Transcript Consumer Demand

CHAPTER 2
DEMAND AND SUPPLY ANALYSIS:
CONSUMER DEMAND
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1. INTRODUCTION
The development process of an economic model
Build the model
with simplifying
assumptions
Develop the
implications of
the model
Compare the
model’s
implications
with the real
world
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2. CONSUMER THEORY: FROM PREFERENCES
TO DEMAND FUNCTIONS
• Consumer choice theory is the part of economics in which we focus on
consumer demand and consumer preferences.
- It addresses consumers’ tastes and preferences.
- It examines the trade-offs that consumers make between or among goods.
- It delves into the choices consumers make, given a set of prices, when
consumers have limited income.
- The limit on income is the budget constraint.
• Models of consumer choice:
- Do not seek to explain why consumers have the tastes and preferences that
they have, but rather why they make the choices they do given their tastes
and preferences.
- Focus on the aggregate behavior of consumers, not that of an individual
consumer.
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3. UTILITY THEORY:
MODELING PREFERENCES AND TASTES
• The consumption bundle (or consumption basket) is the set of goods and
services that the consumer would like to consume.
• Axioms of the theory of consumer choice:
1. We assume that a consumer can make a choice between any two bundles—
the assumption of complete preferences.
- The consumer prefers one to another or is indifferent between the two.
- We refer to this as complete preferences: Consumers are able to make
comparisons and choices.
2. We assume that consumers’ preferences are transitive preferences.
- If a consumer prefers Bundle A to Bundle B and prefers Bundle B to Bundle
C, then the consumer prefers A to C if preferences are transitive.
3. We assume that there is nonsatiation for at least one good.
- There is never too much of that good.
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THE UTILITY FUNCTION
• We represent a consumer’s preferences using a utility function.
• A utility function is a representation of the satisfaction that a consumer
receives from a basket of goods or services.
- The utility of a basket is measured in utils, which represent the ranking of
the utility of the goods and services:
𝑈 = 𝑓 𝑄𝑋1 , 𝑄𝑋2 , … , 𝑄𝑋𝑛
where
𝑄𝑋𝑖 is quantity of good or service i in the bundle
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INDIFFERENCE CURVES
• We can represent preferences with indifference curves, which represent the
utility of each possible combination of a given set of goods and services.
- Because the utility is the same throughout a given curve, the consumer is
indifferent between the combinations on a curve.
• The marginal rate of substitution is the rate at which a consumer will give up
one good or service in exchange for another and still have the same utility.
Good B
• The indifference curve map is a graphical representation of the possible
indifference curves, one for each level of utility.
Curve 3
Curve 1
Curve 1
Good A
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4. THE OPPORTUNITY SET: CONSUMPTION,
PRODUCTION, AND INVESTMENT CHOICE
• The budget constraint (also known as the income constraint) is what can be
bought based on a set of prices of goods and income.
• Consider two goods: Good 1 and Good 2. The budget constraint is
𝑃1 𝑄1 + 𝑃2 𝑄2 ≤ 1
where
𝑃1 is the price of Good 1
𝑄1 is the quantity of Good 1
𝑃2 is the price of Good 2
𝑄2 is the quantity of Good 2
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PRODUCTION FUNCTION AND INVESTMENT
OPPORTUNITY SET
• The production opportunity frontier represents the different quantities of two
goods that a company can produce, considering the trade-off between the two
goods in terms of manufacturing facilities.
- Analogous to the budget constraint for a consumer.
• The investment opportunity set is the set of investment opportunities that an
investor may invest in.
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5. CONSUMER EQUILIBRIUM: MAXIMIZING UTILITY
SUBJECT TO THE BUDGET CONSTRAINT
Step 1
Step 2
Good 2
• Determine the
consumer’s
preferences (utility).
Step 3
• Determine the budget
constraint.
• Determine the bundle
of consumer goods
that maximizes utility
given the budget
constraint.
• Consumers prefer more utility to less and
thus will want the bundles of goods that
maximize utility, given the budget
constraint.
• Looking at a his or her utility function, the
consumer will choose the bundle of goods
that maximizes the utility (the indifference
curve farthest from the origin) within a
given budget constraint.
Indifference curve 1
Indifference curve 2
Indifference curve 3
Good 1
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NORMAL VS. INFERIOR GOODS
• A normal good is a good that a consumer buys more of with increases in
income.
• An inferior good is a good that a consumer buys less of with increases in
income.
• Income effects:
- As income increases, the consumer has a larger budget, and therefore, the
optimal bundle changes, resulting in a higher proportion of the normal good
and a lower proportion of the inferior good.
• Substitution effect:
- Substitution effects are movements along an indifference curve.
- Substitution with income effects: If one of the prices changes (relative to the
price of another), the budget line changes slope and the new bundle of
goods is along the same indifference curve, but a different bundle (tangent to
new line).
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6. REVISITING THE CONSUMER’S
DEMAND FUNCTION
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Change in real
income without
price changes
Parallel shift in
the budget line
Change in real
income from a
price change
Change in the
slope of the
budget line
Substitution
without any
change in real
income
Movement
along the
indifference
curve
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Quantity of Normal Good
INCOME AND SUBSTITUTION EFFECTS
Income effects:
• When income rises, the
demand for normal goods
increases.
• When income rises, the
demand for inferior goods
falls.
Quantity of Inferior Good
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Quantity of Normal Good
BREAKING DOWN INCOME AND
SUBSTITUTION EFFECTS
• A change in the price of a good will result in a
change in the real income of the consumer.
• The change in demand from this change is
the substitution effect.
• A change in income results in an
• increased demand for normal goods, and a
• decreased demand for an inferior good.
A
C
B
QA QB QC
Quantity of Inferior Good
When the price of an inferior good falls, the budget constraint pivots upward
Substitution effect = QB – QA
Income effect = QC – QB
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SPECIAL CASES OF DEMAND
• A Giffen good is an inferior good for which the income effect outweighs the
substitution effect.
- Lowering the price of a Giffen good will result in a decrease in its demand.
- Raising the price of a Giffen good will result in an increase in its demand.
- A Giffen good is an inferior good, but not all inferior goods are Giffen goods.
- There are few Giffen goods.
• A Veblen good is a good for which the demand increases as the price of the
good increases.
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7. CONCLUSIONS AND SUMMARY
• Consumer choice theory and utility theory help us understand consumer
preferences.
• A consumer’s marginal rate of substitution represents the rate at which the
consumer will trade one good for another.
• What a consumer can spend (i.e., the budget) depends on the consumer’s income,
and what a consumer buys depends on the prices of goods and the consumer’s
preferences (i.e., utility).
• A consumer’s equilibrium is the point of tangency between the consumer’s budget
and marginal rate of substitution.
• We can break down changes in demand related to income and substitution effects.
- The income effect is the response in demand for a good when income changes.
- The substitution effect is the response in demand for a good when the relative
prices of goods change.
- When relative prices change, there may be both an income effect (i.e., change in
real income) and a substitution effect.
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7. CONCLUSIONS AND SUMMARY
• A normal good is a good whose demand increases when income increases
(and falls when income falls).
- A Veblen good has a perverse demand: The more is demanded of the good,
the higher the price of the good.
• An inferior good is a good that generally has a decrease in demand as income
increases.
- An extreme case of an inferior good is a Giffen good, for which an increase in
price results in an increase in demand.
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