Download An increase in the price of meals

Chapter 5
Consumer choice and demand
decisions
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
9th Edition, McGraw-Hill, 2008
PowerPoint presentation by Alex Tackie and Damian Ward
©The McGraw-Hill Companies, 2008
Utility (1)
• Utility is a measure of happiness.
• However, we cannot say that one apple can make
me twice as happy as one banana. So, utility is
not a cardinal measure.
• We can easily say that I like apple more than
banana. This kind of measure is called an ordinal
measure.
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Utility (2)
• Total utility of eating five slices of pizza is the
total happiness we get from eating all pizzas.
• If you are talking about eating the first, second,
third, etc. slices of pizza, we are talking about the
marginal utility.
• As you consume more pizzas, the total utility
increases, however, the marginal utility
decreases.
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Example
Qx
0
1
2
3
4
5
6
7
TUx
0
10
18
24
28
30
30
28
MUx
10
8
6
4
2
0
-2
The total and marginal utility of
good x.
4
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Why the Demand Curve is
Downward Sloping
• When you consume a good little, the
marginal utility of the extra unit is
high. Therefore, you are willing to
pay a higher amount for the
additional unit.
• MWP is the inverse function of
demand.
• As you consume more, the MU
decreases.
5
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Optimal Consumption
• The solution which gives the
maximum utility is as follows: On the
margin, the marginal utility per lira
you get should be equal for all goods.
MUX1 = MUX2
Px1
Px2
6
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Four key elements in consumer
choice
• Consumer’s income
• Prices of goods
• Consumer preferences
• The assumption that consumers maximise utility
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Four key elements in consumer
choice
• Consumer’s income
• Prices of goods
• Consumer preferences
• The assumption that consumers maximise utility
©The McGraw-Hill Companies, 2008
The budget line
Consider a student with a
budget of £50 to spend on
meals and films.
A
5
B
4
Films
• Income and prices
together determine the
combinations of the
goods that the consumer
can afford.
• The slope of the budget
line is the ratio of the
prices. (relative price)
• If the income increases,
the budget line shifts
parallel to the right.
6
G
C
3
D
2
E
1
F
0
0
2
4
6
8
10 12
Meals
Price of meals is £5;
price of films is £10.
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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
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Modelling consumer
preferences (2)
Preferred
region
d
c
• but the consumer would
prefer any point in the
preferred region to a
• points like d and e
involve more of one good
and less of the other
compared with a.
a
b
Dominated
region
• a is preferred to all
points in the dominated
region
e
Quantity
of meals
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Modelling consumer
preferences (3)
U2
U2
• 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
Quantity
of meals
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Marginal Rate of Substitution.
The slope at any point on an indifference
curve is the marginal rate of
substitution.
• It is the rate at which a consumer is willing
to trade one good for another.
• It is the amount of one good that a
consumer requires as compensation to give
up one unit of the other good.
• The MRS decreases as you consume more of
that good. This is called decreasing MRS.
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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
• The choice point is at C
U3
• where the budget line is
at a tangent to an IC
B
• Points B and E are also
affordable
C
U3
E
BL
U1
U2
• but give lower utility,
• being on a lower IC.
Quantity of meals
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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
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Films
Normal goods
When both goods are
NORMAL, an increase
in income induces a new
choice point at C'
BL1
BL0
The quantity demanded
of each good increases
C'
C
U2
U1
Meals
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Films
An inferior good and a normal good
BL1
When “meals” is an inferior good
the increase in income takes the
consumer from C to C'
BL0
C'
The quantity of meals falls and
the quantity of films increases
U2
C
U1
Meals
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Adjustment to a price change
• An increase in the price of one good shifts
the budget line
– altering its slope
– which reflects relative prices.
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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.
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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
U2
E
H
BL1
U1
BL0
Meals
Tracing out more of such points at different prices enables us to
identify the Demand curve.
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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. More Expensive: Buy less
• THE INCOME EFFECT
– is the adjustment to the change in real income.
Higher income, buy more of the normal goods,
buy less of the inferior goods.
Total change in the consumption of the goods
are determined by adding up these two effects.
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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
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