4
Consumer Behavior Introduction 4
Chapter Outline 4.1 The Consumer’s Preferences and the Concept of Utility 4.2 Indifference Curves 4.3 The Consumer’s Income and the Budget Constraint 4.4 Combining Utility, Income, and Prices: What Will the Consumer Consume? 4.5 Conclusion Introduction 4
How do consumers make purchases? • This chapter introduces a theory of consumer behavior • The theory is used to investigate why consumers make purchases • Ultimately, consumers are assumed to “optimize” their utility given scarce resources • Consumer theory is the basis for the “demand” side of the supply and demand model The Consumer’s Preferences and the Concept of Utility 4.1
Economists assume consumers are rational and able to “optimize” consumption decisions given scarce resources
Four assumptions about consumer preferences 1. Completeness and rankability • Consumers can compare bundles of goods and rank them 2. For most goods, more is better than less • Non-satiation and “free disposal” 3. Transitivity • Imposes consistency on rankings 4. The more a consumer has of a particular good, the less she is willing to give up of something else to get even more of that good • Referred to as “diminishing marginal utility” The Consumer’s Preferences and the Concept of Utility 4.1
The Concept of Utility Utility is a measure of how “satisfied” consumers are • A measure of happiness or satisfaction • Provides a theoretical basis for decision theory
A utility function describes the relationship between what consumers actually consume and their level of well-being • Can take a variety of mathematical forms • Common assumptions: continuous, differentiable, concave The Consumer’s Preferences and the Concept of Utility 4.1
The Concept of Utility Consider the utility someone enjoys from seeing a movie in a theater vs. watching a DVD U =U (T, D)
where T is the number of movies “consumed” at the theater, and D is the number of DVDs consumed at home. Utility might be represented by U = T 0.8D0.2
In general, movies consumed in the theater add more utility than those consumed at home * this particular functional form is referred to as “Cobb–Douglas” The Consumer’s Preferences and the Concept of Utility 4.1
The Concept of Utility Marginal utility is the additional utility a consumer receives from an additional unit of a good or service. The Consumer’s Preferences and the Concept of Utility 4.1
The Concept of Utility Continuing the previous example, the marginal utility of theater-movies for this consumer is given by DU (T, D) dU (T, D) MU = = T DT dT or, with the prescribed parameters
-0.2 0.2 MUT = 0.8T D The Consumer’s Preferences and the Concept of Utility 4.1
Comparing Consumption Outcomes The “rules” for utility allows only for an ordinal ranking of consumption bundles • An ordinal ranking implies bundles can be ranked from best to worse • A cardinal ranking would allow a person to determine how much better one bundle is, compared to another
Why not cardinal? • Many questions can be answered with only an ordinal ranking – Ex: Predicting what will be consumed • Consumers differ in preferences ‒ Ex: Both between consumers and over time Indifference Curves 4.2
Ordinal rankings mean we care about relative outcomes • Some bundles are better than others, some are worse • Start by considering bundles that are relatively equal
A consumer is indifferent between bundles when he or she derives the same utility level from two or more bundles.
An indifference curve plots out all of the consumption bundles that provide a consumer with the same level of utility or satisfaction. Indifference Curves 4.2
Figure 4.1 Building an Indifference Curve
Number of friends living in building A 10
B 5 C 3 Indifference curve (U)
0 500 750 1,000 Apartment size (square feet) Indifference Curves 4.2
Characteristics of Indifference Curves 1. They can be drawn • Completeness and rankability 2. Curves further from the origin represent higher utility • More is better 3. Curves never cross • Transitivity 4. Convex to the origin • Diminishing marginal utility Indifference Curves 4.2
Figure 4.2 A Consumer’s Indifference Curves
Number of friends U2 has a living in greater utility building
than U 5 1
U2
U1
0 500 1,000 Apartment size (square feet) Indifference Curves 4.2
Indifference curves can never cross Call our movie watcher, Joe Movies at the Theater To see why indifference curves cannot cross, consider bundles D and F • These bundles are on the same indifference curve, therefore Joe must be indifferent between them F E Now, draw another indifference curve through bundle F that intersects the original curve D • Implies Joe is also indifferent between points E and F as well as between points E and D
Why must Joe prefer bundle E to bundle D? DVDs ‒ If more is better, at E he has more of both Indifference Curves 4.2
Figure 4.4 Tradeoffs Along an Indifference Curve
As apartment size gets larger, Michaela is less willing to trade off the number Number of friends for additional apartment size. of friends living in A building
5
B
U1
0 500 1,000 Apartment size (square feet) Indifference Curves 4.2
The Marginal Rate of Substitution Indifference curves describe tradeoffs • How much of one good you are willing to give up for one more unit of another good • The slope of the indifference curve captures this tradeoff We call this slope the marginal rate of substitution Y MRSXY X
Describes the rate at which one is willing to trade off or substitute exactly 1 unit of good X for more of good Y, and be equally well off. Indifference Curves 4.2
Figure 4.5 The Slope of an Indifference Curve is the Marginal Rate of Substitution
Burritos As you move down an indifference curve, you experience a diminishing marginal rate of substitution A
Slope = –2
B
Slope = –0.5 U
Lattes Indifference Curves 4.2
The Marginal Rate of Substitution and Marginal Utility Consider point A from the previous figure Y Qburritos MRSXY 2 XQlattes Sarah is willing to give up one latte (X) to gain two burritos (Y), vice versa;
What does this mean in terms of the change in Sarah’s level of utility?
U MUlattes Q lattes MU burritos Q burritos 0
The change in utility is zero... she is just as well off! Rearranging,
MUburritos Q burritos MU lattes Q lattes
Qburritos MU lattes and finally: MRSXY Qlattes MU burritos Indifference Curves 4.2
The Marginal Rate of Substitution and Marginal Utility The MRS between two goods is equal to the inverse of the goods’ marginal utilities:
Qburritos MU lattes QYX MU MRSlb or MRS XY Qlattes MU burritos QXY MU Observing the tradeoffs that consumers make provides insight as to the relative marginal utilities of goods! What does it mean if the slope of an indifference curve is steeper? Flatter? • Steeper curves imply the consumer is willing to give up a lot of Y to get one unit of X, or could trade 1 unit of X for a lot of good Y • Flatter curves imply the consumer would require a large increase in good X to give up one unit of the good Y, or could trade 1 unit of Y for a lot of good X Indifference Curves 4.2
Figure 4.6 The Steepness of Indifference Curves Indifference Curves 4.2
The Curvature of Indifference Curves: Substitutes and Complements The shape of indifference curves reveals information about the relationship between products • Relatively straight indifference curves describe goods that are more easily substitutable for one another • Indifference curves that are more convex to the origin describe goods that are more complementary to one another
To illustrate, consider extreme cases i. Perfect substitutes are goods that the consumer will trade at a fixed rate and receive the same level of utility (MRS is constant) ii. Perfect complements are goods that the consumer must consume in a fixed proportion Indifference Curves 4.2
Perfect substitutes
2-liter bottles of root beer Consider a typical consumer’s 4 preferences for 1- and 2-liter soda bottles 3 This consumer should be willing to trade one 2-liter bottle for two 1-liter bottles no 2 matter how much of each he or she has MRS is constant in this case 1
U1 U2 U3 U4 0 2 4 6 8 1-liter bottles of root beer Indifference Curves 4.2
Perfect complements
Alternatively, consider preferences for Hotdogs hotdogs and hotdog buns Most consumers will prefer to consume C these goods in constant proportion 3 U3 Consider point A ; this consumer has two A B 2 U2 hotdogs and two buns Adding another hotdog bun (bundle B ) 1 U1 will not increase utility The consumer needs another hotdog as 0 1 2 3 Hotdog buns well (bundle C ) if utility is to increase Indifference Curves 4.2
Figure 4.8 The Curvature of Indifference Curves Indifference Curves 4.2
Figure 4.11 The Same Consumer Can Have Indifference Curves with Different Shapes
Initially, for low levels of utility
(UA), bananas and strawberries might be substitutes.
As utility increases (UB), the consumer might prefer a variety of fruit in their diet more than initially. The Consumer’s Income and the Budget Constraint 4.3
The budget constraint is a curve that describes the entire set of consumption bundles a consumer can purchase when spending all of their income. It is generally plotted alongside indifference curves. • For two goods (X and Y), mathematically:
Income = PX QX + PY QY
To find the slope of the budget constraint, solve for QY
Income PX QY = Qx PY PY Returning to the burrito/latte example, and setting income to $50, the price of lattes to $5, and the price of burritos to $10 yields 1 Or, graphically, QY = 5 QX 2 The Consumer’s Income and the Budget Constraint 4.3
Figure 4.14 The Budget Constraint
Burritos I B P = 5 Slope is negative because y purchasing more lattes means less income for Burritos. 4 Infeasible
C 3
P Why does the 2 Slope = - x = −5/10= − 1/2 P Feasible y budget constraint 1 slope downward?
A I 0 2 4 6 8 = 10 Lattes Px The Consumer’s Income and the Budget Constraint 4.3
Factors that Affect the Budget Constraint’s Position The slope and position of the budget constraint are a function of two factors: income and relative prices 1. Changes in income shifts the budget constraint by changing the intercepts 2. Changes in the price of one good pivots the budget constraint by changing the slope
Consider again the budget constraint for burritos and lattes. The graphs on the next slide represent the following changes: (a) Doubling of the Price of Lattes (b) Doubling of the Price of Burritos (c) Reduction in Income by 1/2 The Consumer’s Income and the Budget Constraint 4.3
Figure 4.15 The Effects of Price or Income Changes on the Budget Constraint
(a) (b) (c)
Burritos Burritos Burritos B Old budget B Old budget B Old budget 5 constraint 5 constraint 5 constraint New budget New budget New budget 4 constraint with higher 4 constraint with higher 4 price for lattes price for burritos constraint with lower income 3 3 3 Loss of feasible B' Loss of feasible B' Loss of feasible bundles bundles 2 2 2 bundles
1 1 Feasible 1 Feasible Feasible bundles bundles bundles A' A A A' A 0 0 0 2 4 6 8 10 2 4 6 8 10 2 4 6 8 10 Lattes Lattes Lattes The Consumer’s Income and the Budget Constraint 4.3
Nonstandard Budget Constraints Quantity discounts • Sometimes, consumers may secure a discounted price if a minimum quantity of a good is purchased (e.g., buy two, get one free) • This results in a kink in the budget constraint
Ex: Income = $100; Ppizza = $10 and Pminute = $0.10 • Initially, the consumer could consume 10 pizzas or 1,000 phone minutes if spent all of their income on either product; Result is normal linear budget constraint ‒ Introduce a quantity discount of $.05 per minute for every minute used over 600 ‒ Result is a kink at 600 minute (and 4 pizzas) because every minute over 600 now only costs $0.05 compared to $0.10 originally
• Graphically, The Consumer’s Income and the Budget Constraint 4.3
Figure 4.16 Quantity Discounts and the Budget Constraint
Phone minutes
1,400
5 cents/minute Infeasible 1,000 Feasible
600 10 cents/minute
Feasible
0 4 10 Pizzas The Consumer’s Income and the Budget Constraint 4.3
Nonstandard Budget Constraints Quantity limits • Alternatively, there may be limits on how much of a good can be purchased (e.g., gasoline in the 1970s)
Ex: Income = $100; Ppizza = $10 and Pminute = $0.10 • Now, instead of a discount after 600 minutes the phone company puts a cap at 600 minutes so his phone will not work after the 600th minute ‒ Result is a kink in the opposite direction as before at 600 minutes
• Graphically, The Consumer’s Income and the Budget Constraint 4.3
Figure 4.17 Quantity Limits and the Budget Constraint Combining Utility, Income, and Prices: What Will the Consumer Consume? 4.4
The concepts of utility and indifference curves describe consumer preferences; the budget constraint describes which bundles are feasible Combining these concepts, we can begin to understand consumer choices
Solving the Consumer’s Optimization Problem Consumers face a constrained optimization problem • Maximize utility, subject to income and market prices
The optimal choice can be interpreted most easily using a graph Combining Utility, Income, and Prices: What Will the Consumer Consume? 4.4
Utility Maximization
Good Y With one budget constraint, search for indifference curve that maximizes utility
A U2
U*
U1 BC* Good X Combining Utility, Income, and Prices: What Will the Consumer Consume? 4.4
Tangency is the key to finding the optimal bundle, and occurs • where the slope of the indifference curve is equal to the slope of the budget constraint ‒ i.e. when the marginal rate of substitution is equal to the price ratio
Mathematically, Slope of indifference curve Slope of budget constraint
MUX PX MRSXY MUY PY MU P X X MUY PY Combining Utility, Income, and Prices: What Will the Consumer Consume? 4.4
What does this imply? Rewriting the tangency condition yields MU P MU MU X X X Y MUY PY PX PY The consumer finds the consumption bundle that provides the most benefit on a cost-adjusted basis • Occurs when marginal utility per dollar spent is equalized across all products
MU MU What does it imply if X Y ? PX PY
‒ Marginal Utility per dollar spent on good X is more than good Y. • Getting more utility per dollar from X so you should consume more of
good X until the MUX decreases until the ratio is equal Combining Utility, Income, and Prices: What Will the Consumer Consume? 4.4
Implications of Utility Maximization What if two consumers have different preferences? • Will they have the same MRS at their optimal bundles? Yes! Because they face the same ratio of prices! Combining Utility, Income, and Prices: What Will the Consumer Consume? 4.4
Figure 4.19 The Consumer’s Optimal Choice
Jack prefers gum over iTunes Although they have different Gum optimal consumption bundles, the MRS for both are the same UM at points J and M because they face the same prices J
UJ
Meg prefers iTunes over gum Budget constraint M
iTunes Conclusion 4.5
This chapter introduced the underlying mechanisms behind consumer choice • Preferences • Prices and income
In Chapter 5, we make the link between consumer behavior and individual and market demand 5
Individual and Market Demand Introduction 5
Chapter Outline 5.1 How Income Changes Affect an Individual’s Consumption Choices 5.2 How Price Changes Affect Consumption Choices 5.3 Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.4 The Impact of Changes in Another Good’s Price: Substitutes and Complements 5.5 Combining Individual Demand Curves to Obtain the Market Demand Curve 5.6 Conclusion Introduction 5
With the consumer choice framework in place, we now link consumer decisions with individual and market demand
These links help determine: • Why shifts in tastes affect prices • What benefits producers offer consumers • How income and wealth affect purchase patterns • What determines how consumers respond to price changes How Income Changes Affect an Individual’s Consumption Choices 5.1
The income effect is the change in optimal consumption choices associated with a change in income (or purchasing power), holding relative prices constant
Is higher income associated with higher consumption of goods? It depends!
For normal goods, higher income is associated with rising consumption • For instance, consider Vacations and Basketball Tickets, both of which are considered normal goods How Income Changes Affect an Individual’s Consumption Choices 5.1
Figure 5.1 A Consumer's Response to an Increase in Income When Both Goods Are Normal
Vacations Income rises
B Q’v A Qv
U2
U1
BC1 BC2 Baseball Tickets Qb Q’b How Income Changes Affect an Individual’s Consumption Choices 5.1
The income effect is the change in optimal consumption choices associated with a change in income (or purchasing power), holding relative prices constant
Is higher income associated with higher consumption of goods? It depends!
Alternatively, for inferior goods, higher income is associated with falling consumption • Consider boxed macaroni and cheese (an inferior good) vs. steak (a normal good) How Income Changes Affect an Individual’s Consumption Choices 5.1
Figure 5.2 Consumer's Response to an Increase in Income When One Good is Inferior
Quantity of Mac and cheese
A Qmac B Q’mac
Income U1 rises U2
BC1 BC2
Q Quantity s of steak How Income Changes Affect an Individual’s Consumption Choices 5.1
Income Elasticities and Types of Goods Chapter 2 introduced the concept of elasticity • Income elasticity describes the response of demand to changing income ‒ Specifically, the percentage change in quantity consumed associated with a percentage change in income %Q Q / Q Q I Mathematically, E D I %I I / I I Q
where I is income and Q is the quantity of a good demanded Q The income effect is given by I How Income Changes Affect an Individual’s Consumption Choices 5.1
Income Elasticities and Types of Goods Thus, the sign of the income elasticity is the same as the income effect
D Q If E 0 0, the good in question is a normal good I I
D Q If E 0 0 , the good in question is an inferior good I I How Income Changes Affect an Individual’s Consumption Choices 5.1
There are two additional sub-types of goods that are common, both of these are classified as normal goods because as income increases, the quantity demanded for them increases as well and vice versa
• Necessity goods: normal goods for which income elasticity is between 0 and 1 ‒ Examples: water consumption, electricity, clothing, etc…
• Luxury goods: normal goods for which income elasticity is greater than 1 ‒ Examples: vacation homes, jewelry, expensive steaks, etc… How Income Changes Affect an Individual’s Consumption Choices 5.1
Tracing the optimal bundle of goods chosen as income increases results in the income expansion path • Helps determine whether a good is normal or inferior, but only two goods can be represented • Can’t directly observe income levels on the curve because both axes represent quantities of goods
A more common way to describe the consumption-income relationship is with an Engel curve • Shows the relationship between quantity consumed of one good and consumer income How Income Changes Affect an Individual’s Consumption Choices 5.1
Figure 5.3 The Income Expansion Path How Income Changes Affect an Individual’s Consumption Choices 5.1
Figure 5.4 An Engel Curve Shows How Consumption Varies with Income Income Income At point D Bottled water / week / week rides become is normal at all Engel $35 Engel inferior $35 income levels curve curve E E 30 30 D 25 D 25 C 20 C 20 B 15 15 B A 10 A 10 5 5
0 1 2 3 4 5 6 7 8 Bus 0 1 2 3 4 5 6 7 8 9 Bottled rides water How Price Changes Affect Consumption Choices 5.2
Just as income affects consumer choices, changes in relative prices— holding income constant—also affects these choices
Deriving a Demand Curve • Demand curves define a relationship between quantity demanded and price • To derive a demand curve, we must understand how a consumer responds to a change in price • By changing one price on an indifference curve—budget constraint map, we can observe changes to consumer choices and then build the demand curve for an individual using these observed changes • The observed price represents the maximum willingness to pay for the last unit consumed How Price Changes Affect Consumption Choices 5.2
Figure 5.7 Building an Individual's Demand Curve
Mountain Dew P = 4 (2 liter bottles) G PG = 1 Income = $20 P = 2 P = $1 10 G G PMD = $2
4 3 2 U U1 3 U2 0 3 5 8 10 14 20 Quantity of grape juice (1 liter bottles)
Price of grape juice ($/bottle)
Carolyn’s $4 demand for 2 grape juice 1 0 3 8 14 Quantity of grape juice (1 liter bottles) How Price Changes Affect Consumption Choices 5.2
Shifts in the Demand Curve When consumer preferences, income, or the prices of other goods change, the demand curve will shift
Consider the example of Mountain Dew and grape juice from the previous figure • Imagine the consumer (Caroline) prefers the taste of Mountain Dew, but had previously limited consumption due to worries about high fructose corn syrup • After hearing advertisements from the Corn Refiners Association claiming corn syrup is identical to cane sugar, her fears are reduced
What might happen to the demand for grape juice? ‒ In order to consume more Mountain Dew, she might reduce her consumption of grape juice How Price Changes Affect Consumption Choices 5.2
Figure 5.8 Preference Changes and Shifts in the Demand Curve Quantity of Mountain Dew (a) Caroline’s indifference curves for PG = 4 P = 1 (2 liter bottles) G grape juice flatten when her P = 2 10 G preference for grape juice decreases relative to her preference for 6 Mountain Dew. At each price level, 5.5 4 she now consumes fewer bottles of
U1 grape juice. PG = 4 U3 PG =U 2 PG = 1
0 2 6 9 20 Quantity of grape juice (1 liter bottles)
Price of grape juice (b) Because she purchases fewer ($/bottle) bottles of grape juice at each price point, Caroline’s demand curve for
grape juice shifts inward from D1 to $4 D 2 D2. 2 1 D1 0 2 6 9 Quantity of grape juice (1 liter bottles) Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
When the price of a good changes relative to another, two things happen 1. One good becomes relatively more expensive, and the other relatively less 2. The total purchasing power of a consumer’s income changes
The substitution effect refers to the change in consumption choices resulting from a change in relative prices • Always negative; when the price of one good relative to another increases, consumption of the former falls, and vice versa The income effect refers to the change in consumption choices resulting from a change in purchasing power • This is the same income effect from Section 5.1 • Can be negative or positive (inferior or normal goods) Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Figure 5.9 The Effects of a Fall in the Price of Basketball Tickets Concert Tickets
B Total 6 A effect 5 U2
U1 BC1 BC2
0 3 5 Basketball tickets
Total effect Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
The total effect of a change in a price is the sum of the substitution and income effects • The total effect is simply the observed change in consumption of a good after a price change
Total Effect = Substitution Effect + Income Effect Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Total Effect = Substitution Effect + Income Effect
Isolating the Substitution Effect • Determine the bundle of goods that would have been chosen at the new price while maintaining utility experienced before the price change • Graphically: on the next slide ‒ To do this for a fall in the price of basketball tickets, shift the new
budget constraint (BC2) inward until it is tangent with the old indifference curve (BC′) ‒ Movement along the original indifference curve (A to A′) Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Figure 5.10 Substitution Effects and Income Effects for Two Normal Goods (a) (c)(b) Concert Tickets
Total effect (+ 1 concert ticket ) B 6 A Income 5 U effect 2 A′ 3
Substitution U1 BC2 effect BC1 BC′ 0 3 4 5 Basketball Tickets Substitution effect Income effect
Total effect (+ 2 basketball tickets) Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Total Effect = Substitution Effect + Income Effect
Isolating the Income Effect • The change in quantities demanded due to the changes in the consumer’s purchasing power after the change in prices. • When the price of basketball tickets decrease, the consumer can afford to purchase a larger bundle than before. ‒ Represented by the change in the quantity of goods consumed from bundle A’ (after the substitution effect) to bundle B ‒ Easy calculation: total effect minus the substitution effect Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Three steps to computing substitution and income effects associated with a price change. Starting with a consumer at an optimal bundle A
1. Draw the new budget constraint and find the new optimal bundle (B ) ‒ A price change for one of two goods rotates or pivots the constraint
2. Draw a line parallel to the new budget constraint, but tangent to the old indifference curve; determine the optimal bundle on the old curve associated with this theoretical budget constraint (A′ )
3. The substitution effect is the difference in quantities between A and A′ and the income effect is the difference in quantities between A′ and B Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
What Determines the Size of the Substitution and Income Effects? 1. Curvature: The size of the substitution effect depends on the curvature of indifference curves What does it mean when an indifference curve is relatively straight? ‒ The 2 goods are relatively substitutable Is the substitution effect larger or smaller along a straighter indifference curve? ‒ Larger, More substitutable = Larger substitution effect 2. Quantity consumed before the price change: The income effect increases with the amount spent on a good before a price change Why does the income effect increase with the amount spent on a good? ̶ The more you can get from trading off consumption of that good Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Example of the Substitution and Income Effects for an Inferior Good It is important to see how the income and substitution effects are opposed to one another with an inferior good.
Consider a consumer choosing bundles of steak and ramen noodles • Suppose the price of ramen noodles (an inferior good) falls • Total effect followed by Income and Substitution effects graphically Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Figure 5.12 A Fall in the Price of an Inferior Good Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Figure 5.13 Substitution and Income Effects for an Inferior Good (b)(c)(a) Changes: Steak 1. Price of ramen noodles has decreased ‒ Sub. Effect positive
2. Relative price of steak has increased Total effect ‒ Sub. Effect negative (more steak) B
3. Relative Income has increased U Income 2 A ‒ Income effect positive for steak effect (normal good) and negative for ramen (inferior good) A′ Substitution effect The income effect dominates the U1 BC BC substitution effect for steak 1 BC′ 2 Ramen Total effect noodles The substitution effect dominates the Income (more ramen noodles) effect income effect for ramen noodles. Substitution effect Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Giffen goods: are goods for which quantity demanded increases as price rises • Inferior goods, but the income effect outweighs the substitution effect • When the price of a Giffen good drops, the substitution effect (which acts to increase demand) is smaller than the income effect ‒ Results in an upward sloping demand curve!
Economists sometimes question whether Giffen goods actually exist • The few examples with humans tend to focus on very poor households and commodity crops (e.g., rice and potatoes) Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Figure 5.14 A Change in the Price of a Giffen Good Decomposing Consumer Responses to Price Changes into Income and Substitution Effects 5.3
Simple Rules about Income and Substitution Effects The Impact of Changes in Another Good’s Price: Substitutes and Complements 5.4
A Change in the Price of a Substitute Good When the price of a substitute good increases, we expect consumption of the primary good to increase • Consider Pepsi-Cola and Coca-Cola The Impact of Changes in Another Good’s Price: Substitutes and Complements 5.4
Figure 5.15 When the Price of a Substitute Rises, Demand Rises
Pepsi 20 At original prices, this consumer purchases 15 A bottles of Pepsi and 5 bottles of Coke 15 U1 When the price of Pepsi doubles, Coke Pepsi consumption increases by 100% (to 10 bottles), consumption and Pepsi consumption falls by 67% (to 5 bottles) falls 10 Coke consumption rose when the price of Pepsi BC2 U2 B BC1 rose, signify that they are substitutes 5
0 5 10 20 Coke Coke consumption rises The Impact of Changes in Another Good’s Price: Substitutes and Complements 5.4
A Change in the Price of a Complementary Good When the price of a complement increases, we expect consumption of the primary good to decrease • Consider ice cream and hot fudge The Impact of Changes in Another Good’s Price: Substitutes and Complements 5.4
Figure 5.16 When the Price of a Complement Rises, Demand Decreases
Ice cream (gallons) At original prices, this consumer 50 purchases 20 tubs of ice cream and BC 1 30 jars of hot fudge. When the price of ice cream doubles, consumption of ice cream falls by 25% (20 to 15 tubs), and 25 BC2 consumption of hot fudge by 33% Ice cream A consumption 20 (30 to 20 jars). falls 15 U1 B U2 Hot fudge consumption decreased when the price of ice cream 0 increased, signifying that they are 20 30 50 Hot fudge complements. (quarts) Hot fudge consumption falls The Impact of Changes in Another Good’s Price: Substitutes and Complements 5.4
A Change in the Price of a Substitutes and Complements When the price of a substitute good increases, we expect consumption of the primary good to increase • Recall the Pepsi-Cola and Coca-Cola example
When the price of a complement increases, we expect consumption of the primary good to decrease • Recall the ice cream and hot fudge example
These relationships help to explain the shifts in demand examined in Chapter 2 The Impact of Changes in Another Good’s Price: Substitutes and Complements 5.4
Figure 5.17 Changes in the Prices of Substitutes or Complements Shift the Demand Curve Combining Individual Demand Curves to Obtain the Market Demand Curve 5.5
The final step linking consumer theory to market demand • Market demand is the horizontal sum of individual demand curves • The market quantity demanded at each price is the sum of the individual quantities demanded at each price
The market demand curve is found by summing horizontally the individual demand curves
Consider the market for wireless speakers Combining Individual Demand Curves to Obtain the Market Demand Curve 5.5
Figure 5.19 The Market Demand Curve
(a)(c) (b) Price ($/wireless Speaker set) B $52
40 A
20 D = Dcousin market Dyou + Dcousin Dyou 0 3 4 6 8 12 Quantity of wireless speaker sets Combining Individual Demand Curves to Obtain the Market Demand Curve 5.5
Mathematically connecting the individual and market demand
Qmarket Qyou Qcousin (5 0.05P) (13 0.25P) Qmarket 18 0.3P
The difference in choke prices implies your demand function is the market demand function for prices between $52 (cousin’s choke price) and $100 (your choke price); • The market demand function applies to prices less than $52
QPPmarket 18 0.3 for $52 5 0.5PP for $52 Conclusion 5.6
This chapter concludes our in-depth analysis of the consumer side of the supply and demand model. We • Examined how income and prices affect consumer choices • Made the link between consumer theory and market demand
In Chapter 6 we begin a parallel in-depth examination of producer behavior.