The Theory of Demand Lecture 7: The Theory of Demand Readings: Chapter 9

he Theory of Demand Lecture 4: The Theory of Demand

Where does demand come from?  Scarcity encourages rational decision-making over household consumption choices.  Rational choice leads to purchase decisions which leads to the social phenomenon of demand.  We therefore build our theory of demand on a theory of rational individual choice. (Methodological Individualism)

What factors influence choice?  An individual’s choices are influenced by:  what they can afford,  their preferences.

How are consumption decisions made?  Search the person’s affordable set to find the consumption choice that provides the highest level of satisfaction given her preferences.  Problem:  Problem: How does a rational individual search the family’s affordable set to find the best choice?  Solution:  Solution: We need a simple model of preferences to explore this decision problem.

A simple model of choice  Choice can be modeled as the result of an interaction between:  1. Affordable Set (or consumption possibilities)  Family income (M) and prices (P) of goods and services given defines a family’s affordable set  The budget line is the boundary between affordable and unaffordable consumption choices  2. Preferences — Indifference Map

A simple application of the model:  As before we will simplify the model by having only two commodities – pop and movies.  The budget line simplifies dramatically  Example: Suppose that income is $30, the price of a movie is $6, and the price of a pop is $3.

Affordable Set Unaffordable Income Movies Pop $30 $6 $3 The Affordable Set Textbook p Pop Movies a b c d e f Budget line Copyright © 1997 Addison-Wesley Publishers Ltd.

Affordable Set and the Budget Line Textbook p Pop Movies a b c d e f Copyright © 1997 Addison-Wesley Publishers Ltd.

Affordable Set  Intercepts measure real income in  movies (x-intercept)  pop (y-intercept)  P m  steeper budget line, fixed pop-intercept  P p  flatter budget line, fixed movie-intercept  M  rightward parallel shift budget line

Preferences and Indifference Curves  Indifference curves  join combinations goods giving equal satisfaction  generally slope downward and bow towards origin  farther from origin  levels of satisfaction  never intersect

A Preference Map Textbook p.173 Movies Pop l0l0 l1l1 g c I2I2 j Copyright © 1997 Addison-Wesley Publishers Ltd.

Preferences and Indifference Curves  Marginal Rate of Substitution (MRS)  magnitude of slope of indifference curve  diminishing marginal rate of substitution — MRS  as move down along indifference curve  substitutability between goods  straighter indifference curves  substitutability between goods  more tightly curved indifference curves

The Marginal Rate of Substitution Textbook p. 174 Movies Pop l1l1 c MRS = 2 g MRS =1 2 Copyright © 1997 Addison-Wesley Publishers Ltd.

The Household's Consumption Choice  At the best affordable point:  each household spends all its income and achieves maximum satisfaction.  each household’s budget line and indifference curve have same slope  MRS = relative price  Despite the fact that every household chooses a different consumption bundle, every household will have the same MRS as every other household because they face the same prices.

c Best affordable point The Best Affordable Point Textbook p. 176 Movies Pop l1l1 5 l2l2 l0l0 i h Copyright © 1997 Addison-Wesley Publishers Ltd.

Predicting Consumer Behaviour  Price effect =  consumption resulting from  price of good  To analyze the price effect, consider our example in which a person with $30 must decide how much of his money to spend on movies and pop.  Suppose the price of movies falls from $6 to $3, while the price of pop stayed constant at $3.  This will alter the affordable set (budget line). continued

Predicting Consumer Behaviour  To see how it affects the budget line consider the following two cases.  If all the $30 is spent on movies, a reduction in the price of movies from $6 to $3 makes it possible to consume as many as 10 movies.  If however, the individual spends all $30 on pop, the reduction of the price of movies would not change his consumption.  Clearly the budget line hinges out.

Price Effect Textbook p. 178 Movies 0 10 Pop 10 l2l2 l1l1 2 6 c Movies $6 5 5 j Movies $3 Copyright © 1997 Addison-Wesley Publishers Ltd.

2 6 a 2 6 c 5 3 b 5 5 j Price Effect and Demand Curve Textbook p P 10 Movies 0 10 Pop 10 l2l2 l1l1 Movies Copyright © 1997 Addison-Wesley Publishers Ltd.

Individual and Market Demand  The last table shows how individual demand is related to individual choice given preferences and an affordable set.  Q: Where does market demand come from?  A: Market Demand  Market demand curve is simply the sum of individual demand.  Graphically this is the horizontal sum of individual demand curves

Individual and Market Demand Curves: Lisa’s Demand Q P 3 Textbook p. 158 Copyright © 1997 Addison-Wesley Publishers Ltd. Lisa’s demand

Individual and Market Demand Curves: Chuck’s Demand P 3 Textbook p. 158 Q Copyright © 1997 Addison-Wesley Publishers Ltd. Chuck’s demand

Individual and Market Demand Curves: Market Demand Q P 3 Textbook p. 158 Copyright © 1997 Addison-Wesley Publishers Ltd. Market demand

Individual and Market Demand Curves 0 P 3 5 Q 0 P 3 Q Lisa’s demandMarket demand Textbook p. 158 (a) 0 P Q Chuck’s demand (b)(c) Copyright © 1997 Addison-Wesley Publishers Ltd.

Predicting Consumer Behaviour  Q: What determines the elasticity of demand?  A: The size of the price effect.  Q: What determines the size of the price effect?  A: Price effect = substitution effect + income effect continued

Predicting Consumer Behaviour  Substitution effect —  price   consumption  Income effect —  for normal goods, (hypothetical)  income   consumption  for inferior goods, (hypothetical)  income   consumption

Income Effect Textbook p. 179 Movies 0 Pop l2l2 l1l j Income $ k 3 Income $21 Copyright © 1997 Addison-Wesley Publishers Ltd.

Income Effect and Change in Demand Textbook p l2l2 l1l1 © 1997 Addison-Wesley Publishers Ltd j 5 b D0D k 3 4 c D1D1 P Movies Pop Movies

Price Effect Textbook p. 180 Movies 0 Pop 4 l2l2 l1l c Income$30 Movies$ j Income$30 Movies$3 7 7 Copyright © 1997 Addison-Wesley Publishers Ltd.

Substitution Effect Textbook p. 180 Movies 0 Pop 10 5 l2l2 l1l c Income$30 Movies$6 4 3 k 7 Income$21 Movies$3 7 Copyright © 1997 Addison-Wesley Publishers Ltd.

Income Effect Textbook p. 180 Movies 0 Pop l2l2 l1l1 4 3 Income$21 Movies$3 7 7 k j Income$30 Movies$3 Copyright © 1997 Addison-Wesley Publishers Ltd.

j Income$30, Movies $3 Price Effect = Substitution Effect + Income Effect Textbook p. 180 Movies 0 Pop 10 l2l2 l1l c Income$30, Movies $6 4 3 k 7 7 Copyright © 1997 Addison-Wesley Publishers Ltd. 5

Predicting Consumer Behaviour  For normal goods  substitution and income effects work in same direction  Example:   P movies  both consumption and income effect push Q movies   Implication: Normal goods tend to be price elastic in demand.

Predicting Consumer Behaviour  For inferior goods  substitution and income effects work in opposite directions  Example:   P bus  substitution effect causes Q bus  but income effect causes Q bus   Implication: Inferior goods tend to be price inelastic in demand.

Value and Demand Theory  Demand Theory can do more than explain demand. It sheds light on questions about value.  Q: What do market values have to do with human values? Many believe that market values are often at odds with human values?  A: Economists used to believe there was no connection between the exchange value (market price) and the use value (intrinsic value) of commodities.

Value and Demand Theory  The reason for this belief in a disconnection between market value and use value is found in The Water Diamond Paradox:  Water has enormous use value but has a low price, while a diamond has little use value yet has a high price.  This seems to suggest that there is no connection between market price and use value.

Value and Demand Theory  Q: Is there no connection between market value (price) and use value?  A: No! There is an important connection.  Water is plentiful. Even though the total utility from water is high, the marginal utility is low. Diamonds are scarce and while the total utility is low, the marginal utility is high.  Marginal analysis shows us the link between market price and use value.

Value and Demand Theory  Q: What is the benefit from participating in markets if you are a buyer?  People will only participate if the price is lower than the value they place on the good.  This creates a consumer surplus that the buyer realizes from her purchase.

Market price Maximum prices willing to pay for 1, 2, 3, and 4 movies Consumer surplus Consumer Surplus: Individual Textbook p P Q D Copyright © 1997 Addison-Wesley Publishers Ltd.

Market price Consumer surplus Consumer Surplus: Market Textbook p P Q D Copyright © 1997 Addison-Wesley Publishers Ltd.

 The model of consumer choice can be used to study the allocation of time between work and leisure.  The two “goods” are leisure and income—where income represents all other goods.  Lisa buys leisure by not supplying labour and by forgoing income.  So the “price” of leisure is the wage rate forgone. Work-Leisure Choices

 The labour Supply Curve  By changing the wage rate, we can find a person’s labour supply curve.  An increase in the wage rate makes leisure relatively more expensive (higher opportunity cost to not working) and  has a substitution effect towards less leisure (towards more work). Work-Leisure Choices

 A higher wage also has a positive income effect on leisure.  If the income effect is weaker than the substitution effect, the quantity of work hours increases as the wage rate rises.  When the wage rate rises from $5 to $10 an hour, work increases from 20 to 35 hours a week—the move from A to B.

 But if the income effect is stronger than the substitution effect, the quantity of work hours decreases as the wage rate rises.  When the wage rate rises from $10 to $15 an hour, work decreases from 35 to 30 hours a week —the move from B to C. Work-Leisure Choices

The move from A to B when the wage rate increases from $5 to $10 an hour means that the labour supply curve slopes upward over this range. Work-Leisure Choices

The move from B to C when the wage rate increases from $10 to $15 an hour means that the labour supply curve bends backwards above a certain wage rate. Work-Leisure Choices

 Historical evidence shows that the average workweek has fallen steadily as the wage rate has increased.  With higher wage rates, people have decided to use their higher incomes in part to “buy” more leisure. Work-Leisure Choices

End of Lecture 7