Partial and general equilibrium, law of demand and demand analysis
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- 3.2.6 Discussion and criticism
3.2.5 Utility of moneyOne of the most common uses of a utility function, especially in economics, is the utility of money. The utility function for money is a nonlinear function that is bounded and asymmetric about the origin. These properties can be derived from reasonable assumptions that are generally accepted by economists and decision theorists, especially proponents of rational choice theory. The utility function is concave in the positive region, reflecting the phenomenon of diminishing marginal utility. The boundedness reflects the fact that beyond a certain point money ceases being useful at all, as the size of any economy at any point in time is itself bounded. The asymmetry about the origin reflects the fact that gaining and losing money can have radically different implications both for individuals and businesses. The nonlinearity of the utility function for money has profound implications in decision making processes: in situations where outcomes of choices influence utility through gains or losses of money, which are the norm in most business settings, the optimal choice for a given decision depends on the possible outcomes of all other decisions in the same time-period. 3.2.6 Discussion and criticismDifferent value systems have different perspectives on the use of utility in making moral judgments. For example, Marxists, Kantians, and certain libertarians (such as Nozick) all believe utility to be irrelevant as a moral standard or at least not as important as other factors such as natural rights, law, conscience and/or religious doctrine. It is debatable whether any of these can be adequately represented in a system that uses a utility model. Another criticism comes from the assertion that neither cardinal nor ordinary utility are empirically observable in the real world. In case of cardinal utility it is impossible to measure the level of satisfaction "quantitatively" when someone consume/purchase an apple. In case of ordinal utility, it is impossible to determine what choice were made when someone purchase, for example, an orange. Any act would involve preference over infinite possibility of set choices such as (apple, orange juice, other vegetable, vitamin C tablets, exercise, not purchasing, etc). 3.3 The income and substitution effects When the price of q1, p1, changes there are two effects on the consumer. First, the price of q1 relative to the other products (q2, q3, . . . qn) has changed. Second, due to the change in p1, the consumer's real income changes. When we compute the change in the optimal consumption as a result of the price change, we do not usually separate these two effects. Sometimes we might want to separate the effects. 3.3.1 The Substitution Effect The Substitution Effect is the effect due only to the relative price change, controlling for the change in real income. In order to compute it we ask what is the bundle that would make the consumer just as happy as before the price change, but if they had to make their choice faced with the new prices. To find this point we consider a budget line characterized by the new prices but with a level of income such that it is tangent to the initial indifference curve. In the diagram on the next page, the initial consumer equilibrium is at point A where the initial budget line is tangent to the higher indifference curve. Consumption at this point is 11 units of good 1 and 8 units of good 2. After an increase in the price of good 1, the consumer moves to point E, where the new budget line is tangent to the lower indifference curve. Consumption of good 1 has fallen to 4 units while consumption of good 2 has increased to 10 units. The substitution effect is the movement from point A to point G. This point is characterized by two things. (1) It is on the same indifference curve as the original consumption bundle; AND (2) it is the point where a budget line that is parallel to the new budget line is just tangent to initial indifference curve. This "intermediate" budget line is attempting to hold real income fixed so we can isolate the substitution effect. The point G reflects the consumer's choice if faced with the new prices (the budget line has the slope reflecting the new prices) and the compensated income (i.e., an income level that holds real income fixed). The substitution effect is the difference between the original consumption and the new "intermediate" consumption. In this case consumption of good 1 falls from 11 to 6.84 while consumption of good 2 increases to 14.27. When p1 goes up the Substitution Effect will always be non-positive (i.e., negative or zero). 3.3.2 The Income Effect The Income Effect is the effect due to the change in real income. For example, when the price goes up the consumer is not able to buy as many bundles that she could purchase before. This means that in real terms she has become worse off. The effect is measured as the difference between the “intermediate" consumption” at G and the final consumption of q1 and q2 at E. Unlike the Substitution Effect, the Income Effect can be both positive and negative depending on whether the product is a normal or inferior good. By the way we constructed them, the Substitution Effect plus the Income Effect equals the total effect of the price change. Alternative Way of Analyzing a Price Change One can also analyze the income and substitution effects by first considering the income change necessary to move the consumer to the new utility level at the initial prices. This constitutes the income effect. The movement along the new indifference curve from the intermediate point to the new equilibrium as the slope of the price line changes is then the substitution effect. See if you can identify the “intermediate” point on the lower indifference curve by shifting the budget line (Hint: q1 and q2 both fall.). 
Figure 1 3.4 The indifference curve In microeconomic theory, an indifference curve is a graph showing different bundles of goods, each measured as to quantity, between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another. In other words, they are all equally preferred. One can equivalently refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles. Map and properties of indifference curves 
Figure 2: An example of an indifference map with three indifference curves represented A graph of indifference curves for an individual consumer associated with different utility levels is called an indifference map. Points yielding different utility levels are each associated with distinct indifference curves. An indifference curve describes a set of personal preferences and so can vary from person to person. An indifference curve is like a contour line on a topographical map. Each point on the map represents the same elevation. If you move "off" an indifference curve traveling in a northeast direction you are essentially climbing a mound of utility. The higher you go the greater the level of utility. The non-satiation requirement means that you will never reach the "top". Indifference curves are typically represented to be: 1. defined only in the positive (+, +) quadrant of commodity-bundle quantities. 2. negatively sloped. That is, as quantity consumed of one good (X) increases, total satisfaction would increase if not offset by a decrease in the quantity consumed of the other good (Y). Equivalently, satiation, such that more of either good (or both) is equally preferred to no increase, is excluded. (If utility U = f(x, y), U, in the third dimension, does not have a local maximum for any x and y values.) The negative slope of the indifference curve reflects the law of diminishing marginal utility. That is as more of a good is consumed total utility increases at a decreasing rate - additions to utility per unit consumption are successively smaller. Thus as you move dowm the indifference curve you are trading consumption of units of Y for additional units of X. The price of a unit of X in terms of Y increases. 3. complete, such that all points on an indifference curve are ranked equally preferred and ranked either more or less preferred than every other point not on the curve. So, with (2), no two curves can intersect (otherwise non-satiation would be violated). 4. transitive with respect to points on distinct indifference curves. That is, if each point on I2 is (strictly) preferred to each point on I1, and each point on I3 is preferred to each point on I2, each point on I3 is preferred to each point on I1. A negative slope and transitivity exclude indifference curves crossing, since straight lines from the origin on both sides of where they crossed would give opposite and intransitive preference rankings. 5. (strictly) convex (sagging from below). With (2), convex preferences implies a bulge toward the origin of the indifference curve. As a consumer decreases consumption of one good in successive units, successively larger doses of the other good are required to keep satisfaction unchanged. Directory: sim sim -> Simon Mckeown Artist C. V. DaDaFest International Artist of the Year 2010 sim -> Viii seb extended Abstracts Sample File: Note Initial Caps sim -> Simscript III release 0 May 23th, 2016 sim -> Concepts and terminology in the Simula Programming Language sim -> Stormwind navigation simulator, which won the Open Data Innovation Contest Apps4Finland in 2013 sim -> Multiscale Simulation Representative publications sim -> United Nations Development Programme Country: Solomon Islands Project Document sim -> Antecedent, antebellum, ante meridian sim -> A simulated Hallucination Mechanism Compared to Hallucination Brain Response Studies Download 0.63 Mb. Share with your friends:
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