All multiple-choice questions and back problems from Mankiw (Ch 9, 22, 14, 15,

16) are extremely important.

Here are few additional notes.

Chapter 22 (Consumer behavior)

1. Note if prices of goods on horizontal and vertical axis are p1 , p2 respectively and m is income of a
consumer then
a. horizontal intercept of the budget line of the consumer (maximum amount of good 1 she can buy
m
with her limited income) is .
p1
m
b. vertical intercept of the budget line (maximum amount of good 2 she can buy) is .
p2

c. budget line will shift (parallelly or

otherwise) only if one or both the intercept change.
d. budget line must remain unchanged so long as both intercepts remain fixed, no matter what
happens to income or prices.

2. Consumer equilibrium means that her budgetary allocation among the quantity of two goods is such that
she maximizes her satisfaction or utility. If she shifts even a rupee of spending from one good to the other
then her utility will fall.

The equilibrium occurs at a bundle on the budget line when slope of the budget line equals the slope of
the indifference curve.
 Magnitude of the slope of the budget line i.e. p1 p2 (slope of the budget line is − p1 p2 ) measures the
quantity of good 2, market wants the consumer to give up, to obtain one additional unit of good 1.

Magnitude of the slope of the indifference curve i.e. − MRS12 (slope of indifference curve at any point on
it is MRS12 which is negative in sign and variable in magnitude along the indifference curve) measures the
quantity of good 2, the consumer is willing to give up for one additional unit of good 1 so that her utility
remains unchanged.

If at some point on the budget line say C, (magnitude of the) slope of the budget line is more than
(magnitude of the) slope of the indifference curve (from C) then it is means that, for an additional unit of
good 1, the amount consumer is willing to give up of good 2 is less than the amount market wants her to
give up. It means that good 2 is relatively more valuable and consumer will move left of C on the budget
line by giving up good 1 and buying additional good 2.

If at some point on the budget line say B, slope of the budget line is less than slope of the indifference
curve (from B) then it is means that, for an additional unit of good 1, the amount consumer is willing to
give up of good 2 is more than the amount market wants her to give up. It means that good 1 is relatively
more valuable and consumer will move right of B on the budget line by giving up good 2 and buying
additional good 1.

3. Let a bundle of good 1 and good 2 be ( x1 , x2 ) . Utility (i.e. total utility) of the bundle TU ( x1 , x2 ) is a real
number. It is the total satisfaction some consumer receives from this bundle. A different consumer may
get different satisfaction i.e. may associate a different total utility number with the same bundle.

Given the preferences of a consumer,

i. all bundles that lie on any indifference curve carry the same total utility number.
ii. a bundle on a higher curve carries a high utility number than a bundle on the lower indifference
curve.
iii. Since more is better, total utility always increases with more is consumed of any good.
 Marginal (incremental) utility of some unit of a good is the change in total utility (number) as the
consumer additionally consumes that unit of the good while keeping the amount of the other good fixed.
Hence

MU ( of x1th unit of good 1) = TU = TU ( x1 , x2 ) − TU ( x1 − 1, x2 )

For example, if good 2 is held at x2 = 1 then

Additional unit of good Total utility from the Marginal utility from the
Bundle
1 bundle extra unit of good 1
(0,1) 50
(1,1) 1 100 50
(2,1) 2 145 45
(3,1) 3 185 40
(4,1) 4 220 35
(5,1) 5 250 30
(6,1) 6 275 25

Note that total utility is increasing as we more and more units of good 1 but the increase in total utility i.e.
marginal utility from successive units of good 1 is declining. This feature of declining marginal utility is
often known as the law of diminishing marginal utility from any good.

4. Along (i.e. for all bundles on) an Indifference curve, TU remains constant. But as you move, say from left
to right, along an indifference curve, you decrease consumption of good 2 and increase consumption of
good 1.

Suppose you are initially consuming ( x1 , x2 ) and decide to move to ( x1 + x1 , x2 − x2 ) that lies on the
same indifference curve as ( x1 , x2 ) . Here x1 , x2  0 . It means you have slightly increased consumption
of good 1 and slightly decreased consumption of good 2.

Since you increase consumption of good 1, you gain some utility. If we assume that increase in good 1
x1 is so small such that amount of good 2 is approximately unchanged or fixed, then the increase in total
utility because of increase in consumption of good 1 by x1 must be equal to MU1  x1 , where MU1 is
the marginal utility of x1th unit of good 1.

Since you decrease consumption of good 2, you lose some utility. If we assume that decrease in good 2
x2 is so small such that amount of good 1 is approximately unchanged or fixed, then the decrease in total
utility because of decrease in consumption of good 2 by x2 must be equal to MU 2  x2 , where MU 2 is
the marginal utility of x2th unit of good 2.

Since ( x1 + x1 , x2 − x2 ) lies on same IC as ( x1 , x2 ) , TU ( x1 + x1 , x2 − x2 ) = TU ( x1 , x2 ) . Therefore the

gain in total utility from increased consumption of good 1 must be equal to the loss in total utility from
decreased consumption of good 2.
 Mathematically MU1  x1 = MU 2  x2
gain in total utility loss in total utility

Hence along the indifference curve, we must have MU1  x1 = MU 2  x2 .

MU1 x2
The condition can be rewritten as = .
MU 2 x1

x2
But remember that along an indifference curve MRS1 for 2 = − . Important to note here that change in
x1
good 2 is −x2 since we have assumed that x2  0 .

MU1
Hence along an indifference curve, we must have MRS1 for 2 = − . This is definition of marginal rate
MU 2
of substitution as a ratio marginal utility of good 1 to marginal utility of good 2.

Remember that marginal utility of any unit of any good is always positive since we have assumed more is
better.

5. Consumer equilibrium (Utility maximization) condition in terms of marginal utilities.

We know that the bundle which provides maximum satisfaction or total utility to the consumer satisfies
the condition that

p1
MRS1 for 2 = −
p2

MU1
But since MRS1 for 2 = − so it must be that consumer equilibrium can be represented as
MU 2

MU1 p MU1 p1
− = − 1 . Cancelling the negative sign, we get =
MU 2 p2 MU 2 p2

MU1 MU 2
The same condition can be rewritten as = .
p1 p2

The last expression means that in equilibrium, the consumer gets the same additional in total utility by
spending a unit of money i.e. one rupee either on good 1 or good 2.
 1 1
In one rupee, consumer can buy either of good 1 or of good 2. The last unit of good 1 or good 2 adds
p1 p2
1 1
to his total utility MU1 or MU 2 respectively. Therefore, 1 rupee can either add MU1  or MU 2  to his total
p1 p2
utility depending on whether he spends this rupee on good 1 or good 2.

If the consumer is spending all her income i.e., she is somewhere on her budget line, then if

1 1
1. MU1   MU 2  then he will buy more of good 1 and less of good 2, since shifting a rupee from good
p1 p2
1 1
2 to good 1 increases total utility as MU1  − MU 2  0
p1 p2
gain loss

1 1
2. If MU1   MU 2  then he will buy more of good 2 and less of good 1, since shifting a rupee from
p1 p2
1 1
good 1 to good 2 increases total utility as MU 2  − MU1   0
p2 p1
gain loss

3. He will stop shifting his spending i.e. reallocating his resource of income from one good to another only when
1 1 MU1 MU 2
MU1  = MU 2  i.e. when = .
p1 p2 p1 p2
6. Income and Substitution effects in case of

a. Two goods for consumption in the same period, say good 1 and good 2. Price per unit of good
1 rises from p1 to p1 while price per unit of good 2 i.e. p2 and income m remain unchanged.

Substitution effect (calculated after holding purchasing power of the consumer unchanged at the
original level, after increase in the price of good 1, by increasing income of the consumer from m
to m +  , through positive income compensation  ) will causes the quantity demanded for relative
expensive good 1 to fall and quantity demanded for relatively cheaper good 2 to rise.

But income effect (calculated after reversing the increase in income made in the last step i.e.
decreasing the income back to m , to make purchasing power fall as it should as the price of good
1 increases) depends on if a good is normal or inferior.
i. Good is normal
Income effect of a decrease in income causes a decrease in the demand for any normal
good, whether 1 or 2.
ii. Good is inferior
Income effect of a decrease in income causes an increase in the demand of any inferior
good, whether 1 or 2.

So, if price of a good 1 increase (everything else unchanged) then

i. Substitution effect and income effect will both decrease quantity demanded of good 1 if
it is normal.
ii. Substitution effect will decrease quantity demanded for good 1 but income effect will
increase quantity demanded of good 1 if it is inferior. Outcome ambiguous.
 a. If increase in quantity demanded due to income effect is less than decrease in
quantity demanded due to substitution effect then good 1 is ordinary and follows
law of demand as its quantity demanded decrease when its price increases.
b. If increase in quantity demanded due to income effect is more than decrease in
quantity demanded due to substitution effect then good 1 is Giffen and violates
law of demand as its quantity demanded increases when its price increases.
iii. Substitution effect will increase quantity demanded for good 2 but income effect will
decrease quantity demanded if good 2 is normal. Outcome ambiguous.
iv. Substitution effect and income effect will both increase quantity demanded of good 2 if
it is inferior.

If price of good 1 decrease (everything else unchanged) then just change increase into decrease
above and vice versa.

b. Consumption and leisure in the labor-leisure choice model, where consumption in money terms
is on the vertical axis and leisure hours on the horizontal axis. Maximum hours available for either
labor or leisure is R . Given an hourly wage rate w , maximum consumption possible is wR when
consumer works and earns for maximum hours.
Price of 1 hour of leisure is the opportunity cost in terms of wage earning forgone which is equal
to w rupees. Since price of 1 rupee of consumption is 1 rupee, slope of the budget line is w . You
may also get slope of the budget line by dividing vertical intercept by horizontal intercept.

Suppose wage rate per hour (i.e. price of an hour of leisure) increases from w1 to w2 . Slope of the
budget line increases and budget line shifts outwards pivoted around R . The outward shifts
represent an increase in purchasing power of the consumer. Note budget line shifts outward, even
when price of leisure has increased.

To calculate the substitution effect, at the new wage level, purchasing power should be decreased
to original level and so income needs to be taken away from the consumer, shifting the budget line
 inwards parallel to the new budget line. Substitution effect will cause a decrease in quantity
demanded of relative expensive good leisure (equivalently increase in the supply of labor) and
increase in quantity demanded of consumption i.e. goods for consumption.

Income effect will cause an increase in quantity demanded of both the goods (assuming both
consumption and leisure are both normal goods) as purchasing power is returned to its new higher
level by returning the income that was taken.

Consequently, both effects will cause increase in consumption but the net effect on leisure
demanded (and therefore labor supplied) is ambiguous since income and substitution effect work
in opposite direction.

If income effect on leisure is stronger than substitution effect on it then quantity demanded for
leisure increases or quantity supplied of labor decreases as wage rate (which is the price of leisure
demanded as well as price of labor supplied) goes up thus violating both law of demand and law
of supply. This lies behind the downward sloping or backward bending portion of the supply curve
for labor where on vertical axis we have wages and on horizontal axis we have quantity of labor
hours supplied. This portion of the supply curve is at the level of wages higher than some critical
level.

If, however, income effect on leisure is weaker than substitution effect on it then quantity
demanded for leisure decreases or quantity supplied of labor increases as wage rate goes up. This
lies behind the upward sloping portion of the supply curve for labor. This portion of the supply
curve is at the level of wages lower than the critical level.

c. Consumption today and consumption tomorrow in model of inter-time consumption choice

with consumption today on the horizontal axis and consumption tomorrow on the vertical axis. We
assume no inflation i.e. no change in prices of goods over the two periods.

Consumer earns as well as saves only in period 1. If his income today is m then most he can
consume or save today is m . If she consumes all her income today then she will have nothing left
to consume tomorrow. If she saves all then maximum, she can consume tomorrow is m (1 + r ) .
Here r is the interest rate expressed in fractions. For example, if interest rate in percentage is 20%
then in fraction it is 20 100 = 0.2 .

No borrowing is possible in period 1. Since there is no income in period 2, how will she pay back
the principle borrowed amount and interest payment on borrowings in period 2.

Let us express price of both consumption today as well as consumption tomorrow in terms of the
amount of consumption tomorrow. Price of an additional 1 rupee spent on consumption today is
its opportunity cost in the form of consumption tomorrow. It is equal to 1 + r rupees, as 1 rupee if
alternatively saved today, will give return of 1 + r rupees tomorrow, which can give a consumption
of 1 + r rupee tomorrow. Price of an additional 1 rupee spent on consumption tomorrow is only 1
rupee of consumption tomorrow.

Slope of the budget line must be price of consumption today divided by price of consumption
tomorrow (you may also find the slope of budget line by dividing vertical intercept by horizontal
intercept). Hence slope is 1 + r . As r increases from r1 to r2 , consumption today becomes
relatively more expensive. Budget line shifts outwards pivoted at maximum consumption today
i.e. m .

Pivoted shift in the budget line outside means that purchasing power has increased. Just as in case
of consumption of two goods in the same period, it means that income should be taken away to
keep the purchasing power at the original level. After the reduction in income, substitution effect
of increase in r will cause decrease in consumption today (i.e. more savings today) and increase
in consumption tomorrow.

When income (that was taken to calculate the substitution effect) is returned to bring the
purchasing power back to its new higher level then this return of income causes the income effect.
Income effect (as income is given back or increased) increases both the consumption today as well
as consumption tomorrow assuming both are normal goods.

Consequently, both effects will cause increase in consumption tomorrow but the net effect on
consumption today (and therefore savings today) is ambiguous since income and substitution
effect work in opposite direction.

If Income effect on consumption today is stronger than substitution effect on it then consumption
today increases or savings today decreases as the interest rate (which is the price of demanding
consumption today as well as price of supplying savings today) goes up thus violating both law of
demand and law of supply. This lies behind the downward sloping or backward bending portion
of the supply curve for savings where on vertical axis we have interest rate and on horizontal axis
we have rupees saved. This portion of the supply curve is at the level of interest rate higher than
some critical level.
 If, however, income effect on consumption today is weaker than the substitution effect then
consumption today decreases or savings today increases as the interest rate goes up. This lies
behind the upward sloping portion of the supply curve for savings. This portion of the supply
curve is at the level of interest rate lower than the critical level.

7. The diagram below shows a forward bending demand for leisure i.e. backward bending supply curve of
labor.
The explanation for the shape of the forward bending demand curve for leisure lies in the shape of the
indifference curves.

Fix a level of leisure, say R* . The demand for leisure curve will be vertical AB*C*D, provided the slope
of the indifference curves (as we move vertically above point A) increases at the same rate as the slope of
the budget line (i.e. the wage rate) because then at the point of tangency, slope of indifference curve always
equals slope of the budget line.

Imagine that if in the beginning (from A to B*), the rate of increase in slope of indifference curves is less
than the rate of growth of wages then slope of the budget line will be more than the slope of the indifference
curve. Hence the optimal bundle will be on the left of B*. Hence the demand curve is downward sloping
in the beginning.

But later if the rate of increase in slope of indifference curves becomes more than the rate of growth of
wages (from C* to D) then while optimal bundle at w3 is at the left of C* but at w4 is at D. Hence the
demand curve becomes upward sloping.

So, what would explain this behavior of preferences?

Increasing slope of indifference curves as we increase consumption at the same level of leisure R* implies
that consumer is willing to give up more and more of consumption (consumption goes up). But why is the
rate of increase in slope lower than rate of increase in wages in the beginning but higher later?

The answer lies in the fact that in the beginning, increasing consumption is more important for satisfaction
than increasing leisure but beyond a certain level of consumption (provided by certain level of wages) has
been reached, increasing leisure is more important than increasing consumption and so consumer is willing
to give up so much consumption for an extra hour of leisure that she ends up increasing her demand for
leisure to maximize her satisfaction.

One application of this analysis is when consumer is already very rich or becomes rich. What would be
the supply of labor in that case?

See the picture on the next page. The optimal bundle will always be ( R , M ) at all level of wages since
with high non-labor income, the consumption is already so high that the slope of the indifference curve
passing through ( R , M ) is extremely high. Any level of wage rate is not persuading consumer to supply
any labor.
Chapter 16 (Monopoly)
Do not leave sections 16.1, 16.4 and 16.5 from Mankiw.

Chapter 15 (Perfect competition)

1. Do not leave section 15.3.

2. Suppose in a perfectly competitive industry, all firms are identical in costs. Then should be identical in
their supply as well. We assume that no change in costs as firms enter or exit.

Although the long run market (aggregate of all firms) supply in this case will be horizontal but the short-
N
run market supply is positively sloped and given by Q ( P ) =  qi ( P ) = Nq ( P ) , where q ( P ) is the short
i =1

run supply curve of an individual firm and N there are total number of firms.

Suppose you are given that MC ( q ) = 3q 2 + 2q then the short run supply curve is nothing but the marginal
cost curve above the shut-down price.

How do we write the short-run supply curve for an individual firm?

Since the firm supplies the output at which the given market price P is equal to MC ( q ) , it means that
P ( q ) = 3q 2 + 2q is the equation of the short run supply curve of a firm.

But to get the short run industry or market supply curve Q ( P ) = Nq ( P ) , we need to express firm’s short-
run supply curve in the form of q as a function of P .

−2  4 + 12 P
If P = 3q 2 + 2q then 3q 2 + 2q − P = 0 . The quadratic equation has two roots . The only
6
−2 + 4 + 12 P −1 + 1 + 3P
positive root is q = = . Hence the short-run supply curve of a firm is
6 3
−1 + 1 + 3P
q ( P) = .
3

3. In the long-run equilibrium of a perfectly competitive firm, it must be that no firm is making positive or negative
economic profit else they will be entry or exit respectively.

What do you think the market price should be then? How is price determined in any market?
4. Remember that when the long run average cost LATC is at minimum at the efficient scale of output q* then
there must be some optimal factory size K * to produce that level of output which cannot be changed in the short
run.

SATC with K * must be tangent to LATC by definition and therefore have same slope where they meet.
Therefore, SATC with K * also has zero slope i.e. minimizes at q* .

Moreover, SMC ( q *) = SATC ( q *) = LATC ( q *) = LMC ( q *) .