Lecture 7: The Theory of Demand. Where does demand come from? What factors influence choice? A simple model of choice

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1 Leture : The Theory of Demand Leture : The he Theory of Demand Readings: Chapter 9 Where does demand ome from? Sarity enourages rational deision-maing over household onsumption hoies. Rational hoie leads to purhase deisions whih leads to the soial phenomenon of demand. What fators influene hoie? An individual s hoies are influened by: what they an afford, We therefore build our theory of demand on a theory of rational individual hoie. (Methodologial Individualism) their preferenes. How are onsumption deisions made? Searh the person s affordable set to find the onsumption hoie that provides the highest level of satisfation given her preferenes. roblem: How does a rational individual searh the family s affordable set to find the best hoie? Solution: We need a simple model of preferenes to explore this deision problem. A simple model of hoie Choie an be modeled as the result of an interation between: 1. Affordable Set (or onsumption possibilities) Family inome (M) and pries () of goods and servies given defines a family s affordable set M The budget line is the boundary between affordable and unaffordable onsumption hoies M = n n. referenes Indifferene Map n n

2 A simple appliation of the model: As before we will simplify the model by having only two ommodities pop and movies. The budget line simplifies dramatially M = op op + Example: Suppose that inome is $, the prie of a movie is $, and the prie of a pop is $. = + op op The Affordable Set a b Affordable Set Inome op d $ $ $ Unaffordable e f Budget line 1 9 Textboo p. 19 Affordable Set and the Budget Line op a b d M = + op op M m = m e Affordable Set Interepts measure real inome in movies (x-interept) pop (y-interept) m steeper budget line, fixed pop-interept p flatter budget line, fixed movie-interept M rightward parallel shift budget line f 1 9 Textboo p. 19 referenes and Indifferene Curves Indifferene urves oin ombinations goods giving equal satisfation generally slope downward and bow towards origin farther from origin levels of satisfation never interset

3 op A referene Map l g I referenes and Indifferene Curves Marginal Rate of Substitution (MRS) magnitude of slope of indifferene urve diminishing marginal rate of substitution MRS as move down along indifferene urve substitutability between goods straighter indifferene urves substitutability between goods more tightly urved indifferene urves Textboo p.1 The Marginal Rate of Substitution The Household's Consumption Choie op MRS = MRS = 1 g At the best affordable point: eah household spends all its inome and ahieves maximum satisfation. eah household s budget line and indifferene urve have same slope MRS = relative prie Despite the fat that every household hooses a different onsumption bundle, every household will have the same MRS as every other household beause they fae the same pries. Textboo p. 1 The Best Affordable oint rediting Consumer Behaviour op l i l Best affordable point rie effet = onsumption resulting from prie of good To analyze the prie effet, onsider our example in whih a person with $ must deide how muh of his money to spend on movies and pop. h Suppose the prie of movies falls from $ to $, while the prie of pop stayed onstant at $. Textboo p. 1 This will alter the affordable set (budget line). ontinued

4 rediting Consumer Behaviour rie Effet To see how it affets the budget line onsider the following two ases. op $ If all the $ is spent on movies, a redution in the prie of movies from $ to $ maes it possible to onsume as many as movies. If however, the individual spends all $ on pop, the redution of the prie of movies would not hange his onsumption. Clearly the budget line hinges out. l $ Textboo p. 1 op rie Effet and Demand Curve l Individual and Maret Demand The last table shows how individual demand is related to individual hoie given preferenes and an affordable set. a b Textboo p. 1 : Where does maret demand ome from? A: Maret Demand Maret demand urve is simply the sum of individual demand. Graphially this is the horizontal sum of individual demand urves Individual and Maret Demand Curves: Lisa s Demand Individual and Maret Demand Curves: Chu s Demand Lisa s demand Chu s demand Textboo p. 1 Textboo p. 1

5 Individual and Maret Demand Curves: Maret Demand Individual and Maret Demand Curves Maret demand (a) (b) () Lisa s demand Chu s demand Maret demand Textboo p. 1 Textboo p. 1 rediting Consumer Behaviour rediting Consumer Behaviour : What determines the elastiity of demand? A: The size of the prie effet. : What determines the size of the prie effet? A: rie effet = substitution effet + inome effet Substitution effet prie onsumption Inome effet for normal goods, (hypothetial) inome onsumption for inferior goods, (hypothetial) inome onsumption ontinued op Inome Effet Inome Effet and Change in Demand op Inome $1 Inome $ l Textboo p. 19 b 199 Addison-Wesley ublishers Ltd. D 1 D l Textboo p. 19

6 op rie Effet Inome $ $ op Substitution Effet Inome $ $ Inome $ $ l Inome $1 $ l Textboo p. 1 Textboo p. 1 op Inome Effet Inome $ $ rie Effet = Substitution Effet + Inome Effet op Inome $, $ Inome $, $ Inome $1 $ l l Textboo p. 1 Textboo p. 1 rediting Consumer Behaviour rediting Consumer Behaviour For normal goods For inferior goods substitution and inome effets wor in same diretion substitution and inome effets wor in opposite diretions Example: movies both onsumption and inome effet push movies Example: bus substitution effet auses bus, but inome effet auses bus Impliation: Normal goods tend to be prie elasti in demand. Impliation: Inferior goods tend to be prie inelasti in demand.

7 Value and Demand Theory Value and Demand Theory Demand Theory an do more than explain The reason for this belief in a disonnetion demand. It sheds light on questions about value. between maret value and use value is found in : What do maret values have to do with human values? Many believe that maret values are often at odds with human values? A: Eonomists used to believe there was no onnetion between the exhange value (maret prie) and the use value (intrinsi value) of The Water Diamond aradox: Water has enormous use value but has a low prie, while a diamond has little use value yet has a high prie. This seems to suggest that there is no onnetion between maret prie and use value. ommodities. Value and Demand Theory Value and Demand Theory : Is there no onnetion between maret value : What is the benefit from partiipating in (prie) and use value? marets if you are a buyer? A: No! There is an important onnetion. eople will only partiipate if the prie is lower Water is plentiful. Even though the total than the value they plae on the good. utility from water is high, the marginal utility is low. Diamonds are sare and while the total utility is low, the marginal utility is high. This reates a onsumer surplus that the buyer realizes from her purhase. Marginal analysis shows us the lin between maret prie and use value. Consumer Surplus: Individual Consumer Surplus: Maret Maximum pries willing to pay for 1,,, and movies Maret prie Maret prie 1 Consumer surplus D 1 Consumer surplus D 1 Textboo p Textboo p. 11

8 The model of onsumer hoie an be used to study the alloation of time between wor and leisure. The two goods are leisure and inome where inome represents all other goods. Lisa buys leisure by not supplying labour and by forgoing inome. So the prie of leisure is the wage rate forgone. The labour Supply Curve By hanging the wage rate, we an find a person s labour supply urve. An inrease in the wage rate maes leisure relatively more expensive (higher opportunity ost to not woring) and has a substitution effet towards less leisure (towards more wor). A higher wage also has a positive inome effet on leisure. If the inome effet is weaer than the substitution effet, the quantity of wor hours inreases as the wage rate rises. When the wage rate rises from $ to $ an hour, wor inreases from to hours a wee the move from A to B. But if the inome effet is stronger than the substitution effet, the quantity of wor hours dereases as the wage rate rises. When the wage rate rises from $ to $1 an hour, wor dereases from to hours a wee the move from B to C. The move from A to B when the wage rate inreases from $ to $ an hour means that the labour supply urve slopes upward over this range.

9 The move from B to C when the wage rate inreases from $ to $1 an hour means that the labour supply urve bends bawards above a ertain wage rate. Historial evidene shows that the average worwee has fallen steadily as the wage rate has inreased. With higher wage rates, people have deided to use their higher inomes in part to buy more leisure. End of Leture

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