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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.