consumer theory 2

Chapter 4

Individual and Market Demand

©2005 Pearson Education, Inc.

CONSUMER CHOICE

©2005 Pearson Education, Inc. Chapter 3 3

Consumer Choice

Given preferences and budget constraints, how do consumers choose what to buy?

Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them


C

F

P

P

F

C Slope -

2

1-

The Budget Line

10

20

A

B

D

E

G

(I/PC) = 40

Food40 60 80 = (I/PF)20

10

20

30

0

Clothing

©2005 Pearson Education, Inc. 5

U2

U3

Indifference Map

Food

Clothing

U1

ABD

Market basket Ais preferred to B.Market basket B ispreferred to D.


HOW DO CONSUMERS CONSUME?

6


Consumer Choice

U3

D

U2

C

Food (units per week)40 8020

Clothing(units per

week)

20

30

40

0

U1

A

B


Consumer Choice

Graphically, we can see different indifference curves of a consumer choosing between clothing and food

Remember that U3 > U2 > U1 for our indifference curves

Consumer wants to choose highest utility within their budget


Consumer Choice

U3

D

U2

C


Clothing(units per

week)

20

30

40

0

U1

A

B

•A, B, C on budget line•D highest utility but not affordable


Consumer Choice

The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line They spend all their income – more is better

2. It must give the consumer the most preferred combination of goods and services


Consumer Choice

U3

D

U2

C


Clothing(units per

week)

20

30

40

0

U1

A

B

•A, B, C on budget line•D highest utility but not affordable•C highest affordable utility•Consumer chooses C


Consumer Choice

Consumer will choose highest indifference curve on budget line

In previous graph, point C is where the indifference curve is just tangent to the budget line

Slope of the budget line equals the slope of the indifference curve at this point


Consumer Choice

Recall, the slope of an indifference curve is:

F

CMRS

C

F

P

PSlope

Further, the slope of the budget line is:


Consumer Choice

Therefore, it can be said at consumer’s optimal consumption point,

C

F

P

PMRS


Marginal Utility and Consumer Choice

When consumers maximize satisfaction:

CF /P PMRS

CF CF /P P /MUMU

Since the MRS is also equal to the ratio of the marginal utility of consuming F and C



Rearranging, gives the equation for utility maximization:

CCFF PMUPMU //


Consumer Choice

It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C)

Note this is ONLY true at the optimal consumption point



Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.

This is referred to as the equal marginal principle.


Consumer Choice

If MRS ≠ PF/PC then individuals can reallocate basket to increase utility

If MRS > PF/PC

Will increase food and decrease clothing until MRS = PF/PC

If MRS < PF/PC

Will increase clothing and decrease food until MRS = PF/PC


Consumer Choice

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

Point B does not maximize satisfaction

because theMRS = -10/10 = 1

is greater than the price ratio = 1/2

+10F U1

-10C

B


Consumer Choice: An Application Revisited

Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of a car

Each group has different preferences



By finding the point of tangency between a group’s indifference curve and the budget constraint, auto companies can see how much consumers value each attribute



Styling

Performance$10,000

$10,000 These consumerswant performance worth $7000 and

styling worth $3000

$3,000

$7,000



These consumers want

styling worth $7000 and

performance worth $3000

$3,000

$7,000

Styling

$10,000

$10,000

Performance



Once a company knows preferences, it can design a production and marketing plan

Company can then make a sensible strategic business decision on how to allocate performance and styling on new cars


CORNER SOLUTION

Chapter 4 26


Consumer Choice

A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another

MRS is not necessarily equal to PA/PB


A Corner Solution

Ice Cream (cup/month)

FrozenYogurt

(cupsmonthly)

B

A

U2 U3U1

A corner solutionexists at point B.

©2005 Pearson Education, Inc. Chapter 3

A Corner Solution

At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line

If the consumer could give up more frozen yogurt for ice cream, he would do so

However, there is no more frozen yogurt to give up

Opposite is true if corner solution was at point A


A Corner Solution

When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio

In this instance it can be said that:

YogurtFrozen

IceCream

P

PMRS


A Corner Solution

If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket


A Corner Solution - Example

Suppose Jane Doe’s parents set up a trust fund for her college education

The money must be used only for education

Although a welcome gift, an unrestricted gift might be better



Original budget line, PQ, with a market basket, A, of education and other goods

Trust fund shifts out the budget line as long as trust fund, PB, is spent on education

Jane increases satisfaction, moving to higher indifference curve, U2



P

Q Education ($)

OtherConsumption

($)

U2A

U1

B

•Jane better off on U2

•B is corner solution•MRS ≠ PE/POG



P

Q Education ($)

OtherConsumption

($)

U2A

U1

B

•If gift is unrestricted, Jane can be at point C on U3

•Better off than with restricted gift

CU3


Individual Demand

Price Changes Using the figures developed in the previous

chapter, the impact of a change in the price of food can be illustrated using indifference curves

For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves


DERIVING DEMAND FROM CONSUMER CHOICE

Chapter 4 37


Effect of a Price Change

Each price leads to different amounts of

food purchased5

U3

D

4

U2

B

12 20

Assume: • I = $20• PC = $2• PF = $2, $1, $0.50

Food (units per month)

Clothing

6 A

U1

4

10



The Price-Consumption Curve traces out the utility maximizing market

basket for each price of food

4

U2

B

12 20

5

U3

D


Clothing

6 A

U1

4

10



By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual

From the previous example:

Demand Schedule

P Q

$2.00 4

$1.00 12

$0.50 20



Demand Curve

Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.


Priceof Food

H

E

G

$2.00

4 12 20

$1.00

$.50


Demand Curves – Important Properties

The level of utility that can be attained changes as we move along the curve

At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing




Priceof Food

H

E

G

$2.00

4 12 20

$1.00

$.50Demand Curve

• E: Pf /Pc = 2/2 = 1 = MRS• G: Pf /Pc = 1/2 = .5 = MRS• H:Pf /Pc = .5/2 = .25 = MRS

When the price falls, Pf /Pc & MRS also fall


Substitutes & Complements

If the price consumption curve is downward-sloping, the two goods are considered substitutes

If the price consumption curve is upward-sloping, the two goods are considered complements

They could be both


CONSUMER CHOICE AND INCOME CHANGES

Chapter 4 45


Individual Demand

Income ChangesUsing the figures developed in the previous

chapter, the impact of a change in the income can be illustrated using indifference curves

Changing income, with prices fixed, causes consumers to change their market baskets


Effects of Income Changes


Clothing(units per

month)

An increase in income,with the prices fixed,

causes consumers to altertheir choice ofmarket basket.

3

4

A U1

5

10

B

U2

D7

16

U3

Assume: Pf = $1, Pc = $2 I = $10, $20, $30


Individual Demand

Income ChangesThe income-consumption curve traces out

the utility-maximizing combinations of food and clothing associated with every income level


Individual Demand

Income Changes An increase in income shifts the budget line

to the right, increasing consumption along the income-consumption curve

Simultaneously, the increase in income shifts the demand curve to the right




Clothing(units per

month)

The Income Consumption Curve traces out the utility maximizing market basket for each income level

3

4

A U1

5

10

B

U2

D7

16

U3

Income Consumption Curve




Priceof

food

An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumer’s demand curve to the right as well.

$1.00

4

D1

E

10

D2

G

16

D3

H


Individual Demand

Income ChangesWhen the income-consumption curve has a

positive slope:The quantity demanded increases with incomeThe income elasticity of demand is positiveThe good is a normal good


Individual Demand

Income ChangesWhen the income-consumption curve has a

negative slope:The quantity demanded decreases with incomeThe income elasticity of demand is negativeThe good is an inferior good


An Inferior Good

Hamburger (units per month)

Steak(units per

month)

30

U3

C

Income-ConsumptionCurve

…but hamburgerbecomes an inferior

good when the incomeconsumption curvebends backward between B and C.

105

AU1

5

20

10

B

U2

Both hamburgerand steak behaveas a normal good, between A and B...


Individual Demand

Engel Curves Engel curves relate the quantity of good

consumed to income If the good is a normal good, the Engel curve

is upward sloping If the good is an inferior good, the Engel

curve is downward sloping


Engel Curves

Food (unitsper month)

30

10

Income($ per

month)

20

4 8 12 16

Engel curves slopeupward for

normal goods.


Engel Curves

Engel curves arebackward bending for inferior goods.

Inferior

Normal

Food (unitsper month)

30

10

Income($ per

month)

20

4 8 12 16


Annual US Household Consumer Expenditures


INCOME AND SUBSTITUTION EFFECT

Chapter 4 59


Income and Substitution Effects

A change in the price of a good has two effects: Substitution EffectIncome Effect



Substitution EffectRelative price of a good changes when price

changesConsumers will tend to buy more of the good

that has become relatively cheaper, and less of the good that is relatively more expensive



Income EffectConsumers experience an increase in real

purchasing power when the price of one good falls



Substitution EffectThe substitution effect is the change in an

item’s consumption associated with a change in the price of the item, with the level of utility held constant

When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good



Income EffectThe income effect is the change in an item’s

consumption brought about by the increase in purchasing power, with the price of the item held constant

When a person’s income increases, the quantity demanded for the product may increase or decrease



Income EffectEven with inferior goods, the income effect is

rarely large enough to outweigh the substitution effect


Income and SubstitutionEffects: Normal Good

Food (units per month)O

Clothing(units per

month) R

F1 S

C1 A

U1

The income effect, EF2, (from D to B) keeps relativeprices constant but increases purchasing power.

Income Effect

C2

F2 T

U2

B

When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.

ETotal Effect

SubstitutionEffect

D

The substitution effect, F1E, (from point A to D), changes the relative prices but keeps real income(satisfaction) constant.


Food (units per month)O

R

Clothing(units per

month)

F1 S F2 T

A

U1

E

SubstitutionEffect

D

Total Effect

Since food is an inferior good, theincome effect is

negative. However,the substitution effect

is larger than the income effect.

B

Income Effect

U2

Income and SubstitutionEffects: Inferior Good



A Special Case: The Giffen GoodThe income effect may theoretically be large

enough to cause the demand curve for a good to slope upward

This rarely occurs and is of little practical interest


Market Demand

Market Demand CurvesA curve that relates the quantity of a good

that all consumers in a market buy to the price of that good

The sum of all the individual demand curves in the market


MARKET DEMAND

Chapter 4 70


Determining the Market Demand Curve

Price A B CMarket

Demand

1 6 10 16 32

2 4 8 13 25

3 2 6 10 18

4 0 4 7 11

5 0 2 4 6


Summing to Obtain aMarket Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DB DC

Market Demand

DA

The market demandcurve is obtained by

summing the consumer’s demand curves


Market Demand

From this analysis one can see two important points:The market demand will shift to the right as

more consumers enter the marketFactors that influence the demands of many

consumers will also affect the market demand


Market Demand

Aggregation is important to be able to discuss regarding demand for different groupsHouseholds with childrenConsumers aged 20 – 30, etc.


The Aggregate Demand for Wheat

The demand for US wheat is comprised of two components:Domestic demand Export demand

Total demand for wheat can be obtained by aggregating these two demands



The domestic demand for wheat is given by the equation:QDD = 1465 - 88P

The export demand for wheat is given by the equation:QDE = 1344 - 138P



Domestic demand is relatively price inelastic (Ed = -0.2)

Export demand is more price elastic (Ed = -0.4)Poorer countries that import US wheat turn to

other grains and food if wheat prices increase


C

D

ExportDemand

Total world demand is the horizontal sum of the domestic demand AB and

export demand CD.

F

Total Demand

A

B

DomesticDemand

E


Wheat

Price

0

10

16

18

Above C, export demand is zero, so domestic demand = total demand = AE segment


CONSUMER SURPLUS

Chapter 4 79


Consumer Surplus

Consumers buy goods because it makes them better off

Consumer Surplus measures how much better off they are


Consumer Surplus

Consumer Surplus The difference between the maximum

amount a consumer is willing to pay for a good and the amount actually paid

Can calculate consumer surplus from the demand curve


Consumer Surplus - Example

Student wants to buy concert ticketsDemand curve tells us willingness to pay

for each concert ticket1st ticket worth $20 but price is $14 so

student generates $6 worth of surplusCan measure this for each ticketTotal surplus is addition of surplus for each

ticket purchased


The consumer surplusof purchasing 6 concerttickets is the sum of the

surplus derived from each one individually.

Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21

Consumer Surplus - Example

Rock Concert Tickets

Price ($ perticket)

2 3 4 5 6

13

0 1

14

15

16

17

18

19

20

Market Price

Will not buy more than 7 because surplus is negative


Consumer Surplus

The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller

Consumer surplus is the area under the demand curve and above the price


Demand Curve

ConsumerSurplus

Consumer Surplusfor the Market Demand

Consumer Surplus

Rock Concert Tickets

Price ($ perticket)

2 3 4 5 6

13

0 1

ActualExpenditure

14

15

16

17

18

19

20

Market Price

CS = ½ ($20 - $14)*(1600) = $19,500


Applying Consumer Surplus

Combining consumer surplus with the aggregate profits that producers obtain, we can evaluate:

1. Costs and benefits of different market structures

2. Public policies that alter the behavior of consumers and firms


Applying Consumer Surplus – An Example

The Value of Clean AirAir is free in the sense that we don’t pay to

breathe itThe Clean Air Act was amended in 1970Question: Were the benefits of cleaning up

the air worth the costs?


The Value of Clean Air

Empirical data determined estimates for the demand for clean air

No market exists for clean air, but can see people are willing to pay for itEx: People pay more to buy houses where

the air is clean


The Value of Cleaner Air

Using these empirical estimates, we can measure people’s consumer surplus for pollution reduction from the demand curve


The shaded area represents theconsumer surplus generated

when air pollution is reduced by 5 parts per 100million of nitrous oxide at

a cost of $1000 per part reduced.

Valuing Cleaner Air

2000

100

1000

5

A

NOX (pphm)Pollution Reduction

Value


Value of Cleaner Air

A full cost-benefit analysis would include total benefit of cleanup

Total benefits would be compared to total costs to determine if the clean up was worthwhile

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Documents

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consumer surplus

export demand

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