Consumer Choice and Related Issues Lecture 4 Consumer Choice and Related Issues

Outline Market Demand Effect of a price change on quantity demanded Income and Substitution Effects Limitations of Consumer choice theory

From individual Demand to Market Demand Market demand curve tells us quantity of a good demanded by all consumers in a market Can derive it by summing individual demand curves of every consumer in that market

Individual and market demand schedules Price (P) $ per Cocoa Sack Quantity Demanded by one individual (q) Cocoa sacks per month Quantity Demanded in the market* (Q) (Cocoa sacks per month) 5 3.5 3,500 4 4.5 4,500 3 6.0 6,000 2 8.0 8,000 1 11.0 11,000 * There are 1000 identical individuals in the market.

Graphical illustration Pp q d1 P d2 d3 d1000 D Q D = d1 + d2 + d3 + d4 … … … d1000 q P Q

Income and Substitution Effects Demand curve actually summarizes impact of two separate effects of price change on quantity demanded Substitution Effect Income Effect Effects sometimes work together, and sometimes opposes each other

Substitution Effect Substitution effects As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed Substitution effect of a price change arises from a change in the relative price of a good And it always moves quantity demanded in the opposite direction to the price change When price decreases, substitution effect works to increase quantity demanded When price increases, the substitution effect works to decrease quantity demanded

The Substitution Effect When the price of a good falls, it is less expensive relative to other goods e.g. coke and pepsi Consumer spend more money on this cheaper good Consumers purchase less of the ‘substitute’ goods whose price is unchanged When the price of concerts fall, Kofi gets more from entertainment budget by buying more concerts Substitution effect

The Income Effect In previous example, when the price of concerts drops from Ghc30 to Ghc10, Kofi can consume more of each, or BOTH goods Graphical illustration Price cut is like an increase in income Consumer can purchase more of the good whose price has fallen, but also more of the other good whose price is unchanged Initial optimal point (D- 3 concerts + 6 movies) costs Ghc150 After decrease in price (Concerts= Ghc10; Movies= Ghc10), costs Ghc90 Extra Ghc60 to be spent!

The Income Effect A price cut gives consumer a gift, which is rather like an increase in income Income effect As price of a good decreases, the consumer’s purchasing power increases, causing a change in quantity demanded for the good Income effect of a price change arises from a change in purchasing power over both goods A drop (rise) in price increases (decreases) purchasing power Income effect can work to either increase or decrease the quantity of a good demanded, depending on whether the good is normal or inferior

Decomposing the SE and IE X2 Optimal bundle is Ea, on indifference curve I1. Ea I1 xa X1

Substitution Effect X2 X1 The new optimum is Eb on U2. The Total Price Effect is xa to xb X2 Eb Ea U2 U1 xa xb X1

Substitution Effect Contd. To isolate the substitution effect we ask…. “what would the consumer’s optimal bundle be if s/he faced the new lower price for X1 but experienced no change in real income?” This amounts to returning the consumer to the original indifference curve (U1)

Substitution Effect X2 X1 A fall in the price of X1 The budget line pivots out from P X2 P* Ea U1 xa X1

Draw a line parallel to the new budget line and tangent to the old indifference curve X2 Eb Ea U2 U1 xa xb X1

The new optimum on U1 is at Ec The new optimum on U1 is at Ec. The movement from Ea to Ec (the increase in quantity demanded from Xa to Xc) is solely in response to a change in relative prices X2 Eb Ea U2 Ec U1 xa xc xb X1

Xa Xc X2 X1 This is the substitution effect. Eb Ea U2 Ec U1

Isolating Income Effect To isolate the income effect … Look at the remainder of the total price effect This is due to a change in real income.

The remainder of the total effect is due to a change in real income The remainder of the total effect is due to a change in real income. The increase in real income is evidenced by the movement from U1 to U2 X2 Eb Ea U2 Ec U1 X1 Xc Income Effect Xb

Combined Effect X2 Eb Ea I2 Ec I1 xa xc xb X1 Sub Effect IncomeEffect

Combining Substitution and Income Effect A change in the price of a good changes Relative price of the good (the substitution effect) and Overall purchasing power of the consumer (the income effect)

Combining Income and Substitution Effects Ultimate impact of price change on quantity demanded will depend on these two effects For normal goods, effects work together to push quantity demanded in same direction. How? For inferior goods, effects oppose each other. How?

Normal goods When the price of a normal good falls Substitution effect increases quantity demanded The price drop increases consumers purchasing power so increases quantity demanded even further When the price of a normal good rises Substitution effect decreases quantity demanded The price hike reduces consumers purchasing power so reduces quantity demanded even further Effects work in the same direction

Inferior goods When the price of an inferior good falls Substitution effect increases quantity demanded The price drop increases consumers purchasing power so decreases quantity demanded When the price of an inferior good rises Substitution effect decreases quantity demanded The price hike reduces consumers purchasing power so increases quantity demanded Effects do not work in the same direction; work in opposing directions

Inferior goods Two opposing forces Either effect could dominate Substitution effect increasing quantity demanded Income effect decreasing quantity demanded Either effect could dominate

Income and Substitution Effects Price Decrease: Ultimate Effect (Almost Always) Substitution Effect P QD Þ QD QD if normal Purchasing Power QD if inferior Price Increase: Substitution Effect P QD Þ QD QD if normal Purchasing Power QD if inferior

Discuss: Limitations of Consumer Choice theory Can the Consumer Choice theory predict behaviour in more complicated, real-world situations? What are some criticisms of the consumer choice theory?

Limitations of Consumer Choice theory Problems with the model: 2 goods Calculations become more complicated, but conclusions are the same Ignores uncertainty Kofi knows exactly how much satisfaction he will get from consuming different combinations of movies and concerts Purchases of used cars? Surgical operations? Income? Imperfect information Model assumes perfect information about the quality of goods and services; and their prices Costly to get this information in the real-world Model ignores option that people can spend more than their incomes Also save incomes People always act selfishly or in their own best interests Main aim is personal satisfaction maximization, in the model Exceptions include charitable giving

Next Class- Mr. Emmanuel Adu-Danso Production and costs in the short-run The production function marginal and total products the law of diminishing returns marginal, total and average product curves Cost concepts short-run cost curves IA date to be determined and will be communicated to students in good time