Consumer behavior and market demand Lecture 5

The market demand Total quantity demanded at each price, holding constant all other influences on demand, is obtained by adding the quantities demanded by all buyers at each price The market demand curve is obtained by adding the individual demand curves of all buyers horizontally

Consumer’s demand The simple model of consumer behavior: an assumption that each consumer: - chooses quantities demanded of all goods in order to maximize his/her satisfaction, given the limits imposed by available income and prices of goods The decisions are taken from the point of view of consumer’s own interests

The budget constraint Specificies the combinations of goods the consumer can afford to buy Graphic presentation of budget constraint The slope of the curve: opportunity cost can be seen in the slope of budget constraint line Tgα =Px/Py = 0O/0L How many Y could be exchanged for one X

Budget constraint line income=50E, Py=10E; Px-5E

Budget constrant line and the increase of income

Budget constraint line and the change of the price

Features of indifference curves

Indifference curves Show a set of consumption bundles among which a consumer is indifferent. All consumption bundles on an indifference curve yield the same level of utility Indifference curve can not cross, the consumption bundle at the cross point have two utility levels – it does not make sense! Higher indifference curves correspond to higher level of utility Indifference curves are negatively sloped The indifference curve first is very steep and then becomes flatter. This flattering out reflects the diminishing marginal rate of substitution The marginal rate of substitution tells how many of good 1 one can consumer give up to get one unit of good 2 and leave utility unchanged

Indifference curve 2

Diminishing marginal rate of substitution A – a small amount of x, it is worth a lot of good y B - a lot of good x, it is worth a small amount of y Consumer prefers to give up 3 films for one meal (situation A) and 1 film only for 1 meal (situation B) Different shapes of indifference curves : food lovers and movie lovers

The consumer’s behavior Optimal consumption bundle: at the point the budget line is tangent to the highest indifference curve It means that the slope of indifference curve equals the slope of the budget line at this point.

Optimal consumption bundle At point E marginal rate of substitution ∆Y/∆X= Px/Py

Consumers equilibrium and change of income 1. Increase in income increases demand for normal good The graph 2. Increase in income diminishes demand for inferior goods

Consumers equilibrium and a change in price How to show on the graph the change in price? Substitution effect of the change in price: adjustment of demand to the change in relative prices Income effect: adjustment of the demad to the change in relative income How to isolate substitution and income effect on the graph (hypothetical budget constrant line; paralel shift)

Giffen paradox inferior goods: increase in price -substitution effect diminishes demand But in some cases (very rare) income effect being result of the lower relative income could be so strong that demand for the good will grow although its price has grown

Income and substitution effect of the price increase versus cross elasticity of the demand Negative cross elasticity of demand (films-meals): income effect stronger than substitution effect- more expensive meals decrease demand for cinema tickets Positive cross elasticity of demand (bread-other food): more expensive bread increases demand for other food. It means that substitution effect stronger than income effect

Impact of the price increase of good „i” on the demad for „i” and „j” goods Assumed type Substitution effect Income effect Total effect i normal negative inferior positive ? Although usually negative j ? Inferior