economics of demand or theory of consumer …agecon2.tamu.edu/people/faculty/mjelde-james/agec...
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1
Economics of Demand
or
Theory of Consumer
Behavior
Chapter 2
Chapter 5 p. 119-120
Topics Topics
• Where are we going?
• Utility Theory
– Marginal utility
• Indifference curves
• Budget constraint
• Consumer equilibrium - The law of demand
• Change in quantity demanded vs. change in demand
• Shifters of demand
• Consumer surplus
Market Market
Q*
Quantity
Supply
Demand
Price
P*
2
What is Utility? What is Utility?
• Jeremy Bentham Introduction to the
Principles of Morals and Legislation 1789
– “Nature has placed mankind under the
governance of two sovereign masters, pain and
pleasure” … mankind “only object is to seek
pleasure and shun pain.”
• Utils
Who is Jeremy Bentham? Who is Jeremy Bentham?
• Jeremy Bentham
1748 -1832
• Philosopher
• Corresponded with
Adam Smith
• Auto-icon
Visit Jeremy at
http://www.ucl.ac.uk/museums/jeremy-bentham/visit
William Stanley Jevons 1835-1882 William Stanley Jevons 1835-1882
• Studied chemistry, mathematics, and
logic in 1850-51 left without a degree
• Returned to college in 1859 earned a
MA degree which included logic, moral
philosophy, political philosophy, history
of philosophy, and political economy
• Drowned while swimming
• “Value depends entirely upon utility” – not
costs as previous thought
3
Dinner! Dinner!
• Who would like a nice premium grill rib eye steak?
Corn on the Cob? How much are you willing to
pay?
Marginal Utility Marginal Utility
• Change in utility derived from a change in consumption of a particular good holding other goods constant
• Law of Diminishing Marginal Utility - as consumption per unit of time increases, marginal utility decreases
• Examples
– Bentham - income
– Jevons – water
– Steak
Indifference / Isoutility Curves Indifference / Isoutility Curves
1 2 3 4 5 6 7 8
Corn ears consumed per week
Ste
ak
s co
nsu
med
per
week
1 2
3
4
5
6
7
8
4
Indifference Curves Indifference Curves
Which bundle would you
prefer more…bundle M or
bundle B?
Which bundle would you
prefer more…bundle M or
bundle B? M
B
1 2 3 4 5 6 7 8
Corn ears consumed per week
Ste
ak
s co
nsu
med
per
week
1 2
3
4
5
6
7
8
The answer is that this we
would be indifferent
because they give us the
same utility. The ultimate
choice will depend on the
prices of these two
products.
The answer is that this we
would be indifferent
because they give us the
same utility. The ultimate
choice will depend on the
prices of these two
products.
Indifference Curves Indifference Curves
1 2 3 4 5 6 7 8
Corn ears consumed per week
Ste
ak
s co
nsu
med
per
week
1 2
3
4
5
6
7
8
Increasing Utility
Preference
Directions
B
A
Indifference Curves Indifference Curves
1 2 3 4 5 6 7 8
Corn ears consumed per week
Ste
ak
s co
nsu
med
per
week
1 2
3
4
5
6
7
8
Which bundle would you
prefer more…bundle C or
bundle N?
Which bundle would you
prefer more…bundle C or
bundle N?
C N We would prefer bundle N
over bundle C because it
gives us more utility or
satisfaction. The question
is whether we can afford
to buy bundle N!
We would prefer bundle N
over bundle C because it
gives us more utility or
satisfaction. The question
is whether we can afford
to buy bundle N!
5
Characteristics Indifference Curves Characteristics Indifference Curves
• Slopes – Negative
• Non-intersection – Do not cross
• Everywhere dense – Can always compare consumption bundles
• Convex to origin – Can not be proved – common sense
Characteristics Indifference Curves Characteristics Indifference Curves
• Slopes – Negative
• Non-intersection – Do not cross
• Everywhere dense – Can always compare consumption bundles
• Convex to origin – Can not be proved – empirically
observe
A B
C
Empirically observe
C and not D
D
Convex to Origin Convex to Origin
M
Food
En
terta
inm
ent
6
Marginal Rate of Substitution Marginal Rate of Substitution
• The rate at which the consumer is willing to substitute one good for another and maintain a constant utility level
• MRS of corn for steak with utility constant
• Notice - rise over run = the slope for a specific segment for a nonlinear curves
corn
steak
Marginal Rate of Substitution Marginal Rate of Substitution
• MRScorn for steak
going from 2 to 3
ears
1 2 3 4 5 6 7 8
1
Corn ears consumed per week
Ste
ak
s co
nsu
med
per
week
1 2
3
4
5
6
7
8
-1
This means the consumer
is willing to give up 1 steak
in exchange for one
additional ear of corn!
This means the consumer
is willing to give up 1 steak
in exchange for one
additional ear of corn!
11
1
corn
steak _
Marginal Rate of Substitution Marginal Rate of Substitution
• MRSsteak for corn going
from 2 to 3 steaks
1 2 3 4 5 6 7 8
-2
Corn ears consumed per week
Ste
ak
s co
nsu
med
per
week
1 2
3
4
5
6
7
8
1
5.02-
1
corn
steak-
This means the consumer
is willing to give up 2 ears
of corn for one additional
steak or 1 ear for ½ steak!
This means the consumer
is willing to give up 2 ears
of corn for one additional
steak or 1 ear for ½ steak!
7
Marginal Rate of Substitution Marginal Rate of Substitution
• Why? – Utility must be constant
– What you give up with one, you must gain with the other!
steak
corn
MU
MU
corn
steakMRS
Budget Constraint Budget Constraint
• Represents the amount of income available for spending on the consumption bundles
• Example corn / steak weekly budget
Psteak x Qsteak + Pcorn x Qcorn Budget
where Psteak and Pcorn represent the price of steak and corn while Qsteak and
Qcorn represent the quantities you purchase during the week.
• Omaha Steaks
– 4 (18 oz.) Private Reserve Bone-in Frenched
Ribeyes $178.00 -- round to $40 / pound
– For ease use pounds of steak
• New York Style Deli
– Own Home Grown Corn on the Cob. Seasonal
Item. Picked fresh daily
– Buy 12 ears delivered to your door $22.50
– For ease let’s use 12 ears and round to $20
FYI! FYI!
8
Budget Constraint – Graph
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
Apply all income to steaks
$200 / 40 = 5 pounds
Apply all income to corn
$200 / 20 = 10 dozen ears Budget Constraint
$40 x steak + $20 x corn = $200
Steak Price Decreases by 1/2 Steak Price Decreases by 1/2
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
9 1
0
Steaks price decreases by 1/2
$200 / 20 = 10 pounds
Apply all income to corn
$200 / 20 = 10 dozen
ears
Original price budget
constraint
After price change budget
constraint
Steak Price Increases by 2 Steak Price Increases by 2
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
9 1
0
Original price budget
constraint
Steak price decreases by
1/2 budget constraint
Steak price doubles budget
constraint
9
Corn Price Changes Corn Price Changes
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
9 1
0
Original price budget
constraint
Corn price doubles
Corn price decreases by 1/2
Income Decreases by 1/2 Income Decreases by 1/2
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
All income applied to steaks
$100 / 40 = 2.5 pounds
Apply all income to corn
$100 / 20 = 5 dozen
ears
Original Budget
Line
Budget Line
at ½ income
Income Changes - Know Income Changes - Know
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
Shifts
- Direction?
- How?
See book / homework
10
• Definition of economics
“…a social science that deals with how consumers,
producers, and societies choose among the alternative uses
of scarce resources in the process of producing, exchanging,
and consuming goods and services”
• Question
How can we combine indifference curves and budget
constraints to examine consumer choice?
Economic - Choices Economic - Choices
• Two goods steak and corn
• Prices - steak $40 / lb and corn $20 / dozen ears
• $200 per week to spend
• Objective
Allocate your limited budget to steak and corn such that you will
maximize your utility
• Solution
Combine budget constraint and indifference curves on one graph. Point
of tangency will be maximum for a given budget and prices.
• In a nut shell – how much steak and how much corn do I buy!
Problem Problem
Budget Constraint – Graph
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
Apply all income to steaks
$200 / 40 = 5 pounds
Apply all income to corn
$200 / 20 = 10 dozen ears Budget Constraint
$40 x steak + $20 x corn = $200
11
Add Indifference Curves
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
Consumption bundle
6 corn and 1 steak
= 6*20 + 1 *40 = $160
Consumption bundle
1 corn and 4.5 steak
= 1*20 + 4.5*40 = $200
Can We Do Better?
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
Consumption bundle
7 corn and 3.5 steak
= 7*20 + 3.5 * 40 = 280
Increasing Utility
Conclude So Far
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1 2
3
4
5
6
7
8
Indifference curves lying below the
budget constraint do not spend all
the budget except where intersect
Indifference curves and points lying
above the budget constraint exceed
our budget
Budget Constraint
12
Can We Do Better?
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8
Consumption bundle
5 corn and 2.5 steak
= 5*20 + 2.5 * 40 = 200
Budget is all spent
Question – can we increase utility?
Objective - Maximize Utility
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8
Indifference Curve – below budget constraint
Can increase utility by moving outward
Not Optimal
Indifference Curves and
points above the budget
Constraint exceeds your
budget - not feasible
Point Indifference Curve is Tangent
to Budget Constraint
Feasible – spends all budget
Maximizes Utility – highest curve obtainable
Tangent Point
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8
Slope of budget constraint = slope of indifference curve
slope of indifference curve =
steak
corn
MU
MU
corn
steakMRS
What is slope of
budget constraint?
13
Slope Budget Constraint
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8
Using x and y intercept points to calculate slope
corn = 0, steak = 5 and corn = 10 and steak = 0
Slope = rise / run = (5-0)/(0-10) = -0.5
Recall how we obtained these points
Income / price of steak = 5 and
Income / price of corn = 10
Steak
Corn
Corn
steak
Corn
steak
P
P
P
I
P
I
)P
I0(
)0P
I(
• Slope of indifference curve = slope of budget constraint
• Slope of indifference curve = MRS = - MUcorn / MUsteak
• Slope of budget constraint = -Pcorn / Psteak
• Therefore,
Tangency Conditions
steak
steak
corn
corn
steak
corn
steak
corn
P
MU
P
MU
P
P
MU
MUMRS
• Point where utility is maximized subject to the budget constraint occurs at
MUCorn MUsteak
Pcorn Psteak
• In other words, the marginal utility derived from the last dollar spent on each good is identical. This can be expanded to include all goods and services purchased by the consumer.
Consumer Equilibrium
=
14
Question What point maximizes utility?
A, B, C, or D
Why?
Question What point maximizes utility?
A, B, C, or D
Why?
Another Example - Consumer Equilibrium Another Example - Consumer Equilibrium
Points B and D
exceed the budget
Points B and D
exceed the budget
Consumer Equilibrium Consumer Equilibrium
Point C does
not maximize
utility…
Point C does
not maximize
utility…
Consumer Equilibrium Consumer Equilibrium
15
Point A maximizes
utility…
Point A maximizes
utility…
Consumer Equilibrium Consumer Equilibrium
Corn Price Change Effect
1 2 3 4 5 6 7 8 9 10 11
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8
Original Price = $20 / doz.
Consumption bundle
2.5 steak and
5 dozen ears of corn
What if price decreases to $15?
What happens to budget constraint?
Corn Price Now $15 / doz
New x-intercept
Same Why
New x-intercept
= 200 / 15= 13.2
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4
5
6
7
8 9
1
0 1
1
New equilibrium
= 2.75 steak and 6 corn
Why an increase in corn
and increase in steak?
16
Income / Substitution Effects
1 2 3 4 5 6 7 8 9 10 11 12 13
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
1
2
3
4
5
6
• Substitution Effect – relative prices
MUCorn / Pcorn = MUsteak / Psteak
• Real Income Effect – market opportunity set
Corn Price Now $50 / doz
New y-intercept same
Why?
New x-intercept
= 200 / 50 = 4
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4 5
6
7
8 9
1
0 1
1
New equilibrium
= 3.125 steak and 1.5 corn
Why an decrease in corn
and increase in steak?
Price Consumption Curve
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Dozen corn ears consumed per week
Ste
ak
s (l
bs)
co
nsu
med
per
week
1
2
3
4 5
6
7
8 9
1
0 1
1
• Indicates the response of the rational consumer
to changes in price of corn alone,
income and price of steak being held fixed.
• Arrow indicates increase utility!
• Negative slope – at lower price consumes
more corn but less steak as price of corn drops
• Positive slope – at higher price consumes more of
both as corn price drops
17
Individual Demand Curve - Corn
Demand Curve for Corn
0
10
20
30
40
50
60
0 2 4 6 8
Quantity
dozen ears of corn
Pri
ce
do
llar
per
do
zen
ears̀
Demand Schedule
Price Quantity
50 1.5
20 5
15 6
Person 1 Person 2 Market
Price Quantity Quantity Quantity
50 1.5 3 4.5
20 5 6 11
15 6 7 13
Market Demand Curve - Corn
The market demand curve is the horizontal
summation of the demand schedules
for all the consumers in the market.
At a price of $50, Person 1 would buy 1.5 dozen
ears of corn while Person 2 would buy 3.
Therefore, the market demand is equal to 4.5
dozen ears at a price of $50.
The market demand curve is the horizontal
summation of the demand schedules
for all the consumers in the market.
At a price of $50, Person 1 would buy 1.5 dozen
ears of corn while Person 2 would buy 3.
Therefore, the market demand is equal to 4.5
dozen ears at a price of $50.
+ =
Market Demand Curve - Corn
Person 1
0
10
20
30
40
50
60
0 5 10
Dozen ears
of corn
Pri
ce
/ p
ou
nd
`
Person 2
0
10
20
30
40
50
60
0 5 10
Dozen ears
of corn
Pri
ce
/ p
ou
nd
`
Market
0
10
20
30
40
50
60
0 5 10 15
Dozen ears
of corn
Pri
ce
/ p
ou
nd
`
18
Demand Curve Jargon
• Specific terms to distinguish between
movement along a demand curve and a shift
in a demand curve
• Change in the quantity demanded is a
movement along a demand curve - Cause
• Change in demand is a shift in the demand
curve - Causes
Movement Examples - Know
• Movement A to B is ?
• Movement A to C is ?
• Movement B to C is ?
• Movement C to A is ?
A B
C
Quantity
Pri
ce
Consumer Surplus
• The demand curve reveals the maximum willingness of
consumers to pay for a corresponding quantity
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
What is the consumer’s
WTP for the 2nd unit?
What surplus does the
consumer receive if
price = $ 6?
19
Consumer Surplus
• What is WTP for the 4th unit? Surplus = ?
• What is WTP for the 6th unit? 8th ? 10th? Surplus = ?
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
What is surplus
at the 14th unit?
Why?
Consumer Surplus
• Sum of surplus at each quantity
• Triangle – below the demand curve and above the price line
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
Consumer Surplus Change
• Triangle area given by points ABC =
consumer surplus at a price = $ 6
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
A
B C
20
Consumer Surplus Change
• What is the change in consumer surplus if price increases to $8?
• Consumer surplus is now triangle ADE lose of area DEBC
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
A
B C
E D
Consumer Surplus
• Calculating the area = (height x width)/2
• = {(11-6) x (10-0)}/2 = 25 utils
0
2
4
6
8
10
12
0 2 4 6 8 10 12 14 16 18 20 22 24
Quantity
Pri
ce
`
Individual Demand Curve - Steak
• Be sure to be able to do the mechanics for
steaks
– Consumer equilibrium
– Change in steak prices holding income and
price fixed – substitution / income effect
– Price consumption path
– Individual demand curve
21
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
`
• Original Consumer Equilibrium
5 corn and 2.5 steak
• Income doubles
What happens?
Income Change Effect
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
~
New y-intercept = 400 / 40 = 10
Income Doubles
New x-intercept
= 400 / 20 =20
New consumer equilibrium
9 corn and 5.5 steak
9*20+5.5*40 =400
Why an increase in both
corn and steak?
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
~
New x-intercept
= 100 / 20 = 5
New y-intercept = 100 / 40 = 2.5
New consumer equilibrium
2 corn and 1.5 steak
2*20+1.5*40 = 100
Why a decrease in both
corn and steak?
Income Halves
22
Income Expansion Path
0
1
2
3
4
5
6
7
8
9
10
11
0 5 10 15 20 25
Dozen Ears of Corn
Po
un
ds
of
Ste
ak
~
• Indicates the response of the rational consumer
to changes in income alone, prices of steak and
corn being held fixed.
• Arrow indicates increase utility!
• Positive slope – both goods normal goods
• Negative slope – one good is an inferior good
What type of goods
are steak and corn?
0
50
100
150
200
250
300
350
400
450
0 1 2 3 4 5 6
Pounds of Steak
Inc
om
e
Engel Curve
Steaks – normal or inferior good? Income and Steaks
Quantity Income
5.5 400
2.5 200
1.5 100
http://ingrimayne.com/econ/elasticity/engel_curve.htm
What about corn?
Engel Curve
Quantity
Inco
me
Normal Good Inferior Good
Quantity
Inco
me
23
Engel Curve
What type of good is this?
Quantity
Inco
me
Summary - Know Summary - Know
• Know Key terms / questions
• What is utility?
• What are indifference curves?
– Direction of preferences
– MRS
– MU
• Know how to graph / interpret a budget
constraint
– Changing prices
– Changing income
Summary - Know
• Consumer equilibrium for an individual for a given price and budget
• Individual consumer’s demand schedule
• Market demand curve
• Price and income expansion paths
• Engel curves
• Change in demand vs. change in quantity demanded
• Consumer surplus