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  • of 57
  • PowerPoint Lectures for
  • Principles of Economics, 9e
  • By
  • Karl E. Case, Ray C. Fair & Sharon M. Oster
  • ; ;
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  • The Market System Choices Made by Households and Firms
  • Fernando & Yvonn Quijano
  • Prepared by:
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  •  FIGURE II.1 Firm and Household Decisions
  • Households demand in output markets and supply labor and capital in input markets.
  • To simplify our analysis, we have not included the government and international sectors in this circular flow diagram. These topics will be discussed in detail later.
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  • The analysis of the interaction between firms and households assumes that:
  • a. Labor and capital are supplied by households.
  • b. Labor and capital are supplied by firms.
  • c. The demand curve for labor illustrates the households’ participation in the labor market.
  • d. All of the above.
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  • The analysis of the interaction between firms and households assumes that:
  • a. Labor and capital are supplied by households.
  • b. Labor and capital are supplied by firms.
  • c. The demand curve for labor illustrates the households’ participation in the labor market.
  • d. All of the above.
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  •  FIGURE II.2 Firm and Household Decisions
  • To understand how the economy works, it helps to build from the ground up. We start in Chapters 6–8 with an overview of household and firm decision making in simple perfectly competitive markets.
  • In Chapters 9–11, we see how firms and households interact in output markets (product markets) and input markets (labor/land and capital) to determine prices, wages, and profits. Once we have a picture of how a simple perfectly competitive economy works, we begin to relax assumptions.
  • Chapter 12 is a pivotal chapter that links perfectly competitive markets with a discussion of market imperfections and the role of government.
  • In Chapters 13–18, we cover the three noncompetitive market structures (monopoly, monopolistic competition, and oligopoly), externalities, public goods, imperfect information, and income distribution as well as taxation and government finance.
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  • Assumptions Pertaining to all of Chapters 6 through Chapter 12
  • perfect competition An industry structure in which there are many firms, each small relative to the industry and producing virtually identical products, and in which no firm is large enough to have any control over prices.
  • homogeneous products Undifferentiated outputs; products that are identical to or indistinguishable from one another.
  • perfect knowledge The assumption that households possess a knowledge of the qualities and prices of everything available in the market and that firms have all available information concerning wage rates, capital costs, and output prices.
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  • Household Behavior and Consumer Choice
  • Fernando & Yvonn Quijano
  • Prepared by:
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  • PART II THE MARKET SYSTEM
  • Household Behavior and Consumer Choice
  • CHAPTER OUTLINE
  • Household Choice in Output Markets
  • The Determinants of Household Demand The Budget Constraint
  • The Basis of Choice: Utility Diminishing Marginal Utility Allocating Income to Maximize Utility The Utility-Maximizing Rule Diminishing Marginal Utility and Downward-Sloping Demand
  • Income and Substitution Effects The Income Effect The Substitution Effect
  • Consumer Surplus Household Choice in Input Markets The Labor Supply Decision The Price of Leisure Income and Substitution Effects of a Wage Change Saving and Borrowing: Present versus Future Consumption
  • A Review: Households in Output and Input Markets Appendix: Indifference Curves
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  • Household Choice in Output Markets
  • Every household must make three basic decisions:
  • How much of each product, or output, to demand
  • 2. How much labor to supply
  • 3. How much to spend today and how much to save for the future
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  • Every household must make three basic decisions. Which of these decisions is more closely associated with the capital market?
  • a. How much of each product to demand.
  • b. How much labor to supply.
  • c. How much to spend today and how much to save for the future.
  • d. How much to invest.
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  • Every household must make three basic decisions. Which of these decisions is more closely associated with the capital market?
  • a. How much of each product to demand.
  • b. How much labor to supply.
  • c. How much to spend today and how much to save for the future.
  • d. How much to invest.
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  • Household Choice in Output Markets
  • The Determinants of Household Demand
  • Several factors influence the quantity of a given good or service demanded by a single household:
  • The price of the product
  • The income available to the household
  • The household’s amount of accumulated wealth
  • The prices of other products available to the household
  • The household’s tastes and preferences
  • The household’s expectations about future income, wealth, and prices
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  • Household Choice in Output Markets
  • The Budget Constraint
  • choice set or opportunity set The set of options that is defined and limited by a budget constraint.
  • TABLE 6.1 Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes
  • Option
  • Monthly Rent
  • Food
  • Other Expenses
  • Total
  • Available?
  • A
  • $ 400
  • $250
  • $350
  • $1,000
  • Yes
  • B
  • 600
  • 200
  • 200
  • 1,000
  • Yes
  • C
  • 700
  • 150
  • 150
  • 1,000
  • Yes
  • D
  • 1,000
  • 100
  • 100
  • 1,200
  • No
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  • Household Choice in Output Markets
  • Preferences, Tastes, Trade-Offs, and Opportunity Cost
  •  FIGURE 6.1 Budget Constraint and Opportunity Set for Ann and Tom
  • A budget constraint separates those combinations of goods and services that are available, given limited income, from those that are not. The available combinations make up the opportunity set.
  • real income Set of opportunities to purchase real goods and services available to a household as determined by prices and money income.
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  • HOUSEHOLD CHOICE IN OUTPUT MARKETS
  • The Equation Of The Budget Constraint
  • In general, the budget constraint can be written:
  • PXX + PYY = I,
  • where PX = the price of X, X = the quantity of X consumed, PY = the price of Y, Y = the quantity of Y consumed, and I = household income.
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  • Refer to the figure below. Suppose that the income of the consumer equals $20. Use the information on the graph to determine the prices of goods Y and X.
  • a. There is insufficient information to answer the question.
  • b. Py = $2, Px = $4
  • c. Py = $2, Px = $3
  • d. Py = $20, Px = $12
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  • Refer to the figure below. Suppose that the income of the consumer equals $20. Use the information on the graph to determine the prices of goods Y and X.
  • a. There is insufficient information to answer the question.
  • b. Py = $2, Px = $4
  • c. Py = $2, Px = $3
  • d. Py = $20, Px = $12
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  • HOUSEHOLD CHOICE IN OUTPUT MARKETS
  • Budget Constraints Change When Prices Rise or Fall
  •  FIGURE 6.2 The Effect of a Decrease in Price on Ann and Tom’s Budget Constraint
  • When the price of a good decreases, the budget constraint swivels to the right, increasing the opportunities available and expanding choice.
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  • Refer to the figure below. What explains the moves in the budget lines in graphs A and B?
  • a. Both the rotation in A and the shift in B are caused by increases in income.
  • b. The rotation in graph A is caused by a decrease in the price of X, while the shift in B is caused by an increase in income.
  • c. Both the rotation in A and the shift in B are caused by decreases in the prices of goods X and Y.
  • d. The rotation in graph A is caused by a change in income, while the rotation in graph B is the result of a decrease in the price of one of the goods.
  • e. None of the above.
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  • Refer to the figure below. What explains the moves in the budget lines in graphs A and B?
  • a. Both the rotation in A and the shift in B are caused by increases in income.
  • b. The rotation in graph A is caused by a decrease in the price of X, while the shift in B is caused by an increase in income.
  • c. Both the rotation in A and the shift in B are caused by decreases in the prices of goods X and Y.
  • d. The rotation in graph A is caused by a change in income, while the rotation in graph B is the result of a decrease in the price of one of the goods.
  • e. None of the above.
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  • The Basis of Choice: Utility
  • utility The satisfaction, or reward, a product yields relative to its alternatives. The basis of choice.
  • marginal utility (MU) The additional satisfaction gained by the consumption or use of one more unit of something.
  • Diminishing Marginal Utility
  • total utility The total amount of satisfaction obtained from consumption of a good or service.
  • law of diminishing marginal utility The more of any one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.
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  • The Basis of Choice: Utility
  • TABLE 6.2 Total Utility and Marginal Utility of Trips to the Club Per Week
  • Trips to Club
  • Total Utility
  • Marginal Utility
  • 1
  • 12
  • 12
  • 2
  • 22
  • 10
  • 3
  • 28
  • 6
  • 4
  • 32
  • 4
  • 5
  • 34
  • 2
  • 6
  • 34
  • 0
  •  FIGURE 6.3 Graphs of Frank’s Total and Marginal Utility
  • Marginal utility is the additional utility gained by consuming one additional unit of a commodity—in this case, trips to the club. When marginal utility is zero, total utility stops rising.
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  • When diminishing returns are present in consumption, the relationship between total utility and marginal utility is as follows:
  • a. Total utility and marginal utility decrease at an increasing rate.
  • b. Total utility increases at an increasing rate while marginal utility decreases.
  • c. Total utility increases at a decreasing rate while marginal utility decreases.
  • d. Total utility decreases at an increasing rate while marginal utility decreases.
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  • When diminishing returns are present in consumption, the relationship between total utility and marginal utility is as follows:
  • a. Total utility and marginal utility decrease at an increasing rate.
  • b. Total utility increases at an increasing rate while marginal utility decreases.
  • c. Total utility increases at a decreasing rate while marginal utility decreases.
  • d. Total utility decreases at an increasing rate while marginal utility decreases.
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  • The Basis of Choice: Utility
  • Allocating Income To Maximize Utility
  • TABLE 6.3 Allocation of Fixed Expenditure per Week Between Two Alternatives
  • (1) Trips to Club per Week
  • (2) Total Utility
  • (3) Marginal Utility (MU)
  • (4) Price (P)
  • (5) Marginal Utility per Dollar (MU/P)
  • 1
  • 12
  • 12
  • $3.00
  • 4.0
  • 2
  • 22
  • 10
  • 3.00
  • 3.3
  • 3
  • 28
  • 6
  • 3.00
  • 2.0
  • 4
  • 32
  • 4
  • 3.00
  • 1.3
  • 5
  • 34
  • 2
  • 3.00
  • 0.7
  • 6
  • 34
  • 0
  • 3.00
  • 0
  • (1) Basketball Games per Week
  • (2) Total Utility
  • (3) Marginal Utility (MU)
  • (4) Price (P)
  • (5) Marginal Utility per Dollar (MU/P)
  • 1
  • 21
  • 21
  • $6.00
  • 3.5
  • 2
  • 33
  • 12
  • 6.00
  • 2.0
  • 3
  • 42
  • 9
  • 6.00
  • 1.5
  • 4
  • 48
  • 6
  • 6.00
  • 1.0
  • 5
  • 51
  • 3
  • 6.00
  • .5
  • 6
  • 51
  • 0
  • 6.00
  • 0
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  • Which of the following statements concerning total and marginal utility is correct?
  • a. Marginal utility is usually larger than total utility.
  • b. Total utility is the sum of marginal utility.
  • c. Marginal utility is the sum of total utility.
  • d. Marginal utility is maximized when total utility equals zero.
  • e. Marginal utility increases when total utility increases.
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  • Which of the following statements concerning total and marginal utility is correct?
  • a. Marginal utility is usually larger than total utility.
  • b. Total utility is the sum of marginal utility.
  • c. Marginal utility is the sum of total utility.
  • d. Marginal utility is maximized when total utility equals zero.
  • e. Marginal utility increases when total utility increases.
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  • The Basis of Choice: Utility
  • The Utility-Maximizing Rule
  • In general, utility-maximizing consumers spread out their expenditures until the following condition holds:
  • utility-maximizing rule Equating the ratio of the marginal utility of a good to its price for all goods.
  • diamond/water paradox A paradox stating that (1) the things with the greatest value in use frequently have little or no value in exchange and (2) the things with the greatest value in exchange frequently have little or no value in use.
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  • In the formula below, the marginal utility per dollar spent on good X is less than the marginal utility per dollar spent on good Y. To increase total utility, the consumer should:
  • a. Increase the consumption of good X.
  • b. Increase the consumption of good Y.
  • c. Increase the consumption of both goods.
  • d. Decrease the consumption of both goods.
  • e. Maintain consumption constant
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  • In the formula below, the marginal utility per dollar spent on good X is less than the marginal utility per dollar spent on good Y. To increase total utility, the consumer should:
  • a. Increase the consumption of good X.
  • b. Increase the consumption of good Y.
  • c. Increase the consumption of both goods.
  • d. Decrease the consumption of both goods.
  • e. Maintain consumption constant
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  • The Basis of Choice: Utility
  • Diminishing Marginal Utility and Downward-Sloping Demand
  •  FIGURE 6.4 Diminishing Marginal
  • Utility and Downward-Sloping Demand
  • At a price of $40, the utility gained from even the first Thai meal is not worth the price.
  • However, a lower price of $25 lures Ann and Tom into the Thai restaurant 5 times a month. (The utility from the sixth meal is not worth $25.)
  • If the price is $15, Ann and Tom will eat Thai meals 10 times a month—until the marginal utility of a Thai meal drops below the utility they could gain from spending $15 on other goods.
  • At 25 meals a month, they cannot tolerate the thought of another Thai meal even if it is free.
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  • Income and Substitution Effects
  • The Income Effect
  • Price changes affect households in two ways. First, if we assume that households confine their choices to products that improve their well-being, then a decline in the price of any product, ceteris paribus, will make the household unequivocally better off.
  • In other words, if a household continues to buy the same amount of every good and service after the price decrease, it will have income left over. That extra income may be spent on the product whose price has declined, hereafter called good X, or on other products.
  • The change in consumption of X due to this improvement in well-being is called the income effect of a price change.
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  • Income and Substitution Effects
  • The Substitution Effect
  • When the price of a product falls, that product also becomes relatively cheaper. That is, it becomes more attractive relative to potential substitutes. A fall in the price of product X might cause a household to shift its purchasing pattern away from substitutes toward X. This shift is called the substitution effect of a price change.
  • Everything works in the opposite direction when a price rises, ceteris paribus. When the price of a product rises, that item becomes more expensive relative to potential substitutes and the household is likely to substitute other goods for it.
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  • Income and Substitution Effects
  •  FIGURE 6.4 Diminishing Marginal
  • Utility and Downward-Sloping Demand
  • For normal goods, the income and substitution effects work in the same direction. Higher prices lead to a lower quantity demanded, and lower prices lead to a higher quantity demanded.
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  • Substitution and Market Baskets
  • When we artificially restrict Ms. Smith’s ability to substitute goods, we almost inevitably give her a more expensive bundle.
  • Income and Substitution Effects
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  • Household Choice in Input Markets
  • The Labor Supply Decision
  • Whether to work
  • How much to work
  • What kind of a job to work at
  • As in output markets, households face constrained choices in input markets. They must decide
  • In essence, household members must decide how much labor to supply. The choices they make are affected by
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  • Household Choice in Input Markets
  •  FIGURE 6.6 The Trade-Off Facing
  • Households
  • The decision to enter the workforce involves a trade-off between wages (and the goods and services that wages will buy) on the one hand and leisure and the value of nonmarket production on the other hand.
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  • Household Choice in Input Markets
  • The Price of Leisure
  • Trading off one good for another involves buying less of one and more of another, so households simply reallocate money from one good to the other. “Buying” more leisure, however, means reallocating time between work and nonwork activities. For each hour of leisure that I decide to consume, I give up one hour’s wages. Thus the wage rate is the price of leisure.
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  • Which of the following best represents the opportunity cost of leisure?
  • a. The decision concerning what kind of job to work at.
  • b. Activities such as swimming, watching TV, reading, or sleeping.
  • c. The wage rate.
  • d. The prices of goods and services.
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  • Which of the following best represents the opportunity cost of leisure?
  • a. The decision concerning what kind of job to work at.
  • b. Activities such as swimming, watching TV, reading, or sleeping.
  • c. The wage rate.
  • d. The prices of goods and services.
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  • Household Choice in Input Markets
  • Income and Substitution Effects of a Wage Change
  • labor supply curve A curve that shows the quantity of labor supplied at different wage rates. Its shape depends on how households react to changes in the wage rate.
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  • Household Choice in Input Markets
  •  FIGURE 6.7 Two Labor Supply Curves
  • When the substitution effect outweighs the income effect, the labor supply curve slopes upward (a).
  • When the income effect outweighs the substitution effect, the result is a “backwardbending” labor supply curve: The labor supply curve slopes downward (b).
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  • An increase in the wage rate has two effects on the demand for leisure: the substitution effect and the income effect. Which of the following describes the income effect?
  • a. As the wage increases, a worker will substitute income for leisure time.
  • b. As the wage increases, the worker’s real income rises, and the demand for leisure will rise.
  • c. As the wage rate increases, firms will substitute workers for other inputs.
  • d. As the amount of output rises, the amount of labor demanded will rise.
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  • An increase in the wage rate has two effects on the demand for leisure: the substitution effect and the income effect. Which of the following describes the income effect?
  • a. As the wage increases, a worker will substitute income for leisure time.
  • b. As the wage increases, the worker’s real income rises, and the demand for leisure will rise.
  • c. As the wage rate increases, firms will substitute workers for other inputs.
  • d. As the amount of output rises, the amount of labor demanded will rise.
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  • Google: Is It Work or Is It Leisure?
  • By providing many services at the workplace, Google has potentially affected the trade-off people make between work and leisure. In the end, without increasing wages, Google may have reduced the marginal utility of leisure and made people more willing to work longer hours.
  • Income and Substitution Effects
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  • Household Choice in Input Markets
  • Saving and Borrowing: Present versus Future Consumption
  • Just as changes in wage rates affect household behavior in the labor market, changes in interest rates affect household behavior in capital markets.
  • Most empirical evidence indicates that saving tends to increase as the interest rate rises. In other words, the substitution effect is larger than the income effect.
  • financial capital market The complex set of institutions in which suppliers of capital (households that save) and the demand for capital (business firms wanting to invest) interact.

budget constraint

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  • budget constraint
  • choice set or opportunity set
  • consumer surplus
  • cost-benefit analysis
  • diamond/water paradox
  • financial capital market
  • homogeneous products
  • income effect of a price change
  • labor supply curve
  • law of diminishing marginal utility
  • marginal utility (MU)
  • perfect competition
  • perfect knowledge
  • real income
  • substitution effect of a price change
  • total utility
  • utility
  • utility-maximizing rule
  • REVIEW TERMS AND CONCEPTS

Appendix

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  • INDIFFERENCE CURVES
  • We base the following analysis on four assumptions:
  • We assume that this analysis is restricted to goods that yield positive marginal utility, or, more simply, that “more is better.”
  • The marginal rate of substitution is defined as MUX/MUY, or the ratio at which a household is willing to substitute X for Y. We assume a diminishing marginal rate of substitution.
  • We assume that consumers have the ability to choose among the combinations of goods and services available.
  • We assume that consumer choices are consistent with a simple assumption of rationality.
  • ASSUMPTIONS
  • A P P E N D I X
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  • DERIVING INDIFFERENCE CURVES
  • A P P E N D I X
  •  FIGURE 6A.1 An Indifference Curve
  • An indifference curve is a set of points, each representing a combination of some amount of good X and some amount of good Y, that all yield the same amount of total utility.
  • The consumer depicted here is indifferent between bundles A and B, B and C, and A and C.
  • Because “more is better,” our consumer is unequivocally worse off at A' than at A.
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  • Refer to the figure. Which point is preferred to the others?
  • a. Point w is preferred to all other points.
  • b. Points u and v, or points along the indifference curve, are preferred to points outside, such as w and t.
  • c. Point t is preferred.
  • d. All points are equally preferred.
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  • Refer to the figure. Which point is preferred to the others?
  • a. Point w is preferred to all other points.
  • b. Points u and v, or points along the indifference curve, are preferred to points outside, such as w and t.
  • c. Point t is preferred.
  • d. All points are equally preferred.
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  • A P P E N D I X
  •  FIGURE 6A.2 A Preference Map: A Family of Indifference Curves
  • Each consumer has a unique family of indifference curves called a preference map. Higher indifference curves represent higher levels of total utility.
  • PROPERTIES OF INDIFFERENCE CURVES
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  • CONSUMER CHOICE
  • At point B:
  • A P P E N D I X
  •  FIGURE 6A.3 Consumer Utility- Maximizing Equilibrium
  • Consumers will choose the combination of X and Y that maximizes total utility.
  • Graphically, the consumer will move along the budget constraint until the highest possible indifference curve is reached. At that point, the budget constraint and the indifference curve are tangent. This point of tangency occurs at X* and Y* (point B).
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  • Refer to the figure below. Which two points yield the same total utility?
  • a. Points w and z.
  • b. Points b and e.
  • c. Points z and e.
  • d. Points b and z.
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  • Refer to the figure below. Which two points yield the same total utility?
  • a. Points w and z.
  • b. Points b and e.
  • c. Points z and e.
  • d. Points b and z.
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  • DERIVING A DEMAND CURVE FROM INDIFFERENCE CURVES AND BUDGET CONSTRAINTS
  • A P P E N D I X
  •  FIGURE 6A.4 Deriving a Demand Curve from Indifference Curves and Budget Constraint
  • Indifference curves are labeled i1, i2, and i3; budget constraints are shown by the three diagonal lines from I/PY to I/PX, I/PX and I/PX. Lowering the price of X from PX to PX and then to swivels the budget constraint to the right. At each price, there is a different utility-maximizing combination of X and Y. Utility is maximized at point A on i1, point B on i2, and point C on i3. Plotting the three prices against the quantities of X chosen results in a standard downward-sloping demand curve.
  • 1
  • 3
  • 2
  • 1
  • 2

Indifference curve

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  • Indifference curve
  • Marginal rate of substitution
  • Preference map
  • REVIEW TERMS AND CONCEPTS


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