Chapter 4

Demand and Behavior

in Markets

The Problem of Consumer Choice Maximize utility

Indifference curve tangent to budget line MRS = price ratio

On budget line

Quantity demanded of a good People seek to purchase at a given price

•2

Optimal consumption bundle

•3

B

B’F

Goo

d 2

(x 2

)

20

Good 1 (x 1)0 20

I1

I2

I3e

x1 + x2 = 20

Demand is homogenous If income and all prices double, the

quantity demanded of all goods remains the same

Reason: same budget constraint

•4

Changes in Income When income only increases,

Normal good: demand for goods increases Inferior good: demand decreases, e.g.

used clothes, bus tickets,.. Show graphically

Superior and inferior goods

•6

Good 1 (x 1)0

Goo

d 2

(x

2)

(a)

Good 1 (x 1)0G

ood

2 (x

2)

(b)

Homothetic Preferences Homothetic preferences

Indifference curves Do not “rotate” as consumer’s income

increases Along any ray from the origin

MRS – constant Increase in income

Proportional increase in goods purchased All goods are superior No change in tastes

•7

•8

D

D’

Good 1 (x 1)0 604020

Good 2 (x

2)

60

40

20

C

C’

B

B’

Income expansion path

r

s

e

Price-Consumption Paths Price-consumption path / curve

Consumption changes One price changes All other prices – constant Consumer’s income – constant

•9

Effects of Price changes on budget Changing relative prices

Optimal bundle Indifference curve tangent to budget line MRS = Price ratio

Good 1 – relatively less expensive Rotation of budget line – flatter

Good 1 – relatively more expensive Rotation of budget line – steeper

•10

•11

As the price of good 1 varies, the slope of the budget line changes leading to different levels of consumption

B*

Good 1 (x 1)0

Good 2 (x

2)

B

B’B”

ef

g

ba c

Demand Curves Demand curve

Relationship between Quantity demanded Price As the price varies Other things constant

Image of the price-consumption path Generated: utility-maximizing behavior

•12

Demand curve for good1

•13

The demand curve for good 1 associates the optimal quantity of good 1 with its price, while holding income and other prices constant.

Good 1 (x 1)0

Price

ba c

p1=2

p1=1

p1=1/2

Demand and Utility Functions Nonconvex preferences

Optimal consumption bundle At the corner of the feasible set

Maximize utility Spend all income on only one good

Demand curve If price > p*, quantity = 0 If price = p*, quantity > 0 As price decreases, quantity increases

•14

Non convex preferences and demand

•15

Non-convex preferences imply optimal consumption bundles at the corners of the feasible set—either point h or point k.

Good 1 (x 1)0

Goo

d 2

(x

2)

(a)

Demand curve.

Non-convex preferences imply jumps in the demand curve.

Good 1 (x 1)0

Price (b)

B

k

p*

p1*

g*

h

e

X1=m/p1

Decomposing the Effects of a Price Change Substitution Effect: change in

consumption caused by a change in relative prices

Income Effect: change in consumption as a result of a change in the budget set

•16

Substitution Effect Change in demand due to substitution

One good (decreasing price) For another good (constant price)

The substitution effect from the decline in price always increases demand

•17

Income Effect Income effect

Decrease in price is equivalent to an increase in real income

The income effect from the decline in price will cause demand to Increase if the good is normal Decrease if the good is inferior

•18

•19

The income effect of the price change is measured by the parallel shift of the budget line from DD’ to BB”. The substitution effect is measured by movement around the indifference curve from e to g.

Good 1 (x 1)0

Good 2 (x

2)

(a)

Downward-sloping demand curve

Good 1 (x 1)0

Price (b)

B’

B

B”

I1

e

D’

D

g I2

f

p”p’

Substitution effect Income effect fe

p”

p’

Inferior Goods: Income and substitution effects work on opposite directions

•20

The substitution effect of a decline in the price of good 1 causes an increase in demand for the good, the move from e to g. Because good 1 is an inferior good, this is partly offset by the income effect, a decrease in demand for the good from g to f .

Good 1 (x 1)0

Good 2 (x

2)

B’

B

B”

I1

e

D’

D

g

I2

f

Substitution

effect Income effect

How does the demand curve for good 1 look

like?

Giffen Goods and Upward-SlopingDemand Curves

Giffen good Upper sloping demand curve Inferior good A price decrease

Substitution effect Increase demand

Income effect Decrease demand

Dominant effect: income effect

•21

Giffen good

•22

The decline in the price of good 1 causes a decline in the demand for that good because the substitution effect (the move from e to g) is more than offset by the income effect (the move from g to f ).

Good 1 (x 1)0

Good 2 (x

2)

B’

B

B”

I1

e

D’

D

g

I2

f

Substitution

effect

Income effect

Identifying normal and Giffen goods

•23

Type of good

Substitution effect Income effect

Normal downward sloping D

Opposite to price change

The good is either superior or inferior but with an income effect that is less powerful than the substitution effect.

Giffen Upward sloping D

Opposite to price change

The good is inferior. The income effect is more powerful than the substitution effect.

Good 1 (x 1)0

Goo

d 2

(x

2)

ef

g

158 18

20

20 4010