Economics of Demand or Theory of Consumer Behavior Chapter 2 Chapter 5 p. 119-12 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 Price Supply P* Demand Q* 1
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? 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 Studied chemistry, mathematics, and logic in 185-51 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 2
Steaks consumed per week Dinner! Who would like a nice premium grill rib eye steak? Corn on the Cob? How much are you willing to pay? 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 Corn ears consumed per week 3
Steaks consumed per week Steaks consumed per week Steaks consumed per week Indifference Curves M B Which bundle would you prefer more bundle M or bundle B? 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. Corn ears consumed per week Indifference Curves Increasing Utility Preference Directions Corn ears consumed per week A B Indifference Curves 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! Corn ears consumed per week 4
Entertainment 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 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 Empirically observe C and not D C D Convex to Origin M Food 5
Steaks consumed per week 1 Steaks consumed per week -1 Marginal Rate of Substitution The rate at which the consumer is willing to substitute one good for another and maintain a constant utility level steak corn MRS of corn for steak with utility constant Notice - rise over run = the slope for a specific segment for a nonlinear curves Marginal Rate of Substitution MRS corn for steak going from 2 to 3 ears _ steak 1 1 corn 1 1 Corn ears consumed per week This means the consumer is willing to give up 1 steak in exchange for one additional ear of corn! Marginal Rate of Substitution MRS steak for corn going from 2 to 3 steaks steak corn 1-2 -.5 This means the consumer is willing to give up 2 ears -2 of corn for one additional Corn ears consumed per week steak or 1 ear for ½ steak! 6
Marginal Rate of Substitution steak MRS corn MU MU corn steak Why? Utility must be constant What you give up with one, you must gain with the other! Budget Constraint Represents the amount of income available for spending on the consumption bundles Example corn / steak weekly budget P steak x Q steak + P corn x Q corn Budget where P steak and P corn represent the price of steak and corn while Q steak and Q corn represent the quantities you purchase during the week. FYI! Omaha Steaks 4 (18 oz.) Private Reserve Bone-in Frenched Ribeyes $178. -- round to $4 / 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 $22.5 For ease let s use 12 ears and round to $2 7
Steaks (lbs) consumed per week 9 Steaks (lbs) consumed per week 9 Steaks (lbs) consumed per week Budget Constraint Graph $4 x steak + $2 x corn = $2 Apply all income to steaks $2 / 4 = 5 pounds Budget Constraint Apply all income to corn $2 / 2 = dozen ears 9 11 Steak Price Decreases by 1/2 Steaks price decreases by 1/2 $2 / 2 = pounds Original price budget constraint After price change budget constraint 9 11 Apply all income to corn $2 / 2 = dozen ears Steak Price Increases by 2 Original price budget constraint Steak price decreases by 1/2 budget constraint Steak price doubles budget constraint 9 11 8
Steaks (lbs) consumed per week Steaks (lbs) consumed per week Steaks (lbs) consumed per week 9 Corn Price Changes Original price budget constraint Corn price doubles Corn price decreases by 1/2 9 11 12 13 14 15 16 17 18 19 2 21 Income Decreases by 1/2 Original Budget Line All income applied to steaks $ / 4 = 2.5 pounds Budget Line at ½ income Apply all income to corn $ / 2 = 5 dozen ears 9 11 Income Changes - Know Shifts - Direction? - How? See book / homework 9 11 9
Steaks (lbs) consumed per week Economic - Choices 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? Problem Two goods steak and corn Prices - steak $4 / lb and corn $2 / dozen ears $2 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! Budget Constraint Graph $4 x steak + $2 x corn = $2 Apply all income to steaks $2 / 4 = 5 pounds Budget Constraint Apply all income to corn $2 / 2 = dozen ears 9 11
Steaks (lbs) consumed per week Steaks (lbs) consumed per week Steaks (lbs) consumed per week Add Indifference Curves Consumption bundle 1 corn and 4.5 steak = 1*2 + 4.5*4 = $2 Consumption bundle 6 corn and 1 steak = 6*2 + 1 *4 = $16 9 11 Can We Do Better? Increasing Utility Consumption bundle 7 corn and 3.5 steak = 7*2 + 3.5 * 4 = 28 9 11 Conclude So Far 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 9 11 Budget Constraint 11
Steaks (lbs) consumed per week Steaks (lbs) consumed per week Steaks (lbs) consumed per week Can We Do Better? Budget is all spent Question can we increase utility? Consumption bundle 5 corn and 2.5 steak = 5*2 + 2.5 * 4 = 2 9 11 Objective - Maximize Utility Indifference Curve below budget constraint Can increase utility by moving outward Not Optimal Point Indifference Curve is Tangent to Budget Constraint Feasible spends all budget Maximizes Utility highest curve obtainable 9 11 Indifference Curves and points above the budget Constraint exceeds your budget - not feasible Tangent Point Slope of budget constraint = slope of indifference curve slope of indifference curve = steak MU MRS corn MU corn steak What is slope of budget constraint? 9 11 12
Steaks (lbs) consumed per week Slope Budget Constraint Using x and y intercept points to calculate slope corn =, steak = 5 and corn = and steak = Slope = rise / run = (5-)/(-) = -.5 Recall how we obtained these points Income / price of steak = 5 and Income / price of corn = 9 11 I I ( ) Psteak Psteak I I ( ) P P Corn Corn P P Corn Steak Tangency Conditions Slope of indifference curve = slope of budget constraint Slope of indifference curve = MRS = - MU corn / MU steak Slope of budget constraint = -P corn / P steak Therefore, MU MRS MU MU P corn corn MU P corn steak steak steak P P corn steak Consumer Equilibrium Point where utility is maximized subject to the budget constraint occurs at MU Corn P corn = MU steak P steak 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. 13
Another Example - Consumer Equilibrium Question What point maximizes utility? A, B, C, or D Why? Consumer Equilibrium Points B and D exceed the budget Consumer Equilibrium Point C does not maximize utility 14
Steaks (lbs) consumed per week 9 11 Steaks (lbs) consumed per week Consumer Equilibrium Point A maximizes utility Corn Price Change Effect Original Price = $2 / doz. Consumption bundle 2.5 steak and 5 dozen ears of corn What if price decreases to $15? What happens to budget constraint? 9 11 Corn Price Now $15 / doz New x-intercept Same Why New equilibrium = 2.75 steak and 6 corn Why an increase in corn and increase in steak? New x-intercept = 2 / 15= 13.2 9 11 12 13 14 15
Steaks (lbs) consumed per week 9 11 Steaks (lbs) consumed per week 9 11 Steaks (lbs) 1 2 3 4 5 6 Income / Substitution Effects Substitution Effect relative prices MU Corn / P corn = MU steak / P steak Real Income Effect market opportunity set 9 11 12 13 Corn Price Now $5 / doz New y-intercept same Why? New equilibrium = 3.125 steak and 1.5 corn Why an decrease in corn and increase in steak? New x-intercept = 2 / 5 = 4 9 11 12 13 14 Price Consumption Curve 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 9 11 12 13 14 16
Price / pound ` Price / pound ` Price / pound ` Price Individual Demand Curve - Corn Demand Schedule Price 5 1.5 2 5 15 6 dollar per dozen ears` 6 5 4 3 2 Demand Curve for Corn 2 4 6 8 dozen ears of corn Market Demand Curve - Corn Person 1 Person 2 Market Price 5 1.5 3 4.5 2 5 6 11 15 6 7 13 The market demand curve is the horizontal summation of the demand schedules for all the consumers in the market. At a price of $5, 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 $5. Market Demand Curve - Corn Person 1 Person 2 Market 6 5 6 5 6 5 4 3 2 5 Dozen ears of corn 4 3 + = 2 5 Dozen ears of corn 4 3 2 5 15 Dozen ears of corn 17
Price ` Price 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? A B Movement A to C is? Movement B to C is? C Movement C to A is? Consumer Surplus The demand curve reveals the maximum willingness of consumers to pay for a corresponding quantity 12 8 6 4 2 What is the consumer s WTP for the 2nd unit? What surplus does the consumer receive if price = $ 6? 2 4 6 8 12 14 16 18 2 22 24 18
Price ` Price ` Price ` Consumer Surplus What is WTP for the 4th unit? Surplus =? What is WTP for the 6th unit? 8th? th? Surplus =? 12 8 6 4 What is surplus at the 14th unit? Why? 2 2 4 6 8 12 14 16 18 2 22 24 Consumer Surplus Sum of surplus at each quantity Triangle below the demand curve and above the price line 12 8 6 4 2 2 4 6 8 12 14 16 18 2 22 24 Consumer Surplus Change Triangle area given by points ABC = consumer surplus at a price = $ 6 12 A 8 6 C B 4 2 2 4 6 8 12 14 16 18 2 22 24 19
Price ` Price ` 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 12 A 8 6 D C E B 4 2 2 4 6 8 12 14 16 18 2 22 24 Consumer Surplus Calculating the area = (height x width)/2 = {(11-6) x (-)}/2 = 25 utils 12 8 6 4 2 2 4 6 8 12 14 16 18 2 22 24 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 2
Pounds of Steak ~ Pounds of Steak ~ Pounds of Steak ` Income Change Effect 11 9 8 7 6 5 4 3 2 1 Original Consumer Equilibrium 5 corn and 2.5 steak Income doubles What happens? 5 15 2 25 Dozen Ears of Corn Income Doubles 11 9 8 7 6 5 4 3 2 1 New y-intercept = 4 / 4 = 5 15 2 25 Dozen Ears of Corn New consumer equilibrium 9 corn and 5.5 steak 9*2+5.5*4 =4 Why an increase in both corn and steak? New x-intercept = 4 / 2 =2 Income Halves 11 9 8 7 6 5 4 3 2 1 New y-intercept = / 4 = 2.5 5 15 2 25 Dozen Ears of Corn New consumer equilibrium 2 corn and 1.5 steak 2*2+1.5*4 = Why a decrease in both corn and steak? New x-intercept = / 2 = 5 21
Income Income Income Pounds of Steak ~ Income Expansion Path 11 9 8 7 6 5 4 3 2 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? 1 5 15 2 25 Dozen Ears of Corn Engel Curve Income and Steaks Income 5.5 4 2.5 2 1.5 45 4 35 3 Steaks normal or inferior good? What about corn? 25 2 15 5 1 2 3 4 5 6 http://ingrimayne.com/econ/elasticity/engel_curve.htm Pounds of Steak Engel Curve Normal Good Inferior Good 22
Income Engel Curve What type of good is this? 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 23