I. ElasticityII. Real and nominal pricesIII. Consumer theoryA. BudgetB. UtilityC. Consumer Decision MakingIV. Production and CostA. FirmB. ProductionC. Production in the short-runD. CostE. Costs in the short runF. Production and cost in the long runV. Profit maximizationA. Profit maximizing output levelB. Dealing with lossesC. The goal of the firm revisitedReview notes 2Econ 101 (Prof. Kelly)Fall 2002I. ElasticityRefer to Review notes 1.II. Real and nominal pricesReal price (or wage) = [Nominal price (or wage) / consumer price index (CPI)] · 100.III. Consumer theory2 good model (goods X and Y)Consumer’s goal is to maximize utility under budget constraint.A. BudgetBudget constraint – The different combinations of goods a consumer can afford with a limited budget, at given prices.Budget line – The northeast boundary of a budget constraint: PX·X + PY·Y = I. The slope of the budget line indicates the spending trade-off between one good and another—the amount of one good that must be sacrificed in order to buy more of another good. The slope of the budget line is −PX /PY (negative of the relative price). Changes in income shift the budget line, keeping the slope fixed. Changes in a price of a good rotate the budget line, keeping the intercept on the axis of the other good fixed.B. UtilityRational preferences – satisfy (1) any two alternatives can be compared, and one is preferred or else the two are valued equally, and (2) the comparisons are logically consistent. For example, (1) any two bundles (X1, Y1) and (X2, Y2) can be compared, and (X1, Y1) is preferred to (X2, Y2), (X2, Y2) is preferred to (X1, Y1), or (X1, Y1) is indifferent from (X2, Y2), and (2) for any three bundles (X1, Y1), (X2, Y2), and (X3, Y3), if (X1, Y1) is preferred to (or indifferent from) (X2, Y2) and (X2, Y2) is preferred to (or indifferent from) (X3, Y3), then (X1, Y1) is preferred to (or indifferent from) (X3, Y3).Utility – pleasure or satisfaction obtained from consuming goods and services (a representation of rational preferences).1Indifference curve – represents all combinations of two categories of goods that make the consumer equally well off (a graphical representation of utility).Assumptions on indifference curves (ICs):(1) ICs are downward sloping (more is better).(2) ICs are curved toward the origin (variety is important).(3) there is an IC through every point and each IC represents a different but constant levelof satisfaction (from condition (1) of rational preferences).(4) ICs never intersect (from condition (2) of rational preferences).Marginal rate of substitution of good Y for good X (MRSXY) – the slope of the indifference curve (a negative number). The MRSXY tells us the decrease in the quantity of good Y needed to accompany a one-unit increase in good X, in order to keep the consumer indifferent to the change.C. Consumer Decision MakingThe optimal combination of goods for a consumer is that combination on the budget line at which the indifference curve has the same slope as the budget line. That is, the optimality conditions are | MRSXY | = PX /PY and the bundle is on the budget line.Marginal Utility – the change in total utility an individual obtains from consuming an additional unit of a good or service. Let MUX be marginal utility of good X and MUY be marginal utility of good Y. It can be shown that | MRSXY | = MUX / MUY at any bundles (X, Y). This implies that one of the optimality conditions can be written as MUX / PX= MUY / PY.Law of diminishing marginal utility – As consumption of a good or service increases, holding everything else constant, marginal utility decreases (a plausible assumption on marginal utility).D. Changes in ( PX, PY, I )In this subsection, suppose that optimal bundle is always chosen for each (PX, PY, I).i). Fix PY and I (or PX and I ). Price-consumption path is derived by connecting optimal bundles for each PX (or PY). If we focus on the relationship between PX (or PY) and demand for X (or Y), we can draw the demand curve for good X (or Y).Substitution effect – a change in the quantity of a good demanded, which results from a change in its relative price, eliminating the effect on real income of the change in price.Income effect – the effect on quantity demanded of a change in real income.A change in demand due to a change in PX (or PY) can be decomposed into substitution and income effects. Suppose we are given two budget lines BL1 (original) and BL2 (new) 2which is tangent to indifference curves IC1 and IC2 at points A and B respectively. To do this, draw an imaginary budget line BL3 which is tangent to IC1 at point C and parallel to BL2. The move from A to C represents the substitution effect and the move from C to B represents the income effect. Demand curves are downward sloping because as a price ofa good increases, the substitution effect for the good decreases the quantity demanded for the good and the income effect for the good decreases the quantity demanded for the good (if it is a normal good) or even if the income effect for the good increases the quantity demanded for the good (if it is an inferior good) this will offset by the substitution effect in almost all cases. ii). Fix PX and PY. Income-consumption path is derived by connecting optimal bundlesfor each income level. If both goods are normal, income-consumption path is upward sloping. If one of the goods is inferior, income-consumption path is downward sloping. (It is impossible for both goods to be inferior under our assumptions.)IV. Production and CostGoal of a firm is to maximize profit. The firm needs to minimize cost in order to maximize profit.A. FirmA business firm is an organization, owned and operated by private individuals, that specializes in production. Production is the process of combining inputs to make outputs.The firm’s profit is defined by revenue minus costs. There are three types of business firms; sole proprietorship (a firm owned by a single individual), partnership (a firm owned and usually operated by several individuals who share in the profits and bear personal responsibility for any losses), and corporation (a firm owned by those who buy shares of stock and whose liability is limited to the amount of their investment in the firm). Most firms have employees to enjoy gains from specialization, to lower transaction cost (the time costs and other costs required to carry out market exchanges), to diversify
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