Download Price-Consumption Curve - McGraw Hill Higher Education

Constraints, Choices,
and Demand
chapter 5
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objectives
• Demonstrate how price and income affect a
consumer’s budget line.
• Determine a consumer’s best choice based on his
preferences and budget line.
• Understand how find a consumer’s best choice by
maximizing a utility function.
• Analyze the effects of changes in prices and income
on a consumer’s demand.
• Show how volume-sensitive prices affect a
consumer’s budget line and choices.
• Explain how economists determine consumers’
preferences based on based on their choices.
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5-2
Overview
• Prices and income determine a consumer’s
budget constraint
• Given her preferences and budget constraint,
a consumer selects the optimal consumption
bundle
• Changes in price or income affect a
consumer’s optimal choice
• Several new tools will allow us to better
represent consumer preferences and behavior
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5-3
Income, Prices, and the Budget
Constraint
• A consumer’s income consists of the money
he receives during some fixed period of time
• A consumer can afford to purchase a
particular consumption bundle if its cost does
not exceed his income for that period
• Budget constraint: cost of consumption
bundle ≤ income
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5-4
Example – Budget Constraint
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5-5
Example – Budget Constraint
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5-6
Changes in Income and the Budget Line
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5-7
Changes in Price and the Budget Line
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5-8
Properties of Budget Lines
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5-9
Choosing Among Affordable Bundles
• B is preferred to A
because it contains
more yogurt and
more pizza than
bundle A
• D is the best choice
because no
affordable bundle
lies on a higher
indifference curve
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5-10
Choosing Among Affordable Bundles
• E is not a best
choice because
there are other
affordable bundles
that are better
than E (for
example, G)
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5-11
Special Case – Perfect Complements
• Maria always buys
the same number of
left and right shoes,
independently of
the slope of the
budget line
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5-12
Interior Solutions
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5-13
Boundary Solutions
• A consumption bundle
that does not contain at
least a little bit of every
good is called a
boundary choice
• Bundle B is the
consumer’s best
affordable bundle, and a
boundary solution
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5-14
Properties of Best Choices
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5-15
Utility Maximization
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5-16
Example – Utility Maximization
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5-17
Example – Utility Maximization
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5-18
Prices and Demand
• Price-consumption curve
• Individual demand curve
• Price changes and shifts in demand
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5-19
Price-Consumption Curve
• The priceconsumption curve
shows how the best
affordable
consumption
bundle changes as
the price of a good
changes, holding
everything else
fixed
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5-20
Individual Demand Curve
• An individual demand
curve describes the
relationship between
the price of a good and
the amount of a
particular consumer
purchases, holding
everything else fixed
• The demand curve is
similar to the priceconsumption curve, with
different axes
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5-21
Price Changes and Shifts in Demand
• A change in the price of one
good can shift the demand
for a second good
• For example, a decrease in
the price of butter (L1 to L3)
causes a decrease in the
quantity demanded of
margarine without a change
in the price of margarine
• Thus, in this example a
decrease in the price of
butter causes the demand
for margarine to shift to the
left
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5-22
Price Changes and Shifts in Demand
• The effect of the change in the price of one
good on the demand for a second good will
depend on whether they are substitutes or
complements (or neither)
• Substitutes: a decrease in P1 leads to a
leftward shift in the demand for P2
• Complements: a decrease in P1 leads to a
rightward shift in the demand for P2
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5-23
Income and Demand
•
•
•
•
Income-consumption curve
Normal vs. inferior goods
Engel curve
Changes in income and shifts in the demand
curve
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5-24
Income-Consumption Curve
• An income effect is the
change in the
consumption of a good
that results from a
change in income
• The incomeconsumption curve
shows how the best
affordable consumption
bundle changes as
income changes, holding
everything else fixed
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5-25
Normal vs. Inferior Goods
Potatoes are
inferior in this
region
Potatoes are normal in
this region
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5-26
Normal vs. Inferior Goods
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5-27
Properties of Normal and Inferior
Goods
1. The income elasticity of demand is positive for
normal goods and negative for inferior goods.
2. We can tell whether goods are normal or
inferior by examining the slope of the incomeconsumption curve.
3. At least one good must be normal starting
from any particular income level.
4. No good can be inferior at all levels of income.
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5-28
Engel Curve
• The Engel curve for a
good describes the
relationship between
income and the amount
consumed, holding
everything else fixed
• In this example, yogurt
is a normal good at all
levels of income
(upward sloping Engel
curve)
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5-29
Engel Curve
• The Engel curve for a
good describes the
relationship between
income and the amount
consumed, holding
everything else fixed
• In this example,
potatoes are normal
when income is less
than $36 and inferior
when income is greater
than $36
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5-30
Income Changes and Shifts in
Demand
• For a normal
good, an increase
in income shifts
the demand
curve to the right
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5-31
Volume-Sensitive Pricing
• So far we have assumed that every good is
available in unlimited quantities at a single price
• In practice, the price paid for a good can depend
on the volume purchased – volume-sensitive
pricing
• Volume penalty occurs when a good’s price per
unit rises with the amount purchased
• Volume discount occurs when a good’s price per
units falls with the amount purchased
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5-32
Example – Volume Penalties
• With a volume penalty on
usage over 500 kwh of
electricity, the portion of the
budget constraint that runs
between bundle C and the
horizontal axis rotates toward
the origin
• When the government or a
supplier limits the amount
that each consumer can
purchase, we say that the
good is rationed
• Rationing is similar to a very
large volume penalty
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5-33
Example – Volume Discounts
• With a volume
discount on usage
over 500 kwh of
electricity, the portion
of the budget
constraint that runs
between bundle C
and the horizontal
axis rotates away
from the origin
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5-34
Determining a Consumer’s
Preferences
• Two ways to learn about consumer
preferences
1. Ask consumers to tell us what they like and
dislike
2. Revealed preference approach: infer a
consumer’s preferences from her actual choices
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5-35
Principle of Revealed Preference
• One consumption bundle is
revealed preferred to another
if the consumer chooses it
when both are available
• If bundle A is purchased, it is
revealed preferred to each of
the bundles in the yellow area
• Each bundle in the blue area
should be preferred to A
• The indifference curve running
through A must lie entirely in
the two unshaded areas
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5-36
Principle of Revealed Preference
• A is revealed
preferred to B
• B is revealed
preferred to E and
all other bundles in
the yellow area
• By transitivity, A
must be preferred
to the bundles in
the yellow area
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5-37
Principle of Revealed Preference
• G is revealed preferred
to A
• All bundles in the blue
rectangle are preferred
to G (by more-is-better
principle). Thus, they are
preferred to A too (by
transitivity)
• If the indifference curve
has a declining MRS, all
bundles in the blue
triangle are also
preferred to A
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5-38
Review
• The consumer’s best choice lies on the budget line
• The affordable bundle that maximizes the utility
function is the consumer’s best choice
• Interior solutions always satisfy the tangency condition
• When the price of one good changes, the demand
curve for another good may shift
• When income changes, the demand for a good will
shift, with the direction of the shift determined by
whether the good is normal or inferior at that level of
income
• Consumer choices reveal their preferences
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5-39
Looking forward
• Next, we will learn how we can use demand
curves to measure changes in consumer
welfare
• We will dissect the effects of a price change,
and we will build a different type of demand
curve that will allow us to better analyze
consumer welfare
• We will also apply what we already know
about demand to build the supply for labor
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5-40