Transcript Consumer Surplus

Chapter 5
Consumer Choice and Demand
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Introduction

We have previously discussed and used
market demand curves



Demand curves reflect the behavior of consumers
in the market
We have also developed a theory of
consumer behavior
We now link our model of consumer behavior
to market demand curves
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Learning Objectives

The most important objectives for this chapter
are:
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To learn how to use budget lines and indifference
curves to derive an individual consumer’s demand
curve for a product.
To understand the substitution and income effects
resulting from a change in price.
To understand the concept of consumer surplus,
and also compensating and equivalent variations.
To understand how individual and market demand
curves are related.
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Deriving Demand


Consider the indifference curve/budget line diagram
used to illustrate a consumer’s choice of a bundle of
goods
Let the price of good X, rise in several steps, and
show the resulting budget line shifts and new
optimal choices
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In the diagram, such a sequence of choices produces
points on the price consumption curve
This exercise generates, for each price of X, a
quantity of X consumed
If we then plot price versus quantity, we obtain an
individual consumer’s demand curve for good X.
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Deriving Demand for Good X
y
Consumer equilibrium
p=p0
A
x0
x
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Deriving Demand for Good X
y
The price of X is higher
p=p1
B
x1
x
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Deriving Demand for Good X
y
The price of X is yet higher
p=p2
C
x2
x
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Changes in Income

In the indifference curve budget line diagram,
illustrate a sequence of changes in income
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Show the income consumption curve.
Use the information in the diagram to plot consumption of
X as a function of income—this is the Engle curve.
Normal and Inferior Goods:
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If consumption of good X increases as income rises, then X
is a normal good.
If consumption of good X decreases as income rises, then
X is an inferior good.
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Income and Substitution
Effects

When a price changes, the consumer changes his
bundle choice
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The budget line shifts, and a tangency between and
indifference curve and the budget line occurs at a different
point
Two effects of an increase in the price of good X

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Substitution Effect: Good X is more expensive in terms of
good Y
Income Effect: Overall purchasing power is reduced
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Income and Substitution
Effects
y
A
x
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Income and Substitution
Effects
y
There is an increase in the
price of good X
A
x
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The Substitution Effect
y
Suppose that the price of X
rises, but the consumer is
compensated with income
to leave him on the original
indifference curve.
B
A
The substitution effect is the
move from A to B.
x
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The Income Effect
y
Now, again consider the
original price change
without compensation paid.
B
C
A
The consumer ends up at
point C, and the movement
from B to C is the income
effect.
x
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Price Decrease?

Can you show income and substitution
effects for a price decrease?
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Normal, Inferior, and Giffen
Goods
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For an individual, a normal good X has a
positive income effect
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An inferior good has a negative income effect
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When income rises, x rises.
When income rises, x falls.
A Giffen good has an upward sloping demand
curve

It is an inferior good and the income effect is
larger than the substitution effect.
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Consumer Surplus
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For an individual item purchased, consumer surplus
is the difference between what the buyer is willing to
pay and what he actually pays.
For any given quantity, a demand curve tells us how
much a consumer is willing to pay for an extra unit
out output.
We can add up total consumer surplus as the area
under a demand curve and above the market price.
Consumer surplus measures the gains to trade to
buyers in a market.
These points apply to market demand curves as well
as individual consumer demand curves.
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Demand and Willingness to
Pay
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Make the composite good assumption
Apply the consumer optimality condition (the tangency
condition):
px px
y
MRS 


x U U 0 p y
1
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The consumer should continue to buy up to the point
where the rate at which one is willing to trade dollars for
units of good X (marginal valuation) is just equal to the
price of good X
 Price on the demand curve is also “marginal
willingness to pay.”
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Consumer Surplus
$/unit
Demand for Melons
D
Q
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Consumer Surplus
$/unit
Demand for Melons
$8
D
Q
1
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Consumer Surplus
$/unit
Demand for Melons
$8
$7
D
Q
1
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Consumer Surplus
$/unit
Demand for Melons
$8
$7
$6
D
Q
1
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Consumer Surplus
$/unit
Demand for Melons
$8
$7
$6
$5
D
Q
1
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Consumer Surplus
$/unit
Demand for Melons
$8
$7
$6
$5
$4
D
Q
1
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Consumer Surplus
$/unit
Demand for Melons
$8
$7
$6
$5
$4
D
Q
1
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Consumer Surplus Review
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The demand curve can be thought of as a
marginal valuation schedule
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For each unit sold, the marginal valuation is
greater than or equal to price.
The buyer’s total consumer surplus from a
good is the sum of the surpluses added up
over from each successive unit.

Consumer surplus can be measured as the area
beneath a demand curve and above the market
price, out to the quantity purchased.
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Consumer Surplus and Price
Changes
P
P0
D
Q
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Consumer Surplus and Price
Changes
P
Loss in Consumer Surplus
P1
P0
D
Q
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Consumer Surplus: A Caveat
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Consider the loss to a consumer when a
price rises
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We have argued that the change in consumer
surplus provides a measure of that loss.
However, it turns out that this is normally only an
approximation.
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Compensating Variation
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The consumer loss could be measured this
way:
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If there is a price rise, how large of an income
supplement would be required to restore the
consumer to her original level of utility?
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Equivalent Variation
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Another measure of the loss associated with
a price increase:
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How much income would have to be taken from a
consumer to leave him with the same lower utility
he would experience after the price increase?
This is NOT normally the same number as the
compensating variation.
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Compensating and Equivalent
Variations
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No Income Effects

Are compensating and equivalent variations
ever identical?
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Yes, it turns out that for the quasi-linear utility
function, there are no income effects on the
demand for good X, and that in this special case,
compensating and equivalent variations are
identical, and both are the same as the
conventional consumer surplus measure.
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Quasi-Linear Utility
U  ky  2 x

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This is a quasi-linear utility function
Show that MRS does not depend on y

This means that the family of indifference curves
are such that at any x, but for various levels for y,
the slope of indifference curves are the same (all
indifference curves are identically shaped, but are
vertically displaced).
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No Income Effects
Compensating and equivalent variations are identical.
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Market Demand Curves
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We illustrated how the demand curve of a
single consumer was derived
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This was the result of a utility maximizing choice
of a consumption bundle.
Market demand curves add up quantities
demanded by all buyers in a market at each
level for price
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Market Demand
John
Paul
George
Ringo
Market
10
3
0
5
0
8
8
5
2
6
0
13
6
7
4
7
1
19
4
9
6
8
2
25
Price
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Individual and Market Demand
Curves
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Applications
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Labor Market
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Backward bending labor supply
Price Indices
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Indexing transfer payments by the CPI
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The End
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