Topic 1:
Lecture 3
•The circular flow model
See Handout
(contains whole
of lectures 3-5)
Agent:
Demand
Households
Supply
Market:
Market:
Goods/Services
Supply
Inputs
Agent:
Demand
Firms
Robin Naylor, Department of
Economics, Warwick
1
Topic 1:
Lecture 3
•Demand
•Consider a Demand Relation:
•What are the influences on Demand for a good . . . ?
px
po
How does a change in
some other influence
affect the demand
curve?
a
b
What does the slope of
the demand curve tell
us?
D
Xo
Robin Naylor, Department of
Economics, Warwick
X
2
Topic 1:
Lecture 3
We can write the demand relation as:
X d  X d ( p | p , p , M ,...)
x y z
Note the crucial difference between
(i) A movement along the demand curve
(ii) A shift in the demand curve
Robin Naylor, Department of
Economics, Warwick
3
Topic 1:
Lecture 3
We can also write the (inverse) demand relation as:
p  p ( X d | p , p , M ,...)
x
x
y z
This is best thought of as the equation that
determines the price the firm can charge for
particular levels of output.
Robin Naylor, Department of
Economics, Warwick
4
Topic 1:
Lecture 3
As a particular example of an inverse demand curve:
1
X d  (a  p).
b
This can be re-written as
p  a  bX d .
How would you interpret the parameters 'a' and 'b'?
How would you draw this demand curve?
Robin Naylor, Department of
Economics, Warwick
5
Topic 1:
Lecture 3
Supply
•Consider a Supply Relation:
•What are the influences on Supply a good . . . ?
How does a change in
some other influence
affect the Supply curve?
px
S
a
po
What does the slope of
the Supply curve tell us?
b
Xo
Robin Naylor, Department of
Economics, Warwick
X
6
Topic 1:
Lecture 3
We can write the (inverse) supply relation as:
p  p ( X s | p ,...).
x
x
y
This is best thought of as the equation that
determines the price the firm requires in order
to induce it to supply particular levels of output.
Example:
p  c  dX s.
Robin Naylor, Department of
Economics, Warwick
7
Topic 1:
Lecture 3
Putting together Supply and Demand:
What is meant by the
‘market equilibrium’?
px
S
What are the possible
properties of a market
equilibrium?
pe
D
Xe
Robin Naylor, Department of
Economics, Warwick
X
8
Topic 1:
Lecture 3
Comparative Statics:
What is the effect on
market equilibrium of a
shift in demand?
px
S
pe
D
Xe
Robin Naylor, Department of
Economics, Warwick
X
9
Topic 1:
Lecture 3
Comparative Statics:
What is the effect on
market equilibrium of a
shift in supply?
px
S
pe
D
Xe
Robin Naylor, Department of
Economics, Warwick
X
10
Topic 1:
Lecture 3
Uniqueness of equilibrium and price bubbles:
Suppose D is the Willingness to Pay for housing. It’s likely to depend on
Consumer Confidence (CC). (i) What happens if CC rises? (ii) What might cause
CC to rise? What is the implication of this?
px
S
pe
D
Xe
Robin Naylor, Department of
Economics, Warwick
X
11
Topic 1:
Lecture 3
Putting together supply and demand:
(1) p  a  bX d ,
(2) p  c  dX s.
How many equations do we have?
And how many unknowns?
Robin Naylor, Department of
Economics, Warwick
12
Topic 1:
Lecture 3
There is a 3rd equation:
(3) X d  X s.
What is this equation, in terms of its Economic meaning?
We can now solve:
Robin Naylor, Department of
Economics, Warwick
13
Topic 1:
Lecture 3
It is straightforward to show that:
X
a c
b d
and
ad bc
p
.
b d
In other words, . . .
Robin Naylor, Department of
Economics, Warwick
14
Topic 1:
Lecture 3
Knowing the values of the parameters gives
us the values of price and quantity traded in equilibrium.
We can also carry out the comparative static exercises
in order to see the effects of changes in the parameters
on the equilibrium values of price and quantities.
How would you do this?
Robin Naylor, Department of
Economics, Warwick
15
Topic 1:
Lecture 4
Demand Analysis (or analysis of ‘Consumer Choice’)
Choice is based on . . .
. . . Preferences and
. . . Constraints
We’ll analyse each of these in turn.
Robin Naylor, Department of
Economics, Warwick
16
Topic 1:
Lecture 4
Demand Analysis: Preferences
Suppose your happiness depends on just 2 commodities
(that you might buy in the market):
e.g., ???
Robin Naylor, Department of
Economics, Warwick
17
Topic 1:
Lecture 4
Demand Analysis: Preferences
E.g., Books and Food
We assume that you have preferences over these goods and that the
nature of your preferences satisfies various properties:
(i) Non-satiation . . .
. . . in words:
(ii) Ordinal Ranking
(iii) Transitivity
(iv) Completeness
Robin Naylor, Department of
Economics, Warwick
18
Topic 1:
Lecture 4
Demand Analysis: Preferences
Non-satiation . . . in a diagram.
B
B1
a
b
F1
F2
Robin Naylor, Department of
Economics, Warwick
F
19
Topic 1:
Lecture 4
Demand Analysis: Preferences
Our assumptions about the properties of preferences imply that we
can represent preferences using Indifference Curves. These ICs
will have properties which depend upon the properties of the
underlying preferences.
B
B1
a
b
F1
F2
Robin Naylor, Department of
Economics, Warwick
We can show that an
IC must slope
downwards because of
non-satiation.
F
20
Topic 1:
Lecture 4
Demand Analysis: Preferences
We can show that ICs cannot cross under the assumptions we have
made about preferences:
IC1
B
IC2
a
c
b
F
Robin Naylor, Department of
Economics, Warwick
21
Topic 1:
Lecture 4
Demand Analysis: Preferences
The slope of the IC is the MRS between the 2 goods (refer to
earlier slides).
B
a
b
IC1
F
Robin Naylor, Department of
Economics, Warwick
22
Topic 1:
Lecture 4
Demand Analysis: Preferences
If the IC is linear, this means that the MRS is constant.
B
a
b
IC1
F
Robin Naylor, Department of
Economics, Warwick
23
Topic 1:
Lecture 4
Demand Analysis: Preferences
It is more common to assume that the MRS is diminishing: why is
this and what does it imply about the IC?
B
a
b
F
Robin Naylor, Department of
Economics, Warwick
24
Topic 1:
Lecture 4
Demand Analysis: Preferences
It is more common to assume that the MRS is diminishing: why is
this and what does it imply about the IC?
B
IC1
F
Robin Naylor, Department of
Economics, Warwick
25
Topic 1:
Lecture 4
Demand Analysis: Preferences
What would it mean if the IC was upward-sloping?
B
IC1
F
Robin Naylor, Department of
Economics, Warwick
26
Topic 1:
Lecture 4
Demand Analysis: Preferences
What would this mean?
B
IC1
F
Robin Naylor, Department of
Economics, Warwick
27
Topic 1:
Lecture 4
Demand Analysis: Preferences
Under the assumption of completeness, there is an IC passing
through every possible point:
B
b
a
IC2
IC1
F
Robin Naylor, Department of
Economics, Warwick
28
Topic 1:
Lecture 4
Demand Analysis: Preferences
The consumer would like to get to the highest possible IC: what
limits this?
c
ICn
B
b
a
IC2
IC1
F
Robin Naylor, Department of
Economics, Warwick
29
Topic 1:
Lecture 5
Demand Analysis: Constraints
We said that our understanding of Consumer Choice rests on the
analysis of Preferences and Constraints. Let’s now turn to
consider Constraints.
Y
Ymax
0
Xmax
Robin Naylor, Department of
Economics, Warwick
X
30
Topic 1:
Lecture 5
Demand Analysis: Constraints
We can represent a budget set and a budget frontier (or constraint)
Y
Ymax
0
Xmax
Robin Naylor, Department of
Economics, Warwick
X
31
Topic 1:
Lecture 5
Demand Analysis: Constraints
We can represent a budget set and a budget frontier (or constraint)
Y
What equation can we give this
constraint?
Ymax
0
Xmax
Robin Naylor, Department of
Economics, Warwick
X
32
Topic 1:
Lecture 5
Demand Analysis: Constraints
The equation tells us that if we spend all our money income, M, on
X and Y, our spending be equal to:
M  xp  yp
x
y
Robin Naylor, Department of
Economics, Warwick
33
Topic 1:
Lecture 5
Demand Analysis: Constraints
Re-arranging, the equation for the budget constraint is:
p
M
y
 xx
py p
y
How do you interpret this equation? And Graphically?
Robin Naylor, Department of
Economics, Warwick
34
Topic 1:
Lecture 5
Demand Analysis: Constraints
The equation of the budget constraint:
M px
y

x
py p
y
Y
Ymax
0
Xmax
Robin Naylor, Department of
Economics, Warwick
X
35
Topic 1:
Lecture 5
Demand Analysis: Constraints
Given the position of the budget constraint, what will be the
consumer’s choice of X and Y? This will depend on their
preferences:
Y
Ymax
0
Xmax
Robin Naylor, Department of
Economics, Warwick
X
36
Topic 1:
Lecture 5
Demand Analysis: Constrained choice
Given the position of the budget constraint, what will be the
consumer’s choice of X and Y? This will depend on their
preferences:
Y
IC3
IC1 IC
2
Ymax
0
Xmax
Robin Naylor, Department of
Economics, Warwick
X
37
Topic 1:
Lecture 5
Demand Analysis: Constrained choice
Given the position of the budget constraint, what will be the
consumer’s choice of X and Y? This will depend on their
preferences:
Y
ICmax
Ymax
0
Xmax
Robin Naylor, Department of
Economics, Warwick
X
38
Topic 1:
Lecture 5
Demand Analysis: Constrained choice
Given the position of the budget constraint, what will be the
consumer’s choice of X and Y? This will depend on their
preferences:
Y
Ymax
a
Y*
0
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
39
Topic 1:
Lecture 5
Demand Analysis: Constrained choice
So, by bringing together preferences and constraints, we have a
model which predicts/explains the consumer’s choices
(demands) for X and Y . . . given . . .?
Y
Ymax
a
Y*
0
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
40
Topic 1:
Lecture 5
Demand Analysis: Comparative Statics
What will happen to the optimal choices of X and Y if there are
relevant changes to the parameters of the model?
Y
What are the ‘relevant
parameters’?
Ymax
a
Y*
0
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
41
Topic 1:
Lecture 5
Demand Analysis: Comparative Statics
What will happen to the optimal choices of X and Y if there are
relevant changes to the parameters of the model?
Y
Consider a change in money
income. How do we show this?
Ymax
a
Y*
0
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
42
Topic 1:
Lecture 5
Demand Analysis: Change in money income
Y
Ymax
a
Y*
0
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
43
Topic 1:
Lecture 5
Demand Analysis: Change in money income
Y
What can you say about
the demand for X as
M↑?
Ymax
Y*
0
And the demand for Y?
â
a
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
44
Topic 1:
Lecture 5
Demand Analysis: Change in money income
Y
What can you say about
the demand for X as
M↑?
â
And the demand for Y?
Ymax
Y*
0
a
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
45
Topic 1:
Lecture 5
Demand Analysis: Change in money income
Y
What can you say about
the demand for X as
M↑?
â
And the demand for Y?
Ymax
Y*
0
a
X*
Xmax
Robin Naylor, Department of
Economics, Warwick
X
46
Topic 1:
Lecture 5
Demand Analysis: Change in money income
Y
What can you say about
the demand for X as
M↑?
And the demand for Y?
Ymax
Y*
0
a
X*
â
Xmax
Robin Naylor, Department of
Economics, Warwick
X
47
Topic 1:
Lecture 5
Demand Analysis: Change in money income
Y
What can you say about
the demand for X as
M↑?
And the demand for Y?
Ymax
Y*
0
a
X*
â
Xmax
Robin Naylor, Department of
Economics, Warwick
X
48