Download chapter5 - FBE Moodle

Chapter 5
5-1
The Consumer’s
Optimization Problem
• Individual consumption decisions are
made with the goal of maximizing total
satisfaction from consuming various goods
and services
• Subject to the constraint that spending on
goods exactly equals the individual’s money
income
5-2
Consumer Theory
• Assumes buyers are completely informed
about:
•
•
•
•
Range of products available
Prices of all products
Capacity of products to satisfy
Their income
• Requires that consumers can rank all
consumption bundles based on the level of
satisfaction they would receive from
consuming the various bundles
5-3
Typical Consumption Bundles for
Two Goods, X & Y (Figure 5.1)
5-4
Properties of Consumer
Preferences
• Completeness
• For every pair of consumption bundles, A and B,
the consumer can say one of the following:
 A is preferred to B
 B is preferred to A
 The consumer is indifferent between A and B
• Transitivity
• If A is preferred to B, and B is preferred to C,
then A must be preferred to C
• Nonsatiation
• More of a good is always preferred to less
5-5
Utility
• Benefits consumers obtain from goods &
services they consume is utility
• A utility function shows an individual’s
perception of the utility level attained from
consuming each conceivable bundle of
goods
5-6
Indifference Curves
• Locus of points representing different
bundles of goods, each of which yields
the same level of total utility
• Negatively sloped & convex
5-7
Typical Indifference Curve
(Figure 5.2)
5-8
Marginal Rate of Substitution
• MRS shows the rate at which one good can
be substituted for another while keeping
utility constant
• Negative of the slope of the indifference curve
• Diminishes along the indifference curve as X
increases & Y decreases
• Ratio of the marginal utilities of the goods
Y MU X
MRS  

X MUY
5-9
Slope of an Indifference Curve &
the MRS (Figure 5.3)
Quantity of good Y
600
A
T
C (360,320)
320
I
T’
B
0
360
800
Quantity of good X
5-10
(Figure 5.4)
Quantity of Y
Indifference Map
IV
III
II
I
Quantity of X
5-11
Marginal Utility
• Addition to total utility attributable to the
addition of one unit of a good to the
current rate of consumption, holding
constant the amounts of all other goods
consumed
MU  U X
5-12
Consumer’s Budget Line
• Shows all possible commodity bundles
that can be purchased at given prices
with a fixed money income
M  PX X  PY Y
or
M PX
Y

X
PY PY
5-13
Consumer’s Budget Constraint
(Figure 5.5)
5-14
Typical Budget Line
Quantity of Y
M
PY
(Figure 5.6)
•A
Y
M PX

X
PY PY
B
•
Quantity of X
M
PX
5-15
Shifting Budget Lines (Figure 5.7)
100
80
R
A
Quantity of Y
Quantity of Y
120
F
100
A
B
N
C
B
D
160 200
240
125
200
250
Z
Quantity of X
Quantity of X
Panel A – Changes in money income
Panel B – Changes in price of X
5-16
Utility Maximization
• Utility maximization subject to a limited
money income occurs at the combination
of goods for which the indifference curve
is just tangent to the budget line
Y MU X PX
MRS  


X MUY
PY
5-17
Utility Maximization
• Consumer allocates income so that the
marginal utility per dollar spent on each
good is the same for all commodities
purchased
MU X MUY

PX
PY
5-18
Constrained Utility Maximization
(Figure 5.8)
50
Quantity of pizzas
45
•A
40
•B
•D
•
E
R
30
IV
III
20
•
C
15
10
0
10
20
30
40
50
60
70
II
T
I
80
90
100
Quantity of burgers
5-19
Individual Consumer Demand
• An individual’s demand curve for a
specific commodity relates utilitymaximizing quantities purchased to
market prices
• Money income & prices held constant
• Slope of demand curve illustrates law of
demand—quantity demanded varies
inversely with price
5-20
Deriving a Demand Curve
(Figure 5.9)
Quantity of Y
100
Px=$10
Px=$8
Px=$5
Price of X ($)
0
50 65
90 100
125
200
Quantity of X
10
8
5
Demand for X
0
50 65
90
Quantity of X
5-21
Market Demand & Marginal Benefit
• List of prices & quantities consumers are
willing & able to purchase at each price, all
else constant
• Derived by horizontally summing demand
curves for all individuals in market
• Because prices along market demand
measure the economic value of each unit of
the good, it can be interpreted as the
marginal benefit curve for a good
5-22
Derivation of Market Demand
(Table 5.1)
Quantity demanded
Price
Consumer 1
Consumer 2
Consumer 3
Market
demand
$6
3
0
0
3
5
5
1
0
6
4
8
3
1
12
3
10
5
4
19
2
12
7
6
25
1
13
10
8
31
5-23
Derivation of Market Demand
Figure (5.10)
5-24
Substitution & Income Effects
• When price changes, total change in
quantity demanded is composed of two
parts
• Substitution effect
• Income effect
5-25
Substitution & Income Effects
• Substitution effect
• Change in consumption of a good after a
change in its price, when the consumer is
forced by a change in money income to
consume at some point on the original
indifference curve
• Income effect
• Change in consumption of a good resulting
strictly from a change in purchasing power
5-26
Income & Substitution Effects:
A Decrease in Px (Figure 5.12)
Total effect of
price decrease
9
=
=
Substitution + Income
effect
effect
+ 4
5
Total effect of = Substitution + Income
price decrease
effect
effect
3
=
5
+
(-2)
5-27
Substitution & Income Effects
• Consider the substitution effect alone:
• Amount of good consumed must vary
inversely with price
• Income effect reinforces the substitution
effect for a normal good & offsets it for an
inferior good
5-28
Summary of Substitution &
Income Effects (Table 5.2)
Substitution Effect
Income Effect
Normal Good
X rises
X rises
Inferior Good
X rises
X falls
Normal Good
X falls
X falls
Inferior Good
X falls
X rises
Price of X decreases:
Price of X increases:
5-29