Download Chapter 5 Consumer choice and demand decisions

Chapter 5
Consumer choice and demand decisions
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
8th Edition, McGraw-Hill, 2005
PowerPoint presentation by Alex Tackie and Damian Ward
Four key elements in consumer choice
• Consumer’s income
• Prices of goods
• Consumer preferences
• The assumption that consumers maximise utility
1
The budget line
Consider a student with a
budget of £50 to spend on
meals and films. Assume also that
Pfilm = £10; Pmeal=£5
6
A
5
B
4
Films
• Income and prices together
determine the combinations of
the goods that the consumer
can afford.
• The budget line separates the
affordable from the
unaffordable.
G
C
3
D
2
E
1
F
0
0
2
4
6
Meals
• Slope BL = relative prices =
Pmeal /Pfilm = PX /PY
2
8
10 12
Modelling consumer preferences
• Assume the consumer prefers
more to less.
• Compared with point a:
– the consumer would prefer
to be to the north-east,
e.g. at c
– but prefers a to such points
as b to the south-west.
c
a
b
Quantity
of meals
3
Modelling consumer
preferences (2)
• a is preferred to all points in
the dominated region
Preferred
region
d
c
• but the consumer would
prefer any point in the
preferred region to a
e
• points like d and e involve
more of one good and less of
the other compared with a.
a
b
Dominated
region
Quantity
of meals
4
Modelling consumer
preferences (3)
• An indifference curve like U2U2
shows all the consumption
bundles that yield the same
utility to the consumer
– ICs slope downwards
(given our assumptions)
– their slope gets steadily
flatter to the right
– ICs cannot intersect
U2
U2
Quantity
of meals
5
Characteristics of Indifference Curves
Wrong!
– ICs slope DOWNWARDS
(given our assumptions)
If they were to slope upwards,
As one moves upward along
the IC, the consumer would
be consuming more and
hence increasing her utility.
This would be against the
definition of the IC.
U2
U2
Quantity
of meals
6
Hence IC’s canNOT slope
upwards.
Characteristics of Indifference Curves
– their slope gets steadily flatter
to the right
U2
This is due to the assumptionof
DIMINISHING MARGINAL
UTILITY: the more the consumer
consumes of one good, the less
the utility she derives from the
consumption of each additional
unit of that good.
i.e. The more meals she has, the
more hungry she becomes for
films, and vice versa.
U2
Quantity
of meals
7
Slope IC = MRS og good Y for
good X = ∆ no of films/ ∆ no
of meals
Characteristics of Indifference Curves
– ICs cannot intersect
U2
Otherwise, the consumer would be
– indifferent between
consumption bundles B and C;
(as they both lie on U1U1)
U1
B
– indifferent between
consumption bundles C and D;
(as they both lie on U2U2)
D
C
U2
– Yet B would be preferable to D
(as B lies to the Northeast of point
D)
U1
Quantity
of meals
which is impossible
8
The consumer’s choice
The point at which utility is maximised is found by bringing
together the indifference curves (U) and the budget line (BL)
U1
U2
U3
• The choice point is at C
• where the budget line is at a
tangent to an IC
B
• Points B and E are also
affordable
C
U3
E
BL
U1
• but give lower utility,
U2
Quantity of meals
9
• being on a lower IC.
Adjustment to an income change
• A change in the consumer’s income shifts the budget
line
• without changing the slope
• The change in the pattern of consumer choice
depends on the nature of the two goods
10
Films
Normal goods
When both goods are
NORMAL, an increase
in income induces a new
choice point at C'
BL1
BL0
C'
C
The quantity demanded
of each good increases
U2
U1
Meals
11
Films
An inferior good and a normal good
When “meals” is an inferior good
the increase in income takes the
consumer from C to C'
BL1
BL0
C'
The quantity of meals falls and
the quantity of films increases
U2
C
U1
Meals
12
Adjustment to a price change
• An increase in the price of one good shifts the
budget line
– altering its slope
– which reflects relative prices.
13
Films
An increase in the price of
meals (1)
The increase in price of meals shifts the
budget line from BL0 to BL1
BL1
BL0
Meals
The increase in price reduces purchasing power.
14
Films
An increase in the price of
meals (2)
The consumer moves from C to
E as the price of meals rises
The overall effect is a
reduction in quantity of
meals demanded
C
E
U2
H
BL1
U1
BL0
Meals
Tracing out more of such points at different prices enables
us to identify the Demand curve.
15
Response to a price change
• The response to a price change comprises two
effects:
• The SUBSTITUTION EFFECT
– is the adjustment to the change in relative
prices
• THE INCOME EFFECT
– is the adjustment to the change in real income.
16
Films
The substitution effect
The hypothetical budget line HH
has the slope of the NEW relative
prices and is tangent to the OLD
indifference curve at D.
H
U2
U1
The SUBSTITUTION EFFECT is
from C to D along U2U2.
D
C
E
U2
H
BL1
U1
BL0
It is always negative. In this
case an increase in the price of
meals leads to a fall in demand
as we move from C to D.
Meals
17
Films
The income effect
• The INCOME EFFECT
is from D to E
H
– it reflects the fall in real
income at constant relative
prices
D
– it may be positive or
negative
C
E
U2
H
BL1
– depending on whether the
good is normal or inferior
U1
BL0
Meals
18
Films
Income and substitution effects for an
inferior good
• The INCOME EFFECT
is from D to E
H
– in this case, it is positive
because the good is inferior
– and income and substitution
effects therefore have
opposite effects on demand
D
C
– but the substitution effect is
greater, so the overall effect is
a fall in demand
U2
E
H
BL1
U1
BL0
Meals
19
Films
Income and substitution effects for a Giffen
good
• The INCOME EFFECT
is from D to E
– in this case, it is positive
because the good is inferior
H
D
– and income and substitution
effects therefore have
opposite effects on demand
C
U2
– but the substitution effect is
smaller, so the overall effect is
an increase in demand
E
H
BL1
U1
BL0
Meals
20
Transfers in cash and in kind
AF is the initial budget constraint
QF
A' 
Films
A
On which the individual settles at e0
e0
Ae1F' is the new budget constraint
e2
e
Given A'e1F’, the best the individual
can do is e1
1
An equivalent cash transfer gives
a budget line of A'e1F'
The individual can now be better
off at e2
F
10
Meals
F'

14
QM
21
Deriving the market demand curve
The market demand curve is the horizontal sum of the
individual demand curves
Price
Consumer 1
Consumer 2
5
Market
11 13
If at a price of £5,
consumer 1 demands
11 units
and consumer 2
demands 13 units
then market demand at
a price of £5 will be 24
units.
24
Quantity
22