have time to reflect
on whether you really want them. It is not a question of ignorance but a lack of care. Your
behaviour is irrational because the marginal benefit of a bit of extra care would exceed the
marginal effort involved.
Imagine that you are going out for the evening with a group of friends. How would you
decide where to go? Would this decision-making process be described as `rational'
behaviour?
You would probably discuss it and try to reach a consensus view. The benefits to you (and to
other group members) would probably be maximized in this way. Whether these benefits
would be seen as purely `selfish' on the part of the members of the group, or whether people
have more genuinely unselfish approach, will depend on the individuals involved.
If you buy something in the shop on the corner when you know that the same item
could have been bought more cheaply two miles up the road from the wholesale
market, is your behaviour irrational? Explain.
Not necessarily. If you could not have anticipated wanting the item and if it would cost you
time and effort and maybe money (e.g. petrol) to go to the wholesale market, then your
behaviour is rational. Your behaviour a few days previously would have be irrational, however,
if, when making out your weekly shopping list for the wholesale market, a moment's thought
could have saved you having to make the subsequent trip to the shop on the corner.
Are there any goods or services where consumers do not experience diminishing
marginal utility?
Virtually none, if the time period is short enough. If, however, we are referring to a long time
period, such as a year, then initially as more of an item is consumed people may start `getting
more of a taste for it' and thus experience increasing marginal utility. But even with such
items, eventually, as consumption increases, diminishing marginal utility will be experienced.
If Ammaar were to consume more and more crisps, would his total utility ever (a) fall to
zero; (b) become negative? Explain.
Yes, both. If he went on eating more and more, eventually he would feel more dissatisfied
than if he had never eaten any in the first place. He might actually be physically sick!
Complete this table to the level of consumption at which total utility (TU) is at a maximum,
given the utility function TU = Q + 60Q ­ 4Q2.
­4Q2
Q
60Q
=
TU
1
60
­4
=
56
2
120
­16
=
104
3
180
­36
=
144
4
240
­64
=
176
5
300
­100
=
200
6
360
­144
=
216
7
420
­196
=
224
8
480
­256
=
224
Derive the MU function from the following TU function:
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Introduction to Economics ­ECO401
VU
TU = 200Q ­ 25Q˛ + Qł
From this MU function, draw up a table (like the one above) up to the level of Q where MU
becomes negative. Graph these figures.
MU = dTU/dQ = 200 ­ 50Q + 3Q˛
3Q2
Q
MU
200
­50Q
+
=
1
200
­50
+
3
=
153
2
200
­100
+
12
=
112
3
200
­150
+
27
=
77
4
200
­200
+
48
=
48
5
200
­250
+
75
=
25
6
200
­300
+
108
=
8
7
200
­350
+
147
=
­3
180
160
140
120
100
80
60
40
20
MU
0
0
1
2
3
4
5
6
7
-2 0
If a good were free, why would total consumer surplus equal total utility? What would be
the level of marginal utility?
Because there would be no expenditure. At the point of maximum consumer surplus, marginal
utility would be equal to zero, since if P = 0, and MU = P, then MU = 0.
Why do we get less consumer surplus from goods where our demand is relatively
elastic?
Because we would not be prepared to pay such a high price for them. If price went up, we
would more readily switch to alternative products.
How would marginal utility and market demand be affected by a rise in the price of a
complementary good?
Marginal utility and market demand would fall (shift to the left). The rise in the price of the
complement would cause less of it to be consumed. This would therefore reduce the marginal
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Introduction to Economics ­ECO401
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utility of the other good. For example, if the price of lettuce goes up and as a result we consume
less lettuce, the marginal utility of mayonnaise will fall.
The diagram illustrates a person's MU curves of water and diamonds.  Assume that
diamonds are more expensive than water. Show how the MU of diamonds will be greater
than the MU of water. Show also how the TU of diamonds will be less than the TU of
water.
MU, P
Pd
Pw
MU water
MU diamonds
Qd
Qw
Define `risk' and `uncertainty'.
Risk: when an outcome may or may not occur, but its probability of occurring is known.
Uncertainty: when an outcome may or may not occur and its probability of occurring is not
known.
Give some examples of gambling (or risk taking in general) where the odds are (a)
unfavorable; (b) fair; (c) favourable.
a. Betting on the horses; firms launching a new product in a market that is already virtually
saturated and where the firm does not bother to advertise.
b. Gambling on a private game of cards which is a game of pure chance; deciding which of
two alternative brands to buy when they both cost the same and you have no idea which
you will like the best.
c. The buying and selling of shares on the stock exchange by dealers who are skilled in
predicting share price movements; not taking an umbrella when the forecast is that it will
not rain (weather forecasts are right more often than they are wrong!); an employer
taking on a new manager who has excellent references from previous employers.
(Note that in the cases of (a) and (c) the actual odds may not be known, only that they are
unfavorable or favourable.)
Which game would you be more willing to play, a 60:40 chance of gaining or losing Rs10
000, or a 40:60 chance of gaining or losing Re1? Explain why.
Most people would probably prefer the 40:60 chance of gaining or losing Re1. The reason is
that, given the diminishing marginal utility of income, the benefit of gaining Rs10 000 may be
considerably less than the costs of losing Rs10 000, and this may be more than enough to deter
people, despite the fact that the chances of winning are 60:40.
Do you think that this provides a moral argument for redistributing income from the rich
to the poor? Does it prove that income should be so redistributed?
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Introduction to Economics ­ECO401
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Arguments like this are frequently used to justify redistributing income and form part of people's
moral code. Most people would argue that the rich ought to pay more in taxes than the poor and
that the poor ought to receive more state benefits than the rich. The argument is frequently
expressed in terms of a pound being worth more to a poor person than a rich person. It does
not prove that income should be so redistributed, however, unless you argue (a) that the
government ought to increase total utility in society and (b) that it is possible to compare the
utility gained by poor people with that lost by rich people ­ something that is virtually impossible
to do.
What details does an insurance company require to know before it will insure a person to
drive a car?
Age; sex; occupation; accident record; number of years that a license has been held; traffic law
violations and convictions; model and value of the car; age of the car; details of other drivers of
the car.
How will the following reduce moral hazard?
a. A no-claims bonus.
b. The driver having to pay the first so many rupees of any claim (called "excess").
c. Offering lower premiums to those less likely to claim (e.g. if a house has a burglar alarm,
it is less likely to be burgled and therefore the insurance premiums for its contents ­ TV,
VCR, etc. can be reduced by the insurance company).
In the case of (a) and (b) people will be more careful as they would incur a financial loss if the
event they were insured against occurred (loss of no-claims bonus; paying the first so much of
the claim). In the case of (c) it distinguishes people more accurately according to risk. It
encourages people to move into the category of those less likely to claim (but it does not make
people more careful within a category: e.g. those with burglar alarms may be less inclined to turn
them on if they are well insured!).
If people are generally risk averse, why do so many people around the world take part in
national lotteries?
Because the cost of taking part is so little, that they do not regard it as a sacrifice. They also are
likely to take a `hopeful' view (i.e. not based on the true odds) on their chances of winning. What
is more, the act of taking part itself gives pleasure. Thus the behaviour can still be classed as
`rational': i.e. one where the perceived marginal benefit of the gamble exceeds the marginal cost.
Why are insurance companies unwilling to provide insurance against losses arising from
war or `civil disorder'?
Because the risks are not independent. If family A has its house bombed, it is more likely that
family B will too.
Name some other events where it would be impossible to obtain insurance.
Against losses on the stock market; against crop losses resulting from drought.
Although indifference curves will normally be bowed in toward the origin, on odd
occasions they might not be. What would indifference curves look like in each of the
following cases?
a. X and Y are left shoes and right shoes.
b. X and Y are two brands of the same product, and the consumer cannot tell them
apart.
c. X is a good but Y is a `bad' ­ like household refuse.
a. L-shaped. An additional left shoe will give no extra utility without an additional right shoe
to go with it!
b. Straight lines. The consumer is prepared to go on giving up one unit of one brand
provided that it is replaced by one unit of the other brand.
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Introduction to Economics ­ECO401
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c. Upward sloping. If consumers are to be persuaded to put up with more of the `bad', they
must have more of the good to compensate.
What will happen to the budget line if the consumer's income doubles and the price of
both X and Y double?
It will not move. Exactly the same quantities can be purchased as before. Money income has
risen, but real income has remained the same.
The income­consumption curve is often drawn as positively sloped at low levels of
income. Why?
Because for those on a low level of income the good is not yet in the category of an inferior
good. Take the case of inexpensive margarine. Those on very low incomes may economise on
their use of it (along with all other products), but as they earn a little more, so they can afford to
spread it a little thicker or use it more frequently (the income­consumption curve is positive).
Only when their income rises more substantially do they substitute better quality margarines or
butter.
Illustrate on an indifference diagram the effects of the following: A ceteris paribus (a) rise
in the price of good Y (b) fall in the price of good X.
a. The budget line will pivot inwards from B1 to B2.
b. The budget line would pivot outward on the point where the budget line crosses the
vertical axis. It is likely that the new tangency point with an indifference curve will
represent an increase in the consumption of both goods. The diagram above can be
used to illustrate this. Assume the budget line pivots outwards from B1 to B2. The
optimum consumption point will move from point a to c.
Illustrate the income and substitution effects in the above question.
See the diagram above. In each case the substitution effect is shown by a movement from point
a to point b and the substitution effect is shown by a movement from point b to point c.
Are there any Giffen goods that you consume?  If not, could you conceive of any
circumstances in which one or more items of your expenditure would become Giffen
goods?
Good Y
Good Y
B1
B1a
c
a
a
B2
b
b
I2
I1
c
B2
I2
B1
B1a
I1
Good X
Substitution
Good X
Income
(b) Decrease in price of X
(a) Increase in price of Y
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Introduction to Economics ­ECO401
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It is unlikely that any of the goods you consume are Giffen goods. One possible
exception may be goods where you have a specific budget for two or more items,
where one item is much cheaper: e.g. fruit bought from a greengrocer (or rehri waala
on the street). If, say, apples are initially much cheaper than bananas, you may be able
to afford some of each. Then you find that apples have gone up in price, but are still
cheaper than bananas. What do you do? By continuing to buy some of each fruit you
may feel that you are not eating enough pieces of fruit to keep you healthy and so you
substitute apples for bananas, thereby purchasing more apples than before (but
probably less pieces of fruit than originally).
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Table of Contents:
  1. INTRODUCTION TO ECONOMICS:Economic Systems
  2. INTRODUCTION TO ECONOMICS (CONTINUED………):Opportunity Cost
  3. DEMAND, SUPPLY AND EQUILIBRIUM:Goods Market and Factors Market
  4. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..)
  5. DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED……..):Equilibrium
  6. ELASTICITIES:Price Elasticity of Demand, Point Elasticity, Arc Elasticity
  7. ELASTICITIES (CONTINUED………….):Total revenue and Elasticity
  8. ELASTICITIES (CONTINUED………….):Short Run and Long Run, Incidence of Taxation
  9. BACKGROUND TO DEMAND/CONSUMPTION:CONSUMER BEHAVIOR
  10. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)
  11. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….)The Indifference Curve Approach
  12. BACKGROUND TO DEMAND/CONSUMPTION (CONTINUED…………….):Normal Goods and Giffen Good
  13. BACKGROUND TO SUPPLY/COSTS:PRODUCTIVE THEORY
  14. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):The Scale of Production
  15. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):Isoquant
  16. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):COSTS
  17. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):REVENUES
  18. BACKGROUND TO SUPPLY/COSTS (CONTINUED…………..):PROFIT MAXIMISATION
  19. MARKET STRUCTURES:PERFECT COMPETITION, Allocative efficiency
  20. MARKET STRUCTURES (CONTINUED………..):MONOPOLY
  21. MARKET STRUCTURES (CONTINUED………..):PRICE DISCRIMINATION
  22. MARKET STRUCTURES (CONTINUED………..):OLIGOPOLY
  23. SELECTED ISSUES IN MICROECONOMICS:WELFARE ECONOMICS
  24. SELECTED ISSUES IN MICROECONOMICS (CONTINUED……………)
  25. INTRODUCTION TO MACROECONOMICS:Price Level and its Effects:
  26. INTRODUCTION TO MACROECONOMICS (CONTINUED………..)
  27. INTRODUCTION TO MACROECONOMICS (CONTINUED………..):The Monetarist School
  28. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME
  29. THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME (CONTINUED……………..)
  30. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME
  31. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..)
  32. MACROECONOMIC EQUILIBRIUM & VARIABLES; THE DETERMINATION OF EQUILIBRIUM INCOME (CONTINUED………..):The Accelerator
  33. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS
  34. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….)
  35. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Causes of Inflation
  36. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):BALANCE OF PAYMENTS
  37. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):GROWTH
  38. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Land
  39. THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS (CONTINUED…….):Growth-inflation
  40. FISCAL POLICY AND TAXATION:Budget Deficit, Budget Surplus and Balanced Budget
  41. MONEY, CENTRAL BANKING AND MONETARY POLICY
  42. MONEY, CENTRAL BANKING AND MONETARY POLICY (CONTINUED…….)
  43. JOINT EQUILIBRIUM IN THE MONEY AND GOODS MARKETS: THE IS-LM FRAMEWORK
  44. AN INTRODUCTION TO INTERNATIONAL TRADE AND FINANCE
  45. PROBLEMS OF LOWER INCOME COUNTRIES:Poverty trap theories: