Consumer Equilibrium and Market Demand Chapter 4

Discussion Topics What are the conditions that describe your initial purchase decision? What makes you change your purchase decision? A representation of the law of demand What is meant by tastes and preferences Use of consumer surplus for benefit calculation 2

Measurement and Interpretation of Consumer Equilibrium (Purchase Decision) 3

Consumer Equilibrium Remember that utility represents the level of satisfaction obtained from alternative bundles (or collection) of goods Assume the consumer wants to maximize utility given his/her limited budget  We also assume that utility only impacted by the consumption of market goods (i.e. price exists) How can we represent this problem graphically and mathematically? Page 54

Increasing Utility Page 54 Consumer Equilibrium Good 1 Good 2 U4U4 U2U2 U3U3 U1U1 U 1 < U 2 < U 3 < U 4 Budget Constraint ($C*) A G1*G1* G2*G2* Point A is consumer equilibrium  → Slope of Indifference Curve = Slope of Budget Line  →MRS 12 = – P 1 /P 2  → At A, MU 1 /MU 2 = P 1 /P 2  → At A, on the boundary of the budget set and on highest indifference curve Previously: Slope of Indifference Curve =MRS Slope of budget line = price ratio 5

Page 54 Consumer Equilibrium Good 1 Good 2 U4U4 U2U2 U3U3 U1U1 A G1*G1* G2*G2* Point A can be interpreted as the combination of goods that generates  The maximum utility (U 3 )  While being limited by a fixed budget ($C*) Increasing Utility 6

Page 54 Consumer Equilibrium Good 1 Good 2 U3U3 A G1*G1* G2*G2* Point A can also be interpreted as the combination of goods that generates  The minimum cost ($C*)  While generating a desired level of utility (U 3 ) Why are these parallel shifts of the budget constraint? C1*C1* C2*C2* C3*C3* C 1 *< C 2 *< C 3 * 7

Consumer Equilibrium We can rearrange the above equilibrium conditions:  → the marginal utility derived from last dollar spent on each good, MU i /P i, is identical  This can be expanded to include all goods and services purchased by the consumer Lets extend this to the textbook example of tacos vs. hamburger consumption Page 54 8

Consumer Equilibrium Utility is maximized by buying  5 $0.50  2 $1.25  Total expenditures equals the weekly budget of $5.00 Utility is maximized by buying  5 $0.50  2 $1.25  Total expenditures equals the weekly budget of $ $5 initial budget

Page 54 Consumer Equilibrium Points B and D exceed the $5 budget  How can you tell? Points B and D exceed the $5 budget  How can you tell? 10

Page 54 Consumer Equilibrium Point C does not maximize utility  How can you tell? 11

Consumer Equilibrium What happens to the above consumer equilibrium when the price of one of the products changes?  Will consumption of both goods change even though only 1 price impacted? Lets assume the price of Hamburgers (P H ) changes  $5.00  $1.25 (Current Price)  $1.00 Page 54 12

Effect of Price Changes Page D Hamburger Consumption per Week Taco Consumption per Week Under original budget line ED: Price of Hamburgers (P H ) = $1.25 Price of Tacos (P T ) = $0.50 Income = $5.00 Equilibrium:  5 Tacos  2 Hamburgers 13 A E

Effect of Price Changes Page D Hamburger Consumption per Week Taco Consumption per Week Budget Line when P H decreases from $1.25, EF: Price of Hamburgers (P H ) = $1.00 Price of Tacos (P T ) = $0.50 Income = $5.00 Equilibrium moves from A to B:  4 Tacos  3 Hamburgers F B A 5 E

Effect of Price Changes Page D E Hamburger Consumption per Week Taco Consumption per Week F B 15 A Budget Line when P H increases to $5.00, EG: Price of Hamburgers (P H ) = $5.00 Price of Tacos (P T ) = $0.50 Income = $5.00 Equilibrium moves from A to C:  5 Tacos  0.5 Hamburger C G

Effect of Price Changes Page D E Hamburger Consumption per Week Taco Consumption per Week F B 16 A C Line CAB represents a consumer demand schedule for hamburgers  Shows how the consumer responds to changes in a good’s price  ↑ in price, ↓ in quantity demanded  Other prices and total expenditures do not change Only hamburger price changing

Lets collect the equilibrium points for the three hamburger price scenarios We can then graph the quantity purchased at each price level  Vertical axis is price  Horizontal axis is quantity  Graph referred to as the demand curve for hamburgers Page 54 Equilibrium Point P H ($/lb) Q H (No.) C$ A$ B$ Effect of Price Changes

Consumer Equilibrium This graph shows the demand curve for hamburgers Page 54 P H ($/Burger) ̶ ̶ ̶ Q H (No. of Burgers) ̶ ̶ ̶ C A B $5.00 $1.25 $1.00 What is the relationship between price and quantity demanded? What is the relationship between price and quantity demanded? 18 Pts. C, A and B correspond to same points on Slide 16 Pts. C, A and B correspond to same points on Slide 16

Effect of an Income Change Page J K Hamburger Consumption per Week Taco Consumption per Week Original Budget Line, KJ: Price of Hamburgers (P H ) = $1.25 Price of Tacos (P T ) = $0.50 Income = $ A Original Equilibrium: 5 tacos/2 hamburgers

Effect of an Income Change Page J K Hamburger Consumption per Week Taco Consumption per Week Budget Line KJ: Income = $5.00 Budget Line GF: Income = $ A B G F Original Equilibrium New Equilibrium Both hamburgers and tacos are normal goods as budget increased from $5 to $6/week  Normal goods are goods whose demand increases with higher budget (income) and decreases with lower budget (income)

Effect of an Income Change Page J K Taco Consumption per Week Budget Line KJ: Income = $5.00 Budget Line GF: Income = $6.00 Budget Line ED: Income = $ A B G F Tacos become an inferior good when budget (income) increased to $8/week  Inferior goods are goods whose demand ↓ with ↑ in the budget and ↑ with ↓ in the budget C E D

Effect of an Income Change Page J K Taco Consumption per Week 22 A B G F C D We can plot demand levels under alternative budgets (income)  Referred to as an Engel Curve

Hamburger Engel Curve Tacos Engel Curve Page 58 Typical shape of a normal good’s Engel curve over all income levels Example of an Engel curve for a good that is an inferior good at higher income (budget) levels 23 Effect of an Income Change

Measurement and Interpretation of Market Demand 24

Concept of Market Demand The above model of consumer behavior focused on a single individual We can extend the above model to one where we refer to overall or total market demand for a city, county, state, country, etc. 25

The market demand curve for a good is the horizontal summation of demand schedules for all the consumers in the particular market In the above example with P H = $1.50  Paula purchases 2 hamburgers/week while  Beth purchases 1 hamburger  → market demand = 3 a price $1.50/hamburger Page 59 Concept of Market Demand Notice the $2 26

Demand Curve Description When discussing events in the market place economists use specific terms to distinguish between movement along a demand curve vs. a shift in a demand curve Movement along a demand curve referred to as a change in quantity demanded Only 1 demand curve, just a different point on it Alternatively a shift in the demand curve referred to as a change in demand Need not be a parallel shift in the demand curve 27

Movement from point A to C is referred to as a change in demand Page 61 Movement from point A to B is called a change in quantity demanded 28

Demand Curve Description Reasons for a change in a demand curve  Change in household income  Change in population characteristics  Number of children  Change in marital status  Household composition  Price of substitutes  Change in anything other then own- price 29

Concept of Consumer Surplus A characteristic of market demand curve  Concept of consumer surplus (CS) or economic well-being  CS is derived from consumption and the fact we have a negatively sloped demand curve (with respect to its own-price) A demand curve reveals the willingness of consumers to pay a certain price for a particular quantity of a good Page

Concept of Consumer Surplus As we showed earlier, consumers are willing to pay a higher price for a lesser quantity  Actually do not have to pay the higher price given the level of supply coming into the market  → Consumers realize a savings Page $/unit Q A Q1Q1 Q2Q2 P1P1 B P2P2 P 2 > P 1 Q 2 < Q 1 31 Why do consumers want to pay less/unit when consuming more?

Page 63 Quantifying Consumer Surplus A C B E D 32 Area ABC is the consumer surplus when market price is $6.  Demand curve implies consumers are willing to pay $10 for the 1 st unit, $9 for the 2 nd unit, etc.  Only had to pay $6 each for all 5 units Area DACE is the gain in consumer surplus if the price falls to $5 Q $

33 Page 63 Quantifying Consumer Surplus A C B E D The level of consumer surplus with a linear demand curve is [(Height × Length)/2] = ([$11-$6]×5)/2=$12.50 The level of consumer surplus with a linear demand curve is [(Height × Length)/2] = ([$11-$6]×5)/2=$12.50 Q $ Height Again, why do we have a consumer surplus? Again, why do we have a consumer surplus?

In Summary Consumer equilibrium for an individual for a given price and budget Individual consumer’s demand schedule Market demand curve Engel curves Change in demand vs. change in quantity demanded Consumer surplus

Chapter 5 examines the concept of an elasticity, one of the most important concepts in all of economics….