econ 103 part 04

8/6/2019 Econ 103 Part 04

1/27

Part 4The Theory of Demand

We have drawn all our demandcurves downward sloping

Why do economists thinkdemand curves normally slope

downward? Market demand curves are

aggregations of individual (orhousehold) demand curves

What factors will affect ahouseholds demand for agood?

8/6/2019 Econ 103 Part 04

2/27

Household ConsumptionChoices

Households buy a variety of goods(a bundle of goods)

Different households buy differentbundles of goods

Household choice will depend on:

- income

- relative prices of goods

- preferences

Income and prices can be shown in abudget constraint

What shapes preferences?

How can a given set of preferences

be represented?

8/6/2019 Econ 103 Part 04

3/27

Budget Constraint

Qy

Qx

Affordable

Unaffordable

Budget constraint with given income = I

and given prices Px and Py:

I = PxQx + PyQy

8/6/2019 Econ 103 Part 04

4/27

Preferences and Utility

Which of the affordable

combinations will a householdchoose to purchase?

The intuitive answer is that thehousehold will choose the bundle of

goods that it likes the best orprovides the most satisfaction of allthe affordable bundles

More formally, if the degree of

satisfaction of all wants and desirescan be measured on a single utilityscale, the household will choose thebundle of goods that maximizes

utility

8/6/2019 Econ 103 Part 04

5/27

Cardinal Utility Theory

When the idea of a utility measure

was first proposed in economics itwas sometimes assumed that one

could think of units of utility in the

same way as units of weight or

temperature Such a measure has a defined unit

that can be added, multiplied, & etc

Many possible units of measure but

they are all linear transformations ofeach other (eg: deg F = 32 + 9/5 C)

8/6/2019 Econ 103 Part 04

6/27

Total and MarginalUtility

More goods give more total utility

More of any particular good will

tend to give less additional total

utility with each increment

Diminishing marginal utility Diminishing marginal utility and the

paradox of value

What is the rule for maximizing total

utility out of a given budget when

each good has diminishing marginal

utility?

8/6/2019 Econ 103 Part 04

7/27

Maximizing Utility

Quantity MUx MUy

1 20 16

2 18 15

3 14 14

4 8 13

5 0 12

Example of two goods x and y

Utility maximizing bundle with an income

Of $6 and Px and Py= $1?

Utility maximizing bundle with an income

$16 and Px=$3 and Py=$2

8/6/2019 Econ 103 Part 04

8/27

Maximizing Utility

The total utility gained from a

given budget will be maximized

where the budget is all spent

and marginal utility per dollar

spent is equalized across allgoods

Rule for a utility maximum:

MUx/Px = MUy/Py orMUx/MUy = Px/Py

8/6/2019 Econ 103 Part 04

9/27

Implications

Maximization is where

MUx/Px = MUy/Py

Fall in Px will increase quantity

demanded for X (decreasing

MUx)

Fall in Px will also affect the

demand for Y. If X and Y are

substitutes demand for Y willfall (increasing MUy)

8/6/2019 Econ 103 Part 04

10/27

Individual and MarketDemand

Market demand curves are the

horizontal summation of the

demand curves of all

individuals or households

8/6/2019 Econ 103 Part 04

11/27

Ordinal Utility Theory

The idea of utility asmeasurable in a cardinal waywas subject to much criticism

The idea of a utility measure as

a rank ordering replaced theidea of cardinal measurement

An ordinal measure is aranking only.

No unit of measurement

Higher numbers imply onlymore preferred

8/6/2019 Econ 103 Part 04

12/27

Preferences

Qy

Qx

Definitely

Less preferred

to A: U5

Bundle A: X,Y

U=5

If both X and Y provide utility

X

Y

8/6/2019 Econ 103 Part 04

13/27

Indifference Curves

A locus of all bundles with the same

utility ranking. The consumer is indifferent

between them

U=5

U>5 (preferred to

Any point on U=5)

U

8/6/2019 Econ 103 Part 04

14/27

A Preference Map

U=5

U=6

Qy

Qx

a

b

c

d

8/6/2019 Econ 103 Part 04

15/27

Preference Maps

In order to draw a preferencemap at all we are assuming:

goods are infinitely divisible(indifference curves are

continuous) Every combination of goods can

be ranked (preferences arecomplete)

Preferences are consistent(indifference curve cannotintersect or touch)

8/6/2019 Econ 103 Part 04

16/27

The Shape ofIndifference curves

Negative slope (more is

preferred to less)

Marginal rate of substitution

(MRS)

Convex to the origin

(diminishing marginal rate of

substitution)

MRS=Qy/Qx keeping utilityconstantslope of the

indifference curve

8/6/2019 Econ 103 Part 04

17/27

Maximizing UtilityOnce Again

In the ordinal utility context

maximizing utility means choosingthat bundle of goods that is on the

highest indifference curve

achievable with given income and

prices

Budget line: I = PyQy+PxQx

PyQy = I- PxQx

Qy = I/Py (Px/Py)QxI/Py is the Y intercept

Px/Py is the slope of the budget line

8/6/2019 Econ 103 Part 04

18/27

Budget line

I/Px Qx

Qy

I/Py

I = PyQy+PxQx

Px/Py is the slope of the budget line

8/6/2019 Econ 103 Part 04

19/27

Utility Maximization:Indifference Curves

U=5

Qx

Qy

Qy*

Qx*

Highest indifference curve

achievable

U=4

U=6

Budget line and indifference curve are tangent.

On budget line and highest indifference curvewhere MRS=Px/Py

8/6/2019 Econ 103 Part 04

20/27

Changes in Income

Changes in income with constant

prices will shift the budget lineoutwards in a parallel fashion

Normal goods will show increased

consumption with higher income

Inferior goods will show decreased

consumption with higher income

Consumer preferences determine if a

good is normal or inferior (shape ofindifference curves)

8/6/2019 Econ 103 Part 04

21/27

Income EffectQy

QxQx Qx

U

U

I

I

Income consumption line

X and Y normal

Qy

Qx

I

IU

U

Qx Qx

X inferior, Y normal

8/6/2019 Econ 103 Part 04

22/27

Changes in Price

Change in the price of X

changes the slope of the budget

line by changing the X intercept

Qy

QxI/Px I/Px

Px>PxI/Py

8/6/2019 Econ 103 Part 04

23/27

Price Effect and DemandCurves

Qy

Qx

Qx

Px

U

U

Qx Qx

Qx Qx

Budget line

with Px

Px

Budget line

with Px

Px

Demand curve for X

8/6/2019 Econ 103 Part 04

24/27

Income and Substitution

Effects of a PriceChange

The effect of a price change on

the demand for a good can be

decomposed into two effects

The substitution effect is the

effect of the change in relativeprices keeping real income

(utility) constant

The income effect is the effecton real purchasing power of the

price change

8/6/2019 Econ 103 Part 04

25/27



Qy

QxQx Qxs Qx

Sub Inc

ab

s

Overall effect (a to b) can be

broken down into a substitution

and income effect

8/6/2019 Econ 103 Part 04

26/27



Income effects of a price change are

usually small--unless the goodaccounts for a high proportion of

expenditure

For normal goods the income effect

works to reinforce substitution effect

and a price decline mustincrease

quantity demanded

For inferior goods the income effectworks against the substitution effect,

but the substitution effect is usually

larger

8/6/2019 Econ 103 Part 04

27/27



What does it take to get an

upward sloping demand curve?The Giffen good case

Giffen goods must be both

inferior and important in thebudget

Very unlikely to come across aGiffen good

Policy uses of income andsubstitution effects--carbontaxes and income tax rebates

econ 103 part 04

Documents