Econ 201 Lecture 4.1 Consumer Demand

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-2 Budget Line We represent the consumption opportunities available to the consumer with a budget line.  Shows the combinations of goods and services consumers are able to consume, given income and prices

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-3 Figure 7.1 The Budget Line

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-4 Budget Line Characteristics Each point on the budget line represents consumption bundles of goods that can be purchased at current prices with a given amount of income. The budget line is a straight line with a negative slope:  Slope of the budget line =  Represents the trade-offs between the goods

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-5 Budget Line Characteristics (cont’d) The intercepts of the budget line represent the maximum amounts of the goods that the consumer can buy.  Found by dividing income by the price of each good Consumption bundles outside the budget line cannot be purchased with the given income.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-6 Figure 7.2(a) The Effect of Changes in Income and Price on the Budget Line

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-7 Figure 7.2(b) The Effect of Changes in Income and Price on the Budget Line

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-8 Assumptions about Consumer Behavior Consumers maximize their well-being, not their income.  Doesn’t rule out altruism  Economists use the term utility to refer to the benefits consumers receive from consuming goods and services.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 7-9 Assumptions about Consumer Behavior (cont’d) Consumers are rational.  They behave in a consistent manner. Consumers have perfect foresight about the satisfaction they will receive from a good or service.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Marginal Utility Consumers make decisions based on the additional benefit from consuming one more unit of a good or service.  Marginal Utility (MU)—the change in total utility that results from a one unit change in consumption.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Maximizing Utility Consumers’ objective is to maximize their utility, given the fact that their income is limited. Consumers do this by comparing the marginal utility of one good to the amount of another good they must give up to get it.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Marginal Utility per Dollar The first step in analyzing consumer behavior is to calculate the marginal utility a consumer receives from each dollar spent on a good or service.  For example:

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Utility Maximization Consumers maximize their utility by allocating their income to the good that yields the highest MU per dollar.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Utility Maximization (cont’d) For example, suppose a consumer purchased two goods, CDs and Pizza:  If MU cd / P cd > MU pizza / P pizza then the consumer should buy more CDs.  If MU pizza / P pizza > MU cd / P cd then the consumer should buy more pizzas.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The Equimarginal Principle Thus, utility is maximized when the marginal utility per dollar is equal across all goods.  The consumer is in equilibrium.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Utility Maximization and Individual Demand Downward-sloping individual demand curves result from consumers maximizing their utility subject to their budget constraint.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Income and Substitution Effects A change in the price of a good leads to two effects:  The substitution effect—consumers will purchase more a good that has become relatively cheaper.  The income effect—a change in the price of a good changes a consumer’s purchasing power.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Income and Substitution Effects (cont’d) For normal goods, the income effect reinforces the substitution effect. For inferior goods, the income effect partially offsets the substitution effect.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Summary All consumers make decisions by allocating their limited income over the goods and services they would like to consume. Consumers maximize utility, are rational, and have perfect foresight.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Summary (cont’d) Consumers will allocate their income such that marginal utility per dollar spent is equal across goods. Other things remaining constant, consumers will alter their purchases of a good when the price of that good changes.  Individual demand is the result of utility maximization.