Transcript Document
Chapter 4 Demand and Behavior in Markets •2 The Problem of Consumer Choice Maximize Indifference curve tangent to budget line MRS = price ratio On budget line Quantity utility demanded of a good People seek to purchase at a given price •3 Good 2 (x 2) Optimal 20 consumption bundle B e I3 I2 F 0 I1 x1 + x2 = 20 B’ 20 Good 1 (x 1) •4 Demand is homogenous If income and all prices double, the quantity demanded of all goods remains the same Reason: same budget constraint Changes in Income When income only increases, Normal good: demand for goods increases Inferior good: demand decreases, e.g. used clothes, bus tickets,.. Show graphically •6 0 (a) Good 2 (x 2) Good 2 (x 2) Superior and inferior goods Good 1 (x 1) 0 (b) Good 1 (x 1) •7 Homothetic Preferences Homothetic preferences Indifference curves Along any ray from the origin MRS – constant Increase in income Do not “rotate” as consumer’s income increases Proportional increase in goods purchased All goods are superior No change in tastes •8 Good 2 (x 2) 60 40 D Income expansion path C s 20 B r e 0 B’ 20 C’ 40 D’ 60 Good 1 (x 1) •9 Price-Consumption Paths Price-consumption path / curve Consumption changes One price changes All other prices – constant Consumer’s income – constant •10 Effects of Price changes on budget Changing relative prices Optimal bundle Indifference curve tangent to budget line MRS = Price ratio Good 1 – relatively less expensive Rotation of budget line – flatter Good 1 – relatively more expensive Rotation of budget line – steeper •11 Good 2 (x 2) B g f 0 B” a e B’ b c B* Good 1 (x 1) As the price of good 1 varies, the slope of the budget line changes leading to different levels of consumption •12 Demand Curves Demand curve Relationship between Quantity demanded Price As the price varies Other things constant Image of the price-consumption path Generated: utility-maximizing behavior •13 Demand curve for good1 Price p1=2 p1=1 p1=1/2 0 a b c Good 1 (x 1) The demand curve for good 1 associates the optimal quantity of good 1 with its price, while holding income and other prices constant. •14 Demand and Utility Functions Nonconvex Optimal consumption bundle At the corner of the feasible set Maximize utility Spend preferences all income on only one good Demand curve If price > p*, quantity = 0 If price = p*, quantity > 0 As price decreases, quantity increases •15 Non convex preferences and demand Good 2 (x 2) (b) Price (a) X1=m/p1 B p1* h p* e k 0 Good 1 (x 1) 0 g* Good 1 (x 1) Non-convex preferences imply optimal Demand curve. consumption bundles at the corners of Non-convex preferences imply jumps the feasible set—either point h or point k. in the demand curve. •16 Decomposing the Effects of a Price Change Substitution Effect: change in consumption caused by a change in relative prices Income Effect: change in consumption as a result of a change in the budget set •17 Substitution Effect Change in demand due to substitution One good (decreasing price) For another good (constant price) The substitution effect from the decline in price always increases demand •18 Income Effect Income effect Decrease in price is equivalent to an increase in real income The income effect from the decline in price will cause demand to Increase if the good is normal Decrease if the good is inferior •19 (a) Good 2 (x 2) Price (b) B D p’ e p” f g I1 p’ I2 p” D’ B” Good 1 (x 1) B’ 0 f Good 1 (x 1) 0 e Substitution effect Income effect Downward-sloping demand curve The income effect of the price change is measured by the parallel shift of the budget line from DD’ to BB”. The substitution effect is measured by movement around the indifference curve from e to g. •20 Inferior Goods: Income and substitution effects work on opposite directions Good 2 (x 2) How does the demand curve for good 1 look like? B f D I2 e Substitution effect g Income effect I1 0 B’ D’ B” Good 1 (x 1) The substitution effect of a decline in the price of good 1 causes an increase in demand for the good, the move from e to g. Because good 1 is an inferior good, this is partly offset by the income effect, a decrease in demand for the good from g to f . •21 Giffen Goods and Upward-Sloping Demand Curves Giffen good Upper sloping demand curve Inferior good A price decrease Substitution Increase demand Income effect effect Decrease demand Dominant effect: income effect •22 Giffen good Good 2 (x 2) B f Income effect D Substitution effect e g I1 0 B’ D’ B” Good 1 (x 1) The decline in the price of good 1 causes a decline in the demand for that good because the substitution effect (the move from e to g) is more than offset by the income effect (the move from g to f ). •23 Identifying normal and Giffen goods Type of good Substitution effect Income effect Normal downward sloping D Opposite to price change The good is either superior or inferior but with an income effect that is less powerful than the substitution effect. Giffen Upward sloping D Opposite to price change The good is inferior. The income effect is more powerful than the substitution effect. Good 2 (x 2) 20 g f 0 e 8 10 15 18 20 40 Good 1 (x ) 1