ECON101 Lecture Notes - Lecture 7: Real Income, Relative Price, Opportunity Cost

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browncrocodile545

27 Oct 2018

School

University of Waterloo

Department

Economics

Course

ECON101

Professor

Corey Van De Waal

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ECON101 Full Course Notes

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Recall: budget line des(cid:272)ri(cid:271)es the limits to the household"s consumption choices: any point on a budget line or inside it affordable, any point outside a budget line unaffordable. We often represent the budget line in the intercept-slope form: Pm/pp: relative price of a movie in terms of pop (slope: relative price is the price of one good divided by the price of another good. A rise in the price of the good on the x-axis decreases the affordable quantity of that good and increases the slope of the budget line. A change in money income brings a parallel shift of the budget line. Slope does not change b/c the relative price does not change. An increase in household income, holding prices constant, will cause a rightward parallel shift of the budget line. An decrease in household income, holding prices constant, will cause a leftward parallel shift of the budget line.

Related Questions

Q1. The following table shows the relationship between outside temperature (T) and number of hot drinks sold (Q).

Outside temperature (T)	Number of hot drinks sold(Q)
0 ⁰F	1000 cups
20	900
40	800
60	700
80	600

a. Graph and briefly explain the relationship. Put the number of hot drinks sold (Q) on the vertical axis and outside temperature (T) on the horizontal axis.

b. Compute the slope of the line? Y-intercept? Show your work.

c. Construct the equation that represents this line. Predict the number of hot drinks sold (Q) at 26 ⁰F. Show your work.

Q2. Discuss the opportunity costs of the following cases, respectively.

a .Go to the movie theater and watch a movie instead of studying for a midterm exam.

b .Suppose that an economyâs PPF is a straight line, rather than a concave curve. What would this say about the nature of marginal opportunity cost as production is shifted from one good to the other?

Q3. Dreamlandâs production possibilities schedule is as follows:

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

POINT	Capital Goods	Consumption Goods
A	0	30
B	2	27
C	4	21
D	6	12
E	8	0

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

a. Draw the production possibilities frontier. Put Capital Goods on the horizontal axis and Consumption Goods on the vertical axis.

b. If this economy is at point C, what is the opportunity cost of one more capital good (i.e., marginal opportunity cost)?

c. Can Dreamland produce 6 capital goods and 21 consumption goods? Explain.

d. Suppose that Dreamland has two possible choices in the future: it devotes only 5% of its resources to producing capital goods over each of the next 10 years, whereas it devotes 20%. In which case is Dreamland likely to experience more rapid economic growth in the future? Explain your reasoning.

Use your knowledge about price-searching firms and two-part pricing to advise the company below. A company has a bar and is trying to decide on the cover charge (if any) and price for each drink. It has done a modest regression study in which it asked customers to classify themselves as light drinkers or heavy drinkers and to indicate the number of drinks they would typically consume during the evening. The estimate from the regression study is that a change in the price equal to $1 per drink causes light drinkers to change their consumption on average by 0.5 drinks per night. However, a change in the price of $1 causes heavy drinkers to change their consumption on average by 1.0 drinks per night. For both groups, a typical consumer will not consume anything once the price reaches $9 per drink. (They may instead go to another bar or not go to a bar at all.) Draw a demand curve for a typical light drinker and for a typical heavy drinker on the same diagram. Explain your diagram. Write equations for the curves in slope-intercept form.

If 300 people visit the bar on a typical evening, with 200 people being light drinkers and 100 people being heavy drinkers, draw an overall demand curve for all of the consumers combined. What is the slope and what is the intercept for this demand curve? Write an equation in slope-intercept form. If the marginal cost of making drinks (the alcohol, the bartender's labor, and the amortized cost of purchasing glasses and cleaning them repeatedly) is constant at $5 per drink, and if no cover charge is assessed, what is the best price to charge for drinks? How many drinks would be sold on a typical evening? What would your profits be? If you cut your price by $1 per drink and assess the maximum possible cover charge without causing a typical light drinker to refuse to enter the bar, would your profits improve? How high would the cover charge be? Calculate both the cover charge and your total profits. Would the new pricing increase profit?

Maybe the best price cut is not exactly $1. Write a profit equation. Profits equal to total revenue minus total cost. Total cost equals $5 times the number of drinks sold. Total revenue equals the price for drinks times the number of drinks sold, plus 300 people times the cover charge. The cover charge equals, for a light drinker, the triangle of consumer surplus above the price but below the demand curve for a light drinker. (The area of a triangle equals one half the base times the height.) You will take the derivative of the profit equation with respect to P or Q and set it equal to zero. For example, use the equation for the total demand curve and solve for Q in terms of P. Then in the profit equation substitute in an expression involving P in place of every Q that was in the original profit equation. Now you can take a derivative of profits with respect to P and set the derivative equal to zero. Eventually, you can solve for the exact best P, Q, and cover charge.

Review of the slope-intercept form: Y= a - bX; a = the intercept on the Y-axis and b = the absolute value of the slope (slope=(change in Y)/(change in X)) For a demand curve: P=a-b Q. The intercept on the vertical axis would indicate a price that is so high that the quantity demanded becomes zero. The slope is the ratio of a change in price divided by the change in quantity demanded; the extra credit problem gives you information to determine the slope for a light drinker and the slope for a heavy drinker.

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Specific assignment: Mark each statement either True or False. If a statement is false, explain (very briefly) why it is false.

Keynes hypothesized that consumption is positively related to income. True

The marginal propensity to consume, MPC, is measured as changes in consumption over changes in income. True

The MPC is merely the percent of oneâs income that is spent to purchase goods and services. True

The MPC is the slope of the consumption function.

If the MPC is .8, then it may be concluded that the MPS must be .2.

If a personâs income is $10,000 and that person is spending $7,500 on consumption, then it may be concluded that that person has a marginal propensity to save of .25.

The MPC and the MPS must sum to one, meaning that 1 â MPC = MPS

Given a linear (straight-line) consumption function, the MPC must be a constant.

At the point graphically at which the consumption function intersects the 45-degree reference line, the MPC must be equal to 1.

If the consumption function lies above the 45-degree reference line, then there must be negative saving in the economy.

Autonomous consumption is that level of consumption spending that is independent of the level of income.

A change in the level of income will shift the consumption function either upward or downward.

A change in the level of consumer wealth will shift the consumption function either upward or downward.

If the MPC has a positive value, then the MPS must have a negative value.

Saving is defined simply as disposable income minus consumption.

If the consumption function has a slope of 4/5, then the saving function must have a slope of .2.

Any factor that would shift the consumption function upward would shift the saving function upward also.

The average propensity to consume (APC), like the MPC, is simply the slope of the basic, Keynesian consumption function.

Given a typical shaped consumption function, as the level of income rises, the APC rises as well.

If a consumption function graphically starts at a point above the origin (i.e., has a positive vertical axis intercept), then the saving function must begin below the origin.

A dramatic rise in household inflationary expectations could be expected to shift the consumption function downward and the saving function upward.

ECON101 Lecture Notes - Lecture 7: Real Income, Relative Price, Opportunity Cost

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