In the Name of God Sharif University of Technology Graduate School of Management and Economics Microeconomics (for MBA students) 44111 (1393-94 1 st term) - Group 2 Dr. S. Farshad Fatemi Consumer Choice & Demand Decisions
Key elements in consumer choice: - Consumer s income - Prices of goods (consumers are price takers and their individual decisions have no effect on these prices) - Consumer preferences which can be translated into utility - The assumption that consumers maximise utility Microeconomics (for MBA students) Dr. F. Fatemi Page 45
Films Budget Constraint Income and prices together determine the combinations of the goods that the consumer can afford. The budget line separates the affordable from the unaffordable. Consider a student with a budget of 50 to spend on meals and films. Price of meals is 5; Price of films is 10. 6 5 4 3 2 1 0 0 2 4 6 8 10 12 Meals Income and all prices measured in the same currency. Microeconomics (for MBA students) Dr. F. Fatemi Page 46
For L products and an income of w: L l=1 p l x l w How the budget constraint changes in response to a change in consumer s income and prices? Microeconomics (for MBA students) Dr. F. Fatemi Page 47
Consumer Preferences Assumption: Consumer always prefers more to less for every good. Compared with point a: The consumer would prefer to be to the north-east (preferred region), e.g. at b But prefers a to such points as c to the south-west (dominated region). Points like f involve more of one good and less of the other compared with a. Microeconomics (for MBA students) Dr. F. Fatemi Page 48
Indifference Curves An indifference curve like I 1 shows all the consumption bundles that yield the same utility to the consumer. ICs slope downwards (given our assumptions) Their slope gets steadily flatter to the right (why?) ICs cannot intersect The tangent on IC is the marginal rate of substitution. Preferences also can be interpreted as a utility function. Microeconomics (for MBA students) Dr. F. Fatemi Page 49
Consumer Choice The point at which utility is maximised is found by bringing together the indifference curves and the budget line The choice point is at a where the budget line is at a tangent to an IC Points b and c are also affordable but give lower utility, being on a lower IC. Microeconomics (for MBA students) Dr. F. Fatemi Page 50
Effect of a change in income on consumer equilibrium A change in the consumer s income shifts the budget line without changing the slope The change in the pattern of consumer choice depends on the nature of the two goods Microeconomics (for MBA students) Dr. F. Fatemi Page 51
Effect of a change in price on consumer equilibrium An increase (decrease) in the price of one good shifts the budget line; altering its slope which reflects relative prices. If the price of pens falls, the consumer s budget line will pivot outward, from B 1 P 1 to B 1 P 2. As a result, the consumers can move to a higher indifference curve, I 2 instead of I 1. At the new price, the consumer buys more pens. Tracing out more of such points at different prices enables us to identify the Demand curve. Microeconomics (for MBA students) Dr. F. Fatemi Page 52
The response to a price change comprises two effects: The SUBSTITUTION EFFECT which is the adjustment to the change in relative prices. The hypothetical budget line HH has the slope of the NEW relative prices and is tangent to the OLD indifference curve at D. It is always negative. An increase in the price of meals leads to a fall in demand as we move from C to D. THE INCOME EFFECT which is the adjustment to the change in real income. It may be positive or negative, depending on whether the good is normal or inferior. Microeconomics (for MBA students) Dr. F. Fatemi Page 53
An example for a positive income effect (inferior good): In this case, it is positive because the good is inferior and income and substitution effects therefore have opposite effects on demand but the substitution effect is greater, so the overall effect is a fall in demand. Microeconomics (for MBA students) Dr. F. Fatemi Page 54
Giffen Good is an inferior good for which the income effect dominates the substitution effect. It is equivalent to an upward demand. In this case, the income effect is positive therefore income and substitution effects have opposite effects on demand but the substitution effect is smaller, so the overall effect is an increase in demand. Microeconomics (for MBA students) Dr. F. Fatemi Page 55
Transfers in cash and in kind AF is the initial budget constraint on which the individual settles at e 0 Ae 1 F' is the new budget constraint Given A'e 1 F', the best the individual can do is e 1 An equivalent cash transfer gives a budget line of A'e 1 F' The individual can now be better off at e 2 Then consumer always weakly prefers a monetary transfer. When the commodity transfer is socially desirable? Microeconomics (for MBA students) Dr. F. Fatemi Page 56
Aggregate Demand The market demand curve is the horizontal sum of the individual demand curves. If at a price of 5, consumer 1 demands 11 units and consumer 2 demands 13 units then market demand at a price of 5 will be 24 units. Microeconomics (for MBA students) Dr. F. Fatemi Page 57