Understanding nominal vs.

real concepts
and normative vs. positive economics with
an illustration

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 1

 The minimum
wage (U.S.)
• The federal minimum wage first instituted in
1938 at a level of 25 cents per hour has been
increased periodically over the years. Recent-
over $7.5 cents per hour.
• In nominal terms, the minimum wage has
increased steadily over the past 70 years.
• In real terms, its 2010 level is below that of
1970s.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 2

 The minimum wage (U.S)
• Although the higher minimum wage would provide a better standard of living for those
workers who have been paid below the minimum- fear of unemployment among
young and unskilled.
• Decision to increase minimum wage involves both positive and normative issues.
• Normative issue: whether any loss of teenage and low skilled jobs is outweighed by
two factors:
➢ Direct benefit to those workers who now earn more as a result.
➢ Any indirect benefits to other workers whose wages might be increased along with the
wages of those at the bottom of the pay scale.
• Positive issue: What will be the extent of unemployment with a higher minimum wage?

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 3

 ❑ Understanding the

Demand Demand and

Supply concepts.
❑ The Market

and Mechanism and its

treatment.
❑ Analysing various

Supply real-world markets

with the tools of
Demand and
Supply.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 4

 Graphical Representation

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 5

 Supply and Demand
• Supply and demand are the two words
that economists use most often.
• Supply and demand are the forces that
make market economies work.
• Modern microeconomics is about
supply, demand, and market
equilibrium
• The basic model of supply and
demand: prices changes, and what
happens when the government
intervenes in the market.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 6

Supply Price Quantity

• Quantity supplied is the amount of a good that sellers are willing

0.00 0
(Market conditions) and able (Cost Conditions) to sell.
0.50 0
• The Law of supply states that, other things equal, the quantity
supplied of a good rises when the price of a good rises.
1.00 1
• The Supply Curve shows the quantity of a good that producers
are willing to sell at a given price, holding constant all other
factors that might affect the quantity supplied.
1.50 2
• The supply curve is the relationship between the quantity supplies
and the price. The relationship can be expressed as an equation:
2.00 3
𝑄𝑠 = 𝑄𝑠 (𝑃)
2.50 4
• The supply schedule is a table that shows the relationship
between the price of the good and the quantity supplied.
3.00 5

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 7

 Price Quantity
Supply Curve 0.00 0
Price of 0.50 0
Ice-Cream
Cone
1.00 1
Re3.00 1.50 2
2.00 3
2.50
1. An 2.50 4
increase
in price ... 2.00 3.00 5

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
18-07-2024 2.S2-3
... MIEincreases quantity
Lectures Ashapurna of cones supplied.
Baruah IIM Raipur 8
Analysis of Supply
• Very low prices do not attract producers to devote
resources to produce a said product.
• Profitable prices enable entrepreneurs to add worker,
machines and other inputs of productions to produce
& supply more.
• Describes price – supply relationship.
• Upward sloping supply curve reflects law of supply.
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 9
Market Supply versus Individual Supply

• Market supply refers to the sum of all individual

supplies for all sellers of a particular good or service.
• Graphically, individual supply curves are summed
horizontally to obtain the market supply curve.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 10

 Determinants of Supply
Goods
price

factors Other
Techno-
Of Goods
logy
supply price

Factor
cost

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 11

 Supply Determinants
Good’s Price:
• Higher money income required to induce producers to produce
more.
• Higher the price, higher the potential to earn and more the
incentive to produce greater quantities.
Other Good’s Price:
• Change in the price of related goods provoke producers to move
away from producing goods having a lower price to producing
goods attracting a higher price.
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 12
 Supply Determinants
Factor Prices:
• Factor prices influence firm’s cost structure.
• Changes relative profitability of business.
• Changes amount supplied.
Level of Technology:
• Two forms of technological advances:
• Lower amount of inputs for same amount of output.
• Same amount of inputs for higher amount of output.
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 13
 Change in Quantity Supplied
Movement along the supply curve.
• Caused by change in price.
Shift in Supply Curves.
• A shift in the supply curve, either to the left or right.
• Caused by a change in any determinant other than price that
alters the quantity supplied at each price.
• This may be input prices, technology, expectations, number of
sellers.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 14

 Movement along Supply Curve
Price of Ice-
Cream S
Cone
C
$3.00
A rise in the price
of ice cream
cones results in a
movement along
A the supply curve.
1.00

Quantity of
Ice-Cream
18-07-2024
0 1 5
S2-3 MIE Lectures Ashapurna Baruah IIM Raipur
Cones
15
 Shifts in Supply Curves
Price of
Ice-Cream Supply curve, S3
Supply
Cone
curve, S1
Supply
Decrease curve, S2
in supply

Increase
in supply

0 Quantity of
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur Ice-Cream Cones 16
Variables
that
influence
sellers

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 17

 Price of Ice Quantity
Demand Cream Demanded
0.00 12
• Quantity demanded is the amount of a good that
buyers are willing and able to purchase.
• The law of demand states that, other things equal,
0.50 10
the quantity demanded of a good falls when the
price of the good rises. 1.00 8
• The demand curve is a graph of the relationship
between the price of a good and the quantity
demanded. 1.50 6
The relationship between quantity demanded and
price can be shown in an equation as: 2.00 4
𝑄𝐷 = 𝑄𝐷 (𝑃)
• The demand schedule is a table that shows the 2.50 2
relationship between the price of the good and the
quantity demanded.
3.00 0
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 18
 Demand Curve
Price of
Ice-Cream Cone
Re3.00

2.50

1. A decrease
2.00
in price ...

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 19
 Market Demand Vs. Individual Demand
• Market demand refers to the sum of all
individual demands for a particular good or
service.
• Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 20

 The Market Demand Curve
The market demand curve is the horizontal sum of the individual
demand curves!
A‘s Demand + B’s Demand = Market Demand

Price of Ice- Price of Ice- Price of Ice-

Cream Cone Cream Cone Cream Cone

2.00 2.00 2.00

1.00 1.00 1.00

7 13
4 8 3 5

Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

When the price is Re1.00, When the price is Re1.00, The market demand at
A will demand 8 ice-cream B will demand 5 ice-cream Re.1.00, will be 13 ice-
cones. cones. cream cones.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 21

Change in Quantity Demanded
Movement along the demand curve.
• Caused by a change in the price of the product
Shifts in Demand Curve.
• A shift in the demand curve, either to the left or right.
• Caused by any change other than price that alters the
quantity demanded at every price.
• To the right is called, “Increase in Demand”.
• To the left if called, “Decrease in Demand”.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 22

 Movement along demand curve
Price of Ice- A tax on sellers of
Cream
Cones
ice-cream cones
raises the price of
B ice-cream cones and
Re.2.00

results in a
movement along the
demand curve.
1.00 A

D
0 4 8 Quantity of Ice-Cream Cones
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 23
 Shifts in the Demand Curve
Price of
Ice-Cream
Cone

Increase
in demand

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Quantity of
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur
Ice-Cream Cones 24
Determinants other than price
• Consumer income
• Prices of related goods
• Tastes and Preferences
• Expectations
• Number of buyers
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 25
 Shifts in Demand Curve
Consumer Income:
• As income increases the demand for a normal good
will increase.
• As income increases the demand for an inferior good
will decrease.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 26

 Shifts in Demand Curve
Prices of Related Goods
• When a fall in the price of one good reduces the
demand for another good, the two goods are called
substitutes.
• When a fall in the price of one good increases the
demand for another good, the two goods are called
complements.
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 27
 Variables that influence buyers

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 28

• Policy makers often want to reduce the amount that
people smoke. There are two ways to achieve this goal.
• One way is to reduce smoking is to shift the demand
curve for cigarettes and other tobacco products.
• E.g., public service announcements, mandatory health
warnings on cigarette packages, prohibition of
cigarette advertising on televisions-
• These are policies aimed at reducing the quantity of
cigarettes demanded at any given price.
• If successful these policies will shift the demand curve
to the left.

Example: Two ways

to reduce smoking
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 29
 Example: Two
ways to reduce
smoking
• Other way is policy makers can try to raise the price of
cigarettes.
• E.g., government taxing the manufacture of cigarettes,
cigarette companies pass much of this tax on to
consumers in the form of higher prices.
• Higher prices encourage smokers to reduce the number
of cigarettes they smoke.
• This represents a movement along the same demand
curve to a point with a higher price and lower quantity.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 30

The Market
Mechanism

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 31

 SUPPLY AND DEMAND TOGETHER

• Equilibrium refers to a situation in which the price has

reached the level where quantity supplied equals
quantity demanded.
• At the equilibrium price, the quantity of the good that
buyers are willing and able to buy exactly balances
the quantity that sellers are willing and able to sell.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 32

 SUPPLY AND DEMAND TOGETHER

• Equilibrium Price
• The price that balances quantity supplied, and quantity
demanded.
• On a graph, it is the price at which the supply and demand
curves intersect.
• Equilibrium Quantity
• The quantity supplied and the quantity demanded at the
equilibrium price.
• On a graph it is the quantity at which the supply and demand
curves intersect.
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 33
 SUPPLY AND DEMAND TOGETHER
Demand Schedule Supply Schedule
Price (Re.) Market Price (Re.) Market
0.00 19 0.00 0
0.50 16 0.50 0
1.00 13 1.00 1
1.50 10 1.50 4
2.00 7 2.00 7
2.50 4 2.50 10
3.00 1 3.00 13

At Re.2.00, the quantity demanded is equal

to the quantity supplied!

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 34

 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone Supply

Equilibrium price Equilibrium

Re.2.00

Equilibrium Demand
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 35
 Equilibrium
• Surplus
• When price > equilibrium price, then quantity supplied
> quantity demanded.

• There is excess supply or a surplus.

• Suppliers will lower the price to increase sales,

thereby moving toward equilibrium.
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 36
 Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream Supply
Cone Surplus

Re.2.50

2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 37
 Equilibrium
• Shortage
• When price < equilibrium price, then quantity demanded >
the quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many buyers
chasing too few goods, thereby moving toward
equilibrium.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 38

 Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream Supply
Cone

Re.2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 39
Three Steps for Analyzing Changes
in Equilibrium

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 40

 How an Increase in Demand Affects the Equilibrium
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream . . .

Supply

Re.2.50 New equilibrium

2.00
2. . . . resulting Initial
in a higher
equilibrium
price . . .
D

0 7 10 Quantity of
3. . . . and a higher Ice-Cream Cones
18-07-2024 quantity sold. 41
S2-3 MIE Lectures Ashapurna Baruah IIM Raipur
 How a Decrease in Supply Affects the Equilibrium
Price of
Ice-Cream 1. An increase in the
Cone price of sugar reduces
the supply of ice cream. . .
S2
S1

New
Re.2.50 equilibrium

2.00 Initial equilibrium

2. . . . resulting
in a higher
price of ice
cream . . . Demand

0 4 7 Quantity of
3. . . . and a lower Ice-Cream Cones
18-07-2024 S2-3 MIE Lectures Ashapurna
quantity Baruah IIM Raipur
sold. 42
 Example:
Demand, Supply, and Obesity
• Increase in number of obese Americans by more than 50% over the last generation,
and obesity may now be the nation’s number one health problem.
• Many explanations of rising obesity suggest higher demand for food.
• Higher income contributing to this higher demand for food.
• A study by economists Darius Lakdawalla and Tomas Philipson suggests that about
60% of the recent growth in weight may be explained this way- i.e., demand has
shifted to the right, leading to an increase in equilibrium quantity of food consumed,
and given, our less strenuous lifestyles, even more weight gain that can be explained
simply by the increased amount we are eating.
• What accounts for the remaining 40% of the weight gain?
Source: https://learn.saylor.org/mod/book/view.php?id=31613&chapterid=8671

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 43

Example: Demand,
Supply, and Obesity

18-07-2024
Fall in the price of
food made possible

S2-3 MIE Lectures Ashapurna Baruah IIM Raipur

by agricultural
innovation, leading to
a substantial
rightward shift in the
supply curve of food.

44
 Example: The Price of Eggs and the Price of
College Education Revisited

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 45

 Example: The Price of Eggs and the Price of
College Education Revisited
• As discussed earlier, we saw that from 1970 to 2010, the real price of eggs fell by 55%, while
the real prices of college education rose by 82%. Cause?
• We can understand these price changes by examining the behaviour of supply and demand
for each good.
• For eggs, the mechanization of poultry farms sharply reduced the cost of producing eggs,
shifting the supply curve downward.
• At the same time the demand curve for eggs shifted to the left as a more health-conscious
population changed its eating habits and tended to avoid eggs. As a result, real price of eggs
declined sharply while total annual consumption increased.
• College Education: supply and demand shifted in the opposite directions.
• Increases in costs of equipping and maintain modern classrooms, laboratories and libraries
along with increases in faculty salaries, pushed the supply curve up. At the same time, the
demand curve shifted to the right as a larger percentage of a growing number of high school
graduates decided that a college education was essential.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 46

From the news:

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 47

 Price Gouging
• Price gouging occurs when companies raise prices to unfair levels. There’s no rule for what
qualifies as price gouging, but it’s not an uncommon occurrence.
• Inflation is a general increase in prices caused by economic factors like demand, costs, and money
supply over time. For this reason, inflation can be identified as an overall increase in prices
throughout an economy over time, while price gouging is localized and opportunistic.

https://online.hbs.edu/blog/post/supply-and-demand-or-price-gouging-an-ongoing-
debate

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 48

Prices and Trust
“Since the price of all the raw
materials including bottle
cork and gas has increased,
we are forced to increase the
price of Soda. Respected
consumers, kindly co-operate.
06-03-2023 onwards Soda:
Rupees 10”

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 49

What Happens to Price and Quantity When Supply or
Demand Shifts?

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 50

Summing Up
• Economists use the model of supply and demand to analyze competitive markets.

• In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.

• The demand curve shows how the quantity of a good depends upon the price.
• According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.
• In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes,
tastes, expectations, and the number of buyers.
• If one of these factors changes, the demand curve shifts.

• The supply curve shows how the quantity of a good supplied depends upon the price.
• According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.
• In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the
number of sellers.
• If one of these factors changes, the supply curve shifts.

• Market equilibrium is determined by the intersection of the supply and demand curves.

• At the equilibrium price, the quantity demanded equals the quantity supplied.

• The behavior of buyers and sellers naturally drives markets toward their equilibrium.

• To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price
and quantity.

• In market economics, prices are the signals that guide economic decisions and thereby allocate resources.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 51

Consumer Behaviour
Consumer Behaviour and
consumer choice
The concept of Utility
Law of Diminishing Marginal
Utility

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 52

Where do demand curves come from?
• Consumer Preferences:
Can be understood with:
• Graphical representation called Indifference
Curve
• Utility Function

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 53

Consumer Behaviour
Theory of consumer behavior: Description of how consumers allocate incomes among
different goods and services to maximize their well-being.
• Consumer behavior is best understood in three distinct steps:
• Consumer Preferences
• Budget Constraints
• Consumer Choices

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 54

Consumer Preference
MARKET UNITS OF UNITS OF
BASKET FOOD CLOTHING • Market basket (or bundle): list with
A 20 30 specific quantities with one or more
B 10 50
goods.
D 40 20 • Table shows alternative market baskets.
E 30 40 • To explain the theory of consumer
G 10 20 behavior, we will ask whether consumers
H 10 40
prefer one market basket to another.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 55

Basic assumptions about Preferences
• The following assumptions impose a degree of rationality in consumer preferences.
• Completeness: Preferences are assumed to be complete.
• Consumers can compare and rank all possible baskets. Thus, for any two market
baskets A and B, a consumer will prefer A to B, will prefer B to A, or will be indifferent
between the two.
• These preferences ignore costs. A consumer might prefer steak to hamburger but buy
hamburger because it is cheaper.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 56

Basic assumptions about preferences
• Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers
basket A to basket B and basket B to basket C, then the consumer also prefers A to C.
Transitivity regarded as necessary for consumer consistency.
• More is better than less: Goods are assumed to be desirable—i.e., to be good.
Consequently, consumers always prefer more of any good to less. In addition,
consumers are never satisfied or satiated; more is always better, even if just a little
better.
• Goods vs. Bads: For goods more is preferred to less, for bads, less is preferred to more.

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Indifference Curve and Indifference Map

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 58

Indifference Curve and Indifference Map
• Indifference Curve: Curve representing all combinations of market baskets that provide
a consumer with the same level of satisfaction.
• The IC, 𝑈1 that passes through market basket A shows all baskets that give the
consumer the same level of satisfaction as does market basket A; these include baskets
B and D. (refer figure above)
• Our consumer prefers basket E, which lies above 𝑈1 , to 𝐴, but prefers 𝐴 to 𝐻 or 𝐺, which
lie below 𝑈1 .
• Indifference Map: Graph containing a set of indifference curves showing the market
baskets among which a consumer is indifferent.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 59

Properties of indifference curve
• Higher indifference curve gives higher level of
satisfaction.
• Indifference curves cannot intersect.
• Indifference curves are downward sloping.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 60

Indifference curves cannot intersect
• If indifference curves intersect, one of the
assumptions of consumer theory is violated.
• According to this diagram, the consumer
should be indifferent among market baskets A,
B, and D. Yet B should be preferred to D
because B has more of both goods.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 61

Shape of IC: downward sloping
• The Marginal Rate of Substitution (MRS): The
magnitude of the slope of an indifference curve
measures the consumer’s marginal rate of
substitution (M R S) between two goods.
• Maximum amount of a good that a consumer is
willing to give up in order to obtain one additional
unit of another good.
• In this figure, the M R S between clothing (C) and
food (F) falls from 6 (between A and B) to 4
(between B and D) to 2 (between D and E) to 1
(between E and G).
• The MRS of food for clothing is −∆𝐶/∆𝐹 ( units of
clothing you give up to consume an additional unit
of food).

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 62

 Diminishing marginal rate
of substitution

• (fourth assumption regarding consumer

preference)
• Convexity: MRS falls as we move down the
IC. The decline in the M R S reflects the fourth
assumption regarding consumer
preferences: a diminishing marginal rate of
substitution.
• When the M R S diminishes along an
indifference curve, the curve is convex.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 63

Is it reasonable to expect IC to be convex!
• Yes.
• As more and more of one good is consumed
then we can expect that a consumer will give up
fewer and fewer units of a second good to get
additional units of the first one.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 64

Marginal utility
• Marginal utility measures the additional satisfaction obtained
from consuming one additional unit of the good.
• Law of Diminishing Marginal Utility: The principle that as
more of a good is consumed, the consumption of additional
amounts will yield smaller additions to utility.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 65

Is it convex always?
• The shape of an IC describes the willingness of
a consumer to substitute one good for
another.
• An IC with a different shape implies a different
willingness to substitute.

18-07-2024 S2-3 MIE Lectures Ashapurna Baruah IIM Raipur 66

Utility
• Utility: Numerical score representing the satisfaction that a consumer gets from a
given market basket.
• Utility function: Formula that assigns a level of utility to individual market baskets.
• 𝑢 𝐹, 𝐶 = 𝐹 + 2𝐶, where F and C are food and clothing
• 𝑈 = 𝑃 × 𝐶, where P and C are pizzas and cookies

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Ordinal utility vs. Cardinal utility
• Cardinal utility function: Utility function describing by how much one
market basket is preferred to another. This approach assumes that
preferences could be measured or quantified in terms of basic units.
• Ordinal utility function: Utility function that generates a ranking of market
baskets in order of most to least preferred.

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Example: Can money buy happiness?
• Economists use the term utility to represent a measure
of the satisfaction or happiness that individuals get
from consumption of goods and services.
• Higher income→ consume more goods and services.
• Does greater income and consumption really translate
into greater happiness?

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In one study, an ordinal scale for happiness was derived from the answer to the following
question.
• “How satisfied are you at present with your life, all things considered?”
• Possible responses ran on a scale from 0 (completely dissatisfied) to 10 (completely
satisfied).
• Income was found to be a very strong predictor of happiness (another strong predictor
was whether a person was employed or not).
• On average, as income increased by one percent, the satisfaction score increased one half
a point.
• Knowing that there is a positive relationship between utility or satisfaction and income, it is
reasonable to assign utility values to the baskets of goods and services that consumers
buy.

Source: Frijters et al. (2004)

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 Can one compare levels of happiness across
as well as within countries? Once again, the
evidence says yes.
In a separate survey of individuals in 67
countries, a team of researchers asked: “All
things considered, how satisfied are you
with your life as a whole these days?”
Responses were given on a ten-point scale,
with 1 representing the most dissatisfied
and 10 the most satisfied. Income was
measured by each country’s per-capita gross
domestic product in U.S. dollars.
Results in figure. (http://www.worldvaluessurvey.org.)

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 Example: Marginal Utility and
Happiness
• A comparison of mean levels of
satisfaction with life across
income classes in the United
States shows that happiness
increases with income, but at a
diminishing rate.
• Figure shows the plot.

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