Day 3

Willingness to Pay

Willingness to Pay

How much is the consumer surplus in

this case?

Willingness to Pay
Consumer

Surplus for case 1 is

Consumer surplus for case 2: $1

Utility Theory

Where:
Utility of the individual i
Quantity consumed of good j
Utility can be seen as a way to
quantify consumer satisfaction with
the current situation or tradeoff.
5

Utility Theory

Imagine this in terms of cars bought,

after the fourth car your utility will

Utility Theory

How much meat are you willing to

sacrifice to get more potato? What
about the other way around? This is

Utility Theory

These bundles represent different quantities, higher bundles=

higher quantity= automatically better

Marginal Rate of
Substitution

Where:
: The amount that you give up from item 1
to get one unit of item 2.
: Marginal utility of item 1
Marginal utility of item 2
(notice that this is the slope of the utility
function!)
9

Optimality

10

Optimality

11

Optimality
At the optimal point the slope of the
utility function is equivalent to the
slope of the budget function thus at
the optimal point we have:
Or equivalently:

12

Partial Differentiation

Just treat the other variable as a
constant.

13

Exercise 3, A,B (From Slides)

A) Define the budget constraint and draw

the graph. Mark the intercept and the
slope and interpret the graph.
B) Explain the combinations of tea (t) and
croissants (c) that can be consumed and
the combinations that are out of reach.
14

Exercise 3, A,B (From Slides)

Solution
Solution A)

Theobjective is to find the consumption possibilities with the budget of

30. To do that we have to find the X intercept (quantity of item c) and the
Y intercept in the graph(quantity of item t). (note that these can be
flipped, but you have specify it on the graph) We do the following steps:
Step 1:
Finding the X intercept .
The general formula is:
Thus:
Meaning:
To find the intercept of the (which is the point where =0) we set to 0
thus:
After rearranging we find the the economic interpretation of this is that if
we buy zero units of we will have enough money to buy a maximum of
15
30 units from

Exercise 3, A,B (From Slides)

Solution
A) continued
Solution

Step 2: Finding the Y intercept (

To find the Y intercept you set the X () to
zero. Thus:
After rearranging we will find that this
means that if we buy zero units from we
will have enough money to purchase 15
units from
16

Exercise 3, A,B (From Slides)

Solution
Solution A) continued
Step 3: Drawing the graph
Blue: The feasibility
region (all possible
combinations)
Red: Infeasible region
(impossible
combinations)

17

Exercise 3, A,B (From Slides)

Solution
Step
4: Finding the slope

There is several methods to find the slope but

we will use the simplest one here.
Remember:
In the graph we already have two known very
easy points. In the current case we considered
the to be on the X axis and the on the Y axis.
We can simply choose the point (0,15) and
(30,0) if we plug it in the formula we will find:
18

Exercise 3, A,B (From Slides)

Solution
Solution
A cont. and B)

Step 5: Economic interpretation
The blue area in the graph shows all the possible
combinations of the croissants and tea that we can
possibly choose GIVEN THE CURRENT PRICES AND
BUDGET. If the prices or budget changes then the
different possible combinations will change.
The slope of means that for each piece you sacrifice
from the Y axis (the croissants in this case) you will gain
2 pieces in the X axis (the tea in this case). This means
that one piece of croissant is worth two pieces of tea.

19

Exercise 3 Part D (From slides)

Utility

function:
a)Draw the indifference curve for a
utility equal 500.
b) Find the optimal utility along with
the optimal consumption bundle.

20

Exercise 3 Part D (From slides)

Solution
a)Utility is known thus you put the quantity
you like in terms of another quantity:

Or
Just put any number in and you will find
the which will allow you to draw the graph
(in the computer of course since it is nonlinear)
21

Exercise 3 Part D (From slides)

Solution
The graph

22

Exercise 3 Part D (From slides)

Solution
b) Optimal point is found when:

Here we have and

To find the and we have to use partial differentiation:
is the derivative of the utility function with respect to which is:
Do the same thing with and you get:
Now applying the formula:
This means that in order to obtain one unit of t you have to give up unit of c, aka 1
unit of t (Y axis) is equal 0.5 unit of c (X axis). (this is the Marginal Rate of
Substitution)
Next step is to put in terms of or the other way around, we will put it in terms of
which gives us in the end:
The next step is to substitute in the income formula which will give you:
you will find that the bundle is and by substituting with 5 in the original formula
you will find that the is 20. Thus the optimal consumption for happiness (utility)
maximization is to eat 5 units of croissant and 20 units of tea.
The final step is to substitute the 20 and the 5 in the utility function in order to23find
the optimal (maximum) utility with the budget of 30.

Exercise 3 Part D (From slides)

Solution
Graphically
Utility

Budget
Optimal point of consumption

24

Elasticity

When
all other equal, the response of demand (or
supply) to price changes is characterized by a term
called elasticity.
Price elasticity of demand:
Where:

25

Elasticity

Quantity
changes slower than price!

26

Elasticity

Quantity
changes faster than price!

Notice how the flatter the line the higher the elastic
and vice versa.
27

Elasticity

Price

is fixed, perfect elasticity!

28

Elasticity

Demand

is fixed! No elasticity!
29

Elasticity

Unit
elasticity! Price and quanitity
change at the same percentage (same
speed)!
30

Elasticity Exercise
Price of milk per liter

Demand of milk in liters

15
20

100
90

is the price of demand for milk? What type of price elasticity

31

Solution to Elasticity

Step 1:
Find the percentage change in quantity.
Step 2:
Find the percentage change in price.
Step 3:
Apply the formula

This means that the price changes faster than the demand,
32
demand is not very sensitive to price changes.

Exercise 4 (from slides)

A) Graph the demand function for both levels

of income.
B) Calculate the elasticity when the price
changes from 8 to 10 for income at 30,000
C) Calculate the income elasticity of demand
for an income increase from 30,000 to
33
36,000 at the price of 12.

Exercise 4 (from slides)

Solution

Answer A)
To draw a graph you need to find the function. We already have the table and we just have to
follow the steps. This is for the income level of 30,000
Step 1:
Find the slope.
By choosing any two arbitrary points, say (40,8) and (32,10) we find the slope to be:

Step 2:
Find the Y intercept.
Remember from class 1:
Choose any arbitrary point from the table say we choose (40,8), substitute in the formula:
After rearranging you will find:
Mark this point on the Y axis
Step 3:
Find the X intercept by setting Y to 0
X will be 72
Mark this point on the X axis
Step 4:
Connect these two points with a straight line and then magic will happen!

34

Exercise 4 (from slides)

Solution

Answer A. Cont)

35

Exercise 4 (from slides)

Solution
Answer

A. Cont)
For the income of 36,000 just apply the
same steps and you will get the
following function:

36

Exercise 4 (from slides)

Solution

The Graph

37

Exercise 4 (from slides)

Solution
Answer
B)

For the income level of 30,000.

Step 1:
Calculate the percentage change in quantity
Step 2:
Calculate the percentage change in price
Step 3:

38

Income Elasticity of Demand

How
much will the demand of a certain
object change with the income?

If:

39

Exercise 4 (from slides)

Solution
Answer C)

Same logic, the only difference is you divide over percentage change in income
instead of change in price.
Step 1:
Find the percentage change in quantity
Step 2:
Find the percentage change in income
Step 3:
Apply the formula

40

Exercise 2 (from slides)

Two
consumers have the following
demand functions:

A) Determine the price which the

aggregate demand function has a
bend in the line
B) Calculate the aggregate demand
below the bended line.
41

Exercise 2 (from slides)

Solution

Answer A)
To find the bend you have to draw the graph using the following steps:
Step 0:
Change the functions to the normal form (price in terms of demand and not
demand in terms of price, thus the first function becomes: )
Step 1:
Make Y (P in this case) 0 and put a mark on the X(D in this case) intercept.
when

Step 2:
Make Y (P in this case) 0 and put a mark in the X intercept (D in this case)
Step 3:
Use a ruler to connect both points with a straight line and bingo!
Do the same with the other function and you will get the graph on the next
page
42

Exercise 2 (from slides)

Solution

43

Exercise 2 (from slides)

Solution
Answer
A. Cont)

Finding the bend.
By reading the graph, notice that the price 15 down to 10
only consumer blue is buying, and below the price of 10
consumer red starts buying stuff too. Thus the bend
occurs at the point when the price goes down to 10.
A more precise way to find the bend is by finding the
aggregate function which is then setting it equal to the
higher function
You will find that P=10 which is the bending point.
44

Exercise 2 (from slides)

Solution
The graph with the bend

45

Exercise 2 (from slides)

Solution
Answer
B)

At the bend we start looking at the total demand of
consumer 1 and consumer 2, thus to find the function
of the total demand for consumer 1 and consumer 2 we
have to add both demand functions (WHEN IT IS
DEMAND WITH RESPECT TO PRICE AND NOT THE
OTHER WAY AROUND)
You have to find which is simply:
Which is the aggregate demand function.
By setting P to 0 you will find the X intercept which is
25.
46