Presentation on theme: "Consumer Demand Theory II"— Presentation transcript:
1 Consumer Demand Theory II Session 3, EA 4th July, 2007 Prof. Samar K. Datta
2 Overview of items intended to be covered in this session Consumer ChoiceInterpretation of consumer equilibrium: Equi-marginal principleCorner solutionDiminishing MU & diminishing MRSIncome effect and distinction between normal and inferior goodsEngel curvePrice consumption curve and demand curveSubstitutes and complementsExamples /Food for thought2
3 Two conditions for optimal consumer choice 1) Must be located on the budget line.2) Must give the consumer the most preferred combination of goods and services (i.e., maximum satisfaction).69
4 indifference curve are Consumer ChoicePc = $2 Pf = $1 I = $80Clothing(units perweek)AAt market basket Athe budget line and theindifference curve aretangent and no higherlevel of satisfactioncan be attained.At A:MRS =Pf/Pc = .540U2Budget Line3020204080Food (units per week)78
5 Marginal utility and consumer choice When consumers maximize satisfaction:Since MRS is also equal to the ratio of the marginal utilities of consuming F and C:115
6 Marginal utility and consumer choice The equation for utility maximization can be alternatively expressed as:116
7 Marginal utility and consumer choice Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.This is referred to as the equal marginal principle.117
8 A Corner Solution A U2 U3 U1 A corner solution exists at point B. B FrozenYogurt(cupsmonthly)AU2U3U1A corner solutionexists at point B.BIce Cream (cup/month)84
9 Condition for corner solution MUX/PX > MUY/PYImplications of corner solution: brand loyalty at any price?
10 Questions on diminishing MU & diminishing MRS Does diminishing MRS necessarily imply diminishing MUs?Does diminishing MUs necessarily imply diminishing MRS?
11 Income Changes, Income Consumption Curve, and Shift in Demand Curve An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.Thus, increase in income shifts the demand curve to the right.4
12 Income Consumption Curve Clothing(units permonth)D716U3Assume: Pf = $1Pc = $2I = $10, $20, $30510BU2Income-ConsumptionCurveAn increase in income,with the prices fixed,causes consumers to altertheir choice ofmarket basket.34AU1Food (unitsper month)
13 Income Changes & Shifts in the Demand Curve PriceoffoodAn increase in income,from $10 to $20 to $30,with the prices fixed,shifts the consumer’sdemand curve to the right.16D3H10D2G4D1E$1.00Food (unitsper month)
14 Normal vs. Inferior Good Normal Good - The income-consumption curve has a positive slope:The quantity demanded increases with income.The income elasticity of demand is positive.Inferior Good - The income-consumption curve has a negative slope:The quantity demanded decreases with income.The income elasticity of demand is negative.4
15 An Inferior Good 15 30 Steak (units per month) 10 5 20 Hamburger CSteak(units permonth)Income-ConsumptionCurve…but hamburgerbecomes an inferiorgood when the incomeconsumption curvebends backwardbetween B and C.10520AU1BU2Both hamburgerand steak behaveas a normal good,between A and B...Hamburger(units per month)
16 Individual Demand Engel Curves Engel curves relate the quantity of good consumed to income.If the good is a normal good, the Engel curve is upward sloping.If the good is an inferior good, the Engel curve is downward sloping.4
17 Engel Curves 30 Inferior Normal 20 10 4 8 12 16 Income ($ per month) Engel curve isbackward bendingfor inferior goods.InferiorNormal2010Food (unitsper month)481216
18 Price Consumption Curve Clothing(units permonth)The price-consumptioncurve traces out theutility maximizingmarket basket for thevarious prices for food.6APrice-Consumption CurveU15DB4U3U2Food (unitsper month)412204
19 Individual Demand Curve Priceof FoodDemand CurveIndividual Demand relatesthe quantity of a good thata consumer will buy to theprice of that good.HEG$2.0041220$1.00$.50Food (unitsper month)4
20 Derivation of Demand Curve from Price Consumption Curve Clothing (units per month)Price of food
21 Substitutes and Complements Two goods are considered substitutes if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other.e.g. movie tickets and video rentalsTwo goods are considered complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other.e.g. petrol and motor oilTwo goods are independent when a change in the price of one good has no effect on the quantity demanded of the other.4
22 Substitutes and Complements If the price consumption curve is downward-sloping, the two goods are considered substitutes.If the price consumption curve is upward-sloping, the two goods are considered complements.4
23 Example: College Trust Fund OtherConsumption($)The trust fund shifts the budget lineAU1A: Consumption before the trust fundU2BB: Requirement that the trust fundmust be spent on educationCU3C: If the trust could be spent onother goods – i.e., unconstrainedPQEducation ($)92
24 Example: Gasoline Rationing Spendingon othergoods ($)5,000U1C15,0002,000DWith a limit of2,000 gallons,the consumer movesto a lowerindifference curve(lower level of utility).18,000U2B20,000A20,000Will the consumerbe necessarily worseoff at D?Gasoline(gallons per year)123
25 Food for thoughtHow would you display effect of income tax (proportional or progressive) with or without certain exemptions (e.g., on medical insurance)?How will commodity taxation change consumer equilibrium?How will income taxation influence labor supply?How will consumer indifference curves look like if one good is a bad, or both goods are bad?Is it possible to display exchange between two people having fixed endowments of two goods and no income, when there are no formal markets or prices to facilitate exchange?
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