Download Utility and Preference

ECONOMICS-MSCSM1-33
(PhD Economics)
After this lesson you should be able to:
• Explain economic concepts models used in your
industry and the economy
• Discuss micro and macroeconomic issues
that affect the working of the economy
• Determine the difference between micro and
macroeconomic policies and their effects on
the domestic and world economy.
• Introduction
Microeconomics –Price theory
• Consumer Behaviour
• Production and cost
• Firm Organisation
• Distribution and Welfare
• Macroeconomics: consumption, investment, BOP,
policy analysis, Economic Growth.
SCOPE OF ECONOMICS
ECONOMICS IS CONCERNED WITH
ALLOCATION OF LIMITED RESOURCES
TO SATISFY COMPETING ENDS.
Introduction: Economic Problem
• Needs and Wants are Unlimited
• Resources to satisfy needs and
wants are Limited
• Subsequently leads to scarcity of
goods & services (therefore need
to economise)
CONTINUE
• In that respect you need to allocate scarce
resources toward competing ends.
• This implies that we should make choices – by
making choices that will lead to satisfying our
needs and wants or get the best value in use.
• How does society deal with scarcity?
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1. Economic Growth (GDP).
2. Improve the use of Available
Resources.
3. Reduce Wants & Needs.
HOW DO YOU ACHEIVE THE
ABOVE?
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• Through:
1. Allocative efficiency
2. Productive Efficiency
3. Equity
4. Full Employment
Problems of Economic organisation
Three Fundamental Problems.
1. What commodities/services shall be produced
and in what quantities? That is, how much
and which of alternatives goods and services
shall be produced? For example: oranges,
butter, wheat for bread, maize, water, shoes,
clothes. When in what quantities?
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2. How shall goods/services be
produced? That is by whom and with
what resources and in what
technological manner are they to be
produced. Who farms? who
produces for exports – diamonds,
shoes, gas, coal etc? In what
quantities?
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3. For whom shall the goods/services
be produced? That is who is to enjoy
and get the benefits of the goods
and services produced?
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• The what, How and for Whom questions in a
free market economy are determined
primarily by a system of prices (or markets, of
profits and losses).
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• Scarcity – The What to produce, How & for
Whom could not be a problem if resources
were unlimited. Scarcity – implies resources
are limited, therefore, make choices. We
assume that human beings are rationale, that
is they will try to make choices that will
maximize their satisfaction (utility).
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• Economics is derived from Geek word
meaning the management of household –
hence use house wife example – house
keeping allowance should push you as far as
possible get the most out of it. Maximize
utility from limited resources she seeks to
obtain the maximum satisfaction for the
family- certain goods are obtained i.e.
Necessities (quantities by habits)
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• Streets full of competing goods make choices.
Cost/benefit looked at for each good.
Opportunity Cost
In all walks of life, having this means going
without “that” we therefore speak of
opportunity cost. The cost of something in
terms of alternative forgone (more accurately
in terms of the best alternative sacrificed). DG.
Economic Growth
The meaning of Economic Growth
The resources are limited, while needs/wants
are unlimited. If the economy is experiencing
unemployed resources, the economy’s actual
output is below its potential output.
DG
PRODUCTION POSSIBILITY FRONTIER
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• Point U the economy is producing inside the
production possibility curve. At this point
output can be increased in the short-term
policy measures that should absorb the idle or
unemployed resources and move to I (one).
• Full – employment does not mean the
economy will grow. Full – employment implies
that the existing resources are fully employed.
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• Growth is a long- term phenomenon
• Full employment simply means the economy
is producing at a point on the productionpossibility curve “I” growth means over time
the production-possibility curve pushes
outward to curves II & III. Growth mainly
refers to the standard of living rather than to
output only.
• Growth examples: Improvement happens
gradual- country examples – China, Asian
Tigers, South Korea, Taiwan, Singapore,
Thailand, Hong-Kong to a lesser extent –
Malaysia &Indonesia.
• With this growth you get more taxation
revenue and better standard of living for all in
the country.
Achieving Growth
Factors Producing Growth
1. A rise in the productivity of existing
factors of production. This can be done
by improvement of organization,
training of workers, better use of
capital equipment, better working
conditions for labour force.
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2. An increase in the available stock of factors of
production.
a) Rise in labour input (population growth)
b) Development of natural resources
c) Additional capital equipment. Distinguish
between ‘widening’ and ‘deepening’ capital.
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3. Technological Change
• Innovation can improve productivity
• Technological improvement- a machine can
replace the job done by men.
4. Fundamental Changes in the composition of
the national output. As a country develops
spending switches from : agriculture to
manufacturing to services. Growth rates
improve as countries industralize.
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5. Sustained Improvement in the terms of trade.
• Improvement in terms of trade
• BOP improvement
• Increase of Imports
How a free enterprise system solves
the basic economic problem
• The price system is used to solve the
economic problem in a free market economy.
• What things will be produced is determined
by the dollar vote of consumers every day in
their decision to purchase this good and not
that good.
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• How things are produced is determined by the
competition of different producers. The
method that is cheapest at any given time
because of both physical efficiency and cost
efficiency will displace a more costly method
of production. Producers are forced to keep
cost down by using efficient methods of
production.
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• For whom things are produced is determined
by supply and demand in the markets for
goods and services. From these marketsincome (rent, interest, wages, profits) are
realised.
• The competitive price system uses supplydemand markets to solve the trio of economic
problems – what, How
Supply-Demand Flow Chart
Household, Firm (Businesses), Goods Market,
Factor Market.
Supply and demand discussion
Consumer Behaviour and demand
Economic Agents:
Resource Owners• Provide inputs (The market dictate type of
production)
• Resource owners receive money income
• The money income, make them consumers
Entrepreneurs-
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• Organize production
• Determine the supply of goods and services in
the market
• Receive profits
• They also enter the market as consumers
Consumers- All people who earn and use
income from whatever source are referred to
as consumers.
Utility and Preference
• The aim of every household is to
spend limited money income in
such a way that economic well –
being is maximized.
The nature of commodities
• Goods and services consumed by
household are called commodities
• Commodities provide a flow of
consumption services per unit of
time.
Full Knowledge
• Assume each consumer has full binformation
about consumption decisions
• Consumer know goods/services in the markt
• Consumer knows the prices and that these
price will not change per unit of time due to
the consumer action
• Consumer know income per unit time
For demand functions and Indifference
curves (Assume)
a) Consumer aware of the existence of
some goods and services
b) Prefers some goods to others
c) Possesses money Income
Consumer Preference
 Individual – household derives satisfaction or Utility
from the services provided by the commodities
consumed per unit time.
 Per given period the consumer consumes a variety of
different commodities or commodity bundles. In order
to achieve the objective of maximization of satisfaction
or Utility for given level of income.
 Consumer ranks different commodity bundles and
choose among the alternative bundles.
COMMODITY BUNDLES
i. ‘A’ and ‘B’: if ‘A’ provides more satisfaction
than ‘B’ implies ‘A’ is preferred to ‘B’. If ‘A’
and ‘B’ provide same satisfaction implies
consumer is indifferent between ‘A’ and ‘B’ .
ii. If ‘A’ preferred to ‘B’ and ‘B’ preferred to ‘C’
then ‘A’ is preferred to ‘C’.
Preference is a transitive relation –example:
prefer a car to house and a house to lorry
hence prefer car to a lorry.
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Similarly : If ‘A’ is indifferent to ‘B’ and ‘B’ is
indifferent to C then ‘A’ is indifferent to C.
You can also used this concept when dealing
with different strategies in terms of
preference.
Rank ordering of commodity bundles
Bundle amount(X ) amount(Y) rank order
A
6
6
4
B
3
5
3
C
4
3
3
D
5
2
3
E
3
4
2
F
1
4
1
G
2
2
1
H
3
1
1
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• Bundle ‘A’ preferred to all other bundles
• Indifferent among bundle B, C & D. ETC
Utility and Preference
More utility is assigned to A in the table .
• Utility function provides an ordinal
measurement of the utility provided by
commodity bundles.
THE UTILITY CONCEPT
• The term Utility means the satisfaction that a
consumer receives from whatever goods and
services the individual consumes.
• ‘Utility’ is the attribute possessed by a
commodity or service to satisfy a human
want/need, to yield satisfaction to the
consumer.
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• It is important to distinguish utility derived
from unrelated items, and items which are
related. For example: Bread and Clothes – the
concept of utility works when the consumer,
consumes the same good/service at specified
time.
Total and marginal Utility
Total Utility
• The total utility attained from a commodity
refers to the entire amount of satisfaction a
consumer receives from consuming it at
various rates.
• An essential feature of utility concept is that
one commodity may be substituted for
another in consumption in such a way as to
leave the level of utility unchanged.
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Graphs- Total and marginal utility curves:
Marginal Utility
• Definition: The change in total utility resulting
from a one unit change in consumption per
unit of time is the marginal utility of a good.
As the amount consumed of a good increases,
the marginal utility (Mu) of the good (or the
extra utility added by its last unit) tends to
decrease
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Quantity Total Utility Marginal Utility
0
0
1
4
4
2
7
3
3
9
2
4
10
1
5
10
0
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Type of utility
• The ordinal utility function tells us about how
the consumer ranks the bundles of goods. It
tells us about preference. It does not tell us
the intensity of that preference (or likes and
dislike)
• The ordinal utility function helps in
understanding consumer theory, as long as we
deal with choice in conditions of certainty.
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• The cardinal utility function will rank the
bundles and tell us about intensity of the likes
and dislikes. The cardinal utility function
measures utility in ‘utils’. Cardinal utility is
useful when dealing with choice in the case of
risk.
Utility and Indifference Curve
• When we talk of ordering we are getting to an
indifference curve. Thus, link utility with
indifference curves implies Iso-utility.
Indifference Curve
• An indifference curve is a locus of points or commodity
bundles, among which the consumer is indifferent.
Each point on an indifference curve yields the same
total utility as any other point on that same
indifference curve. If the utility function is given by
U = F(X1, X2........Xn) where X is the amount of good 1
consumed, X2 the amount of good 2 consumed, and so
on, then an indifference curve is defined as the set of
all commodity bundles (X1......Xn) that satisfy the
equation U(X1,X2..Xn)=c where c is the constant level
of utility for that indifference curve.
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• Graphs of Indifference curves:
Characteristics if Indifference Curves
a) An indifference curve passes through each point
in the commodity space.
b) Indifference curves cannot intersect.
c) Indifference curves are negatively sloped.
d) Indifference curves are convex to the origin.
e) The higher or further to the right is an
indifference curve, the higher the bundles are
on the curve in the consumers preference
ordering, this is, bundles on higher indifference
curves are preferred to bundles on lower
indifference curves.
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Graph of intersect:
We start from the premise that consumers are
rational, and that there is a transitive
(consistent) relationship in indifference
curves.
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• If ‘R’ is preferred to ‘Q’, then ‘P’ should
be preferred to ‘Q’, but P & Q are on the
same indifference curve (hence
inconsistent). Suppose you have bundles:
1, 2 , 3; and 1 preferred to 2 and 2
preferred to 3 then 1 is preferred to 3
(consistent hence rational).
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Graph: Indifference curves are negatively sloped.
• The is particular shape involves what is colled a
diminishing marginal rate of substitution
between goods. This shape implies that the more
of good X there is relative to good Y in the bundle
to begin with, the more X is required to
compensate the consumer for the loss of a given
amount of Y. {MRSxy or MRSx for Y. This is
diminishing}.
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• The marginal rate of substitution of X for Y is
the ratio of the amount of X needed to
compensate for a small loss of Y to that loss of
Y. It is given by the slope of the indifference
curve which is negative and becomes more
negative (it is diminishes) as we move down
the curve from left to right.
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Graph: Indifference curves are convex to origin.
Convexity – means that the indifference curve
lies above its tangent at each point.
Equi-Marginal Principle
• People will allocate their expenditures among
goods in such a manner that the ratio of
marginal utility to price (Mux/Px = Muy/Py
etc) for each good is identical. In this way a
consumer with a finite income will maximize
the utility he can gain. If he/she deviated from
this combination by buying more of some
goods and less of others he/she would lose
more utility than he/she would gain.
Relative Price
• The relative price of a commodity is the price of that
good in terms of some other good. It represents the
terms of trade or trading ratio between two goods. In
the case of two goods X and Y , the relative price of X
in terms of Y is the price ratio Px/Py , where px is the
nominal price of X and Py is the nominal price of Y. The
relative price of X in terms of Y : Px/Py tells how many
units of Y must be given up to get 1 unit of X. Similarly,
the ratio Py/Px is the relative price of Y in terms of X
tell how many units of X must be given up to get 1 unit
of Y. (trading ratio, opportunity cost, terms of trade).
Theory of consumer behaviour
Limited money Income:
• Every consumer has limited income
• The problem of the consumer is to spend the
limited income in a way that gives him/her
maximum satisfaction.
• Assume that there are two goods X and Y
bought in quantities x and y
• Consumers income ‘M’ Fixed
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•
•
•
•
•
Amount spent on X is xPx
Amount spent on Y is yPy
M ≥ xPx + yPy
Consider equality
M = xPx + yPy this an equation of a straight
line. Solve for y
• Y = (1/py)M – (Px/Py) x
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• Y = M/Py – (Px/Py)x (straight line)
• Give Budget line.
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Budget line: The budget line is the set of
commodity bundles that can be purchased if
the entire money income is spent. Its slope is
the negative of the price ratio.
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Shifting the Budget line:
Income (DG)
If M income changes ∆M to M’ where M’ > M
(price fixed). An increase in income will move
the budget line to the right in the commodity
bundle space.
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Price change (relative price) - DG
Price of X change to P*x
-(Px/Py) to – (P*x/Py) where P*x > Px
- (P*x/Py) < - (Px/Py)
Marginal rate of Substitution
DG
Suppose we have commodity, X and Y:
Commodity ‘Y’ can be substituted for
commodity “X” and the consumer remain
with the same satisfaction .
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• What the rate at which consumers are willing
to substitute one commodity for another?
• Bundle at point R [0X1 of X; 0Y of Y.
• Bundle at point P[0X2 of X; 0Y2 of Y.
• The consumer is willing to substitute X1X2
units of X for Y1Y2 units of Y. The rate at which
he is willing to substitute X for Y is ....
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(0Y1 – 0Y2)/(0X2 – 0X1) = (RS/SP) = tanƟ
The ratio shows that the consumer is willing to
give away Y1Y2 of Y units to get 1 unit of X
(same level of indifference curve). As the point
R moves toward the tangent TT’ at point P the
movement becomes very small and the slope
is colled MRSx for Y
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• MRS: The marginal rate of substitution of X for
Y measures the number of units of Y that must
be sacrificed per unit of X gained so as to
maintain a constant level of satisfaction. The
marginal rate of substitution is the negative of
the slope of an indifference curve at a point. It
is defined only for movements along an
indifference curve.
The solution to the choice problem:
Consumer Equilibrium
• The consumer wants to maximize satisfaction
given all consumption patterns available.
Hence the consume wants to maximize utility.
• Equilibrium at A because there are no forces
at this point to move the consumer from A.
The budget line is tangent to the indifference
curve.
Income Consumption Curve
• We would like to know and predict how the
consumer behaves, with respect to bundles of
goods chosen when:
a) Income changes
b) Price of X changes
c) Price of Y changes
• Change in income, Px and Py constant
• The slope of budget line does not change.
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• The slope of budget line tells us how X is
substituted for Y and depends on Px/Py the
ratio of the prices.
• An increase in income will lead to the budget
line shifting to the right, and consumer will get
more of X and Y. DG
Price consumption curve
• Holding Py and Income constant vary price of
X. DG
Demand Curve
Distribution of Income
• The Lorenz Curve:
• The lorenz curve is used in the calculation of
measures of inequality. The Lorenz curve plots
cumulative percentages of total income received
against cumulative percentages of income
recipients, starting with the smallest income
recipient. A point on the curve gives the
percentage of the population that accounts for a
given percentage of total income (DG)
Short and Long run
• Short run: refers to that period of time in
which the input of one or more productive
items are fixed (factor of production include –
land , labour, capital). The changes in product
output should be achieved using variable
inputs e.g. Labour, fertilizer,; while, land and
macinary remain fixed.
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• Long run: A period or time or planning period
in which all inputs are variable. Things like
land area, large capital equipment and
machinery, farm building can be changed in
response to the need to increase/decrease
product output.
The Production Function
Concept:
Production function refers to the physical
relationships between a firm’s inputs of
resources and its output of goods and services
per unit of time, leaving prices output.
continue
• Generally production Function can be
presented as:
Q = f(K, L)
two inputs
Where: Q = output (product)
K, L = inputs, capital and labour
Isoquant
• Definition – An isoquant is a curve in input
space showing all possible combinations of
inputs physically capable of producing a given
level of output. (DG)
• Isoquant slope downward to the right
• Isoquants do not intersect
• Isoquant are convex to the origin
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• Example: suppose digging a dam using labour
and capital the more labour you use for given
capital the more difficult it becomes to
substitute capital for labour. Additional labour
will compensate for smaller and smaller
amounts of capital. Suppose there is A & B
resources to produce fixed output it becomes
difficult to substitute A for B. That means
addition of A compensate smaller amounts of
B.
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• This principle is called diminishing marginal rate
of technical substitution of A for B (MRTSab).
• MRTSab is measured at any point on an isoquant
or iso-product or equal product curve of the
slope of the isoquant at that point. MRTSab – it is
the amount of one resource lost that will be just
compensated for by an addition unit of another
resource (output being kept constant)
The Law of diminishing returns
• The law of diminishing returns states that: If
the input of one resource is increased by
equal increments per unit of time while the
inputs of other resources are held constant,
total product output will increase; but beyond
some point the resulting output increases will
become smaller and smaller.
Returns to scale
• The concept of returns to scale refers to what
happens to output when every input is
increased in equal proportion.
1. If successive equal increments of all factor
inputs yield successively smaller increases in
output we have deceasing (or diminishing)
returns to scale.
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2. If they yield equal increments in output we
have constant returns to scale.
3. If they yield successively increasing
increments in output we have increasing
returns to scale. (DG)
Cost function
• Isocost- describe the quantities of capital and
labour services that can be bought per unit of
time for a given cost outlay.
• C = wL + rK
Solve for K
K = C/r – (w/r)L
Isoline
continue
• Show Equilibrium:
Short –run profit maximization the
marginal approach
• Perfect competition-characteristics
• Profit maximization by the marginal approach
• DG
The short run equilibrium is achieved at point E.
At point E MR = MC
In a perfectly competitive firm MR =P also MC
=p=MR
continue
• To determine whether a firm is making a profit
or a loss we compare price and average total
cost (P, ATC) corresponding to the equilibrium
rate of output.
• If price is greater than unit cost the firm will
make a profit in short run
• If price per unit is less than unit cost there is a
loss.
Monopoly Profit
Characteristic:
DG
The profit maximising monopolist will set output
where MC = MR at X bar. The demand curve or
AR will give the price. The monopolist cannot
set both output and price. It has to set one of
them (output or price) and the market will
give the other. Profit is given by area
OX(Bar)MP – oX (Bar)L
Oligopoly
• An oligopolistic exist in a market, if an action
by one firm firm’s selling price provokes a
reaction by another or its competitor and the
reaction will , in turn, affect the original firm’s
revenue.
• Oligopoly is characterised by markets forms,
where there is a small number of sellers.
Classified as 2 to 20 firms form oligopoly. This
could be the small number we are referring to.
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• Duopoly – is a special case of oligopoly, it is
the lower limit of oligopolies. The oligopoly
structure is between the two extremes it si
perfect and monopoly.
MACROECONOMICS
Macroeconomics deals with:
• Behaviour of the economy as a whole
• Total output of goods and services
• Growth of output
• Rate of Inflation
• Unemployment
• BOP (Balance of Payment)
• Exchange Rate
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•
•
•
•
Consumption
Investment and savings
Government expenditure
Foreign Trade
KEY CONCEPTS
Gross National Product (GNP)
GNP gives the value of all goods and services
produced in an economy per unit time, usually
one year, but could be prepared on a quarterly
basis.
GNP can be given in:
• Nominal or current dollar
• Real or constant dollar
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• Nominal measures GNP at prevailing or
current period prices.
• Real or constant GNP use a base year.
• Per capita: implies GNP/population
• Potential real GNP: or potential output
• Is the output that can be realized if there was
full employment.
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• GNP (Gap) = potential GNP – Actual GNP this
is an indicator that can be used to measure
economic (slack) waste of productive
resources due to higher level of
unemployment
• Productivity implies (output/workers) or
output per worker
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• GDP – Gross Domestic Product:
GNP excluding net property abroad.
GDP is an estimate of incomes accruing to
residents and generated within the country
only
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Macroeconomics performance (indicators)
• Growth in real GDP (increase implies strength
in the economy).
• Unemployment rate (increase) sign if
weakness in the economy.
AD & AS
The main concern in macroeconomics is
a) Level of output
b) Price level or inflation rate
Both indicators output/inflation rate are
obtained by analysis of AD & AS. For many
years AD has been used to manage the
economies. But emphasis has shifted to
supply side economics, hence, structural
adjustment programs.
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• AD is the relationship between spending on
goods and services and price
• AS - show a relationship between the amount
of output firms produce and the price level
• Inflation is the rate of increase/decrease of
price level.
• Expansionary AD policies lead to an increase
in inflation rate and low AD reduce inflation
rate
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• Inflation = (Pt – Pt-1)/Pt-1 *100
• Remember CPI – consumer price index is not
inflation
t is current period, t-1 is previous period time
Question: Briefly describe the inflation
behaviour for Zimbabwe.
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Stabilization Policy
The two broad policies used to influence the
economy are:
a) Monetary policy: In most countries this policy
is controlled by central bank
Instruments used
• Open market operation
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• Changes in stock of money
• Changes in the rate of interest (bank rate).
This is the rate used by central bank on lending
money to commercial banks. The bank rate is
also used to control commercial banks. All
other rates follow the movement of bank rate.
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b) Fiscal policy: this policy is under the control of
the government of the day.
Instruments used
Tax rate
Government spending (Budget surplus/deficit)
These two policies affect the economy through
the effects they have on AD. The policies are
often referred to as demand management
policies.
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• Stabilization policies are policies that
moderate fluctuations of the economy.
Fluctuations are experienced in:
• Inflation rate
• Output (GNP)
• Unemployment
The fluctuations in these variables can be off-set
by stabilization policies.
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• In policies of stabilization politics is involved
for example: inflation/unemployment levels.
• Stabilization policy is known as countercyclical
policy because it moderates trade cycle or
business cycle. This means regular cycle of
booms, declines, recessions and recoveries
Business cycle DG
Aggregate demand(AD) & aggregate
supply(AS)
• AS – we mean Gross national product (GNP)
• AD – we mean Gross national expenditure
(GNE)
• DG- of AD & AS
• AD – total demand for goods /services in the
economy. The AD can be shifted through
monetary and fiscal policy. AS – shows price
level associated with each level of output. AS
–can be shifted by use of fiscal policy.
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• Interaction of AD & AS give price level and
output.
National Income Accounting
• National Income: A measure of the money
value of the goods/services becoming
available to the nation from economic activity.
National Income Accounting Approach.
1. Income approach:
• Profits, Employment, rent, dividends, wages,
salaries
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2. Expenditure Approach:
• Consumption
• Investment
3. Output (product) Approach:
• Output of sectors
NOTE THAT:
Income = Expenditure = output (very important)
GNE - deflator
• The gross national expenditure (GNE) gives a
measure of inflation known as GNE-deflator.
• The GNE –deflator is the ratio of nominal GNE
in a given year to real GNE.
Basic models of
Aggregate demand
• Two sector economy:
DG of household and firm
• Three sector economy:
DG of household, firm and government
• Four sector economy:
DG of household, firm, government and rest of the
world
GNP = C + I + G + X – M + NTI
AS =
AD
Consumption Function
• Assume: Consumption function is a linear
function of income.
• DG of consumption function
• C = Ć + cY (consumption function)
Where: Ć > 0 ; 0 < c < 1 and note that Ć is
intercept; c is the slope.
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• C is marginal propensity to consume
• 1 unit increase in income results in c increase
in consumption
• 0 < c < 1 means out of $1 increase in income
only a fraction goes to consumption.
• Example: c = 0.8 then $1 increase in income
mean only 80c goes to consumption or
increase by 80c
Consumption and Savings
Since only a fraction of the increase in income
goes to consumption, the other fraction goes
to savings.
1–c
Y=S+C
S = Y – C by definition this is the saving function
S = Y – C replace C by its equation
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S = Y – (Ć + cY )
S = - Ć + (1-c)Y /// this is the saving function.
Marginal propensity to save s = 1- c .
The saving function is the mirror image of the
consumption function. At low levels of income
savings is –ve, C > Y at low incomes and ‘S’ is
-ve while C < Y at higher incomes
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Saving Function:
DG of Savings and Income
Equilibrium Income and output
Y=C+I
(Equilibrium Equation)
C = a + cY (Consumption Equation)
I = I(bar)
Substitute
Y = a + cY + I(bar)
Y – cY = a + I(bar)
Y(1-c) = a + I(bar)
Y = {a + I(bar)}/[1-c] Equilibrium Income
How saving and Investment determine
Income
• graph
The multiplier concept
• The multiplier is simply number which when
multiplied by a change in some exogenous
(independent) variable, gives a resulting
change in aggregate income.
• An increase in private investment will cause
income and employment to expand; a
decrease in investment will cause them to
contract.
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• Income analysis shows that an increase in
investment will increase national income by a
multiplied amount – by an amount greater
than itself, investment spending is high
powered, double duty spending.
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• This amplified effect of investment on income
is called the “multiplier”. It is a number that
shows how much above unity is the increase
in income resulting from each increase in
investment.
• Multiplier = ∆Y/ ∆I ; where, Y is income & I is
investment, ∆ is change. Rearranging the
formula we get: ∆Y = multiplier x ∆I
Multiplier formula
• The size of the multiplier is determined by
MPC.
• Series: Geometric progression
• Show equation
• Where, r is mpc, as long as value of r is less
than 1 in absolute terms
• Multiplier is reciprocal of mps.
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• ∆Y = (1/mps) *∆I
• ∆Y = (1/1-mps)* ∆I
• 1/1 +r and r is common ratio – in case of
multiplier common ratio is mpc,
• m = 1/1 – mpc
• If mpc is 2/3
• m = 1/(1-2/3) = 3
• The larger the mpc the larger the multiplier will
be.
PRICES AND THE SUPPLY OF MONEY
• changes in the money supply have an important role
in causing the C + I + G spending to shift upward and
downward
-cost –push inflation
-demand-push inflation
Inflation
Definition: By inflation we mean a time of generally
rising prices for bread, car, agricultural products,
rising salaries, rent, etc. Deflation means a time
when most prices and costs are falling.
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• Galloping hyperinflation is when a price
increase leads to wages and cost incease,
which again lead to a further increase of
prices, wages and costs (Discuss this kind of
inflation giving examples).
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• Money: money is defined in terms of how it is
used or what it can buy.
The Role of money
i. Medium of exchange
ii. A store of wealth or value
iii. A unit of account
iv. A standard of deferred payment
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Money includes – coins and paper money
outside banks, demand deposits (checking
accounts) at commercial banks etc.
Demand for money
According to Keynes (1936) money demand falls
into the following motives:
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1.Transaction motive
2.Precautionary motive
3.Speculative motive
Concept
Transaction motive: The transaction demand for
money shows how much money households
want to hold in order to carry out their day-today transactions
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Concept
Precautionary motive: The precautionary
demand for money shows how money much
money households wants to hold in order to
meet any unforeseen emergencies.
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Concept
Speculative motive: The speculative demand for
money shows how much money households
(speculators) want to hold at various market
rates of interest (various bonds prices).
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Monetary policy tools
1. The legal reserve requirement – commercial
banks keep a percentage of their demand
deposits on reserves with central bank.
2. Open – market operations: open – market
operations are the buying or selling of
government bonds in the open market in order
to effect the demand deposits of commercial
banks and thereby the money supply.
ELASTICITY OF DEMAND
Price elasticity of demand:
• Definition- A measure of the percentage
change in one variable in respect of a
percentage change in another variable.
• ᶯ = {ΔQ/ΔP}/(Q/P) = marginal
function/average function
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• Elasticity = proportional change in quantity/
proportional change in price.
• Proportional change in quantity = ΔQi/Qi*100
• Proportional change in price = Δpi/Pi*100
Where: Δ is change in ; Qi is quantity; Pi = price
of good or fare. Small change is known as point
elasticity of demand. If Δ is large you get arc
elasticity.
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If Law of demand is operates: a fall in price will
result in a rise in demand .
Compute elasticity of demand given the
following:
Price before change = $10, price change = $20
Quantity before change = 200; Quantity change
= 100.
• If answer is greater than 1
elastic
• If answer less than 1
inelastic
• If answer equal 1
Unitary
Cross-Price Elasticity
Assume good x and good y – (prices Px , Py) and
quantity q
Definition: The responsiveness of quantity
demanded of one good to a change in the price
of another good or
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Cross-elasticity of demand = proportional
change in quantity of good x divided by
proportional change in price of good y. (write
the formula?)
If cross elasticity is greater than zero the good is
a substitute. If the cross elasticity is less than
zero the good is a complementary good.
ARC - Elasticity
Cross-elasticity of demand = proportional
change in quantity of good x divided by
proportional change in price of good y. (write
the formula?)
If cross elasticity is greater than zero the good is
a substitute. If the cross elasticity is less than
zero the good is a complementary good.
INCOME ELASTICITY
Definition: Responsiveness of demand to a
change in income is referred to as income
elasticity of demand.
Income Elasticity of Income = (ΔQ/Q ) / (ΔM/M)
= ΔQ/ΔM * M/Q