Download 1. Optimal Choice and Demand 2. Change in the Price of a Good (a

Optimal Choice and Demand
• Recall we have been working the example in which there are just two
good: food and clothing.
Individual and Market Demand
1. Optimal Choice and Demand
• Figure 4.1
2. Change in the Price of a Good
• Suppose the consumer’s weekly income is $20 and the price of food is
$1 and the price of clothing is $2.
2
1
(a) Income Effect
(b) Substitution Effect
• Maximizing point is B.
3. Adding Up: From Individual to Market Demand Curves
• Suppose the price of food increase to $1.
4. Consumer Surplus
• Suppose the price of food decreases to $0.50.
5. Network Externalities
• The price-consumption curve or price-expansion path is the set of
utility maximizing bundles as the price of one good varies (holding
constant income and the prices of all other goods).
• We can use the price-consumption path to trace out the demand curve.
• The demand curve is sometime called the “willingness to pay curve”
• Also note that utility of the consumer is increasing as we move down
(to the southeast) the demand curve.
Income Changes
• Figure 4.2
4
3
– Recall the marginal rate of substitution measures the maximum of
one good the consumer is willing to pay in order to obtain one unit
of the other good.
– As the price of food falls, the price ratio and the MRS fall as well.
Because the consumer is maximizing utility, the MRS of food for
clothing decreases as we move down the demand curve.
– That is, the more food a consumer buys, the units of clothing he or
she is willing to give up in order to buy an additional unit falls.
• An increase in income results in an outward parallel shift of the budget
constraint.
• The income-consumption curve is the set of utility maximizing bundles as income varies (and prices are held constant).
• Changing income shifts the entire demand schedule (curve).
• Here’s what he found
The Consumption Possibilities of American Workers, 1895-200
• Over the past century, the budget line of the typical American worker
has shifted radically outward as the nation as become vastly richer.
• J. Bradford DeLong’s paper at
http://econ161.berkeley.edu/TCEH/Slouch wealth2.html
6
5
• DeLong compared the cost of a number of items in the 1895 Montgomery Ward catalog to the cost of similar items today by calculating
the number of hours an average worker would need to work to earn
enough money to buy them.
– In 1895, an average worker’s annual income would have bought 7.7
one-speed bicycles; in 2000, it would have bought 278 bicycles.
– In 1895, the worker’s income would have bought 45 full sets of dinner
plates; 2000, it would have bought 556 sets.
– In 1895, a worker’s income would have bought 0.83 of a Steinway
piano; in 2000 it would have bought 1.8 pianos.
• On average incomes have grown 7-fold
• Underestimates growth since lots of items, (e.g. computers, cell phones)
were not available at any price in 1895.
• If we assume that the worker puts in 2,000 hours per year – 40 hours
for 50 weeks – we can calculate how many units of each good a worker
could purchase by spending an entire year’s income only on that good.
• ADVERTISEMENT: On March 23, we will have a guest speaker.
– Professor Benjamin Friedman of Harvard University, will discuss his
new book The Moral Consequences of Economic Growth.
Where Have All the Farmer’s Gone?
Engle Curves
• In 1940 about 17 percent of the country lived on farms. Today it is less
than 1 percent.
• Another way of showing how a consumer’s choice of a particular good
varies with income is to draw an Engle curve – a graph relating the
amount of the good consumed to the level of income.
• Food as a income elasticity of demand of much less than 1.
• A normal good is a good that a consumer purchases more of as income
rises holding prices constant.
8
7
– That is, the income elasticity of demand is positive.
– Examples: Broadway tickets, really most goods
• An inferior good a good that a consumer purchases less of as income
rises holding prices constant.
– That is, the income elasticity of demand is negative.
– Examples: taking the bus, Ramin noodles
– As consumers grow richer, other things equal, spending on food rises
less than income.
– Share of incomes spent on food will decrease.
• Technological progress has led to shifts out in the supply curve for food.
– This leads to a decrease in the price of food.
– Demand for food is price-inelastic so total revenue for farmers has
gone down.
– Consumers have gained from farming’s technological progress, not
farmers.
• Farming is a victim of success.
Change in the Price of a Good: Income and Substitution Effects
• Earlier in this lecture, we analyzed the overall effect of a change in the
price of a good.
• We want to decompose the overall effect of a change in the price of a
good into two effects: income and substitution.
The Income Effect
The Substitution Effect
10
9
• When the price of a good falls, the good becomes cheaper relative to
other goods. Conversely, a rise in the price makes the good more expensive relative to other goods.
• When the price of a good falls, the consumer’s purchasing power increases, since she can now buy the same bundle of goods as before the
price decrease and still have money left over to buy more goods. Conversely a price increase lowers the consumer’s purchasing power since
she can no longer afford to buy the same bundle.
• The income effect is the change in the amount of the good that a
consumer would buy as her purchasing power changes, holding prices
constant.
• In either case, the consumer experiences a substitution effect.
• The substitution effect is the change in the amount of a good that
would be consumed as the price of the good changes, holding constant
all other prices and the level of utility.
– For example, if the price of food rises, the consumer may substitute
other goods for food to achieve the same level of utility.
The Substitution Effect in 3 Easy Steps
We are looking at Figure 4.6
1. Find the initial bundle (the bundle the consumer chooses at the initial
price). Point A.
The Income Effect
2. Find the final bundle (the bundle the consumer chooses after the price
falls). Point B.
(a) The decomposition bundle reflects the price change so it must lie on
the on budget line that is parallel to new budget line.
(b) The decomposition basket reflects the assumption that the consumer
achieves the the initial level of utility so the budget line must be
tangent to the initial indifference curve.
• Hence the substitution effect accounts for the consumer’s movement
from point A to point D.
12
11
3. Find an intermediate decomposition bundle that will enable us to identify the portion of the changing quantity due to the substitution effect.
We can find this basket by keeping two things in mind.
• Still looking at point Figure 4.6 the income effect accounts for the movement from point D to point B.
• For normal goods the income effect is positive.
• For inferior goods the income effect is negative.
– See Figure 4.7
• The substitution effect is always the same direction.
• Total effect is the sum of the income and substitution effects.
Upward sloping demand curves? The Giffen Good
• An economist Giffen is supposed to have observed that during the 19th
century a rise in the price of imported wheat led to an increase in the
price of bread but that consumption of bread by the British working
class increased.
So Do People Really Behave Like This?
• Article in the reading packet “To have and to hold”
• While there is some doubt that what Giffen asserted really occurred, it
is certainly possible.
14
13
• Suppose that bread is the diet staple of a great many people and that its
price rises sharply. This may be expected to compel larger expenditures
on bread, further impoverishing many households to the point where
they are forced to substitute bread (even though it is more expensive)
for other more luxurious forms of nourishment.
• If (neoclassical) theory is correct ...
– I hand you a bundle on your budget constraint and markets are free
and flexible.
– You should trade to your optimum point regardless of where you
start.
• Some experimental work finds an “endowment effect” particularly when
the stakes are not big.
• While theoretically possible, the fact is that such cases are all but unknown in the real world.
• Also find more experienced traders to behave more like the theory predicts.
• In this case the income effect is larger than the offsetting substitution
effect.
• Figure 4.8
Adding Up: From Individual Demands to Market Demands
• Can verify for the health-conscious consumer
⎧
⎪
⎪
⎨
• The market demand curve relates the quantity of a good that all
consumers in a market will buy to its price.
Qh(P ) = ⎪⎪⎩
• We can obtain the market demand curve by simply summing up horizontally all the individual demand curves.
⎧
⎪
⎪
⎨
Qc(P ) = ⎪⎪⎩
• Assume there are two consumers
16
15
Price Health Conscious
Casual
Market Demand
($/liter) (liters/month) (liters/month) (liters/month)
5
0
0
0
4
3
0
3
3
6
0
6
2
9
2
11
1
12
4
16
(1)
• Can verify for the casual consumer
• Let’s work through an example: orange juice.
1. health conscious – like o.j. for its nutritional value and taste
2. casual – like o.j. just for taste
15 − 3P when P < 5
0
when P ≥ 5
6 − 2P when P < 5
0
when P ≥ 3
(2)
• Market Demand is the sum of these two curves
Qm(P ) = Qh(P ) + Qc(P )
= (15 − 3P ) + (6 − 2P )
= 21 − 5P
• So market demand is
⎧
⎪
⎪
⎪
⎪
⎪
⎪
⎨
21 − 5P when P < 3
Qm(P ) = ⎪⎪⎪ 15 − 3P when 3 ≥ P < 5
⎪
⎪
⎪
⎩ 0
when P ≥ 5
(3)
Consumer Surplus
• A few things to keep in mind
• Voluntary trades only occur when both sides are better off trading than
not trading.
18
17
– Construction of market demand curve involves adding quantities –
not prices.
– Market demand curves can be kinked due to addition consumers
entering the market.
– The market demand curve will shift to the right as more consumers
enter the market.
– Factors that influence the demands of many consumers will also
effect market demand.
• Recall earlier that we referred to the demand curves as the “willingness
to pay” curve.
• Consumer surplus is the difference between what a consumer is willing
to pay for a good and the amount actually paid.
• We can think of consumer surpluses in terms of a single demand curve
or in terms of a market demand curve.
• Consider the demand curve for time on a tennis court.
Network Externalities
• So far we have viewed consumers as “lone rangers” who make consumption choices independently of others. In particular we used to assumption when adding up individual demand curves to obtain a market
demand curve.
• Consider Figure 4.16
– Demand curve shifts out the more people other people buy the good.
• But it is often the case that one person’s choice affects another’s.
• Sometime these effects are positive. In this case we call it a bandwagon
effect.
– Fashion or fads – think back to 9th grade.
– cell phones
– Microsoft Windows
20
19
• We say a network externality exists when the amount of good demanded
by one consumer depends on the number of other consumers who purchase the good.
• Demand becomes more elastic.
• Recall that when demand becomes more elastic, the quantity effect on
total revenue outweighs the price effect.
• To maximize revenue, firms set low a price, sell high a quantity.
Snob Effects
• This idea goes back to Thorstein Veblen in the Theory of the Leisure
Class in 1899. He first suggested that some commodities were consumed
not solely for intrinsic qualities, but because they carried snob appeal.
• For some people, individual demand curves shift in the more other
people consumer.
21
– One of the reason people drive Ferraris, Lamborginis, Maybachs is
not just because of the fine performance, but because these are cars
that only very few people can afford.
– Being “exclusive” is a product characteristic that some people value.
• Not just “snob appeal” but any time, by enjoyment of a good is lowered
by someone else’s consumption of a good: crowds at an amusement
park, traffic on I-95.
• Figure 4.17
• In this case, the network effects make demand more inelastic.
• Recall that revenue maximizing strategy with inelastic demand is to
sell at high prices and low quantities.