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Chapter 4
Individual and Market Demand
©2005 Pearson Education, Inc.
CONSUMER CHOICE
©2005 Pearson Education, Inc. Chapter 3 3
Consumer Choice
Given preferences and budget constraints, how do consumers choose what to buy?
Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them
©2005 Pearson Education, Inc. Chapter 3 4
C
F
P
P
F
C Slope -
2
1-
The Budget Line
10
20
A
B
D
E
G
(I/PC) = 40
Food40 60 80 = (I/PF)20
10
20
30
0
Clothing
©2005 Pearson Education, Inc. 5
U2
U3
Indifference Map
Food
Clothing
U1
ABD
Market basket Ais preferred to B.Market basket B ispreferred to D.
©2005 Pearson Education, Inc.
HOW DO CONSUMERS CONSUME?
6
©2005 Pearson Education, Inc. Chapter 3 7
Consumer Choice
U3
D
U2
C
Food (units per week)40 8020
Clothing(units per
week)
20
30
40
0
U1
A
B
©2005 Pearson Education, Inc. Chapter 3 8
Consumer Choice
Graphically, we can see different indifference curves of a consumer choosing between clothing and food
Remember that U3 > U2 > U1 for our indifference curves
Consumer wants to choose highest utility within their budget
©2005 Pearson Education, Inc. Chapter 3 9
Consumer Choice
U3
D
U2
C
Food (units per week)40 8020
Clothing(units per
week)
20
30
40
0
U1
A
B
•A, B, C on budget line•D highest utility but not affordable
©2005 Pearson Education, Inc. Chapter 3 10
Consumer Choice
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line They spend all their income – more is better
2. It must give the consumer the most preferred combination of goods and services
©2005 Pearson Education, Inc. Chapter 3 11
Consumer Choice
U3
D
U2
C
Food (units per week)40 8020
Clothing(units per
week)
20
30
40
0
U1
A
B
•A, B, C on budget line•D highest utility but not affordable•C highest affordable utility•Consumer chooses C
©2005 Pearson Education, Inc. Chapter 3 12
Consumer Choice
Consumer will choose highest indifference curve on budget line
In previous graph, point C is where the indifference curve is just tangent to the budget line
Slope of the budget line equals the slope of the indifference curve at this point
©2005 Pearson Education, Inc. Chapter 3 13
Consumer Choice
Recall, the slope of an indifference curve is:
F
CMRS
C
F
P
PSlope
Further, the slope of the budget line is:
©2005 Pearson Education, Inc. Chapter 3 14
Consumer Choice
Therefore, it can be said at consumer’s optimal consumption point,
C
F
P
PMRS
©2005 Pearson Education, Inc. Chapter 3 15
Marginal Utility and Consumer Choice
When consumers maximize satisfaction:
CF /P PMRS
CF CF /P P /MUMU
Since the MRS is also equal to the ratio of the marginal utility of consuming F and C
©2005 Pearson Education, Inc. Chapter 3 16
Marginal Utility and Consumer Choice
Rearranging, gives the equation for utility maximization:
CCFF PMUPMU //
©2005 Pearson Education, Inc. Chapter 3 17
Consumer Choice
It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C)
Note this is ONLY true at the optimal consumption point
©2005 Pearson Education, Inc. Chapter 3 18
Marginal Utility and Consumer Choice
Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.
This is referred to as the equal marginal principle.
©2005 Pearson Education, Inc. Chapter 3 19
Consumer Choice
If MRS ≠ PF/PC then individuals can reallocate basket to increase utility
If MRS > PF/PC
Will increase food and decrease clothing until MRS = PF/PC
If MRS < PF/PC
Will increase clothing and decrease food until MRS = PF/PC
©2005 Pearson Education, Inc. Chapter 3 20
Consumer Choice
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Point B does not maximize satisfaction
because theMRS = -10/10 = 1
is greater than the price ratio = 1/2
+10F U1
-10C
B
©2005 Pearson Education, Inc. Chapter 3 21
Consumer Choice: An Application Revisited
Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of a car
Each group has different preferences
©2005 Pearson Education, Inc. Chapter 3 22
Consumer Choice: An Application Revisited
By finding the point of tangency between a group’s indifference curve and the budget constraint, auto companies can see how much consumers value each attribute
©2005 Pearson Education, Inc. Chapter 3 23
Consumer Choice: An Application Revisited
Styling
Performance$10,000
$10,000 These consumerswant performance worth $7000 and
styling worth $3000
$3,000
$7,000
©2005 Pearson Education, Inc. Chapter 3 24
Consumer Choice: An Application Revisited
These consumers want
styling worth $7000 and
performance worth $3000
$3,000
$7,000
Styling
$10,000
$10,000
Performance
©2005 Pearson Education, Inc. Chapter 3 25
Consumer Choice: An Application Revisited
Once a company knows preferences, it can design a production and marketing plan
Company can then make a sensible strategic business decision on how to allocate performance and styling on new cars
©2005 Pearson Education, Inc.
CORNER SOLUTION
Chapter 4 26
©2005 Pearson Education, Inc. Chapter 3 27
Consumer Choice
A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another
MRS is not necessarily equal to PA/PB
©2005 Pearson Education, Inc. Chapter 3 28
A Corner Solution
Ice Cream (cup/month)
FrozenYogurt
(cupsmonthly)
B
A
U2 U3U1
A corner solutionexists at point B.
©2005 Pearson Education, Inc. Chapter 3
A Corner Solution
At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line
If the consumer could give up more frozen yogurt for ice cream, he would do so
However, there is no more frozen yogurt to give up
Opposite is true if corner solution was at point A
©2005 Pearson Education, Inc. Chapter 3 30
A Corner Solution
When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio
In this instance it can be said that:
YogurtFrozen
IceCream
P
PMRS
©2005 Pearson Education, Inc. Chapter 3 31
A Corner Solution
If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket
©2005 Pearson Education, Inc. Chapter 3 32
A Corner Solution - Example
Suppose Jane Doe’s parents set up a trust fund for her college education
The money must be used only for education
Although a welcome gift, an unrestricted gift might be better
©2005 Pearson Education, Inc. Chapter 3 33
A Corner Solution - Example
Original budget line, PQ, with a market basket, A, of education and other goods
Trust fund shifts out the budget line as long as trust fund, PB, is spent on education
Jane increases satisfaction, moving to higher indifference curve, U2
©2005 Pearson Education, Inc. Chapter 3 34
A Corner Solution - Example
P
Q Education ($)
OtherConsumption
($)
U2A
U1
B
•Jane better off on U2
•B is corner solution•MRS ≠ PE/POG
©2005 Pearson Education, Inc. Chapter 3 35
A Corner Solution - Example
P
Q Education ($)
OtherConsumption
($)
U2A
U1
B
•If gift is unrestricted, Jane can be at point C on U3
•Better off than with restricted gift
CU3
©2005 Pearson Education, Inc. Chapter 4 36
Individual Demand
Price Changes Using the figures developed in the previous
chapter, the impact of a change in the price of food can be illustrated using indifference curves
For each price change, we can determine how much of the good the individual would purchase given their budget lines and indifference curves
©2005 Pearson Education, Inc.
DERIVING DEMAND FROM CONSUMER CHOICE
Chapter 4 37
©2005 Pearson Education, Inc. Chapter 4 38
Effect of a Price Change
Each price leads to different amounts of
food purchased5
U3
D
4
U2
B
12 20
Assume: • I = $20• PC = $2• PF = $2, $1, $0.50
Food (units per month)
Clothing
6 A
U1
4
10
©2005 Pearson Education, Inc. Chapter 4 39
Effect of a Price Change
The Price-Consumption Curve traces out the utility maximizing market
basket for each price of food
4
U2
B
12 20
5
U3
D
Food (units per month)
Clothing
6 A
U1
4
10
©2005 Pearson Education, Inc. Chapter 4 40
Effect of a Price Change
By changing prices and showing what the consumer will purchase, we can create a demand schedule and demand curve for the individual
From the previous example:
Demand Schedule
P Q
$2.00 4
$1.00 12
$0.50 20
©2005 Pearson Education, Inc. Chapter 4 41
Effect of a Price Change
Demand Curve
Individual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50
©2005 Pearson Education, Inc. Chapter 4 42
Demand Curves – Important Properties
The level of utility that can be attained changes as we move along the curve
At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the MRS of food for clothing equals the ratio of the prices of food and clothing
©2005 Pearson Education, Inc. Chapter 4 43
Effect of a Price Change
Food (units per month)
Priceof Food
H
E
G
$2.00
4 12 20
$1.00
$.50Demand Curve
• E: Pf /Pc = 2/2 = 1 = MRS• G: Pf /Pc = 1/2 = .5 = MRS• H:Pf /Pc = .5/2 = .25 = MRS
When the price falls, Pf /Pc & MRS also fall
©2005 Pearson Education, Inc. Chapter 4 44
Substitutes & Complements
If the price consumption curve is downward-sloping, the two goods are considered substitutes
If the price consumption curve is upward-sloping, the two goods are considered complements
They could be both
©2005 Pearson Education, Inc.
CONSUMER CHOICE AND INCOME CHANGES
Chapter 4 45
©2005 Pearson Education, Inc. Chapter 4 46
Individual Demand
Income ChangesUsing the figures developed in the previous
chapter, the impact of a change in the income can be illustrated using indifference curves
Changing income, with prices fixed, causes consumers to change their market baskets
©2005 Pearson Education, Inc. Chapter 4 47
Effects of Income Changes
Food (units per month)
Clothing(units per
month)
An increase in income,with the prices fixed,
causes consumers to altertheir choice ofmarket basket.
3
4
A U1
5
10
B
U2
D7
16
U3
Assume: Pf = $1, Pc = $2 I = $10, $20, $30
©2005 Pearson Education, Inc. Chapter 4 48
Individual Demand
Income ChangesThe income-consumption curve traces out
the utility-maximizing combinations of food and clothing associated with every income level
©2005 Pearson Education, Inc. Chapter 4 49
Individual Demand
Income Changes An increase in income shifts the budget line
to the right, increasing consumption along the income-consumption curve
Simultaneously, the increase in income shifts the demand curve to the right
©2005 Pearson Education, Inc. Chapter 4 50
Effects of Income Changes
Food (units per month)
Clothing(units per
month)
The Income Consumption Curve traces out the utility maximizing market basket for each income level
3
4
A U1
5
10
B
U2
D7
16
U3
Income Consumption Curve
©2005 Pearson Education, Inc. Chapter 4 51
Effects of Income Changes
Food (units per month)
Priceof
food
An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumer’s demand curve to the right as well.
$1.00
4
D1
E
10
D2
G
16
D3
H
©2005 Pearson Education, Inc. Chapter 4 52
Individual Demand
Income ChangesWhen the income-consumption curve has a
positive slope:The quantity demanded increases with incomeThe income elasticity of demand is positiveThe good is a normal good
©2005 Pearson Education, Inc. Chapter 4 53
Individual Demand
Income ChangesWhen the income-consumption curve has a
negative slope:The quantity demanded decreases with incomeThe income elasticity of demand is negativeThe good is an inferior good
©2005 Pearson Education, Inc. Chapter 4 54
An Inferior Good
Hamburger (units per month)
Steak(units per
month)
30
U3
C
Income-ConsumptionCurve
…but hamburgerbecomes an inferior
good when the incomeconsumption curvebends backward between B and C.
105
AU1
5
20
10
B
U2
Both hamburgerand steak behaveas a normal good, between A and B...
©2005 Pearson Education, Inc. Chapter 4 55
Individual Demand
Engel Curves Engel curves relate the quantity of good
consumed to income If the good is a normal good, the Engel curve
is upward sloping If the good is an inferior good, the Engel
curve is downward sloping
©2005 Pearson Education, Inc. Chapter 4 56
Engel Curves
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
Engel curves slopeupward for
normal goods.
©2005 Pearson Education, Inc. Chapter 4 57
Engel Curves
Engel curves arebackward bending for inferior goods.
Inferior
Normal
Food (unitsper month)
30
10
Income($ per
month)
20
4 8 12 16
©2005 Pearson Education, Inc. Chapter 4 58
Annual US Household Consumer Expenditures
©2005 Pearson Education, Inc.
INCOME AND SUBSTITUTION EFFECT
Chapter 4 59
©2005 Pearson Education, Inc. Chapter 4 60
Income and Substitution Effects
A change in the price of a good has two effects: Substitution EffectIncome Effect
©2005 Pearson Education, Inc. Chapter 4 61
Income and Substitution Effects
Substitution EffectRelative price of a good changes when price
changesConsumers will tend to buy more of the good
that has become relatively cheaper, and less of the good that is relatively more expensive
©2005 Pearson Education, Inc. Chapter 4 62
Income and Substitution Effects
Income EffectConsumers experience an increase in real
purchasing power when the price of one good falls
©2005 Pearson Education, Inc. Chapter 4 63
Income and Substitution Effects
Substitution EffectThe substitution effect is the change in an
item’s consumption associated with a change in the price of the item, with the level of utility held constant
When the price of an item declines, the substitution effect always leads to an increase in the quantity demanded of the good
©2005 Pearson Education, Inc. Chapter 4 64
Income and Substitution Effects
Income EffectThe income effect is the change in an item’s
consumption brought about by the increase in purchasing power, with the price of the item held constant
When a person’s income increases, the quantity demanded for the product may increase or decrease
©2005 Pearson Education, Inc. Chapter 4 65
Income and Substitution Effects
Income EffectEven with inferior goods, the income effect is
rarely large enough to outweigh the substitution effect
©2005 Pearson Education, Inc. Chapter 4 66
Income and SubstitutionEffects: Normal Good
Food (units per month)O
Clothing(units per
month) R
F1 S
C1 A
U1
The income effect, EF2, (from D to B) keeps relativeprices constant but increases purchasing power.
Income Effect
C2
F2 T
U2
B
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.
ETotal Effect
SubstitutionEffect
D
The substitution effect, F1E, (from point A to D), changes the relative prices but keeps real income(satisfaction) constant.
©2005 Pearson Education, Inc. Chapter 4 67
Food (units per month)O
R
Clothing(units per
month)
F1 S F2 T
A
U1
E
SubstitutionEffect
D
Total Effect
Since food is an inferior good, theincome effect is
negative. However,the substitution effect
is larger than the income effect.
B
Income Effect
U2
Income and SubstitutionEffects: Inferior Good
©2005 Pearson Education, Inc. Chapter 4 68
Income and Substitution Effects
A Special Case: The Giffen GoodThe income effect may theoretically be large
enough to cause the demand curve for a good to slope upward
This rarely occurs and is of little practical interest
©2005 Pearson Education, Inc. Chapter 4 69
Market Demand
Market Demand CurvesA curve that relates the quantity of a good
that all consumers in a market buy to the price of that good
The sum of all the individual demand curves in the market
©2005 Pearson Education, Inc.
MARKET DEMAND
Chapter 4 70
©2005 Pearson Education, Inc. Chapter 4 71
Determining the Market Demand Curve
Price A B CMarket
Demand
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
©2005 Pearson Education, Inc. Chapter 4 72
Summing to Obtain aMarket Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DB DC
Market Demand
DA
The market demandcurve is obtained by
summing the consumer’s demand curves
©2005 Pearson Education, Inc. Chapter 4 73
Market Demand
From this analysis one can see two important points:The market demand will shift to the right as
more consumers enter the marketFactors that influence the demands of many
consumers will also affect the market demand
©2005 Pearson Education, Inc. Chapter 4 74
Market Demand
Aggregation is important to be able to discuss regarding demand for different groupsHouseholds with childrenConsumers aged 20 – 30, etc.
©2005 Pearson Education, Inc. Chapter 4 75
The Aggregate Demand for Wheat
The demand for US wheat is comprised of two components:Domestic demand Export demand
Total demand for wheat can be obtained by aggregating these two demands
©2005 Pearson Education, Inc. Chapter 4 76
The Aggregate Demand for Wheat
The domestic demand for wheat is given by the equation:QDD = 1465 - 88P
The export demand for wheat is given by the equation:QDE = 1344 - 138P
©2005 Pearson Education, Inc. Chapter 4 77
The Aggregate Demand for Wheat
Domestic demand is relatively price inelastic (Ed = -0.2)
Export demand is more price elastic (Ed = -0.4)Poorer countries that import US wheat turn to
other grains and food if wheat prices increase
©2005 Pearson Education, Inc. Chapter 4 78
C
D
ExportDemand
Total world demand is the horizontal sum of the domestic demand AB and
export demand CD.
F
Total Demand
A
B
DomesticDemand
E
The Aggregate Demand for Wheat
Wheat
Price
0
10
16
18
Above C, export demand is zero, so domestic demand = total demand = AE segment
©2005 Pearson Education, Inc.
CONSUMER SURPLUS
Chapter 4 79
©2005 Pearson Education, Inc. Chapter 4 80
Consumer Surplus
Consumers buy goods because it makes them better off
Consumer Surplus measures how much better off they are
©2005 Pearson Education, Inc. Chapter 4 81
Consumer Surplus
Consumer Surplus The difference between the maximum
amount a consumer is willing to pay for a good and the amount actually paid
Can calculate consumer surplus from the demand curve
©2005 Pearson Education, Inc. Chapter 4 82
Consumer Surplus - Example
Student wants to buy concert ticketsDemand curve tells us willingness to pay
for each concert ticket1st ticket worth $20 but price is $14 so
student generates $6 worth of surplusCan measure this for each ticketTotal surplus is addition of surplus for each
ticket purchased
©2005 Pearson Education, Inc. Chapter 4 83
The consumer surplusof purchasing 6 concerttickets is the sum of the
surplus derived from each one individually.
Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21
Consumer Surplus - Example
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
14
15
16
17
18
19
20
Market Price
Will not buy more than 7 because surplus is negative
©2005 Pearson Education, Inc. Chapter 4 84
Consumer Surplus
The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller
Consumer surplus is the area under the demand curve and above the price
©2005 Pearson Education, Inc. Chapter 4 85
Demand Curve
ConsumerSurplus
Consumer Surplusfor the Market Demand
Consumer Surplus
Rock Concert Tickets
Price ($ perticket)
2 3 4 5 6
13
0 1
ActualExpenditure
14
15
16
17
18
19
20
Market Price
CS = ½ ($20 - $14)*(1600) = $19,500
©2005 Pearson Education, Inc. Chapter 4 86
Applying Consumer Surplus
Combining consumer surplus with the aggregate profits that producers obtain, we can evaluate:
1. Costs and benefits of different market structures
2. Public policies that alter the behavior of consumers and firms
©2005 Pearson Education, Inc. Chapter 4 87
Applying Consumer Surplus – An Example
The Value of Clean AirAir is free in the sense that we don’t pay to
breathe itThe Clean Air Act was amended in 1970Question: Were the benefits of cleaning up
the air worth the costs?
©2005 Pearson Education, Inc. Chapter 4 88
The Value of Clean Air
Empirical data determined estimates for the demand for clean air
No market exists for clean air, but can see people are willing to pay for itEx: People pay more to buy houses where
the air is clean
©2005 Pearson Education, Inc. Chapter 4 89
The Value of Cleaner Air
Using these empirical estimates, we can measure people’s consumer surplus for pollution reduction from the demand curve
©2005 Pearson Education, Inc. Chapter 4 90
The shaded area represents theconsumer surplus generated
when air pollution is reduced by 5 parts per 100million of nitrous oxide at
a cost of $1000 per part reduced.
Valuing Cleaner Air
2000
100
1000
5
A
NOX (pphm)Pollution Reduction
Value
©2005 Pearson Education, Inc. Chapter 4 91
Value of Cleaner Air
A full cost-benefit analysis would include total benefit of cleanup
Total benefits would be compared to total costs to determine if the clean up was worthwhile
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