Chapter 1 Appendix

1. Chapter 1 Appendix

2. Indifference Curve Analysis • Market Baskets are combinations of various goods. • Indifference Curves are curves connecting various market basket combinations of goods that make an individual equally happy.

3. Assumptions about Preferences • Persons can rank market baskets. • Rankings are transitive. • More is preferred to less. • The marginal rate of substitution is diminishing.

4. Figure 1A.1 Indifference Curves B1 60 Expenditure on Other Goods per Month (Dollars) B2 50 U3 U2 U1 0 40 50 Qx Gasoline per Month (Gallons)

5. The Marginal Rate of Substitution The amount of expenditure on other goods that a person will give up in order to get an additional unit of one good is called the marginal rate of substitution or the marginal benefit of a good.

6. The Budget Constraint The budget constraint is the combination of goods that a person can afford.

7. The Budget Constraint in Algebraic Terms I = PxQx+ SPiQi Where: I is income Pi is the price of good i Qi is the amount of good i purchased

8. Figure 1A.2 The Budget Constraint A 100 Expenditure on Gasoline per Month Expenditure on Other Goods per Month (Dollars) F D 60 Expenditure on All Gasoline per Month Other Goods Except B Qx 0 40 100 Gasoline per Month (Gallons) C

9. Figure 1A.3 Consumer Equilibrium A Expenditure on Other Goods per Month (Dollars) E 40 U3 U2 U1 B 0 60 Qx Gasoline per Month (Gallons)

10. Equilibrium Condition PX = MBX

11. Figure 1A.4 Changes in Income A' A Expenditure on Other Goods per Month (Dollars) B B' 0 Qx per Month

12. Figure 1A.5 Changes in the Price of Good X A Expenditure on Other Goods per Month (Dollars) 0 B B B '' ' Qx per Month

13. Income and Substitution Effects • The income effectis the change in the monthly (or other period) consumption of a good due to changing purchasing power of fixed income caused by the good’s price change. • The substitution effectis the change in the monthly (or other period) consumption of the good due to the change in its price relative to other goods.

14. Figure 1A.6 Income and Substitution Effects 150 50 100 Expenditure on Other Goods per Month (Dollars) E' E1 U2 20 E2 U1 40 45 60 Qx Gasoline per Month (Gallons) The Income Effect The Substitution Effect

15. The Law of Demand • The demand curve slopes downward. • As the price rises, the quantity demanded falls.

16. Figure 1A.7 The Law of Demand Price 0 Qxper Month D = MB

17. % Change in Quantity Demanded DQD/QD = % Change in Price DP/P Price Elasticity of Demand ED =

18. Consumer Surplus • Net benefit that consumers obtain from a good • Total benefit to consumers from obtaining a good, less the money they give up to get the good.

19. Figure 1A.8 Consumer Surplus A Consumer Surplus Market Price B Price P D = MB Q 0 1 Gasoline per Month

20. Figure 1A.9 The Work Leisure Choice A Income per Day E 40 U3 U2 U1 B 0 16 24 Leisure Hours per Day

21. Budget line for time allocation I = w(24 – L) Where: I is income W is wage L is the amount of time devoted to leisure